Archives for posts with tag: investment philosophy
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The answer is simple — who knows?

And frankly, unless you work at CNBC, Bloomberg or the local paper, it’s not your job to find an answer. Despite what the media says that it’s Trump’s fault for starting a trade war, or it’s because of machines doing the trading that caused the fall, the point is that those are all conjecture.

No one really knows why the markets crashed on Wednesday and Thursday.

If it was Trump, then why did the markets wait till the 10th and 11th of October? Trade wars have been a feature of Trump’s presidency since he took office. If trade wars were the factor, then why did markets still go up before coming down?

Ditto for machines or any other reasons that the media provides.

The Good News

The good news is that investing in the market doesn’t take the IQ of a Nobel prize winner to do well. What it takes is a good sense of when we have value emerging in the markets.

Typically, value emerges in the emerge when prices go down. After all, the same burger from McDonald’s is the same burger whether it’s priced at $2 or $4. Value emerges at $2 because you get the same product that you might have otherwise paid $4 for in normal times.

Of course, the markets aren’t as simple as buying burgers. You have to question if the burger remains the same? Unscrupulous operators may reduce the size of the patty or cut back on the sauce. That’s precisely what could happen even if a stock gets cheaper. Maybe the stock is cheaper due to fundamental reasons. i.e. The company’s business is taking a turn for the worse.

Being able to see value means being able to see if the company’s fortunes are taking a temporary hit or a permanent hit. Or being able to see if the drop in price is much more severe than the downturn in the fortune of the business. This takes experience and a lot of study.

Proceed with Caution

Before anyone gets too excited, I’m not saying that markets couldn’t go down further. Heck, in Singapore, we haven’t even reached the commonly-held definition of a bear market which is 20% down from the most recent peak. In the U.S., markets aren’t even 10% down.

But what I’m saying is that if the current downtrend continues for a few more weeks, it will provide a buying opportunity that could rival some of the best times to buy.

Unfortunately, for that to happen, we’ll see some more pain for investors.

In part 1, I detailed the most important takeaways from ‘The Intelligent Investor‘ (although in my haste, I left out the idea of Margin of Safety). In this part, I want to show you the parallels between the act of buying the book and investing.

This is essentially the second reason why I asked my younger brother to buy the book. I wanted to see what his thought and action process was like.

Reason 2: Buying stocks from a value perspective is pretty much like buying anything else

intelligent-investor-benjamin-graham

#1: Hardcover or Softcover?

Now, there are various ways to think about the difference but let’s take a look at the first factor that comes to mind — price.

Hardcover books are more expensive than softcover books although the first print comes out earlier than the softcover. In the past, I used to automatically buy the softcover version of the book since I figured that I was getting the same content for a cheaper price.

As the years have passed, I’ve come to realise that hardcover version of the book lasts much longer than the softcopy version of the book. Sadly, my own copy of ‘The Intelligent Investor’ is an example of this.

For things that you genuinely treasure, it never makes sense to consider only the price of the stock. In investing, the parallel to this would be buying stocks just by looking at price. Some people who buy stocks actually think that a stock that costs $10 is a more expensive stock that cost $1.*

The other parallel is to remember that sometimes, cheap stuff is cheap for a reason. Just like the book, a stock that sells for pennies (aptly called “penny stocks”) could reflect the actual fundamentals of the company.

#2: Borrowing before buying

Although I recommended that my brother buy the book, one other thing he could have done is go to the library to borrow the book first. You may say that he trusted me, as his brother and someone who knows a thing or two about the markets and therefore didn’t have to check the book out first.

However, borrowing the book is a smart thing to do if you want to know whether it’s worth spending your money on. In investing, this is akin to fundamental analysis where a would-be investor investigates the earnings, assets and cashflows of the firm in order to know what price to pay for the stock.

This could also be a good step before you decide whether it’s worth buying the hardcopy or just the softcopy, or whether the book is even worth buying at all.

Conclusion

In short, most people know exactly what to do when they buy a product. They check out the reviews, they compare the specifications between one product and another and they also compare where they can buy the good for the best price as well as other factors like delivery and any warranties from the manufacturer.

It’s strange that many people don’t do this when it comes to investing. They don’t compare the returns from one investment to another, whether those investments are guaranteed or the guarantee is merely a probability. They buy high for fear of missing out and sell low for fear of losing everything. Swayed by fluctuations in price, they hold investments for ever shorter periods of time.

It’s just weird.

Investment should be like buying anything else. Thinking of it as such will make you a better investor.

 

Notes:

In case you’re wondering, paying $1 or $10 for a stock doesn’t matter. What matters is how much you pay relative to the earnings per share.

Some weeks back, my younger brother wanted to learn about investing. I thought about it long and hard for quite a few weeks and eventually, I told him to go and buy this book – The Intelligent Investor by Benjamin Graham, the version with annotations by Jason Zweig.

intelligent-investor-benjamin-graham

Don’t call yourself an investor if you haven’t even read this

Who is Ben Graham?

Benjamin Graham is more famously known as Warren Buffett’s professor and former boss. Graham, together with Dodd, wrote the classic textbook, Security Analysis. Essentially, Graham is the godfather of Value Investing.

Graham biggest contribution was to popularise the idea that buying stocks should be a function of what you get relative to what you pay for. What you pay for is the price but what you get is a share of the profits and assets of the business. In essence, Graham popularised the use of the P/E (price-to-earnings) ratio and, together with Dodd, suggested normalising earnings before comparing with price, which is basically what Shiller’s Cyclically Adjusted Price to Earnings (CAPE) ratio is.

Anyway, I told my brother to buy the book for two reasons and this post is essentially for him.

 

Reason 1: It’s the right way to think about Investing

I don’t mean to offend anyone from what I’ve seen, too many people approach business and investing the wrong way. They learn wrong ideas and end up doing stupid things until they either realise it too late or never at all.

Many people think that investing is all about buying low and selling high and they fail to understand what it really means to buy a stock. From ‘The Intelligent Investor’, there are three important lessons to learn.

#1: Price is what you pay, Value is what you get

Buying a stock means buying a share of the business which is why stocks are also known as ‘equities’ which basically translates into ownership. The essence of Graham, which is at the core of what Buffett and other Value Investors believe, is that an owner of the business cares about the assets of the business and what earnings or cashflows those assets can bring the owner.

Now, the majority of “investors” in Singapore only care about price. They know how much they bought a share of Singtel for. And they know how much they can sell one share of Singtel in the market right now. Why? Because the price is the simplest piece of information to find.

Better investors can cite the earnings, cashflows or dividends that the business can bring in each year. But imagine you’re a business owner. Will those metrics be enough? You’d probably want to know other things: How your competitors are doing? What do customers think of the product? What are the largest components of the cost of production?

The first important lesson from Graham is that being a stockholder means being an owner of the business. If you only buy the stock based on its price and the hope that the price will go higher than the price that you paid for it, that’s speculation. And Graham made it quite clear in the book that therein lies the difference between investing and speculation.

The trick is knowing which activity you’re engaging in.

#2: Price and Value can, and will diverge

The second important idea from Graham is that the stock market is driven by emotion, short-termism, and irrational behaviour. He personified the market as a fellow called Mr. Market who quotes you prices on the stocks each business day.

As Buffett understood, the advantage investors have is that an investor can afford to ignore Mr. Market and take advantage of his over-pessimism or over-optimism. On days where Mr. Market believes that the world is going to end, he ends up quoting prices that are so low that it’s benefit to buy. On days where he thinks markets will keep going up forever, he’ll quote prices that are so high that the business will never be able to provide a decent rate of return for investors*.

#3: Price and Value will converge (eventually)

Of course, for Value Investing to work out, prices and value must converge. In other words, buying at prices that are low relative to value lead to good returns because the market will eventually recognise that the company is worth much more than the current price and therefore bid prices back up to what the company is actually worth.

The problem with this is that this recognition can take time. For example, prices of financial stocks remained fairly depressed following the Global Financial Crisis of ’08-09 and it was only until last year (2017) that bank stocks finally started to gain some favour again.

This is why the great economist, John Maynard Keynes, who was a pretty successful investor as well, said that the markets can remain irrational longer than you can remain solvent. This is why many investors caution against the use of excess leverage. For the majority of retail investors, leverage is something to be VERY careful of. If you choose to proceed, do so with caution.

On the other hand, prices tend to come down fast. So if you’ve bought at a very high price relative to value, don’t expect to hang on to your gains for long. Once again, taking on leverage by shorting the market is also not for the faint-hearted. There are many Value Investors who short Growth and have paid a high price for it. When you short, being early is (almost) the same as being wrong.**

I wanted to do this in one post but it’s gone on for a little too long. In the second part, I’ll show you the parallel between buying “The Intelligent Investor” and investing.

Notes:

*The classic example of knowing how ridiculous the market was when a dot-com CEO told his shareholders that given the company’s share price at the time, he would need to return them 10 years worth of revenues in order for them to just break even. I thought it was Cisco but I can’t seem to find a source for this. Cisco’s price to sales went as high as 37 though.

**For those interested in finance, go watch ‘The Big Short’. It’s accessible and the heroes in the show almost lost everything by being early.

I’m only a dad to my cat but my own father showed me the extent a dad would go to for his children. The best (and probably, worse) habits I developed came from observing what my dad would do and I wouldn’t have it any other way.

To all dads, Happy Father’s Day!

Now, here’s two light, but important, reads to keep you busy:

 

WHY THE BEST THINGS IN LIFE ARE ALL BACKWARDS (Mark Manson)

As I tell my students sometimes, “Common sense isn’t so common.”

There are things in life that are counter-intuitive and if you often fall prey to things that require counter-intuition, then perhaps the best solution is to read widely and make a list of situations that defy common sense.

Mark Manson’s post is particularly instructive on how certain situations require us to do less, NOT more, in order to achieve our desired outcome. Unfortunately, it’s a lesson that even the best and brightest often fail to understand.

Do yourself a favour and understand it.

Sometimes, less is more.

 

Your Risk Tolerance Is An Illusion: Wait Until You Start Losing Big Money (Financial Samurai)

It’s easy to say that you’ll remain invested even when things go south or to understand that most people can’t time the market, or that you’ll start investing in a big way when markets are down 30%.

But until you actually experience a downturn in the markets, you won’t know what you’ll actually do. I know, because I’ve also felt this way in ’08-09, 2012, and more recently, in 2015-2016.

I don’t know when or how deep the next downturn will be. All I know is I have a better process for the next time.

The post on Financial Samurai should give you some inspiration to start thinking about how you might behave during the next downturn. With that, you can start thinking about your investment process.

brown eggs on brown wooden bowl on beige knit textile

Should you have more baskets to store your eggs? Is more always better?

You’ve probably heard the saying “Don’t put all your eggs in one basket”. The wisdom goes that at least if you drop the basket, you won’t have to worry about losing all your eggs.

In the investing world, the same logic can apply. Having a portfolio of many stocks means that if one company fails, bringing the value of its stock down with it, an investor’s portfolio should not be affected to a large degree. In the finance literature, this is known as eliminating non-systemic risk.

In general, portfolios with 10 or more stocks reduce the amount of volatility dramatically relative to the market and once the portfolio reaches 30 or more stocks, volatility is reduced to barely above a percentage point. (see here)

Unfortunately, there are a few problems with just having a larger number of stocks in your portfolio.

 

Industry-specific Risk

It doesn’t matter if you have many stocks if they all belong to the same industry and that industry is currently in the midst of a cyclical decline or the various players in the industry were all engaged in unsavoury practices.

In 2008-2009, the financial industry was hit by the downturn in the U.S. housing market. This led to credit being frozen in the banking sector and once the dominoes fell, even the better-capitalised banks felt some pain.

More recently, many Singapore-listed firms in the oil & gas sector were also hit when oil prices fell from over a hundred US dollars to a low of 30 US dollars. The bigger players such as Keppel Corp and SembCorp saw their share prices fall to multi-year lows and haven’t recovered much despite oil prices climbing up to about 70 US dollars.

Smaller companies that provided services to the offshore gas industry suddenly found demand for their services dry up and those that were up to their eyeballs in debt have been in serious trouble for some years now.

In short, having a large number of stocks doesn’t matter if a large number of them all depend on the same economic factors for profit.

 

Geographic or Location Risk

The same goes for companies that all depend on a certain location for profit. It’s also well-known that investors tend to have a home-bias. This means that investors tend to put a huge chunk of their portfolio in their home country.

If the country has a huge domestic economy and many of the companies are dependent on that country for business, then when the economy goes south, the fortunes of those companies will all be affected.

Similarly for the stock market, having all your stocks in a single market could mean terrible returns. from 1999-2009, investors in the S&P 500 would have made less than 0% returns p.a. This is the “lost decade” that many investment books talk about.

What those books neglect to mention is that the “lost decade” happened for the S&P 500. Other asset classes within the U.S., as well as markets outside the U.S., fared much better. For example, the MSCI EM Emerging Markets (Net) Index returned 9.78% in annual total returns for the same period.

 

Where Conventional Diversification Fails

So, if you diversified across a number of stocks, industries, and markets, you should be fine right?

Not so fast.

Research has shown that when a crisis hits, many asset classes that seem uncorrelated start seeing their correlations move to one:

But it has been well documented that correlations tend to increase in down markets, especially during crashes (i.e., “left-tail events”). Studies have shown this effect to be pervasive for a large variety of financial assets, including individual stocks, country equity markets, global equity industries, hedge funds, currencies, and international bond markets.

To make matters worse, research also finds that:

Not only did correlations increase on the downside, but they also significantly decreased on the upside. This asymmetry is the opposite of what investors want. Indeed, who wants diversification on the upside? Upside unification (or antidiversification) would be preferable. During good times, we should seek to reduce the return drag from diversifiers.

In other words, different asset classes may move out of step in bull markets while they all seem to move in the same direction when the bear bites. This results in diversification that causes a drag on returns in bull markets while offering little protection from the bear.

However, the article also finds that the two asset classes that are useful for diversification are a mix of Stocks and Bonds. Specifically, the study used Treasuries in the bond mix which suggests that Treasuries go up when Stocks go down due to a flight to safety.

 

Main Takeaways

The main lessons from this are to be aware that while diversification is necessary within the asset class, we don’t want to add too many asset classes to the mix thinking that that will be the solution to preventing the entire portfolio from tanking at the same time. The bigger lesson would be to have a sense of whether valuations are rich or cheap as well as to rebalance the portfolio towards the optimal mix.

Alternatively, you can take Andrew Carnegie’s advice to “put all eggs in one basket and watch that basket” but I wouldn’t recommend it; It’s too much work. Furthermore, it’s hubris to think that you are better than many of the people who analyse companies for a living. This may work for investors like Warren Buffett* but unless you think that you’re that good, you should spread your investments.

Just don’t spread them too thin.

 

Notes:

*Actually, even Warren Buffett had his share of mistakes like Dexter’s Shoes so imagine if all he owned was that shoe company.

So bitcoin has blasted off to more than 15,000 USD. At one point it almost hit 20,000 USD but quickly fell back to around 16,000 USD where it stands today. The ride so far has been really volatile; Major papers were talking about bitcoin as a mania when the prices were around 7,500 USD and then prices took off even more from there.

The question I have is: how many people will actually become permanently more well off due to the rise in bitcoin prices? Given fact that only about 1,000 people own 40% of all bitcoin so far (source here), that seems like a paltry number of the total people who have bought some bitcoin.

So here’s what I think.

Many people bought too few bitcoins

A core group of bitcoin buyers who were early probably bought too little too early. So even if they were in the game as an investor (I’m leaving out the miners for now), they probably saw this as nothing more than a novelty and probably have nothing more than $10,000 invested. Some may even only have a few hundred and the majority probably have a few thousand invested. This is true especially for younger people who don’t have much moolah, to begin with.

So let’s take the middle and saw that most of them have $5,000 in bitcoin and that they got in somewhere at the beginning of the year. To make things easy, let’s say that they bought it at a $1,000 per bitcoin. As it stands, these people have turned their $5,000 into $75,000. That’s a great return and no small sum but in the great scheme of life, that’s not life-changing. Even $10,000 turning into $150,000 is fantastic but once again, that’s not the kind of money one retires on. That kind of money is just a nice bonus for the year which people will probably spend on holidays, a nice meal, or a new toy (e.g. car, yacht etc.)*

How many cashed out along the way?

And the above is assuming no one cashed out along the way. Someone who bought at $1,000 would have been extremely tempted to cash out way before the prices hit $15,000. We see this is stock markets all the time where people buy a stock at 10 and cash out way before the stock even hits 20. So I’m willing to bet that a good majority of people who bought at $1,000 might have even cashed out at $2,000 or $3,000.

They would have then experienced serious sellers’ regret as they price continued to climb and maybe they would have got in again at $5,000. Thing is, they probably got out again at $7,000 or $8,000. Want to guess what price they recently got in again at?

The point is, guessing how much returns someone made by comparing prices now and at the beginning of the year is quite futile as most buyers probably never hung on long enough to enjoy the full run-up. And for all you know, they ploughed ever greater sums at much higher prices based on the early success of their trade.

How many are ready to handle their new found wealth?

Even for those who were in bitcoin from the early days and have held on until know, how many of them are now facing the agonising decision of whether to continue holding the coin or divesting?

You have to remember that the swings in bitcoin prices will make some people very nervous. Imagine having 10,000 bitcoins and seeing your wealth change by $30,000,000 in a matter of hours when the price of bitcoin increased to 19,000 USD and then fell to close at 16,000 USD.

And how many of these newly made multi-millionaires are ready to deal with this amount of money? We have to remember that there have been many others like them in the form of lottery winners, NFL players and NBA stars who suddenly came into wealth and then saw they wealth all evaporate in just a few months or years.

Tough choices to make

Many people in the investing community are looking really dumb right now for saying that bitcoin is a bubble and that it’ll burst or that the price cannot go any higher (I actually think it can) but that’s always the case before the bubble has burst.

But if you’re holding on to bitcoin, you have tough choices to make:

  • Do I cash out now and gain some utility from spending my gains?
  • Do I hold? Just in case bitcoin prices go up further?
  • Should I go back in/ go in now in case I miss the boat?

I wouldn’t want to be in bitcoin given the current environment.

Notes:

*Which is good for businesses.

So, this story turned up on my Facebook feed this morning and I thought it’s an excellent example of how life sometimes requires struggle before you see the reward. The story is about how the Philadephia 76ers basketball team is starting to see the results of a strategy that was started some years back. The strategy consisted of being deliberately bad for a few years in order to get better players that would be around for the longer haul. Unfortunately, the owners of the team couldn’t wait long enough to see the results and forced the general manager in charge of the strategy out. I’m not an expert on basketball and there might have been a less painful way to turn a team around but the one thing you can’t argue is that the strategy didn’t work because going by the 76ers current record, things are certainly much better than before.

What I think is important is that the above also applies to many areas of life. Some months back I read Paulo Coelho’s The Alchemist for the first time and the book tells a simple tale of never giving up and having faith in the journey that you have to take in order to reach your dreams. While the story doesn’t reflect the complexities of real life, the struggles that the character goes through for practically the entire tale does provide a cautionary tale for anyone who dreams of success- that the path to success is often filled with numerous false starts and it is a long and arduous journey not for the faint of heart.

Since humans develop habits by the way of a cue, routine and feedback, savings money is a pretty easy thing to do. Money that comes in from a paycheck (the cue) can be channeled to an account used for investing (the routine) and as you see that amount get bigger, you feel a sense of satisfaction (the feedback which is positive).

However, things can screw up when it comes to investing. After putting money into a carefully selected invested, the value of the investment could decrease. This leads to the investor questioning his or her ability when it may be no fault of theirs if markets tank in general. It may also not be of concern if the stock tanks in the short term due to unnecessary pessimism. The bigger question is, will the investor be able to stomach a decline in value of their holdings?

This is where I think it’s absolutely necessary to have an investment process which should be able to do a few things. One, it should help an investor enter or exit the market during periods of extreme valuation. Two, it should help investors select securities (equities or bonds) which have a more than fair chance of surviving in the long-run. Three, results should be evaluated over a period of at least 3-5 years and certainly not just over a year or two.

Having said that, sometimes we also need a little faith that we’re doing the right thing. Trust the process.