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How to invest in a bear market

Mark Tobin
February 11, 2018

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Well after a turbulent week in the markets, some people are asking if this is the beginning of a new bear market. Some might say, are we even out of the GFC bear market? Considering the ASX has not yet eclipsed its previous all-time high, which is in stark contrast to US & UK markets. 

While it’s too early to tell at this stage if this is a major downturn in equity markets, it’s 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. 

BEAR MARKET SHOPPING LIST

I have a watch list of what I 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, despairing investors 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 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 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. 

While good operating businesses are top of my bear market shopping list, I will also 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. 

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 also helps from a mental or psychological stand point. As many investors find investing in bear markets mentally very difficult due 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 to 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. 

Published: Monday, February 12, 2018


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