Investing lessons ten years on from the financial crisis
The financial crisis caused havoc across the globe, with central banks having to take extraordinary steps to rescue economies as the banking system ground to a halt, trade faltered and unemployment soared. Ten years on markets are buoyant, debt remains cheap and optimism runs high. What lessons can investors take from the crisis?
The financial crisis that started in 2007 and peaked in 2008 affected people across the globe. Its impact is still felt a decade later. For those who were working in the investments industry at the time, the crisis was an extraordinary event. Many fortunes made in the markets boom of the mid-2000’s were lost almost overnight, and the surest of asset classes were found to completely lack diversification as panic selling and no willing buyers drove asset prices down across the board.
I was working as a junior portfolio manager on an emerging markets fund at the time, and witnessed our portfolios losing more than 60% of their value and shedding over $1 billion in assets under management while we worked frantically behind the scenes to assess whether our structured product counterparties would stay solvent.
Ten years later, with financial disaster averted, or, depending on your viewpoint, just temporarily postponed, we briefly outline the main lessons learnt from that period.
1. Valuations matter
In the years before the financial crisis, vast amounts of money had surged into emerging markets. Valuations, as expressed by price-to-earning (P/E) ratios, exceeding those in developed markets for the first time. The story of good demographics, an emerging middle class, and a commodity supercycle was strong enough for investors to ignore weak corporate governance, questionable political regimes, and a supply-side response to high commodity prices which led to the development of alternative sources of energy.
Ten years on, income plays have been the asset class of choice with European High Yield bonds now offering a headline yield of just 1.8% (17 Aug 2017), down from 11% in 2011. Investors should tread carefully, once the quantitative easing (QE) spigot is eventually turned off, capital losses beckon.
2. Central banks still wield an enormous amount of power
The US Federal Reserve has for years had considerable influence on global economic conditions. In response to the dotcom crash interest rates were cut from 6.5% to 1%, and then Alan Greenspan famously raised US interest rates by 0.25% on 17 consecutive occasions between 2004 and 2006 to try and tame inflation. His critics, many using the benefit of hindsight, argue that he was too slow to react and created the conditions that caused the financial crash of 2007-2008. With interest rates still at rock bottom across much of the globe, a re-emergence of inflation and a sustained tightening cycle would have a big impact on the valuations of equity and credit markets. Underestimate central banks at your own peril.
3. Diversification works
Nobel Prize winner, Harry Markowitz, once described diversification as the only ‘free lunch’ in finance. This still holds true, whether it is having several equities (rather than one) to reduce your portfolio volatility or investing in a globally diversified portfolio. Owning assets which are not completely correlated to each other will reduce your portfolio volatility and drawdown in the next market shock.
In the last financial crisis long-dated government bonds protected the family silver, but in the next crisis, which could possibly be inflationary, or some other unknown danger, it may well be something else. Allocating a chunk of your wealth to a professional wealth manager greatly reduces the risk of having a dangerously one-sided asset allocation.
4. Ignore the optimists
If it looks too easy to make money, the easy money has already been made. Fear of missing out is something we all suffer from, and can lead us to make very poor decisions with our investing capital. Most ten year investment windows had asset classes or sectors, where it was easy to make money. Over the past 20 years, internet stocks, emerging markets, and gold were all flavour of month — until they weren’t. Giant tech stocks are now back in fashion, while private equity style investing (accompanied with a slick video clip) has been made readily accessible on crowdfunding platforms. Unfortunately it would appear that not much due diligence is being done on the underlying companies — caveat emptor.
5. Holding too much debt is dangerous
We see this time and time again. The majority of companies that go bankrupt do so because they have too much debt on the balance sheet and cannot pay their creditors when trading conditions weaken.
Along with banks, heavily indebted UK home builders were one of the most affected sectors of the financial crisis. The share price of Persimmon, a stalwart of the FTSE 100, fell by 85% in the two years to the end of 2008 as it struggled with a debt to equity ratio of 46 times. Like many other companies in the sector, it now is flush with cash (supported, for now at least, by the UK Government’s ‘help to buy’ scheme) and has no debt at all. Come the next crisis, sectors which have not transformed their balance sheets will feel the pain the most.
6. Do your own research
Conventional wisdom suggests that stock markets are broadly efficient, but on a frequent basis this is shown not to be the case in individual companies, where bargains can frequently be had. Companies and sectors which are priced virtually for bankruptcy can have the most remarkable turnaround in performance.
Investment Trusts and smaller cap stocks in particular have very sparse analyst coverage, with much of it being fairly bland output from the company broker, as large investors struggle to buy and sell meaningful positions. Having an edge in many different securities is very difficult (this is why fund managers struggle to consistently outperform with over 60 holdings), but it is possible for a diligent investor to develop a real expertise in a few of their best ideas from reading annual reports, listening to management calls and knowing company products better than the market as a whole.