VALUE INVESTING
Things To Do In A Crisis

By Stephen Bland (TMFPyad)
July 8, 2005

Back in February 2004, I selected Shell (LSE: SHEL) for the first Value Investor high yield portfolio (HYP). It has since then become that portfolio's biggest gainer by a long way, up 56% on capital alone or 64% including dividends received. Overall, my high yield picks are up 17% to date, outperforming the mainstream value picks which have returned 6.5%.

Now my usual selection process for HYPs in the publication, which I construct by adding one new share in each monthly edition, is to rank the market's biggest caps by descending yield and then work my down the list, selecting a new share from the next sector not already held. Before picking it, I'll check that it appears to satisfy a few simple safety measures such as the level of debt, cover and so on which means that some shares may be rejected and I have to go further down the list. However, these tests are not applied mechanically and I will bend them to the circumstances as I see fit.

But I stepped outside the above process when selecting Shell. February 2004 was the second pick for this portfolio and thus I should still have been looking very near the top of the yield list. Shell was definitely not the second highest yielder in a new sector, the first having been a bank. In fact, it was some way down the yield rankings. I had though noticed that the shares were depressed because of an admission that they had earlier overstated oil reserves. The fall in the shares thus boosted its modest yield somewhat. Note that even its depressed state, Shell was not a particularly high yielder but I always like to see one or more holes in the ground in an HYP. Mining and oil together form a very substantial proportion of the market so that crucial sector diversification would be compromised by ignoring them.

So sooner or later I would likely have chosen Shell or another big oil or miner for the portfolio, even if it meant accepting a modest yield. Like the practised fake smile of a politician, I just had to have one. My gut told me that Shell's difficulties would in practice and over time have less influence on its great qualities as an income share for Value Investor readers than a fart on the direction of a hurricane. Typically I felt, the market was over reacting negatively to the news and we had a true crisis play on our hands. So I bought Shell for the portfolio prematurely. On my usual selection process it wasn't Shell's turn yet in that February, there were plenty of good shares in other sectors yielding much more before I got there. But I allowed them to jump the gun.

My definition of a crisis play, which I consider a branch of value, is when a big cap share is marked down temporarily because the market has substantially over reacted to some problem in the company. The investor has to judge that the perceived crisis is actually no such thing. In other words the last thing you want to see in a crisis play is a real crisis. You have to consider whether the matter hitting the share is really going to make any difference to it over time. Shell in February 2004 was a classic example of this for me. I saw it as extremely unlikely that longer term, which is what matters for HYPers, the reserves accounting problem would make any difference to anything.

It is one of the characteristics of the stock exchange, of human nature really, that investors sometimes over react to situations. This may be across the market as we saw on Thursday with the terrorist attacks in London or with individual shares encountering some difficulty. Similarly this happens on the upside too. Anyone who follows the market for any time will have seen examples of shares pushed up to daft unsustainable heights.

Good crisis plays don't happen too often. But when they do, nice profits can be made over the short term. Stick with large blue chip type shares if you're going in for this because that type of share is more likely to put in the necessary recovery once the overblown crisis has blown over. And you should pick up a decent yield whilst waiting.

Note that this is not a risk free game. There is always the possibility that the crisis you perceive as temporary and minor, and to which you think the market has over reacted, turns out to be much worse than you expected. There may really be something wrong enough to justify the mark down. In such a case the shares might not recover and be set on a downward trend. It's a judgement call on your part but try to look for things that are isolated in nature, so that even if they do hit eps it will be for that accounting period only. A few examples I recall from the past include periodic tobacco health scares, again with oils a major tanker spill and one of the big banks having lost serious money on derivatives trading.

Crisis plays are one of the value style situations that I watch out for on behalf of readers of Value Investor. You can join them here by signing up for a free 30-day trial.