How to Find Recession Proof Stocks?

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To prepare the Little Bluey Portfolio for future investment opportunities, and more importantly prevent permanent loss of capital, I have been evaluating the current economic climate, in particular, Australia.

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  • Australia’s Macroeconomic situation.
  • Australia’s Trading Partners & GDP.
  • The Stock Search Process to Identify Recession-proof Stocks.
  • The Companies [Members only].

There is quite a bit of uncertainty surrounding the Australian macro-economic environment.

Rising levels of unemployment, including underemployment, among the general public, is a direct result of the government shutdowns across the nation in response to the Chinese Coivd-19 virus.

Today, the Federal Government released the latest GDP figures came in at 1.4%.

The current Australian Bureau of Statistics (ABS) unemployment figures are 6.2% for April, with the underemployment rate jumping 4.9% from 8.8% to 13.7%

ABS

The current Australian Bureau of Statistics (ABS) unemployment figures are 6.2% for April, with the underemployment rate jumping 4.9% from 8.8% to 13.7%

According to the ABS: Employment decreased 594,300 to 12,418,700 people. Full-time employment decreased 220,500 to 8,656,900 people and part-time employment decreased 373,800 to 3,761,800 people.

If the media pundits are correct and over a million people become unemployed, it would push the unemployment rate over 10%, which has been that high since 1991.

And, according to the Australian Federal Treasury: As of 20 May 2020, 910,055 businesses had enrolled in the JobKeeper program.

Of these, 759,654 had made claims with their eligible employees and had their applications processed. This resulted in $8.7 billion of approved payments to those 759,654 businesses, covering around 2.9 million employees.

We’ll need to wait till 18 June for the ABS to release the May unemployment figures.

Some rays of sunshine are shining through with Seek.com reporting the following:

  • New job ads posted on SEEK during the fortnight ended 24 May are up 39.7% compared to April 2020. This is a further uplift from 26.8% In the previous two weeks.
  • The biggest contributors to job ad growth are Trades & Services, Hospitality & Tourism, Healthcare & Medical, Administration and Office Support and Education & Training. [Good news, as I own People Infrastructure (PPE.ASX) in the Bluey Portfolio, which is primary in the Healthcare & Medical industry]

How Will Our Trading Partners Influence Our Economy?

The Reserve Bank of Australia (RBA) explains how the Terms of Trade affects our economy as Australia is a relatively open, trade-exposed economy. Which means that changes in other countries’ demand for our goods and services can have significant implications for our economy.

For example, an increase in global demand for Australia’s exports, if not matched by an increase in supply, will result in an increase in the price of those exports. The ratio of export prices to import prices is called the terms of trade.

You may remember the mining boom of 2010, where the prices of commodities, used to produce steel and generate energy, saw a significant rise due to global demand for these commodities and with supply unable to keep pace with demand.

China’s response to the global financial crisis was to stimulate its economy through rapid urbanisation and industrialisation, which significantly added to this demand for our commodities.

As a result, pushing up our terms of trade around 75% above the long term average. This significant improvement in our terms of trade had flow-on effects within our economy, with a high demand for labour in the mining industry that increased wages paid to those workers, higher housing prices, larger sources of tax revenues and profits for shareholders.

What is interesting is that the growth in non-mining sectors helped offset the deflation in the mining boom from 2011 to 2016. Assisted with deflation in the Australian dollar from 2013 to 2015.

According to the latest RBA figures.

China won’t be coming to our rescue this time. According to the RBA China statistics, the manufacturing Purchasing Managers Index (PMI) and industrial production have only recovered slightly after falling off a cliff, but fixed-asset investment and real retail sales have not improved. Therefore the demand for commodities from China will be fragile for some time.

The above GDP chart is sobering, with Government contributions to GDP growth the strongest out of all the industries. Our weak Australian dollar seems to be the only thing working in our favour at the moment.

Business confidence can be seen in the levels of investment as a share of nominal GDP.

Additionally, this NAB & RBA chart track business confidence.

From this ABS & RBA chart falling levels of investment equivalent to 1990s levels of investment were occurring before Covid-19 hit. It should be noted that as the Service Industry is Australia’s largest industry, most service companies require much lower levels of investment in fixed assets as compared to asset-heavy industries like mining. It is to be expected to see a downward trend in business investment as a share of nominal GDP.

Lastly, and what concerns me the most is the level of household debt sitting at 187%, according to the RBA’s 9th of April financial snapshot. But the two factors working currently in our favour are low-interest cash rates and the Government’s Jobseeker and Jobkeeper policies.

These two factors are insulating households from debt pain, but for how long?

As I write this, the ABS just released the latest Balance of Payments and International Investment Position update yesterday, with Australia recording a trade surplus of $8.4 billion in the March quarter of 2020.

ABS Chief Economist Bruce Hockman said:

“The impact of COVID-19 was evident across the Balance of Payments this quarter, with falls for imports and exports of both goods and services in volume terms”.

“Goods imports volumes decreased for March quarter across a broad range of consumption and intermediate goods as a result of February’s supply chain disruption in China. A slight rebound was seen in March led by computing equipment due to both the alleviation of some supply constraints and increased work and study from home activity. While the balance of services fell only modestly, the COVID-19 travel restrictions significantly drove down travel services volumes for both imports and exports. Travel services exports was spared further weakness as a substantial number of international students had arrived prior to border closures.

On the financial side, COVID-19 effects drove a surge in activity as investors sold off financial assets and sought liquidity from financial intermediaries. Australia’s financial position remained stable despite this heightened activity, as liabilities were effectively hedged against volatility in the foreign exchange market”.

Here is a link to the ABS Upcoming Announcements page – link.

The only thing I am certain of is that Australia’s 20-something years of GPD growth without a recession is at great risk.

How To Prevent Permanent Loss Of Capital?

How do we position our shareholdings in light of these macroeconomic snapshots to protect our shareholdings from permanent loss of capital, as well as prepare us to seize investment opportunities when the time comes?

What we’ll do is simply separate the industries that fall within the two categories; Discretionary spending from Non-discretionary spending.

This will allow us to identify the defensive companies, companies who thrive during recessions, that we buy to help protect our shareholdings from permanent loss of capital. Woolworths and Coles are two examples.

Discretionary Vs. Non-Discretionary Spending

As a general rule of thumb, non-discretionary spending refers to purchases on necessary essential everyday items, such as rent, mortgage, groceries, and utilities.

Whereas, discretionary spending refers to non-essential purchases contingent upon your lifestyles, such as a new car, luxuries items, and holiday travel.

According to recent news media reports two most of the common items that people who accessed their super for early release were for debt repayments and gambling, but this is from a small sample of just 13,000 people out of 1.75 million people who accessed their super.

Four out the top five items (excluding gambling) are non-discretionary purchases.

  • Credit Lending
  • Supermarkets
  • Discount Department Stores
  • Automotive

And, I would add (am I missing an industry?):

  • Telecommunications
  • Home Improvement
  • Transportation
  • Household & Personal (products).

From this list, we can begin to look for companies within each industry.

The ASX can help us out, as they have this search option to view each company listed in each industry – Link. Screenshots below.

Health Checks

As you look through the companies within each industry, there are some quick and easy checks we can make to assess the health of each company.

For instance:

  • Operating leverage.
  • Debt payments (financial leverage).
  • Free cash flow.

Operating Leverage

“Businesses are subject to operating leverage. Profits equal revenues minus costs (or expenses). Revenues are the result of sales, and we know that sales fluctuate for a large number of reasons. So do costs, and different kinds of costs fluctuate in different ways, particularly in response to changes in sales. Most businesses have some costs that are fixed, some are semi-fixed, and some that are variable.”

Howard Marks, Mastering the Market Cycle.

Within in Step 3 – Evaluating the Asset Value, we have used financial ratios to evaluate the efficiency and profitability of the companies, such as Woolworths.

For example, here is a screenshot of Woolworths financial ratios.

One financial ratio, in particular, is the operating margin, which measures how much profit a company makes on a dollar of sales, after paying for variable costs of production, such as wages and raw materials, but before paying interest or tax.

You can see that Woolworths makes 29 cents on every dollar of sales revenue, which will remain stable over the years as Woolworths falls in the non-discretionary category.

You will see quite a bit of inconsistency from year to year, in the operating margins of discretionary businesses as they tend to more reliant on the economy growing.

Financial Leverage

A company financed by equity, and no debt, will see its net income fall by 20% if its operating profit fell 20%

But where a company is financed by both debt and equity, it will see its net income fall further than its operating profit. This is due to interest payments eating into the operating profits.

For example, Woolworths owed interest to the tune of $174 million on the $2.85 billion in debt (only 28% of equity), in 2019 (Annual Report).

And, in 2019 Woolworths had $2.35 billion in operating profits, and after interest payments earned $2.22 billion ($126 million was deducted as interest payments, see note 2.3).

If operating profit fell 20% to $1.88 billion, then earnings after interest payments fall by 21.24%.

A company with debt to equity less than 30% is preferred.

Free Cash Flow

I believe free cash flow is the most crucial metric to measure the health and profitability of a company. No matter what economic cycle we find ourselves in, cash flow is king.

It involves looking at the statement of cash flows.

Free cash flow equals net operating cash flows minus capital expenditures.

From the screenshot below, Woolworths produced $957 million in free cash flow, and in 2018 produced $1.146 billion in free cash flow.

In Summary

You will find these defensive companies segregated into their respective industries under the tab called Investment Opportunites, found on the right-hand panel [within the Blueprint].

No matter during the economic cycle, you should be looking to protect your investments from permanent loss of capital, as it is easy to get carried away with the crowd when times are good, such as when there is a stock market boom. This is the most dangerous time to invest as investment standards fall to justify purchases of high flying stocks, as we saw during 2007 and in 1999.

You’re invited to join Australia’s fastest-growing community of investors – 0 to 4700+ within 4 months! – by joining the Share Investors Blueprint – Click here.

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Yours in investing,

Adam C. Parris

Article by Searching For Value