The Top 10 Depression Stocks

"Really? The Top 10 Depression Stocks? That's a preposterous headline." I'd guess that's what you're probably thinking.

But when I asked "Is This the Market Bottom?" on March 6 (it was a lucky guess), one striking piece of data came out of my research: Despite the conventional belief that the Great Depression was a terrible time to invest, investors who bought stocks in 1931 -- just prior to a 71% market drop -- would still have broken even in less than five years!

And stocks that the average investor bought after they became even cheaper -- say, at the start of 1932 -- would have multiplied in value more than 15 times during the next 22 years:

Sources: Ibbotson Associates and author's calculations. Assumes reinvested dividends.

Some did even better
And then there were the best Great Depression stocks -- those that surpassed even these excellent long-term returns. Despite the recent market run-up, the economy remains dicey -- unemployment rates are still rising and rival what we saw at this stage in the Depression. So I decided to write this follow-up to my recent column profiling the top 10 stocks from the last recession to see what lessons we can learn that would help our investing.

Here are the top 10 Great Depression stocks:

Sources: Center for Research in Security Prices at The University of Chicago Booth School of Business, in SmartMoney, Ibbotson Associates, and author's calculations.

While it's tempting to conclude from this list that basic manufacturing stocks will lead us out of this recession, it's not totally clear that this generalization applies because manufacturing makes up a much smaller portion of our economy today.

Three of the top 10 Depression stocks were members of the defense industry. And if you dig a bit further into their histories, you'll find that another five supplied the war effort or benefited indirectly.

So what lessons can we draw from this information?

1. Searching for today's "defense stocks"
We shouldn't assume defense heavyweights like Boeing and Lockheed Martin will repeat the performance of their Great Depression counterparts. At the height of World War II, defense spending as a percentage of GDP was 10 times what it is now.

Instead of military spending, today the government is pouring billions into combating what Warren Buffett has called "an economic Pearl Harbor." But the names of the top 10 Depression stocks suggest it won't be easy to predict which companies will benefit most. Who would have guessed that International Paper, Zenith Radio, and Bulova Watch would begin selling the military ultrastrength shipping crates, bomb fuses, and aircraft instruments, respectively? It definitely wasn't obvious that the disruption of European paper imports would cause wood pulp prices to spike and boost paper maker Crown Zellerbach's earnings some 30%.

Likewise, it's not clear whether broadband upgrades will primarily benefit telcos like AT&T (NYSE: T) or smartphone makers like Research In Motion (Nasdaq: RIMM). Will the push toward electronic medical records help Quality Systems (Nasdaq: QSII), which performs such upgrades, or lower health-care costs for insurers such as Aetna (NYSE: AET)?

As during the Depression, there will be real beneficiaries of the government's response to this "economic war," but the names of the top 10 Depression stocks suggest that it won't be easy to figure out who the primary ones will be.

2. The eternal recurrence
I was surprised that not one financial stock even made the list of the top 50 Depression stocks! With some 9,000 bank failures between 1930 and 1934, I had expected shares of surviving banks to soar as they gained market share and their beaten-down valuations rebounded.

But a 1933 Federal Reserve study explains that the banking system, which had been growing faster than both the U.S. population and the overall economy for years, had been overbuilt to the point of declining profit margins and loan quality.

Like the 1930s, today's banking industry appears to be undergoing a massive correction after years of insane overbuilding. At the peak in 2006, financials made up an absurd one-quarter of the entire stock market capitalization. Returns on assets for many banks were below even withered 1920s industry levels, and they still have terrible loans on their books.

So while we will probably see some big winners emerge from the beaten-down financial industry, the fact that it may not return to its former size suggests there could be fewer big winners than many expect. If you're going to be investing in banks today, you'll need to have a firm understanding of their liabilities, the strength of their assets, their business models, and their management teams.

3. Buy the best
Many of the top Depression stocks had competitive advantages, which are especially important in a tough economic environment. They help retain business when customers are cutting back and ensure that the company can continue to operate profitably. Here are just a few:

• Economies of scale: International Paper, which was formed in a gigantic merger between 17 pulp plants and paper mills, was big enough to squeeze suppliers in its early years and fund massive R&D projects later on. Coca-Cola (NYSE: KO) is a modern-day exemplar of scale advantages.
• Switching costs: The Navy had relied on Electric Boat to make high-quality submarines since 1900. Because the company's services are so integrated into its customers' operations, Paychex (Nasdaq: PAYX) enjoys a sticky customer base marked by high retention rates.
• Brand: Bulova Watch, which introduced ladies' watches, clock radios, and electric clocks, was known for quality and innovation. Today, Dolby Labs (NYSE: DLB) resembles Bulova.

How to invest during depressions
The list of the top 10 Depression stocks, along with the experiences of some of the world's most successful investors (Templeton, Graham, and Buffett), demonstrates that economic downturns can be a great time to pick up bargain stocks. It also shows that macro events can have surprising winners, so investing on that basis can be tricky. Finally, it teaches that companies with competitive advantages often perform especially well in uncertain times.

Our Motley Fool Inside Value team is seeing a number of companies with strong competitive advantages trading at bargain prices today. If you'd like some help getting started, click here to see our favorite stock ideas free for the next 30 days.

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This article was originally published June 12, 2009. It has been updated.

Ilan Moscovitz doesn't own shares of any company mentioned. Coke and Paychex are both Inside Value and Income Investor recommendations. Quality Systems and Dolby Labs are Stock Advisor selections. The Fool has one of the top 10 disclosure policies.