Editor’s Note: Everyone is talking about the Dow entering bear territory. But how can investors profit in a bear market? You could try walking like a master and try to emulate says Lynn Carpenter. Be like Buffett. Play it long.

Now It’s a Bear, Who’s Hunting?

Lynn Carpenter

Until last week, opinion varied on whether we were really in a new short-term bear market this year or not. A few market watchers will declare a bear market when the indexes are down 15% from their latest peak, but most hold out for a 20% fall from the latest high. It is now official. Last Friday, the Dow Jones Industrial Average was down 20% from its October 2007 high.

The S&P is almost there—down 18.9% as of Friday. And the Nasdaq is off 19.1%.

What does this mean? I’ll give you 95% odds that one man in Omaha is plenty happy these days. A year from now, we will probably get the list of stocks Warren Buffett and like-minded value shoppers have been scooping up while they’re cheap.

Buffett doesn’t have to reveal what he is buying and selling immediately because it would move the market and rob him of his chance to finish the job. But eventually the facts are revealed, and with the many good companies at low prices, he should be dancing.

You would be, too, if you’re inclined to walk like the master. To be like Buffett, though, requires a long-term outlook. In this day, when a “strong buy” rating from a broker may be downgraded to “hold” two months later, people tend to think a one-year outlook is long term. It’s not.

Thinking very long term is one of Buffett’s great open secrets. His favorite holding period is “forever.” But he also holds some stocks for a mere two, three or five years. And I suggest you give that goal serious consideration. At Rising Tide, I don’t even consider recommending a stock unless I expect it to be a good investment for two years or longer. I prefer stocks that have an obvious five-year positive edge about them. The market may intervene to delay rewards, but the stocks with good long-term outlooks eventually do well for the wisely patient investor.

The other thing it takes to be like Buffett is good business sense. He evaluates companies, not stocks. I don’t know his exact method, just the few facts that everyone knows about how he does that. Buffett has never shared the whole mystery with anyone. That includes people who have written books about him and ex-daughters in law. But I do know that one of his key criteria is return on equity. He says that clearly enough in his Berkshire Hathaway (BRK.A) annual letters. ROE is a measure of profits compared to shareholders’ stake in the company.

Given that, you can be sure Buffett is also looking at ROA (return on assets), which eliminates the boost that came from borrowed cash.

At Rising Tide, ROE and ROA are prime criteria. They are far more important than price to earnings, which is ambiguous backward-looking information unless you know much more information about the quality of the past numbers… whether write-downs were one-time events, a growth surge was a new trend or a fluke… the industry level P/E… the company’s usual level… and so on. (All this is spelled out in the annual Rising Tides Sector Outlook, with industry-level standards.)

Buffett has also talked about stocks with “moats,” meaning protection around their business that keeps competitors at bay. I use a Five Forces model, but the focus is the same. It is about strategy and competition, about identifying a good business and management with good ideas and execution. I don’t think how you approach evaluating the business prospects of a company matters nearly as much as realizing that it’s important to do it. A share of stock is nothing but a slice of ownership in a business. Any stock you buy based on any reason other than the quality of the business is a speculation, not a true investment.

Buffett won’t be crying in his beer because the market is acting like a teenager with a facial zit on prom night. This market is not tragedy for long-term investors. It is opportunity.

But it sure is awful for anyone who was planning to cash in his or her winnings this year. Sellers are getting bad prices. It’s the buyers who have the edge now.

Which brings me to the other thing I tell my Rising Tide pals frequently: If you have money in stocks that you plan to use within the next two to five years, you are taking far too much risk. That money belongs in something that will return your capital to you, in full, on demand. No questions asked. Stocks are for the long run.

You don’t need to know everything about how Buffett invests to do a good job yourself. You just have to practice three things:

1. Look for companies with earnings and profit power. Return on equity is a good tool for that.
   
2. Make it your goal to find and only buy the kind of stock that you expect to go up for the next five years based on increased earnings and sales. Even value investors admire growth; they simply insist on getting it at a fair price.
3. Think about the business, its strategy, its management, its competition and industry. This is what investing is all about, owning a slice of a good business.

Source: Now It’s a Bear, Who’s Hunting?