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I recently read the book Tap Dancing to Work. Compiled by Carol Loomis, Tap Dancing to Work is a collection of articles published on Fortune magazine between 1966 and 2012 that are on Warren Buffett or authored by himself. 

Even though some of these articles were penned more than 50 years ago, they hold insights that are still relevant today. With that, here’s a collection of some of my favourite quotes from the book. 

On why buying mediocre companies at a cheap price is not ideal

“Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original ‘bargain’ probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces- never is there just one cockroach in the kitchen.

Second, any initial advantage you secure will be quickly eroded by the low returns that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realise a high return. But the investment will disappoint if the business is sold for $10 million in 10 years and in the interim has annually earned and distributed only a few percents on cost. Time is the friend of the wonderful business, the enemy of the mediocre.”

In his 1989 annual letter to Berkshire Hathaway shareholders, Buffett outlined some of the mistakes he made over his first 25 years at the helm of the company. One of those mistakes was buying control of Berkshire itself. At that time, and being trained by Ben Graham, Buffett thought that buying a company for a cheap price would end up being a good investment.

However, such bargain-priced stocks may take years to eventually trade at their liquidation value. This can result in very mediocre returns, even after paying a seemingly low price for the company and its assets.

Buffett later reasoned that “it’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

On why Berkshire does not leverage more

“In retrospect, it is clear that significantly higher, though still conventional, leverage ratios at Berkshire would have produced considerably better returns on equity than the 23.8% we have actually average. Even in 1965, we could have judge there to be a 99% probability that higher leverage would lead to nothing but good. Correspondingly, we might have seen only a 1% chance that some shock factor, external or internal, would cause a conventional debt ratio to produce a result falling somewhere between temporary anguish and default.

We wouldn’t have liked those 99:1 odds- and never will. A small chance of distress or disgrace cannot, in our view, be offset by a large chance of extra returns. If your actions are sensible, you are certain to get good results; in most such cases, leverage just moves things along faster.”

It is often tempting to invest on margin (in other words, borrowing to invest) as it can accelerate your gains. However, using leverage to invest can also result in distress and bankruptcy, both for the individual investor and companies alike.

Take the 2008 crisis for instance. The S&P 500 – the US’s stock market benchmark – lost approximately 50% of its value. An investor who invested on a 50% margin would have faced a margin call and his entire portfolio would be wiped out. 

Although cases like this are infrequent, as Buffett believes, it is always better to err on the side caution.

On the simple economics of valuing a financial asset

“A financial asset means, by definition, that you lay out money now to get money back in the future. If every financial asset was valued properly, they would all sell at a price that reflected all of the cash that would be received from them forever until judgement day, discounted back to the present at the same interest rate.”

In 1998, Buffett and Bill Gates spoke at the University of Washington, answering any questions that students threw at them. One of the students questioned whether the traditional way of valuing companies was still relevant at that time.

Buffett’s simple method of valuation can be applied to any financial asset. For a stock, it involves coming up with a prediction of the company’s future free cash flows and discounting them back to the present. This simple method of valuation is the ideal method of valuing a stock and is still used by numerous investors today. 

On risk

“The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the popularity- the reasoned probability- of that investment causing its owner a loss of purchasing power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see (he goes on to describe gold), a nonfluctuating asset can be laden by risk.”

In his 2011 Berkshire letter to shareholders, Buffett addressed the topic of risk. Investors are often concerned about the possibility of making a paper loss in their investments.

However, volatility should not be misconstrued as risk. Buffett instead defines risk as the chance of suffering a permanent loss or the inability of the investment to produce meaningful growth in purchasing power.

On being thankful and giving back…

Buffett is not just a brilliant investor but also a terrific human being. His humility and generosity are clearly demonstrated by his philanthropic pledge to donate 99% of his wealth to charity.

“My luck was accentuated by my living in a market system that sometimes produces distorted results, though overall it serves our country well. I’ve worked in an economy that rewards someone who saves the lives of others on a battlefield with a medal, rewards a great teacher with thank-you notes from parents, but rewards those who can detect mispricings of securities with sums reaching into the billions. In short, fate’s distribution of long straws is wildly capricious.

The reaction of my family and me to our extraordinary good fortune is not guilt, but rather gratitude. Were we to use more than 1% of my claim checks on ourselves, neither our happiness nor our well-being would be enhanced. In contrast, the remaining 99% can have a huge effect on the health and welfare of others. That reality sets an obvious course for me and my family. Keep all we can conceivably need and distribute the rest to society, for its needs. My pledge starts us down that course.”

The Good Investors’ Conclusion

Tap Dancing to Work is a priceless collection of articles describing Warren Buffett as a person, a business owner, and an investor. The articles that Warren Buffett penned himself, many of them excerpts from his own annual Berkshire shareholders’ letters, hold immense insights into the global economy and investing. There are many more insights in the book and I encourage all Buffett fans to find the time to read 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.

Capital allocation is one of the most important decisions a company’s leaders have to make. Good capital allocation will enable the company to grow profits and maximise shareholder returns.

In this article, I will share what are some common uses of capital and how I assess whether management has made good capital allocation decisions. 

The different uses of capital

I will start of by describing some of the ways that companies can make use of their financial resources.

1. Reinvesting for organic growth

First, companies can invest their capital to expand the business. This can take multiple forms. For instance, a restaurant chain can spend money opening new stores, while a glove manufacturer may spend cash increasing its annual production capacity. Companies can also spend on research and development for new products or improving an existing product.

A company should, however, only spend on organic growth when there are opportunities to expand its business at good rates of return.

2. Acquisitions and mergers

Big companies with substantial financial strength might decide to acquire a smaller company. An acquisition can help a company by (1) removing a competitor, (2) gaining intellectual property and technology, (3) achieving vertical integration, or (4) increasing its market share and presence. 

Ultimately, acquisitions should lead to long-term financial gain for the company and shareholders.

3. Pay off debt

Another way that a company can use its financial resources is to pay down existing debt. This is most effective when interest rates on its debt are high and paying off the debt provides a decent rate of savings.

This is true for a company that has taken on a lot of debt to grow and needs to reduce its debt burden to keep its cost of capital low. Reducing overly high leverage may also be necessary for a company to survive an economic crisis.

4. Share buybacks

A company can also choose to buy back its own shares in the open market. This reduces the number of outstanding shares. What this does is that it increases the size of the pie that each shareholder owns. Share buybacks can create shareholder value if the stocks are bought back below the true value of the company.

5. Pay dividends

Lastly, a company may choose to reward shareholders by returning the excess cash it has to shareholders as dividends. A company may also pay a dividend if there’s no other effective way to use its cash; in such an instance, returning cash may be more beneficial for a company’s shareholders than it hoarding cash.

What’s the best way to use its financial resources?

With so many different ways for a company to use cash, how do investors tell if management is making the best use of a company’s resources to maximise shareholder returns?

Unfortunately, there is no one-size-fits-all solution. Shareholders need to assess manager-decisions individually to see if each makes sense. 

That being said, there is one useful metric that investors can use to gauge roughly how well capital has been allocated. That is the return on equity (ROE).

A firm that has been making good capital allocation decisions will be able to maintain a high ROE over the long term. It is also important to see that the company’s shareholder equity is growing, rather than being stagnant (a stagnant shareholder equity implies that a company is simply returning capital to shareholders).

Facebook is an example of a company that has been using its capital effectively to grow its business. The social network’s ROE has grown from 9% in 2015 to 28% in 2018. Furthermore, even after accounting for a US$5 billion fine, Facebook still managed to post a 20% ROE in 2019, demonstrating how efficiently the company is at maximising its resources. Facebook’s high ROE is made even more impressive given that the company has no debt and has not paid a dividend yet.

The best capital allocator

While we are on the subject, I think it is an appropriate time to pay tribute to one of the best capital allocators of all time- Warren Buffett. He has compounded the book value per share of his company, Berkshire Hathaway, at 18.7% per year from 1965 to 2018.

That translates to a 1,099,899% increase in book value per share over a 53-year time frame. 

If you invest in Berkshire, you are not merely investing in a business. You are also banking on one of the best money managers of the past half-century.

Buffett’s success in picking great investments to grow Berkshire’s book value per share has, in turn, led to the company becoming one of the best-performing stocks of the last half-century in the US.

The Good Investors’ conclusion

Too often, investors overlook the importance of companies having good capital allocators at the helm. Unfortunately, Singapore is home to numerous listed companies that seem to consistently make poor capital allocation decisions. 

These decisions have led to poor returns on equity and in turn, stagnant stock prices. It is one of the reasons why some stocks in Singapore trade at seemingly low valuation multiples.

Knowing this, instead of merely focusing on the business, investors should put more emphasis on the manager’s ability and how capital is being allocated in a company.

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.

As I write this, the novel coronavirus (2019-nCoV) has infected 43,103 people globally and caused the deaths of 1,018 people. China has been the hardest-hit country, accounting for the lion’s share of the infected cases (42,708) and deaths (1,017).

This disease outbreak has already caused plenty of human suffering, especially in China. No one knows how widespread the 2019-nCoV will become around the world. The eventual impact of the virus on the global economy is also impossible to determine. If you’re an investor in stocks in Singapore and/or other parts of the world, it’s understandable to be worried.

A look at the past

But in times like these, we can look at history to soothe our fraying nerves. This is not the first time the world has fought against epidemics and pandemics. If you’re curious about the difference, this is the definition given by the CDC (Centres for Disease Control and Prevention) in the US: 

“Epidemic refers to an increase, often sudden, in the number of cases of a disease above what is normally expected in that population in that area… Pandemic refers to an epidemic that has spread over several countries or continents, usually affecting a large number of people.”

My blogging partner, Jeremy, included the chart below in a recent article. The chart illustrates the performance of the MSCI World Index (a benchmark for global stocks) since the 1970s against the backdrop of multiple epidemics/pandemics. He commented: 

“As you can see from the chart… the world has experienced 13 different epidemics since the 1970s. Yet, global stocks – measured by the MSCI World Index – has survived each of those, registering long term gains after each outbreak.”

The chart does not show what happened to stocks in the 1910s and 1920s. In 2009, the H1N1 pandemic arose (this is covered in the chart), but it was not the first time the virus had reared its ugly head. The first H1N1 pandemic lasted from 1918 to 1920. The first outbreak infected 500 million people worldwide, of whom 50 million to 100 million died. It was a dark age for mankind.

A tragedy for us, a normal time for investing

But from an investing perspective, it was a normal time. Data from Robert Shiller, a Nobel Prize-winning economist, show that the S&P 500 rose 10% (after dividends and inflation) from the start of 1918 to the end of 1919. From the start of 1918 to the end of 1923 – a six-year period – the S&P 500 rose 48% in total (again after dividends and inflation), for a decent annual gain of 6.8%. There was significant volatility between 1918 and 1923 – the maximum peak-to-trough decline in that period was 30% – but investors still made a respectable return.

I wish I had more countries’ stock market data from the 1910s and 1920s to work with. But the US experience is instructive, since some historical accounts state the country to be the source of the 1918-1920 H1N1 pandemic.

I’m not trying to say that stocks will go up this time. Every point in history is different and there’s plenty of context in the 1910s and 1920s that’s missing from today. For example, in December 1917, the CAPE ratio for the S&P 500 was 6.4; today, it’s 32. (The CAPE ratio – or cyclically-adjusted price-to-earnings ratio – is calculated by dividing a stock’s price with its average inflation-adjusted earnings over the past 10 years.) The interest rate environment was also drastically different then compared to now.

There are limits to the usefulness of studying history. But by looking at the past, we can get a general sense for what to expect for the future. And history’s verdict is that horrific pandemics/epidemics have not stopped the upward march of stocks around the world. 

The Good Investors’ take

The human tragedies of a virus outbreak like what we’re experiencing now with the 2019 n-CoV are painful. But as investors, there’s no need to panic if we’re investing for the long run – which is what investing is about, in the first place – and assuming our portfolios are made up of great companies.

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.

Ray Dalio published an article in July 2019 that captured plenty of attention from the investment industry. When Dalio speaks, people listen. He is the Founder, Chairman, and Co-Chief Investment Officer of Bridgewater Associates, an investment firm that is currently managing around US$160 billion.

The times they are a-changin’

In his article, Dalio shared his view that a paradigm shift will soon occur in financial markets. He defines a paradigm as a long period of time “(about 10 years) in which the markets and market relationships operate in a certain way.”

The current paradigm we’re in started in late 2008/early 2009, according to Dalio. Back then, the global economy and stock market reached their troughs during the Great Financial Crisis. The paradigm was driven by central banks around the world lowering interest rates and conducting quantitative easing. The result is we’re now in a debt-glut, and a state of “relatively high” asset prices, “low” inflation, and “moderately strong” growth.

Dalio expects the current paradigm to end soon and a new one to emerge. The new paradigm will be driven by central banks’ actions to deal with the debt-glut. Dalio thinks that central banks will be doing two key things: First, they will monetise debt, which is the act of printing money to purchase debt; and second, they will depreciate currencies. These create inflation, thus depressing the value of money and the inflation-adjusted returns of debt-investors. For Dalio, holding gold is the way for investors to navigate the coming paradigm.

Plus ça change (the more things change)… 

I don’t invest based on paradigm shifts, and I’m definitely not abandoning stocks. In fact, I prefer stocks to gold. Stocks are productive assets, pieces of companies that are generating cash flows. Meanwhile, gold is an unproductive asset which just sits there. Warren Buffett explained this view better than I ever can in his 2011 Berkshire Hathaway shareholders’ letter:

“Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.

What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth – for a while…

… Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At [US]$1,750 per ounce – gold’s price as I write this – its value would be [US]$9.6 trillion. Call this cube pile A.

Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about [US]$200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than [US]$40 billion annually). After these purchases, we would have about [US]$1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with [US]$9.6 trillion selecting pile A over pile B?

Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about [US]$160 billion. Buyers – whether jewelry and industrial users, frightened individuals, or speculators – must continually absorb this additional supply to merely maintain an equilibrium at present prices.

A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.

Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the [US]$9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.”

…plus c’est la même chose (the more they remain the same)

But Dalio’s opinion on a coming paradigm shift led me to an inverted thought: Are there things that don’t change in the financial markets? Inverting is a powerful concept in both business and investing. Here’s Jeff Bezos, founder and CEO of US e-commerce giant Amazon, on the topic (emphases are mine):

“I very frequently get the question: “What’s going to change in the next 10 years?” And that is a very interesting question; it’s a very common one. I almost never get the question: “What’s not going to change in the next 10 years?” And I submit to you that that second question is actually the more important of the two — because you can build a business strategy around the things that are stable in time… 

…[I]n our retail business, we know that customers want low prices, and I know that’s going to be true 10 years from now. They want fast delivery; they want vast selection. It’s impossible to imagine a future 10 years from now where a customer comes up and says, “Jeff, I love Amazon; I just wish the prices were a little higher.” “I love Amazon; I just wish you’d deliver a little more slowly.” Impossible.

And so the effort we put into those things, spinning those things up, we know the energy we put into it today will still be paying off dividends for our customers 10 years from now. When you have something that you know is true, even over the long term, you can afford to put a lot of energy into it.”

My inverted-thought led me to one thing that I’m certain will never change in the financial markets: A company will become more valuable over time if its revenues, profits, and cash flows increase faster than inflation. There’s just no way that this statement becomes false.

Finding great companies – companies that are able to grow much faster than inflation – is something I’ve been doing for more than nine years with my family’s investment portfolio, and for nearly three-and-a-half years in my previous role helping to run The Motley Fool Singapore’s investment newsletters.

But there’s a problem: Great companies can be very expensive, which makes them lousy investments. How can we reconcile this conflict? This is one of the hard parts about investing.

The tough things

Investing has many hard parts. Charlie Munger is the long-time sidekick of Warren Buffett. In a 2015 meeting, someone asked him:

“What is the least talked about or most misunderstood moat? [A moat refers to a company’s competitive advantage.]”

Munger responded:

“You basically want me to explain to you a difficult subject of identifying moats. It reminds me of a story. One man came to Mozart and asked him how to write a symphony. Mozart replied: “You are too young to write a symphony.” The man said: “You were writing symphonies when you were 10 years of age, and I am 21.” Mozart said: “Yes, but I didn’t run around asking people how to do it.””

I struggle often with determining the appropriate price to pay for a great company. There’s no easy formula. “A P/E ratio of X is just right” is fantasy. Fortunately, I’m not helpless when tackling this conundrum. 

“Surprise me”

David Gardner is the co-founder of The Motley Fool and he is one of the best investors I know. In September 1997, he recommended and bought Amazon shares at US$3.21 apiece, and has held onto them since. Amazon’s current share price is US$2,079, which translates into a mind-boggling gain of nearly 64,700%, or 33% per year.

When David first recommended Amazon, did it ever cross his mind that the company would generate such an incredible return? Nope. Here’s David on the matter:

“I assure you, in 1997, when we bought Amazon.com at $3.21, we did not imagine any of that could happen. And yet, all of that has happened and more, and the stock has so far exceeded any expectations any of us could have had that all I can say is, no one was a genius to call it, but you and I could be geniuses just to buy it and to add to it and to hold it, and out-hold Wall Street trading in and out of these kinds of companies.

You and I can hold them over the course of our lives and do wonderfully. So, positive surprises, too. Surprise.”

There can be many cases of great companies being poor investments because they are pricey. But great companies can also surprise us in good ways, since they are often led by management teams that possess high levels of integrity, capability, and innovativeness. So, for many years, I’ve been giving my family’s investment portfolio the chance to be positively surprised. I achieve this by investing in great companies with patience and perseverance (stocks are volatile over the short run!), and in a diversified manner.

It doesn’t matter whether a paradigm change is happening. I know there’s one thing that will not change in the stock market, and that is, great companies will become more valuable over time. So my investing plan is clear: I’m going to continue to find and invest in great companies, and believe that some of them will surprise 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.

Share buybacks is one of the more divisive topics in investing.

If you’re not familiar with the topic, share buybacks refer to a company repurchasing its own shares. Put another way, buybacks occur when the company uses its cash to purchase its own shares in the open market.

Simple economics suggests that share buybacks boost share prices by reducing the number of outstanding shares in the market. Fewer outstanding shares means remaining shareholders now own a larger piece of the pie.

However, share buybacks also reduce the company’s cash position. As such, the size of the pie is also smaller after share buybacks. 

So when are share buybacks good for shareholders and when are they detrimental?

When do share buybacks make sense?

Share buybacks can benefit shareholders if they tick certain boxes. The great Warren Buffett is a big fan of buybacks at the right price. He once said,

“The best use of cash, if there is not another good use for it in business, if the stock is underpriced is a repurchase.”

One advantage share buybacks have over dividends is that share buybacks reward shareholders in a more tax-effective manner in certain countries. In the US, local shareholders are taxed on dividends, while foreign shareholders from certain jurisdictions incur a 30% withholding tax. These taxes invariably reduce shareholder’s returns. But with share buybacks, companies can reduce their shares outstanding without incurring any tax expenses.

Share buybacks should also be most beneficial when shares are bought back below their true value. Apple, for instance, has a share buyback plan that reduced the total shares outstanding of the company. The share buybacks were made at strategic periods when shares of Apple traded at unfairly low valuations.

Competing for capital…

But share buybacks should only be undertaken when it is the best use of capital. On top of buybacks, a company has so many ways to deploy its cash, such as paying dividends, reinvesting the cash into the company, and acquiring other firms. Management, hence, needs to examine each possibility before deciding which is the best way to allocate capital. Jamie Dimon, CEO of JP Morgan Chase, reiterated:

“Buybacks should not be done at the expense of properly investing in our company.”

Again, Apple is a great example of buybacks done right. The iPhone maker generated more than US$50 billion in free cash flow each year for the past few years. Its shares were trading well below what the management believed to be its intrinsic value. As a result of its share repurchase plan, despite a fall in net income in the fourth quarter of fiscal 2019, Apple still managed to post a slight increase in earnings per share.

With more than US$100 billion in net cash, finding ways to put the capital to use can be a tough ask for Apple. That’s why I believe Apple’s decision to use the cash for buybacks when its share price was depressed is a prudent use of its excess cash.

When are share buybacks bad?

As mentioned at the start, share buybacks can be bad for shareholders too. This can happen when companies decide to pursue buybacks for the wrong reasons.

Below are some commonly cited but bad reasons I’ve come across that companies use to validate their buyback plan:

• To prop up their share price
• As a means to negate the impact of dilution due to share-based compensation
• To fend off an acquirer
• To boost earnings per share
• Because they have run out of ideas for the cash

Such companies do not take into account whether the shares are cheap or not. Simply buying back shares to boost earnings per share or prop up the share price is not good to shareholders if the stock is overpriced.

Worse still, companies that buy back shares so that they can negate the impact of dilution without thinking about the stock price will invariably hurt shareholders.

I also believe that companies that use debt to make buybacks are asking for trouble. Buybacks should only be made when the company has excess cash and as a way to reward shareholders.

In addition, in Singapore, paying dividends is just as beneficial to shareholders as buybacks. Dividends in Singapore are not taxed and by paying out dividends, shareholders can decide for themselves if they wish to reinvest the dividends back into the company by buying more shares.

The Good Investors’ conclusion

Buffett is a big fan of share buybacks and with good reason too. It is a tax-efficient way (in certain countries) of rewarding shareholders and are a great way to allocate capital if the company’s shares are trading below its true value.

However, buybacks can also harm investors if the company buys back shares that are overpriced or do not provide a good return on capital.

As investors, we should not assume that buybacks are always the most efficient use of capital. We need to look deeper into the decision-making process to assess if management is really making the best possible capital allocation decision for growing shareholder value over the long-term.

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.

Odyssey is an epic ancient Greek poem that is attributed to Homer. It was composed nearly 3,000 years ago, but it can teach us plenty about modern-day investing. 

An ancient epic

Odyssey recounts the tale of Odysseus, a Greek hero and king. After fighting for 10 long years in the Trojan War, Odysseus finally gets to go back to his home in Ithaca. Problem is, the way home for Odysseus was fraught with danger.

One treacherous part of the journey saw Odysseus having to sail past Sirenum Scopuli, a group of rocky small islands. They were home to the Sirens, mythical creatures that had the body of birds and the face of women.

The Sirens were deadly for sailors. They played and sang such enchanting melodies that passing sailors would be mesmerised, steer toward Sirenum Scopuli, and inevitably crash their ships.

Odysseus knew about the threat of the Sirens, but he also wanted to experience their beguiling song. So, he came up with a brilliant two-part plan.

The Greek hero knew for sure that he would fall prey to the seductive music of the Sirens – all mortal men would. So for the first part of his plan, he instructed his men to tie him to the ship’s mast and completely ignore all his orders to steer the ship toward Sirenum Scopuli when they approached the islands. For the second part, he had all his men fill their own ears with beeswax. This way, they couldn’t hear anything, and so would not be seduced by the Sirens when the ship was near Sirenum Scopuli.

The plan succeeded, and Odysseus was released by his men after his ship had sailed far beyond the dark reaches of the Sirens’ call.

A modern tragedy 

One of the great tragedies of modern-day investing is that we, as investors, are self-sabotaging.

Peter Lynch is one of the true investing greats. During his 13-year tenure with the Fidelity Magellan Fund from 1977 to 1990, he produced an annualised return of 29%, turning every $100,000 invested with him into $2.7 million. But the investors in his fund earned a much lower return. In his book Heads I Win, Tails I Win, Spencer Jakab, a financial journalist with The Wall Street Journal, explained why:

“During his tenure Lynch trounced the market overall and beat it in most years, racking up a 29 percent annualized return. But Lynch himself pointed out a fly in the ointment.

He calculated that the average investor in his fund made only around 7 percent during the same period. When he would have a setback, for example, the money would flow out of the fund through redemptions. Then when he got back on track it would flow back in, having missed the recovery.”

A 7% annual return for 13 years turns $100,000 into merely $241,000. Unfortunately, Lynch’s experience is not an isolated case.

In the decade ended 30 November 2009, CGM Focus Fund was the best-performing stock market fund in the US, with an impressive annual gain of 18.2%. But the fund’s investors lost 11% per year on average, over the same period. CGM Focus Fund’s investors committed the same mistake that Lynch’s investors did: They chased performance, and fled at the first whiff of any temporary trouble.

Two data points don’t make a trend, so let’s consider the broader picture. Investment research outfit Morningstar publishes an annual report named Mind The Gap. The report studies the differences between the returns earned by funds and their investors. In the latest 2019 edition of Mind The Gap, Morningstar found that “the average investor lost 45 basis points to timing over five 10-year periods ended December 2018.”

45 basis points equates to a difference of 0.45%, which is significantly lower than the performance-gaps that Lynch (22% gap) and CGM Focus Fund (29% gap) experienced. But the Morningstar study still highlights the chronic problem of investors under-performing their own funds because of self-sabotaging behaviour.

(If you’re wondering about the distinction between a fund’s return and its investors’ returns, my friends at Dr. Wealth have a great article explaining this.)

Tying the tales together

On his journey home, Odysseus knew he would commit self-sabotaging mistakes, so he came up with a clever plan to save himself from his own actions. The yawning chasm between the returns of Magellan Fund and CGM Focus Fund and their respective investors show that the investors would have been far better off if they had taken Odysseus’s lead. 

Having a fantastic ability to analyse the financial markets and find great companies is just one piece of the puzzle – and it’s not even the most important piece. There are two crucial ingredients for investing success.

The first is the ability to stay invested when the going gets tough, temporarily. Even the best long-term winners in the stock market experience sickening declines from time to time. This is why Peter Lynch once said that “in the stock market, the most important organ is the stomach. It’s not the brain.” The second key ingredient is the ability to delay gratification by ignoring the temptation to earn a small gain in order to earn a much higher return in the future. After all, every stock with a 1,000% return first has to jump by 100%, then 200%, then 300%, and so on.

We’re in an age where we’re drowning in information because of the internet. This makes short-term volatility in stock prices similar to the Sirens’ song. The movements – and the constant exposure we have to them – compel us to act, to steer our ship toward the Promised Land by trading actively. Problem is, the Promised Land is Sirenum Scopuli in disguise – active trading destroys our returns. I’ve shared two examples in an earlier article of mine titled 6 Things I’m Certain Will Happen In The Financial Markets In 2020. Here are the relevant excerpts:

“The first is a paper published by finance professors Brad Barber and Terry Odean in 2000. They analysed the trading records of more than 66,000 US households over a five-year period from 1991 to 1996. They found that the most frequent traders generated the lowest returns – and the difference is stark. The average household earned 16.4% per year for the timeframe under study but the active traders only made 11.4% per year.

Second, finance professor Jeremy Siegel discovered something fascinating in the mid-2000s. In an interview with Wharton, Siegel said:

“If you bought the original S&P 500 stocks, and held them until today—simple buy and hold, reinvesting dividends—you outpaced the S&P 500 index itself, which adds about 20 new stocks every year and has added almost 1,000 new stocks since its inception in 1957.”

Doing nothing beats doing something.”

We should all act like Odysseus. We should have a plan to save us from ourselves – and we should commit to the plan. And there’s something fascinating and wonderful about the human mind that can allow us to all be like Odysseus. In his book Incognito: The Secret Lives of the Brain, David Eagleman writes (emphasis is mine):

“This myth [referring to Odysseus’s adventure with the Sirens] highlights the way in which minds can develop a meta-knowledge about how the short- and long-term parties interact. The amazing consequence is that minds can negotiate with different time points of themselves.”

Some of you may think you’re an even greater hero than Odysseus and can march forth in the investing arena without a plan to save you from yourself. Please reconsider! Nobel-prize winning psychologist Daniel Kahneman wrote in his book, Thinking, Fast and Slow:

“The premise of this book is that it is easier to recognize other people’s mistakes than our own.” 

My Odysseus-plan

So what would our Odysseus-plans look like? Everyone’s psychological makeup is different, so my plan is not going to be the same as yours. But I’m still going to share mine, simply for it to serve as your inspiration:

• I commit to never allow macro-economic concerns (some of the recent worries are the US-China trade war and the unfortunate Wuhan-virus epidemic) to dominate my investment decision making.
• I commit to focus on the performance of the business behind the ticker and never allow stock price movements to have any heavy influence on my decision to buy or sell a share.
• I commit to invest for the long-term with a holding period that’s measured in years, if not decades.
• I commit to not panic when the stock market inevitably declines from time to time (volatility in the financial markets is a feature, not a bug).
• I commit to diversify smartly and not allow a small basket of stocks to make or break my portfolio.

I can’t tie myself to a ship’s mast, but I can keep my plan within easy visual reach so that I can sail safely toward the real Promised Land each time I find myself getting seduced by the Sirens’ song. If you have your own plan, we would love to hear from you – please share it in the comments section below, or email it to us at thegoodinvestors@gmail.com!

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.