advice I learned the very hard way

The markets are clearly crashing. The overwhelming preponderance of folks want out of the stock market. Fear reigns supreme. What can we do about this?

Each of my previous posts has been a lead up to this post where I hope to provide each of you out there with actionable advice.

The first thing to remember is that all of investing boils down to four very simple words. Yes, only four words: “buy low, sell high.” Stock prices are obviously very low right now and many of you may be thinking, “I have some cash and I should invest right now.”

My advice would be to sit this out for now. Why? Because of a painful lesson I learned the very hard way; namely, with my shareholders’ money. The lesson comes courtesy of AES Corporation (ticker: AES). I initially did analysis on this business way back in 2000 and that work led me to believe that AES was worth $49/share. AES is the largest independent owner of power plants around the world. They own hydroelectric, coal, natural gas, wind, and geothermal plants. I saw them as a play on what I believed would be an impending energy crisis. So the lesson is that I am a genius with tremendous foresight, right? Wrong. Way wrong.

AES experienced a series of calamities all having to do with the weather. Their hydro-electric plants were located in South America and friggin‘ Brazil (Brazil!) was experiencing drought. Who’d a thunk it? The Amazon was having a drought. So rainfall was down which meant that water through the dams AES owned were down which meant that they had less power to sell which meant they had lower revenues and lower profits. And did I mention that they had a contract with the country of Brasil that required them to deliver a bare minimum of power to people? AES was in violation of the contract, so on top of everything else they were paying fines and facing the prospect of losing their contract. The shortfall in profits led to a shortfall of cash which led to tremendous fear that AES could not pay its bills. Most notably there was a possibility that they could not make the interest payments on their debt. The stock fell as low as $2.00 per share!!!!! Ouch! Especially if you were one of my shareholders (does all of this sound familiar?).

If you were one of my shareholders you would have witnessed yours truly purchasing shares in AES all the way to the bottom. After the stock lost almost half of its value I purchased a bunch more of AES, believing that the bottom had been reached. Then when it fell from the $20s I purchased more around $10. Why did I keep purchasing shares of AES when everyone else was selling? Because my fundamental models suggested a valuation of AES of $49/share.

Needless to say, my company, Davis Selected Advisers, looked on my decisions with suspicion. However, the single largest amount of shares I bought in AES were around $5/share, when I was told by my Institutional Salesperson at Lehman Brothers, “Dude, you are the market in AES today.” What he meant was that I was the one buying all of the shares available for sale. Eventually, as I said, AES bottomed out around $2/share! My shareholders who owned AES originally around $40/share suffered tremendous losses.

So what is the lesson? You might think that it is about AES – it is not. AES eventually traded back up around $40/share, and my average cost in AES was probably between $8-$10/share. So my shareholders did very, very well by my decisions. No, the lesson is this (and the reason why it is pertinent to the situation we are confronted with today):

When the sky is falling in a particular stock, or the market in general: cash is king! My lesson was that it would have made much more sense for the bottom of AES shares to have been reached definitively. Knowing definitively meant that once AES reached $2/share, there had to be a change in the business that was AES. This was evidenced by a series of votes held by its debtholders agreeing to lower AES’s interest payments in exchange for an extended debt maturity. Meaning that the debtholders erased one of the conditions that, had it not been met, would have resulted in a technical default and bankruptcy for AES. Additionally, AES fired a number of its executives and replaced them with new executives. And lastly, these new executives announced a thorough plan designed to get AES out of trouble. These changes were then followed by a period of stability in AES’s shares. Then AES started reporting results that were in accord with their new operating plans. The share prices started to go up again. This was the time to buy. The fact is that share prices fall a lot, lot, lot faster than they rise. So the lesson, stated succinctly is this:

Do not buy in a free-fall market. It is better to wait for a bottom to have been reached and leave some upside on the table, rather than continue to lose money on the way down.

So to summarize:

• wait for a bottom to have been reached
• the bottom is identifiable when extreme steps are taken to remedy the problems causing the tremendous fall in values
• wait for the period of stabilization
• wait for evidence that the extreme steps taken have resulted in genuine change
• then buy

In our current market situation, what is missing is a regulatory framework that supports the proper ethical environment necessary for having confidence in the financial markets. Right now, cash is absolutely king (and damn I wish I had a bunch); sit on that cash. Wait for the continued sell offs to abate. Then look for regulatory change and language coming out of the financial market participants and politicians that focuses on proper ethics. Heads will need to roll, too. That is the architects of this disaster need to lose their jobs – the Presidential election will see a change in the faces of the regulators. This is a good thing. Then wait to see how the economy performs. If the economy continues upward then it would be time to deploy your cash. In the meantime, make good use of your time and do some research as to where you would like to invest once the stabilization has occurred.

I hope that helps put some meat on the bones of my previous posts and why they provided valuable context for what I wrote about today.

With a big smile sent your way!

Jason