Safe-Haven Stocks: Finding Firms that Flourish During Recessions

Methodologies for Harnessing Cyclical Sensitivity

Source: MidJourney, "The Business Cycle Around the World"

As the COVID-19 pandemic forced economies into lockdown in 2020, traditional educational institutions struggled to adapt. However, an online education platform experienced an unprecedented surge in demand. With people seeking to upskill during the downtime, this platform saw exponential growth and the single greatest QoQ increase in sales of the last few years.

Owning recession-proof businesses, or even better, businesses that thrive during crises or recessions, could save you from many headaches. Now, how do you identify these companies? What characteristics do they have? In this article, I’ll share an approach to do exactly that and my investment checklist at the end. Let's go.

Classifying Companies by Cycle Sensitivity

To begin, let's see how companies can be classified based on the economic cycle. Generally, companies are grouped into three categories:

-Cyclical: companies or industries are very sensitive to economic cycles. This means they tend to perform well when the economy is booming and perform poorly during recessions.

-Countercyclical: These go in exactly the opposite direction, they do very well during recessions. 

-Recession resistant: companies that are not directly affected by recessions, their profits are relatively stable throughout the economic cycle.

Below there’s an incomplete list of different industries grouped according to their exposure to the economic cycle.

---

Cyclical

1. Travel and tourism: people tend to travel more when they feel financially secure, making this industry very cyclical.

2. Mining and resources: these industries see swings in line with global economic conditions and raw material prices.

3. Hospitality and leisure: this includes hotels, restaurants and entertainment venues, which tend to see greater activity during good economic times.

4. Manufacturing: demand for manufactured goods can decline during economic downturns as businesses and consumers reduce spending.

5. Construction industry: construction, especially residential, tends to be cyclical because it is linked to interest rates and consumer confidence.

6. Advertising and marketing: companies tend to spend more on advertising during good economic times and less during recessions.

7. Luxury goods: when consumers have more disposable income, they are more likely to splurge on luxury goods. There's some nuance here, as extreme luxury brand may not be affected by recessions.

8. Oil and gas Industry: energy demand increases during economic expansions and decreases during contractions.

9. Retail industry: non-essential retail often rises and falls with the economy as people have more or less disposable income to spend on goods.

10. Airline industry: similar to travel and tourism, the airline industry is directly affected by the health of the economy.

11. Consumer electronics: people typically put off purchasing new electronic devices during economic downturns, making this a cyclical industry.

12. Automotive industry: sales of new cars tend to increase during economic booms and decrease during recessions.

Countercyclical

1. Online education: economic downturns often drive individuals to seek affordable, flexible learning opportunities to enhance their skill sets or pivot careers.

2. Education industry: viewed as a fundamental necessity, educational demand may rise during economic slumps as people invest in personal development or career transitions.

3. Subprime loan industry: recessions can force individuals to seek alternative financing options, leading them to higher-interest lenders when conventional credit becomes inaccessible.

4. Discount stores and large-scale stores: economic hardships typically push consumers towards budget-friendly retailers, prioritizing essential purchases and seeking cost-effective alternatives for everyday items.

Recession Resistant

1. Food and beverage industry: people always need to eat, no matter what the economy is doing.

2. Healthcare industry: people continue to need medical care and medications, regardless of the economic situation.

3. Public services (energy, water, gas): people always need these basic services, regardless of the economy.

4. Consumer staples industry: this includes goods like toilet paper, toothpaste, and soap that people buy regardless of the economy.

5. Funeral services: although it may seem bleak, the need for funeral services is constant.

6. Telecommunications: the need for telecommunications services such as internet and mobile phones is constant.

7. Security industry: regardless of the economy, businesses and individuals still need to protect their property.

8. Alcohol and tobacco industry: although it may vary depending on the region and local laws, demand for these products often remains stable regardless of the economy.

---

Back in Time: Evaluating Company Performance During Economic Slumps

Okay, if you know the industry to which the company belongs, you should already have a good grasp of its cyclicality. But let's dig deeper.

How did the company responded to past recessions? For this, you can do a qualitative analysis or a quantitative analysis. Both are valuable. 

For quantitative analysis, you can examine:

• Fluctuations in sales during recession years.

• Fluctuations in operating profits during recession years.

• Fluctuations in net profits during recession years.

For qualitative analysis, it would be ideal to have access to annual reports and quarterly call transcripts. In this case, you could examine:

• The MD&A (Management Discussion and Analysis) section of the 10-K, if in the United States, or annual reports in other countries, especially during recession years, to understand what the management team was saying about the company situation.

• Transcripts of quarterly calls, especially during recession years, to try to find questions from analysts related to how the company is doing during the economic slump.

• News articles about the company during recession years to see if they mention how they are affecting the company's sales.

It is important to keep in mind that if a company did well during past recessions it does not mean that it will do well in a future recession. To understand if there has been a change in the situation, review the following:

• The product mix that the company had during the last recession and compare it with the current mix, to try to predict if it will behave in the same way.

• The demand and supply situation of the industry during the last recession. It may be that a company came out of a previous recession well only because there was excess demand and restricted supply. It must be verified that these conditions remain the same in the industry.

The Cycle and the Company’s Clients

So far, you know which industry the company belongs to and its general sensitivity to the cycle. You also know how the company reacted to past recessions and have assessed if the situation has changed. Now let’s take a look a the company’s clients.

There are 3 things you can look at: 

• Percentage of recurring sales secured with contracts: the higher this percentage, the greater the company's independence from the economic cycle.

• Percentage of the end customer's budget allocated to the company's products: If this percentage is very low, it is likely that purchases from the company will not be affected during periods of low economic activity.

• Percentage of clients exposed to the economic cycle: The higher this percentage, the greater the company's exposure to the economic cycle. A clear example is suppliers to the automotive industry, which are exposed to the economic cycle in the same way as automobile manufacturers.

Cost Structures and Profit: Operating Leverage in Times of Crisis

Operating leverage determines how changes in sales affect a company's profits. For some companies, a small drop in sales may not significantly impact profits. However, for others, a similar decline in sales may pose a survival issue.

Operating leverage is higher in companies that have a greater ratio of fixed costs relative to variable costs. This means that a small change in sales can have a significant impact on operating profits.

The equation to calculate operating leverage is:

\(Operating Leverage= Contribution Margin / Operating Profit (EBIT) ​ \)

Therefore, a company with a high degree of operating leverage has a higher proportion of fixed costs and can therefore generate higher profits with increases in sales. 

However, this also means that if sales fall, losses may be greater as fixed costs will remain the same. As a result, companies with a high degree of operating leverage typically have higher risk.

So how risky are cyclical companies with high operational leverage and high financial leverage? Let’s see.

The Double Risk of Highly Leveraged Cyclical Companies

If a company has a lot of operating leverage in addition to debt, this can create a situation where the combination of risks grows exponentially.

In such a company, a minimal drop in sales could lead to a significant decrease in profits, which could affect its ability to pay interest on debt, potentially leading to bankruptcy if it cannot meet these obligations.

To have a clear idea of the risk in these companies, it is important to know what the break-even point is in terms of sales level.

Assessing the Break-Even Point of a Company

What is the break-even level in sales for a company? It is basically the level of sales necessary to cover both fixed costs and variable costs.

While the concept of break-even point is deceptively simple, its real-world application in financial analysis demands a more nuanced approach. The conventional wisdom that equates fixed costs with immutability often falls short in capturing the dynamic nature of business operations. Consider the following:

1. Asset Flexibility: Capital equipment, often categorized as a fixed cost, can be liquidated or repurposed, altering the cost structure.

2. Human Capital Dynamics: Staffing levels, typically viewed as a fixed expense, can be adjusted through strategic workforce management.

3. Real Estate Adaptability: Lease agreements, another presumed fixed cost, may be subject to renegotiation or early termination clauses.Because of all this, you would have to calculate a range for level of fixed costs, and based on that, determine break-even sales level.

How can you have an idea on where the fixed costs are for a given company?

1) Check the Balance

The first thing you can check is the percentage of fixed assets in relation to total assets. If this percentage is very high, it is likely that the company also has a high fixed cost structure. 

Conversely, if the percentage of fixed assets relative to total assets is low, the company's cost structure is likely to be more flexible.

What is considered low and what is considered high? Generally, a percentage below 20% could be considered low, while a percentage above 60% could be considered high.

2) Review the Income Statement

Definitely, the most important thing is to review the income statement, where you can directly observe the costs the company is incurring and how fixed they may be.

Here again, we could observe what the management team says in relation to the cost structure in the MD&A section of the 10-K or the annual reports.

Some basic rules of thumb to remember: 

• If the workforce is unionized, this is likely a significant fixed cost. 

• Most fixed costs are included within SG&A, "Selling, General and Administrative Expenses". These expenses include all costs not directly linked to the production of a good or service.

• Any expense that includes long-term contracts can be considered a fixed cost. 

Always use your judgment and try to assess if a given cost is absolutely necessary for running the business and cannot be done without.

Conclusion

Finding companies that can capitalize on crisis opportunities is not easy but thinking hard about the business and applying the framework shared above can go a long way.

Founded in 2012, Coursera had already been steadily growing, but the pandemic accelerated its growth trajectory dramatically. During the pandemic's peak, Coursera reported a 640% increase in enrollments. The demand for online learning soared as individuals sought to make productive use of their time at home and improve their employment prospects in an uncertain job market.

Now, you can perform a deeper analysis of a company's resilience to economic fluctuations, which can be especially useful when seeking stability in your investments. As always, I share my investment checklist for this topic below.

Investment Checklist

• Does the company belong to any of these typically cyclical industries?

  •  Automotive Industry: Sales of new cars tend to increase during economic booms and decrease during recessions.    

  •  Construction Industry: Construction, especially residential, tends to be cyclical because it is linked to interest rates and consumer confidence.

  • Retail Industry: Non-essential retail often rises and falls with the economy as people have more or less disposable income to spend on goods.

  • Travel and Tourism: People tend to travel more when they feel financially secure, making this industry very cyclical.

  •  Real Estate: The buying and selling of homes and other real estate often rises and falls with the economy.

  • Luxury Goods: When consumers have more disposable income, they are more likely to splurge on luxury goods.

  •  Manufacturing: Demand for manufactured goods can decline during economic downturns as businesses and consumers reduce spending.

  • Airline Industry: Similar to travel and tourism, the airline industry is directly affected by the health of the economy.

  • Hospitality and Leisure: This includes hotels, restaurants and entertainment venues, which tend to see greater patronage during good economic times.

  • Consumer Electronics: People often put off purchasing new electronic devices during economic downturns, making this a cyclical industry.

  • Mining and Resources: These industries often see swings in line with global economic conditions and commodity prices.

  • Financial Services: This industry, especially lending and investment services, tends to be cyclical. During a booming economy, more individuals and businesses seek loans and make investments.

  • Oil and Gas Industry: Energy demand often increases during economic expansions and decreases during contractions.

  •  Furniture Industry: Furniture sales often rise and fall with the real estate market and the economy.

  • Advertising and Marketing: Companies tend to spend more on advertising during good economic times and less during recessions.

• Does the company belong to any of these typically countercyclical industries?

  • Discount Stores and Large-Scale Stores: In times of economic difficulty, consumers often cut back on non-essential expenses and look for more consumer goods at low prices.

  • Education Industry: Education is considered a basic need, and demand can even increase during recessions if people decide to improve their skills or change careers.

  • Online education: During a recession, many people choose to acquire new skills or training, and online education can offer an affordable and flexible option.

• Is the company in any of these typically recession-resistant industries?

  • Food and Beverage Industry: People always need to eat, no matter what the economy is doing.

  • Healthcare Industry: People continue to need medical care and medications, regardless of the economic situation.

  • Public Services (Energy, Water, Gas): People always need these basic services, regardless of the economy.

  • Consumer Staples Industry: This includes goods like toilet paper, toothpaste, and soap that people buy regardless of the economy.

  • Funeral Services: Although it may seem bleak, the need for funeral services is constant.

  • Telecommunications: In the modern era, the need for telecommunications services such as internet and mobile phones is constant.

  • Security Industry: Regardless of the economy, businesses and individuals still need to protect their property.

  • Alcohol and Tobacco Industry: Although it may vary depending on the region and local laws, demand for these products often remains stable regardless of the economy.

• Analysis of the company's history: Research how the company has handled past economic downturns. How were your sales, operating profits and net profits affected in the recession years?

• Income diversification: Where does the company's income come from? If you rely heavily on a single product, service, customer or market, you may be more susceptible to economic cycles.

• Elasticity of demand for the product/service: The demand for some products and services is inelastic, meaning that it does not vary much with changes in the business cycle. However, companies that offer "luxury" or non-essential goods or services can see a large decline in demand during recessions.

• Positioning in the value chain: Companies that are closer to the end consumer (for example, retailers) may be more affected by economic cycles than those that are further away (for example, raw materials companies).

• Company Report Research: Read the Management Discussion and Analysis (MD&A) section of the company's annual reports and quarterly call transcripts, especially during recession years.

• Product mix analysis: Has the company changed its product mix since the last recession? If so, how might that affect your performance in a future recession?

• Evaluation of demand and supply conditions of the industry: Consider industry conditions during the last recession and whether those conditions still exist.

• Analysis of recurring sales: What is the percentage of recurring sales secured with company contracts? If this percentage is high, the company could have a greater degree of independence from the economic cycle.

• Consideration of the client's budget: What percentage of the end customer's budget is allocated to the company's products? If this percentage is low, it is likely that purchases from the company will not be as affected in times of recession.

• Assessment of clients' exposure to the economic cycle: If a high proportion of the company's customers are also exposed to the economic cycle, as is the case with suppliers to the automotive industry, the company could have greater exposure.

• Examine the level of operating leverage: Analyze the operating leverage formula and calculate the company's level. A company with a high degree of operating leverage may have higher risk, but also higher potential returns. 

• Determine the break-even sales level: Know the company's breakeven sales level, which is the level necessary to cover both fixed and variable costs. This will give you an idea of ​​how much the company's sales can fall before it starts incurring losses.

• Evaluate fixed assets: Analyzes the percentage of fixed assets over the company's total assets. A company with a high percentage of fixed assets may have a more rigid cost structure, which can make it more vulnerable in tough economic times.

• Debt management: How does the company manage its debt? A company with a high level of debt may have difficulty surviving an economic downturn.

• Cash reserves: Companies with strong cash reserves may be able to better withstand periods of economic downturn.

• Relationship with suppliers: If a company has a strong and stable relationship with its suppliers, this could help mitigate some of the negative effects of economic cycles.

Sources

• Marks, H. (2021). Mastering the market cycle: Getting the odds on your side. Houghton Mifflin Harcourt.

• Schumpeter, J. A. (1939). Business cycles: A theoretical, historical, and statistical analysis of the capitalist process. McGraw-Hill.

• Shearn, M. (2011). The Investment Checklist: The Art of In-Depth Research.