Chip Maloney |
Investing Through Bear Markets and Corrections
These are tough markets for Canadian microcap investors. The toughest in a number of years in my opinion. The TSX Venture Index is down more than 25% in 2015. The stock prices of many small companies I follow are down more than 70% from their peaks. Granted some of these stocks got ahead of themselves. Whether you call this a bear market or a market correction, it has still been a tough year overall.
A market correction is generally thought of as a reversal of at least 10% in a stock market, whereas a bear market is usually considered a downturn of 20% or more. I’ve previously been through two bear markets and a few market corrections. My first ever investment was made in early 2000, near the peak of the technology bubble. Six months later, that investment was cut in half, and it was an introduction to my first bear market. That bear market lasted for nearly two years. It was definitely a learning experience, and I realized that during bear markets, stocks can fall well below your lowest estimate of fair value.
I thought I had it all figured out going into the next bear market in 2008. I had a 15% cash position in my portfolio and some hedges going into September 2008. In early October, I started to deploy my cash as some values were starting to appear. Some of these early purchases fell 50% within a few days of buying. Those types of rapid losses will test your psyche. I ended 2008 down 30%. I was fortunate compared to some other microcap investors who were down a lot more than that. When you are down 30%, you start to question whether your past record of out-performance was just luck rather than skill. You wonder if you should just chuck it all in an index fund and retire from active investing.
There are a range of emotions that investors go through during market corrections and bear markets, from fear and helplessness to total despair. In the 2008 market correction, it felt like the financial world was imploding. Every news station you turned on had an apocalyptic message about the stock market and financial system melting down. It was tough not to be fearful – not only were stock portfolios being decimated, but many people had to deal with the fear of losing their jobs and homes.
In the current market, many Canadian microcap stocks are off of their highs by more than 50%. In some cases, the stocks had gotten ahead of the business fundamentals, and the correction was warranted. However, there are some pockets of the market where the underlying companies have continued to see fundamental improvements in their underlying businesses, yet their stocks have been cut in half or more, to prices below their true value. Some of these companies’ businesses are much stronger than they were when they were trading at double their stock price a year ago.
In some cases, a temporary slowdown in growth rates has whacked 50% off of a company’s market cap. Should a few quarters of slower growth and temporarily weaker cash flows really impact the value of a business that will likely go on to prosper for the next fifteen years? Business results don’t always happen in a straight line from bottom left to top right and growth doesn’t always progress equally in three month quarterly increments. So when investors punt the stock of a high quality company out of their portfolio because of a few quarters of weaker results, this makes about as much sense as the Pittsburgh Penguins trading Sidney Crosby for a fourth line winger because the Penguins missed the playoffs one year. If you think of business progress in this way, you can take advantage of corrections, instead of being taken advantage of.
With that introduction, here are ten insights I’ve learned from navigating previous bear markets:
1) Bear markets and corrections give you the chance to buy high quality companies at attractive prices. In John Rothchild’s excellent book The Davis Dynasty: Fifty Years of Successful Investing on Wall Street
2) Corrections often give you the chance to swap out mediocre companies for good quality companies within your portfolio. Both types of companies get hammered in a correction, however, it is often the high quality companies that bounce back the fastest out of a correction. Inevitably, even the best investors often have a few dogs in their portfolio that are lower quality companies that were bought during favorable economic conditions. Often these purchases happen near market tops, when bargains are scarce. When the correction happens, because good companies fall along with poor quality companies, it is a chance to swap out of the poor quality companies and prune the dead-fall so that your portfolio can flourish during the next leg up in the market.
3) Often the most liquidity during bear markets and corrections will come when stock prices are still falling. If you have done your homework, and you think a stock is a good buy, don’t be afraid to buy at this point, even though the stock may continue to fall. It will often feel like you are catching a falling knife. If the stock price keeps falling after you’ve taken most of your position, the natural tendency is to think “what if I had just waited a little longer for the bottom, and bought my entire position at the bottom, I would be much further ahead”. The problem with this line of thought is that there are often very few shares traded within spitting distance of the bottom, and the stock price often rebounds sharply off the bottom with the final capitulation. It is also important to remember that you made the best decision to buy at the point you did, with the information you had, even though the stock may have continued to fall. If you assess the stock price as attractive based on the fundamentals, don’t be afraid to buy even though it may continue to fall. You may feel like an idiot in the short term, but you will usually get your revenge in the long term.
4) Corrections give you the chance to diversify your portfolio into multiple ideas with similar expected values. Towards the end of bull markets, investors often find it much more difficult to find ideas that meet their investment criteria and they often end up concentrating their portfolios into their best few ideas. Corrections give you the chance to diversify your portfolio as valuations on quality companies come down across the board. Many investors prefer to remain concentrated into their few best ideas. But if you are like me, with a preference for more concentrated positions, but still favoring a certain amount of diversification, you can take the opportunity to increase the size of your smaller positions that are now selling at equally attractive valuations as your larger positions in order to diversify risk.
5) Opportunities in special situations increase during corrections when accompanied by weak economic conditions and tighter credit conditions. Inevitably, it is at times like these that some good companies with weak balance sheets have no choice but to recapitalize. Often, there are securities that are issued as part of a recapitalization that can turn out to be attractive investments. In early 2009, The Brick Group was a furniture and electronics retailer that ran into financial trouble and had to recapitalize and bring in new management. After they fixed the capital structure, The Brick Group still had a very solid business with a strong brand and some of the best retail locations in Canada. As part of the recapitalization, it had to issue a large amount of debt, and to make the debt deal attractive to investors, it had to attach warrants to the debt deal. The warrants soon came free trading, and I made an investment in the warrants. Although I only caught the first half of the move, the warrants were a twenty-five bagger over three years from my initial purchase.
6) Don’t be afraid to hold some cash or cash equivalents. These days, I rarely hold cash, but I usually will have a few special situations that will be turning into cash in the near future. It might be a portfolio position that is being taken over and you are waiting for the deal to complete. Or it may be a risk arbitrage play where you are trying to buy below the announced price that a company will be acquired at in order to capture a reasonably safe return over a short holding period. During corrections, companies with strong balance sheets take advantage of competitors with weak stock prices by acquiring them at opportunistic prices. In my experience in 2008 and 2009, there was little to no change in the completion rate on these deals. The risk arbitrage spreads widened with less competition from other investors for these deals because there was a perception that they were less likely to complete during weak markets. The nice thing about these arbitrage opportunities is that they are a source of cash coming into the portfolio at different times during a correction. So as the cash comes into the portfolio as the takeovers complete, you can take advantage of weak stock prices at different points in time during the correction.
7) Make your largest positions the stocks with the least amount of downside. In late 2008, Jannock Properties was my largest position. Jannock was trading at 8.5 cents, and was in the final inning of a liquidation that would soon pay out 15 cents. One director was buying shares hand over fist. It was a lay up. Jannock ended up paying a large dividend six months later, but I didn’t have to hold on that long because the gap between price and value had narrowed within a few months, and I was able to exit and redeploy the cash into other cheap stocks. If you can find stocks with very low downside and some leverage to the upside, it pays to make them your largest positions.
8) Master your emotions and decision making biases. There are certain biases in our thinking that tend to get accentuated with market corrections. One bias that can be prevalent during corrections is loss aversion, where investors already having seen their portfolios decimated become paralyzed by the fear of continued losses. Investors also suffer from availability bias, where they look at the most recent losses in their portfolio and think the trend is likely to continue. Another bias that is prevalent during corrections is social proof which is a type of peer pressure where investors’ actions are influenced by seeing other investors selling to protect from further losses. They must know something you don’t know, right? All these decision making biases prevent investors from taking advantage of corrections. If you can be aware of these biases and try to neutralize them, you are more likely to be on the right side of a trade during corrections.
9) If you do start to feel helpless as your portfolio is getting crushed, focus instead on assessing and re-assessing your current positions. You want to be rechecking your assumptions and analysis on positions you own, and comparing new opportunities to what you already own. In 2008, when my portfolio was hitting new lows, I doubled back to re-assess all my positions and made sure I was getting on the phone to call people in my network – other investors, management and industry contacts – to find out what was happening on the ground in real time. It doesn’t mean you have to make drastic changes to your portfolio, but when you do this, not only does it improve your information flow, but it also helps to deal with the downward volatility as it gives you a sense of control, and changes your psychology from being a passive participant to engaging actively in your portfolio.
10) And finally, remember that periods of poor returns are historically followed by periods of high returns, so focus on the long term. Although it provides little consolation in the middle of a bear market or correction, try to remind yourself that the returns following these weak markets are usually quite good. Having a long term investment time horizon will allow you exploit the fact that most investors are investing with a short time horizon. If you are willing to lean into the wind during corrections and buy stocks from short term focused investors because you are willing to delay gratification and wait for the long term payoff, you give yourself a much better chance to achieve above average returns over the long term. After the 2000-2002 and 2008 bear markets, the few years coming out of the bear markets produced the highest returns of my investing career. As night follows day, good returns generally follow poor returns in the markets.
To end, arguably the best piece of literature on how to handle bear markets and corrections is a poem written by Rudyard Kipling over one hundred years ago. When you are feeling despair from losses adding up in your portfolio, try reading this. Hopefully it will give you the determination to persist.
If
by Rudyard Kipling
If you can keep your head when all about you
Are losing theirs and blaming it on you,
If you can trust yourself when all men doubt you,
But make allowance for their doubting too;
If you can wait and not be tired by waiting,
Or, being lied about, don’t deal in lies,
Or being hated don’t give way to hating,
And yet don’t look too good, nor talk too wise:
If you can dream—and not make dreams your master,
If you can think—and not make thoughts your aim;
If you can meet with Triumph and Disaster
And treat those two impostors just the same.
If you can bear to hear the truth you’ve spoken
Twisted by knaves to make a trap for fools,
Or watch the things you gave your life to, broken,
And stoop and build’em up with worn-out tools:
If you can make one heap of all your winnings
And risk it on one turn of pitch-and-toss,
And lose, and start again at your beginnings,
And never breathe a word about your loss;
If you can force your heart and nerve and sinew
To serve your turn long after they are gone,
And so hold on when there is nothing in you
Except the Will which says to them: “Hold on!”
If you can talk with crowds and keep your virtue,
Or walk with Kings—nor lose the common touch,
If neither foes nor loving friends can hurt you,
If all men count with you, but none too much;
If you can fill the unforgiving minute
With sixty seconds’ worth of distance run,
Yours is the Earth and everything that’s in it,
And—which is more—you’ll be a Man, my son!