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How to Protect From Black Swans and Black Boxes

Sun, 23 Dec 2012

The financial crisis proved that tumultuous events can and do happen, and investors need to keep a long-term perspective in a market that is incredibly short-term focused, says StockInvestor editor Paul Larson.


Video Transcript

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. After more than 10 years of fairly tumultuous stock market returns, many investors have re-evaluated their strategies and made some adjustments. I am here today with Paul Larson, our chief equity strategist and also the editor of the Morningstar StockInvestor newsletter, to talk a bit about some of the adjustments that he has made.

Paul, thanks for joining me today.

Paul Larson: Thanks for having me.

Glaser: So, looking back on some of the great recession, the tech boom and then bust, and even looking back to the saving and loan crisis, when you look past all of these market-shaking events, what have been your big takeaways? What have you learned, and how have you made adjustments to that?

Larson: Well, one of the things that I learned in the financial crisis and the credit crisis was to handle companies that have a high deal of leverage with a great amount of care. This is because when you have companies that have a relatively high level of debt, it does reduce your margin of safety both at the company level as well as an investor level, because when you have that debt, it just amplifies all the company's losses that it might have. So, debt at the company level can turn a relatively minor mistake at the investor level and make into a much bigger one.

Glaser: What about companies that maybe don't give you a ton of disclosure, that you kind of just have to trust management a lot. Have you seen any problems of that over the past few years here?

Larson: Sure. Another way that the crash really altered my strategy was, I'm much more wary of companies that have so-called black-box balance sheets, where they have difficult-to-value things on the balance sheet, where we as individual investors looking at the SEC filings, don't get a very good feel for what the actual value of those assets are. So, regarding financials firms, which are leveraged as well as fall into those what you might call black-box type situations, I am very careful with those types of companies.

Glaser: A lot of times with these black boxes, perception is really important. The market kind of still trusts that company until it doesn't anymore, until something blows up. How can you as an investor can guard against that or think about that in terms of risk that you just don't know what the market's going to wake up and think tomorrow?

Larson: Well, another set of companies that I am a little bit more careful with these days are companies where they are dependent on that perception of the company for the underlying health of the business. Again, the financial-services firms yet again don't do very well here because perception and reputation does have a very important impact on the company's ability to operate their ongoing business.

So, again, those companies that are dependent on the good graces of the market to stay open day-in and day-out, well, if perception of those firms change, that that can also alter the underlying business. So, I much prefer businesses that are so-called real Main Street businesses that are not dependent on the capital markets.


Glaser: But certainly some real businesses still need those markets. CarMax is a big holding for you, and the company has a lot of receivables they might have to securitize. When you think about a company like that, how much risk is are you willing to take on that front?

Larson: Well, I am willing to take some risk, and thankfully a lot of companies also saw the connection between perception and reality and have taken steps in recent years to deleverage and also reduce their dependence on the capital markets. So, I still own CarMax, but I own it in a smaller proportion than I did before the crash.

Glaser: Certainly, we heard a lot, particularly in 2006-07 of these pronouncements of "Housing prices have never fallen before, so therefore they'll never fall in the future." There was kind of a dismissal that these so-called black swan events that could ever happen. I think it's very clear now that they do happen on somewhat of a fairly regular basis. How do you protect against that in your portfolio? How you've altered your strategy to try to guard against those issues?

Larson: Well, I think I have a much more open mind than I did a decade ago regarding the possibility of these black swans coming in. When you look at a given situation, there are basically two potential outcomes: it could revert to mean, or it could be different this time. I think a lot of times people too often assume that it's going to revert to mean and not often enough consider the possibility that it is going to be different this time. I think since the financial crisis, I am much more open to considering those scenarios that haven't happened in history.

Glaser: So, it seems like there are a lot of in potentially negative things here where we're worried about black-box balance sheets, worried about this changes in perceptions and lack of confidence. Is there anything that has either somewhat stayed the same that investors can look at and say, "Well, there is all this stuff, noise going on here, but I can still focus on these things to really help drive my returns and to help potentially beat the market"?

Larson: Right. Well, I think the one way that we've been able to beat the market historically and I think that we'll be able to use this again in the future is to simply maintain in a better perspective, to have a long-term perspective in a world that is filled with short-term incentives. You have money managers that are worried about making their quarter or making their year to either get their bonuses or to simply maintain their employment. Well, if you can have a longer-term perspective and not worry so much about whether this company is going to meet or miss its quarterly earnings, and worry about where it's going to be five or 10 years from now, having that longer-term perspective, I think gives us a leg up over the rest of the market that is again incredibly short-term focused.

Glaser: So, it sounds like there is still an opportunity when the market has some short-term worries to get those long-term gains.

Larson: Right. One other simple rule that seems to still work today. It worked before, and still works today is the "fear and greed" idea, and that is to be a fearful when others are greedy or greedy when others are fearful. Another way to say it is, buy on the cannons and sell on the trumpets. That idea has served me very well, and I think it will continue to serve all of us well in the feature.

Glaser: Paul, thanks for talking with me today.

Larson: Thanks for having me.

Larson: For Morningstar, I am Jeremy Glaser.

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