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Protecting Yourself in a Bubbly World

A recent Forbes article, written by economic analyst Jesse Colombo and titled Why Singapore’s Economy Is Heading For An Iceland-Style Meltdown, has been making the rounds lately, so much so that it has inadvertently prompted a response from the Monetary Authority of Singapore after the media queried the regulatory body.

The basic premise of the Forbes article is that Singapore is in the midst of many economic and financial bubbles that are inflated by cheap credit spurred by the United States’ massive monetary stimulus programme. MAS’s response however, indicated that our country “is not facing a credit bubble that puts the country or its banking system at any risk of crisis.”

While I have no intention to wade into the debate nor refute or support the Forbes article’s premise, the article does bring up the pertinent issue of how investors can protect themselves in a bubbly world fueled by cheap credit, if one exists.

And to address that, the simplest way to protect our portfolio, would be to invest in companies with robust balance sheets; companies that have a history of operating successfully and profitably without the need for undue leverage.

When I think of a credit bubble, I’m often reminded of the wise words of Warren Buffett on the topic. This is what American billionaire investor Warren Buffett wrote in his 2010 Berkshire Hathaway shareholder letter (emphasis his):

Companies with large debts often assume that these obligations can be refinanced as they mature. That assumption is usually valid. Occasionally though, either because of company-specific problems or a worldwide shortage of credit, maturities must actually be met by payment. For that, only cash will do the job.

Borrowers then learn that credit is like oxygen. When either is abundant, its presence goes unnoticed. When either is missing, that’s all that is noticed. Even a short absence of credit can bring a company to its knees. In September 2008, in fact, its overnight disappearance in many sectors of the economy came dangerously close to bringing [the entire United States] to its knees.”

In other words, if a company has no need for leverage in the first place, it can avoid being “brought to its knees” when credit freezes, as might well happen if a credit bubble pops. And in any case, being imbued with a strong balance sheet also gives any company a great chance of tiding over tough times.

Of course, one might ask, why should an investor even invest in the first place knowing there’s a bubble? For starters, it can be remarkably tough to spot a bubble, and even if one is spotted, it also becomes next to impossible to tell when it’ll pop. The latter’s a notion shared by Nobel Prize-winning economist Robert Shiller.

Trying to time the market based on bubbles can also be extremely hazardous for one’s investing portfolio. Just ask money manager John Hussman, whose flagship fund, the Hussman Strategic Growth Fund, has collapsed in value by close to 20% since the start of 2009, a period of five years that saw the widely-followed American stock market index, the S&P 500, gain some 120%.

Hussman’s fund has suffered so badly because of his “short” position (a “short” in the stock market is an attempt to profit from falling prices) in the American stock market stemming from his belief that it is in a bubble and is bound to collapse.

Using the Straits Times Index’s (SGX: ^STI) weightings for its individual components as of 30 Sep 2013, the weighted average total debt to equity ratio for the index stands at 77%. While that ratio would likely not send alarm bells ringing, there’s also room for improvement.

Within the blue chips – excluding the banks – some of the bigger culprits for propping up the ratio include telecom operator Starhub (SGX: CC3) and commodities trader Olam International (SGX: O32).

On the other hand, index-components with robust balance sheets include stock exchange operator Singapore Exchange (SGX: S68), aircraft engineering outfit SIA Engineering Company (SGX: S59), and full-service carrier Singapore Airlines (SGX: C6L).

Company

Total debt to equity ratio

Starhub

828%

Olam International

219%

Singapore Exchange

0%

SIA Engineering

0.9%

Singapore Airlines

7.3%

Source: S&P Capital IQ

Outside the index, there are also companies like Super Group (SGX: S10), Raffles Medical Group (SGX: R01), and Vicom (SGX: V01) that have managed to keep remarkably clean balance sheets over the years while still being able to grow their sales and profits.

All things equal, it will be the companies with debt-laden balance sheets that require the closest scrutiny from investors.

Foolish Bottom Line

To be certain, I’m not saying companies with solid balance sheets will necessarily make good investments in the event of a credit bubble popping. Far from it. There’s plenty of other factors that can influence the long-term outcome of an investment, and chief among those, are a company’s future profits and cash flow.

If Singapore’s economy does implode due to the bursting of a credit bubble, like what happened to Iceland back in 2008, there’s likely to be severe short-term pain everywhere you look.

But like I mentioned, it’s hard to tell if: 1) whether there’s even a bubble; and 2) when a bubble will pop even if there is one. While we would all very much like to believe that we live in a world where we are in full control of matters, the unfortunate truth is, we exist in a realm of imperfect information.

In an imperfect world, we should be preparing, instead of predicting. And in the process of preparing, let’s not lose out on a great avenue to build long-term wealth – the stock market. By ensuring my portfolio is filled with companies that are able to withstand rough times, that’s how I would protect myself in a credit-bubbly world.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares of Super Group, Raffles Medical Group, and B-class shares of Berkshire Hathaway.