Beached

Equities can be seen as a “call option” [1] on the future growth of a company; once the liabilities due to bondholders are paid, the surplus accrues to shareholders in the form of dividends/share buybacks, etc. or are re-invested to generate future growth in the firm. At least, this is what happens most of the time, but every now and then, things go awry, a company fails and the “call option” expires worthless. It is not a common occurrence, but when it does happen, the shareholders tend to lose everything.

So it was last week, with the announcement that Thomas Cook, the venerable travel agent, had gone into liquidation as they failed to find the c.£200 million needed from outside sources to keep the company afloat. A succession of profit warnings in the last few years has seen its share price fall from 140p to just 4p as of last week. A huge debt burden (see analysis at the bottom of the article), a consequent lack of working capital and the demise of the package holiday business – not helped by the increase in terrorist-related events in some of their main markets (Europe and Turkey) in 2016 and the fall in Sterling post-Brexit, making overseas travel more expensive has seemed to seal their fate (a time-line of events can be found here). Thomas Cook bondholders looked to have seen the problems coming…[2]

Of course, this has implications for Index fundholders, or at least did; but this is a feature not a bug of Index investing. As the Index weighting of an asset falls, so too does the corresponding Index fund weight. This can be done either by selling the holdings OR by not increasing the size of the current holdings, thereby seeing it drift lower by default; either way, the exposure of the Index fund is reduced in line with the performance of the share. As of the end of August 2019, EBI 100 (UK Bias) – the portfolio with the largest potential exposure to TC – had a weighting of 0.05%, compared to 0.07% as of the end 2014. Neither of these numbers is in any way material, but let us assume a worse case scenario – even if we assume a 3% Index weighting as of the end of 2014, a £100 investment in the Index will incur a loss of just 3% (i.e. £3), assuming that the shareholders are completely wiped out. In reality, the loss will, for those holding the portfolio from 2015, likely be 0.07% ( or 7p per £100 invested). A £500,000 portfolio would lose £350 in total…..

The mathematics of diversification (via Index funds) works well – losses WILL happen, but to focus solely on those losses might miss the bigger picture. The aim is to benefit from overall market returns, which involves both winners and losers. Presumably, the elimination of one competitor will strengthen the position of all the others in the travel business (which EBI would also own) so, unless overseas holidays become a thing of the past, the potential profits are merely transferred to other firms in the industry. It is NOT normal for a reduction in competition in a market to lead to lower profit margins for those left standing.

What can investors do about this? In truth, nothing, and nor should they try. Index constituents’ weights are in a constant state of flux, as their fortunes wax and wane, but WHICH ones will do well is, ex-ante, impossible to predict. Changing the weights of a share in a portfolio or an Index implies a view on the future, which would defeat the purpose of an Index fund. There is no more reason to focus on individual stocks in an Index than there is to focus on individual stocks full stop. As the Index itself sees gains, investors also benefit in the same proportion. There is no scope for beating the Index, but that should not be the aim. There has been a succession of analysts telling us how the demise of Thomas Cook was “inevitable” but this is hindsight bias and thus of little import. What many of these forecasters fail to mention is how many times they have been in error (or for how long they have been forecasting this). Index funds do not forecast events; they aim to harvest returns from the whole market and until this ceases to be their modus operandi, there is no reason to do anything else but hold and wait.

[1] A call option gives the holder the right to buy an asset at a pre-determined price. Thus, as the price rises, it becomes more valuable (and vice versa)

[2] A similar situation will have already happened with Venezuelan bonds (to some bond funds). As the country has spiraled into chaos (as we documented a year or so back), the country’s bonds have plummeted. In fact, Venezuela has not been an investment-grade (IG) credit since 1983, so for EBI investors, there have been no losses incurred. But in theory, IF the country had fallen from IG to sub-investment grade, many bond funds would have been required to sell them – which is another reason to stick to high-quality issuers. Thomas Cook bonds were rated B+ by S&P as recently as November 2018, far below the BBB rating required for Investment Grade status.