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What We’re Reading (Week Ending 12 July 2020)

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 12 July 2020:

1. Habits: The Art of Compounding Choices – Oliver Sung

The key to designing the environment in a way that actually works for sustaining habits is to scale the desired habit down to the smallest, simple thing.

Want to read 20 book pages every night? Leave a book on your pillow every day you wake up and make your bed.
Want to drink more water and less alcohol? Make water the default choice by having nothing else in the fridge.
Want to save more money? Automate your savings transfers and keep the savings account at a different bank than your checking account.
Want to practice more guitar? Place it right in the center of your living room.

Forming the right habits is really all about thinking ahead to the second-order consequences of even the smallest choices and decisions. Secondly, it’s about creating the right system to make them incredibly easy to start and impossible to fail.

2. The Coffee Can Edge – John Huber

The coffee can portfolio is one of the simplest and most interesting concepts in all of portfolio management theory. It’s a term coined in 1984 by Robert Kirby, a portfolio manager who noticed that one of his clients did better than his own portfolio by secretly using all of Kirby’s buy recommendations but ignoring his sell recommendations. This particular client would put around $5,000 into each stock that Kirby bought, and then never touched the stock again. He put the stock certificate in the proverbial “coffee can” and didn’t think about it again. The results of each individual decision varied widely. Some stocks lost a majority of their value, some went up by an average amount, but a few performed incredibly well. The biggest winner was worth $800,000 (on a $5,000 initial investment).

One benefit of the coffee can approach is it forces you to think about what companies will be looking like in 5-10 years, as opposed to next year or the year after, which is the time frame that most investors (even those in the value investing community) tend to reside. The coffee can incentivizes you to think about two types of companies: the durable businesses that are likely to maintain their competitive position; or the businesses with the potential for much greater earning power in the future (and thus much greater value).

I wrote a series five years ago discussing the importance of returns on capital inside of a business, with the idea that there are two groups of companies in the world: those that are increasing their underlying value per share, and those that are eroding it. While it’s possible to make money buying stocks of mediocre businesses perhaps by buying something cheap and flipping it a year later, I’ve always thought that the vast majority of losses in the stock market come from picking the wrong business, not picking the wrong valuation on the right business.

3. Three people with inherited diseases successfully treated with CRISPR – Michael Le Page

Two people with beta thalassaemia and one with sickle cell disease no longer require blood transfusions, which are normally used to treat severe forms of these inherited diseases, after their bone marrow stem cells were gene-edited with CRISPR.

Result of this ongoing trial, which is the first to use CRISPR to treat inherited genetic disorders, were announced today at a virtual meeting of the European Hematology Association.

“The preliminary results… demonstrate, in essence, a functional cure for patients with beta thalassaemia and sickle cell disease,” team member Haydar Frangoul at Sarah Cannon Research Institute in Nashville, Tennessee, said in a statement.

4. Markets Bombed, Investors Carried On – Jason Zweig

Almost 95% of the 5 million investors in 401(k) and similar retirement plans run by Vanguard Group didn’t make a single trade in the first four months of 2020. Fewer than 1% moved their money entirely out of stocks.

All told, including 8 million households with individual accounts, only 12% of Vanguard’s investors traded between late February and early May, says Karin Risi, managing director of Vanguard’s retail investor group. Among those who did trade, two-thirds bought stocks rather than selling.

From late February through the end of March, fewer than 3% of the 2.2 million participants in retirement plans run by T. Rowe Price Group Inc. made any changes to their portfolios. “It’s a testament to people learning that this is a long-term investment,” says Kevin Collins, head of T. Rowe Price’s retirement-plan services.

5. The Broker Who Saved America – Joshua M. Brown

Solomon uses this role to access enemy military installations and to undermine German support for the Brits. He is sabotaging from the inside, talking the Hessians out of fighting for the English king. When these insurgency activities are discovered, Solomon is arrested again. This time, he pulls out a gold coin that had been sewn into his clothes and bribes a guard to let him escape. He flees to Philadelphia and arranges for his wife and son to meet him there. For the second time, Solomon has arrived in a new American city penniless and forced to start over.

By this time, the tide has turned and the Continental Army is beginning to pile up victories. The army is still, however, massively underfunded. General Washington is without readily available cash and is hamstrung by this lack of financial flexibility. He makes frequent requests to the Continental Congress to send money, but very little money comes. Into this breach steps Haym Solomon, ready to serve in the capacity in which he is best suited – as broker to the fledgling America.

Now that his merchant finance business is up and running again, Solomon begins funneling his own personal profits from the enterprise directly to the revolution. According to records of the time, he extends no-interest “loans”, many of which were never repaid, to James Monroe, Thomas Jefferson, James Madison, and even Don Francesco Rendon, the Spanish Court’s secret ambassador.

6. News by the ton: 75 years of US advertising – Ben Evans

It’s very common for people – especially newspaper people – to look at the newspaper and internet series in these charts and conclude that all the money went from newspapers to internet. There’s also a tendency to try to calculate Google and Facebook’s share of that ‘internet’ line. This can get you onto shaky ground quite quickly. As that change in share of GDP (and my phase ‘suspiciously flat’) should suggest, what’s actually happened is that the market has been both reallocated and repriced, a lot of money left the data that’s being captured here, and a lot of other money came in.

So: if you talk to people at both Google and Facebook and in the agency world, you’ll hear that perhaps two thirds to three quarters of money spent on Google and Facebook is money that was never spent on traditional advertising – it’s coming from SMEs and local businesses that might have spent in classified at most but probably wouldn’t have done even that. $60bn of consumer spending went through Shopify last year – it’s safe to assume those vendors spent money on advertising, but how many of them would have bought an ad in a local newspaper? This has also come at much lower prices: Facebook in particular has been massively deflationary to online advertising: it offers vast quantities of relevant advertising inventory at much lower prices and much lower entry costs than you’d have needed in print, let alone TV.

7. 99% of Long-Term Investing Is Doing Nothing; the Other 1% Will Change Your Life – Morgan Housel

Napoleon’s definition of a military genius was, “The man who can do the average thing when all those around him are going crazy.” It’s the same in investing.

Building wealth over a lifetime doesn’t require a lifetime of superior skill. It requires pretty mediocre skills — basic arithmetic and a grasp of investing fundamentals — practiced consistently throughout your entire lifetime, especially during times of mania and panic…

… To demonstrate my meaning, I used Yale economist Robert Shiller’s market data going back to 1900 and created three hypothetical investors. Each has saved $1 a month, every month, since 1900.

The first is Betty. She doesn’t know anything about investing, so she dollar-cost averages, investing $1 in the S&P 500 every month, rain or shine.

Sue, a CNBC addict, invests $1 a month into the S&P, but tries to protect her wealth by saving cash when the economy is in recession, deploying her built-up hoard back into the market only after the economy officially exits a recession.

Bill, a mutual fund manager whose only incentive is to look right in the short run, invests $1 a month, but stops investing in stocks six months after a recession begins, and only puts his money back into the market six months after a recession ends.

After 113 years of investing, who’s won? Boring Betty takes it by a mile:

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.

Making Sense Of Japan’s Epic Stock Market Bubble

Japanese stocks were in an epic bubble in late 1989. Understanding the size of the bubble gives us important perspective.

From time to time, Jeremy and myself receive questions from readers that are along this line: “Will the stock market of [insert country] be like Japan’s? Compared to its peak in late 1989, the Nikkei 225 Index – a representation of Japanese stocks – is still 40% lower today.”

It’s a good question, because Japanese stocks have indeed given investors a horrible return since late 1989, a period of more than 30 years. But perspective is needed when you’re thinking if any country’s stock market will go through a similar run as Japan’s stock market did from 1989 to today. Here’s some data for you to better understand what Japanese stocks went through back then:

Japanese stocks grew by 900% in US dollar terms in seven years from 1982 to 1989; that’s an annualised return of 39% per year.
At their peak in late 1989, Japanese stocks carried a CAPE (cyclically-adjusted price-to-earnings) ratio of nearly 100; in comparison, the US stock market’s CAPE ratio was ‘only’ less than 50 during the infamous 1999/2000 dotcom bubble. The CAPE ratio is calculated by dividing a stock’s price with its inflation-adjusted 10-year-average earnings. Near the end of May 2020, Japanese stocks had a CAPE ratio of 19, while US stocks today have a CAPE ratio of 30.

The data above show clearly that Japanese stocks were in an epic bubble in late 1989. It is the bursting of the bubble that has caused the painful loss delivered by Japan’s stock market since then.

If you’re worried about the potential for any country’s stock market to repeat the 1989-present run that Japanese stocks have had, then you should study the valuations of the country’s stock market. But you should note that there are two things that looking at valuations cannot do.

First, valuations cannot tell you the future earnings growth of a country’s stock market. If the earnings of a country’s stocks collapse in the years ahead for whatever reason (natural catastrophe, disease outbreak, war, incompetent leadership etc.), even a low valuation could prove to be expensive.

Second, valuations cannot protect you from short-term declines. What it can only do is to put the odds of success in your favour. In an earlier article, 21 Facts About The Wild World Of Finance and Investing, I shared the two charts below:

*Source: Robert Shiller’s* *data; my calculation*

They show the returns of the S&P 500 from 1871 to 2013 against its starting valuation for holding periods of 1 year (the first chart) and 10 years (the second chart). You can see that the relationship between valuation and eventual return – the higher the valuation, the lower the return – becomes much tighter when the holding period lengthens.

To end, I have another important takeaway from Japan’s experience: It’s important to diversify geographically. Global stocks have grown by around 5% per year in US dollar terms from 1989 to 2019, despite (1) the terrible performance of Japanese stocks in that period, and (2) Japan accounting for 45% of the global stock market by market capitalisation in early 1989.

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.

Should We Wait For a Market Pullback?

Are you waiting for the stock market to pull back? Here are some thoughts on market timing and why I prefer to be always invested.

Just a glance at the price chart of a stock market index will tell you that stocks don’t go up in a straight line. Stocks go up in a zig-zag pattern, making peaks and troughs.

Wouldn’t it be wonderful if we could keep buying at troughs and selling at peaks? We’d all be extremely rich. But the reality is it’s impossible. Even the best investors will tell you that timing the market perfectly is a pipedream. Yet, time and again, I still hear novice investors who are trying to do exactly that.

“The market looks expensive now. Maybe I should wait for another day.”

This statement may seem innocuous and something that many investors are feeling now. It is also understandable. The S&P 500 in the US fell by more than 30% from 19 February 2020 to 23 March 2020, but has since recovered almost all of the losses. Meanwhile, COVID-19 cases continue to surge and lockdowns are still imposed in many parts of the world.

I’m not saying that I know for a fact that stocks will keep rising from here. However, trying to time the market over the long-term will likely do you more harm than good. According to asset management firm Franklin Templeton, missing just a few of the stock market’s best days will severely damage your returns:

Source: https://www.franklintempleton.com/forms-literature/download/GOF-FL5VL

Staying fully invested over the 20 years leading up to December 2019 would have given you a 6.06% total annual return. However, miss just the best 10 days and your return would fall to only 2.44% per year. Miss the best 20 days, and your return drops to a negligible 0.08%. Miss the 30 best days and you are looking at a -1.95% annual loss. That would be 20 wasted years of investing.

I can draw one simple conclusion from this: The risk of staying out of the market is huge. Because of this, I much prefer a way less risky, albeit boring, approach of staying invested. By doing this, I know that I will not risk missing out on the best trading days of the market.

Less stress

Timing the market is also extremely stressful. Even for investors who are able to get it right once in a while, do the extra returns justify the effort? You’ll need to constantly monitor the market, find opportunities to buy and sell and are likely to still end up messing things up (see above).

Imagine you sold your investments just before some of the best trading days occur and the index/stock you are investing in never goes back to where you sold it at. You’d have missed out on some gains.

And what would you do next? Would you be able to convince yourself to buy back in at a higher price than you sold? You will likely continue compounding your mistake by never investing again. That’s a big mistake as historically the stock market tends to keep making new highs.

Final words

Time is your greatest friend in investing. There will always be reasons not to invest in the market.

The legendary investor Peter Lynch once said that “Wall Street makes its money on activity; you make your money on inactivity.” Investors who are tempted to time the market should remember these wise words.

3 Great Investing Lessons From My Favourite Warren Buffett Speech

Warren Buffett is one of my investing heroes.

He’s well known for producing incredible long-term returns at Berkshire Hathaway since assuming leadership of the company in 1965. What is less well-known is that he ran his own investment fund from 1957 to 1969 and achieved a stunning annualised return of 29.5%; the US stock market, in comparison, had gained just 7.4% per year over the same period.

Buffett has given numerous speeches and interviews throughout his long career. My favourite is a 1984 speech he gave titled The Superinvestors of Graham-and-Doddsville. I want to share three great lessons I have from the speech.

On what works in investing

Buffett profiled nine investors (including himself) in the speech. These investors invested very differently. For example, some were widely diversified while others were highly concentrated, and their holdings had no significant overlap.

There were only two common things among the group. First, they all had phenomenal long-term track records of investment success. Second, they all believed in buying businesses, not tickers. Here’re Buffett’s words:

“The common intellectual theme of the investors from Graham-and-Doddsville is this: they search for discrepancies between the value of a business and the price of small pieces of that business in the market.”

I firmly believe that there are many roads to Rome when it comes to investing in stocks. A great way is to – as Buffett pointed out – look at stocks as part-ownership of a real business. This is what I do too.

On risk and rewards

I commonly hear that earning high returns in stocks must entail taking on high risks. This is not always true. Buffett commented:

“It’s very important to understand that this group had assumed far less risk than average; note their record in years when the general market was weak.”

A stock becomes risky when its valuation is high. In such an instance, the potential return of the stock is also low because there’s no exploitable gap between the stock’s price and its intrinsic value. On the other hand, a stock becomes less risky when it’s priced low in relation to its intrinsic value; this is also when its potential return is high since there’s a wide exploitable-gap. So instead of “high risk / high return,” I think a better description of how investing works is “low risk / high return.”

It’s worth noting that a stock’s valuation is not high just because it carries a high price-to-earnings (P/E) or price-to-sales (P/S) ratio. What is more important here is the stock’s future business growth in relation to the ratios. A stock with a high P/E ratio can still be considered to have a low valuation if its business is able to grow significantly faster than average.

On why sound investing principles will always work

Will sharing the ‘secrets’ to investing cause them to fail? Maybe not. This is what Buffett said (emphasis is mine):

“In conclusion, some of the more commercially minded among you may wonder why I am writing this article. Adding many converts to the value approach will perforce narrow the spreads between price and value. I can only tell you that the secret has been out for 50 years, ever since Ben Graham and David Dodd wrote “Security Analysis”, yet I have seen no trend toward value investing in the 35 years I’ve practiced it. There seems to be some perverse human characteristic that likes to make easy things difficult.”

Surprisingly, it seems that human nature itself is what allows sound investing principles to continue working even after they’re widely known. Investing, at its core, is not something difficult – you buy small pieces of businesses at a price lower than their value, and be patient. So let’s not overcomplicate things, for there’s power in simplicity.

Is It Too Late To Invest in Stocks Now?

We are in a recession yet the S&P 500 has bounced strongly since March 2020. Why is this and does that mean stocks are overvalued now?

The S&P 500 index continues to defy gravity even as COVID-19 cases rise in the US.

Investors whom I’ve been talking to are understandably getting nervous. Will the S&P 500 eventually come crashing down to reflect the recession the world is living in?

Distinguishing the S&P 500 index from the economy

The first thing I want to point out is that the S&P 500 is not an accurate representation of the US economy.

The S&P 500 represents a basket of 500 of the biggest companies listed in the US. Although it may be tempting to assume that this basket of stocks should rise and fall in tandem with the whole economy, reality looks different.

There are 32 million businesses in the US, so the S&P 500 is just a fraction of this. In addition, the S&P 500 is a market-cap-weighted index that is heavily weighted toward just a few big firms such as Apple, Amazon, Alphabet, and Facebook. These mega-cap tech companies have arguably thrived during the COVID-19-induced lockdown.

Amazon, for example, had a big jump in sales due to the need for social distancing. Facebook double-downed on investing its spare cash. With so much cash on their balance sheets, these tech giants can find bargains at a time when other businesses are struggling for cash.

If these mega caps rise in value, it can positively skew the S&P 500.

But should we invest at all-time highs?

Another concern is whether we should invest at all-time high prices? The reality is that the S&P 500 reaching new all-time high prices is actually not that uncommon.

Engaging-data.com has some interesting data related to this topic. Between 1950 to 2019, there were a total of more than 17,000 trading days. Of which, the S&P 500 reached an all-time high on 1,300 days. Interestingly, if you invested on days after the S&P 500 reached all-time highs, you’d be doing just as well as if you invested on any other day.

The chart below compares your returns if you bought at all-time high (ATH) prices vs if you bought at any other time.

If you bought the S&P 500 the day after it hit a new high, your mean return over five years was 53.7%. If you bought on any other time, your mean return was 50.0%. I checked the 10-year return data, and the numbers point to the same conclusion. The mean return after 10 years, if you bought at a high, was 103.2% compared to 114.7% if you bought on all trading days.

The data shows that investing during new market highs, contrary to popular belief, gives you very similar returns to if you invested at any other time.

If this is a market peak?

But what if this market high is a peak and stocks do come crashing down after this? In this case, your returns will most likely not be as good as if you invested before or after the crash. However, that doesn’t mean you will have poor returns per se.

Ben Carlson, a respected financial blogger and wealth manager wrote an insightful piece in 2014 on investing just before a market crash.

In his article, Carlson wrote about a fictional investor who somehow managed to time his investments at all the worst times over a 40-year period. The investor invested in the S&P 500 just before the crash of 1973, before Black Monday of 1987, at the peak of the tech bubble in 1999, and at the peak before the start of the Great Financial Crisis of 2008.

Though this frictional investor was a terrible market timer, he was a long-term investor and never sold any of his positions. Despite his terrible luck in market timing, he ended up making a 490% return on his investment over his 40-year investing period.

This goes to show that even if you invest just before a crash, stocks tend to rebound and will eventually reach new peaks.

Final Takeaways

There are a few takeaways here:

It may be scary to invest in the stock market when it is at an all-time high. It is especially scary when the economy is in a recession, as we are seeing today. However, the S&P 500 is not the economy.
Not all companies have businesses that live or die by the broad economy. Some thrive during times of crisis and investing in these “anti-fragile” companies can pay dividends down the road.
Whether the S&P 500 is at an all-time high or not shouldn’t make a difference to a long-term investor. The stock market tends to keep making new highs.
Even if stocks were to fall dramatically tomorrow, if the past is anything to go by, investing in a broad index like the S&P 500 over the long-term will still provide a very decent return over a sufficiently long investing period.

What We’re Reading (Week Ending 5 July 2020)

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!

Here are the articles for the week ending 5 July 2020:

1. 40 Things I’ve Learned in 40 Years – Cullen Roche

1) Always try to be a good person. This is the most obvious one and also often the hardest one. Life is hard and everyone is fighting their own personal battles. Help them through it by being kind enough to try to understand their battle.

2) Never mistake money for wealth. The person who mistakes money for wealth will live a life accumulating things, all the while mistaking a life of owning for a life of living.

3) Never stop learning. Life is one big lesson and the older you get the more you’ll realize how little you know. Never lose an unquenchable thirst for knowledge and understanding.

2. Why We’re Blind to Probability – Morgan Housel

Let’s say you’re a 75-year-old economist. You started your career at age 25. So you have half a century of experience predicting what the economy will do next. You’re as seasoned as they come.

But how many recessions have there been in the last 50 years?

Seven.

There have only been seven times in your career that you’ve been able to measure your skills.

If you want to really judge someone’s abilities you would compare dozens, hundreds, or thousands of attempts against reality. But a lot of fields don’t generate that many opportunities to measure. It’s no one’s fault; it’s just the reality of the real world is messier than an idealized spreadsheet.

It’s an important quirk, because if someone says “there’s an 80% chance of a recession,” the only way to tell if they’re right is to compare dozens or hundreds of times they made that exact call and see if it came true 80% of the time.

If you don’t have dozens or hundreds of attempts – sometimes you have one or two – there’s no way to know whether someone who says “75% chance of this,” or “32% chance of that” is right or not. So we’re all left guessing (or preferring those who profess certainty, which is easier to measure).

3. Behind the Fall of China’s Luckin Coffee: a Network of Fake Buyers and a Fictitious Employee – Jing Yang

A group of Luckin employees had already begun helping sales along by engineering fake transactions, starting the month before the IPO, according to people familiar with the operation. The employees used individual accounts registered with cellphone numbers to purchase vouchers for numerous cups of coffee. Between 200 million and 300 million yuan of sales ($28 million to $42 million) were fabricated in this manner, according to a person familiar with the matter.

The undertaking became more complex. In late May 2019, orders began flooding in under a fledgling line of business that involved selling coffee vouchers in bulk to corporate customers, according to internal records reviewed by the Journal.

Alongside bona fide voucher sales, to a few regular clients such as airlines and banks, the records show numerous purchases by dozens of little-known companies in cities across China. These companies repeatedly bought bundles of vouchers, often in large amounts. Rafts of orders sometimes came in during overnight hours.

Qingdao Zhixuan Business Consulting Co. Ltd., situated in China’s northern Shandong province, bought 960,000 yuan ($134,000) worth of Luckin vouchers in a single order, according to the documents. They show it made more than a hundred similar purchases from May to November of 2019.

Mainland China and Hong Kong corporate-registry records link this company to a relative of Mr. Lu, to an executive of Mr. Lu’s previously founded Ucar Inc. and to a Luckin executive, via a complex web of other companies and their directors and shareholders. Qingdao Zhixuan also has the same telephone number as a branch of CAR Inc. and is registered with a Ucar email address.

4. How Big is the Racial Wealth Gap? – Nick Maggiulli

Unfortunately, even when we control for a household’s education level, the wealth gap still exists between White and non-White households. In fact, the median Black household with a college degree has a net worth similar to the median White household without a high school diploma.

Yes, you read that right. A college degree barely gets a Black household past where a White household is with no high school education.

5. The Anthropause: How the Pandemic Gives Scientists a New Way to Study Wildlife – Matt Simon

“There is an amazing research opportunity, which has come about through really tragic circumstances,” says lead author Christian Rutz, an evolutionary ecologist at the University of St. Andrews and Harvard University. “And we acknowledge that in the article. But it’s one which we as a scientific community really can’t afford to miss. It’s an opportunity to find more about how humans and wildlife interact on this planet.”

Historically, this has been difficult to study. Researchers might have been able to compare how species behave in a protected area versus a neighboring unprotected area, or an urban versus a rural environment. “The problem with all of these approaches is that they usually refer to just a handful of sites,” says Rutz. “And what happened here in the anthropause is that we have this global slowing of human activity, which gives us these really valuable replicates, where we can look at the effects of human activity across geographic regions, across ecosystems, and importantly, also across species.”

Take the fishers—carnivorous mammals in the weasel family—living in North America. “They were supposed to be out in the woods far away from people, and somehow they entered cities again,” says ecologist Martin Wikelski of the Max Planck Institute of Animal Behavior and University of Konstanz, coauthor on the anthropause paper. “This is a change in culture—it’s not a genetic change.”

6. SITALWeek #251: How a Handful of Chip Companies Came to Control the Fate of the World – NZS Capital, LLC

Photolithography is a good example. In short, when the light source used in the process had to change from a wavelength of 193nm to 13.5nm to accommodate smaller, more intricate patterns on leading-edge chips of ever-decreasing geometry, only one company even tried to do it.

Extreme ultraviolet lithography (EUV) is an almost magical process. In a vacuum, 50,000 microscopic droplets of molten tin are fired every second in a stream as one laser strikes each one so precisely that they flatten into discs before another bombards them with so much power that they become balls of plasma shining with EUV light. The machines cost almost $200 million, can be the size of a house and are contained within ultraclean environments to keep out even a single speck of dust. The scanners and lasers that power EUV lithography are so complex that a decade ago many scientists believed them to be an impossibility, and Nikon, ASML’s key competitor, viewed the technology as so complicated that it didn’t even attempt to develop an EUV tool.

Because of its unique mastery of EUV, ASML has built a de facto monopoly in manufacturing the machines that make the most advanced chips. The Dutch company expects to ship about 35 scanners this year, taking the total used by foundries around the world to around 100. TSMC and Samsung are already in high-volume manufacturing with EUV, while Intel will be using the process from 2021.

Without EUV, Moore’s Law, which states that the density of transistors on a chip will double about every two years, would likely have reached its limitations. But because of the process, TSMC is building 7nm and 5nm fabs, and is investing another $20 billion on a 3nm node foundry, while Samsung, South Korea’s biggest company, said in May 2020 it started building a 5nm facility near Seoul based on EUV as part of a $116 billion plan outlined in April 2019 to compete with TSMC in contract chipmaking.

7. The Nifty Fifty and the Old Normal – Ben Carlson

Although the Nifty Fifty stocks got crushed after being bid up so much by investors in the early-1970s, their long-term results were still pretty good. Jeremy Siegel published Revisiting The Nifty Fifty in 1998. He published the annual returns from 1972 through the summer of 1998 for these stocks along with their 1972 P/E ratios and subsequent earnings growth rates:

Many of the stocks at the top of the list showed extraordinary performance. Some of these stocks were terrible investments. But you can see over this multi-decade period, this group actually more or less kept up with the overall stock market. Despite crashing from lofty levels, over the long-term the Nifty Fifty did just fine.

The Dark Side of Commission-Free Trading

Commission-free trading is great for the long-term investor. However, it also leads to more frequent trading, which may lead to poorer results.

Commission-free trading has skyrocketed in popularity in the US. Pioneered by Fintech startup, Robinhood, commission-free trades has revolutionised the world of investing there.

It removes the frictional cost of investing in stocks and ETFs, making investing accessible to anyone and everyone.

For long-term investors, commission-free trading is great. Zero trading fees mean higher returns. It also “democratises” trading such that anyone, even those with a few hundred dollars to spare, can start investing in a diversified portfolio.

But what’s the catch?

Although is it hard to argue with the obvious benefits of commission-free trading, there’s a catch: It creates short-term trading behaviour.

In the stock markets, there’s data to show that long-term investors tend to do better than those who move in and out of the market.

Investors are traditionally bad market timers and tend to buy during a market peak and sell at a market bottom. This short-term trading mindset has caused retail investors to often lag the overall market, far under-performing investors who simply bought to hold.

Encourages poor trading behaviour

Just because something is free, does not mean we should be doing more of it. This is the case for trading.

Unfortunately, the rise of commission-free trading platforms has created more short-term trading mindsets. People trade frequently just because it doesn’t cost them anything. So while investors save money on trading fees, their investment returns suffer due to poor investing behaviour.

In the book Heads I Win, Tails I Win: Why Smart Investors Fail and How to Tilt the Odds in Your Favor, financial journalist Spencer Jakab discussed how poor investor behaviour led to poor returns, even though the underlying asset performed well. An interesting example he gave was the case of the Fidelity Magellan Fund managed by legendary investor Peter Lynch. Even though the fund earned around 29% per year during Lynch’s tenure as manager of the fund from 1977 to 1990, Lynch himself estimated that the average investor in his fund made only 7% per year. This was because when he had a setback, money flowed out and when there was a recovery, money flowed in, having missed the recovery.

Good investing behaviour is the most important factor to improve long-term returns

Commission-free trading is undoubtedly a good thing for investors who are able to stick to the long-term principle of investing. However, for those who are tempted to trade more often due to the zero trading fees, commission-free trading may end up doing more harm than good.

A Quick Thought On “Expensive” Software Stocks

Are young software companies expensive?

A few days ago, I was mucking around with historical data on Alphabet, the parent company of the internet search engine of our time, Google. I found some interesting data on this company that led to me writing this short but hopefully thought-provoking article.

Alphabet was listed in August 2004 and closed its first trading day at a share price of US$50. By 31 January 2005, Alphabet’s share price had risen to US$98, and it carried an astronomical price-to-earnings ratio of 250. On 31 January 2005, Alphabet’s revenue and profit were respectively US$2.67 billion and US$222 milion, giving rise to a profit margin of 8.3%.

Today, Alphabet’s share price is US$1,418, which represents an annualised return of 19% from 31 January 2005. Its P/E ratio has shrunk to 29, and the company’s revenue and profit are US$166.7 billion and US$34.5 billion, respectively, which equate to a profit margin of 21%.

Today, many software companies – especially the young ones categorised as software-as-a-service (SaaS) companies – carry really high price-to-sales ratios of 30 or more (let’s call it, 35). Those seem like extreme valuations, especially when we consider that the SaaS companies are mostly loss-making and/or generating negative or meagre free cash flow. If we apply a 10% net profit margin to the SaaS companies, they are trading at an adjusted P/E ratio of 350 (35 / 0.10).

But many of the SaaS companies today – the younger ones especially – have revenues of less than US$2.7 billion, with huge markets to conquer. The mature SaaS companies have even fatter profit margins, relative to Alphabet, of 30% or more today. So, compared to Alphabet’s valuation back then on 31 January 2005, things don’t seem that out-of-whack now for SaaS companies, does it? Of course, the key assumptions here are:

The young SaaS companies of today can go on to grow at high rates for a long period of time;
The young SaaS companies can indeed become profitable in the future, with a solid profit margin.

Nobody can guarantee these assumptions to be true. But for me, looking at Alphabet’s history and where young SaaS companies are today provides interesting food for thought.

Pain Is Part And Parcel of Long Term Investing

Investing in the stock market is not always sunshine and butterflies. Steep draw downs happen. But learning to endure pain can be hugely rewarding.

Much ink has been spilt about the great benefits of investing in the stock market. We constantly read about the power of compounding, how investing in stocks can help you beat inflation and the beauty of passive income from dividends.

But there’s a flip side to all this. Stock prices will fall every so often.

The size of the drawdowns can be big and they can happen frequently. It’s inevitable and will always be part and parcel of the stock market.

That’s what makes long term investing so hard

Fundsmith is the UK’s largest fund by assets under management and also one of the country’s top-performing funds. Its annualised return since inception (from November 2010 to May 2020) is 18.2%, compared to the MSCI World Index’s gain of 11.2% per year.

Its investment philosophy is summed up by three simple but profound investing principles: (1) Buy good companies, (2) Don’t overpay, and (3) Do nothing.

But Fundsmith is quick to point out that though their investment philosophy may sound easy, it is anything but. In fact, Fundsmith says that the most difficult part is following its third principle – doing nothing.

As investors, we are so caught up in the day-to-day commentary about the market that doing nothing to your portfolio is so mentally difficult. One of the reasons why this is so because investors tend to try to avoid pain as much as possible. It’s human nature.

Infants enter the world with a natural instinct to avoid pain. Think of the time you touched a hot surface, and immediately retracted your hand. This is just one example of our bodies reacting to pain.

In his book Thinking Fast and Slow, Daniel Kahneman refers to our instinct of avoiding pain as System 1 thinking, which is the automatic and fast-thinking part of the brain. But this instinct, though very useful in certain situations, can cause us to make very bad decisions in the stock market. Instead, we should force ourselves to think logically and more in-depth when it comes to investing, using the slow, logical thinking part of the brain- what Kahneman terms System 2.

Our human tendency to avoid pain

In his recent article Same As It Ever Was, Morgan Housel writes:

“There are several areas of life where the best strategy is to accept a little pain as the cost of admission. But the natural reaction is to say, “No, no, no. I want no pain, none of it.”
The history of the stock market is that it goes up a lot in the long run but falls often in the short run. The falls are painful, but the gains are amazing. Put up with one and you get the other.
Yet a large portion of the investing industry is devoted to avoiding the falls. They forecast when the next 10% or 20% decline will come and sell in anticipation. They’re wrong virtually every time. But they appeal to investors because asking people to just accept the temporary pain of losing 10% or 20% – maybe more once a decade – is unbearable. The majority of investors I know will tell you that you will perform better over time if you simply endure the pain of declines rather than try to avoid them. Still, they try to avoid them.
The upside when you simply accept and endure the pain from market declines is that future declines don’t hurt as bad. You realize it’s just part of the game.”

Opportunities created

Yet, it is this same aversion to pain that creates opportunities in the stock market. My blogging partner, Ser Jing, wrote in an article of his:

“It makes sense for stocks to be volatile. If stocks went up 8% per year like clockwork without volatility, investors will feel safe, and safety leads to risk-taking. In a world where stocks are guaranteed to give 8% per year, the logical response from investors would be to keep buying them, till the point where stocks simply become too expensive to continue returning 8%, or where the system becomes too fragile with debt to handle shocks.”

In other words, the fact that stocks are so volatile is why stocks can continue to produce the kind of long-term returns it has done. Investors are put off by the volatility, which causes stocks to be frequently priced to offer premium returns.

Final words

Investing in the stock market is never going to be a smooth journey. Even investing legends have endured huge drawdowns that have resulted in their net worth moving up and down. Warren Buffett, himself, has seen billions wiped out from his net worth in a day. Yet, his ability to accept this pain and invest for the long-term makes him able to reap the long-term benefits of investing in stocks.

Morgan Housel perhaps summed it up best when he wrote: “Accepting a little pain has huge benefits. But it’ll always be rare, because it hurts.”

HUYA Inc: A Company Riding on Tailwinds of Chinese Gaming

The Chinese Gaming market is expected to grow at double digits for the foreseeable future. HUYA is one company that can capitalise on this booming market.

The Chinese gaming market is expected to grow 14% per year from 2019 to 2024. One company that is likely to benefit from this is HUYA Inc (NYSE: HUYA).

Instead of competing directly with other gaming companies, HUYA Inc is a gaming streaming platform where gaming fans can watch live video game content. It earns money by selling advertising space, and virtual items to users.

The virtuous loop

HUYA is one of two (the other being DouYu) dominant live-game streaming platforms in China. HUYA also hosts eSports events, which are professional e-gaming tournaments.

As a leading player in the game streaming industry in China, HUYA boasts a large network of streamers and viewers. This has resulted in a network effect.

Streamers create content for viewers, which leads to more viewers. The ability to reach a larger audience attracts more streamers to choose HUYA as their streaming platform. More streamers leads to more content for viewers, and round and round the flywheel goes.

Track record of growth

HUYA has demonstrated that it has been able to use its industry-lead to great effect.

The monthly average users on its platform, HUYA Live, grew 28.8% to 150.2 million in the fourth quarter of 2019 compared to the same period a year ago. The number of paying users increased fairly proportionately by 27.6% to 13.4 million. But most impressively, the average spend per paying user increased by a staggering 40.6% to RMB 595.2 in 2019 compared to RMB 423.1 in 2018.

Putting everything together, HUYA’s revenue from live streaming (virtual gifts) spiked by 79.5% in 2019. Its advertising revenue also saw an 81% increase. The strong growth is nothing new for HUYA as it merely extends its winning streak of growth since 2016. The table below shows HUYA’s total net revenues from 2016 to 2019.

Source: My compilation of data from F-1 and 2019 Annual report

A profitable business model

HUYA’s amazing growth is one thing but, to me, the most important aspect of any business is whether it has cost structures that enable it to turn a profit. HUYA ticks this box. The Chinese live gaming streaming platform was operationally profitable in 2018 and 2019. Margins have also started to widen as HUYA starts to enjoy economies of scale.

In the first quarter of 2020, HUYA reported an operating profit margin of 5.8% compared to just 1.8% in the same quarter last year.

As HUYA continues to increase its topline, I expect margins to improve substantially as its operating expenses increase much slower than revenue.

Robust balance sheet and positive free cash flow

As of 31 March 2020, HUYA had no debt, and RMB 10.3 billion (US$1.45 billion) in cash, cash equivalents, restricted cash, short-term deposits, and short-term investments.

It also generated around RMB 1.9 billion in free cash flow in 2019. It has been producing positive operating cash flow and free cash flow since 2017.

With its strong cash position and the ability to generate cash from its core business, HUYA has the financial muscle to continue spending on expanding its product offering and to grow its user and streamer base.

Strategic owners

Another thing that HUYA has going for it is that Tencent Holdings is its majority shareholder. In April this year, Tencent exercised its option to acquire an additional 16.5% of shares from HUYA’s previous owner, JOYY. After the transfer of shares, JOYY has 43% total voting power, while Tencent Holdings has 50.9% of the voting rights.

Tencent is the world’s largest video gaming company. It owns some of the biggest game developers in the world such as Riot Games, which owns League of Legends. Tencent also has strategic stakes in game developers such as Supercell (the makers of Clash of Clans) and Epic Games (whose platform was used to develop Fortnite).

I think that HUYA can leverage its relationship with Tencent to further consolidate its position as one of the top video game live streaming platforms in China.

Risks

A discussion about any company will not be complete without talking about the risks. As a Chinese company listed in America, the big risk that everyone is talking about is the possibility that Chinese companies may be forced to delist from the US stock market.

On top of that, Chinese companies listed in America do so via American depository receipts (ADRs), which in turn own an interest in a variable interest entity (VIE). This VIE has contractual rights to participate in the economic interests of the actual operating company in China. The structure is really complex, and there could be potential loopholes where certain parties can use to exploit owners of the ADRs. Although this has not been done before for HUYA, there is that possibility that investors need to be aware of. Moreover, if China’s regulatory authorities should deem the VIE contracts to be invalid in the future, owners of the ADRs could be wiped out.

There is execution risk too. HUYA is still a relatively young company and was only listed in 2018.

In addition, Chinese companies face regulatory risks that could derail its growth. The Chinese government has been known to implement very strict rules on internet companies – that could potentially disrupt HUYA’s business.

Competition is another factor to keep in mind. For now, HUYA enjoys a strong position as one of two big players in this space in China. But things could change if new entrants emerge that somehow have a better platform and are able to attract streamers.

Final Words

I’m keeping an eye on HUYA. It operates in a fast-growing market and I expect to see double-digit growth for at least a few years. In addition, the company is already profitable, has enough cash on its balance sheet for expansion, and has strategic shareholders that it can leverage.

On HUYA’s valuation, the company currently trades at around 3.3 times 2019’s revenue. Based on its current gross margin of around 18% and the potential economies of scale as it grows, I think HUYA can easily settle at a 10% operating margin.

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.