Tips on How to Manage Money in a Bear Market
One of the biggest challenges for investors is managing money well in a bear market. Are markets going to go down further? Are they going to rebound? Most importantly, what do I do? Here are several tips to make it easier to manage money during a downturn.
Cash is good to have on hand because it serves as a buffer against losses and allows you to buy great companies at lower prices. I know what you are thinking: If I knew that the market was going to decline so far and so fast, I would have cash on hand, but what do I do now? The good news is that many governments around the world allow capital losses to offset against gains. In effect, this means governments help to cushion the blow. So if the laws in your country allow capital losses to be used to reduce taxes, then make sure to harvest your losses if a bear market ensues.
Critically, you need to evaluate the prospects of these companies before selling. Ask yourself: Could this capital be reinvested to earn higher expected returns versus risks? If the answer is yes, then you have just discovered a cash source.
Coupons and Dividends
You can also invest in assets that pay you cash, too, namely coupons on debt instruments and dividends from stocks. Again, this cash provides you with some downside protection if volatility’s growl starts to sound like a bear. For example, a 5% dividend yield is also a 5% cushion against losses. Additionally, in a bear market, if the fundamentals of a security remain strong but the market price declines, then yields go up. In effect, you can buy yield protection more cheaply. It is particularly important to truly do your fundamental analysis to ensure that that coupon or that dividend can be paid. Regarding dividends, many strong companies also continue to increase their dividends per share, even in a bear market. Asymmetric returns relative to risks is the name of the game.
Companies with High Cash Balances
One backdoor way of having a portfolio rich in cash is to invest in companies that themselves have high cash balances on their balance sheets. Just like in your own case, businesses with cash are also able to cushion the blows from a weakening economy and to also selectively acquire other businesses cheaply to improve their competitive position. Better yet, the company may invest those cash balances in new, higher growth projects (though few companies seem to want to these days). Last, companies with high cash balances can also return money to you directly by paying off debt, and thus increasing profits; buying back outstanding shares; and even paying a dividend. All of this cash can only benefit an investor in a bear market.
Pay Attention to Industry Fundamentals
If the market is in full, growling-beast Kodiak mode but the economy has not worsened, there are harbingers of downturn that you should be aware of. One potential leading indicator is the weakest company in an industry. Weak firms usually begin to struggle before the entire industry struggles. This may give you an advance warning of impending doom.
One additional industry fundamental to track is the sales results of companies that sell the latest and greatest consumer marvel. Usually these goods — like new and expensive smartphones and televisions — are not necessary. When sales of these types of goods slow, it usually signifies a downturn is well underway. Also, while we are on the subject, consumer confidence, in my experience, is the least reliable early warning system of recession. Instead, consumer confidence tends to lag by a significant period of time.
Does your investment charter allow you a little flexibility? Say, if you are an equity manager, can you have some small portion of your assets in preferred stocks or fixed income? My point is that if you like a credit, and by that I mean a cash-paying entity, you can change where in the income statement you own a claim on the cash flow. Moving up the income statement can mitigate the damage from a bear market but still ensure access to the prospects of the credit. This is especially true for convertible securities, but even vanilla debt securities can receive a credit rating upgrade that may drive capital gains while you wait out the bear market environment. From my perspective, you have already done the work of analyzing the business, why not make your entry into their capital structure slightly more conservative?
Buy Companies That Focus on Return on Invested Capital (ROIC)
There are many numbers for management of businesses to target. My favorite is return on invested capital (ROIC). Though I may be a throwback, I still like it when company management is constantly focused on managing capital for highest return and treats it as precious. When management thinks this way then equity market downturns are likely advantageous for these firms relative to competitors. They typically deploy cash in a sophisticated fashion. That is, they manage money the way I try to manage money.
Bear markets are no fun. As Shelby Cullom Davis is famous for saying, however: “You make most of your money in a bear market, you just don’t know it.” He means that prudent investing has outsized rewards when executed in stock market downturns.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.