What Now?

By Brad Thomason, CPA

 

A friend of mine reminded us of an important principle the other day.  He said that during times of distress, assets move from the weak hands to the strong hands.

My friend, Pratik Sharma, is a managing director at Atyant Capital, and he made his comment at a conference we were both attending last week in Belize.  Both of us were there to speak about our respective areas of interest (gold and gold mining stocks in his case; tax liens and real estate in mine).

I mention this principle because there seems to be increasing news that the economic recovery may stall or even wrap back on itself.  Numerous closely-watched indicators seem to be pointing in the wrong direction.  Fidelity is reporting that loans from 401(k) accounts are increasing.  A news article out this morning describes how credit card rates are on the rise.  In other words, for many, this continues to be a time of distress.

Now the idea of assets moving from weak hands to strong hands may sound like a callous or unjust notion.  But this dynamic, at the broad level, isn’t so much about one party taking advantage of another, as much as it is the simple result of a basic principle in mathematics.  The principle goes by various names, but the one you often see in popular writing is the “Gambler’s Ruin.”  It basically describes how “chips” inevitably flow from the small stack to the big stack, and it is a key component of the widely known truth that in the casino world you can’t “beat the house” (since they are the ones who have the big chip stack).

In the business and investment world, this principle is what gives meaning to the old adage that “cash is king.”  When conditions are right for assets to flow from weak to strong, you want to be strong, and having cash is a form of strength: cash allows you to do things that others can’t.  Cash allows you to hold on to what you have, and maybe even buy more, as those around you who need cash are not able to hold on to the other assets they have.

This simple truth seems to be one of those secrets that’s hidden in plain sight.  Every legendary investor from Warren Buffett to George Soros to Boone Pickens has used this theme over and over again to make lots of money.  They wait for some sort of disturbance to arrive before making their major asset purchases, then they move in, picking things up at a discount.  Discounts today often set the stage for bigger gains tomorrow.  Yet average investors and business managers seem much less tuned in to this potential.  But the rich do in fact get richer, in part because they have math on their side.

Here’s a simple analysis to illustrate the point.  We’ll use the stock market as a proxy for general conditions, and assume that prices rise when lots of people are able to buy, and fall when they aren’t able to add to their positions (note that selling is just a subset of not-adding/not-buying) and demand tapers off.  If you had invested an equal amount of money into the stock market for the last 5 years (2005-2009) when the market was at its highest point of the year, you’d have an average entry point of about 1,385 on the S&P.  Conversely, if you’d done the same thing, but at the low point for each year, your average would be around 1,000.  That’s a pretty substantial difference.  Compare that to the current level of about 1,080, and you can see just how big a difference there is between the 2 cases.  Buying at the high would have you down about 22% right now; but if you’d bought at the low you would be ahead.

Now the point of that example is not to suggest that you should try to time all of your purchases to market bottoms.  Doing so is quite difficult (some say impossible) and comes with a lot of potential bugaboos that go beyond the scope of this discussion.  The point is, however, that when you buy really does make a difference.  The effect is maximized when you are able to buy at the time that few others can or will do the same.

We may not know exactly when the bottom is going to occur, but we do know that if the distress level is on the rise and prices are moving lower, we have certainly avoided buying at the top.  So we’re already ahead of the first scenario.  As conditions remain weak, or worsen, those with fewer financial resources ultimately have to start liquidating assets to remain solvent.  That selling activity drives prices lower, perpetuating the cycle.

Those who have resources provide an exit strategy for these sellers (they’d be in a much bigger mess if no one was willing to buy what they had), and achieve entry points which make the prospect of future returns (usually once the markets or economy turn around) that much greater.

So if the economic recovery is stalling out, what now?

Well, especially if you are dealing with assets that don’t trade on an exchange market (like real estate, interest in a business, etc), if you don’t have to sell right now, you probably shouldn’t volunteer to.  Selling right now probably means you’ll get a lower price.  This is a buyer’s market right now, and it’s unlikely to differentiate between those that just want to sell and those being forced to.  Conversely, if you have some idle capital, keep an eye on assets that attract you, but were historically too expensive for your tastes.  You might just find yourself in a position to buy in at a much lower level than you ever thought was possible.

The dynamic that is in effect right now is pretty clear.  Those at risk of needing to sell greatly outnumber those who could buy if the right price comes along.  Capital has a very high value.  The smart play is to protect it and use it accordingly.

Whether we like this idea or not is really beside the point.  It’s one of the structural realities of the way markets work, and if we are going to be impacted by it, then benefiting from it, or at least staying out of its way, sure beats suffering as a result of it.

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