Arguably, the best time to be an investor is during a bear market. Yes, there is increased risk, but there is also increased opportunity. While it is easier to make money trading in a secular bull market, a bear market provides the opportunity to buy core positions at deep discounts.
There are two main challenges to successfully navigating a bear market. The first is your emotions. If you are prone to Cramer like wild mood swings where the latest news headline will turn you from wanting to buy everything to never owning a stock again, then bear market investing isn’t for you.
The second challenge is balancing optimism about the long run with a thorough analysis of the immediate risks. Just because a stock of a “good company” with “temporary” problems is down 50%, doesn’t guarantee that two years out it will have recovered and you’ll have doubled your money.
The real risk of a bear market is companies do (or have done to them) things that permanently impair the future upside. That brings us to today’s lesson.
There are three ways to permanently destroy value in a stock. One you do to yourself. The other two can be done to you (though with good analysis you can assess the risk of them and hopefully avoid them).
Lock In Your Loss
The first way to lose is locking in your loss by selling at the bottom. Sometimes this is done for you. If you are investing professionally, your CIO can tell you to reduce risk at the wrong time and force you to cut positions at the bottom. You should be aware of this possibility before betting on volatile names to recover.
Even if you don’t have that risk, you still have to make sure you have the self discipline to not panic sell when the mood turns dire (unless something really has changed).
Company Destroys Future Earnings
The second way to lose is if the company takes actions that prevent a full recovery. For the stock to fully recover in the future, the company’s earnings need to fully recover when the economy improves.
Thus, don’t worry about how bad near term earnings get, as long as they do no damage to the long term earnings power. Your focus (and the management’s) should be entirely on avoiding long term impairment.
One of the more common ways to impair earnings power is when a management exits a line of business at the bottom, either because of fear of future losses or to raise capital. Think of all the businesses the banks and insurers exited ten years ago.
Another way to give up earnings power is to permanently cede market share because of damage to the brand or cutting off advertising to prop up near term earnings. These are self inflicted wounds, but some management teams aren’t forward looking and will sacrifice the long term for the near term.
The flip side of this is companies can increase future earnings power by making a smart acquisition of a distressed asset if they have the balance sheet strength to play offense.
Equity Dilution
The third way to lose is through dilution. Some companies will do defensive capital raises either out of necessity (rating agency or regulatory pressure) or desperation (management wants to remove the tail risk of failure so locks in the low on the stock). Your job as an investor is to gauge the risk of a dilutive capital raise.
The thing that makes dilutive capital raises so painful is they gut the recovery earnings power because the share base grows so much. Let’s do a simple example.
A company has 1B shares. The stock was trading at $20 but has crashed to $8. It needs to raise $800M in equity to avoid getting downgraded to junk because its interest coverage has collapsed.
When the stock was still at $20, raising $800M would have only raised the share count 4%. Raising it at $8 means the share count goes up 100M, or 10%. Thus, ultimate earnings power is cut 10%.
Maybe that doesn’t sound so terrible, but if you look back to the financial crisis, there are plenty of examples of dilutive capital raises increasing share count 25% or 50% or, in extreme cases, over 100%.
Carnival Cruise
For a recent example of this in practice, let’s look at what happened to Carnival (ticker CCL). The combination of near term earnings pressure (from having to slash capacity) and likely long term market share loss (the demand for cruises will likely take years to recover) put Carnival in an untenable position.
On one hand, they were dealing with a liquidity crisis caused by the immediate pain, while, on the other, they were looking at a future of much reduced earnings power. Carnival actually entered the crisis with a relatively strong balance sheet (A rated) which allowed them some flexibility to raise debt in addition to equity (and amazingly still hanging on to an investment grade rating).
They did a massive $6B capital raise last week. For perspective, it wasn’t that long ago the market cap was above $30B. They raised $4B of debt, $1.75B in converts, and $0.5B of new equity. The incremental interest expense alone is over $500M p/t.
The common is more than 10% dilutive to share count vs. the 1% it would have been a few months ago. Worse, the convert adds another 30+% to the share count if it makes it in the money. Combined, the fully diluted share count increases close to 50%! Even if you believed Carnival is truly stable now, your upside has been cut in half. Converts at the bottom are the devil’s work.
Advice to Analysts
Don’t trust what companies tell you in a time like this. I’m not saying they’re lying (though some of them perhaps are). It’s more that they don’t always have real time information (or understanding).
There were certainly plenty of times during the financial crisis where the investors were ahead of the company executives in understanding the gravity of things. That will probably be the same when it comes to the investment writedown risk.
On the medical component, the best assumption is that anyone you’re talking to probably doesn’t fully understand the effects on their business yet. Don’t take a declaration of confidence as fact. And no matter how convincing it is, don’t assume it is still true tomorrow. The facts are changing quickly. Something the IR told you last week may not be so this week.
Similarly, what the CEO told the CFO last week may no longer hold. The CFO or IR isn’t always going to be current with what’s in the CEO’s head about the dividend or waiving payments or headcount cuts nor what the board is planning to bring up about capital on the next call.
Advice to Companies
The best thing a company can do for investors is put out a stress test. What happens to earnings if shutdown lasts through June…through September…through year end? What happens to capital is the S&P goes to 1600, the 10 year goes to 0 and stays there for three years, and investment losses repeat 2008?
Companies hopefully are doing these analyses for themselves anyway. They should be shared with investors as well as what contingencies are available to manage worst cases.
What is not advisable is taking stands like “we don’t believe investment losses can get that bad” or “we don’t believe revenue can drop that much” or “we don’t believe claims can get that high”. The simple truth is nobody knows right now how bad the economy can get.
Drawing lines in the sand only accomplishes one thing: it gets you an investor base who believes your statements. Then, if you’re wrong, you’ve pissed off your entire investment base.
Better to talk about stress outcomes, then give an opinion of why you think you are or are not likely to approach anything near that stress. Then, you can get investors who might say “I don’t believe their base case, but I’m comfortable with the stress if their base is wrong”.