How to Navigate a Slow-Growth Economy

Tips for producing solid returns even as companies' earnings slow down.

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After the dust clears from the furious rally in stock prices, what will happen next? It's the question in the back of every investor's mind, and the answer could be far from encouraging. The way many economists see it, the market is headed for a sustained period of slow growth as the tepid borrowing environment and sluggish employment prospects balance out the recent rash of enthusiasm.

For investors, this turning point in the market provides ample reasons for tempered expectations. But even amid a slowdown, there are a number of opportunities for solid returns. Here are some tips for navigating a slow-growth economy.

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Pay attention to dividends. Under normal market conditions, investors can expect a healthy balance of dividend payments and companies' earnings growth to anchor their returns. But if corporate earnings falter in a slow-growth climate, dividends will take on mounting importance.

On its surface, this is a troubling proposition, mostly because the recession caused struggling companies to slash their dividends and the situation hasn't improved much during the recovery. But even though the overall dividend yield for S&P 500 companies lingers at a paltry 2 percent, there are pockets of the market where dividends remain strong.

Josh Peters, editor of Morningstar's monthly DividendInvestor newsletter, uses the example of Altria, the parent company of Philip Morris USA. "Within that S&P 500 figure of 2 percent, you've got a lot of companies like your Googles and your Apples that pay nothing. But you've also got companies like Altria that have a 7 percent dividend yield," he says. This high yield, he notes, provides a cushion in slow-growth periods, since dividends compensate for stalled earnings increases. "Altria just does not have to grow very fast—it doesn't have to raise its dividend [or] its earnings very much—in order for you to have an overall return that is decent," he says.

This insulation often stems from the business models that companies with strong dividends tend to adopt. "For them, the dividend is a high priority," says Peters. "They run the business so they can pay that dividend and raise it over the long run. And that means that they leave room for perhaps a slower economic environment or a recession." Apart from Altria, Peters singles out McDonald's, utilities provider Southern Co., and Chlorox.

Meanwhile, he argues that companies that don't pay out steady dividends could potentially suffer in the next couple of years. "If a slow-growth economy is going to hand out its punishment to companies that need the earnings growth the most . . . it's going to make it a lot harder to own a stock like that," he says. "If you don't have a decent dividend yield that provides a basis for getting a regular, predictable return, then it's 100 percent just a bet on earnings growth and valuation expansion, and I think a slow economic growth environment makes both of those much harder to achieve."

Look for innovation. Stocks across the board got a boost from renewed investor confidence as the market moved off of its March lows, but that honeymoon effect looks destined to fade. "We're moving on from the early economic improvement and all the stocks being helped by just being undervalued and by better prospects across the board," says Kim Scott, manager of the Ivy Mid Cap Growth fund. "Now you really need to separate the wheat from the chaff, and there are still plenty of good growth companies out there. I wouldn't say it's a candy store, but there are a lot of good companies."

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For Scott, looking for innovation is the key to finding companies that can bring in solid earnings, even in a slow-growth economy. By sector, she likes information technology, industrial technology, and portions of healthcare and consumer discretionary. As for companies, she says that a number of common household names, such as J. Crew, Urban Outfitters, and Chipotle, have the types of innovative business models that can provide investors with some immunity to slow growth.

"These are the kinds of companies where you still see opportunity," she says. "They have great concepts that appeal to consumers. They still have the opportunity to grow their square footage, and then as the economy recovers, they're going to get same-store sales growth."

Overall, though, prospects for earnings boosts look likely to decrease in the near future. But Scott believes investors are already braced for that outcome. "I think generally expectations are tempered," she says. "I think that's been done."

Understand the labels. Investors love to kick around terms like slow growth, but it's important that they also know where the economic forecasts are coming from. After all, understanding how the market entered a phase is the first step to approximating when the phenomenon will pass. In this case, slow growth is the result of high unemployment rates and a rough credit environment.

"We had a society that was using credit egregiously, and that's come to a screeching halt," says Scott. "And so the forced or voluntary reduction in the use of credit by consumers is a reason why we'll have a slower-growth economy."

Peters compares the current recovery to the economy's growth in the years following the recession that kicked in around the turn of the century. The last time around, the credit markets were not nearly as tight. "If you look at the next economic expansion, you don't really have much prospect that wage growth is going to accelerate because you're still going to have globalization acting as a damper on wages, to say nothing of 10 percent unemployment or higher coming out of this recession," he says. "[And] you're not going to have that secondary driver of borrowing to enable consumers to spend beyond means or spend all the way up to their means."