In a recent article entitled, Whatever You Do, Avoid Major Mistakes, I suggested that investors study-up on the subject of counterparty risk. Under a constructionist definition, the term equates to default risk as defined by the inability of a party to live up to its contractual obligations. The failure of a debtor to meet its obligations under a credit arrangement is a counterparty risk as is failure to perform under a swap or option agreement.
A Broader Definition Needed
However, for investors, a broader definition of the term is more appropriate to reflect that: a) counterparty risk arises when a major player(s) in a firm's value-chain fails to perform whether contractually or not, b) the mere thought or mention of default gives rise to counterparty risk, and c) counterparty risk reverberates out from the source of the problem such that it can involve not just two, but multiple parties serially / simultaneously. This more encompassing definition explains a lot of what is going today:
- China's faltering economy has seriously disrupted supply chain relationships beginning, notably, with miners as close as Australia and as far away as South America. For example, questions have been raised about Rio Tinto (NYSE:RIO), Glencore (OTCPK:GLCNF) and Freeport-McMoRan (NYSE:FCX) three of the largest mining companies in the world.
- The collapse in oil prices has now reverberated well away from drillers to servicing, pipeline, storage and tanker companies, landlords and hoteliers housing field personnel, banks, municipalities, states, and even countries. Take, for example, Kinder Morgan (NYSE:KMP), the Royal Bank of Canada (NYSE:RY), or Statoil (NYSE:STO) / Norway.
- The gadget business that is over-saturated with products amid slackening demand has created problems along the value-chain including between the likes of Samsung (OTC:SSNLF) and Qualcomm (NASDAQ:QCOM).
- Bricks retailers such as The Gap (NYSE:GPS) and Aeropostale (NYSE:ARO) are beating their brains out over fashion style and space utilization resulting in downstream impact to shopping center REIT's as in the case of CBL & Associates (NYSE:CBL).
Distancing Yourself from Counterparty Risks
It's therefore understandable that some investors are scared. Stocks and bonds that they thought were fairly valued and perfectly safe are tanking. Moreover, fears are being whipped up by the likes of hedge fund managers who actually have lost their a$$ and are looking down the barrel at significant redemptions. Some would have us believe that the world is going to hell. It's not. I personally see no reason to sell everything and to blow up an income stream in order to protect principle in these extremely volatile markets.
BUT, if you haven't already, the time is rapidly passing to put more distance between your portfolio and counterparty risks. This begins in one of two ways: a) By stepping back to consider macro changes that are developing / underway and how they may affect your holdings, or b) By taking a micro perspective and 'looking back through' your portfolio to 'see' what negative consequences may be coming at you from interrelated sectors. The idea is to get away, as quickly as possible, from ground zero.
On my end, earlier this year, I took three actions to put more distance between our portfolio and counterparty risks: 1) I sold Corning (NYSE:GLW) not because I don't like the company - I really do - but because of concerns about the weakening gadget business, 2) I divested our positions in Chevron (NYSE:CVX) and Royal Dutch Shell (NYSE:RDS.B) even though as integrated companies they have fared a lot better than 'pure plays' in the oil production business, and 3) I bailed on JPMorgan Chase (NYSE:JPM) believing that they have not been completely forthright about their exposures to oil and related sectors. In other words, I have concerns that, like other financial institutions, JPM may not have a handle on their counterparty risks.
At the same time, I am sitting tight with positions in industries / companies that are more insulated from counterparty risks and whose demand for their products and services is relatively inelastic - military defense contractors, water management firms, and pharmaceutical companies. Also, I continue to make investments in what I feel will be growth areas such as in the fight against migrating tropical diseases.
Two Directions to Alpha
Like everyone else, I have suffered losses so far this year. However, by moving away from counterparty risks, my losses have been 3 to 4% less than comparable indices. Remember, just as alpha-level performance is doing better than the market when it is up, it is also doing less bad when the market is down.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.