Investing in a crisis – outside thinkers

We’ve been reading a lot since the COVID-19 pandemic hit, and here are some thoughts on articles we’ve found interesting. They deal with how investors should approach crises in a broad sense, but also offer some more specific ideas for you to think about. We hope you find these useful in helping to frame your own thinking and strategy for dealing with our current situation.

We don’t necessarily agree with all the arguments, but we think you might find them thought provoking. This article is also not personal advice. If you’re unsure, please seek advice.

All investments fall as well as rise in value, so you could get back less than you invest.

VERDAD – Crisis Investing: How to Maximise Return During Market Panics

Shortly before the COVID-19 pandemic began dominating headlines across the world, Dan Rasmussen at Verdad Capital published a report on investing during market panics. It highlights both the opportunities in market panics but also the difficulty of capturing them.

“[If] history is any indicator, those skittish during the great bull market will be panic stricken when volatility hits.”

It’s one thing to be a rational, level headed investor after 10 years of strong stock market returns. It’s much harder to keep your cool during a pandemic when the market is down 29%. But that’s what we must try to do – emotional decisions are likely to be bad ones.

Rasmussen and his colleagues also study past market panics to try to gauge what worked and what didn’t. They find that stocks trading on low valuation ratios, like price-to-earnings, do better than those trading on high ratios. This has usually been the case historically too, but outperformance is heightened during times of crisis.

It’s not hard to see why this should be the case. Who wanted to buy the stocks of housebuilders or banks during the 2008 financial crisis? These sectors were particularly badly damaged, the shares collapsed and brave investors could buy in at very low prices. Of course, not every investment in these companies will be successful – part of the reason they’re lowly rated is because risk in these sectors is very high.

Lower Rated Stocks Have Outperformed Higher Rated Stocks

Scroll across to see the full chart.

Past performance is not a guide to the future. Source: Refinitiv, HL, 31/03/20.

This graph shows the outperformance of the FTSE 350 companies with the lowest price to book value over the third with the highest price to book value each year. The outperformance was highest after the Dot Com Bubble, Financial Crisis and Brexit/oil price fall in 2016.

Think of the airlines today. The stocks are trading at very low valuations compared with their histories because the companies are facing enormous challenges. Some of them are likely to either go bust or require a bailout from the government. Either would be painful for shareholders.

Rasmussen and his colleagues also find that profitable companies that make lots of cash do better than unprofitable companies that burn through cash. Again, this makes complete sense, as unprofitable companies often need extra money from investors to keep going. When markets are riding high this can be easy – but it’s much harder to get investors to stump up new capital in a crisis. While profitable companies have a cushion to fall back on in tough times, unprofitable companies have very little room for things to go wrong.

Interestingly, the paper argues that debt isn’t a good or bad thing by itself. According to Rasmussen, debt makes bad outcomes worse and good outcomes better. In other words, highly indebted companies offer more risk and more potential reward, which makes sense to us.

Aswath Damodaran – A Viral Market Meltdown

Damodaran, a Professor of Finance at the Stern School of Business in New York, has been providing weekly analysis of markets during the COVID-19 pandemic. Lots of his analysis is data driven, and there’s a lot to unpack in the current crisis before we can form a sketch of what’s going on.

Damodaran points out that yields on US government bonds have fallen as investors have looked for safety, though this has moderated recently. The difference between the yield on government debt and corporate debt, known as the “spread”, has widened sharply. This is especially true for higher-risk, less financially secure borrowers. This tells us that bond investors are expecting defaults among financially weaker companies.

He also finds that capital intensive, indebted industrial companies have seen their shares hit hardest – this makes sense if investors are worried about debts and possible defaults.

After surveying the damage, Damodaran turns to potential strategies investors could adopt. He argues that your view on the speed of the economic recovery should determine your investment strategy. We’re not entirely sold on this idea because we’re generally wary of economic forecasts, but thinking through how you might approach different scenarios can be useful.

If you think the economic recovery will be quick, and that we’ll suffer little structural damage, Damodaran thinks there are two sensible approaches.

One is to go hunting among companies that have seen big share price falls in the last few weeks. The balance sheet matters here, because companies that are carrying excessive amounts of debt might not make it through even a short, sharp shock. But financially strong businesses that were profitable last year could come back if the crisis proves short lived.

The far riskier option is to look for truly distressed companies – those with high fixed costs and lots of debt. Damodaran acknowledges that lots of these investments will go to zero, but if you buy a lot of them and the economy recovers quickly, your gains could outweigh your losses. We think this is a very risky strategy. If you’re wrong about the speed of the economic recovery this could go very badly indeed. Even if you’re right, success isn’t guaranteed.

On the other hand, if you’re more pessimistic about our economic prospects, Damodaran thinks you should go for quality businesses. This means profitable companies with strong balance sheets and enviable competitive positions. If you had your eye on a quality company but thought the price was too demanding, then this might be the time to pick up some shares at a more reasonable price. We think this is a sensible approach no matter what the market’s doing. As Warren Buffett once said, “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.” So do we.

The other approach would be to try and predict the long term structural changes the pandemic might cause. This could mean looking at ways to take advantage of a surge in remote working, or more local supply chains. We’re not a fan of this approach either, mainly because it involves making fairly precise forecasts. We’re also not sure if these types of companies will do as well when we get back to some kind of normality. Still, if you have high conviction in your predictions, then allocating a small portion of your portfolio to taking advantage of them might not be a terrible idea.

Howard Marks – Nobody Knows I & II

On 19 September 2008, shortly after Lehman Brothers went bust, American value investor Howard Marks sent a memo to clients called “Nobody Knows”. He recently released a part two in the wake of the COVID-19 pandemic.

As the title suggests, no one knows for sure what’s going to happen in the next few months. And that’s okay. Investors don’t need to call the bottom exactly – market timing is extremely hard to get right in the best of circumstances.

Marks recalls a quote from the eminent economist John Kenneth Galbraith, “There are two kinds of forecasters – those who don’t know, and those who don’t know they don’t know.”

So, instead of trying to catch the very bottom of the market, Marks recommends investors stick to thinking about the difference between price and value. In other words, don’t worry about whether stocks are going to fall further. Ask whether you’re getting good value for your money.

We think this is a useful way to approach investing in all conditions, but it’s particularly helpful during volatile periods. The temptation is to wait for a really bad day, or to avoid investing after a bounce because you hope the market will fall again. This sort of thinking can easily lead to putting off decisions, and you can miss opportunities. We’ve already written about the value of investing monthly and part of the benefit is that it stops you over thinking each decision.

How to make the most of a falling market

We’ve found going back to read articles and papers written during the last few bear markets helpful in adding perspective. After Lehman’s collapse in 2008, many thought the entire financial system could collapse. Marks argued, as the crisis was unfolding, that investors had to behave as though a recovery was going to happen. This is because the drastic actions needed to profit from an unlikely worst case scenario would put you in a terrible position when the much more likely recovery takes place.

Keeping your cool

We think that the world will return to something approaching normal once the pandemic is over. Some things will be different, and we hope societies learn and adapt for the next time something like this strikes.

We’ve seen the markets drop many times before, and they might fall further yet. However, if there’s one thing we should focus on, it's that in the past they’ve recovered.

In the meantime, as investors, we need to stay cool and remember that the crises of history often look like buying opportunities in the rear view mirror. Remember that past performance is not a guide to the future.

Stock market drops – lessons from history

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