5 Hard Lessons From 5 Cruel Years

LONDON -- For many people, it was the run on Northern Rock in September 2007 that first brought the looming credit crunch -- and ensuing recession -- to their notice.

But the generally accepted "official" start of the credit crunch was actually a bit more than a month earlier -- Aug. 9, precisely five years ago, when French bank BNP Paribas prevented investors from taking money out of two funds that were heavily exposed to subprime-related investments.

And while it took several months for all the dominos to drop, the collapse of Lehman Brothers, HBOS, and Bradford and Bingley -- not to mention the almost terminal implosions at many other financial institutions -- can be traced back to the events of August 2007.

So, five years on, what lessons are there for investors to learn?

1. The story has changed -- but have the facts?
In a few short years, financial stocks had morphed from boring yield plays into a "Masters of the Universe" investment thesis that was altogether racier. Thanks to an acquisition spree and lending largesse under go-getting ex-Sir Fred Goodwin, for instance, Royal Bank of Scotland (LSE: RBS.L  ) had become Europe's second-largest bank.

Far from being reviled, bankers were lauded as wealth creators, rewarded with "light touch" regulation, and seen as supermen -- with bonuses to match. As with former pipeline operator Enron several years earlier, the boring had become brilliant, with a glitzy new business model to match. It couldn't last -- and it didn't.

2. Valuations matter
A rising tide lifts all boats, and share prices, buoyed by a sea of cash, rose faster than earnings -- much faster. On June 15, 2007, for instance, the FTSE 100 closed at a lofty 6,732.

In its wake, huge numbers of shares had been carried along. Some sectors fared better than others, of course. A lot of that cheap cash and easy credit had gone into the construction industry, propelling shares such as Barratt Developments and Taylor Woodrow skyward.

Canny investors, we now know, had moved into cash, awaiting the return of genuine bargains. It takes nerve to go against the crowd, but that's how money is made.

3. Cash is king
Read any account of the credit crunch -- my own favorite is Andrew Ross Sorkin's Too Big To Fail -- and one lesson is crystal clear. It's a lesson that holds true for both investors and the companies they invest in: Hold too little cash, and you could be stuffed; hold enough, and you can duly load up when bargains appear.

The directors of Lloyds Banking Group (LSE: LLOY.L  ) doubtless thought they were getting a bargain when they snapped up HBOS. As we now know, it was a poisoned chalice.

Forty-eight hours before Lehman Bros went bust, Barclays (LSE: BARC.L  ) had come close to buying all of it -- including its dodgy subprime portfolio. But post-bankruptcy, fast footwork and ready cash bought it the bit that it actually wanted: the Lehman "broker dealer" operation.

4. Diversification matters
Lured by tasty-looking yields and the prospect of capital gains, many investors lost sight of the age-old wisdom of diversification. Many, for instance, convinced themselves that Royal Bank of Scotland was one sort of bank, and mortgage-centric Northern Rock quite another.

Today, equally alluring yields are on offer from RSA Insurance Group, Aviva, and Admiral -- very different businesses, to be sure, but all insurers at heart. Tempted? Tread with care.

5. Don't invest in what you don't understand
Mocked for less-than-stellar returns during the dot-com boom, Warren Buffett robustly defended himself, pointing out that he didn't invest in what he didn't understand. And as he didn't understand how many of the emerging dot-com businesses could make money, he wasn't going to invest in them.

That same wisdom would have served many investors well before the credit crunch, as they poured money into funds and stocks that were awash with subprime mortgages and overpriced construction projects. For those with eyes, the signs were there -- take Michael Lewis' The Big Short, for instance -- as were the opportunities to profit.

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More investing ideas from Malcolm Wheatley:

Malcolm owns shares in Lloyds Banking Group and Aviva. He does not have an interest in any other shares mentioned. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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