Being flexible is one of the reasons why I outperformed the market.
At the end of October 2019, I left The Motley Fool Singapore after nearly seven joyful years when the company ceased operations.
In May 2016, The Motley Fool Singapore launched its flagship investment newsletter, Stock Advisor Gold. I’m proud to say that as of 31 October 2019, Stock Advisor Gold had produced a return of 30.6% since the introduction of its first-ever recommendation on 20 May 2016. In comparison, the service’s benchmark, the S&P Global Broad Market Index – a measure for global stocks – had produced a gain of just 16.4% in the same period.
My ex-colleagues in Fool SG’s investing team and I essentially doubled the global stock market in around 3.5 years. I was there every step of the way, leading investing discussions, finding opportunities, dissecting the ideas, maintaining coverage on active recommendations, and more. Here’s how we did it.
The product
A description of Stock Advisor Gold helps set the stage for discussing the winning investing process.
Stock Advisor Gold gave one Singapore stock recommendation and one International stock recommendation every single month. It did so since its inception, come rain or shine. In all, we made 82 recommendations in Stock Advisor Gold.
The 30.6% return mentioned earlier is the simple average of the returns of all the recommended stocks in Stock Advisor Gold, and it includes dividends. Each time we make a recommendation, we also track the performance of the S&P Global BMI (again including dividends) – so the 16.4% performance number refers to the average return someone could theoretically earn if she bought the S&P Global BMI each time Stock Advisor Gold recommended a stock instead of buying the recommended pick.
Stock Advisor Gold’s recommendations typically had an investment time horizon of three years or longer. We were long-term investors.
3 lessons from our investment process
I see three key factors that contributed to our success.
#1 Flexibility
We were flexible in our investment thinking. I believe that investment consultants who try to style-box Stock Advisor Gold will be flummoxed. We had all kinds of stock recommendations in the service.
There was a special-situation: We judged that a transport operator had transformed from a capital-intensive business with no ability to match revenue with its costs into a capital-light cash-flow generating business that is now able to earn contracted revenues that are effectively on a cost-plus model. We had companies that own properties as their main business that are priced at massive discounts to the true market values of their real estate; and these companies came from both ends of the market-capitalisation spectrum. We had small-cap stocks with low valuations that are riding on the volatile but steadily-climbing growth of the world’s appetite for semiconductors and rubber gloves. We had large-cap stocks with high valuation multiples but solid profits and cash flows that are leading the way on trends with tremendous global growth opportunities, such as robotic surgery, DNA analysis, online travel, and more. We had small-cap Software-as-a-Service stocks that were loss-making and burning cash but that are building tremendously sticky and soon-to-be profitable customer bases.
I see our ability to find investment ideas from so many different corners of the market as a strength because it widened our opportunity-set tremendously. It also allowed us to develop a more expansive worldview, which sharpened our investment thinking.
#2 A focus on what matters
At Stock Advisor Gold, we glanced at macro-economics only occasionally – we had a laser-focus on business fundamentals. It was a company’s long-term business prospects in relation to its current stock price that guided our thinking on whether it was an attractive investment opportunity or not.
Let’s look at Netflix as an example (it was not a recommendation in Stock Advisor Gold). The trade war between the US and China has been and continues to be one of the biggest stories in the financial world. But will the squabbles between the two giant economies really quench the public’s appetite for high-quality video programmes that are available 24/7 for a low monthly fee? Will a trade war dampen Netflix’s desire to constantly improve the quality of its programming and streaming capabilities? I don’t think so. And it’s those two factors that really matter for the prospects of the company’s business.
Besides, the gap between a macroeconomic event and the movement of a company’s stock price can be a mile wide. For example, from 30 September 2005 to 15 September 2015, the per-ounce price of gold in Australia had grown by nearly 10% annually from A$621 to around A$1,550. But an index for Australian gold-mining stocks, the S&P / ASX All Ordinaries Gold Index, lost 4% per year in the same period, falling from 3,372 points to 2,245. In another example, despite stunning 15% annual GDP growth in China from 1992 to 2013, Chinese stocks actually fell by 2% per year; Mexico on the other hand, saw its stock market produce an annual gain of 18%, despite its economy growing at a pedestrian rate of just 2% per year.
#3 Being clear on the limits of our knowledge
We strived to be clear on what we did not know, and invested accordingly. We had no idea how commodity prices will move, so in Stock Advisor Gold, we stayed away from companies that we judged to be heavily dependent on commodity price movements for their revenues. We weren’t sure how interest rates would move, so we did not make any investment decisions that depended heavily on the movement of interest rates in certain directions.
Put another way, we aimed to be crystal clear on the limits of our knowledge, and we made sure we never overstepped the boundary. We had safeguarded ourselves against overconfidence.
Conclusion
In investing, the process is even more important than the results. That’s because results can be affected by luck. A bad break could momentarily cause a good process to produce poor results, but over time, the process will prevail. I’m glad that Stock Advisor Gold achieved excellent results with what I deem to be a sound process. I hope all of you who have read this article are able to take away something useful to improve your own investing process. And if you happen to be an ex-member of Stock Advisor Gold or The Motley Fool Singapore, I thank you for your trust and your continued interest in following my investing thoughts.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
The world of finance is full of wild and interesting facts.
The world of finance and investing is full of wild facts and surprising things that I think investors have to know, because they can help shape our investment behaviours for the better. Here are 24 of them, and their related lessons. This article is a work-in-progress, with additions to be made over time. [Note: The latest additions were made on 11 April 2024]
1. Stocks with fantastic long-term returns can be agonising to own over the short-term.
From 1995 to 2015, the US-listed Monster Beverage topped the charts – its shares produced a total return of 105,000%, turning every $1,000 into more than $1 million. But Monster Beverage’s stock price had also dropped by 50% or more from a peak on four separate occasions.
From 1997 to 2018, the peak-to-trough decline for Amazon in each year ranged from 12.6% to 83.0%, meaning to say that Amazon’s stock price had experienced a double-digit peak-to-trough fall every year. Over the same period, Amazon’s stock price climbed from US$1.96 to US$1,501.97, for an astonishing gain of over 76,000%.
Lesson: Volatility in the stock market is a feature, not a bug.
2. The stock price of a company that deals with commodities can fall hard even if the prices of the related-commodities actually grow.
Gold was worth A$620 per ounce at the end of September 2005. The price of gold climbed by 10% per year for nearly 10 years to reach A$1,550 per ounce on 15 September 2015. An index of gold mining stocks in Australia’s market, the S&P / ASX All Ordinaries Gold Index, fell by 4% per year from 3,372 points to 2,245 in the same timeframe.
In 2015, oil prices started falling off a cliff. The lowest price that WTI Crude reached in 2016 was US$26.61 per barrel, on 11 February. 10 months later on 21 December 2016, the price had doubled to US$53.53. Over the same period, 34 of a collection of 50 Singapore-listed oil & gas companies saw their stock prices fall; the average decline for the 50 companies was 11.9%.
Lesson: The gap between a favourable macroeconomic event and a share’s price movement can be a mile wide.
3. Investors can lose money even if they invest in the best fund.
The decade ended 30 November 2009 saw the US-based CGM Focus Fund climb by 18.2% annually. Sadly, the fund’s investors lost 11% per year over the same period. How?!? CGM Focus Fund’s investors chased performance and bailed at the first whiff of trouble.
Lesson: Timing the market is a fool’s errand.
4. Stock prices are significantly more volatile than the underlying business fundamentals.
Nobel-prize-winning economist Robert Shiller published research in the 1980s that looked at how the US stock market performed from 1871 to 1979. Shiller compared the market’s performance to how it shouldhave rationally performed if investors had hindsight knowledge of how dividends of US stocks changed. The result:
The solid line is the stock market’s actual performance while the dashed line is the rational performance. Although there were violent fluctuations in US stock prices, the fundamentals of American businesses – using dividends as a proxy – was much less volatile.
Lesson: We’ll go crazy if we focus only on stock prices – focus on the underlying business fundamentals instead!
5. John Maynard Keyens was a great economist and professional investor. Interestingly, his early years as a professional investor were dreadful.
Finance professors David Chambers and Elroy Dimson published a paper in 2013 titled John Maynard Keynes, Investment Innovator. It detailed the professional investing career of the late John Maynard Keynes from 1921 to 1946 when he was managing the endowment fund of King’s College at Cambridge University.
Chambers and Dimson described Keynes’ investing style in the early years as “using monetary and economic indicators to market-time his switching between equities, fixed income, and cash.” In other words, Keynes tried to time the market. And he struggled. From August 1922 to August 1929, Keynes’ return lagged the British stock market by a total of 17.2%.
Keynes then decided to switch his investing style. He gave up on trying to time the market and focused on studying businesses. This is how Keynes described his later investing approach:
“As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes.”
Chambers and Dimson’s paper provided more flesh on Keynes’ business-focused investing style. Keynes believed in buying investments based on their “intrinsic value” and that he preferred stocks with high dividend yields. An example: Keynes invested in a South African mining company because he held the management team in high-regard and thought the company’s stock was selling at a 30% discount to his estimate of the firm’s break-up value.
So what was Keynes’ overall record? From 1921 to 1946, Keynes beat the British stock market by eight percentage points per year. When he tried to time the market, he failed miserably; when he started investing based on business fundamentals, he gained stunning success.
Lesson: Invest by looking at stocks as pieces of businesses – it’s an easier route to success.
6. Having extreme intelligence does not guarantee success in investing.
The hedge fund Long Term Capital Management (LTCM) was staffed full of PhDs and even had two Nobel Prize winners, Myron Scholes and Robert Merton, in its ranks. Warren Buffett even said that “If you take the 16 of them [in LTCM], they probably have the highest average IQ of any 16 people working together in one business in the country, including Microsoft or whoever you want to name – so incredible is the amount of intellect.” LTCM opened its doors in February 1994. The firm eventually went bust a few years later. One dollar invested in its fund in February 1994 became just 30 cents by September 1998.
In 2009, Andrew Lo, a finance professor at the Massachusetts Institute of Technology, started his own investment fund in the US. 2009 was the year when many major stock markets around the world bottomed after the global financial crisis started a few years earlier. Lo’s fund gained 15% in 2010, but then lost 2.7% in 2011, 7.7% in 2012, and 8.1% in 2013. The fund was shut in 2014. The S&P 500 in the US nearly doubled from the start of 2009 to the end of 2013.
Larry Swedroe’s book, The Quest for Alpha: The Holy Grail of Investing, described the track record of MENSA’s investment club in the US. MENSA’s members have IQs in the top 2% of the global population. In the 15 years ended 2001, the S&P 500 gained over 15% per year, while MENSA’s US investment club returned just 2.5% per year.
Lesson: Warren Buffett once said, “You don’t need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ.” It’s more important to invest with the right investment framework and have control over our emotions than it is to have extreme intelligence.
7. A stunning number of stocks deliver negative returns over their entire lifetimes.
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 lifetimes. JP Morgan defined “lifetime” as the “time when the company first exists in public form and reports a stock price, and until its last reported price in 2014 or until the date at which it was merged, acquired or for some other reason delisted.”
Lesson: Given the large number of stocks that deliver losses to investors, implementing a robust investment framework that helps to filter out potential losers can make a big difference to our investing results.
8. Going against the herd can actually cause physical pain.
Psychology researchers Naomi Eisenberger, Matthew Lieberman, and Kipling Williams once conducted an experiment whereby participants played a computer game while their brains were scanned. The participants were told they were playing the game with two other people when in fact the other two were computers. The computers were programmed to exclude the human participant after a period of three-way play. During the periods of exclusion, the brain scans of the human participants showed activity in the anterior cingulated cortex and the insula. These are the exact areas of our brain that are activated by real physical pain.
Investor James Montier recounted the experiment in his bookThe Little Book of Behavioral Investing and wrote: “Doing something different from the crowd is the investment equivalent of seeking out social pain.”
Lesson: Investing is not easy, especially when there’s a need to go against the crowd. Make plans to deal with the difficulties.
9. One of Warren Buffett’s best long-term investments looked like a loser in the first few years.
Buffett started buying shares of the Washington Post company (now known as Graham Holdings Company) in 1973 and spent US$11 million in total. By the end of 2007, Buffett’s Washington Post stake had grown by more than 10,000% and was worth US$1.4 billion. By all accounts, Buffet’s Washington Post investment was a smashing success. But here’s the kicker: The Washington Post’s stock price fell by 20% after Buffett’s investment and stayed at that level for three years.
Lesson: Great investments take time to play out. Be patient!
10. It’s easier to make long-term predictions for the stock market than short-term ones.
Source: Robert Shiller’s data; author’s calculation
The two charts above use data on the S&P 500 from 1871 to 2013. They show the returns of the S&P 500 against its starting valuation for holding periods of 1 year (the chart on the left) and 10 years (the chart on the right). The stock market is a coin-toss with a holding period of 1 year: Cheap stocks can fall just as easily as they rise, and the same goes for expensive stocks. But a different picture emerges when the holding period becomes 10 years: Stocks tend to produce higher returns when they are cheap compared to when they are expensive.
Lesson: Invest with a long time horizon because we can make better predictions and thus increase our chances of success.
11. Simple investment strategies often beat complex ones.
Investment manager Ben Carlson wrote in 2017 that the investment performance of US college endowment funds couldn’t beat a simple strategy of investing in low-cost index funds.
For the 10 years ended June 2016, the US college endowment funds with returns that belonged to the top-decile had average annual returns of 5.4%. Carlson described the investment approach of US college endowment funds as such:
“These funds are invested in venture capital, private equity, infrastructure, private real estate, timber, the best hedge funds money can buy; they have access to the best stock and bond fund managers; they use leverage; they invest in complicated derivatives; they use the biggest and most connected consultants…”
In the same 10-year period, a simple portfolio that Carlson named the Bogle Model (after the late index fund legend John Bogle) produced an annual return of 6.0%. The BogleModel consisted of three, simple, low-cost Vanguard funds: The Total US Stock Market Index Fund (a fund that tracks the US stock market), the Total International Stock Market Index Fund (a fund that tracks stocks outside of the US), and the Total Bond Market Index Fund (a fund that tracks bonds). The Bogle Model held the three funds in weightings of 40%, 20%, and 40%, respectively.
Lesson: Simple investing strategies can be really effective too. Don’t fall for a complex strategy simply because it is complex.
Note: An earlier version of this article was published at The Smart Investor, an investing website run by my friends.
The fact below was added on 5 December 2019
12. Buying and holding beats frequent trading.
Jeremy Siegel is a finance professor from Wharton, University of Pennsylvania and the author of several great books on investing. In 2005, he published a book, The Future For Investors. Wharton interviewed him to discuss the research for the book, and Siegel shared an amazing statistic (emphasis is mine):
“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.”
The S&P 500 is not a static index. Many stocks have been added to it while many stocks have also removed. So, we can also see the S&P 500 as a ‘portfolio’ of stocks that have experienced very active buying and selling. What Siegel discovered was that over a period of nearly 50 years, a long-term buy-and-hold ‘portfolio’ of the original S&P 500 stocks would have outperformed the actual S&P 500 index that had seen all that relatively frantic ‘trading’ activity.
Lesson: Active trading is bad for our returns. To do well in investing, patience is an important ingredient.
The facts below were added on 8 January 2020
13. It’s incredibly difficult to make money by trading currencies.
The Autorité des Marchés Financiers (AMF) is the financial regulator in France – think of them as the French version of the Monetary Authority of Singapore. In 2014, the AMF published a study on individual forex traders. It looked at the results of 14,799 individual forex traders for a four-year observation period from 2009 to 2012 and found some astonishing data:
89% of the traders lost money
The average loss was €10,887 per trader
The total loss for the nearly 15,000 traders was more than €161 million
Lesson: Trading currencies could be a faster way to lose money than lighting your cash on fire.
14. Historically, the longer you hold your stocks, the lower your chances of losing money.
Based on data for the US stock market from 1871 to 2012 that was analysed by Morgan Housel, if you hold stocks for two months, you have a 60% chance of making a profit. Stretch the holding period to 1 year, and you have a 68% chance of earning a positive return. Make the holding period 20 years, and there’s a 100% chance of making a gain. The chart below, from Morgan, illustrates these:
15. Huge moves in stocks that should not have happened, according to mainstream finance theories, have happened.
In 12 August 2019, Argentina’s key stock market benchmark, the Merval Index, fell by a stunning 48% in US-dollar terms. That’s a 48% fall. In. One. Day.
According to investor Charlie Bilello, the decline was a “20+- sigma event.” Mainstream finance theories are built on the assumption that price-movements in the financial markets follow a normal distribution. Under this framework, the 48% one-day collapse in the Merval Index should only happen once every 145,300,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000 years.
For perspective, the age of the universe is estimated to be 13.77 billion years, or 13,770,000,000 years.
Lesson: The movement of prices in the financial markets are significantly wilder than what the theories assume. How then can we protect ourselves? Bilello said it best: “We must learn to expect the unexpected and be prepared for multiple outcomes, with diversification serving as our best defense.”
The facts below were added on 31 January 2020
16. Timing the market based on recessions simply does not work.
In an October 2019 blog post, investor Michael Batnick included the following chart:
The red line shows the growth of $1 from 1980 to late 2019 if we bought US stocks at the official end-date of recessions, and sold stocks at the official start-dates. A $1 investment became $31.52, which equates to an annual return of 9.3%. That’s not too shabby.
But if we had simply bought and held US stocks over the same period, our dollar would have grown by 11.8% per year to become $78.31. That’s a significantly higher return.
Lesson: Trying to side-step recessions can end up harming our returns, so it’s far better to stay invested and accept that recessions are par for the course when it comes to investing.
17. The market is seldom average.
Data from Robert Shiller show that the S&P 500 had grown by 6.9% per year (after inflation and including dividends) from 1871 to 2019. But amazingly, in those 148 years, only 28 of those years showed a return of between 0% and 10%. There were in fact 74 years that had a double-digit gain, and 23 years with a double-digit decline.
The chart below shows the frequency of calendar-year returns for the S&P 500 from 1871 to 2019:
Source: Robert Shiller’s data; my calculations
Lesson: Market returns are rarely average, so don’t expect to earn an average return in any given year. Don’t be surprised too and get out of the market even if there has been a big return in a year.
The facts below were added on 11 February 2020
18. An entire country’s stock market can go crazy.
The stock market’s a great place to build wealth over the long run. Data from the Credit Suisse Global Investment Returns Yearbook 2019 report show that developed economy stocks have generated a return of 8.2% per year from 1900 to 2018 – this turns $1,000 into $10.9 million. Meanwhile, stocks from emerging markets have climbed by 7.2% per year from 1900 to 2018, turning $1,000 into $3.7 million.
But there’s also the case of Japan. The country’s main stock market benchmark, the Nikkei 225 Index, hit a peak of nearly 39,000 in December 1989, more than 30 years ago. It sits below 24,000 today, a decline of around 40% from the high point in December 1989.
The reason Japanese stocks have delivered this poor return over such a long period of time is because they had crazy-high valuations. Investor Mebane Faber pointed out in a blog post a few years ago that Japan’s stock market had a CAPE ratio of nearly 100 at the peak. 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.
For context, the US stock market’s highest CAPE ratio since the 1870s was 44, which was reached in December 1999, at the height of the dotcom bubble. From the 1870s to today, the average CAPE ratio for US stocks is just 17.
Lesson: The entire Japanese stock market went crazy in the late 1980s, resulting in a disastrous return for investors even after more than 30 years. The experience of Japan’s stock market is also a great reminder that we should diversify our investments geographically.
19. Some of the best investors in the world don’t know what the stock market will do over the short-term.
What do Peter Lynch, Warren Buffett, and Jim Simmons have in common? They all would easily belong to any “Greatest Investors” list.
Lynch was the manager of the US-focused Fidelity Magellan Fund from 1977 to 1990. During his 13-year tenure, he produced an annual return of 29%, nearly double that of the S&P 500. Meanwhile, Buffett has been in control of his investment conglomerate, Berkshire Hathaway, since 1965. From then to 2018, he grew the book value per share of Berkshire by 18.7% per year by using its capital to invest in stocks and acquire companies. Over the same period, the S&P 500 compounded at merely 9.7% annually. As for Simmons, he runs Renaissance Technologies, an investment firm he founded. Renaissance’s flagship is Medallion Fund, which generated an astonishing annual return of 66% (before fees) and 39% (net of fees) from 1988 to 2018.
There’s another thing that Lynch, Buffett, and Simmons all have in common: They have no clue what the stock market will do over the short-term.
“What the market’s going to do in one or two years, you don’t know. Time is on your side in the stock market. It’s on your side. And when stocks go down, if you’ve got the money, you don’t worry about it and you’re putting more in, you shouldn’t worry about it. You should worry what are stocks going to be 10 years from now, 20 years from now, 30 years from now.”
Buffett wrote a famous op-ed for The New York Times in October 2008, at the height of the Great Financial Crisis. In it, Buffett shared:
“Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month or a year from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.”
There’s an incredible story on Simmons panicking in December 2018, after the US stock market had suffered a steep drawdown. Simmons asked his financial advisor if he should be selling short, literally a day before the US market reached the trough of its decline.
It’s easy for us to think that investing masters like Peter Lynch, Warren Buffett and Jim Simmons will be great at predicting what the stock market is going to do over the short run. But the truth is, they don’t. They have no idea.
Lesson: We can still achieve great long-term investing results even if we have no idea what the market’s going to do over the short run.
The facts below were added on 23 March 2020
20. Recessions and market crashes are inevitable
Economist Hyman Minsky passed away in 1996. When he was alive, his ideas were not well-known. But they gained widespread attention after the Great Financial Crisis of 2007-09.
That’s because Minsky had a framework for understanding why economies go through inevitable boom-bust cycles: Stability itself is the seed of instability. When an economy is stable and growing, people feel safe. This feeling of safety leads to people taking on more risk, such as borrowing heavily. The system in turn becomes fragile.
Minsky’s idea can be applied to stocks too. Let’s assume that stocks are guaranteed to grow by 9% per year. What will this world look like? The only logical result would be that people would keep paying up for stocks, till the point that stocks become way too expensive to return 9% a year. Or people will pile on risk, such as borrowing heavily to buy stocks.
But bad things happen in the real world and they happen often. And when stocks are priced for perfection, bad news will lead to market crashes.
Despite the inevitability of recessions and market crashes, stocks have still done very well over time. Between 1928 and 2013, the S&P 500 had, on average, fallen by 10% once every 11 months; 20% every two years; 30% every decade; and 50% two to three times per century. So stocks have declined regularly. But over the same period, the S&P 500 also climbed by 283,282% in all (including dividends), or 9.8% per year.
21. Volatility clusters – and its important implication
Volatility has been the name of the game for the financial markets in recent times. This is what the S&P 500 in the US has done over the past two weeks:
9 March 2020: -7.6%
10 March 2020: +4.9%
11 March 2020: -4.9%
12 March 2020: -9.5%
13 March 2020: +9.3%
16 March 2020: -12.0%
17 March 2020: +6.0%
18 March 2020: -5.2%
19 March 2020: +0.5%
20 March 2020: -4.3%
We can see that really good days are mixed together with really bad days. This clustering of volatility is actually common. Investor Ben Carlson produced the table below recently (before March 2020) which illustrates the phenomenon.
The clustering means that it’s practically impossible to side-step the bad days in stocks and capture only the good days. This is important information for us, because missing just a handful of the market’s best days will destroy our returns.
Fund manager, Dimensional Fund Advisors, which manages more than US$600 billion, shared the following stats in a recent article:
$1,000 invested in US stocks in 1970 would become $138,908 by August 2019
Miss just the 25 best days in the market, and the $1,000 would grow to just $32,763
Lesson: It is important that we stay invested. But this does not mean we should stay invested blindly. Companies that currently are heavily in debt, and/or have shaky cash flows and weak revenue streams are at much higher risk of running into severe problems, whether the economy is healthy or in trouble. It’s good practice to constantly evaluate the companies in our portfolios.
The facts below were added on 17 October 2022
22. Rising interest rates have been met with rising valuations
There’s plenty of attention being paid to interest rates because of its theoretical link with stock prices. Stocks and other asset classes (bonds, cash, real estate etc.) are constantly competing for capital. In theory, when interest rates are high, the valuation of stocks should be low, since bonds, being an alternative to stocks, are providing a good return. On the other hand, when interest rates are low, the valuation of stocks should be high, since the alternative – again, bonds – are providing a poor return.
But the real relationship between interest rates and stock market valuations is nowhere near as clean as what’s described in theory. Yale economist Robert Shiller, who won a Nobel Prize in 2013, has a database on interest rates and stock market prices, earnings, and valuations going back to the 1870s. According to his data, the US 10-year Treasury yield was 2.3% at the start of 1950. By September 1981, it had risen to 15.3%, the highest rate recorded in Shiller’s dataset. In that same period, the S&P 500’s price-to-earnings (P/E) ratio moved from 7 to… 8. That’s right, the P/E ratio for the S&P 500, a broad-based US stock market index, increased slightly despite the huge jump in interest rates.
(It’s worth noting too that the S&P 500’s P/E ratio of 7 at the start of 1950 was not a result of earnings that weretemporarily inflated.)
Yes, I’m cherry picking with the dates for the second point. For example, if I had chosen January 1946 as the starting point, when the US 10-year Treasury yield was 2.2% and the P/E ratio for the S&P 500 was 19, then the theoretical relationship between interest rates and stock market valuations would appear to hold up nicely.
Lesson: Interest rates have a role to play in the movement of stocks, but it is far from the only thing that matters. Moreover, one-factor analysis in finance – “if A happens, then B will occur” – should be largely avoided because clear-cut relationships are rarely seen.
23. Peak valuations for stocks don’t happen at the lowest interest rates
In Point 22 above, I mentioned that “the real relationship between interest rates and stock market valuations is nowhere near as clean as what’s described in theory [where the theory is that rising rates will lead to falling valuations].” The chart below, which I first saw from a Twitter user with the handle @modestproposal, is a great example.
It illustrates the relationship that the S&P 500’s price-to-earnings (P/E) ratio has with 10-year bond yields in the USA. Interestingly, the S&P 500’s P/E ratio has historically and – noticeably – peaked when the 10-year bond yield was around 5%, and not when the 10-year bond yield was materially lower at say 3% or 2%.
Lesson: Don’t assume that peak valuations for stocks must happen at the lowest interest rates.
The fact below was added on 11 April 2024
24. Buying stocks at all-time highs leads to higher returns than buying stocks at random timings
Intuitively, it makes sense that investing in stocks when they are at all-time highs should lead to poorer returns than if you were to invest in stocks at any random day. But history suggests otherwise. According to Ritholtz Wealth Management (link leads to a video; watch from 38:00 mark), the average annualised return for the S&P 500 since 1970 for someone investing at all-time highs has been 9.43% for one year, 10.53% for three years, and 9.63% for five years. Meanwhile, the average annualised return for the self-same periods for someone investing at any day would be 9.13%, 8.85%, and 8.93%, respectively. These are shown in the chart below:
Source: Ritholtz Wealth Management’s The CompoundYoutube channel
Lesson: Do not stay away from stocks just because they are at all-time highs – time in the market is way more important than timing the market
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 investing framework has helped me produce significant market-beating returns since October 2010.
The very first stock market in the world was established in Amsterdam in the 1600s. A few hundred years have passed since, and a stock exchange today looks very different even from just 20 years ago. But one thing has remained constant: A stock market is still a place to buy and sell pieces of a business.
Having this basic but important understanding of the stock market leads to the next observation, that a stock’s price movement over the long run then depends on the performance of the underlying business. In this way, the stock market becomes something easy to grasp: A stock’s price will do well over time if the underlying business does well too. The next logical question then follows: Is there a way to find companies with businesses that could do well in the years ahead? From experience and logical reasoning, I believe the answer is “Yes!”
I’ve been investing for my family since October 2010, and over the past nine years, I’ve developed a framework for picking companies that have a good chance of growing at high rates for long periods of time. I focus on finding companies that meet all or most of the following six criteria.
My investment framework
1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market.
This criterion is important because I want companies that have the capacity to grow. Being stuck in a market that is shrinking – such as print-advertising for instance, which has shrunk by 2.3% per year from 2011 to 2018 – would mean that a company faces an uphill battle to grow.
An example of a company with smaller revenue in relation to a fast-growing market is, believe it or not, Facebook, a company I own shares of. Facebook’s revenue over the last 12 months is US$66.5 billion, of which most come from digital advertising. The company’s revenue, as large as it is, is still just a fraction of the global digital advertising market, which was US$283 billion in 2018 and expected to grow to US$518 billion in 2023. In turn, the global digital advertising market was less than half of the global advertising spend of US$617 billion in 2018. An example of a company that I own shares of with large revenues in relation to a fast-growing market is Intuitive Surgical, maker of robotic surgery systems. Intuitive Surgical’s revenue over the last 12 months is US$4.2 billion, while the worldwide robotic surgical market is forecast to jump from US$4.1 billion in 2015 to nearly US$10 billion by 2020. Intuitive Surgical’s systems handled 1.04 million surgical procedures in 2018, which seems like a large number, but only 5% or so of surgeries worldwide are done with robots today.
2. A strong balance sheet with minimal or a reasonable amount of debt.
A strong balance sheet enables a company to achieve three things: (a) Invest for growth, (b) withstand tough times, and (c) increase market share when its financially-weaker companies are struggling during periods of economic contraction. I typically want a company to have more cash than debt. If there are significant levels of debt, then I will want the debt to be a low multiple of free cash flow. If I’m looking at a bank, the level of cash and debt is inconsequential, so my attention will be on the leverage ratio, which is the ratio of the bank’s total assets to shareholders’ equity.
3. A management team with integrity, capability, and an innovative mindset.
A management team without capability is bad for self-explanatory reasons. Without an innovative mindset, a company can easily be overtaken by competitors. Meanwhile, a management team without integrity can fatten themselves at the expense of shareholders. There are a few things we can look at to understand how a company’s management team fares on these fronts.
On integrity:
How has management’s pay changed over time relative to the company’s business performance? It’s not a good sign if management’s pay has increased or remained the same in periods when the company’s business isn’t doing well.
How is management compensated? Ideally, we want management to be compensated based on metrics that make sense to us as a company’s shareholders. PayPal, another company I own shares of, excels in this regard, in my view. In 2018, the lion’s share of the compensation of PayPal’s key leaders came from the following: (a) Stock awards that vest over a three-year period; (b) restricted stock awards that depend on growth in the company’s revenue and free cash flow over a three-year period; and (c) which applies specifically for the CEO, stock awards that depend on the performance of PayPal’s share price over a five-year period.
Are there high levels of related-party transactions (RTPs)? RTPs are business transactions made between a company and organisations that are linked to said company’s management. A good example will be the famous hotpot restaurant operator, Haidilao. In 2018, Haidilao’s top five suppliers accounted for 38.4% of the company’s total purchases of RMB 10 billion, and four of the top five suppliers were linked to management. The presence of high levels of RTPs in a company could mean that management is using said company to enrich entities that are linked to them – that’s not ideal for the company’s other shareholders. In the case of Haidilao, it appears that management has been treating shareholders fairly; the company’s net profit margin has been at a healthy level (for a restaurant operator) of at least 9% going back to 2016.
On capability:
Does the company have a good culture? Some clues on a company’s culture can be found on Glassdoor, a website that allows a company’s employees to rate it anonymously. Unfortunately, Glassdoor’s coverage mostly extends to only US companies for now.
Has the company managed to successfully grow its important business metrics over time? Going back to Intuitive Surgical, the number of surgical procedures worldwide performed with the company’s robots has increased significantly from 68,000 in 2007 to 1.04 million in 2018. Meanwhile, the installed base of Intuitive Surgical’s robotic surgery systems worldwide has jumped from 795 in 2007 to 5,406 today.
On innovation:
It requires some judgement in assessing a management team’s ability to innovate. There are three companies that I think are great examples of having innovative management.
First is US e-commerce and cloud computing giant Amazon, which I own shares of. Amazon started selling just books online when it was founded in 1994 but expanded its online retail business into an incredible variety of product-categories over time. In 2006, the company launched its cloud computing business, AWS (Amazon Web Services), which has since grown into the largest cloud computing service provider in the world.
Second is the international video streaming provider Netflix, which I also own shares of. Netflix’s co-founder and CEO Reed Hastings said in 2007: “We named the company Netflix for a reason; we didn’t name it DVDs-by-mail. The opportunity for Netflix online arrives when we can deliver content to the TV without any intermediary device.” This shows that Netflix’s leaders were already thinking about building a video streaming business right from the very beginning, back when video streaming wasn’t even a widely used term.
Third is MercadoLibre, another company that I have a stake in. MercadoLibre started life in the late 1990s operating online marketplaces in Latin America that connects buyers and sellers. In the early 2000s, MercadoLibre started an online payments service, MercadoPago, that now also includes online-to-offline (O2O) payments services. In addition, the service helps facilities online payments for merchants and consumers that are outside of the company’s online retail platform. In the third quarter of 2019, off-platform payment volume on MercadoPago exceeded on-platform payment volume in Brazil (the company’s largest market), for the first time ever. Then in 2013, MercadoLibre launched its shipping solution, MercadoEnvios. MercadoLibre’s service-innovations all help to drive further growth in the company’s marketplace business, and in some cases, even create new growth areas outside of the company’s main platform.
4. Revenue streams that are recurring in nature, either through contracts or customor-behaviour.
Having recurring business is a beautiful thing because it means a company need not spend its time and money looking to remake a past sale. Instead, past sales are recurring, and the company is free to find brand new avenues for growth.
A company in my portfolio, Adobe, provides subscription services for software used in many different areas including digital marketing and creation of digital content. The subscriptions provide recurring revenue for Adobe and accounted for 88% of the company’s US$9.0 billion in revenue in its fiscal year ended 30 November 2018.
Recurring revenue from customer behaviour is embodied by the digital payments company, Mastercard, another stock-holding of mine. Each time you swipe your Mastercard credit card, the company earns a fee; in 2018, Mastercard processed US$5.9 trillion in payments (that’s a lot of swiping!). Intuitive Surgical is also another good example of a company with high-levels of recurring revenue from customer behaviour due to its razor-and-blades business model. The company generates revenue from the one-time sale of its surgical robot systems. But it also supplies the accessories that are used with the robots and provides the necessary maintenance services. The accessories and maintenance services generate recurring revenues for Intuitive Surgical and accounted for 70% of the company’s total revenue of US$3.7 billion in 2018.
5. A proven ability to grow.
It’s important that a company has shown that it’s able to grow so that the chances of future growth are higher. And by growth, I’m looking at big jumps in revenue, net profit, and free cash flow over time. Sometimes, just revenue and free cash flow are good enough. I am generally wary of companies that (a) produce revenue and profit growth without corresponding increases in free cash flow, or (b) produce revenue growth but suffer losses and/or negative free cash flow. But I will be happy to make exceptions for some relatively young SaaS (software-as-a-service) companies that produce strong revenue growth but currently still generate losses and/or negative free cash flow.
A company’s track record is important, because it is easy for anyone to promise the sky – delivering on the promise is another matter, and it’s not easy to do. Amazon is a good example of a company with a strong history of growth. From 2013 to 2018, revenue tripled from US$74 billion to US$233 billion, while free cash flow jumped nearly nine times from US$2 billion to US$17 billion. PayPal Holdings is another good instance. From 2013 to 2018, revenue more than doubled from US$6.7 billion to US$15.5 billion, profit rose from US$1 billion to US$2 billion, and free cash flow increased from US$1.6 billion to US$4.7 billion.
6. A high likelihood of generating a strong and growing stream of free cash flow in the future.
The actual value of a company, in general, is the amount of cash it can generate over its entire life. So, the more free cash flow a company can produce, the more valuable it is. It’s important to note that free cash flow is not a relevant metric to use when assessing banks – the book value per share will be more appropriate.
A good example of a company that embodies this criterion, in my view, is Alphabet, the parent of the internet search giant Google (I own shares of Alphabet). Alphabet has a strong history of generating free cash flow, and it likely can continue doing so in the future, since the advertising business of Google is so lucrative. From 2013 to 2018, Alphabet’s free cash flow increased from US$11.3 billion to US$22.8 billion, while the free cash flow margin (free cash flow as a percentage of revenue) only slipped slightly from 20% to a still-strong 17%.
Conclusion
Companies that excel in all six criteria may still turn out to be poor investments. It’s impossible to get it right all the time in the investing game, so I believe it is important to diversify. And believe me, there are stocks in my family’s portfolio that are big losers (down 50% or more). But by sticking with companies that meet most or all of the six criteria above, I believe that the winners can more than make up for the losers. This is something that has happened to my family’s portfolio.
Another important point to note is that patience is needed in investing. Even the best winners in the market suffer painful declines from time to time. From 1997 to 2018, the peak-to-trough decline for Amazon’s stock price in each year ranged from 12.6% to 83.0%, meaning to say that Amazon’s stock price had experienced a double-digit peak-to-trough fall every year. Over the same period, Amazon’s stock price climbed from US$1.96 to US$1,501.97, for an astonishing gain of over 76,000%. My family’s portfolio still holds many of the stocks bought in 2010, 2011 and 2012 (we first bought Amazon shares in 2014 and are still happy owners). By having patience, we allow the underlying businesses of the companies we own shares in to shine and carry our portfolio to new heights over time.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
I started investing in October 2010 and have learnt a lot along the way. Here are 24 evergreen lessons so that you, dear reader, can become a better investor.
Market facts
1. There are many hucksters out there. Always ask for their track record. How many “students” they have, how long they have been in the business, or much money they are managing does not matter. The key is, how have they done over a long period of time (five years and more)?
2. Stocks represent part ownership of a living, breathing business.
3. If a business does well over time, its stock price will too, eventually; if a business does poorly, so too will its stock price.
4. According to the Credit Suisse Global Investment Returns Yearbook 2019 report, Developed economy stocks have climbed by 8.2% per year from 1900 to 2018 – this turns $1,000 into $10.9 million. Emerging economy stocks have climbed by 7.2% per year rom 1900 to 2018 – this turns $1,000 into $3.7 million.
5. But stocks have been volatile over the short run – it happens to even the best of stocks.
6. From 1997 to 2018, the peak-to-trough decline for Amazon.com’s share price in each year ranged from 12.6% to 83.0%, meaning to say that Amazon’s share price had experienced a double-digit peak-to-trough fall every year. Over the same period, Amazon has seen its stock price climb from $1.96 to $1,501.97, for an astonishing gain of over 76,000%.
7. It makes sense for stocks to be volatile. If stocks went up 8% per year like clockwork without volatility, investors will feel safe, and safety leads to risk-taking. In a world where stocks are guaranteed to give 8% per year, the logical response from investors would be to keep buying them, till the point where stocks simply become too expensive to continue returning 8%, or where the system becomes too fragile with debt to handle shocks. Thing is, there are no guarantees in the world. Bad things happen from time to time. And when stocks are priced for perfection, any whiff of bad news will lead to tumbling prices.
8. Investing in stocks allows you to be a silent partner to some of the best businessmen and investors on the planet.
Investing psychology
9. There are always things to worry about and the future is always uncertain. But that does not mean we shouldn’t invest.
10. The past 53 years from 1965 to 2018 included the Vietnam War, the Black Monday stock market crash (when US stocks fell by more than 22% in a day), the “breaking” of the Bank of England (when the UK was forced to allow the pound to have a floating exchange rate), the Asian Financial Crisis, the bursting of the Dotcom Bubble, the Great Financial Crisis, Brexit, and the US-China trade war. But in those 53 years, the book value of Warren Buffett’s Berkshire Hathaway grew by 18.7% per year while its stock price increased by 20.5% per year. An 18.7% input has still led to a 20.5% output despite all these things to worry about.
11. Loss aversion is a psychological bias most people have where a loss feels twice as painful as an equivalent gain. Put in place systems to help you deal with the psychological pain when stocks fall from time to time.
12. The most important organ for investing is not the brain, but the stomach. We must not be scared off by short-term declines.
How to invest
13. The most sensible investment philosophy should be built on the idea that stocks represent part ownership of a living, breathing business. And there are times when a stock has a price that’s significantly lower than the value of its underlying business – investing is about identifying these instances!
14. There are many different ways to invest with the philosophy above. The three broad categories are: (a) Finding a large group of stocks that are cheap based on their financial statements; (b) Finding a handful of stocks that are cheap based on their financial statements and appraisal of their current business conditions; and (c) Finding stocks that are cheap based on how well their businesses may do in the future.
15. There are three financial statements every listed company must report: (a) Income statement; (b) Balance sheet; and (c) Cash flow statement.
16. The income statement measures how much sales a company makes, and how much profit the company makes; the balance sheet tells us what a company owns, and what it owes; the cash flow statement tells us how much cash a company brings in. It’s important to have basic accounting knowledge so you can track the progress of a company. Each financial statement has many important things to look at, but there are a few that are critical.
17. Critical things for the income statement:
Revenue (how much sales a company makes)
Gross profit margin
Operating profit margin
Net profit margin
Net profit (what’s left from sales after deduction of all expenses)
We typically want fat gross margins, fat operating margins, and fat net profit margins.
18. Critical things for the balance sheet:
Level of cash and level of debt; we typically want cash to be significantly higher than debt
Slightly less important things are total assets (what the company owns), total liabilities (what the company owes), and total equity (total assets minus total liabilities).
19. Critical things for the cash flow statement:
Operating cash flow (the cash flow generated from the company’s normal business operations)
Capital expenditure (what the company has spent to maintain its business at the current state)
We typically want high operating cash flow and low capital expenditure; the difference between operating cash flow and capital expenditure is free cash flow – the higher the better.
20. Going back to point 14, in this article I will focus mainly on the third broad category on how to invest: Finding stocks that are cheap based on how well their businesses may do in the future. A few quick words on the first and second broad categories of investing first…
21. Finding a large group of stocks that are cheap based on their financial statements: It focuses on finding a large group of stocks with share prices that are low in relation to their net profit and/or their total equity, and buying an entire basket of them. This basket is typically held for anywhere from a quarter to two-years, and the search-and-investing process is then repeated.
22. Finding a handful of stocks that are cheap based on their financial statements and appraisal of their current business conditions: It focuses on the analysis of a company’s business and financials to determine its underlying intrinsic value (nearly always how much cash it can generate from now to eternity, discounted back to the present), and then buying only a small handful of stocks with share prices that are much lower than their underlying intrinsic values.
23. The third broad category – finding stocks that are cheap based on how well their businesses may do in the future – is where I have found the most success in, and find the most intellectually stimulating. To do well in this area requires two very important things: (a) Patience, because share prices need time to reflect the strengths of the business, and because compounding takes time, and (b) a strong stomach to withstand volatility.
24. I find stocks with all or most of the following characteristics: (1) Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market; (2) Strong balance sheets with minimal or reasonable levels of debt; (3) Management teams with integrity, capability, and an innovative mindset; (4) Revenue streams that are recurring in nature, either through contracts or customer-behaviour; (5) A proven ability to grow; (6) A high likelihood of generating a strong and growing stream of free cash flow in the future. For a more thorough take on the six criteria, head here.
Note: An earlier version of this article was published at The Smart Investor, an investing website run by my friends.
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.
Here’s how my family’s investment portfolio has performed since October 2010.
I have been investing for my family since October 2010. The portfolio that I manage consists of US-listed stocks, so I track my returns against the most widely-followed US stock market benchmark, the S&P 500.
The portfolio contains over 50 stocks, and its return is net of trading fees and does not include dividends. The S&P 500 return does not include any hypothetical trading commissions but does include dividends.
I’m sharing my family’s investing journey to serve as inspiration for what’s possible by applying a long-term, business-focused mindsetto investing in the stock market.
As of 31 May 2020
The articles below are discussions on some of the stocks that are in 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.
