The time for investor caution is upon us
A lot of stuff has to break: what to do about it (plus hidden risks for stock investors)
In this update:
Setting a high bar for stocks
A hidden risk for stock investors: convertible bonds
Another hidden risk for stock investors: dual share structures
Very real, and mounting, economic and financial risks
The strengthening case for owning gold, or gold-linked investments
The West's financial condition has made it strategically weak
As risks rise, some thoughts on how to position investor portfolios
I'm now back at my desk and focused on OfWealth and the markets again. That was after an intense period sorting out my ageing parents' affairs during January.
My plan this week was to send a new stock analysis (for paid readers only, given the amount of work involved). You can find past ones here, and there will be plenty more in future.
I only write analyses of stocks that I would be prepared to invest my own money into. This policy sets a very high bar. Also, it's certainly different to almost all other investment newsletter writers that I've come across.
But it also has its drawbacks. Namely, that I typically have to trawl through dozens of companies before I find even one or two that are attractive. This is time consuming. But I believe that it's worth it in the end. The devil is in the details.
On Monday this week I started a deep dive on a company called Stride Inc. (LRN). It has compelling growth prospects in the area of online education, and seems to be reasonably priced (P/E of 15ish). The business focus is in the US for now, and there could be international expansion potential in future.
But once I got into the weeds, a.k.a. the notes to the financial accounts, I hit a big question mark. The company issued a slug of convertible bonds in 2020 which could result in significant dilution for current shareholders.
Convertible bonds pay low interest rates to investors (in this case 1.125%). But, to make up for this low rate, investors also get a call option to buy company shares in future at a fixed "strike" price. If the stock price goes up a lot in the interim, the option can become very valuable. At the bond's maturity date, an issuing company's liabilities can be settled with cash, shares, or a combination.
The first problem is that when the bonds mature they may have to be refinanced by borrowing at a much higher interest rate, which would crimp future company profits.
Complicating matters further, in this case the company also entered into financial derivative transactions called "capped calls". This is common for convertible bond issuers. It potentially reduces the share dilution and/or eventual cash cost to the company. But it means the eventual outcome is much harder to predict, along with the financial impact on the company.
In short, convertible bonds - especially when combined with capped calls - make assessing a stock far more complex. So I've had to put Stride into the "too hard" box.
Next I turned my attentions to a company called Chewy Inc. (CHWY). The core of this business is selling food and medications for pets online, in the US market. Again there is future scope for international expansion. Chewy is also just starting to expand into the veterinary business. As such, it has similarities to the UK's Pets At Home Group (PETS.L), but with far less weighting to the veterinary side for now.
Chewy has achieved high top-line sales growth in the past, although that has now sharply slowed as it matures. However, the company also tipped into bottom-line profit in 2022/23, and profit margins are expected to leap in the coming years. This means its sky-high price-to-earnings (P/E) ratio should plummet from its current very high level. Such a pattern is typical of a high-growth company as starts to mature. Which is also, usually, when the risks for investors reduce significantly.
But again I found something that I don't like. In this case, it's a potential governance issue. The company has a dual share structure of "A" and "B" shares. The B-shares have 10 times as many votes as the A-shares, and well over 90% of the votes on company resolutions. They are owned by an investment company, which also dominates the corporate board appointments.
You may not think this is an issue, since it's reasonable to expect the B-share investors to protect their stake. Surely they wouldn't damage the company?
But I've been burnt in such situations before, where insiders have all the control. For example, there are risks that the board decides to suddenly load the company with massive debt, perhaps for an ill-advised acquisition or to pay themselves a fat dividend. That would leave the business in bad financial shape, most likely to the detriment of outside shareholders.
Alternatively, a controlling shareholder of this type might approve huge management share option awards, thus diluting existing shareholders. In fact, I did notice that such dilution was already quite a bit higher than I like. Any company share count that's consistently growing above about 1% a year requires a sceptical eye, in my opinion. That's taking value away from outside shareholders.
Another possibility, in such situations, is that the controlling B-share investors could award themselves large amounts of warrants. Warrants are basically the same as call options, in that they give their holders the right to buy shares in future at a fixed price, resulting in dilution of ownership for others. The difference is that warrants are issued by companies instead of investment banks, can’t be traded, and tend to be longer dated.
Of course, I'm not saying for a second that Chewy's B-share investors will do any of these things, or act in other ways detrimental to outside A-share investors. But I don't like that kind of extra uncertainty and risk.
So I decided that Chewy was too, er, chewy for my investor taste.
In any case, the issues highlighted above are excellent examples of things that potential stock investors should always look out for. That's why I've written about them here.
Unfortunately, the necessary information in such cases is usually buried in the fine print of company reports, and often explained in very technical language, or with insufficient details given.
Before investors buy any stocks, especially outside of the blue chips, they should find out the following (amongst many other things):
Is there likely to be major future stock dilution due to convertible bonds, excessive executive stock option awards, or stock warrants?
Is there a potential governance issue due to majority insider ownership or majority voting rights awarded to insiders?
If the answer to either question is "yes", then think very carefully before investing. As always, the potential upsides have to significantly outweigh the potential downside risks.
If the answer to either question is "I don't know", do more research until you do know, or walk away.
Mounting risks of recession and severe financial fallout
On top of those specifics, there's general recession risk that could adversely affect either of these companies.
Of course, in theory, people will want to keep paying for their kids' education or their pets' food and medications. But if spending money gets tight enough then there will be customer attrition. Such an outcome is highly likely to hit profits for a time, and thus stock prices.
So I've decided to draw a line under both these stocks, at least for now. But I've shared the names in case you want to take a look for yourself.
Yet all is not lost. There's a small group of other companies that could really fit the bill, in terms of what I believe is probably coming down the macro-economic pipes.
But remember: no one has a crystal ball. Positioning your investments is about weighing up probabilities and possibilities. Actual outcomes can be a complete surprise. (The most obvious recent example being the impact of the Covid-19 pandemic, and the government / central bank policies to handle it.)
Anyway, the aforementioned group of companies give exposure to precious metals, especially gold, and in a different way to owning the metal itself or investing in gold miners. What's more, over the long haul at least (e.g. past 15 years), they have all significantly outperformed gold itself, and gold mining stocks, and silver for that matter.
More to come on that soon, hopefully. I need to get into the weeds (company financial notes) and update myself on the current details, before doing a full write up on one or more of these stocks.
The strengthening case for gold, or gold-linked investments
Even more fundamentally, why is my interest in gold on the rise?
In short, the heavily-indebted developed world has just endured a massive interest rate shock.
Central bank policy interest rates have gone from near zero in 2022 to above 5% in places such as the US and UK, or 4% in the eurozone.
It would be very strange if this doesn’t cause major financial casualties.
We already know that much commercial real estate is in distress, especially offices and retail spaces.
Indebted companies are starting to go bust in droves. To give one example, it was recently reported that the number of companies going bust in England & Wales hit a 30 year high in 2023.
And many individuals and families must surely get squeezed when they find out that their mortgage rate has rocketed, or their car loan, or the rate on their (unpayable) credit card balance.
All of this points to a harsh recession being on the cards. But these things hit with a time lag. I believe that we're now at or close to that tipping point.
The most obvious casualties will be the lending banks, as debts go bad and have to be written off. The problem is that the specific casualties won't be so obvious to identify in advance.
This is because the global financial system has a mind boggling myriad of interlinkages and interdependencies. A financial time bomb that's ticking away in one corner of the world can cause explosions on the other side of the world.
I read about one such example just today (Thursday). Shares of a significant Japanese bank called Aozora plunged 21% in Tokyo. That was after the bank slashed the value of some of its US office tower loans by more than 50% (as reported by Bloomberg).
You may well ask why a Japanese bank is up to its neck in US office loans. It's a very good question. But it's also a good illustration of the interconnected risks in the banking system, and the difficulty of spotting them in advance.
Meanwhile, to cite another example, shares of New York Community Bancorp plunged 37% on Wednesday. This bank was the one that acquired troubled Signature Bank last year, in the previous mini regional bank crisis in the US. (More from the Financial Times for those interested.)
I wrote about last year's sudden bank crisis and how it happened back in March 2023 (see here). At the time, I said the following:
I wouldn't touch US banks with a bargepole for now, at least until the dust has settled. I also recommend avoiding UK and other European bank shares.
This isn't a full blown financial crisis, in terms of triggering widespread bank insolvencies. At least, not yet. But these things have a habit of spreading...
I'll extend that warning further afield today, given the latest Japan debacle. I wouldn't touch any bank stocks for the foreseeable future. It's just too hard to work out where the bombs are hidden.
There will be a time to buy carefully selected bank stocks at bargain prices. But, in my opinion, things are likely to get far worse before they get better.
As you can see from the following chart of an index fund tracking US regional banks, bank stock prices have started heading back down again.
SPDR Regional Banking ETF (KRE) - past five years (US bank index)
Source: Stocks (an app)
To reiterate, there's an elevated risk of significant recessions starting this year. Borrowers, and anyone relying on their spending power, are getting hit. So are lenders, as more and more debts go bad. Unemployment is likely to rise meaningfully as businesses cut back their spending. Many businesses will go bust.
Actually, I think there's a good case that corporate default rates on loans and bonds will be far higher than almost anyone is expecting.
For nearly four decades, between 1981 and 2020, bond yields and borrowing rates were on a general downward trend. This meant that borrowers could keep refinancing at lower and lower rates. Even distressed companies with high leverage could restructure their debts at lower rates and live to fight another day.
But that option is now gone. Pretty much any money borrowed after about 2010 can only be refinanced at higher rates. Anything borrowed since 2012 can only be refinanced at much higher rates. Thus, it’s highly likely that the proportion of loan and bond defaults will be far higher than practically any active bankers or corporate bond investors expect, based on their historical models, after four decades of easier and easier money. None of them have worked in a rising rate environment before.
You'd think all this makes buying government bonds, such as US treasuries or UK gilts, a shoe-in for investors. There's no default risk, and once things get really bad, central banks will almost certainly cut policy interest rates once more. Albeit too late to stop the carnage, as always.
Combined with a potentially big sell-off in stocks, as corporate earnings fall due to recessionary conditions, and the usual Pavlovian "flight to safety" into supposedly "risk-free" government bonds, this should drive down bond yields and raise their prices.
In fact, I think that's likely to happen over the coming months or quarters. But what concerns me is what comes next.
A big recession would hit tax revenues, thus blowing a hole in already-stretched government finances. Big fiscal deficits will get even bigger. Thus, governments will have to borrow at an even faster rate.
To take one example, the US budget deficit was more than 6% last year. This year it's expected to reach a similar level, assuming no recession. But what if there is a deep recession? Could the US budget deficit reach 7%? 8%? 9%? More?
To be running such a big deficit already, when the economy is meant to be growing, is pretty irresponsible. In fact, a large part of the GDP "growth" is probably a result of government deficit spending, funded with money borrowed from other people. In other words, it's bad growth. A mirage. Fakery.
What happens if government fiscal deficits blow out even further, in the US and beyond?
Will governments raise taxes? Unpopular.
Will governments slash spending on areas such as welfare and defence? Unpopular (or impossible).
Or will central banks, once again, print masses of money to buy up the new excess supply of government bonds, whilst suppressing market bond yields at the same time (versus where they would be if the bonds were just sold on the open market)?
That seems likely. What's more, given the scale of the government problem, central bank money printing could easily exceed the opposite drop in money created via lending by commercial banks, as they get into trouble.
Prior to the idiotic pandemic response, in the years following the global financial crisis, QE money printing was mainly an offset to shrinking bank lending. Thus it kept the system afloat. But then it got out of control.
During the pandemic, there was no bank credit contraction, but massive QE to fund government largesse (by soaking up a spike in government bond issuance to pay for stimulus handouts). Price inflation was the result, once economies were reopened with a far larger stock of money supply (mainly bank deposits) and people got spending again.
What if the necessary future response to keep governments afloat is so large that it once again drives up the aggregate money supply, potentially quite sharply? Even with the disinflationary pressures of economic recession, the net inflationary effect could mean CPI rates pop up well above the typical 2% targets again. (Not that they've even got that low yet.)
We’re talking stagflation combined with financial repression (suppressed bond yields and interest rates).
Would government bonds that then yield 2% or 3% be a good bet if inflation was at 4% or 5%, or more? Obviously not.
What's more, private sector liquidation of bond holdings - given their unattractiveness in such circumstances - could force central banks to buy even more or them with printed money, to keep the market stable and the government funded. It could descend into a vicious doom loop.
In such a scenario, something would have to give. Inflationary money printing plus suppressed interest rates implies weak currencies. The mighty dollar could become distinctly less strong. Other major currencies could follow it down.
In effect, there would be one or more sovereign crises. But this time in developed economies instead of their usual domain, being poorer countries.
Sovereign crises are characterised by currency and/or bond market meltdowns (along with everything else economic). Given central bank actions, currencies could be the first to go. If inflation got bad enough, central banks might then have to about-face and withdraw support from bond markets. At which point bonds would most likely crash as well, as bond markets are swamped by new issuance from increasingly desperate governments.
Meanwhile, all of this chaos would most likely be driving an even bigger stake through the heart of GDP. Not least since, eventually, governments would be forced (and I really mean forced) to slash spending, which itself is recessionary. Not to mention the likely political and social turmoil as disgruntled populaces rebel, either at the ballot boxes or on the streets.
Incidentally, here's something that I don't see mentioned nearly often enough, or ever for that matter. With Western governments already up to their necks in debt, with high deficit spending continuing in peacetime, with taxes already at high levels, what will happen if a major conflict does break out?
After all, there’s so much chatter in political and media circles about World War III that it’s almost as the populace is being gaslighted. It seems like we’re being softened up for something. (Or should that be hardened?)
If the Ukraine war spills over into other European countries? If things get out of control in the Middle East? If sabre-rattling North Korea does invade the South? If China does make a move on Taiwan?
How will Western governments fund the required leap in defence spending? Put another way, in strategic terms, they have already put themselves in a very weak financial position. How will they cope if a major conflict breaks out?
To repeat, all of these situations... major recessions, spiralling debt defaults, massive money printing, a breakdown in government finances, the outbreak of major wars... they're just scenarios.
But they certainly seem plausible to me. Put another way, the probabilities of another major economic setback, the potential for new financial crises, and the risk of more conflict are all meaningful, if never certain.
Some thoughts on portfolio positioning
Having exposure to gold is one way to hedge that risk. But even though the case is strong enough, I'm certainly not suggesting that anyone goes all in on the yellow metal. However, I believe it's prudent to get at least some exposure early, before the potential rush.
With multiple recessions already started or looming, and at least pockets of further distress in the financial sector, it seems prudent to take a cautious stance.
Building up cash reserves is probably a good idea, to hedge against major stock market falls and to provide dry powder to pick up future bargains. You can do this by letting dividend income pile up for a while, or by trimming investments to get there more quickly. "Cash" could include buying short-dated (less than one year to maturity) government bonds / bills, which have little price volatility and decent yields.
Owning deep value stocks (often with high dividend yields or large stock buyback programmes), especially of companies with no or low debt, is also a good way to go. That's because such stocks already have a lot of bad sentiment baked in. That doesn't make them immune from sharp stock market falls that drag everything down for a time. But it does lower the risk on a multi-year view, in general terms.
Casting around for high-growth disruptor companies, that are unlikely to be badly affected by economic slowdowns in the West, is another sensible option. That is, as always, provided the stocks can be bought at a sensible price in the first place. (See here for a potentially good example that I wrote about in December.)
Longer-dated government bonds could do well for a time too, over the coming months or quarters, and assuming recession kicks in. But keep an eye out for distress in government finances, or the central bank money spigots turning back on, or an inflationary spike in commodity prices such as oil (Middle East risk), and prepare to get out swiftly if need be.
And finally, returning to gold exposure, look out for my forthcoming stock analysis.
Please send comments or questions to the email shown below.
Until next time,
Rob Marstrand
email: ofwealth@substack.com
The editorial content of OfWealth is for general information only and does not constitute investment advice. It is not intended to be relied upon by individual readers in making (or not making) specific investment decisions. Appropriate independent advice should be obtained before making any such decision.