Is the bear out of hibernation?

After a turbulent week in the markets, some people are asking if this is the beginning of a new bear market? While it is too early to tell at this stage if this is a major downturn in equity markets it is probably a good time to think about how to invest if - and when - the next bear market or big equity market fall comes around. Whether it’s right now, or next month, or at some other point in the future, it will come, so best to be prepared.

A Bear Market Shopping List

It is useful to have a watch list of what you think are really great stocks. These are stocks where the underlying business has good margins, high returns on equity, good cash flow, low debt and solid management teams. 

However, as that list of qualities suggests, these companies would be what every investor is looking for. Hence, they generally trade at high P/E valuations, or in layman’s terms are generally very expensive most of the time. So, I am waiting for somewhere around the nadir (you will never pick the absolute bottom) of the next bear market to hopefully pick them up at a more reasonable price, or better yet at bargain basement prices.

Just like in the heady days of bull markets when investor hubris can drive stocks to extreme valuations. In bear markets, investors can feel like they are standing at the gates of hades and through feelings of utter despondency and despair can cause extreme valuations on the opposite end of the spectrum just as readily. By way of example let’s look at WAM Capital Limited in the late stages of the GFC (Feb 2009). I have simplified the numbers somewhat and ignored tax assets.

Listed Equity Portfolio $34.7m

Cash at Bank                $82.3m

Short Portfolio             $(0.4)m

Total Assets                 $116.6m

Market Capitalisation $82m based on an average share price of $0.80 around the end of Feb 2009.

In other words, you were getting the entire WAM Capital equity portfolio for free or in other words the “market” thought WAM’s entire equity portfolio was worth zero!

WAM’s top 3 holdings per its Feb 2009 NTA were as follows

• Reckon Limited (RKN)
• Melbourne IT Limited (MLB)
• McMillan Shakespeare (MMS)

These are stocks younger investors who weren’t around in 2009 will even recognise today. A good few others from that NTA announcement are still around. Bear in mind that this was an equity portfolio assembled by portfolio managers Geoff Wilson AO and Matthew Kidman at the time. Yet the “market” implied or communicated to investors via WAM’s share price that all their stocks picks would go bankrupt and WAM’s investors would be left with nothing from this equity portfolio. Well WAM Capital trades at $2.44 today and has paid out some handsome fully franked dividends along the way. In terms of their stock picks MMS for example traded around $2.80 in Feb 09 and trades today about $16.50. 

Taking MMS, buying it in Feb 09 and holding it until today would have given you a compounded annual return of nearly 22% versus about 13% for WAM over the same period. Both are very nice reruns and both these returns exclude the dividends and the franking benefits! This is why good operating businesses are top of my bear market shopping list as the operating leverage and returns are generally larger. I will, however, be keeping an eye on the LIC sector more broadly for bargains like WAM in 2009. Especially given the growth in the LIC sector in the past few years. A low-risk bargain is still nice if you can get it and buying a $1 for $1 in cash is about, as low risk as it gets in the sharemarket.  

Cash is King

Now it’s great having a shopping list but you also need the cash to buy these bargains at that moment in time. As is always the case this is the exact time you don’t have cash. So, I already have a small portion of capital tucked away and earmarked to draw on for exactly these types of purchases in the next bear market.

Having it set aside now with a designated future purpose I think also helps from a mental or psychological standpoint. As many investors find investing in bear markets mentally very difficult due to the high levels of uncertainty and the negative hype generated by the media. By committing the cash to bear market investing now I believe you will be better equipped mentally at least, to deploy it at the time.

This capital is only making small returns in the bank currently but the point is I want to be able to put that capital work at the time I need it. Could it be earning more by being invested in the market or somewhere else? Of course, it could. However, I am willing to take that opportunity cost so as to have dry powder ready when required.

Hopefully, the marginal opportunity cost lost now will be more than offset by the long-term gains from purchasing things like WAM in Feb 09 in the next bear market. This is where I am backing myself to find and execute on some bargains to some extent. Easier said then done but I guess in life you have to back yourself at some point.

The bear will come

A bear market - and probably a couple - will happen during your investing lifetime.

So, it’s better to make some plans for it now instead of trying to figure out what to do when the market (or your portfolio) is in the middle of being mauled by the bear.