Saturday, January 17, 2015

Preparing for the Next Bear Market

The opportunity to secure ourselves against defeat lies in our own hands, but the opportunity of defeating the enemy is provided by the enemy himself. - Sun Tzu
Earlier this week, a friend asked me what I thought could end this bull market. I searched for a smart answer and concluded that it was the one that investors haven't fully considered yet. Recalling my experience from the financial crisis, I said that it's always the punch you didn't see coming that knocks you out.

Keep an eye on your pic-a-nic baskets
Fearing this answer might be unsatisfactory, I floated a guess that there could be unforeseen consequences of falling oil prices.

There -- an answer more befitting an industry veteran.

The fact is, we have no idea what specific event or events will end this bull market, though it'll be obvious in hindsight, of course. Maybe someone will guess right, make leveraged bets on their thesis, make millions or billions and write a book about it, but for every one of those guys, there are legions who guessed wrong and are far worse off.

As long-term, business-focused investors, we shouldn't care much about what causes the next bear market. To borrow a phrase from Peter Lynch about macroeconomics, if you spend 13 minutes thinking about this, you've wasted 10 minutes. If anything, you're more likely to stress yourself out and make emotional trades in a quixotic mission to avoid your envisioned losses.

Rather than scramble to reposition your portfolio for the next bear market, we're much better off focusing on the things we can control. For one, look to learn more about the businesses we already own and the ones in which we've taken an interest.
  • How might a bear market impact management's current strategy?
  • If the current management team was in place during the financial crisis, how did they handle that challenge? Were they honest in their evaluation of the marketplace or did they try to put on a good face? 
  • Does management have a track record of making opportunistic acquisitions and investments (buybacks, etc.) in down markets?
  • Is the company's balance sheet prepared to handle a few lean years? 
  • Is the dividend well covered by both earnings and free cash flow?
By asking ourselves these types of questions now while the market is still strong, we'll be better prepared for when Mr. Market grows despondent again and offers us opportunities to invest in quality businesses at attractive prices. Indeed, it's only when Mr. Market makes such offers that we're able to sow the seeds of long-term market outperformance.

Related posts
What I've been reading/listening to this week
  • What Reese's peanut butter cups can teach us about investing -- Sova Group
  • The most under-appreciated investment skill is patience -- Time
  • Is investing really a zero sum game? -- Monevator
  • What makes for an exceptional company? -- CFO
  • Peter Lynch speech from 1994 -- YouTube
  • Understanding global capital allocation practices -- Michael Mauboussin 
  • A dozen things I've learned from Tom Murphy -- 25iq
The book I'm currently reading:
Stay patient, stay focused.