Looming Recession Will Trigger Economic Darwinism

by: Henry Miles

Many economists and institutional investors believe the world is soon to enter a recession with all its implications for corporate survivalists.

Some companies will think beyond declining organic revenues and pursue acquisitions; most businesses will reduce staff and slash overhead.

Investors should consider how to benefit from M&A while focusing on product and service providers that can deliver immediate cost take-out.

It's impossible to log on to a financial website these days without seeing an article about the coming recession. Here's one on Reuters reporting the views of Greg Jensen, co-Chief Investment Officer at Bridgewater. As for U.S. business economists, here are their predictions for 2020. Concerns are also welling up in Germany. And, here's a final link to an article registering the opinions of 500 CFOs, not quite half of them from North America.

These predictions are not without foundation. Quantitative tightening, trade and tariff wars, corporate bond devaluations, a partially inverted yield curve, and carnage in the stock market may foretell, if not have triggered, a coming decline in GDP. For those wanting more information about leading indicators of recession, I commend to you these excellent SA articles, the first contributed by Atle Willems in 2016 and the second written just recently by new SA contributor, Benjamin Solomon.

With some education and background in these forces, last February, I became wary and rotated 25% of our equities into purchased money funds comprised of T-bill, repos, and other short-maturity, high-grade instruments. At the same time, I wrote an SA article about my thinking. Along about midsummer, I increased our money market allocation to 33%. Given the tremors of Q4, this turned out relatively well. Although we're down - who isn't with equity holdings - our 3-month and 1-year total returns have beaten the overall market by a like percentage. Moreover, we have powder dry for reinvestment.

Recession will set in motion a round of Economic Darwinism - (thrive), survive, or die.

Businesses that are unable to adapt will be acquired or "introduced" to the Bankruptcy Code. As this no-frills report by the Skadden Arps law firm shows, Chapter 11 filings tripled between 2006 and 2009.

Banks offer an especially good mirror on recessions because they do business with the economy at large and their higher financial leverage refracts challenges that their clients face. Recessions have always contributed to consolidation in the financial services industry as we see in this Wiki list of banks that disappeared during the Great Recession, 2007 through 2012. Closer up, we've seen it in JPMorgan Chase (JPM) that was partially assembled from the failures such as Chemical Bank, Washington Mutual, and Bear Sterns. We've also seen it in Bank of America (BAC) that became more dominant through its acquisitions of troubled organizations such as Security Pacific and Merrill Lynch.

M&A as an Option

I'm a long investor who has generally lost interest in financial services. However, I am drawn to agribusiness that is in their very own recession brought about by over-supply evidenced by the cyclical weakness in commodity prices. At a micro-level, an opportunity may be coming into view for an in-market acquisition of Bunge (BG). Why; because:

  • Activist investors recently forced the addition of new board members and a change-out in company's CEO.
  • New management may reengage with Archer Daniels Midland (ADM) and/or Glencore (OTCPK:GLNCY) both of whom approached Bunge about a year ago.
  • Trade and tariff disputes may motivate China to stabilize their crop-based supply chain in the U.S.

This brings me to COFCO, China's national "Cereals, Oils, and Foodstuffs Corporation". Under-reported in the last few weeks, COFCO recently joined the "GrainBridge" blockchain. This is significant because in modernizing intercompany administration, operations, and logistics, COFCO is aligning with the "ABCD's" - ADM, Bunge, Cargill (private), and Louis Dreyfus (private) - that essentially control the soft commodity business worldwide.

Even though COFCO is believed to be #4 in revenues of that group - ahead of only Dreyfus - were they to acquire and merge with Bunge, the combination would put them in second place still behind Cargill but ahead of ADM. This would not only go a long way toward solving China's supply chain problems, but it would position the country in the crop-based trade oligopoly. Whether with COFCO, ADM, or Glencore, many eyes are on Bunge; we're long, as we are ADM and GLNCY.

The coming recession could also spur M&A activity in the fossil fuel business especially among major integrated oil companies that are looking to expand into renewable energy. Sunday's full one-hour of "Meet the Press" that was devoted to climate change/global warming may spur more business leaders into action. In wind, for example, I'm personally bullish on Siemens (OTCPK:SIEGY) with their majority interest in Siemens Gamesa (OTCPK:GCTAY). We also have a position in Orsted Energy (OTCPK:DNNGY) that is coming on strong in wind and, like Siemens, has staying power. Because of their size, Siemens and Orsted are not acquisition targets. However, Vestas (OTCPK:VWDRY) may be a different story. As recently as 2015, it was #1 in wind and thought to be untouchable. But the company has slipped into second place and may start drawing the interest of suitors, especially an oil major. The same may be said for solar. Could a company like First Solar (FSLR) come into play? Either way, I'm a happy hold.

The point here is not to simply zoom in on two industries/sectors that may see M&A activity as a result of recessions in progress or on the horizon. Rather, it is to suggest that investors look closely at the areas that interest them and attempt to gauge which companies will benefit from the recession whether as acquirers or acquirees.

Over the years, I was in the middle of several well-conceived and implemented acquisitions and mergers in the financial services industry. Including during a recession, through M&A we drove productivity by eliminating redundancy and substituting relatively expensive labor with relatively inexpensive technology. We followed well-scripted and coordinated project plans that had us converting acquirees on to our systems within a few months before taking out costs. Our pursuit of operating leverage was relentless and the uplift to shareholder value was substantial. Two sizable M&A integrations doubled our stock price and then doubled it again. The approach worked, for us.

Productivity is a Must

Whether or not through M&A, during recessions almost every corporation throws more emphasis on productivity being a ratio of output over input - revenues to expenses, etc. During hard times, companies usually focus on the denominator because it's easier to control. Cost savings measures come in various forms but most notably as layoffs or reduction-in-force, "RIF", programs. This report by the Bureau of Labor Statistics graphs unemployment rates across 10 recessions that occurred between 1948 and 2011.

Fast payback is the key to productivity in times of trouble.

Companies can't afford to wait for a return on some labor-saving investment. Here, heading into recession, blockchain and robotics/AI may command even more attention for their cost savings potential and because a lot of upfront R&D has been completed and systems are nearly ready for prime time. For the record, I have no interest in blockchain with respect to cryptocurrencies that I consider to be bogus. No, I'm thinking about the GrainBridge, FoodTrust, TradeLens, TradeFinance, ADNOC, and CLS blockchains and their potential to offer quick and substantial payback through the reduction of operations costs and administrative overhead. Consortium members should benefit but two major companies facilitating blockchain processing may benefit even more - IBM (IBM) and Accenture (ACN), both of which we own.

And consider this - robotics/AI can be integrated with blockchain to optimize flow, remove barriers and bottlenecks, and identify best-practice counterparties and processes. It doesn't require much more than an open mind to understand how powerful such combinations could be in improving time-to-market and quality while lowering expenses - demurrage, spoilage, shrinkage, overhead, and so forth.

It is impossible to overestimate the impact that the broad range of robotics/AI technologies will have in the coming years including in the delivery of productivity. For example, lest anyone dismiss as a pipedream the notion of driverless vehicles, check out these links about the goings-on with buses, trucks, ships, and trains. While the need for fewer drivers is not good for employment, it may be very welcome for delivery and transportation companies. We are still committed to ABB (ABB) and Nvidia (NVDA). In addition, with cash available, last week I bought the downdraft and added Google/Waymo (GOOG) (GOOGL) to our holdings. I'm feeling that demand for self-driving commercial transport may begin to arc in 2019.

Recessions Happen

As hard as one searches the annals of economic history, nowhere will one find agreement on the underlying causes of recessions. Triggers vary event to event even though the basic remedies to recession are generally agreed - monetary and/or fiscal stimulus coupled with curbs on speculation. Unfortunately, we seem to have run out the string on all these cures. If we are on the brink of a recession - and I suspect that we are - there is good news:

As with natural selection, times of stress have a way of culling the weak while creating space for the strong.

If investors are wise in how they prepare for and respond to recession, they are likely to exit the other end better than they entered. Even if you don't believe that recession is around the corner, the exercise of applying a worst-case economic scenario to your investments is worthwhile. And, oh, by the way, if you're panicky, there are always fear-trade investments.

Disclosure: I am/we are long ABB, ACN, ADM, BG, DNNGY, FSLR, GLNCY, GOOGL, IBM, NVDA, SIEGY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Always do your own due diligence in consultation with a licensed and competent financial adviser who understands your unique needs and puts your interests ahead of their own. Remember, there are added considerations in owning foreign securities including those associated with ADR sponsorship, buying and selling the pinks, foreign withholding taxes on dividends, and fees. (All my proceeds from contributing to SA go to charity.)