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How to invest well during a recession

A recession is not the end of the world, says this Canadian analyst — in fact, it can be the beginning of some very profitable investments.

It would be nice if we could toss the word “recession” out of our vocabulary for a while. Not to mention “subprime,” “slowdown” and other terms that stare glumly out at us from the financial pages.

But it’s there, like a tree fallen across the highway. If we don’t deal with it, we’ll never get anywhere.

So go ahead and deal with it, is the advice of one Canadian portfolio manager. In the process, you’re bound to discover some very good investments.

“Investors hate everything — the world, in their eyes, is ending,” writes Mr. Peter Hodson in Investor’s Digest of Canada. “Settle down, people. We have been in recession before. It is not, in fact, the end of the world — it is a recession. Deal with it.”

Mr. Hodson happens to have some investments in his portfolio that are doing very well, thank you, as we’ll see in a moment.

And for those who don’t think a recession is a time to be ultra-cautious, we have a couple of juniors recommended in the same advisory.

Too cheap to ignore

Mr. Hodson asks that investors look beyond the obvious victims of the current troubles. “If you ignore financial companies, where the bulk of the problem lies,” he says, “companies aren’t doing too badly.”

He cites the S&P 500. Overall earnings on the index are down for the fourth quarter of 2007, but if you subtract financial firms from the 300 companies that have reported so far, earnings are actually up 18 per cent.

“Growth companies are too cheap to ignore, in my view,” says the portfolio manager. The S&P Growth Index is trading at 16 times price-to-earnings and the S&P Value Index at 20 times price-to-earnings. “All the financial sector losses have resulted in the ability to buy growth companies at cheaper valuations than value companies.”

This is pretty close to being historic, he adds. “I can’t say this has never happened before, but I can’t recall this valuation gap happening in my 20 year career. If you can buy a faster-growing company more cheaply than a slow-growth company, why wouldn’t you?”

What’s more, things that were supposed to stop happening as a recession set in are still happening.

Takeovers and China

Takeovers were supposed to end, says Mr. Hodson. “But someone forgot to tell Microsoft, which is now willing to throw around $44 billion in cash to buy Yahoo. Someone also forgot to tell BHP Billiton about the death of takeovers, as BHP recently formalized its $147 billion offer for Rio Tinto.”

China was supposed to start running out of gas as the U.S. slowed down. Not yet. Reaching into the portfolio at the Sprott Growth Fund he manages, Mr. Hodson pulls out Yucheng Technologies Ltd. (NASDQ-YTEC), which provides technology to banks. Its revenues jumped by 49 per cent in the fourth quarter.

No slowdown there, observes the portfolio manager. He also has high hopes for the fourth-largest jewellery maker in China, Fuqi International Inc. (NASDQ-FUQI). It trades at 12 times earnings now, but it is expected to grow by over 35 per cent this year.

The analyst has a few more random thoughts on this market, and one more intriguing recommendation.

Volatility and earnings yields

The Chicago Board Options Exchange has a volatility index, generally known as VIX. It has just hit a six-year high, says Mr. Hodson, and volume has been spiking on the NYSE.

These are pretty sure indicators of panic selling in the markets. “What’s more,” says the portfolio manager, “we have had more days of one per cent plus swings in the market this year than ever before.” Based on this pattern, the market now has a 50 per cent chance of rising or falling more than one per cent each day.

“This type of volatility has been known to mark market bottoms,” comments Mr. Hodson.

Earnings yields, on the other hand, are starting to look very attractive. Overall earnings have slowed down, but the yields look much better than bond yields. Plus, the rapid decline in short-term interest rates has caused the yield curve to sharpen steeply.

“According to some analysts,” says this analyst, “we have never had a recession while there was a steep yield curve in place. It allows the banks to borrow short and lend long at higher rates — locking in a nicer spread (assuming your clients can pay you back!).

Next he puts some coal on the fire.

Perfect storm in coal

“There seems to be a perfect storm brewing in the coal sector,” says Mr. Hodson. “Snowstorms in China, floods in Australia, power shortages — you name it — there have been lots of production delays in the coal market. Overlaid with continued strong demand, it is no surprise coal prices continue to hit record highs.”

He has several coal stocks in his portfolio, most notably Walter Industries Inc. (NYSE-WLT). Walter never gets any respect, says the portfolio manager, because it also owns a small house building company. But coal accounts for 95 per cent of Walter’s revenue and all of its profit. The stock is up 22 per cent this year (and it has risen since the article was written) with a 10 times forward price-to-earnings ratio.

Mr. Hodson does not want his Investor’s Digest readers to think he is entirely bullish. The market does require some prudence. “A big gold position helps me sleep at night.” With interest rates going down and “a giant liquidity wave pouring over the world,” gold should continue to be a place of refuge for investors everywhere, he concludes.

Gold in Hercules

If gold is a haven, then a major new gold discovery in Northern Ontario is certainly worth mentioning. Admittedly, many of those who seek safety in gold will not transfer their affection to the risky business of junior miners.

But Mr. Mike Kachanovsky, a specialist in junior mining stocks, not only likes the discovery made by Kodiak Exploration Ltd. (TSX/V-KXL), he thinks they go about their business the right way.

“Kodiak is not the kind of junior miner that would be content to poke a few holes in a property and ride a resource bull market,” he says. Looking for large mineral deposits, it acquired the Hercules property in the Beardmore-Geraldton mining district.

The property is in an area known for its high-grade deposits, but deep forest cover and other impediments had made it difficult to exploit. So far, the exploitation has gone very well. Indeed, based on the high grades of gold encountered so far, says the analyst, “Hercules could become one of the most exciting gold discoveries in Canada.”

The upside of a major discovery makes it worthwhile to put up with volatility and risk, according to this analyst. “I think Kodiak is going to be a good news story for a long time to come.”

Kodiak gained the attention of speculators last year and the shares rose, but the market correction pulled them back down at the beginning of this year. The shares have risen from $2.46 to $3.20 since this article was published.

Oil in the North Sea

Not content to bring you one junior in the midst of a tumultuous market, we have one more interesting example. It is an energy firm that has graduated from exploration to production.

Mr. Brian Hoffman, whose area of expertise is junior oil and gas stocks, is not terribly concerned with a potential drop-off in the price of crude oil. Companies whose reserves and production are heavily weighted to oil should do well for the next several years.

Ithaca Energy Inc. (TSX/V-IAE) of Calgary is one that is planning lots of growth in both reserves and production in the North Sea. The company has exploration and development properties spanning 561,542 acres in the region and a management team that knows how to handle them.

It has also become a producer. The company’s wholly owned U.K. subsidiary has agreed to acquire Talisman Energy’s 100-per-cent interest in the Beatrice oilfield in the North Sea. That will turn the company into a producer of 1,800 barrels of oil equivalent a day at a field that has yielded more than 165 million barrels since 1979.

With this deal, Ithaca acquires lots of infrastructure, including three offshore drilling facilities and an onshore storage facility. It is also enjoying success on several of its exploration and development projects.

The stock is thinly traded, Mr. Hoffman tells his readers in Investor’s Digest of Canada, but the “share price has the potential to increase significantly from the current level if Ithaca is able to successfully execute the exploration and development of its North Sea properties.”

Trading at $2.74 when this issue went to press, Ithaca opened today at $2.92.

A couple of lively looking juniors may be a bit of a stretch for many investors in times like these. But at least one portfolio manager believes that this recession is just the time to go looking for growth stocks.

It is not the end of the world, but it could be the beginning of some beautiful profits.