Recession.
The dreaded "R" word held sway in August 2019 unlike any other time since at least the Great Recession days of a decade ago. Here's the thing, though: Recessions are difficult to predict, both in occurrence (will it happen at all?) and in timing (if so, when?). Plus, every recession looks a little different. In 2008, it was housing and banks that bore the brunt of the pain. In the early 2000s, it was the internet stock bubble.
So when a recession happens again, it's anyone's guess as to who or what will suffer outsized losses.
It's far easier to assess the health of individual companies than it is the global economy. Thus, it's always good practice to do a portfolio review, take some profits off the table, and cut out the companies that aren't doing so hot. As technology stocks have (rightfully) been leading the charge in the markets, this is a good place to start -- especially considering that many aren't running a true profit yet.
Here are a few metrics to monitor when making hard decisions about what to let go, especially if a recession is looking imminent.
Image source: Getty Images
Companies with no free cash flow
Many investors keep a close watch on earnings, a simple measure of profitability that conforms with generally accepted accounting principles, or GAAP. Earnings don't tell the whole story, though, as noncash expenses like depreciation on assets are included in the metric. To figure out if a company's actual cash balance is increasing or not, investors need to take a look at a company's free cash flow, money left over after cash operating expenses and capital expenditures are paid for.
Given the definition, free cash flow would be a good place to start when determining whether to sell a tech company if an economic downturn is nigh. A slew of companies report negative earnings yet still post positive free cash flow that largely goes unnoticed by many investors. A few examples of unprofitable businesses that are actually cash flow positive are cybersecurity outfit Zscaler (ZS +1.57%), big data company Alteryx (AYX +0.00%), and Shopify (SHOP 0.26%) -- which just recently entered positive territory. Simply selling companies such as these because they have negative earnings without a little extra due diligence doesn't cut it.
Granted, some businesses intentionally run in the red, burning cash off the balance sheet in order to maximize top-line growth. Should a downturn negatively hit results, some might be able to tighten up and save some cash. Many are still small, though, and need the growth in order to climb out of their operating hole. A good indicator of trouble is selling, general, and admin (SG&A) expenses that are well over half of -- or sometimes close to equal to -- total revenue. When a downturn hits, stocks in that unenviable position are the ones likely to get punished the most by the market. While SG&A expense certainly isn't the end-all, be-all metric, some stocks that might carry extra risk are Appian (APPN +1.62%), Fastly (FSLY +3.52%), and Anaplan (PLAN +0.00%).
Data by YCharts.
Companies with below-average profit margins
Speaking of spending too much money, gross profit margin is another metric to look at if de-risking your portfolio sounds like a good idea. Gross profit subtracts the cost it takes to actually make a product or produce a service. Remember Econ 101? There's this thing called scale: make too little of a product or service and gross profit is low. As more sales are added, though, average costs fall and profit margins grow. Companies that haven't yet reached this optimal balance sit in a precarious situation, as it means they have little wiggle room to ride out a storm.
Two that come to my mind are the high-profile 2019 IPOs Uber (UBER +0.18%) and Lyft (LYFT +0.38%). For many tech-based service providers, gross profit margins well in excess of 50% are ordinary. Not so here. Through the first six months of 2019, Uber's gross profit was 45.4% and Lyft's was 33.5%. An added concern is that, though both are growing revenues by double digits, gross profit is decreasing as they add new lines of business in an attempt to reach a profitable scale. Uber's year-ago gross profit was 53.3% and Lyft's was 38.6%.
When you add in SG&A expenses, companies like Uber and Lyft that have low gross profit margins and are operating in the red suddenly look even less attractive during an economic slowdown. Dealing with excessive and inflexible cash burn in times of uncertainty makes managing a business that much harder.
Companies with cyclical businesses
When considering whether to sell, another area of consideration is how sensitive a tech company is to consumer spending. Some stocks get clobbered in a recession not because sales are falling but because their stock valuation was higher than what the average investor found acceptable. If the business is still going strong, these are ideal "buy the dip" candidates. Others, though, are less durable and fall because fewer consumers are buying.
A cyclical type of business like this is normal, but if a cyclical business is already in the red when times are good, things could get a lot worse when they aren't. Retailers, consumer electronics, semiconductors, and automakers are all examples of cyclical businesses that tend to decline in times of recession. Shopify and its e-commerce platform again comes to mind as facing some risk, not just because it caters to small businesses and retailers but also because shares are up an incredible 180% in 2019 alone as of this writing. It's a great company with a long-term winning strategy, but a breather could be in store if consumer shopping activity taps the brakes.
Since autos and computer chips tend to get knocked around a bit from recessions, Tesla (TSLA 5.46%) and Ambarella (AMBA 1.06%) -- both of which have positive free cash flow but negative earnings -- could get even bumpier than they are already. Though Tesla is still a high-growth manufacturer, there are big question marks regarding its ability to sustain positive free cash flow as it works to build its scale here and abroad. Ambarella, for its part, has also been enduring some turbulent times and is indicating it has turned a corner. Both Tesla and Ambarella are proof that a business's fortunes can rise and fall independent of the economy's, but a recession could nevertheless make life more difficult if cyclical consumer spending eases.
Image source: Getty Images.
Keep positions small, stay nimble
Don't get me wrong -- I'm not saying to bail out of the above companies completely. As mentioned before, it's hard to say if and when a recession might hit, and in the meantime, many stocks are likely to keep growing. There are also those unknown events and developments that overwhelmingly change the narrative for a business for the better. Thus, investing in high-growth stocks come hell or high water isn't a bad idea.
After all, a good offense is sometimes the best defense, especially when change is happening at a rapid pace like it is today. Recession or not, that pace of change will continue. Shoppers will keep making increasing use of the internet, propping up companies like Shopify; businesses will need to keep operations safe, which plays into the hands of cybersecurity outfits like Zscaler; and big data isn't getting any smaller, so data analytics software like Alteryx will remain in high demand. Tech companies that keep the pedal to the metal and reap benefits for doing so could keep winning.
What's the answer, then, to our headline question? "Unprofitable" stocks need not head for the chopping block if recession looms. By all means, though, if less risk is your goal, keep positions smaller, hold cash, and use said cash to add to your best holdings in small increments over time. Guessing the bottom of a downturn is a fool's errand, so rather than time it, average it.
