How to Make Your Stocks Earthquake Resistant
Rather than attempting to time the market, focus on constructing an earthquake-resistant stock portfolio that can withstand financial upheavals
The market has been shaky in the past couple of months to say the least. This has made many of you lose a lot of money on ill-timed bets on stock- and market moves. I am here to tell you that there is better way to invest in times like this.
Often when I talk to both seasoned and beginner investors, they tell me the same things: “The market is so hot right now, I think it’s time to go all in!” or “The big crash is coming, sell everything you got!”
Sure, they might have a point, or even be right, but the truth is that most often they’re wrong. That’s not because my friends are particularly unintelligent or bad at predictions, it’s because it’s really really hard to predict the stock- or real-estate market.
Table of Content:
The Earthquake Fallacy
A Tale of Two Investors: Rei and Yuri
The Property Market Post-Earthquake
Earthquake-Proofing Your Stocks
The Role of Company Debt
ADVANCED: The Recession Test
Conclusion: Building a Resilient Portfolio
The Earthquake Fallacy
As we’re in Japan, what better way to showcase my point than to talk about investing in the form of earthquakes.
First, the basics, just as a seismologist would use various tools and data to predict and prepare for earthquakes, I, too, use specific tools for my investment journey.
There are many so-called stock terminals out there, but you need to choose one to get the insight required to know if a stock you’re looking to buy is earthquake proof.
For free terminals, I recommend Google Finance and Yahoo Finance. Both are quite basic, but they have every stock you can think of.
If you are willing to pay for better information, I recommend these terminals:
Simply Wall ST - An extremely easy to use and that show stocks and their most important numbers in easy-to-understand and visual displays. Best platform for people getting in to investing.
TIKR - A super versatile platform that has every data point you can imagine. Highly recommended for more seasoned investors.
Your broker platform - most brokers have decent platforms and it's definitely worth checking out your before you buy an additional one.
Now, let's move on to a tale of two investors in Tokyo: Rei and Yuri.
A Tale of Two Investors, Rei and Yuri:
Rei is certain that a massive earthquake will hit Tokyo any day. In fact, he’s been certain of this for the past 10 years. During that time, he has been wanting to buy a condominium in Tokyo. However, he has hold off, waiting to pick an underpriced condo when people are panicking after the massive earthquake has hit.
Yuri is also certain that a massive earthquake will hit Tokyo. However, 10 years ago, she decided to go against her fears and buy a lovely condominium in central Tokyo. To calm her fears, when she bought the condo, she made sure it was up to the absolute latest earthquake standards.
Sure, there is no house in the world that can withstand every earthquake, but equipped with Japan’s latest earthquake-standards, her condo could withstand almost anything but a Tsunami.
So while Rei has been renting a place for the past 10 years, Yuri has been making an impressive return of almost 80% on her property investment!
Sure, there will most likely be a big earthquake in Tokyo in the coming years, that could cause property prices to drop, especially if the properties in question are damaged.
Funny enough, this is a bad reason not to invest in properties in Tokyo.
First, if a large part of the housing stock gets destroyed during that earthquake, we might even see property prices go up as the supply dwindles.
Second, and perhaps more importantly is that even if property prices fall, the fall will most likely be less than their initial purchasing price, especially if you bought it long ago.
Just look at the world’s largest stock index, the S&P 500, over the past 30 years:
The dark gray sections indicate the three big recessions we’ve had in the past 30 years, with the .com bubble in 2001, the bank collapse in 2008, and the Covid-19 shock in 2020.
As you can see, despite these massive shocks to the financial markets, the S&P 500 has continued to climb during this whole period. Hence, even if you might not have been able to time the market perfectly, you have almost certainly made money investing in stocks in the S&P 500 during this time.
Now, imagine how much more money you’d make if the stocks you invested in are recession, or “earthquake”, resistant!
Earthquake-Proofing Your Stocks
Again, just as with properties, there is no fireproof way to “earthquake” proof your stocks entirely, but there are definitely ways to make sure they can withstand almost any shock.
These are the two ways I use to make sure my stocks are earthquake resistant:
1. Company Debt
The easiest way to get an overview of a stock’s resistance to a recession is to look at its Debt/Equity ratio.
The Debt/Equity ratio measures a company's financial leverage, illustrating the proportion of debt used to finance the company's assets relative to the value of shareholders' equity. In other words, it shows how much debt the company is using to run its business compared to what it owns.
A low Debt/Equity ratio is generally seen as good, particularly in times of rising interest rates and an impending recession. A low ratio indicates that the company has not relied heavily on borrowing to finance its operations. As interest rates rise, the cost of servicing debt increases, which can squeeze profit margins. If a recession hits, businesses with less debt are likely to weather the storm better as they have fewer financial obligations to meet.
For instance, a Debt/Equity ratio of 0.3 means the company has 30 cents of debt for every dollar of equity. This is typically seen as a healthy level, suggesting that the company has a good balance between debt and equity and may be more resilient in facing an economic downturn.
On the contrary, a high Debt/Equity ratio can be a red flag. A high ratio suggests the company is heavily reliant on debt to finance its operations. When interest rates rise, these companies may find it increasingly difficult to service their debt. Furthermore, in a recession, these businesses may face a higher risk of financial distress or even bankruptcy.
For example, a Debt/Equity ratio of 2.0 means the company has 2 dollars of debt for every dollar of equity. This high ratio implies the company may struggle to meet its financial obligations in a rising interest rate environment, and during a recession, its survival could be at risk.
Even though the Debt/Equity ratio tolerance is different for every industry, as a rule of thumb, if you think a recession is coming or is already here, never invest in a company with a higher Debt/Equity ratio than 2.
On to my second way of making sure my stocks are earthquake resistent
2. ADVANCED: The Recession Test
The second way is a bit more complicated, but it’s an amazing way to hedge your investments, and it’s called The Recession test.
The goal of the Recession test is to get a hypothetical Price-to-earnings (P/E) ratio of a company in a recession environment. If that P/E ratio is high, it means that it is a risky company to invest in if a recession is about to hit.
Firstly, let's understand what the test entails. The "Recession Test" uses a company's lowest operating margin during previous challenging times as a benchmark to project its potential performance in a future recession. The critical elements you need are the company's historical revenue, operating margin, the current turnover, the tax rate, and the number of shares.
Let's create a hypothetical scenario using a fictitious company, 'Nippon Tech,' traded in Japanese Yen (JPY).
For this example, we'll use the following data:
By assessing this historical data, we note that Nippon Tech's lowest operating margin since 2000 occurred in 2002, at 4.8%. That year represented a challenging economic period, thus providing a good benchmark for how Nippon Tech may perform during another recession.
Next, apply this 4.8% operating margin to Nippon Tech's current turnover. Suppose their current turnover for the last four quarters is around 3,500 million JPY.
How to calculate the recession test on Nippon Tech
This calculation provides us with the Earnings Before Interest and Taxes (EBIT):
EBIT = Current Turnover * Lowest Operating Margin = 3,500 * 0.048 = 168 million JPY.
Assume a tax rate of 22%. The post-tax profit would be:
Post-tax profit = EBIT * (1 - Tax rate) = 168 * 0.78 = 131.04 million JPY.
Now, divide this post-tax profit by the number of shares in Nippon Tech to get the earnings per share (EPS). Assume Nippon Tech has 12 million shares outstanding:
EPS = Post-tax profit / Number of shares = 131.04 / 12 = 10.92 JPY per share.
Lastly, to get the Price to Earnings (P/E) ratio, we divide this EPS with the current share price. Let's assume Nippon Tech's current share price is 200 JPY:
P/E ratio = Current Share Price / EPS = 200 / 10.92 ≈ 18.3.
In our test, a lower P/E ratio in such a "worst-case" scenario suggests a lower valuation and, consequently, a greater resilience to a potential recession. Hence, Nippon Tech has barely passed our recession test:
Recession Test P/E Benchmark
If you do these tests to your stocks, not only have you learned a great deal about the fundamentals of stock-investing, but you have also checked if your stocks can withstand a financial earthquake!
Summary of the Recession test
Step 1: Collect the historical data of the stock (annual revenue, operating margin).
Step 2: Identify the lowest operating margin in the given period.
Step 3: Apply this margin to the current turnover to find the Earnings Before Interest and Taxes (EBIT).
Step 4: Adjust EBIT for the tax rate to find post-tax profit.
Step 5: Divide post-tax profit by total shares to find Earnings Per Share (EPS).
Step 6: Divide the current share price by EPS to find the Price to Earnings (P/E) ratio.
Step 7: Analyze the P/E ratio. A lower ratio indicates potential resilience in a recession.
Conclusion: Building a Resilient Portfolio
In the grand scheme of investing, nothing comes with a guarantee. However, having the right tools and understanding how to use them can give us a fighting chance against the unpredictable tremors of the financial markets. And remember, it's not about outsmarting the earthquake; it's about building a portfolio that can withstand the shakes and still stand tall. Whether it's by examining a company's debt levels or putting them through the Recession Test, these methods are about ensuring your investments aren't just glamorous beachfront properties destined to be swept away at the first sign of a tsunami.
So, brace yourselves, hold on tight, and always make sure your portfolio is as earthquake ready as a Tokyo skyscraper. After all, Rome wasn't built in a day, and neither will your earthquake-proof investment portfolio. But with the right foundations, it might just weather the storm.