On Tuesday evening, the Treasurer Josh Frydenberg discussed the impact of COVID-19 on the economy with the economics editor from The Australian. In this conversation, Frydenberg stated that we are definitely in a recession. Not only that, but this time, an Australian recession will be worse than it was in 1991. I had just entered the workforce prior to the 1991 recession, and an experience like that is not something that you easily forget.
If this is where we are headed once the smoke clears from the coronavirus pandemic, then I think it would be wise to structure your portfolio accordingly. This is something I have been contemplating for a few weeks now. Some businesses will flourish and grow, others will stagnate, and yet others will come under very extreme cost pressures.
In particular, companies and people will be looking to increase the amount of capital on hand.
Cashflow in an Australian recession
Companies with lumpy, milestone-based revenue streams can find themselves living off cash in hand for an extended period of time. For instance, companies like engineering firms, consultants, project managers and construction/maintenance contractors.
In the event of an Australian recession, this effect worsens. For instance, the overall amount of work may go down, or the time between invoice and payment may extend, leaving the service provider more reliant on fewer milestone payments.
With the importance of cashflow in mind, here are 2 ASX shares that could find themselves in great demand if we move further into a recession.
CML Group Ltd (ASX: CGR)
CML Group is a small cap designed for hard times. The company specialises in short term credit for small and medium enterprises. CML's main generator of revenue is what's known as invoice factoring, which is a mechanism companies can use to smooth out payments. An invoice factoring company pays the invoice for you, minus a fee, and then takes payment when the client company pays. In some cases the factoring company will collect the payment directly from the client. This is a simplistic explanation, but you get the general idea.
CML recently reported strong monthly growth in volumes as business restrictions eased. In 2020, even with the COVID-19 total lockdown, the company financed over $1.7 billion in invoices compared with $1.6 billion for FY19.
Moreover, it has a 9 year average return on equity (ROE) of ~15%. This means for every dollar of net assets the company has, they earn 15c. I think this is a good level and shows the company has high margins.
CML Group also provides 2 other credit mechanisms businesses may need in an Australian recession. First, asset finance, either secured against current machinery or to purchase new machinery. Second, trade finance. This allows businesses to import products from overseas without having to spend their own working capital.
Sezzle Inc (ASX: SZL)
In hard times, people are generally less likely to make long-term credit commitments. In fact, they tend to cut back spending in a whole range of areas. Buy now, pay later (BNPL) companies are the latest iteration of short-term credit providers. The business model charges merchants instead of consumers. Consequently, it is a more attractive method for products and, increasingly, for services.
Operating within Australia, the 2 major market players are Afterpay Ltd (ASX: APT) and Zip Co Ltd (ASX: Z1P). However, I have always preferred Sezzle Inc, a company I own shares in.
Sezzle is headquartered in the United States, operating directly in the US$5.4 trillion dollar retail market. The company announced earlier this week that it now has a network of 1.48 million users and 16.1 thousand merchants.
This is useful for 2 reasons. First, I believe the company remains undervalued and has a long growth trajectory ahead of it. Second, the US population is ~13 times larger than Australia. Therefore, no matter how bad the economy is in the US, there will always be a greater number of people who can spend money as opposed to an Australian recession.
The risk here is that of unsecured debt. When times get tough unsecured debts are often the first to be jettisoned. However, in the case of Sezzle there are light credit checks in place, and the timeframe for repayments is very small. Consequently, I think this lessens the chance of a high defaults levels.
Foolish takeaway
When the hard times come people act differently. Individuals become less secure in their employment, while companies try to ensure they maximise capital on hand. The 2 companies above help to manage cashflow, while keeping debt commitments to a short term horizon.
I think companies like these will flourish in an Australian recession, and I am carefully considering adding CML Group to my own portfolio.
