A common phrase we’ve heard over the past five years is that the world’s bankers ‘haven’t learnt the lessons of the 2008 financial meltdown’.
The argument is that they’re making the same mistakes now that they made during the 2000s leading up to the meltdown.
Of course, that’s not true. The bankers have learned their lesson. They’ve learned they can take as many risks as they like, because governments and central banks will ultimately bail them out of any problems.
And besides, let’s not just blame the bankers. They are after all just responding to investor demands in a low interest rate environment. In order to give investors bigger returns the bankers have to create riskier and more complex investment products.
So it shouldn’t surprise you to hear that after nearly six years of record low interest rates, risky investments are making a comeback…
Now, if you’re looking for us to tell you not to invest in risky investments, you’re out of luck.
Remember that aside from penning these notes to you each day, our full time job is seeking out some of the riskiest investments on the market – tech stocks and small-cap stocks.
So the last thing you’ll hear from us is the idea that you shouldn’t take risks.
Our view is that every investor should have exposure to varying levels of risk in their portfolio depending on their attitude to risk and their desired return.
But that doesn’t mean you should invest in any old risky asset. In fact, there are some investments you should stay away from whatever the potential reward.
Take this as an example. If you want any proof the bankers are back in business with risky asset, check out this report from the Financial Times:
‘Risky lending practices that were a hallmark of the boom years before the financial crisis are staging a comeback in the US as companies take advantage of investor hunger for higher returns.
‘The issuance of payment-in-kind [PIK] toggle notes, which give a company the option to pay lenders with more debt rather than cash in times of squeezed finances has surged in recent months.‘
As we understand it, these deals in effect capitalise interest payments. If a company can’t – for instance – make a repayment on a $10 million loan, it has the option to increase the size of the loan instead, without receiving the increased loan amount from the lender.
Regardless of how they work, the reason they exist is undeniable. Even the banker-loving, mainstream Financial Times admits it. It’s because of ‘investor hunger for higher returns.‘
But as we say, while the bankers create them, the ultimate cause is the zero and near-zero central bank interest rate policies. If central banks didn’t keep rates artificially low in order to induce inflation, investor ‘hunger‘ would be satisfied by higher yielding and less risky assets.
That said, the current market conditions are what they are. Us bleating about it 24/7 won’t help. And neither will completely ignoring risky assets when the alternative is earning less (next to nothing when you take inflation into account) in supposedly ‘safe’ assets.
However, there are risks and then there are risks.
We prefer calculated risks. We like risks that are easy or fairly easy to identify. That’s why our risk of choice is the small-cap and technology markets.
One of the speakers at the 4th Annual Australian Microcap Investment Conference made a key point that we hadn’t really ever thought about. He said that he prefers investing in small-cap stocks because they have very simple structures.
He said that in most cases, small-cap stocks have a single or limited line of business. That makes it easier to analyse them and identify potential risks.
That’s spot on. It’s partly why small-cap and technology stocks can be so volatile. They can rise and fall on a single piece of good or bad news. But because the business structure is usually so simple you can anticipate those risks in advance.
You can then decide if the risk is worth taking based on the potential for reward.
By contrast, who really knows how these PIK loans work? Are the risks easily identifiable? If not, how can you possibly anticipate them?
The really scary thing about these debt products is that many investors buy them assuming they’re as safe as a corporate bond or some other structured investment.
That means investors probably invest more than they should, as they look for any possible way to boost their income and growth returns.
In short, we’ve said for the past two years that investors can’t afford not to take risks in this market. Back in 2011, interest rates were nearly twice as high as they are now, but the market was just as volatile and risky.
Today it’s risky in a different way. The main risk is that low interest rates have pushed investors into making investment decisions they otherwise wouldn’t make. Many are investing in risky assets not because they like risk, but because they believe they are safe or they have no choice but to invest in them.
Bottom line: we encourage you to take risks with your investments. But be careful. We advise taking calculated risks, and most of all, making sure you understand the risks before you make the investment.
If you do that, and manage your risk taking sensibly you stand a great chance of getting a boost to your returns, and minimise the odds of getting a nasty surprise.
Cheers,
Kris+
From the Port Phillip Publishing Library
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