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How to Profit in a Recession

Let me guess: You're probably excited about some of the bargains in the market right now, but scared that we could be in for a protracted recession -- or even depression. Let's face it, the words "nationalization" and "our banks" have collided in the same sentence more than once in recent memory.

So how can you reconcile the desire to take advantage of what could end up being the opportunity of our lifetimes with the desire not to lose any more money?

How about buying into a very specific business model that (I think) is not only one of the best on this planet but also extremely well-suited for a recession?

Salivate over this business model
This business model is one in which:

  1. Raw materials (or other variable costs) are a high percentage of costs.
  2. Raw materials are turned into a unique product with a strong brand.
  3. Products are consumable and deliver an essential service to the buyer.

What you want are excellent businesses that are consistent crowd-pleasers, but which have some built-in competitive advantages and the ability to economize when times are tough. Companies like these are great long-term bets and resistant to the effects of recessions.

Keep the costs variable
Companies with a high percentage of variable costs, especially variable costs like raw materials, have a huge advantage over companies with a high percentage of fixed costs, because they are inherently more nimble.

That's especially important in a recession. If a company experiences a rapid drop in sales and doesn't lower its costs quickly, it could lose money. Yet a company with a lot of its costs in raw materials (a variable cost) can reduce purchases in line with demand and maintain margins.

The problem is that most companies' costs are fixed in salaries, machinery, marketing, rent, or interest -- little of which can be adjusted easily. Think about Caterpillar (NYSE: CAT  ) or General Motors (NYSE: GM  ) , with their huge fixed costs. Even knowledge-based businesses like Accenture have high fixed costs in the form of employee salaries. In fact, it's the rare excellent business that also has large raw material inputs.

Can you keep a secret?
But just the existence of variable costs isn't enough. If your product requires a lot of corn, wheat, sheet metal, or even oil, you're starting with ingredients that are available to everyone else. There's no inherent advantage there.

But a proprietary process that turns those raw materials into something valuable does create an advantage.

Think about alcoholic drinks. Diageo (NYSE: DEO  ) , for example, produces Smirnoff vodka, Tanqueray gin, Jose Cuervo tequila, and Johnnie Walker whiskey. Their inputs? Water, grain, energy, and labor. The inputs aren't all that expensive, but the end product is -- because Diageo has secret processes to manufacture each drink. Don't try this at home.

In the end, then, Diageo charges a premium for its unique brands while at the same time keeping its costs very low.

An investor's best friend
Variable costs and a proprietary process are good -- but they become excellent when they produce consumables that deliver high value to the customer.

The brilliance of consumables is obvious (steady replacement demand), but having a consumable product the customer loves is even better -- because the customer will keep buying it during a recession.

Many people are still going to buy General Mills' (NYSE: GIS  ) Cheerios and Ralcorp's (NYSE: RAH  ) Raisin Bran in a recession, and they're not going to leggo Kellogg's Eggos even if unemployment hits 15%. Likewise, it's unlikely your average Southerner is going to stop imbibing Brown-Forman's (NYSE: BF-B  ) Jack Daniels Tennessee Whiskey just because the economy is in a funk.

A world without Scotch tape?
Food and beverages are the obvious examples, but they aren't the only ones. Consider 3M Company. Many of 3M's products are indispensible, small-ticket items, meaning they won't suffer the same downturn as bigger-ticket items like industrial machinery. Companies are unlikely to put off buying Scotch tape or Post-It notes because of a recession, nor is the surgeon going to skimp on face masks or wound dressings. Fifty percent of 3M's cost of goods sold is accounted for by raw materials, and many of 3M's products are consumable.

Take a nibble today
You can take advantage of the market and protect yourself from recession's downside by buying excellent companies that can control both their costs and their market share. They may not be recession-proof, but they are recession-resistant -- and many of them are trading at historically low multiples.

These are the kinds of companies we look for at Motley Fool Inside Value. If you'd like to get all of our recommendations, including our five best ideas for new money now and a discounted cash flow calculator you can use to evaluate companies on your own, consider taking a free, 30-day trial. Just click here to get started -- there's no obligation to subscribe.

Fool analyst Andrew Sullivan does not own any of the shares mentioned. Diageo is a Motley Fool Income Investor pick. 3M and Accenture are Inside Value picks. The Motley Fool has a disclosure policy.

Read/Post Comments (2) | Recommend This Article (30)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 19, 2009, at 4:55 PM, FOOLAHA wrote:



  • Report this Comment On March 01, 2009, at 5:36 PM, breathless9 wrote:

    Granted, we don't know how long this recession will last. But, unless you are an

    elderly person who needs to be ultra conservative, this is the time to take some

    degree of risk, buying into firms like CEMEX, at a time when Obama is talking large scale construction. Or Tele Norte (TNE) in Brazil which has nowhere to go but up -- down the road apiece. Duh, it's become a big time player down there.. Yep, and then there's the Bank of Ireland, which even has the government post office as a client, which is a source of many, many loan applications. At less than $2 per share you're not risking the family jewels.

    And yes, I'm an investor in these firms.

    I back my talk with my own money..

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