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You Can Pick Stocks in a Recession

This column was originally published on RealMoney on March 21 at 11:45 a.m. EST. It's being republished as a bonus for readers.

No matter how dire it is, there's always hope -- and this is particularly true of the stock market. But it takes the right approach. Even if the economy is in a recession, stock-pickers can succeed. You just have to know what to look for.

If you are raising a family, thinking about paying for a college education or two, putting money in the stock market or considering buying a house, you can't help but be worried about the signs of an impending recession. Many economists are saying the U.S. is sitting on an economic house of cards, ready to collapse at any moment. Among the clearer signals of a recession, they say, are:

  • The inverted yield curve. The past 10 out of 11 recessions (or some other random statistic like this, I forget the exact number) have occurred after an inverted yield curve. I can go through the arguments of why this statistic might be meaningless and why the inverted yield curve might be different this time, but suffice to say, in the privacy of my office, with only tears to comfort me, I'm as scared as the next guy.

  • A bunch of deficits. The current account deficit, the trade deficit, the savings deficit. We seem, as a culture and a government, to be deficient in every way according to the economists, starting with Stephen Roach at Morgan Stanley and ending with Warren Buffett -- two guys I respect immensely (although I'll note that Roach was saying the same thing in October 2002 and Buffett was bearish in 1981). Buffett's partner, Charlie Munger, in the 2003 Berkshire Hathaway annual meeting, went so far as to say, "You better start burying your valuables in your backyard before the government seizes them," before Buffett quieted him down.

  • ARMs. Some time in the next one to 50 months, 10 hundred million adjustable-rate mortgages are going to be "readjusted," and everyone who was previously paying $50 a month is now going to have to start paying $10,000 a month. Or something like that. The housing bubble will burst, consumer spending will collapse and Wal-Mart will go out of business.

    OK, those are the worst-case scenarios of the impending recession of 2006 (now postponed until 2007, most economists believe).

    My feeling is so what? Right now, the economy as expressed by the gross domestic product has been growing by 3% to 4% a year, with some quarters missing or beating that range. For the first quarter of 2006, economists believe we'll clock in a 4% to 5% annualized rate. Last quarter, it was about 1% to 1.4%, depending on the next revision.

    A recession is when that number comes in negative for two quarters. For instance, if the GDP "grows" --1% for two quarters, then we are in a recession.

    Many of the contributors on this site are stock-pickers, including myself. When I'm looking for a stock, I'm not looking for something that can grow at the snail's pace of the GDP. I (and all the other stock-pickers on this site, such as Jim Cramer, Robert Marcin, Cody Willard, etc.) look for companies that have some of the following characteristics:

  • Huge, double-digit, if not triple-digit, growth. For instance, if a chain of stores is on the East Coast, experiencing solid same-store sales growth and starting to build stores on the West Coast, this is growth that will far exceed the GDP, regardless of whether the economy is growing or declining by 1%.

  • Undervaluation, based on assets on the balance sheet and stable cash flows. Even if one of these companies has cash flows that decline, the strength of the balance sheet alone should make it shine in a recessionary period. For instance, if a company is in a declining business but has 40% of its market cap in cash and has a fairly consistent earnings yield of 15% with millions of customers, then I'm comfortable owning that in a recession. An example that comes to mind is EarthLink (ELNK).

  • Economy independence. For instance, I've written before about debt-collection companies. These companies tend to flourish in both a growing economy and a declining economy. Also, a company like Medallion Financial (TAXI), which lends on taxi medallions, tends to be economy-independent. When more people are unemployed, there's higher demand for the medallions from an enlarged pool of would-be cab drivers.

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