If you invest in stocks, I think there are 5 questions you should always ask yourself. But they are even more prominent now given the coronavirus.
I started a recent article with the sentence: “It’s an understatement to say that stocks have been volatile of late.”
From 14 February 2020 to 8 March 2020, the S&P 500 in the US has declined by 12.1%. I mention the US stock market because it is by far the largest in the world. I’ve never thought it makes sense to find reasons for the short-term movements of stock prices. But I think it’s pretty clear that the coronavirus, COVID-19, is the key reason for the declines seen in recent days.
The number of people who are infected with COVID-19 has been rising significantly, with the death toll tagging along. The virus is also making its way into more countries over time.
Source: World Health Organisation
Global corporate giants such as Apple, Visa, and Mastercard have warned of pressures to their businesses because of COVID-19 (see here, here, and here). Airlines are some of the worst-hit groups of companies, with UK airline Flybe entering bankruptcy earlier this month; last week, Southwest Airlines in the US warned of a “very noticeable, precipitous decline in bookings.” In China, the PMI (purchasing managers’ index) for February 2020 came in at 35.7, the lowest seen since tracking began in 2004 (a reading below 50 indicates a contraction in factory activity). In 2008 and 2009, during the height of the Great Financial Crisis, China’s PMI reached a low of 38.8.
We’re clearly in an environment now where stocks are volatile and the world is grappling with a public health crisis and recessionary fears. Many of you are likely wondering what you should be doing now with your investment portfolios. If you invest in stocks, I think there are five questions you should always ask yourself. But they are even more prominent now given the current situation:
What is my investing time horizon? If you’re investing in stocks with capital you need within the next five years, it’s always dangerous to do so. The danger is amplified given the current situation. Stocks are volatile over the short run, sometimes without reason. But over the long run, stock prices reflect business fundamentals and have delivered great returns.
Do I have a sound investment framework? An investment framework guides the way you select your investments. I have my own personal criteria to find businesses that can grow at high rates over a long period of time. It has served me well for nearly a decade. But that’s not the only way to invest. Do you have a framework that is based on sound investing logic? If you don’t, it’s always a dangerous time to invest – doubly so, now.
Do I have a sound investing plan? An investing plan is like an investing schedule – it guides us on when we put money to work in stocks. Some investors prefer a dollar-cost-averaging strategy, where a certain amount of capital is invested in stocks at regular intervals. That’s fine. Some prefer to be fully-invested at all times. There are also others who prefer to have a cash cushion that they will deploy depending on the magnitude of the market’s decline. These are all fine too. There are two crucial aspects to an investing plan: (1) Does it fit our temperament; and (2) does it make investing sense? If the first aspect fails, it does not matter how good our plan is – we will not stick to it. The second aspect is important for self-explanatory reasons.
Do I have a basic understanding of market history? Knowing what has happened in the past can give us context for what to expect next. It can also prevent us from panicking when stocks decline. Some critical information to know include: (1) How often do stocks decline? (2) How have stocks performed over the long-term through recessions? (3) Are short-term declines common even when stocks climb over the long run? I have shared these things before and they can be found here and here.
Do I understand my own investing temperament? How we react to market declines can have a tremendous impact on our returns as investors. The investors of legendary fund manager Peter Lynch made only 7% per year despite him producing an incredible annual return of 29% for 13 years; that’s because Lynch’s investors had poor temperament, selling quickly whenever there was a short-term decline in his fund. If you know you have a poor investing temperament, then set up an investing plan that can save you from yourself.
These questions won’t guarantee that you will come out ahead when the COVID-19 crisis blows over. But I’m sure they’ll greatly increase your chances of success.
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 late economist Hyman Minsky has an excellent framework for understanding why market crashes are bound to happen from time to time.
It’s an understatement to say that stocks have been volatile of late. This is what the S&P 500 in the US has done since last Monday:
24 Feb 2020: -3.4%
25 Feb 2020: -3.0%
26 Feb 2020: -0.4%
27 Feb 2020: -4.4%
28 Feb 2020: -0.8%
2 Mar 2020: +4.6%
3 Mar 2020: -2.8%
4 Mar 2020: 4.2%
And at the time of writing (10:00 pm, 5 Mar 2020 in Singapore), the S&P 500 is down by 2.8%. Deutsche Bank analyst Torsten Slok said last Friday that the speed of the S&P 500’s decline “is historic.” Many are surprised by the ferocity of the recent fall in US stocks.
It’s oh so common
Given the current state of affairs, I think it’s an apt time as any to revisit an important fact about stocks: Declines and volatility are common. I wrote recently:
“Between 1928 and 2013, the S&P 500 has, on average, fallen by 10% once every 11 months; 20% every two years; 30% every decade; and 50% two to three times per century.”
At this point, some of you may be wondering: Why are market crashes so common? This is what I want to discuss in this article too. For an answer, we’ll need to turn to the late Hyman Minsky.
Stability is destabilising
Minsky was an economist. He wasn’t well known when he was alive, but his views on why an economy goes through boom-bust cycles are thought-provoking and gained prominence after the 2008-2009 financial crisis.
In essence, Minsky theorised that for an economy, stability itself is destabilising. I first learnt about him, and how his ideas can be extended to the stock market, a few years ago after coming across a Motley Fool article written by Morgan Housel. Here’s how Housel describes Minsky’s framework:
“Whether it’s stocks not crashing or the economy going a long time without a recession, stability makes people feel safe. And when people feel safe, they take more risk, like going into debt or buying more stocks.
It pretty much has to be this way. If there was no volatility, and we knew stocks went up 8% every year [the long-run average annual return for the U.S. stock market], the only rational response would be to pay more for them, until they were expensive enough to return less than 8%. It would be crazy for this not to happen, because no rational person would hold cash in the bank if they were guaranteed a higher return in stocks. If we had a 100% guarantee that stocks would return 8% a year, people would bid prices up until they returned the same amount as FDIC-insured savings accounts, which is about 0%.
But there are no guarantees—only the perception of guarantees. Bad stuff happens, and when stocks are priced for perfection, a mere sniff of bad news will send them plunging.”
In other words, great fundamentals in the stock market (stability) can cause investors to take risky actions, such as pushing valuations toward the sky or using plenty of leverage. This plants the seeds for a future downturn to come (the creation of instability).
Why bother?
Some of you may now be thinking: if stocks are prone to exhibit boom-bust behaviour, why bother at all with long-term investing? Because of this:
I mentioned earlier that US stocks had frequently crashed from 1928 to 2013. The chart just above shows how the US market performed over the same period after adjusting for dividends and inflation. It turns out that the S&P 500 gained 21,000%, or 6.5% per year. Remember, that’s a 6.5% annual return, after inflation, for 85 years. Sharp short-term declines were seen, but there’s a huge long-term gain at the end.
Then there’s also this:
Source: S&P Global Market Intelligence
The US e-commerce giant Amazon (which is in my family’s investment portfolio) was a massive long-term winner from 1997 to 2018, with its share price rising by more than 76,000% from US$1.96 to US$1,501.97. But in the same timeframe, Amazon’s share price also experienced a double-digit top-to-bottom fall in every single year (the declines ranged from 13% to 83%). Again, sharp short-term declines were seen, but there’s a huge long-term gain at the end.
Missing the good times
Here’s another thought some of you may now have (I’m not psychic, trust me!): Why can’t we just side-step all the big downward moves and invest when the clouds have cleared? Wouldn’t this make the whole investing experience more comfortable?
Yes, you may be more comfortable, but you’re very likely going to earn much lower returns.
Dimensional Fund Advisors, a fund management company with more than US$600 billion in assets under management, shared the following stats in an article:
$1,000 invested in US stocks in 1970 would become $138,908 by August 2019
Miss just the 25 best days in the market, and the $1,000 would grow to just $32,763
So, missing just a handful of the market’s best days will absolutely decimate our return. Unfortunately, the market’s best and worst days tend to cluster, as seen in the table below from investor Ben Carlson. As a result, it’s practically impossible to side-step the bad days and capture only the good days. To earn good returns in stocks over the long run, we have to accept the inevitable bad times.
Source: Ben Carlson
Don’t be scared
Markets will crash from time to time. It’s something we have to get used to. Wharton finance professor Jeremy Siegel once said that “volatility scares enough people out of the market to generate superior returns for those who stay in.” So don’t be scared. And please don’t attempt to flit in and out of your shares – patience is what ends up paying in investing.
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.
DKAM Capital Ideas Fund may not be that well-known in this part of the world. However its 17.2% annual return since 2008 is definitely worthy of attention.
Actively-managed funds have had a bad reputation in recent years. High fees and poor performance have resulted in the outflow of money from active funds to passive funds. But that’s not to say that there are no active funds that can outperform the market.
DKAM Capital Ideas Fund, run by Donville Kent Asset Management, is one such fund. From its inception in 2008 to 31 January 2020, the North American-focused fund has delivered a compound annul return of 17.2%, compared to the S&P 500’s 11.7%.
For a fund, even outpacing its relevant index by a few percentage points can be hugely rewarding for its investors. This can be seen in the huge difference between DKAM Capital Ideas Fund’s total return and the S&P 500’s. Cumulatively, the fund’s total return since inception is 503.7%, compared to the S&P 500’s 251.9% over the same 12-year period.
With such an impressive track record of growing shareholder wealth, I decided to take a look at some of DKAM Capital Ideas Fund’s materials to see what is the secret behind its success.
It looks for compounders
Some funds invest in “value stocks” and wait for these stocks to rise to their true value before selling. While this is a decent strategy, it requires active management of capital once these “value stocks” hit what the fund managers believe is their true value.
DKAM Capital Ideas Fund, on the other hand, invests in true compounders. Compounders are companies that can grow their value multiple-fold over the long term. True compounders have much higher upside potential and investors need not move in and out of positions to reap the gains.
A broad approach to screening
To look for these compounders, DKAM Capital Ideas Fund uses a broad approach to screening and idea generation.
The first step the fund manager takes is to screen for companies that have a high return on equity, typically more than 15%. A high return on equity suggests that a company is making good use of its shareholders’ equity to generate returns.
On top of that, the fund manager also sources for potential new ideas through the use of other basic screens, communication with industry contacts, the media, and publications.
This broad approach to idea generation has enabled the fund to unearth lesser-known companies.
For instance, as of 31 January 2020, 25 of DKAM Capital Ideas Fund’s positions are not in any major indices.
Long-short but with with a bias towards long
As a long-short fund, DKAM Capital Ideas Fund goes both “long” and “short” equities. (To go long means to invest in stocks with the view that they will appreciate in price; to go short means to invest in stocks with the view that they will decline in price.) The table below shows the fund’s exposure as of January 2020.
The short position covers some of the market’s downside risk while the long position is able to leverage up due to hedges from the shorts.
But overall, the net exposure of the fund is still 100.5% long.
DKAM Capital Ideas Fund short strategy is based on factor analysis and consists of companies that are essentially an inverse of its investment framework.
Bias toward small caps
Donville Kent Asset Management also believes that the small caps universe provide a unique opportunity.
Companies with small market capitalisations are less well-known and hence may have a good risk-reward profile. In a recent article, the fund noted that the top-performing stocks in Canada over the past decade started with an average market cap of C$796 million in 2009. The article explained:
“This is definitely on the small side and many of these stocks would not have met the minimum size requirements for most investors in 2009. We think this is where a lot of the opportunities are, hence why it is important to be open to investing in small companies. Every big company was at one point a small company. Looking back over the trajectories of these companies over the last 10 years shows that strong growth is definitely possible.”
The Good Investors’ view
DKAM Capital Ideas Fund is a fund that stands out in an industry that is gaining a bad reputation in recent years. Its long-term performance is driven by an approach that has enabled them to find gems that other investors have yet to uncover.
If you wish to read more of their investing insights, you can head to the ROE Reporter (the name of its newsletter) segment of the fund’s website.
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.
First, Li Lu’s views on China’s economy are worth paying attention to. Many of you likely don’t know who he is, but he’s an excellent investor in China. I have never been able to find Li’s investment track record, but one piece of information that I’ve known for years convinces me of his brilliance: Charlie Munger’s an investor in Li’s fund, and Munger has nothing but praise for it. Munger himself is an incredible investor with a well-documented track record, and he’s the long-time right-hand man of Warren Buffett. In a May 2019 interview with The Wall Street Journal, Munger talked about Li:
“There are different ways to hunt, just like different places to fish. And that’s investing.
And knowing that, of course, one of the tricks is knowing where to fish. Li Lu [of Himalaya Capital Management LLC in Seattle] has made an absolute fortune as an investor using Graham’s training to look for deeper values. But if he had done it any place other than China and Korea, his record wouldn’t be as good. He fished where the fish were. There were a lot of wonderful, strong companies at very cheap prices over there…
…Now, so far, Li Lu’s record [at Himalaya] is just as good with a lot of money as it was with very little. But that is a miracle. It’s no accident that the only outside manager I’ve ever hired is Li Lu. So I’m now batting 1.000. If I try it one more time, I know what will happen. My record will go to hell. [Laughter.]”
Second, I think Li’s essay contains thought-provoking insights from him and Koo on the economic future of the Western world, Japan, and China. These insights are worth sharing with a wider audience. But they are presented in Mandarin, and there are many investors who have little or no knowledge of the language. I am fortunate to have sufficient proficiency in Mandarin to be able to grasp the content (though it was still painful to do the translation!), so I want to pay it forward. This also brings me to the third reason.
Google’s browser, Google Chrome, has a function to automatically translate Li’s Mandarin essay into English. But the translation is not the best and I spotted many areas for improvement.
Before I get to my translation, I want to stress again that it is my own self-directed attempt. So all mistakes in it are my sole responsibility. I hope I’ve managed to capture Li Lu’s ideas well. I’m happy to receive feedback about my translation. Feel free to leave a comment in this post, or email me at thegoodinvestors@gmail.com.
Translation of Li Lu’s essay
This year, the book I want to recommend to everyone is The Great Recession Era: The Other Half of Macroeconomics and The Fate of Globalisation, written by Gu Chao Ming.
The book discusses the biggest problems the world is currently facing. First: Monetary policy. In today’s environment, essentially all the major economies of today – such as Japan, the US, Europe, and China – are oversupplying currencies. The oversupply of these base currencies has reached astronomical levels, resulting in the global phenomena of low interest rates, zero interest rates, and even negative interest rates (in the case of the Eurozone). These phenomena have never happened in history. At the same time, the increase in the currency supply has contributed very little to economic growth. Except for the US, the economies of most of the developed nations have experienced minimal or zero growth. Another consequence of this situation is that each country’s debt level relative to its GDP is increasing; concurrently, prices of all assets, from stocks to bonds, and even real estate, are at historical highs. How long will this abnormal monetary phenomenon last? How will it end? What does it mean for global asset prices when it ends? No one has the answers, but practically all of our wealth is tied to these issues.
Second: Globalisation. The fates of many countries, each at different stages of development, have been intertwined because of the rising trend of globalisation over the past few decades. But global trade and capital flows are completely separate from the monetary and fiscal policies that are individually implemented in each country. There are two consequences to this issue. Firstly, significant conflicts have developed between globalisation and global capital flows on one end, and each country’s economic and domestic policies on the other. Secondly, international relations are increasingly strained. For instance, we’re currently witnessing an escalation of the trade conflict between the US and China. There’s also rising domestic unrest – particularly political protests on the streets – in many parts of the world, from Hong Kong to Paris and Chile. At the same time, far-left and far-right political factions are increasingly dominating the political scene of these countries at the expense of more moderate parties, leading to heightened uncertainties in the world. Under these circumstances, no one can predict the future for global trade and capital flows.
Third: How should each country’s macroeconomic and fiscal policies respond to the above international trends? Should there be differences in the policies for each country depending on the stage of development they are at?
The three problems are some of the most pressing issues the world is facing today. The ability to answer even just one of them will probably be an incredible scholarly achievement – to simultaneously answer all three of them is practically impossible. In his book, Gu Chao Ming provided convincing perspectives, basic concepts, and a theoretical framework with sound internal logic for dealing with the three big problems. I can’t really say that Gu has given us answers to the problems. But at the very least, he provides inspiration for us to think through them. His theories are deeply thought-provoking, whether you agree with them or not.
Now let’s talk about the author, Gu Chao Ming [Richard C. Koo]. He is the Chief Economist of Nomura Research Institute and has had a strong influence on the Japanese government over the past 30 years. I first heard of him tens of years ago, at a YPO international conference held in Japan. He delivered a keynote speech at the event, explaining Japan’s then “lost decade” (it’s now probably a “lost two decades” or even “lost three deacdes”). Gu Chao Ming explained the various economic phenomena that appeared in Japan after its bubble burst. These include zero economic growth, an oversupply of currency, zero interest rates, massive government deficit, high debt, and more. The West has many different views on the causes for Japan’s experience, but a common thread is that they resulted from the failure of Japan’s macroeconomic policies.
Gu Chao Ming was the first to provide a completely opposite viewpoint that was also convincing. He introduced his unique and new economic concept: A balance sheet recession. After the bursting of Japan’s asset-price bubble, the balance sheet of the Japanese private sector (businesses and households) switched from rapid expansion to a mode of rapid contraction – he attributed Japan’s economic recession to the switch. Gu provided a unique view, that driving the balance sheet recession was a radical change in the fundamental goal of the entire Japanese private sector from maximising profits to minimising debts. In such an environment, the first thing the private sector and individuals will do when they receive money is not to invest and expand business activities, but to repay debt – it does not matter how much currency is issued by the government. The sharp decline in Japanese asset prices at that time placed the entire Japanese private sector and households into a state of technical bankruptcy. Because of this, what they had to do, and the way they repaired their balance sheets, was to keep saving and paying off their debts. This scenario inevitably caused a large-scale contraction in the economy. The Japanese experience is similar to the US economic crisis in the 1930s. Once the economy begins to shrink, a vicious cycle forms to accelerate the downward momentum. During the Great Depression in the 1930s, the entire US economy shrank by nearly 46% within a few years.
The Japanese government dealt with the problem by issuing currency on a large scale, and then borrowing heavily to make direct infrastructure investments to digest the massive savings of Japanese residents. Through this solution, the Japanese government managed to maintain the economy at the same level for decades. There’s no growth, but the economy has not declined either. In Gu Chao Ming’s view, the Japan government’s macroeconomic policies were the only right choices. The policies prevented the Japanese economy from experiencing the 46% decline in economic activity that the US did in the 1930s. At the same time, the Japanese private sector was given the time needed to slowly repair their balance sheets. This is why Japan’s private sector and households have gradually returned to normalcy today. Of course, there was a price to pay – the Japanese government’s own balance sheet was hurt badly. Japanese government debt is the highest in the world today. Nonetheless, the Japanese government’s policies were the best option compared to the other choices. At that time, that was the most unique view on Japan that I had come across. Subsequently, my observations on Japan’s economy have also confirmed his ideas to a certain extent.
The Western world was always critical of Japan’s policies. Their stance on Japan started to change only after they encountered the Great Recession of 2008-2009. This is because the Western world’s experience during the Great Recession was very similar to what Japan went through in the late 1980s after its big asset-bubble burst. At the time, prices of major assets in the West were falling sharply, leading to technical bankruptcy for the entire private sector – this was why the subsequent experience for the West was eerily similar to Japan’s. To deal with the problem, the main policy implemented by the key Western countries was the large-scale issuance of currency, and they did so without any form of prior agreement. At the time, the experience of the Great Depression of the 1930s was the main influence on the actions of the central banks in the West. The consensus among the economic fraternity after evaluating the policies implemented to handle the Great Depression of the 1930s was based predominantly on Milton Friedman’s views, that major mistakes were made in monetary policies in that era. Ben Bernanke, the chairperson of the US Federal Reserve in 2008, is a strong proponent of this view. In fact, Bernanke thinks that distributing money from helicopters is an acceptable course of action in extreme circumstances. Consequently, Western governments started issuing currency at a large scale to deal with the 2008 crisis. But the currency issuance did not lead to the intended effect of a rapid recovery in economic growth. The money received by the private sector was being saved and used to repay debts. This is why economic growth remains sluggish. In fact, the economy of the Eurozone is bordering on zero growth; in the US economy, there are only pockets of weak growth.
The first response by Western governments to the problem is to continue with their large-scale currency issuance. Western central banks have even invented a new way to do so: Quantitative easing (QE). Traditionally, central banks have regulated the money supply by adjusting reserves (the most important component of a base currency). After implementing QE, the US Federal Reserve’s excess reserves have grown to 12.5 times the statutory amount. The major central banks in the West have followed the US’s lead in implementing QE, resulting in the selfsame ratio reaching 9.6 times in the Eurozone, 15.3 times in the UK, 30.5 times in Switzerland, and 32.5 times in Japan! In other words, under normal economic conditions, inflation could reach a similar magnitude (for example, 1,250% in the US) if the private sector could effectively deploy newly issued currency. Put another way, if the newly issued currency were invested in assets, it could lead to asset prices rising manifold to reach bubble levels or provide strong stimulus to GDP growth.
But the reality is that economic growth is anaemic while prices for certain assets have been rising. The greatest consequence of this policy is that interest rates are close to zero. In fact, the Eurozone has around US$15 trillion worth of debt with negative rates today. This has caused questions to be raised about the fundamental assumptions underpinning the entire capitalistic market system. At the same time, it has also not produced the hoped-for economic growth. Right now, the situation in Europe is starting to resemble what Japan experienced back then. People are starting to rethink the episode in Japan. Interest in Gu Chao Ming’s viewpoints on Japan and its fiscal policies are being reignited in the important Western countries.
Gu Chao Ming used a relatively simple framework to explain the phenomena in Japan. He said that an economy will always be in one of the following four regimes, depending on the actions of savers and investors:
Under normal circumstances, an economy should have savers as well as borrowers/investors. This places the economy in a positive state of growth. When an ordinary economic crisis arrives, savers tend to run out of capital but borrowers and investing opportunities are still present. In this scenario, it’s crucial that a central bank plays the role of supplier of capital of the last resort. This viewpoint – of the central bank having to be the lender and supplier of capital of the last resort – is the conclusion that the economic fraternity has from studying the Great Depression of the 1930s. Central banks provide the capital, which is then lent to the private sector.
But nobody thought about what happens to an economy when the third and fourth regimes appear. These regimes are unprecedented and characterised by the absence of borrowers (investors). For instance, there have been savers in Japan for the past few decades, but the private sector has no motivation to borrow for investments. What can be done in this case? In the 2008-2009 crisis, there were no savers as well as borrowers in the Western economies. Savers were already absent when the crisis happened. In the US, the private sector was mired in a state of technical bankruptcy because asset prices were falling heavily while there were essentially no savers. At the same time, there were no investment opportunities in Europe. Even after a few rounds of QE and the massive supply of base currencies, nobody was willing to invest – there were simply no opportunities to invest in the economy. When people got hold of capital, they in essence returned the capital to banks via negative interest rates. This situation was unprecedented.
The key contributions to the body of economic knowledge by Gu Chao Ming’s framework relates to a better understanding of what happens in the third and fourth regimes where borrowers are absent. Let’s take Japan for example. It is in the third regime, where there are savers but no borrowers. He thinks that the Japanese government should take up the mantle of being the borrower of last resort in this situation and use fiscal policy to conduct direct investments. A failure to do so will lead to a contraction in the economy, since the private sector is unwilling to borrow. And once the economy contracts, a vicious cycle will form, potentially causing widespread unemployment and economic activity to decline by half. The societal consequences are unthinkable. We know that Hitler’s rise to power in the 1930s and a revival in Japanese militarism in the same era both had direct links to the economic depression prevalent back then.
The fourth regime, one where savers and borrowers are both absent, describes the 2008-2009 crisis. When a fourth regime arises, the government should assume the roles of both provider of capital of last resort, and borrower of last resort. In the US during the 2008-2009 crisis, the Federal Reserve issued currency while the Treasury department used the TARP (Troubled Asset Relief Program) Act to directly inject capital into systematically important commercial and investment banks. The actions of both the Fed and the Treasury stabilised the economy by simultaneously solving the problems of a lack of savers and borrowers. Till this day, Western Europe is possibly still trapped in the third or maybe even the fourth regime. There are no savers or borrowers. Structural issues in the Eurozone make matters worse. Countries in the Eurozone can only make use of monetary policy, since they – especially the countries in Southern Europe – are restricted from using fiscal policy to boost domestic demand. These constraints within Europe could lead to catastrophic consequences in the future.
Gu Chao Ming used the aforementioned framework to analyse the unique problems facing the global economy today (the appearance of the third and fourth regimes). He also provided his own views on the current economic policies of developed nations.
He considered the following questions: Why did both Western Europe and the US lumber toward asset bubbles? In addition, why were they unable to discover the path that leads to a return to growth (the US did return to growth, but it is anaemic) after their asset bubbles burst? To answer these questions, Gu Chao Ming provided what I think is his second unique perspective, which is meaningful for the China of today. He shared that an economy will have three different stages of development under the backdrop of globalised trade.
Let me first introduce an important concept in development economics – the Lewis Turning Point. In the early days of urban industrialisation, surplus rural workers are constantly attracted by it. But as industrialisation progresses to a certain scale, the surplus of workers in the rural areas now becomes a shortage, leading to the economy entering a state of full employment. This is the Lewis Turning Point, which was first articulated by British economist W. Arthur Lewis in the 1950s.
Gu Chao Ming’s first stage of development refers to the early days of urban industrialisation, before the Lewis Turning Point is reached. The second stage happens when the economy has moved past the Lewis Turning Point and is in a phase where savings, investments, and consumption are all in a state of intertwined growth. This is also known as the Golden Era. In the third stage of development – a unique stage that Gu Chao Ming brought up – the economy enters a state of being chased, after it passes a mature growth phase and becomes an advanced economy. Why does this happen? That’s because investing overseas in developing countries becomes more advantageous as the cost of domestic production reaches a certain level. In the earlier days, the advantages of investing overseas in developing countries are not clear because of cultural and institutional obstacles. But as domestic production costs rises to a certain height, while other countries are simultaneously strengthening their infrastructure to absorb foreign investments, it becomes significantly more attractive to invest overseas compared to domestically. At this point, capital stops being invested in the country, and domestic wages start to stagnate.
In the first stage of development (the pre-Lewis Turning Point phase), owners of capital have absolute control. This is because rural areas are still supplying plenty of labour, and so the labour force is generally in a weak position to bargain and does not have much pricing power. Companies tend to exploit workers when there are many people looking for work.
In the second stage of development (when the economy is past the Lewis Turning Point and enters a mature growth phase), companies need to rely on investing in productivity to raise their output. At the same time, companies need to satisfy the demands of the labour force, such as increasing their wages, improving their working environment, providing them with better equipment, and more. In this stage, economic growth will lead to higher wages, because shortages are starting to appear in the labour supply. A positive cycle will form, where a rise in wages will lead to higher consumption levels, driving savings and investments higher, and ultimately higher profits for companies. During the second stage, nearly every member of society can enjoy the fruits of economic development. Meanwhile, a consumer society led by the middle class will be formed. Living standards for each level in society are improving – wages are rising even for people with low education levels. This is why the second stage of development is also known as the Golden Era.
Changes in society start to appear in the third stage of development. For the labour force, only those in highly-skilled roles (such as in science and technology, finance, and trade etc.) will continue to receive good returns from their jobs. Wages in traditional manufacturing jobs that require low levels of education will gradually decline. Wealth-inequality in society will widen. Domestic economic and investment conditions will deteriorate, and investors will increasingly look to foreign shores for opportunities. At this juncture, GDP growth will rely on continuous improvements in technology. Countries that excel in this area (like the US for example) will continue to enjoy GDP growth, albeit at a low pace; countries with a weaker ability to innovate (such as Europe and Japan) will experience poor economic growth, and investments will shift toward foreign or speculative opportunities.
Gu Chao Ming thinks that the Western economies had entered the third stage of development in the 1970s. Back then, they were being chased mainly by Japan and Asia’s Four Dragons. Fast forward to the 1980s and China had started to open itself to the international economy while Japan entered the phase of being chased. While being chased, a country’s domestic economic growth opportunities tend to decrease sharply. At the same time, any pockets of economic growth tend to form into frothy bubbles. It was the case in Japan, the US, and Western Europe. Capital flowed into real estate, stocks, bonds, and financial derivatives, forming massive bubbles and their subsequent bursting. Even after a bubble bursts, the country’s economic growth opportunities and potential remain extremely limited. As a result, the economy’s ultimate goal shifts from maximising profits to minimising liabilities. That’s because on one hand, the private sector has nowhere to invest domestically, while on the other, it wants to repair its balance sheet. In this way, predictions that are based on traditional economic theories will fail.
Gu Chao Ming pointed out that the functions of a government’s macro policies should change depending on what stage of development the economy is at. And so, different policy tools are needed. This view has meaningful implications for China today.
In the early phases of industrialisation, economic growth will rely heavily on manufacturing, exports, and the formation of capital etc. At this juncture, the government’s fiscal policies can play a huge role. Through fiscal policies, the government can gather scarce resources and invest them into basic infrastructure, resources, and export-related services etc. These help emerging countries to industrialise rapidly. Nearly every country that was in this stage of development saw their governments implement policies that promote active governmental support.
In the second stage of development, the twin engines of economic growth are rising wages and consumer spending. The economy is already in a state of full employment, so an increase in wages in any sector or field will inevitably lead to higher wages in other areas. Rising wages lead to higher spending and savings, and companies will use these savings to invest in productivity to improve output. In turn, profits will grow, leading to companies having an even stronger ability to raise wages to attract labour. All these combine to create a positive feedback loop of economic growth. Such growth comes mainly from internal sources in the domestic economy. Entrepreneurs, personal and household investing behaviour, and consumer spending patterns are the decisive players in promoting economic growth, since they are able to nimbly grasp business opportunities in the shifting economic landscape. Monetary policies are the most effective tool in this phase, compared to fiscal policies, for a few reasons. First, fiscal policies and private-sector investing both tap on a finite pool of savings. Second, conflicts could arise between the private sector’s investing activities and the government’s if poorly thought-out fiscal policies are implemented, leading to unnecessary competition for resources and opportunities.
When an economy reaches the third stage of development (the stage where it’s being chased), fiscal policy regains its importance. At this stage, domestic savings are high, but the private sector is unwilling to invest domestically because the investing environment has deteriorated – domestic opportunities have dwindled, and investors can get better returns from investing overseas. The government should step in at this juncture, like what Japan did, and invest heavily in infrastructure, education, basic research and more. The returns are not high. But the government-led investments can make up for the lack of private-sector investments and the lack of consumer-spending because of excessive savings. In this way, the government can protect employment in society and prevent the formation of a vicious cycle of a decline in GDP. In contrast, monetary policy is largely ineffective in the third stage.
For China’s current development, discussions on the use of macro policies are particularly meaningful. Although there are different viewpoints, the general consensus is that China had passed the Lewis Turning Point a few years ago and entered a mature growth phase. Over the past decade, we’ve seen accelerating growth in the level of wages, consumer spending, savings, and investments. But even when an economy has entered a new stage of development, the economic policies that were in place for the previous stage of development – and that have worked well – tend to remain for some time. The lag in the formulation and implementation of new policies that are more appropriate for the current stage of development comes from the inertia inherent in government bodies. This mismatch between macro policies and the stage of development the economy is at has happened in all countries and stages. For instance, Western economies are still stuck with macro policies that are more appropriate for the Golden Era (fiscal policy). Actual data show that the current policies in the West have worked poorly. Today, many Western countries (including Japan) are issuing currencies on a large scale and have zero or even negative interest rates. But even so, these countries are still facing extremely low inflation and slow economic growth while debt levels are soaring.
In the same vein, China’s government is still relying heavily on policies that are appropriate for the first stage of development even when the country’s economy has grown beyond the Lewis Turning Point. In the past few years, we have seen a series of measures for economic reforms. Their intentions are noble, meant to fix issues that have resulted from the industrialisation and manufacturing boom that occured in the previous development stage. But in practice, the reform measures have led to the closures and bankruptcies of private enterprises on a large scale. So from an objective standpoint, the reform measures have, at some level, produced the phenomenon of an advance in the state’s fortunes, but a decline for the private sector. More importantly, it has hurt the confidence of private enterprises and caused a certain degree of societal turmoil and loss of consumer-confidence. All of these have lowered the potential for economic growth in this stage.
Today, net exports contribute negatively to China’s GDP growth while consumption has a share of 70% to 80%. Private consumption is particularly important within the consumption category, and will be the key driver for China’s future economic growth. In the Golden Era, the crucial players are entrepreneurs and individual consumers. The focus and starting point for all policies should be on the following: (1) strengthening the confidence of entrepreneurs; (2) establishing market rules that are cleaner, fairer, and more standardised; (3) reducing the control that the government has over the economy; and (4) lowering taxes and economic burdens. Monetary policy will play a crucial role at this juncture, based on the experiences of many other developed countries during their respective Golden Eras.
During the first stage of development, China’s main financial policy system was based on an indirect financing model. It’s almost a form of forced savings on a large scale, and relied on government-controlled banks to distribute capital (also at a large scale) at low interest rates to manufacturing, infrastructure, exports and other industries that were important to China’s national interests. This financial policy was successful in helping China to industrialise rapidly.
At the second stage of development, the main focus should be this: How can society’s financing direction and methods be changed from one of indirect financing in the first stage to one of direct financing, so that entrepreneurs and individual consumers have the chance to play the key borrower role? We’ve seen such changes happen to some extent in the past few years. For instance, the area of consumer credit has started developing with the help of fintech. There are still questions worth pondering for the long run, such as whether property mortgages can be done better to unleash the potential for secondary mortgages. During this stage, some of the most important tools in macro policy include: Increasing the proportion of direct financing in the system; enhancing the stock market’s ability to provide financing for private enterprises; and establishing bond and equity markets. In addition, the biggest tests for the macro policies are whether the government can further reduce its power in the economy and switch its role from directing the economy to supporting and servicing it.
Over the past few years, the actual results of China’s macro policies have been poor despite the initial good intentions when they were implemented. This is because the policies were simply administrative means. The observation of the economic characteristics of China’s second stage of development also gives us new perspectives and lessons. During the Golden Era of the second stage of development, some policies could possibly have better results if they were adjusted spontaneously by market forces. In contrast, directed intervention may do more harm than good. These are the most important subjects for China today.
Currently, Japan, Western Europe and the US are all in the third stage of development while China is in the second. This means that China’s potential for future growth is still strong. China’s GDP per capita of around US$10,000 is still a cost-advantage for developed nations in the West. At the same time, other emerging countries (such as India) have yet to form any systemic competitive advantages. It’s possible for China to remain in the Golden Era for an extended period of time. China’s GDP per capita is around US$10,000 today, but there are already more than 100 million people in the country that have a per-capita GDP of over US$20,000. These people mainly reside in the southeast coastal cities of the country. China actually does not require cutting-edge technology to help its GDP per capita make the leap from US$10,000 to US$20,000 – all it needs is to allow the living standards and lifestyles of the people in the southeast coastal cities to spread inward throughout the country. The main driver for consumption growth is the “neighbour effect” – I too want for myself what others eat and possess. Information on the lifestyles of the 100 million people in China’s southeast coastal cities can be easily disseminated to the rest of the country’s 1 billion-plus population through the use of TV, the internet, and other forms of media. In this way, China’s GDP per capita can reach US$20,000.
In the years to come, the level of China’s wages, savings, investments, and consumption will all increase and create a positive cycle of growth. Investment opportunities in the country will also remain excellent. Attempts to unleash the growth potential in China’s economy would benefit greatly if China’s government can learn from the monetary policies of the Western nations when they were in their respective Golden Eras, and make some adjustments to the relationship between itself and the market. Meanwhile, Western nations (especially Western Europe) could learn from the positive experiences of the fiscal policies of Japan and China, and allow the government to assume the role of borrower of last resort and invest in infrastructure, education, and basic research at an even larger scale. Doing so will help developed nations in the West to maintain economic growth while they are in the third stage of development (of being chased).
The idea of adjusting policies and tools as the economy enters different stages of development is a huge contribution to the world’s body of economic knowledge. Economics is not physics – there are no everlasting axioms and theories. Economics requires the study of constantly-changing economic phenomena in real life to bring forth the best policies for each period. From this viewpoint, the theoretical framework found in Gu Chao Ming’s book is a breakthrough for economic research.
Earlier, I mentioned three big questions that the world is facing today and that the book is trying to answer. They are the most intractable and pressing issues, and it is unlikely that there will be perfect answers. Gu Chao Ming has a deep understanding of Japan, so the views found in his book stem from his knowledge of the country’s economic history. But is Japan’s experience really applicable for Europe and the US? This remains to be seen. QE, currency oversupply, zero and negative interest rates, high asset prices, wealth inequality, the rise of populist politics – these phenomena that arose from developed countries will continue to plague policy makers and ordinary citizens in all countries for a long period of time.
For China, it has passed the Lewis Turning Point and is in the Golden Era. The economic policies (particularly the fiscal policies) implemented by Japan and other developed countries in the West during their respective Golden Eras represent a rich library of experience for China to learn from. It’s possible for China to unleash its massive inherent economic growth potential during this Golden Era, so long as its policymakers know clearly what stage of development the country is at, and make the appropriate policy adjustments. China’s future is still promising.
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.
Although most companies will likely see COVID-19 impact their sales, Teladoc could benefit from the epidemic as more clients warm up to its services.
I try not to let short-term factors affect my long-term investing decisions. The COVID-19 outbreak is one such short-term factor. It is most definitely going to impact economic growth and corporate earnings this year for many countries. But it will likely have no economic impact five years from now.
So despite the huge drop in the S&P 500 and Dow Jones Industrial Average in the US stock market last week, I am still resolutely holding on to all my stocks. I believe that the economic impact will be short-lived and companies with strong balance sheets, recurring income, and steady free cash flow will be able to weather this storm.
At the same time, I am not hopping on the bandwagon of overly-hyped companies that could benefit from the coronavirus situation over the short-term, such as mask and glove producers. These manufacturers may see a sharp spike in revenue over the next few quarters, but the jump in sales will likely only be a one-off event.
All that being said, I think this latest global virus outbreak could still potentially throw up some unique long-term opportunities. One company I see benefiting long term from the outbreak is Teladoc Health Inc (NYSE: TDOC).
Why COVID-19 could benefit Teladoc
Teladoc is the leading telemedicine company in the US. It provides video consultations for primary care, dermatology, and behavioural health. The company’s app makes getting professional healthcare advice so much easier. Patients simply need to open the app and start a video consulting session with a doctor. Best of all, this can be done in the comfort of your own home, which is all the more important when you are suffering from an illness and don’t want the hassle of travelling to your local clinic.
The COVID-19 outbreak in the US could be the catalyst that Teladoc needs for faster adoption of its technology. Video consultations will reduce the spread of infections, enable patients to get real-time advice, and increase the consultation-efficiency for doctors. All of these advantages are important at a time when the virus is rampant and patients need access to quick and effective advice.
CEO Jason Gorevic also said in the company’s latest earnings conference call, “We also see that once members use our services for the first time, they are much more likely to use us again.” As such, if COVID-19 does increase adoption of Teladoc during this time, the likely impact will be that patients who use the technology for the first time will continue using it in the future.
Strong growth even before the outbreak
Although the COVID-19 epidemic will likely increase the rate of adoption of video consultations around the world, Teladoc has already seen rapid growth even without this catalyst.
Teladoc reported a 32% increase in revenue in 2019. The total number of visits increased by 57% to 4.1 million, exceeding the company’s own projections.
And the leading telehealth company is expecting more growth in 2020. Even before factoring the spread of COVID-19 in the US, Teladoc reported in its latest earnings update that 2020 revenue will increase by 25% at the low-end. Over the longer term, Teladoc expects to grow between 20% to 30% a year.
Huge addressable market
Back in 2015, Teladoc said in its IPO prospectus that the Centers for Disease Control and Prevention in the US estimated that there were 1.25 billion ambulatory care visits in the United States per year. Of which, 417 million could be treated by telehealth. And that figure should be much larger today.
Teladoc, therefore, has plenty of room to grow into. In 2019, despite the 57% spike in the number of visits, total visits were still only 4.1 million. That is less than 1% of its addressable market in the US alone.
The international market provides another avenue of growth. Online consultations could be an even greater value-add in countries with lower doctor-to-patient ratios and where access to doctors is even more prohibitive. Right now, international markets only contribute less than 20% of Teladoc’s revenue.
Recurring revenue model
Another thing I like about Teladoc is its revenue model. The telemedicine company has recurring subscription revenue that it derives from employers, health plans, health systems, and other entities. These clients purchase access to Teladoc services for their members or employees.
The revenue from these clients is on a contractually recurring, per-member-per-month, subscription access fee basis, hence providing Teladoc with visible recurring revenue streams.
Importantly, the subscription revenue is not based on the number of visits and hence should have a huge gross profit margin for the company.
Teladoc ended 2019 with 36.7 million US paid members, a 61% increase from 2018. In 2019, this subscription access revenue increased 32% from a year ago and represented 84% of Teladoc’s total revenue.
Other significant catalysts
Besides the COVID-19 outbreak, there are possible catalysts that could drive greater adoption of Teladoc services in the near future.
Mental health services driving B2B adoption: As mental health continues to become an increasingly important health issue, Teladoc’s mental health product has been a significant contributor to its B2B adoption.
Expanding its product offering: Teladoc launched Teladoc Nutrition in the fourth quarter of 2019, offering personalised nutrition counselling. Nutrition is becoming an increasingly important aspect of preventive medicine and the new service could add significant value to existing and new clients.
Regulatory shifts in the US: In April 2019, the Centers for Medicare & Medicaid Services finalised policies that could potentially benefit Teladoc. Its new policies increase plan choices and benefits and allow Medicare Advantage plans to include additional telehealth benefits. Jason Gorevic, Teladoc’s CEO, commented on this: “We view this as further evidence of CMS encouraging the adoption of virtual care in the Medicare population, and we continue to see a significant avenue for growth within the Medicare program.”
Acquisition of InTouch Health: Besides organic growth drivers, Teladoc is expected to complete the acquisition of InTouch Health in the near futue. InTouch Health is a leading provider of enterprise telehealth solutions for hospitals and health systems.
The Good Investors’ Take
The COVID-19 situation is likely going to hinder the growth of many companies in the near term at least. However, Teladoc looks like one that will buck the trend and will instead benefit in both the short and long run from the epidemic.
Besides the COVID-19 catalyst, the long-term tailwinds surrounding the truly disruptive service and Teladoc’s first-mover advantage in this space gives it an enormous opportunity to grow into.
There are, however, risks to note. Competition, execution risk, and the company’s inability to generate consistent free cash flow are all potential risks. Moreover, the telehealth provider’s stock trades at more than 16 times trailing revenue, a large premium to pay. Any hiccups in its growth could cause significant volatility to its share price.
Nevertheless, I think the reasons to believe it can grow in the long-term are compelling. Its addressable market is also big enough for multiple players to split the pie. If Teladoc can even service just 20% of its total addressable market, it will likely be worth many times more by then.
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.
Bill.com’s stock has more than doubled since it went public late in 2019. Is the financial back-office solutions SaaS company worth investing in?
2019 was a mixed year for IPOs. While big names such as Uber and Lyft failed to live up to the hype, others such as BeyondMeat and Zoom were roaring successes.
One company that was hot straight off the bat was Bill.com (NYSE: BILL), whose share price surged 65% on its first trading day. The cloud-based software provider helps small and medium-sized businesses manage customer payments and cash flow.
After releasing a good set of results for its first quarter as a listed company, Bill.com’s share price jumped again and are now trading an eye-popping 143% above its IPO price.
With the surge in price, I decided to take a deeper look into the company and whether its shares at today’s price is a good investment opportunity. I will analyse Bill.com using my blogging partner Ser Jing’s six-point investment framework.
1. Is Bill.com’s revenue small in relation to a large and/or growing market, or is its revenue large in a fast-growing market?
Bill.com’s main clientele are small and medium businesses (SMB). According to the US Census Bureau, there were 6 million SMBs in the US in 2018. Data from SME Finance Forum pointed to 20 million SMEs globally in 2019. These numbers translate to a market opportunity of US$30 billion globally and US$9 billion domestically for Bill.com, based on an average revenue of US$1,500 per customer.
Comparatively, Bill.com, as of the end of 2019, served just 86,000 customers and had a US$156 million revenue run rate. That means it is serving just 2.6% of its total US addressable market, giving it a huge opportunity to grow into.
We’ve not even touched the international market opportunity yet. Bill.com currently operates only in the US and if and when it opens its doors internationally, we could see another big wave of growth.
The 61% year-on-year jump in core revenue in the quarter ended 31 December 2019 also demonstrates that the company is on the right track to fulfilling its vast potential.
CEO and founder, Rene Lacerte, outlined five key drivers of growth during the latest earnings conference call that will help Bill.com capitalise on its market opportunity:
Invest in sales and marketing activities to acquire new customers
Seek increased adoption by existing customers by increasing the number of its customers’ employees who become regular users (Bill.com charges each company a fixed amount per user)
Grow the number of network members (network members are suppliers and clients that customers can interact with through the platform)
Enhance platform capabilities through R&D
Expand internationally
2. Does Bill.com have a strong balance sheet with minimal or a reasonable amount of debt?
As is the case for most fast-growing start-ups, Bill.com is still loss-making and burning cash. The company had negative free cash flow of around US$10 million and US$8 million in fiscal 2018 and 2019 (the company’s fiscal year ends on 30 June).
Thankfully, Bill.com is flushed with cash after its IPO. At end-2019, the company had no debt, and US$382 million in cash and short term investments. This puts Bill.com in a commanding position financially and it also means that the company should have the financial power to continue investing for growth.
It is also positive to note that the company’s sharp rise in share price could also open the door for it to raise more money through issuing shares (in a reasonable manner!) to boost its balance sheet in the future.
3. Does Bill.com’s management team have integrity, capability, and an innovative mindset?
Rene Lacerte has an impressive resume. He is a serial entrepreneur who sold his last startup, PayCycle, to Intuit for US$170 million. It was at PayCycle when he realised how difficult it was to run the back-office operations of a company. Hence, he started Bill.com to streamline the back-office processes of SMBs.
His track record as an entrepreneur is a testament to his ability to innovate and lead a team. Bill.com has a 13-year track record of growth and has consistently improved its service and grown its network of partners.
These initiatives have helped build Bill.com into a platform that customers trust and stick with.
I think Lacerte has a clear vision for the company and he has put in place a good framework to achieve that. In addition, his decision to take the company public last year is also smart, given the high valuation that he managed to raise new capital at.
When looking at a company’s management team, I also like to assess whether the compensation structure is incentivised to boost long-term shareholder value.
I think Bill.com has a fair incentive structure. Rene Lacerte is paid a base salary of US$350,000 and also given option awards. As the option awards vest over a multi-year period, it incentivises him to grow long-term shareholder value.
4. Are Bill.com’s revenue streams recurring in nature?
Bill.com has a predictable and recurring stream of revenue. The cash management software company derives its revenue through (1) monthly subscriptions, (2) transaction fees, and (3) interest income from funds held on behalf of customers while payment transactions are clearing.
Monthly subscriptions are recurring as Bill.com’s customers tend to auto-renew their subscriptions. Transaction fees are not strictly recurring in nature, but approximately 80% of total payment volume and the number of transactions on Bill.com’s platform in every month of fiscal 2019 represented payments to suppliers or from clients that had also been paid or received from those same customers in the preceding quarter.
In other words, Bill.com’s customers tend to make recurring payments or collect recurring fees over the platform. This, in turn, generates recurring transaction fees for Bill.com.
In the quarter ended December 2019, subscription and transaction revenue made up US$33 million of the total revenue of US$39.1 million.
Bill.com also has a decent customer retention rate of 82% as of June 2019. The net dollar-based retention rate is an indicator of how much more customers are spending on the platform, net of upsells, contraction, and attrition. Ideally, the number should be more than 100%. Bill.com’s net dollar-based retention rate was 110% for fiscal 2019 and 106% for 2018. Put another way, Bill.com’s customers as a group, paid 10% and 6% more in 2019 and 2018, respectively.
The increase in net spend by existing customers is a good indicator that Bill.com has a business model that promotes recurring and growing revenue from its existing clients.
5. Does Bill.com have a proven ability to grow?
Bill.com has barely gotten its feet wet as a listed company so it has yet to prove itself to the investing public. However, as a private company, Bill.com has grown by leaps and bounds.
The chart below shows the annual payment growth and milestones that it has achieved since 2007.
Bill.com grew to 1,000 customers in three years after launching its demo in 2007. In 2014, it hit 10,000 customers and today serves more than 86,000 customers.
As the company’s revenue is closely linked to the number of customers it serves and the payment volume handled through its platform, Bill.com’s revenue has also likely compounded at an equally rapid pace over the years.
Most recently, Bill.com reported a strong set of results in its first quarter as a listed company with core revenue up 61% in the quarter ended December 2019.
6. Does Bill.com have a high likelihood of generating a strong and growing stream of free cash flow in the future?
As mentioned earlier, Bill.com is still not free cash flow positive. However, I believe the company has a clear path to profitability and free cash flow generation.
For one, its existing customers provide a long and steady stream of cash over a multi-year time period. As such, the company can afford to spend a higher amount to acquire customers.
In its S-3 filing, Bill.com showed a chart that illustrated the value of its existing customer base.
Source: Bill.com S-3
The chart is a little blur so let me quickly break it down for you. The orange bars illustrate the revenue earned from the customers who started using Bill.com’s software in the fiscal year 2017. The revenue earned from the cohort increased from US$6.7 million in FY17 to US$14.2 million and US$17.3 million in FY18 and FY19, respectively.
The dark blue chart shows customer acquisition costs related to getting the 2017 cohort onto its platform. Once the customers are using the platform, they tend to stay on and there is no need to spend more on marketing. Hence, there is no dark blue bar in FY18 and FY19.
The dotted black line is the contribution margin from the cohort. Contribution margin rose from -108% (due to the high customer acquisition cost that year) in FY17 to 73% and 76% in FY18 and FY19, respectively.
In short, the chart demonstrates the multi-year value of Bill.com’s customers and the high potential margins once the customers are on its platform. These two factors will likely drive profitability in the future for the company.
Risks
Execution-risk is an important risk to take note of for Bill.com. The relatively young SaaS firm is just finding its feet as a public company and will need to execute on its growth plans to fulfill its potential and deliver shareholder returns.
With barely three months of a public track record to go on, investors will need to take a leap of faith on management to see if they can actually deliver.
There is also key-man risk. Lacerte is the main reason for the company’s success so far. His departure, for whatever reason, could be a big blow to the company.
In addition, the market for financial back-office solutions is fragmented and competitive. Some of Bill.com’s competitors may eat into its market share or develop better products.
That said, Bill.com has built up an important network of partners and businesses that are already supported on its platform. This network effect creates value for its current customers and I think it is difficult for competitors to replicate.
Valuation
Now we come to the tricky part- valuation. Valuation is always difficult, especially so for a company that has yet to generate free cash flow and with an uncertain future. I will, therefore, have to make an educated guess on where I see the company in the future.
According to its own estimate, Bill.com has a market opportunity of US$39 billion worldwide. To be a bit more conservative, let’s cut this opportunity by half and then assume it can achieve a 20% market share at maturity in five to 10 years’ time.
If that comes to fruition, Bill.com can have annual revenue of US$3.9 billion. Given its high 75% gross profit margin, I will also assume that it can achieve a net profit margin of 25%. Mathematically, that translates to an annual profit of US$975 million.
If the market is willing to value the company at 25 times earnings by then, Bill.com could be worth close to US$24.4 billion.
Today, even after the spike in Bill.com’s share price, it has a market cap of just around US$3.8 billion. In other words, the stock could potentially rise by more than 600% over the next five to 10 years if it lives up to the above projections.
The Good Investors’ conclusion
Bill.com has had a good start to life as a listed company, with shares soaring above its IPO price.
It also ticks many of the boxes that Ser Jing and I look for in our investments. It has a huge addressable market, a proven track record of growth, and a clear path to profitability. The injection of cash from the IPO also gives it a war chest to invest in international expansion.
On top of that, its market cap is still a fraction of its total addressable market and potential future market value. There are risks but if Bill.com can live up to even a fraction of its potential, I believe its stock could rise much higher.
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.
Fears related to the coronavirus (COVID-19) have caused stocks to fall. Economies are also at risk of facing a recession. What should investors do?
Stock markets around the world have fallen in recent times. For instance, the S&P 500 in the US was down by 6.6% from last Friday (21 February 2020) to Wednesday (26 February 2020). At our home in Singapore, the Straits Times Index has declined by 5.1% from 17 January 2020 to 26 February 2020.
I hate to attach reasons to short-term market moves. But this time, it’s pretty clear that fears related to COVID-19, the most recently discovered coronavirus that has infected humans on a large scale, are the culprits.
What scares us
These fears exist for good reasons – there could be a global economic downturn in the works. Already, businesses of many large companies around the world have been affected by COVID-19. In the US, these include Apple, Microsoft, and Booking Holdings (which is in my family’s investment portfolio) just to name a few. In Singapore, property giant CapitaLand, airline caterer SATS, and even Temasek Holdings (one of the Singapore government’s investment arms), have enacted pay cuts because of difficult business conditions.
Plenty of human suffering have happened because of COVID-19, and sadly no one knows how widespread the disease outbreak will be. And from an investing angle, I don’t think anyone knows the eventual effects that COVID-19 will have on the global economy and financial markets (you should run from anyone who claims he/she does!).
Lessons from the past
History is not, and will never be, a perfect guide for the future. But in an uncertain time like this, studying the past can give us context and soothe our nerves.
I’m looking mostly at the US stock market and economy, since there is good long-term data for me to work with.
The chart below shows all the recessions (the dark grey bars) in the US since 1871. You can see that recessions in the country – from whatever causes – have been regular occurrences even in relatively modern times. They are par for the course, even for a mighty economy like the US.
The following logarithmic chart shows the performance of the S&P 500 (including dividends) from January 1871 to February 2020. It turns out that US stocks have done exceedingly well over the past 149 years (up 46,459,412% in total including dividends, or 9.2% per year) despite the US economy having encountered numerous recessions. If you’re investing for the long run, recessions can hurt over the short-term, but they’re nothing to fear.
Source: Robert Shiller data; National Bureau of Economic Research
Having an idea of how often stocks have fallen – for whatever reasons – is also useful to put the current mini-meltdown in stocks into perspective. Between 1928 and 2013, the S&P 500 has, on average, fallen by 10% once every 11 months; 20% every two years; 30% every decade; and 50% two to three times per century. Over the same period, US stocks have climbed by 283,282% (including dividends), or 9.8% per year. Stocks frequently decline hard even while they’re in the process of earning good long-term returns for investors. So when stocks fall, it’s not a sign that something is broken – it’s just a natural part of the game.
It’s worth noting too that global stocks have registered solid long-term gains despite multiple occurrences of deadly disease outbreaks in the past. This is shown in the following chart:
Some of you might be thinking: Now that there’s a heightened risk of a global recession, should we try to time the stock market? I don’t think so. Why? Look at the chart below. The red line shows the return we could have earned from 1980 to today in the US stock market if we had sold stocks at the official start of a recession in the country and bought stocks at the official end. The black line illustrates our return if we had simply bought and held US stocks from 1980 to today. It turns out that completely side-stepping recessions harms our return significantly, so it could be better to stayinvested for the long run.
This does not mean we should stay invested blindly. Companies that currently are heavily in debt, and/or have shaky cash flows and weak revenue streams are likely to run into severe problems if there’s an economic downturn. If a global recession really happens, and our portfolios are full of such companies, we may never recover. It’s always a good time to re-evaluate the companies in our portfolios, but I think there’s even more urgency to do so now.
A sage’s wise words
I want to leave the final words in this article to Warren Buffett. In an interview with CNBC earlier this week, the Oracle of Omaha shared his thoughts on how investors ought to be dealing with COVID-19. He said (emphasis is mine):
“Look, the tariff situation was a big question market for all kinds of companies. And still is to some degree. But that was front and center for a while. Now coronavirus is front and center. Something else will be front and center six months from now and a year from now and two years from now. Real question is — where are these businesses gonna be five and ten and 20 years from now? Some of them will do sensationally, some of them will disappear. And overall I think America will do very well — you know, it has since 1776…
…We’ve got a big investment in airline businesses and I just heard even more flights are canceled and all that. But flights are canceled for weather. It so happens in this case they’re gonna be canceled for longer because of coronavirus. But if you own airlines for 10 or 20 years you’re gonna have some ups and down in current. And some of them will be weather related and they can be all kinds of things. The real question is you know, how many passengers are they gonna be carrying 10 years from now and 15 years from now and what will margins be and– what will the competitive position be? But I still look at the figures all the time — I’ll admit that…
…[Coronavirus] makes no difference in our investments. There’s always gonna be some news, good or bad, every day. In fact, if you go back and read all the papers for the last 50 years, probably most of the headlines tend to be bad. But if you look at what happens to the economy, most of the things that happen are extremely good. I mean, it’s incredible what will happen over time. So if somebody came and told me that the global growth rate was gonna be down 1% instead of 1/10th of a percent, I’d still buy stocks if I liked the price at which — and I like the prices better today than I liked them last Friday…
… We’re buying businesses to own for 20 or 30 years. We buy them in whole, we buy them in part. They’re called stocks when we buy in part. And we think the 20- and 30-year outlook is not changed by coronavirus.”
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.
Mastercard has been in my family’s portfolio for a number years and it has done well for us. Here’s why we continue to own Mastercard.
Mastercard (NYSE: MA) is one of the 50-plus companies that’s in my family’s portfolio. I first bought Mastercard shares for the portfolio in December 2014 at a price of US$89 and subsequently made three more purchases (in February 2015 at US$85, in March 2017 at US$111, and in June 2019 at US$267). I’ve not sold any of the shares I’ve bought.
The purchases have worked out very well for my family’s portfolio, with Mastercard’s share price being around US$303 now. But it is always important to think about how a company’s business will evolve going forward. What follows is my thesis for why I still continue to hold Mastercard shares.
Company description
The US-headquartered Mastercard should be a familiar company to many of you who are reading this. Chances are, you have a Mastercard credit card in your wallet. But what’s interesting is that Mastercard is not in the business of issuing credit cards – it’s also not in the business of providing credit to us as consumers.
What Mastercard does is to provide the network on which payment transactions can happen. Here’s a graphical representation of Mastercard’s business:
Source: Mastercard 2019 annual report
Let’s imagine you have a Mastercard credit card and you’re buying an item in a NTUC supermarket. The transaction will involve five parties: Mastercard; the cardholder (you); the merchant (NTUC); an issuer (your bank that issued you the credit card); and an acquirer (NTUC’s bank). The transaction process will then take place in six steps:
Paying with your Mastercard credit card: You (cardholder) purchase your item from NTUC (the merchant) with your credit card.
Payment authentication: NTUC’s point-of-sale system captures your account information and sends it to NTUC’s bank (the acquirer) in a secure manner.
Submission of transaction: NTUC’s bank gets Mastercard to request an authorisation from your bank (the issuer).
Authorisation request: Mastercard sends information of your transaction to your bank for authorisation.
Authorisation response: Your bank authorises your transaction and pings the go-ahead to NTUC.
Payment to merchant: Your bank sends the payment for your transaction to NTUC’s bank, which then deposits the money into NTUC’s bank account.
Mastercard’s revenue comes from the fees it earns when it connects acquirers and issuers. In 2019, Mastercard earned US$16.9 billion in net revenue, which can be grouped into five segments:
Domestic assessments (US$6.8 billion): Fees charged to issuers and acquirers, based on dollar volume of activity, when the issuer and the merchant are in the same country.
Cross-border volume fees (US$5.6 billion): Charged to issuers and acquirers, based on dollar volume activity, when the issuer and merchant are in different countries.
Transaction processing (US$8.5 billion): Revenue that is earned for processing domestic and cross-border transactions and it is based on the number of transactions that take place.
Other services (US$4.1 billion): Includes services such as data analytics; consulting; fraud prevention, detection, and response; loyalty and rewards solutions; and more.
Rebates and incentives (-US$8.1 billion): These are payments that Mastercard pays to its customers. Revenues from domestic assessments, cross-border volume fees, transaction processing, and other services collectively make up Mastercard’s gross revenue. We arrive at Mastercard’s net revenue when we subtract rebates and incentives from gross revenue.
With the ability to handle transactions in more than 150 currencies in over 210 countries, it should not surprise you to find that Mastercard has a strong international presence. In 2019, the US accounted for just 32% of the company’s total revenue; no other individual country took up a revenue-share of more than 10%.
Investment thesis
I had previously laid out my six-criteria investment framework in The Good Investors. I will use the same framework to describe my investment thesis for Mastercard.
1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market
On the surface, Mastercard’s business already looks huge. The company processed 87.3 billion switched transactions in 2019, with a gross dollar volume of US$6.5 trillion; these helped to bring in US$16.9 billion in net revenue.
But the total market opportunity for Mastercard is immense. According to a September 2019 investor presentation by the company, the size of the payments market is US$235 trillion. From this perspective, Mastercard has barely scratched the surface.
Source: Mastercard September 2019 investor presentation
It’s worth noting too that around 80% of transactions in the world today are still settled with cash. So there are still plenty of cash-based transactions available for Mastercard to divert to its network.
Mastercard formed a JV with NetsUnion Clearing Corporation last year to conduct business in China. Earlier this month, the JV received in-principle approval from China’s central bank to operate in the country. Prior to this, Mastercard had no operations in China, so the regulatory approval could pave the way for a huge new geographical market for the company. NetsUnion Clearing Corporation’s stakeholders include China’s central bank, the People’s Bank of China. The JV will be able to apply for formal approval within a year.
2. A strong balance sheet with minimal or a reasonable amount of debt
At the end of 2019, Mastercard had US$7.7 billion in cash and investments on its balance sheet, against US$8.5 billion in debt. This gives rise to US$0.8 billion in net debt.
I generally prefer a balance sheet that has more cash than debt. But I’m not troubled at all in the case of Mastercard. That’s because the company has an excellent track record in generating free cash flow. The average annual free cash flow generated by Mastercard in 2017, 2018, and 2019 was US$5.0 billion, which compares well with the amount of net-debt the company has.
3. A management team with integrity, capability, and an innovative mindset
On integrity
Ajay Banga, 60, is Mastercard’s President and CEO. He has been CEO since July 2010, and I appreciate his long tenure. In 2018, Banga’s total compensation was a princely sum of US$20.4 million. But that is reasonable when compared with the scale of Mastercard’s business – the company’s profit and free cash flow in the same year were US$8.1 billion and US$5.5 billion, respectively. More importantly, his compensation structure looks sensible to me as a shareholder of the company. Here are the important points:
In 2018, 66% of Banga’s total compensation was from stock awards and stock options that vest over multi-year periods (three years and four years, respectively).
The stock awards are based on Mastercard’s revenue and earnings per share growth over a three-year period. I emphasised “per share” because Mastercard shareholders can only benefit from the company’s growth if there is per-share growth.
The value of the stock awards and stock options are nearly the same.
The lion’s share of the compensation of most of Mastercard’s other key leaders in 2018 also came from stock awards and stock options. This is illustrated in the table below.
Source: Mastercard 2019 proxy filing
It’s worth noting too that Mastercard’s management each have many years of experience with the company. Current CFO Sachin Mehra replaced Martina Hund-Mejean when the latter retired in April 2019; Mehra first joined Mastercard in 2010. The fact that Mastercard promotes from within is also a positive sign for me on the company’s culture.
There’s also a point I want to make on the alignment of interests between Banga and Mastercard’s shareholders: As of 26 April 2019, he controlled 1.859 million Mastercard shares which have a value of around US$563 million at the current share price. That’s a sizeable stake which likely places him in the same boat as other shareholders of the company.
On capability and innovation
Mastercard is a digital payment services provider. Some of the key business metrics that showcase the health of its network are: (1) Gross dollar volume, or GDV, of payments that flow through the network; (2) cross-border volume growth; (3) the number of processed transactions; and (4) the number of the company’s cards that are in circulation. The table below shows how the four metrics have grown in each year since 2007. I picked 2007 as the start so that we can understand how Mastercard’s business fared during the 2008-09 Great Financial Crisis.
Source: Mastercard annual reports and earnings updates
It turns out that Mastercard’s management has done a great job in growing the key business metrics over time. 2009 was a relatively rough year for the company, but growth picked up again quickly afterwards. As mentioned earlier, current CEO Ajay Banga had been leading the company since 2010, so the increases in the business metrics from 2007 to 2019 had happened mostly under his watch.
As another positive sign on Mastercard’s culture (I talked about the promotion from within earlier), we can look at Glassdoor, a website that allows a company’s employees to rate it anonymously. 96% of Mastercard’s employees who have submitted a review approve of Banga’s leadership, while 81% will recommend a job in the company to a friend. I credit Mastercard’s management, and Banga in particular, for building a strong culture.
Coming to innovation, Mastercard’s management has, for many years, been improving the payments-related solutions that it provides to consumers and organisations. This is aptly illustrated by the graphic below, which shows the changes in Mastercard’s business from 2012 to 2018:
Source: Mastercard September 2019 investor presentation
Here are some interesting recent developments by Mastercard:
Launched Mastercard Track in 2019; Mastercard Track is a B2B (business-to-business) payment ecosystem which helps to automate payments between suppliers and buyers.
Drove blockchain initiatives in 2019, in the areas of cross-border B2B payments and improving provenance-knowledge in companies’ supply chains.
Implemented AI-powered solutions to prevent fraudulent transactions and improve fraud detection.
In particular, the B2B opportunity is huge and worth tackling, because companies do encounter many pain-points that are related to payment issues. This is shown in the graphic below.
Source: Mastercard September 2019 investor presentation
4. Revenue streams that are recurring in nature, either through contracts or customer-behaviour
I think Mastercard is a great example of a company with recurring revenue from customer-behaviour. Each time we make a purchase and we pay with our Mastercard credit card, the company takes a small cut of the payment.
I showed earlier that the company handled trillions in dollars worth of payments in 2019, and processed billions in transactions. These numbers, together with the fact that no individual customer accounted for more than 10% of Mastercard’s revenues in 2019, 2018, and 2017, lend further weight to my view that the company’s revenue streams are largely recurring in nature.
5. A proven ability to grow
The table below shows Mastercard’s important financials from 2007 to 2019:
Source: Mastercard annual reports
A few key points about Mastercard’s financials:
Net revenue compounded decently at 12.6% per year from 2007 to 2019; over the last five years from 2014 to 2019, the company’s annual topline growth was similar at 12.3%.
The company also managed to produce net revenue growth in 2008 (22.7%) and 2009 (2.1%); those were the years when the global economy was rocked by the Great Financial Crisis.
Net profit surged by 18.2% per year from 2007 to 2019. Mastercard’s net profit growth from 2014 to 2019 was similarly healthy at 17.5%. Net profit was negative in 2008 because of large legal settlement expenses of US$2.5 billion incurred during the year, but it is not a cause for grave concern for me.
Operating cash flow grew in most years for the entire time frame I studied; increased markedly with annual growth of 21.8%; and had been consistently positive. The growth rate from 2014 to 2019 was still impressive at 19.2% per year.
Free cash flow, net of acquisitions, was consistently positive too and had stepped up from 2007 to 2019 at a rapid clip of 20.1% per year. The annual growth in free cash flow from 2014 to 2019 was 16.8% – not too shabby. It’s worth noting that Mastercard’s capital expenditure of US$2.6 billion in 2019 is significantly higher compared to the past primarily because of large acquisitions totalling US$1.4 billion. Without the acquisitions, Mastercard’s free cash flow in 2019 would be much higher at US$7.0 billion.
The net-cash position on Mastercard’s balance sheet was positive from 2007 to 2018 and had dipped into negative territory only in 2019. I mentioned earlier that I’m not troubled by Mastercard currently having more debt than cash, since the company has been adept at producing free cash flow and the amount of net-debt is manageable.
Mastercard’s diluted share count declined by 24% in total from 2007 to 2019, and also fell in nearly every year over the same period. This is positive for the company’s shareholders, since it boosts the company’s per-share earnings and free cash flow. For perspective, Mastercard’s free cash flow per share compounded at 20.0% per year from 2014 to 2019, which is higher than the annual growth rate of 16.8% over the same period for just free cash flow. Mastercard’s share price has also increased by a stunning amount of nearly 3,000% in total since the start of 2007. This means that the share buybacks conducted over the years by Mastercard’s management to reduce the share count have been excellent uses of capital.
In Mastercard’s 2019 fourth-quarter earnings conference call, management guided towards net revenue growth in the low-teens range for 2020. Growth in the first quarter of 2020 was expected to be around two percentage points lower than the whole year. But in late February, Mastercard updated its forecast for net revenue growth. The ongoing outbreak of COVID-19 has negatively impacted cross-border travel and cross-border e-commerce growth. As a result, Mastercard now expects its 2020 first-quarter net revenue growth to be “approximately 2-3 percentage points lower than discussed [during the earnings conference call].” Mastercard added:
“There are many unknowns as to the duration and severity of the situation and we are closely monitoring it. If the impact is limited to the first quarter only, we expect that our 2020 annual year-over-year net revenue growth rate would be at the low end of the low-teens range, on a currency-neutral basis, excluding acquisitions. We anticipate giving further updates on our first-quarter earnings call.”
No one knows what kind of impact COVID-19 will eventually have on the global economy. But I’m not worried about the long-term health of Mastercard’s business even though COVID-19 has already made its mark. My stance towards COVID-19 is that this too, shall pass.
6. A high likelihood of generating a strong and growing stream of free cash flow in the future
There are two reasons why I think Mastercard excels in this criterion.
First, the company has a long track record of producing strong free cash flow from its business. Moreover, its average free cash flow margin (free cash flow as a percentage of revenue) in the past five years from 2014 to 2019 was strong at 33.5%. In 2019, the free cash flow margin was 32.9%.
Two, there’s still tremendous room to grow for Mastercard in the entire payments space. The company has a strong network (the number of currencies it can handle; the number of countries it operates in; the sheer payment and transaction volumes it is processing; the billions in its self-branded credit cards that are circulating) as well as a capable and innovative management team that has integrity. These traits should lead to higher revenue for Mastercard over time. If the free cash flow margin stays fat – and I don’t see any reason why it shouldn’t – that will mean even more free cash flow for Mastercard in the future.
Valuation
I like to keep things simple in the valuation process. In Mastercard’s case, I think the price-to-earnings (P/E) ratio and price-to-free cash flow (P/FCF) ratio are suitable gauges for the company’s value. That’s because the company has been adept at producing positive and growing profit as well as free cash flow for a long period of time.
Right now, Mastercard carries trailing P/E and P/FCF ratios of around 38 and 56 at the current share price of US$303. These ratios look expensive, and are also clearly on the high-end (see chart below) when compared to their own histories over the past five years.
(Note: The chart above is from Ycharts and the P/FCF ratio excludes the impact of acquisitions. Using my own numbers for Mastercard, the company’s P/FCF ratio falls to 44 if I remove acquisition-related effects. My P/FCF ratio and that from YCharts are not the same, but they are similar enough. Moreover, I’m only relying on the P/FCF chart for general guidance.)
But I’m happy to pay up, since Mastercard excels under my investment framework. I also want to point out that Mastercard not only has a large market opportunity – the chance that it can win in its market is also very high, in my view. Put another way, Mastercard scores well in both the magnitude of growth and the probability of growth. For companies like this, I’m more than willing to accept a premium valuation. But the current high P/E and P/FCF ratios do mean that Mastercard’s share price could be volatile going forward. This is something I have to be – and I am – comfortable with.
The risks involved
There are a few key risks that I see in Mastercard.
First is a leadership transition. Mastercard announced earlier this month that long-time CEO Ajay Banga will become Executive Chairman on 1 January 2021. Current Chief Product Officer, Michael Miebach, will succeed Banga as CEO on the same date. Given the timeline involved, the transition seems planned. Miebach, who’s relatively young at 52 this year, joined Mastercard in June 2010. Again, this promotion from within is a positive thing in my view. Banga has high-praise for Miebach, commenting in the announcement:
“As the company moves into this next phase of growth, we have a deep leadership bench–with Michael at the helm–to take us to the next level. He has a proven track record of building products and running businesses globally.
Over his career, Michael has held leadership positions in Europe, the Middle East and Africa and in the U.S. across payments, data, banking services and technology. During the course of Michael’s 10 years at Mastercard, he has been a key architect of our multi-rail strategy–including leading the acquisition of Vocalink and the pending transaction with Nets–to address a broader set of payment flows. He’s also a visionary who kickstarted much of the work behind our financial inclusion journey.
I am excited to continue working closely with Michael and supporting Mastercard’s success when I become Executive Chairman.”
Miebach looks like a safe pair of hands and Banga will still continue to have a heavy say on Mastercard’s future given his upcoming role as Executive Chairman. But I will be keeping an eye on this leadership transition.
Competition is the second risk I’m watching. I mentioned in my investment thesis for PayPal (a digital payments services provider) that the payments space is highly competitive. There are larger payment networks such as that operated by Mastercard’s competitor, Visa (which processed US$11.6 trillion on its platforms in the 12 months ended 30 September 2019). In my PayPal thesis, I also said:
“Then there are technology companies with fintech arms that focus on payments, such as China’s Tencent and Alibaba. In November 2019, Bloomberg reported that Tencent and Alibaba plans to open up their payment services (WeChat Pay and Alipay, respectively) to foreigners who visit China. Let’s not forget that there’s blockchain technology (the backbone of cryptocurrencies) jostling for room too. There’s no guarantee that PayPal will continue being victorious. But the payments market is so huge that I think there will be multiple winners – and my bet is that PayPal will be among them.”
Just like PayPal, there are no guarantees that Mastercard will continue winning. But I do think the odds are in Mastercard’s favour.
Regulations are the third risk I’m watching. Payments is a highly regulated market, and Mastercard could fall prey to heavy-handed regulation. Lawmakers could impose hefty fines or tough limits on Mastercard’s business activities. In general, I expect Mastercard to be able to manage any new legal/regulatory cases if and when they come. But I’m watching for any changes to the regulatory landscape that could impair the health of Mastercard’s business permanently or for a prolonged period of time.
Lastly, there is the risk of recessions. Mastercard did grow its net revenue in 2009, but the growth rate was low. I don’t know when a recession in the US or around the world will hit. But when it does, payment activity on Mastercard’s network could be lowered. As I mentioned earlier, COVID-19 has already caused a softening in Mastercard’s business activity.
The Good Investors’ conclusion
To wrap up, Mastercard excels under my investment framework:
The payments market is worth a staggering US$235 trillion and Mastercard has barely scratched the surface.
The company currently has more debt than cash, but the net-debt level is manageable and the company has a strong history of producing free cash flow.
Mastercard’s management team has proved itself to be innovative and capable, but that’s not all – the company’s leaders also have sensible compensation structures that align their interests with shareholders.
Mastercard’s revenue streams are highly likely to be recurring in nature (each time we make a payment with a Mastercard service or product, the company gets a cut of the transaction).
The company has a long history of growing its net revenue, profit, and free cash flow, while keeping its balance sheet strong and reducing its share count.
There is a high likelihood that Mastercard will continue to be a free cash flow machine.
The company does have a high valuation – both in absolute terms and in relation to history. But I have no qualms with accepting a premium valuation for a high-quality business.
I’m also aware of the risks with Mastercard. I’m watching the leadership transition and also keeping an eye on risks that are related to competition, the regulatory landscape, and recessions.
But after weighing the pros and cons, I’m happy to allow Mastercard to continue to be in my family’s investment portfolio.
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.
ARK Innovation ETF has an annualised return of 21.7% since its inception in 2015, far outpacing the S&P 500. Here are some things we can learn from it.
ARK Innovation ETF is an actively managed exchange-traded fund run by ARK that focuses on US stocks. As of December 2019, the tech-focused fund boasts a 21.7% annualised return since its inception in late 2014, making it one of the top-performing funds globally. Its performance is also well ahead of its comparative benchmark, the S&P 500, which returned just 11.7% annualised over the same time frame.
So how did ARK Innovation ETF do it?
I took a look at some of the blog posts from ARK’s investing team and its investing principals to find out what is driving the ARK Innovation ETF’s market-beating performance.
It invests for the long-term
Benjamin Graham was one of the pioneers of long-term investing. He once said that “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
What this means is that stocks can get mispriced in the stock market simply because of the whims of investors. Over the long run, though, a stock will tend to gravitate towards its true value.
ARK invests with this principle in mind. It explains:
“The market easily can be distracted by short-term price movements, losing focus on the long-term effect of disruptive technologies. We believe there is a time arbitrage ARK can take advantage of. We seek opportunities that offer growth over 3-5 years that the market ignores or underestimates.”
It doesn’t mind going against the grain
ARK is not your typical Wall Street fund manager. In fact, many of its views go against the traditional beliefs of Wall Street.
For example, Wall Street often likes to categorise different types of innovation. But ARK believes that innovation “cannot be boxed into sectors, geographies or market caps.”
It also doesn’t mind having vastly different opinions from the rest. For instance, ARK is famous for being one of the most bullish funds about Tesla, which is also one of the most heavily shorted stocks in the market today.
It goes big on high-conviction stocks
A truly exceptional opportunity does not come around often. And Charlie Munger is famous for saying that the important thing when you find one is to “use a shovel, not a teaspoon.”
I think ARK abides by the principle, betting big on stocks that it believes in.
For instance, 10% of ARK Innovation ETF’s portfolio is in Tesla. ARK is one of the vocal supporters of Elon Musk’s brainchild. So far, the concentrated position has worked well for ARK with Tesla’s stock price up four-fold over the past five years and nearly doubling so far this year.
Open-source approach to research
Instead of relying solely on its own in-house research, ARK is open to new ideas from the public. It frequently publishes its research and encourages readers to provide more insight and comments. ARK believes that its “open research ecosystem allows for an organised exchange of insights between portfolio managers, director of research, analysts and external sources”.
The Good Investors’ conclusion
ARK’s unique approach has certainly worked well for it. The ARK Innovation ETF is now one of the top-performing and most respected funds in the market.
I also have a feeling that year ARK Innovation ETF will extend its winning streak in 2020 due to the recent surge in Tesla’s share price.
Investors who want to learn more about ARK’s research can head here.
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.
Hint: The US market’s rise may not have much to do with the frequently-heard accusations of the Federal Reserve artificially inflating stock prices.
Since the start of 2010, the US stock market – as measured by the S&P 500 – has nearly tripled, from 1,124 points to more than 3,300. This meteoric rise in US stock prices has prompted plenty of commentary within the investment community on its underlying drivers.
A frequent “culprit” cited is the Federal Reserve in the US. Many investors and market commentators have blamed the US central bank for driving stock prices higher because of its interest rate policy (of keeping rates low) and quantitative easing (the act of pumping money into the economy via the purchase of mostly government-related financial assets).
The chart above is plotted with data from Nobel Prize-winning economist, Robert Shiller. It shows changes in the S&P 500’s price, dividends, and earnings since the start of 2010. Over the past decade, all three numbers have basically increased hand-in-hand. Put another way, the meteoric rise in the S&P 500 I mentioned earlier could be explained by a similarly big jump in the fundamentals of American businesses.
I was inspired to plot my chart after I came across the following tweet by Morgan Housel, one of my favourite finance writers:
Housel’s chart showed that the S&P 500’s price and its dividends have climbed in lock-step since 2010. This suggests that the US market had been driven higher because of improvements in its underlying business fundamentals. But I was curious to know if the increase in dividends is sustainable. This is why I plotted my own chart which included earnings growth. Turns out, there has been a commensurate increase in earnings for the US market. The S&P 500 has done what Warren Buffett wrote in his 2018 Berkshire Hathaway shareholders’ letter:
“On occasion, a ridiculously-high purchase price for a given stock will cause a splendid business to become a poor investment – if not permanently, at least for a painfully long period. Over time, however, investment performance converges with business performance.”
None of the above is meant to say that the S&P 500 will continue climbing over the next year, or the next 10 years. Over the short run, sentiment can change on a dime; a rise in investors’ pessimism over the future – whether warranted or unwarranted – will drag stock prices lower. Over the long run, if the rise in earnings for US businesses in the past was unsustainable, then there could be a collapse in the S&P 500 in the future.
But what we do know now is that there is a very good reason why US stocks prices have grown so much over the past decade – their businesses have done very well too.
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.
