What the coronavirus has taught us about investing
We are in a genuinely uncertain situation. It’s rare that market participants have to not only deal with financial uncertainty but their own mortality at the same time. This probably hasn’t occurred since WW2 when blitzkriegs were the norm in Europe. Since we’re sure you’ve been inundated with coronavirus related news and financial pieces, we will keep this one simple. Just our observations and what we’ve learned about investing through this process. We hope it helps you augment your investment strategy over the next several months and in the future.
What we’ve learned/re-learned about investing during this period:
1) Leverage is becoming lethal: We’ve never been huge fans of leverage, and any of our clients know the first thing we recommend in any portfolio is restricting, lowering, or down-right cutting leverage (especially if assets and liabilities are mismatched!). The velocity and ferocity of this market has reinforced why we are so careful with it. Margin calls have obliterated portfolios because as asset prices dive, investors find that their liabilities don’t follow in tandem, which creates a recipe for mass wealth destruction. In full honesty, we have been okay with clients having a 0.3-0.5 debt/equity ratio, but going forward we may have to reconsider this.
2) Always know what your upcoming liabilities are and plan for it: For most of us, we have a regular stream of outgoing cash for expenses, but every so often we have a huge lump sum (tax, ballooning mortgage payment, etc) due. Make sure you are hyperaware of these and always have cash at the ready for them. One way we’ve seen this manifest is clients with large Private Equity liabilities. Do expect that when prices are depressed, private equity funds will call for more committed capital (they wouldn’t be doing their job if they didn’t!). Most banks don’t offer leverage against private equity assets, so this puts you in an even more precarious position in a market like this. If you don’t have the cash at the ready, you will not be able to borrow against the private equity asset. Further, you’ll find if you try to borrow against your other assets at current depressed prices, you may not have enough margin thus perversely triggering a margin call when banks liquidate assets to honour the private equity capital call. Luckily we’ve managed this for our clients very well, and that has kept us at relative peace.
3) Don’t assume liquidity will be there: This is for all the fixed income investors. Market participants assumed that in a pinch (for cash needs or to pay down leverage) they could sell their bonds. The illiquidity in the market has shocked investors as even investment grade bonds bid-offer spreads quote 10 points wide. High yield bonds have seen 30-40 point moves in a single day! Considering the risk/reward investors might as well have bought equity. Going forward don’t assume all assets will be liquid just because they were in good times, and always remember the old Mark Twain quote “It's not what you don't know that kills you, it's what you know for sure that ain't true."
4) There is no appropriate length of time to hold an asset you don’t know well/aren’t comfortable with: We signed on a client literally 1 week before the market tanked (we never claimed to be good at timing) and the client had a number of assets we didn’t like. While we recommended the client remove 50% of those assets immediately, we held on to the rest. This was foolish; we knew they were weak assets and not ones we wanted the client holding over the long-term, but didn’t sell in case markets bounced. The market did not forgive our “thumb-sucking”. We eventually sold the entire position, but at a much lower value.
5) Make sure you have the right clients: This is for anyone managing/advising money. This is a very stressful period even for the most serious investors (heck even Warren Buffet said that the virus situation was “scary stuff” – although he’s probably getting through it by hugging Berkshire’s enormous cash pile), so its very important to bring on the right clients who keep a cool head with the long-term in view. If your clients are freaking out, you’re going to freak out too, and give into fear. We can honestly say we have phenomenal clients, during this period we received plenty of calls on strategy but not a single one due to panic. While we are unsure if our clients have chosen the right investment advisor, we are 100% sure we have chosen the right clients.
Our general observations about the ongoing situation:
1) Stay-at-home notices/lockdowns: While we’re supportive of lock-down measures, travel bans, and social distancing and hope that this coordinated global effort over the next 30-60 days or so brings down the rate of infection, we don’t think it will be practical in the long-run. While the economic impact will be severe, we’re not talking about just that. We feel humans will struggle to stay indoors. As a species we’ve only been majorly indoors for a relatively short part of our history. In fact, in ancient Greece, people (especially men) spent a maximum of 20-30 mins of non-sleeping time in their homes[1]. In the end we suspect a Singapore type model might be more appropriate where life continues but in a more restricted manner with aggressive temperature checking, large gatherings cancelled, common-sense hygiene practiced, and where mild cases of the virus (which is 80-90% of them) are treated at home with medication and self-quarantine.
2) Market Volatility: A lot of the sharp moves down we have seen recently have been driven by margin calls. We have heard from private bankers that they've had to sell client's portfolios at poor prices because clients were over-leveraged and couldn't meet the margin requirements. Further, reports from our network in the US tells us that the same is happening with funds who have to maintain certain volatility thresholds, and are following the rule "If it has a bid, sell it". This implies that a lot of the decline is not fundamentally driven but technical, which would mean that once the initial margin calls are clear the market volatility should decline (although that doesn't mean the market will go back up).
3) The bottom: We don’t know where the bottom is, but as long-term investors there comes a time that if you’re not buying at bargain prices you’re not doing your job. We don’t know exactly when that time is, but we can say with certainty we’re closer to that point now than we were two weeks ago.
4) Going forward: Ok this one is a bit of a prediction (which in general we don’t like making), but while the current situation is very uncertain, we take comfort in the fact that every major obstacle mankind has faced has been overcome. We take comfort by the global coordination to stop this invisible enemy and the huge progress in vaccines. We will overcome this.
That’s all for us this week. If you want to chat about your portfolio, you know where to find us! Stay safe out there, and as usual happy investing!
[1] Weiner, Eric “The Geography of Genius”