Investing in the Growth Recession

 | Aug 29, 2011 | 3:00 PM EDT
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August 2011 will likely go down as a month to remember in the history books of stock market investing. Not only did the market experience extreme volatility, but Mr. Market could not make up his mind. A 500-point drop in the Dow one day was followed by a 400-point rise the next day. And this pattern went on for the better part of the month. A couple of years ago, when the economy was climbing out of the Great Recession, investors were warned about the "new normal" state of the economy. These two words become the new catchphrase.

Catchphrase or not, I think the appropriate description today is "growth recession." Despite the contradiction in terms, it is indeed possible to have a growth recession. Simply defined, a growth recession is an economic state in which corporate activity is experiencing growth during a period of high unemployment, stagnant productivity and weaker consumer data. Seeing as how the U.S. economy is so reliant on consumption, the natural tendency is to lose full faith in the economy.

Going forward, however, the days of 5.5% unemployment may simply be a thing of the past, and the new natural rate of unemployment may likely be around 7%.

Just think about how business has evolved over the past two decades. Thanks to Amazon (AMZN), we likely no longer need traditional bookstores, which eliminates certain types of jobs. The labor force is shifting from a bricks-and-mortar base (requiring more labor) to a digital one (less labor required).

Investors who continue to use the old 5.5% benchmark rate of unemployment are ignoring the flip side: We still have 91% employment. And even if 7% is the new natural rate of unemployment, 93% employment is fantastic, especially if it means people are producing more.

Of course, when housing does recover, it's almost certain that significant jobs will be added to fill ancillary needs. In the meantime, disciplined investors who invest because they want to own part of a business at an attractive price should consider what investing in this growth recession means. As a personal rule, I'm simply choosing to avoid businesses that rely on consumer discretionary products or services that are quickly eliminated when it's time to cut back.

I'm also not saying that one needs to invest in Kroger (KR), however, because it's a grocery store and everyone needs to eat. I am looking for solid growth alongside a favorable entry price. Oil rig operator Ensco (ESV) is a good candidate. Shares trade for $47, or 16.4x trailing earnings, and carry a nice dividend yield of 3%. Shares trade at par to book value despite the strong cash flow generation of the business. Based on next year's analyst estimates, Ensco trades for less than 8x earnings. More important, the next several years should be fruitful as the need for ultra-deepwater rigs increases.

Timken (TKR) sells a variety of industrial goods to agriculture, automotive, mining and construction industries. Over 30% of business comes from overseas, and insiders own over 10% of the company. The balance sheet has no net debt, and profits are recovering from the bottom in 2009. Even though the company lost money in 2009, free cash flow was over $400 million that year. That figure was likely inflated by an abnormal change in inventory, but even in 2010, free cash flow was nearly $200 million. Timken currently has a market cap of $3.6 billion and an enterprise value of $3.4 billion.

The economy clearly needs to improve; even a growth recession is not a sustainable model going forward. But if an investor is willing to look beyond the headlines and exercises caution, then downside market volatility can provide fruitful seeds of opportunity.

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