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During a recession, the stock market relentlessly punishes growth investors buying long positions in stocks. Since the level of confidence in earnings estimates erodes rapidly and growth rates are hard to predict, stocks across industries correct and continue to decline further over time.

However, there are stocks and sectors that do not succumb to slowing or negative economic growth, and materially outperform the broader stock market. It is important for investors to ferret out such names in order to outperform the market.

There are pockets of stocks that are either counter-cyclical or recession-insulated, and demonstrate low correlation to a downturn in an economic cycle. These companies have a unique target audience, and they serve a compelling and critical need.

Some medical stocks related to drugs, devices, and genetics can perform well in a recession environment. The needs these companies serve cannot be deferred.

Thoratec (THOR) is a good example of such a stock. The company has a heart assisting pump device that is required in the case of congestive heart failure. When the patient suffers from a weak heart, the solution is to use the pump to relieve the burden on the heart. The life-and-death issue prevents the decision from being deferred even in uncertain economic times. Additionally, much of the cost for the device is paid by insurance companies or through Medicare/Medicaid coverage. Now, the device is also being looked at as a destination therapy or a permanent solution, rather than only a temporary relief arrangement till a transplant heart can be found. Thoratec appears insulated from weak economic spending due to its compelling offering for an urgent need.

Federal government spending is vast and quite uncorrelated to economic cycle. In times of economic contraction, the government may be forced to spend more aggressively to stimulate the economy. That is why economists wryly note that when the US economy encounters a downturn, Washington does not have to suffer the same consequence. Homeland security is a sensitive area and one that should not witness any budget cutbacks.

Similarly, spending on equipment for the safety of troops and the fight against terrorism will not encounter a spending curtailment. American Science and Engineering (ASEI) uses its proprietary technology to provide scanning equipment that identifies weapons and explosives, as well as contraband and people hidden in vehicles and containers. Its equipment has critical relevance. To support the troops on the two war-fronts, the equipment can be used to scan for possible explosives loaded in vehicles to target troops. For homeland security, the equipment can be used to prevent illegal trafficking of people and contraband, as well as detect weapons and explosives more effectively than typical X-ray machines at airports and other public transit points. The company meets a critical need, where spending decisions cannot be deferred. Consequently, ASEI appears insulated from an economic recession.

Medicaid is a state-run health program, partially funded by the federal government. During periods of economic stress, unemployment rises and consequently Medicaid spending increases as there is a surge in people seeking Medicaid help. HMS Holdings (HMSY) is a company that assists states in recovering Medicaid payments that should have been paid by third-party insurers. HMS collects a fee on the amount it helps recover, using its proprietary databases and algorithms. The company is expected to recover close to $1 billion for the various states in 2008. As unemployment rises, Medicaid spending increases, and this grows the opportunity for the company. HMS Holdings has a business model that thrives even more when the economy experiences a recession.

All these stocks have outperformed the market by a significant margin during 2008. Investors should note that even in these economically weak times, there are many such stocks that deliver durable revenue and earnings growth, and materially outperform the market. Investors need to focus on companies with unique characteristics which armor their businesses from economic volatility. Growth companies can indeed still be found in a recession.

Disclosure: author holds a long position in THOR, no positions in HMSY or ASEI.

Source: Three Recession-Proof Growth Stocks