How to invest in a bear market

Paralysis and panic is behind us now.

How to invest in a bear market
The FTSE All Share Index lost 29pc in 12 months and there is more pain in store.

By David Stevenson, manager of the Ignis Cartesian UK Opportunities Fund
Published: 10:32PM BST 15 Jun 2009

UK equity investors have had a torrid time of it in the last year. The FTSE All Share Index lost 29pc in the 12 months to the end of March and there is more pain in store. Recent stock market rallies should be taken for what they were, short-term technical bounces rather than the market bottoming on improved fundamentals.

That said, for investors who are able to stomach the volatility and take a longer term view, there are positives. The UK stock market is at one of its lowest points in the last ten years.

In the coming 12 to 18 months, it is likely to fall further taking valuations to levels of 'cheapness' that only present themselves once or twice in a lifetime. Making the most of these opportunities, however, requires a suitable investment approach and there are key considerations for investors in a bear market.

Companies are under considerable pressure and investors need to look in detail at what they are potentially buying into.

This requires careful balance sheet analysis as heavily indebted businesses may not survive the coming years. This may seem extreme but is a reality of economic cyclicality. Companies with low or sustainable levels of borrowing, and which therefore have a degree of control over their future, are relatively attractive, especially when combined with a secure dividend yield.

Earnings provide a barometer of corporate health and are under pressure across the market. Investors can, however, mitigate that risk by targeting certain types of companies.

Defendable earnings are important and are typically generated by companies with big franchises, large market shares and leverage over competitors or suppliers, allowing them to eke out more market share or a better margin. Thinking big is generally a sensible approach.

Big brands have a footprint that will allow them to survive through a difficult environment. Companies like Vodafone, Centrica and Unilever are all likely to outperform, operating in areas where spending remains necessary. Food retailers and pharmaceutical companies are also attractive.

Investors should also focus on sectors that offer predictable growth, rather than those dependent on support from the economic cycle.

Secular trends currently include the long-term growth of outsourcing, both in the public and private sector, and the maintenance and operation of critical infrastructure, such as utility and telecommunication networks and transport links. Both of these should offer resilience in a downturn and will benefit if the government's stimulus plans come to fruition.

It pays for investors to be sceptical in all market conditions but particularly during a downturn. It is important to think independently and not be fooled by consensus views.
Fundamental analysis of balance sheets and earnings will give a clearer picture of companies' future prospects. This then allows a portfolio to be built 'bottom-up' without necessitating a 'top-down' view on overarching macroeconomic, consensus or benchmark themes.

For investors seeking exposure to the market via mutual funds it is important to analyse the investment approach of fund managers. There is a temptation for managers to alter their process when short-term performance numbers disappoint, as can happen in volatile markets.

This, however, tends to be detrimental. Proper analysis of a manager's track record is therefore important, paying particular attention to longevity, consistency of approach and performance during previous downturns.

Certain managers are suited to a rising market, others, typically those able to best identify potential balance sheet holes and signs of earnings weakness, fare better when business models come under increased pressure, as is currently the case.

Another point to consider is the level and type of trading in a fund. Fund managers are generally not good short-term traders. Investment views need to be made on at least a one year basis, and a bear market does not change that.

A sharp pickup in turnover within a portfolio may indicate panic trades or a fundamental shift in strategy. In a bear market the number of attractive stock ideas tends to fall.

This may justify holding a more concentrated portfolio, and then adding new positions when opportunities arise. The important point is to make sure a fund manager is not holding low conviction stocks for the sake of diversification.

Finally, it will pay to be patient. The UK stock market will recover, but not overnight. At the moment market conditions remain challenging and it would be foolish to invest expecting the market to bounce back straightaway.

Equities tend to move before economic data picks up but with the current levels of volatility it is prudent to wait for clear signs that leading indicators are improving and government stimulus packages have laid solid foundations for growth.

This is likely to be some way off but by reinforcing a portfolio based on the points above, and taking advantage of increasingly attractive valuations, long-term investment opportunities in the UK can be exploited.

http://www.telegraph.co.uk/finance/personalfinance/investing/5545094/How-to-invest-in-a-bear-market.html