Leverage, the search for yield and the high impact of low probability events in 2005

by Ashik Shah on 30 April 2005

This has been a tough year for investors in public stock markets. Most major market indices have shown very poor performance. The investor, working hard to build capital, faces major problems in growing the wealth of his family. The safest place seems to park funds seems to be in the bank, but then its value will be eroded by inflation and low interest rates. Even some guaranteed products, offered with gearing, have actually caused losses. However, whenever a new product or fad appears, many investors make the unwise decision of rushing to invest, having been advised that they are onto the next “sure” thing, whose success is “guaranteed.” So often, the investor blindly and hastily makes a decision which will possibly result in the loss of hard-earned capital. I do not need to really remind anyone of the experience with the internet and technology bubbles.

Recently, there has been a lot of news about hedge funds and their current problems. It is safe to say that they have become a very large and aggressive force in the markets and have accumulated a huge amount of capital, and then some of them leverage it several times over. However, little is understood about these vehicles and how they operate.

While hedge funds have become the most recent fashion in investment, it is disappointing to note how poorly some have performed and how much faith investors have put in them. Some of the funds will certainly have excellent performance, although the best ones are typically closed to new investors, while some of these funds will merely go out of business, taking investors’ hard-earned capital with them. Having said all this, of course, it is important to note that the term “hedge fund” covers a wide variety of strategies ranging from fairly conservative to speculative.

Despite this uncertainty, and bad experiences in various asset classes, the investor is driven by poor returns from bank deposits to search for yield in high-risk investments. It is not surprising that many investors have thus turned to the apparently steady returns of hedge funds with their absolute return and low volatility strategies, supposedly able to deliver returns to investors in any given market.

However, the last year or so has presented major problems for the investor in hedge funds. Many have experienced losses and volatility. Many funds had benefited from the low interest environment allowing them to gear up and invest in higher-yielding assets, often known as the “carry” trade. In addition, many had used sophisticated models which have somehow failed to take into account certain widely recognised or expected events. The recent downgrade of the debt of General Motors and of Ford caught many by surprise. Some of the models had not expected such events, and they were termed low-probability events. However, they did occur and they caused damage.

There are several lessons which can be learnt from these recent events. Sometimes investors forget some of the basic rules of capital growth. First of all, capital must be preserved and the portfolio must be created in such a way that it can withstand events with low probability but with the potential for future damage. In our greed as investors we often forget about the downside due to our hunger for the upside. Some of the shrewdest investors, Warren Buffett and Charlie Munger, have repeatedly stated that they actually spend a lot of time thinking about the consequences of high-impact but low probability events, and this is how a conservative investor should position his investments.

Secondly, some of the smartest investments in history have been very, very simple. The investor must understand the nature of the investment being made so he is not caught by surprise. Over-reliance on models and rocket-science often means that we lose sight of common sense, which is ultimately a friend of the conservative investor.

Value investment is simply investing in companies which are selling at a discount, the “Margin of Safety,” to the value which a businessman might pay for them, the intrinsic value. Often this value is found by looking in places where the market or “crowd” is not looking, and away from the current fashions or trends. The investments which Kurm has made have all fallen in this category.

For example, Kurm has currently exited the investment in MCI, which was made when the “crowd” or market was extremely bearish on the telecoms stocks. When the crowd was greedy about telecoms and pushed share prices to all time highs in the recent bubble, Kurm was fearful of such investments, but when the crowd was afraid, Kurm became greedy and took advantage to buy cheaply and the recent exit has been very profitable, as merger talk has now become conclusive.

Kurm’s investments in unlisted companies are also promising, and these businesses are progressing well in terms of value creation. In addition to the core holdings in the US public markets, Kurm might soon invest in public companies in the United Kingdom and Europe, where I am currently investigating some interesting opportunities.

Wherever Kurm invests, the advice will always follow the principles of investing with a margin of safety in instruments selling below their long-term underlying business value. It is this consistent and disciplined application of simple business-minded investment which will provide preservation of capital and long-term growth for investors and their families.

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The views expressed and comments made on this website are not personal advice based on your circumstances. The purpose of this website is to provide information and analysis to help you make your own informed investment decisions. If you are not confident making your own investment decisions you should contact a firm which is authorised and regulated by the Financial Conduct Authority (such as Ashik Shah & Co. Ltd.) so that a qualified financial adviser, after considering your personal circumstances and investment objectives, can make personal recommendations of investments which are suitable for you. Whether you make your own investment decisions or prefer to follow the recommendations of a financial adviser you should always remember that your capital will be at risk and that investments can go down in value as well as up.

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