On Monday, March 10, shares of Bear Stearns declined 11% on rumors of a potential liquidity crisis. CEO Alan Schwartz maintained that "Bear Stearns' balance sheet, liquidity, and capital remain strong." Former CEO and current Bear board member Alan "Ace" Greenberg dismissed the liquidity rumors as "totally ridiculous." The stock closed that day at $62.30.
You know what happened next.
On Sunday, March 16, JPMorgan Chase struck a deal to buy the beleaguered investment bank -- for $2 a share. JPMorgan subsequently raised its offer, ultimately buying out Bear for $9.35 per share.
This startling chain of events has caused investors to ask three questions:
- Could I have seen this coming?
- How can I prevent something like this from happening in the future?
- "Ace" is a really sweet nickname! How can I get people to call me that?
Good questions, Ace
To the first question: No. After all, if British businessman Joe Lewis, who steadily bought Bear shares through the end of 2007, couldn't have seen this coming, the odds weren't good for us. The Bear Stearns blowup seems obvious in hindsight, but it came as a shock at the time. This was a powerful, experienced firm that consistently ranked as one of Fortune's most admired companies.
We knew Bear was in trouble as early as last summer, when two of its hedge funds blew up. But few investors, if any, foresaw such a cataclysmic collapse. Many seasoned veterans were left holding the bag -- including Lewis, Bear's largest shareholder, who watched nearly half of his $2.5 billion fortune disappear overnight.
Avoiding another Bear
Brace yourself for some bad news: There's another Bear Stearns out there. You may already own it. And just like with Bear Stearns, chances are you won't see the collapse coming until it's too late.
Fortunately, there are several steps that you can take to protect your portfolio against another Bear attack, or at least limit the damage if it does occur.
There's no shame in having a "too hard" pile
Warren Buffett and Charlie Munger are presented with thousands of potential investments each year, but according to Munger, they "put almost all in the 'too hard' pile and sift through a few easy" investment opportunities. This cautious approach certainly hasn't hurt the dynamic duo's returns -- and it shielded them from exposure to the Internet bubble.
If you can't explain, clearly and concisely, how a company makes money, or if you don't have a good grasp on industry dynamics and key risk factors, that company probably belongs in your "too hard" pile. No matter how cheap Gilead Sciences (NASDAQ:GILD), Xilinx (NASDAQ:XLNX), or Akamai Technologies (NASDAQ:AKAM) become, they'll never occupy a spot in my portfolio; these companies are simply too tough for me to wrap my head around. In fact, I don't even know how to pronounce Xilinx.
If you insist on buying complicated companies with highly uncertain futures, like Freddie Mac (NYSE:FRE) or Fannie Mae (NYSE:FNM), limit your exposure to a small percentage of your portfolio -- no more than 10% should go toward the entire group -- and be prepared to kiss that money goodbye.
An inside job
In addition to a simple, easy-to-understand business model, you should also look for quality, shareholder-friendly management. When analyzing a company's management team, Motley Fool co-founder Tom Gardner always asks: "Would I want the CEO babysitting my kids? Would I want the CFO managing my portfolio?"
You may not have the same access to senior management that Tom does, but you can get a sense of the chief officers' trustworthiness by reading annual reports and listening to conference calls. Does management tend to gloss over bad results and make excuses, or does it own up to mistakes?
Apple (NASDAQ:AAPL) CEO Steve Jobs' passion for his company's products is absolutely infectious. Much of the credit for Apple's resurgence can likely be attributed to his leadership. Even better, Jobs has a significant chunk of his net worth invested in the company. This signals that his incentives are aligned with those of shareholders. It's not foolproof, but the absence of any such executive incentives should give you pause.
Diversify, diversify, diversify!
Finally, let Joe Lewis' misfortune serve as a warning. A diversified portfolio can withstand the brunt of a Bear Stearns or two -- a concentrated portfolio cannot. Tom recommends that investors hold a minimum of a dozen stocks, preferably spread across numerous industries. Of course, the appropriate number of stocks will vary depending on an investor's experience and risk tolerance, but as a general rule, if the performance of any single position is keeping you up at night, your portfolio is not sufficiently diversified.
At Motley Fool Stock Advisor, Tom and his brother David Gardner have suffered a few Bear Stearns-style blowups over the past five years (cough Krispy Kreme cough). But thanks to their diversified collection of great companies, the Fool co-founders have produced average returns of 48% per pick, versus 9% for the S&P 500. To see all of Tom and David's recommendations, as well as their best buys for new money now, click here to join us for a 30-day free trial.
This article was originally published May 5, 2008. It has been updated.
Rich Greifner 's "too hard" pile also includes "Through the Fire and Flames" on expert difficulty. Rich owns shares of Freddie Mac and Fannie Mae. Apple is a Stock Advisor selection. Akamai is a Rule Breakers recommendation. The Fool has a disclosure policy.
