Only “boring” investors who presciently owned government bonds or “lucky” shorts who had short sold everything else registered positive returns.
Equities (both developed and emerging market), residential and commercial property, credit investments and commodities all fell sharply in value. Defensive assets (traditional widows and orphans stocks and high quality corporate bonds) fell. Alternative assets (private equity and hedge funds) that were meant to perform differently to other asset classes and diversify investment portfolios also fell.
Volatility reached astonishing levels. Correlation between asset classes hovered close to one as all prices moved in unison mimicking gold medal winning synchronized divers. An investment in a Zambian copper mine behaved almost identically to a bond issued by a high quality corporation in Scandinavia.
What the “geeks bearing Greeks” and their quantitative investment models, risk analysis and trading strategies made of all this is unknown.
Fundamentals of value were largely irrelevant as the ‘great de-leveraging’ (surely the financial word of 2008) dominated. In recent years, cheap and abundant money (mainly borrowed) drove up the value of other assets. As the debt in the financial system was reduced, money became scarce and expensive triggering a sharp fall in asset prices. Anybody who had borrowed to purchase financial assets had to stump up margins or were forced to sell to reduce debt.
A shortage of buyers and lack of available liquidity meant that generally selling risky assets was nigh impossible. The marginal seller, usually distressed, and the cash rich buyer, increasingly scarce, set market prices. Central banks and governments, depending on the plan du jour to save the world, were “buyers of last resort”.
The process is far from complete. Many hedge funds took refuge behind “gates” – the new buzzword for suspending redemptions - putting off liquidating positions. The hope was that markets would miraculously improve in the New Year (I think it was 2009 that they were referring to but am not sure!).
Investment logic undeniably changed. Any business model based on availability of cheap and abundant debt, such as private equity or hedge funds, is now questionable. Anybody with major amounts of debt to refinance in the immediate future or any other financial cash calls (such as margin calls on credit downgrades) is carefully scrutinized.
In recent years, the value of real and financial assets were driven by a combination of higher earnings from the “great moderation” (strong economic growth and low interest rates) and an expansion of price earning multiples.
During this period, earnings also became “financialised”. Companies relied on financial engineering to boost earnings. Industrial companies boosted profits by financing purchases of their products, acquiring, merging and de-merging, borrowing to share buybacks, or trading in financial instruments. Financial sector profits rose to around 30-40% of total corporate profitability.
Prices reflected high termination or resale values; that is a ‘greater fool’ with even greater leverage would come along and buy whatever the investor had bought at an even higher price. This reflected the “leveraged” bid (from private equity, hedge funds and share buybacks) and financial engineering. All this now is a distant and fond memory that is unlikely to return until collective memory fades and scar tissue heals.
Investors are now focused on cash flows (income or dividends) from the investment. Capital gains have joined the list of endangered species. Prices must equate to the cash flows discounted back at capitalisation rates factoring in much higher costs of capital. Valuation fundamentals, that Benjamin Graham would have recognised, are once again fashionable.
Some of this is already in the price. Nobody knows whether assumed earnings sufficiently factor in the low growth environment ahead or whether the higher costs of capital have been incorporated.
A change in investment patterns favouring debt over equity is likely. Current credit margins are pricing in very high levels of default on high quality debt. Abundance of cheap debt drove down debt margins boosting equity returns. As credit margins increase there is a transfer of value from equity to debt. Potential equity raisings and asset sales as companies de-leverage also increase the risk of dilution of equity returns.
The form of investment may also change. Investors want to get as close to the cash flows as possible and avoid complex investment structures. Leveraged investment vehicles are out of fashion. Absolute rather than relative returns will be sought.
Management of the “liability” side of funds, specifically redemption risk, is increasingly important. Investors will be wary of the risk of value erosion in pooled investment structures (such as mutual funds and unit trusts). In 2008, unrelated redemption pressures drove down values of pooled investment and absorbed scarce liquidity. Closed end funds and self liquidating structures may become the new new thing.
Fund manager’s fees will be under pressure. A fee of 1% plus management expenses of 1% for a fund where the returns are negative will not pass muster. The hedge fund standard 2% and 20% of performance will only be acceptable for exceptional managers with a long history of high and stable returns (like Mr. Bernard Madoff) or where the performance fee is paid on realised returns.
We are, of course, in a “new paradigm”. Investors will need to adjust their expectations. The new investment mantras may well be:
1. Flat is the new up. 2. Debt is the new equity. 3. Dividends are the only return. 4. If you’re looking for the bottom of the market there’s a special offer - buy one you get the next one free.
The best investment story of 2008 relates to a banker who had a modest shareholding in his employer – a storied investment bank. Upon being transferred to London, he sold the stock to finance a Range Rover. As business in London turned down, the banker was transferred to Dubai.
When selling his Range Rover, he suffered a loss of around 50% of the price he paid barely six month ago. The interesting thing was that the proceeds from the sale of the car (despite the 50% loss) would have allowed the banker to purchase five times the number of shares he sold to finance the car. 2008 is perhaps the only year on record in which a distressed price for a Range Rover outperformed equities.
In Iceland, where there is an oversupply of Range Rovers as the economic good time ended, the cars are now known as “Game Overs”. For investors 2008 was also a case of game over.
Look back in horror!
© 2009 Satyajit Das
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).