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How do you think through recessions?


AzCactus
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I read Baupost's letter on Valuewalk and was intrigued that Klarman spends much of his time talking through recessions and presumably preparing his clientele for the next one.  The links to the letters are below:

 

Part 1: http://www.valuewalk.com/2015/03/baupost-group-2014-letter/

Part 2: http://www.valuewalk.com/2015/03/baupost-group-2014-letters/

 

But I want to know your thoughts on recessions generally, how you kept your head in 2008 and how you are positioning your portfolio for 2015 and the next recession.

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I bought through recession.  I average down all the way to the bottom.  For example, during 2008-2009, it's my first encounter with a bear market but I bought REIT ETF: XRE, VNQ to the bottom and sold them on the way up. Now I own a tiny amount of REIT because they are over valued.  So it's important to always have additional funding on a short notice.

 

 

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I would suggest reading Nate Silver's "Signal and the Noise" for some context around forecasting the economy.  You only need to read the chapter on economics. 

 

Anyway, I personally view recessions as inevitable, but unpredictable.  The stock market doesn't even really correlate all that well with the economy.  Take a look at the attachment here.  I've posted this before, but I created a worksheet that compares GDP and stock market growth annually going back to 1950.  It's very interesting and may be helpful. 

 

All that being said, my wife and I max out our 401k through payroll deferral.  That money is systematically going into the market.  My wife and I also do Roth IRA conversions every year which equates to $11k.  Additionally I try to build up my taxable investments annually at a similar rate.  My mentality is our 401ks are buying into the market over time.  I don't spend any time monkeying around with them.  However, with the Roth and taxable savings, I allow that to build up in cash until I find something that seems attractively priced.  This is also the cash that sits and waits for the next correction.  To me it seems like a nicely overall balanced strategy. 

Recessions_and_the_stock_market.xlsx

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I think probably the easiest / most straight forward thing to do to manage your capital through a recession is to always plan as if a recession *might* happen soon in the way you structure your portfolio today.  That is to say, if you invest in a company that may be hurt by a recession (badly), then size the investment appropriately (or mentally be aware of the trade off you are making).  Buy companies who will do well over the whole business cycle... ie, companies that will (long term) benefit from recessions as they take share.

 

I think trying to predict a recession is probably not a great idea, but perhaps bending your portfolio structure within some bands based on overall market valuation is appropriate (kind Graham's notion, but maybe using different tools to shift conservative / aggressive, or perhaps using other valuation techniques).

 

Just some ideas of how to approach this:

1) Do more workouts / liquidations / merger arb when Shiller PE (or your chosen valuation metric) is >20x+

2) When markets are scary (going down fast), look for historically great firms that are down a lot with newly low margins... but that used to have high margins.  Few want to bet on expanding future margins in a crash, but that is the time to do so.

 

For me personally, what kept me sane through the crash was knowing that most of my companies would survive with minimal dilution (it was a bet I made before I bought and before there was a recession), and even if the economy contracted heavily, I would own survivors who could buy assets cheap, consolidate competitors, and take share... of the companies I owned that weren't great quality, I felt their liquidation values even in depression were better than market prices so my downside was limited.

 

The final thing is perhaps more a mental thing than anything else which is that you have to think about how you will think / act in a deep recession before one comes.  Are you holding cash now to deploy in a recession?  If so, you must force yourself to deploy it when the time comes... if you are a pessimistic person, you can always predict worse during a bad market... and you can logically convince yourself not to act (raise discount rates, increase margin of safety, lower long term per share growth estimates, all of the above).  If you are an "always fully invested" person, just keep going... don't change your style during the downturn.  I think there is logic to both positions, and much of how conservative you should act is a personal / emotional / risk tolerance thing... but make sure you are honest with yourself ahead of time and don't decide to "learn" a bunch of new stuff right as the world is falling apart.

 

I found selling cheap to buy cheaper during the recession was hard just because prices would move so fast... you don't need to make a decision every day, but just maybe every month re-evaluate what you own and think "should I still own these, in these proportions?".

 

I found that every few years it's good to go back and read business articles from past recessions... you will remember that nothing is new, there is always uncertainty.  Buy assets for less than they will ultimately deliver to you in cash, use a margin of safety, and never convince yourself you know it all... that's all you can do.  Keeping market history fresh in your mind is a good way to keep your head when the battle starts.

 

My 2 cents,

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Ben,

 

I appreciate the response.  In my case I am holding cash--but not necessarily because I think a recession will be in 6 or 12 months.  I am ultimately holding cash because there aren't investments I really love too much right now.  Additionally, the cash I have may not necessarily get invested in stocks some maybe used for property of some kind.  The one issue I would hope to avoid that you allude to is selling when things are at bottom to buy something that you think maybe an even better bargain.  In my case I am more comfortable holding some cash now (maybe 15-20%) not selling towards the bottom but go on offense and wait things out.

 

Given your reputation--your 2 cents are worth much more than that.

 

David

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