The UK recession may last until next spring. This is the warning by many economists. Indeed, some of them are struggling to see how the economy will grow in the remaining quarter of this year.
Moreover, the government’s new measures to tackle Covid-19, announced on Tuesday, will place further restrictions on businesses, lowering earnings and profit forecasts.
The silver lining for savvy investors is this usually means stock prices drop too. But, markets often demonstrate volatility, synonymous with risk and the increased threat of losing your money.
Here’s how I’m going to mitigate this risk and make the most of UK recession share prices.
Use a margin of safety
Losing some money, even if only on paper, is all part of investing.
But, I like to try and ensure I don’t lose a lot of it. After all, “never lose money“ is a phrase legendary investor Warren Buffett lives by, and he doesn’t seem to do too badly from it!
So for me, investing in the UK recession, this means having a margin of safety in my stock purchases. A margin of safety is the difference between investment and speculation. In more practical terms, it’s crudely the difference between the earnings yield of the stock and the rate of interest on bonds.
Many UK bonds are currently selling with interest rates around 1%–2%. But, prices are high which means overall yields are low. So I don’t think it’s surprising many people are looking to the power of stocks to grow their wealth.
The earnings yield is what the market expects the future earning power of the stock to be. It’s approximately the inverse of the price-to-earnings (P/E) ratio. But, in a recession, it’s important for the ratio to reflect the pressures on the individual firm.
Indeed, this often means choosing counter-cyclical stocks such as utilities and tobacco companies. With these types of stocks, business and revenues shouldn’t change significantly throughout the downturn, so you can be reasonably confident of the safety of your investment.
Needless to say, these companies should also be well managed, with good cash flow and a strong balance sheet. They then possess good earnings power.
The UK recession reduces your risk
In addition, the margin of safety depends on the price paid for the stock. So, this means it often increases in recessionary times, reducing the chance of my wealth being destroyed by volatile movements on the FTSE.
Buying shares after a stock market crash or in a recession, often means not overpaying for an investment. So, to some extent, I can control the consequences of being wrong.
When I buy shares at bargain prices, even if the earnings don’t turn out as promising as I expected, I may still receive a return, however small. And if the company survives into better times, the returns may well increase.
A margin of safety means you reduce your risk of losing money. Just like Buffett.
So, a recession in the UK has a silver lining for investors. This is the prospect of buying cheap shares in quality companies, and with a margin of safety available for mistakes.
These will help mitigate the risk of market volatility and help to grow my wealth. Even in troubled times. Now, to find those shares…