The best articles we’ve read in recent times on a wide range of topics, including investing, business, and the world in general.
We’ve constantly been sharing a list of our recent reads in our weekly emails for The Good Investors.
Do subscribe for our weekly updates through the orange box in the blog (it’s on the side if you’re using a computer, and all the way at the bottom if you’re using mobile) – it’s free!
But since our readership-audience for The Good Investors is wider than our subscriber base, we think sharing the reading list regularly on the blog itself can benefit even more people. The articles we share touch on a wide range of topics, including investing, business, and the world in general.
Here are the articles for the week ending 7 June 2020:
Meanwhile, we may also see complexity where only chaos exists. This tendency manifests in many forms, such as conspiracy theories, superstition, folklore, and logical fallacies. The distinction between complexity and chaos is not a semantic one. When we imagine that something chaotic is in fact complex, we are seeing it as having an order and more predictability than is warranted. In fact, there is no real order, and prediction is incredibly difficult at best.
Complexity bias is interesting because the majority of cognitive biases occur in order to save mental energy. For example, confirmation bias enables us to avoid the effort associated with updating our beliefs. We stick to our existing opinions and ignore information that contradicts them. Availability bias is a means of avoiding the effort of considering everything we know about a topic. It may seem like the opposite is true, but complexity bias is, in fact, another cognitive shortcut. By opting for impenetrable solutions, we sidestep the need to understand. Of the fight-or-flight responses, complexity bias is the flight response. It is a means of turning away from a problem or concept and labeling it as too confusing. If you think something is harder than it is, you surrender your responsibility to understand it.
Why? Because the content they seek out is evergreen. It’s always available. I can go watch Orange is the New Black, one of the original shows and it’s valuable to me today. So the marginal value of Netflix is increasing as their customer base increases as opposed to a lot of services where the more customers there are, it degrades in quality and becomes even harder to acquire them and then they have to spend marketing costs to acquire them.
And that’s just where companies fall apart. So many companies based their sort of projections and calculations on the cost of acquiring a customer at the beginning. The problem is at the beginning you’re serving your ideal customer, the one that really wants your product, and so they’re going to look over the problems with your product, et cetera, et cetera. They’re going to be easy to acquire and usually your marginal customer gets more and more difficult to acquire. You have to spend more money, and what happens is Facebook and Google actually end up taking all your profit over time.
“I might never have gone into the banking business,” he later recalled, if he hadn’t gotten into a shouting match with the head of a local bank about its reluctance to make small loans to individual borrowers. In 1904, Giannini founded a bank of his own in San Francisco, called Bank of Italy, to do just that.
Then, on April 18, 1906, an earthquake struck the Bay Area, killing more than 3,000 people and setting the city ablaze.
Realizing the fires were heading toward his bank, Giannini heaved $80,000 of gold and cash into two horse-drawn produce wagons. He buried the money under crates of oranges to hide it from looters rampaging through the streets. For weeks afterward, he recalled later, the bank’s money smelled like oranges.
By the next day, the Bank of Italy had burned to the ground. But Giannini rode in from his home in San Mateo, where he had stashed the money. With San Francisco still smoldering, he set up a desk on the wharf and plunked a sack of gold on it, under a cardboard sign on a stick that read BANK OF ITALY: OPEN FOR BUSINESS.
Giannini lent to almost everyone with a legitimate need, on one condition: They had to raise half of what they needed elsewhere. That forced them to enlist their friends and family in the recovery of their business or the rebuilding of their home.
Then Giannini would lend the other half, often accepting little more than people’s character as their collateral. After all, he’d just gotten others to assume half the bank’s risk. What’s more, much of the hoarded cash the borrowers raised from their friends and family ended up as Bank of Italy deposits—or was invested in shares of its stock.
Some things are always changing and can’t be known. There can also be a handful of things you have unshakable faith in – your permanent assumptions.
Realizing it’s not inconsistent to have no view about the future path of some things but unwavering views about the path of others is how you stay humble without giving up. And the good news when the world is a dark cloud of uncertainty is that those permanent assumptions tend to be what matter most over time.
Mr. Rao, who was working remotely that Monday, walked down the 20 steps to his home office at 4:30 a.m. to discover the debt markets were already in disarray. He started calling the senior Wall Street executives he knew at many of the big banks.
Executives told him that Sunday’s emergency Fed rate cut had swung a swath of interest-rate swap contracts in banks’ favor. Companies had locked in superlow interest rates on future debt sales over the past year. But when rates fell even further, the companies suddenly owed additional collateral.
On that Monday, banks had to account for all that new collateral as assets on their books.
So when Mr. Rao called senior executives for an explanation on why they wouldn’t trade, they had the same refrain: There was no room to buy bonds and other assets and still remain in compliance with tougher guidelines imposed by regulators after the previous financial crisis. In other words, capital rules intended to make the financial system safer were, at least in this instance, draining liquidity from the markets.
One senior bank executive leveled with him: “We can’t bid on anything that adds to the balance sheet right now.”
At the same time, the surge in stock-market volatility, along with falling prices on mortgage bonds, had forced margin calls on many investment funds. The additional collateral they owed banks was also booked as assets, adding billions more.
The slump in mortgage bonds was so vast it crushed a group of investors that had borrowed from banks to juice their returns: real-estate investment funds.
The Fed’s bond-buying program, unveiled that Sunday, had earmarked some $200 billion for mortgage-bond purchases. But by Monday bond managers discovered the Fed purchases, while well-intentioned, weren’t nearly enough.
“On that first day, the Fed got completely run over by the market,” said Dan Ivascyn, who manages one of the world’s biggest bond funds and serves as investment chief at Pacific Investment Management Co. “That’s where REITs and other leveraged-mortgage products started getting into serious trouble.”
According to historians, pandemics typically have two types of endings: the medical, which occurs when the incidence and death rates plummet, and the social, when the epidemic of fear about the disease wanes.
“When people ask, ‘When will this end?,’ they are asking about the social ending,” said Dr. Jeremy Greene, a historian of medicine at Johns Hopkins.
In other words, an end can occur not because a disease has been vanquished but because people grow tired of panic mode and learn to live with a disease. Allan Brandt, a Harvard historian, said something similar was happening with Covid-19: “As we have seen in the debate about opening the economy, many questions about the so-called end are determined not by medical and public health data but by sociopolitical processes.”
Endings “are very, very messy,” said Dora Vargha, a historian at the University of Exeter. “Looking back, we have a weak narrative. For whom does the epidemic end, and who gets to say?”
Here are some reminders I like to consider when thinking through big moves like this:
I cannot predict the direction of the stock market over the short-term.
I cannot predict the magnitude of stock market moves.
I cannot predict when market moves are going to start or stop.
The stock market doesn’t always make sense nor does it have to.
The stock market has the ability to make everyone look foolish at times.
Things looked bleak in March. Now things look not so bad considering the S&P 500 is down just 2-3% on the year. What happens next is anyone’s guess.
I don’t know.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
Small business owners will tell you how much of a hassle accounting can be. This is why it’s no surprise that cloud-based accounting software is growing in popularity. Not only do they automate part of the accounting process, but cloud software is also accessible over multiple devices, is easily shareable, have multiple add-on features to integrate other aspects of the business, and are automatically upgraded over the cloud.
Xero Limited (ASX: XRO), as one of the first cloud software-as-a-service (SaaS) accounting tools provider, is one of the beneficiaries of this trend. Xero originated in New Zealand and is listed in the Australia stock market. Today, it dominates its core Australia and New Zealand markets, and counts more than 2 million subscribers worldwide.
Using my blogging partner Ser Jing’s six-point investment framework, I analyse whether Xero has the potential to be a long-term compounder.
1. Is Xero’s revenue small in relation to a large and/or growing market, or is its revenue large in a fast-growing market?
Xero, as of 31 March 2020, served 2.285 million customers. Of which, around 1.3 million were from Australia and New Zealand, 613,000 from the UK, 241,000 in North America, and 125,000 in the rest of the world.
These numbers are tiny compared to the total number of SMEs (small, medium enterprises) in the regions. It is estimated that Australia and New Zealand have around 2.2 million and 487,000 SMEs, respectively. Meanwhile, the US has more than 30 million and the UK has 5.9 million.
Accounting is something that every company needs to do. But, cloud accounting penetration is still small. In the UK, North America, and the rest of the world, cloud adoption for accounting software is still less than 20%. This means cloud accounting software companies can grow into a largely untapped market. Yes, there are numerous players, such as Intuit’s QuickBooks, or MYOB in Australia, but the global market could be big enough for a few large players to coexist.
Xero is by far the market leader in Australia and New Zealand – and growth has slowed down there. However, Xero’s growth in other markets is still robust as subscriber count in the UK, North America, and the rest of the world increased by 32%, 24%, and 51%, respectively, in the fiscal year ended 31 March 2020 (FY2020).
Even if Xero is able to win just 10% of the total addressable market in the English speaking world, it could see a multi-fold increase in revenue.
2. Does Xero have a strong balance sheet with minimal or a reasonable amount of debt?
It is important that Xero has the financial resources to oversee the spending that is required to gain market share in its relatively younger markets. On this front, Xero looks to be in good shape.
As of 31 March 2020, it had cash and short term deposits of NZ$536 million, and NZ$424 million in debt in the form of convertible notes. The convertible notes only mature in 2023 and can be settled in shares. As such, Xero has financial flexibility should it choose not to settle the notes in cash.
More importantly, Xero turned the corner in FY2020 as it recorded its first annual profit. The company also generated positive free cash flow. This should provide further ammunition for the company to pursue its organic growth goals or to make a strategic acquisition.
3. Does Xero’s management team have integrity, capability, and an innovative mindset?
Xero’s management team has so far demonstrated all three of these qualities. Xero has been able to grow consistently in its core markets due to strategic investments in its products, offering an open-source system for developers to build apps on its platform. It is also consistently adding new features to its product to cater to customers needs.
In FY2020, Xero rolled out Xero Tax in the UK to enable customers to digitally prepare files accounts and tax returns. It also rolled out HQ VAT in the UK so that customers can fulfill the UK government’s “Making Tax Digital” requirements.
Xero’s steady growth in revenue and its market-leading position in its home market in New Zealand and Australia is testament to the strength of management’s execution so far.
As Xero operates in a crowded market, innovation will be key when it comes to who can gain more market share. Xero has done well in this space so far and has consistently spent large sums of money upgrading its software. This innovative mindset will be vital in the company’s quest to gain meaningful market share in its less developed markets.
Glassdoor ratings are not always the most reliable, but it can be a good indicator of whether a company’s CEO is pushing the right buttons to motivate and keep his staff happy. Steve Vamos, the current CEO of Xero, boasts a solid Glassdoor rating of 89%. Vamos took over from Xero founder Rod Drury two years ago and has continued the company’s fast growth.
4. Are Xero’s revenue streams recurring in nature?
Recurring revenue is a wonderful thing to have for any business. It allows the business to plan for the future more accurately and to expend more resources on growing the business rather than retaining existing customers.
Xero has a beautiful base of recurring revenue. Its recurring subscription revenue made up 97% of total revenue in FY2020. Customers typically pay a monthly subscription for Xero’s software services.
Xero has created a sticky customer base for a few reasons. First, once you get started on Xero, it is hard to get out of it. That’s because customers have all their data logged into the software. Moving that data from one software to another can be a gruelling task.
Second, Xero has accountant partners who use Xero software. These accountant partners attract clients and in turn get rewarded by being listed on the Xero advisor directory, which gives them access to other clients. This has created a virtuous cycle that keeps on giving for both accountants and Xero.
The stickiness of Xero’s customer base is demonstrated by the low churn rate. In Xero’s last two financial years, the monthly churn rate for its customers was 1.1% and 1.13%. This means almost 99% of Xero’s customers continue using its services month after month.
5. Does Xero have a proven ability to grow?
I think the answer to this is a clear yes. Xero started as a tech start-up in 2006, and has grown from just a few thousand customers in its early days to one that serves more than 2 million worldwide.
It has executed its growth strategy well even as it expands internationally. The chart below is a visual representation of the growth in Xero’s user base over the past 11 financial years.
Perhaps more importantly, the user base growth has translated meaningfully into annualised monthly recurring revenue (AMRR). In FY2020, AMRR grew by 29%, while operating revenue grew 29%.
6. Does Xero have a high likelihood of generating a strong and growing stream of free cash flow in the future?
Xero reached an inflection point in FY2020. The company registered its first-ever operating profit. It was also the second consecutive year that the company generated positive free cash flow.
I believe Xero’s free cash flow margins can improve as it scales.
Xero boasts a high gross margin of 85.2%, which means that it has the potential to earn very high net profit margins should other costs decrease as a percentage of revenue.
As the company scales, I expect sales and marketing expenses to decrease as a percentage of revenue. Currently, sales and marketing expenses are 43.6% of revenue. This has a lot of room to drop, especially as revenue grows.
Xero’s product and design costs have also been north of 30% of revenue. Although product-upgrades are a necessary expense to keep Xero ahead of its competitors, the company has complete control over how much to spend on development costs. As it scales, this cost should also decrease as a percentage of revenue.
Risks
The biggest threat to Xero is competition from other accounting SaaS players. As mentioned earlier, accounting software is a crowded space. There are big-name players such as Intuit’s Quickbooks and Sage that are fighting for market share.
Xero, while dominant in Australia and New Zealand, will need to execute its growth strategy well to grow in its less developed markets.
Customers store important information on Xero’s software. A cyber attack could reduce trust among its users.
Inability to execute its expansion outside of its core markets is another risk for Xero. The company’s shares are currently priced for growth (more on this below) so if the company cannot match investors’ expectations, the share price may fall.
As a company that serves largely SMEs, Xero is also affected by the COVID-19 pandemic. The healthcare crisis could cause millions of SMEs to permanently close its doors. Xero may, in turn, suffer a significantly higher churn rate during this time and lower gross subscriber additions. In its recent earnings update for FY2020, Xero’s management wrote,
“[T]rading in the early stages of FY21 has been impacted by the COVID-19 environment. The continued uncertainty surrounding COVID-19 means it would be speculative for us to say anything more at this time on its potential impact on our expected performance for FY21.”
Valuation
The final piece of the analysis is to find out what is a good price to pay for the company. I like to compare what I think is a potential future value of the company in five to 10 years’ time versus the company’s current market cap.
Based on very rough estimates, let’s assume Xero can penetrate 80% of all SMEs in its core market in ANZ, 20% in the more developed UK market, and 10% in the young and competitive US market.
This translates to slightly over 9 million customers. The average revenue per user remains at around NZ$30 a month, which means Xero will earn revenue of about NZ$3.2 billion.
Let’s make two more assumptions. First, it can earn a net profit margin of 25% (which to me is conservative considering its gross margin of 85%), and second, the market is willing to price it at 30 times earnings. This will mean that Xero will command a market cap of around NZ$24 billion in five to 10 years’ time. Currently, Xero has a market cap of NZ$13.2 billion.
Last words
Xero has all the makings of a great company. It boasts (1) a huge addressable market to tap into, (2) a strong balance sheet, (3) a management team with a track record of solid execution, (4) a proven track record of growth, (5) recurring revenue and (6) the ability to generate steady and high free cash flow margins.
Its market cap today also gives it room to grow further.
There are risks, though. Execution risks and competition can stifle its growth. However, given all that I’ve seen so far, the risk-reward profile still is fairly appealing to me.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
We are in a state of chaos now across the world with COVID-19. Then there’s also the current riots in the US. How can the world rebuild itself?
Wow. The following is how author Robert Kurson described the riots that happened in the US:
“After thirty minutes, the police obliged them, smashing and clubbing and kicking and dragging anyone they could reach—demonstrators, onlookers, journalists—and it didn’t matter that the network television cameras were filming or that people were yelling “The whole world is watching!” or that those in the streets weren’t Vietcong or Soviets but the sons and daughters of fellow citizens; all that mattered for the next eighteen minutes of brutality and mayhem was that something had fractured in America and no one had any idea how to stop it, and after order was restored there still seemed to be cries coming from the streets, even though there was no one left to make them.
Among the millions who watched the unedited footage on television, there hardly seemed a soul among them—rich or poor, young or old, left or right—who didn’t wonder if America could be put back together again.”
Could America be put back together again…? Yes. Because Kurson’s description appeared in his book Rocket Men, and was written about 1968. Riots erupted in the US after the assassinations of Martin Luthor King Jr. and Robert Kennedy during the year. Both men were giants in the country’s socio-political landscape.
(I want to quickly digress here and give credit to one of my favourite investment writers, Ben Carlson. I came across Kurson’s passage in one of Carlson’s recent blog posts.)
The riots that Kurson wrote about could well be used to describe what’s happening in the US today. The current social tension in the country – sparked by the tragic death of George Floyd while in police custody – is heartbreaking. Even for someone like me living thousands of kilometres away in Singapore, I can feel it.
2020 has been brutal so far. Economies around the world effectively ground to a halt in the first half of the year as countries scrambled to fight against COVID-19. And nobody knows just how much psychological trauma individuals from all the affected countries have suffered because of social distancing, lockdowns, and closed businesses. And with COVID-19 still looming in the background, the George Floyd riots came crashing in.
“One key thing I’ve learnt about humanity is that our progress has never happened smoothly. It took us only 66 years to go from the first demonstration of manned flight by the Wright brothers at Kitty Hawk to putting a man on the moon. But in between was World War II, a brutal battle across the globe from 1939 to 1945 that killed an estimated 66 million, according to National Geographic.
This is how progress is made, through the broken pieces of the mess that Mother Nature and our own mistakes create…
… There are 7.8 billion individuals in the world today, and the vast majority of us will wake up every morning wanting to improve the world and our own lot in life.. Miscreants and Mother Nature will wreak havoc from time to time. But I have faith in the collective positivity of humanity. When there’s a mess, we can clean it up. This has been the story of our long history.”
Humanity’s progress has never been smooth. There are always things to worry about. But tomorrow will be a brighter day.
Disclaimer:The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.I, the author, will be making sell-trades on the stocks mentioned in this article over the coming weeks.
My takeaways from “The Big Short”, a great movie on how a few real-life investors foresaw the 2008-09 financial crisis and profited wildly from it.
My girlfriend is currently taking online courses on financial analysis for her own personal development. The content can be really dry for her at times. To spice up her learning, I recently suggested that she watch the movie, The Big Short.
The film came out in 2015 and is based on the 2010 book by renowned author Michael Lewis, The Big Short: Inside the Doomsday Machine. Both the movie and book depict the real-life experience of a few groups of investors who foresaw the 2008-09 US housing and financial crisis and profited from it.
When the movie first came out, I was so excitedthat I helped organise an outing to watch it with a group of friends who are also keen investors. I remember being captivated by the film.
After recommending The Big Short to my girlfriend (she loves the movie too – yay!), I decided to rewatch it last weekend. It was the first time I did so, five years after I initially saw the film. In my second run, I experienced the same captivation I did as on my first. But this time, I also came away with investing lessons that I want to share – perhaps a by-product of me having this investment blog that I love writing for.
Lesson 1: The market can remain irrational longer than you can remain solvent
The characters in The Big Short mostly used leveraged instruments – credit default swaps (CDSs) – to make their bets that the housing market and the financial instruments tied to the housing market would fall. This is a simplified explanation, but the financial instruments that were tied to the housing market were essentially bonds that were each made up of thousands of mortgage loans from across the US.
The CDSs are like insurance contracts on the bonds. If you own a CDS, its value will rise significantly, or you will receive a big payoff, if the value of the bonds fall or go to zero. But before the decline happens, you have to pay regular premiums on the swaps as long as you own it. Moreover, you have to meet margin calls on the CDS if the value of the bonds increase.
The investors depicted in The Big Short suffered temporary but painful losses to their portfolios because of the premiums and margin calls they had to pay prior to the flare up of the housing and financial crisis. Their experience reminded me of a great quote that is commonly attributed to the legendary economist John Maynard Keynes, but that is more likely to have originated from financial analyst Gary Shilling:
“The market can remain irrational longer than you can remain solvent.”
If the housing and financial crisis did not erupt when they did, the investors in The Big Short may have suffered debilitating losses if they held onto their CDSs long enough. This is a key reason why I do not short financial assets nor use leverage. Some investors can do it very successfully – the ones in The Big Short certainly did – but it’s not my game.
Lesson 2: Investing can be a lonely affair
One of the real-life investors profiled in the movie and book is Dr Michael Burry. The movie did not explore much of Burry’s earlier life before he invested in the CDSs, but his real backstory is amazing.
Growing up, Burry was somewhat of a loner. But he managed to excel academically and eventually graduated with a medical degree. He worked in a hospital for some time, but found that his real interest was in stock market investing. When he was a doctor, he spent his free hours researching stocks and writing about them on the internet. His sharing was excellent and attracted the attention of the well-known investor Joel Greenblatt (the character Lawrence Fields in the movie is based on him). Burry eventually left medicine to establish his investment firm, Scion Capital, with Greenblatt’s seed capital.
Burry’s reputation was built on his uncanny ability to pick stocks mostly through bottoms-up, fundamental analysis. In Scion’s early days, he posted tremendous returns for a few years by shorting overvalued stocks and investing in undervalued ones. But in 2005, after he discovered the house of cards that the US housing market was built on and decided to invest in CDSs, his investors started turning on him. They had no faith in his ability to find investment opportunities outside of the stock market. They wanted him to stick to his knitting.
The Big Short depicted the intense emotional loneliness that Burry felt when his investors turned their backs on him. Some even threatened to sue. Burry was vindicated in the end. In 2007, the US housing market started to collapse and the bonds that were built with the mortgage loans failed. Burry’s CDSs soared as a result. But he was so burnt out by the experience that he decided to close Scion Capital after cashing in the profits.
What was even sadder is that even though Burry made a lot of money for his investors in Scion Capital – the fund gained 489% in total, or 27% annualised, from its inception in November 2000 to June 2008 – the relationships he had with his investors, including his mentor Greenblatt, had mostly soured beyond repair.
At times in investing, we may be the only ones who hold a certain view. This could be a lonely and draining experience (although it’s probably unlikely that we will face the same level of isolation that Burry did) so we have to be mentally prepared for it.
Lesson 3: Famous investors can be very wrong at times too
This is related to Lesson 2. Joel Greenblatt produced a 40% annualised return for 20 years with his investment fund, Gotham Capital, that he co-founded in 1985. That’s an amazing track record. But Greenblatt got it wrong when he butted heads with Dr Michael Burry’s decision to invest in CDSs.
It’s very important for us as investors to know what we don’t know. As I mentioned earlier, Burry started his investing career by being a very successful stock picker who did bottoms-up fundamental analysis. Being a good stock picker does not mean that you will automatically be good at other types of investments. I believe this was Greenblatt’s concern and I sympathise with him. This is because it was a legitimate worry that Burry may have ventured into an area where he had zero expertise when he shorted the US housing market through CDSs.
This is not meant to be a criticism of Greenblatt in any way. His results are one of the best in the investing business. I would have been worried about Burry’s investment actions too if I were in Greenblatt’s shoes. What I’m trying to show is just how difficult investing in the financial markets can be at times, and that even the best of the best can get it wrong too.
Lesson 4: Luck can play a huge role in our returns
One of the central characters in the movie and the book is hedge fund manager Steve Eisman (named Mark Baum in the film) who first heard of the CDSs trade from a bond trader at Deutsche Bank, Greg Lippmann (named Jared Vennett in the film). What is amazing is that Eisman only knew about the idea because of a mistake that Lippmann made.
Lippmann wanted to introduce his idea of shorting the housing market with CDSs to hedge funds that had a certain characteristic. One hedge fund Lippmann discovered that fit his bill was Frontpoint. Eisman’s hedge fund was named Frontpoint – but the problem was Eisman’s Frontpoint was not the Frontpoint Lippmann was looking for. Lippmann only realised his mistake when he met Eisman in person. Nonetheless, Eisman saw the logic in Lippmann’s idea. He made the trade for his Frontpoint, and the rest as they say, is history.
This goes to show how important luck can be to our investment returns. Eisman only knew about the idea because Lippmann suffered a case of mistaken identity. Sure, Eisman may have eventually discovered the same idea independently. But this is a counterfactual that is impossible for us to ever know. What we do know is that Lady Luck had smiled on Eisman, and to his credit, he acted on it.
Disclaimer:The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
Alibaba is the leading e-commerce payer in China. Here are some of my thoughts on the company’s growth opportunities and risks.
China has one of the most advanced e-commerce economies in the world. It boasts the world’s largest e-commerce market, with a volume of US$1.94 trillion in 2019. That’s more than thrice the US e-commerce market, which ranks second.
Much of that volume was fueled through China’s largest e-commerce player, Alibaba Group Holdings Limited (NYSE: BABA).
The e-commerce giant has already seen the price of its US-listed shares close to triple from the IPO level of US$68 in 2014. In this article, I take a look at some of the major trends fueling Alibaba’s growth.
A powerful network effect
Alibaba is the biggest player in China’s e-commerce space. However, that does not mean that it has run out of room to grow. China’s e-commerce market is still expected to grow by double digits well into the mid-2020s. Alibaba is the undisputed leader in 2019, taking in 55.9% of retail e-commerce sales, with second place JD.com some way off at 16.7%.
Source: Alibaba 2019 Investor Day Tmall presentation
As the market leader, Alibaba’s B2C (business-to-consumer) platform, Tmall, is well placed to ride on the coattails of the growing e-commerce market. It is the platform of choice for businesses to launch their new products. More than 50 million new SKUs were launched in Tmall in 2018 alone. In Alibaba’s 2019 investor day presentation, the company stated that new products made up 53% of Tmall Apparel’s total GMV in August 2019.
This demonstrates the power of Tmall’s network effect. The large number of annual active accounts on Tmall attracts new product launches on the platform, which in turn, creates value for users. This is a virtuous cycle that can keep on giving for Alibaba.
A global presence
Besides Taobao and Tmall in China, Alibaba also has a global e-commerce presence. Alibaba has invested heavily into Lazada and Ali Express. Lazada is a fast-growing e-commerce platform in Southeast Asia, while AliExpress is a global retail market place that enables consumers across the globe to buy directly from manufacturers and distributors in China.
Tmall Global is a platform where overseas brands and retailers can reach Chinese consumers.
With e-commerce growing quickly in Southeast Asia and other parts of the world, Alibaba has planted the seeds to take advantage of this secular uptrend.
A high margin model
Alibaba’s unique business model creates a high margin, cash-generating business. Instead of holding its own inventory, Alibaba monetises its high user base through auxiliary services. This includes pay-for-performance marketing services which bump merchants up in the search list, or display marketing services where merchants pay for display positions.
In addition, Alibaba also earns commissions on transactions based on a percentage of the transaction value.
In the fiscal year ended 31 March 2020 (FY2020), Alibaba recorded a free cash flow margin (free cash flow as a percentage of revenue) of 25% in US dollar terms. This free cash flow margin includes the other non-profitable businesses that Alibaba is currently trying to grow (more on this later).
Targeting growth
Though founder Jack Ma has stepped down from the hot seat, Alibaba has kept its foot on the pedal.
It has set a hard target of serving more than 1 billion Chinese consumers, and to facilitate more than RMB10 trillion of consumption on its platforms, by 2024. This translates to 50% growth in GMV in the next four to five years.
I think Alibaba can likely achieve its target on both counts. So far, its 780 million consumers in China account for around 85% and 40% of the Chinese population in developed and less developed areas, respectively. As internet penetration increases in the less developed regions, I think the gap in user penetration between the developed and less developed regions will narrow.
Alibaba has also set its sights on growing its global e-commerce platforms. Lazada is Southeast Asia’s fastest-growing e-commerce platform with 50 million annual active users.
Source: Alibaba 2019 Investor Day Lazada presentation
And though Shopee is a strong competitor to Lazada in the region, I think the market in Southeast Asia is big enough for two large players to coexist.
Cloud Computing: an important growth driver
Besides its core e-commerce segment, Alibaba also has cloud computing, digital media, and innovation initiatives.
The three other segments are relatively small compared to its core e-commerce business but Alibaba Cloud could potentially become an important source of profits and cash flows in the future.
Alibaba Cloud is the world’s third largest, and Asia Pacific’s largest, infrastructure-as-a-service and IUS (Infrastructure Utility Service) provider. Similar to Amazon Web Services, Alibaba Cloud emerged due to Alibaba’s need to operate its websites at a massive scale. Subsequently, Alibaba decided to monetise this technology by providing it to other third party customers.
Clouding computing is Alibaba’s fastest-growing segment, with revenue growth of 62% year-on-year in FY2020.
Although this segment is still unprofitable, cloud services could be a hugely profitable and high margin business as demonstrated by Amazon Web Services. As Alibaba scales its cloud computing business, it can possibly become a profitable high margin business.
Risks
As with any company, there are risks. Chinese companies have come under scrutiny after the recent high profile case of Luckin Coffee’s fraudulent business activities. The US has also threatened to delist Chinese companies from their stock exchanges.
If you buy into Alibaba’s shares on the NYSE (New York Stock Exchange) in the US, you are also only the owner of an ADR (American depository receipt) of a variable interest entity (VIE) that in turn has an interest in Alibaba’s economics. This ownership structure may not be as robust as owning a direct interest in a company.
There is also the risk that Alibaba is not able to execute its growth strategy well, especially in Southeast Asia where there is stiff competition from numerous players.
Alibaba’s shares are also priced at a premium to the broader market. At its current share price, it trades at around 25 times FY2020’s earnings and 29 times free cash flow. If Alibaba is not able to grow as fast as the market expects, there may be a valuation compression.
Final thoughts
Alibaba comes with its own set of risks. The VIE structure, high valuation, and competition in Southeast Asia are just some of the risks to note. But Alibaba also has the potential to become a good long-term investment. It is a dominant player in a fast-growing market, has a network effect that is difficult to erode and its cloud computing segment could become an important cash generator in the future.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
9 years 7 months and 6 days. This is how much time has passed since I started managing my family’s investment portfolio of US stocks on 26 October 2010. 19.5% versus 12.7%. These are the respective annual returns of my family’s portfolio (without dividends) and the S&P 500 (with dividends) in that period.
As of 31 May 2020
I will soon have to say goodbye to the portfolio. Jeremy Chia (my blogging partner) and myself have co-founded a global equities investment fund. As a result, the lion’s share of my family’s investment portfolio will soon be liquidated so that the cash can be invested in the fund.
The global equities investment fund will be investing with the same investment philosophy that underpins my family’s portfolio, so the journey continues. But my heart’s still heavy at having to let the family portfolio go. It has been a huge part of my life for the past 9 years 7 months and 6 days, and I’m proud of what I’ve achieved (I hope my parents are too!).
In the nearly-10 years managing the portfolio, I’ve learnt plenty of investing lessons. I want to share them here, to benefit those of you who are reading, and to mark the end of my personal journey and the beginning of a new adventure. I did not specifically pick any number of lessons to share. I’m documenting everything that’s in my head after a long period of reflection.
Do note that my lessons may not be timeless, because things change in the markets. But for now, they are the key lessons I’ve picked up.
Lesson 1: Focus on businessfundamentals, notmacroeconomic or geopolitical developments – there are always things to worry about
My family’s portfolio has many stocks that have gone up multiple times in value. A sample is given below:
Some of them are among the very first few stocks I bought; some were bought in more recent years. But what’s interesting is that these stocks produced their gains while the world experienced one crisis after another.
You see, there were alwaysthings to worry about in the geopolitical and macroeconomic landscape since I started investing. Here’s a short and incomplete list (you may realise how inconsequential most of these events are today, even though they seemed to be huge when they occurred):
2010 – European debt crisis; BP oil spill; May 2010 Flash Crash
2011 – Japan earthquake; Middle East uprising
2012 – Potential Greek exit from Eurozone; Hurricane Sandy
2013 – Cyprus bank bailouts; US government shutdown; Thailand uprising
2014 – Oil price collapse
2015 – Crash in Euro dollar against the Swiss Franc; Greece debt crisis
2016 – Brexit; Italy banking crisis
2017 – Bank of England hikes interest rates for first time in 10 years
2018 – US-China trade war
2019 – Australia bushfires; US President impeachment; appearance of COVID-19 in China
2020 (thus far) – COVID-19 becomes global pandemic
The stocks mentioned in the table above produced strong business growth over the years I’ve owned them. This business growth has been a big factor in the returns they have delivered for my family’s portfolio. When I was studying them, my focus was on their business fundamentals – and this focus has served me well.
In a 1998 lecture for MBA students, Warren Buffett was asked about his views on the then “tenuous economic situation and interest rates.“ He responded:
“I don’t think about the macro stuff. What you really want to do in investments is figure out what is important and knowable. If it is unimportant and unknowable, you forget about it. What you talk about is important but, in my view, it is not knowable.
Understanding Coca-Cola is knowable or Wrigley’s or Eastman Kodak. You can understand those businesses that are knowable. Whether it turns out to be important depends where your valuation leads you and the firm’s price and all that. But we have never not bought or bought a business because of any macro feeling of any kind because it doesn’t make any difference.
Let’s say in 1972 when we bought See’s Candy, I think Nixon [referring to former US President, Richard Nixon] put on the price controls a little bit later, but so what! We would have missed a chance to buy something for [US]$25 million that is producing [US]$60 million pre-tax now. We don’t want to pass up the chance to do something intelligent because of some prediction about something we are no good on anyway.”
Lesson 2: Adding to winners work
I’ve never shied away from adding to the winners in my portfolio, and this has worked out well. Here’s a sample, using some of the same stocks shown in the table in Lesson 1.
Adding to winners is hard to achieve, psychologically. As humans, we tend to anchor to the price we first paid for a stock. After a stock has risen significantly, it’s hard to still see it as a bargain. But I’ll argue that it is stocks that have risen significantly over a long period of time that are the good bargains. It’s counterintuitive, but hear me out.
The logic here rests on the idea that stocks do well over time if their underlying businesses do well. So, the stocks in my portfolio that have risen significantly over a number of years are likely – though not always – the ones with businesses that are firing on all cylinders. And stocks with businesses that are firing on all cylinders are exactly the ones I want to invest in.
Lesson 3: The next Amazon, is Amazon
When I first bought shares of Amazon in April 2014 at US$313, its share price was already more than 200 times higher than its IPO share price of US$1.50 in May 1997. That was an amazing annual return of around 37%.
But from the time I first invested in Amazon in April 2014 to today, its share price has increased by an even more impressive annual rate of 40%. Of course, it is unrealistic to expect Amazon to grow by a further 200 times in value from its April 2014 level over a reasonable multi-year time frame. But a stock that has done very well for a long period of time can continue delivering a great return. Winners often keep on winning.
Lesson 4: Focus on business quality and don’t obsess over valuation
It is possible to overpay for a company’s shares. This is why we need to think about the valuation of a business. But I think it is far more important to focus on the quality of a business – such as its growth prospects and the capability of the management team – than on its valuation.
If I use Amazon as an example, its shares carried a high price-to-free cash flow (P/FCF) ratio of 72 when I first invested in the company in April 2014. But Amazon’s free cash flow per share has increased by 1,000% in total (or 48% annually) from US$4.37 back then to US$48.10 now, resulting in the overall gain of 681% in its share price.
Great companies could grow into their high valuations. Amazon’s P/FCF ratio, using my April 2014 purchase price and the company’s current free cash flow per share, is just 6.5 (now that’s a value stock!). But there’s no fixed formula that can tell you what valuation is too high for a stock. It boils down to subjective judgement that is sometimes even as squishy as an intuitive feeling. This is one of the unfortunate realities of investing. Not everything can be quantified.
Lesson 5: The big can become bigger – don’t obsess over a company’s market capitalisation
I’ve yet to mention Mastercard, but I first invested in shares of the credit card company on 3 December 2014 at US$89 apiece. Back then, it already had a huge market capitalisation of around US$100 billion, according to data from Ycharts. Today, Mastercard’s share price is US$301, up more than 200% from my initial investment.
A company’s market capitalisation alone does not tell us much. It is the company’s (1) valuation, (2) size of the business, and (3) addressable market, that can give us clues on whether it could be a good investment opportunity. In December 2014, Mastercard’s price-to-earnings (P/E) ratio and revenue were both reasonable at around 35 and US$9.2 billion, respectively. Meanwhile, the company’s market opportunity still looked significant, since cashless transactions represented just 15% of total transactions in the world back then.
Lesson 6: Don’t ignore “obvious” companies just because they’re well known
Sticking with Mastercard, it was an obvious company that was already well-known when I first invested in its shares. In the first nine months of 2014, Mastercard had more than 2 billion credit cards in circulation and had processed more than 31.4 billion transactions. Everyone could see Mastercard and know that it was a great business. It was growing rapidly and consistently, and its profit and free cash flow margins were off the charts (nearly 40% for both).
The company’s high quality was recognised by the market – its P/E ratio was high in late 2014 as I mentioned earlier. But Mastercard still delivered a fantastic annual return of around 25% from my December 2014 investment.
I recently discovered a poetic quote by philosopher Arthur Schopenhauer: “The task is… not so much to see what no one has yet seen, but to think what nobody has yet thought, about that which everyone sees.” This is so applicable to investing.
Profitable investment opportunities can still be found by thinking differently about the data that everyone else has. It was obvious to the market back in December 2014 that Mastercard was a great business and its shares were valued highly because of this. But by thinking differently – with a longer-term point of view – I saw that Mastercard could grow at high rates for a very long period of time, making its shares a worthy long-term investment. From December 2014 to today, Mastercard’s free cash flow per share has increased by 158% in total, or 19% per year. Not too shabby.
Lesson 7: Be willing to lose sometimes
We need to take risks when investing. When I first invested in Shopify in September 2016, it had a price-to-sales (P/S) ratio of around 12, which is really high for a company with a long history of making losses and producing meagre cash flow. But Shopify also had a visionary leader who dared to think and act long-term. Tobi Lütke, Shopify’s CEO and co-founder, penned the following in his letter to investors in the company’s 2015 IPO prospectus (emphases are mine):
“Over the years we’ve also helped foster a large ecosystem that has grown up around Shopify. App developers, design agencies, and theme designers have built businesses of their own by creating value for merchants on the Shopify platform. Instead of stifling this enthusiastic pool of talent and carving out the profits for ourselves, we’ve made a point of supporting our partners and aligning their interests with our own. In order to build long-term value, we decided to forgo short-term revenue opportunities and nurture the people who were putting their trust in Shopify. As a result, today there are thousands of partners that have built businesses around Shopify by creating custom apps, custom themes, or any number of other services for Shopify merchants.
This is a prime example of how we approach value and something that potential investors must understand: we do not chase revenue as the primary driver of our business. Shopify has been about empowering merchants since it was founded, and we have always prioritized long term value over short-term revenue opportunities. We don’t see this changing…
… I want Shopify to be a company that sees the next century. To get us there we not only have to correctly predict future commerce trends and technology, but be the ones that push the entire industry forward. Shopify was initially built in a world where merchants were simply looking for a homepage for their business. By accurately predicting how the commerce world would be changing, and building what our merchants would need next, we taught them to expect so much more from their software.
These underlying aspirations and values drive our mission: make commerce better for everyone. I hope you’ll join us.”
Shopify was a risky proposition. But it paid off handsomely. In investing, I think we have to be willing to take risks and accept that we can lose at times. But failing at risk-taking from time to time does not mean our portfolios have to be ruined. We can take intelligent risks by sizing our positions appropriately. Tom Engle is part of The Motley Fool’s investing team in the US. He’s one of the best investors the world has never heard of. When it comes to investing in risky stocks that have the potential for huge returns, Tom has a phrase I love: “If it works out, a little is all you need; if it doesn’t, a little is all you want.”
I also want to share a story I once heard from The Motley Fool’s co-founder Tom Gardner. Once, a top-tier venture capital firm in the US wanted to improve the hit-rate of the investments it was making. So the VC firm’s leaders came up with a process for the analysts that could reduce investing errors. The firm succeeded in improving its hit-rate (the percentage of investments that make money). But interestingly, its overallrate of return became lower. That’s because the VC firm, in its quest to lower mistakes, also passed on investing in highly risky potential moonshots that could generate tremendous returns.
The success of one Shopify can make up for the mistakes of many other risky bets that flame out. To hit a home run, we must be willing to miss at times.
Lesson 8: The money is made on the holding, not the buying and selling
My family’s investment portfolio has over 50 stocks. It’s a collection that was built steadily over time, starting with the purchase of just six stocks on 26 October 2010. In the 9 years, 7 months and 6 days since, I’ve only ever sold two stocks voluntarily: (1) Atwood Oceanics, an owner of oil rigs; and (2) National Oilwell Varco, a supplier of parts and equipment that keep oil rigs running. Both stocks were bought on 26 October 2010.
David Gardner is also one of the co-founders of The Motley Fool (Tom Gardner is his brother). There’s something profound David once said about portfolio management that resonates with me:
“Make your portfolio reflect your best vision for our future.”
The sales of Atwood Oceanics and National Oilwell Varco happened because of David’s words. Part of the vision I have for the future is a world where our energy-needs are met entirely by renewable sources that do not harm the precious environment we live in. For this reason, I made the rare decision to voluntarily part ways with Atwood Oceanics and National Oilwell Varco in September 2016 and June 2017, respectively.
My aversion to selling is by design – because I believe it strengthens my discipline in holding onto the winners in my family’s portfolio. Many investors tend to cut their winners and hold onto their losers. Even in my earliest days as an investor, I recognised the importance of holding onto the winners in driving my family portfolio’s return. Being very slow to sell stocks has helped me hone the discipline of holding onto the winners. And this discipline has been a very important contributor to the long run performance of my family’s portfolio.
The great Charlie Munger has a saying that one of the keys to investing success is “sitting on your ass.” I agree. Patience is a virtue. And talking about patience…
Lesson 9: Be patient – some great things take time
Some of my big winners needed only a short while before they took off. But there are some that needed significantly more time. Activision Blizzard is one such example. As I mentioned earlier, I invested in its shares in October 2010. Then, Activision Blizzard’s share price went nowhere for more than two years before it started rocketing higher.
Peter Lynch once said: “In my investing career, the best gains usually have come in the third or fourth year, not in the third or fourth week or the third or fourth month.” The stock market does not move according to our own clock. So patience is often needed.
Lesson 10: Management is the ultimate source of a company’s economic moat
In my early days as an investor, I looked for quantifiable economic moats. These are traits in a company such as (1) having a network effect, (2) being a low-cost producer, (3) delivering a product or service that carries a high switching cost for customers, (4) possessing intangible assets such as intellectual property, and (5) having efficient scale in production.
But the more I thought about it, the more I realised that a company’s management team is the true source of its economic moat, or lack thereof.
Today, Netflix has the largest global streaming audience with a pool of 183 million subscribers around the world. Having this huge base of subscribers means that Netflix has an efficient scale in producing content, because the costs can be spread over many subscribers. Its streaming competitors do not have this luxury. But this scale did not appear from thin air. It arose because of Netflix’s CEO and co-founder, Reed Hastings, and his leadership team.
The company was an early pioneer in the streaming business when it launched its streaming service in 2007. In fact, Netflix probably wanted to introduce streaming even from its earliest days. Hastings said the following in a 2007 interview with Fortune magazine:
“We named the company Netflix for a reason; we didn’t name it DVDs-by-mail. The opportunity for Netflix online arrives when we can deliver content to the TV without any intermediary device.”
When Netflix first started streaming, the content came from third-party producers. In 2013, the company launched its first slate of original programming. Since then, Netflix has ramped up its original content budget significantly. The spending has been done smartly, as Netflix has found plenty of success with its original programming. For instance, in 2013, the company became the first streaming provider to be nominated for a primetime Emmy. And in 2018 and 2019, the company snagged 23 and 27 Emmy wins, respectively.
A company’s current moat is the result of management’s past actions; a company’s future moat is the result of management’s current actions. Management is what createsthe economic moat.
Lesson 11: Volatility in stocks is a feature, not a bug
Looking at the table in Lesson 1, you may think that my investment in Netflix was smooth-sailing. It’s actually the opposite.
I first invested in Netflix shares on 15 September 2011 at US$26 after the stock price had fallen by nearly 40% from US$41 in July 2011. But the stock price kept declining afterward, and I bought more shares at US$16 on 20 March 2012. More pain was to come. In August 2012, Netflix’s share price bottomed at less than US$8, resulting in declines of more than 70% from my first purchase, and 50% from my second.
My Netflix investment was a trial by fire for a then-young investor – I had started investing barely a year ago before I bought my first Netflix shares. But I did not panic and I was not emotionally affected. I already knew that stocks – even the best performing ones – are volatile over the short run. But my experience with Netflix drove the point even deeper into my brain.
Lesson 12: Be humble – there’s so much we don’t know
My investment philosophy is built on the premise that a stock will do well over time if its business does well too. But howdoes this happen?
In the 1950s, lawmakers in the US commissioned an investigation to determine if the stock market back then was too richly priced. The Dow (a major US stock market benchmark) had exceeded its peak seen in 1929 before the Great Depression tore up the US market and economy. Ben Graham, the legendary father of value investing, was asked to participate as an expert on the stock market. Here’s an exchange during the investigation that’s relevant to my discussion:
“Question to Graham: When you find a special situation and you decide, just for illustration, that you can buy for 10 and it is worth 30, and you take a position, and then you cannot realize it until a lot of other people decide it is worth 30, how is that process brought about – by advertising, or what happens?
Graham’s response:That is one of the mysteries of our business, and it is a mystery to me as well as to everybody else. We know from experience that eventually the market catches up with value. It realizes it in one way or another.”
More than 60 years ago, one of the most esteemed figures in the investment business had no idea how stock prices seemed to eventually reflect their underlying economic values. Today, I’m still unable to find any answer. If you’ve seen any clues, please let me know! This goes to show that there’s so much I don’t know about the stock market. It’s also a fantastic reminder for me to always remain humble and be constantly learning. Ego is the enemy.
Lesson 13: Knowledge compounds, and read outside of finance
Warren Buffett once told a bunch of students to “read 500 pages… every day.” He added, “That’s how knowledge works. It builds up, like compound interest. All of you can do it, but I guarantee not many of you will do it.”
I definitely have not done it. I read every day, but I’m nowhere close to the 500 pages that Buffett mentioned. Nonetheless, I have experienced first hand how knowledge compounds. Over time, I’ve been able to connect the dots faster when I analyse a company. And for companies that I’ve owned shares of for years, I don’t need to spend much time to keep up with their developments because of the knowledge I’ve acquired over the years.
Reading outside of finance has also been really useful for me. I have a firm belief that investing is only 5% finance and 95% everything else. Reading about psychology, society, history, science etc. can make us even better investors than someone who’s buried neck-deep in only finance books. Having a broad knowledge base helps us think about issues from multiple angles. This brings me to Arthur Schopenhauer’s quote I mentioned earlier in Lesson 6: “The task is… not so much to see what no one has yet seen, but to think what nobody has yet thought, about that which everyone sees.”
Lesson 14: The squishy things matter
Investing is part art and part science. But is it more art than science? I think so. The squishy, unquantifiable things matter. That’s because investing is about businesses, and building businesses involves squishy things.
Jeff Bezos said it best in his 2005 Amazon shareholders’ letter (emphases are mine):
“As our shareholders know, we have made a decision to continuously and significantly lower prices for customers year after year as our efficiency and scale make it possible. This is an example of a very important decision that cannot be made in a math-based way.
In fact, when we lower prices, we go against the math that we can do, which always says that the smart move is to raise prices. We have significant data related to price elasticity. With fair accuracy, we can predict that a price reduction of a certain percentage will result in an increase in units sold of a certain percentage. With rare exceptions, the volume increase in the short term is never enough to pay for the price decrease.
However, our quantitative understanding of elasticity is short-term. We can estimate what a price reduction will do this week and this quarter. But we cannot numerically estimate the effect that consistently lowering prices will have on our business over five years or ten years or more.
Our judgment is that relentlessly returning efficiency improvements and scale economies to customers in the form of lower prices creates a virtuous cycle that leads over the long term to a much larger dollar amount of free cash flow, and thereby to a much more valuable Amazon.com. We’ve made similar judgments around Free Super Saver Shipping and Amazon Prime, both of which are expensive in the short term and—we believe—important and valuable in the long term.”
On a related note, I was also attracted to Shopify when I came across Tobi Lütke’s letter to investors that I referenced in Lesson 7. I saw in Lütke the same ability to stomach short-term pain, and the drive toward producing long-term value, that I noticed in Bezos. This is also a great example of how knowledge compounds.
Lesson 15: I can never do it alone
Aaron Bush is one of the best investors I know of at The Motley Fool, and he recently created one of the best investing-related tweet-storms I have seen. In one of his tweets, he said: “Collaboration can go too far. Surrounding yourself with a great team or community is critical, but the moment decision-making authority veers democratic your returns will begin to mean-revert.”
I agree with everything Aaron said. Investment decision-making should never involve large teams. But at the same time, having a community or team around us is incredibly important for our development; their presence enables us to view a problem from many angles, and it helps with information gathering and curation.
I joined one of The Motley Fool’s investment newsletter services in 2010 as a customer. The service had wonderful online forums and this dramatically accelerated my learning curve. In 2013, I had the fortune to join an informal investment club in Singapore named Kairos Research. It was founded by Stanley Lim, Cheong Mun Hong, and Willie Keng. They are also the founders of the excellent Asia-focused investment education website, Value Invest Asia. I’ve been a part of Kairos since and have benefited greatly. I’ve made life-long friends and met countless thoughtful, kind, humble, and whip-smart people who have a deep passion for investing and knowledge. The Motley Fool’s online forums and the people in Kairos have helped me become a better human being and investor over the years.
I’ve also noticed – in these group interactions – that the more I’m willing to give, the more I receive. Giving unconditionally and sincerely without expecting anything in return, paradoxically, results in us having more. Giving is a superpower.
Lesson 16: Be honest with myself about what I don’t know
When we taste success in the markets, it’s easy for ego to enter the picture. We may look into the mirror and proclaim: “I’m a special investor! I’ve been great at picking growth stocks – this knowledge must definitely translate to trading options, shorting commodities, and underwriting exotic derivatives. They, just like growth stocks, are all a part of finance, isn’t it?”
This is where trouble comes. The entrance of ego is the seed of future failure. In the biography of Warren Buffett, The Snowball: Warren Buffett and the Business of Life, author Alice Schroeder shared this passage about Charlie Munger:
“[Munger] dread falling prey to what a Harvard Law School classmate of his had called “the Shoe Button Complex.”
“His father commuted daily with the same group of men,” Munger said. “One of them had managed to corner the market in shoe buttons – a really small market, but he had it all. He pontificated on every subject, all subjects imaginable. Cornering the market on shoe buttons made him an expert on everything. Warren and I have always sensed it would be a big mistake to behave that way.”
The Shoe Button Complex can be applied in a narrower sense to investing too. Just because I know something about the market does not mean I know everything. For example, a few years after I invested in Atwood Oceanics and National Oilwell Varco, I realised I was in over my head. I have no ability to predict commodity prices, but the business-health of the two companies dependson the price of oil. Since I came to the realisation, I have stayed away from additional commodity-related companies. In another instance, I know I can’t predict the movement of interest rates, so I’ve never made any investment decision that depended on interest rates as the main driver.
Lesson 17: Be rationally optimistic
In Lesson 1, I showed that the world had lurched from one crisis to another over the past decade. And of course, we’re currently battling COVID-19 now. But I’m still optimistic about tomorrow. This is because one key thing I’ve learnt about humanity is that our progress has never happened smoothly. It took us only 66 years to go from the first demonstration of manned flight by the Wright brothers at Kitty Hawk to putting a man on the moon. But in between was World War II, a brutal battle across the globe from 1939 to 1945 that killed an estimated 66 million, according to National Geographic.
This is how progress is made, through the broken pieces of the mess that Mother Nature and our own mistakes create. Morgan Housel has the best description of this form of rational optimism that I’ve come across:
“A real optimist wakes up every morning knowing lots of stuff is broken, and more stuff is about to break.
Big stuff. Important stuff. Stuff that will make his life miserable. He’s 100% sure of it.
He starts his day knowing a chain of disappointments awaits him at work. Doomed projects. Products that will lose money. Coworkers quitting. He knows that he lives in an economy due for a recession, unemployment surely to rise. He invests his money in a stock market that will crash. Maybe soon. Maybe by a lot. This is his base case.
He reads the news with angst. It’s a fragile world. Every generation has been hit with a defining shock. Wars, recessions, political crises. He knows his generation is no different.
This is a real optimist. He’s an optimist because he knows all this stuff does not preclude eventual growth and improvement. The bad stuff is a necessary and normal path that things getting better over time rides on. Progress happens when people learn something new. And they learn the most, as a group, when stuff breaks. It’s essential.
So he expects the world around him to break all the time. But he knows – as a matter of faith – that if he can survive the day-to-day fractures, he’ll capture the up-and-to-the-right arc that learning and hard work produces over time.”
To me, investing in stocks is, at its core, the same as having faith in the long-term potential of humanity. There are 7.8 billion individuals in the world today, and the vast majority of us will wake up every morning wanting to improve the world and our own lot in life – this is ultimately what fuels the global economy and financial markets. Miscreants and Mother Nature will wreak havoc from time to time. But I have faith in the collective positivity of humanity. When there’s a mess, we can clean it up. This has been the story of our long history – and the key driver of the return my family’s portfolio has enjoyed immensely over the past 9 years, 7 months, and 6 days.
My dear portfolio, goodbye.
Disclaimer:The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.I, the author, will be making sell-trades on the stocks mentioned in this article over the coming weeks.
The best articles we’ve read in recent times on a wide range of topics, including investing, business, and the world in general.
We’ve constantly been sharing a list of our recent reads in our weekly emails for The Good Investors.
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But since our readership-audience for The Good Investors is wider than our subscriber base, we think sharing the reading list regularly on the blog itself can benefit even more people. The articles we share touch on a wide range of topics, including investing, business, and the world in general.
Here are the articles for the week ending 31 May 2020:
A system is deemed ergodic if the expected value of an activity performed by a group is the same as for an individual carrying out the same action over time. Rolling a dice is an example of an ergodic system. If 500 people roll a fair six-sided dice once, the expected value is the same as if I alone roll a fair six-sided dice 500 times.
The Russian roulette example is a non-ergodic system. The expected value of the group differs sharply to the average of an individual carrying out the action through time. In the group situation the average outcome is to live and become wealthy. As an individual performing the activity through time – on average – I am dead. In a non-ergodic system the group expected value is deeply misleading as it pertains to individual experience.
Although these may seem like somewhat frivolous examples, the concept of ergodicity is incredibly important. Much of classical economics assumes about human behaviour is founded on the expected average outcome of the group (see Expected Utility Theory). This works under the assumption that most environments or situations are ergodic, when in fact this is not the case.
A lot of really important technologies started out looking like expensive, impractical toys. The engineering wasn’t finished, the building blocks didn’t fit together, the volumes were too low and the manufacturing process was new and imperfect. In parallel, many or even most important things propose some new way of doing things, or even an entirely new thing to do. So it doesn’t work, it’s expensive, and it’s silly. It’s a toy.
Some of the most important things of the last 100 years or so looked like this – aircraft, cars, telephones, mobile phones and personal computers were all dismissed.
But on the other hand, plenty of things that looked like useless toys never did become anything more.
This means that there is no predictive value in saying ‘that doesn’t work’ or ‘that looks like a toy’ – and that there is also no predictive value in saying ‘people always say that’. As Pauli put it, statements like this are ‘not even wrong’ – they give no insight into what will happen. You have to go one level further. You have to ask ‘do you have a theory for why this will get better, or why it won’t, and for why people will change their behaviour, or for why they won’t’?
In Primary 4, he and his classmates started playing this traditional local game called “kuti kuti” where each player will control a small plastic animal. Each player is to maneuver his/her animal around the table with the aim of resting his/her animal over the other player’s animal. Once that is done, the game is won and the winner takes possession of the loser’s animal. This was very much like how I used to play the flag erasers with my friends when I was younger.
He started playing with large plastic animals. One weekend, he was out with his maternal grandfather when he saw a pack of the plastic animals selling for $2.50 for a pack of 10. He bought the pack, or his grandfather did anyway, and brought his new toys to school. He managed to sell each plastic animal for $1! In a few days, he sold all of them. Pretty good margin, lol.
He did not tell me any of this until it was over. When I found out about his transgressions away from school work, I did what any responsible parent would do. I laid down the law.
“Son, I need to tell you that your school work is the most important thing for you at this point.”
Pause.
“I’d also like you to think about growing this business.”
Jeff Bezos, at the outset of their earnings call, warned shareholders they “may want to take a seat.” He has done this several times. “This” is snatching profits from the jaws of shareholders to reinvest in the firm. With the exception of Netflix, no firm has been given this much runway. Bezos has used every foot of it to set aloft a vessel that nobody will likely catch. Imagine a Spruce Goose but at twice the speed of sound.
Bezos told investors that the $4 billion in profits they were expecting would be reinvested. The investment had a theme: Covid-19. Specifically, Bezos outlined a vision for at-home Covid tests, plasma donors, PPE equipment, distancing, additional compensation, and protocols to adapt to a new world. Jeff Bezos is developing the earth’s first “vaccinated” supply chain.
The genius here is breathtaking. Walmart can’t follow, as they don’t own their distribution for last-mile commerce. Outside of Walmart, few firms have the balance sheet to pull this off. Maybe FedEx, UPS, or Prologis? But it’s unlikely they could make this sort of investment, this fast — it would be perceived as reckless.
Epic Games was founded by Tim Sweeney and Mark Rein in 1991. Sweeney is the CEO and majority/controlling shareholder, while Tencent owns roughly 40%. As a private company, Epic does not publicly disclose its financials. According to press reports, it was valued at roughly $15B in 2018 (when it last raised capital) and is currently raising more at a “significantly higher” price, per Bloomberg.
Compared to Facebook, Amazon, Apple, Microsoft and Google, which are worth $600B to $1.4T, Epic’s valuation is modest. However, Epic has the potential to become one of the largest, most influential tech companies in the world. This might seem hyperbolic to those who know Epic only as the marker of the hit video game Fortnite: Battle Royale. In fact, even long-time fans of Epic’s games might find such a pronouncement odd given Fortnite has generated more revenue in three years than the rest of Epic has in almost as many decades. But behind the scenes, it looks increasingly likely that Epic will be at the very center of society’s digital future.
By definition, people who lack the expertise in a given field required for superior judgments also lack the expertise required to assess their level of expertise. As I mentioned, they qualify as John Kenneth Galbraith’s forecasters “who don’t know they don’t know.”
While re-reading my memo, I realized I had left out an important further ramification. Not only do most people fail to possess superior expertise – as well as the ability to know it – but they also lack the ability to figure out who does have it. That’s the catch: you may have to be an expert in a field in order to be able to figure out who the true experts are. That’s why research in most fields is subjected to “peer review,” meaning a review by experts, (not to be confused with “a jury of one’s peers,” meaning other lay citizens)…
… Nowadays, like everyone else, I’m bombarded with conflicting views regarding the wisdom of rapidly reopening the U.S. economy. Yet I recognize that not only is my opinion on that topic of little value, but I also don’t have the expertise required to know for sure whose opinion does count. What I do know is that the last thing I should do is choose an expert because his or her opinions agree with mine, and allow confirmation bias to affect my decision…
… So (a) true expertise is scarce and limited in scope, (b) expertise and predictive ability are two different things, and (c) we all should be careful about whom we listen to and how much weight we give to their pronouncements.
What we probably don’t realize is that walking can be a kind of a behavioral preventive against depression. It benefits us on many levels, physical and psychological. Walking helps to produce protein molecules in muscle and brain that help repair wear and tear. These muscle and brain molecules—myokines and neurotrophic factors, respectively—have been intensively studied in recent years for their health effects. We are discovering that they act almost as a kind of fertilizer that assists in the growth of cells and regulation of metabolism. They also reduce certain types of inflammation.
These essential molecules are produced by movement and the increased brain and body activity created by movement. If you’re not moving about, placing heart and muscle under a bit of positive stress and strain, these molecules aren’t produced in sufficient quantities to perform their roles.
Modern Capitalism has never seen anything quite like the novel coronavirus SARS-CoV-2. In a matter of months, the deadly contagious bug has spread around the world, hobbling any economy in its path. In the United States, where consumer spending accounts for more than two-thirds of economic activity, commerce has come to a standstill as people stay home to slow the virus’ spread. Hotels and restaurants and airlines have taken massive hits; Delta has cut its flight capacity by 70 percent. One in five US households has already lost work. And that’s all because of the vulnerabilities of the human worker. When we get sick—or we have to shelter in place to avoid getting sick—the work that depends on people grinds to a stop.
Why haven’t the machines saved us yet?
This economic catastrophe is blowing up the myth of the worker robot and AI takeover. We’ve been led to believe that a new wave of automation is here, made possible by smarter AI and more sophisticated robots. San Francisco has even considered a tax on robots—replace a human with a machine, and pay a price. The problem will get so bad, argue folks like former presidential candidate Andrew Yang, we’ll need a universal basic income to support our displaced human workers. (UBI seems to have actually arrived, in a sense, with the Trump administration’s proposed payout to American households to weather the crisis: A $1,000 check for most, with an extra $500 for every child.)
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
The leader of the US’s Central Bank has warned investors of the danger in stocks. Should we be worried for our investment portfolios?
Here’s an excerpt of a speech by the leader of the Federal Reserve, the central bank of the US, warning of danger in stocks in the country:
“Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past.
But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy?
We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy.
But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.”
Trouble ahead?
Are you worried about the implications of the speech? Don’t be. That’s because the speech was delivered on 6 December 1996 – more than 23 years ago – by Alan Greenspan, who was the chairperson of the Federal Reserve at the time. Greenspan’s speech has since become well-known for the phrase “irrational exuberance” because it happened only a few short years before the infamous Dotcom bubble in the US imploded in late 2000.
But what’s really interesting is that the S&P 500, the major benchmark for the US stock market, has gained526% in total including dividends, from December 1996 to today. That’s a solid annual return of 8%. This reminds me of two important things about investing.
Worries, worries
The first thing is, to borrow the words of the legendary fund manager Peter Lynch, “there is always something to worry about.”
The content of Greenspan’s speech could well be used to describe the financial markets we’re seeing today. The S&P 500 has bounced 36% higher (as of 28 May 2020) from its 23 March 2020 low after suffering a historically steep coronavirus-driven decline of more than 30% from its 19 February 2020 high. Moreover, the S&P 500 has a price-to-earnings (P/E) ratio of 22 today, which is not far from the P/E ratio of 19 seen at the start of December 1996.
Yet anyone who got scared out of the US stock market back then by Greenspan’s speech, and crucially, failed to reinvest,would have missed out on more than 23 years of good returns. Some individual stocks in the US have delivered significantly higher returns, so the opportunity costs for anyone who stayed out would have been immense.
Time heals
The second thing is, time can wash away plenty of mistakes in the financial markets.
The past 23-plus years from 1996 to today contained plenty of jarring episodes for the economies and the financial markets of the US and many other countries. Here’s a short and incomplete list: The 1997 Asian Financial Crisis; the bursting of the Dotcom bubble in late 2000 that I already mentioned; the 2008-09 Great Financial Crisis; Greece’s debt crisis in 2015; Italy’s banking troubles in 2015; and the US-China trade war in 2018.
Yet, investors who stayed invested have been rewarded, as Corporate America grew steadily over the years.
Words of caution
I’m not saying that the US stock market will be higher 1 or 2 years from now. Nobody knows. When the Dotcom bubble burst after Greenspan gave his famous “irrational exuberance” speech, the S&P 500 fell by nearly half. It recovered, only to then get crushed again during the 2008-09 Great Financial Crisis. The chart below shows this.
What I want to illustrate is that it makes senseto invest even when the world is mired in trouble, if we have a long time horizon for our investments.
Now, I want to stress that having a long time horizon is not a magical panacea.
If our portfolio is filled with stocks that have lousy underlying businesses, staying invested for the long run will destroy our return. This is because such a portfolio becomes riskier the longer we hold onto it, since value is being actively eroded.
If we invest in stocks at ridiculous valuations, staying invested can’t save us too. Japan’s a great example. Its main stock market barometer, the Nikkei 225 index, is today more than 40% lower than the peak seen in late 1989. This is because Japanese stocks were valued at nearly 100 times their inflation-adjusted 10-year average earnings near the late-1989 high. The good thing is Japan-level bubbles are rare. It’s the exception, not the norm.
So, if the stocks we own today have reasonable valuations and have decent-to-great underlying businesses, we can afford to be patient. In such cases, time can be a great healer of stock market wounds.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
Just a few multi baggers in your stock market portfolio can make a world of a difference. Here are some factors I consider when looking for a mutli bagger.
The term, multi-baggers, when applied to the stock market, was coined by legendary investor Peter Lynch in his book One up on Wall Street.
It refers to a stock that delivers more than a 100% return on our investment. Seasoned investors will tell you that just having a few multi-baggers in your portfolio can make a world of a difference.
Imagine if you had used just 1% of your portfolio to buy Netflix in 2007 at US$2.57 per share. You’d have a 163-bagger in your portfolio today. That 1% position will now be worth 163% of your initial portfolio. Even if the other 99% of your portfolio went to zero, you’d still be sitting on a positive return.
But how do we unearth such long-term winners? Here are some things that I consider when looking at which stocks can be multi-baggers over the next few years.
Potential market opportunity
The amount of revenue that a company can earn in the future is a key factor in how valuable the company will be worth.
As an investor, I’m not focused on quarterly results or what percentage year-on-year growth a company achieves in the short-term. Instead, I’m more focused on the total addressable market and how much the company could make a few years out.
Let’s take Guardant Health as an example. The company is one of the leading liquid biopsy companies. It has non-invasive tests to identify cancers with specific biomarkers for more targeted therapy. In addition, the company is developing non-invasive tests that could detect early-stage cancer, which has a market opportunity of more than US$30 billion a year. Together with its late-stage precision oncology test, Guardant Health has a market opportunity of more than US$40 billion in the US alone.
Guardant Health is still in its infancy with just US$245 million in revenue in the last 12 months. If its early-stage cancer tests gain FDA approval and is adopted by insurance companies, Guardant Health could easily increase its sales multiple folds.
Clear path to profitability
Besides increasing revenue, companies need to generate profits and cash flow too. As such, investors need to look at free cash flow and profit margins.
For fast-growing companies that are not yet profitable, I tend to look at gross margins. A company that has high gross margins will be more likely to earn a profit during its mature state.
Using Guardant Health as an example again, the liquid biopsy front-runner boasts 65% gross margins on its precision oncology testing. Such high margins mean that the company can easily turn a profit with sufficient scale as other costs decrease as a percentage of sales.
An enduring moat
To fulfil its potential, the company needs to be able to fend off its competition. A moat can come in the form of a network effect, a superior product, a patent or other competitive edges that a company may have over its competitors.
On a side note, I don’t consider first-mover advantage a moat unless it operates in an industry where a network effect is a valuable moat.
In Guardant Health’s case, the company’s tests are protected by patents, which prevents other companies from copying their products.
Management that can execute
Potential is one thing, but can the company execute its plans? This is where management is important. The company’s CEO needs to have a clear vision and execution plan.
Management is a touchy subject and requires a lot of subjective analysis. My blogging partner, Ser Jing, wrote an insightful article recently on how we can assess the quality of management.
Comparing current market cap with the potential market cap
Finally, after identifying a company that has a high probability of growing sales and profits multiple folds, we need to assess if its current market cap has room to grow into a multi-bagger.
It’s no use buying into a company that has all its future earnings baked into its market value.
If Guardant Health can increase its sales to just 20% of the US$40 billion addressable market in the US alone, and generate a 25% profit margin, it will earn US$2 billion in profit annually.
Assuming the market is willing to give it a price-to-earnings multiple of 30, that translates to a US$60 billion market cap.
At the time of writing, Guardant Health’s market cap is around US$8.3 billion. If Guardant Health can execute its growth strategy well over the next 5 to 10 years, it can become a multi-bagger.
Final words
Multibaggers can be the difference between a market-beating portfolio and an average one.
However, finding a multi-bagger is not easy. The company needs to tick many boxes. And even so, there is always the risk that the company does not fulfil its potential. In Guardant Health’s case, biopharmaceutical companies have to jump through many hoops to earn the honey pot at the end of the rainbow.
For the liquid biopsy market, Guardant Health needs its early-stage cancer test clinical trials to (1) meet its primary end goals, (2) gain regulatory approval, (3) earn trust from insurance companies and finally ,(4) be adopted by clinicians. These hurdles will not simply fall over and there are risks that the company will fall flat in any one of these.
As investors, we therefore, need to consider the risk-return profile of a company before deciding if the it makes sense for our portfolio.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
Investing in stocks is often made overly complex. Here are 3 easy analogies using real-world phenomena to help you understand the stock market.
The word “analogy” is defined by the Cambridge Dictionary as a “comparison between things that have similar features, often used to help explain a principle or idea.” It is a useful way for us to understand a topic that’s complicated or new to us.
One topic that is often made overly complex is investing in stocks. Fortunately, I have three analogies – sourced from greater minds – that can help us cut through the fluff and get to the point about the core of stock market investing.
Watching the right thing
The first analogy is from Ralph Wagner, who ran the US-based Acorn Fund from 1970 to 2003. During his tenure, he led Acorn Fund to an impressive annual gain of 16.3%. This is also significantly better compared to the S&P 500’s return of 12.1% per year over the same period.
Wagner once said:
“There’s an excitable dog on a very long leash in New York City, darting randomly in every direction. The dog’s owner is walking from Columbus Circle, through Central Park, to the Metropolitan Museum. At any one moment, there is no predicting which way the pooch will lurch.
But in the long run, you know he’s heading northeast at an average speed of three miles per hour. What is astonishing is that almost all of the dog watchers, big and small, seem to have their eye on the dog, and not the owner.”
In Wagner’s terminology, the stock price is the pooch, while the underlying business of the stock is the owner. Instead of watching the dog (the stock price), we should be focusing on the owner (the business).
My favourite example of this is Warren Buffett’s investment conglomerate, Berkshire Hathaway. The chart below shows the percentage change in Berkshire’s book value per share and its share price for each year from 1965 to 2018. There were years when the two percentages match closely, but there were also times when they diverged wildly. A case of the latter is 1974, when Berkshire’s book value per share grew by 5.5% even though its share price fell sharply by 48.7%.
Source: Berkshire Hathaway 2018 shareholders’ letter
In all, Berkshire’s book value per share increased by 18.7% per year from 1965 to 2018. Meanwhile, its share price was up by 20.5% annually over the same period. An input of 18.7% had led to a similar output of 20.5% over the long run despite wide differences at times during shorter timeframes.
Predictions are hard
Dean Wlliams is the owner of the second analogy. There are only two things I know about Williams. I couldn’t find anything else about him online – if you know more about him, please reach out to me! First, he’s an investor who was part of Batterymarch Financial Management. Second, he wrote one of the best investment speeches I’ve ever come across. The speech, delivered in 1981, is titled Trying Too Hard.
Here’s the analogy:
“The foundation of Newtonian physics was that physical events are governed by physical laws. Laws that we could understand rationally. And if we learned enough about those laws, we could extend our knowledge and influence over our environment.
That was also the foundation of most of the security analysis, technical analysis, economic theory and forecasting methods you and I learned about when we first began in this business. There were rational and predictable economic forces. And if we just tried hard enough… Earnings and prices and interest rates should all behave in rational and predictable ways. If we just tried hard enough.
In the last fifty years a new physics came along. Quantum, or subatomic physics. The clues it left along its trail frustrated the best scientific minds in the world. Evidence began to mount that our knowledge of what governed events on the subatomic level wasn’t nearly what we thought it would be. Those events just didn’t seem subject to rational behavior or prediction. Soon it wasn’t clear whether it was even possible to observe and measure subatomic events, or whether the observing and measuring were, themselves, changing or even causing those events.
What I have to tell you tonight is that the investment world I think I know anything about is a lot more like quantum physics than it is like Newtonian physics. There is just too much evidence that our knowledge of what governs financial and economic events isn’t nearly what we thought it would be.”
Newtonian physics – the laws of nature governing our daily life – is neat and tidy. You can calculate gravity, air resistance, motion etc. with precision. This is how NASA managed to calculate precisely how long it would take for a spacecraft to travel from Earth to Pluto. In January 2006, NASA launched the New Horizons spacecraft, which reached Pluto in July 2015. The five billion kilometre journey “took about one minute less than predicted when the craft was launched,” according to NASA.
Quantum physics – the laws of nature governing atomic or subatomic particles – is far messier. When I first learnt about quantum physics in school, I was fascinated by the idea that it is impossible to simultaneously measure a particle’s position and velocity. In fact, the act of measuring a particle itself can change the thing you’re trying to probe.
What Williams is trying to bring across in his analogy is that investing is messy, just like quantum physics. Investing does not lend itself easily to tidy predictions, such as those common in Newtonian physics. This is shown clearly in the tweet below by investor Ben Carlson.
The third analogy comes from Jeremy Grantham, the co-founder and investment strategist of the asset management firm GMO. At the end of 2014, GMO managed US$116 billion in assets.
Financial journalist Maggie Mahar shared the following quote from Grantham in her excellent bookBull: A History of the Boom and Bust, 1998-2004:
“Think of yourself standing on the corner of a high building in a hurricane with a bag of feathers. Throw the feathers in the air. You don’t know much about those feathers. You don’t know how high they will go. You don’t know how far they will go. Above all, you don’t know how long they will stay up…
…Yet you know one thing with absolute certainty: eventually on some unknown flight path, at an unknown time, at an unknown location, the feathers will hit the ground, absolutely guaranteed. There are situations where you absolutely know the outcome of a long-term interval, though you absolutely cannot know the short-term time periods in between. That is almost perfectly analogous to the stock market.”
Making sense of short-term events in the stock market is practically impossible – just like how it’s impossible to tell how a feather will travel when it’s in the air. But over the long run, it’s easier to make sense of what’s going on in the stock market. Over time, richly valued stocks and stocks with poor business results tend to come down to earth, while stocks with underlying businesses that do well tend to rise significantly. This is similar to how a feather will hit the ground eventually.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
