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Anyone can make money when times are good. However, it is a sign of strength when businesses can thrive during downturns. We do not mean to say that you should look at business that benefit from downturns. Such as collection agents or receivable financing companies. These industries benefit when things are bad but are depressed when conditions are good.
Walmart is a good example of such a business. When times are good, it does decently since everyone needs chap groceries and goods. When times are rough, it does even better. Compare them to the like of the fresh market and other high end groceries and you will see the difference. While the quality of food at the latter supermarket is undoubtedly better, your concern as an investor is the business and its economics.
There are some key factors you can look at when figuring out how recession proof a business is. Look at the number of supplier and customer it has. Companies will disclose this in the induction of their annual 10-k filings. If more than 90% of revenues drive from single customer, this is a very bad sing. Remember, public companies in average sell hundreds of millions of dollars’ worth of product and services per year. If a single customer drive 90% of this revenue, what is going to happen if that customer hits a rough patch?
Similarly, having just one supper is a risky move. In some industries, having a single supplier is a feature, not a bug. However, even in these businesses, mangers typically have backup plans to mitigate the loss of a supplier. This is why the troubles that befell Intel over the past few years have not affected their customers too much. They had backup suppliers ready to go.
Lastly. Leverage is an especially recent feature to consider. Leverage refers to the retro of debt to quality on a company’s balance sheet. In our current low interest rate environments, companies have taken on huge level of debt sing it is cheap. With the Feb indicating that they will be maintaining low interest rats for the foreseeable future, this might lead to management asking things easy and underestimating the risk of overleverage themselves.
The best way to think about leverage is to compare it to an investment you might t routinely make. Let us take the case of a house you buy. If the home is worth 100000 dollars and you borrow 90000 to finance it, you own just 10% of the property. If you rent the property out to pay for the monthly mortgage, this looks like a great decision. However, what happens when you tenant move out and you cannot find someone else? All those mortgage payments will come out of your packet and if you cannot afford to make them, the house gets foreclosed.
This is pretty much what happens to companies as well. The tricky thing with companies is that they need to service debt from revenues. Due to the very nature of the business, revenues will move up and down. It is not as if companies can accurately predict what might happen tomorrow. Look at the number of bankruptcies and layoffs that concurrent due to the pandemic enforce lockdown. This is surefire indicator of how companies have overleveraged themselves to the point that two to three months’ worth of lockdowns topped them into red.
It is a bit like a household not having enough emergency cash to pay for three months’ worth of living expenses, which is extremely risky. As investors, we often pay special attention to the good times but neglect the bad. As intelligent investor always considers risk above reward. Eliminate how you could lose money and you will automatically start making money.
