The Globe and Mail, Report on Business
Published October 4, 2008

“Finding the right answers is easy; it's asking the right questions that's difficult.”

Tim Price, the director of investment at PFP Wealth Management in London, started a recent blog posting with that old saying. As we go through these confusing and scary markets, Mr. Price's approach is a good one. Investors, both professional and amateur, have to figure out what the questions are. Here are my six.

Do we need to adjust our worst-case scenarios?

For many people, their portfolio has crashed through what they thought was the "worst-case" scenario for the market and individual stocks and bonds. They hadn't counted on Potash Corp. trading at six to seven times earnings. Nor did they expect the bonds of one of the good guys, Toronto-Dominion Bank, to yield over two percentage points more than Government of Canada issues.

Do those floors need to be lowered knowing what we know now about the world economy, banking conditions and inflation? In most cases, they do, but analysts and portfolio managers have to be careful they don't get carried away. At times like this, it's easy to let the doom and gloom influence the numbers. We can talk ourselves out of buying stocks that are at rock bottom.

How does the severity of the crisis reset the world order?

Recapitalizing the banking industry and de-leveraging the U.S. consumer and government will take time and will have a profound effect on the business environment. The necessary recession we're having will be worse because of it. Some industries will get hammered, and weak players that stayed alive by the good graces of low interest rates and a booming economy will disappear.

But out of this crisis will come far too many pronouncements of secular change and new paradigms. In many industries, the Wall Street meltdown will have little impact on sales, profits or strategy, and will get scant mention in the 2009 annual reports. For companies in these industries, September, 2008, will be a small dip on the stock charts.

Has the long-term outlook of companies we own changed materially?

I don't mean the short-term earnings outlook resulting from the economic slowdown. Some, all or too much of that has already been factored into stock prices. No, we need to cut through the market and media noise and ask, is the company's product or service going to be relevant in the future? Has its position in the market changed? Is it strong enough to benefit from the economic weakness as its competitors fall by the wayside?

In most portfolios, there are holdings that have seen material deterioration to the long-term outlook. These are "Nortel-like" situations where "no matter what happens, it ain't goin' back to $120," because of a combination of equity dilution, industry changes and an excessive valuation. The distressed financials are in this category.

But there are many companies that will come out of this with as good or better prospects than they had before. Consider Warren Buffett's recent purchase, a $5-billion (U.S.) investment in Goldman Sachs. His thinking goes something like this: Capitalism will continue to exist. Capital-raising is part of capitalism. Goldman is the best investment banker in the world by a large margin. It will have considerably less competition going forward. And it needs money right now, so it's a good time to cut a deal.

I'm looking for high-quality, industry-leading companies that have been hit unduly hard, and yet like Goldman, are going to come out of this in a stronger position. Names like Cisco, HSBC and General Electric come to mind. My friends from the dark side tell me that high-quality corporate bonds represent the best value they've ever seen.

Are we allocating assets to areas that have the highest expected return? (Or are we invested in areas that have done well over the past few years?)

Unfortunately, none of us is the second coming of Mr. Buffett, who is the best asset allocator on the planet. We don't have the psychological makeup or resources to be as bold as he is, but we can go in the same direction.

There have been dramatic changes in market values, which makes it likely that there are opportunities to improve the positioning of our portfolios. What was right six months ago may no longer be optimal. From current levels we are now looking at double-digit returns from equities over the next few years and the reward-to-risk measure on corporate credit is much better.

Will we be going up with as much as we went down with?

There are two parts to weathering the market storm. First, it's important to preserve capital on the way down. That goes without saying. The second part, however, will be measured a few years from now and involves making sure we fully participate when the markets go up the other side of the valley. It's easier if we got the first part right, but both elements will factor into our returns three to five years from now.

Are we having fun yet?

Okay, so maybe the answers aren't so easy. And these may not be the most important questions. Every analyst or portfolio manager will ask different ones.

But whatever they are, if they bring discipline to the investment process and allow for a dispassionate assessment of reward and risk, they serve their purpose.