The Benefits of a Bear Market

"You make most of your money in a bear market, you just don't realize it at the time."

That was according to legendary investor and investment banker Shelby Cullom Davis who reportedly borrowed $100,000 in 1947 and grew it to $800 million by the time of his death in 1994.

On the surface, that quote may seem counterintuitive. How does a long term investor make money when the market is dropping 30%, 40%, 50%, or more? After all, Shelby Cullom Davis didn't amass his fortune by short selling or loading up on puts.

But if you consider the statement for any length of time, the truth of it begins to hit home. And it really is a profound concept:

The cheaper stocks are when you purchase them, the higher your future rates of return will be when they begin going back up. The more the share price comes down, the more of the company you can afford to buy.

The power of that statement is, admittedly, based upon one very important assumption - that you've actually got money, either cash in reserve or inflows of new funds, to put to work.

Obviously it does you no good for the stock of a great company to go on sale if you're already fully invested and have no cash to buy new shares.

But from a strictly mathematical perspective, the less you pay for your high quality investments, the higher your rates of return will be from those investments in the long run. That's true both in terms of dividend yield and capital appreciation. It's this mathematical principle, I believe, which is the main intent of the Shelby Cullom Davis quote.

But as I watched the stock market basically get cut in half in roughly 18 months from late 2007 to early 2009, I came to discover additional insights in that quote.

The Real Benefit of a Bear Market

I've come to realize - not just intellectually, but in my gut and in my portfolio - just how important it is to invest in only the highest quality companies during severe market declines, companies with long term sustainable profits, durable competitive advantages, and strong balance sheets.

There are two crucial advantages to doing so:

• Those stocks should - ideally - fall less than their peers during the bad times, and they should also recover more quickly once the good times return
• They also have a much better chance simply surviving a bear market.

Of the two, the second advantage is the more important one. Severe bear markets aren't about growing an empire. They're about survival, pure and simple.

Bear markets are a plague, and if you're going to be a long term investor, you'll need to know how to invest in a secular bear market as well as in cyclical bear markets.

You'll need and want a portfolio comprised of companies with the strongest, most resilient constitutions, companies that will recover from the plague to thrive another day.

An example: Warren Buffett's Berkshire Hathaway owns shares in two banks - Wells Fargo and U.S. Bancorp - and one credit card company - American Express.

Now obviously, these stocks were down big time during the Great Recession bear market of 2008-2009. But all three of these companies survived intact while many of their peers were going down for the count, being absorbed by other companies, or suffering severe and permanent impairment.

I think it's telling all the financial stocks that Buffett didn't own - Washington Mutual, Wachovia, Bear Stearns, Lehman Brothers, Citigroup, and even Bank of America.

The point is that while Berkshire's investment holdings and book value may have taken a temporary hit (albeit a large one) on its investment in financials, Buffett avoided permanent hits by avoiding shares in the inferior - and much riskier it turned out - financial models.

During a bull market, it may not matter much what stock you own. In a bull market, there are no shortage of "good" stocks. Think back to the late 1990s. Shares of companies that never made a penny of profit and never would make a penny of profit nevertheless made quite a few people millionaires, at least temporarily and on paper.

It's only during a bear market that the massive gulf between great, resilient businesses and the all those mediocre businesses that had previously been considered "good" or "solid" finally becomes apparent.

More Than Just Attractive Valuations

Bear markets, I believe, produce more than just attractive valuations - I believe the truly traumatic ones also produce the next generation's greatest investors.

Just look at how many great value-oriented investors emerged either directly from the Great Depression or from its long shadow - Benjamin Graham, Warren Buffett and Charlie Munger, Sir John Templeton, Philip Fisher, Roy Neuberger, Philip Carret, Richard Russell, Shelby Cullom Davis from above, and plenty of others I'm sure I'm overlooking.

What made them so disciplined, patient, and successful? Undoubtedly, it was witnessing, or rather experiencing, the ferociousness of bear markets firsthand.

Most importantly, it will teach you this - to invest as though every market is a bear market.

And that's a tried and true method for growing real, sustainable, and substantial wealth.

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