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Year-In-Review 2022

Regrettably, it’s been a long while since I’ve written an article. Initially due to NS and subsequently because I had to hit the ground running at my internship. Now that I’m starting to get used to the intensity (hopefully), I am looking to get back into writing because I enjoy sharing what I have learnt and have also found it to be beneficial in terms of helping me collect my thoughts. In fact, this year I am hoping to write more broadly about things I’ve observed/read and learnt that may be useful to you guys. For now, since it’s the start of the year, I thought I’d take the opportunity to do a review and layout my plan for the year ahead money-wise.

Disclaimer! Nothing written in this article should be construed as investment advice.

Where are we headed in 2023?

As I am not a seer, I won’t try to predict where the markets are headed, but I will lay out some facts. From its trough in October 2022, the S&P500 has rebounded by 12%. This rally suggests that investors are optimistic that the worst is behind us – that inflation has peaked and that would prod the Fed to cut interest rates later this year, even as Fed officials insisted that it was too early to think about shifting policy.

However, recent macro economic data seems to suggest otherwise. U.S. job growth accelerated at the start of the year as employers added a robust 517,000 jobs, well above the 2019 pre-pandemic average of 163,000. This pushed the unemployment rate to a 53-year low of 3.4%, raising doubts on whether inflation is under control.

When I first saw these numbers, I couldn’t wrap my head around it. During the same period, big tech companies were announcing massive layoff every other day. How could all the huge layoffs and the talk of recession be reconciled with the strong macro economic data? I did some research and it turns out that these tech companies account for only 2% of the American workforce. The hiring is happening in a much bigger part of the economy, the service sector, which includes all kinds of businesses – everything from restaurants and hotels, to dry cleaners and hospitals. The employees in those sectors account for about 36% of all private sector payrolls.

So while I don’t know where the markets are headed, I would be cautious of declaring that inflation has peaked and I wouldn’t rule out the possibility of the Fed keeping interest rates higher for longer.

Portfolio Review

Since the start of 2022 until today, my portfolio has suffered from a decline of ~9%, slightly better than the S&P500, which is down more than 16%. While a significant portion of my portfolio is in the index, the decline was partially offset by the relatively strong performance of my Singapore investments.

Still, this is nothing to be satisfied with as it is now plain as day that it was much better to hold cash throughout 2022. However, hindsight is 20/20 so I try not to harp on it too much. The bright side is that because I deploy my capital in tranches instead of in a lump sum, I still have dry powder to take advantage of the correction that is still playing out.

After a review, I don’t see any deterioration in the fundamentals of my portfolio companies that warrants selling any of them. As I genuinely don’t know where the markets will be tomorrow, one month or six months from now, I am happy to hold what I already have in my portfolio and continue dollar cost averaging as the year progresses.

Note: This only includes my invested capital and does not include cash

Plan for 2023

As of now, I have no plans to divest any of my holdings and intend to continually invest more throughout the year, no different than what I have been doing last year. I do however, plan to make minor tweaks in allocation as I add to my portfolio.

Broad-based ETFs tracking the S&P500 and the world index will continue to form the foundation of my portfolio and I will continue to DCA throughout the year, maintaining my allocation to ETFs.

One thing that will be different for me this year is that I will be less active in looking for individual businesses to invest in, simply due to limited time and capacity. That being said, I will still continue to monitor those that are already on my watchlist. One of which, I will share more on below.

At the time of writing, I find REITs to be priced at a very attractive level with some of the well established REITs boasting 5-6% yields. The somewhat depressed prices could be attributed to the high interest rates, which translates to increased cost of borrowing for REITs. However, I believe that well-managed REITs with comfortable gearing ratio, high proportion of fixed interest debt and high interest coverage ratio will have no issues delivering satisfactory returns to shareholders. On top of that, REITs remain my only viable mean for exposure to real estate at the moment and their steady dividends can provide stability to my portfolio if markets make a turn for the worse. Thus, I have taken the opportunity to increase my exposure to REITs in the first two months of 2023 and will likely continue to add to my position if prices become even more attractive.

Finally, T-bills remain a good place to park short term cash, with the latest issue yielding 3.9%. As I’ve mentioned on my telegram channel multiple times, I have been adding to my T-bills position throughout 2022. However, they are more of a short term investment and I hope to recycle the capital into equities and REITs should prices become more attractive in the later part of this year.

Biggest Mistake of 2022

No doubt, I have made many mistakes in 2022. None, however, is as costly as this one of omission. In mid 2022, I had my eye on LVMH, and conducted due diligence on the business and its various brands. Even without owning any of their products, I appreciated the ubiquity of their brands and how they are synonymous with wealth and status. The brilliance of Bernard Arnault has also been something I have read about and admired for quite some time. The world’s largest fashion house thus checks all the right boxes. Ultimately, I chose to hold off on buying any LVMH shares because the market levels looked frothy.

Fast forward to today, the share price has increased by more than 40% while my portfolio has slumped along with the markets and I still don’t own a single LVMH share, so I am literally slapping myself for that mistake.

At today’s prices, I am calling it over-priced, so check back in a year to see whether I am right about that… Nonetheless, LVMH is one of the companies that I will be watching closely this year.

I must admit, it’s great to be writing again and I really hope the stuff I share is beneficial to you guys. In view of my commitments, I am looking to publish less often but dive into greater detail each time and hopefully provide greater value in each article. I already have a couple of exciting ideas, so stay tuned!

Posted on by CTKS

Economic Moats – Part 3 of 3

In the previous articles on economic moats, we learnt how companies can create lasting competitive advantages and why it is important to invest in companies that possess these. In this final article of the series, I will be sharing where to find economic moats and other pertinent things to look out for.

Finding Moats

One of the biggest advantages being a retail investor is that we can invest our money wherever we prefer. We are not forced to invest in industry A or industry B so we are free to ignore what we don’t like and buy what we do. This is especially important if we wish to build a portfolio of companies with economic moats because it is a lot easier to dig a moat in some industries than others. Some industries are brutally competitive while others are less competitive and able to sustain solid returns on capital. That’s the reality of life, the economics of some industries naturally support economic moats while others do not.

In technology, software companies tend to have an easier time creating moats than hardware companies. This is not simply an accounting issue but has a strong basis on the way these two broad categories of products are used. A piece of software often needs to be integrated with other pieces of software to work properly, which leads to higher switching costs.

Companies that cater directly to the consumer, like restaurants and retailers, often have a very hard time building competitive advantages. With low switching costs, customers can simply walk down the street with minimal effort required to look for a better deal. People often confuse trend and hype for economic moats. However, investors should be wary because it could very easily be copied or fall out of favour.

On the other hand, companies that provide services to businesses have a much easier time creating economic moats. This is because they are often able to integrate themselves with their clients’ businesses, creating high switching costs and pricing power.

Another thing to note here is that moats are absolute, not relative. The fourth-best company in a structurally attractive industry may very well have a wider moat than the best company in a brutally competitive industry. Hence as intelligent investors, we don’t have to invest in every part of the market. Simply go where the money is.

Measuring a company’s profitability

Now that you know where to look for economic moats, what is the best way to measure a company’s profitability? In order to do so, we have to look at how much profit the company is generating relative to the amount of money investing in the business.

Investing in a company is similar to investing in a mutual fund. A mutual fund takes investors’ money and invests it in stocks or bonds to generate a return, and a mutual fund with a 12 percent return is going to compound shareholders’ wealth faster than a mutual fund with a return of 8 percent. Companies are similar. A business that can generate huge returns relative to the investments made is going to compound money for shareholders much faster than a capital intensive business that generates mediocre returns.

The first method to measure return on capital is using return on assets (ROA). Very broadly speaking, a non financial company that can consistently generate an ROA of 7 percent is likely to have some kind of competitive advantage. However, this metric works well if a company’s balance sheet is purely assets, but many firms are at least partially financed with debt, which give their returns on capital a leverage component that we need to take into account.

The next metric is return on equity (ROE). ROE measures the efficiency that a company uses shareholders’ equity. However, one flaw of ROE is that companies can take on a lot of debt to boost their ROE without becoming more profitable. Thus, it is a good idea to look at ROE alongside how much debt a company has (debt-to-equity ratio). As a rule of thumb, companies that can consistently crank out ROE of 15% without excessive financial leverage is likely to have some form of economic moat.

Finally, there is return on invested capital (ROIC), which is the best of both worlds. It measures the return on all capital invested which includes both equity and debt, thus removing the distortion that debt can have on ROE. As with ROA and ROE, a higher ROIC is preferable to a lower one.

Management and moats

This may sound counter-intuitive but management does not matter as much as we may think when it comes to building economic moats. While we can all remember companies such as Starbucks that managed to dig an economic moat in brutally competitive industries, these are the exceptions rather than the rule. When it comes to whether a company has an economic moat, the competitive dynamics of the industry will have a greater impact than any managerial decisions.

This is not to say that the quality of the management does not matter. Great managers can add value to a business and I’d much rather have intelligent capital allocators at the helm than a bunch of clowns. But the truth of the matter is, management itself is not a sustainable competitive advantage. Managers come and go but companies in a tough industry are stuck there.

The bottom line is that we should bet on the horse, not the jockey. The quality of management matters but far less than economic moats. As Warren Buffet puts it, “When management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”

Eroding Moats

Finding a great company with strong economic moats is not the end of the process. We have to continuously monitor the business performance as there are a number of ways that moats may be eroded.

  1. The first way that a company may lose its competitive advantage is if it loses the technological race to stay on the cutting edge. Most technology companies have a hard time building a lasting competitive advantage because of how fast technology advances. As long as they do not continuously innovate and improve their offerings, a better product will eventually breach their moat.
  2. That being said, technological disruption can pose as a threat to non-tech companies as well and can occur at the most unexpected moments. This is because these companies can look like they have a strong moat before a technological shift permanently hurts their economics. Think about Kodak, which for decades dominated the market for analogue photography, and which today struggles to compete against digital cameras. A similar story can be told for newspapers vs the internet.
  3. Shifts in the structure of industries
    1. Consolidation of a once-fragmented group of customers can also harm economic moats because it increases their bargaining power
    2. Entry of low-cost workforce
    3. Entry of irrational competitor/government-linked entity
  4. Bad growth. This is used to describe company ventures into areas outside of its expertise that are unsuccessful. This inefficiency of capital allocation brings down their return on capital, making the company less attractive as an investment.

These developments will result in increased competition and reduced pricing power. The end result is that the company will have lower profitability and returns on capital. Therefore, one useful sign of moat erosion is when a company that has regularly been able to raise prices starts getting push back from customers.

Competitive analysis of a company

Finally, I would like to leave you with this three step process that Pat Dorsey, a guru on economic moats, uses to determine whether companies have moats. His book, “The Little Book That Builds Wealth” has been a tremendous inspiration for this series and I’d definitely recommend picking it up if you’d like to learn more about economic moats.

  1. We want to look at returns on capital over as long a period of time as possible, as a poor year or two does not disqualify a company from having a moat. If the company has not earned decent returns on capital and the future is not likely to be appreciably different from the past, there is no moat. After all, a competitive advantage should show up in the numbers, and a firm that has not yet demonstrated the ability to earn a greater than average return on capital is a long shot that we shouldn’t bet on.
  2. Step two is trickier and involves identifying a competitive advantage. This is a challenging but crucial step because it is entirely possible that even a company with a record of good returns on capital might not have a moat. In such a case, the company’s profitability can very quickly fall off a cliff if the trends change or competitors copy them. If we didn’t think about why high returns will stay high, we would just be driving by looking in the rearview mirror, which is rare a good idea. Thus, it is necessary to think carefully about what exactly the company’s competitive advantages are and how it will keep competitors at bay. Knowing this will allow us to tell if the firm’s economic moat has been breached.
  3. Once we have identified the competitive advantage that allows the company to generate greater than average returns, we have to figure out how durable that advantage is. Because this is more of a craft than a science, we shouldn’t try to slice things too finely. Pat Dorsey recommends dividing companies into just three categories: wide moat, narrow moat, and no moat.

In this series, I have explained what economic moats are, why they matter and how to identify them. I hope that you will be able to apply these pointers to your investment analysis and that they will help you make wiser investment decisions and become wealthier.

Posted on by CTKS

Economic Moats – Part 2 of 3

In last week’s article we covered the value proposition of economic moats, the four horsemen of false moats and two examples of sustainable competitive advantages. In this article, I will be going through two more economic moats that are extremely hard to breach.

Moat 3: Network Effect

The network effect is by far one of the most sustainable economic moats. It can be found in industries where the value of the good or service increases with the number of people using it. In other words, the most valuable network-based products will be the ones that attract the most users, creating a virtuous cycle that squeezes out smaller networks and increases the size of dominant networks.

By virtue of its characteristic, the network effect is much more common among businesses based on information or knowledge transfer than among business based on physical capital. This is because information is what economist call a “non-rival” good.

Rival goods are goods that can be used by only one person at a time. On the flip side, non-rival goods mean that one additional person using the good does not diminish the amount available to the next person. In today’s information age, there are more and more industries that can potentially build an economic moat using the network effect. Think of social media networks (Facebook, Instagram, Twitter), payment networks (American Express, Visa, Mastercard, Paypal), ecommerce platforms (Amazon, Alibaba, Ebay) and video sharing platforms (Youtube). The greater the number of users of these platforms, the greater the content, convenience and options there are and thus the greater the value provided to all users.

Even financial exchanges benefit from network effects. As more buyers and sellers aggregate on an exchange, there is greater liquidity. The added value to users of the network is that greater liquidity leads to lower spread, which reduces costs. That’s how futures exchanges such as the Chicago Mercantile Exchange (the Merc) and the New York Mercantile Exchange (NYMEX) become so profitable with wide moats.

However, the same cannot be said about stock exchanges which have weaker moats despite having deep pools of liquidity as well. This is evident by falling returns on capital of stock exchanges in recent years as competition has moved in while futures exchanges have maintained very robust profitability. The reason for this is that futures contracts are captive to an individual exchange – if I buy a futures contract on the NYMEX or the Merc, I have to sell it there. This means that liquidity is limited to each futures exchange. Whereas for stocks, liquidity is not limited to any exchange because people can buy on one exchange and sell on another.

The takeaway here is that for a company to benefit from the network effect, it needs to operate a closed network. When networks open up, the network effect can dissipate very quickly.

One way to identify network effects is to do some financial sleuthing to see whether operating income per node (customer/branch) increases as the number of nodes increases. This may be an indication that the value proposition to customers is increasing as the network expands, thus giving the company some pricing power.

Moat 4: Cost Advantages

When it comes to cost advantages, the question is not so much whether the company has cost advantages, but whether competitors are able to replicate it. Some cost advantages can be durable while others can easily be replicated by a competitor. In order to answer this question, we have to dig deep and find out how these cost advantages arise.

Another pertinent point to be said about cost advantages is that it matters more in industries where price is a large portion of the customer’s purchase criteria. The more price sensitive the consumer is with respect to purchasing the good, the greater the value of having a cost advantage is to the company.

Without further ado, let’s talk about the four ways of getting sustainable cost advantages.

1. Process advantages

In theory, process advantages should not exist long enough to constitute much of an economic moat. After all, if a company figures out a way to deliver the same quality for cheaper, competitors are sure to try and replicate it. This does happen but in reality, it takes much longer than one might expect.

Examples of businesses that have dug moats using process advantages are Southwest Airlines and Dell. Southwest did so by flying only one type of jet, minimising expensive ground time and cultivating a thrifty employee culture. Dell cut out distributors, sold direct to buyers and kept inventory very low by building PCs to order.

The real question is not how these companies achieved the cost advantages but why competitors did not just copy them. In the case of airlines, those premium airlines were unwilling to create a culture like Southwest simply because their business is built around treating some passengers like royalty and charging them for the privilege. As for Dell, its competitors were too reliant on the resellers and retailers. In both cases, competitors would literally have to blow up their existing business in order to replicate these processes.

However, fast forward both cases, their moats are significantly weaker today than they were five or 10 years ago. This is because new competitors have entered the industry and replicated these processes. So, process-based moats are worth watching closely because the cost advantages often slips away as competitors either copy the low-cost process or invent one of their own.

2. Advantageous location

These type of cost advantages are more durable than one based on process because locations are much harder to duplicate.

Mentioned in the previous article as well, waste and aggregate produce share a unique quality – low value-to-weight ratio. Thus, it is very uneconomical to transport these goods far away. So, companies with landfills and quarries located closer to their costumers almost invariably have lower costs, which means competitors that are further away will be priced out of the market. Combine this with the fact that nobody wants more landfills and quarries than necessary in their town, both enjoy extremely strong economic moats as localised monopolies. Ironically, these businesses that people often shun make excellent investments!

3. Access to unique, world-class asset

This third type of cost advantage is typically limited to commodity producers. If a company is lucky enough to own a resource deposit with lower extraction costs than any other comparable resource producer, it will likely have a competitive advantage. One interesting example is a company called Compass Minerals, which operates in the rock-salt industry. Due to the geology and the massive size of its mine, Compass is able to produce rock salt at some of the lowest costs on the globe. Coupled with its great location that allows Compass to ship salt into the American Midwest at low cost along rivers and canals, Compass has a pretty durable cost advantage over its competitors. This is an example of how two competitive advantages can come together to create an even stronger economic moat.

Such cost advantages are not limited to companies that dig stuff out of the ground. Aracruz Cellulose, a Brazilian company, is not only the largest producer of paper pulp in the world but also the lowest cost producer. Well, when Eucalyptus trees mature in about seven years in Brazil compared with 10 years in Chile and 20+ years in America, its no wonder that Aracruz is able to produce more pulp with less capital invested than anyone else.

4. Economies of scale

When thinking about cost advantages that stem from scale, remember one thing: The absolute size of a company matters much less than its size relative to rivals. Two massive firms that dominate an industry – Boeing and Airbus for example – are unlikely to have meaningful cost advantages relative to each other.

In order to understand scale advantages, it’s important to remember the difference between fixed and variable costs. Take a local grocery store for example, its fixed costs are rent and salaries for some base level of staffing, The variable costs would be the cost of merchandise and perhaps extra compensation for high traffic times of the year. Contrast this to a real-estate brokerage office. Aside from an office, a phone, a car, and a computer, there are little fixed costs. Very broadly speaking, the higher the level of fixed costs relative to variable costs, the more consolidated an industry tends to be, because the benefits of size are greater.

Cost advantages arising from greater scale can stem from large distribution networks, manufacturing scale and dominating niche markets (it is much better to be a big fish in a small pond than a bigger fish in a bigger pond).

Although manufacturing scale tends to get all of the attention in Economics 101, cost advantages stemming from large distribution networks or dominance of a niche market are just as powerful – and, in an increasingly service-oriented economy, they are more common as well.

Some companies go one step further. By continually passing on cost advantages arising from greater scale in the form of lower prices to customers, they dig a unique moat known as scale economies shared. Lower prices results in more customers and greater spending per customer, resulting in greater scale. As the company repeatedly share the cost savings with customers, a virtuous cycle arises, creating a sustainable economic moat while continually benefitting the consumers as well. This strategy has been successfully employed by retailers such as Costco, Walmart and Amazon. These businesses focus on increasing the value proposition they bring to customers by simultaneously driving prices down and improving the customer experience. Scale begets price reductions which then begets scale. This method of creating a mutually beneficial relationship with customers is truly one of the most sustainable economic moats out there.

In this article, we have learnt that network effects can lead to a very durable economic moat and cost advantages may also be a competitive advantage in price sensitive industries. However, there is no use in knowing the theory of economic moats if we are unable to put the knowledge to use and identify companies with durable competitive advantages. Therefore, in the final article, I will be sharing where to find economic moats and how to identify them. Join my telegram channel here to make sure you don’t miss it!

Posted on by CTKS · 2 Comments

Economic Moats – Part 1 of 3

Like a deep, broad trench that protects medieval castles from invaders, economic moats protect businesses from competitors, allowing them to prosper. In this three part series, I will be sharing why finding economic moats should be central to an investor’s analysis, examples of sustainable moats, where to find them, how to identify them and other intricacies of economic moats.

Why do economic moats matter?

Moats matter for many reasons. First, it allows a company to create more value. As economic moats prevent competitors from stealing their business, companies with strong moats are able to earn greater than average returns on investment and compound money for investors for a longer period of time. In today’s highly unpredictable world, one thing remains certain – businesses will go where the money is. Moats are thus extremely important for highly profitable companies to protect its bottom line.

Placing an emphasis on finding economic moats also enforces investment discipline, making it less likely we will overpay for a hype stock. By forcing ourselves to assess whether a company’s edge is durable, we can prevent ourselves from getting caught in a trap where we invest in a fast growing company whose competitive advantage may disappear overnight.

This brings me to my next point. Investing in companies with economic moats will lower the odds of permanent capital impairment. When a company possesses strong economic moats, it is unlikely that its revenue and earnings will take huge permanent hits due to increased competition. This protects investors from permanent capital loss.

Finally, economic moats help make a company more resilient. As companies launch new growth initiatives, there are bound to be some failures. Even when a new launch completely flops, companies with economic moats are able to fall back on its core business and their ability to generate positive returns will not be severely hindered.

With the points mentioned above, it is safe to say that all things equal, investors should be willing to pay more for a company with an economic moat than one without.

Four commonly mistaken moats

Moats are extremely hard to identify and many investors mis-identify these four characteristics as economic moats. Sad to say, chances are that they will be disappointed as competition increases.

Great products

Great products are very important to win over customers but they are not moats in and by themselves. This is especially so if others can easily copy them.

Strong market share

Bigger is not necessarily better when it comes to digging an economic moat. While there are cases where market share can help build an economic moat, it largely depends on the industry. Kodak (film), IBM (PCs), Netscape (internet browsers), General Motors (automobiles), Corel (word processing software) have shown that market leadership can be fleeting. The question to ask is not “whether a firm has high market share” but rather “how the firm achieved that share”.

Great execution (efficiency)

Being more efficient is an excellent strategy that can help improve profitability by cutting costs. However, unless it is something proprietary that cannot be copied, it is not an economic moat.

Great management

Yes, you don’t want an idiot running the firm but great managers are not economic moats. Managers come and go and as Peter Lynch once said, “go for a business that any idiot can run – because sooner or later, any idiot probably is going to run it.”

Moat 1: Intangible Assets

Brands

Brands are one of the strongest economic moats as they are notoriously hard to replicate. However, a caveat must be said here that popular brands does not necessarily endow it’s owner with a competitive advantage. Brands are only an economic moat if it increases consumers’ willingness to pay or increases customer captivity. For example, Sony is an extremely well known brand but you probably would not spend more on a Sony DVD player than one from Philips, Samsung or Panasonic. On the contrary, many would pay double to get an iPhone compared to other smartphone brands.

The second way brands can create economic moats is by increasing customer captivity. For instance, when you buy a can of coke, you know exactly what you are getting. While The Coca-Cola Company may not able to sell a can of coke for double the price of Pepsi, many people will keep choosing coke over other drinks because of the positive experience associated with the brand.

Patents

While patents can prove to be a very strong economic moat, they have finite life and can be challenged. Furthermore, they are vaguely defined and guessing which team of lawyers will win a patent battle is a game with poor odds. In general, beware of any firm that relies on a small number of patented products for its profits as any challenge may severely harm the company’s profits and will be impossible to foresee.

Patents only constitute a truly sustainable competitive advantage when the firm has a demonstrated track record of innovations as well as a wide variety of patented products. 3M for instance has thousands of patens and hundreds of products.

Otherwise, patents can only serve to give companies a head start to building other more sustainable forms of economic moats.

Regulatory Licenses

This advantage is most potent when a company needs regulatory approval to operate in a market but is not subject to oversight with regards to pricing. Think of utilities versus pharmaceutical companies. Utilities have near monopoly but since water and electricity are basic needs, politicians watch prices like a hawk and it is unlikely that utilities will be able to earn phenomenal returns on equity. Pharmaceutical companies on the other hand, operate in a highly regulated industry but are free to set the prices.

There are two ways to build an economic moat using regulatory licenses, either single licenses or multiple smaller, hard-to-get approvals. The bond rating industry (Moody’s), slot machine industry and for-profit education are all examples of single licenses or approvals. These regulatory licenses are extremely difficult to get, allowing them to earn much greater than average returns on capital. However, this results in an over reliance on that one license. If the government ever chooses to grant more licenses, the profitability of these companies will be severely hindered.

Multiple smaller, hard-to-get approvals thus form deeper and wider economic moats because they are unlikely to all disappear overnight en masse. Common examples would be NIMBY (”not in my backyard”) companies such as waste haulers and aggregate producers – nobody wants a landfill or stone quarry located in their neighbourhood so getting new ones approved is close to impossible. Yet, these markets are highly localised because it is not economical to transport trash hundreds of miles away and trucking aggregates 40 or 50 miles will incur too much cost for producer, pricing them out of the market. This results in a local monopoly.

Contrast this to another industry with strong NIMBY characteristics – refinery. Refined gasoline has a much higher value-to-weight ratio meaning that it can be moved very cheaply via pipelines so distance is not an issue. Thus, this form of economic moat can be found in NIMBY industries that have low value-to-weight ratio (ie transportation costs are high).

Moat 2: Switching Costs

Companies that make it tough to use a competitor’s product or service creates a switching costs. If consumers are less likely to switch, company can charge more, maintaining a high return on capital.

Switching costs come in many flavours and the following is a non exhaustive list:

  • Uncertainty (consumer banks, financial services, asset managers)
  • Highly integrated with a company’s processes (taxation and accounting software, data processers, back-office processing)
  • Retraining costs (Adobe, Autodesk)
  • High upfront costs (healthcare and laboratory equipment)

The issue with finding businesses with high switching costs as an economic moat is that it can be challenging to identify businesses with switching costs unless you use the product yourself as you need to put yourself into the customers’ shoes. Furthermore, consumer-oriented firms generally suffer from low switching costs as you can walk into another clothing store or buy another brand of toothpaste from another grocery store with almost no effort. Businesses marketing consumer goods thus have to compete on economies of scale or brand.

This means that in order to find businesses with high switching costs, investors have to look at other areas such as at the workplace instead of their personal consumption patterns.

So far, we have learnt why economic moats are so valuable, some traps when it comes to identifying economic moats and two forms of sustainable competitive advantage. In the next article, I will be covering another two highly desirable moats that investors should keep an eye out for, stay tuned by joining my telegram channel here!

Posted on by CTKS

Common Stocks and Uncommon Profits

Despite being a classic, “Common Stocks and Uncommon Profits” remains one of the best investment books I have read as it contains many timeless principles on how to profit from the stock market. Here, I will share some of Philip Fisher’s most valuable insight on assessing whether a company is a suitable investment.

Scuttle-buttling

A term coined and popularised by Fisher, scuttle-buttling refers to the act of obtaining information of a company from those who deal with it. This includes competitors, vendors (suppliers), customers, employees, university and government researchers, ex employees and executives of trade associations.

You should note that the executives of the company itself, the very people who should know the company best, are not on that list. And neither is the media. This is because it is often not in the executives’ interest to be completely upfront about everything regarding their business. Additionally, the press does a rather poor job reporting what truly matters.

Social butterflies will thus be overjoyed to learn that their broad network can give them invaluable insight into businesses that the general public do not have access to. Others, on the other hand, will find that they may not have such connections and in most situations, they may even have none.

Thankfully, scuttle-buttling is not the be-all and end-all when assessing a company. It is merely one of the methods investors can utilise to obtain surprisingly accurate information. Occasionally, the opportunity to utilise this technique will arise and investors should know what kinds of questions to ask.

15 points to look for in a company

1. Does the company have products or services with sufficient market potential to make possible a sizeable increase in sales for at least several years

This is a point that is repeated time and time again by may wildly successful investors. We want to invest in a business that has a long runway, not one that has a spurt in growth that quickly drops off in a few years. This does not mean that the revenue and earnings must increase every year as revenue and earnings don’t grow linearly. A few bad years are fine as long as the general trend in the long run is clearly increasing.

There are two types of businesses that can accomplish this. The first type is those that are “lucky and able” to do so. Their revenues grow due to unforeseen increase in demand out of the firm’s control. Many natural resource companies fall into these category where stumbling into an extremely valuable deposit can make or break the company – it is mostly a product of luck and cannot be foreseen. The second group is the “lucky because they are able” group. They strategically position themselves for growth by creating new products of entering new industries. Such companies actively seek out new business prospects. This category is where we wish to concern ourselves.

2. Does management have determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?

The companies that have the greatest appreciation in price are those that are able to achieve prolonged periods of high growth. It thus goes without saying we wish to invest in companies that are actively reinvesting profits to achieve even greater growth.

A simple marker for this is to look at how much a firm invests in research and development. The best results usually arise when R&D is devoted to products that are complementary to the current business model. Think about Apple expanding their product line and Microsoft investing heavily into gaming.

3. How effective are the company’s R&D efforts in relation to its size

The question to ask here is “how much profit does $1 investing in research produce?” This looks like a rather straightforward question but is actually relatively challenging to answer. A simple comparison can be made between the percentage of revenue invested in research each year and the growth in revenue and earnings can bear some insight. However, investors have to be aware that the fruits of R&D may only show up materially in five or even 10 years down the road. Thus, they have to be looking at a long period for such comparisons to be useful.

4. Does the company have an above average sales team

In today’s competitive world, most products don’t just sell themselves. The ability of a company’s sales team is almost as important as the product itself. An outstanding product will not be profitable if a company does not know how to market it and push it out to customers. However, the ability of a sales team is intangible and there is no financial ratio to assess this. Thus, many investors choose to ignore it. This is where scuttle-buttling is useful as employees and customers will almost surely have insight that the general public do not.

5. Does the company have a worthwhile profit margin

Firms with higher margins are more resilient during periods of high inflation and are able to maintain profitability even if competition increases. Persistently high margins are also an indication of an economic moat that allows the company to charge a premium while keeping competitors at bay.

Occasionally, low margins are temporary as majority of profits are reinvested. Such was the case with Amazon and Netflix in the past. These company can prove to be interesting investments as they may be underappreciated by the general public. Otherwise, it is wiser to stick to firms with higher profit margins.

6. What is company doing to maintain or improve profit margins?

While a surge in demand may improve a company’s profit margins, the effect is only temporary. We are more concerned with long term structural changes that will create sustainable improvements in the company’s margins. Some examples include reducing costs by harnessing economies of scale or building an economic moat that will allow it to raise prices and/or protect it’s profit margins from competitors.

7. Does company have outstanding labour personnel relations

Fisher argues that the benefits of excellent relations compared to mediocre ones is underestimated. To get a rough gage of labour relations, look at employee turn over rate, whether there is unionisation and a history of constant and prolonged strikes. However, do note that having unions and strikes are not instant red flags, how they interact with the company is much more important than whether there is a union.

8. Does company have outstanding executive relations

We hope to see that the company promotes executives based on ability and not connections. This is often an issue in family led organisations. Scuttle-buttling can yield many useful information regarding this point. When there is an executive position being filled, we hope to see that it is someone from inside the company rising through the ranks. Be wary of companies that consistently hires new personnel to fill the highest levels of management. This could signal that the there is a lack of talent or that the management is not fair.

9. Does company have depth to its management

We don’t want the company to be a one man show where the entire company depends on one personality. We want teamwork, all the way at the highest level of management. This is definitely a hard quality to assess but a look at the management compensation can provide some hints. Furthermore, we can use an elimination process – it is easier to spot which companies are a one man show.

10. How good are the company’s cost analysis and accounting controls?

Cost analysis and accounting controls are crucial to making good business decisions. However, this is hard to analyse. The best investors can do is analyse other metrics such as profitability as a company that performs well in other areas will likely do well in this as well.

11. Are there other aspects of business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition

Looking at a company’s growth and earnings may not be sufficient to ascertain if they are outstanding investments. There may be other aspects apart from their core business that is crucial to their growth strategy. Some examples include handling insurance, real estate, patents, customer relations and service, sales team and manufacturing know how.

12. Does company have long term or short term outlook on profits?

As buy-and-hold investors, we want to invest in a company to be able to compound earnings for a very long time. It thus follows that we don’t want to invest in a company that maximises short term profits in order to pump up it’s stock at the expense of reinvestment for future growth.

This can be observed from a company’s actions and growth strategy which can be found in it’s annual reports. I find it useful to pen down some of the pointers of the company’s growth strategy and brainstorm on where evidence of such actions will show up, be it increased expenditure on sales and marketing or increased R&D. These plans have long gestation period and it is useful to go a few years back to see how the company has progressed.

13. Will it require equity funding that will dilute current shareholders?

Take a look at debt, cash flows and cash on hand and compare it to how much they need to reinvest in order to achieve their goals. If they are short on cash and have exhausted all debt options, they will likely need to issue shares in the short term. This will dilute shareholders and might mean that the company may not be a good investment.

14. Does management talk freely about its affairs when times are good but “clams up” when troubles and disappointments occur?

It is part and parcel of business to have ups and downs. By the law of averages, not all new initiatives will succeed and there is bound to be costly failures. Even the best companies in the world such as Microsoft and Amazon are not spared from these failures. Such failures present excellent opportunities to assess the management team. Executives that clams up either has no plan or does not have a sense of responsibility to shareholders.

15. Does company have management of unquestionable integrity?

This is undoubtedly the most important factor in assessing whether a company will make a great investment. Even if all the other 14 points are excellent but management is not honest, investors should stay away from the company as it is unlikely that management will be fair to shareholders.

These 15 points can be used as a checklist. With the exception of the last point, it is not necessary to be outstanding in all the other 14 points for a company to qualify to be a good investment. A company that lacks in one or two points but does exceptionally well in the other points can still make an excellent investment. I hope that this article summarises what to look for in a company and helps you make sound investment decisions in time to come.

Posted on by CTKS · 1 Comment

Multi-baggers: InMode

InMode is an Israeli company that develops and markets energy-based, minimally-invasive medical treatment in three main aesthetics market. Namely face and body contouring, medical aesthetics and women’s health.

InMode seeks to fill a “treatment gap” which comprises of patients who are

  • in the age range of 35-60 years old
  • looking for comparable results to plastic surgery, but without the shortcomings of full surgery (downtime and scars)
  • large population of patients whose skin is not responsive to other procedures
  • affordable, office-based, out-patient procedure

The industry in which InMode operates in is expected to reach USD$141 billion by 2028, representing a CAGR of 14.7% over that period. Today, North America is the dominant regional market, accounting for 37%. However, Asia Pacific is expected to register the fastest CAGR on account of rising target population.

As mentioned before, lower cost, shorter downtime and reduced side effects compared to traditional means help bolster demand for minimally-invasive procedures.

As you can see, InMode’s platforms can be categorised into three main types: Minimally Invasive, Non-Invasive and Hands-Free.

Additionally, their products are capable of doing a wide variety of procedures and they have more than one solution for each procedure. This increases consumer choice and caters to their various needs.

InMode’s products have three main components:

  1. Platforms – Includes user interface with touch screen
  2. Handpieces and Hands-free applicators – The mode of application of energy over treatment area
  3. Proprietary Software – manages proper system performance and capable of automatic temperature control, system calibration and detection of any malfunction. This allows the practitioner to focus on the treatment as the system is automatically managed by the software.

As of 2020, most of InMode’s revenue is generated from the US market. However, growth in revenue from the international market outstrips that of the US market. This is evident by the rising proportion of revenue coming from the international market.

InMode has a very established distribution network spanning worldwide. They are thus poised to tap on international growth, particularly in Asia, which is expected to see the greatest rise in demand for such procedures.

I won’t bore you with numbers so I will just bring your focus to a few key points. However, you are encourage to analyse deeper if you wish to.

As a small company with market cap of USD$4 billion, InMode has demonstrated robust profitability that leave most growth companies in envy. Despite a lackluster second quarter in 2020 due to the Covid-19 Pandemic, InMode quickly recovered and achieved 32% growth in revenue from 2019 to 2020. This is a testament to the resilience of their business and adaptability of their management and staff.

The largest expense for InMode by far is sales and marketing. I expect this to continue to rise in the future as InMode expands their distribution network. This is their main method to drive sales growth and I would be happy to see them spending more in this area if it results in sustained revenue growth.

Lastly, InMode has consistently high gross profit margins (84-86%) and operating margins (35-38%). This indicates the presence of some form of economic moat that allows InMode to earn supernormal profits.

InMode’s growth strategy comprises of four main pillars:

  1. Increase sales presence to target and expand addressable market globally – investors can observe this by watching their expenditure on sales and marketing over time
  2. further penetrate existing customers and drive recurring revenues through the sales of consumables and services – investors can thus expect that recurring revenues as a percentage of total revenues will increase over time
  3. Leverage existing technology to expand into new minimally and non-invasive applications – we can monitor this by keeping our eyes peeled for new product releases
  4. Tuck-in acquisitions and strategic partnerships – InMode is at the stage where they are bringing in truckloads of cash and are capable of acquiring smaller companies. However, investors need to keep a look out on whether their acquisitions are sensible and worth it

Using the assumptions shown, I value InMode’s intrinsic valuation to be about USD$66 per share. At the time of writing, InMode’s share price closed at USD$46.85, representing a margin of safety of around 29%.

The compensation for the President and Chief Medical Officer is relatively high compared to other companies. However, on account of the CEO and CTO’s extremely modest compensation, this can be interpreted as a recognition of key talent and that InMode is not a one-man show. This is also indicative of a fair and humble management, both desirable attributes in my opinion.

Additionally, the CEO and CTO both have greater than 10% ownership in the company. As you may recall from my previous post, owner-operators are key attributes of multi-baggers.

Another point to note is that Steve Mullholland is the owner of one of the patents of InMode’s products. His significant ownership of more than 10% also indicates his confidence in the company.

Together, insiders own almost 38% of the company and have significant skin in the game. Shareholders can thus be assured that their interests are aligned.

I see three main risks with InMode.

  1. InMode faces competiiton from larger pharmaceuticals which may have greater resources
  2. Main form of economic moat is patents, which will expire eventually
  3. CEO was co-founder of a similar company (Syneron Candela) and left that company for unknown reasons. There is a real possibility that he may leave InMode abruptly as well

Investors thus have to monitor these three aspects closely. Particularly on the second point, the earliest expiration date on some of InMode’s oldest patents is 2027. Thus, they have five years to develop other economic moats such as brand recognition or cost advantage.

To sum it up, InMode operates in an favourable industry with excellent economics. As a small company, they have a proven track record of growth, high ROE and profitability. Their consistently high margins are indicative of some form of economic moats. To top it all off, management is fair, modest and owner-operators. InMode thus checks the boxes of a potential multi-bagger. In fact, I have already taken a long position on InMode.

If you wish to discuss further about InMode or investing in general, feel free to reach out to me here or join The Dollar Sapling telegram channel to start a discussion!

Disclosure: I am long InMode. I wrote this article myself, and it expresses my own opinions. I am not receiving any compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: I am not a financial advisor and this information should not and cannot be construed as financial advice. It is merely for me to keep track of my thought processes. Any investment involves the taking of substantial risks, including (but not limited to) complete loss of capital. Always do your own analysis and research before making any financial decisions and consult a qualified financial advisor if you have to. Click here for the full disclaimer.

Posted on by CTKS · 1 Comment

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!