Five rules for navigating a market crisis – Part 1
When it comes to finding a way through a market crisis, there are five rules investors would do well to follow – first and foremost among which can be summed up as ‘Fix the roof’
These are strange days indeed – with just one oddity being that, while offices have been closed for months, many people will be feeling as if they have never needed a holiday more. Certainly, here on The Value Perspective, the year so far has brought some of the most intensive weeks and months we have experienced in our career. So what have we been doing with our time?
Adding in the bursting of the dotcom bubble in 2000/01 and the 2008/09 crash, this is the third market crisis we have experienced as professional investors. As we noted in Time to be brave, every period of market volatility is unique in its own way – with this one showing unprecedented speed on the way down and, arguably even more disconcertingly, on the way up again.
With every crisis, however, here on The Value Perspective, we have learned lessons and developed a set of behaviours that should better enable us to protect capital and make the most of opportunities for our clients. This will not prevent the stocks we buy from being any less volatile – nor, sadly, our hair from going a bit greyer every cycle – yet our experience suggests it will help our clients to make money over the longer term.
Fix the roof
When it comes to navigating a market crisis, there are five rules that investors would do well to follow – first and foremost among which can be summed up as ‘Fix the roof’. When we buy a stock, we take it as read things will grow worse. That does not make us pessimists but realists – as value investors, we will typically be buying businesses where things are far from rosy.
Before you do anything else, then, you need to work out how the present period of market volatility will affect the companies you already own. We have found the best way of addressing that question is to focus on balance sheets – after all, while there are plenty of ways for investors to lose money in the short term, one sure-fire way to make that loss permanent is to buy into a company with inappropriate amounts of debt.
As we said at the start, every crisis is a little bit different so what does that mean in practice? Take 2008 as an example, where you effectively saw wholesale global banking markets shut down overnight. No bank would lend to another for fear it was about to blow up, which meant anyone whose funding relied on bank lending was instantly insolvent. We had to work out the implications very quickly – and sell the affected businesses.
Over the years, we have finessed our thinking on corporate indebtedness to arrive at a seven-point checklist, which you can see below and we have discussed in more detail in The ‘seven deadly sins’ of company debt. These are the checks we go through with every company we own and, when we did so in the first phase of the crisis in March and April, it showed us these businesses were, on average, in good shape.
Seven deadly sins – More than one way to scan a debt
- Solvency ratios
- Covenant ratios
- Debt repayment
- Pensions and other creditors
- Working capital
- Cash conversion
Source: The Value Perspective
We would, of course, have been very disappointed if this had not proved to be the case for our portfolios – after all, balance-sheet analysis is a core part of our investment process. Even so, there were a handful of businesses where the balance sheet was weaker than we might have wanted, given the environment we were facing, or where we judged we had too much exposure to similar risks across stocks or sectors.
In those cases, we reduced our positions accordingly – with the sale of HSBC across portfolios being a good example. We also held discussions with certain management teams about raising small amounts of incremental new equity with a view to helping their businesses to see out the current downturn and realise the considerable upside we believe resides in them.
In the final analysis, avoiding all debt will not make you money but understanding debt’s place within a business may stop you from losing it. In our next two pieces, we will discuss our remaining four rules for navigating a market crisis: ‘Get to the coalface’ and ‘Trust your process’; and ‘Keep your discipline’ and ‘Be brave’.
Fund Manager, Equity Value
I joined Schroders in 2001, initially working as part of the Pan European research team providing insight and analysis on a broad range of sectors from Transport and Aerospace to Mining and Chemicals. In 2006, Kevin Murphy and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Kevin and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.
The views and opinions displayed are those of Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans, Simon Adler, Juan Torres Rodriguez, Liam Nunn, Vera German and Roberta Barr, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated.
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