Category: General Investing

I’m writing this article on the morning of 21 April 2020 (Tuesday) in Singapore. On the night of 20 April 2020, the price of oil fell to negative territory. I’m referring specifically to contracts for deliveries of West Texas Intermediate (WTI) crude oil in early May. 

Here are some quick thoughts I have on this development…

1. Scott Sagan, a professor of political science, once wrote that “things that have never happened before, happen all the time in history.” Last night was the first time ever that oil prices became negative. Historic and fascinating? Yes. Surprising? It shouldn’t be. Crazy things happen all the time in the world of finance.  

2. I hope investors are not lured to invest in oil & gas stocks simply because the price of oil is now so low. There are two important things to note: 

• Predicting the future of oil prices is practically impossible. In 2007, Peter Davies gave a presentation titled What’s the Value of an Energy Economist? He said in the presentation that “we cannot forecast oil prices with any degree of accuracy over any period whether short or long.” Back then, Davies was the chief economist of British Petroleum (LSE: BP), one of the largest oil & gas companies in the world.
• Oil & gas stocks need not follow the movement of oil prices. In mid-2014, oil prices started falling from around US$100 per barrel. WTI reached a low of US$26.61 in February 2016 before doubling to US$53.53 just 10 months later (on 21 December 2016). I tracked the share prices of a group of 50 oil & gas stocks in Singapore’s stock market and found that over the same period, 34 of them saw their share prices fall. The average decline for all the 50 companies was 11.9%.

3. Investing in an oil & gas stock also means the need to study its financials and – especially in today’s climate – its balance sheet. Even before the historic slump in oil prices on Monday night, there have already been oil & gas companies in the US effectively going bankrupt (see here and here). And speaking of financial trouble…

4. I fear for Singapore’s oil & gas giant Sembcorp Marine (SGX: S51). As of 31 December 2019, Sembcorp Marine, which builds oil rigs and other types of vessels, had S$389 million in cash but S$1.4 billion in short-term debt and S$3.0 billion in long-term debt. The company had S$2.9 billion in short-term liabilities but just S$2.5 billion in short-term assets. Of the short-term assets, only S$389 million is in cash; the bulk of it are in “contract assets” worth S$1.5 billion. Unfortunately, “contract assets” consist of recognised revenue for ongoing projects and don’t represent real cash until the projects are delivered. In crisis situations – and we are in a crisis situation – all liabilities become real and most assets except cash have to be heavily discounted. 

5. Given the rapid deterioration in global economic conditions since end-2019, it’s likely that Sembcorp Marine’s financial health has weakened significantly from an already poor condition from what I just described in Point Four. The good thing is that Sembcorp Marine’s majority shareholder is Sembcorp Industries (SGX: U96), which is controlled by Temasek Holdings, one of the Singapore government’s investment arms. So it’s likely that financial support for Sembcorp Marine will be strong, if push comes to shove. That said, financial support for Sembcorp Marine does not necessarily mean that its shareholders will end up fine on the other side of this crisis.

6. I’ve stopped having an interest in investing in oil & gas companies for many years because I know my limitations. Investing in oil & gas companies, in my opinion, requires skills that I don’t – and will never – have. I just hope that investors who are tempted to invest in oil & gas stocks because of the historical fall in oil prices on Monday night are fully aware of the risks involved and go in with their eyes wide open.

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.   

One of my heroes in the investment industry is Warren Buffett. His brainchild, Berkshire Hathaway (NYSE: BRK-A)(NYSE: BRK-B), is one of the 50-plus companies in my family’s investment portfolio. We’ve owned Berkshire shares since August 2011, and I shared my investment thesis on the company recently in The Good Investors.

In my Berkshire thesis, I discussed the fantastic track record of profitability that the company’s insurance subsidiaries have produced over the years. I shared that the track record is the result of Buffett’s unique mindset in managing the insurance subsidiaries:

“Next, Buffett also does not push for short-term gains at the expense of Berkshire’s long-term business health. A great example can be seen in Berkshire’s excellent track record in the insurance industry: Its property and casualty (P/C) insurance business has recorded an underwriting profit for 15 of the past 16 years through to 2018. In contrast, the P/C industry as a whole often operates at a significant underwriting loss; in the decade ended 2018, the industry suffered an underwriting loss in five separate years.”    

A missing piece

Years ago, I read a document from Buffett suggesting that Berkshire does not pay its insurance employees based on the policy-premiums they bring in. That’s because Buffett does not want to incentivise his insurance employees to chase unprofitable insurance deals when premiums across the industry do not make sense.

I wanted to include Buffet’s unique remuneration structure for his insurance employees in my Berkshire investment thesis. I thought it was a beautiful illustration of a simple but unreplicable competitive advantage that Berkshire has in the insurance industry. But when I was writing the thesis, I forgot where I came across the information and I could not find it after a long search. So I decided to leave it out.

Found again

As luck would have it, I finally found it again. All thanks goes to my friends Loh Wei and Stanley Lim! Stanley runs the excellent investment education website, Value Invest Asia. He recently interviewed Loh Wei, who talked about Berkshire and Buffett’s unique mindset for remunerating his insurance employees.

After watching the interview, I asked Loh Wei where he found the information and was guided toward the source that I came across years ago: Buffett’s 2004 Berkshire shareholders’ letter.

Wisdom from the Oracle of Omaha

Here’s what Buffett wrote (emphases are mine):

“What we’ve had going for us is a managerial mindset that most insurers find impossible to replicate. Take a look at the facing page. Can you imagine any public company embracing a business model that would lead to the decline in revenue that we experienced from 1986 through 1999? That colossal slide, it should be emphasized, did not occur because business was unobtainable. Many billions of premium dollars were readily available to NICO [National Indemnity Company] had we only been willing to cut prices. But we instead consistently priced to make a profit, not to match our most optimistic competitor. We never left customers – but they left us.

Most American businesses harbor an “institutional imperative” that rejects extended decreases in volume. What CEO wants to report to his shareholders that not only did business contract last year but that it will continue to drop? In insurance, the urge to keep writing business is also intensified because the consequences of foolishly-priced policies may not become apparent for some time. If an insurer is optimistic in its reserving, reported earnings will be overstated, and years may pass before true loss costs are revealed (a form of self-deception that nearly destroyed GEICO in the early 1970s).

Finally, there is a fear factor at work, in that a shrinking business usually leads to layoffs. To avoid pink slips, employees will rationalize inadequate pricing, telling themselves that poorly-priced business must be tolerated in order to keep the organization intact and the distribution system happy. If this course isn’t followed, these employees will argue, the company will not participate in the recovery that they invariably feel is just around the corner.

To combat employees’ natural tendency to save their own skins, we have always promised NICO’s workforce that no one will be fired because of declining volume, however severe the contraction. (This is not Donald Trump’s sort of place.) NICO is not labor-intensive, and, as the table suggests, can live with excess overhead. It can’t live, however, with underpriced business and the breakdown in underwriting discipline that accompanies it. An insurance organization that doesn’t care deeply about underwriting at a profit this year is unlikely to care next year either.

Naturally, a business that follows a no-layoff policy must be especially careful to avoid overstaffing when times are good. Thirty years ago Tom Murphy, then CEO of Cap Cities, drove this point home to me with a hypothetical tale about an employee who asked his boss for permission to hire an assistant. The employee assumed that adding $20,000 to the annual payroll would be inconsequential. But his boss told him the proposal should be evaluated as a $3 million decision, given that an additional person would probably cost at least that amount over his lifetime, factoring in raises, benefits and other expenses (more people, more toilet paper). And unless the company fell on very hard times, the employee added would be unlikely to be dismissed, however marginal his contribution to the business.

It takes real fortitude – embedded deep within a company’s culture – to operate as NICO does. Anyone examining the table can scan the years from 1986 to 1999 quickly. But living day after day with dwindling volume – while competitors are boasting of growth and reaping Wall Street’s applause – is an experience few managers can tolerate. NICO, however, has had four CEOs since its formation in 1940 and none have bent. (It should be noted that only one of the four graduated from college. Our experience tells us that extraordinary business ability is largely innate.)

The current managerial star – make that superstar – at NICO is Don Wurster (yes, he’s “the graduate”), who has been running things since 1989. His slugging percentage is right up there with Barry Bonds’ because, like Barry, Don will accept a walk rather than swing at a bad pitch. Don has now amassed $950 million of float at NICO that over time is almost certain to be proved the negative-cost kind. Because insurance prices are falling, Don’s volume will soon decline very significantly and, as it does, Charlie and I will applaud him ever more loudly.” 

In the quotes above, Buffett referenced a table of financials for NICO. The table is shown below. Note the red box, which highlights the massive decline in NICO’s revenue (written premium) from 1986 to 1999. 

Can you do it?

“What we’ve had going for us is a managerial mindset that most insurers find impossible to replicate.” This is the simple but unreplicable competitive advantage that Buffett and Berkshire has in the insurance industry. It is simple. You just have to be willing to tolerate a huge decline in business volume – potentially for a long time – if the pricing for business does not make sense. But it is unreplicable because it goes directly against our natural human tendency to be greedy for more. 

If we spot similar simple but unreplicable competitive advantages in companies, it could lead us to fantastic long-term investment opportunities. Jeff Bezos, the founder and CEO of Amazon.com (NASDAQ: AMZN), shared the following in his 2003 Amazon shareholders’ letter (emphasis is mine):

“Another example is our Instant Order Update feature, which reminds you that you’ve already bought a particular item. Customers lead busy lives and cannot always remember if they’ve already purchased a particular item, say a DVD or CD they bought a year earlier.

When we launched Instant Order Update, we were able to measure with statistical significance that the feature slightly reduced sales. Good for customers? Definitely. Good for shareowners? Yes, in the long run.”

Bezos was able to cut through short-term greediness and focus on long-term value. I also shared Bezos’s quote above in my recent investment thesis for Amazon. My family’s investment portfolio has owned Amazon shares for a few years. Here’s a chart showing much a $10,000 investment in Amazon shares would have grown to since the company’s 1997 listing:

Competitive advantages need not be complex. They can be simple. And sometimes the really simple ones end up being the hardest, or impossible, to copy. And that’s a beautiful thing for long-term investors.

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.

Shorting is the act of investing in stocks in a way that allows you to profit when stock prices fall. It is the opposite of going long, which is investing in a way that allows you to profit when stock prices rise. 

I’ve been investing for nearly a decade now and have done fairly well. But I’ve never shorted stocks. That’s because I recognise that shorting requires different skills from going long. In the financial markets, I only want to do things that I’m sure I know well. In this article, I want to share two real-life examples on why it’s so difficult to short stocks.

My investment club

The first example starts with an informal investment club I belong to named Kairos Research. It was founded by Stanley Lim, Cheong Mun Hong, and Willie Keng. They are also the founders of the excellent Asia-focused investment education website, Value Invest Asia. 

I’ve been a part of Kairos for many years and have benefited greatly. I’ve made life-long friends and met countless thoughtful, kind, humble, and whip-smart people who have a deep passion for investing and knowledge. Being in Kairos Research greatly accelerated my learning curve as both an investor and human being.

To join the club and remain in it requires a membership “fee” of just one stock market investment idea per year. It’s a price I’ve gladly paid for many years and I will continue to do so in the years ahead. 

Riding all the way up

In one of our gatherings in June 2019, a well-respected member and deeply accomplished investor in the club gave a presentation on Luckin Coffee (NASDAQ: LK). 

Luckin is a company that runs coffee stores in China. Its stores mainly cater for to-go orders and the company was expanding its store count at a blistering pace. Within a year or so from its founding near the end of 2017, it already had more than 2,000 stores in China. Luckin is considered a formidable competitor to US-based Starbucks in China; Starbucks counts the Middle Kingdom as its largest international growth market. 

At the time of my club mate’s presentation, Luckin’s share price was around US$20, roughly the same level from the close of its IPO in May 2019. He sold his Luckin shares in January 2020, around the time when Luckin’s share price peaked at US$50. Today, Luckin’s share price is around US$4. The coffee chain’s share price tanked by 76% from US$26 in one day on 2 April 2020 and continued falling before stock exchange operator NASDAQ ordered a trading halt for Luckin shares. 

Not the first time…

In January 2020, Muddy Waters Research said that it believes Luckin is a fraud. Muddy Waters Research is an investment research firm. Luckin denied the accusations and its share price only had a relatively minor reaction. There was a gradual slide that occurred in Luckin’s share price since then, but it happened with the backdrop of stock markets around the world falling because of fears related to the COVID-19 pandemic. 

The wheels came off the bus only on 2 April 2020. On that day, Luckin announced that the company’s board of directors is conducting an internal investigation. There are fraudulent transactions – occurring from the second quarter of 2019 to the fourth quarter of 2019 – that are believed to amount to RMB 2.2 billion (around US$300 million). For perspective, Luckin’s reported revenue for the 12 months ended 30 September 2019 was US$470 million, according to Ycharts. The exact extent of the fraudulent transactions has yet to be finalised. 

Luckin also said that investors can no longer rely on its previous financial statements for the nine months ended 30 September 2019. The company’s chief operating officer, Liu Jian, was named as the primary culprit for the misconduct. He has been suspended from his role. 

Given the announcement, there could potentially be other misdeeds happening at Luckin. After all, Warren Buffett once said that “What you find is there’s never just one cockroach in the kitchen when you start looking around.”

It’s tough being short

Here’s a chart showing Luckin’s share price from its listing to 2 April 2020:

The first serious allegations of Luckin committing fraud appeared only in January 2020, thanks to Muddy Waters Research. But it turns out that fraudulent transactions at Luckin could have happened as early as April 2019. From 1 April 2019 to 31 January 2020, Luckin’s share price actually increased by 59%. At one point, it was even up by nearly 150%.

If you had shorted Luckin’s shares back in April 2019, you would have faced a massive loss – more than what you had put in – even if you had been right on Luckin committing fraud. This shows how tough it is to short stocks. Not only must your analysis on the fundamentals of the business be right, but your timing must also be right because you could easily lose more than you have if you’re shorting. 

Going long though is much less worrisome. If you’re not using leverage, poor timing is not an issue because you can easily ride out any short-term decline.

Even the legend fails

The other example I want to highlight in this article is one of the most fascinating pieces of information on shorting stocks that I’ve ever come across. It involves Jim Chanos, who has a stellar reputation as a short seller. A September 2018 article from finance publication Institutional Investor mentioned this about Chanos:

“Chanos, of course, is already a legend. He will go down in Wall Street history for predicting the demise of Enron Corp., whose collapse resulted in a wave of prosecutions and the imprisonment of top executives — the kind of harsh penalties that have not been seen since.”

The same Institutional Investor article also had the following paragraphs (emphasis is mine): 

“The secret to Chanos’s longevity as a short-seller is Kynikos’s flagship fund, the vehicle where Kynikos partners invest, which was launched alongside Ursus in 1985. Kynikos Capital Partners is 190 percent long and 90 percent short, making it net long. Unlike most long/short hedge funds, however, the longs are primarily passive, using such instruments as exchange-traded funds, as the intellectual effort goes into the short side.

Chanos argues that by protecting the downside with his shorts, an investor can actually double his risk — and over time that has proved a winning strategy. Through the end of 2017, Kynikos Capital Partners has a net annualized gain of 28.6 percent since launch in October 1985, more than double the S&P 500. That has happened even though the short book — as represented by Ursus — has lost 0.7 percent annually during the same time frame, according to a recent Kynikos document Institutional Investor has obtained.”

It turns out that Chanos’s main fund that shorts stocks – Ursus – had lost 0.7% annually from October 1985 to end-2017! That’s Jim Chanos, a legendary short-seller, losing money shorting stocks over a 32-year period! 

My conclusion  

Stocks with weak balance sheets, inability to generate free cash flow, and businesses in rapidly declining industries are likely to falter over the long run. But it’s far easier to identify such stocks and simply avoid them than it is to short them. 

Besides, the math doesn’t work in my favour. The most I can make going short is 100% while my potential loss is unlimited. On the flipside, the gain I can earn going long is theoretically unlimited, while my potential loss is capped at what I’ve invested.

When we go short, we run the risk of losing more than we can afford – that’s true even for fraud cases. As a result, I’ve always invested with the mentality that going short in the stock market is far riskier than going long.

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.

“Fear incites human action far more urgently than does the impressive weight of historical evidence.”

Jeremy Siegel, Stocks for the Long Run

The COVID-19 pandemic has thrown markets into a frenzy. The month of March was likely the most volatile period in stock market history. Traders were zig-zagging in and out of the markets, causing daily swings of up to 10% in the S&P 500. 

COVID-19 is indeed a black swan event. No one really knows what will happen and how the market will pan out in the short-term. With so much uncertainty, what should long-term investors do now?

Focus on things that you can predict

There are many things we can’t predict in the stock market. But investing is not about accurately predicting everything that will affect stock prices. Instead, it’s about focusing on stuff that you can predict. It’s about investing in companies that are likely to succeed in the long-term.

Terry Smith is the founder of Fundsmith, the manager of the UK’s largest fund, Fundsmith Equity Fund. Here’s what Smith wrote in a recent letter to his investors:

“What will emerge from the current apocalyptic state? How many of us will become sick or worse? When will we be allowed out again? Will we travel as much as we have in the past? Will the extreme measures taken by governments to maintain the economy lead to inflation? I haven’t a clue. Rather like some of the companies we most admire, I try to spend very little time considering matters which I can neither predict nor control and focus instead on those which I can affect.”

Don’t forget that the stock market is the best place to invest for the long term

In times such as this, it is easy to forget that the stock market is actually the best place to invest your money for long-term returns.

According to data from NYU finance professor Aswath Damodaran, US stocks have outperformed bonds and cash by a wide margin over the long run. From 1928 to 2019, US stocks produced an annual return of 9.7%, while bonds (10-year treasuries) had a 4.9% return per year.

In a recent video, Motley Fool co-founder David Gardner shared:

“From day one, when we started the Motley Fool 27 years ago, we said three things. Number one, the stock market is the best place to be for your long-term money. Number two, the stock market tends to rise 9 to 10% a year. That includes every bad week, quarter, month, year, bear market… and number three, make sure that you are invested in a way that you can sleep well at night.”

Don’t try to time the bottom

One of the most-asked questions among investors today is “Have we reached the bottom?”

I think that nobody really knows the answer to that. But it should not stop us from investing.

If you insist on only buying at the trough, you might miss a few good opportunities. In fact, I’ve heard of stories of investors who planned to enter the market at the bottom but missed out when their preferred-bottom never came. As stocks rose and got more expensive, they couldn’t bring themselves to buy and missed out on years of gains.

Billionaire investor Howard Marks mentioned in his latest memo:

“The old saying goes, “The perfect is the enemy of the good.”  Likewise, waiting for the bottom can keep investors from making good purchases.  The investor’s goal should be to make a large number of good buys, not just a few perfect ones.”

But remember to pick the right stocks

If you intend to invest in individual companies rather than an index-tracking fund, then it is important to remember that not all companies are created equal.

The well-followed S&P 500 index in the US has risen steadily over the long-term but a lot of its return can be attributed to only a handful of outperforming companies.

In fact, my blogging partner Ser Jing reported an interesting statistic in an earlier article. He wrote:

“ A 2014 study by JP Morgan showed that 40% of all stocks that were part of the Russell 3000 index in the US since 1980 produced negative returns across their entire lifetime.”

That’s an astounding statistic and goes to show that simply investing in any random stock will not guarantee you positive returns, even if you hold for the long run.

Picking the right companies is as important as choosing the right asset class to invest in. It is perhaps even more important for times such as today, where poorly-managed companies with weak balance sheets are fighting for their survival. As Warren Buffett once said, “Only when the tide goes out do you discover who’s been swimming naked.”

Stay calm and keep investing…

It is an understatement that markets are volatile. We are also likely going to see sharp drops in earnings from many companies in the next few quarters. Already Starbucks has guided for a 46% fall in earnings for the first quarter of 2020 and I expect to see many more companies reporting similar if not worse figures than this.

However, over the long-term, I expect earnings for well-run companies to return and for life to eventually return to normal. 

Instead of focusing on the next few quarter results, I am keeping my eye on long-term results and which companies can survive the current economic standstill.

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.

Some investors may be wondering why stocks have not fallen more. The S&P 500 in the US has rebounded sharply in recent days and is now down by just 15% year-to-date.

Yet US companies are expected to see their earnings decline much more than 15% in the next few quarters. This will make their price-to-earnings ratios seem disproportionately higher than they were last year.

So why is there this gap between stock prices and earnings?

Discounted cash flow

The answer is that stock prices are not a reflection of a single year of earnings. Instead, it is the accumulation of the future free cash flow or earnings that a company will produce over its entire lifetime discounted back to today.

This economic concept is known as the discounted cash flow model. Investor Ben Carlson wrote a brilliant article on this recently.

For example, let’s assume Company ABC is expected to earn $10 per share per year for the next 10 years. After discounting future cash flows back to the present day, at an 8% discount rate, the company’s shares are worth $67.10.

But let’s assume that because of the COVID-19 crisis, ABC’s earnings in the first year is wiped out. But it still can generate $10 a year in the remaining nine years after that. Using the discounted cash flow model, ABC’s shares are still worth $57.84

Despite a 100% decline in earnings in the coming year, ABC’s share price is worth just 14% less.

Other bad case scenarios

There are worse scenarios that can play out, but as long as a company’s long term future cash flow or earnings remains somewhat stable, its share price should not fall as much as its near-term earnings.

For instance, let’s assume that instead of earning $10 per share in the coming year, Company ABC now makes a loss of $10 per share. But in year 2 onwards, business returns to normal and it can generate its usual $10 per share for the next nine years. In this case, Company ABC’s shares are now worth $48.58, or 28% less than before.

Let’s make the situation worse. Let’s assume Company ABC has a $10 per share loss in year 1 and has zero cash flow in year 2. Let’s also assume that business only returns to normal in year 3. Its shares, in this case, are still worth $40.01, a 40% decline.

History shows that stocks fall less than earnings

This is the reason why stocks tend to fall far less than short-term earnings declines. We can look at the Great Financial Crisis as a reference. 

According to data from Nobel Prize-winning economist Robert Shiller, the S&P 500’s earnings per share fell 77.5% from $81.51 in 2007 to $18.31 in 2008.

But the price fell much less. The S&P 500 closed at 1520.71 in July 2007 and reached a low of 757.13 in March of 2009. That translated to a 50% decline in stock prices.

Simply put, a 77.5% decline in earnings translated to ‘only’ a 50% decline in stock price. 

Not only did the S&P 500’s price fall much less than earnings, but the subsequent years have also shown that stocks may have fallen too low. Investors who bought in at the troughs of 2009 enjoyed better-than-normal returns over the next 10-plus years.

Assuming stock prices fall in tandem with one-year forward earnings is short-sighted and does not take into account all the future cash flows of a company.

Last words on the price-to-earnings ratio

I guess the takeaway for this post is that you should not be scared off stocks by the high price-to-earnings ratio of companies that will likely appear in the coming months (a high price-to-earnings ratio because of a large decline in earnings but less drastic fall in share price).  

The fall in earnings, if only temporary, should logically only cause a small decline in the value of the company, especially if it can continue to make profits consistently over the extended future.

It is natural that the PE ratio will be high if a company’s earnings disappear in the coming year. But the disappearance of the earnings could be temporary. When COVID-19 blows over, some companies – not all – will see business resume.

For now, the PE ratio is a useless metric as earnings are battered down temporarily, making the figure appear disproportionately high. We should instead focus on normalised earnings and whether a company can continue to generate free cash flow in the future.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

Financial markets all over the world have been in a state of turmoil in recent weeks because of the COVID-19 crisis. In uncertain times like these, you may look up to famous investors to emulate their actions. That’s understandable. After all, following authoritative figures can provide a sense of security.

But I’m here to tell you that following famous investors blindly is incredibly dangerous. 

Blind faith

A few weeks ago, I recorded a video chat with Reshveen Rajendran. During our conversation, Resh shared the story of his friend’s investment in Occidental Petroleum (NYSE: OXY), an oil & gas company. Resh’s friend had invested in Occidental’s shares at around US$40 each, only to see the share price fall sharply. At the time of recording, Occidental’s share price was around US$16 (it is around US$14 now). Resh’s friend did not know what to do with his/her Occidental investment.

After we finished recording, I had a further discussion with Resh. I thought there could be a really good educational element in the story of his friend’s investment in Occidental.

I found out that the friend’s investment thesis for Occidental was to simply follow Warren Buffett. But here’s the thing: Buffett’s investment in Occidental is radically different from what we as individual investors can participate in.

Buffett’s bet

In August 2019, Buffett invested in Occidental through his investment conglomerate, Berkshire Hathaway (NYSE: BRK-A)(NYSE: BRK-B). What Buffett bought was US$10 billion worth of preferred shares in Occidental. He wanted to provide Occidental with capital to finance its planned US$38 billion acquisition of Anadarko Petroleum Corporation, a peer in the oil & gas industry.

Occidental’s preferred shares that Buffett invested in are not publicly-traded. So individual investors like you and I can’t invest in them. The preferred shares come with an 8% annual dividend that Occidental is obliged to pay until they are redeemed; the dividend means that Occidental has to pay Berkshire US$800 million every year (8% of Berkshire’s US$10 billion investment) in perpetuity or until redemption of the preferred shares happen. Occidental has the option to redeem the preferred shares at US$10.5 billion any time after August 2029. In other words, Berkshire is guaranteed to make a return of at least 8% per year from its Occidental preferred shares as long as the oil & gas company does not go bust. 

Investing in Occidental’s preferred shares the way that Buffett did is very different from buying Occidental shares in the stock market. The normal Occidental shares we can purchase (technically known as common shares or ordinary shares) don’t come with any dividend-guarantees. Occidental is also not obliged to redeem our shares at a small premium to what we paid. If we buy Occidental shares, how well our investment will do over a multi-year period will depend solely on the business performance of the company. Buffett’s investment in the preferred shares comes with protection that we can’t get with the ordinary shares.

No cover

To the point about protection, consider the following. In March 2020, Occidental slashed the quarterly dividend on its ordinary shares by 86% – from US$0.79 per share to just US$0.11 per share – to save around US$2.2 billion in cash. That was the company’s first dividend reduction in 30 years. Occidental needed to take extreme measures to protect its financial health in the face of a sharp decline in oil prices. Meanwhile, there’s nothing Occidental can do about the 8% dividend on Buffett’s US$10 billion preferred shares investment – Occidental has to continue paying the preferred dividends. To add salt to the wound, Occidental’s US$0.11 per share in quarterly dividend works out to just US$392 million per year, which is less than half of the US$800 million that Buffett’s preferred shares are getting in dividends annually. 

Yes, Buffett did buy some ordinary Occidental shares after his August 2019 investment in the oil & gas company’s preferred shares. But the total invested sum in the ordinary shares is tiny (around US$780 million at the end of 2019, or an average share price of US$41.21) compared to his investment in the preferred shares. 

We can end up in disaster if we follow Buffett blindly into an investment without understanding his idea’s key traits. Buffett’s reputation and Berkshire’s actual financial clout gives him access to deals that we will never have. 

Following authority into disaster

Resh’s story about his friend’s investment in Occidental shares reminded me of something that Morgan Housel once shared. Housel is currently a partner with the venture capital firm Collaborative Fund. Prior to this, he was a writer for The Motley Fool for many years. Here’s what Housel wrote in a 2014 article for the Fool:

“I made my worst investment seven years ago.

The housing market was crumbling, and a smart value investor I idolized began purchasing shares in a small, battered specialty lender. I didn’t know anything about the company, but I followed him anyway, buying shares myself. It became my largest holding — which was unfortunate when the company went bankrupt less than a year later.

Only later did I learn the full story. As part of his investment, the guru I followed also controlled a large portion of the company’s debt and and preferred stock, purchased at special terms that effectively gave him control over its assets when it went out of business. The company’s stock also made up one-fifth the weighting in his portfolio as it did in mine. I lost everything. He made a decent investment.”

Housel also committed the mistake of blindly following a famous investor without fully understanding the real rationale behind the investor’s investments.

In conclusion

It’s understandable if you want to follow the ideas of famous investors. That’s especially so during uncertain times, like the situation we’re in today. But before you do, please note that a blind adherence can be dangerous. Famous investors can invest in financial instruments in the same company that we can’t get access to. Or, their investment motives may be completely different to ours even for the same shares.

It’s always important to know why we’re investing in something. “I’m buying because Buffett or [insert name of famous investor] is buying” is not a valid investment thesis. 

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.

This is a short article about important data you have to note if you’re reading broad economic conditions as a gauge for when to buy stocks. It was inspired by a recent question from a friend:

“While I understand that it’s impossible to time the market precisely, doesn’t it make sense to sell stocks and keep cash when you are fairly certain of a sustained economic decline (e.g. Covid)?”

During the 08/09 Great Financial Crisis, the S&P 500 in the US bottomed in early-March 2009. But interestingly, many stocks actually bottomed months before that, in November 2008. In The Good Investors, I have shared my investment theses for a number of US-listed companies in my family’s investment portfolio. Some of these companies were listed back in November 2008, and they include Netflix, Berkshire Hathaway, Amazon, Intuitive Surgical, MercadoLibre, Booking Holdings, and Mastercard.

The chart immediately below shows the share price changes from January 2008 to December 2009 for the individual stocks mentioned and the S&P 500. Notice the two red bubbles showing the time when most of the individual stocks bottomed (the one on the left) versus when the S&P 500 bottomed (the one on the right).

The individual stocks I talked about – Netflix, Berkshire, Amazon, Intuitive Surgical, MercadoLibre, Booking, and Mastercard – are companies that I think have really strong business fundamentals. They wouldn’t be in my family’s portfolio, otherwise! 

Now, let’s look at another chart, this time showing the US’s economic numbers from 1 January 2008 to 31 December 2010. The economic numbers are the country’s unemployment rate and GDP (gross domestic product). Notice the red bubble: It corresponds to November 2008, the time when most of the aforementioned stocks with strong business fundamentals bottomed. Turns out, the US’s GDP and unemployment rate continued to deteriorate for months after the individual stocks bottomed.

The observations I just shared have never been widely discussed, based on my anecdotal experience. But they highlight something crucial: It turns out that individual stocks – especially the companies with strong fundamentals (this is subjective, I know!) – can find a bottom significantly faster than economic conditions and the broader market do. 

The highlighted thing is crucial for all of us to note, in today’s investing environment. Over the next few months – and maybe even over the next year – It’s very, very likely that the economic data that are going to be released by countries around the world will look horrendous. But individual stocks could potentially reach a bottom way before the deterioration of economic conditions stops. If you miss that, it could hurt your portfolio’s long run return since you would miss a significant chunk of the rebound if you came in late.

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.

It’s great to learn from our own mistakes. But it’s even better to learn from those of others. COVID-19 has brought extreme market volatility and economic distress to the world. In a time like this, it’s easier for us to make investment mistakes.

I’m here to share the eggs I’ve had on my face in the stock market and what I’ve learnt from them, so that you can benefit from my errors. 

The backdrop

I started investing for my immediate family on 26 October 2010. The portfolio I help manage consists of stocks listed in the US market. There are currently over 50 stocks in it.

Some of the biggest losers in the portfolio include Atwood Oceanics, Ford (NYSE: F), Gilead Sciences (NASDAQ: GILD), GoPro (NASDAQ: GPRO), National Oilwell Varco (NYSE: NOV), Tapestry (NYSE: TPR), Under Armour (NYSE: UAA), and Zoe’s Kitchen.

Atwood Oceanics and Zoe’s Kitchen were privatised in October 2017 and November 2018, respectively, and I sold their shares on September 2016 and November 2018. I sold National Oilwell Varco in June 2017. I still own the other stocks mentioned.

Lesson 1: It’s okay to fail if you have the right investment framework 

My family’s investment portfolio has clearly had many epic losers. But from 26 October 2010 (the inception of the portfolio) to 29 March 2020, the portfolio has still grown in value by 16.0% annually, without including dividends. This is significantly higher than the S&P 500’s return of 10.7% per year over the same period, with dividends.

It’s okay to have multiple failures in your portfolio. There’s an investment framework that I’ve been using for my family’s portfolio for years. It has guided me towards massive winners, such as Netflix (NASDAQ: NFLX), Amazon (NASDAQ: AMZN), and MercadoLibre (NASDAQ: MELI). The winners in the portfolio have more than made up for the losers.

If you’re investing with a sound investment framework, then don’t beat yourself up too hard if some of your stocks are down big. Look at your performance from a portfolio-perspective, and not harp on how each position is doing.

Lesson 2: Diversify smartly, and stay away from commodity-related companies

Atwood Oceanics and National Oilwell Varco are companies in the oil & gas industry. When I invested in them, Atwood was an owner of oil rigs while National Oilwell Varco was supplying the parts and equipment that kept oil rigs running.

They were among my first-ever investments, back when I was a greenhorn in the stock market. I invested in them because I wanted to be diversified according to sectors. I also thought that oil & gas was a sector that is worth investing in since demand for the commodities would likely remain strong for a long time. My views were right, but only to a small extent. I was wrong on two important areas.

First, it is important to be diversified according to sectors (and geography too!). But there are some sectors that are just not worth investing in for the long run because their economic characteristics are poor. For instance, the energy, materials, and transport sectors have historically produced poor returns on invested capital. This is illustrated in the chart below from a 2006 McKinsey report which mapped out the average return on invested capital for various sectors from 1963 to 2004. Charlie Munger, Warren Buffett’s long-time lieutenant, once said:

“Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much different than a six percent return – even if you originally buy it at a huge discount.”

Second, demand for oil did indeed grow from 2010 to 2016. But oil prices fell significantly over the same period. The trends in oil consumption and oil prices for that period are depicted in the chart below.

The sharp fall in oil prices despite the rising demand illustrates the difficulty in predicting oil prices. In fact, it’s practically impossible. I recently learnt about a presentation that Peter Davies gave in 2007 titled What’s the Value of an Energy Economist? In it, he said that “we cannot forecast oil prices with any degree of accuracy over any period whether short or long.” Back then, Davies was the chief economist of British Petroleum, one of the largest oil & gas companies in the world.

With lower oil prices, the business results and share prices of Atwood Oceanics and National Oilwell Varco plummeted. The chart below shows National Oilwell Varco’s share price and earnings per share from 2010 to 2016 (data for Atwood Oceanics is not available since it’s now a private company). I think the predicament of Atwood Oceanics and National Oilwell Varco can be extrapolated to other commodity-related companies. It’s tough to predict the price movements of commodities; this in turn makes it difficult to have a good grasp on the business results of a commodity-related company over a multi-year period.

Lesson 3: Not selling the losers is as important as not selling the winners

You’ll notice that my family’s portfolio is still holding onto many of the big losers. The sales of Atwood Oceanics and National Oilwell Varco happened because of something that Motley Fool co-founder David Gardner shared a few years ago:

“Make your portfolio reflect your best vision for our future.”

Part of the vision I have for the world is that our energy-needs are entirely provided by renewable sources that do not harm the precious environment we live in. For this reason, I made the rare decision to voluntarily part ways with stocks in my family’s portfolio (referring to Atwood Oceanics and National Oilwell Varco).

I sell stocks very rarely and very slowly. This aversion to selling is by design – because it strengthens my discipline in holding onto the winners in my family’s portfolio. Many investors tend to cut their winners and hold onto their losers. Even in my earliest days as an investor, I recognised the importance of holding onto the winners in driving my family portfolio’s return. Being very slow to sell stocks – even the big losers – has helped me hone the discipline of holding onto the winners. And this discipline has been a very important contributor to the long run performance of my family’s portfolio.

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.

US airlines finally got something to cheer about.

Earlier this week, US senate leaders came to an agreement on a US$2 trillion stimulus bill. A whopping US$60 billion of that will be used to bail out struggling US airlines.

Airlines, in return, must forgo layoffs until the fall (sometime in the fourth quarter of 2020), accept limits on executive compensation and dividends, and maintain certain routes. Despite the limitations, I think this is a deal the airlines will happily take to save themselves from bankruptcy.

Bailouts are nothing new though. The US has a long history of bailing out companies that were deemed too important to fail. These companies either provided essential services, accounted for a decent chunk of the economy, or employed a large number of people.

But bailouts take different shapes and forms. The ways that the government injects cash into companies (or individuals), the kind of industries the government tries to save, and the impact on shareholders differ every time.

In light of the latest bailout, I decided to take a short trip down memory lane to see the different kinds of bailouts that have occurred.

The Great Depression

One of the greatest economic catastrophes of modern history occurred from 1929 to the early 1940s. It was the longest, deepest, and most widespread depression of the 20th century.

In 1933 US President, Franklin D. Roosevelt took the oath of office and started implementing solutions to bring the economy out of the recession. 

One of the things he did was to bail out struggling homeowners. At that time, the national unemployment rate was around 25%, so many Americans who lost their jobs were unable to pay off their home mortgages and were left homeless. 

The Home Owners’ Loan Corporation was set up to solve the problem. The newly formed government agency purchased defaulted mortgages from banks and refinanced them at lower rates, allowing about a million homeowners to benefit from lower mortgage rates.

This bailout was targetted at individuals at that time and kept people off the street. However, it was not until World War II ended that the depression was officially over and the post-war boom began.

The Great Financial Crisis

The next most important economic crisis occurred much more recently in 2007-2008. Known as the Great Financial Crisis, the collapse of Lehman Brothers amid the bursting of the housing bubble culminated in a global financial crisis.

However, this time, the US government’s response was swifter and the bailouts introduced saved banks, restored confidence, allowed banks to lend again, and eventually led to the 12-year bull market that ended this year.

So what did the US government do in 2008? The Emergency Economic Stabilisation Act of 2008, often called the “bank bailout,” was signed into law by then-President George W. Bush. The new law led to the creation of the US$700 billion Troubled Asset Relief Program (TARP) to inject capital into banks. But these funds were not given as grants, rather they were used to purchase toxic assets from the banks.

A key part of the US federal government’s plan was to buy up to US$700 billion of illiquid mortgage-backed securities. These were essentially a bundle of home loans packed into one.

On top of that, the US government injected cash into banks through the purchase of preferred stock. Citibank needed a particularly big injection of capital, with the government purchasing US$45 billion in preferred and common Citigroup stock. Selling stock when your share price is down 80% is never going to be pretty and Citigroup shareholders learnt that the hard way as they were diluted almost six-fold. Till today, Citigroup’s share price is still more than 80% off the high it reached in 2007. However, what the bailout achieved was to save Citigroup from insolvency and shareholders could at least survive to fight another day.

Overall, TARP improved the balance sheet and reduced the potential losses of banks and financial institutions.

The net effect for the government was also positive as it was reported that TARP recovered US$441.7 billion of US$426.4 billion invested, earning a US$15.3 billion profit when everything was done and dusted.

COVID-19 Crisis

Fast forward to today and we are once again seeing a massive bailout, this time with the aviation industry.

As mentioned earlier, struggling US airlines are getting an early Christmas present this year, to the tune of US$60 billion.

According to a draft of the legislation, airlines will receive up to US$25 billion in direct grants. That’s practically free money for the airlines as long as they promise not to layoff workers till the fourth quarter of 2020, accept limits on executive compensation and shareholder dividends.

Additionally, the bill also grants US$25 billion in loans and loan guarantees for passenger airlines and US$4 billion for cargo air carriers. The promise of loans will help struggling airlines raise much needed new capital even if the banks won’t lend to them.

The news is, of course, great for shareholders and employees. Employees get to keep their jobs while shareholders don’t have to worry about potential bankruptcies. The injection of cash will tide airlines through this challenging period. Airline shares have been creeping up since rumours of a bailout began.

The Good Investors’ conclusion

Bailouts may seem like a bad word but they are great for shareholders. The injection of cash into a company can tide them through when all hope seemed to be lost.

However, bailouts also bring to light that the company was not managing its finances well enough. Overleverage, bad investments, and in the case of Airlines, overspending on share buybacks destroyed their balance sheets to the brink of collapse.

Although bailouts can eventually save the day, they are one-off special situations and investors should never rely on them to get them out of trouble.

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.