Category: Special Events

We’ve constantly been sharing a list of our recent reads in our weekly emails for The Good Investors.

Do subscribe for our weekly updates through the orange box in the blog (it’s on the side if you’re using a computer, and all the way at the bottom if you’re using mobile) – it’s free!

But since our readership-audience for The Good Investors is wider than our subscriber base, we think sharing the reading list regularly on the blog itself can benefit even more people. The articles we share touch on a wide range of topics, including investing, business, and the world in general. 

Here are the articles for the week ending 18 February 2024:

1. Where Will Virtual Reality Take Us? – Jaron Lanier 

In the intervening decades, V.R. has thrived at two extremes in the quest for “killer apps.” It has long been an established industrial technology: if you’ve flown, ridden, or sailed in a factory-built vehicle in the last thirty years, virtual reality may have played a central role. It’s been used to design surgical procedures and train surgeons ever since our first simulated gallbladder, at Stanford Med, some three decades ago; Boeing, Ford, and many other companies started using VR for design in the early days as well. And then there are the visionary, mystical, and philosophical applications. V.R. can be a way of exploring the nature of consciousness, relationships, bodies, and, perception. In other words, it can be art. V.R. is most fun when approached that way.

In between the two extremes lies a mystery: What role might V.R. play in everyday life? The question has lingered for generations, and is still open. Gaming seems likely—but, for most gamers, not so much. There are many reasons why V.R. and gaming don’t quite work, and I suspect that one is that gamers like to be bigger than the game, not engulfed by it. You want to feel big, not small, when you play. (“Star Wars” might have got this right with holographic chess.) Apple’s initial round of Vision Pro apps, like those from its competitors, aren’t entirely compelling, either, and can even have a lonely, dystopian flavor. (Watching a simulated big-screen movie, by yourself?) But my belief is that the quotidian killer apps will come. Maybe you’ll use V.R. to learn quickly about the Airbnb at which you’ve just arrived. Maybe V.R. will help you assemble ikea furniture. Maybe!

Virtual-reality headsets come in various forms. A major divide has to do with how they acknowledge the real world. Some headsets obscure the surrounding environment completely; this is typical in gaming headsets. But there is another option, which I used to call “mixed” reality, and which came to be known as “augmented” reality in the nineteen-nineties. Some mixed or augmented headsets, such as the Microsoft HoloLens or the system created by Magic Leap, allow you to see the real world through the headset glass so that it can be combined with virtual content using challenging optical techniques. Others, like Apple’s Vision Pro and the recent offerings from Meta, capture the real world with cameras, then render it as part of the virtual environment so that it can be combined with fabulated content.

Camera-based mixed reality is vastly easier to accomplish than the optical version, but it is concerning. Early research by a Stanford-led team has found evidence of cognitive challenges. Your hands are never quite in the right relationship with your eyes, for instance. Given what is going on with deepfakes out on the 2-D Internet, we also need to start worrying about deception and abuse, because reality can be so easily altered as it’s virtualized…

… For most of the technology’s history, however, virtual experiences have been hard to build and maintain. This has been one of V.R.’s biggest problems. I saw the first V.R. teaching demonstration of general relativity at least as early as 1992, and have seen dozens more since then; they’re often wonderful, and help users grasp the concept in new ways. But they only run for a year or so because there are too many variables in a V.R. system for creators to keep experiences available. Graphics chips change, and with them the layers of mediating software. That’s true for other programs, too, but with V.R., when the properties of a headset (like field of view) or an input device shift, the whole experience and interaction method must often be rejiggered. It’s too much ongoing effort, so it usually doesn’t happen; developers move on to other projects. The exceptions have been locked-down V.R. experiences that assume a minimal level of interaction, which limits the magic…

…Apple is marketing the Vision Pro as a device you might wear for everyday purposes—to write e-mails or code, to make video calls, to watch football games. But I’ve always thought that V.R. sessions make the most sense either when they accomplish something specific and practical that doesn’t take very long, or when they are as weird as possible.

The practical side of V.R. is a scattering of wonderful niches: in addition to surgical simulation and vehicle design, the technology is used by oil companies to simulate geological structures, by drug companies to envision molecules, and by planners working on city centers. The new frontier, which might apply more to everyday life, is the spontaneous creation of practical apps that you might not even bother to save. My research group, for instance, has presented a prototype system—the “mixed-reality copilot”—that allowed us to recreate, with a single voice request, a program that allows you to use your hands to paint and sculpt with virtual stuff. A decade ago, it took months to make that kind of program. Hopefully, in the near future, one will be able to ask for a V.R. relativity simulation tailored for a student who has color blindness and A.D.H.D., and it will simply appear. More prosaically, you might walk through a facility in augmented reality, asking an A.I. for instant advice about potential safety hazards and fixes. These ideas might even work already: one of the curious features of this accelerated period of A.I. development is that there aren’t enough minutes in the day to try everything.

On the weird edge, it turns out you can change your body plan in V.R. You can become different animals. You can map your body to that of a lobster or an octopus, and experience, to a significant extent, the control of that other body. The brain has had to adapt to many body plans over the course of its evolution, and it’s pre-adapted to work with more. When you change your body, you can also play with the flow of time. By shifting the rhythm of the natural sway of your limbs, and also how the objects around you move and change in response, you alter the reference points that your brain uses to mark the flow of time. You can speed it up or slow it down. In V.R., you can change the rules of the world. You can exist in strange geometries that are too hard to describe in words. You can become an archipelago of parts instead of a continuous animal. You can blend and share bodies with others, to a surprising degree…

…There are fresh, urgent reasons to reaffirm the value of experience. It is impossible to judge technology without a sense of its purpose—and its only plausible purpose is to benefit people, or perhaps animals, or the over-all ecosystem of the planet. In any case, if we pursue technologies that make it hard to delineate the beneficiaries—for instance, by blending brains into robotics not to cure a disease but just because it seems cool—then we make the very idea of technology absurd. The central question of the technological future is how to identify the people who are supposed to benefit from technology, especially if they seem to have melted into it. If people aren’t special, how can we act in a way that benefits people? We can’t. The principles of ethics, design, and even technology itself become nonsense. What can that specialness be? It must be something that is not technologically accessible, since technology expands unpredictably. It’s a little mystical. The definition of people must be one of apartness. We must now put people on pedestals, or they will drown.

When I put on a V.R. headset, I still notice that I am floating there, that I exist independently of the information I experience. But then there’s the moment I take off the headset, which is the very best. In the nineteen-eighties, we used to try to sneak flowers or pretty crystals in front of people before they would take off their headsets; it was a great joy to see their expressions as they experienced awe. In a sense, this was like the awe someone might experience when appreciating a flower while on a psychedelic drug. But it was actually the opposite of that. They were perceiving the authentic ecstasy of the ordinary, anew.

This is the kind of experience you can have only if you use V.R. fleetingly, not constantly. Here we come to one of the greatest differences between what I love about virtual reality and how it is often promoted today. Venture capitalists and company-runners talk about how people will spend most of their time in V.R., the same way they spend lots of time on their phones. The motivation for imagining this future is clear; who wouldn’t want to own the next iPhone-like platform? If people live their lives with headsets on, then whoever runs the V.R. platforms will control a gigantic, hyper-profitable empire.

But I don’t think customers want that future. People can sense the looming absurdity of it, and see how it will lead them to lose their groundedness and meaning…

…But the truth is that living in V.R. makes no sense. Life within a construction is life without a frontier. It is closed, calculated, and pointless. Reality, real reality, the mysterious physical stuff, is open, unknown, and beyond us; we must not lose it.

Just because owning a major tech platform is desirable, that doesn’t suggest there is no other way to succeed in the technology business. There are water companies and soda companies, and then there is fine wine. All are viable businesses. The metaphor isn’t perfect, but I suspect that V.R. entrepreneurs will find their sweet spot by emulating Napa Valley…

…A.I. is often portrayed as a godlike, transcendent project that will take over the fabric of our physical reality, leading to a singularity, meaning nothing that matters now is likely to matter after. But singularities, like the ones we hypothesize in black holes, are the very definition of ignorance. There is no learning that bridges the before and after of a singularity. It is the absolute rejection of intelligence. Virtual reality is sometimes stirred into this mix. But our best understanding of how reality works is entirely bound to finitude. Physics is all about conservation principles. There are no infinities, only S curves. There is no free lunch. Technical culture often longs for freedom from finitude. A profound truth, however, is that the greatest mysteries are found in conserved systems, which can become rich and complex, not in infinite ones, which stretch out like blank white sheets to the edge of the cosmos.

And so another urgent question is whether people can enjoy the storied reality of finitude after coming down from the high of fake infinity. Can being merely human suffice? Can the everyday miracle of the real world be appreciated enough? Or will the future of culture only be viral? Will all markets become Ponzi-like fantasies? Will people reject physics forever, the moment we have technology that’s good enough to allow us to pretend it’s gone?

2. Pods, Passive Flows, and Punters – Drew Dickson

You’ve surely noticed what has happen to Nvidia lately. We used to just call these winners FANGs, and then FAANGs and then FAMANGs, but Nvidia has insisted on joining the league table. It now has a $1.7 trillion market cap. And in the last five years, the stock is up about 1,700%. Guess what else is up about 1,700%?

Nvidia’s earnings estimates.

How about Facebook, aka Meta, which goes through periods of hatred and love with equal vigor? Well, over the past seven years it has bounced around a lot but still has generated nearly 260% returns. And forward earnings projections? They’re up 280%.

We can stretch things further back, and look at Google over the past 14 years (earnings up 885%, stock up 980%); or Amazon during the same period (earnings up nearly 2,500%, stock up about 2,800%).

Or we can go waaay back and analyze Microsoft over the past 22 years. Forward earnings projections have increased from $0.93 in February of 2002 to $11.57 today. That’s nearly 1,150%. The stock is up just over 1,200%.

And finally, from one of my favorite former-CEOs Reed Hastings, we have good old Netflix. About 18 years ago, analysts were forecasting that Netflix would generate 11 cents of earnings in the coming 2006 year. Here in 2024, they are forecasting a whopping $17 of earnings in the coming year. That is a whopping EPS increase of 14,889%.

And how about the stock? We’ll it is up a whopping 14,882%.

Fundamentals matter, sports fans. Fundamentals matter.

Admittedly, some of these examples above are very long-term, but even when we self-select with some of the biggest, most exciting, long-term winners out there, and ignore the losers (of which there are many), it is still clearly apparent that it is the fundamentals that matter most.

So basically, it probably isn’t terrible advice to ignore the rest of it. Ignore the noise. Ignore the talking heads on CNBC. Ignore prognostications of meme-stock sith lords. Ignore the volatility. Embrace it, actually. And just focus on the fundamentals. Get those right, and you will likely win.

3. “The Practice Of Value Investing”, by Li Lu – Graham Rhodes

If you invest in a company in a sustainably growing economy, your company’s profits and your investment return will also grow sustainably.  If you speculate on other people’s short-term trading behaviour, there can only be one result in the end:  gains and losses must equal because this is a zero-sum game.  If you add up the gains and losses of all speculators in the market, they will sum to zero.  This is the biggest difference between investing and speculating.  I’m not denying that there are some speculators whose chances of winning are higher and who can go on winning for longer; equally there are some who will always be the sucker at the table and never strike it rich.  If you give it enough time though, when you add the winners and losers together, the net result will be zero.  The reason is that speculating on short-term behaviour in the market adds nothing to the economy nor to corporate earnings growth.  Some people say they use a mixed model of “80% investment, 20% speculation”.  If they do 70-80% of their work correctly, then such participants’ returns will reflect the compound growth of the modern economy.  However, the remaining portion will be caught up with all the other speculators and their result will be the same – zero.

Now that you know this result, will you choose to be an investor or a speculator?  This is a personal choice and there is no right or wrong answer.  The only difference is the impact you will have on society.  Investors will help all parts of society enter modernity’s virtuous cycle – the stage in which it enjoys continuous compound growth.  If you are interested and would like to learn more about this, you can refer to my monograph, “Discussions on Modernisation”.

Relatively speaking, the speculative part of the market verges on being a casino.  From a social welfare point of view, we do not want this casino to be too big.  However, without it, the market would not exist.  We should therefore see speculation as a necessary evil – and a part of human nature – which cannot be removed.  We cannot deny the parts of human nature which love to gamble and speculate but we cannot let them overwhelm us.  Otherwise, society will sooner or later face the consequences.  The wounds of the 2008-2009 Global Financial Crisis from which we have just emerged are still fresh in our memories.  And once you understand the principle of a zero-sum game, you will begin to see these speculators as Mr. Market…

…There was another company at the time which taught me something revealing.  This company owned a lot of gas stations, and so I became interested in gas stations.  There were two gas stations near where I lived, one on each side of the same intersection.  However, I realised that one gas station had many more customers, and that cars would come to it regardless of which direction they were heading.  Both gas stations had the same price and their gas was the same as it was made to the same standard.  I felt this was very strange and since it was my company’s gas station anyway, I went to have a look.  The gas station which attracted all the customers was run by a family of Indian immigrants, who all lived there too.  As soon as a customer arrived, they would come out to offer him a glass of water.  Whether you wanted it or not, they would always offer it to you first and then strike up a conversation.  If the kids were home from school, they would come out and help you tidy up your car.  The other gas station was run by a typical American.  He wasn’t a bad guy but the gas station didn’t belong to him.  He was just an employee hired by the real owner, so he wouldn’t come out from the store and nor would he pay much attention to what was happening outside.  Thanks to this one difference, I calculated that in a given period, one gas station attracted almost four times as much traffic as the other.

From then on, I realised it was important to know whether a company’s manager had an owner’s mindset.  Through this, I began to gradually understand how a company could earn money and why it could earn more than others.  The example of the two gas stations is a perfect illustration because they sold the same product and were otherwise identical.  However, one’s service was slightly superior to the other’s and so it received four times as much traffic.  What motivated that Indian fellow?  He was an immigrant, like me.  He needed money and if he couldn’t bring in business, he would have financial difficulties.  The other manager could be indifferent because he could just take his salary while pretending to do his job.  This was the difference.  I therefore began to take great interest in how a company is run, its competitive advantages, and the sustainability of these competitive advantages…

…The next attribute is relatively special.  You must be both extremely patient and extremely decisive, even though they are in contradiction.  When there are no opportunities, you might go for years without taking any action.  But as soon as an opportunity arrives, you must be able to become extremely decisive and act without hesitation.  I have been Charlie Munger’s investment partner for sixteen or seventeen years now.  We meet for dinner at least once a week and I’ve developed a deep understanding of him.  Let me tell you a story about his investments.  Charlie subscribes to Barron’s, a weekly magazine about the stock market published by the Wall Street Journal.  He’s read this magazine for approaching 40-50 years for the purpose of finding investment ideas.  And how many has he found in this time?  One!  There has only been one and he only found it after reading the magazine for more than thirty years.  And he hasn’t found another in the ten years since.  This hasn’t stopped him from continuing to read the magazine every week though.  He is extremely patient and can go for a long time without doing anything at all.  But when he finds an opportunity, he will go all in.  And this particular investment made him a lot of money.  So this is what’s required of an exceptional investor:  he must have extreme patience and stay focused even when there are no opportunities.  When an opportunity does come, he must then have the ability to move swiftly and decisively…

…When I was young, I always wondered about the meaning of life.  Later, I gradually came to realise that the meaning of life is the pursuit of true knowledge.  True knowledge can change your life and your fate; it can even change the world.  Moreover, mankind is completely different from what else we can observe in the material world.  The world we can see is one in which entropy increases.  Energy flows from high places to low places; big things devour small things.  If a large celestial body hits a smaller one, it will crush it.  The entire planet and our universe are to a certain extent heading towards annihilation.

But the world of man is not the same.  Mankind can turn the world into one in which entropy decreases.  We can reverse entropy’s course.  Through study, man can go from ignorance to erudition; through self-cultivation, man can become a virtuous person who contributes to society.  Man can create things which were previously unimaginable.  Since man’s arrival, the earth has changed.  Today, we can even leave this planet for the stars; it is entirely possible that we go on to change the universe.  As I mentioned earlier, the first investment I made was related to the wireless telephone.  At the time, I hadn’t really figured out what that was.  Twenty-six years later, who can bear to part with their mobile phone?  Mobile phones, the internet and all these things were game changers born of knowledge.  The internet is based on TCP/IP which is a protocol.  At their heart, computers are permutations and combinations of 0s and 1s combined with a diode which uses silicon and electricity to tell those 0s and 1s apart.  This is how knowledge can create changes which turn our world upside down.

4. Hong Kong’s death has been exaggerated – Michael Fritzell

The National Security Law in June 2020 was indeed a watershed moment for Hong Kong’s judiciary. Now that individuals seen to be endangering national security can be extradited to mainland China, there’s a fear that they will no longer receive fair trials.

But let’s look at the positive side of things. In reality, the National Security Law has really just had two major effects. One is emigration, and the other is stopping public demonstrations.

Since 2020, roughly 400,000 people have left Hong Kong, according to this data from the Hong Kong Immigration Department. But, if you calculate the cumulative number, net migration has actually started to decrease:

In other words, people are now moving back to Hong Kong. These could be individuals who avoided Hong Kong during COVID-19 and are now willing to return. They could also be people who changed their minds about living overseas, knowing that Hong Kong is a great place to make money. In the early 1990s emigration wave, many of those who left for Vancouver or elsewhere ultimately came back to Hong Kong.

While it’s certainly negative that hundreds of thousands of people have left Hong Kong, it’s not implausible that mainland Chinese immigration could make up for the shortfall. In fact, Hong Kong’s residential rents rose 8.1% in 2023 due to immigration from the mainland.

For now, the Hong Kong legal system remains reliable. The conviction rate for Magistrate’s courts in Hong Kong was 54% last year, far higher than mainland China’s 99.95%. This seems to suggest that Hong Kong judges are still independent. Hong Kong still ranks #23 in WJP’s Rule of Law Index, ahead of the United States.

Between Hong Kong and Singapore, the former remains a far larger financial hub. The aggregate market cap of Hong Kong-listed companies is 10x that of Singapore. Its assets under management are US$2.2 trillion – far higher than Singapore’s US$1.5 trillion. There are 2,000 licensed asset managers in Hong Kong vs just 1,200 in Singapore.

A key competitive advantage for Hong Kong is that its currency is freely convertible and pegged to the US Dollar. This enables the Chinese government and its companies to raise overseas capital while maintaining capital controls within mainland China.

It’s also the case that Hong Kong’s taxes are uniquely low:

• The highest marginal income tax is 17%.
• There is no capital gains tax.
• There is no withholding tax on dividends or interest income.
• There is no GST.
• There is no estate duty.
• There is no wealth tax.
• There is a 15% tax rate on rental income but with a standard deduction of 20%.
• Most import duties to Hong Kong are zero, making imported goods cheap.
• The stamp duty for purchasing residential property is 15% for foreigners and 7.5% for locals, but this stamp duty could soon be removed.

For these reasons, the PwC and the World Bank recently ranked Hong Kong as the region with the most friendly tax system in the world.

The Hong Kong government remains committed to its low-tax policy. Hong Kong has agreed to implement a minimum corporate tax rate of 15% from 2025, but so has many other major economies. The budget deficit is projected to continue at over HK$100 billion in FY2025, but 3% of GDP remains modest.

While I don’t want to minimize the political shift that has taken place, for Hong Kong companies, it will be mostly business as usual. Hong Kong will continue to attract the ultra-wealthy through its low taxes, and it will continue to be used to raise capital for companies in China and beyond.

After Hong Kong’s zero-COVID policy was lifted at the end of 2022, the economy has actually been on a solid footing. Hong Kong’s retail sales grew +16% year-on-year in 2023, though remaining almost 20% below the peak in early 2019:

A major component in Hong Kong retail sales comes from tourism to Hong Kong, which is now back to around 70% of the pre-COVID level:

But don’t expect a full recovery in tourism spending. Before 2019, a large portion of Hong Kong retail sales to tourists comprised goods smuggled into mainland China. In 2021, China’s border controls tightened up significantly, and most of such business now occurs through legitimate channels. I wrote about such smuggling here.

One business that is booming is Hong Kong life insurance products sold to mainland Chinese visitors. Related premiums already exceed the pre-COVID-19 level, suggesting strong demand for USD-linked policies.

Hong Kong’s real GDP grew +4.3% in the fourth quarter of 2023. Hong Kong’s export growth has now turned positive at +11% year-on-year. The unemployment rate remains just 2.9%, suggesting that jobs are plentiful…

…What’s weighing on the Hong Kong economy is the interest rate environment. Since the Hong Kong currency is pegged to the US Dollar through a currency board arrangement, it effectively imports its monetary policy and interest rates from the United States…

…Now that HIBOR has reached over 4% borrow rates for households and companies remain above the nominal income growth in the economy. In my view, that means that monetary policy remains restrictive…

…Another longer-term worry is geopolitics. If a war were to break out in Taiwan or elsewhere, US sanctions could be imposed on Hong Kong. It could lose its special trade status. Import tariffs would be imposed, and it would be subject to the same export controls as China. If the Hong Kong Dollar were to be de-pegged to another currency. But as long as the currency remains freely convertible, Hong Kong will continue to retain its competitive advantage as a hub for raising overseas capital.

5. A beginner’s guide to accounting fraud (and how to get away with it): Part VI – Leo Perry

On 9th September 2018 serial entrepreneur Luke Johnson shared his experience and wisdom in an article in The Times newspaper titled ‘A business beginner’s guide to tried and tested swindles’. Five days later HMRC petitioned the High Court to wind up his business, the cafe chain Patisserie Valerie, for an unpaid tax bill. He didn’t notice. Unfortunately I didn’t either.

On 10th October Pat Val halted trading in its shares and suspended its CFO. It noted “significant, potentially fraudulent, accounting irregularities” that had materially impacted the cash position. I was familiar enough with the brand. I worked in an office a few doors down from one. It never seemed busy but there was nothing in the accounts that gave me good reason to think about shorting the company. But if I’d been able to now I would have, even at half the price it was halted at. The reason I was so confident it was screwed was precisely because I hadn’t spotted anything wrong in its numbers before (neither, apparently, had anyone else as there were no publicly disclosed shorts on the FCA list).

Pat Val’s published accounts were as straightforward as you’d expect from a simple business like a cafe. Sales taken in cash, not much held as stock and a few prepaid expenses. The only line items of any size on the balance sheet were the capitalised cost of fitting out stores, and money sitting in a bank. Not a lot to tweak if you needed to meet numbers. That’s why the company saying that its cash position was significantly misstated, while it was short on detail, had to mean that (probably) sales and (almost certainly) profit were faked. Working backwards there couldn’t really be any other story.

Things unravelled fast. The next statement from the company, later the same day, disclosed the winding up petition from a month earlier. The following day Pat Val said it couldn’t continue trading without a capital injection, which really amounted to saying the £30m of “cash” on its balance sheet wasn’t in the bank at all. And the day after that its CFO Chris Marsh was arrested. One trick (I should say allegedly, I guess) is depositing fat cheques just before year end – to show a big credit at the point in time when you know the auditor is going to look – only for them to bounce a few days later. Another is borrowing money – again giving a big credit to cash – and just not mentioning the debt part in the accounts. Most of the time that would still show up as higher interest payments (see e.g. Globo), but when rates are close to zero you can get away with a lot more.

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Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. We currently have a vested interest in Alphabet (parent of Google), Amazon, Apple, Meta Platforms, Microsoft, and Netflix. Holdings are subject to change at any time.

We’ve constantly been sharing a list of our recent reads in our weekly emails for The Good Investors.

Do subscribe for our weekly updates through the orange box in the blog (it’s on the side if you’re using a computer, and all the way at the bottom if you’re using mobile) – it’s free!

But since our readership-audience for The Good Investors is wider than our subscriber base, we think sharing the reading list regularly on the blog itself can benefit even more people. The articles we share touch on a wide range of topics, including investing, business, and the world in general. 

Here are the articles for the week ending 17 December 2023:

1. J&J Hired Thousands of Data Scientists. Will The Strategy Pay Off? – Peter Loftus

Johnson & Johnson is making one of the biggest bets in the healthcare industry on using data science and artificial intelligence to bolster its work.

The 137-year-old pharmaceutical and medical-device company has hired 6,000 data scientists and digital specialists in recent years, and spent hundreds of millions of dollars on their work, such as using machines to scour massive health-record datasets. Last year the company opened a state-of-the-art research site near San Francisco that houses advanced data science…

…The long game, though, is a goal that has seen a lot of hype but less concrete proof that it will become a reality: using AI for drug discovery.

Startup biotechs are in the early days of human testing of AI-discovered drugs. Google this year introduced cloud-based AI tools to assist drugmakers in finding new treatments. But it could still be years before an AI-discovered drug is approved for sale by regulators.

Some pharmaceutical leaders have expressed skepticism that AI could ever discover new drugs any better than humans can.

J&J says it has an edge: a massive database called med. AI that it can sift for patterns to help speed up drug development. The info includes “real-world data”—anonymized information collected from everyday patient visits to doctors and hospitals—and years of clinical-trial results…

…J&J says it has already used machine learning to help design an experimental cancer drug that is scheduled to start human testing next year.

A few things make J&J’s effort different, Khan says. Its data-science workers are tightly integrated into the company’s strategic decisions on drug research. The company’s massive datasets—med. AI has more than three petabytes of information—are made available to tens of thousands of employees. And it has hired people who aren’t just data scientists but also have skills in chemistry, biology or drug development…

…Analysts consider J&J to be one of the most active large drugmakers in its commitment to AI. Market intelligence firm CB Insights recently ranked it third of 50 companies in its Pharma AI Readiness Index, which tracks companies’ patent applications, investments, deal making and other efforts related to AI…

…Today, most of the company’s drug-development projects incorporate some aspects of data science, up from just a handful five years ago. Its San Francisco-area research site in Brisbane, Calif., places data-science projects alongside R&D focused on finding treatments for retinal and infectious diseases. Many of J&J’s data workers are spread across multiple company locations including in the U.S., China and Belgium…

…In one recent project, J&J scientists led a collaboration of 13 drug companies that analyzed blood samples collected from more than 50,000 people in the U.K. as part of a national database called UK Biobank. They identified thousands of genetic variants that influence levels of certain blood proteins, about 80% of which weren’t previously known.

J&J plans to analyze the dataset using AI and machine learning to help spot patterns. This in turn could lead to new drugs or diagnostics that target the gene-protein links to various diseases. In the past, industry scientists would look for such molecular drug targets by scouring academic papers. The AI-enabled approach could spot many more targets, more quickly.

The company also is using an AI algorithm to study digitized images of biopsies to detect subtle differences between tumors, which could lead to identifying genetic subtypes for certain tumors. Researchers could use this information to make a medicine that specifically targets the genetic subtype…

…J&J and its partners amassed six million patient records, stripped of individuals’ identities. including more than eight million electrocardiogram readouts. An electrocardiogram, or ECG, is a procedure to record the electrical signals in the heart. They fed the records into a software algorithm to teach it to spot patterns in the electrical readings that were present in patients later diagnosed with pulmonary hypertension. Using the algorithm in conjunction with ECG’s can shorten the time to a pulmonary hypertension diagnosis by 12 to 18 months, J&J says.

The Food and Drug Administration has granted “breakthrough device” designation to the algorithm, for products that could improve diagnoses or treatment of serious diseases. The FDA hasn’t approved the algorithm but a decision could come next year.

2. Lenders of Last Resort – Marc Rubinstein

So La Jolla, California-based Silvergate paid a visit to its local Federal Home Loan Bank in San Francisco. As a “member”, it was entitled to draw on special loans. By the end of the year, it had tapped the Home Loan Bank for $4.3 billion, up from $0.7 billion at the end of September. Although it paid them all back by the beginning of March, the loans provided Silvergate with a lifeline that kept it afloat longer than its fundamentals warranted.

Silvergate wasn’t the only struggling bank to make the trip to San Francisco. Three of the Federal Home Loan Bank’s six largest customers at year end 2022 would cease to exist a few months later; some 38% of its outstanding advances were to borrowers who wouldn’t make it. And it’s not the first time the Federal Home Loan Bank of San Francisco (FHLBSF) has found itself in that position. Two of its biggest four borrowers at the end of 2007, accounting for 32% of advances, failed over the course of the following year.

The optics haven’t been lost on FHLBSF’s regulator, the Federal Housing Finance Agency (FHFA). In a report released earlier this month, authorities made a number of proposals to reform FHLBSF and its peers. The regional bank failures, they said, “highlighted the need for a clearer distinction between the appropriate role of the FHLBanks, which provide funding to support their members’ liquidity needs across the economic cycle, and that of the Federal Reserve, which maintains the primary financing facility for troubled institutions with immediate, emergency liquidity needs.”

So who are these Federal Home Loan Banks? Few outside the US financial services industry are familiar with them. Yet, with $1.3 trillion of assets, they wield a power that dwarfs their low profile…

…In August 1931, with American homeowners facing an unprecedented wave of mortgage foreclosures, President Herbert Hoover summoned the country’s housing experts to a Conference of Home Building and Home Ownership. Around 3,700 delegates attended and the event generated 11 volumes of reports. The mortgage industry at the time was a patchwork of different interests: Country banks offered mortgages in the West, mutuals dominated in the Northeast and savings-and-loan institutions operated nationally, with a market share of 38%. While some of these lenders had access to emergency credit support, not all of them enjoyed such benefits. Banks could access the Federal Reserve system, farms could access the farm loan system, but savings-and-loans (S&Ls) had nothing. A key proposal of the Conference was to set up a system of credit support for the S&Ls.

On October 15, 1932, the Federal Home Loan Bank system officially opened. Modeled after the Federal Reserve system, it comprised a network of 12 banks, initially capitalized with $125 million from the federal government. Savings-and-loan institutions could become members by subscribing to shares of their local Home Loan Bank. With membership came access to a borrowing window, where S&Ls could pledge home loan assets as collateral in return for liquid funds. By putting up $100 worth of single-family mortgage loans, say, they could borrow $75 of cash.

In the space of a year, just over 2,000 of the country’s nearly 11,000 S&Ls joined, and over the next four years another 3,900 paid up. This group formed the core of the mortgage industry, going on to hold 92% of all S&L assets by 1950.

For much of the early history of the FHLBank System, eligible collateral was limited to home mortgage loans…

…To secure the funds to make available for borrowers, Federal Home Loan Banks issued bonds into the market. From the very beginning, FHLBanks were jointly and severally liable for each other’s debt, reducing risk and making their bonds an attractive proposition for investors. The system’s first debt issue in 1937 was “oversubscribed many times within a few hours.”

Their bonds also carry an implicit government guarantee. Although all obligations of the FHLBanks are required to “plainly state that such obligations are not obligations of the United States and are not guaranteed by the United States,” nobody really believes that. Government influence courses through these institutions…

…Because FHLBanks do not directly lend money, their role is obscured. But by providing a cheap source of funding for S&Ls, they played a part in the expansion of home ownership in the US and all subsequent mortgage cycles…

…The Federal Home Loan Banks might have had their day with the demise of savings-and-loan institutions in the 1980s and the rise of securitisation as an alternative means of obtaining liquidity from traditionally non-liquid mortgage assets. But rather than retire them, policymakers changed the rules to keep them in the game…

…As of September this year, they had pre-approved $3.6 trillion of collateral to lend against. Around half is single-family mortgages, but commercial real estate loans (20%), multifamily mortgage loans (10%), and mortgage securities (10%) appear as well…

…When it became clear S&Ls were not going to recover, policymakers repositioned FHLBanks, allowing them to accept commercial banks and credit unions as members so long as they had at least 10% of their assets in residential mortgage loans. Initially, a hierarchy of other criteria were also imposed to limit the extent to which these new members could obtain access to borrowings. But in 1999, these were eliminated leaving only the 10% threshold. By 2004, S&Ls made up only 16% of members, down from 100% in 1989. Today, they make up just 9%. Of the system’s 6,494 members, the majority are commercial banks…

…Silvergate Capital became a member of the Federal Home Loan Bank of San Francisco in 1997. It had been founded as a savings-and-loan institution but was reorganized into a bank by new owners a year earlier. At the time, its business strategy and profile were consistent with the FHLBank System’s mission. Over 10% of total assets comprised residential mortgages and it met all other statutory conditions of membership.

By 2022, though, Silvergate held only $38 million of one-to-four family real estate loans on a balance sheet of $15.5 billion. Once you’re in the FHLBank Club, you’re in. As long as you have sufficient collateral, and aren’t in breach of some basic financial requirements (like having positive tangible capital) you are eligible to borrow from the FHLBank System…

… At the end of 2021, the weighted average rate charged by home loan banks was close to 1%. Even after the Fed embarked on its hiking cycle, FHLBank money cost members 4.6% on average at the end of September.

Federal Home Loan Banks are able to offer such good rates because of their ability to raise funds so cheaply. In the nine months through to the end September, their average funding cost was 4.80%. The system keeps a spread of 0.34% but otherwise such beneficial funding rates get passed on to members…

…The FHLBank System is proud of its role connecting domestic financial institutions – many of them small, community-focused lenders – to the global capital markets. In this sense it acts no differently from other wholesale banks overseas (although unlike German Landesbanken which lost theirs in 2005, FHLBanks still retain state support).

But in the aftermath of Silvergate and the regional bank failures earlier this year, the FHFA is reviewing the emergent role the system has taken on as a lender of last resort. “Ensuring that the FHLBanks are not acting as lenders of last resort for institutions in weakened financial condition will allow the FHLBanks to use their available liquidity to provide financing to all members so they can continue to serve their communities,” it writes in its report.

The problem is that by being so readily available in the good times, banks may be more inclined to tap the same resource in the bad times, particularly as their FHLBank contact isn’t incentivized to ask questions. FHLBanks underwrite the collateral pledged rather than the institution, so as long as collateral is available and a sufficient haircut is applied (25% in the case of single-family mortgage loans, on average) the money will be there. (Unless they leave it too late in the day when debt markets have closed and FHLBanks are unable to raise funding – a feature in Signature Bank’s collapse.)

Perhaps because FHLBank funding was so easy to access, many banks did not have systems in place to access the legitimate lender of last resort – the Fed. According to the official post-mortem into Silicon Valley Bank, “SVB did not test its capacity to borrow at the discount window in 2022 and did not have appropriate collateral and operational arrangements in place to obtain liquidity.” The FHFA has committed to embark on an education drive but it may not alleviate the stigma the Federal Reserve’s discount window carries which emerges partially because it is used so infrequently.

3. Chinese borrowers default in record numbers as economic crisis deepens – Sun Yu

Defaults by Chinese borrowers have surged to a record high since the outbreak of the coronavirus pandemic, highlighting the depth of the country’s economic downturn and the obstacles to a full recovery.

A total of 8.54mn people, most of them between the ages of 18 and 59, are officially blacklisted by authorities after missing payments on everything from home mortgages to business loans, according to local courts.

That figure, equivalent to about 1 per cent of working-age Chinese adults, is up from 5.7mn defaulters in early 2020, as pandemic lockdowns and other restrictions hobbled economic growth and gutted household incomes…

…Under Chinese law, blacklisted defaulters are blocked from a range of economic activities, including purchasing aeroplane tickets and making payments through mobile apps such as Alipay and WeChat Pay, representing a further drag on an economy plagued by a property sector slowdown and lagging consumer confidence. The blacklisting process is triggered after a borrower is sued by creditors, such as banks, and then misses a subsequent payment deadline…

…The personal debt crisis follows a borrowing spree by Chinese consumers. Household debt as a percentage of gross domestic product almost doubled over the past decade to 64 per cent in September, according to the National Institution for Finance and Development, a Beijing-based think-tank.

But mounting financial obligations have become increasingly unmanageable as wage growth has stalled or turned negative in the midst of the economic malaise.

As a growing number of cash-strapped Chinese consumers have struggled to make ends meet, many have stopped paying their bills. More Chinese residents are also struggling for work: youth unemployment hit a record 21.3 per cent in June, prompting authorities to stop reporting the data…

…China Merchants Bank said this month that bad loans from credit card payments that were 90 days overdue had increased 26 per cent in 2022 from the year before. China Index Academy, a Shanghai-based consultancy, reported 584,000 foreclosures in China in the first nine months of 2023, up almost a third from a year earlier.

Life for blacklisted borrowers can be difficult as they navigate dozens of state-imposed restrictions. Defaulters and their families are barred from government jobs, and they can even be prohibited from using toll roads.

4. The Fed Matters Less Than You Think – Ben Carlson

The Federal Reserve plays an important role in our economy and the functioning of the credit markets. But investors give the Fed far too much credit and blame for how things shake out in the financial markets.

The Fed does control ultra short interest rates by setting the Fed Funds Rate but they don’t control the long end of the curve…

…The 10 year went from a low of 3.3% in the spring then shot up to 5% this fall for no apparent reason whatsoever. Since then yields have fallen back to 4.2% in a hurry. That’s not the Fed; that’s the market.

A lot of people want to blame the Fed for allowing inflation to get out of control following the pandemic. I do agree the Fed should have acted sooner.

But would it have mattered as much as people think?

Just look at the path of inflation readings across other developed economies:

All of these countries had different fiscal and monetary policy responses to the Covid outbreak. And yet inflation rates all went up at the same time and fell at the same time…

…Obviously, the increased consumer demand that came about because of the fiscal policy response played a huge role in these supply chain problems. Inflation came about from supply problems that coincided with pent-up consumer demand.

But that wasn’t the Fed’s doing. The government was trying to keep the economy afloat while corporations were preparing for armageddon.

The Fed’s low interest rate policies don’t control the stock market either. Rates matter but they’re not the be-all-end-all.

Yes, rising interest rates were one of the reasons for the bear market in 2022. Going from 0% to 5% in such a short period of time certainly changed the dynamic in the markets. But that doesn’t mean the stock market only goes up when interest rates are low.

That’s silly talk.

The Fed raised rates 375 basis points last year and the stock market sold off. But the Fed raised rates another 150 basis points and has shrunk the size of its balance sheet in 2023. The Nasdaq 100 is up almost 50% on the year. The S&P 500 has risen 20%…

…I know everyone wants to say the only reason we had a bull market in the 2010s is because of the Fed but isn’t it possible stocks went up a lot because they crashed 60% during the Great Financial Crisis?

And if low interest rates are the sole reason stocks go up, why didn’t we see massive bull markets in European and Japanese stocks in the 2010s as well? Their rates were even lower than ours…

…The Fed doesn’t matter as much as you might think when it comes to something as big and complex as the $27 trillion U.S. economy or the $50 trillion U.S. stock market.

5. Not all growth is created equal – Thomas Chua

Business growth is often celebrated. Yet, not all growth is good for shareholders.

Tom Murphy, the former chief executive of Capital Cities, once summed up this approach with a metaphor: “The goal is not to have the longest train, but to arrive at the train station first using the least fuel.” here, the train symbolises a company’s size, while the fuel represents the capital required to grow…

…Buffett’s test is based on a simple idea: A company should only retain earnings if they can create at least a dollar of market value for every dollar retained. This criterion ensures that the money kept by the company works as hard as, or harder than, it would in shareholders’ hands.

Suppose you own a 10 per cent risk-free bond with an unusual feature: Each year, you are given the option to either take the 10 per cent coupon in cash or reinvest it in more 10 per cent bonds.

Assuming that you do not need the money, your decision to take the coupon in cash or reinvest it should be based on one factor – what is the latest interest rates offered by these risk-free bonds today?

If the prevailing rate falls to 5 per cent, then reinvesting into your existing 10 per cent bonds is the better move because this 10 per cent interest rate is more than what the market currently offers.

However, if the prevailing rate rises to 15 per cent, then you would not want to reinvest in the 10 per cent bond. Instead, you should take your coupons and invest them in new bonds with a 15 percent interest rate.

This bond analogy applies to a company’s earnings too. If the profits can be reinvested at higher returns than the shareholders could earn themselves, then the earnings should be retained…

…Increasing shareholder value is not just about growth, but also about judicious capital allocation. The Starbucks and Teledyne case studies are a reminder that growth is not an end in itself, but rather a means to an end – with the desired result of the creation of shareholder value.

We should always scrutinise management’s capital allocation decisions, applying Buffett’s one-dollar test: Are they creating at least a dollar of market value for every dollar retained?…

…In the absence of good reinvestment opportunities, shareholders are better off if management simply returns excess capital via dividends or share buybacks.

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

There’s a gap in the investing world that I think all investors should beware. It’s a gap that can be a mile (or kilometre – depending on which measurement system you prefer) wide. It’s the gap between a favourable macroeconomic trend and a company’s stock price movement.

Suppose you could go back in time to 31 January 2006, when gold was trading at US$569 per ounce. You have an accurate crystal ball and you know the price of gold would more than triple to reach US$1,900 per ounce over the next five years. Would you have wanted to invest in Newmont Corporation, one of the largest gold producing companies in the world, on 31 January 2006? If you said yes, you would have made a small loss on your Newmont investment, according to O’Higgins Asset Management. 

Newmont’s experience of having its stock price not perform well even in the face of a highly favourable macroeconomic trend (the tripling in the price of gold) is not an isolated incident. It can be seen even in an entire country’s stock market.

China’s GDP (gross domestic product) grew by an astonishing 13.3% annually from US$427 billion in 1992 to US$18 trillion in 2022. But a dollar invested in the MSCI China Index – a collection of large and mid-sized companies in the country – in late-1992 would have still been roughly a dollar as of October 2022, as shown in Figure 1. Put another way, Chinese stocks stayed flat for 30 years despite a massive macroeconomic tailwind (the 13.3% annualised growth in GDP). 

Figure 1; Source: Duncan Lamont

Why have the stock prices of Newmont and Chinese companies behaved the way they did? I think the reason can be traced to some sage wisdom that the great Peter Lynch once shared in a 1994 lecture (link leads to a video; see the 14:20 min mark):

“This is very magic: it’s a very magic number, easy to remember. Coca-cola is earning 30 times per share what they did 32 years ago; the stock has gone up 30 fold. Bethlehem Steel is earning less than they did 30 years ago – the stock is half its price 30 years ago.”

It turns out that Newmont’s net income attributable to shareholders was US$1.15 billion in 2006; in 2011, it was US$972 million, a noticeable decline. As for China’s stocks, Figure 2 below shows that the earnings per share of the MSCI China Index was basically flat from 1995 to 2021.

Figure 2; Source: Eugene Ng

There can be a massive gap between a favourable macroeconomic trend and a company’s stock price movement. The gap exists because there can be a huge difference between a company’s business performance and the trend – and what ultimately matters to a company’s stock price, is its business performance. Always mind the gap when you’re thinking about investing in a company simply because it’s enjoying some favourable macroeconomic trend. 

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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 currently have no vested interest in any companies mentioned. Holdings are subject to change at any time.

Constellation Software is a company with an incredible long-term track record. Its founder and CEO, Mark Leonard, writes in his shareholder letters that a company should not hoard capital unnecessarily.

I completely agree. Money that a company cannot effectively invest should be returned to shareholders as soon as possible. 

Capital hoarding dilutes returns

Here is an illustration of why capital hoarding dilutes returns.

Let’s say there are two companies: Company A and Company B. They will each generate $1 in free cash flow per share per year for 10 years before they cease operating. The difference is that Company A returns all its annual free cash flow to shareholders each year while Company B hoards its cash. Company B also earns negligible interest, and only returns all of the cash to shareholders in one go at the end of 10 years.

With the above as a backdrop, Company A’s shareholders will receive $1 each year as dividends. On the other hand, Company B’s shareholders will receive $10 as a dividend once, in the 10th year. While the total amount that is eventually returned to both sets of shareholders is $10, shareholders of Company A will be much wealthier after 10 years.

This is because shareholders of Company A can invest the dividends earned each year. A shareholder of Company A who is able to invest the dividends at 10% per year, will end up with $15.90 per share after 10 years if all the dividends are invested.

How this impacts the valuation

In the scenario above, investors should be willing to pay more for Company A’s shares. 

We can calculate the values of the shares of Company A and Company B using a discounted cash flow model to get the present value of the stream of cash flows that will be returned to shareholders.

Using a 10% discount rate, Company A’s shares have a present value of $6.76 per share. Company B’s shares on the other hand, have a value of just $4.24. This makes sense as Company A’s shareholders will end year 10 with $15.90 per share, while Company B shareholders will end year 10 with just $10 per share.

As you can see, two identical companies that generate the exact same cash flow can have significant differences in their value simply due to whether the company is maximising shareholder returns by returning cash to shareholders appropriately.

Real-life impact

Unfortunately, in the real world, I notice many companies that hoard cash unnecessarily. This is especially rampant in the Singapore stock market, where many companies are controlled by wealthy families who may not have minority shareholder interests at heart. These companies hoard cash and pay only a minimal amount of dividends each year, which ends up not maximising shareholder value.

But that’s not the most destructive thing. Spending the cash on investments that destroy shareholder value is even more damaging to shareholders. Some examples of poor capital spending include buying back overpriced shares, making poor acquisitions, buying lousy assets, or diversifying into poor businesses.

Bottom line

Proper capital management can have a massive impact on the value of a company’s shares. When building valuation frameworks, investors often assume that the cash generated each year will be returned to shareholders in that same year. But that’s not usually the case. Some companies may keep the capital and invest it well, thereby creating more value for shareholders. But some may hoard the cash or make poor investments. 

We have to keep this in mind when thinking about how much we should pay for a company’s shares.

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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 do not have a vested interest in any companies mentioned. Holdings are subject to change at any time.

This morning, I gave a presentation for iFAST Global Markets’ Virtual Symposium – Strategies to Build Wealth During the Bear Market event. I would like to thank the iFAST Global Markets team, in particular Ko Yang Zhi, for their invitation. The title of my presentation is the same as the title of this article you’re reading. You can check out the slide deck for my presentation by hitting this orange button:

You can also find my speech, along with the accompanying slides, below!

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Presentation

[Slide 2] Hi everyone, I’m Ser Jing. I launched Compounder Fund, a global equities investment fund, July 2020 together with my friend Jeremy Chia. The both of us also run an investment blog called The Good Investors, with the URL (www.thegoodinvestors.sg). Prior to Compounder Fund and the blog, I was with The Motley Fool Singapore from Jan 2013 – Oct 2019. For those of you who may not know, The Motley Fool Singapore was an investment website and we specialised in selling investment research online.

[Slide 2] During this presentation, I’ll be sharing myths regarding the stock market that I commonly read or hear about. These myths are dangerous if they’re not debunked because they can harm your long-term investing returns by influencing your investing behaviour in negative ways. During the presentation, I’ll need your participation. There will be a few questions I’ll be asking, and I need your help to answer them. I’ll be covering nine myths in all, and there will be some time for a Q&A at the end. With each myth that I debunk – with factual data – I’ll also discuss a key lesson that we can learn from each of them. 

[Slide 3] Before I dive into the presentation, nothing I say should be taken to be investment advice or a recommendation to act on any security or investment product. I may also have a vested interest in the stocks mentioned during this presentation

[Slide 4] Let’s start with the first myth. Imagine that you’re now back in 1992 and you found a country that had a GDP (gross domestic product) of US$427 billion. You also have a perfect crystal ball that’s telling you that this country’s GDP would go on to compound by 13.7% per year till 2021, ending the year with US$17.7 trillion in GDP. Take a second to think if you would want to invest in the stock market of this country in 1992? Note that these are all real figures.

[Slide 5] The country I’m talking about here is China and if you said yes to my question, a dollar that you had invested in the MSCI China Index – a collection of large and mid-sized companies in the country – in late-1992 would have become roughly… a dollar by October this year. You heard that correctly: Chinese stocks have been flat for 30 years despite a 13.7% annualised growth in GDP over the same period. The reason is because stocks ultimately go up if their underlying businesses do well.

[Slide 6] And in the case of China, you can see that the earnings per share of the MSCI China Index was basically flat from 1995 to 2021.

[Slide 7] So the first myth I want to debunk is that a country’s stock market will definitely do well if its economy is growing robustly. And the lesson here is that the gap between a favourable macroeconomic event and the movement of stock prices can be a mile wide. 

[Slide 8] Now for the second myth. Let’s go back in time again, this time to September 2005 – in case you’re wondering, we’ll be doing quite a bit of time travelling in today’s presentation. You’re in September 2005 now and you can see that gold is worth A$620 per ounce. The perfect crystal ball you had in Myth 1 is now telling you that the price of gold would climb by 10% per year to A$1,550 in September 2015. The golden question facing you now in September 2005 is this: Do you want to invest in Australian gold mining stocks for the next 10 years?

[Slide 9] If you said yes, you would be sitting on a loss of more than 30%. The S&P / ASX All Ordinaries Gold index, an index of gold-mining stocks in Australia’s stock market, fell by 4% annually from 3,372 points in September 2005 to 2,245 in September 2015.

[Slide 10] So the second myth is this: You should definitely invest in a commodity-producer’s stock if you’re sure that the price of the commodity will rise. The lesson here is the same as the first myth’s: The gap between a favourable macroeconomic event and the movement of stock prices can be a mile wide. In that mile are things like the quality of the business, the capability of the management team, the balance sheet strength of the company, and so on.

[Slide 11] Moving on to the third myth, I need your help to choose between two groups of real-life US-listed companies that you would prefer to invest in if you could go back in time to 2010.

[Slide 12] The first group comprises Company A, Company B, and Company C. This chart shows their stock prices from the start of 2010 to the end of 2021 – Company A is the purple line, Company B is orange, and Company C is blue. More specifically, the chart shows the percentage declines from a recent high that each company’s stock price had experienced in that timeframe. The chart looks brutally rough for all three companies. Their stock prices declined by 20% or more on multiple occasions from 2010 to 2021. In fact, Company B’s stock price had fallen by 40% from a recent high on four separate occasions, and Company C even suffered an 80% drop in 2011. Moreover, their stock prices were much more volatile than the S&P 500; the S&P 500 is a major stock market index in the USA and it experienced a decline of 20% or more from a recent high just once in early 2020. 

[Slide 13] The second group of companies are Company D, Company, E, and Company F. This table illustrates their stock prices and revenue growth from the start of 2010 to the end of 2021, along with the S&P 500’s gain. The second group has generated tremendous wealth for their investors, far in excess of the S&P 500’s return, because of years of rapid business growth.

[Slide 14] This chart is a pictorial representation of the stock price gains that Company D, Company E, Company F, and the S&P 500 have produced.So take a second to think about which group you would like to invest in. As a quick recap: The first group had experienced severe volatility in their stock prices in the 2010-to-2021 time frame, often falling by huge percentages.

[Slide 15] I’m guessing that most of you would prefer to invest in the second group. But here’s what’s interesting: Both groups refer to the same companies! Company A and Company D are Amazon; B and E are MercadoLibre, and C and F are Netflix. Amazon and Netflix are likely to be familiar to all of you watching this, but MercadoLibre is not – it is an e-commerce and digital payments giant that focuses on Latin America.

[Slide 16] The third myth is that great long-term winners in the stock market will make you feel comfortable on their way up. But this myth couldn’t be further from the truth. Even the market’s best winners will make you feel like throwing up as they climb over time and there are two lessons here: (1) Volatility in the stock market is a feature and not an anomaly, and (2) The route to huge gains in the stock market will feel like a sickening roller-coaster.

[Slide 17] We’re now at the fourth myth, and it relates to something interesting about the stock price returns and business growth of Amazon, MercadoLibre, and Netflix. This table shows the revenue growth and stock price movement for all three companies in each year from 2010 to 2021. You will notice that the trio have each: (1) exhibited excellent revenue growth in each year for the period; (2) underperformed the S&P 500 in a few calendar years, sometimes significantly; and (3) seen their stock prices and business move in completely opposite directions in some years. But yet, all three of them have produced excellent business growth with matching stock price returns, as I discussed in Myth 3.

[Slide 18] The experience of Amazon, MercadoLibre, and Netflix are not isolated examples. In fact, Nobel-prize-winning economist Robert Shiller once 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 should have rationally performed if investors had perfect knowledge on the future changes in its dividends. The result is the chart you’re looking at now. 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. The legendary investor Ben Graham has a beautiful analogy for the stock market, that it is a voting machine in the short run but a weighing machine in the long run. Plenty of shorter-term voting had taken place in the US stock market over the course of history. But importantly, the weighing scale did function beautifully. From 1871 to 1979, historical data on US stocks maintained by Shiller show that the S&P 500’s dividend and price had increased by 2,073% and 2,328%, respectively. 

[Slide 19] So the fourth myth is this: If a stock’s underlying business does well every year, the stock’s price will also do well each year. In fact, and this is the lesson: A company’s stock price can exhibit stomach-churning short-term volatility even when its underlying business is performing well, but in the long run, business fundamentals and stock prices do match up nicely.

[Slide 20] We’re at the fifth myth now, and I need your help to quickly think about this question: We’re now at the start of the year 1990 – how do you think the US stock market will fare over the next five years and the next 30 years, if I tell you that all three of the following will happen during the year: In July, the USA will enter a recession and a month later, the country will fight in a war in the Middle East and the price of oil will spike?

[Slide 21] Turns out, the S&P 500 was up by nearly 80% from the start of 1990 to the end of 1995, including dividends and after inflation. 

[Slide 22] From the start of 1990 to the end of 2019, US stocks were up by nearly 800%.

[Slide 23] What’s also fascinating is that the world saw multiple crises in every single year from 1990 to 2019, as the table here illustrates. Yet, the S&P 500 had steadily marched higher in that period.

[Slide 24] The myth here is that stocks can only do well during peaceful times. But the truth – and the lesson – is that uncertainty is always around, and disasters are always happening, but that does not mean we should not invest as stocks can still do well even in the face of trouble.

[Slide 25] For Myth No. 6, let’s consider the importance that some of the best investors in the world place in trying to predict the short-term movement of stock prices. We can use Peter Lynch and Warren Buffett as examples. But first, I’ll quickly run through why the both of them are widely considered to be investing greats. 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 with outstanding businesses. Over the same period, the S&P 500 compounded at less than 10% annually. 

[Slide 26] So how do Lynch and Buffett incorporate short-term predictions on the stock market in their investing process? They don’t. In an old interview with PBS, Lynch said: “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.”

[Slide 27] Then there’s Buffett, who 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.”

[Slide 28] Myth No.6 is something I hear often, and that is that great stock market investors know exactly what’s going to happen to stock prices in the next month or year ahead. But as I’ve discussed, even the best in the business have no clue what stocks would do in the short run, and yet that did not prevent them from clocking incredible long-term returns. So the lesson here is that 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. 

[Slide 29] The seventh myth involves stocks and recessions. What do you think will happen if you have perfect clairvoyance and are able to tell when the US economy will enter and exit a recession and thus sell stocks just before a recession hits and buy them back just before a recession ends?

[Slide 30] If you had this clairvoyance from 1980 to 2018, you would wish you did not have the special ability. According to research from Michael Batnick, a dollar invested in US stocks at the start of 1980 would be worth north of $78 around the end of 2018 if you had simply held the stocks and did nothing. This is the black line in the chart. But if you invested the same dollar in US stocks at the start of 1980 and expertly side-stepped the ensuing recessions to perfection, you would have less than $32 at the same endpoint. This is the red line.

[Slide 31] The seventh myth is that it is important for stock market investors to side-step recessions. But the data shows us an important 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.

[Slide 32] Moving to Myth No. 8, when we’re in an economic downturn, I think it’s natural to assume that it’s safer to invest when the coast is clear. But the reality is that the stock market tends to recover before good news about the economy arrives. For example, if we go back to the most recent recession in the USA prior to COVID, that would be the recession that lasted from December 2007 to June 2009. In that episode, the S&P 500 reached a trough in March 2009 of around 680 points. Back then, the unemployment rate in the country was around 8%. But by the time the unemployment rate reached  a peak in late 2009 at 10%, the S&P 500 was already around 50% higher than where it was in March 2009 and it has never looked back.

[Slide 33] So the myth here is that we should only invest when the coast is clear. But as the data shows – and to borrow a Warren Buffett quote I mentioned earlier, “if you wait for the robins, spring will be over.”

[Slide 34] And last but not least, we’re at Myth No.9, where it’s about interest rates and stocks. 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. And falling valuations for stocks would then lead to falling stock prices. But the real relationship between interest rates and stocks is nowhere near as clean as what’s described in theory.

[Slide 35] Ben Carlson’s research has shown that the S&P 500 climbed by 21% annually from 1954 to 1964 even when the yield on 3-month Treasury bills (a good proxy for the Fed Funds rate, which is the key interest rate set by the USA’s central bank, the Federal Reserve) surged from around 1.2% to 4.4% in the same period. In the 1960s, the yield on the 3-month Treasury bill doubled from just over 4% to 8%, but US stocks still rose by 7.7% per year. And then in the 1970s, rates climbed from 8% to 12% and the S&P 500 still produced an annual return of nearly 6%.

[Slide 36] Meanwhile, data from Robert Shiller show that the US 10-year Treasury yield was 2.3% at the start of 1950. The yield reached a peak of 15.3% in September 1981. 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 increased slightly despite the huge jump in interest rates.

[Slide 37] 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 were temporarily inflated, as can be seen by the trend for the index’s earnings per share in preceding and subsequent five-year periods.

[Slide 38] Then we have this chart, which illustrates the historical relationship that the S&P 500’s price-to-earnings (P/E) ratio has had with 10-year Treasury yields. It turns out that 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%.

[Slide 39] The ninth myth is this: Rising interest rates are definitely bad for stock valuations and thus stock prices. But what the evidence shows is that stock valuations and prices have risen over time even when interest rates have soared. So there are two important lessons here: (1) While interest rates have a role to play in the movement of stocks, it is far from the only thing that matters; (2) one-factor analysis in finance – “if A happens, then B will occur” – should be largely avoided because clear-cut relationships are rarely seen.

[Slide 40] I’ve come to the end of my presentation today and I’m happy to take questions!

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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 currently have a vested interest in Amazon, MercadoLibre, and Netflix shares mentioned. Holdings are subject to change at any time.

Acquisitions often pose an analytical challenge for investors.

Should the fee be considered an operating expense, capital expense, or another sort of expense? What if part or all of the acquisition was financed using stock? How will the company’s financial standing be impacted? Is the acquisition fee too expensive? These are just some of the questions that shareholders need to answer.

The intricacies of each acquisition make analysing them a headache for investors. However, by breaking an acquisition assessment into parts, we can form a systematic approach to cover all angles.

Here is a short primer on the things to look out for in acquisitions.

Accounting for cash outlay

Free cash flow is often calculated as operating cash flow less capitalised expenses. On the cash flow statement, capitalised expenses are the purchase of property, plant, and equipment and other capitalised expenses such as capitalised software costs. 

Acquisitions do not fall into these categories and investors may sometimes exclude cash outlays from acquisitions from the calculation of annual free cash flow.

I believe the right way to account for the acquisition fee is by deducting it as a capital expenditure. This is because when acquiring another company, you are effectively buying over the company’s assets such as customers, technology, infrastructure, and talent.

If you were to build all of this from the ground up, you would have to spend money buying properties, acquiring talent, and on marketing to acquire customers etc. These costs would be counted as either current expenses or capitalised expenses. Acquiring a company should, therefore, be given a similar treatment.

Let’s take Adobe’s acquisition of Figma as an example.

Adobe announced last month that it would be buying Figma for US$20 billion at face value. US$10 billion of that is in cash, and the rest is in a fixed number of Adobe shares (at the time the deal was announced, the shares were worth US$10 billion). The $10 billion in cash is coming out of Adobe’s balance sheet and will have a very real impact on the cash on hand and the amount of cash that the company will be able to return to shareholders via buybacks or dividends.

As such, we need to account for it as capital expenses that reduce the company’s free cash flow. In the last twelve months, Adobe generated US$7 billion in free cash flow. If we deduct US$10 billion (the cash outlay for the acquisition of Figma), we see that Adobe has an adjusted free cash flow of negative US$3 billion.

But given that it is a one-off expense, does this mean anything? A resounding, yes.

When I assess free cash flow, I’m not scrutinising free cash flow over a single year. I’m examining the average free cash flow generated over multiple years. The acquisition cash outlay pulls down the long-term free cash flow average for Adobe, but it also paints a more complete picture of the cash flow that can be distributed to shareholders over time.

Consider dilution when looking at stock-based financing, instead of the current dollar amount

Many deals nowadays include some element of stock-based financing. Stock-based financing is a little bit more tricky to analyse than cash as stock prices can fluctuate.

Depending on the price of the stock, the dollar amount of stock that was used to finance the deal could be higher or lower. The Adobe-Figma deal is a good example. As mentioned earlier, the value of Adobe shares being offered to Figma shareholders was worth US$10 billion when the deal was revealed to the public. Today, with the steep fall in Adobe’s stock price, the value of those shares has declined by more than 20% to around US$7.7 billion.

Instead of worrying about the dollar value of the stock-based financing, I prefer to look at the number of shares that are being issued.

In the Adobe-Figma deal, Figma shareholders will receive about 27 million shares. In addition, employees and executives at Figma will receive an additional 6 million Adobe shares that will vest over the next four years. As of 23 September 2022, Adobe had 465 million shares outstanding. The Figma acquisition will increase the share count by 30 million, which represents dilution of around 6%.

In other words, all of Adobe’s future free cash flows will need to be shared with this new batch of shareholders, which will reduce Adobe’s cash flows per share by 6%. 

This is the real cost of stock-based financing.

Is the acquirer overstretching its finances?

Now that we know the true cost of the acquisition, the next thing we need to consider is whether the acquirer has sufficient cash to finance the deal.

Ideally, the acquirer needs to have either cash on hand or sufficient cash flow generation ability to ensure that any debt incurred can be easily repaid.

Let’s take a look at the Adobe-Figma deal again.

Adobe ended its latest fiscal quarter with US$5.8 billion in cash and US$4.1 billion in debt. To fund the US$10 billion cash outlay for the Figma deal, Adobe would have to use some of its cash on hand and borrow at least US$5 billion. Whatever the ratio of debt to cash on hand used, the $10 billion cash outlay will leave Adobe with net debt of US$8.3 billion. 

Although this is a historically high debt load for Adobe, I don’t see it as much of an issue. As mentioned earlier, Adobe generated US$7 billion in free cash flow in the last 12 months. If it can generate similar amounts of cash after the deal, it will be able to easily repay some or even most of the debt within a year, should management decide to.

Analysing the target company

Another important aspect of the deal is the quality of the company being acquired. Assessing the quality of a target company can be done in two parts. First, does the target possess a quality business?

As with assessing any company, we need to study aspects such as the quality of management, historical growth, ability to innovate etc. 

Again, I will use the Adobe-Figma acquisition as an example. Figma strikes me as a solid and innovative business. Its annual recurring revenue is growing sharply and its product seems well-loved by customers. Other elements of Figma look good too, such as its product-release cadence, and management capability and innovativeness. For example: Figma was launched in 2012 as the world’s first design tool purpose-built for the web, and it has a net-dollar retention rate of more than 150%.

Second, will the combined entity work well together?

In the Adobe-Figma deal, it does seem that many possible integrations could happen when the two companies combine. Scott Belsky, Adobe’s Chief Product Officer, recently spoke at-length about the synergies he sees between the two companies’ products. Acquiring Figma will also be a good way for Adobe to tap into a different type of user base.

Another element of the deal that is often overlooked is the effect of removing a competitor. In the Adobe-Figma deal, Adobe is effectively removing a growing competitor.

Does the price match the value?

Now that we have identified both the cost and the benefits of the deal, we can then assess if the price matches the value gained from the acquisition. This requires an estimation of the net cash flow generated from the acquisition.

In the Adobe-Figma deal, we need to estimate the net future cash flow benefit from the deal. We then compare these cash flows with the cash flows that were given up, which includes the US$10 billion cash outlay and the 6% dilution. You can find an example of a financial model here.

Final Thoughts

Given the many intricacies of a deal, acquisitions can be tricky for investors to assess. Presentation slides offered by a company’s management will inevitably present a compelling case for an acquisition. But some acquisitions may not turn out to be positive for shareholders of the acquirers. As such, shareholders need to do their due diligence when assessing an acquisition.

With stock prices of many companies falling sharply in recent months, and some companies still generating healthy amounts of free cash flow even in this downturn, we could potentially see more deals being struck in the near future.

If you are a shareholder of a company making an acquisition, try to look at the deal from the perspective of how it will impact the cash flows paid to you by your company over the long term. This is the bedrock of all analysis and should be the foundation to build your assessment.

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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. Of all the companies mentioned, I currently have a vested interest in Adobe. Holdings are subject to change at any time.