Making money in volatile markets

Q: How can I make money in volatile markets?

This is a great question from a young investor, especially in the context of COVID-19 (Coronavirus) which is currently impacting world markets. We are seeing headlines such as "the fastest -10% fall from market-highs ever", "Market down -21% in 20 days" and "Markets fall the maximum to limit-down".

Knowing that the young investor who asked me about this has very little trading experience, let alone an understanding of the share market, I used an example that he could relate to using: - A monthly pay cheque; and - Going shopping in the pre-Christmas sales

We'll look at how professionals invest and how you can, very simply, copy what they do. The analogy of Christmas sales and pay cheques is a long bow to draw, but we'll bring it back to real life money-making in the sharemarket at the end.

I said to the young investor:

"Imagine that you work on an oil rig for a month at a time. You get flown out there by helicopter, work for a month and then fly home to see your family.

You fly out from home at the end of November and get handed your pay cheque when you arrive on the rig.

You know full-well that the cheque is useless, because there are no banks on the oil rig, and while you do have great internet access there, you can't bank your cheque to fill up your credit card or PayPal account until you get home.

Your pay cheque, along with everyone else's, is $10,000 for the month, but you can't spend the money until you get back to the mainland to bank your cheque.

The company you work for pays their staff with cheques which are made out to 'Cash', so anyone can bank the cheque and receive the money.

It's now December and you want to start your Christmas shopping, but you have no money, just a cheque that can't be used for online shopping while you're on the oil rig.

The pre-Christmas internet sales start and you want to start spending the money which is locked up in your pay cheque.

You approach a colleague, Tommy Tight-fist, who is known to save every cent he earns and you suggest giving him your $10,000 cheque if he transfers you $9,000 today to start your Christmas shopping. He agrees.

You now have $9,000 in your bank account and in between your work shifts, you start your online shipping. You know that you 'lost' $1,000, but you knew this was a good thing to do because you wanted the money now and this way you'll be able to complete your Christmas shopping - and even better, you'll be buying things on sale!

Tommy has basically 'bought a dollar, for less than a dollar'. More specifically, Tommy has just bought $10,000 for $9,000. That's a pretty good deal, but Tommy too, has to wait until he gets to land in early January to cash in his newly purchased pay cheque from you, before he makes any 'profit' - until then he's out of pocket $9,000.

As December rolls on and the online sales get bigger and better, more colleagues go to Tommy and ask for a similar deal to yours.

Tommy does many more deals including: - Bob, who got in early and managed to agree to $8,000 for his $10,000 pay cheque - David, who then negotiated with Tommy and got $7,000 for his $10,000

Adam, Tommy's last 'customer' was so desperate to be a part of the online sales that he sold his cheque to Tommy for only $1,000 because that's all Tommy had left in his bank account. Adam has 'lost' $9,000 and Tommy is set to make $9,000 profit from his transaction with Adam - when he gets back to the mainland and can bank Adam's cheque.

Tommy now has a bottom draw full of $10,000 cheques. 15 cheques in fact, which are worth a total of $150,000 - but only when he can get to a bank.

If Tommy had to sell all the cheques today, while still on the rig, he would have to accept whatever price he could get for them - this is called the 'market price'.

Now let's bring this analogy back to the share market:

There are companies on the ASX that are just like Tommy's bottom draw. Let's say there's one called Bottom Draw. You can buy shares in Bottom Draw and own a little bit, or a 'share', of the whole portfolio - just like owning a portion of Tommy's bottom draw.

Bottom Draw is as a company on the ASX that buys investments similar to the monthly pay cheques. They provide money, or 'liquidity', when needy companies require money urgently. These needy companies sell things they own (assets) to Bottom Draw for very cheap prices, in order to get the money very quickly. Bottom Draw are effectively buying a dollar for less than a dollar, just like Tommy did in our analogy.

In times when the market is falling rapidly, such as now, when the COVID-19 spread is causing havoc on global share markets, many investors are panicking and trying to sell at any price just to get their hands on cash today. This is like the oil rig worker Adam, selling his pay cheque for only $1,000 just to get his hands on money immediately.

While Bottom Draw know they will be able to realise the true value of the assets later, they must wait for a 'liquidity event' to sell the assets they've bought at very cheap prices - just like Tommy waiting to get back to the mainland to bank all of his cheques. Landing safely back on land is Tommy's 'liquidity event'.

Bottom Draw are patient and wait until they can sell the assets for a fair price again and often they will have a locked-in event that pays a set price - like the $10,000 cheques being deposited at the bank.

Like Tommy's bottom draw full of cheques, shares in Bottom Draw will look like a terrible investment to anyone who only looks at today's market value of these investments.

However, to those who have looked at the detail of what Bottom Draw actually do, they know that holding shares in Bottom Draw is a bargain. They're a bargain because on 'face value' when you look at Bottom Draw, they only have heavily discounted assets - like a draw with 15x $10,000 cheques that can only be sold today for 1 tenth of what they're worth - until the real value of the cheques can be realised (when the liquidity event of going back to the mainland occurs).

Bottom Draw have set up liquidity events for most, if not all of their respective assets. When Bottom Draw ride out the storm of market volatility and get to the pre-determined liquidity event, suddenly Bottom Draw can cash in the cheques and what looked to be worth very little, is suddenly worth much more, like the $150,000 worth of cheques.

You and I can actually buy shares in companies like Bottom Draw any day of the week on the ASX. Here are the key points to note:

- We can buy and sell shares in companies like Bottom Draw - Companies like Bottom Draw normally pay dividends which are often higher dividends than the Big Four banks (Commonwealth Bank etc.) - The ASX makes companies like Bottom Draw stick to very strict reporting and compliance rules which provide high levels of transparency for investors like you and me - Other companies similar to Bottom Draw are listed on the ASX and are called Listed Investment Companies, or 'LICs' for short. - LICs can have very different specialties such as long-term investing, value investing or small-cap shares.

The above story about Bottom Draw is based on real investments that the ASX-listed LIC, Global Value Fund (GVF.ASX), consistently make in their portfolio for their investors.

GVF is an LIC which is often referred to as an 'alternative investment'. They are referred to as alternative because the way they make money for their investors is not generally linked to how most other share investors make money.

In fact, GVF often make their greatest profits in turbulent times like these volatile COVID-19 markets, via investments just like the ones described above. They have been doing this consistently since 2014.

Here is an interview with the GVF team discussing their approach to investing and some of their positions in 2019.

Note - this is not personal advice.