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Many watching the market are concerned that regardless of the outcome of an attempt to avoid the fiscal cliff there will be a recession in 2013.

Without a doubt, a recession would be unwelcomed by investors with a short investment horizon (1-3 years), but for those with a longer investment horizon, say 3+ years, it could be a great opportunity for profit. So what should potential investors do to prepare for this opportunity? Three things:

  1. Accumulate cash and review your portfolio
  2. Identify sectors that will see market prices depressed in a recession
  3. Find the stocks within the sector with the best fundamentals

Accumulate cash and review your portfolio

This does not mean sell off your portfolio; it means do not buy more stocks for now. If a recession in 2013 happens, you want to have cash ready to scoop up stocks for cheap. Hedge funds started doing this as early as August and continued into October.

It also makes sense to review your portfolio. Again, the idea is not to sell off your entire portfolio. The idea here is to prune the portfolio of any investments that no longer look attractive if we were to see a recession in 2013. If the reason why you invested in a particular equity is not affected by a short or long recession, then feel free to ride it out. The purpose of this review is to reduce or eliminate positions whose underlying reasons for purchase are impacted by a 2013 recession.

Identify sectors that will see market prices depressed in a recession

From 2009-2010, the 10 industries hit hardest by the recession (from worst to least) were:

  1. Building material and supplies dealers
  2. Home furnishing stores
  3. Lumber and other construction material wholesalers
  4. Other motor vehicle dealers
  5. Cement and concrete product manufacturing
  6. Newspaper, periodical, book, and directory publishers
  7. Furniture stores
  8. Printing and related support activities
  9. Office supplies, stationery, and gift stores
  10. Traveler accommodation

Some other industries that see depressed market prices as demand slumps include shipping, railroads, freight services, and high-end consumer products. If the recession is severe, demand for oil can decline and with it the price of oil and gas companies.

Find the stocks within the sector with the best fundamentals

The fundamentals of a company determine if the business will flourish during a recession or not. We want to find the companies that have a strong balance sheet, but are selling at a discount because of fear for the industry. The three key metrics to look at are:

  1. Net margin - the ratio of net income to revenue that measures how much profit the company makes per dollar of goods sold. The higher the net margin is relative to the industry average the better, as this means the company is profiting more than the companies it competes with per dollar of sales.
  2. Operating ratio - the ratio of operating expenses to net income measures the company's ability to generate profit if revenue decreases. In a recession, there is a high probability revenue will decline and therefore we want companies that have lower cost structures than its peers, allowing it to still generate wealth for shareholders even if revenues decline.
  3. Current ratio - the ratio of current assets to current liabilities will help determine if the company will be able to meet its short-term debt obligations. Look for companies that have higher current ratios than their peers do, as they are more likely to live through the recession.

5 quick picks by industry

Building material and supplies dealers - In this industry I like Beacon Roofing Supply (BECN) because it has a higher net margin and comparable current ratio than peers.

Cement and concrete product manufacturing - For this industry I like James Hardie Industries SE (JHX) and Cementos Pacasmayo S.A.A (CPAC). Cementos is a little safer with a higher current ratio than James Hardie, but I like that James Hardies leads the industry with a net margin of 20%.

Railroads - In the Railroad industry, I like Union Pacific Corporation (UNP) and Kansas City Southern (KSU). The both have high net margins and decent current ratios. I'm passing on Canadian National Railroad Company (CNI) for now because the current ratio is less than one. This could be due to share buybacks, but without further analysis I'd avoid it as it could have trouble paying debt in a recession.

Conclusion

A recession can offer great opportunity if investors are prepared for it. As the ancient roman philosopher, Seneca said, "Luck is what happens when preparation meets opportunity." In the next few days, I will do a deeper dive on the different industries and quick picks above. I would love to hear in the comments section any that companies you think could do well if a recession hit in 2013 or any companies in particular you would like me to look at.

Source: 5 Quick Picks For A 2013 Recession