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!

Posted on by CTKS · 3 Comments

The Resilient Investor

Black Swans are events that come as a surprise but have a major and disproportionately huge effect. In his book, “The Black Swan”, Nassim Nicholas Taleb argues that in today’s increasingly winner-takes-all world, Black Swans are becoming more frequent. Though not always bad, some Black Swans can lead to severe market crashes (most notably the Global Financial Crisis and the Covid-19 Pandemic). Somewhat related to my previous article on change and uncertainty, in this article, I will cover how investors can remain resilient in the face of volatility and uncertainty which is characteristic of our world today.

1. Respect uncertainty

While it is impossible to reliably predict recessions and market crashes, we can prepare for them by removing our vulnerabilities. As Charlie Munger once said “all I want to know is where I’m going to die, so I’ll never go there”. By reflecting on our potential pitfalls, we can become more financially resilient to crises. This applies not just to our portfolio but to almost all areas of life.

The most straightforward way to respect uncertainty is to have enough cash in reserve to act as a cushion because we never know what the future may hold. This is a point that I often repeat because having an adequate emergency fund is crucial. Having sufficient cash will help tide us over in the event of a prolonged downturn. For instance, if we did not have an adequate emergency fund during the Covid-19 Pandemic and were one of the unfortunate people who were furloughed, we would be forced to dip into our portfolio to tide us over. However, that period also coincided with a severe market downturn. Thus, we would have wound up selling some stocks at a significant loss. This highlights the importance of having sufficient cushion to avoid such a precarious situation which will require us to liquidate our portfolio at a loss. While this will mean that we will have idle cash on hand, this is the price to pay to be resilient, and one that we should be willing to pay.

2. Never depend on the kindness of strangers

Next, as resilient investors, we should never depend on the kindness of strangers. This means that we should avoid being in a spot where we are at the mercy of someone or something that is completely out of our control. A good example of this is to avoid excessive borrowing. While leverage can boost our returns in the short term, it diminishes our ability to stay afloat when disaster strikes. In other words, debt erodes our “staying power”. This is because when we take on debt, we are essentially promising the bank, or whoever we borrowed from, that we will consistently make a series of payments no matter whether times are good or bad. Thus, during periods of downturn when we may not have a stable source of income and our portfolio will likely be performing poorly, we will still be obligated to make payments. This is one scenario where we will be at the mercy of the creditor. More often than not, one will be forced to liquidate his assets at a loss just to meet the obligations. Thus, during the good times, take the opportunity to reduce and eliminate bad debt and avoid excessive leverage.

A corollary to this is that we should also avoid investing in businesses that take on excessive debt and/or are capital intensive. Such businesses have high fixed costs that need to be paid no matter whether times are good or bad. For instance, airlines consistently incur high fixed costs in terms of aircraft maintenance and typically have a debt-laden balance sheet. This means that even during periods where few planes are being flown (such as the past year and a half), cash is continuously being burnt. A company with high fixed costs will require a constant cash flow just for survival, making them more risky as they are more likely to go bankrupt during a severe crisis.

3. Instead of fixating on short-term gains or beating benchmarks, we should place greater emphasis on becoming shock resistant, avoiding ruin and staying in the game

As previously covered in my article on diversification, a certain degree of diversification can reduce the risk of our portfolios as the complete failure of a single holding will not lead to financial ruin. Indeed, doing so will incur an opportunity cost in terms of potential returns forgone. For instance, instead of having a hundred percent of our portfolio in cryptocurrencies that can potentially return 2x, 3x, or even 10x our money, we may be holding blue-chip stocks or making contributions to CPF that have lower returns. While I agree that diversification will mean that we will not be maximising our returns, I would argue that a sufficiently diversified portfolio is necessary to avoid financial ruin.

In fact, maximising returns should not be the goal if you are looking to create long-term wealth for your family and retirement. The goal should be wealth preservation and growing your savings at an adequate rate so that you can enjoy your golden years. If you are looking to create long-term, resilient wealth, you cannot operate like a heat seeking missile. Always be wary of greed.

This will also mean that there will undoubtedly be times when you may lag the market, but you must have the resilience to stay the course and trust in your framework.

4. Beware of overconfidence and complacency

During a bull market such as the one we are in the midst of now, we may be seduced by a false sense of safety. With every stock taking off to the moon, we may fall into a state of complacency and be overconfident of our ability to pick individual stocks. During such instances when the entire market seems to be defying gravity, we as investors should be keenly aware that this may signify excessive optimism in the market.

This quote from Warren Buffet can provide insight into how we should behave, “be fearful when others are greedy, and greedy when others are fearful.” When the market seems to be obsessed with chasing high returns, driving the valuations of companies sky high, all the more should we be wary of chasing fads.

This is not to say that we should attempt to time the market. We should stay the course and continue to dollar cost average. At the same time, abide by the timeless laws of the stock market which act like the laws of gravity. Continue to follow sound principles and invest in great businesses at a cheap prices. This will protect us from permanent loss when disaster strikes.

5. Always require a margin of safety and be keenly aware of your exposure to risk

Last but most definitely not least, the fifth method of being resilient is to always demand a margin of safety. A margin of safety in terms of investing can be seen as the percentage difference between the stock price and what each share is actually worth. A company selling at a price significantly below the intrinsic value of the company is said to provide a margin of safety. As resilient investors, we should demand an adequate margin of safety which acts as an insurance against mistakes, which are bound to happen. It is said that we should expect to be wrong a third of the time. Having a margin of safety means that even when we are wrong, we will not be severely wrong such that we will incur devastating losses. Shoot for the stars and land on the moon. On a similar note, we should focus on our exposure to risk. Always ask yourself “what could go wrong?” and “what is the consequence going to be?”. A margin of safety will help reduce the consequences of mistakes on our portfolio.

Similarly, the concept of a margin of safety applies to life as well. When we are making plans, we should also factor in a margin of safety. For instance, if we want to retire with a million dollars at 65, aim to hit a million by 55 and everything else will be icing on the cake. This way, even if we suffer a setback such as getting retrenched or falling severely ill, we have sufficient cushion and may still be on track to hit our goal. Shoot for the stars and land on the moon.

I find this quote from Jeffrey Gundlach, a successful investor and businessman, apt to sum up this article on how to remain financially resilient: “Make your mistakes nonfatal. It’s fundamental to longevity. And ultimately, that’s what success is in this business: longevity.” In essence, limiting our downside is key to building long-term wealth.