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What should investors be wary of in a downturn?

Uncertainty and instability make for challenging conditions for investors. And the coronavirus pandemic of 2020 has certainly created some extraordinarily volatile market conditions, causing dramatic falls in economic and business activity all over the world.

So what about the investment outlook for the economy in 2021? Well, with vaccine hopes on the horizon, with any luck it should be a case of repairing all the economic chaos caused in 2020.

But the process of picking up the pieces of 2020 and getting the UK – and global – economy into shape isn’t an entirely simple one.

Although the UK pushed itself out of recession (defined as two consecutive quarters of declining GDP) in the summer and autumn, the second lockdown in November sharply reined back in the recovering economy. As a result, the UK is expected to record a decline of more than 10 percent of GDP for 2020.

What this shows is that the road to recovery is rocky. If the EU-UK trade deal transition runs smoothly and the rollout of a worldwide COVID-19 vaccine meets with success, we may yet see economic buoyancy in 2021. But it’s a fragile recovery and could easily be thrown off course.

So how should investors assess the resilience of a particular company’s stock to adverse trading conditions and economic headwinds?

Here are three key pointers to help you decide for yourself what the right stocks are for tough economic conditions.

1 – Take the macro view – look at a whole industry first

If you’re worried about further economic trouble ahead, one useful tactic is to consider businesses that tend to outperform the market in tough economic circumstances. Here are some ideas:

Avoid cyclical sectors

Many businesses are cyclical. That is to say that their success is tied directly to the ups and downs of the wider economy. Traditional retailers, banking institutions and manufacturers of high-end consumer goods are prime examples of this.

Look into providers of essential goods and services.

Stuff that people and businesses need is the last thing that will be cut when belts have to be tightened. Healthcare is a prime example of this: drug makers, biotech firms and manufacturers of medical kit are generally resilient in a downturn. Similarly, firms will be reluctant to scrimp on cybersecurity, while freight and logistics firms offer a service that is in constant demand, whatever the state of the economy.

Think about businesses that prosper in hard times

Where do consumers spend their money in hard times? Discount retailers… shops that offer goods that are cheaper than the norm. When belts are being tightened, businesses like these often experience a boost.

2 – Companies with the most cash are the most resilient

Put very simply indeed, a company with plenty of cash can ride out an economic storm and stay afloat longer.

In essence, a company with lots of cash reserves – how much money a business has after covering all its operating costs – is a sign of one that’s being run efficiently.

It’s also a sign of flexibility. A cash-rich company can cover rising bills without sinking into debt, and even make strategic investments – the period immediately following a downturn, for example, is a prime time for a company to make acquisitions at bargain basement prices.

3 – Debt will kill a company in a downturn

Debt is traditionally seen as a very bad thing for a company in times of recession, but it is important to understand the context: investing in loans in order to grow is something most businesses must do. But the key is to take on debt only in moderation.

To see if a company is drowning in debt, you should look at its debt-to-equity ratio. This is the comparison of the value of a company’s assets against its overall debt obligations. If the ratio is too high, it’s a sign that the company could be using debt to help pay for its growth. In a recession, that’s a bit of a red flag.

Digging a bit deeper, you can also look at how much of the debt is short-term. If a company’s debts are mostly to be paid off within a year, then even a high debt-to-equity ratio may not be a problem.

High levels of long-term debt, however, can be a major drain on cash resources and will hurt a firm’s resilience and ability to weather recession safely.

So what’s the lesson?

Troubled economic times shouldn’t necessarily be cause for investors to shy away from shares or simply sell up. But it is wise to look at making your purchases more resilient to tough economic times. If you’re careful you might even pick some stocks that can prosper in economic headwinds.

What is certainly true is that a few defensive shares will make your overall portfolio and personal finance much more balanced and able to withstand a recession.

Uncertain how to approach the market in 2021? Book a FREE consultation with one of our financial team.

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