5 Hard Lessons From 5 Cruel Years

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By

Malcolm Wheatley

Published in Investing on 13 August 2012

The credit crunch began five years ago. What have investors learned?

For many people, it was the run on Northern Rock in September 2007 that first brought the looming credit crunch -- and ensuing recession -- to their notice.

But the generally accepted 'official' start of the credit crunch was actually just over a month earlier -- 9 August, precisely five years ago, when French bank BNP Paribas prevented investors from taking money out of two funds that were heavily exposed to subprime-related investments.

And while it took several months for all the dominos to drop, the collapse of Lehman Bros, HBOS, and Bradford and Bingley -- not to mention the almost terminal implosions at many other financial institutions -- can be traced back to the events of August 2007.

So, five years on, what are the lessons for investors?

1) The story's changed -- but have the facts?

In a few short years, financial stocks had morphed from being dull and boring yield plays into a 'Masters of the Universe' investment thesis that was altogether racier. Thanks to an acquisition spree and lending largesse under go-getting ex-Sir Fred Goodwin, for instance, Royal Bank of Scotland (LSE: RBS) had become Europe's second-largest bank.

Far from being reviled, bankers were lauded as wealth-creators, rewarded with 'light touch' regulation, and seen as supermen -- with bonuses to match. As with former pipeline operator Enron, several years earlier, the boring had become brilliant, with a glitzy new business model to match. It couldn't last -- and it didn't.

2) Valuations matter

A rising tide lifts all boats, and propelled by a sea of cash, share prices rose faster than earnings -- much faster. On 15 June 2007, for instance, the FTSE 100 (UKX) closed at a lofty 6,732.

In its wake, huge numbers of shares had been carried along. Some sectors more than most, of course. A lot of that cheap cash and easy credit had gone into the construction industry, propelling shares such as Barratt Developments (LSE: BDEV) and Taylor Woodrow (LSE: TW) skywards.

Canny investors, we now know, had moved into cash, awaiting the return of genuine bargains. It takes nerve to go against the crowd, but that's how money is made.

3) Cash is king

Read any account of the credit crunch -- my own favourite is Andrew Ross Sorkin's Too Big To Fail -- and one lesson is crystal clear. And it's a lesson that holds true for investors, as well as the companies that they invest in. Hold too little cash, and you could be stuffed. Hold enough, and you can duly load up when bargains appear.

The directors of Lloyds Banking Group (LSE: LLOY) doubtless thought they were getting a bargain when they snapped up HBOS. As we now know, it was a poisoned chalice.

48 hours before Lehmans went bust, Barclays (LSE: BARC) had come close to buying all of it -- including its dodgy subprime portfolio. But post-bankruptcy, fast footwork and ready cash bought it the bit that it actually wanted: the Lehman 'broker dealer' operation.

4) Diversification matters

Lured by tasty-looking yields and the prospect of capital gains, many investors lost sight of the age-old wisdom of diversification. Many, for instance, convinced themselves that Royal Bank of Scotland was one sort of bank, and mortgage-centric Northern Rock quite another.

Today, equally alluring yields are on offer from RSA Insurance Group (LSE: RSA), Aviva (LSE: AV) and Admiral (LSE: ADM). Very different businesses, to be sure -- but all, at heart, insurers. Tempted? Tread with care.

5) Don't invest in what you don't understand

Mocked for less-than-stellar returns during the dotcom boom, Warren Buffett robustly defended himself, pointing out that he didn't invest in what he didn't understand. And as he didn't understand how many of the emerging dotcom businesses could make money, he wasn't going to invest in them.

That same wisdom would have served many investors well pre-credit crunch, as they poured money into funds and stocks that we now know were awash with subprime mortgages and over-priced construction projects. For those with eyes -- look at Michael Lewis' The Big Short, for instance -- the signs were there. As were the opportunities to profit.

And speaking of opportunities to profit, as we explain in a special free report from The Motley Fool -- The One UK Share Warren Buffett Loves -- Buffett himself has recently been loading-up on one particular out-of-favour share. What's more, it has a crystal-clear business model that amply passes his famous 'refrigerator test'.

British, with significant overseas operations (and profits), his holding in it now tops 5%. To discover its name, download the report. It's free, and can be in your inbox in seconds.

Want to learn more about shares, but not sure where to start? Download our latest guide -- "What Every New Investor Needs To Know" -- it's free. The Motley Fool is helping Britain invest. Better.

More investing ideas from Malcolm Wheatley:

> Malcolm owns shares in Lloyds Banking Group and Aviva. He does not have an interest in any other shares mentioned.

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ANuvver 13 Aug 2012 , 9:44pm

Oh TSCO again. Look guys, it was a mollified Ben Graham "if the company died tomorrow" asset play. It also put the Buffet halo over the business. If you want US exposure (a good idea IMHO) then why not just fill in your W8-BEN, buy BRK and have done. For most here, I suspect that wouldn't involve very much duplication.

Far more interesting to me is that WB recently reported an unusually high cash position. When someone like him thinks heffalump season is on the cards, I take note.

While we're talking about the Holy Fool (or one of them, at least) it's also interesting that he appears to be scaling back revenue expectations from his cash-cow insurance operations. From an ownership perspective that implies a bit of shine coming off the magic of free float (ie the business equivalent of "let me look after that fiver for you").

I reckon an analysis of BRK on those sort of lines would be of more interest than his perceived interest in Britain's banana habits, and the tedious anecdotals that inevitably result about how many cashiers were on rotation in Salop last Wednesday night...

goodlifer 13 Aug 2012 , 10:10pm

I wasn't a player in the game until the spring of 2009, and I find all this both puzzling and fascinating.

It seems to me that any mug could have made money during these last three years; and that the really dangerous times were those preceding the crunch.

I can't help thinking people who came unstuck must have hung onto shares which were hopelessly overvalued, and/or paid stupid prices for what they bought.

In other word they forgot the time-honoured basics of sensible investing

Is that too uncharitable?

As I've said, wasn't in the market at the time and if i've got it all wrong I'd dearly love to know why.

lootman 14 Aug 2012 , 10:24am

Anuvver,

Actually you don't even need to bother with a W8-BEN form for buying shares in BRK, as it has never paid a dividend, hence there would be no tax withholding anyway.

But you're absolutely right. If you want to buy what Buffett buys, then buy his company rather than second guess what he might buy or what you think he still holds.

MDW1954 14 Aug 2012 , 10:49am

If you want to buy what Buffett buys, then buy his company rather than second guess what he might buy or what you think he still holds.

Hello, lootman.

That's fine as far as it goes, but I'm surely not alone in wanting to limit my exposure to America. I have all the America I want at the moment, thanks, stuffed into a low-cost S&P500 tracker that has done the business very nicely.

For me -- and, I suspect, investors like me -- Buffett's UK holdings are of more interest than his American ones.

Malcolm (author)

paulgmoody 14 Aug 2012 , 10:52am

Well said ANuvver.

Like you I would appreciate analysis of what Warren Buffet is doing via Berkshire Hathaway than trying to avoid the same (overly worn) MF advertising mantra. Liking your point about BRK's revenue from insurance operations by the way.

Can't afford the BRK shares myself but considering drip feeding into JP Morgan North America IT (JAM) as an alternative for US exposure (it has Berkshire Hathaway, Apple and Exxon amongst its top ten holdings)

Paul

lootman 14 Aug 2012 , 11:04am

MDW,

Point taken, and I have a couple of super-cheap US ETF's myself, as well as a selection of direct US shareholdings.

But bear in mind that many of WB's core US holdings derive a significant amount of their earnings from outside the US. Coke, IBM, McDonalds all earn more overseas than in the US. And of course WB does venture overseas, not just with Tesco and Glaxo, but with Sanofi, PetroChina etc.

Also, BRK is very tax-efficient since, as a company rather than a fund, it doesn't have to distribute any earnings.

I think we both agree it's a great money-making machine. We might differ on exactly how to benefit from that.

lootman 14 Aug 2012 , 11:05am

Paul,

The A shares of BRK may be unaffordable but the B shares are about fifty quid each. They don't confer voting rights but do you really care about that?

ANuvver 14 Aug 2012 , 11:41am

lootman:

re your W8-BEN point, fair enough logically, but I reckon most brokers would require you to submit one before they unlock your access to *any* US assets.

BRK seems to me, in all but name, rather like a US-centred investment trust with diversified international income flows. WB's buyback mandate gives the baby Bs a pretty resilient floor around the mid $70s, but with the SP nudging $85, I'd like some weakness before buying. I don't see an immediate company-specific cause for a drop on the horizon, so it would have to be general US market weakness.

Malcolm:

Personally, I want a little more targetting out of US access than tracking the S&P, expecially in an environment of predominantly sideways markets. But I can understand, and respect, your choice. I'm not adverse to KISSing areas and sectors where I only have a broad strategic understanding and want to keep my time for those areas where I'm more comfortable.

ANuvver 14 Aug 2012 , 12:02pm

goodlifer:

Seems you were born under the sign of the bear, so to speak!
I rather agree with you generally - I was an aggressive buyer in 09 and in August last year. But then I was fortunate to be in a position to act that way.

One point to bear in mind is that it is, in some respects, harder and takes more courage to sell high than to buy low.

Most successful bulls have developed strict discipline so as to take money off the table when things seem to going well.

One of the subtlest dangers is that the justification of "well, I've got a handsome paper gain as a cushion" can lead to complacency, especially for those such as us, who call ourselves investors, rather than traders.

A hypothetical question for you: if you'd made 70odd% in three years, during a very challenging market, on a dividend-paying blue chip that is still robust and looks good going forward - would you topslice your position? (That's a real company, right now.)

Back to the top - I find it interesting that WB is so cash-heavy right now. Of course, he's looking to buy companies outright, but the stance seems highly significant to me. I have a significant pile of sponds on the sidelines myself right now (and no, I didn't do it because he did!) My watchlists are getting a lot of loving attention.

Events, dear boy, events!

paulgmoody 14 Aug 2012 , 12:07pm

lootman,

Good point. I'm not bothered about the voting rights so maybe I should wait, save a bit more and be patient for a little weakness in price. Thanks for the info.

Paul

ANuvver 14 Aug 2012 , 1:20pm

Paul:

Patience is one of the greatest advantages a private investor has.
The great man himself has been known to spend 5-10 years essentially doing nothing. He was watching all the time, of course...

BFTB 14 Aug 2012 , 1:44pm

Fellas,

How come the FTSE100 is so high right now? It's close to the top of its trading range in the last two years despite most stats over the last few months pointing down. Am sitting on a bit of cash and the old trigger finger is getting itchy. Is there going to be downswing sometime soon iyho or has the market at the current level got fundamental support?

jeff700 14 Aug 2012 , 2:02pm

Nobody's learnt anything, and it's a most tragic thing.

The ones with common sense are still doing what they were doing before 2007. Selling shares on the rallies- buying gold on the dips.

goodlifer 14 Aug 2012 , 3:09pm

BFTB
"Is there going to be downswing sometime soon iyho or has the market at the current level got fundamental support?"

Anyone who knows the answer to that one will soon be so rich it isn't even funny.

goodlifer 14 Aug 2012 , 3:43pm

ANuvver

"If you'd made 70 odd% in three years,..., on a dividend-paying blue chip that is still robust and looks good going forward - would you topslice your position? (That's a real company, right now.)"

I'd think about it very seriously.

In my seldom very humble opinion, it.s a rare share that's worth
more than about fifteen times earnings but there's no idiot-proof formula.

Just use your loaf and accept the possibility you may get it wrong.

ANuvver 14 Aug 2012 , 4:08pm

goodlifer:

BATS.

PS, humility is often overrrated. My father won the prize for humility, etc...

brightncheerful 14 Aug 2012 , 5:22pm

Amongst the times to buy is when they want your cash, not when you want to spend.

goodlifer 14 Aug 2012 , 8:00pm

Quick look at the numbers, and I'd probably hang on for now, but perhaps think again if they climbed to twenty or more tines earnings.

I wouldn't touch BATS anyway.
Item one on my checklist is, "Would I be happy to work for this company, if need be, or for one of the family to do so?"

duffmanchon 14 Aug 2012 , 9:21pm

Sell sell sell! The market is defying gravity let alone macroeconomics!

goodlifer 14 Aug 2012 , 10:51pm

duffmanchon

How important are gravity and macroeconomics?
How do you explain the market's reluctance to do what you think it ought?

"There's nothing wrong with my forecasts but the weather keeps getting it wrong."

It would suit my book to see Footsie - I don't mean the economy, I mean Footsie - plummet, as the experts keep on predicting, but for some reason it never seems to happen,

Why?

duffmanchon 15 Aug 2012 , 11:45am

Everyone is waiting to see what happens in the Eurozone in September. Article on the Guardian today saying volumes are the lowest for 10yrs, so any rally over the last few weeks has to be seen in that context. I have everything crossed for a big fall down to 5,000 ish. I think Neil Woodford is right in his annual report, the west is in for a prolonged slump. In Japan they had ups and downs in the stock market but the trend was down, I'm afraid we might get the same here. His portfolio is defensive and return from dividends should compensate for little capital growth, I can't see the likes of VOD/AZN/BATS rocketing on a bit of good news from the EZ.

goodlifer 15 Aug 2012 , 2:59pm

Thanks duffmanchon.
"Everyone is waiting to see what happens in the Eurozone in September."

Not true.
Everyone but me, just possibly.

Anyway let's keep on hoping somebody's got it right at last.
But I'm not holding my breath.

bythefates 16 Aug 2012 , 6:54pm

we're shagged?

bythefates 16 Aug 2012 , 6:55pm

And what did you learn over the last five years?

man overboard man overboard

bythefates 16 Aug 2012 , 6:55pm

Hey at least Alice Coopers looking well :)

bythefates 16 Aug 2012 , 6:59pm

Dear warren i have a pound left in my account and i was hoping you could turn that into a million quid what do you say?

Lots of love bythefates
p.s tough this recession eh?

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