A Beginner’s Guide to Investing in a Downturn

Do you want to buy low and sell high? Let me tell you a secret. That’s exactly what hundreds of thousands of traders and fund managers around the world want to do, but no one gets it consistently right. Not even Warren Buffett and Peter Lynch. If highly trained professionals and legends fail to consistently buy low and sell high, where does that leave us? The key to investing is to stack up the odds in our favor, one layer at a time.

LAYER 1: Downturn is the greatest opportunity 

“If the stock is grossly overpriced, even if everything else goes right, you won’t make any money, ” wrote legendary investor Peter Lynch in his book One up on WallStreet. I believe the converse of what he said fits perfectly in a downturn. If the stock is grossly underpriced, even if plenty of things goes wrong, you will still make money.  Finding undervalued stocks in an overvalued market is like searching for a needle in a haystack, but finding an undervalued stock in an undervalued market is like finding a needle in a stack of needles. A downturn is the best time to invest because an undervalued market gives you a wide margin of safety. You will have to work really hard to find a long term loser in a downturn. If you manage to find a fundamentally strong company and invest in the middle of a recession, your investment will keep yielding for a very long time. Compared to plenty of other companies in the S&P 500, Procter and Gamble and AT&T didn’t do really well. But had you bought a single share in both companies by the end of March 2009, you will be counting a return of 115.69% by the close on April 17th, 2020. Not a bad return after the market is 20% off its peak. Your investment value adjusted to inflation will be safe even if the market drops another 30% from here. That’s the advantage of investing during the downturn. It took just 13 months for several stocks to recover their pre-great-recession price. The best time to invest in a company like Microsoft comes in a downturn when valuation decouples itself completely from the fundamentals and the future of the company. [caption id="attachment_20012" align="aligncenter" width="620"] Chart created by Author: Data Source Yahoo Finance MSFT[/caption] Microsoft’s quarterly revenue growth during this period was 9.44%, 1.60%, -5.58% and -14.22%. Its worst quarterly performance came right before Microsoft regained its pre-financial crisis pricing. It’s clear that Microsoft’s business earnings and revenue growth had nothing to do with its 2009 market valuation. If you had bought a single unit of SPY, an ETF that tracks the S&P 500 index, in February 2008 and held it till April 17th, 2020, you will be sitting on a return of 275.75%.

LAYER 2: Never forget your list

There are more than 3,500 securities listed in the United States. Now spice it up with ETF’s, Mutual funds, bonds, options, and futures — the list of available investment vehicles is nearly endless. To be a successful investor, you only need a handful of winners, not hundreds of them. Decision Paralysis is a clear and present danger to investing. “Research shows that if you’re surrounded by an abundance of options, you typically end up less satisfied with your final decision than if you’d been given fewer options in the first place,” says Psychologist Eva M. Krockow Ph.D. Do yourself a favor and always keep a list of, preferably a handful, investment ideas ready. Complicating is easy, keeping it simple is the hard part.

LAYER 3: Get yourself an Insurance

The key to investing in a downturn does not lie in how smart we are in picking the company, but how smart we are about our own weakness. If we are worried about the money we have already invested in the market, the odds are stacked up against us. Will you be able to convince yourself to invest more when the positions you hold are already losing value in double digits every week? Will you blame an investor who closed his position in Microsoft after it declined 40% in 2008–09? Hindsight was not the comfort he would have had. Hedge your portfolio. Hedging is not just for big fund managers. Small investors like us can use hedging as an active strategy to not only protect our investment but also to make sure that we don’t panic when the market crashes. Hedging costs money but so does car insurance premiums. Will you drive your car without insurance? You compare insurance providers, check their quotes, negotiate a better deal if possible. But at the end of it all, you pay the premium year after year. You never saw that as an unnecessary expense. Our investment portfolio is worth a lot more than our car, but we rarely think about buying insurance. Hedging - Example: Let us assume that I am ready to invest $30,000 and I think there is a good chance that the economy might face a severe, prolonged downturn. I am also worried that the market will keep going up in the short term and I will lose a great entry point. I am kind of confused as I am thinking in all directions. But I have decided to dip my toe anyway and create the following plan:

1. Invest $20,000 in SPY, an ETF that tracks the S&P 500 index.
2. Set aside $1,000 to $2,000 for hedging.
3. Hold the rest as cash.
4. Invest the cash if the market declines by more than 50% in the next 12 months.

Execution: S&P 500 index @ 2,776

1. I buy 72 units of SPY. A total investment of $19,969.
2. Buy 1 Put contract (strike price of $250) with an expiry date of November 30, 2020.
3. I hold a cash position of $8,345

Resultant Scenarios: Six Months later When the hedge expires in November, my portfolio value would have changed as follows. The hedge would have taken a good bite of my profits had the market moved higher. But my portfolio would have lost just 3% if the market declined by more than 45%. Hedging would have done what it was supposed to: make sure that I don’t collect outsized losses when the market goes crazy on the downside. Note: I have not included commissions as part of the calculations. SPY ETF does not accurately track the S&P 500 index. If you are comfortable with options, you can consider a bear put spread to reduce the cost of your hedge.

Layer 4: Divide your investment into Categories

Peter Lynch grouped stocks into six categories: Slow Growers, Stalwarts, Fast Growers, Cyclicals, Asset Plays, and Turnarounds. I will just add one more to his list: Portfolio Insurance. Segregating assets into categories makes it easier to manage your portfolio. It will remind you why you bought the stock and what your expectations were when you bought them. Slow Growers: Established companies that are past their high growth pace. I will keep companies like McDonald's, Procter & Gamble or Starbucks in this group. Stalwarts: Companies that are highly unlikely to go out of business. I will keep companies like Apple, Google, Microsoft, and Berkshire Hathaway in this list. Thanks to a net cash position, the odds of these companies going bankrupt is extremely low. Make sure that you keep a high degree of threshold on any company that enters this list, the harder your selection criteria the better. I recommend placing only companies with a net cash position on this list because companies with no debt don’t go bankrupt. Fast Growers: Small companies with an aggressive growth rate. Cyclicals: Companies in cyclical industries such as airlines and auto. Both these industries are well known for the boom-bust cycle. Asset Plays: These are companies that trade far below their value, making them an attractive bet for investors. According to Peter Lynch, this could be “any company that’s sitting on something valuable that you know about, but that the Wall Street crowd has overlooked.” Turnarounds: Companies that are barely surviving. But if they turn things around and fix the problems they are facing, the stock price will rebound. Portfolio Insurance: Bear markets tend to be short-lived and you need insurance only when you are anticipating a bear market. According to Invesco, the average length of bull markets since 1956 is 55.1 months. The average length of a bear market is just 11.7 months. If you are investing since 1956, you would have bought insurance for your portfolio less than 18% of the time. Key Points to Remember: Some companies will qualify to be in multiple categories. But if you know why you are making the purchase, you will place them in the right category. Once they are positioned in the right place, it will be easy for you to decide when to sell and when not to sell the position. When fundamentals change, companies must be repositioned to the respective category, forcing you to automatically change your expectations. Category Rebalancing - Example: Let’s assume that I have bought shares in Apple and Google. I place them under the Stalwarts section as the odds of both the companies going bankrupt is extremely low. Ten years after I purchased them, a new management team decides to binge on debt and both companies drift quickly towards net debt. I will now remove them from Stalwarts and place them under the Slow growers. Re-balancing a portfolio is easier with categories than without it. During a recession, I will be least worried about the companies that I placed under Stalwarts. I will exit turnarounds and asset plays, question my cyclical positions and take a real close look at companies placed under slow growers. Investing is not rocket science. To be successful you need knowledge of simple math, a small dose of common sense, a decent amount of discipline, and an ability to accept mistakes. Things, a lot of us have. But somehow we have all managed to make it appear more difficult than it actually is. If you can break the complexity down and set the terms of your engagement, you will start off from a favorable position. Make sure that you are the one who dictates the terms of your portfolio, not the stock’s current price.