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Learning from the Credit Crisis?

The global credit crisis of 2007-2009 left most investors - even professional investors - with deep scars. It also provided investors and would-be investors with reasons to remain on the sidelines. However, if our aim is to increase our understanding, to take control of our own finances and investments, then the 2007-2009 years provided us with an important lesson: that an understanding of risk, and control of risk, is as important as our search for returns.

The global credit crisis ruthlessly uncovered the excessive risk investors were taking leading up to early 2008. No one needs tell us in Ireland of that fact. But in order that we can learn from the past and avoid a similar fate in the future we must first understand how to recognise risk. It is a good deal easier than you may think.

We may be tempted never to buy a risk asset again after a downturn that has devastated Ireland. But we must also recognise that it is in the past, and that today's investor in bank deposits is unlikely to earn any meaningful return for several years. Similar to the aftermath of World War 2, savers are being penalised with no return in order to assist in reducing the cost of carrying society's burden of debt. And for reasons I outline towards the end of this article guaranteed products and hedge (absolute return) funds, which offer the prospect of equity-like returns without the volatility, are not the answer unless you are an investment intermediary or a bank looking to generate commission.

Benjamin Graham, author of The Intelligent Investor (1949) described risk as the threat of a permanent loss of capital. So how can we identify risk in investing?

In Ireland, we have (had) a preference for property investing, and perhaps we could start by defining risk in this relatively straightforward asset class. We might say that there are three major risks in property that we need to understand in order to avoid the risk of a permanent loss and to benefit from the above average returns this asset class has historically delivered when compared to bank deposits or non-risk assets in general. I would describe the three main risks in property investing as;

  • Location risk
  • Debt risk
  • Valuation risk

Location Risk
Property returns are fairly homogenous. By this I mean that if property prices in any given region are rising then more or less all property prices are rising. Of course, properties in the more sought after locations can rise faster. In property, then, so long as you don't buy a property in a bog or on the side of a cliff in general you are likely to benefit from rising prices if the market in general is rising. Location risk is easy to understand.

Debt Risk
As we now know, the major specific risk peculiar to property investing is the use of debt. Property investing, by definition, tends to be lumpy. In stock market investing, you can buy into property companies on a piece meal basis without you, the investor, using any debt whatsoever. In physical property investing, it is unlikely that you will have sufficient monies saved to buy a second property outright at the outset. As we are all now aware, property prices can fall as well as rise and if they fall when you have bought and you have used debt then you can quickly enter a negative equity situation. This, in itself, is not the real risk. So long as you have sufficient rental income (after costs) to meet your interest and some capital repayments then you can continue to service your borrowings. This, of course, brings us to the third risk.

Valuation Risk
This is the risk of overpaying for a property asset. On its own, the risk is not fatal but when debt is attached the combination is fatal, as we now fully understand. The rental yield in property is a sensible and easy-to-understand guide to value. But the level and direction of interest rates also play an important part in assessing when the rental yield is sufficient to warrant a property purchase. In an era of double-digit interest rates, a rental yield of below interest rates should act as a cautionary flag, although it is trickier to determine valuation risk if the rental income is growing, as it might be if the economy is robust and demand is lifting rents. In the 1995 to 2007 cycle, a progressively lower interest rate environment made property rental yields look attractive. But rental yields simply fell too low. In 2003, interest rates in Europe started to rise making the rental yields look decidedly less attractive. Even worse, as a nation, we took on a huge quantum of debt between 2002 and 2007 at a time when interest rates had started to rise. We were fooled by rising property prices and took our eyes off values. This is valuation risk.

Assessing Risk in Markets is No Different
In the stock markets we are dealing mainly with businesses - manufacturing businesses, property companies, technology companies along with pharmaceutical, mining, distribution and many other business types. But the three principle risks are largely the same. In stock market investing one might class the three major risks as the;

  • Business risks
  • Financial risks
  • Valuation risks

Business Risk
Business models change and a good business model in one era does not guarantee that it will remain a good business model in all economic and business conditions.

Many business models are undermined by ongoing advances in technology. Indeed, advances in technology will continue in the years ahead - and this is probably the only thing that is certain in the business world. Changes in fashion occur at regular intervals in all areas of life, altering consumer habits, tastes and demand. The retail industry is in a constant state of flux, and companies in the sector that fail to adapt simply disappear, while new companies take their place with new products to satisfy the demands of the marketplace.

The regulations and legislation that drive many industries also change the landscape by creating opportunities and threats for both existing players and new entrants. For example, pharmaceutical companies are under constant threat of product patent expiry, which significantly reduces the margin on existing products, as new entrants are free to compete with the introduction of generic alternatives. Indeed, approval of new drug discoveries by regulators has become ever more onerous, so that even well-established pharmaceutical companies have been finding it more difficult to bring new drugs to market than was the case 10 or 20 years ago. For these reasons, the concept of a blue-chip stock, one that can be held for the long-term, is probably a misleading one. The simple fact is that there are far fewer true blue-chip stocks in the global markets than most investors appreciate.

For a variety of reasons, then, the profits a company is making today could be lower in three to five years' time - the business risk.

Financial Risk
Management can add too much debt to the business, which can undermine an otherwise good business with catastrophic consequences for shareholders. Assessing the financial risk in companies is also a difficult, if not impossible, task for the majority of private investors. Unless you have training that allows you to read and understand financial statements, and experience of businesses in different sectors, you cannot expect to be able to assess the financial risk in a company. And even if you are an accountant, you may be able to figure out the company's debt position and its cash flows, but how do you know how vulnerable those cash flows are if recession hits? After all, the stability or defensiveness of a company's cash flows varies enormously from one industry to another. It is not easy for the majority of private investors to evaluate financial risk.

Valuation Risk
Good businesses, even conservatively financed ones, still have to be bought in the stock market at good value in order to secure decent returns. The valuation risk in a share is also a minefield. As with property, it is not simply today's earnings or dividend that determines the right value for a share but a myriad of different factors from the stability or defensiveness of its earnings to its growth prospects, the competitive landscape and its financing. For example, a stable defensive company with an earnings yield of 7% and a dividend yield of 3% may offer good value when long-term interest rates are at 2% (as they are at present in the US, UK and Germany); yet that same value looks much less appealing if long-term interest rates are 6%. In practice, most private investors struggle to cope with valuation risk.

Avoiding the Permanent Loss
Any one of these three risks - business, financial or valuation - can expose the investor to a permanent loss. In the stock market, with its greater liquidity and consequent volatility, it is not easy to distinguish between the opportunity presented by temporary declines in prices and the threat of a permanent loss. If you cannot tell the difference, then how do you know how to react to declining prices in a bear market and decide whether you need to:

  • Cut a loss;
  • Add to your position; or
  • Stay as you are.

Investing Through Funds Lowers Risk
All is not lost however. The stock markets are nothing if not flexible and investing through funds hugely lowers the odds of private investors succumbing to the three major risks and ending up with permanent losses.

But Costs are an Important Consideration
However funds come with added costs. There are two ways to keep these frictional costs to a minimal. The first is to use a low-cost, online stock broking account. The second is to buy low-cost funds. Funds quoted on the stock markets - which include exchange-traded funds and investment companies - carry the lowest costs as they do not need to be marketed. Unit-linked funds in Ireland, Mutual Funds in the US and Unit Trusts in the UK are all sold via intermediaries and are hampered by the attendant marketing and seller costs.

To earn better than bank deposit returns means you must buy risk assets. Over the years, when risk assets - like property and businesses quoted on stock markets - are priced fairly, the returns are well above bank deposit returns. It is referred to as the risk premium, the extra return for taking the risk. To benefit from investing in risk assets you must buy value, diversify and ensure you do not succumb to the volatility.

Guaranteed Products and Absolute Return Funds are not the Answer
Buying a guaranteed product is not the answer, far from it in fact. Here, you simply hand the extra returns over to the product seller, in the vast majority of cases.

Hedge and absolute return funds have two disadvantages compared to sensibly valued equities or property. The first is that their higher annual costs significantly detract from the returns they can generate from markets. The second is that they earn their return by trading markets, a much higher risk proposition. I doubt Irish investors are aware that the global hedge fund industry has delivered negative returns after inflation from 2003 to 2011 inclusive. Yet the financial services industry in Ireland is heavily pushing both guaranteed products and absolute return funds to clients - the offer of decent returns alongside lower volatility. My view is that these fund types will continue to disappoint the majority of private investors.

Volatility in the stock market is not be to feared. It is the nature of markets to be volatile. We must remember that volatility is not the same as risk. Trying to eliminate volatility while seeking equity-like returns, by buying guaranteed products or hedge (absolute return) funds, is fool's gold. It does not exist.

Ardle Culleton
30th August 2012