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March 7, 2016

Going up in flames

German Pellets, a manufacturer of wood pellets for heating, has filed for bankruptcy. Local private German investors were the main source of funding and they probably lost nearly €250m. We have not invested in German Pellets and want to provide a quick check-list that hopefully helps other investors avoid similar disasters.

Warning sign #1: If a company only targets private investors

Institutional investors employ a large number of professional analysts that are well trained at spotting potential flaws in a business model or even fraud. If a company is looking to avoid institutional investors as a source of funding it should make you immediately sit up and take notice. German Pellet only targeted local retail investors.

Warning sign #2: Exceptionally high return

There is no such thing as a free lunch.  If a company can get cheap financing why should they offer high returns to private investors? In almost all cases it is a sign that the company is cut off from other sources of funding – never a good sign.

But when is high too high? German Pellets issued their last debt with a 7.25% coupon at a time when European High Yield bonds were trading at (or below) 4%. There is a reason why High Yield bonds used to be called  junk bonds – they are risky. Hence if High Yield bonds only offer a yield of 4%, you need to realize that an investment that offers nearly twice the return will come with signficant risks attached.

Warning sign #3: Storytelling

Private investors love a good story. Some more than they love facts. This isn’t entirely surprising because most private investors are ill-equipped to analyse financial data and it is easier to invest in a good story. Renewable investing, the business German Pellets was in, is clearly one of the current hot investment themes. But thematic investing rarely works out as most investors in solar, wind, internet or other hot themes du jour can attest. The basic rules also apply for sustainable investing: diversify as much as possible to limit your risk. Investors should therefore avoid single stocks and narrow thematic funds as much as possible.

Warning sign #4: Business model is just a bet

Would you invest in a company whose survival solely depends on the prices of oil? Probably not. This would be more akin to a bet than a proper long-term investment. However, this is exactly what investors in German Pellets did. They bet that the price of oil would not fall below the production costs of wood pellets. Sadly that bet didn’t work out as the oil price more than halved in 2015. Since most private investors will not be able to fully understand the risks of each business model, the best advice is to avoid single stocks.

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