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How To Build the PERFECT Recession-Proof ETF

According to history, there are five different factors that an investment should have in order to outperform the market during an economic recession.

Each factor is like a different ferret that forms the Gotron of recession investing.

Rick and Morty’s Gotron Episode

I apologize for the Rick and Morty analogy if you are not a fan of the show! Unfortunately, I cannot find a single stock or ETF that has all of these mythical ferret factors. So I’ve decided to build one.

Inthis article, I’m going to go over the five factors that perform best during a recession and show you how to build an ETF that captures them all.

On the go? Watch my video here:

The Five Factors

1. Value

Let us begin by dividing the entire stock market into two piles: Growth companies versus value companies. Do you know which one performs better during a recession?

Growth companies are the ones that everyone loves and thinks will be super successful in the future. Because the market loves these companies so much, the stock price is high compared to the current profits of the company.

One perfect example is Tesla. It has grown a ton and it is still considered a growth stock because the general market believes it will grow a lot more.

Imagine I own a lemonade stand and I offer to sell it to you for $720. You would probably ask me, how much does your lemonade stand profit per year? $10. What? Seems overpriced, right? Well, this is the exact ratio of Tesla’s current stock price-to-earnings ratio: 75 to 1 or $750 to $10.

Tesla’s current PE ratio

But if that same lemonade stand had a deal in the works to be the official sponsor of the NFL and would soon be profiting $1 million, then you would not be bothered by the $720 price tag today.

Simply put, a growth stock is a company with a bright future. It sounds like I have just made a pretty strong case for investing in growth companies, but there’s a catch.

A recession is not a good time for a company to grow. When a recession hits and the market loses faith in the growth of a company, the price drops down to reflect a slower growth trajectory or no growth at all.

Similarly, if my lemonade stand lost the brand deal with the NFL and I’m back to only selling lemonade to my neighbors, you would value it much less.

Now let’s talk about value companies. A value company is one that has a low stock price compared to how much it earns. It’s like a bargain. The catch here is that usually there is a reason for a company to be priced slightly lower. It could be that the company doesn’t have much growth potential, a bad earnings report, or bad public perception, whether it’s warranted or not.

Imagine again that I am offering to sell you my value lemonade stand. Except this time, I have already expanded across my whole neighborhood, so there isn’t much growth potential. The stand profits $10 per year, but this time it only costs you $50 to buy the lemonade stand. Not a bad deal. That is a price-to-earnings ratio of 5, or $50 over $ 10 per year.

Historically, value stocks tend to outperform during bear markets and economic recessions while growth stocks tend to excel during bull markets or periods of economic expansion. Value stocks perform better because they are already priced on the low side when the market drops and they are typically larger and more stable companies.

2. Sector

The second factor that affects the recession performance of a company is the sector of the economy that it is in. You can imagine that my lemonade stand might take a hit as people in my neighborhood cut back on unnecessary spending.

S&P 500 Sectors and the Market Cycle

If I was smart, I would find a way to pivot into selling toilet paper to all my neighbors. Not sure how that conversation would go. The bottom line is that bottoms need toilet paper regardless of the state of the economy.

The sectors of the economy that tend to perform best during a recession are known as defensive sectors. Defensive sectors include consumer staples, energy, utilities, and healthcare. I’m looking for a heavier representation in these sectors instead of the more cyclical sectors for recession investing. If you are just investing in the S&P 500, then you are investing more heavily in cyclical sectors. The S&P 500 is roughly 70% cyclical and only 30% defensive.

3. Diverse

If you pick the wrong company to invest in, you could be in the red for years or lose everything. According to Harvard Business Review, 80% of public companies do not reach their pre-recession profit levels 3 years after the recession and about 17% of these companies don’t even survive.

Recession investing is like walking through a minefield. Picking just one company that you think will make it through is risky. I would rather spread my investment over many companies that all have a strong chance of performing well. That way I don’t get hurt too much by a single company going out of business.

4. Company Size

Do you think size matters? The size of the company. Get your mind out of the gutter.

You might think that bigger is always better but that is not the case. Smaller companies have historically outperformed larger companies during economic recession and recovery. Investing in smaller companies does carry more risk, however, since a smaller company is more likely to go out of business during a recession. That is why it’s crucial for the previous boxes to also be checked when investing in smaller companies.

5. Dividend

The final box that I’m looking to check may come as a surprise to you. This is a topic that is highly debated in the investing world. Do dividends matter?

The distribution of a dividend results in a reduction in share value.

Many people love to point out the fact that the stock price drops by the amount of the dividend, and that there is no free money.

No new money gets created when a dividend gets paid.

Technically, this is true in theory but investing is a messy business and stocks are not always priced perfectly, especially during a recession. When there is a lot of fear and uncertainty in the market stocks are commonly trading at a lower value than their theoretical real value.

For instance, fear in the market causes people to irrationally sell shares in my neighborhood toilet paper company even though business in my neighborhood is good. Toilet paper is gold.

Let’s say my toilet paper stock drops from $100 a share to $50 a share purely from fear. If my toilet paper stand is doing well, I can still offer the same $5 dividend, then my shareholders will get a 10% return during this time instead of just a 5% return.

Dividend Illustration by author

For every 10 shares they own, they will get enough in dividends to buy another share at a discount. On the other hand, if my company did not offer a dividend, then my shareholders would not be able to take advantage of the discount. Assuming my profits were never hurt, the stock price would eventually recover to previous levels, and my shareholders would still have the same number of shares.

Dividends offer increased returns during a recession when companies are undervalued due to fear and uncertainty.

Value, defensive, diverse, small, dividend. With these five factors combined, the perfect recession ETF is formed.

The Perfect ETF

Now I just have to buy some shares. Oh wait, it doesn’t exist. I looked and looked to no avail. I could not find a single ETF that hit all of my marks.

Hold on though… an ETF is just a collection of stocks. There is nothing stopping me from investing in hundreds of companies. Just kidding, that would take forever. However, I can combine multiple ETFs to create the properties that I’m looking for.

Let’s first find the ETFs in the sectors that I want to invest in. The four factors I’m interested in are consumer staples, energy, healthcare, and utilities. Now there is a fifth ETF at the end, but it only makes sense after looking at these first four. So stay with me.

Vanguard offers low-cost ETFs in just about every category you could want. When I say low cost, I’m referring to the expense ratio. The expense ratio is the percentage of the stock price that you pay per share every year. An expense ratio greater than 0.5% would be considered high in my opinion.

1. Consumer Staples

Vanguard consumer staples ETF has ticker VDC. The expense ratio is 0.1%, so not bad. It has a solid dividend at 2.55% and is 100% consumer staples. This one checks a lot of my boxes. Where this ETF is lacking is on the value and size front. Morningstar.com is a great resource for evaluating ETFs. They provide a map that gives you a feel for the value and size component at a glance. We can see here that VDE is heavily weighted in large companies and just slightly leaning towards value. To compensate for this, I will have to add some more small-cap valuated ETFs.

Vanguard Consumer Staples ETF — VDC

2. Energy

Vanguard’s energy ETF is ticker VDE. VDE also has a very low expense ratio of 0.1% and a solid dividend of 2.99%. Once again, if we look at Morningstar, we can see that this ETF is heavily weighted towards larger companies, but also heavily leaning towards value. This ETF also checks a lot of the boxes, but we’re still lacking the size component.

Vanguard Energy ETF — VDE

3. Healthcare

Vanguard’s healthcare ETF is ticker VHT. Once again, we’ve got a 0.1% expense ratio and a smaller dividend yield this time of 1.52%. As you can see from Morningstar, this ETF is also heavily weighted towards larger companies, and it is just very slightly leaning towards value. You can see a common theme here with these Vanguard ETFs. They will check many of the boxes, but not all the boxes. That’s why we have to combine several to create the perfect recession investment.

Vanguard Healthcare ETF — VHT

4. Utilities

Vanguard’s utilities, ticker VPU. Once again, 0.1% expense ratio, and this time with a great dividend yield of 3.63%. This ETF gives me a lot more exposure to mid-size companies and is also heavily weighted towards value which is great, however, we are still leaning towards larger companies with this ETF.

Vanguard Utilities ETF — VPU

Here is the fifth and final ETF that you’ve been waiting for.

5. Small Cap Value

The final Vanguard ETF that I want to add to finally get me some exposure to small-cap value companies is ticker VBR, Vanguard’s small-cap value ETF.

The expense ratio is even lower than the previous ones at just 0.7% and has a great dividend yield of 2.49%. As you might have guessed, Morningstar shows this ETF is heavily weighted toward small-cap value companies, which is perfect for rounding out our recession-custom ETF.

Vanguard Small-Cap Value ETF — VBR

After I input the percentages of the five respective holdings into my Excel spreadsheet, I can see the final breakdown. By putting 20% of my cash into the five ETFs, I am incredibly diversified, with exposure to about 1,500 companies.

Calculations by author

I have heavy exposure to the four defensive sectors and very slight exposure to the more cyclical sectors. The cyclical exposure comes from the Vanguard small-cap value ETF. So the fact that they are smaller value companies does give them an advantage over the other companies in the cyclical sectors.

Additionally, the overall portfolio is heavily weighted towards value in general. Finally, the 2.64% dividend is very good, especially when compared to the current dividend yield of the S&P 500, which is at 1.56%.

S&P 500 ETF Current PE Ratio

By creating your own ETF, you can easily check all the boxes that historically give superior recession returns. One of the most powerful benefits of investing in ETFs is diversification, but it is not the only way.

Many investors prefer to take more control over their investments and select individual companies to make up their portfolios. This method takes more time, skill, and research.

Before you start investing in individual companies, you gotta watch this video on my top 3 recession-proof companies. I go over all the tools and strategies that I use when researching companies to invest in.

Until next time.

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