Good crises should never be wasted. They can lay bare poor business practices, weak players and bad public policy. They can also teach us valuable lessons, and with the oil collapse playing out, we've been given a chance to learn real time.
I didn't see that coming
The price decline seemingly came with no warning. Nobody was calling for it. Analysts weren't using $50 (U.S.) oil in their earnings models, or even $70 or $80.
In his quarterly letter, Jeremy Grantham of Boston-based GMO, an astute observer and predictor of bubbles, admonished himself for missing it.
From this collective whiff comes lesson No. 1. Never count on analysts and economists to call a major turn in the market, whether it be commodities or stocks. It's impossible to do with any precision and there's too much career risk in getting it wrong.
It's cyclical, baby!
Outside of coffee, toothpaste and bathroom tissue, there aren't many things that are non-cyclical.
Most everything is affected by the level of economic activity and is sensitive to changes in supply and demand.
High prices lead to more investment in the sector, the emergence of substitutes and less consumption. Low prices curtail investment, rationalize the competitive landscape and lead to increased demand.
The fact that oil prices were on either side of $100 for four years didn't mean the oil cycle had been repealed. Nor does an extended period of prosperity mean that real estate, bank stocks and high yield bonds are in the toothpaste category.
Diversification – always
Over the past 20 years, there have been some powerful themes that dominated investor behaviour, the most prominent ones being technology, the commodity supercycle, the loonie's rise and fall, gold, investors' love/hate/love relationship with foreign stocks and, of course, 2008. In each case, we saw too many investors diverge from their target asset mix and jump on the irresistible trend of the day.
The number of investors that loaded up on energy was fairly limited this time (outside of Alberta), but the crisis is nonetheless a reminder that making a bet on a secular or cyclical trend has to be done in the context of a diversified portfolio. You don't want to be so heavily invested that you can't add more if the price goes down, or worse yet, have your portfolio devastated.
Swimming naked
Good economic times and low interest rates help paper over a lot of cracks, and invariably lead to regrettable business decisions. Companies with high cost structures and/or leveraged balance sheets are able to thrive. The rock stars are the fast moving CEOs and empire builders. Prudent management is not rewarded.
But as Warren Buffett has said, "You only find out who is swimming naked when the tide goes out." In other words, it's full cycle returns that are important, not two- or three-year runs. You want your CEOs and portfolio managers to be fully clothed at all times.
Dividends – not a valuation measure
The merits of dividends have been well documented. I hear it often from investors, "I love my dividends." But it's important to remember that a stock yield is not the same as a bond yield. It's not a valuation tool. The highest yielding stock is not the necessarily the best investment.
Nor are dividends a risk control measure. In the oil patch, the high-yielding stocks were some of the hardest hit in the second half of 2014. The companies that cut their dividend saw their stocks get hammered, while the ones that maintained their payouts still got hit because investors anticipated a cut.
For dividend investors, the path to good returns at a reasonable risk is not the highest yield, but rather a portfolio of dividend-paying stocks trading at or below what they're worth.
Opportunity
Mr. Market is prone to be overdramatic. He doesn't like a change of trend, and more times than not overreacts to short-term news and economic jolts. As a result, every crisis and meltdown brings with it opportunity driven by overly conservative profit forecasts and low valuations. When profit turns up, price-earnings multiples usually follow, which makes for a powerful recovery. So don't waste this oil crisis. There are important lessons to be (re)learned.
Tom Bradley is president of Steadyhand Investment Funds Inc.