There is a lot of panic out there at the moment.
People who invested large portions of their portfolio in the stock market have taken a real beating.
It is times like these that provide an expensive education for those who have forgotten or never knew some of the golden rules of investment:
- Never keep a significant majority of your investments in the stock market (I don’t care what your age is either, no young person who has lost half their portfolio is getting it back any time soon);
- Always adequately diversify your portfolio;
- Don’t invest in things that you don’t understand;
- Don’t invest in companies that have high debt levels;
- Don’t invest in companies that have only been listed for a short period of time (anything less than 10-12 years);
- The great Ben Graham advised not to pay more than 15 times the last three year’s average earnings – this is very sensible advice and those who stuck to it are now experiencing far less pain than most;
- Don’t borrow money to invest in stocks;
- There is nothing new under the Sun. The laws of finance were laid down a very long time ago and there is no one who has ever managed to change those laws (even if it looked like they had temporarily);
- No one cares more about your money than you do. Many are now seeing the folly of entrusting their savings to people who had less expertise (and far less care) in investing their money than they would have had;
- The media will be most enthusiastic about the stock market when it’s the worst time to buy and most pessimistic when stock markets have fully priced in the worst possible scenario.
Now, I just want to pick up on those last three points.
There is nothing new under the Sun
Nearly all large corporate collapses follow a similar path:
1. Those running the company have some initial success;
2. Their initial success attracts followers;
3. This following allows the company to raise debt and equity during good economic times;
4. The company expands aggressively using debt to overpay for assets at the height of the cycle;
5. The economy turns down, conditions change;
6. Debt cannot be repaid or refinanced;
7. The company collapses.
In the 1990-91 downturn we saw companies like Adsteam, Qintex, Bond Corp, Rothwells and many others collapse. Fast forward to 2008 and we can substitute: Allco, MFS, Babcock & Brown, ABC learning, Centro and a number of listed property trusts. These companies and trusts may have had different businesses, but there was practically no difference in the modus operandi of any of them.
The above steps to corporate collapse could be circumvented by either the lenders to these companies or their auditors (in cases where the financial statements provided by the companies clearly misrepresented the true financial position of the company). However, there was no resistance on these fronts.
At the height of any boom the banks are more than willing to indulge in all sorts of imprudent lending practices. They just never learn. And rest assured, they will repeat this folly in the decades to come once the memories of 2008 fade.
Auditors are the accomplices of banks. Auditors were willing to state that the relevant company’s reported financial position was “true and fair” (when it was anything but that). As long as they can extract exorbitant fees from the client, they are happy. If they end up being sued (as they always do), they have professional indemnity insurance to take care of most of the costs.
No one cares more about your money than you do
A cursory glance at the balance sheets of most failed companies (in cases where the audit had actually been done properly) would have revealed high levels of interest bearing debt in relation to tangible equity - danger sign number one.
Further, most failed companies have very short histories as listed companies - danger sign number two. This is always a danger sign because these companies had never been through a bear market (and all that it brings).
The point I would like to make here is that private companies cannot come under attack from short sellers, they do not have hundreds (or thousands) of people scrutinizing their accounts looking for vulnerabilities and they are not subject to having their “values” gyrate widely as those trading the shares are gripped by fear or greed. These are the reasons why a listed company is different to a private company.
All of these companies had business models that were predicated on boom times continuing indefinitely - danger sign number three.
Did those buying shares (or those recommending others buy shares) in companies like Allco, MFS and Babcock & Brown actually understand how those companies made money? Danger sign number four.
These danger signs didn’t worry many financial advisors and stockbrokers – they thought these companies were great investments and bought them aggressively for their clients.
Clients now realize that they were paying for “expert” advice, but there was no expertise evident in the advice that they received, in fact the opposite could be said. Does the client get his money back? You know the answer (and it can’t be described as anything other than criminal).
I cannot emphasize it enough, you just have to do your own research - no one cares more about your money than you do.
The Media
Following are some excerpts from an article written by one of Australia’s most respected business commentators in December 2007:
“My prediction for 2008 is that the global economy will muddle through America’s problems with sub-prime mortgage defaults, and that the share market will likely produce another year of double-digit returns.”
VERDICT: WRONG. MARKETS HAVE “RETURNED” NEGATIVE 50% OR SO.
“The housing collapse has been going for two years and has not sent the US economy into recession – indeed the data is suggesting that the fourth quarter of 2007 may be the low point in the economic cycle.”
VERDICT: WRONG. THERE WAS STILL A LONG WAY TO GO.
“There is no real evidence at this stage that the losses from the sub-prime crisis will be any greater than those from the savings & loan crisis of the late 1980s – that is, 2.5% of US GDP ($US350 billion or so).”
VERDICT: WRONG. LOSSES ARE NOW FAR IN EXCESS OF $US350 BILLION.
“In fact, the reaction to the sub-prime crisis in lending to corporations at this stage is nowhere near the degree of tightening that occurred in 2000-01 and led to a recession in the second half of 2001.”
VERDICT: WRONG. THE DEGREE OF TIGHTENING IN 2008 IS GREATER THAN THAT OF 2000-01.
“My own portfolio has about 10% cash at present and I am comfortable with that.”
VERDICT: HE MUST HAVE LOST AN ENORMOUS AMOUNT OF MONEY!
ADDITIONAL COMMENT: WE WERE ALREADY 5 MONTHS INTO THE CREDIT CRISIS WHEN HE MADE THESE COMMENTS!
I reproduced the above excerpts to show than even revered commentators have no predictive ability whatsoever. (Incidentally, the same individual was scaring the living daylights out of people by mid 2008 with all sorts of doomsday scenarios – what a pity he didn’t do that in December 2007.)
Our friend above was not alone with regard to his forecasts and I could have picked any number of ridiculously optimistic predictions for 2008 that appeared on respected web sites and also in newspapers. It’s the old story of looking at the recent past and extrapolating it into the future – a technique certain to lose you money over time.
Moral of the story: Don’t believe media commentators - they don’t get it right. Journalists are just that – journalists.
Take your cues from highly successful investors with long track records. They know far more than media commentators, economists or newsletter writers. And yes, they don’t tell you what they are doing each week, but they do occasionally grant interviews or write articles or comment in publicly available reports and some have even written the odd book – listen to what they say.
