Don’t swim naked (when you’re investing)

In our latest monthly update for UK investors, Robert Scammell discusses the importance of not taking on too much risk, using a well-known analogy by legendary investor Warren Buffett.

Warren Buffett famously once said that “It’s only when the tide goes out that you learn who has been swimming naked.”

With the market returns we’ve seen over the past few months it would be fair to say the tide has been ebbing away and is now well and truly out. It’s also fair to say that we’ve found out who has been swimming naked. I believe the original quote was intended to highlight the risks of being overly leveraged – more on that later. The recent falls in the markets have been broad-based, but some areas have suffered more than others, with the most speculative areas (such as meme stocks, cryptocurrencies and non-fungible tokens) and companies that were over-leveraged – in other words, those with limited cash flows and weak profits – hit hardest.

The technology sector and what are typically referred to as growth assets have performed particularly badly this year. The S&P 500 was down 13% to the end of April, while the S&P 500 Growth index had lost around 20%. The S&P Value index, by contrast, had fallen by less than 6%. In fact, value’s outperformance of growth in April was the highest since the tech bubble burst in 2000, as we can see in Chart 1.

Source: Kempen, May 2022

At the stock level, Netflix is down 68% so far this year and Peloton has lost 64% (and is now 90% below its highs). Even Amazon has lost 25% and Google 21%. The valuation changes of these two companies alone mean investors are nearly USD 800 billion worse off (equivalent to the GDP of Switzerland). Many growth companies do not pay dividends so have been hard hit by rising interest rates, high debt, low free cashflow and poor profits or even losses – in other words, they have been swimming naked. 
What distinguishes 2022 is that bonds – including government bonds – have fallen at the same time as equities (Chart 2 shows the combined returns of US equities and Treasuries).  

Source: Kempen, May 2022

This is different from what we have experienced over the past 20 years, with each stock market crisis during that period having been met with cuts in interest rates and / or quantitative easing (which typically supports equity valuations). We now find ourselves in a situation in which everything is going down at once. This is where being over-leveraged as an investor (rather than as a company) can create problems.  

What does all this mean for pension schemes? Historically, they have typically used leverage to increase their LDI hedge while maintaining a diversified portfolio of assets to generate returns.  When yields were falling, this worked well as they were able to fund their leveraged positions without any trouble. But now, with yields rising, leverage is also increasing. To ensure leverage remains at safe levels, pension funds have to allocate more capital to LDI, and that needs to be funded either from cash or by selling return-seeking assets. With everything falling in value, that can result in a fund becoming a forced seller of those risky assets.

Some funds may have levered their equity exposure as well as their LDI to free up cash to invest in other asset classes (something we always thought was a step too far due to the risk of equities and bonds falling at the same time). Funds in this situation will have suffered particularly badly over the past four months, especially if they used the extra cash to invest in illiquid assets or those that are costly to trade, such as credit. Such funds might be looking for some clothes right now.

And how does the current situation compare with the 2008 crisis? Back then, we saw wholesale value destruction as assets such as mortgage-backed securities that were previously deemed valuable were in fact found out to be worthless. Worse was that many of these assets were on banks’ balance sheets. This resulted in a banking crisis, wholesale nationalisation of banks, recession and a steady process of deleveraging and balance sheet repair. While the current period of volatility has again been caused by assets being overvalued, the crucial difference from 2008 is that these assets are on the balance sheets of individuals, not banks. While it is of course painful for many people, what we are experiencing does not represent – yet – a systemic global financial crisis.

As always when investing, moderation is key. Some exposure to tech within a well-diversified portfolio of risk assets can be a good source of performance potential and provides exposure to future growth and increases in productivity. Using leverage to help diversify your risks is also sensible. Too much of these things, however, can result in serious problems when the tide goes out, as it inevitably does.

About the author:

Robert Scammell is a senior portfolio manager responsible for developing Kempen’s LDI proposition for UK clients, sitting on both our UK Asset Allocation Committee and UK LDI Committee.

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