Recession Proof - Searching for Evidence

Sep. 16, 2008 10:44 AM ETXLP, IDU1 Comment
Brad Ferris profile picture
Brad Ferris
59 Followers

Recession proof…what is it?

There’s been abundant discussion of late in the business media, among investors and in economic circles about the probability/inevitability of a US recession, its global effects and how to best position an investment portfolio against those risks.

A recession, by definition, is two consecutive quarters of negative GDP growth in an economy. But recessions, by this definition, have grown increasingly scarce in recent years as economies instead have felt the effects of an economic slowdown in activity due in some part to the effect of globalization. Currently we’re witnessing an increase in the jobless rate among western economies, a drastic increase to energy prices and inflation concerns appearing publicly on the minds of consumers and Central Banks around the world.

But there’s a group of individuals who continue to use the term “Recession Proof” without truly examining the criteria of what makes something invincible to a slowdown in business and consumer demand. There are certainly recession proof occupations, but what about services, products or businesses?

In The Foster Effect I dismissed the term recession proof in favour of something I define as distinctly different: recession resistant. Recession proof leads an investor to believe that an investment is immune to economic factors or risk-free. In truth very few (if any) businesses today are positioned to continue operating and growing their businesses as well or better in a period of retraction than in any period of growth. A company can position itself to maximize opportunity and minimize risk, but at the end of the day it is providing a good or service that can be replaced with something else or nothing at all.

In periods of growth there are abundant excesses and in periods of retraction those excesses are used up or abandoned completely depending entirely on demand. If such a business did exist, its competitive advantage would not only be sustainable but rather have a moat encircling its operations as large as an ocean.

Recession resistant in my view is a much better term to use when examining an investment that does not immediately appear to be economically sensitive. There will be exceptions, but for the most part, resistant should be the term used.

Let’s look at the following industries that are often categorized as “Recession Proof” and examine them with a qualitative perspective of an individual consumer or business:

Consumer Staples:

Investments in consumer staples are a very popular strategy in times of economic uncertainty by a large number of investors. Consumer staples are viewed as frequently purchased products that are used on a daily basis and not something many can easily go without. These include items such as food, personal hygiene products, household cleaning products or diapers.

The problem with labelling a consumer products company as recession proof is that they’re still economically sensitive due in part to how their products and pricing are structured. Remember my series on The Importance of Brands and how many of today’s leading consumer products companies manufacture and sell both their own individual label brands and generic versions for wholesale or discount retailers. The difference in the profit margins between a premium and generic brand at times can be in excess of 50% or more. When consumers are placed in an economically sensitive environment, price can play a very tangible role in their choice between a premium and generic brand when the cost-benefit analysis in their eyes is equal.

Assume for a moment that a company sells premium/generic brands during a normal economic period in a ratio of 75/25. What happens during a period of slower consumption if that ratio shifts down to 60/40? For a company with annual sales in the billions the impact to their bottom line could be in the millions of dollars. Often management balances this shift by cost cutting initiatives in anticipation of changes in demand and some price increases can help, but if corporate leaders are behind the ball it can take a number of quarters to catch up to the trend and re-align their operations to current demand.

Funeral Homes:

This is an area where many investors proudly advocate that they’ve found a truly recession proof investment. People live, people die and when they die they like to go out in style. The issue with an investment in the memorialisation products, mortuary or funeral business is that these products and services are still dependent on consumer demand and available finances. While some individuals have the foresight to secure life insurance, pre-pay for plots or set aside funds for their planned departure; many others leave the financial burden to their families and not everyone can afford what they might like in both good times or bad.

While alternate services might still not be relatively cheap, there are options such as cremation, less expensive caskets or flat vs. elevated headstones to keep costs realistic. Families can elect for a smaller funeral service, spend less on flowers, transportation or other higher margin, less necessary services for the funeral homes.

Utilities:

An investor should first recognize that many utilities operate within a regulatory environment that involves significant political influences and controls over what rates they are able to charge residential and commercial customers. As anyone with a teenager in their home knows all too well, trying to cut your household utilities costs such as water, electricity, or heat gets you termed as a cheap parent and it’s something than many of us do even without children. This is a direct result of our attempt to control costs in the household that might otherwise result in higher monthly bills as money tightens.

In an environment of economic sensitivity there are a higher number of issues that come up for utility companies: an increase in the number of late payments or cancellations among customers, rate reviews lengthened by regulatory boards, and pricing is exposed to higher levels of scepticism by those regulatory committees that are filled with politicians intent on protecting the cost to consumers. This can lead to higher project cost deferrals or absorption on project developments that otherwise would continue if/when rates are increased.

Telecoms:

While the bulk of revenues for these companies continue to come from regular subscriptions of landlines, mobile and cable products; fees play a large part in the profitability of pricing models telecommunication companies design and utilize. Maintenance fees, call display, messaging features and airtime incentives are all components of pricing. While a current subscriber may be stuck paying those fees until the end of the contract, new customers or those changing to new plans may elect to defer non-essential services for a period of time until their discretionary spending is in appropriate order.

The high cost of infrastructure to drive per unit costs down continues to be a heavy burden for many companies to overcome. The increasing competitive pressures on margins, consumer/business hesitation for limited data plans and a high number of non-essential features/accessories might also have an effect on profit growth in a measurable way during a slower economic period.

Dividends:

When you compare the recent increases of dividends, or absence of dividends, among these groups of stocks, the dividend achievers are becoming easily distinguishable from the dividend believers. Companies with a history of consistent moderate dividend growth and strong management continue to position themselves for new economic challenges and investor expectations for conservative growth. Their competitors on the other hand who have raised their dividend and payout substantially over the past few years during a prolonged growth phase are now encountering a more challenging environment and are electing to instead protect their current payouts and indicate indirectly to the market that profit growth might stall or retreat.

While many of the companies in these industries continue to profit and grow from the need by consumers and businesses for their products or services, none are completely immune to relative changes in demand based on the economic climate and sensitivity of consumers. Some of these companies will continue to perform well while others struggle. An investor should be aware of the risks in grouping a category or sector of stocks as recession proof and instead view those investments as recession resistant depending on their level of economic sensitivity.

Those select companies that have weathered the storm before might do well again with similar performance, but an investor shouldn’t make the mistake of assuming that a product or service is invincible or impervious to changes in demand or behaviour.

This article was written by

Brad Ferris profile picture
59 Followers
Brad Ferris is the author of Triage Investment Blog and President of Triage Capital Management Incorporated.He is 30, lives in London Ontario Canada and holds a Graduate Diploma in Business Administration Marketing as well as a Bachelor’s of Science in Nursing. Brad is also a practicing Registered Nurse.Brad has been investing independently over the past thirteen years and has developed a truly unique perspective on equity markets, security analysis and fundamentals of portfolio construction that combine his education, personal and professional experiences into a productive and successful approach. His ability to critically assess companies can be seen both in his writing and professional experiences where he applies his knowledge for the benefit of his readers and clients.

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