It is usual for investors to dislike cyclical stocks. In the end, who could predict macro-economic trends accurately on a consistent basis to buy and sell at near-perfect timings? If such a discipline could be studied, the wealthiest group of people on this planet would be economists!
At Urbem, we fully recognize our inability to make calls on cycles, which in itself is an edge for our investment process in our view. But at the same time, we think that recession provides a unique advantage for a small portion of cyclical businesses - it helps weaken or even wipe out competitors. Such companies can benefit from an economic downturn, as they are market leaders with a sustainable competitive moat, strong balance sheet and robust cash flows that support continuous investments to widen the gap between them and their peers.
Take Graco (NYSE:GGG) as an example. This leading manufacturer of fluid handling systems is exposed to the cyclical industries of its clients, which include construction, machinery and automotive. The company dug itself a wide and deep moat by focusing on a niche market and earning a reputation for high quality in the market through decades.
Graco was struck during the financial crisis but still managed to generate an almost 10% return on assets. Meanwhile, its close competitor, Nordson (NASDAQ:NDSN), could not break even (see below).
While many other businesses in the space like Nordson were busy with making ends meet, Graco continued to invest in technology and innovation to widen the moat and fuel growth. We applaud the management's long-term vision of delivering shareholder value. As you can see below, the company increased its research and development spending during both of the previous two recessions, when its operating profit was trending down.
Looking at the management's response below to our earlier inquiries regarding the cyclical risk, we have reason to believe that the company is fully prepared to take advantage of any recession coming in its way.
"We have the same business model that was in place during the last recession, and I see no reason why things would be materially better or worse if we went through a similar period today. We manage the business for the long term, so there would not be any big changes in our resource commitments. Decremental margins in our business are pretty ugly when revenues decline." - Mark W. Sheahan, Chief Financial Officer
"Graco's model is centered on going through distribution. As a result, its structure allows our channel partners to invest in salespeople, training, and services as the business grows. If we were to hit a recession, our distributors/channel partners would have to adjust first. Graco, would see some adjustments in its variable costs but not on the fixed cost side. As a result, decremental margins would be significant. But that is okay with us. We are in a great position, given our GM to continue to invest as we move through the cycle. So, nothing significant would change in our operations or our strategies. Back in 08/09, we made some adjustments in our workforce (we had to layoff about 200 factory employees, needed to ensure or factories were still focused on productivity), and we double our investment in R&D. By the way, by the end of 2009, we rehired all but 2 of the 200 employees we had been released." - David K. Newman, Investor Relations Director
Similar to Graco, Pennsylvania-based SEI Investments (NASDAQ:SEIC), a leading provider of investment processing, investment management and investment operations solutions, should also have no fear regarding the upcoming economic downturn. The company developed its enduring competitive advantages through the high switching cost of its highly-scalable platforms, which provide a full spectrum of front-to-back-office services.
As shown below, SEI Investments was able to deliver a more than 10% return on assets during the financial crisis, which is far below the historical average but high enough for the business to survive and thrive. In the meantime, the company aggressively spent more cash on investments in 2009.
We think the recession could be a double-edged sword for a business like SEI Investments that aims to help clients improve efficiency, as Chief Financial Officer, Dennis McGonigle, said in a reply to our inquiry:
"If we have an upcoming recession that results in disrupted markets, we usually see additional market opportunity emerge as the markets we serve become more attracted to outsourcing of technology, operations and asset management. We are not immune to market moves, however as '08 and '09 showed our business is financially resilient, our balance sheet is strong and our willingness and ability to lean into clients pays off in the long-term."
Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the financial market. We own shares of SEI Investments.
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This article first appeared on GuruFocus.