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Buy Right And Hold On Or Buy Low Sell High?

Buy low sell high, duh! Everyone knows that that is the way to make money in the stock market. You buy something for less than what it is worth and attempt to sell it at a higher price in the future. Yet, many investors have taken this saying out of context, creating this misguided notion that they have to frequently buy and sell in order to make a profit. They thus end up trading, attempting to make a quick profit. Perhaps the tendency to do so is innate. We all know that dips and corrections are part and parcel of the markets but it remains something that is psychologically challenging to endure. However, studies after studies have shown that the money is in holding on.

The logic behind buying right and holding on is so simple that many belittle it. When you invest in a great business capable of generating greater than average return on investment for many years, time is on your side. Simply holding on will allow your investment to compound.

I recently read “100-to-1 in the stock market” by Thomas W. Phelps and “100 baggers” by Christopher Mayer, two books analysing 100 baggers. A 100 bagger is a stock that has appreciated a 100-fold. Thus, a $10,000 investment will turn into a million dollars. My initial reaction is that stocks like this must be few and far between. I was proven wrong.

In “100-to-1 in the stock market”, Thomas W. Phelps found that starting from 1932, a different stock could have been bought in each of thirty-two different years and every dollar invested would have grown to $100 or more by 1971. In fact, from 1932 to 1964, more than 365 different securities appreciated a 100-fold or more in four to forty years.

At this point, I was of the opinion that technology has advanced by leaps and bounds since then and there is not much left to invent or innovate. Thus, such monstrous growth enjoyed by companies of the past is unlikely to repeat itself.

I was proven wrong once again, and happily so. In his book “100 Baggers”, Christopher Mayer again found more than 365 different 100 baggers from 1962 through 2014. The important lesson to draw here is not that we missed another 365 opportunities. Instead, it is that as long as humans remain humans, the world will keep changing. Consumer trends will constantly evolve, leading to new unmet demand which require new inventions and innovations, creating the next generation of 100 baggers.

Additionally, both books detailed 100 baggers in a wide variety of industries, not just in emerging sectors such as technology, internet and biotech but also in “boring” and “old-school” industries such as consumer businesses. While it may be hard to fathom that there are that many future 100 baggers, history has shown that they are out there, waiting to be found.

If you are convinced that there are many future 100 baggers out there waiting to be discovered by those who seek them, here are a few qualities of 100 baggers to aid you in your search.

1. Growth, growth and more growth

There is no way around it. For the share price of a company to appreciate a 100 fold, it’s earnings has to increase tremendously. So, you need growth – and lots of it. But not just any growth. You want quality, value-adding growth. You want to avoid companies that doubles it’s earnings but also doubles the total shares outstanding. In other words, focus on earnings per share instead of raw earnings. At the same time, beware of companies that increase sales by cutting prices or acquiring companies for inflated prices. Both of these drive down return on equity – the company is investing more and getting back less. These are kind of growth you want to avoid. Focus on companies that has lots of room to expand and reinvest its earning. Such companies will be able to compound earnings over an extremely long period of time. These qualities will show up in the balance sheet as high organic growth (growth without acquisition) and high return on investment.

2. Lower multiples and smaller companies preferred

Growth is only one part of the equation. The other half of the DNA of a 100 bagger is a huge increase in earnings multiple. For instance, if price-to-earnings (PE) ratio remains the same, earnings will have to increase a 100 fold in order for the company to be a 100 bagger. However, if PE ratio quadruples, earnings only need to increase 25 fold. Now that is a much more achievable feat. Together, lots of growth and a low multiple forms the twin engine of 100 baggers.

Along a similar note, smaller companies are preferred. Big tech do have decent growth rates but do you think they are able to grow to a 100 times? Probably not. Apple, as great as it has been and is, won’t become a 100 bagger from current levels. At a 100 times of today’s value, Apple’s market cap will be more than 12 times the size of the US economy. It could be a good stock for some time yet, but eventually, the law of large numbers start to work against you. That being said, you don’t have to go looking at penny stocks. Mayer found that the median sales figure of the 365 names in his study was about $170 million. As a rule of thumb, he recommends focusing on companies with market caps of less than $1 billion.

The caveat here is that while lower multiples and smaller market cap are preferred, they are by no means a prerequisite. There are certainly many great businesses that have higher multiples (and justifiably so). This does not make them poor investments. On the flip side, there are many companies with low multiples because they are declining. Beware of these value traps. Similarly, there are many great companies with market caps above $1 billion that have the DNA of a multi-bagger. The point I am trying to make here is that nothing is cast in stone. Always make your own judgement.

3. Economic moats are a necessity

100 baggers are requires a high return on capital for a long time. A moat will keep competitors at bay, allowing the company to compound it’s earnings at above average rates for a long time. Without moats, competitors will steal away market share, driving return on investment down. Thus, extraordinary growth rates without moats are simply unsustainable. A company with a great product but no barriers to entry may be able to return double or even triple one’s investment. However, they will rarely return much more than that. It thus pays to spend some time thinking about whether the company in question possess economic moats. A moat, no matter how narrow, is a necessity.

4. Owner-operators preferred

Although not a necessity, it does help to have a owner call the shots as well. A CEO with some skin in the game will have his/her interest aligned with yours. What’s good for them is good for you, and vice versa. You can thus have greater conviction that they won’t take actions that allow them to gain at your expense. You can figure out how much stake the executives of a company has in it’s proxy report. I recommend that you spend additional time to do some research on whether the shares that the executive owns are mainly options given to them or common stock that they have purchased. The common wisdom is that options will align the interest of the management team with that of the shareholders. I won’t dive into details, but fixed price options with a long expiration date have the potential to distort the management’s interest. It is best if management own commons stock, and even better if they have to fork out their own money to buy them. That being said, there are many 100 baggers that are not owner led. Having an owner-operator is just an added benefit that gives you conviction to hold on through thick and thin.

Of course, finding a 100 bagger is easier said than done. However, even if I do not find a 100 bagger, I am optimistic that this search will turn up some decent multi-baggers, making the effort more than worthwhile. Nonetheless, 100 bagger or not, the most crucial step in the search for multi-baggers is to hold on.

“To make money in stocks you must have the vision to see them, the courage to buy them and the patience to hold them. Patience is the rarest of the three.”

Thomas Phelps

There is no use in buying right if one does not hold on.

Posted on by CTKS

Inflation, Interest Rates and Time Value of Money

Given the recent jitters in the markets driven by inflation data, talks about tapering and rising interest rates, I thought I’d write an article discussing the issue at hand. Don’t get me wrong, I have previously shared about the futility of attempting to predict macroeconomic trends and my view has not changed. However, it is still important to understand these fundamental concepts and what they mean for investors.

Inflation

Inflation in layman terms is an increase in prices. This phenomenon is caused by an imbalance between supply and demand. As the pandemic threatened to force the global economic machine to a grinding halt in 2020, governments around the world rushed to prop up demand by flooding the markets with liquidity. However, the production of goods could not keep up with surging demand, driving prices up.

In other words, inflation results from efforts to get something for nothing. If the governments gave away money by taking away an equal amount through taxation, no inflation would result as the balance between supply and demand would be unchanged.

Consensus amongst most economist seems to be that a low and stable inflation is desirable for economic growth while deflation and persistently high inflation are both detrimental to economic growth.

Interest

Interest is the price of time. It measures the cost of having or doing now what we hope to be able to pay for later. Anything bought with borrowed money will cost more than buying with cash upfront. The difference is the price of time. This is true whether the borrower is an individual, a company, a city or country.

The buyer of time takes on an obligation to return the borrowed money and pay for the right to use the money now. In other words, debt.

There is nothing inherently good or bad about debt and interest. Debt is a merely a tool. Whether it is beneficial or detrimental depends on how one uses it. Many people have been ruined by debt. Many others have made their fortunes with borrowed money. The difference is whether the time borrowed is used profitably so that it is worth it.

Time value of money

This is a concept that is central to investing. Simply put, a dollar today is worth more than a dollar tomorrow. This is true for the following reasons

  1. Inflation means that a dollar can buy more today than the same dollar can tomorrow
  2. The ability to invest means that you may incur a opportunity cost
  3. The risk of not being paid back as the entity that owes you money may go bankrupt means that you would want to be paid as soon as possible

These three factors have similar effects. The promise of being paid $1,000 ten years later is worth less than $1,000 today. In fact, you will likely accept $800 if you believe that you are able to get a fair rate of return by investing your money elsewhere.

When we invest, we are forgoing spending that sum of money today. In order for this to be worthwhile, we must receive the same amount of money in face value plus some as compensation for the erosion of purchasing power, opportunity cost and the risk that we are undertaking.

Tying it all together

The relationship between interest rates and inflation is as such.

Nominal interest rates = Inflation + Real interest rates

The higher the rate of inflation the greater the cost of buying time – in other words, the higher the interest rate.

One of the greatest delusions is that the government can keep interest rates low while continuing to inflate the money supply. Sounds awfully familiar? This delusion stems from the widespread belief that the FED controls interest rates. In reality, the FED does not dictate interest rates as they are merely one of the factors that influence interest rates.

Looking at the divergence between inflation and interest rates today, it is only a matter of time before both converge.

However, the million dollar question isn’t “when will interest rates rise?” or “is hyperinflation coming?” No one has the answers to these questions. Instead, investors should all ask this question: “what type of businesses do well regardless of inflation?”

Traditional wisdom says that businesses with the greatest tangible assets will do well during times of inflation. This sounds intuitive but there is actually one type of business that does even better during periods of high inflation.

During periods of high inflation, the capital light business will do much better. The winning formula is intangibles of lasting value with relatively minor requirements for tangible assets. All things equal, the less capital intensive business will do better than asset-heavy businesses in the face of inflation.

By intangible assets, I am not referring the intangible assets and goodwill stated on their balance sheets that are likely not worth anything close to their stated value. When I refer to intangible assets, I mean economic goodwill in the form of competitive advantages that are difficult to quantify. This exists in various forms such as pervasive reputation with consumers based on past experiences with products and personnel (Amazon), brand name (Apple, Coke), being the low cost provider (Costco), network effect (Facebook) and many more.

Why do these companies do better than others during inflationary periods?

It goes without saying that when we invest, we want our investments to grow in real terms (ie be able to purchase more goods and services). This is done by achieving a rate of return in excess of inflation. And the best way to do so is to invest in businesses that are able to raise prices easily without investments in a lot of assets. Companies with these two qualities are able to earn returns far in excess of inflation (think about the companies mentioned above).

Note that throughout the entire article I give no thought to what the FED is going to do, whether inflation is here to stay or what interest rates will be tomorrow. It’s not that these are unimportant. They do influence the markets but they are simply unpredictable. Investors will do much better if they focus their efforts on things that they can control, such as picking excellent companies.

Posted on by CTKS

Two Things I Wish I Knew Before I Started Investing

It has been slightly more than a year since I started investing which so happens to coincide with an unprecedented period in the stock market. However, this makes for an excellent environment to learn. In what can be considered a short span of time in the grand scheme of things, I have truly learnt a lot. So much that I can’t possibly articulate all my thoughts in a single post. In order to avoid boring you to death, I will keep it short and share two key lessons I have learnt over the past year that have brought about paradigm shifts in the way I invest.

1. The stock market is forward looking

Throughout 2020 all the way till the start of 2021, there was widespread skepticism that arose from the seemingly disconnect between the stock market and the macroeconomic numbers. How can the stock market continue to go up every single day when unemployment claims in the United States climb into the tens of millions and consumer confidence hovers around historic lows? Many, including me, were questioning whether the markets are adequately reflecting the potential for long term damage to earnings and cash flows due to the Covid-19 pandemic induced crisis.

A look at the correlation between % changes in Real GDP and US Stocks in the past 60 years can shed some light on the situation.

The graph looks like someone’s heartbeat but pay attention to the table. Note that the correlation between the stock market and real GDP in the same quarter is slightly negative. This implies that the markets do not reflect what the economy is doing today. At first glance, this seems absurd. Our intuition tells us that since the stock market depends on the earnings of the businesses and the very same businesses are the basis of the economy, real GDP and the stock market should be correlated.

However, if we consider that it is investors’ expectations that drive the stock market, things start to fall in place. When we take a look at the correlation between what the market does today and what the economy does in the following quarters, we start to see a significant positive correlation. In other words, the stock market does not reflect what the economy is doing in this time period. Instead, it tries to predict what the economy will do in the future, although rather noisily.

What I mean by noise here is that the stock market forecasts future economic growth imperfectly. If the stock market does its forecasting job extremely well, we will expect the correlation to be close to 1 (maybe 0.9, for example). However, the correlation is in fact only about 0.26. The market is doing its job of forecasting but makes a lot of mistakes. There is an old saying on wall street, that the stock market has predicted nine out of the last five recessions. Take a moment to read that sentence again. The stock market occasionally predicts recessions that never occur. These dips brought about by excessive pessimism creates buying opportunities for investors.

There are two implications of this. First, there is no use worrying about what is happening to the economy today. Since the market is a forecasting machine, today’s news has already been priced in. We should be focusing on what lies ahead of us. We need to shoot where the rabbit is going to be, not where the rabbit was. This sounds like common sense yet investors frequently do just the opposite. We must pay attention to what the market is expecting of a company and exercise independent thought to make projections of what we believe will be possible. For companies with valuations that cannot be justified by an average growth rate, the market is in effect predicting higher than average growth. What we should focus on then is whether the company is likely to beat expectations, just meet expectations or even fall short. While high growth rates are important, it is not the silver bullet to finding a great investment. What matters more is whether the company can exceed expectations.

Second, the market as a whole can be surprisingly accurate at predicting what happens next. Ever since the Covid-19 induced crash in March 2020, the stock market has been on a steady climb. The market was forecasting that vaccines can be rolled out in record time and economies will recover much faster than expected. On the other hand in November 2020, every expert was saying that there’s no chance the vaccine can be developed so quickly and there is no chance that the economy will recover that quickly. Guess who was proven to be more correct as 2021 unfolded?

Stock market: 1, Experts: 0.

This shows the value in staying the course and ignoring the noise, a reassurance for passive investors. However, this is not to say that the markets are always right. As mentioned above, it is an imperfect forecasting machine and there are times when unjustified fear causes a stock market crash. This merely creates more buying opportunities. Again, a boon for investors with a long horizon.

2. Focus on quality, not how cheap the stock is

When I first started investing, I was a bargain hunter. I was constantly looking the cheapest companies. I searched for companies with the lowest PE ratio and PB ratio.

The logic is simple. Often, stocks trading at huge discounts do so due to unwarranted reasons. When the clouds clear and investors realise that the future of the company is much brighter than they had previously thought, the stock price starts to ascend. However, I learnt the hard way that not all companies selling at low prices are good investments. Sometimes, their low prices are justified by deteriorating fundamentals such as increased competition, erosion of economic moats and a multitude of other reasons. For instance, I had invested in Perdoceo Education Corporation (PRDO), a company providing higher education. I found it cheap at the time as it was spotting extremely low PE and PB ratios. However, I failed to take into account the underlying economics of the business. The education industry was extremely competitive and PRDO was not an industry leader. Neither did it have strong economic moats, nor was there any reason to believe that things were going to be more upbeat for PRDO moving forward. I bought the stock at USD$13.40 and sold it at USD$11.86 for a 11.5% loss. Since then, the stock has gone sideways and is now sitting at $11.78.

At about the same time that I first invested in PRDO, Apple and Facebook (now Meta), two other companies I was considering, were trading at USD$130 and USD$260. I did not invest in either because I felt that they were selling at fair value and was not cheap enough. If I had invested in these wonderful companies then I would be sitting on a very comfortable gain of 30-35% today. This brings to mind a quote from Warren Buffet, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

This remains one of my biggest investing mistakes so far and it reminds me that the greatest mistakes we make are often one of omission, not commission.

PRDO could very well witness a jump in its share price if more people find that its stock is trading too cheaply as it did when its share price hit a bottom of USD$9.65. However, without improving fundamentals, PRDO will not see huge growth in earnings in the future, and shareholders are unlikely to enjoy high returns in excess of the market average. On the other hand, companies with strong and improving fundamentals will enjoy strong growth in revenue and earnings, generating market beating returns for shareholders. In the long run, this is the way to attain returns worth many times that of the invested capital.

Needless to say that my portfolio today looks quite different from a year ago. As someone who claims to be a long term investor, I am disappointed in myself as well. However, it is a testament to how my strategy has changed over the past year. Now, instead of searching for the cheapest stocks, I look for underappreciated business with strong fundamentals and excellent long term prospects. This businesses need not be ridiculously cheap, they just need to be selling with an adequate margin of safety. Is this strategy better? Only time will tell…

If you are interested in other mistakes I have made, check out this article!