First, I want to make clear that I do not predict a decline in stock prices for any particular reason or in any particular time in this article. Stock prices are mostly out of control of any individual investor and are notoriously hard to predict, thus I believe a long-term investor should not focus on ups and downs in the market. This certainly holds true for investors who want to limit their time and effort devoted to investing to a few hours a week. (I think this is what most people should do; they would do much better financially by becoming a specialist in their primary occupation, whether it is being an entrepreneur or an employee.)
My aim is to think about strategies for sleeping well even during market turmoil. The current US stock market appears richly priced and I do not see any apparent bargains among larger companies. High valuations have often led to small returns in the last century, either because of a significant decline of market prices and the following "catching up," or a prolonged period of measly returns.
Moderate returns are not a big concern for me in this low interest rate environment: even a 5-6% return would be better than the current yield on safe long-term bonds. There are plenty of dividend growth stocks available which have dividend yields similar to long-term government bonds, but carry little interest rate risk and have been increasing distributions above the pace of inflation for decades (and it is very likely they will keep doing so in the future), thus I view stocks as clearly preferable to "risk-free" bonds in a stagnant prices scenario.
On the other hand, steeper or prolonged market declines are psychologically uncomfortable. I firmly believe that bear markets and general stock price "corrections" will come in the future about as much as they had in the past---and with the same unpredictability. Larry Swedroe describes a nice framework for portfolio construction which distinguishes need, ability and willingness to bear the risk of investing in stocks instead of safe bonds (see this article, some of his books, or his column at CBS Money Watch for more on this topic). Without willingness, which includes the psychological capability of withstanding stock price movements and emotions associated with them, investing a large portion of your savings into stocks is a bad idea no matter how big your need or ability is. Therefore, I find it important to improve willingness. Some of my thoughts on the topic are shared in this article.
Before delving into concrete strategies, I want to stress that no stock is immune to (possibly wild) market price swings. Historical data are pretty convincing that in periods of market declines and/or recessions, the correlation among movements of stock prices increases. A likely reason for this is the herd behavior of frightened investors leading to mass sell-offs. Since many of them hold mutual funds, those mutual funds must rather quickly sell huge blocks of stocks; hence whatever the fund manager thinks of any particular stock he owns, a portion of his position is sold to fund investor withdrawals. In this way, good businesses are sold together with bad ones and prices go down. Although we do not know when this will occur, we can be pretty sure that it will occur, and I would like to find a strategy that allows me to capitalize on opportunities that arise during periods of market declines.
The simplest investment strategy, suggested to the general public both by academic research and by many successful investors, is to buy a low-cost index fund as soon as one has money available. This is a sound approach to get average returns, but a 50% decline can derail a great portion of the investors and they would sell in the worst moment. Therefore, one would want to complement this strategy with ignoring all the information noise. This is not practically possible for most investors - it simply does not go unnoticed that your friends are losing jobs, your colleagues are discussing huge investment losses, or your parents have savings cut in half and cannot afford to visit you. Nevertheless, the core of a small portfolio should be a well-chosen collection of index funds because of its cost-efficiency and cheap diversification. (As an investor from a small European country, I do not want too large of an exposure to any single market or currency, and I think even US investors make a good choice if they include a significant portion of international and emerging market stocks.)
Personally, I have another problem with this approach, and it is the urge to do something to improve my returns. I'm a big fan of value investing, so my urge is more to buy something that got cheaper than to sell to avoid further loss, but I cannot do that if I have all the money in index funds. Moreover, I find it annoying to buy an index fund containing too many companies which I think are overpriced; that happens quite often during bull markets. (For an example, I want to avoid ARMH at the moment and would prefer a double dose of INTC instead. I have found no ETF truly following a value approach; most of those claiming it are simply overweight in financials and a few other sectors.)
Focus on income stream
A viable strategy is to ignore prices and focus on income stream. This strategy leads to much less volatile results and thus less psychological discomfort. The income stream can be composed of various parts: interest from a bond portfolio, dividends, rent and other real estate income, social security etc. For the stock market part of this, dividend growth investing is a good option. The nice thing here is that the income stream can be used for reinvestment in the best opportunities available, be it real estate, cheap stocks or whatever. My experience is that even in a declining market, it is a pleasure to utilize opportunities, and if you have a nice sum each month to reinvest, you can feel quite happy even though many of your investments have declined in price. Of course, you have to be rather sure that the price decline is only temporary and your future income from the investments is not in jeopardy, but this holds for many blue chip companies and real estate properties. If you buy quality, time and low prices are your friends.
Focus on book value
Another approach is to focus on book value instead of market prices. Most companies are increasing book value in time because of retained earnings. This is especially true for companies not paying dividends, e.g. Berkshire Hathaway (BRK.A, BRK.B) - its CEO Warren Buffett also uses book value as a measure of performance. Of course, one has to choose companies that are able to reinvest earnings in a favorable way, but many large companies have long-term average returns on equity of at least 12% to 15%. This approach would fail for companies having negative equity or trading with a large P/B multiple because reinvestment of dividends will not increase an investor's share of equity sufficiently or will even decrease it. One possible way to value companies with negative (or too small) equity is to discount future cash flows and arrive at some present value. This calculated value can change from year to year, but will do so with less volatility than the market price if we limit ourselves to companies with cash flows predictable for at least a decade. A similar complication is that not all equity is equal and some is of "higher quality" than another, so it is questionable to just add two numbers together. There are some more troubles, for instance, if your book contains derivative contracts, then market volatility can distort their accounting value quite a lot if standard methods are used to evaluate it. For these (and other) reasons it is not practical to take book value in any given moment as a meaningful number, but I believe that the growth of book value approximates the growth of real value in longer term. Still, it makes me feel good that my companies are increasing their equity and my share of their assets year on year, and if they can acquire assets from bankrupt competitors, all the better.
Profit from stock buybacks
One more strategy is to invest a portion of the portfolio in reasonably-valued companies which engage in significant share repurchases. The best companies of this kind do not stop buybacks in recessions when stock prices are low and curtail them if the stock price is too high. Of course, in order to be able to purchase shares in bad times they need plenty of free cash flow in those bad times, and thus we have to choose among companies which have revenues protected by long-term contracts, sell necessary products (while they can control the price) or are even benefiting from a recession in some way, e.g. bargain retailers with budget-pressured customers flocking to them or Berkshire with billions ready for cheap acquisitions. One can emulate stock buybacks by reinvesting dividends, but it is less tax efficient (unless you do it in some tax-advantaged account where you might not have the flexibility to do so) - one has to take care of it periodically, and companies with high yields often lack other required qualities, e.g. they carry too much debt or tend to cut dividends exactly in times of recessions.
If you invest in individual companies and do not have extreme self-discipline and weak emotional reactions, I would suggest the following to ease your discomfort during market declines.
1. Keep plenty of cash (or liquid safe short-term investments) at hand. It allows you to pay for your expenses without selling assets and exploit investment opportunities that may arise. I would suggest to keep at least 6-12 months of expenses plus 5-10% of your portfolio in cash, especially if you have a mortgage or are not completely sure of your employment. Holding cash decreases returns, but gives you a lot of safety (both real and perceived).
2. Create a stable stream of passive income. It gives you financial flexibility: you can spend the money, reinvest if opportunities arise, or repay a mortgage. A potential job loss, prolonged period of illness or extended maternity leave would be financially less stressful.
3. Avoid companies with a meaningful risk of bankruptcy (e.g. a one-time event crippling a nuclear plant or oil rig operator).
4. Avoid companies with a large debt load. They are not flexible enough to exploit opportunities arising during a recession. (Note that a large debt-to-equity ratio is meaningless if the debt can be repaid from free cash flow in a year or two. If you are interested in stories of highly indebted companies not performing well, have a look at E.ON (OTCQX:EONGY), which is selling assets in unfavorable period to decrease debt pressure, and Telefonica (TEF), which has been struggling with debt for years.)
5. Choose among companies with diversified revenue sources and with revenues and cash flows predictable for many years. The concept of moats also comes into mind here.
6. Choose among companies generating a good deal of free cash flow which are actually distributing that cash to shareholders, either through dividends or stock repurchases. In both cases make sure they have not stopped their good practices in the last recession or two.
7. Invest with a margin of safety. If your assumptions are slightly wrong, or the business deteriorates in a recession, that margin makes sure that you still get a satisfactory (although not spectacular) return.
In this way, I feel comfortable having about 80% of my long-term portfolio in stocks. Even my wife feels comfortable with this level. I have recently received an interesting bit of investment advice from psychologist Dr. Lacho: let your spouse be your emotional indicator in investing - even if she knows nothing about investing, she is very capable of judging if you have an inner peace about a particular investment. You should invest only if both of you have peace of mind. If you are honest in communicating with your spouse, she will have no problem detecting that you are investing mostly because of unjustified hopes of a quick gain or that you have bad conscience after a sloppy reading of an annual report.
Finally, I do not think that one cannot make profits on companies not meeting these criteria. I believe that even hefty profits can be made on them. Nevertheless, I would choose a different time to buy them. For instance, I would love to buy more shares of BASF (OTCQX:BASFY), a leader of chemical industry, but I'm willing to wait a few years for some kind of recession or crisis when such cyclical companies can be bought much cheaper.
Examples of suitable companies
Although I know what I want to buy, it is not so easy to find particular investments. I have not found a way to screen for companies which make smart stock repurchases (e.g. buy a lot in 2008 and 2009, but not a lot if P/E is more than 20) and I have no access to raw data. Therefore, I would be very thankful for readers' suggestions of companies meeting my criteria listed in the article. Some of the companies I have found are the following.
Berkshire Hathaway (BRK.A, BRK.B)
BRK has become a conglomerate combining top management of stock market investments with various operating businesses (railroads, electric utilities, retailers) and vast insurance and reinsurance operations. At all times, it keeps at least $20 billion of cash at hand for operating purposes, and usually has about the same amount ready to be invested. It has little very highly rated debt. BRK currently does not pay dividends and has a clearly stated repurchase policy: it is buying under 1.2 times book value which the management considers to be significant undervaluation. This threshold is, however, hardly ever met because qualities of BRK are widely known; anyway, it puts a floor on the stock price. BRK has historically outperformed in bear markets and lagged in wild bull markets. The stock currently trades at about 1.5 times book value and so I view it as moderately undervalued to fairly valued with smaller than average risk.
Big Blue has moved from hardware manufacturing to software and services in the past decade. This has increased margins and diversified sources of revenue. IBM enjoys certain scale advantages and a moat of switching costs type, although it might not be very deep. It also has a strong brand and very capable research and development teams. Currently it trades with a P/E ratio of only about 13, much less than an average S&P 500 company, and has a 2% dividend yield. Part of this unfavorability comes from concerns about the decline of cloud computing profits, but those form just a small part of its business; thus I think those concerns are exaggerated. Although cloud computing margins can be very narrow in the future because of the commodity-like nature of computing services, customers need much more than just a share of cloud resources - they need applications and software suited to their particular needs, and here Amazon and other providers of cloud services are no match for IBM. The company has little debt (short-term plus long-term debt less than two times earnings) and generates a lot of free cash flow which is used mostly for share repurchases. The qualities of IBM have not escaped the eye of Buffett who gives IBM, and its buyback strategy, a lot of praise in the 2011 Berkshire Hathaway annual report.
Brookfield Infrastructure (BIP)
This business structured as a partnership associated with BAM appears ideal for becoming a part of a strong income stream basis. The partnership owns and operates various infrastructure assets: ports, railroads, transmission lines, natural gas pipelines, toll roads ... Dividend yield is attractive at about 4.9% and revenues are protected by long-term and regulated contracts, usually with allowance for inflationary increases. The leverage is significant, but the management has performed successful steps in decreasing risks related to debt (more on this in my recent analysis of BIP) and I think that distributions are safe and nicely growing.
Other good candidates are Wal-Mart (WMT), Illinois Tool Works (ITW) and Costco (COST), but I have not analyzed them in detail. From the financial standpoint, I also like INTC and their repurchase program, but I'm afraid there is too much to monitor about the company because of technology-related risks, so it does not fit well into this category.
Additional disclosure: I also own other stocks mentioned in the article via various ETFs.