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5 steps to successful recession investing

Knowing we're in for a recession is one thing. Choosing which stocks to buy is another. This 5-step checklist will help you sort through the potential opportunities.Value investors don't change their spots just because a recession is on the way. It's...

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5 steps to successful recession investing

Posted: 03 Jun 2009 - 15:59 pm - [view: 3541]

Knowing we're in for a recession is one thing. Choosing which stocks to buy is another. This 5-step checklist will help you sort through the potential opportunities.

Value investors don't change their spots just because a recession is on the way. It's always about assessing value and ensuring you're receiving it in spades. But if assessing value ultimately comes down to working out how much free cash a business will generate between now and Judgement Day, it's important to know if Judgement Day might arrive early, with that debt repayment due next quarter.

Here are five questions to ask of a potential opportunity in the face of a likely recession.

Step 1: Will the business survive?

It may be a simple question, but it often won't have a simple answer. The starting point here is to consider whether the company's sales will be affected and, if so, by how much. Next you need to consider the nature of the cost base: falling sales with variable costs is one thing, but falling sales and fixed costs, quite another.

Profit margins can disappear quickly in the latter case, so the next step is to check how big they are to start with. Would the company still be profitable with sales at a much lower level?

In the current capital drought, it's important to know whether a business generates ample cash or whether it will need more capital to survive.

Management experience will also make a difference. The ideal management team will have prospered in the face of previous downturns. And the incentives will be in place for them to hang around through this period.

Step 2: Will the capital structure survive?

It's blatantly obvious that Melbourne's prestigious 530 Collins Street is going to survive as a business. The vast majority of tenants will keep paying their rent and the operating costs are minimal. But its owner, GPT Group, has a more precarious future. That's because the business is burdened with a mountain of debt and it's having to raise more money from security holders at punitively low security prices, thereby transferring value from the previous providers of capital to the new.

It's important to assess whether a company's capital structure will stand up to tougher conditions. If it doesn't have the resilience to withstand the next few years, then the underlying business's strength might prove irrelevant.

Step 3: Can it strengthen its competitive position?

After those two negative questions, the third is more positive: after surviving the downturn, will the company prosper come the inevitable upturn?

With the notable exception of insolvency practitioners, few businesses will actually increase their profitability during a recession. But some can set themselves up for substantially more profit once the recession ends.

Recessions make the strong stronger and the weak disappear. Ask yourself how a company's market share, competitive position and financial strength line up against its competitors. Are these factors likely to improve, or weaken, over the course of a recession?

Step 4: Will the business produce, on average, an acceptable return on its capital over the economic cycle?

Just as a mediocre business's wonderful earnings at the top of the economic cycle can fool you into thinking it's a wonderful business, a lack of earnings in a recession can blind you to a good business's potential.

Forget about this year's earnings and focus on what the business might earn in an average year. You still need to assess the business's quality but, when adjusting for the effects of a recession, a useful approach is to analyse the company's return on capital over a long period of time -10 years or more, if possible.

You can then apply an average to its current capital base to arrive at a proxy for a sustainable level of earnings - a good business should earn in excess of 12% on its capital, a mediocre one around 8-12%, and any business earning much less than 8% on its capital is a poor one.

Be aware, though, that this method uses past results to predict the future, and so is only useful for comparatively stable businesses. Also, many modern businesses don't need much capital (Seek for example), which makes an analysis of return on capital misleading or irrelevant. But you still want to know what the business might earn over the coming decade, and the past can be revealing.

In practice, though, you can never be sure how much money a company will make, so rough numbers and a fat margin of safety are likely to provide the best results.

Step 5: Can you buy it at an attractive price?

Once you're comfortable that the business will survive - and preferably strengthen its position - during the recession, that current owners will get the economic benefit of the next upswing, and that you have a feel for a sustainable level of earnings, then it's time to determine an appropriate price.

This is obviously a very big question. For our purposes, though, suffice it to say that this is no time to be paying fancy prices. We'd suggest paying no more than five times average earnings for a mediocre business, especially when some of the best are trading at around 10 times earnings.

This is a genuine bear market, and in genuine bear markets you get the chance to buy some genuine bargains.

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