VALUE INVESTING
Crisis Investing

By Stephen Bland (TMFPyad)
October 8, 1999

Crisis investing is a cousin of value investing. Both styles attempt to select shares which are in some way rated at a level that appears, as perceived by the investor, to be unreasonably low by whatever the market norms are at the time. But there are distinct differences.

These differences arise because value shares require certain fundamentals of the company to be attractive – the sort of ratios to which I have referred often in previous articles in this series and to which I adhere to the point of clinical obsession. However, crisis shares do not require the same sort of detailed analysis of shares to find the mark. What they do require, though, is a crisis of some sort, either affecting the share itself or perhaps the sector, coupled with a decent, preferably FTSE 100, share that has been unfairly afflicted by the malaise concerned.

Both value and crisis rely on that most unwavering and rock-solid of foundations – human nature. It is fairly obvious, to anyone following the markets at even the most superficial level, that rises and falls in particular shares or sectors are very often overdone. In a word, fashion. Shares will be chased up to unsustainable levels because they are flavour of the month, only to become unloved and unwanted a short time later. Similarly those that are unloved will be will frequently be cast out like financial lepers, condemned to isolation and exile, sniffed at only by the likes of me perhaps. Then, like magic, they may become resurrected after a time when it becomes clear that the quarantine was excessive.

Study these waves of popular support and condemnation. And then comes the hard bit. Force yourself to think the opposite way. We are looking for the down wave, the condemnatory, ostracised cycle of a share or sector. Not just the weak fashion waves which ebb and flow like the minor tides of the Mediterranean but the big ones. The hurricane-induced Atlantic tidal wave that crushes shares, good and bad alike, in its path.

It is in practice immensely difficult, for a lot of people, to do the opposite of everyone else, especially when the big guns of negative fashion are against you. It sounds easy when discussed in abstract here but you need to fight hard to maintain credibility in the face of bad news from the press, down the pub and so on. It took me a long time to do it. I used to be a dedicated follower of fashion in shares and paid dearly for that dubious privilege.

You cannot plan crisis investing in the same way as value investing. By definition a crisis is a rare event. I will comb the market regularly looking for my type of value shares, filtering on my criteria. But a crisis play just happens through a combination of circumstances. It is chance occurrence upon which those with the requisite cojones can frequently capitalise to their profit. And it can be quite a ride. Not for fainthearts. This is white knuckle, brown trousers stuff. But it is an investment strategy quite unlike value investing.

An example will illustrate the point. There was a well-publicised perceived financial crisis in Asia last year. The major bank HSBC (LSE: HSBA) was driven down to absurdly low levels due to its involvement in the area. I believe the price to earnings (P/E) ratio was close to seven, a figure which I regard as a buy signal for banks in general. The shares were so cheap that their yield caused them to be selected for the pyad 26 high yield mechanical portfolio. Without even checking the fundamentals of HSBC it was fairly clear that the downward push on the bank had been exaggerated. As so often, the market had overplayed the effect of the crisis, if it even was that, and hit everything remotely connected with the region. The shares rose dramatically within a few months.

Easy to say now, you might comment, and you would be right. How to get in at the bottom, though? "You can't time it" is the short answer. You have to find what you believe to be the low point and go in. Don't keep dithering or you will probably miss out. Make a decision and back it. But as a result you must be prepared for further falls before any rise. I cannot stress this point too strongly.

Taking HSBC again, in a real bear squeeze the shares could easily have halved again from a P/E of seven down to three or four. If that had happened, and believe me I have seen that sort of thing in crisis plays, many weak players would have been flushed out as their investment fell by 50%. But if you were right at seven, and major international banks were otherwise trading on a P/E of say 15, then you stood a good chance of making serious profits in the almost inevitable recovery even though you had to go through heavy falls first, after going in.

HSBC is an example of a whole gamut of shares being affected by a crisis, taking down the good with the bad. The other type is where a single share is hit by an internal crisis, not by some external disaster.

A while back, NatWest (LSE: NWB), by chance another bank, was hit by an internal problem of losses on some sort of derivative trading; I forget the details. The sort of thing that afflicts banks occasionally. Poor old NatWest got trashed as a result. I think the shares went down to 600-odd pence. But it struck me that the whole thing was grossly overdone. Analysts calculated the effect on EPS and whatever it was, it was just for that year. But the shares had as a result been driven down to levels far below those of its direct competitors. A level which assumed EPS would be hit for a very long time. A classic example of individual company crisis.

But against these two winners, you have to accept the risk, reasonably high by my standards, that it will go wrong. When it works it really motors. But sometimes the shares will go nowhere, or maybe fall further and not make it back up in the short term.

Here are the important rules of crisis investing as I see them:

1. Back only blue chip shares in the crisis game. Don't play it with anything below FTSE 350 shares, preferably the 100 index only. You don't need to do the full fundamentals check as with full value, just make sure the company is profitable and isn't too much in debt. Rising EPS and a decent yield are useful. Remember we are looking for shares that although temporarily down, will ride out the crisis comfortably and stage a major recovery. That is far more likely with top quality shares than small caps. Minimise the downside.
2. Use P/E and yield as your guides to the depth of the fall. Compare the ratios of your mark to those of similar shares not affected by the crisis. We are looking for massive comparative underpricing of the shares. Perhaps 50% under on these ratios. Learn to love it. Become a financial masochist, attracted to the pain of certain events. Get excited, for example, when an oil tanker loses its cargo at sea – it may mean you can pick up the oil company's shares temporarily on the cheap.
3. This is a short-term play. A stock market one night stand. A financial wham bam thank you ma'am. Not a long romantic affair. As with all shares, never fall in love. Wait till the shares deliver their heart to you then cut them dead. Use 'em and lose 'em.
4. Be prepared for further falls before the rise. Nobody times the bottom except by pure luck. Believe in yourself. You know it has been overdone. Don't sell just because the share goes down more, provided of course it retains its fundamental soundness.
5. In contrast to 4, you must equally come to realise that sometimes you may have got it wrong. The share that seemed so attractive in the dark after a few drinks may look a bit rough the next morning. If after a decent period it hasn't made it, then consider taking a hit and getting out. You have probably made a mistake. But admit it, don't try and talk yourself into staying on. If they don't deliver, turn out to be mere teasers, dump 'em. Don't let them become long term hangers-on.

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