3 Stocks To Help Survive A Bear Market

The stock market has officially entered a bear market, with the S&P 500, Nasdaq, and Dow Jones Industrials all down more than 20%. In light of that, I thought I’d cover a few stocks that I think are likely to outperform going forward. The thesis on WHY each one of them is likely to outperform is different, but I look at that as a feature not a bug – if the future develops differently than I expect (and it always does!) having diversification in terms of corporate strengths (not just number of positions) is always a benefit. With all that said, I’ll jump right in with the first of the three.

Interactive Brokers (IBKR)

This brokerage firm is a secularly growing business that has significant competitive advantages. I use them personally, and their automation of things like corporate actions is miles better than their competition, and the pricing is also much better. US-based investors I speak with often don’t see as big a difference between IBKR’s services and their competition, because the US brokerage business is much more competitive than brokerage in the rest of the world. But for international customers, Interactive Brokers is generally competing with the brokerage divisions of local banks, and it almost always has more scale and better pricing. A huge percentage of their staff are software engineers, which means they continue to build systems to deepen that scale advantage (e.g., by adding automated access to markets in new countries).

From a ‘bear market’ perspective, there are two big reasons why IBKR will benefit from the current macro situation. The first is that inflation has proved to be persistent rather than transitory, and interest rate hikes are not likely to be reversed any time soon. IBKR was previously not getting the full spread on customer cash held with the firm, because rates were so low. Now that the Fed funds rate has jumped a full 1.50%, they are receiving their full spread, and the amount they are earning on balances where they don’t pay interest has continued increasing. In fact, based on guidance from their last conference call, a 1.5% increase in the Fed funds rate increases annual income by approximately $489 MM, which is very, very material for a firm that had $1.54 billion of income in the trailing twelve-month period. That also only accounts for current interest rates, and further increases should add about $50 MM in earnings for every 0.25%.

Markets that are dropping also tend to have more volatility, which increases trading volumes as well. The last few months, trading volumes have been up slightly compared to the prior year, but April 2022 was down from March 2022. Trading volumes have been on a tear the last few years, so even flat volumes position them for significant earnings growth this year due to interest rates.

Berkshire Hathaway (BRK.B) (BRK.A)

Warren Buffett’s firm is probably the grand-daddy of value investing, and they also have huge cash balances, to go with the continued ability of their businesses to generate cash for investment. Some of their businesses (the utilities) are especially resistant to recession, but I think the biggest reason to consider an investment in Berkshire Hathaway during a bear market is that they are likely to do well allocating cash during the downturn. Even if all they do is buy back stock, they’ll get a great deal more stock for their money during the downturn, as the price of Berkshire Hathaway has declined with the general market.

Berkshire is probably the firm that would benefit the most from a truly generational panic in the market, as their fortress balance sheet allows them to become a capital provider of last resort during market dislocations. In the COVID-19 panic, the Federal Reserve stepped in with essentially unlimited capital to the markets, which eliminated most opportunities to provide capital at attractive rates in the private market. However, I think it is unlikely the Fed will deploy cash using a firehose this time around, as inflation has become a significant concern, both for them and politicians on both sides of the aisle. That makes them more likely to let markets settle out where they may and probably means that some businesses that would have otherwise found financing simple to obtain may end up taking the “10% coupon plus conversion rights” deals that Buffett has made a great deal of money on with distressed firms in the past.

Ross Stores (ROST)

Ross Stores is a discount retailer with a focus on apparel and home goods. The firm re-sells closeouts and other discounted merchandise, and does so with significant scale. The firm has been a compounder over many years and generally does well during economic recessions for two primary reasons. The first is that a big source of inventory for them is goods that other firms haven’t been able to sell for some reason – either overstocks from retailers or items that manufacturers couldn’t sell to retailers. Both sources of inventory are likely to have higher supply (and thus bigger discounts) during recessions. The other big benefit of recessions for the firm is that consumers become more conscious of their spending and many will trade down from full price retailers to discount retailers, which expands the size of their available market.

I believe the market is suffering from recency bias on Ross, as they did poorly during the most recent (COVID-19 caused) recession. They had to close their stores and in-person shopping was severely limited. They don’t sell online as the nature of their goods (one-offs), their customers (underbanked), and their suppliers (who don’t want to price match the discounts) make that impractical.

I think that any upcoming recession is likely to be more of a “regular” recession than a “shelter-in-place” recession, and so their business shouldn’t be as affected as it was during COVID-19. I also think that while inflation is pernicious, it is possible that incomes at the very low end of the economic scale might keep up with it. There is a significant labor shortage right now, including for unskilled labor. If their customers get raises that offset inflation, it shouldn’t hurt them.

Residential rents have been up significantly across their store footprint, which is sunbelt focused. That hurts their customer’s spending power. However, significant residential construction is also underway in most of their markets as a result of rising rents and low cap rates for residential rental properties. While rents may not drop, I do expect them to at least stabilize, which should take some of the pressure off their customers going forward.

A recession is also likely to reduce freight rates, which have been a significant issue for their earnings recently. The firm is still growing their store count quickly, and given how strong their return on assets/return on equity is, that makes sense. A recession has the benefit of allowing them to get locked-in leases on new stores at low rental rates, which builds a base of profitability for years to come. I’ve done a full write-up on Ross for subscribers.

Conclusion

All three firms have had their share prices decline with the market as rising interest rates to combat inflation stoke fears of a recession. However, all three firms have unique characteristics that make their businesses resistant to a bear market. As the market begins to realize these characteristics, I expect all three to outperform, but I do think the fact the benefits to all three are different does provide some diversification value.