Lesson one:
Having completed a mechanical engineering degree, I chose the natural career path in finance and started with JP Morgan in August 1987. To help raise the deposit for my first flat in London, I sold all of the small parcels of shares that I had acquired throughout the Thatcher era privatisations.
I sold those shares to my father. Two months later, in October 1987, we had Black Monday and the stock market crash.
While it was personally fortuitous to exit my economic exposure to equities, it was a decision my father continues to remind me of to this day. My subsequent highly leveraged exposure to the property market didn’t play out as well as I had hoped.
As such, lesson one is that markets are extremely difficult to time.
Lesson two:
I founded Phoenix Portfolios in 2006, just in time to fully establish ourselves for the GFC. To say those first few years were volatile would be an understatement!
Our first institutional client funded us in December 2006 with a $34 million mandate to invest in Australian property securities. Over the subsequent 22 months, we received a further $2 million of inflows, and along with market appreciation, the portfolio’s value reached $42.6 million by October 2007. Life was good.
Between October 2007 and March 2009, we received a further $1.8 million of inflows. However, by March 2009, the listed property sector had fallen 75 per cent.
The value of the mandate dipped under $10 million. We didn’t just go down with the market, we managed to do a little bit worse.
The story does have a better next chapter. Timing the upturn is often just as difficult as timing the downturn. The client still remains a client. Net inflows into that portfolio since March 2009 to date are close to zero, but the portfolio value has moved from just under $10 million to just over $70 million today.
Markets are volatile, and timing is difficult, so lesson two is don’t forget lesson one.
Lesson three:
The GFC was all about debt. The below graph shows the increase in spread costs for three and 10-year money for an A-Rated corporate borrower assuming, of course, that you could even secure a refinance.
The GFC was really a debt crisis, and property securities suffered on many fronts:
- Too much debt going into it;
- Too much concentration in debt providers;
- Too much concentration in debt maturity; and
- Falling asset values, which made gearing get worse.
There is nothing wrong with using debt as part of a capital structure. However, it is important to understand debt and manage the risks associated with the debt.
Today, property securities provide much more disclosure with respect to the mix of different types of debt and tenure they have, so we can see how they are managing the risk. The average level of gearing (debt to assets) is also around 30 per cent, materially lower than a decade ago.
Therefore, lesson three is debt has covenants – debt matures, and as such, debt levels and diversification matter.
Lesson four:
While we all like to think of ourselves as ‘investors’, what makes up a large part of our time is really ‘risk management’. Debt is one aspect of this, but there are many other factors to consider when making investment decisions.
Investing is about really understanding the nature of the business of the stocks in which we invest, in order to understand the risks they will encounter and to estimate the sensitivities around the assumptions we make in determining a valuation.
Sometimes, we will get assumptions wrong – so we need to have some idea how bad things might get under various scenarios. Can our stocks ride out a storm, or might they be forced to liquidate at the worst possible time? Importantly, it’s about risk management, not risk avoidance.
If you avoid risk, you will get the risk-free return (minus fees). However, if you successfully understand and are therefore able to manage risk, you will deliver a risk adjusted return, which over the long term should be higher.
Lesson four is, simply, understand your risk.
Lesson five:
Understanding and managing risk applies whether you are investing in stocks directly, or investing in a Managed Investment Scheme. So, from your perspective, when you buy units in any MIS, you need to understand how that fund is going to be managed, and what to expect under various scenarios.
We spend a lot of time trying to make sure our investors understand how we manage their money, because we believe that knowledge will empower them to either partner with us over the long term, or to take their money to a manager whose style is a better fit with their own.
Our investment style may not suit everyone. It is obviously better to know upfront and make an informed decision than to make knee-jerk reactions to unpleasant or surprising outcomes.
Our first wholesale client that I discussed earlier has a very clear understanding of how we invest, and what type of outcomes are likely under various scenarios. That knowledge would no doubt have contributed to their confidence to ride out the GFC, and ultimately deliver a much better long-term outcome for their clients.
Lesson five is to understand the investment process.
Lesson 6:
There is nothing like a major market disruption to help identify weaknesses in investments or business models. As Warren Buffet says, “only when the tide goes out do you discover who has been swimming naked.”
Are the people who are making decisions with our capital motivated appropriately? Are their interests aligned with ours? Do they have skin in the game? Will they put shareholders first?
At the bottom of the GFC, Australia’s oldest REIT, GPT, under pressure from the banks, raised equity to repay debt. They conducted a one-for-one issue in October 2008, which doubled the shares on issue. This was followed by another one-for-one issue in May 2009, which doubled the shares on issue again.
The incoming CEO took a very conservative stance to keep his bankers happy, but at the expense of any shareholder who may have been unable to participate.
If there is one single lesson I would take from the GFC, it is this one: the governance structure and alignment of interest is really important, particularly over longer timeframes.
Lesson six is the most important lesson: Governance really matters!
Conclusion
The GFC taught us a number of lessons we continue to apply today. It’s not easy to forecast markets. It’s also important to understand risk, the investment process and, most importantly, the governance structure of the business you are investing in. These are all things you can research, and can make a big difference in the long run.
Stuart Cartledge, managing director, Phoenix Portfolios
