Trading Strategies: recession risk brings buying opportunities

The prospect of a recession is likely to cause alarm for many stock market investors. After all, a decline in economic activity typically means lower company earnings and weaker investor sentiment that together prompt falling share prices.

With the UK economy’s growth rate amounting to minus 0.1% in January, its performance continues to be extremely weak. This figure follows disappointing growth in the second half of last year. Having expanded by 0.8% and 0.4%, respectively, in the first two quarters of 2024, the economy flatlined in the third quarter and grew by just 0.1% in the final quarter of the year.

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Given that inflation is currently 100 basis points above the Bank of England’s target, with the central bank currently forecasting that it will rise by a further 70 basis points later this year, the prospect of rapid monetary policy easing seems somewhat distant. And even if the Bank of England cuts interest rates at an increasingly fast pace, the existence of time lags means they are unlikely to have their full impact on the economy until next year.

Therefore, it would not be a major surprise if two consecutive quarters of negative growth, which amounts to a recession, are recorded at some point in the near future.

A history of boom and bust

The UK economy has, of course, experienced several recessions over recent decades. Therefore, if it does deliver two successive quarters of negative growth, it would merely be following a long-term cycle of boom and bust.

Crucially, though, it has always recovered from past recessions to record impressive growth in the following years. For example, even major economic setbacks such as the oil price shock of the 1970s, the aftermath of the winter of discontent during the early 1980s, five successive quarters of negative growth in the early 1990s and the global financial crisis in the 2000s, ultimately proved to be temporary, with GDP growth returning to positive territory thereafter.

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Therefore, long-term investors should not become overly concerned about the potential for a period of negative economic growth. Indeed, it can provide an opportunity to purchase high-quality stocks when they trade at extremely low levels. They have the potential to deliver generous capital gains in the long run as improved operating conditions caused by a return to positive economic growth lead to an increase in profitability. In addition, investors who purchase stocks during a downbeat economic period can benefit from a material shift in market sentiment as pessimism gradually returns to optimism.

Seeking fundamentally sound companies

Clearly, any stocks purchased during a recession, or in advance of it, need to have the financial strength to overcome a period of challenging trading conditions. As such, checking a company’s debt levels can be hugely worthwhile. Doing so provides guidance on whether a business is capable of surviving a sudden reduction in profitability. Those firms that do not appear to have a sufficiently sound financial position may be best avoided.

Similarly, companies that have a clear competitive advantage may outperform their peers during a period of lacklustre economic growth. For example, firms that have lower costs than their rivals may be able to implement a more competitive pricing strategy to maintain, or improve, their market position while their peers struggle to do likewise. Firms that have a substantial amount of customer loyalty, meanwhile, may find that their sales are more robust than those of their rivals as consumers increasingly prioritise spending during a weaker economic environment.

Companies that have a sound financial position and a clear competitive advantage may also be better placed to capitalise on an eventual upturn in the economy’s performance. They may be able to invest in opportunities that present themselves during a recession, such as acquisitions, or grow their market share ahead of improved operating conditions. And while the process of recovery following a recession can take several years to be completed, long-term investors who purchase firms with solid fundamentals have typically been rewarded in similar situations in the past.

An uncertain near-term future

Past performance is not a guide to future performance.

Auto Trader Group (LSE:AUTO)’s share price has slumped by 14% in the past six months. This is significantly behind the FTSE 100 index’s 6% rise over the same period, with investors appearing to have at least partly factored in an uncertain near-term outlook for the UK-focused online automotive marketplace.

Indeed, its financial prospects could come under a degree of pressure amid a challenging economic environment. A continued rise in inflation may mean that the Bank of England is less likely to implement a looser monetary policy. Higher-for-longer interest rates could squeeze demand for new and used vehicles, since they are typically paid for via debt.

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An uncertain economic environment, furthermore, may cause consumers to postpone or avoid major discretionary purchases. A slower pace of interest rate cuts also has the potential to weaken the outlook for wage growth. When combined with a higher rate of inflation, this may prompt a cost-of-living squeeze that weighs on Auto Trader’s financial performance. This may lead to heightened volatility in its share price over the coming months.

A high-quality business

Of course, the company’s solid fundamentals mean it is well placed to overcome an uncertain operating environment. For example, it had a net cash position in excess of £11 million at the time of its half-year results in September last year. It also has a strong competitive position, as evidenced by a return on equity figure of 48% in its latest financial year. Given that this was achieved with the use of minimal debt, it suggests the firm is well placed to deliver a relatively strong financial performance over the long run.

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Indeed, Auto Trader is a hugely dominant firm. In the first half of its current financial year, for instance, over three-quarters of all minutes spent on automotive marketplaces were on its website. This provides the company with significant pricing power, given there is a lack of alternatives within the industry. It also means the firm’s revenue could prove to be more stable and resilient than would otherwise be the case.

A long-term opportunity

Almost inevitably, a strong financial position, a clear competitive advantage and a dominant market position mean that the stock has a premium valuation. Even after its share price fall in recent months, Auto Trader has a forward price/earnings ratio of 23. This is relatively high, even while the FTSE 100 index is close to its record level.

However, Auto Trader’s operating environment is highly likely to improve over the long run. Inflation is forecast to fall to 2% by 2027, according to the Bank of England, with its decline expected to provide scope for the central bank to cut interest rates. This should have a positive impact on the economy’s performance and on consumer spending habits, since wage growth could continue to be positive in real terms.

The company, therefore, is highly likely to enjoy improved trading conditions over the coming years that provide a catalyst for its bottom line. This could have a positive impact on its share price performance. Given that it is well placed to overcome potential challenges in the meantime, it appears to have a favourable risk/reward ratio on a long-term view.

Robert Stephens is a freelance contributor and not a direct employee of interactive investor.