In our previous article, “ Wealth Management – 10 Truths”, we wrote about the risks of managing portfolios with fewer than 30 single stock holdings. As a memory refresher, there is every likelihood that a portfolio with a small number of bets will not be sufficiently diversified. In layman’s terms a single event or risk factor could inflict disproportionate damage to even the most carefully selected narrow portfolio. With the daily implosion of the Deutsche Bank share price this writer has been experiencing flashbacks of a common feature of retail investor portfolios, specifically holding too many companies in a portfolio which are dependent on the use of other people’s money. If that sounds like a rather broad or vague description of a business please be warned that it is entirely deliberate.
A former boss of mine when building a very successful fund management business used to use this phrase “use of other people’s money” as a key risk filter in his investment process. His thinking was that companies which relied on other people’s money could experience terminal damage if one day people suddenly stopped providing additional funds or even worse, wanted the immediate return of funds already provided. Our memory banks should still recall the credit crisis of 2008/2009 but that use of “credit” is possibly too narrow a term; the Chernobyl moment for the financial system was a meltdown in liquidity. In a nutshell, the normal transmission system of monies between financial institutions froze as fear dominated and thousands of banking entities tried to hoard capital. Unfortunately, banks were not the only entities whose everyday need for funds was critical. The credit freeze wrought havoc across a vast swathe of commercial franchises dependent on funding for their operations or the survival of their balance sheets. Hence, our earlier use of a broad descriptor for companies at risk and how that might be very relevant to retail investors today.
We already mentioned Deutsche Bank(DBK) but it would be a mistake to believe that the absence of DBK in your portfolio means you need not read any further. Bluntly, if one of Europe’s largest banking asset pools is valued at less than 20% of its book value then there is a real possibility of some seriously disturbing headlines about that book to come. It would also be a mistake to think this is just a DBK problem. The worry signal for this writer is that the market value of Europe’s top 8 banks is approximately equal to that of JP Morgan with a fraction of the European bank assets ie. the market is signalling significant “issues” in the European banking system. Take your pick from the following:
- Italy has a massive debt problem which has not been dealt with in the QE era. Now political rumblings of a parallel currency (the Mini-BOT) could put Brexit in the little league of EU break-up threats.
- Interest rates at new lows in Europe(record lows in Germany) make it impossible for banks to make any significant profits plus a potential growth slow down which would bring asset impairment pain.
- Europe is, in fact, the largest trading bloc on the planet. It is the economic region most exposed to global trade and…. Trade Wars.
- Brexit… say no more or Boris.
- Lastly, and keeping with a Chernobyl theme, there is a worrying lack of reassurance about DBK’s $50 trillion(yes that’s trillion) derivatives book. Warren Buffett once called derivatives as weapons of mass destruction (WMD) and a quick check of unexplained losses at DBK in recent years does coincide with a Kremlin-esque silence from Frankfurt. The leakage of profits has been remorseless as €30 billion of caputal raised since 2010 has ended up with a bank valued at just €12 billion.
The problem for retail investors with small numbers of holdings is that the absence of banks in a portfolio may not insure against lasting damage. Remember those companies who need other people’s money? Well then it might be worth checking the portfolio for the following kinds of companies:
- Companies involved in insurance – think assets and liabilities not matching suddenly.
- Companies with too much leverage/debt – way more than 2009!
- Companies involved in real estate – global real estate at record highs and 2008 a distant memory…
- Companies who service banks and insurance companies – fintech is hot, until it’s not?
This writer’s experience of retail investor portfolios is that the vast majority of portfolios are far more exposed to liquidity/credit risk than appearances would suggest. It might be worth a re-check of the portfolio and identify exactly how many holdings use other people’s money or provide services to same. As my old boss used to also say “ I love investing in companies who don’t need my money”. Think food, beverages, petfood, razor blades, pizzas and toothbrushes. Then think about the difference between debt and equity and know the event risks associated with the former. Conversely, providing equity to a company selling goods/services on an everyday basis with little need of ongoing debt/liquidity facilities can be a fantastic wealth creator over time and over sudden liquidity shocks.
For those looking at the long term, equity crowdfunding is a great way to diversify a portfolio and find franchises whose business models are less reliant on a creaking banking system and the kindness of strangers.
“Every lie we tell incurs a debt to the truth” – Chernobyl: episode 1 – May 2019.