Rules For Defensiveness
When it comes to the equity portion of an investor's portfolio, there are guidelines and strategies of portfolio management to help manage and reduce volatility. A few considerations include:
1) Sell losers. The market can sniff out problems with the fundamentals of a company even if the market doesn't know what the problem is yet. A company experiencing fundamental problems is not likely to find a resolution during an economic slowdown or recession. The closer to a recession, the greater the risk a challenged company will face increased secular headwinds. If a company is operating under normal economic conditions and experiencing stagnant or declining revenue, cash flow and/or earnings, that trend will likely only be amplified in an economic slowdown. The old gardening adage, 'pull your weeds, water your flowers'. Course correct your portfolio by selling losing positions.
2) Use capital losses. Sell/re-balance over-weight holdings, especially those with low adjusted cost base. For example, investors who have longer term holdings that have large embedded gains, such as banks, pipelines, and railway companies.
3) Identify companies that are highly leveraged to Gross Domestic Product. Typically, these include sectors such as commodities (energy, metals, certain industrial companies, and possibly banks who are highly levered to the credit cycle). As the consumer and commercial activity slows, reposition the portfolio to companies that offer 'sticky' services and revenue streams (for example, consumer staples).
4) Identify companies with high leverage or exposure to the already stretched and indebted Canadian consumer. The Canadian consumer debt is at a all time high, and currently sits around 180% debt to annual income (as of Q3 2019). This level on personal debt is akin to consumer debt in the U.S. in 2007, which contributed to the financial crisis. Levered consumers will be coerced to cut costs quickly and will eliminate superfluous expenses in tough economic times. This includes cable packages, banking services, low brand value retailers, home improvement (Cable / telecommunications, consumer focused banks, weak retailers, home construction).
5) Identify stressed balance sheets . Too much debt, near-term maturities or falling cash flows could breach debt covenants and force painful restructuring. Each industry has different levels of acceptable debt. For example, a utility can manage larger debt levels than a cyclical commodity producer. However, in general, when a company has long-term debt in excess of 1.5 or 2.0 times the company's annual cash flow, it should be reviewed to ensure the balance sheet continues to be in the confines of what is reasonable for the industry. If a company has a large portion of debt that is maturing and requires re-financing when credit spreads are high or the company is distressed, it could materially impact the company's capital structure and compromise equity unfavorably. Any company approaching it's debt covenants is likely in a precarious position. See #6 for examples of industries that are particularly susceptible to this.
6) Quality of dividends – high payout ratio could be signaling slow growth ahead. Increasing payout ratios could also indicate borrowing to pay dividends. In Canada, culprits for risk of dividend decreases or dividends suspensions include highly leverage companies and/or real estate investment trusts, energy producers, commodity producers, asset managers or companies that require significant capital expenditures to maintain or grow revenues, such as construction companies, engineering firms or financiers.
7) Competitive vulnerability – if a company is not #1 or #2 in a sector, it can be beaten up by a higher margin competitor in a recession. Stay with the 'best-in-class' companies. Larger revenue base and brand values prove to be more resilient than weaker competitors in economic slowdowns.
8) Relative strength breakdowns – stocks/sectors that have broken down before a market peak often suffer the biggest declines when the bear market gets underway. If there is already an existing trend of funds flowing from a company or sector, it is only likely to expedite when the market hits periods or significant volatility.