"All companies need to perform in all business conditions. When the economy is on an upswing, all businesses do very well. But, you need to identify the company that has done better when the economy is in a state of recession; that company is the real winner.'
"Here is a scenario to consider. When the economy is on an upswing, businesses generate more revenue and more earnings. The company has cash on its balance sheets and the business is adding cash each quarter. Senior management wants to expand the business as soon as possible. They are formulating aggressive plans to become a big company in a short period of time, either through acquisition or fast-paced expansion.'
"To support the aggressive growth, they use bank debt, leveraged up as much as possible. The banks also think that the company will generate the same level of increased earnings in the future and allow the company management to leverage up to the maximum possible level. During boom times, the company might have acquired other businesses at an inflated price.'
"After the economy booms, the stock market soars. Ultimately, stock prices reach bubble levels and finally burst. Then reality comes into the picture. The economy slides back into recession. Companies' revenues start falling faster. Management might not be able to cut cost fast enough. Because of falling revenues, earnings start to fall. The company's management faces difficulty when servicing acquisition debt, starts to violate the financial covenants, and finally ends up in bankruptcy.'
"This kind of cycle happens all the time. The 1990s tech boom created a bubble in the stock market. It finally burst in 2000 and the economy slid back into a recession until 2003. In 2003, the real estate bubble started. Banks were lending money to commercial and residential developers and sub-prime borrowers, thinking that real estate prices would never come down. When reality set in, the financial crisis hit in late 2008.'
"If a company's management is capable or experienced enough to understand business cycles, they act prudently. They conserve cash when the economy is in expansion and run the existing business as usual. When the economy bursts, less well-capitalised companies get into trouble. The well-run businesses acquire the troubled companies at fire-sale prices or take away market share when their competitors end up in bankruptcy.'
"This is what happened during the last financial crisis; the well-capitalised banks absorbed the troubled banks. When you are researching a company for a possible investment, do the research and find out how the company performed during the last recession. If they come out stronger than before, that kind of company will reward the shareholders very well over the long term."
(pp. 59-60, 'Creating a Portfolio like Warren Buffett: A high return investment strategy' by Jeeva Ramaswamy – Wiley)