Investing's Five Pillars of Wisdom

Technical chartists and market commentators are telling us that what we are experiencing now is a bear market triggered by a serious downturn in the US housing market and unforeseen domino effects across the globe emanating from fundamentally flawed, opaque financial investment products.

That may be the case, but it doesn't mean the end of the world is nigh. Equally, it doesn't mean the sharemarket has become a no-go zone for everyone looking to invest.

Here are the Five Pillars of Wisdom that may help investors adapt to the sharemarket’s climate change.

1. Every bear market creates a platform for the next bull market. This is not some creative spin invented by stockbrokers eager to lure retail investors back into the market. Look at how the stockmarket has moved up over the longer term: every downturn in history has been followed by subsequent upswings that ultimately took markets to higher levels. There's a simple mathematical way to prove this. At times of earnings stress and insecurity – such as right now – overall price/earnings (P/E) multiples fall below historical trend and when things pick up again they rise (because we all become more optimistic).

Let's put this principle in practice: ANZ Bank (ANZ) shares are currently trading at a 2008-09 P/E of about 9.7. The major banks are used to having multiples of up to 15 (sometimes higher) over the past decade. But let's not be too greedy in this. Let's assume ANZ's multiple will recover to 13 once the main clouds over the sector have disappeared. This would push ANZ shares up to $30, more than 32% above their current $22-something.

This simple exercise instantly demonstrates the potential in ANZ shares, even without including the 6.8% in estimated dividend yield. However, the above example only shows why the shares are currently labelled "undervalued" or "cheap"; it doesn't tell us when the time has arrived for ANZ shares to return to a more normalised P/E.

Think logically and you'd probably agree that before we can see ANZ shares back at $30 (they peaked at $31.74 in October last year) the market will need more clarity about what's happening with financial institutions on a global scale and more insight into how the economic downturn will affect the bottom line and balance sheets of Australian financial institutions.

Long-term investors are having a field day at these unusually low valuations, but it all depends on what your horizon is. ANZ is very unlikely to go bankrupt, so the "potential" is very much locked in – but only if you're in the game for longer than short or medium term. Think three years at least and you're likely going to look back with fond memories about the day you decided to step in.

2. Value is of little value. This is as good as any other time to start practising the power of the word “value”: Every morning, before you get out of bed, say three times: "Value is of little value". This is to be repeated at least two more times before the end of the day. This should help you cope better with stockbrokers, market commentators, financial planners and other experts who will be telling you, over and over again, that Australian shares, and especially banks, insurers, property trusts and builders, are currently cheap as chips.

They are, but as stated in Wisdom Number One, this tells you nothing about the timing of their recovery. What you want to be looking at for the short and medium term is "Security", "Growth" and "Momentum"; probably best to have all combined into one.

In August last year, consensus expectations were for the banks to grow their profits by 12% this year. Current concerns are that profit growth for the sector might turn out negligible for the year. This is a big change and explains why banking stocks' P/E multiples have fallen so dramatically. What about 2008-09? We don't know yet, but concerns are mounting. Overall, the trend in earnings forecasts for the broader market is still negative.

The only exception, as a group, are resources. But investors better be careful, because this does not apply to all resources stocks. As traditional safe haven sectors such as banks, property trusts and utilities are currently jinxed because of negative sentiment and negative news flow, the market is currently trading without any defensive sectors. This means increased volatility, across the board.

And because resources stocks are being promoted as "the new defensives", they will logically make up a bigger part of investors' portfolios in the year ahead. It won't make the overall market less volatile, however, it will probably do the opposite. (It still beats me how anyone can promote any stock that swings between $33 and $36 within the same week as "defensive", but I will not argue with the fact that resources stocks are the place to be).

Resources stand out because annual contract settlements seem to be generating higher prices than the ones pencilled in by securities analysts, while spot prices for the likes of copper, aluminium and oil have surprised to the upside in the first two months of the year. What this means is that earnings forecasts throughout the sector are trending up (against the overall trend). In addition, precious metals are still forecast to move higher. Oil and gas forecasts are constantly subject to revisions, but they too have surprised on the upside thus far.

Special mention must be made of oil and gas companies (also proving how little "defensive" the new defensives are). The February results season has revealed that, despite crude oil being up about 67% over the past year, most companies in the sector did not report any growth in profits. Some, such as Caltex (CTX), even issued a profit warning for the year ahead. The key to the outlook for these companies is keeping costs down while actually achieving the planned production growth. A stronger Aussie dollar is too often ignored as well by analysts and investors.

In general, look for companies that did well during the reporting season; they will enjoy the positive momentum. And the market is obviously trusting them in continuing to do well. Jump on beaten-down stocks at your own peril. As again proven this week by the likes of Allco Finance (AFG) and ABC Learning Centres (ABS), there's no natural limit to the amount of negative news possible and, equally, what has become cheaper today can always become even cheaper tomorrow. Another wisdom to keep in mind is: negative news begets more negative news. Investors ignore this at the risk of losing substantial amounts of money.

3. Watch your attitude, dude! If you want to make a living as a trader, here's one very important rule I learned from people who have spent many decades trading in the markets: keep the trend as your friend, always.

What this means, in effect, is that during a bull market you are likely to make easier (and more) profits by punting on the fact that share prices will go up. However, because we are no longer in a bull market you should adjust your attitude. Immediately. This means you are likely to be better off by going short (speculating on stocks to fall) or, if your mindset doesn't allow for such a reverse focus, to stick to a short-term trading horizon. In other words: you're either in the market short or for a short time only. Probably better to be both at the same time.

However, this necessary change of attitude is not confined to traders, it goes for all types of investors with all types of experience, goals and time horizons. During bull markets positive factors tend to grow on their own and become a craze. Think about how everyone jumped on uranium '¦ and then they all went into iron ore stocks '¦ and then into coal. In between we had nickel and then lead. Under negative circumstances, it's the negative things that are magnified. All of a sudden nobody wants to have any part of any property trust any more. And every retailer will soon find fewer customers on his doorstep, with less to spend. And every company that delivers the slightest disappointment gets hammered. Think QBE, a long-distance outperformer that was sold off earlier this week because its results did not offer any positive surprises.

It is at times like this that investors experience the true meaning of "risk". Don't try to be a hero. The odds are stacked against you. A recent study by Credit Suisse found companies that disappointed during results season in a negative market tend to underperform by 100% or even more, and this underperformance was likely to last for many months, in some cases for many years. As I said above: negative things are magnified.

In a bull market there's always the chance for a takeover to save the occasional dud. In a negative market like the one we're experiencing right now there's no such deus ex machina (help from out of nowhere): this market will show no mercy and if your only hope is for a takeover to save your investment, you're truly in dire straits. Remember what happened to (the company formerly known as) RAMS (RHG)?

Separately, Macquarie Group (MQG) reportedly offered to take over debt and major assets of Allco and put a value of $1 on the remainder of the company (that's right: one dollar!).

If value is of little value during negative times, risk will show its full weight in fool's gold. The sharemarket has become a more uncertain, volatile and risky place – all at once.

Again, there's a simple mathematical explanation why negative factors matter more at times like these: if a certain stock falls 20%, let's say from $1 to 80¢, it will have to rise by 25% to return where it was (back at $1). Imagine what this means for shareholders who still own shares of Allco, MFS (MFS), RHG, Centro or ABC Learning Centres.

The overall decline of P/Es plays a big role as well. In December, Commonwealth Bank (CBA) shares peaked at $62.16. The average price target was about $60 at the time; they are now $45. The average price target has fallen to $51. What if you bought the shares at $58? That's what I am talking about: change your attitude. Simply order a few drinks and get over it. Ask yourself whether remaining a shareholder of CommBank is the best way to regain your losses.

4. Better to ignore the noise. There's always a lot of noise in and around financial markets, and I am not necessarily talking about rumours that turn out to be no more than hot air.

Last week I read that Woodside Petroleum (WPL) was the only blue-chip that was trading higher than at the start of the year. Compared with the sharemarket peak in early November, you'd be hard pressed to find many stocks that are still sitting on a gain. (For a broader view of the stocks among the Top 300 that are trading stronger than at the start of year, see James Frost's feature, Precious copper).

Take a close look from early February on and you'll see that BHP Billiton (BHP) shares went from $36 to nearly $40. Alumina Ltd (AWC) shares went from $5 to beyond $6. Shares of Energy Resources of Australia (ERA) are now above $22 compared with $18 in late January. With the exception of Alumina, which is pretty much trading at its average price target, most price targets for resources stocks are still 17% and more above today's price levels (with upside bias). Maybe that's the real story you should be looking at.

Part of this constant noise relates to the fact that half the market finds itself repeatedly behind the curve, and completely ignorant of it. The latest fashion in the finance industry is to use sentences such as "apparently ignoring the fact that the US may soon be in recession, investors continue to push commodity prices to new highs". (Watch out for this, every major newspaper has a variant on this sentence in its columns on a daily basis).

Investors had better learn how to ignore these false signals, as the use of this sentence merely proves the author has yet to catch up with how things have changed over the past few weeks.

As I wrote last week (See A safe-ish place to dig in), sudden changes on the supply side have fundamentally improved the outlook for commodities such as coal, platinum and aluminium, but also for resources in general. I also wrote that if I were a hedge fund trader I would have repositioned myself from being short to turning long the industry. The latest data from the futures market indicates that's exactly what has happened over the past few weeks. Speculators, hedge funds and large fund managers have jumped on commodities and gone long. Are these people, sometimes referred to as the "smart money" in the markets, ignoring a possible recession in the US? Think again: why are they called "smart money"?

Equally, many a commentator still has to catch up with the fact that what used to work in a bull market may not necessarily still work in this fundamentally changed environment. Much has been made out of the fact that directors of ANZ Bank, including chief executive Mike Smith, have been buying extra shares since the recent sell-down. Past analyses have suggested that imitating directors buying shares in their own companies can be a highly profitable trading strategy. (To read more about trends in directors' trades, See Keith Neilsen's feature, Directors’ specials.)

However, the question has to be asked whether this was not merely something that used to work in a bull market environment. My personal observations are that directors and managers often have a poor record in understanding the finer elements of the financial market, but also in anticipating key points of reversal. At least one director of RAMS bought extra shares after the successful IPO was met by a gradually weaker share price on the market last year. Several directors of high tech company Arasor International (ARR) bought shares last year to stop the share price rot. The shares have now sunk below $1 from the $3-something they once used to trade at.

And what about management at Paladin (PDN), who decided to buy in extra product near uranium's spot price peak of $136–138 a pound last year? Eddie Groves, the chief executive of ABC Learning Centres has been buying stock consistently throughout the past year but it did little to save him from a vicious sell-of this week, which saw the stock plunge more than 40% in a single session.

Investors should no longer be looking at which directors are buying into their own company, but at which directors and major shareholders are selling some of their stock.

5. Things are seldom that different, really. It always sounds much better to talk of things as though they never happened before and surely this must be the worst crisis ever and the worst derailment of global financial markets in the history of mankind. It will probably turn out that this is not so. And things won't be so different to what we've seen before, either. P/Es for banking stocks may be at a 17 year low, but they were still lower during the 1980s and in the early 1990s when another financial crisis hit global markets (and Westpac almost went bankrupt).

If you really take the time to analyse what's happening and put it in the right context, you'll see that despite all the confusion, the fears, the sell-downs and the noise, things have in essence not changed much from how they were before the start of this year.

Banking stocks have been underperforming the broader market since early 2006. Prices for commodities have continuously surprised on the upside. And every year economists and analysts predict they have peaked. What were the best-performing stocks in 2007? They were almost all resources-related. What happened to companies that disappointed last year? Most of them underperformed the broader market.

The main difference between now and then is that underperformance now equals a total negative return. As I said before, negative things are magnified, but the stronger stocks will still do better than the weaker ones. Risks have become real, but the basic principles of good investing are still the same: it all comes back to earnings and to how companies manage to secure and grow them. The more earnings they grow, the more appreciation they receive. The same principle applies for how secure the market feels about this growth.

Life on the stockmarket has become tougher, but you still have to play the winners and let go of the losers. It's just that punishments for not obeying the rule come quicker and much harder. And as always, there is no such thing as a watertight guarantee.

Rudi Filapek-Vandyck is editor of FN Arena, an online news and analysis service.