Stocks for the Next Great Depression

The parallels between the current economic fiasco and the Great Depression just keep getting stronger.

Both disasters originated with excessive leverage. In the 1930s, it was overleveraged speculators buying stocks. This time, it was overleveraged speculators buying too much house with too little cash, enabled by overleveraged financial institutions that blindly assumed housing prices would only go up, up, up.

On top of that, poorly crafted government reactions exacerbated both situations. During the Depression, the protectionist Smoot-Hawley tariff triggered global retaliation and contributed to a worldwide recession. More recently, poorly executed bank seizures and excessive subsidizing of failure have distorted the market's ability to correct its excesses. Add a dash of protectionism from the "Buy American" provisions in the recent stimulus act -- and the potential for retaliation -- and you've got quite a foundation for Great Depression II.

But what does that mean for you and your portfolio?

Can you invest through this mess?
Given those parallels, the Great Depression and its aftermath offer us some salient reminders as we slog through today's doldrums:

  • The country as a whole survived the Depression.
  • As important as debt is to the overall economy, too much debt can be deadly.
  • The soundest and strongest companies of the era survived, and later thrived.

In other words, take a deep breath. Despite all the gloom and doom (and it's real gloom and doom), this doesn't likely spell the end of life as we know it.

But until the country's debt woes are brought under control, this situation is likely to continue. Right now, the credit markets are still tough to crack for all but the strongest borrowers, even prominent banks are still on the rocks, and the overall economy doesn't exactly look healthy.

All of that doesn't mean you should stay out of the market. In fact, it means that you should be invested in companies that are strong enough to survive -- and that will thrive when the recovery comes.

What to look for
A key characteristic of that strength is being able to stay out of the debt crisis that's hamstringing companies in industries as diverse as finance, automakers, and homebuilders.

With financing as tight as it is today, even profitable companies can be undone by debts if they can't pay them off or refinance them when they come due. Thus, companies that have limited debt or avoided it altogether are far better positioned to ride out these trying times.

But what counts as "limited"? Here are two definitions worth considering:

  • Below half a year's revenue. This helps ensure that the debt is manageable relative to the overall size of the business.
  • Below the company's tangible book value. With tangible equity (more tangible assets than total debt), a company can offer collateral for secured loans that may be more palatable to squeamish debt investors than typical senior unsecured bonds. That's crucial if the credit market is still frozen when its debt matures.

Show me the money!
Just keeping debt at manageable levels isn't enough -- you also want operational strength. That means finding companies that are profitable today and have substantial free cash flows when compared to their reported earnings.

Put together a strong balance sheet with decent earnings supported by cash flows, and you have the makings of a company with a strong chance of surviving today and thriving tomorrow. Here are just a few that fit these criteria and are worth a closer look:

Company

Debt-to-Revenue Ratio

Debt-to-Tangible Book Value Ratio

Trailing Free Cash Flow
(in millions)

Trailing Earnings
(in millions)

Qualcomm (Nasdaq: QCOM  )

0.02

0.01

$1,907

$1,679

Western Digital (NYSE: WDC  )

0.07

0.18

$528

$487

CarMax (NYSE: KMX  )

0.05

0.21

$68

$59

Hormel Foods (NYSE: HRL  )

0.05

0.26

$496

$282

Lincoln Electric (Nasdaq: LECO  )

0.05

0.13

$242

$155

NCR (NYSE: NCR  )

0.06

0.94

$296

$165

Hillenbrand (NYSE: HI  )

0.17

0.39

$116

$100

Data provided by Capital IQ.

In severe economic contractions like these, traditional measures of value like the price-to-earnings ratio are much less important. Certainly, earnings still count. But if a company doesn't have the assets to support its financial structure or the real cash flow to back up its earnings claims, then all the earnings in the world are meaningless.

What happens next?
Even President Obama admitted that, when it comes to the economy, "Things are going to get worse before they get better." And that means preparing for the worst. If this mess truly does turn into the next Great Depression, owning shares of solid companies will position you well to ride out the storm.

And if we recover sooner than folks expect, then those strong companies will likely be among the best-positioned to take advantage of weaknesses the crisis has exposed in their competitors. Whatever happens next, now is the time to focus on strengths and invest in companies with the wherewithal to persevere today and thrive tomorrow.

At Motley Fool Inside Value, our focus has always been on finding companies with solid financials and true long-term staying power. As these tough times continue, we're using that focus to pick up shares of some of the world's most resilient companies at bargain-basement prices. If you're ready to prepare your portfolio for what's left of this mess -- and the recovery that will eventually follow -- join us today. You can start your own 30-day free trial by clicking here.

This article was originally published March 3, 2009. It has been updated.

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At the time of publication, Fool contributor and Inside Value team member Chuck Saletta did not own shares of any company mentioned in this article. CarMax and Lincoln Electric are Inside Value recommendations. The Fool has a disclosure policy.


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  • Report this Comment On June 06, 2009, at 1:30 PM, EvanRowe wrote:

    Great Depression 2.0 is another way to look at it. There are many comparisons at the cosmetic level, housing of the 2000s to stocks of the 1920s, over leverage, to much wealth in too few hands, but these are symptoms of broader social-economic problems.

    Too much technology is certainly playing a role in a more rapid and massive de-skilling than usual. I believe that normal market cycles have the tendency to de-skill only part of the population at a time. Enough to keep more people employed. But sometimes, you have these Kondratieff winter type of collapses, and I believe they are technological in nature.

    Consider:

    Mass media being practically turned into an unmonetizable commodity. Film, music, and news media, all in the same boat on this front.

    Advertising through google models of replacing ad agencies with technology.

    topping this with the already existing trend of greater manufacturing sophistication and industrial food production.

    Perfect storm. People are redundant, and the statist models of protecting the profitability of corporations (AKA Reaganomics/supply side economics) are no longer going to be able to sacrifice workers to keep the investment cycle going from one new thing to the next on the back of an ever cheapening cost of labor.

    Supply side is going to be finished until some future generation longs for the way it never was, and tries to bring us back.

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