Lessons Learnt from the 2008-2009 Bear Market

I know what some readers may be thinking from the title – that we are still in the midst of a bear market as no pundit or prognosticator has come out boldly to proclaim that the bear market has ended and that we are in a bull market. But obviously, from the way valuations and market prices have risen since May 2009, there is no doubt that the worst has probably passed for the global economy, and I would like to take the opportunity to share some lessons I had learnt through this emotionally and psychologically trying period. Note that this is my first true bear market, and it happens to be one of the worst in the last 70 years. In fact, this period of time would now go down in history as “The Great Recession”, characterized by the collapse of large investment banks such as Bear Stearnes and Lehman Brothers and the near-failure of the global financial system. These events shook the core of the banking system and caused many to re-think their model of capitalism and the so-called “greed” that accumulated over the years, resulting in the last 18 months of riveting terror. Many fortunes were lost and portfolios decimated as the bear market swept across the globe like a financial tsunami. From the ashes of the destruction, I have picked up more valuable nuggets of wisdom than I could possibly salvage from books, and I now pen them down here. They are in no particular order of merit.

1) Valuations can never be too low – When evaluating companies for purchase, one would usually look at valuation metrics as one of the criteria for determining if a stock was considered “cheap” or “expensive”. This is based on historical levels of valuation and one can also benchmark this against the broader index to obtain some level of comparison, albeit a rough one. What the bear market has taught me is that valuations can be pushed down to ridiculously low levels, so much so that it almost becomes ludicrous for companies to trade at such levels. During the Great Depression, Benjamin Graham discovered that many companies were better off dead than alive, for the share price was just a fraction of their cash value (or net asset value), creating a unique situation where there was plenty of margin of safety. Similarly, during the 2008 Bear Market, the manic mood swings of Mr. Market created a whole lot of bargains; but the discerning investor had to separate the wheat from the chaff and find out which companies were cheap for a good reason; and which were cheap by virtue of a wrongful appraisal by Mr. Market. The concept of margin of safety may appear irrelevant in the short-term as prices keep dipping to new lows; but this is a necessary by-product of loss aversion, over-reaction bias and forced selling/margin calls, and may not necessarily reflect the true state of affairs of the company. Though valuations can never be too low, they should be low enough for an investor to take comfort in his choice of selection of security which he feels will be able to generate a decent long-term return for him.

2) Optimism is the enemy of the rational buyer – This phrase, though oft repeated, struck me as particularly true during the bear market. When things were rosy in 2006 and 2007, companies were reporting rising revenues and profits all over the place; as well as fattening their order books and clinching contracts at breakneck speed. Examples are of course companies like Cosco and Swiber, which had full and burgeoning order books which lasted for the next 2-3 years and could seemingly guarantee steady and consistent revenues and profits for the short-term. Similarly, manufacturing companies such as textile companies in China were also reporting bullish sales and increasing production capacity in anticipation of even more orders. But once the sharp recession hit, it brought along a near standstill in global trade and an almost total collapse in freight rates, and many ships are still anchored, idling, off the waters of the East Coast of Singapore. Companies like Cosco faced many order cancellations and delays, while companies like Swiber saw their newbuild vessels being delayed in Chinese yards, resulting in third-party costs building up and leading to overall higher COGS. Textile companies in China faced over-capacity and collapsing demand and could not offload their massive inventories; and many had to make write-offs which hit their bottom line. All these events occurred amidst the backdrop of the sudden and unprecedented economic crisis, and the rational buyer could not have anticipated any of these events (on hindsight, it may have seemed obvious; but I can honestly admit I didn’t think that things would get that bad at the time). Which brings me back to my point – that optimism is very bad for purchasing companies because it implicitly assumes that things will chug along as planned; and positive expectations have already been factored into valuations, making market prices very high. When something unexpected occurs, the investor has scant margin of safety and is forced to acknowledge that all the optimism and hope had been just a pipe dream. The bear market has taught me to be wary of optimism and exuberance and to temper this with realism and caution.

3) The economy lags behind the stock market – Though I had read the theory behind this statement, only now had I personally witnessed it and known how true it can be. This is the reason markets are so difficult to time accurately. Market movements can foresee and predict the state of the economy well in advance, and acts as a leading indicator on the state of the real economy well before it can be detected by any economist. Markets in late 2007 and early 2008 had already began to tumble sharply even before the news of the severe recession had broken out, and in May 2009 the most amazing rebound I had ever witnessed propelled the index to its current levels, and has allowed it to remain there in advance of any news of an economic recovery (i.e. green shoots). This was my single most important lesson from the bear market – that valuations will revert to the mean eventually and one should stay vested. From the week beginning May 4, 2009 till May 13, 2009, in a mere 8 trading days, my portfolio had recovered from a loss of S$40,000 to a mere loss of S$1,000, which showed to me how powerful and unexpected a rebound can be. I still remember the stunned voices of my friends proclaiming that this would be a suckers’ rally and that prices will fall to new lows as in March 2009; but so far it is already late October and they have been forced to admit that they had well and truly “missed the boat”.

4) Avoid companies with high gearing – The bear market had also illustrated to me the dangers of owning companies which were highly leveraged, and I had entered the bear market owning several companies with such characteristics, such as Ezra, Swiber and China Fishery. Suffice to say that in the middle of the bear market, there was a sharp scramble (for myself) to evaluate the underlying business and financial strength for my companies, and I did encounter several sleepless nights wondering if my companies would survive or simply fall flat on their face. Such terrible stress came along because of my disregard for gearing and how it can be a double-edged sword. The sad case of Ferrochina imploding under a mountain of debt clearly illustrates the high risks of investing in highly geared companies when downturns hit. I count myself very fortunate to have escaped relatively unscathed while still holding on to these highly leveraged companies; and this has forced me to re-examine my investment criteria and to choose companies with less-grandiose growth plans and which have a stronger and more stable Balance Sheet. My recent purchase of MTQ has incorporated this lesson as it is a company with decent (not stellar) growth prospects and is in net cash and generates positive operating cash inflows every financial year. Moving forward, my selection criteria will encompass more of such slow growers and I will adopt a less aggressive approach to finding growth companies, and balance this out with stability of dividend yield and a sufficiently strong financial position.

5) Mistakes take time to surface – This is one of the “scary” aspects of investing. When investing during “normal” times, where economic growth is positive and everyone is gainfully employed, one may not realize if one had made a mistake or not due to the fact that valuations are at mid-cycle and everyone is reasonably positive about the macro-environment and about equities in general. Hence, it takes a somewhat long period of time (at least 3 to 5 years) for one to know if one has gone off a tangent and the company one had invested in is a dud. Recently, I found out the hard way about mistakes in investing in Swiber and Ezra as their Balance Sheets were heavily geared. Of course, one aspect of this may also be my inexperience and naivety in believing that the companies will become cash flow positive in time, while ignoring the fact that their business model does not allow them to do so.

6) Believe in yourself – Yes I know this sounds awfully clichéd, but had I not stuck to my guns and my beliefs throughout the entire bear market, I may have floundered, panicked and sold my shares at a significant loss. With a rigorous set of investment rules in mind and properly articulated selection criteria for companies, I used this framework for my decision-making as to whether I should hold on, increase my positions or divest. I am thankful that I had added to positions which I felt comfortable with (in Ezra, Boustead and Tat Hong), and not to those which I felt were inherently more risky (e.g. FSL Trust and Pacific Andes). All I can say is that I am glad to have formulated my investment philosophy before the bear market had hit, and also had the fortitude to hold out amid the mental pain of seeing one’s portfolio slide nearly 60% at one point. Note that the process (as I remember) was difficult and mentally draining, but coming out of it relatively unscathed in something I would always remember and rejoice over. I must remember, though, not to get complacent as I still have many years ahead of me in investing and will definitely go through many more bear markets before I retire as a working adult. I resolve to learn, grow and adopt as an investor, in order to survive and generate a decent long-term return for myself above inflation.

I would like to take this opportunity to thank my mentors in regards to value investing. Benjamin Graham for introducing the concept of margin of safety and for defining the difference between investment and speculation, Warren Buffett for his frugality and his strict selection criteria for companies, Charlie Munger for advocation of a multi-disciplinary matrix to analysing companies, and Phillip Fisher for his qualitative aspects involved in appraising suitable companies. Without these guys, I would have been lost and adrift in a sea of uncertainty.