Final stories and lessons from the global financial crisis; Turning bullish too early; My February 2009 letter to investors; A beautiful memorial for Charlie Munger

1) Today, I'm wrapping up my three-part series in my recent daily e-mails...

If you've been following along, I've been discussing the global financial crisis (earlier this month was the 15th anniversary of the market bottom in 2009) – how I handled it, what I got right and wrong, and some big lessons I learned from it.

In Thursday's e-mail, I recounted how in 2008 I met someone who opened my eyes to how bad things were going to get. This led me to reposition my fund much more defensively and warn everyone who would listen about the looming calamity.

Then on Friday, I traced the market collapse. It began in earnest when Lehman Brothers filed for bankruptcy in September and continued into the end of the year, when I was featured in a 60 Minutes segment that aired on December 12, 2008 called "The Mortgage Meltdown" (video here and summary here).

The carnage didn't end until early March 2009, when the S&P 500 Index bottomed down more than 50% from its peak only 17 months earlier.

This chart starts on October 1, 2007, just before the market peak, and ends on April 1, 2009, not long after the market bottom:

As I said in Friday's e-mail:

I was a full three months too early in calling the bottom. And that sure was painful, as the market fell another 25% from the end of 2008 through March 2009.

During the initial drop in the market, I'd correctly positioned the hedge funds I was managing very defensively. But in the final part of the crash, in the first 10 weeks of 2009, my funds were falling just as much as the market because I'd turned bullish too early, buying stocks and trimming my short book.

This is something every investor has to deal with at some point – in fact, usually many points – in their career: What do you do when a particular stock (or, worse yet, all of your stocks) are crashing?

Back then, just about everyone I knew – even those of us who had correctly anticipated the crisis – had turned bullish too early.

We all thought that the hideous plunge in November 2008 (which you can see in the chart above), followed by the rally into December, marked the bottom... so we were positioned aggressively for the rally we expected.

Instead, we all got plastered in the first nine weeks of 2009 as the market plunged another 25%.

I remember at the time calling my buddy Lloyd Khaner of Khaner Capital, a hedge fund similar to mine, and asking him how things were going. He replied, "I have my flak jacket and helmet on, and am hiding under my desk!"

My friend Guy Spier of Aquamarine Capital told a similar story recently when he was the guest on William Green's Richer, Wiser, Happier podcast (part 1 here and part 2 here) (an excellent interview by the way). His comment to William at the time: "We're bleeding from every orifice!"

The first thing you need to do is set aside your emotions – pain (you just want it to stop) and regret ("why wasn't I more patient?") – and approach the situation rationally... which is very hard to do because you just want to sell and end the pain.

Then you need to figure out if you're wrong or just early. If you bought a 50-cent dollar and other investors' panicky selling pushes the stock down another 20% and it's now a 40-cent dollar, it doesn't necessarily mean you should sell – and might even want to add to your position.

But adding to a position that goes to zero is a sure route to ruin, so you'd better be right that the company is going to survive – and really is worth what you think it is. This is where good analysis comes in...

2) Lastly, if you're managing other peoples' money, you need to stabilize your base of capital. If your investors panic and yank their money, you'll be forced to sell even if you want to be buying.

To build (or at least maintain) their confidence, I made an extra effort to write thoughtful in-depth monthly letters during the crisis. Here's the one I sent on March 3, 2009, only six days before the market bottom. I started by apologizing for the fund's losses:

We apologize for what has now been five months of truly dreadful performance – by far the worst of our careers. The fact that it has coincided with the worst stock market downturn since the Great Depression and that we have outperformed the market is no excuse. We have not done our job, which is not only to make money during good times, but also to protect our assets during bad times.

With the benefit of hindsight, our spectacular performance in September lulled us into believing that if the market continued to decline, which was our expectation, the stocks we owned were cheap enough that they'd hold their own and, in addition, our short book would protect us. Consequently, we were bold rather than cautious – and paid the price.

As bearish as we've been for at least a year, we still underestimated this economic crisis, which is unlike any we've experienced in our lifetimes. Our best guess is that it will turn out to be the most severe economic downturn since the Great Depression (though we don't think things will get anywhere near that bad – let's call it the Great Recession).

I then shared historical data showing how cheap the market was and how much stocks had rallied in the two prior times the Dow Jones Industrial Average had hit a 12-year low:

That said, we think a severe, extended economic downturn is priced into the market, so we don't think more major market declines are likely either. As Buffett wrote in his just-released annual letter, "the economy will be in shambles throughout 2009 – and, for that matter, probably well beyond – but that conclusion does not tell us whether the stock market will rise or fall."

There are certainly good reasons to believe that U.S. stocks are cheap. As of the end of February 2009, the Dow Jones Industrial Average and the S&P 500 had both tumbled by more 50% from their peaks – the largest drop since the Great Depression – and were at lows not seen since 1997. Specifically, yesterday the Dow hit a 12-year low, an extremely rare event that has occurred only twice before, on April 8, 1932 and December 6, 1974.

In both prior cases, the economy and unemployment were still 4-9 months away from reaching their worst points (in 1974, the unemployment rate was only 6.6% and it peaked at 9% six months later), yet it was still an excellent time to invest (as the chart below shows): in 1932, though the market fell an additional 34%, within six months it was up 5%, and in 1974, December 6th marked the exact day the market bottomed and it was up 45% six months later.

I continued with sharing this chart:

And as I also noted:

Valuation measures also indicate that stocks are cheap. Based on data from Yale economist Robert Shiller, U.S. stocks today trade at a cyclical price-to-earnings ratio of 12.3, their lowest level since 1986 and well below their historical average, dating back to 1870, of 16.3. (The cyclical P/E compares stock prices to average earnings over the previous 10 years in an attempt to smooth out booms and busts.) Over the past 125 years, when stocks have traded at this level, they have doubled on average over the next decade.

I concluded that:

[We] are finding the greatest number of cheap stocks in our careers. With fear running rampant, some of the best businesses are priced today as if their earnings will never rise again, and many lesser businesses are priced as if they might go out of business entirely.

While we profess no great insight into calling the bottom of the market, we have never felt greater certainty that with patience and perseverance we will be well rewarded by the stocks we own at current prices.

To my credit, I never panicked and continued buying insanely cheap stocks all the way to the bottom (though to my discredit, I failed to cover my short positions as the market started to rally, which cost me dearly – a topic I've discussed in many prior e-mails).

And to their credit, my investors didn't panic either... which enabled me to play a strong hand throughout the crisis.

So what are the lessons here?

• During times of market turmoil, you must be able to set aside your emotions and think clearly and rationally. This is, of course, easy to say, but very hard to do, as the vast majority of humans are hard-wired to be irrational around financial matters, especially when they're losing money.

If you're not able to do this (there's no shame – most people can't), then you shouldn't try to pick stocks – just dollar-cost average into index funds and then never look at the markets or your portfolio.

• Being early and being wrong look identical in the early stages of a downturn – but it's critical to be able to distinguish between the two. Again, if you're not able to consistently do so, don't try to be an investor.

• If you manage other peoples' money – and you're losing it – the natural inclination is to feel embarrassment and go hide in a cave. But you have to do the opposite: communicate more often and in-depth to build confidence and make sure they don't panic and withdraw their money, thereby forcing you to sell at exactly the wrong time.

3) I was deeply honored that the Munger family invited me to the "Celebration of Life" for the late Charlie Munger, which took place in Los Angeles eight days ago.

It was a private event, so I can't talk about it, other than to say it was a beautiful tribute to a great man – and to share this nice post by someone else who was there: A memorial for Charlie Munger. Excerpt:

Charlie Munger, who died in November within sight of his 100th birthday on Jan. 1, fell ill at his home in Santa Barbara. When he got to the hospital, a nurse asked him how he was. "I'm dying," he said. "How are you?"

His daughter Emilie Munger Ogden told the story Sunday afternoon during his family's beautifully organized celebration of life at Harvard-Westlake School...

Emilie also said he placed a call from his hospital bed to Warren Buffett, his friend since 1959 and longtime business partner. During the service, Buffett's daughter, Susie, said the two native Nebraskans, self-proclaimed agnostics, developed an instant man crush. At investing giant Berkshire Hathaway, she said, quoting her father, Warren is the builder, but Charlie was the architect.

The two-hour service allowed plenty of time for Charlie's famous aphorisms. "You can't guarantee happiness," he said. "But you can guarantee misery." Another daughter, Wendy, said his chief questions were "what the hell is going on here?" and "why the hell is it happening?" Clarity and truth were persistent themes. Famously impatient with ideology and cant, Charlie was [known] to believe that people in denial always make bad decisions. He called the best relationships "seamless web(s) of deserved trust."

Speaking of Charlie and his second wife, Nancy (also the name of his first), their son Philip Munger's voice cracked when he said, "My mother and my father were a home for each other." In a video, a parade of adorable grandchildren and great-grandchildren repeated favorite words of Charlie's such as twaddle, kapow, skedaddle, and wise-a**ery.

Best regards,

Whitney

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