The 3 Most Important Things To Look For In A Company Before Pouring A Cent Into Them During A Recession.

he shutdown of the global economy caused by coronavirus has brought with it Australia’s first recession since 1991. The good news is, history tells us recessions bring with them excellent investing opportunities if you’re looking for exceptional returns (you should be).

So what is a recession?

The economic impact of COVID-19 has been monumentally bad and has driven Australia into recession. But what is a recession? Well in layman’s terms, a recession is marked by a temporary economic decline during which trade and industrial activity are reduced. Recession is widely identified when an economy’s GDP (Gross Domestic Product) contracts for two consecutive quarters. The recession we’re currently in is a result of the negative GDP growth observed in Q1 and Q2.

This recession will be a result of the widespread loss of jobs and the subsequent plummeting levels of consumer confidence, causing global economies to shrink. And unfortunately, Australia isn’t sheltered from this. Given global economies are so heavily intertwined nowadays, Australia’s economic fate is heavily dependent on international economies to support our GDP growth.

During a recession, the value of certain assets like stocks can decline sharply, which spreads fear and uncertainty across markets. And it’s that uncertainty that leads people to make emotionally driven decisions with their investments. Recessions are generally shortlived in nature in comparison to market booms. This is why it’s important to block out the fear, think logically, and most importantly, think long term.

How Can You Profit From A Recession?

During a recession, fear is widespread while greed is eradicated, which can cause dramatic fluctuations in stock valuations. This is a result of investors converting their stock to more defensive assets like fixed interest (bonds), cash, and gold. This pushes the price of a company’s stock down. Quickly.

These sharp declines are usually enough to panic most retail investors like you and me out of the market, causing further declines in stock valuations. During times of extreme volatility, emotion usually throws all logic out the window, which means it’s common for retail investors to sell low, not buy low.

If you’re one of a few who’s prepared, you’ll be ready to take advantage of other people’s mistakes caused by their fear of short term market volatility. Recessions bring with them extraordinary opportunities to invest in wonderful companies at heavily discounted prices to their underlying value. Think of it this way, if someone offered you $2 in exchange for $1 you’d take it, right? What a no-brainer! This process is known as value investing, and if it’s done properly, it can generate market-beating returns.

Take The Great Recession in 08/09 as an example. On March 9th, 2009, the S&P500 finally hit its bottom. At that time fear was everywhere. The world was in the midst of its greatest economic downturn since the great depression and seemed as fragile as ever. But you know what happened next? The S&P500 skyrocketed 69.5% upwards over the following year. I guess that’s why Warren Buffett likes to be greedy when others are fearful!

If you’ve come this far I assume you’re interested in capitalizing on the opportunities recessions can offer savvy investors. So without further ado, let’s dive into a few filters that will guide you in determining a companies likelihood of surviving the recession and prospering for years after the recession.

1. Invest In Companies With Competitive Advantage During a Recession

If you’re choosing to buy into an individual business, the first thing you want to know is if its future is predictable. You want a business that you can count on to continue growing its profits, which will subsequently compound shareholders’ money over the long term (10 years+).

To ensure a company has a good level of predictability, it needs to have some level of competitive advantage to protect it from competitors. You don’t’ want to own a business without a competitive advantage because it’s very easy for a competitor to replicate the business model, taking away your share of the profits! Take the Oil business as an example. If you own an Oil business, you have essentially zero protection from competitors. If someone wants to sell Oil cheaper than you, you either have to drop your prices or you’re out of business!

So What Does A Competitive Advantage Look Like?

Think about a company like Microsoft or Apple. They’re so heavily ingrained in our daily lives that moving to another provider is just not worth the hassle.

Or what about the brands you know and love like Nike and Starbucks? These are brands you’re willing to pay more for because you trust them. That’s a competitive advantage.

You’ll usually find that businesses with strong histories of thriving in past market declines possess huge competitive advantages. If you’ve got your eye on a certain business, check out how it did during previous market downturns like the GFC in 08/09. If you find that it survived and prospered coming out of tough times, you can attribute it to a strong competitive advantage complemented by a healthy balance sheet.

2. Resolute Balance Sheet

Nearly every bankruptcy can be traced back to a foundation of weak balance sheets that cracked under the pressure of excessive debt. Companies, households, and governments load up on debt during good times, only to struggle to repay those debts when the economy takes a turn for the worse. As Warren Buffett says, “it’s only when the tide goes out that you discover who’s been swimming naked”.

If you’re Investing during a recession (or at any time for that matter), it is imperative to look for companies that have a robust balance sheet to weather stormy economic conditions.

What is a balance sheet?

A balance sheet is a statement of a companies assets, liabilities, and equity at a particular point in time. By becoming familiar with a business’s balance sheet, you can understand if they have low debt, healthy levels of cash reserves, and if the business is growing equity for its shareholders. These are all crucial factors to consider to determine if the business has sufficient staying power.

Where to find the balance sheet?

The balance sheet can be found on a business’s annual and quarterly reports. Conveniently, these reports are downloadable from the investor relations sections of a company’s website. There are also some great sites that I personally use like, Quick FS and Macro Trends that provide 10 Years + of companies’ financial data for free!

To get you going, I’ve listed a few metrics I look at to get a better glimpse into how healthy a balance sheet is:

1. Net cash — You want this to be growing.
2. Current Ratio — This should be 2 or above (dependent on the industry)
3. Book value per share — You want this to be growing.
4. Total Long Term Debt — Ideally this should be reducing and less than net cash available.
5. Total debt/equity — A solid D/T ratio varies by industry, but it should not be above 2.

3. Recession & Consumer Demand

During a recession, consumer confidence is down, which means the demand for most luxury products and services is depressed. Think Car Manufacturers, Airlines, Cruise Liners, High End-Fashion retailers, etc. When money isn’t flowing freely as it was pre-recession, people are less inclined to spend on what they don’t need.

But there are a select few industries that prosper in a recessionary environment. These are businesses that see a spike in demand when consumers reduce their spending on expensive goods that they can no longer afford. Instead, consumers focus their spendings on consumer staples like groceries and pharmaceuticals. They’ll also spend on small luxuries like a takeaway meal, a case of beer, or a new book.

The Stay At Home Economy

It’s also worth considering the shift in lifestyle this recession has imposed. We’re now all spending a lot more time at home, which bodes well for certain companies. Think about the services you’re using a lot more of now that you’re stuck at home. Maybe you’re working from home and video conferencing with Microsoft Teams or Zoom? Or you could be spending much more on Amazon now that we’re advised not to visit physical stores. Whatever the case may be, there’s no doubt that this recession will boost demand for some companies, while reducing it for others.

The Money Pal Verdict

The factors above should guide you in the right direction when filtering through prospective investment opportunities. But keep in mind that there are lots of other details to consider before investing into an individual company. Successful active managers are willing to take all the time they need to understand a few companies inside and out. If that’s not you, then you’re probably better off owning market tracking index funds. And there is nothing wrong with that. Investing in the whole market with index funds provide the average return while minimizing the downside risk associated with owning individual stocks.

The fact is that low-cost index funds are the most sensible stock market investment for the great majority of investors. Great investors like Ben Graham, John Bogle and Warren Buffett took this position many years ago, and everything I have seen since reinforces this truth for me.

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