Recession is a friend of the long-term investor
We are in the second half of 2022 and the economy’s outlook is 180 degrees opposite to what it was one year back. There is an understandable fear of a looming global recession. A downturn directly affects livelihood and standard of living, so it’s natural to feel a little scared. Many millions face the real threat of financial struggles that may last for years. The well-off investors are on the edge of their seats too as their portfolios bleed red.
However, if you don’t live paycheck-to-paycheck and have some financial cushion, it’s helpful to remember that a recession can be a boon for your investments, especially if you invest in quality businesses for the long-term.
There are two reasons for this:
1) A great business is a better bet against the recession
Let me illustrate this point with the help of an example about the fate of two businesses in the 1980s. This one is from the traditional farming industry and it’s very instructive.
John Deere and International Harvester were the top players in North America’s farming equipment market in the 1950s and 60s. By the early 1970s, John Deere had emerged as a stronger business because of better products and prudent financial management. Compared to International harvester, its profit margins were higher (14% vs 8%) and its debt ratio was lower (31% vs 44%).
Both companies were growing fast in the 50s and 60s, but things changed quickly during the recession the of 1970s. The US entered a period of higher interest rates that led to a sharp decline in demand and net incomes.
International Harvester had huge debts. When the farmer demand plummeted, its thin margins didn’t generate enough cash to service those debts. Within a matter of 3 years from 1979–1982, its net worth declined by about 99% from $2.2B to $23M. It tried restructuring the debts, but could not succeed and finally became defunct in 1985. The recession literally destroyed the business.
John Deere’s story played out entirely differently. It was not immune to the downturn either. Its earnings declined and growth slowed during the recession, but it weathered the storm because it had better margins and lower debt. In 1981, it even raised from equity markets that it used to build extra capacity and expand internationally. It quickly filled the gap left open by International Harvester, and by 1990, it had become the largest producer of farming equipment in the world. Its stock price has grown by 35x since then.
John Deere not only survived the recession in the 1980s but also went on to deliver huge returns to its investors.
This is not an isolated story. There are ample examples across industries to show that great businesses come out stronger after a recession. When things go south, they too struggle just like everyone else. Their earnings are not impressive because there is low demand across the board. But they use their competitive advantages to stay afloat. Under the hood, they gain market share even as the competition gets decimated. When the tide turns, like it always does, they come back stronger. They capture the soaring demand while commanding a larger share of the market.
This brings us to the second reason why recessions are doubly beneficial for patient long-term investors:
2) You reduce your risks and increase return potential because everything is available at a discount
Consider the current market situation we are in right now. As liquidity dries up and Fed continues to raise interest rates, investors are withdrawing money from the market. The prices of most technology stocks have dropped anywhere from 30% to 90%. S&P 500 has corrected by over 20% from its peak in less than 12 months.
While it doesn’t feel good to watch your wealth shrink, this is a better time to find bargains for new investments. Of course, this does not mean that everything is available at a discount or below its fair price. But it does mean that there are more buying opportunities than what existed a year or so back.
The purchase price is one of the biggest determinants of your future returns. And a recession hands you a rare opportunity to turn the risk-reward ratio in your favor.
Prices have corrected for most businesses by a meaningful factor in the last 12 months. The table shows the correction in prices for 5 such stocks.
What does this mean for long-term investors?
There are two key implications for the long-term investor: 1) Do the homework to identify strong businesses because they are better bets against recession, and 2) Remember that recession is a much better time to buy stocks. You take less risk and have a larger upside.
I have said nothing new or groundbreaking in this post. I intend to only remind the readers to not lose perspective when there is so much noise all around. If anything, you should feel more confident in making new investments now.
Needless to say that none of this matters if the recession brings financial hardships. It may very likely get worse before it gets better. And recessions can last a very long time. But if you are fortunate that your life won’t turn upside down, take advantage of some opportunities that Mr.Market provides.
These times might feel gloomy and it’s important to remain cautious, but there are also reasons to be optimistic if you are a long-term investor.
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