Crisis Investing (IV)
Crisis: a time of intense difficulty, trouble, or danger
Financial Crisis: any of a broad variety of situations during which some financial assets suddenly lose a large part of their nominal value
Dear Mr. Market,
Crises are fascinating times. Stories about how an individual or group stoically faced and overcame a crisis will go down in history forever. In 1940, during one of the darkest hours in WWII, with France on the brink of collapse to the Nazi regime and Britain’s survival being calculated in just weeks, Winston Churchill delivered his “We Shall Fight on the Beaches” speech. His call to fight in seas, oceans, hills, streets, and beaches — to “never surrender” is regarded as one of the most rousing and iconic addresses of WWII.
However, on the other hand, crises often leave most of us as victims in its devastating wake. While the panic and overreactions roar around us, logic and rationality flies out the window and fear and emotions take over. We no longer make objective decisions as everything is tainted by the fear and unknown.
Since this is a discourse on value investing, we will be examining market crises and how we can navigate them so we come out unscathed, as crises can potentially open the door to profitable investing.
Symptoms of a Crisis
Market crises are nothing new- we just need to crack open a history book and read about the 1997 Asian financial crisis, Black Monday in 1987, the Savings & Loan Crisis of the 1980s/1990s, or the 1979 Oil Crisis. Each crisis was characterized by:
- Being the major news of the day
- An army of expert interviews
- Forecasts about things “never being the same again”
- Emergence of abundant opportunities
Information on the crisis is everywhere- television, radio, newspapers, and more recently, social media. It’s all anyone can talk about and it’s almost impossible to avoid being swept up by the tsunami of information (and mis-information).
During market crises or panics, normal guidelines of value disappear. What a business is worth no longer matters- the only thing that matters is the price tumbling lower and lower. Meanwhile, the so-called experts and news media are constantly describing how bad things are, reinforcing the panic.
In addition, most crises are unique and nothing exactly like the current crisis has ever occurred in history- history doesn’t repeat itself but it often rhymes (Mark Twain). Faced with the unknown, our flight or fight reaction kicks in and most of us inevitably fly by selling stocks at whatever price with no regard to value.
Historical Crises
In Contrarian Investing Strategies, David Dreman examines 11 major crises since WWII- 6 were political, the other 5 were economic/financial. He measures the DJIA at the bottom of each crisis then the subsequent performance one and two years later. The results are remarkably consistent:
A buyer at the bottom would have made money one year later on 10/11 crises with an average gain of 25.8%; two years later, he/she would have made money on all the crises with an average of 37.5%.
Of course, no one can time the bottom exactly, but even being 10/15/20% off the bottom, an investor buying into the crisis would have reaped above-average returns.
In The Dhandho Investor, Mohnish Pabrai also lists 9 crises; every crises resulted in double-digit declines in the DJIA in a few days/weeks. But a few months later, most of the losses had been recovered:
It is important to keep in mind that not all crises occur on a market/global scale- crises can occur at a business level or industry-wide scale. For example, think Deepwater Horizon Oil Spill, or the American Express “salad oil crisis” in the 1960s. Each crises impacted a specific company and a keen investor would have been able to turn them into a nice profit (e.g. Warren Buffet & the Salad Oil Crisis)
Crisis Investing Checklist
Hopefully, the above part is enough to convince you that during crises, the right reaction is to buy and not sell. If you’re able to stomach the panic and volatility, the odds are on your side that you’ll come out ahead in a year or two. So the question now becomes- how do you determine what to buy?
Below are a few rule of thumbs:
- Diversify: No matter how cheap a group of stocks looks, you can never know for sure that you’re not getting a bad one. And it’s not just diversifying by buying a basket within an industry, but by diversifying across sectors (Dreman).
- Look at a Company’s Financial Strength: a company that is financially sound is a good indicator of how well a company sail through tough times; looking at a company’s debt-to-capital structure, current ratio, or leverage ratio all provide valuable information on how solid the company’s foundation is (Dreman). Benjamin Graham rule of thumb for a financially sound company is that the shareholder equity should be at least 50% of total assets.
- Pay Attention to Price and Value: just because you are diversifying across companies that are financially sound, it doesn’t mean you should pay too much for them. Always keep in mind intrinsic value and only buy when the price you pay is less than the intrinsic value and incorporates a margin of safety. “Price is what you pay and value is what you get.” -Warren Buffet.
- Don’t Wait for the Dust to Settle/Don’t Avoid Discomfort: if you wait for the dust to settle and the uncertainty has been resolved, there will be no great bargains left. Why? Because everyone else has also recognized that. As Howard Marks writes in The Most Important Thing:
Whenever the debt market collapses, for example, most people say, “We’re not going to try to catch a falling knife; it’s too dangerous.” They usually add, “We’re going to wait until the dust settles and the uncertainty is resolved.” What they mean, of course, is that they’re frightened and unsure of what to do.
The one thing I’m sure of is that by the time the knife has stopped falling, the dust has settled and the uncertainty has been resolved, there’ll be no great bargains left. When buying something has become comfortable again, its price will no longer be so low that it’s a great bargain.
Thus, a hugely profitable investment that doesn’t begin with discomfort is usually an oxymoron.
Conclusion
The world is not a stranger to crises- there always seems to be something going on that is making the front page news. If you approach every crisis as an opportunity, as opposed to panicking, you’ll be able to keep a more level headed mind amid the thundering wave of overreactions. We’ll end this letter with a few quotes:
The Chinese word for “crisis” (simplified Chinese: 危机, pinyin: wēijī) is composed of two Chinese characters signifying “danger” and “opportunity”, respectively.
“The Chinese use two brush strokes to write the word ‘crisis.’ One brush stroke stands for danger; the other for opportunity. In a crisis, be aware of the danger — but recognize the opportunity.” — John F. Kennedy
“Cash combined with courage in a time of crisis is priceless.” — Warren Buffett
“There have been four great buying opportunities in my adult lifetime. The first was in 1973 and ’74, the second was in 1982, the third was in 1987 and the fourth was in 2008 and 2009. And this [Covid-19 Crisis] is the fifth one. Those are the sorts of events that you see when markets are making historic lows, the news is just bleak all around.” — Bill Miller
Until next time. Vale.
Did you enjoy this?
You might also like the other posts in this series…
- Mr. Market and Stoicism (I)
- Why Value Investing Works (II)
- How to Intelligently Search for Value Investing Opportunities (III)
- A Mean-Reverting Walk Down Wall Street (V)
Or some of my other musings…
