I DON’T WANT TO GO THROUGH A GREAT RE­CES­SION AGAIN

Bear mar­kets are fine, but one melt down was enough, Tom Bradley writes.

Saskatoon StarPhoenix - - FINANCIAL POST - Tom Bradley is pres­i­dent of Steady­hand In­vest­ment Funds, a com­pany that of­fers in­di­vid­ual in­vestors low-fee in­vest­ment funds and clearcut ad­vice. He can be reached at tbradley@steady­hand.com

I ex­pe­ri­enced Black Mon­day in Oc­to­ber 1987 as a young an­a­lyst, and ground through the tech wreck as CEO of a large as­set manager. They were bad but turned out to be pre­sea­son games com­pared to the fall of 2008.

It wasn’t plum­met­ing stock prices that makes me say that, al­though the de­clines were pre­cip­i­tous. Nor the fact that I’d just co-founded an as­set man­age­ment com­pany. No, it was be­cause the foun­da­tion of the cap­i­tal­ist sys­tem was crum­bling un­der­neath us.

Iconic in­vest­ment firms that just weeks be­fore were strut­ting their stuff sud­denly were go­ing down (Lehman Brothers) or be­ing sold for scrap (Bear Stearns, Mer­rill Lynch). Many banks were bank­rupt and trust in the fi­nan­cial com­mu­nity had van­ished. No­body knew who was sol­vent — “If I can’t deal with Lehman, who can I deal with?” The fall­out was huge. With banks and bond in­vestors in cri­sis mode, credit dried up and com­pa­nies need­ing short-term fund­ing were shut out. The biggest in­dus­try of all, North Amer­i­can au­tos, needed a bailout.

There’s much to say about this re­mark­able pe­riod. I’m go­ing to hit on a few things that re­main im­printed on my brain.

‘LIM­ITED DOWN­SIDE’ IS AN OVERUSED PHRASE

In good times, we’re prone to fool­ing our­selves about how much down­side risk there is. “The stock may go down, but it won’t fall far.”

The re­al­ity is that if prof­its go down and/or weren’t sus­tain­able (as was the case with in­vest­ment deal­ers and banks prior to the cri­sis), earn­ings fore­casts can go down a lot.

If price-to-earn­ings mul­ti­ples also drop to re­flect weaker growth and fail­ing con­fi­dence, there’s a dou­ble whammy — lower valu­a­tions on lower earn­ings — which makes for big price de­clines. In­vestors ben­e­fit from this on the way up (higher mul­ti­ples on higher earn­ings), but have trou­ble vi­su­al­iz­ing the pos­si­bil­i­ties in the rarer down pe­ri­ods.

WHEN THERE’S A LACK OF TRANS­PARENCY AND PLENTY OF LEVER­AGE, PRO­CEED WITH CAU­TION

When the cri­sis hit, it be­came ap­par­ent the mega global banks, which are lev­ered by na­ture, were black boxes. No­body re­ally knew what was inside. We learned that when there’s oper­at­ing and/or fi­nan­cial lever­age, cash flows need to be pre­dictable and vis­i­ble.

This les­son ex­tends be­yond fi­nan­cial com­pa­nies. Valeant was a high flyer that came back to earth when earn­ings weren’t real, the valu­a­tion shrunk, and the debt load be­came un­man­age­able.

IN TIMES OF STRESS, THE STRONG GET STRONGER

Prof­itable, well-fi­nanced, non-fi­nan­cial com­pa­nies came through the cri­sis with fly­ing colours. Sure, their stocks went down, but they didn’t need to di­lute their share­hold­ers or bor­row at usu­ri­ous rates to weather the storm. Ul­ti­mately, their out­look im­proved as weaker com­peti­tors strug­gled or dis­ap­peared.

DOWN MAR­KETS TRANS­LATE INTO HIGHER FU­TURE RE­TURNS

In the depths of de­spair, I heard many in­vestors say they no longer ex­pected much from their stock port­fo­lio.

This couldn’t have been fur­ther from the truth.

In bear mar­kets, stocks go down con­sid­er­ably more than the prospects for the un­der­ly­ing busi­nesses.

There are ex­cep­tions but, with a di­ver­si­fied port­fo­lio, in­vestors should be in­creas­ing their re­turn ex­pec­ta­tions, not low­er­ing them. Shelby Davis once said, “You make most of your money in a bear mar­ket: you just don’t re­al­ize it at the time.”

EAS­IER SAID THAN DONE

What struck me most about the cri­sis, how­ever, was how fer­tile a set­ting it was for mak­ing se­ri­ous in­vest­ment mis­takes. Weak mar­kets are won­der­ful for longterm in­vestors be­cause stocks are on sale, but in the heat of the mo­ment it’s ex­tremely hard to do the right thing.

In late 2008 and early 2009, many in­vestors sold stocks or got out of the mar­ket com­pletely. They couldn’t af­ford to lose any more. Very few of them got rein­vested in a timely man­ner. In­deed, the hang­over from the cri­sis per­sists to­day.

Since that time, I’ve done two things in par­tic­u­lar to pre­pare clients and my­self for the tough, gut wrench­ing de­ci­sions.

First, I never say “if ” a fund goes down. It’s al­ways “when.” And sec­ond, I leave room to buy more. I don’t want my cash and risk bud­get used up when I re­ally need it.

I’m fully pre­pared to go through more bear mar­kets and re­ces­sions. I just never want to go through an­other fi­nan­cial cri­sis like we had ten years ago. One was enough.

THE AS­SO­CI­ATED PRESS

Clerk Michael Hill puts his hand on his face in the Euro Dol­lar op­tions trad­ing pit as stock mar­kets shud­dered and then col­lapsed in a cas­cad­ing panic dur­ing the fi­nan­cial cri­sis of 2008.

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