In Search of Recession Proof Stocks

On Wednesday the 14^th of August in the US something not seen since 2007 shocked investors around the world. The yield curve between US Treasury 2 year and 10 year bonds inverted.

This means the historical expectation of investors demanding higher yields for longer term holdings had shattered, albeit briefly, as the curve, or spread between short- and long-term interest rates, flattened again.

By the end of the trading day in New York, the Dow Jones Industrial Average (DJIA) had fallen 800 points, or 3%. The carnage followed to the ASX where early Thursday morning trading saw a drop of 154 points, around 2.3%.

Frightened investors looking for advice are deluged with varying opinions on the impact of an inverted yield curve over time, with some citing its accuracy in predicting recessions and others heralding it as a “BUY” signal.

Few analysts are predicting a recession soon, with advocates of the predictive capability of an inverted yield curve reminding us the gap between the inversion and the onset of a recession can be as long as two years.

While opinions vary on the likelihood of a global recession, no one can dispute the fact investors are abandoning equities in favor of bonds, regardless of the country of origin. That is a clear sign of weakening market sentiment. Investors who have been in the game awhile know sentiment, or perception, often flies in the face of reality. In the US and here in Australia as well, there are those pointing to positive signs of economic stability, but apparently of little notice to the investing community as a whole, given the extreme volatility in global stock indices in recent days.

To add to this toxic mix, the US 30 Year bond yield dropped to its lowest level ever, with the potential for investors fleeing into 30 Year bonds to lose money over the life expectancy of the bond, with rising inflation and deteriorating economic conditions.

Taking profits of selling at a loss and shifting to the relative safety of fixed income bonds is one strategy for navigating challenging economic times. Another is to take available investing dollars and buy “recession-proof” stocks.

Among the many criteria for selecting a recession proof stock one can find in an Internet search, two bear mentioning.

1. The good or services the company provides are essential components of life that are not easily curtailed in the event of an economic downturn.
2. The price of the goods or services are within the capacity of consumers to reach, albeit with a struggle.

During the GFC many supposed “recession proof” stocks failed to live up to their promise, especially those who failed to meet the first criterion.

The ASX contains some of the best health care stocks on the planet, with all of them meeting one or both of the two criteria:

• CSL Limited (CSL)
• ResMed Incorporated (RMD)
• Ramsay Health Care Limited (RHC)
• Cochlear Limited (COH)

The following price movement chart from the Reuters financial website shows these four powerhouse stocks avoided the precipitous falls experienced by most ASX blue chip stocks in the GFC.

The GFC began to gather steam with the declines in the US housing market in 2007 with its full fury unleased by the collapse into bankruptcy of US investment bank Lehman Brothers in October of 2008.

Note than none of the four plunged in the wake of the GFC, with share price stabilising and Ramsay Health Care the first to begin an upward trek, with its “market darling” status interrupted first by management changes, followed by lackluster performance from acquisitions in France and the UK, and finally by cost pressures forcing consumers to seek medical care in public hospitals, rather than the private hospitals owned and operated by Ramsay.

The company that best meets the twin criteria of essential need and affordable price is blood plasma and vaccine provider CSL Limited. While all four companies should benefit from ageing populations around the world, hearing implants from Cochlear and sleep apnea devices from ResMed in some cases may be more desirable than essential. However, CSL, Cochlear, and ResMed all have the advantage of coverage in varying forms from both private insurance and state and federal government assistance. As a private hospital operator, Ramsay faces competition from publicly funded hospitals.

The following table lists some key investment metrics and share price performance for these four ASK health care growth stocks.

From time to time in their upwards ascent, many growth stocks are subject to downgrades due to “valuation” concerns. Newcomers to share market investing might find this puzzling as it seems some stocks are punished for being too successful.

A recent case helps to explain the rationale behind analyst downgrades on valuation concerns. Venerable US investment bank Goldman Sachs downgraded shares of Cochlear from a BUY to a NEUTRAL rating, citing classic “valuation” concerns stemming from the stock price appreciation of 18% since April, moving the price to within one percent of Goldman’s price target. So, Goldman downgraded the stock while at the same time raising the price target to $212.00, a figure already exceeded by the COH 52 week high.

The Goldman analysts go on to cite issues that suggest future growth will not justify the high price of the stock, chief among them EU funding caps and challenges of serving an ageing population.

In Goldman’s view, cochlear implants for seniors will be a more difficult sale than implants for paediatric clientele. This may be the case, but the ageing population in the eyes of most investors and market commentators will provide strong headwinds for all four of these stocks.

Cochlear makes implantable hearing devices for all ages, with a reported 550,000 devices implanted, according to the company’s website. Investors who have been in the markets for a decade remember the disastrous recall of a flagship Cochlear product in 2011. The aftermath included numerous analyst predictions the company would lose market share to rival Advance Bionics. The share price took a substantial hit but once the problem was resolved it began to rise, non-stop with some bumps in the road along the way.

While a private hospital provider like Ramsay can continue to acquire properties and work to lower costs and improve efficiencies, the company lacks a major competitive advantage of the other three big name ASX health care companies – research and development leading to technological breakthroughs in new and existing products. Since the 2011 fall, Cochlear has introduced multiple innovative offerings to the market.

Ramsay has also earned negative commentary from Goldman Sachs, with the bank maintaining its SELL rating on the stock citing long term concerns:

• “RHC is currently growing above industry averages, as corroborated by recent performance and industry feedback. We believe this is achievable due to its scale and market-leading portfolio but, over the long-term we believe it is difficult for any player with such dominant share to sustainably outperform the market, as demonstrated historically. In any case, recent industry data suggests that in-patient volumes are continuing to deteriorate, a trend which RHC will struggle to avoid with >30% share.”

One could easily argue that Cochlear’s investing more than AUD$160 million dollars in research and development bodes well for its future. The R&D impact cannot be underestimated. Despite the Goldman downgrade of Cochlear, Full Year 2019 Financial results showed both revenue and profit increases of about 7% in the face of a new competitive product launched in the US and Germany. However, company management points to rebounding sales in those regions with the introduction of the Nucleus Profile Plus Series. Coupled with other new product launches throughout the remainder of 2019 has the company promising strong growth into 2020.

The Cochlear share price got a bump on the positive financial report, the third consecutive year of rising revenues and profit.

ResMed, like Cochlear, is primarily a medical device manufacturer specialising in sleep apnea treatments. The company’s impressive R&D efforts over the years have digitised a formerly mechanical offering with multiple cloud-based applications for diagnosis, treatment, and equipment management.

The company’s product line shows both depth and breadth, all focused on the broad category of sleep disorders. While the company has grown revenue in each of the last three fiscal years, net profit slipped from FY 2017 to FY 2018, before rebounding strongly in FY 2019 with an increase of 35%.

With its line of digital apps, the company is now generating revenue from both software and hardware sales. For FY 2019 software as a service (SaaS) sales posted the largest percentage increase – 76% — of all ResMed operating segments. The company increased its R&D budget from USD$155.1 million in FY 2018 to USD$180.7 million. Revenues were up 11% and net profit was up 7%.

Following the results Goldman Sachs upgraded its price target for RMD to USD$21.20, with the opinion RMD shares are cheaper than both CSL and COH with similar growth metrics.

CSL Limited has been in business for more than 100 years and now is a global leader in the development of innovative biotherapies and influenza vaccines, operating in two segments.

1. CSL Behring develops and distributes plasma therapies (plasma products and recombinants), for the treatment of a variety of disorders, from bleeding disorders to immunodeficiency to neurological disorders, many being life-threatening conditions.
2. Seqirus develops and distributes non-plasma biotherapeutic products and influenza related vaccine products.

CSL continued its consecutive streak of rising revenue and profit with FY 2019 revenue increase of 11% along with a 17% profit increase. The company expects to take a hit from its changing distribution model in China but still sees net profit after tax (NPAT) growth in FY 2020 of between 7% and 10%.

CSL historically has spent 10% of its revenue on R&D. Following the FY 2019 release, Credit Suisse raised it recommendation from NEUTRAL to OUTPERFORM, along with a price target increase to $249.

A major attraction for buy and hold investors with CSL stock is the number of products the company produces that are lifesaving.