10 quality shares in sectors that can fend off recession

Different sectors tend to do well in different phases of the cycle, so stock screen expert Ben Hobson has picked out the stocks in the right place to deliver big profits.

In last year’s turbulent market conditions, a few business sectors did well but many others suffered. With a recession widely expected this year, it is possible we’ll see a shift in the sectors that do well and those that do not. Keeping an eye on these trends could help guide your investment decisions in 2023.

It has been a case of new year but more of the same vibe for UK shares in the first couple of weeks of 2023.

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After 12 months of inflation and economic headaches conspiring against many firms, all eyes have been on the trading updates and results hitting the newswires.

Of all the surveys that monitor the country’s economic health, these updates will likely give us some of the first real clues to if and where a recession is starting to bite.

So far, the messages have been mixed…

Take retail. There aren’t many sectors that are quite as sensitive to consumer spending as the high street. But there have been some welcome surprises, with expectation-beating news from companies such as the fashion chain Next (LSE:NXT), small-cap footwear firm Shoe Zone (LSE:SHOE) and greeting cards seller Card Factory (LSE:CARD).

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But it hasn’t all been good news. The recruitment sector is a useful leading indicator of the economic weather. That is because recruitment firms tend to feel it first when businesses put the brakes on hiring (and vice versa). Shares in mid-cap recruiter Robert Walters (LSE:RWA) slumped this week on news of a profit warning. Unsurprisingly, the read-across meant a number of other recruiters saw their prices tumble too.

There was also a profit warning at computer games developer Frontier Developments (LSE:FDEV). This company was one of the big Covid winners two years ago when we were all confined to our homes. Over Christmas, sales of one of its major new games have been disappointing. It blamed the profit-miss on economic conditions and the price-sensitivity of its customers.

These are just a few anecdotal reports, and it is still not clear what the future holds. But mixed fortunes like these, and news of some companies doing well and others floundering, does nothing to settle the nerves of investors.

Keeping an eye on a recovery

Last year, it was a similar story. With the market in bear territory, winners and losers from a sector perspective soon emerged. Shares in energy, utilities, healthcare and consumer products and services were resilient and in some cases did astonishingly well.

The reasons were varied. Sectors such as energy and utilities were well placed to take advantage of the macro environment. Some firms in these sectors also looked attractively priced and did well from increasing interest in value shares last year.

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A broader reason was that these sectors were the classic defensive option that investors turn to in times of turbulence. Predictable, resilient business models plus good dividend yields made them the least-worst option in equities.

According to analysts at the investment company Invesco, we’re likely to see a shift in sector performance as investors begin to look ahead to a recovery.

They examined five bull market phases since the mid-1970s that followed economic downturns like the one we are facing now. In each new cycle they show how the market shifts between different phases, with more sectors building momentum in each new phase.

As the table below shows, there is some overlap in which sectors tend to do well in different phases of the cycle. But the trend is clear. As the market recovers and turns bullish, investors rotate out of defensive sectors into industries that tend to rebound quickly early in a recovery. The phases become more bullish from there.

Table based on data from Invesco

Right now, Invesco reckon that defensive sectors - especially healthcare, consumer products and services, personal care, and drug and grocery stores - are likely to remain among the safest options as the economy braces for recession. And while banks and retail might be slower to build momentum, they believe technology could be an early winner as the market prices in a recovery.

With that in mind, this week I’ve applied a set of quality and volatility checks to firms in these defensive and technology sectors. I’ve used what’s known as beta as a proxy for volatility. Beta is a measure - in this case taken five years - of how sensitive a stock price is to the movement of the wider market. A beta of less than 1.0 indicates that the share price tends to rise and fall less than the market average over time.

The screen looks for:

Quality:

• Operating margin (trailing 12-month and 5-year average) greater than 10%
• Free cash flow margin (5-year average) greater than 10%
• Return on equity (trailing 12-month and 5-year average) greater than 10%
• Return on capital employed (trailing 12-month and 5-year average) greater than 10%

Volatility:

• Beta (a measure of the share price’s sensitivity to the market movements) less than 1.0

Trend:

• Results are sorted based on 1-year relative price strength

Data: SharePad

All the companies in this table pass a basic set of quality rules. It’s not infallible, but faced with economic turbulence it makes sense to be prioritising solid profitability. You can see the operating margins of these firms is generally well into double-digits, which suggests financial strength.

Bioventix (LSE:BVXP), the clinical diagnostics firm, scores well here with an average margin of 77%. Together with ConvaTec Group (LSE:CTEC), both firms are the top price performers over one year, with market-adjusted gains of around 30%.

In terms of valuation, the price/earnings ratios of these shares tends to be relatively high. So these could be seen as pricey - although research is essential. That’s not surprising given that they are high quality names in sectors that have been popular over the past year. Shares in Kainos Group (LSE:KNOS) trade on a trailing P/E of 38.1, while the lowest P/E in the table is 8.4x at healthcare giant GSK (LSE:GSK).

Finally, the lowest beta (the share with the lowest sensitivity to the market) is found in the largest company: Unilever (LSE:ULVR), at 0.27 - although they are all low beta shares.

Taking a defensive view in 2023

There’s a well-known saying in finance that ‘the past is no guide to the future’. Usually it is framed in the context of bullish outperformance. But it’s also true that history is no guide to predicting which sectors will do badly and which ones might protect you in a recession.

Last year, the classic defensive parts of the market delivered a more resilient performance than many others. It is what you would hope might happen. That may start to change as the market looks ahead to an eventual recovery. As it does, it would be reasonable to think there will be a change of leadership in the sectors performing well - and keeping an eye on those shifting currents could be a useful guide.

Ben Hobson is a freelance contributor and not a direct employee of interactive investor.