One of the most common pieces of feedback we are currently receiving is that many potential stock market participants would prefer to wait until ‘things are less uncertain’ before committing extra funds to equity markets. In an ideal world, this sounds a perfect strategy. However, stock markets rarely behave in an ideal way.

‘Less uncertainty’ would seem to equate to a mixture of better economic news, better corporate news, a belief that we have seen the worst of the large negative surprises and a greater flow of cash into equities. Unfortunately, by the time these factors can finally be ticked off a checklist we will probably be closer to the top of the market than the bottom.

So rather than waiting for less uncertainty, the equity investor looking to maximise his returns would be more likely to benefit if he dealt only when there was great uncertainty. Of course, there would be no guarantee that conditions could not become even more uncertain (i.e. worse) and prices fall further but providing he was buying well below fair value that would not be a problem in the long term.

We think of the timing our purchases of stocks in the same way as pulling an elastic band. It is never clear how far the elastic band will stretch but ultimately it will do one of two things i) bounce back or ii) break. Imagine the elastic band can be pulled back a total of x notches but that no-one knows what x is. The player of this game will be rewarded the longer he waits for it to bounce back PROVIDED he does finally bet on it bouncing back. The only way he doesn’t win is if the elastic band breaks. On the other hand, he definitely CANNOT win if he never bets on the elastic band bouncing back. And obviously, he will win far less (and possibly even lose) if he waits for the elastic band to bounce back before placing his bet.

Taking the game a bit further, it would appear to make no sense for the player to make bets on when the elastic band bounces back IF he knows that a large number of bands actually break and that the money he makes on those bouncing back will not cancel out the losers.

While this tortuous analogy has been ‘stretched’ to its limit, it is very useful in explaining our strategy so far in 2008.

i)                    As always, we know we always have to deal in uncertain times. Whenever all participants are certain, markets are typically expensive and preparing to fall.

ii)                  We have a lot of elastic bands (stocks) in case some do break (fall significantly)

iii)                We are happy to buy stocks provided they have already been stretched significantly from their fair value

iv)                If they stretch even further we are happy to buy more, providing that we still believe they will bounce back

v)                  We won’t keep betting more and more on a bounceback. We will sometimes simply maintain our position.

vi)                If we lose confidence in the bounceback or worry that a break has become more likely or can find other stocks where we believe the odds of a bounceback/break are more attractive we are happy to switch

vii)              The stocks most attractive to us are those where we see significant gains from a bounceback combined with lowest probability of a break.

This strategy explains why our only bank holding is HSBC and why we have no housebuilders. Banks have highly geared and opaque balance sheets. Yes, they may get through this difficult period and may even prosper in the years ahead but as we have seen in the US with Bear Stearns, Lehman Brothers, Fannie Mae and Freddie Mac the risk of equity investors losing all or most of their money in banks should not be minimised.

Similarly, while it is clear that at some point in the next few year housebuilding volumes will recover strongly it is unclear how the large housebuilders will fare until then. With many of them having significant levels of debt and poor cashflow (not selling any houses but finishing the building of partially built ones is an expensive game) their bankers have the upper hand in the relationship and housebuilders are already finding themselves paying higher rates and diverting what cashflow they are receiving straight to the banks. The possibility remains that these companies could be significantly smaller in 3 or 4 years time and therefore not be well placed for the ensuing recovery.

It is this ‘tail risk’ which we are currently most wary off and keen to avoid in selecting equities.