Rewrite your investment rules

It is now clear that 2009 is going to be one of the most challenging years for investors. So many benchmark rules of investing have been turned on their heads during the great panic of 2008 that it is difficult to figure out where your money should go this year.

Warren Buffett, the stock market guru, once said: “A simple rule dictates my buying. Be fearful when others are greedy; and be greedy when others are fearful.”

The fear is palpable all around us and Buffett says he is moving all his investible wealth into US equity markets, which have taken such a terrible beating that the Sage of Omaha believes this is the time to accumulate distressed stock.

Is he right? Of course, simple rules are a dime a dozen. But recent events have made fools out of some pretty smart economists, central bankers, market-watchers and, of course, investors who once spouted popular wisdom as if they had a 20-year track record of massive profits. Some of them did; all of them are now penniless.

As a result, this may be a good time to rewrite some of the popular rules of stock investment – and perhaps even create some new ones. Because no one can predict with any useful degree of certitude how equity markets will roll over the next 12 months.

Prem Watsa, Chairman of Canada-based Fairfax Financial Holdings, thinks equity markets might still have a long way to fall before hitting bottom. This crisis, Watsa says, follows 20 years of “excess optimism” and will not be finished in a matter of months.

Lower interest rates and bank bail-outs are clearly not enough to guarantee a nice, clean market recovery. When the financial crisis passes, we will be left in the middle of a significantly weakened global economy, larger government deficits and a semi-nationalised free market system. And nobody – not the bulls, not the bears – knows for certain what stocks, bonds, commodities (including oil), exchange rates, housing, inflation or global economic growth will do in the short term.

Given that the only certainty you can bank on in 2009 is the fact that there will be uncertainty, here are some new ways to look at stock investment.

REFINANCE TO WIN

Companies worldwide have $4 trillion (Dh14.68trn) in debt due to be repaid or refinanced over the next 18 months. Working out what to do with that sum – roughly equivalent to Japan’s annual economic output – looks like the next phase of the global financial crisis.

In normal times, companies have two options when debt payback looms. In Europe, most go to their banks. But while that route isn’t closed, it has narrowed since banks fell into crisis and some lenders have failed or merged, reducing available lending. All of them are trying to reduce the loans they have outstanding and for those who are lending, loans are more expensive, even for borrowers with strong credit ratings. Less robust customers have an unenviable choice: Come back next year, or don’t come back at all.

For those who cannot borrow on terms they can afford, an uncertain future awaits. Some will try to raise equity – though stock market gyrations make that a nail-biting prospect. Others could issue convertible securities – essentially debt with equity characteristics. Such instruments are suited to volatile times, but they can prove expensive.

Perhaps the lending drought will self-correct. If companies pay high enough interest rates, income-oriented investors will become interested and banks may increase lending too. After all, when companies go to the wall, lenders are left unpaid or forced to take equity in place of their loans. Something has to give before then, or the crisis may well pass back to the banks themselves.

Look for stock in companies actively refinancing their debt. With US interest rates down to zero and European, Asian and Middle Eastern rates heading there, the refinance opportunity is definitely the smart move. However, with banks using their bail-out funds to fix balance sheets before they lend, there may not be enough cash to go round. The minute you see a bank refinance a company’s debt, go for its stock. If the bank thinks the firm is good for it, so should you.

Quick Tip: Don’t let the companies beat you to the refinance opportunity. Lower lending rates also mean you can refinance your own debt – whether it is a car loan, home loan or just the simple pleasures loan (otherwise known as the personal loan).

CASH IS KING

However many times you say this, it bears repeating. The way a company manages its cash-flow has traditionally been one of the strongest factors that determines how investment-worthy it is. Strong cash-flow and prudent management create a win-win for the company as well as its investors. This rule is more valid today than it has ever been in the past so, as ever, look for strong cash-flows then seek out the companies that have put effective cash-conservation plans in place.

The financial controller of one company in the UAE recently told me how the group has devised a two-pronged cash-management plan – defensive and offensive – created with the express purpose of dealing with the credit crunch and frozen capital markets. The defence team comes up with ways and means of cutting costs effectively without affecting expansion plans, aggressively looking at ways to recover cash that is due to the company, and taking a second look at all planned outlays.

The offence team has but one goal – seek out companies or assets that are in dire straits but have the basic ability to recover from an economic slowdown, with the express intention on acquiring them. This well-structured plan has even enthused the group’s bankers, who have put in place financial arrangements to kick the plan into motion once targets and time-frames are decided.

Quick Tip: Don’t lag behind on your own cash-management initiatives. Cut unimportant expenses, conserve cash by deploying it in fixed-income instruments and be ready to move swiftly when a turnaround presents attractive opportunities.

RESTRUCTURING AND CONSOLIDATION

Cash-management would be a pointless exercise if a company did not restructure operations with two outcomes in mind – strengthening current revenues and positioning for quick future recovery.

As credit remains frozen, inexperienced firms fret and start cutting out the largest expenses from their balance sheets.

The smart ones, however, cut out the non-productive ones. The inexperienced firms then shut down or merge units that need a constant flow of operational cash while the smart ones consolidate to become stronger and better positioned in their industries for current and future growth.

Needless to say, you should seek out the smart companies and watch their progress.

Quick Tip: Finding the smart investment that can generate quick profits after an economic turnaround begins is not a matter of luck. Newspapers are one source of such information but the smart investor will also use this period of investment inactivity to learn some key new skills, including the ability to read a balance sheet.

SECTORS AND REGIONS

The industry or sector that a company operates in is as important to recovery as the geographical region in which it is based or has the largest operations.

For instance, conventional wisdom will dictate that you stay as far away from banking stocks as you can – after all, weren’t the greedy bankers the ones who caused this crisis in the first place?

Contrarian wisdom says that if the world’s banking system does not recover quickly, the rest of the economy will take much longer.

On the other hand, will Middle East banks find their financial footing before their compatriots in the US or India?

These are questions that need to be examined seriously by the smart investor and applied to stocks that are short-listed for recovery buying.

Quick Tip: Investors who have the option of putting money into multiple regional markets – such as expatriates in the UAE – have the potential of stepping out of their financial morass faster than single-country investors can. The ability to diversify investment regionally, as well as sector wise is a much more powerful tool.

BACK TO BASICS

Traditional investors have this very powerful rule: Focus on the fundamentals. The downturn could last several years and investing using quantitative judgement does not work very well in such a scenario – qualitative judgement needs to step in.

Any fool can make a company look good when everything is booming so look for companies that have historically done well in bad economic conditions.

These may not be “cool” stocks to own – they may comprise companies that manufacture power generators, for example – but they will provide the bedrock of your portfolio. Fundamental principles of valuation and financial management continue to hold.

Quick Tip: Whatever economic and political changes 2009 brings, managers and investors will need strong financial knowledge. Above all, keep a long-term perspective.

The great bears 

If you have no stomach for risk, now may be a good time to deleverage yourself. Paying down credit cards, loans and mortgages offers a guaranteed and relatively healthy return. That said, bear markets always separate the men from the boys.

Financial pundits say there are three types of bears that maul investors. The most common are “cyclical bears”, which take markets down about 20 to 25 per cent from peak to trough. The most rare are the “devastating bears”, which shave 75 to 90 per cent off stock values, such as the Japanese collapse in the 1990s or the sell-off in Chinese shares.

What most markets are currently experiencing looks nothing like the mother of all devastating bears that attacked during the Great Depression, when stocks lost 90 per cent of their market value. The great panic of 2008 has seen about 45 to 60 per cent of stock values vanish into thin air due to a mauling by the third category – the “secular bear”.

 

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