The investment lessons to learn from the China and energy crises

This article first appeared in the Telegraph.

I have reached the age when I am almost as interested in not losing money as I am in making more of it. I’m not so ancient that I can disregard the inevitable erosion of my purchasing power by inflation. I do still need to keep pace with rising prices. But I am more than prepared to leave the riskier opportunities to others while I follow Warren Buffett’s dictum: rule number one, don’t lose money; rule number two, don’t forget rule number one.

This is the lens through which I have been watching recent events during what is turning out to be an unusually nervous September. And while I cannot claim to have any unique insight into the Chinese property market, gas prices or the breakdown of global supply chains, I can see some important defensive lessons for investors in all three of these stories.

The first lesson offered up by the travails of China’s second largest property developer is that when something looks too good to be true it usually is. I can only take at face value the stories of high pressure selling of so-called wealth management products to homebuyers and even to Evergrande’s own employees, but if someone came to me with a ‘safe and secure’ 11.5% return then alarm bells would ring loud and clear. In a low yield world, that kind of return is only achievable with a commensurate level of risk.

The second reminder for equity investors is that they come a long way down the pecking order when a company runs into trouble. Debts are a fixed liability. They have to be repaid even if a business’s source of income starts to dry up. And they have to be cleared before there’s anything left over for the owners of a company’s shares. This is why Evergrande’s equity is worth 85% less than it was at the start of the year. There is a reason that shares offer better returns in the long run than bonds. The chance of losing everything is greater.

The jury remains out on the third lesson from the Evergrande affair. It is usually the case that troubles come not single spies but in battalions. This is particularly the case in the property sector where speculative excess can be contagious. It would be amazing if others had not gone to similar lengths to keep their heads above water. To use another Buffettism, it only becomes obvious who is swimming naked when the tide goes out. But they are not generally doing so alone.

The second business story from which investors can learn plenty this week is the natural gas price spike. The first investment lesson it provides is the importance of thinking carefully through what could go wrong rather than focusing exclusively on what you hope could go right. The seven-fold expansion of the UK’s retail energy suppliers in the decade to 2017 was the product of an overabundance of the opposite kind of wishful thinking. There was always a fundamental flaw in a market in which retail prices were capped but wholesale prices were not. You need be neither particularly clever nor unduly pessimistic to see what could, and did, go wrong there.

The second lesson here is the old one of eggs and baskets. Britain has been more successful than many other countries in reducing its reliance on coal-fired power stations and so meeting its carbon emissions targets. But we have done so at a cost. We are now overly reliant on one source of energy, particularly when the wind fails to blow and we have neglected to invest in storage, of both gas and renewable energy.

Lesson three from this month’s gas leak is the importance of joining the dots. I’ve learned a great deal about CO2 in the past week that I didn’t know before. That it is a by-product of making fertiliser, which higher gas prices have rendered uneconomic. That it plays a key role in the transportation of fresh food, is a coolant in nuclear power, is used in invasive surgery and in growing cucumbers. Both this interconnectedness and the overconcentration highlighted by the previous lesson can only be mitigated by proper diversification.

The third unfolding story with clear implications for investors is the breakdown of supply chains and the disruptions and shortages it has brought in its wake. The lesson here is around resilience and sustainability, which we as investors are sometimes happy to overlook in our search for short-term returns.

Again, this is a story about concentration and the lesson is: be careful what you wish for. Supply chains have been fatally weakened as we have bowed at the altar of low consumer prices. We have consoled ourselves for years that powerful, oligopolistic buyers such as supermarkets use their dominance over their suppliers for the benefit of their customers, but the insidious combination of Brexit and Covid has lifted the lid on the hidden costs of that asymmetry of power.

When cheap migrant workers go home and the fruit is rotting on the trees, when Chinese ports are closed by the next wave of infections, when air freight is stranded because there are no passengers to justify the flights they hitch a ride on, then we realise the fragility of a system designed to be super-efficient most of the time but which grinds to a halt when grit is thrown in the machine.

Sustainability has a cost and investors chasing environmental, social and governance purity need to recognise this too. Food is too cheap if you believe in decent conditions for animals and workers. Energy too if you are serious about tackling climate change. As investors, we can be pro cake and pro eating it but not generally at the same time.

Five-year performance

Past performance is not a reliable indicator of future returns

Source: Refinitiv, total returns as at 31.8.21.