"It's only when the tide goes out that you learn who's been swimming naked."
It wasn't just investment banks and hedge funds which were caught swimming naked during the credit crisis of late 2008 and early 2009 — many ordinary investors were undressed as well. In fact, Buffett's proverbial beach quickly became the world's largest nudist colony.
It has now been over two years since the market began its remarkable recovery and passions have cooled; it is time to prepare a forward strategy to deal with the next financial panic.
Permanent Losses of Capital and the Market Crash
Remarkably, there are only two major groups who suffered significant permanent loss of capital from the 2008/2009 bear market. The first group consisted of reckless investors who employed excessive margin in an attempt to magnify profits. Their net worth was systematically eliminated by margin calls. To loosely quote Buffett, they were "taken out of the game" due to their foolish employment of leverage. The second group suffered permanent capital loss as a result of their emotions. In other words, they sold on fear and subsequently maintained high cash positions while stock prices were significantly undervalued. Unfortunately for them, many chose to maintain their high cash positions throughout the two year rally.
In my last article I cited the remarkable quote by Schloss: "Timidity prompted by past failures causes investors to miss the most important bull markets." That quote applied in spades following the market crash which ended in March of 2009. Many financially-wounded investors were emotionally unable to redeploy cash back into the equity markets. If they had merely held their positions throughout the crisis instead of being influenced by daily quotes or quarterly statements, they would have recouped most or all of their paper losses within a period of two years.
Don't Panic Sell
I am often amused by survival guides which list the steps to take for such things as; what to do when one gets lost in the woods or procedures to take if one encounters a bear. They frequently begin with the admonishment "Don't Panic", as if the individual had any choice. I guess their perception of panic reflects a typical Three Stooges episode where Larry, Mo, and Curly run around in circles until their heads bang together.
I am not going to advise investors not to panic. Rather, I am going to suggest that they do not allow their emotions to dictate when they sell their holdings. I am also going to suggest that they do not allow their emotions to influence them to maintain cash positions for an extended period during bear markets. Large market declines in 2008 and 2009 accorded intelligent investors a great opportunity to sell and create tax losses to carry forward so long as they quickly redeployed their remaining account balances back into the extremely undervalued equity markets. In the small-cap arena, a number of good companies turned up on net/net screens. Many larger stocks were now trading at historically low price to book and price to cyclically adjusted earnings ratios. Furthermore, their dividends were now becoming very attractive as a result of dropping share prices. It was the perfect time for investors to rebalance and upgrade the quality of their portfolios, while at the same recording tax losses which would allow them to keep a higher percentage of their future capital gains. I recall reading that Mohnish Pabrai worked feverishly in November of 2008 to realign his portfolio.
A personal example is in order. For about a decade I have been fascinated with the cycle in Automated Optical Inspection (AOI) companies. However, my fascination should not be confused with the concept of mastery. As a testament to my ineptitude in trading the AOI stocks, I will cite Camtek (CAMT). I originally bought CAMT shortly after 9-11 at around $2 per share. I subsequently rode it up to about $4 and then back down the elevator, purchasing thousands of shares more in the $0.25 to $0.30 cent range. At .30 it was trading at a huge discount to cash minus total liabilities. The stock rose steadily up to $7 or $8 per share, although I do not recall selling a single share; I must have believed it was the next Microsoft.
Anyway, following the financial debacle I sold my Camtek shares in the one dollar range, creating a slight tax loss. But more importantly, I was able to exchange my shares for their superior rivals Orbotech Ltd. (ORBK) and Rudolph Technologies Inc. (RTEC). Both of which are larger and much higher quality companies in terms of earnings power. The kicker was that they were now much cheaper than Camtek in terms of book value. Orbotech and Rudolph Technologies turned up on value screens as net/net propostions, selling at about a 50% discount to their current assets less total liabilities. I sold my Gray Television Inc. (GTN) holdings as well, redeploying the modest amount of value left in that "investment", into the aforementioned AOI companies. At least my monumental stupidity in purchasing excessive shares of Gray Television was now useful as a tax loss to carry forward.
Suggestions on Rebalancing Portfolios During Selloffs
Russell Napier pointed out in his exhaustive study of the four great bear markets of the 20th century that three out the four bear markets were deflationary rather than inflationary in nature. http://www.amazon.com/Anatomy-Bear-Lessons-Streets-Bottoms/dp/9628606794 The huge market plunge in late 2008 and early 2009 was deflationary in nature. The obvious question is what difference does such a distinction make? I believe that deflationary conditions require a slightly different investing approach than inflationary ones.
Allow me to discuss the above distinction through the eyes of an asset-based value investor. During periods of deflation, current assets, particularly cash, offer a much greater margin of safety than long-term assets. Exactly the reverse is true during periods of inflation. The reason is clear if one thinks in terms of the replacement value of a company's assets rather than strictly the price to book value. Replacement values for long term assets decline during deflationary periods and rise during inflation periods. Simply stated, it costs less to reproduce the long-term assets of a business, such as factories, when labor and material costs are low. Exactly the opposite is true during times of inflation.
In terms of current assets, cash and current assets which can quickly be turned into cash become much more important during periods of deflation. Cash not only holds its value during such times, it also provides a company with the ability to weather financial turmoil during periods when credit is contracting and extremely difficult to attain; should the business turn illiquid. During inflationary times cash and current assets quickly lose a percentage of their value (with the possible exception of inventory), while the value of long-term assets built in pre-inflationary dollars increase significantly in value. Thus, a company with an abundance of desirable long term assets becomes an acquisition target, since it is cheaper to assimilate as opposed to reproduce the assets.
To summarize: Focus on net/nets and companies with a high percentage of their book value in current assets during deflationary market crashes. Focus on companies with low book values and a high percentage of their equity in long term assets built in pre-inflationary dollars during inflationary market crashes. The latter example would have been the case during the highly inflationary bear market of the 1970s.
Remember That All Bear Markets End
Investors need to keep perspective and realize that a market crash is a temporary albeit painful phenomena. For investors who have a surplus of cash to invest, bear markets can represent the buying opportunity of a lifetime. Try to use low market valuations rather than market momentum as an incentive to maintain investment or add to market positions even if it feels like the wrong thing to do at the time.
The only real losers during the market crash of 2008/2009 were the leverage players and emotional-based investors who were scared out of their positions. Investors who focused on the intrinsic value of their holdings rather than downward momentum recovered all or most of their paper losses within two years.
Savvy investors used the market downturn to rebalance their portfolios, accruing tax losses to carry forward, while staying fully invested and emerged with higher quality portfolios with greater intrinsic values.
Ascertain whether the market crash is deflationary or inflationary in nature and invest accordingly.
Bear markets are a temporary phenomenon. Maintain stock positions during such times or better yet, increase equity positions if cash is available. Buying when equities are cheap is imperative in achieving long-term capital appreciation.
Also check out:
- Mohnish Pabrai Undervalued Stocks
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- Stocks that Mohnish Pabrai keeps buying
About the author:
John EmersonI have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies.