How to Invest in Crises and Maximize Returns in Equity Markets

Read our selected excerpts from one of the best research papers on "How to manage money during bear markets & Crises" from VerdadCap (https://verdadcap.com/)

Key Excerpts (Ours Emphasis)

Markets are the opposite. Bull markets are all bullish in their own ways. The leaders in one expansion are almost never the leaders in the next.
But crises are alike. For example, the classic factors that Nobel Prize winner Eugene Fama and his research partner Ken French developed: size, value, and investment. The smallest decile of stocks (SMB), the cheapest decile of stocks (HML), and the most conservative capital deployment decile of stocks (CMA) perform much better during crises and with much higher consistency than at other times.
The higher returns to quantitative investing accrue from the abnormally bad behavior of humans. During bad economic times, investors and lenders panic.
When investors and lenders panic, they reduce new lending and new investment as they attempt to de-risk their balance sheets.
During recessions, the high-yield spread (spread of 6.5% & above) spikes upward and default rates soar. This stress rewards companies that are profitable and cash generative, while weak firms and companies that are investing heavily and burning cash struggle and often go bankrupt.
6.5% as the high-yield spread threshold was used to describe high level because it is roughly 1 standard deviation above the long-term average (~4%).
Simple, logical quantitative factors are significantly more predictive during these times of economic crisis than they are during expansions.
Companies like Tesla and WeWork may thrive during expansions when money is cheap, but such excesses do not long survive in times of market turmoil.
High-yield spread is used as a prime measure of economic distress. This economic indicator measures the spread between the borrowing rate for below-investment-grade bonds and the corresponding safe interest rate. The high-yield spread is a gauge for monitoring market sentiment for small and micro-cap companies because it combines real world economic consequences and the temperature of the market.
“financial accelerator” events is defined as the first month in which high-yield spreads break above 6.5% and where the preceding 24 months were below 6.5%.
For calculating returns during these events, we start investing 3 months after spreads hit 6.5%. Usually, high-yield spreads continue to rise after they hit 6.5%, peaking a few months later
The best performing asset class during these periods has historically been small value stocks by a country mile with an average return of 32% during crises period.
The above strategy of buying Small cap stock during "Financial Accelerator" events called as Crisis investing – and the specific factors we propose (Point 15) – can be effective between 75% and 90% of the time, which is about as predictable as the real world gets.
Private Equity does not perform well during crises due to:

a) Investors with large PE allocations therefore find their capital flows are pro-cyclical, investing the most money when debt is cheap and multiples are high and the least money during times when the high-yield spread is wide and deal valuations are low.

b) Also equity returns are maximized in the 2-3 months after high-yield spreads hit 6.5%. It would be near impossible for a private equity investor to deploy meaningful amounts of capital into multiple opportunities in 2-3 months while borrowing rates for debt are rising.

14. Even distressed funds which specializes in buying debt ridden near bankruptcy also underperforms small cap multi factor crises investing style due to huge fees they charge.

15. While creating a portfolio of small caps (suitable number of stock here can be 30 - 50) during the “financial accelerator” event following characteristics/factors should be looked in small caps:

a) Highest asset turnover - investors want to be buying businesses that they know will make the most efficient use of the resources they have available.

b) Consistent Positive Net Income and CFO - Companies generating positive net income and cash flow, who are less reliant on capital markets in times of stress, will perform better.

c) Lowest Volumes stocks - Volume is defined as monthly number of shares traded divided by the total number of shares outstanding. Since in times of panic when everyone is a seller, shareholders in low volume stocks are required to liquidate at any price if they want to get out of their position.

d) Lowest valuation Multiples - : Focus on small caps where EV/EBITDA, P/B, P/E, and FCF yield have fallen the most and are historically at the lowest levels.

e) Decreasing Leverage - Companies that can deleverage during times of stress show healthy operating characteristics, and by paying down debt they are reducing the default risk for equity holders.

f) Above average Net Debt/Enterprise Value - Surprisingly Higher debt has also lead to higher returns during crises as per historical data. Higher levels of leverage can increase average returns, but can also lead to a higher number of defaults. When combined with other factors like positive cash flow, high asset turnover, debt paydown, and a high value measure, adding leverage can increase returns by exposing investors to the right tail of leverage-amplified return outcomes.

16. The kind of investments that the multifactor model favors are unquestionably not the most popular or well-known stocks. They are often small, with low liquidity, and can be in cyclical or beaten-down industries

How to Invest in Crises and Maximize Returns in Equity Markets

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