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.
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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)