Tough economic and market conditions provide operational and financial adversity for most companies. Reductions in cash flow pose significant risks to companies' financial success. And, because the duration of a recession or adverse market conditions are difficult to predict, there is a risk that prolonged stagnation will cause an entity to go right out of business. However, some businesses don't feel the same pinch. This makes them good defensive stocks during bad market conditions.

Tutorial: Stock-Picking Strategies

How Recessions Hurt
Tough economic times turn risk into operational and financial duress. A company may be forced to reduce expenses, lay off nonessential employees and minimize purchases, acquisitions and capital expenditures. A business typically has obligations it can't eliminate, such as payroll, rent, leases, taxes and capital expenditures; these must be met with limited cash availability. (If you're interested, take a look at our article A Review of Past Recessions for a historical refresher.)

A recession hits the pocketbooks of a business's customers too, whose reduced spending impacts the company in turn. As customers reduce their spending, the number of product orders decreases; customers may not pay their bills, thus reducing the working capital of the companies they owe and leaving the business with write-downs. Contractors are often hit hardest. Their services focus on new projects - perhaps installing building equipment, working on new construction sites, or roofing and tiling work. In tough market conditions, their customers will also cut down on expenses and reduce service orders as part of a broader effort to conserve cash.

Favored Investment Industries
Risk is a critical variable for investors when deciding where to park their money. Companies that have a business model insulated from economic downturns are viewed as attractive and safe investment opportunities. A cash cow can continue to produce cash flow streams despite lagging economic activity. (Read Spotting Cash Cows to learn how to identify these companies.)

There can be several reasons why a company fares well during a recessionary period:

1. The company provides critical repair and maintenance services, or sells essentials.
Companies that provide nonessential services are typically the first to receive tough operational and financial blows from a recession. Consumers can choose to cut their own grass or paint their own houses, putting the residential contractor in tough financial times.

Certain service companies, however, provide essential and critical services to their customers that cannot be so easily reduced or eliminated. For instance, refineries and chemical plants hire engineering firms and consultants to conduct periodic assessments of their equipment, wirings and processes. These are ongoing reviews that cannot be eliminated simply to save a few dollars in expenditures. Another example is waste management. Neighborhoods and businesses certainly will not allow trash to pile up around their establishments, no matter how bad the economy gets.

Similarly, companies that manufacture an important product that breaks down with a certain level of frequency and needs to be replaced tend to hold up well during tough times. For instance, a maker of engine seals and gaskets will tend to have more stable revenue streams. Good seals and gaskets ensure that a car engine performs smoothly. These types of products also eventually break down. Thus, the product must be replaced to ensure an engine continues to work. How about a printer cartridge? When it runs out of ink, you are forced to order another one and replace the cartridge. That's a classic case of a relatively insulated model. (For a related article on defensive stocks, check out Guard Your Portfolio With Defensive Stocks)

2. The company serves a customer base that is insulated from economic meltdown.
Nuclear and power generating facilities, for the most part, have stable revenue. So do companies that transport oil and energy commodities. There are limited or no substitute products or services in these business models; it will take more than a recession to force people to give up electricity! Some rail cars that carry and ship certain cargo can also be relatively insulated. For example, a rail company may have a long-term contract with the military to ship fuel, munitions and material to various destination points around the country. These types of companies are considered more stable in tough economies. Companies that serve government contracts tend to continue to perform well, as these contracts are likely to continue through a recession, providing these companies with steady cash flows.

3. The company provides products or services that are mandated by government regulation or compliance rules.
Security agencies and their personnel inspect the millions of tons of imported goods cargo entering the United States at various shipping ports and channels. These inspections are necessary in preventing drugs, smuggled weapons and other non-permitted goods from entering the country. Such security precautions are mandated by government and local authorities and unless there is an unusual oversupply of qualified personnel who can perform these services, such businesses will continue to see business demand, despite a lagging economy.

Another example is pipeline inspection. The United States has millions of miles of underground pipelines that carry oil and gas across the country. Ruptures and pipe damage can cause explosions that kill citizens. Thus, pipeline inspection is a required activity to help ensure such assets are in good condition. Another required activity for public companies and most government agencies is the performance of an audit by an external agency. Auditing firms have a stable supply of work from these types of clients.

4. The company provides proprietary, niche or highly defensible products or services within the marketplace

A company may have an offering that is considered best-in-class in the industry. For example, a drilling equipment manufacturer may have patented pipes and related equipment that make it important for its drilling customers to use. It is possible that in hard economic times, its customers will elect to use these more reliable products and reduce or eliminate orders from competitors. Pharmaceuticals and healthcare companies with drug patents are also classic examples of companies with relatively inelastic demand for their products. (For more insight, read Economics Basics: Elasticity.)

The Bottom Line
Economic downturns pose financial problems for many companies, but there are companies that continue to generate revenue despite adverse market conditions. If a company serves an insulated market, provides critical repair and maintenance services or sells a consumable product, its business is unlikely to plummet, even in the worst market conditions. Additionally, products or services mandated by the government offer good opportunities for stable business, as do companies that provide a proprietary or patented product or service.

Even during recession, money continues to flow in an economy. There are profitable companies out there, but it is up to smart investors to find them. (For further reading, take a look at Industries That Thrive On Recession)

Related Articles
  1. Investing

    Time to Bring Active Back into a Portfolio?

    While stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
  2. Economics

    Investing Opportunities as Central Banks Diverge

    After the Paris attacks investors are focusing on central bank policy and its potential for divergence: tightened by the Fed while the ECB pursues easing.
  3. Stock Analysis

    The Biggest Risks of Investing in Pfizer Stock

    Learn the biggest potential risks that may affect the price of Pfizer's stock, complete with a fundamental analysis and review of other external factors.
  4. Savings

    How Americans Can Open a Bank Account In Thailand

    Have your paperwork in order and be sure to shop around.
  5. Savings

    Opening a Bank Account in Costa Rica as an American

    It shouldn’t be too hard to do, provided you have the appropriate documentation and forms. But be prepared for lots of paperwork!
  6. Markets

    PEG Ratio Nails Down Value Stocks

    Learn how this simple calculation can help you determine a stock's earnings potential.
  7. Investing

    How to Spot Secular Bull Markets vs. Secular Bear Markets

    A guide to identifying secular bull and bear markets.
  8. Financial Advisors

    Bull vs. Bear Markets: How to Be Prepared for Both

    Bull and Bear Markets are a reality that every investor must be prepared for. Here are a few tips.
  9. Savings

    A Quick List of FSA Eligible Expenses

    The ABCs of FSAs: What you can and can't use your Flexible Spending Account funds for.
  10. Investing

    What’s the Difference Between Duration & Maturity?

    We look at the meaning of two terms that often get confused, duration and maturity, to set the record straight.
  1. Which mutual funds made money in 2008?

    Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
  2. Who decides if a financial security should be escheated?

    There is no one entity who "decides" to escheat assets. Rather, financial institutions are required to report inactive accounts ... Read Full Answer >>
  3. What does low working capital say about a company's financial prospects?

    When a company has low working capital, it can mean one of two things. In most cases, low working capital means the business ... Read Full Answer >>
  4. Do interest rates increase during a recession?

    Interest rates rarely increase during a recession. Actually, the opposite tends to happen; as the economy contracts, interest ... Read Full Answer >>
  5. Do nonprofit organizations have working capital?

    Nonprofit organizations continuously face debate over how much money they bring in that is kept in reserve. These financial ... Read Full Answer >>
  6. How long do I need to keep income tax records?

    Keep all tax-related records for at least three years. For example, keep your 2015 tax return, filed in early 2016, at the ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  2. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  3. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  4. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  5. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  6. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
Trading Center