The Globe and Mail, Report on Business
Published March 21, 2009

It is hard to find an individual investor who thinks that now is the right time to buy into the stock market. People that are holding cash are happy and have no intention of parting with their GICs any time soon. Those that are more fully invested and have lost money are traumatized. They don't want to lose any more, so they too are sitting tight.

Most investors know they should be buying stocks when prices are down and people are fearful, but they need to see signs of recovery before they'll move.

In a recent letter entitled Reinvesting When Terrified, Jeremy Grantham, co-founder and chairman of investment management firm GMO, focused on this topic. He said: "Every decline will enhance the beauty of cash until, as some of us experienced in 1974, 'terminal paralysis' sets in." He went further to say, "Those with a lot of cash will miss a very large chunk of the market recovery."

Mr. Grantham is one of the few who correctly predicted in 2007 that there were bubbles everywhere. But stock markets have halved and he and his colleagues now feel that the S&P 500 is 30 per cent undervalued.

In light of Mr. Grantham's view and my impressions, it's interesting to look at what professional investors are doing today. It's dangerous to generalize from the informal discussions I've had with analysts and portfolio managers, but a few trends do emerge.

I can definitively say that the pros are feeling just as beaten up as individual investors. I haven't talked to anyone who isn't going through the worst time in their career. Everyone is losing money and sleep.

Having said that, some managers are genuinely excited about the opportunities being presented to them and are in a buying mode. One manager said to me: "I'm long-term greedy." He's buying companies where he's "confident that earnings five years out will be significantly higher." He also is finding defensive stocks at low valuations. "It's the best of both worlds."

Edinburgh Partners, the manager of our Global Equity Fund, has decisively moved from defence to offence by reducing the cash reserve significantly (to 6 per cent of the fund currently from 18 per cent in the middle of last year) and shifting into stocks that are likely to do better in a market recovery.

But enthusiasm like this is rare. Generally, I'm finding that managers remain cautious and are moving slowly to deploy any available cash. They are wary of being caught in another downdraft with no ammunition left, and some have to worry about future redemptions.

The words I'm hearing most are "nibbling," "topping up" and "liquid companies." Rob McConnachie at Dixon Mitchell Investment Counsel told me that they have moved their clients about half way back to their maximum equity weighting. The stocks they're buying are the ones that were hardest hit, like the financials. "We're not buying the utilities or consumer staples."

Rick Howson's team at Saxon Mutual Funds is focused on companies with "a strong liquidity position." They're not interested in the less well-financed ones that look cheap.

Over the long haul, studies have consistently shown that individuals do worse than the funds they invest in. This is due primarily to performance chasing (i.e. buying last year's star) and too much trading. Every study I've seen reveals a substantial shortfall in client returns.

Over the past year or so, however, I would suggest that the amateurs have done better than the professionals. More individual investors (but certainly not most) got out of the market, reduced their equity weighting significantly or at least delayed investing new money. On the other hand, portfolio managers were more limited as to how much cash they could hold, even when they did see the downturn coming. For example, equity managers still have to own some stocks.

But I think that by the end of this cycle, the situation will have returned to its natural order.

The professionals are more likely to take advantage of the opportunities available and will be more fully invested when the recovery comes.

To deal with the paralysis and uncertainty, Mr. Grantham recommends that people have a plan for investing their cash, or rebalancing their portfolio. Otherwise, they just won't do anything.

I've been advising our clients to take a similar tack. For people who have a large cash position - perhaps they sold a property or transferred cash into their account - we encourage them to immediately move at least a third of the way (and preferably half) toward their long-term equity target.

We don't know whether the bottom is behind us or ahead of us, but markets now look to be undervalued. We want our clients' portfolios to reflect the fact that the reward versus risk balance is again in their favour.

In the current economic context, we can't expect clients to move from paralysis to greed in one move, but we urge them to take a step in that direction. And then another step. And another step.

Because as Mr. Grantham so eloquently puts it: "If you invest too little after talking about handsome potential returns and the market rallies, you deserve to be shot."