The signs of recession are very alarming, which has now convinced me that a US recession, and probably a global recession, is imminent. Since the Nasdaq Composite is now officially in a bear market, it looks like it will be tough to invest in the next 12-24 months.
To prepare my portfolio for these circumstances, I focused on attractively valued dividend-paying stocks with earnings that resist the forces of recession. Additionally, I use covered call strategies to maximize the likelihood of a positive return. I’m not just looking to beat the market, I want healthy, positive returns.
There are four stocks that have made the cut so far and I have opened long positions in each. These choices include Verizon Communications Inc. (VZ), Omega Healthcare Investors, Inc. (OHI), British American Tobacco plc (BTI), and Bristol-Myers Squibb Company (BMY).
The recession is catching up with us
One can never be certain of the future, especially of a future recession. There is no point in frequently “crying wolf” and proclaiming that a recession is imminent every year when it is clear that it is not. However, the data accumulates and therefore my confidence increases. Let’s briefly review the evidence.
For starters, retail sales rose strongly. A significant drop or slowdown in retail sales is often a sign of a recession, as can be seen in the recessions of 2001, 2008 and 2020.
However, when we adjust retail sales for inflation, using the Producer Price Index, we find that retail sales have already been declining since 2021. This suggests that the United States could enter in recession.
Similarly, US real GDP growth has turned negative. This is often correlated with a spike in the probability of a recession, although the probability has not moved yet today.
The unemployment rate in the United States is now very low, around 3.6%. Unfortunately, this level of unemployment preceded each of the last three recessions. Low unemployment is not a cause of recession, but the correlation in combination with all the other factors is worrying.
Now it gets interesting. Two of the strongest correlations with the recession are the change in the price of oil and the inversion of the yield curve. Not all yield curves have inverted recently, however, many have included the 10-year Treasury minus 2-year curve. There is some debate over how long the curve should remain inverted, but what can be determined is that the last four recessions have been preceded by inversions. To compound the problem, oil prices have risen dramatically. It is also a common prelude to recession, as was observed in 2001 and 2008.
After a brief rebound in 2021, consumer confidence has started to decline again. Sentiment levels are approaching those reached in 2009 at the height of the Great Recession.
The yield curve inversion was short this time, which may indicate a false signal. But if not, it predicts trouble for stock markets which typically experience their most volatile cycles after the yield curve inverts.
Therefore, I choose my positions carefully. I’m looking for positions that will withstand the recession, but also perform well if there is no recession.
Call for backup – Verizon Communications Inc.
Verizon is trading at a mixed P/E of 8.58 following the stock price‘s recent decline in response to lower expectations. That compares to his normal P/E of 14.71. During the recessions of 2008 and 2020, the stock price fell. However, VZ was overvalued at the start of the 2008 recession, priced at 19 times earnings, and earnings were sustained through each recession. The stock reached a low valuation of 10x P/E during the 2008 recession, higher than the current multiple.
VZ pays a forward dividend of 5.5% with a strong dividend history of 18 consecutive years, including through two recessions. The dividend is currently well covered with a payout ratio of 46.8%. The dividend receives overall positive ratings from Seeking Alpha and is a solid high yield in my assessment.
To maximize the probability of return, I use a covered call strategy on this position. I start with the 50 strike calls on May 20, 2022 which yield an annualized return of 5.6%. If I wanted to lock in the yield for a longer duration, I would go for the 52.50 strike on August 19, 2022 for an annualized return of 2.4%.
Retire with grace – Omega Healthcare Investors, Inc.
Omega is trading at a blended P/FFO of 8.08. The stock has traded poorly over the past year due to continued non-payment of rent by several operators. Despite the difficult conditions, I expect the company to persevere and continue its long-term successes. The normal P/FFO for OHI is 12.47. During the 2008 recession, the share price was volatile and the FFO fell slightly by 8.5%, but overall performance was adequate for the circumstances. The shares traded as low as 8.16 P/FFO.
OHI pays a forward dividend of 10.5% and although dividend growth has been lacking recently, the company has avoided a dividend cut for the past 16 consecutive years. The forward AFFO payout ratio is 99%, which is uncomfortably high. There is a serious risk that the dividend will have to be reduced. However, I think such a reduction would be temporary and I don’t need a 10% dividend for this job to be attractive to me. Here’s what CFO Robert Stephenson had to say about it on the latest earnings call:
Consistent with how we’ve talked about it in the past, to the extent that we’re working on these restructurings, but we think the long-term cash flow will — won’t be affected or the impact is minimal, so I believe that we will be consistent with our dividend policy. And I guess the best example of that is the gulf coast that we had.
We have $30 million in rent, and in the first quarter we’re not going to collect rent because they’re bankrupt. But we’re going to redeploy those assets by selling them, and we’ll end up with, let’s call it, $300 million net that we’re going to redeploy.
So the ultimate resolution to the Gulf Coast situation is a push from a cash flow perspective. And I think to the extent that some of these other restructurings are in the same area and there’s no reason to go ahead and say, “Hey, we’re going to change our dividend policy “But as everyone on this call knows, it’s a changing environment. We’re going to be as transparent as possible.”
What I would say today, the policy is the same, unless we see a long-term impact on our cash flow, we don’t change the dividend.
Seeking Alpha only rates the dividend yield which is very high.
To maximize the probability of return, I use a covered call strategy on this position. I start with the 28 strike calls on May 20, 2022 which yield an annualized return of 6.7%. If I wanted to lock in the return for a longer duration, I would go for the September 16, 2022 strike of the 30th for a 3% annualized return.
Don’t let profits go up in smoke – British American Tobacco plc
British American Tobacco is trading at 9.24 P/E. This compares to a normal P/E of 14.16. During the recessions of 2008 and 2020, the stock price fell by 45% and 40%. But stocks started 2008 at a P/E multiple of 18.3x and 2020 at 10.5x. Earnings in 2008 fell 14.4%, but recovered quickly. At the depth of the 2008 recession, stocks were trading at 11x P/E.
BTI pays a forward dividend of 7.09%. The dividend has had an erratic history since 2015, but the long-term compound growth rate of the dividend is 9.5%. Seeking Alpha’s “D” rating for consistency is well deserved, but I think the safety and growth ratings are too harsh. The high payout ratio of 66.9% is intentional as the dividend is a priority for the company.
To maximize the probability of return, I use a covered call strategy on this position. I start with the 45 strike calls on May 20, 2022 which yield an annualized return of 4.2%. If I wanted to lock in the yield for a longer duration, I would opt for the September 16, 2022 50 Strike for an annualized return of 1.5%.
Keep your wallet healthy – Bristol-Myers Squibb Company
Bristol-Myers Squibb is trading at a P/E of 9.92. This compares to a normal P/E of 18.07. Earnings continued to grow during the recessions of 2008 and 2020, although the stock price fell. BMY was trading at a low P/E multiple of 7.7x in 2008.
BMY pays a forward dividend of 2.87% with 15 consecutive years of dividend growth. Seeking Alpha’s dividend ratings are all first class for BMY. The cash dividend payout ratio is a respectable 28.8%.
To maximize the probability of return, I use a covered call strategy on this position. I start with the 80 Strike calls on May 20, 2022 which return an annualized return of 4.9%. If I wanted to lock in the yield for a longer duration, I would opt for the September 16, 2022 50 Strike for an annualized return of 3.8%.
With many signs of recession, it’s time to adjust my portfolio. Instead of going for home runs, I focus more on hits to increase the likelihood of positive returns. These four dividend-paying stocks offer the potential for double-digit returns without depending on stock appreciation. They include businesses whose earnings are resilient to the recession. This, combined with attractive valuations, limits downside risk. The covered call strategy is designed so that if my shares are called, I will be happy to take my profits and redeploy the capital on the next trade.