We have probably just entered a recession, defined as an economic decline that lasts several quarters. Recessions are generally scary times for individuals, businesses and the stock market. Yet this is an unusual recession. Given that the current recession was caused by a pandemic, not the bursting of an asset bubble, with unprecedented government action To combat the economic fallout, there is considerable debate over whether this recession will be quick or if it could evolve into a longer depression.

While young investors with a long-term horizon probably shouldn’t do much for their portfolios, older investors in retirement or nearing retirement may wish to hedge against this worst-case scenario, especially since the stock market has rebounded so much from its March 23 lows. . Damn, even Warren Buffett is selling stockswithout buying them.

If you’re worried about a recession and a double-dip in the market but still want to stay invested, here’s how to position your portfolio.

Buy recession-proof stocks, eliminate economically sensitive cyclicals

A classic strategy that applies to all recessions is to buy the shares of companies that will be less affected by an economic decline and to sell the shares of companies that are more sensitive to the overall economy. Moreover, since this recession is triggered by a global pandemic, you can also turn to defensive stocks that also play on the economy at home.

Typical recession-proof sectors include basic consumption shares or utilities. Examples of consumer staples companies include Procter & Gamble (PG 0.98%), the world’s largest consumer staples company, which makes everyday household items such as toilet paper, soap, shampoo and other products people need to buy at the right places. like in bad times. Another recent staple star was Clorox (CLX -0.75%)which has profited greatly from the fact that it sells disinfectant wipes that people are using to clean surfaces more than ever before.

Utilities provide basic necessities such as water, electricity and gas to individuals and businesses. Often, utilities are safe because they have monopoly or near-monopoly status over a given area. However, these companies are often regulated by governments, which limits prices and growth. Still, the prospects for stable cash flow and dividends make them very attractive at times like these.

An example is Fool favorite NextEra Energy (BORN 0.46%), which operates electric utilities in Florida, a state experiencing strong growth thanks to the retirement of baby boomers. Additionally, NextEra also owns several renewable energy projects, which positions it well for a more sustainable future. Combine that with one of the highest credit ratings of any utility, and NextEra is a reliable dividend stock for the venture investor, especially during a recession.

On the other hand, if you fear a prolonged downturn, you should probably avoid economically sensitive stocks. These may include bankswhich tend to do well when the economy is doing well and vice versa, or consumer discretionary stocks which make big ticket items such as automobiles.

In times of recession, people find it harder to repay their loans and interest rates fall, putting even greater pressure on the income of bank lenders. And in tough times, people also cut back on major purchases such as cars, which means they can hold on to their existing cars more than buying new ones.

Banks and automobiles are examples of cyclical stocks which tend to thrive in good times and collapse in bad times. In general, you should be wary of investing in cyclicals if you think we’re on the verge of another downturn. However, if the economy emerges from the current slowdown sooner, these cyclical stocks may have more upside. Nonetheless, for those predicting or unable to afford a deeper and longer lasting downturn, it is best to avoid cyclical stocks altogether for now.

Buy stocks with good balance sheets, sell stocks with bad balance sheets

During a prolonged economic downturn, a company balance sheet comes to the fore. The balance sheet is the financial statement where a company’s assets and liabilities are listed side by side, including a company’s cash flow versus debt.

Clearly, in an economic downturn, companies that have saved money are much safer than those that have spent all their money, either on growth or on paying dividends and shareholder buyouts. Additionally, companies with good balance sheets tend to have cash-generating activities anyway, so good balance sheets are a double good place to look and start buying during a downturn.

An example of this would be Alphabet (GOOG -1.48%) (GOOGL -1.38%), the parent company of Google. Alphabet’s dominant digital advertising segments are excellent, high-growth, high-margin businesses, which have provided the company with an incredible $117.2 billion in cash on its current balance sheet, up from just 5 billions of dollars in long-term debt.

This pile of cash is looking pretty good right now. Even though Alphabet’s core digital advertising business is being hit hard by the advertising decline, the company continues to generate cash, continues to invest in its new businesses such as the cloud, and is even buy back more shares while its share price is falling.

On the other hand, if a business has high levels of debt and its revenue suddenly disappears, it could find itself in big trouble. In a bad case, heavily leveraged stocks fall during a recession and stay low as the company in question tries to climb out of the debt hole it has gotten itself into. Often this means raising more capital, which dilutes current shareholders. This is what is happening now with highly indebted airlines, which now need government bailouts which could be very expensive. That’s apparently why Warren Buffett exited all of his airline stocks the last quarter. In the worst case, high debt could lead to bankruptcy, which just happened to a 108-year-old retailer JC Penney (JCPN.Q).

Of course, not all heavily indebted companies are doomed. For example, mobile telecommunications stocks are highly leveraged, but mobile phone subscriptions are fairly recurring, high-margin revenue and profit streams. On the other hand, when you have high levels of debt combined with a business that is cyclical, or hard hit by the coronavirus like airlines or brick-and-mortar retailers like JC Penney, it’s a deadly combination. All things being equal, stick to cash-rich balance sheets.

For the upside, lean into high-growth stocks

Finally, recessions can be a great time to buy stocks of companies with compelling long-term growth histories. Why would I advocate looking at growth stocks in a recession, which tend to trade at higher valuations? A few reasons.

First, in a recession, interest rates fall and lower interest rates make future cash flows more attractive relative to current cash flows. This benefits growth stocks which may not have much earnings today, but strong earnings growth, suggesting better earnings in the future. Second, when growth wanes in a recession, companies that can still grow get higher valuations. Third, companies capable of scaling up are largely in the midst of big, long-term technology trends that offer more efficient ways of doing business. These innovations are currently being accelerated by the stay-at-home economy as businesses feel the need to digitize and automate their operations. These types of businesses can actually go from strength to strength in the long run during a recession.

A great place to look today are innovative cloud software stocks, many of which have not only weathered the coronavirus recession well, but have actually increased in value in 2020. These include stocks like Twilio (TWLO -10.03%), which provides cloud-based communication services to enterprise customers. With so many businesses losing their ability to physically interface with customers, Twilio has seen an increase in demand as businesses turn to mobile messages and email to notify and track customers. Another high growth stock is Datadog (DDOG -10.72%), which monitors cloud usage and provides valuable analytics to its enterprise customers. A third example is Teladoc Health (TDOC -5.54%), which allows people to speak with doctors remotely, rather than having to visit a physical office. Unsurprisingly, it’s seeing a boom in use.

Twilio, Datadogand Teladoc have all seen big spikes in their stock prices recently after recently announces strong revenue growth, so they can each experience setbacks from here. Yet, in the long run, these stocks should continue to do well. If you’re worried about a prolonged downturn, look for similar stocks with recurring earnings, strong growth profiles, and products that help companies weather the current recession. Although seemingly “expensive,” strong revenue growth should provide a floor under these names during the recession and a rise on the other side.

Three Ingredients for a Recession-Proof Portfolio

In conclusion, a recession-proof portfolio should be made up of stable stocks of consumer staples and utilities, stocks of companies with cash-rich balance sheets, and young growth companies focused on businesses that offer new, more efficient ways of doing business. If you build a portfolio with these three elements and avoid highly leveraged, cyclical, or non-growth companies, your portfolio should hold up well in a prolonged recession.