What should investors look for in a downturn?

2020 has been an odd year for investors. The market’s swings and roundabouts mirrored the sudden fall in business activity around the world.

While we all hope 2021 will be a calmer, more prosperous year, undoing the economic damage caused by the pandemic isn’t going to happen overnight. With that in mind, we think it’s worth understanding different ways to evaluate whether a company is well-prepared for potentially sluggish growth ahead.

Are we in a recession?

Not quite.

Economists define a recession as two consecutive quarters where the value of goods and services bought and sold within a particular economy declines.

Gross Domestic Product (GDP) in the UK declined during the first two quarters of the year, but has seen a marked improvement over the past few months. A second lockdown halted activity in the economy again in the fourth quarter, so full-year GDP is expected to show an 11% decline.

2021 holds the promise of a recovery, albeit a slow one, if the vaccine allows a return to normalcy and the UK’s exit from the EU isn’t too problematic. But the fact remains – as long as the threat of a lockdown exists, so does the threat of another recession.

A recession is the worst-case scenario, but a return to growth won’t offer a magic pill to reinvigorate struggling businesses either. Even if we avoid a double-dip recession, growth in the economy next year is expected to be meagre at best.

Picking the right industry

The simplest way to scan for stocks that could do well in tough times is to zoom out to the wider industry.

Being in a sector prone to outperformance during downturns in the economy can be advantageous, but it doesn’t guarantee success. However, it offers a good starting point for investors worried about another recession in 2021.

Cyclical businesses, or those whose success is directly tied to the ups and downs of the economy, carry a much greater risk when a recession is on the cards. By contrast, discount retailers and value brands tend to see demand remain stable, or even rise, as consumers look for ways to cut back.

Another sector investors could think about is healthcare. People need healthcare to live, so it’s one of the last things they’re likely to cut out in times of financial hardship. Drug makers responsible for generic brands, medical device makers, and biotechs offering specialized treatments can all be good places to look for shelter from an economic decline.

Businesses will look for ways to cut back during a recession, but there are some services they simply can’t afford to skimp on. Cybersecurity falls into that category, especially with remote working at an all-time high, making it another sector that could be worth looking into.

Freight and logistics is another area worth thinking about – while personal travel has been stunted, goods still need to make their way to customers. That’s particularly true in the case of the pandemic, which has accelerated consumers’ shift to online shopping.

Of course, there are no guarantees. All investments and the income they pay can rise and fall in value, so you could get back less than you invest.

Cash is king

Just because a stock comes from an industry that will face recession-related headwinds doesn’t mean you should write it off. In fact, the best prepared businesses can rise to the top of the pack in beaten down sectors.

Cash is the amount of money a business has left over after covering its costs. A lot of cash suggests a business is running efficiently.

Not only does a hefty cash pile mean a business can pay its bills without taking on new debt, but it also opens the door for strategic investments. This means a business has the fire power to capitalise on growth opportunities when the cycle starts to turn again.

We only have to look back to between 2007 and 2010 to see this in action.

The financial crisis brought markets to their knees and companies that were able to acquire struggling rivals at bargain basement prices delivered an average total shareholder return of 10.5%. That’s compared to an average return of 3.3% for those who battened down the hatches to wait out the storm.

Remember though, past performance isn’t a guide to future returns.

How to evaluate cash positions

The first port of call is the quick ratio, which measures a company’s liquid assets, or those which can be converted to cash quickly, against its liabilities.

In short it tells you if a firm can pay its bills without needing extra financing. A quick ratio over 1 suggests the firm has excess cash on hand and could make for a good recession-resistant pick.

Quick Ratio = (Current Assets- Inventory- Prepaid Expenses)/Liabilities

The quick ratio is a snapshot, and a good place to start, but it falls short in some areas and therefore should not be looked at in isolation.

Accounts receivable, for example, are included in a company’s current assets. It’s money the company is waiting to receive from its customers, but hasn’t been paid yet. Those funds depend on customers paying their bills on time and aren’t as dependable in times of economic hardship.

To take it a step further, you could consider free cash flow (FCF), which gives us a more realistic picture of a company’s cash position.

FCF is the cash a firm has on hand after paying for operating expenses, like payroll, as well as capital expenditures, like equipment maintenance.

A company with healthy free cash flows will have the flexibility to invest during a recession and is more likely to deliver more favourable returns to shareholders. And, if dividends have been cut in the wake of difficulties, a company with healthy free cash flows will be able to resume shareholder payments faster than those with weak cashflows.

Remember, no dividend is guaranteed though.

Debt is the enemy

Debt is often seen as the kiss of death during recessions, and it can be. But it’s important to remember that taking on loans to invest in growth is a necessary evil for most businesses. Moderation is key.

Several things influence how much debt a company can, and should, take on – from the industry they’re in, to the size of the firm and how long it’s been operating. The most important thing to remember when it comes to levels of debt is that they’re meaningless unless you view them within the context of peers.

How much is too much?

There are a few different ways to evaluate whether a company’s debt is dragging it down. The first is by comparing a company’s total long-term debt obligations to the value of its assets with the debt to equity ratio. A high debt to equity ratio suggests a company is financing its growth through loans, a risky strategy in tough times.

Short-term debt that’s due to be paid off in a year or less, is considered less risky than long-term debt because it usually costs less to finance. For that reason, evaluating the debt to equity ratio alone isn’t enough to determine whether a stock will be immune to a recession.

A firm saddled with long-term debt will be struggling against a drag on its cash well into the future. That can make it a poor choice for those looking to insulate their portfolios against recession headwinds.

How we pick our 5 shares to watch

What to remember

A decline in the economy doesn’t automatically mean it’s time to dump your shares and run. For those prepared to take a long-term view, now could be the time to identify some potentially more defensive stocks, as part of a balanced portfolio.

This article isn’t personal advice. If you’re not sure if an investment is right for you, you should get advice.

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