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90

Pharmaceuticals

Precrisis

1 year before

Crisis

September 30, 1990

Postcrisis

1 year after

Price to Earnings

26.0

16.5

19.0

Price to Book

10.0

Dividend Yield

2.0%

3.7%

2.8%

Prices had risen to these levels because of the fear that inflation was out of control. Inflation, accompanied by sky-high interest rates, had been devastating to the bond market. Many longer-term bonds had declined as much as 50%, in addition to the further losses caused by declining purchasing power through the falling real value of the dollar.

Now look at Figure 12-2. Although the yields in 1982 on long govemment bonds were their highest of the century, the inflation rate was

Figure 12-2

Long Govemment Yields Before and After Inflation

15% -

10% -

5% -

0% .

1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984

Long Term Gvt. Bond Yield

- Inflation

Real Yield

Table 12-2b

Precrisis, Crisis, and Postcrisis Fundamentals-Pharmaceutical Stocks



RULE 31

(A) Diversify extensively. No matter how cheap a group of stocks looks, you never know for sure that you arent getting a clinker.

(B) Use the value lifelines as explained. In a crisis, these criteria get dramatically better as prices plummet, markedly improving your chances of a big score.

What Are the Risks of Crisis Investing?

What unique risk factors should you look at if you decide to invest in a crisis? Measuring risk-as value managers, including myself, use the phrase-involves several factors, all of which become substantially more important in crisis.

I. The first is a companys financial sti-ength, its abihty to sail through tough times unscathed. If I buy a group with enormous financial muscle, like the pharmaceuticals, I have very litde chance of losing my capital because of financial problems. Thats why I devote a lot of attention to balance sheets and other measures of financial strength, including debt to capital structure. Look no further dian the LBO (leveraged buyout) excesses of the 1980s to see the merits of this one.

down significandy from its 1980 pealc. Normally die yield on government bonds after deducting inflation is 1/2% to 2%. In early 1982 this "real yield" stood at over 5%, and, with inflation declining, reached 6% within a few months. So once again the price/value ratios provided investors with double the margin of safety or more in crisis than under more normal circumstances. Shortly thereafter, as noted in the previous chapter, bonds had one of the sharpest rallies of the century, with 30-year zero-coupon governments more than doubling in months.

The bottom line to the investor is that crisis investing pays off, whether it is for the stock market as a whole, a single industi7, the bond market, or other markets. It is the ultimate way of playing investor over-reaction. Ifyou get the combination ofa panicky market and an industry or sector panic, such as occurred with financial stocks, the potential rewards are that much larger.

Two key rules for investing in crisis were presented on pages 262 and 265. Heres a diird.



2. The second measure of risk is adequate diversification (which we have already touched on). Not only by industry but by company and by sector. No matter how cheap a company or industry appears, things can still go wrong. Thats why in the bank crisis we only took small positions in any single bank, even though the good regional banks traded at giveaway prices. The industry was dirt cheap and there were enough strong banks whose prices had been clobbered to build a diversified portfoho without taking much risk on any single one. Similarly, we didnt put all our chips into the banking industry, or even the financial sector, although it appeared to be a screaming buy. Had we done so we would have chalked up a much larger score. However, the risk of keeping all the eggs in one basket was just too high.

3. The third measure of risk involves price, certainly a lesser consideration in a crisis, but nevertheless still there. Even if a company is a tower of financial strength, that doesnt mean I havent paid too much for its stock. This is particularly true in a panic. As we have seen, in a crisis you can demand even lower price-to-value ratios than in more normal times. Whats more you will get tiiem! So dont be overanxious as stocks free-fall. What looks dirt cheap can often drop another 20% or 30%. Remember my experience with First Fidelity Bank.

These value measures of risk can not only be used to avoid losing money in normal markets but are essential armor if you want to enter the world of crisis investing. In a world of panic, with perceptions of danger greatly magnified, you must have a number of benchmarks to keep your perspective.

Panic brings out the worst fears about a company or an industry. Often, as in the case of the bank stocks during the financial crisis of 1990, the focus is on whether the company or industry in question can survive. This is where financial strength is critical. By looking at the balance sheet and other financial statements, you or your financial consultant can get a good idea of whether the company has the staying power to ride through a crisis relatively unscathed.

The measurements I gave you-on low price/earnings, price-to-cashflow, price-to-book value, yield-can be supplemented by a number of important financial ratios outlined in chapter 3. Combining these yardsticks provides a clearer perspective of the financial risk you are taking, and thus whether you should buy the stock in a crisis.

Last, but certainly not the least important, the psychological aspect of the risk situation must be held at bay. Although, to this time, it has not been examined in the marketplace, it is normally most pervasive in pe-



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