How to Spot the Post-Recession Winners Now
Think like a crisis manager... The next 'unthinkable'... How to spot the post-recession winners now... Most companies won't get better quickly... The traits of the few that will thrive... Extreme Value's latest 'breakaway' stock...
'Think about the unthinkable'...
That's what renowned crisis management expert Dr. Ian Mitroff urges readers to do in his excellent 2005 book, Why Some Companies Emerge Stronger and Better from a Crisis: 7 Essential Lessons for Surviving Disaster.
Seven months ago, I (Mike Barrett) took Mitroff's advice.
At the time, stocks were regularly hitting new all-time highs and many investors were convinced nothing could stop the mega-bull market. That made it a great time to ponder the unthinkable... like something stopping the bull dead in its tracks.
To help me get in the right frame of mind, I read President Herbert Hoover's diary of the Great Depression.
I didn't sleep well the next few nights. And I shared what I learned from the Great Engineer – and three striking parallels to the present – in our first Digest of 2020...
No. 1: Don't underestimate the potential for economic "contagion," or for the problems of economies to spread like a contagious disease.
No. 2: Years of commodity overproduction turns disastrous when economic crisis erupts.
No. 3: "New Economic Era" sentiment breeds dangerous complacency.
You see, 90 years ago, on the eve of the world's greatest financial calamity, investors were ignoring disturbing economic realities...
As I put the pieces together and started thinking about today's economic environment, it suddenly became plain-as-day obvious that investors were once again making the same terrible mistake.
Little did I know that the next "unthinkable" event was just a few weeks away.
Initial estimates by business consultancy McKinsey & Co. are that the pandemic-induced financial pain sustained during the second quarter of 2020 will exceed all of the losses sustained during the Great Depression.
If you read my January 2 Digest, you were better prepared than most.
One of my recommendations was the purchase of fractional gold American Eagles. They're similar in every way to the standard 1-ounce ("oz") version, just smaller (1/2 oz, 1/4 oz, and 1/10 oz).
Good luck finding a reputable dealer that'll even take your order today. Fractionals are in very short supply. I won't be surprised if the problem persists well into 2021 (and perhaps beyond).
Now it's time to start thinking about the next 'unthinkable'...
That's a return to normalcy, then growth – and who the winners will be.
How long the pandemic and its after-effects will linger is still a huge unknown.
Surprisingly, many CEOs are confident that when the good times return, their companies will perform even better than they were pre-crisis.
Don't count on it. I say that because historical precedent suggests the exact opposite.
In the midst of the Great Recession in 2008, three Harvard University business professors determined there was little research to help companies survive a recession, then exploit the post-recessionary good times.
So over the course of 2009, they made it their mission to develop such research.
How to find the post-recession winners...
The three colleagues – professors Ranjay Gulati, Nitin Nohria, and Franz Wohlgezogen – studied 4,700 public companies, looking closely at how they performed before, during, and after the three previous recessions (1980 to 1982, 1990 to 1991, and 2000 to 2002).
Their research focused on how all 4,700 adjusted spending on six items – as economic conditions went from good to bad and back to good again:
- Number of employees
- Cost of goods sold ("COGS")
- Research & development (R&D)
- Marketing
- Capital expenditures (capex)
- Acquisitions
The companies they studied ultimately fell into one of four strategy-shift categories:
- Prevention-focused: Cut back spending more than their competitors.
- Promotion-focused: Increased spending in at least one area by more than their
rivals. - Pragmatic: Utilized both prevention and promotion strategies.
- Progressive: Reduced cost of goods sold, but didn't cut employees more than their peers. Also spent more on marketing, capex, and acquisitions.
The results, in the words of the researchers, were "startling."
Roughly 80% – the vast majority – had yet to regain their pre-recession growth rates for sales and profits three years after the recession was over.
Alternatively, just 9% were actually performing better on key financial metrics than they had before and were also achieving "breakaway" status – meaning outperforming industry peers by at least 10% in terms of sales and profit growth.
Now you know why immediate skepticism is the correct reaction if you hear a CEO expressing confidence that his or her company will be one of the post-crisis winners.
It reminds me of what happens when you ask people if they possess above-average intelligence. The majority always say yes, a statistical impossibility.
Interestingly, the Harvard study determined that 'progressive' firms tended to be the biggest post-recession winners...
Progressive managers didn't quickly fire large numbers of employees. (Kind of like AT&T just yesterday announced it was doing.) They also didn't see the tough times as an opportunity to hastily grab market share.
Instead, they deftly balanced modest cost cutting and capital spending in a way that helped the company survive tough times, then thrive as growth returned.
These companies were also most likely to achieve "breakaway" performance.
A perfect illustration of this is how two industrial giants, Honeywell (HON) and General Electric (GE), handled the Great Recession of 2008 to 2009.
In a recent Fortune interview, former Honeywell CEO David Cote recalled his belief that the way the company went into the recession was how they'd come out. In other words, he assumed that business units with deep revenue declines (like aerospace) would at some point quickly bounce back.
As Cote put it, "Our assumption was that if it's a V in, it's a V out."
GE, on the other hand, was primarily focused only on the "V in" and what needed to be done to weather the recession. They'd deal with the "V out" when the time came.
Consequently, GE laid off workers for three straight years. By the time things were starting to improve in 2010, their workforce was 12% smaller than it was pre-recession.
Honeywell, in contrast, preserved its ability to bounce back quickly by implementing widespread furloughs. Employees in the most impacted divisions stayed home for longer and collected unemployment insurance. And when market conditions improved, they returned to normal work hours.
By 2010, Honeywell's workforce was actually 7% larger than it had been pre-recession. As Cote recalls...
The key was that our people never stopped being Honeywell employees. These weren't layoffs; their jobs were waiting for them. They were waiting to return, skills intact, when the recovery began. Instead of concentrating pain on 10% of our people, we spread lesser pain to everyone.
By the end of 2012, three years after the recession ended, Honeywell's profitability had returned to where it was in 2007. GE's had not. It should be no surprise that Honeywell's stock strongly outperformed GE's between 2010 and 2012 by 22%.
The key takeaway is this: as the current downturn ends and growth resumes, we want to own the Honeywell's, not the GE's.
Now, let's look a little closer at the attributes of a 'breakaway' company...
There are nine possible combinations of "offensive" and "defensive" actions that management typically considers when adjusting to a recession.
Defensive measures include cutting employees, improving operational efficiency, or both. Offensive strategies include developing new markets, acquiring new assets, or both. There's no single combination that consistently works best for every company. However, the Harvard study discovered an important tendency among the breakaway winners...
They were selective with cost cutting, and they were more likely to focus on improving operational efficiency rather than just laying off a large percentage of their employees to abruptly lower costs.
Crucially, these gradual efficiency gains also enabled the companies to keep spending precious capital on the resources that eventually fuel breakaway performance: marketing, R&D, and acquisitions.
For example, during the 2000 recession, retailer Target (TGT) made a handful of smart moves...
It increased its marketing and sales expenditures by 20% and its capital expenditures by 50% over pre-recession levels. And it grew the number of stores it operated from 947 to 1,107 and added 88 SuperTarget stores to the 30 it had already set up.
And it did this all while trying to reduce costs, improve productivity, and enhance the efficiency of its supply chain. Target consolidated smaller retail brands under its umbrella. And instead of trying to "do online" alone, it partnered with Amazon (AMZN).
In another instance, discount retailer TJX Companies (TJX), which operates T.J. Maxx and Marshalls, added 300 stores to its network of 1,350 from 2000 to 2002. It increased its retail square footage by almost 25% and nearly doubled its capital expenditures.
At the same time, TJX's competitors were scaling back growth plans, so real estate options were more plentiful and prices were lower.
The time to buy the next post-recession winners is now...
In my last Digest essay, I shared three reasons why I've never been more excited about the Extreme Value portfolio...
Our May recommendation being a bona fide breakaway stock is the fourth reason. Extreme Value is the only Stansberry publication where you can read all about it.
Let's take a closer look at how we found it...
The Harvard study concluded that breakaway companies had two key attributes following a recession:
- Improved financial performance
- Sales and profit (earnings per share, or "EPS") growth beating peers by at least 10%
To evaluate the first attribute, I focused on the operating, net, and free cash flow margins of both our May recommendation and the average of its three closest competitors.
Margins improved for both following two of the last three recessions (1990, 2001, and 2009). This wasn't surprising. The companies operate in an attractive industry and are highly regarded.
But as you can see below, once the downturns ended, our May recommendation really shined.
Three years after each recession, sales and profit growth were clearly breaking away by more than 10% compared to its peers. The only exception was EPS growth in 2012...
A stock generating breakaway revenue and earnings growth typically produces breakaway investment results as well. This one is no exception.
As you can see below, since its first sales and earnings breakaway in 1993's post-recession era, shares have provided an annual average return of 17%, beating its peer average over the same period (and trouncing the benchmark S&P 500 Index)...
We can't know when the current downturn ends and growth will resume...
But we do know three things that are far more important...
First, shares of this company are currently priced at a substantial 25% discount to our intrinsic value estimate, due to the broad market sell-off. Rarely do you get the opportunity to buy such a high-quality business at this kind of discount.
Second, the primary fuel for much of its past breakaway success was acquisitions, and the potential for many more remains bright. There are still thousands of potential targets, and the company has access to roughly $1 billion in capital for new deals.
Third, because markets always look ahead, you can't wait until sales and profit growth start to breakaway to buy. If you do, the opportunity will be lost to more enterprising investors.
That's why we're recommending subscribers buy shares now...
Back in December, with the stock market climbing higher by the day, the unthinkable was the possibility of a sudden market sell-off. It made sense to imagine how this might impact your portfolio and what changes were necessary.
Today, it's the exact opposite... With countless businesses reluctant to reopen and some degree of social distancing likely to persist, the unthinkable is a world that has figured out how to recover from (and properly manage) these new realities.
And although it's hard to see right now, we will recover from this pandemic. And as we do, the stage will be set for the market's next big winners.
To learn more about Extreme Value's newest breakaway addition, click here now. If you don't already subscribe, you can give the newsletter a try risk-free today.
New 52-week highs (as of 6/17/20): Electronic Arts (EA), JD.com (JD), KraneShares MSCI All China Health Care Index Fund (KURE), Lonza (LZAGY), Match Group (MTCH), Novo Nordisk (NVO), Sea Limited (SE), Spotify Technology (SPOT), and The Trade Desk (TTD).
In today's mailbag, longtime reader Woody P. shares just about every COVID-19 one-liner you could imagine... Do you have a comment or question? Send it to feedback@stansberryresearch.com.
"Covid Thoughts...
"They say you can't fix stupid. Turns out you can't quarantine it either.
"I don't like the fact that my chances of survival seem to be linked to the common sense of others.
"People keep asking, 'Is coronavirus really that serious?' Listen up! Casinos and churches are closed. When heaven and hell agree on the same thing, it's probably pretty serious.
"Now that teachers finally have a chance to use the restroom, there's no toilet paper.
"Shout out to all the parents who never taught their kids respect, and now they're stuck at home with the little darlings.
"Have to say that the Class of 2020 outdid themselves with Senior Skip Day this year.
"Cops now say... 'Come out with your hands washed!'
"Police confront nudist sunbathers over not wearing face masks amid coronavirus outbreak.
"And just like that... having a mask, rubber gloves, duct tape, plastic sheeting, and rope in your trunk is OK.
"Never in my whole life would I imagine my hands would consume more alcohol than my mouth!
"Ask not what staying home on the couch can do for you, but what staying home on the couch can do for your country.
"Ladies... time to start dating the older dudes. They can get you into the grocery store early.
"I can't believe I can walk into a store to buy weed, but I have to meet my hairdresser in a dark alley with unmarked bills to get a haircut.
"Have you noticed that since beauty salons are closed, selfies are down 68%?
"Sitting at the bar in the kitchen at night, I tried a pickup line on my wife. She gave me a fake phone number. What's up with that?
"It's been a blessing being home with the wife for six weeks now. We've caught up on everything I've done wrong for the past 20 years.
"Not to brag, but I haven't been late for anything for the past 21 days!
"Breaking news: Wearing a mask inside your home is now highly recommended. Not so much to prevent coronavirus, but to stop eating." – Paid-up subscriber Woody P.
Regards,
Mike Barrett
Orlando, Florida
June 18, 2020
P.S. If you haven't already, don't forget to sign up for our colleague Dr. Steve Sjuggerud's real estate webinar coming next Wednesday, June 24, at 8 p.m. Eastern time.
We've wanted to cover the real estate market in depth for a while now. (Believe it or not, we never have in our 20-year history.) And we're excited to say that Steve and his True Wealth team are finally doing it.
Click here to make sure you don't miss out on what Steve has to say next week about the massive wealth-growing opportunities in real estate today and in the years ahead.