Stockpicking in a bear market 13 comments

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Stockpicking in a bear market can be a hazardous business, because going long in deflationary conditions is by definition an attempt to pick a bottom (whether intermediate bottom or long-term bottom) on the stock price. It is easy to be bloodied by the falling knife, especially if one attempts to catch it naked (eg. contra, no ability to hold). One could thus simply choose to avoid risk and not hold stocks altogether, which is the reason why we have a bear market at all --- risk aversion leads to lower volumes and the stock prices drop by gravity due to lack of support. But yet, if we define risk as the potential loss on investment over say 3-5 years, rather than the standard textbook definition of price volatility which I have always maintained is more appropriate for short-term leveraged players than for long-term investors (see my article on risk), then buying stocks during a bear market could be a low-risk proposition indeed (because you are buying at a lower base and hence risk of losing is lessened over the long term), assuming that the bear cycle reverses in several years.

I feel that a good model for picking stocks in a bear market would be to examine the cash bailout potential of a stock over the medium to long term. I build my ideas based on the "cash bailout" concept as espoused by Martin Whitman in his book "The Aggressive Conservative Investor", which was written in the late 1970s when stagflation gripped the US. The general idea is to view a stock with regard to its potential to allow the holder to eventually bail out; under this umbrella of "cash bailouts", selling in the open market for capital gains is but one of the bailout exits; other potential exits include dividends and privatisation.

This way of viewing a stock is especially useful in a bear market where most small-cap stocks may be thinly-traded and selling out of them may be difficult. Yet, illiquid small-caps often offer the best potential gains. I adopt a two-horizon approach to picking these stocks in a bear market.

The two horizons refer to the medium-term horizon (6-12 months) and the long-term horizon (3-5 years). Under each of these horizons, I examine the cash bailout potential of the stock. For the medium term, I naturally demand lower potential returns as opposed to the long-term horizon.

Under the medium-term horizon, two main factors to look out for are privatisation potential and dividend yield. These are the two main cash bailout avenues in a recession/bear market where liquidity and capital gains opportunities might be limited. Dividend streams tend to be more easily predictable especially for older companies, and high dividends, perhaps in excess of 5-10% yield, would be a good clearing mark for potential stockpicks. Privatisation potential is harder to judge, but on top of the usual "good earnings/business" criteria, I would expect that tight ownership under a strong cash-rich owner, an operating niche or desirable brand name and steady free cashflows (operating cashflow minus investing cashflow) would attract potential privatisation offers from parties such as the main shareholder, business competitors or private equity funds.

Under the long-term horizon, capital gains look like a more viable, and probably the most profitable, cash bailout avenue. This is of course the preferred bailout avenue of the long-term growth investor. Two main issues must be considered with respect to stockpicking for this horizon: firstly, how many times can the stock price appreciate; secondly, can the company's fundamentals survive the recession unblemished. For the former, I would consider that if one is targeting 3-5 years down the road, he should be picking a stock with the potential to be at least a 4-5 times multibagging potential. That would translate to about 30-40% annualized gains --- quite ambitious but nonetheless a good way to filter out the real bargains among the many cheap pennies floating around in a bear market. Of course, the devil is in the details: the judgment of appreciation potential is critical and clearly the selected stock might not fulfil its hoped-for potential. For the second issue, it boils down to an examination of the company's accounts and operating business. I would say that the balance sheet (complete with footnotes) is the single most important source of information to make the judgment. Things to look out for would be heavy debt, contingent liabilities (under footnotes), consistently negative operating cashflows and insider selling. As Warren Buffett says about car racing, to finish first, you must first finish.

Ideally the selected stock would be satisfactory on all counts, both medium-term and long-term. But it may be difficult to find one that has multi-bagger potential and yet has clear indications of being taken over, say. Or it might pay miserly dividends. In my view, the dividends and the fundamental strength of the business to negotiate through the recession override the other two factors in terms of importance. Ultimately, they are the ones that are most easily judged from current and past data, can be judged objectively, and provide a clear operating basis to fall back on should privatisation or capital appreciation not work out. In short, they provide a floor for the stock price. Look out for these two parameters most of all.