I’ve been known to call for recessions too early in the cycle. About two years ago, I predicted we would hit a recession in the following 12-18 months. I whiffed on that prediction. While many economic indicators were pointing towards a decline, others kept the US economy afloat.
I’m a little hesitant here, but I have to admit that I do think we are about to go into a tough economic cycle. Billionaire investor Chamath Palihapitiya agrees.
Get default alive.
— Chamath Palihapitiya (@chamath) September 23, 2023
If you can’t, then create a cash runway (minimize burn) to get to mid 2026.
This is going to be bumpy.
In that post, he is suggesting that startups get to a position of being default alive. Meaning, that the startup can survive and/or is profitable without additional investment. With risk-free US Treasuries paying 5%ish, it is harder for investors to fund startups that are high-risk.
Existing businesses are experiencing similar challenges with funding.
If things are tough, and possibly getting tougher, the question I’ve been asking is, “What type of business is best suited to survive a recession?”
I recently answered this question on X, and below are the three key factors I came up with. For context, one of the reasons I am thinking this through is that I am considering purchasing an existing business.
The product is a need, not a want
There are certain things that people just can’t live without. The easy ones are things that fit into Maslow’s Hierarchy of Needs. That’s things such as food, shelter, and water.
Once you reach the third layer (the second layer includes health and employment), you get into things that are important, but not critical for survival. Those things are things people want but don’t need.
Businesses that are recession-proof sell things people need. For example, grocery stores. Sure, there are some nuisances around whether higher-end versus low-cost grocery stores thrive in recessions. Stores like Dollar Tree are known to print money during economic downturns.
Conversely, premium products that target the middle class tend to see sales drop during a tough economic cycle. Notice that I didn't say luxury items. Those seem to defy economic issues. Likely because the wealthy are less impacted by recessions.
The product doesn’t rely on discretionary income
This requirement is very similar to the need versus want point. But, it goes a step further.
Even during recessions, there are some people who still have discretionary income. They have stable jobs with strong incomes and are still able to save, invest, and spend money on things like vacations. The difference is that they may spend less on those things.
Think about gas stations. During recessions people still buy gas. Those with less secure incomes or less discretionary income just buy less of it. They choose not to take extra long-haul trips.
High margins
The final thing I look for is a business that has high margins. Meaning that their net income as a percentage of revenue is high (low COGS and low operating expenses).
Having high margins means the business can afford all kinds of challenges. If a recession hits and you have to lower your prices to increase demand the business can afford that change. High margins also allow a business to ramp up expenses, such as Marketing, when other businesses are having to cut expenses. In fact, there are some business models that do just that. When their competitors are reducing Marketing budgets, they increase theirs in an effort to make a grab for market share.
What business fits my requirements?
If I was just looking for a business with high margins, I’d buy a software business or some other business where you produce the product one time and are able to sell it over and over. My online courses would also fit that definition. I spent the time and money to produce them once and they have continued to bring in revenue, with little to no effort. But, most software and my online courses don’t fit the other two requirements.
So, what businesses do fit my requirements?
I came up with a few:
- Healthcare
- Utilities
- Food and Grocery
- Waste Management
- Telecommunications
- Insurance
They aren't perfect, but these are industries that fit my requirements pretty well. They generally fall into the first two tiers of Maslow's Hierarchy of Needs.
How would I personally go about picking an exact industry to buy a business in?
I would focus on industries that I already understand pretty well (for example, I know insurance well) and then overlay that with other skill sets that I can bring to the table to improve the operational efficiencies of such a business. For example, maybe there is an insurance business that is performing well but isn’t maximizing income because it doesn’t have a well-thought-out Marketing strategy.
Buying a business, even in a seemingly recession-proof industry,
By the way, if buying an existing business sounds intriguing to you but you don’t have a lot of capital to invest, you can always leverage the search fund model.
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