With the yield curve inverting and the S&P 500 (SPX) reaching a 20% drawdown, it’s official; the majority of market participants believe a recession is on its way. However, in times such as these, it’s helpful to bear quotes in mind such as Warren Buffett’s: “Be fearful when others are greedy and greedy when others are fearful.”
Daniel Price of BlackRock (BLK) recently opined about investor sentiment during market volatility. According to Price, most investors tend to buy high and sell low whenever they get panic-stricken by economic shocks. Thus, investors forget that the golden rule to investing is to buy low and sell high instead of the opposite.
Although Price’s argument is evidence-based, there’s no guarantee that broad-based market prices will fully recover. However, there’s a way to stay invested in a recession that could still yield positive returns most of the time; it’s called factor investing.
Quality-Factor Investing
Stock-market-listed securities can be divided into segments, otherwise known as factors. Although certain factors exhibit collinearity, they mainly act independently relative to economic circumstances.
The factors are primarily categorized according to value, market capitalization, momentum, quality, and dividend yield. The quality factor embodies a group of exchange-listed companies that provide solid return metrics, robust balance sheets, dominant market share, and operational efficiency.
According to the Goldman Sachs (GS) recession manual: “During the 12 months before a recession, defensive sectors and ‘quality’ factors have generally outperformed. Across five recessions since 1981, the average experience saw energy, consumer staples, health care, and utilities outperform the index.”
High-quality stocks could likely sustain their performance, even in a recession. The reason being is down to risk-aversion and household obligations. Many households will remain invested, even in a recession, as they must match their clients’ household and pension needs.
Nonetheless, risk-aversion could still be a prevalent feature, leading investors and money managers alike to opt for more robust stocks rather than growth stories. Thus, the quality factor could be provided with key habitat support.
Value-Factor Investing
Alternatively, the value factor could be more appealing to longer-duration investors that are looking to “invest when there’s blood in the streets” instead of curbing portfolio risk in a bear market.
The value factor measures stocks on book value and usually considers a stock undervalued when it’s trading at a price/book ratio of below one. Value essentially seeks assets that are struggling but that could provide significant upside whenever the market receives systemic support.
Renowned financial academics Kenneth French and Eugene Fama have proven that value stocks offer superior risk versus return prospects. Additionally, Warren Buffett utilizes a deep-value approach when he invests because he believes that seeking underappreciated companies provides the best return prospects.
Concluding Thoughts
Quality factor investing provides a method that could curb portfolio risk during an economic downturn, whereas value-factor investing provides a more forward-looking approach in that it utilizes an evidence-based “buy-the-dip” approach. Both strategies are proven methods. However, investors should bear in mind that market prices are random; thus, nothing is ever guaranteed.
