There was good news and bad news about the consumer price index report yesterday morning.

On the plus side, core inflation, which excludes food and energy categories, only rose 0.2% between November and December. The reading for the preceding 12 months was 3.2%. Economists had expected it to increase by 0.3% and 3.3%, respectively.

The market certainly liked it. All the major indexes were up on the news.

As for the bad news…

I think I can speak for most consumers when I say that’s still too much on top of all the other price hikes we’ve endured the last four years. But I guess it could have been worse.

And it’s worth noting that consumer prices including food and energy rose 0.4% in December and 2.9% for the year. Expectations were for 0.3% and 2.9%.

Even with the core inflation “bright spot,” those numbers remain notably off from the 2% inflation target. Here’s Chair Powell from January 31, 2024 [emphasis added]:

The Fed’s monetary policy actions are guided by our mandate to promote maximum employment and stable prices for the American people. My colleagues and I are acutely aware that high inflation imposes significant hardship, as it erodes purchasing power, especially for those least able to meet the highest costs of essentials like food, housing, and transportation. We’re highly attentive to the risks that high inflation poses to both sides of our mandate, and we’re strongly committed to returning inflation to our 2% objective.

Translation: We’re not cutting rates yet.

But what a difference a few months make. Here’s Powell at Jackson hole last August:

The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.

Translation: Okay, now we’ll cut.

The Fed then lowered rates three times – and in short succession – late last year despite obvious indicators showing how inflation was not yet under control. All things considered; I don’t expect much more talk of a “soft landing.”

As I said on Tuesday, I do think we’re headed toward a recession in the next 15 months. In which case, it’s time to properly prepare.

The Way Through a Downturn Starts With Smart Thinking

Now, as I also said on Tuesday, I don’t expect a severe downturn. Just a mild one. And as I said on Wednesday, there are ways you can properly prepare for a recession regardless.

The key is to “avoid the losers” and let the winners “take care of themselves.” That’s a quote from Howard Marks, co-founder and co-chairman of Oaktree Capital Management, the world’s largest investor in distressed securities.

It’s a profound point, and I did explain it further throughout the article, including with this:

… smart investors commit to finding sturdy investments. And then they let those assets run for as long as they can.

They don’t chase fads. They don’t chase “sucker yields.” They don’t get euphoric, and they don’t panic. They study the facts and then they follow those facts into stable purchases that grow in the good times and last through the bad times.

If that sounds great, it is. I gave you some numbers yesterday from The Wide Moat Letter… how, under this mindset, we made gains in 15 out of the 17 stock sales (or trims) we recommended last year. That makes for an 88%-win rate – an accomplishment worth talking about.

But how do you identify these sturdy companies in the first place? Well, that’s what I want to address today.

A fellow analyst, Robert Hutten, recently commented on one of my articles, providing a succinct list to look out for. While he was specifically referring to real estate investment trusts (“REITs”), most of the advice is applicable across the stock spectrum:

Look for ones that have investment-grade finances. Stay away from ones that are on the wrong side of a macro trend. Look for ones that have a decent yield with a sustainable payout ratio (say below 75%). Look for management that has a good track record and has articulated a plausible way forward. Keep the total REIT investment a reasonable but not exorbitant part of a balanced portfolio.

It’s like he read my mind.

Digging Further Into This Safety-First Investment Style

My regular readers know I’m a safety-first investor, so I’m going to break down each of Hutten’s points down a bit further. If we really are headed toward a recession – and we always are since every expansion eventually comes to an end. It’s only a matter of when – then I want you to be as properly prepared as possible.

So, here’s a closer examination of how to evaluate an investment opportunity:

1. Look for companies with investment-grade finances. This means they have reasonable debt levels (which admittedly varies from business to business and sector to sector) with obvious resources to pay those obligations off on time. In addition, their assets are secure and growing. And they’re well-respected by their clients, their shareholders, and the financial institutions they borrow from. The more so, the better, since that means they’ll be paying lower rates on the aforementioned debt.

2. Stay away from those that are fighting macro-economic trends. It’s okay not to follow every fad. In fact, it’s almost always safer that way. But a company that can’t recognize and properly react to lasting changes – and as quickly as possible – is a company that’s doomed to fail. A negative example would be Blockbuster, which refused to embrace the world as it went increasingly higher tech. And now it’s no more.

3. Choose companies with decent yields and sustainable payout ratios. This is dividend-company specific, of course, but that’s the kind of company I typically recommend. Because most of them don’t feature fast-growing stocks, they need to make up for it with sizable payouts compared to their stock prices. REITs, for instance, offer about an average 4% yield, with some safely hitting 9% or 10%. But the key word here is “safely.” You need to make sure they’ve still got enough money to pay their bills and grow. Robert mentioned a payout ratio. That’s simply the percentage of earnings paid out as dividends. And 75% is a good rule of thumb. If this figure gets too high, it runs the risk of being a “sucker yield,” meaning it’s not sustainable.

4. Stick with management teams that boast strong track records and clearly stated goals, complete with smart ways to achieve those goals. Always ask who’s in charge of the businesses you’re interested in. Are they ethical? Are they intelligent? Are they experienced? And are they upfront about what they’re going to do with your money? If not, buyers beware.

5. Don’t fall in love with any given stock. Even if a company’s balance sheet is the most beautiful thing you’ve ever seen… it’s on the ball about assessing economic changes… it has an excellent and sustainable dividend yield… and it boasts the best leadership possible… you still don’t want to put it up on a pedestal. Go ahead and assign a slightly larger portion of your portfolio to that investment if you’d like, but don’t overdo it. There is no such thing as a perfectly protected company, which is why we want to own a healthy number and variety of assets to reduce our overall risk.

Follow those guidelines, and your portfolio should be in a healthy place, leaving you to rest easy no matter what the larger market does from here.

And, yes, these are the exact qualities we look for in our premium research services. If we publish any recommendation, you can rest assured knowing it has checked these boxes.

Regards,

Brad Thomas
Editor, Wide Moat Daily

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Do you agree with Brad that these guidelines will help your portfolio be in a healthy place? Write us at feedback@widemoatresearch.com.