Tough economic and market conditions present most companies with operational and financial adversity. Reductions in cash flow pose significant risks to financial success and, because the duration of a recession is difficult to predict, there is a risk that prolonged stagnation will cause an entity to go right out of business. Some businesses don't suffer from downturns as severely as their peers, however, making them good defensive stocks for a down market.
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 certain amount of payroll, rent, leases, taxes and capital expenditures can't be eliminated, so these have to be met with limited cash availability. (See also, "A Review of Past Recessions.")
A recession hits the pocketbooks of a business' 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, 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 such as 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.
How to Spot a Recession-Proof Company
Investors hoping to minimize downside risks arising from a recession should look out for the following qualities in a company:
1. The company provides critical repair and maintenance services, or sells essentials.
Companies that provide nonessential services are typically the first to get hit in a recession. Consumers can choose to cut their own grass or paint their own houses, for example, 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. Refineries and chemical plants hire engineering firms and consultants to conduct periodic assessments of their equipment, wiring and processes. These are ongoing reviews that cannot be eliminated simply to save a few dollars in expenditures. Another example is waste management. It would take more than a recession for neighborhoods and businesses to allow uncollected trash to pile up.
Similarly, look out for companies that manufacture an important product that breaks down with a certain level of frequency and needs to be replaced. A maker of engine seals and gaskets will tend to have relatively stable revenue streams even in bad times. Good seals and gaskets ensure that a car engine performs smoothly, but must periodically be replaced. Printer cartridges are another classic case of an insulated business model. (See also, "Guard Your Portfolio With Defensive Stocks.")
A common strategy during recessions is to invest in consumer staples stocks, which offer products that households are unlikely to cut back on drastically, such as toothpaste, sponges and shampoo. These firms also tend to pay generous dividends. Grocery stores, makers of cosmetics, companies providing funeral services, and beer, wine and liquor manufacturers make attractive investments for similar reasons.
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: people don't give up electricity during a recession. 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 to prevent drugs, smuggled weapons and other non-permitted goods from entering the country. Such security precautions are mandated by government and local authorities, so unless there is an unusual oversupply of qualified personnel who can perform these services, such businesses will continue to enjoy healthy demand at all points in the business cycle.
Another example is pipeline inspection. The U.S. has millions of miles of underground pipelines that carry oil and gas across the country. Ruptures and pipe damage can cause fatal explosions, so inspections are mandatory. Audits by third parties are also mandatory for public companies and most government agencies, giving auditing firms a stable supply of work.
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. Perhaps a drilling equipment manufacturer has patented pipes and related equipment that its drilling customers can't go without. Pharmaceutical and healthcare companies with drug patents also enjoy relatively inelastic demand for their products. (See also, "Economics Basics: Elasticity.")