What experience tells us about investing and risk
Personal experience goes a long way in influencing our behaviours, especially if those experiences are engrained over a long period of time.
My grandfather was born in 1913 in Melbourne, Australia. His teens coincided with the Great Depression of the late 1920s and early 1930s, a time when Australian wool and wheat exports suffered from a collapse in international demand and unemployment soared.
Such a prolonged event had a significant impact on his psyche and attitude towards risk throughout the rest of his life. It even extended to counselling his children. When my grandfather asked my father about his university intentions and likely future career, dad ventured that he was keen to study engineering. The career choice was quickly shut down as “too cyclical”. The same went for becoming a solicitor. Only when my father, who later became a surgeon, alighted on medicine was he given the green light, with the words “there will always be sick people”.
My mother has always had a positive view on property as an investment class. Her views were shaped by her positive experiences with buying a house and a flat in the 1980s and 1990s.
These were two people separated by decades with very different experiences and thus attitudes to risk. It will be interesting to see if there is a lasting change in attitudes towards risk, both financial and personal, as we emerge from the pandemic. I suspect any changes to attitude will be influenced by length of time it takes economies and people to recover, and the severity of the downturn in the meantime.
In its simplest form, the term ‘risk’ can be explained as the probability that an event occurs and what stands to be lost should that event occur. For the vast majority of time, the outcomes of events are very predictable. The problems occur in the ‘tails’. These are the extreme events. The events that occur very infrequently, but have a big impact.
For businesses the coronavirus is a so-called ‘known unknown’. But pandemics aren’t new. The World Health Organization lists four influenza pandemics over the last century and specifically listed an influenza pandemic among its own list of Ten threats to global health in 2019, which stated that “the world will face another influenza pandemic – the only thing we don’t know is when it will hit and how severe it will be”1 .
That’s the thing with risk, we are often blind to the actual size of any potential threat. As financial journalist Michael Lewis wrote in his recent book The Fifth Risk: “People are really good at responding to the crisis that just happened, as they naturally imagine whatever just happened is most likely to happen again. They are less good at imagining a crisis before it happens – and taking action to prevent it.”2
In most annual reports you will find a section called ‘Principle Risks and Uncertainties’. This chapter details the main risks that management sees to the successful implementation of its business plan. Usually it is a smorgasbord of threats which include internal issues such as industrial action or loss of contracts. External threats typically include cyber breaches, a heightened competitive environment and adverse government regulation.
It is worth looking at this section to see which risks are explicitly identified (and maybe thinking about some that aren’t). Most of the risks highlighted are based on occurrences that have happened to the company or to its competitors. This section does not tend to quantify the severity of the risks faced, however, it probably would not be imprudent to assume that any forecasts would be based on historical precedent.
The impact of previous pandemics
The airline industry is no stranger to exogenous risks whether they be volcanic eruptions, terrorism or airborne diseases. Numerous companies identify influenza, Severe Acute Respiratory Syndrome (SARS) and Middle Eastern Respiratory Syndrome (MERS) as potential risks. SARS and MERS had appreciably higher mortality rates than COVID-19 but were stamped out relatively quickly by prompt government action. SARS predominantly affected Asian airline travel in 2003 but had little lasting impact on European demand.
It is noticeable how much better the Asian countries have dealt with COVID-19. Maybe our lack of preparedness in the West partly stems from the fact that we haven’t had to deal with recent pandemics of sufficient severity to put in place contingency plans? After all, it is very difficult to plan for conditions you haven’t experienced.
Our most recent experience with a pandemic was the H1N1 influenza pandemic in 2009. Compared to the better known and deadly 1918 Spanish Flu pandemic, which is estimated to have killed around 50 million people3 , the 2009 version was much less severe but still resulted in some 350,000 deaths globally. Looking at passenger data from the International Air Transport Association (IATA), global passenger traffic fell just 2.4% during 2003 despite the confluence of SARS and the war in Iraq.
The 2009 financial crisis, which coincided with the H1N1 flu pandemic, had a bigger impact on demand, with the air passenger demand experiencing “the largest ever post-war decline of 3.5%” according to IATA. Current forecasts for global passenger traffic (as of 29 September 2020) estimate a decline of 66% in 2020. This fall in global demand is nearly 20 times greater than has ever been experienced for the whole industry. Truly a tail risk and it is unsurprising that a number of airlines have gone out of business or will be saddled with huge amounts of debt for years to come.4
Assessing risk: What might be gained, or lost
Just as important as an event’s probability is the consequence of the event: What stands to be gained or lost.
If debt is added into the equation the outcome is magnified in both directions. A so-so acquisition in terms of returns can be juiced up by the addition of debt. Let’s suppose I buy a pub for £100,000 that makes £10,000 of profits before tax, funded 100% from my savings i.e. equity - the pre-tax return on my investment is 10% (£10,000 pre-tax profits / £100,000 equity).
Now suppose the deal is funded from £50,000 equity and taking out a £50,000 loan at an interest rate of 5%. The pre-tax profits fall by £2,500 to £7,500 due to the 5% annual interest charge on the £50,000 of debt. However, my pre-tax return on investment rises from 10% to 15% (£7,500 of pre-tax profits / £50,000 of equity). If I am optimistic about the pub’s prospects, or just that debt is plentiful and cheap, I could fund the deal with £25,000 equity and a £75,000 loan. My return on investment would rise to a very attractive 25%. What’s not to like?
Since the 2008/2009 crisis, central banks have flooded financial markets with liquidity. In the first couple of years after the crisis interest rates for corporate borrowers went up as lenders, who were scarred by defaults and short of capital, were able to charge more. As the recession receded and central banks kept policy rates low, the availability of debt improved. The rate at which credit worthy or investment grade companies could borrow in sterling fell from over 6% prior to the crisis to under 2.5% today.5
This fall in interest costs immediately increases the return to equity holders. Less interest paid means more profit for the equity holder. It’s not only creditworthy borrowers that have benefitted from falling interest rates. So-called leveraged loans to less credit-worthy entities have seen rapid growth over the last decade, fuelled by a step up in merger and acquisition and buy-out activities.
Microsoft’s founder Bill Gates has given many amazing things to the world, but in the wrong hands an Excel spreadsheet can become an instrument of financial destruction. In an instant, an acceptable financial return on my decision to buy the pub can be transformed, via the addition of a pile of debt and some optimistic assumptions, into something a lot more appealing. It ignores real life though; the rough that almost inevitably comes with the smooth.
Lenders (for the most part) aren’t stupid. They want to know they can be paid back. Company management and their advisors are required to model the “what if it gets bad” scenarios when taking on high levels of debt. As we have seen it is much more difficult to model the tails, the “what if it gets really, really bad” scenarios. How many highly indebted companies modelled a pandemic affecting their business? Very few, I would wager.
The roll call of companies bankrupted by excess debt throughout history is testament to the persuasive powers of mammon.
The dangers of debt
Severe economic downturns present difficult times for most companies and the coronavirus pandemic has exposed many companies carrying too much debt. Recessions force companies to scale back on expansion plans, control costs and conserve cash. Difficult decisions must be made about staff levels. Management has enough issues to deal with. However, add in the weight of a large debt pile and interest payments to a company that is struggling, and the situation quickly becomes toxic. We avoid companies with very high levels of debt for this reason. In tough situations debt ranks above equity in terms of seniority. Your return as an equity holder can be quickly wiped out, as the debt that made a deal look so attractive in the first place is swapped back into equity at the behest of the banks.
When the going gets tough investors tend to sell their most indebted companies first. Share prices of UK-listed companies falling 60%, 70%, and 80% are not uncommon this year. To the end of September, 52 constituents of the FTSE All Share, or one in 12 companies, had fallen 60% or more.6 Some have had bad luck to be in the sectors most affected by social restrictions and lockdowns. However, it is not a coincidence that amongst this list of worst performers are a large number of companies with high levels of debt.
It is worth remembering that a company whose share price has declined 80% needs to increase five times just to get back to where it started. We do not believe we need to take that risk with your money. That’s an arduous journey and one that we want to avoid as far as possible with our investors’ money. We hope that management teams eventually learn of the dangers of excessive debt, but history teaches us that unfortunately greed often trumps sensibility, especially when debt is cheap.
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