Who Does Well in a Recovery?

Today's trading lacked the sizzling action of previous weeks, although that's likely a welcome change. The Dow Jones Industrial Average closed up 1.1%, the S&P/TSX Composite gained 1.2%, and the price of oil (Brent crude, to be precise) added 2.4% after a wild week, closing down 22% from last Friday. 

Brent Crude Price | Source: Bloomberg Apr 24, 2020

While it's likely that we're not out of the woods yet, it might be a good time to start talking about what happens when we are out of the woods. Who does well coming out of market crashes? Who fares poorly?

Two Polar Opposites Lead Returns

There are two kinds of equities that tend to fare best in recoveries from big crashes, and they couldn't be more different: value stocks (particularly those that pay dividends) and small cap stocks tend to lead recoveries. 

Although the two groups couldn't be more different, this starts to make sense when you think about it a little. Nobody gets hurt more on the way down than small-cap stocks, which are typically thought of as higher-risk satellite holdings. In a crunch, investors like to pare down on their holdings of small companies with growth potential, preferring to hold onto their big, established names. Couple this with the fact that small caps trade on less liquid markets, and thus are more susceptible to overreactions one way or another, and you can see how the prices of good companies with good growth potential get crushed. The ones that survive have a lot of headroom once the crisis passes, and trade at attractive prices. Picking the ones that survive is the tricky part.

Value stocks, defined as companies that trade at a low price-to-earnings ratio, do well in recoveries because a bear market makes conservative investors of us all. A lot of people who scoffed at investing in big boring companies three months ago are in quarantine right now, reading Benjamin Graham's books* and considering a trip to Omaha when all of this is over.

We tend to skew towards the latter, as anyone who remembers us banging the table about large-cap dividend yields will attest to. It's not the way to achieve optimum returns, you'll need a little more risk to do that, but it's a great way to build out the core of your portfolio.

*We highly recommend "The Intelligent Investor"

Is this the recovery?

It might be, but we're a little skeptical. We still haven't gotten past COVID-19, whether or not remdesivir works. We're pretty sure that getting bleach or sunlight into your body won't help, and vaccines and treatments are still in their early trial phase. We can be sure that a vaccine won't cure the massive unemployment brought on by this pandemic, and that's going to be the source of economic struggle in the weeks and months ahead. COVID-19 doesn't hurt the economy on its own, it does it by putting people out of work. Curing COVID-19 is only the first step in the process towards recovery.

We are recommending that clients with extra cash available deploy some of it into large, dividend paying value stocks. If nothing else, these names will form a good basis of a buy-and-hold strategy in the years to come.

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