A good company does not need to always remain a good investment. We have to focus on the good deal which has a good price with limited risk and potential for return is substantial.
Changes in the availability of the credit create a fluctuation among the economic activities which tends to have resulted in the economy and profits cycle. The credit cycle has an immerse important for economic development. Corporates require additional capital to grow further and unavailability of capital make it hard for them to grow.
Similar situations we have experienced recently with the financial companies where they have brought short term borrowings to support long-term lending. And their failure to the repayment of short-term borrowings has created a crisis.
The occurrence of the credit cycle
This leads to again starting the same cycle. It takes time to complete the entire cycle but it will complete for sure.
As the Economist said earlier this year, “the worst loans are made at the best of times.”
Reduction into the money supply into the economy has led to liquidity crisis and slowdown into the economy.
Money is also a commodity as other commodities so that when the competition starts getting increased, financial institutions have to make availability of money at cheaper rates. This brings down the margins of the financial institutions. Cheaper money invites to more borrowers and borrowing without discipline resulted in the huge negative consequences. When anything easily available then we do not value it particularly and that leads to destruction.
We cannot predict the time and the extent of the cycle but sure enough that cycle will going to occur and also, we can say that we are either near to occurrence or not.
It is difficult to take a call on the economy while investing but we can keep track of the supply/demand picture relating to capital. For knowing where we stand in the cycle, we need to track the credit cycle. Mast bull market getting inspired by the availability of the credit without any care for the future consequences. And the most bear market is the result of the unavailability of finance for the different projects.
When margin calls hits for the levered firms then they were forced to sell their assets or need to bring additional capital to survive. Such period forced people to sell debt securities and that will have resulted in the lower prices of debt securities. At such a lower price, yield becomes so attractive that investors can start taking buying position on it.
When we see an environment like fear of losing money, unwillingness to lend and invest regardless of merit, shortages of capital everywhere, economic contraction and difficulty refinancing debt defaults, bankruptcies and restructurings, low asset prices, high potential returns, low risk and excessive risk premiums then it is a natural time to start investing.
So that when we see these events then we have to be ready to be cautious because these events invite an increase in debt level, issuance of unsound & overpriced securities etc. These all become a starting step of a bust. When the credit cycle is in an expansion phase then we have a huge issuance of the securities that means people accepting new issuance. But extensions of it in the way of unsound & overpriced securities. Also, we heard stories like next Infosys, next Microsoft, management performing like Warren Buffett, etc. etc.
Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation.
Read for more detail: Mastering The Market Cycle: Getting the odds on your side by Mr.Howard Marks