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1 Stock to Avoid Before a Recession

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The Canadian economy probably does not have many years of good times ahead of it. The way government is spending money, the excessive debt that many households maintain, and the fact that oil prices are once again a drag on the economy are all indications that bad times lie ahead. Asset prices, especially real estate, are sky high, making this leveraged nation very fragile to any economic downturn.

It stands to reason that companies that are leveraged to the economy will be negatively impacted by any negative shock.  The most vulnerable ones operate in the financial industry, particularly companies that make loans to highly indebted individuals. One company that might be negatively impacted by an economic downturn is goeasy Ltd. (TSX:GSY). The company started out as a lease-to-own furniture company, but has since expanded its operations to become a non-prime consumer lender.

With the debt addiction in full swing over the last decade, it is the non-prime lending business that has been the biggest driver for the company. The company saw a huge increase of 26.5% in revenue as compared to the third quarter of 2017. Goeasy noted in its earnings release that this was largely driven by a 58.5% increase in its consumer loan portfolio. Results like this are pretty solid.

Its dividend is also quite attractive for income investors. The company currently pays out a respectable 2.24% dividend, which has been increasing steadily over time. The company ticks all the boxes of an excellent investment.

This non-prime business has been massively profitable for the company, which explains why it has decided to refocus from its furniture lease-to-own business to the much less capital intensive, much higher margin consumer loan strategy. As a business, goeasy has been very well run. The company is making a lot of money, so what’s the problem? The way I see it, the issue comes down to the cost of money and the ability of people to borrow. 

If you think of money as a commodity, the historically low interest rates that have persisted over the past several years are the equivalent of $100 per barrel oil that the commodity companies saw over the decade prior to 2015. As per this comparison, companies like goeasy are a price-takers of a sort, with strong demand for their commodity, loans supported by favourable market conditions, the job and housing markets.

If their customers begin to dry up, or worse, start to default on their loans at ever increasing rates the situation could become dire in a hurry. Either a downturn in the housing market or the job market could affect people’s ability to take on new debt or pay down existing loans.

Even more likely is the possibility that both situations will occur simultaneously, as recession-related job loss would put pressure on people’s ability to hold onto their homes and pay down debt, especially given the current state of consumer debt at this time. This company is Canada focused, unlike the larger Canadian banks, and is very exposed to the fate of the Canadian consumer.

As a company, goeasy seems to be very well run. But continuing the analogy of debt as a commodity, the company is a price-taker and would most likely be negatively impacted if the commodity, debt, is no longer in high demand. As we have seen with many commodity companies in recent years, even the best companies struggle and see their share prices go down when their commodity is under pressure.

Thanks to historically low interest rates, debt demand is at all-time highs. The good times are currently rolling for companies operating in the debt industry. But the cost of debt and interest rate levels are currently rising, and dark clouds appear to be approaching on the economic horizon. If you expect the debt party to continue, by all means buy a company like goeasy. However, if you’re worried about a looming recession, now might be a good time to cut loose.

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Fool contributor Kris Knutson has no position in any of the stocks mentioned.

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