The Benefits of a Bear Market

by

Brad Castro

That was according to legendary investor and investment banker Shelby Cullom Davis who reportedly borrowed $100,000 in 1947 and grew it to $800 million by the time of his death in 1994.

On the surface, that quote may seem counterintuitive. How does a long term investor make money when the market is dropping 30%, 40%, 50%, or more? After all, Shelby Cullom Davis didn't amass his fortune by short selling or loading up on puts.

But if you consider the statement for any length of time, the truth of it begins to hit home. The cheaper stocks are when you purchase them, the higher your future rates of return will be when they begin going back up. The more the share price comes down, the more of the company you can afford to buy.

The power of the statement is, admittedly, based upon one very important assumption — that you've actually got money, either cash in reserve or inflows of new funds, to put to work. Obviously it does you no good for the stock of a great company to go on sale if you're already fully invested and have no cash to buy new shares.

But from a strictly mathematical perspective, the less you pay for your high quality investments, the higher your rates of return will be from those investments in the long run. That's true both in terms of dividend yield and capital appreciation. It's this mathematical principle, I believe, which is the main intent of the Shelby Cullom Davis quote.

But as I watched the stock market basically get cut in half in roughly 18 months from late 2007 to early 2009, I came to discover additional insights in that quote.

The Real Benefit of a Bear Market

But second, and far more important, they’re the ones that have the best chance of simply surviving bear markets. Bear markets aren’t about growing an empire. They’re about survival, pure and simple. Bear markets are a plague, and if you’re going to be a long term investor, you’ll need and want a portfolio comprised of companies with the strongest, most resilient constitutions, companies that will recover from the plague to thrive another day.

An example: Warren Buffett’s Berkshire Hathaway owns shares in two banks—Wells Fargo and U.S. Bancorp. I think the general consensus as I write this (May 2009) is that the three healthiest large U.S. banks (perhaps the only three healthy large U.S. banks) are JP Morgan Chase, Wells Fargo, and U.S. Bancorp (although U.S. Bancorp is considerably smaller than the other two).

But the point is that while Berkshire’s investment holdings and book value may be taking a temporary hit on its investment in financials, Buffett avoided permanent hits by avoiding shares in inferior—and riskier—financial models such as Citigroup, Washington Mutual, and Wachovia (which, incidentally, was at one time, pre-subprime mortgage madness, a terrific and very conservatively run bank). And, in my mind, the jury is still out on Bank of America.

During a bull market, it may not matter much what stock you own. Think back to the late 1990s. Shares of companies that never made a penny of profit and never would make a penny of profit nevertheless made quite a few people millionaires, at least temporarily and on paper.

More Than Just Attractive Valuations

What made them so disciplined, patient, and successful? Undoubtedly, it was witnessing, or rather experiencing, the ferociousness of bear markets firsthand. If you live through a severe enough bear market and survive it, or lose everything and have the courage to start over (as opposed to giving up and swearing off the stock market forever as many of its victims do), you’re going to have a different perspective from the uninitiated.

Getting burned bad enough in a bear market will teach you to insist on quality in all of your investments, and it will teach you to do your due diligence and approach investing from a much more careful and, therefore, healthy point of view.

Most importantly, it will teach you this—to invest as though every market is a bear market. And that’s a tried and true method for growing real, sustainable, and substantial wealth.