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By Jeremy Glaser and Paul A. Larson | 11-26-2012 02:00 PM

How to Protect From Black Swans and Black Boxes

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.

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.

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