When I started in this business prior to the dot-com bubble I had some vague sense that share values declined, but I had almost no concept that a company could actually go bankrupt. This was the late 90s and share prices simply didn’t just go to zero.
Naively, I assumed that if a company was publicly listed and that millions of investors had ownership then the company had legitimacy and therefore wouldn’t fail. I also assumed, even more naively, that for a company to be publicly listed it must have been thoroughly vetted. Was I ever in for a wake-up call.
Below is the dramatic rise in Internet company failures as the tech sector became irrationally speculative. Sadly, I would have owned a few of these.
Internet company failures
Source: Michael Mauboussin (“More Than You Know: Finding Financial Wisdom in Unconventional Places”)
To a much lesser extent, I received another reminder of bankruptcy dangers as the wildfires raged this fall throughout California. The big westcoast utility PG&E, which was recently forced to intentionally black out most the San Francisco Bay area because of the forest-fire danger, has seen its share price plunge 69% y-t-d. It now sits on the cusp of complete failure. But, amazingly, PG&E has already filed for bankruptcy once this year and did so as well in 2001 in the wake of the Enron scandal. It’s already a two-time loser. No pun intended, but how many times will investors allow themselves to get burned? PG&E was removed from the S&P 500 earlier this year.
According to a recent Innosight report, the average life span for a company in the S&P 500 has been about 33 years. However, by 2027 this number will fall to just 12 years. In fact, S&P 500 company life spans have been steadily declining for decades.
Now, naturally, some of this longevity decline is due to factors that may be favourable for investors such as takeovers, but the reduced life spans are also frequently a result of bankruptcies—a rapid failure of companies to adapt to new, disruptive market forces. The rise of Amazon, for instance, continues to wreak havoc on the retail sector. According to the same Innosight report, at least 21 US retailers filed for bankruptcy protection in 2017 including chains such as Toys R Us, The Limited, Payless, and Gymboree. And a recent BMO report further highlights that there were more bricks-and-mortar store closures (as measured by total square footage) in 2017 than in 2008, which, of course, was the heart of the financial crisis.
Bankruptcies are always a fact of life, but if you over-concentrate in the wrong sectors then your investments are in even more danger. Are you listening cannabis investors?
The overall number of bankruptcies obviously increases during recessions, but what investors should be aware of is that there’s a constant randomness (if that can be considered a phrase) to bankruptcies even during strong economic periods. In fact, even when the economy is good, bankruptcy levels can spike for seemingly no reason. It’s just part of the natural cycle of the economy. In other words, don’t be lulled into complacency with your stock portfolio just because the economy is stable. Your odds don’t particularly improve in terms of avoiding a complete corporate failure just because the economy is doing well and the overall market is trending higher (see chart).
Bankruptcy landmines lurk everywhere and overall economic strength often doesn’t reduce their numbers. Bankruptcies have a life of their own.
S&P 500 (orange line) vs the Bloomberg Bankruptcy Index (white line): Even with the economy and markets humming along, bankruptcy levels can spike at any time
Remember this if you’re trying to make a living through speculative stock-picking. A broad-based ETF, in contrast, doesn’t even skip a beat if an individual company goes belly up because the ETF will own many more companies that have weathered the storms, handled the competition and succeeded.
If you want to more easily step over the dead bodies strewn throughout the corporate world, own an ETF.
Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Vice President, Private Client Group, Raymond James Ltd.
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