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Rupert Hargreaves
Rupert Hargreaves
Articles (366)  | Author's Website |

Seth Klarman: How to Act in a Bear Market

Advice from the renowned value investor

December 06, 2017

In today’s market, after nearly a decade of low volatility and steadily rising stock prices, it is easy to forget the turmoil that gripped the stock market, and the world, in 2008-09.

Even though a crash might seem a million miles away currently, you never know when the next decline might arrive, so it is always best to prepare for the worst. The best way to prepare is to read accounts of investors given at the time.

This will not give you answers as to when the next crash will arrive (all but impossible to predict), but it will provide a sort of template as to what goes on.

Learning from Klarman

One of the most fascinating accounts of investing during the crisis comes from Seth Klarman (Trades, Portfolio). In February 2009, Klarman wrote an article in Value Investor Insight titled, "The Value of Not Being Sure." Within the article, he detailed how he was investing in the crisis and why he thinks fear is such a great motivator. 

Klarman begins his piece discussing the need for investors to separate the ideas of volatility and risk. He then goes on to note that with markets down 40% to 50%, this might be difficult as “there is a vicious circle in effect (the reverse of the taken-for-granted virtuous circle that buoyed the markets and economy in good times). This vicious circle results from the feedback effects on the economy of lower securities and home prices and a severe credit contraction, and, in turn, effects of a plunging economy on credit availability and securities and home prices.”

In such an environment, it is difficult to find winners above the refuse. Bargain hunters who jumped into the market in 2008 went on to be “surprised by the magnitude of the selling pressure” and “extent to which deterioration the business fundamentals has come to justify the lower market prices.”

This problem is just part of the value process, Klarman said. Not all declines are equal. The weaker companies will fail, weaker investors will sell out at the bottom and value investors, who are prepared to wait, will be well rewarded.

“It turns out you won’t be able to accurately tell who’s been swimming naked until after the tide comes back in.”

He goes on to say that trying to time the market, especially in the throes of a bear market, is a waste of time. You will not be able to pick the bottom and prices rise quite quickly. The best method is to choose your bets and then weather further declines if they materialize.

“While it is always tempting to try to time the market and wait for the bottom to be reached (as if it would be obvious when it arrived), such a strategy has proven over the years to be deeply flawed...the price recovery from a bottom can be very swift. Therefore, an investor should put money to work amidst the throes of a bear market, appreciating that things will likely get worse before they get better.”

Markets are not controllable, but your process is. As Klarman notes, “Controlling your process is absolutely crucial to long-term investment success in any market environment.” A focus on process, not outcome, will help you make the right decisions in a falling market and not become a slave to your emotions, which may lead you to make mistakes.

Part of the process has to be flexibility. Investing is an uncertain business, and no matter how rigorous your process, you should be prepared to make changes if the facts change as well. This is Klarman’s defense of uncertainty. He argues that uncertainty motivates diligence as “one pursues the unattainable goal of eliminating all doubt.”

“It is much harder psychologically to be unsure than to be sure; certainty builds confidence, and confidence reinforces certainty. Yet being overly certain in an uncertain, proactive, and ultimately unknowable world is hazardous for investors. To be sure, uncertainty breeds doubt, which can be paralyzing. But uncertainty also motivates diligence, as one pursues the unattainable goal of eliminating all doubt. Unlike premature or false certainty, which induces flawed analysis and failed judgments, a healthy uncertainty drives the quest for a justifiable conviction.”

Overall, Klarman believes process and uncertainty are the keys to surviving a downturn and managing a successful investment process in general.

About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. Prior to his investing and writing career, Rupert was as a proprietary currency trader. Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

Visit Rupert Hargreaves's Website


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Comments

csucag2
Csucag2 - 1 week ago    Report SPAM

Any thoughts on what we should invest in when the next bear market comes? Obviously a lot of money was made if money was invested in 2008/9 even in the indexes but what investments gave even greater returns? Was it net nets for example? I had just started investing in 2008 so I didn't know how to profit by the once in a generation opportunity, if we have another opportunity coming up (although it may not be as great) I would like to get it right this time.

Rupert Hargreaves
Rupert Hargreaves - 1 week ago    Report SPAM

I would say you have three choices:

  1. Dollar cost average index funds
  2. Buy net-nets or cheap stocks (assuming you have time to do the research to make sure you're buying value, not a value trap)
  3. Good companies at great prices/compounders. I wrote something on this a few days ago: https://www.gurufocus.com/news/603927

Personally, I'm using all options with a rough 10%/30%/60% weighting (currently using this strategy and will continue as the market falls).

csucag2
Csucag2 - 1 week ago    Report SPAM

Thanks for your thoughts. I heard an interview with Tobias Carlisle where he said that he bought net nets at this time and made 250% return in 9 months (or a year I forget) however he worked out that if he had just bought all net nets rather than doing his own research and picking which net nets to invest in he would have made 750% in the same time frame!

Rupert Hargreaves
Rupert Hargreaves - 1 week ago    Report SPAM

That's a great point and I don't doubt that it's true. The problem I've found with this is that buying everything requires a large portfolio, I mean putting just $250 into 100 different net nets is not practical because with some of these stocks you could be looking at a 5/10% bid/ask spread and then commissions on top which will make a larger slice of the pie with the smaller amount. You could say avoid the large spreads, but that takes you back to stage one, you're picking stocks not buying the whole basket. Also, another thing to consider is emotion. It's inevitable that some picks will go to zero. Do you have what it takes to ignore these and carry on with the strategy? Maybe, but if you don't the whole thing could fall apart. If you research and know an opportunity well, the risk of you screwing up is much reduced. Hindsight is a wonderful thing but in the real world there will always be constraints that hold us back.

csucag2
Csucag2 - 1 week ago    Report SPAM
Thanks for your thoughts again, they make sense. The stock market is expensive and there will likely be consequences (Howard Marks (Trades, Portfolio) recent commentaries) but I am staying fully invested (in cheap value stocks as always) as I of course can't time the market and so I won't be sitting on the sidelines in this bull market and its collapse. This will inevitably bring about losses (hopefully my losses will be less than some others due to my value investments) but the way to cope with this I think is to know that there will be great opportunity after this (Pzena's latest commentary shows that it's not all bad!) so I want to be prepared to make the most of it. This is my interest at the moment. I wish I had made more notes in recent years of articles where people stated how they did well in the last crisis (taking some with a pinch of salt of course), for example I know Tepper makes a lot in down markets but I don't think I can clone his ideas. History won't repeat itself but it does rhyme. Do we invest in the net nets, magic formula, quality, stocks in the most distress etc? This is the question in my mind at the moment. There could be an opportunity to make some great returns!

jtdaniel
Jtdaniel premium member - 1 week ago

Hi Rupert and Csucag2,

Just my take -- A bear market can provide the ideal opportunity to really average down on your favorite holdings or to finally own the best name(s) on your watch list (Visa, Core Labs and AB-InBev in my case). Thanks (well, sort of) to being bought out of my positions in Anheuser-Busch and Wrigley in the fall of 2008, I was able to average down on American Express and Microsoft.

Super cheap stocks are not my game, but I would be wary of small, capital-intensive businesses with significant debt, as they may not be able to survive a credit crisis. Best, dj .

Rupert Hargreaves
Rupert Hargreaves - 1 week ago    Report SPAM

Hi Dj,

I agree with your view here as well. I think the key thing is to stick to your strategy. If you like compounders, buy more. If you like indexes, buy more. If you like net nets, buy more. It's all about having a plan, sticking to it and not panicking. I think that's essentially what Klarman is trying to say.

As a point of principle, I always stay away from companies with lots of debt!

csucag2
Csucag2 - 1 week ago    Report SPAM

Thanks for your response dj, helpful.

Kbannon77
Kbannon77 premium member - 1 week ago

I have found that the best way to ensure you succeed is to stick with your system, whatever it is. Well-founded confidence is worth more than any analysis in a bear market.

In other words, if you don't have a system for identifying attractive investments, there's no way you'll be able to handle a bear market.

gfh
Gfh premium member - 2 days ago

Thanks, this certainly reinforces Warren Buffet's point that it is often better to pay for quality than reach for value.

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