Markets learning long-forgotten lessons of prudence and diligence in 2007

Short-term fluctuations do happen in markets, as the last few months have shown in particular, and probably will over the next few months also, as the financial world begins to learn long-forgotten lessons of prudence and diligence.

For some time now global capital markets have been frothy.  Yields have typically been low and valuations high, supported by excess liquidity.  This liquidity has arisen from a number of sources:  commodity producers, trade surpluses, the carry trade, and relaxed credit criteria, to name a few major ones.  The latter two are a function of confidence in the financial markets.

The carry trade has largely been characterised by the borrowing Yen and investing in higher-yielding currencies such as the New Zealand Dollar.  In recent weeks, and, as mentioned in previous letters, the carry trade comes under pressure when confidence and liquidity come into question.

Recent years have seen banks and financial institutions increasingly making loans which they almost immediately package and then sell on to various buyers in the financial markets, securitising them.  Buyers include pension funds, other banks, insurance companies, and hedge funds too.  A number of these buyers borrow funds on a short-term basis and then invest them in assets that are held for much longer.  This means that they need to continuously refinance themselves as their funding matures.  However, when the markets lose confidence, they are not able to refinance themselves so easily, and so must try to sell their assets to raise liquidity. Unfortunately, the markets have now shown their lack of confidence in certain asset classes.  The sub-prime mortgages of US households seems to have much poorer credit-quality than expected and so many of the financial institutions have suffered losses.

Some of their investors have redeemed their investments, and many more may well do.  As the asset prices have fallen, some have faced margin calls.  Again, this all requires them to raise liquidity.  Some of the securitised assets and more complex investments, including derivatives, have not been so easy to sell and so these institutions have had to sell other, better quality, more liquid assets, such as shares.

Until recently private equity houses had been able to raise huge amounts of money on favourable terms without onerous covenants, at very high multiples of the profit of the business to be bought.  This in turn supported public equity markets.  However, banks have become more cautious in their lending and many have actually temporarily stopped lending in this sector.

Many investors and institutions have used quantitative models, which had generated good short-term results.  However, many of them were caught short by recent volatility.  The models were unable to deal with the fact that markets are so inter-connected, or correlated, and that events which they believe to happen once in a hundred years happen far more frequently.  Investors like Warren Buffett and Charlie Munger have often spoken about preparing themselves for the high impact of small probability events.

The problems in a small part of the US financial markets have thus spread over to global financial markets.  This is called contagion, just as when a disease spreads.  Investors had become very complacent and too comfortable.  The last few years have treated financial investors too well and many of them began to become too confident in their abilities, when all that they were doing was riding a wave.  They began treating liquidity as the ease with which they could raise borrowing, when it is really the ease with which an asset can be sold, and they forgot that risky assets are more likely to lose money even if they offer a higher return.  As a result many of the financial institutions and hedge funds have damaged their balance sheets and rendered a disservice to investors.

As investors forgot the basic ideas of risk and liquidity, they began to travel further afield for higher returns than available in their local markets.  They looked at emerging markets for public and private equity and for property investments.  For example, the current yield on commercial property in the UK does not cover the funding costs and the idea of yield compression leading to capital appreciation seems to be unjustified.  Secondary locations had begun to be priced more like primary locations.  As investors reconsider risk and liquidity, they will re-price assets.  Currently fear has replaced greed, which might offer opportunities before rationality returns.

While recent volatility has impacted on Kurm’s investments, too, there has been no fundamental deterioration in the quality of the assets in which Kurm has invested.  The funds and securities in which Kurm has invested are all driven by a basically conservative approach to assessing the intrinsic value of the underlying businesses.  The balance sheets are strong and the businesses sound.  Market uncertainty typically presents opportunities for long-term patient investors.