Opportunity Fund and Navigating Market Corrections

In the last 50 years, there were 6 market corrections that lasted over a year before hitting their lows. 3 of them resulted in market declines near 50%. Those years are the following:

1973-1974: S&P Correction Lows: -48%

2000-2002: S&P Correction Lows: -49%

2007-2009: S&P Correction Lows: -57%

The average decline during recessions for the last 50 years comes to about -19.7% as of 2018. If you look at the average days in recession over this period, it’s about 6 months and 18 days.

Prolonged declines in markets will seem like forever for many who have not experienced this. Don’t let the market scare you away. Let history be a lesson. In my short investing experience of about 20 years, I feel fortunate to have experienced a prolonged decline twice in my lifetime which was during the tech bubble and the great recession. The experience profoundly had an impact on my investment philosophy today.

 

The Tech Bubble (2000-2002)

Duration of correction: 929 Days (2 years, 6 months, 17 days)

When the tech bubble imploded, I was new to the investment world and had no idea what I was doing. I was a trading mess, like a chicken running around with his head chopped off. I jumped in and out of the markets like I was playing hopscotch. It was the longest correction in the last 50 years, and I had no clue. I simply thought it was normal market behavior and it was my job to successfully step in and out. 😊 Fortunately, I didn’t allow the markets to discourage me even with the losses I’ve experienced.

The Great Recession (2007-2009)

Duration of correction: 517 Days (1 year, 4 months, 31 days)

Fast forward to 2007, we had another historic correction. The largest correction in the last 50 years with markets declining 57%. It’s easy to look back and think, “what an opportunity!”. However, people were really scared. When people lose their jobs and homes by the masses, things become very real quickly. Positive news was a rare occurrence and mostly doom and gloom presided.

I was lucky to have sold large amounts of my holdings prior the nosedive towards the end of 2008 in order to raise capital for real estate. I rode the bubble up with massive gains outperforming the S&P by a wide margin prior the 2018 market collapse. I held no more than 15 individual stocks. Most of my gains were from a handful of stock holdings such as CAT, CVX, XOM, MA, MON, MCD, X, NUE, UPS, WMT, and PKX. I had no idea the markets would dive so sharply and thinking back, there is no denying I was very fortunate on the timing.

Don’t Time. Navigate.

Before I get into further details, I would like to remind you my investing philosophy was molded by my personal life experience and just sharing my personal perspective on things. How do you know when the next big event is around the corner? It’s impossible. I gave up trying to time the market long time ago. I’ve learned early that I am simply horrible at trading and trying to time the markets.

Learning about the economy, I have come to the realization that you can only measure its temperature and pulse at best. Just as anyone may catch a random flu at any given moment, the economy is no different. Unforeseen geo-political factors to even the weather can throw a wrench into the system.

So, if timing the markets is nearly impossible then what? Navigate. How do you navigate these corrections? Just as a sailor would in the high seas of course! 😊 You open your sails when the wind becomes volatile. What the heck am I talking about? 😊

 

Opportunity Fund (OF)

I really don’t have many regrets in my life but a select few that never seem to leave my mind. One was back during the great recession when property values tanked. There was an opportunity to purchase a condo in downtown Los Angeles for about $250,000 for a 2 bedroom / 2 bath. It was a distressed pocket listing my realtor brought to my attention which was walking distance from my place of business. I had no doubt that this was an amazing opportunity being about $30,000 under market value. Properties were being dumped on the markets and the seller was desperate to let the condo go. But I was short on cash to make the purchase due to a recent investment property I had acquired just 2-3 months prior. I had spent nearly all my cash on the down payment on the prior property. Long story short, deal was lost due to a few thousand dollars and today it is now worth about $850,000 to $900,000.

There are few of these regrets that have become major lessons to me in my life. Having no cash is like a baseball outfielder with no mitten. Doesn’t matter how many balls come flying your way if you can’t catch them.

Hence the importance of the opportunity fund. The OF is separate from the emergency fund. It is part of the investment portfolio. It is cash or cash equivalent funds that is specifically parked for the purpose of scoring opportunities.

What is the ideal amount for the OF

This will be different for everyone. It will be customized to one’s risk appetite. Personally, I like to keep my range between 4-12% of my total investment portfolio.

Generally, the OF will increase as markets become expensive and drop as markets become cheaper. How do I replenish the fund? I take profits by selling growth stocks that have increased in value that is not inline with my determined weight for the holding. Or, in most cases I simply contribute savings towards the fund.

Have a Game Plan

If you are an active investor you must have a game plan that works for you. As a long term investor, I follow a simple rule when it comes to navigating corrections. Remove all emotions out of the whole process and stick to a set of principles that fits my investment objectives.

There are few popular methods investors use to deploy cash at specific points of the correction systematically. One method I use is the following.

The game plan was determined based on market corrections from the prior 50 years on the S&P. The OF is divided into 6 lots in which they are deployed depending on the magnitude of the decline on the S&P. How much you deploy is adjustable to your risk tolerance. However, each lot should not weight too heavy on any individual lot and may be adjusted to your likings.

If the market decline goes beyond 40%, that may be a point where I may deploy the remainder of the 4% depending on the magnitude of the opportunity. At that point, it’s highly likely you will come across amazing opportunities.

 

There are many disciplined game plans discussed among active investors but whats important is everyone’s game plan should be adjusted to one’s risk appetite. Having a game plan is a great way to help mitigate and remove emotional decision making during times of extreme volatility.

So, I modeled out my game plan to see how it would perform during the financial crisis of 08’.

Model is based of historic monthly returns of the S&P which shows returns incrementally increasing the more you held in your OF fund prior to the crisis. During this period, one will have deployed all 6 lots and left only with the 4% slack remaining. No additional investments. If you held 12% in your OF from July 1, 2007, you may have outperformed market returns by 17.05% by August 1, 2018.

How about periods of low market volatility?

Smaller amounts of corrections result to lower spreads in potential out-performance. The period shown above only resulted to 2 cash lot deployments in the period.

No corrections? Yes, you can trail market returns if you hold too much cash. It’s somewhat of a balancing game that may potentially provide better chances to land opportunities in markets.

Now, imagine if you factor in your additional re-investments from your FCF and dividends! You can see why I get excited when markets turn south. 😊

Why is my range capped by 4% on the downside?

My father once said something to me in my early 20’s that resonated with me ever since. He believed that most people will come across at least 3 major opportunities in their lives. He personally felt he had about 3 or 4 major opportunities in his life in which he failed to take advantage. Occasionally, he would share the stories of such regrets in his past.

Throughout my life, I questioned customers, family, friends, partners, employees, etc. about their lives. About their successes and missed opportunities. Overtime, my views have been reinforced as many generally agreed with the assumption. However, what also caught my attention was how it related to what I was observing in the equity markets.

 

In terms of opportunity in markets, a decline of about 50% only came 3 times in the last 50 years. A chance to buy the market at a 50% discount is extremely rare. Unfortunately, we had two of those near 50% declines in one single decade between the years 2000-2008. Lives were changed for those who were able to take advantage of the opportunity during such times. Mines did.

You don’t need to grasp them all. One major opportunity is all that is needed to change lives. You don’t want to be left with no cash when such event presents itself. Hence the 4% slack at minimum.

“I will never risk getting caught short of cash.” Warren Buffett

Speaking of the Oracle.

From 2007 to 2008, cash holdings dropped by about 42% during the massive correction. Some of the deals Warren Buffett did in result of the financial crisis were the following:

Goldman Sachs. Invested 5 billion in preferred shares that paid 10% in dividends.

Bank of America. Invested 5 billion in preferred shares that paid 6% in dividends.

General Electric. 3 billion in preferred shares that paid 10% interest.

USG Corporation. 300 million loan issued with an annual interest rate of 10%.

Harley Davidson. 303 million loan issued with an annual interest rate of 15%.

BNSF Acquisition for 44 billion.

Conclusion

On one hand, too much cash can be a drag on your investments. However, being caught with no cash during such opportunities of a lifetime may leave you with regrets. Having cash in your OF is a good problem to have if maintained with discipline.

As important it is to have an OF, having the ability to run into a burning building when everyone is running out is another whole topic I will get into next time.

The results are clear in my life and those around me. Those who have took advantage of the financial crisis are doing quite well today and those who haven’t are much of the same. Too often I come across stories of regrets for doing nothing during such times. Don’t be another regret story. It doesn’t hurt to have some dry powder ready at all times.

So, do you guys have an OF? Do you have a disciplined game plan on how you utilize the fund? 😊 Would love to hear and learn about them!

Thank you for reading.