How to spot recession-busting stocks

In a recession, there's one type of company that has a far better than average chance of doing well. It's a company that increases its research and development (R&D) through the hard times, to steal a march on its competitors.

I've been studying this for the past three decades, and the evidence is overwhelming.

There are two companies I know of that ratcheted up their investment in R&D in the jaws of the last recession. When the economy turned up, sales exploded and their share prices tripled.

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It's exactly this kind of R&D-intensive company we need to look for in this recession, too

Many managers believe that a recession is a time for companies to cut expenditures of all kinds to ensure survival. This may well be the only option for a company that enters a recession with a weak business. Its balance sheet may be stretched. Its bankers may not be prepared to advance the money needed to see it through what is going to be a difficult year or two. If so, what choice does it have but to cut back?

However, a profitable company with a sound business model has other options. If it meets certain criteria, it will enter a recession from a position of strength. Let me explain those criteria

A good starting point when looking for a recession-busting stock is that the company will have a record of growth, good profitability and strong overseas sales. It will also have a leading position in its market niche, net cash on the balance sheet. And it will steadily reinvest in new products and services.

Typically, what I find is that a company of this type has sufficient profits to consider increasing its R&D investment. It can do this even if sales are falling due to the recession killing demand for its products. And, as I'll explain, that increase in R&D in tough times is a good strategy

You might ask why a company would increase R&D as sales and profits are falling. The reason is that many of its competitors are likely to be reducing R&D or at least flat-lining it. This means that the company has a once-in-a-decade opportunity to make big improvements in its range of products and services relative to those of its competitors.

Customers will therefore see much greater differences between competing products on the market when the upturn comes. The company will have developed clearly superior products and services that customers will be keen to buy. So it should gain market share without having to undercut competitors on price. In fact, it should be able to charge a premium for clearly superior performance, reliability and service.

And this approach has worked in previous recessions

You can see how this has worked in the past. The strategy of increasing innovation in a recession was followed by a number of well-known companies in the 2001-2003 downturn even through sales were falling

For example, Autonomy (LON:AU) now a FTSE 100 software company saw its sales decline between 2000 and 2003 but doubled R&D over this period. And Renishaw (LON:RSW) a FTSE 250 metrology company saw its sales decline between 2001 and 2002, but increased its already large R&D investment each year to 2004. Sales had recovered to their 2001 levels by 2004 but R&D had by then increased by over 25%.

What effect did these changes have on the share prices of the two companies? The short answer is that they both increased markedly. Between early May 2003 and early May 2006, Autonomy's share price tripled and Renishaw's almost tripled (it increased by over 2.8 times).

So how are they doing in the current recession and more importantly, can they do as well as they did last time? Well, Autonomy is an excellent company and continues to do well. But it's fairly valued at current prices. I'd want to see the price fall before I considered this as an investment making it undervalued.

And as for Renishaw, its share price has fallen a lot already, and it recently issued a profit warning. Again, it's a solid company with the right strategy for innovation in a recession. That means when the upturn in the economy comes, it should have an advantage over the competition. That could lead to a useful share price rise. But we need to see clear indications of demand improving in its customers' markets before considering this as an investment.

But you get the idea. Look for companies that are increasing R&D investment and you start to find stocks that could not only survive the recession but outperform when the good times return.

This article was written by Dr Mike Tubbs for The Right Side