Techniques for Investing in Bear Markets

With markets at multi-year lows in many countries, investors who use fundamental analysis to evaluate shares have become increasingly interested as markets have fallen further and further.

We know that Warren Buffett is investing much of his personal portfolio in US stocks and we know that other great investors like Seth Klarman are moving away from cash and into equities.

But how do you approach investing in a bear market? To be honest, the techniques used to invest in a bear market are not that different to the techniques used in any other market.

What follows are a few techniques that I have found useful in my investing and I think they have particular relevance for bear markets.

The Closed-End Fund Route

In a bear market some investors will get fearful about going out on a limb and selecting individual companies for investment (despite the fact that they think the prices are attractive).

One way to deal with this is to buy a long established, good quality listed closed-end fund at a discount to tangible book value (this will be the subject of an upcoming post). This avoids the need to select individual companies but still gets you into the market at low levels.

I believe this to be an excellent technique and a particularly valuable one for those who are not completely confident in their stock picking abilities. Even if you are confident in your stock picking abilities there is no shame in following this route. There is nothing stopping you from making individual stock picks and also putting some money in a closed-end fund.

There are some closed-end funds that have excellent records over long periods of time and those are the ones you want to be in and you want to be in at a discount to tangible book value.

Averaging

Another technique that you absolutely must use in a bear market is “averaging”. This involves initially buying only a fraction of the shares that you actually wish to buy.

For example, you may have decided that company XYZ is attractively priced and you want to buy 1,000 shares. What I do in this situation is normally buy 300-400 shares initially and then wait to see if the price moves down. If the price subsequently moves down by around 15% or so and I am still happy with my valuation of the company (i.e. there have been no adverse developments), I will buy another 300-400 shares and so on.

Now, some people will say that averaging down is a mistake. All I can say is that I have had success with this technique. Provided you have done your research properly, have patience and do not get emotional regarding weekly or monthly fluctuations, this can work very well (even more so in a bear market because prices tend to get cheaper and cheaper).

Being Very Selective

Another technique you can use is to be very selective regarding what you invest in (you should always be doing this). What I’m particularly looking for in a bear market is to buy into very high quality companies at prices which represent long-term historical lows in terms of price-to-book values, price-to-enterprise values, and price-to-earnings values and with the added advantage of a high dividend yield.

When I say “high quality”, I’m generally talking about large well established low debt companies that usually have some barriers to entry and have large market share – and I want them cheap.

When there is a general crisis, all companies will suffer. What you as an investor want to do is just pick off the very highest quality companies that have been adversely affected by what has been going on in sectors of the market that they are not involved in.

The 52 Week Low

You are unlikely to buy a company at its bear market low, you will usually enter either before (or after) it reaches its lowest price. That’s just the way it is and you have to accept that.

Once a bear market has been going for a year or more, you can start to look at the 52 week low prices for the companies you are interested in and attempt to buy close to those price lows. This gives you some idea of how low a price may go – it is definitely not fool-proof but can be used as a general guide. I know I’m bringing an element of charting into things here, but in this case it’s quite valid.

Have a look at what the analysts are saying

If you read my posts here regularly, you would know that I’m very skeptical regarding the forecasting of earnings, however, I will always look at what the analysts are estimating for the current year. Once we go beyond the current year’s estimate, we are getting into much more uncertain territory and I would place much less value on estimates 2-3 years out.

If the analysts are forecasting a material reduction in earnings, I will reassess my valuation accordingly. Analysts can and do get forecasts wrong. However, if 15 analysts follow a company and they are saying (on average) that earnings will decline by 30% for the current year, it would be foolish to ignore that.

Using all of these techniques should assist you in investing in bear markets and help limit downside risk.