Avoid These Stocks If A Recession Hits

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The U.S. stock market – and global markets in general – all seem to be confident about the future once again. Analysts have recently been reassuring everyone that the issue had nothing to do with a precarious economy at all.

It was due to the Bank of Japan unexpectedly raising rates, which then triggered “carry trade” fears here in the U.S. and elsewhere. A carry trade, for everyone who never heard of it before, happens when someone borrows the currency of a country with low interest rates (e.g. Japan) in order to then invest it somewhere with high interest rates (e.g. the U.S.).

Since this was apparently happening a lot and on institutional levels, all the Bank of Japan had to do to reverse the slide was assure that it “will not raise its policy interest rate when financial and capital markets are unstable.”

End of story, right? It would be a nice, neat conclusion if that was truly the case. But I’m afraid it’s not really so simple.

There are still good reasons to be concerned about the state of the stock market and the larger economy. As I stressed in recent days, there are no good reasons to panic. You do, however, want to stay informed about the negative possibilities right along with the positives. In which case, I need to bring up the “Sahm Rule.”

You might have heard it mentioned in the last month or so. Named for Claudia Sahm – an economist and former Federal Reserve employee – it states that whenever unemployment rises 0.5% or more above the low over the past 12 months, a recession is around the corner.

This rule has a near-perfect record over the past 50 years, producing only one false positive in that time frame. And I found it interesting that Jerome Powell was asked about it at a recent press conference. For his part, he referred to it as more of an “observation” than a “rule.” But, again, this observation has been too accurate too many times to ignore.

That’s why I still want to address recessionary environments now – even while the markets are back on their “everything is awesome” kick. Today, we’ll look at sectors to avoid. But, first, here is a look at something else.


How REITs Fare in a Recession

I’m not a market timer, as most of you know. And I don’t believe in hopping in and out of stocks based on daily information. Even years of lagging share prices aren’t enough to make me sell in and of itself.

At the risk of sounding repetitive – because I know I preach on this topic all the time (and I’m certain I’ll preach on it again) – quality stocks almost always hold up in the long-term regardless. Like the proverbial ant, these companies plan for bad times when everyone else is celebrating easy growth.

It may seem counter-intuitive, but many well-managed real estate investment trusts (REITs) can actually manage downturns gracefully.

By way of example, Realty Income (O) maintained its topline revenue between December 2008 and December 2009. Funds from operations – an important metric for REITs – increased modestly by 3%. Same store rents increased 0.7%. And the company even managed to increase its dividend by 1.2%. Those figures might not blow your hair back, but context is everything.

Here is a real estate investment trust holding up well during the worst real estate market in living memory. The stock itself might have struggled (excluding dividends, it was roughly flat over those 12 months), but the business held up fine. And new, all-time highs were at hand by 2010.

This is possible because REITs – owing to their setup – are legally required to allocate at least 90% of their taxable income to shareholders. Because of that, they tend to handle their finances conservatively.

That’s why I consider so many of them to be long-term plays. I buy them and keep them for years – even decades – unless their fundamentals take a turn for the worse or their shares get so overpriced that it becomes foolish not to take a profit.

With that said, I don’t buy REITs blindly in any economic environment. And I avoid some altogether when a recession seems inevitable.


If “They’re” Not Staying There, Your Money Shouldn’t Either

Let’s start with lodging REITs, a category of landlords with a very bad habit of underperforming during recessions. In fact, we’re already seeing several of these companies report diminished returns and/or expectations in the last round of quarterly earnings.

Host Hotels & Resorts Inc (HST), for instance, reported its Q2 results on July 31. While it beat some estimates, met others, and topped revenue expectations, Host Hotels & Resorts ultimately reduced its full-year diluted earnings outlook from $1.00-$1.08 to $0.95-$1.03.

The larger sector, meanwhile, has cut its expected revenue per available room – a key hotelier metric – by an average 140 basis points for the fiscal year. This makes sense considering how lodging customers tend to be more price sensitive during recessionary periods.

Travel, as a general rule, is not a necessity. Not for individuals or families. Not for businesses. So when money gets tight, travel becomes much harder to justify.

Knowing that, many hotel landlords are quick to offer discounts and/or increase their marketing efforts. And that means reduced profits either way, meaning they have less to pass on to shareholders.

This isn’t to say my team and I are rejecting the sector completely, though. There are still limited-service hotels we’re looking at, which don’t offer continental breakfasts, onsite restaurants, and other elements that ramp up operating costs.

As such, they’re more budget-friendly for travelers and more likely to get business than their more expensive competitors. REITs like Apple Hospitality (APLE) and Chatham Lodging (CLDT) fit into this category, both of which might be worth investigating further.


Billboards and Office Buildings Are Set to Struggle Too

You might not even know this, but billboard REITs are “a thing.”

Those large signs you see on the side of the road advertising everything from Chick-fil-A to legal services to hotlines? The vast majority of them are owned by one of two companies: Lamar (LAMR) or Outfront Media (OUT). Both of them are publicly traded REITs.

These companies can make a decent bit of money with decently sized dividends for investors under the right conditions. However, like hotels, the billboard business tends to underwhelm during recessions as their clients cut their own advertising budgets in response to lapses in consumer spending. Nor is that the only factor going against them.

They also tend to work with lower operating margins of 30% compared to the REIT sector average of 65%-70%. To put it another way, billboard companies borrow more heavily to keep the lights on – which puts a greater burden on them when income isn’t flowing as well. Naturally, then, we’re avoiding these companies for the time being.

Speaking of debt burdens, we all know that office buildings aren’t what they used to be. Much of the white-collar country is still working from home at least a few days a week, leaving corporations with less need for extensive floor space.

Unfortunately for office REITs, a recession would only exacerbate this new reality. Hiring trends will slow, stop, or reverse. And executives everywhere will be looking to cut costs wherever possible.

Add in the artificial intelligence element, and we could see even more stress on office landlords regardless of economic shifts. This phenomenon is expected to have a major impact on employment needs once fully implemented, leaving even less need for communal workplaces. Which means we want to devote even less of our portfolios to office landlords.

Instead, we want to own companies that are invaluable, offering products and services that people need – not just want. There are entire sectors that offer such valuable resources both inside and outside of the REIT world.


More By This Author:

I Bet You’ve Never Thought Of McDonald’s Like This Before
There Are Much Better Apples To Bite Into
I’m Rooting For A Recession

Brad Thomas is the Editor of the Forbes Real Estate Investor.

Disclaimer: This article is intended to provide information to interested parties. ...

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