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!