The stock market has struggled throughout 2022, with many stocks failing to provide positive returns for investors. The S&P 500 has entered a bear market as the economy struggles with inflation, the Federal Reserve continues to raise rates, and recession fears spook investors.
Declines like these often lead investors to look for more defensive stocks. However, developing a sustainable investment strategy is a good idea regardless of market conditions. Stocks can be volatile at times, so finding safer stocks to invest in can make your portfolio more resilient during those down periods.
How to find safer stocks to invest in
Finding safer stocks to invest in can seem like a tall order, but it’s less challenging when done in a systematic way. In other words, it’s easier once you know what to look for. Plus, the best online stock brokers usually have stock screeners to make it easy to find safer stocks.
1. Consider companies with larger market caps
Larger companies are often among the safer choices of stock picks. The reasons are many but include diverse revenue streams, economies of scale, and greater resources at their disposal.
For example, they tend to have more money for research & development and advertising. They also tend to attract the best talent and have better distribution networks than smaller competitors.
No single company is a completely safe investment, and this includes large-cap companies. However, these companies are generally less likely to become insolvent than very small companies.
2. Pay attention to valuation multiples
Valuation multiples are metrics that attempt to gauge the financial performance of a company and its stock. Common valuation multiples include price-to-earnings (P/E) ratio, price/book ratio, and dividend yield. If these numbers don’t align with the competition, the stock could be overvalued or underpriced.
For example, if a stock has a high P/E ratio, this means the stock has a high price relative to the company’s earnings. However, some industries tend to have higher P/E ratios than others, so you should only compare companies to their direct competitors. The same can be said when considering other valuation multiples, such as dividend yield.
3. Target non-cyclical businesses
If a business is cyclical, it is likely to experience volatility during an economic downturn because consumers tend to cut back on spending during these times. Stocks in these industries are also known as consumer discretionary stocks. For example, companies in the entertainment and travel industries tend to struggle more during a recession.
However, people are less likely to cut back on expenses like utilities and healthcare. Indeed, the state of the economy is not often a major factor in whether people pay their electric bills or go to the doctor. Hence, these can be considered non-cyclical industries.
4. Find companies with increasing dividends
Consistently increasing dividends are another sign that a company is moving in the right direction financially. The most resilient companies are able to increase their dividends through thick and thin, even during a recession. Once again, the companies that consistently increase their dividends tend to be in non-cyclical industries, such as consumer staples and pharmaceuticals.
5. Look for companies with a competitive advantage
Competitive advantage is less quantifiable than some of the items mentioned above, but it is equally important. Companies with strong brand loyalty could fall into this category, as could those who have patented a unique process or product that sets them apart. If you think about the brands that define entire industries, they likely have a competitive advantage. Apple is just one example of many companies like this.
Risk factors to watch out for
There are certain risk factors to consider when looking for safe stocks. Some of these factors correspond with companies that other investors may target, such as those targeting high returns. But when you are looking for safety, these are some of the risk factors to keep on your radar.
- Penny stocks: You might think a stock that sells for 50 cents per share is a great opportunity; after all, you can buy hundreds of shares for very little money. Imagine what would happen if the share price increased to $10! However, penny stocks often tell the tale of troubled companies in danger of going under or at least fizzling out slowly.
- Unprofitable companies: Companies that don’t make money are not always a bad investment; for example, startups in developing industries may have a negative profit for several years before being back in the black. If these companies succeed, they can reward investors with high rates of growth. However, these new industries can also be unstable and unpredictable, so they probably aren’t the best bet for safe stocks.
- Unsustainable dividends: High dividends can be tempting if you are looking for a consistent payout, but they can also be a warning sign. For example, if the company pays a high percentage of its earnings in the form of dividends, it may not be sustainable. Keep in mind that this may not apply to REITs, which are required by the SEC to distribute at least 90 percent of taxable earnings to shareholders as dividends.
- Companies with too much debt: High levels of debt aren’t necessarily bad, but they can be worrisome in certain cases. For example, companies with high debt-to-capital or debt-to-equity ratios can be risky and may not be the safest investments, at least in the short term.
Economic uncertainty will lead almost any investor to look for stocks that are a safer bet. Large-cap companies with favorable valuation multiples tend to fall in that category. So, too, are those in non-cyclical industries.
However, there are also some risk factors to consider. High debt loads, unsustainable dividend payments, and lack of profitability are some signs that a company may not be a safe investment. While no stock is completely safe, finding companies with strong fundamentals while avoiding the red flags can make your investments less risky.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.