Fears of a serious market correction, or full-blown crash, have been mounting in recent weeks. Rising interest rates, inflation and political headwinds have all conspired to make the current market bull run look rather brittle. The February drop was one of the nastiest single trading days in history, but it was relatively minor compared to a true downturn.
I addressed some of these issues in a recent article, in which I asked readers “Are You Ready for a Crash?” The answer for most investors is probably no. But there is still time to prepare. And we can turn to one of history’s greatest value investors for guidance: Warren Buffett (Trades, Portfolio).
Let’s take a look at how Buffett has successfully weathered past market storms and what investors should know in order to navigate them in the future.
When the rules change, stop playing
The Buffett Partnership, Warren Buffett (Trades, Portfolio)’s first investment vehicle, opened for business in 1956. His success was immediate. Between 1957 and 1969, Buffett delivered an annualized net-of-fees return of 24.5%. The Dow Jones Industrial Average returned just 7.4% annually over the same period.
In 1968 alone, Buffett Partnership investors saw a staggering 58.8% return. It is thus surprising, perhaps, that Buffett’s 1967 annual shareholder letter struck a rather pessimistic tone:
“The results of the first ten years have absolutely no chance of being duplicated or even remotely approximated during the next decade…Such statistical bargains have tended to disappear over the years…When the game is no longer being played your way, it is only human to say the new approach is all wrong, bound to lead to trouble, etc. I have been scornful of such behavior by others in the past. I have also seen the penalties incurred by those who evaluate conditions as they were - not as they are. Essentially I am out of step with present conditions. On one point, however, I am clear. I will not abandon a previous approach whose logic I understand (although I find it difficult to apply) even though it may mean foregoing large and apparently easy profits to embrace an approach which I don't fully understand, I have not practiced successfully and which, possibly, could lead to substantial permanent loss of capital.”
In other words, Buffett was having ever more trouble identifying bargain value stocks. This was thanks in large part to a sustained bull market that had pulled asset prices up across the board. Eventually, rather than attempt to modify his strategy or overpay for new investments, Buffett simply folded his tent and went home. He closed the Buffett Partnership in 1969 and essentially retired.
But be ready to jump back in when the time is right
Of course, we all know Buffett did not stay retired. When the wheels came off the bull market in the years following his retirement, Buffett did not sit on his hands. Instead, he jumped back in and never stopped. After a steep correction, bargains were suddenly available once again, allowing the "Oracle of Omaha" to swoop in and scoop them up while other market participants were busy reeling from their losses. Buffett had the dry powder necessary to exploit the downturn when it came.
In the decades since, Buffett has continued the strategy, if not the exact pattern – he has never felt it wise to exit the market entirely as he did in 1969. Instead, he has focused on excellent companies that produce significant cash flow to guarantee he has substantial cash resources to invest when opportunities present themselves. In 1988, that meant buying a big piece of Coca-Cola (KO, Financial) when its share price was down in the dumps. In 2008, it meant investing in Goldman Sachs (GS, Financial) when it was in severe distress.
By keeping cash on hand for opportunistic acquisitions, as well as having ready access to considerable leverage capital via the float of Berkshire Hathaway’s (BRK.A, Financial) (BRK.B, Financial) insurance empire, Buffett can buy bargains when they emerge while other investors’ liquidity is dried up and margin accounts busted.
You can do it too
The lesson for us mortal investors is clear: By adhering to a value strategy, we can achieve outsized returns. But that comes at the price of potentially foregoing gains in the short run. I do not use a purely Buffettesque value investing strategy, but many investors try to do so. The trick is not simply to invest in the same things Buffett is buying. It is also a matter of understanding the market and when prices are getting out of control.
By keeping some cash on hand as dry powder, or having ready access to additional investment capital (via loans, margin, etc.), investors can exploit market corrections, profiting while others panic. That requires great discipline and mental fortitude at times, but those investors who stick to their strategy and give themselves room to maneuver during corrections will benefit handsomely from their patience and perseverance.
Disclosure: I/We own no stocks discussed in this article.
