I wrote yesterday that I think the risks of market upsets are higher than they've been for quite some time. While I'm not predicting a crash, there are a number of risks on the horizon and this, combined with a very bullish investor mindset, makes me think investors should be wary.
During a market crash is the worst time to have to sell shares, so I think it is incumbent on investors to consider in advance what kind of businesses they would not like to own if the market should crash. I can think of three distinct possibilities:
- Companies with very high levels of debt like Sydney Airport Holdings Pty Ltd (ASX: SYD), Transurban Group (ASX: TCL) and Amcor Limited (ASX: AMC). The risk is exacerbated if the business itself is cyclical and if large repayments are coming due soon. Amcor, for example, has $777 million (as of the half-year results) due in October 2018, which it is currently working to refinance.
- Companies with a cyclical business model like Rio Tinto Limited (ASX: RIO) and Whitehaven Coal Ltd (ASX: WHC), especially since the iron ore and coal markets are strongly dependent on Chinese demand.
- Companies being priced for growth, especially where the business is not demonstrably profitable, or that growth is strongly dependent on the price and availability of debt. Afterpay Touch Group Ltd (ASX: APT) is a possible candidate, as are businesses like G8 Education Ltd (ASX: GEM) where growth is delivered by debt-funded acquisitions.
It's important to note that preparing for a market crash is a nuanced effort. If you truly wanted to avoid or protect against a market crash, you should just sell all of your stocks. That is not a smart decision, since predicting market crashes is not easy – as the old saying goes, pundits predicted 37 of the last 5 market crashes – so the actual decision of how to prepare will be up to the individual.
Depending on the size of your portfolio, it is also worth keeping in mind that you can build up cash via saving extra, rather than having to sell stocks. Having more cash on hand can be useful for ameliorating the impact of a market crash – especially if you can buy cheap shares at the bottom.
I'm not saying that you should sell all or even any of the above companies, what I am saying is that bad things happen in situations where investors have bet too heavily on risky business models, especially when the investors have used debt (such as margin loans). I also think that a lot of investors are blind to many of the risks in the market at present, especially with the recent glorification of 'start-up' style business models that plan to be unprofitable for the foreseeable future.
I think it would be prudent to consider reducing the size of your holdings in risky businesses and consider holding more cash.
