Reprinted courtesy of the National Post
by Tom Bradley
I experienced Black Monday in October 1987 as a young analyst, and grinded 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.
The strong get stronger in times of stress
Profitable, well-financed, non-financial companies came through the crisis with flying colors. 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 long-term 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.
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