Follow Buffett to thrive in the bear pit

With America\'s stockmarket arguably past its low point, Warren Buffett\'s strategy of buying good stocks at their cheapest is clearly the right approach - but not all investors find it easy.

There is a good chance that the American stockmarket reached its bear market low in October. Even if that turns out not to be so, for anyone with a longer-term time horizon the stockmarket offers a return potential that is well above average, and better than it offered in October 2002, the bottom of the last bear market.

In a recent editorial in The New York Times (October 17) Warren Buffett makes the point that the best time to invest is most often when stock prices are down, the outlook is uncertain and investors are fearful. We are facing such times. He further notes that those who seek the safety and security of cash may feel more comfortable in the short term but “have opted for a terrible long-term investment asset, one that pays virtually nothing and is certain to depreciate in value”.

While offering no opinion on the short-term direction of stock prices, Buffett writes: “Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later.” Those sitting on the sidelines waiting for the outlook to improve are forgetting that the stockmarket normally bottoms well before either sentiment or the economy turns up.

Like generals, investors are prone to fighting the last war. For over a year it has paid handsomely to eschew risk and be maximally defensive. Those who looked for the light at the end of the tunnel have been greeted, each time, by yet another oncoming freight train, while those who remained defensive have been right, and therefore see no reason to alter their stance. This dynamic is why the latest Barron’s Big Money poll (November 3) shows that 92% of res- pondents say the market is either fairly valued (30%) or undervalued (62%) and 69% say that stocks will be the best-performing asset in 2009, but only 20% of respondents are aggressively positioned to take advantage of it. This is a classic case of people talking bullish and acting bearish.

Investors now face a classic good news/bad news situation. The good news is that stocks are cheap and, for the first time in a good while, investors are being paid to take risk. The bad news is that the economy is probably in the midst of a severe recession; bottom-up earnings estimates are still way too high, and the market is likely to remain unusually volatile. Resolving this conundrum will be investors’ principal challenge over the coming months.

One approach to balancing the risks of short-term volatility against the rewards of long-term investing is to be like Warren Buffett and simply buy good stocks when they are cheap and ignore the near-term fluctuations of the market. The problem with trying to be like Buffett is that most investors do not have his equanimity or his brains. They do not know how to value businesses as well as he does, and they are prone to letting market fluctuations influence their investment judgments. If they are money managers themselves they may have – or at least feel they have – more short-term performance pressure than he faces, and may be subject to client redemptions in a way that he is not.

In short, being like Buffett is not easy, but that does not mean it is not the right thing to do. Investors should continue to focus on valuation, ignoring, as far as possible, short-term volatility. In general the stocks that offer the best combination of upside potential and downside protection are the mega-caps.

The second approach to balancing short-term risk against long-term potential is to analyse the nature of the latest bear market, probing for its underlying causes and looking for clues to when the problems that caused it will be resolved. Phase one was a garden-variety bear market, which began in October 2007 and ended in July 2008, with the market discounting a fairly typical and relatively mild recession in America, Japan and Europe. July 15 marked the bottom of this phase and the market rallied in August, led by the financial stocks, on early evidence that credit conditions were improving in America.

Phase two of the bear market began in early September with a series of what turned out to be disastrous decisions by Hank Paulson, the American Treasury secretary. These included placing the Government Sponsored Enterprises into conservatorship (punishing common and preferred shareholders severely), leaving Lehman Brothers debt holders to fend for themselves following Lehmans’ bankruptcy – rather than protecting them, as in the case of Bear Stearns – and effectively nationalising American International Group, again on punitive terms to equity holders. These events in combination precipitated a collapse in investor confidence, a mini-run on the money market funds and a freezing up of the fixed-income markets, first in America and then globally. The commercial paper market shut down, as did the interbank lending market. Credit spreads of all descriptions blew out on the upside and a global equity market meltdown ensued in September and October.

There are several signs that the second, far more vicious phase of the bear market may be ending. Liquidity is being restored to the system. The London Interbank Offered Rate is coming down and the Ted spread (the difference between interest rates on interbank lending and those on short-term American government debt) narrowed from a high of 4.57% on October 10 to 2.40% at the month end, and then to 1.99%. Lending markets are beginning to open up and the commercial paper market is reviving.

Now that money from the Troubled Asset Relief Program (Tarp) is getting into market participants’ hands, the massive government interventions and capital injections are producing the desired result, both here and abroad. Given how violently equity markets sold off in the second phase of the bear market, they have the potential to snap back equally sharply as more normal credit conditions are restored. Investors sitting on the sidelines risk missing this rally.