Adapting to the financial evolution

While some companies are struggling to survive in this new financial environment, others are thriving. In these uncertain markets, investors should take heed of two factors: risk and quality.

Evolution is not always a gradual process. Sometimes, evolutionary advance occurs suddenly, in response to external disruptions: an asteroid crashes into the earth, the dinosaurs are wiped out, mammals take their place. This time last year, an asteroid hit the financial system in the shape of the bankruptcy of Lehman Brothers. Overnight, the world changed.

The Dow Jones Industrial Average plummeted, falling by 504 points. Because it was exposed to Lehmans’ debt, the Reserve Primary Fund – a money market fund – lowered its share price below $1, breaking the buck. Panic ensued, triggering a run on money market funds and financial institutions. Credit markets closed. The limitations of some of Wall Street’s favoured risk management systems were exposed.

Lacking insurance from AIG, container ships remained in port and the global flow of goods dried up.

Those companies and investors able to adapt to this frightening new environment survived. For others, including the bulge-bracket banks of Wall Street, it was what palaeontologists term an “extinction event”.

A year on and several closely-watched indicators have returned to more normal levels. The so-called “fear gauge”, the Vix, has fallen from the elevated levels of a year ago; credit markets are open for business again; commodity prices have risen; goods and capital are both flowing freely through the arteries of the global economy.

So, has normality been restored? Not quite. Banks are lending again, but at much reduced levels. The economic environment and investment landscape has changed almost beyond recognition. Some old friends (Woolworth’s, Bradford & Bingley) are no longer with us, while others (General Motors, Citigroup) limp on in a diminished form. But while some companies are struggling to survive in this environment, others are thriving.

While the wider market and economic environment remains in flux, a number of fundamental truths have remained constant. For investors, successful adaptation has meant learning – or, in some cases re-learning – two lessons.

First, is the importance, and limitations, of risk controls. The chaos that followed the collapse of Lehman Brothers demonstrated that there is no silver bullet when it comes to managing risk – no single metric can adequately describe the risks to which investors expose themselves. In particular, the tumult that followed Lehmans’ failure highlighted the dangers of over-relying on value-at-risk (VAR) calculations – a measure of a portfolio’s (or an institution’s) potential losses. While VAR is good at predicting small day-to-day losses in the normal part of the risk distribution curve, last September showed that it does not function well in extreme conditions. VAR has its uses, but investors should be wary of placing too much faith in any single measure of risk.

Instead, measures such as VAR are just one of a suite of tools that investors can use to think about the risks they are taking. This year has shown that the information produced by quantitative tools such as VAR is most effective when it is filtered through the lens of peer-group discussion, judgement and – most importantly – years of experience.

The second lesson is that quality matters. In the years that led up to the credit crunch, some investors urged companies to concentrate on maximising short-term returns, sometimes at the expense of balance sheet strength. A pervasive mood of optimism and overconfidence made holding cash seem an unprofitable anachronism. That changed when Lehmans collapsed. With banks no longer lending and credit markets frozen, the attractions of investing in companies able to finance their own operations became clear. As markets fell, high quality stocks held up better than their peers. Of course, lower-quality stocks have had a good run in recent months. Over the longer term, however, the market seems likely to retain its renewed appreciation of high quality stocks. When the banks start lending again, they will lend to those with strong brands and market positions, dependable cashflows and, above all, strong balance sheets.

As the memory of the grim events of last September fades, keeping these two lessons in mind will stand investors in good stead. And there are reasons to look ahead with cautious optimism. Huge volumes of cash remain parked in money market funds. The meagre returns on cash will, at some point, prompt investors to seek higher returns offered by equities. And while markets may not look attractive on a price/earnings basis, measures of book value suggest that stocks may be reasonably priced.

Despite those encouraging signs, it is necessary to offer a few words of caution. The world has pulled back from the brink of the financial abyss, but only thanks to vast fiscal and monetary stimulus. The public sector’s balance sheet has expanded to an unprecedented degree, and it remains unclear what the long-term consequences will be. The future path for prices, exchange rates and asset markets is uncertain.

What does seem certain, however, is that the eventual unwinding of that public debt and the end of quantitative easing will transform the economic and investment landscape once again. Investors who have taken the lessons of the past year to heart will not only survive in this new environment, but prosper.