Is the U.S. economy headed for a recession? Opinions on the matter are plentiful, ranging from a firm "no" to an assured "yes," with plenty of predictions of something in between the extremes. Nobody can know for sure. However, what we can know is that it rarely hurts to plan for the worst, even if it doesn't actually occur.
While no stock is ever completely recession-proof, here's a rundown of the top four attributes of the market's most downturn-resistant companies.
1. They have perpetually marketable goods or services
It may be a bit obvious, but it needs to be said all the same -- not every company sells a product that people and companies will pay for in all economic environments.
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Take automobiles, for instance. When the economy is strong and incomes and corporate profits are high, cars are generally an affordable, justifiable purchase. When the economy weakens, salaries are slumping, and people fear for their jobs, interest in taking out auto loans tumbles.
Conversely, there are some goods and services perpetually in fairly steady demand regardless of economic circumstances. Think groceries, healthcare, and utilities. While consumers may adjust their spending on such things when money is tight, the majority of people will put a priority on buying enough food and keeping the lights from getting turned off.
2. They have healthy balance sheets
There's nothing inherently wrong with a company borrowing money to invest in growing its business. There is something wrong, however, with a company borrowing a ton of money when its profit margins are already paper-thin. If highly leveraged companies' businesses start to struggle even slightly, such thin profits can rapidly turn into losses. This, in turn, can force an organization to take on even more debt just to survive a tough period.
Take AT&T (T +1.26%) as an example. It's been considered a blue chip stock for a long time. In retrospect, though, we can look back on its strategy of depending on debt to fuel expansions of its business over the course of the past decade as a mistake. Now, AT&T is sitting on $124 billion worth of long-term debt that costs it nearly $6 billion per year in interest payments. After it pays out dividends to the tune of another $8 billion each year, what's left from its $20 billion or so in annual earnings is just not enough to cushion it against the impact of a recession.
What "healthy" means depends on the business in question, of course.
3. They have strong gross profit margins
In this same vein, to protect your portfolio from the worst impacts of recessions, look for companies with strong gross profit margins.
Gross profits aren't the same as net profits. Gross profits are simply the difference between sales and the net costs of the products or services being sold, and they can be highly variable. Net profits are what's left over after all the relatively fixed bills such as interest payments, rent, and taxes are paid. It matters because gross profit margins reflect the "wiggle room" a company has when price cuts are necessary.
Amazon (AMZN 0.87%) is a prime example of how a low-profit-margin company can quickly fall into financial trouble when the going gets tough and it has no room to lower prices. Although the e-commerce giant historically produced massive revenue (and massive revenue growth), through 2019, only between 2% and 6% of that revenue was turned into net profits. Chalk it up to the organization's low-price model and low-cost shipping perks. Now, with its inventory and operating costs soaring due to inflation, Amazon's net profit margins have been whittled down to practically nothing.
Amazon is adapting by laying off up to 18,000 people and cutting other costs as well. It remains to be seen, however, when or even if these measures will restore the company to profitability. In the meantime, there's so little capital left to work with that Amazon is borrowing $8 billion it arguably shouldn't need to borrow.
4. They have proven efficiency
Finally, the stocks that fare best in the midst of recessions often belong to companies that operate the most efficiently -- even when times are good and they don't have to focus on efficiency.
As is the case with healthy balance sheets or strong gross profits, efficiency can be a somewhat subjective metric. Biopharma companies, for example, seemingly spend a great deal of money to develop new drugs, even knowing that most of their pipeline candidates won't be approved. But it's frequently worth it when an effective drug comes out of those expensive R&D efforts and can be brought to the market. Similarly, telecom outfits' investments in improving their infrastructure are meant to prevent the loss of customers to competitors as much as they're meant to attract new customers, which can make it difficult to gauge just how well those outlays are paying off.
It takes some level-headed comparisons to spot an industry's smartest, most-effective management teams. However, that exercise can point investors toward the stocks best-positioned to support a portfolio's value even when the economy is weak.
