Knowing the characteristics of those companies that tend to be the most recession-proof can be a huge advantage for investors. That's because tough economic and market conditions present most companies with operational and financial adversity. However, some businesses don't suffer from downturns as severely as their peers, thus making them good defensive stocks for investors to buy during a down market. Here we review why recessions have such a big impact on companies and five characteristics that will help you spot potential recession-proof companies.
- Investors who can correctly identify those companies that are recession-resistant have an opportunity to make profits during market downturns.
- Companies that are not recession-resistant may have cash flow problems that force them to lay off employees, reduce expenses, and incur debt to stay afloat.
- Companies that are recession-resistant will continue to have stable revenue streams regardless of whether the economy is up or down.
- Examples of such companies are those that sell consumer essentials, provide critical repair services, manufacture proprietary products, or provide mandated services.
How Recessions Hurt
For many companies, tough economic times turn risk into operational and financial duress. A company may be forced to reduce expenses, including laying off employees. They may be forced to 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.
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.
Building 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
Reductions in cash flow pose significant risks to the financial success of any company. 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. Investors hoping to minimize downside risks arising from a recession should look for companies that have at least one of the following five characteristics: 1) provides critical repair services 2) sells consumer essentials 3) serves customers insulated from downturns 4) provides mandated products or services 5) sells proprietary or specialized products.
Provides Critical Repair Services
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. For example, 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.
Sells Consumer Essentials
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.
Serves Customers Insulated From Downturns
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.
Provides Mandated Products or Services
Security agencies and their personnel inspect the millions of tons of imported goods and 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 the inspection of pipelines. 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.
Sells Proprietary or Specialized Products
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 do without. If they are the only company offering these pipes, then customers who need the product will need to continue to do business with them during good times and bad.
Pharmaceutical and healthcare companies with drug patents also enjoy relatively inelastic demand for their products. This means that consumers' buying habits stay the same regardless of whether the price for the product goes up or down. Insulin is an example of a drug where the demand is inelastic. For diabetics who need insulin to survive, the demand for the drug remains high even if the price fluctuates.