Is your portfolio prepared for economic winter?

If we're heading into a recession, you'll want your stocks to have these qualities.

In Australia today, economists are arguing that declining property and stock prices, coupled with weak wage growth and high levels of private debt may cause a recession. In a recessionary scenario, most stocks are likely to take a tumble, but there are a couple of things to be positive about.

First, those that survive or emerge during a recession will likely thrive. More than half of all Fortune 500 companies were founded in recessions or a bear market, and the two most recent recessions in Australia saw corrections followed by substantial rallies. In the early 1980s recession, the All Ordinaries Index fell by 13 and 14 per cent in 1981 and 1982 respectively, but went on to gain 67 per cent in 1983. In the early 1990s recession, the index fell by 18 per cent in 1990, only to add 34 per cent over the course of 1991. Although it's a sample size of just two - far too small to draw any conclusions from - we know empirically that future returns are likely to be the highest following periods of low returns, and vice versa.

Second, so long as humans inhabit the Earth, our standard of living is likely to rise. We have evidence in the form of hundreds of thousands of years of human history. Our early hunter-gatherer ancestors were largely vulnerable to disease, predation, starvation and injury. But one improvement at a time, compounded over thousands of years, saw them progressively evolve into present-day society, in which food, water, shelter, energy, medicine and education are ubiquitous across developed countries. Even in the worst of recessions, self-interested entrepreneurs will continue to find ways to satisfy the needs of people, and for that reason, step by step, businesses will recover over time. The message is clear: don't worry, be happy - at least over the very long term.

But even so, long-term gains are only possible if your portfolio can survive the occasional economic shock. Howard Marks tells us to 'never forget the six-foot-tall man who drowned crossing the stream that was five feet deep on average'. We need to be prepared for all eventualities.

If we're preparing for a recession, one strategy is to invest in defensive stocks - businesses that provide goods that are less sensitive to the economic cycle: think healthcare, groceries and utilities. But these might not be the best opportunities at the time. Another option is to find a few companies that actively benefit from economic downturns - perhaps bankruptcy lawyers, for example, but listed examples of these are hard to find. Another alternative still is to have a large weighting in cash, but this is also inefficient - over the long term cash promises the lowest return of all asset classes.

There is perhaps a better way: Looking for businesses that are able to increase their market share and improve their competitive position in recessions, leaving them well positioned for the inevitable economic upturn that follows. They'll have the following hallmarks:

Hallmarks of a 'winter-ready' business

#1: Strong balance sheet

Companies with a strong balance sheet can run at a loss for longer, which means they can continue to focus on their operations while their competitors are worrying about refinancing. They're also able to maintain or grow their investment in areas such as marketing and product development while competitors are forced to hold back on spending. Additionally, a cash hoard means they can also take advantage of opportunities to acquire flailing competitors at depressed levels.

Examples: ARB Corp, Platinum Asset Management.

#2: Management with skin in the game

Management with high levels of personal stock ownership are less likely to walk away when things get really tough in a recession. They're also less susceptible to external pressure, allowing them the freedom to make bold decisions when crisis calls for it. It also means if a capital raising does come, it's likely to be relatively friendly to existing shareholders.

Examples: ARB Corp, Platinum Asset Management, Reece HoldingsFortescue Metals Group, Audinate Group, TPG Telecom, Hansen Tecnhologies, United Overseas Australia.

#3: Management that allocates capital effectively

Good value instincts are especially important in recessions, where acquisitions may become available at discount prices. Acquisitions mean increased market share and likely, an improved market position. 

Examples: CSL, Washington H Soul Pattinson, Macquarie, BHP Billiton

#4: Sustainable competitive advantage

Businesses that have sustainable competitive advantages are able to add some sort of value to their customers that competitors can't. And if there's anything laissez-faire economics tells us, it's that those businesses that provide the most value to their customers will remain well rewarded - even in tough times - because if they weren't they'd simply disappear.

In contrast, recessions are likely to destroy weak competitors. 'It's not until the tide goes out that we can see who's swimming naked', the saying goes. In an economic expansion, companies and consumers lever up, confidence grows and people begin to spend more. It's why it's possible for companies with a poor balance sheet, flimsy product offering or weak management to be buoyed in a way they otherwise couldn't be.

Examples: Cochlear, Sydney Airport, Ramsay Health Care, ASX

So those are four things to look for, but the above, of course, totally ignores the short term. The benefit a recession offers to these types of businesses doesn't come in the form of increased sales, it comes in the form of an improved market position or increased market share. That will only pay dividends over the long term. It also completely ignores price - so it's not worth chasing these companies at any level. But by having a good chunk of your net worth in companies that have the above qualities, particularly when they join our Buy list, you'll hopefully be able to benefit from a recession over the long run.

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