Lessons From a Bear Market
by Marshall Kaplan & William Mann

With global equity markets off 50% from the late-2007 high and a likelihood of further bad news on the economy and earnings over the next few quarters, we thought it appropriate to step back and assess what we have learned from this difficult period. Bear markets are very effective in exposing problems, exploiting weaknesses and punishing hubris. We believe it is important to use the experience to learn from mistakes and find ways to improve investments, so as to prosper in an eventual upturn.

A Sell Discipline Trumps Conviction
Selling stocks is a "negative art." Most investors find it easier to identify the positive traits of a company than to recognize and act upon an investment decision gone wrong. Investors often justify a plummeting share price by deriving ever-new reasons to hold on to a stock that similarly may be out of style.

We call this "thesis drift," and it can have a meaningful negative impact on performance. If an investor's original investment thesis is damaged, quite possibly the market's view is, too. This can lead to rapid downward share-price movements when the market comes around to recognizing the flaw. Swift, thorough and realistic reassessment – in combination with emotional detachment – are all key to avoiding thesis drift and the damage it can inflict on your portfolio.

Balance Sheet Strength Is Paramount
We have long focused on the importance of a company's financial flexibility – characterized by a strong balance sheet and the ability to generate significant free cash flow – in our stock selection process.

During the last year, companies that rely on outside financing, friendly capital markets or rising asset values to support their business models have found that they are no longer in control of their destiny. Over the past several weeks, there has been a resurgence of capital-raising, especially in Europe, which has led to higher stock prices. Such results tend to be short-lived as the underlying weaknesses in the firms remain.

The market recognizes these differences. For instance, we took the Standard & Poor's 500 stocks, excluded the financial stocks and sorted the remainder based on the ratio of net cash as a percentage of market capitalization on Sept. 30, 2008. Then we tracked the returns through 23 Feb, 2009. The top quartile of companies experienced an average loss of -11.5%, while the bottom quartile posted -60.3%.

Furthermore, financial flexibility is a major driver of dividends, something that is at the top of the list when evaluating investments. In the current high-dividend-yield environment, it is important to separate companies with sustainable dividends from those with dividend yields that only appear high because the stock price has fallen and the earnings are suspect, creating a temporary high ratio of dividend to stock price. In this latter case, the market must anticipate that the dividend will be cut soon to conserve precious cash.

Stock price performances have shown meaningful divergence between companies maintaining (or even increasing) dividends and those that can’t. We expect this theme to deepen over coming quarters. Consequently, we caution investors to maintain a watchful eye over dividend payout ratios and forecast earnings growth as a health check on dividend sustainability and growth.

Avoid Mental Accounting
Investors have a tendency to perform "mental accounting." This is a theory, developed in the 1980s, positing that individuals tend to divide their assets into separate categories or "mindsets" and account for them differently. Essentially, it says that people value some dollars more than others. For instance, $1,000 won with a lottery ticket may be treated as "fun money" and spent on something frivolous, while the same amount that is earmarked for a retirement-account contribution is treated as indispensable.

However, in fact, a dollar is a dollar. Likewise, with investment portfolios, we have been guilty of congratulating ourselves when dodging one potential pitfall while another company already in our portfolio is subjected to the same forces as the company we avoided.

Fear Is Often Inversely Correlated With Buying Opportunities
Opportunities exist in the current market, but it takes a willingness to go against the current negative sentiment to invest in them. It also takes a lot of patience to hold them while waiting for the market to recognize their true value.

The current market volatility requires a willingness to act quickly on investor misperceptions – as emotionally charged markets are often driven by fear and greed, rather than by the careful analysis of fundamentals. Often, the right portfolio action to take is also the most difficult one to take.

Avoid Narrow Focus and Scan the Horizon.
Investors tend to focus on the ongoing themes – say, the collapse of financial stocks or the expected increase in infrastructure spending. It is equally important to keep an eye out for emerging themes, which may exert as much influence on share prices as existing forces.

For instance, while the market's attention was focused on the unfolding financial crisis in Western Europe, it was slow to recognize the rapid deterioration of Eastern Europe. This opened up a second front, potentially just as damaging as existing pressures that first surfaced in the west.

Identification of new themes can have a meaningful, positive impact on portfolio performance, if acted upon quickly.

Bear Markets Don't Last Forever
While hindsight affords us the luxury of seeing things through a rear-view mirror, it is the road ahead that provides promise.

Indeed, cash levels at non-financial firms are at historically high levels, and the S&P 500 trades at approximately 15 times our current forecast of $51 for 2009 operating earnings.

Our proprietary sentiment indicators are at levels that have historically proven to be attractive entry points for equity investors, and traditional valuation metrics such as price/sales ratio and price/book value are at 20-year lows.

However, until we have greater clarity on the economic outlook, focusing on companies with strong financials, organic growth opportunities and reasonable valuations should prove to be a prudent strategy.


________________________________________________________________________________________

The authors are equity strategists at Smith Barney Private Client Investment Strategy.