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What We’re Reading (Week Ending 26 July 2020)

The best articles we’ve read in recent times on a wide range of topics, including investing, business, and the world in general.

We’ve constantly been sharing a list of our recent reads in our weekly emails for The Good Investors.

Do subscribe for our weekly updates through the orange box in the blog (it’s on the side if you’re using a computer, and all the way at the bottom if you’re using mobile) – it’s free!

But since our readership-audience for The Good Investors is wider than our subscriber base, we think sharing the reading list regularly on the blog itself can benefit even more people. The articles we share touch on a wide range of topics, including investing, business, and the world in general.

Here are the articles for the week ending 26 July 2020:

1. I Gave a Talk to a Federal Credit Union – Nathan Tankus

First we have the idea of a legal system. It may seem obvious that money starts with law, but that isn’t necessarily obvious to most academics. It’s certainly not where a traditional money and banking textbook would start. MMT emphasizes that money is inherently legally designed and grounds money in the functioning of the legal system which authorizes its existence and enforces legal obligations denominated in money. We’ll return to this crucial point in a bit.

Second there is the idea of physical resources. These are raw materials, physical land, machinery, factories etc. which are necessary to produce goods and services that the government needs to accomplish its goals. Production is the combination of these physical resources with labor and technology to produce useful goods and services. The most obvious example of this is of course war time. Governments need to produce tanks, guns, rations, uniforms etc. to fight wars and they need their domestic populations to produce those resources. Modern Monetary Theory may have “monetary” in the name, but the ultimate object of MMT academics in the policy sphere is to use our monetary system in order to mobilize physical resources. Thus, the availability and usability of physical resources is important to Modern Monetary Theorists.

The final part of the definition is the most important part. In my experience, this is the idea at the foundation of MMT that people learning about it tend to have the most difficult time grasping. It’s also a point that is consistently overlooked and underemphasized by mainstream journalists who try to produce “explainers” about MMT. This is the idea that specific financial instruments have value, in fact that they are monetized, because those instruments can be used to pay legally enforceable obligations. The most obvious and important obligation that money can settle is one’s tax bill, but all sorts of legal obligations can be settled with money. Lawsuits, child support, damages, fines, fees and all sorts of other court ordered monetary payments can be settled with specific financial instruments which legal systems treat as money. I can’t emphasize enough that money is money because it can be used to settle legal obligations within a specific jurisdiction.

2. Hacked Printers. Fake Emails. QuestionableFriends. Fahmi Quadir Was Up 24% Last Year, But It Came at a Price – Michelle Celarier

In response, she believes, the company initiated “cybersurveillance, including numerous hacking attempts with aggressive measures to obtain sensitive information about us and our personal lives,” she wrote to investors in August.

“We are not fearful,” she bragged in that letter. “When companies resort to such intrusive and illegal tactics against a small fry, perhaps we are not as small as they think we are and more importantly, perhaps it’s the company that’s shaking in its boots,” she added.

Quadir declined to tell Institutional Investor the name of the company, but said she’d received emails falsely purporting to be a journalist she knew, leading her to believe it was an attempted hacking.

That wasn’t all.

“We’ve received documents from lawyers, but it’s not actually from those lawyers. And there was a time in my home — I have a basically defunct printer at my home — when suddenly, in the middle of the night, I think it was like 2:00 a.m., the printer just turns on and starts printing emails from whistleblowers. In the middle of the night!”

Quadir has since brought on cybersecurity experts “to clean everything,” she says. “I’m not concerned for my safety; I think this just comes with the territory. Did we expect it to all happen in the first year of launching? No. But it’s just the lengths these companies go to intimidate.”

3. How the U.S. Consumer Became the Most Resilient Force in the Economy – Ben Carlson

To pay for all of this stuff the Roaring Twenties also introduced installment payment plans. The phrase “buy now, pay later” became part of the popular nomenclature during this time.

Robert Gordon estimates by the end of the 1920s consumer credit financed 80-90% of furniture sales, 75% of washing machines, 65% of vacuums, 25% of jewelry and 75% of radios.

Previous generations attached a social stigma to borrowing. The 1920s chipped away at this idea as people purchased products that didn’t exist for those generations.

And while the country as a whole achieved a level of prosperity from 1923-1929 like never before, farmers were decimated. The depression of 1920-1921 cut the price of farm products in half and they regained just a fraction of those losses by the end of the decade. Incomes for farmers fell more than 60%.

The end of agriculture as the dominant career choice in the early part of the 20th century led to an urbanization boom. The first Sears store opened in Chicago in 1925. By the time the expansion was coming to an end in 1929 they were up to 300 stores, mainly in big cities.

4. Quarterly Investment & Market Update, Summer 2020 Q2 – Ensemble Capital

One mistake we think some investors have made during this unprecedented period is substituting a forecast of the virus for a forecast about the economy or financial market performance.

While clearly, the pandemic is a huge negative impact on the economy, they are not the same thing. And stocks are not a direct reflection of the US economy.

The market doesn’t care about the economy today, it cares about corporate cash flows over time.

So while today it seems that the stock market and the economy are totally disconnected, in reality stock prices are reflecting a view that while the economy is very bad now, it will recover in the years ahead. And in fact, you don’t even need to believe the entire US economy will recover to understand the rebound in the market.

While the S&P 500 is often referred to as “the market” and is the benchmark by which we evaluate our strategy, it represents what are essentially the 500 largest, most well capitalized companies in the country. These are the companies best positioned to manage through a period of very severe economic conditions. Meanwhile, the S & P 600, an index of smaller companies shown by the dotted orange line on the chart, is still down 20% this year.

5. The Nine Essential Conditions to Commit Massive Fraud – Josh Brown

When it comes to the massive frauds – the kind that wipe out tens of billions of dollars and result in career-ending, corporation-killing infernos, there are some necessary conditions that seem to appear with great regularity accompanying them. These are the conditions that allow the seed of a fraud to take root and germinate, they provide the fertile ground and atmosphere letting the sprout become something larger, thornier and more interconnected with the flora around it.

Ivar Krueger aka The Match King was one of the most notorious purveyors of investment fraud who ever lived. His story is relatively unknown in modern times despite the fact that the global scale of what he did was ten times more intricate and ultimately destructive than anything Madoff attempted. When you read about the details of the Krueger saga, you realize that everything that’s happened since (and will happen hence) is merely an echo of an old story.

6. Repetition Economics: The Story of the Hunter, the Mammoth, and The Wolves – Breaking The Market

You decide to throw the wolves a bone, literally, and give up the deer to them. As hoped, they leave you alone and start to eat the deer. Oh well, there is still some food at home. Hopefully you don’t see them again.

But the next day you catch another deer and on your way back the wolves show up again. It was pretty clear the way they devoured the deer last time they can be vicious animals so you don’t really want to mess with them. You lose the deer to the wolves again and leave. There’s not as much food at home, but there is still some.

Same thing happens again the next day, losing the deer to the wolves.

And then on the 4th day, when the wolves show up to the hunt again, you’ve had enough. The food has run out at home. It’s pretty clear if you keep losing your kills to the wolves you’re going to starve. You can’t keep repeating this process. And so on day 4 you decide to roll the dice and fight them off.

7. A Golden Oldie: The Best Investor You’ve Never Heard Of – Jason Zweig

That was the same year that another Grinnell trustee, Robert Noyce, called Rosenfield to tell him about a new company he was starting. Noyce had been kicked out of Grinnell in his junior year for stealing a 25-pound pig from a nearby farm and roasting it at a campus luau; his physics professor, who felt Noyce was his best student ever, got the expulsion reduced to a one-semester suspension. Noyce had never forgotten the favor, which was why he was offering the college a stake in his start-up, NM Electronics.

Was Rosenfield interested? “The college wants to buy all the stock that you’re willing to let us have,” he told Noyce instantly.

Grinnell’s endowment put up $100,000, while Rosenfield and another trustee each kicked in $100,000 more, enabling the school to supply 10% of the $3 million in venture capital that Noyce and his sidekicks, Gordon Moore and Andrew Grove, raised for the company that they soon renamed Intel.

By 1974, three years after Intel went public, Grinnell’s endowment had more than doubled to $27 million — even as the stock market lost 40% of its value.

Meanwhile, Rosenfield was keeping his eyes, and his mind, wide open. In 1976, Rosenfield heard from Buffett that a TV station, WDTN of Dayton, was for sale. Endowments rarely control private companies, but Rosenfield thinks like a businessman, not a bureaucrat. He grabbed WDTN for Grinnell at just $12.9 million, or a mere 2 1/2 times revenues at a time when TV stations were selling for three to four times revenues.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

Board Games, Coffee Cans, and Investing

Doing nothing is one of the most important actions we can take as stock market investors, but it is also one of the hardest things to do.

David Gardner is the co-founder of The Motley Fool, and he’s one of the best stock market investors I know.

There’s a fascinating short story involving David that can be found in a 2016 Fool.com article written by Morgan Housel titled Two Short Stories to Put Successful Investing Into Context.

In the article, Morgan shared a conversation he had with David. Once, Morgan spotted David playing video games at the Fool’s office and asked him in jest: “If you had to give up board games, video games, or stocks, which would you quit?” (For context, David is a huge fan of board games.)

David’s response surprised Morgan: He would choose to quit stocks rather than board games or video games. Here’s Morgan recounting David’s brilliant explanation in Two Short Stories to Put Successful Investing Into Context:

“Games are hands-on by design. They are meant to be played, not left alone.
But a good portfolio can prosper for decades with minimal intervention. A basket of stocks is not a board game with turns and rounds. It’s something that should be mostly hands-off. After a proper allocation is set up, one of the biggest strengths of individual investors is what they don’t do. They don’t trade. They don’t fiddle. They don’t require daily monitoring. They let businesses earn profit and accrue to shareholders in uneven ways.
David’s point was that he could be happy never touching his investments again, because he currently owns a big, diverse set of companies whose long-term future he’s bullish on.”

David’s response echoes one of my favourite investing articles, The Coffee Can Portfolio, written by investment manager Robert G. Kirby in the 1980s.

In The Coffee Can Portfolio, Kirby shared a personal experience he had with a female client of his in the 1950s. He had been working with this client for 10 years – during which he managed her investment portfolio, jumping in and out of stocks and lightening positions frequently – when her husband passed away suddenly. The client wanted Kirby to handle the stocks she had inherited from her deceased husband. Here’s what happened next, according to Kirby:

“When we received the list of assets, I was amused to find that he had secretly been piggy-backing our recommendations for his wife’s portfolio. Then, when I looked at the total value of the estate, I was also shocked. The husband had applied a small twist of his own to our advice: He paid no attention whatsoever to the sale recommendations. He simply put about $5,000 in every purchase recommendation. Then he would toss the certificate in his safe-deposit box and forget it.
Needless to say, he had an odd-looking portfolio. He owned a number of small holdings with values of less than $2,000. He had several large holdings with values in excess of $100,000. There was one jumbo holding worth over $800,000 that exceeded the total value of his wife’s portfolio and came from a small commitment in a company called Haloid; this later turned out to be a zillion shares of Xerox.”

The revelation that buying and then patiently holding shares of great companies for the long-term had generated vastly superior returns as compared to more active buying-and-selling helped Kirby to form the basis for his Coffee Can Portfolio idea. He explained:

“The Coffee Can portfolio concept harkens back to the Old West, when people put their valuable possessions in a coffee can and kept it under the mattress. That coffee can involved no transaction costs, administrative costs, or any other costs. The success of the program depended entirely on the wisdom and foresight used to select the objects to be placed in the coffee can to begin with.”

Doing nothing is one of the most important actions we can take as stock market investors, and it has served me immensely well. It is also one of the hardest things to do. But I hope those of you reading this article can achieve this. Don’t just do something – sit there!

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

The Fascinating Facts Behind Warren Buffett’s Best Investment

The Washington Post Company is one of the best – if not the best – investment that Warren Buffett has made in percentage terms. What can we learn from it?

One of the best returns – maybe even the best – that Warren Buffett has enjoyed came from his 1973 investment in shares of The Washington Post Company (WPC), which is now known as Graham Holdings Company. Back then, it was the publisher of the influential US-based newspaper, The Washington Post.

Buffett did not invest much in WPC. He controls Berkshire Hathaway and in 1973, he exchanged just US$11 million of Berkshire’s cash for WPC shares. But by the end of 2007, Buffett’s stake in WPC had swelled to nearly US$1.4 billion. That’s a gain of over 10,000%.

There are two fascinating facts behind Buffett’s big win with the newspaper publisher.

First, WPC’s share price fell by more than 20% shortly after Buffett invested, and then stayed there for three years.

Second, WPC was a great bargain in plain sight when Buffett started buying shares. In Berkshire’s 1985 shareholders’ letter, Buffett wrote:

“We bought all of our WPC holdings in mid-1973 at a price of not more than one-fourth of the then per-share business value of the enterprise. Calculating the price/value ratio required no unusual insights. Most security analysts, media brokers, and media executives would have estimated WPC’s intrinsic business value at $400 to $500 million just as we did. And its $100 million stock market valuation was published daily for all to see.
Our advantage, rather, was attitude: we had learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values.”

How many investors do you think have the patience to hold on through three years of losses? Buffett did, and he was well rewarded. Patience is the key to successful investing. It is necessary, even if you have purchased shares of the best company at a firesale-bargain price.

Warren Buffett has investing acumen that many of us do not have. But there are also times when common sense and patience is more important than acumen in making a great investment. Buffett himself said that no special insight was needed to value WPC back in 1973. What was needed to earn a smashing return with the company was the right attitude and patience.

What Causes Share Prices to Increase?

Share price appreciation and dividends are the primary drivers of returns for shareholders.

In an earlier article, I discussed how stock prices are a function of future cash flows to the investor. In much the same light, investors sometimes value stocks based on multiples to earnings or revenue. This is because revenue and earnings is what ultimately drives cash flow to shareholders.

In this article, I discuss how business fundamentals and valuation growth may drive capital appreciation.

The two key factors

The equation below shows the relationship between share price appreciation, valuation, and a company’s growth.

Share price appreciation = Earnings/revenue growth X Price-to-earnings/revenue multiple expansion

Put simply, a company’s share price is driven by earnings/revenue growth and changes in the price-to-earnings/revenue multiple.

Increases in the price-to-revenue/earnings multiples are usually driven by a better outlook, new information, or market participants appreciating a company’s future prospects.

How to use this information?

As investors, knowing how stock prices rise can help us to pick stocks.

The sweet spot is to find a company that will grow its earnings/revenue and is also likely to experience valuation-multiple growth.

But companies that can grow revenue/earnings at a quick pace without a valuation multiple expansion can still serve investors very well. For example, a company that is growing earnings at 20% per year, and does not experience a valuation compression, will give shareholders capital appreciation of 20% per year.

Too often, investors focus on the second part of the equation, hoping that valuation-multiple expansion can drive stock price appreciation, without taking into account that business performance also drives stock price performance.

In fact, even if there is a valuation compression, a company can still be a good investment if revenue or profit grows faster than the valuation squeeze. To illustrate this, I came out with a simple example. Let’s assume Company ABC grows revenue at 70% per year but is expensively priced at 60-times sales.

The table illustrates what happens to ABC’s share price if there is a valuation compression each year.

As you can see, ABC’s share price grew a decent 25% per year despite the price-to-sales multiple dropping from 60 to 30. The above example can give us perspective on what we are experiencing in today’s investing environment.

There are numerous technology companies that are growing at a triple or high double-digit pace, and are expected to grow at these rates for the next few years At the same time, their price-to-revenue multiples are so high that is it likely the multiple will fall over the years. But if the top-line can grow faster than the contraction in the valuation multiple, we will still see the shareholders of these companies be handsomely rewarded.

Risks to growth

Before you invest in any richly-priced stock, you must know that high valuation multiples also pose a risk. If a company cannot grow revenues or profits as fast as its valuation contracts, its stock price may fall off a cliff.

As such, investors need to be mindful that a rich valuation also comes at a cost. Valuation contraction can be extremely painful for investors if the company does not live up to the kind of growth that the market is expecting of it.

Final words

Deep value investors tend to focus on the second part of the equation, hoping that the market will realise that a company’s valuation multiple is too low – when the market becomes aware of its folly, the valuation multiple could expand, which could lead to stock price growth.

But don’t underestimate the importance of the first part of the equation- business growth. This is ultimately the longer-term determinant of a company’s share price. Valuation multiples can only expand up to a certain point before the expansion becomes unsustainable, while business growth can continue for years. Business growth can lead to huge stock price appreciation and is to me, the best way to find multi-baggers over the long term.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

What We’re Reading (Week Ending 19 July 2020)

We’ve constantly been sharing a list of our recent reads in our weekly emails for The Good Investors.

Do subscribe for our weekly updates through the orange box in the blog (it’s on the side if you’re using a computer, and all the way at the bottom if you’re using mobile) – it’s free!

Here are the articles for the week ending 19 July 2020:

1. Here We Are: 5 Stories That Got Us To Now – Morgan Housel

We are lucky that a lot of today’s economy can shift seamlessly into remote work. It wouldn’t have been possible to this extent if Covid-19 struct in 2010 instead of 2020.

But it again sets up a stark contrast of haves and have nots, and groups of people who are experiencing Covid-19 in different ways.

Massachusetts did a survey in April that tells the story:

88% of those with an advanced degree can work from home, vs. 35% with a high school degree or less.
75% of those making more than $150,000 a year can work from home, vs. 44% of those earning less than $50,000 a year.
74% of salaried workers can get their jobs done from home, vs. 40% of hourly workers.

There is a long history of economies being hit with downpours. But this is the first in which perhaps 70% of the economy has a sturdy umbrella while 30% is left to get soaked…

… In 1900 roughly 800 per 100,000 Americans died each year from infectious disease. By 2014 that was 45.6 per 100,000 – a 94% decline…

…This decline is probably the best thing to ever happen to humanity.

To follow that sentence with “but” is a step too far. It’s a wholly good thing.

However, it creates an anomaly.

We are medically more prepared to fight disease than ever before. But, psychologically, the mere thought of a pandemic has never felt so foreign, so unprecedented, so upending.

What was a tragic but expected part of life 100 years ago is now a tragic and inconceivable part of life in 2020.

2. 5 Thoughts on a World with No Yield – Ben Carlson

If you’re waiting for valuations to revert back to some magical 15x average CAPE ratio from 1871 you may be waiting for a long time if the low yield environment is here for some time.

The best argument against this line of thinking is a place like Japan where interest rates have been on the floor since 1990. Rates have been low or negative in many European countries for a number of years now too.

My counterargument to that case would be the United States now makes up 55% of the global equity market cap. Fifty percent of all Americans take part in the stock market (it was just 1% of the population in the Great Depression). Americans are on their own when it comes to saving and investing for retirement and we have a much worse social safety net than these other countries.

At the height of the dot-com bubble, the highest stock market valuations in history, investors could still earn 5-6% yields on U.S. Treasuries. That is not the case today.

Valuation is not useless but it does require context.

3. Charlie Songhurst – Lessons from Investing in 483 Companies – Patrick OShaughnessy and Charlie Songhurst

There’s a book by Will Durant called Caesar and Christ, it’s a whole history of Rome, from the founding to 500 AD and sort of the full history and afterwards. So it’s interesting to think, how would you invest through that? Do you buy or sell Roman real estate when Caesar’s murdered? Cause you get a civil war and you get chaos, but then you get Augustus and peace afterwards. Then when you get this whole state of bad emperors and it looks like everything’s going to fall apart, maybe you would sell and then you get Hadrian and the good emperors and you get a great hundred years.

It makes you think about sort of volatility and about having to make decisions with only information available at that time. And what’s so interesting is, you do get this sort of pattern of going from a power and sort of fashion being to have your base in city of Rome, to being out in Capua or out in the smaller provinces. And that cycle seems to co-exist for like the 500 years of history. And if you look at London, I think the peak population was in the 1930s. I think it’s still higher than the present population. Or it may just have peaked so maybe that’s the beginning of one of these great 40 year demographic changes, but people move back to the suburbs or not. This is speculation. I certainly don’t have as much conviction on it as I do on startup stuff…

…Often my enthusiasm has been greater than my competence and it’s the people that bet on the enthusiasm more than the competence, I’m eternally grateful to them.

4. Netflix CEO Reed Hastings Responds To Whitney Tilson: Cover Your Short Position. Now – Reed Hastings

Next in the litany of Whitney threats is market saturation. In 2011, this is unlikely to affect us. Streaming is growing rapidly; it is propelling Hulu, YouTube, Netflix and others to huge growth rates. Streaming adoption will likely follow the classic S curve, and we’re still on the first part (acceleration) of the S curve. Since we expanded into streaming, Netflix net subscriber additions have been 1.9m in 2008, 2.9m in 2009, and over 7m this year (estimated). While saturation will happen eventually, given the recent huge acceleration of our business specifically, and streaming generally, saturation seems unlikely to hit in the short term.

The next issue is what Whitney calls our “weak content.” While Whitney may think “Family Guy” is weak content, our subscribers do not. Furthermore, our huge subscriber growth to date has been built on this “weak content,” so imagine how much upside we have as we improve our content, as we are always trying to do. I think what Whitney may be misunderstanding is that at $7.99 per month, consumers don’t expect to have everything under the sun. A variant of this misunderstanding is when DirecTV (DTV) advertises against Netflix, calling out some Netflix content weaknesses. When an $80 per month service is picking on an $8 per month service, the $8 per month service just gets more attention from consumers and grows even faster.

5. 3 lessons from owning FAANG stocks for over a decade – Chin Hui Leong

In January 2007, I bought shares of a little known, US-based business doing DVD rentals by mail. Little did I know that, by doing so, I had bought the first of a set of five coveted stocks that are now affectionately known as “FAANG”.

You see, that DVD-rental business slowly but surely morphed into a massive global online streaming service. The company’s name? Netflix (NASDAQ: NFLX).

I still own around half of my shares from 13 years ago, and those shares are up over 160 times my original cost.

But that was not all.

6. State of the Cloud 2020 – Byron Deeter, Elliott Robinson, Hansae Catlett, Mary D’onofrio

By 2020 it’s estimated that the average cost of a data breach will be over $150 million, with the global annual cost forecast to be $2.1 trillion. New laws such as GDPR and CCPA are creating the demand for enterprises to tighten their data privacy practices.

“While many tech companies were architected to collect data, they were not necessarily architected to safely store data. Today there’s not just a rift, but a chasm between where data privacy technology, processes, and regulations should be and where they are, thus creating massive amounts of “privacy debt,” wrote Partner Alex Ferrara in his Data Privacy Engineering Roadmap.

“Like technical debt, privacy debt requires reworking internal systems to adapt and build to the newest standards, which will not only make consumers happier but also make companies better.”

We’re seeing a new category of technology dedicated to helping enterprises, large and small, comply with global privacy regulations and help protect consumer data. For example, last year Bessemer invested in BigID’s Series C, a data intelligence platform that finds, analyzes, and de-risks identity data, allowing enterprises to understand where their sensitive data lives, at scale.

7. “One of the Investment Greats” Explains His Portfolio Strategy – Robert Korajczyk and Lou Simpson

Well, I think you need a combination of quantitative and qualitative skills. Most people now have the quantitative skills. The qualitative skills develop over time.

But, as Warren used to tell me, “You’re better off being approximately right than exactly wrong.” Everyone talks about modeling—and it’s probably helpful to do modeling—but if you can be approximately right, you will do well.

For example, one thing you need to determine is: Are the company’s leaders honest? Do they have integrity? Do they have huge turnover? Do they treat their people poorly? Does the CEO believe in running the business for the long term, or is he or she focused on the next quarter’s consensus earnings?

An Important Thing To Know About Stock Market Risk

Stock market risk is at its highest when everyone thinks there’s no risk; conversely, risk is at its lowest when everyone thinks it’s very risky.

A few days ago, I published Investing is Hard. In the article, I shared two things:

One, snippets of the State of the Union Address that two former US presidents, Bill Clinton and Barack Obama, gave in January 2000 and January 2010, respectively.
Two, the subsequent performance of US stocks after both speeches. Clinton’s speech was full of optimism but the US stock market did poorly in the subsequent decade; on the other hand, Obama’s bleak address was followed by a decade-plus of solid gains for US stocks.

Here’s the snippet from Clinton’s State of the Union Address:

“We are fortunate to be alive at this moment in history. Never before has our nation enjoyed, at once, so much prosperity and social progress with so little internal crisis and so few external threats. Never before have we had such a blessed opportunity — and, therefore, such a profound obligation — to build the more perfect union of our founders’ dreams.

We begin the new century with over 20 million new jobs; the fastest economic growth in more than 30 years; the lowest unemployment rates in 30 years; the lowest poverty rates in 20 years; the lowest African-American and Hispanic unemployment rates on record; the first back-to-back budget surpluses in 42 years. And next month, America will achieve the longest period of economic growth in our entire history.

My fellow Americans, the state of our union is the strongest it has ever been.”

This is the S&P 500 from January 2000 to January 2010:

The snippet from Obama’s State of the Union Address is this:

“One in 10 Americans still cannot find work. Many businesses have shuttered. Home values have declined. Small towns and rural communities have been hit especially hard. And for those who’d already known poverty, life has become that much harder. This recession has also compounded the burdens that America’s families have been dealing with for decades — the burden of working harder and longer for less; of being unable to save enough to retire or help kids with college.”

The chart below shows the S&P 500 from January 2010 to today:

I think that Investing is Hard highlights an important idea about stock market risk: The riskiest time to invest is when everyone thinks there’s no risk; conversely, it’s the safest time to invest when everyone thinks risk is at its highest.

But why is this so? We can turn to the ideas of the late economist, Hyman Minsky, who passed on in 1996. When he was alive, Minsky was not well-known. It was after the Great Financial Crisis of 2007-09 that his ideas flourished.

That’s because he had a framework for understanding why economies go through inevitable boom-bust cycles. According to Minsky, stability itself is destabilising. When an economy is stable and growing, people feel safe. And when people feel safe, they take on more risk, such as borrowing more. This leads to the system becoming fragile.

Minsky was talking about the economy, but his idea can be extended to stocks. If we assume that stocks are guaranteed to grow by 8% per year, the only logical result would be that people would keep paying up for stocks, until stocks become way too expensive to produce that return. Or people will invest in stocks in a risky manner, such as borrowing to invest. But there are no guarantees in the real world. Bad things happen. And if stocks are priced for perfection in a fragile system, emergence of bad news will lead to falling stock prices.

The world of investing is full of paradoxes. The important idea that risk is at its highest when the perception of risk is at its lowest is one such example.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

How Future Dividends Drive Capital Growth in Stocks

What do we get when we buy a stock? In simplified terms, we are paying upfront for the rights to receive its future dividends.

The ultimate goal of investing is simply to make money.

The art of picking good investments is complicated but it boils down to one key question: What is the future cash investors can generate from an asset today? If we invest in real estate, rental income and resale value will determine our investment returns. For bonds, the cash flow is derived from coupons and the redemption value at maturity. Similarly, when we buy a stock it gives us the right to earn a stream of dividends in the future.

Companies that don’t pay dividends

But what if a company does not pay dividends? A famous example is Warren Buffet’s Berkshire Hathaway, which has only paid a dividend once since Buffett took over in 1965. Why then would a shareholder buy such a company if he is not going to earn any dividends from it?

The answer, though, still boils down to dividends. Shareholders believe that eventually, Berkshire will start paying them dividends. This, in turn, makes the company’s shares valuable so that it can then be sold to another investor.

I’ve drawn up a simple example to explain this.

Let’s assume Company ABC can earn $10 per share in year 1. From year 1 to year 10, it reinvests its entire profit and does not pay any dividend. During this time, it grows its profit by 30% per year.

From year 11 to year 20, it pays out 50% of its profit and reinvests the other 50% and grows its profits by 15% per year.

Eventually, in year 21, the company has run out of ways to grow its profits and decides to payout 100% of its profits to shareholders. It is able to earn this level of profit till eternity.

The table below shows how the value of the company changes over time based on the discounted dividend model.

I used a discount rate of 10% to calculate the value of the future dividend stream to the shareholder. As you can see, even though the company did not pay out any dividends in year 1, its shares still had value due to the promise of future dividends starting from year 11. The company’s share price grew as we got closer to the dividend-paying years.

As a result, even though shareholders in the first 10 years did not earn a cent in dividends, they still made money through capital gains.

From this example, we see the value of the company grows as the discount rate for the future cash flow decreases the closer we get to the dividend-paying years.

In addition, a company’s market value can also rise if there is an unexpected increase in earnings that results in a higher potential dividend.

Final words

Investing is ultimately about the future cash flow an investment brings for the investor.

In the case of stocks, it all boil down to dividends. Even capital appreciation is driven by (1) growth in dividends and (2) the smaller discount we apply to future dividends as the dividend stream draws closer.

Investing Is Hard

Near the start of every year, the President of the United States delivers the State of the Union Address. The speech is essentially a report card on how the US fared in the year that just passed and what lies ahead. It’s also a good gauge of the general sentiment of the US population on the country’s social, political, and economic future.

In one particular year, the then-US President said:

“We are fortunate to be alive at this moment in history. Never before has our nation enjoyed, at once, so much prosperity and social progress with so little internal crisis and so few external threats. Never before have we had such a blessed opportunity — and, therefore, such a profound obligation — to build the more perfect union of our founders’ dreams.

We begin the new century with over 20 million new jobs; the fastest economic growth in more than 30 years; the lowest unemployment rates in 30 years; the lowest poverty rates in 20 years; the lowest African-American and Hispanic unemployment rates on record; the first back-to-back budget surpluses in 42 years. And next month, America will achieve the longest period of economic growth in our entire history.

My fellow Americans, the state of our union is the strongest it has ever been.”

In another particular year, the US President of the time commented:

“One in 10 Americans still cannot find work. Many businesses have shuttered. Home values have declined. Small towns and rural communities have been hit especially hard. And for those who’d already known poverty, life has become that much harder. This recession has also compounded the burdens that America’s families have been dealing with for decades — the burden of working harder and longer for less; of being unable to save enough to retire or help kids with college.”

What do you think happened to the US stock market after the first and second speeches? Take some time to think – and no Googling allowed! If you had to bet on whether US stocks rose or declined after each speech, how would you bet?

…

Ready?

The first speech was delivered in January 2000, by Bill Clinton, near the peak of the dotcom bubble that saw US stocks – represented by the S&P 500 – fall by nearly half just a few years later. By the end of 2010, US stocks were lower than where they were when President Clinton gave his State of the Union Address.

The second speech was from President Barack Obama and was from January 2010. The US stock market bottomed out in March 2009 from the Great Financial Crisis. And from January 2010 to today, US stocks have been on an absolute tear, rising three-fold.

Investing is hard because the best time to invest can actually feel like the worst, while the worst time to invest can feel like the best time to do so. I’ve said before that I think “investing is only 5% finance and 95% everything else.” This 95% includes psychology and control of our emotions. But we humans are highly emotional creatures – and this is why investing is hard. The best antidote I currently have, is to be diversified geographically, and to invest regularly and – crucially – mechanically.

What We’re Reading (Week Ending 12 July 2020)

The best articles we’ve read in recent times on a wide range of topics, including investing, business, and the world in general.

We’ve constantly been sharing a list of our recent reads in our weekly emails for The Good Investors.

Do subscribe for our weekly updates through the orange box in the blog (it’s on the side if you’re using a computer, and all the way at the bottom if you’re using mobile) – it’s free!

Here are the articles for the week ending 12 July 2020:

1. Habits: The Art of Compounding Choices – Oliver Sung

The key to designing the environment in a way that actually works for sustaining habits is to scale the desired habit down to the smallest, simple thing.

Want to read 20 book pages every night? Leave a book on your pillow every day you wake up and make your bed.
Want to drink more water and less alcohol? Make water the default choice by having nothing else in the fridge.
Want to save more money? Automate your savings transfers and keep the savings account at a different bank than your checking account.
Want to practice more guitar? Place it right in the center of your living room.

Forming the right habits is really all about thinking ahead to the second-order consequences of even the smallest choices and decisions. Secondly, it’s about creating the right system to make them incredibly easy to start and impossible to fail.

2. The Coffee Can Edge – John Huber

The coffee can portfolio is one of the simplest and most interesting concepts in all of portfolio management theory. It’s a term coined in 1984 by Robert Kirby, a portfolio manager who noticed that one of his clients did better than his own portfolio by secretly using all of Kirby’s buy recommendations but ignoring his sell recommendations. This particular client would put around $5,000 into each stock that Kirby bought, and then never touched the stock again. He put the stock certificate in the proverbial “coffee can” and didn’t think about it again. The results of each individual decision varied widely. Some stocks lost a majority of their value, some went up by an average amount, but a few performed incredibly well. The biggest winner was worth $800,000 (on a $5,000 initial investment).

One benefit of the coffee can approach is it forces you to think about what companies will be looking like in 5-10 years, as opposed to next year or the year after, which is the time frame that most investors (even those in the value investing community) tend to reside. The coffee can incentivizes you to think about two types of companies: the durable businesses that are likely to maintain their competitive position; or the businesses with the potential for much greater earning power in the future (and thus much greater value).

I wrote a series five years ago discussing the importance of returns on capital inside of a business, with the idea that there are two groups of companies in the world: those that are increasing their underlying value per share, and those that are eroding it. While it’s possible to make money buying stocks of mediocre businesses perhaps by buying something cheap and flipping it a year later, I’ve always thought that the vast majority of losses in the stock market come from picking the wrong business, not picking the wrong valuation on the right business.

3. Three people with inherited diseases successfully treated with CRISPR – Michael Le Page

Two people with beta thalassaemia and one with sickle cell disease no longer require blood transfusions, which are normally used to treat severe forms of these inherited diseases, after their bone marrow stem cells were gene-edited with CRISPR.

Result of this ongoing trial, which is the first to use CRISPR to treat inherited genetic disorders, were announced today at a virtual meeting of the European Hematology Association.

“The preliminary results… demonstrate, in essence, a functional cure for patients with beta thalassaemia and sickle cell disease,” team member Haydar Frangoul at Sarah Cannon Research Institute in Nashville, Tennessee, said in a statement.

4. Markets Bombed, Investors Carried On – Jason Zweig

Almost 95% of the 5 million investors in 401(k) and similar retirement plans run by Vanguard Group didn’t make a single trade in the first four months of 2020. Fewer than 1% moved their money entirely out of stocks.

All told, including 8 million households with individual accounts, only 12% of Vanguard’s investors traded between late February and early May, says Karin Risi, managing director of Vanguard’s retail investor group. Among those who did trade, two-thirds bought stocks rather than selling.

From late February through the end of March, fewer than 3% of the 2.2 million participants in retirement plans run by T. Rowe Price Group Inc. made any changes to their portfolios. “It’s a testament to people learning that this is a long-term investment,” says Kevin Collins, head of T. Rowe Price’s retirement-plan services.

5. The Broker Who Saved America – Joshua M. Brown

Solomon uses this role to access enemy military installations and to undermine German support for the Brits. He is sabotaging from the inside, talking the Hessians out of fighting for the English king. When these insurgency activities are discovered, Solomon is arrested again. This time, he pulls out a gold coin that had been sewn into his clothes and bribes a guard to let him escape. He flees to Philadelphia and arranges for his wife and son to meet him there. For the second time, Solomon has arrived in a new American city penniless and forced to start over.

By this time, the tide has turned and the Continental Army is beginning to pile up victories. The army is still, however, massively underfunded. General Washington is without readily available cash and is hamstrung by this lack of financial flexibility. He makes frequent requests to the Continental Congress to send money, but very little money comes. Into this breach steps Haym Solomon, ready to serve in the capacity in which he is best suited – as broker to the fledgling America.

Now that his merchant finance business is up and running again, Solomon begins funneling his own personal profits from the enterprise directly to the revolution. According to records of the time, he extends no-interest “loans”, many of which were never repaid, to James Monroe, Thomas Jefferson, James Madison, and even Don Francesco Rendon, the Spanish Court’s secret ambassador.

6. News by the ton: 75 years of US advertising – Ben Evans

It’s very common for people – especially newspaper people – to look at the newspaper and internet series in these charts and conclude that all the money went from newspapers to internet. There’s also a tendency to try to calculate Google and Facebook’s share of that ‘internet’ line. This can get you onto shaky ground quite quickly. As that change in share of GDP (and my phase ‘suspiciously flat’) should suggest, what’s actually happened is that the market has been both reallocated and repriced, a lot of money left the data that’s being captured here, and a lot of other money came in.

So: if you talk to people at both Google and Facebook and in the agency world, you’ll hear that perhaps two thirds to three quarters of money spent on Google and Facebook is money that was never spent on traditional advertising – it’s coming from SMEs and local businesses that might have spent in classified at most but probably wouldn’t have done even that. $60bn of consumer spending went through Shopify last year – it’s safe to assume those vendors spent money on advertising, but how many of them would have bought an ad in a local newspaper? This has also come at much lower prices: Facebook in particular has been massively deflationary to online advertising: it offers vast quantities of relevant advertising inventory at much lower prices and much lower entry costs than you’d have needed in print, let alone TV.

7. 99% of Long-Term Investing Is Doing Nothing; the Other 1% Will Change Your Life – Morgan Housel

Napoleon’s definition of a military genius was, “The man who can do the average thing when all those around him are going crazy.” It’s the same in investing.

Building wealth over a lifetime doesn’t require a lifetime of superior skill. It requires pretty mediocre skills — basic arithmetic and a grasp of investing fundamentals — practiced consistently throughout your entire lifetime, especially during times of mania and panic…

… To demonstrate my meaning, I used Yale economist Robert Shiller’s market data going back to 1900 and created three hypothetical investors. Each has saved $1 a month, every month, since 1900.

The first is Betty. She doesn’t know anything about investing, so she dollar-cost averages, investing $1 in the S&P 500 every month, rain or shine.

Sue, a CNBC addict, invests $1 a month into the S&P, but tries to protect her wealth by saving cash when the economy is in recession, deploying her built-up hoard back into the market only after the economy officially exits a recession.

Bill, a mutual fund manager whose only incentive is to look right in the short run, invests $1 a month, but stops investing in stocks six months after a recession begins, and only puts his money back into the market six months after a recession ends.

After 113 years of investing, who’s won? Boring Betty takes it by a mile:

Making Sense Of Japan’s Epic Stock Market Bubble

Japanese stocks were in an epic bubble in late 1989. Understanding the size of the bubble gives us important perspective.

From time to time, Jeremy and myself receive questions from readers that are along this line: “Will the stock market of [insert country] be like Japan’s? Compared to its peak in late 1989, the Nikkei 225 Index – a representation of Japanese stocks – is still 40% lower today.”

It’s a good question, because Japanese stocks have indeed given investors a horrible return since late 1989, a period of more than 30 years. But perspective is needed when you’re thinking if any country’s stock market will go through a similar run as Japan’s stock market did from 1989 to today. Here’s some data for you to better understand what Japanese stocks went through back then:

Japanese stocks grew by 900% in US dollar terms in seven years from 1982 to 1989; that’s an annualised return of 39% per year.
At their peak in late 1989, Japanese stocks carried a CAPE (cyclically-adjusted price-to-earnings) ratio of nearly 100; in comparison, the US stock market’s CAPE ratio was ‘only’ less than 50 during the infamous 1999/2000 dotcom bubble. The CAPE ratio is calculated by dividing a stock’s price with its inflation-adjusted 10-year-average earnings. Near the end of May 2020, Japanese stocks had a CAPE ratio of 19, while US stocks today have a CAPE ratio of 30.

The data above show clearly that Japanese stocks were in an epic bubble in late 1989. It is the bursting of the bubble that has caused the painful loss delivered by Japan’s stock market since then.

If you’re worried about the potential for any country’s stock market to repeat the 1989-present run that Japanese stocks have had, then you should study the valuations of the country’s stock market. But you should note that there are two things that looking at valuations cannot do.

First, valuations cannot tell you the future earnings growth of a country’s stock market. If the earnings of a country’s stocks collapse in the years ahead for whatever reason (natural catastrophe, disease outbreak, war, incompetent leadership etc.), even a low valuation could prove to be expensive.

Second, valuations cannot protect you from short-term declines. What it can only do is to put the odds of success in your favour. In an earlier article, 21 Facts About The Wild World Of Finance and Investing, I shared the two charts below:

*Source: Robert Shiller’s* *data; my calculation*

They show the returns of the S&P 500 from 1871 to 2013 against its starting valuation for holding periods of 1 year (the first chart) and 10 years (the second chart). You can see that the relationship between valuation and eventual return – the higher the valuation, the lower the return – becomes much tighter when the holding period lengthens.

To end, I have another important takeaway from Japan’s experience: It’s important to diversify geographically. Global stocks have grown by around 5% per year in US dollar terms from 1989 to 2019, despite (1) the terrible performance of Japanese stocks in that period, and (2) Japan accounting for 45% of the global stock market by market capitalisation in early 1989.