These Companies Will Get Better in a Recession

No one enjoys a recession. Sales, profits, and bonuses fall, and companies lay off employees. But for some companies, a recession may end up being one of the best things that could happen.

Really 
The headlines are dire, and for good reason. But even amid all the bad news, there's a simple fact that keeps being overlooked: Certain companies will increase the value of their franchises considerably in a recession.

But it's not every company that can turn a recession to its advantage. The ones that can are leaders in their industries -- companies with strong brands, higher margins, and prudent levels of debt.

How do they do it? Three ways:

• Competitors go out of business.
• Companies increase their earnings per share through share repurchases or acquisitions at bargain prices.
• Continued internal investment leads to increased market share and productivity gains.

1) Becoming king of the world 
The most direct way a company can benefit from a recession is pretty simple: Competitors go bust. Best Buy will probably benefit from Circuit City's liquidation just like Toyota Motor would benefit if General Motors went under -- because removal of that supply from the market would increase demand for competitors' cars. Seeing companies go out of business isn’t pretty, but it helps stronger competitors.

2) Buying up value 
Share repurchases and acquisitions are another way value can be created. In a recession, asset values typically fall to historically low levels. A company with a strong cash position can scoop up its own shares or make acquisitions for very low prices.

This is beneficial because buying shares at low prices reduces shares outstanding. The same earnings over fewer shares equal higher earnings per share -- and, theoretically, a higher stock price.

For example, The Washington Post generated a mind-boggling amount of value for its shareholders in the 1970s when it (at Warren Buffett's suggestion) repurchased vast quantities of its shares at prices well below what it was worth. Similarly, buying a business at a depressed price can add to a company's earnings per share, and the lower prices mean there is more cash for shareholders -- and all of that means benefits down the road.

That's what MidAmerican Energy was trying to do when it agreed to buy Constellation Energy when the latter was having liquidity issues. MidAmerican agreed to buy the whole company for the bargain price of $4.7 billion, but the deal fell through when Constellation found someone willing to pay $4.5 billion for half of its nuclear power business.

Even though it didn't end up acquiring a quality asset on the cheap, MidAmerican stands to earn more than $1 billion on the $1 billion it initially lent to Constellation.

Having the flexibility to invest in one's own shares and those of distressed companies can give a company quite an edge.

3) Internal investment 
All businesses need to continually invest in themselves in order to improve. This is because investments in areas like research and development and productivity initiatives should lead to higher sales, lower costs, and hence, higher margins.

Yet in a downturn, less-well-off companies are forced to put off these expenditures because the more pressing need is to keep the business profitable. But companies with high operating margins and strong cash flows can continue to invest in themselves when times are bad, and therefore have opportunities to gain over their weaker competitors.

You can see this in the automotive industry. From 2002 to 2006, Toyota's operating margin ranged from 7% to 10%, whereas both Ford's and General Motors' ranged from negative 5% to 3%. Toyota's margins were higher because it invested heavily in automated production systems and lean manufacturing initiatives over many years and, as a result, was much better positioned to weather the current crisis than its American competitors.

Investing in yourself -- especially when your competitors can't -- usually leads to a payoff down the road.

Stick with the best 
Even recessions can be blessings in disguise for strong, well-run businesses -- but it takes some time for these blessings to become apparent. And that's why it's important to identify now the companies that will likely enjoy these advantages going forward.

To get us started, I ran a screen using CAPS, The Motley Fool’s 130,000-member investment community, for mid- and large-cap companies with large cash hoards and strong competitive positions; seven are highlighted. A large cash balance is one sign of a potential winning investment in an uncertain world, because it can protect the company against unforeseen difficulties or allow the company to play offense by buying back shares or acquiring competitors. 

Sources: Capital IQ and Motley Fool CAPS; data as of May 21.

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This article was originally published Feb. 15, 2009. It has been updated.

Fool analyst Andrew Sullivan does not own any of the shares mentioned. PACCAR and Best Buy are Motley Fool Stock Advisor recommendations. Coca-Cola, Best Buy, and Wal-Mart are Inside Value picks. Coca-Cola and Sysco are Income Investor choices. The Motley Fool owns shares of Best Buy. The Motley Fool has a disclosure policy.