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I recently reconnected with a schoolmate of mine whom I’ve not seen for many years. He wanted to learn more about investing and I was happy to help. We had a wonderful time chatting in person and catching up with each others’ lives.

During our conversation, he asked a great question that I’ve never been asked before: “Why do investors lose money in the stock market?” I came up with two reasons, and I think they’re worth fleshing out in an article. 

Reason 1: Greed and fear

I think the theme of greed and fear in the market is best illustrated with the histories of the Fidelity Magellan Fund and the CGM Focus Fund, both of which invested in US stocks.

During his 13-year tenure running the Fidelity Magellan Fund from 1977 to 1990, Peter Lynch produced one of the greatest track records of all time: A 29% annualised return. That rate of return turns $1,000 into more than $27,000 in 13 years.

But what’s stunning is that Lynch’s investors earned far lower returns than he did. Spencer Jakab, a financial journalist with The Wall Street Journal, explained in his book Heads I Win, Tails I Win why that was so (emphasis is mine):

“During his tenure Lynch trounced the market overall and beat it in most years, racking up a 29 percent annualized return. But Lynch himself pointed out a fly in the ointment.

He calculated that the average investor in his fund made only around 7 percent during the same period. When he would have a setback, for example, the money would flow out of the fund through redemptions. Then when he got back on track it would flow back in, having missed the recovery.”

In essence, investors got greedy when Lynch had a purple patch and poured into the Fidelity Magellan Fund. But the moment Lynch’s fund hit some temporary turbulence, they fled because of fear. Greed and fear had led to investors buying high and selling low.

A similar tale befell the CGM Focus Fund. In the decade ended 30 November 2009, the CGM Focus Fund was the best-performing US stock mutual fund, with a gain of 18.2% annually. But shockingly, its investors lost 11% per year over the same period. How? CGM Focus Fund’s investors chased performance and bailed at the first whiff of trouble. That’s greed and fear, again.

It’s the same problem when it comes to investing in individual stocks. Some investors blindly chase a stock that has been rising (because of greed), only to sell at the first sign of temporary trouble (because of fear). What they don’t appreciate is that volatility is a feature of the stock market, not a bug. Even the best-performing stocks over the long run suffer from sickening short-term declines.

Reason 2: Not knowing what they’re investing in

The second reason is that many investors do not have a sound framework for investing. They buy a stock based on hot tips. Or they focus on superficial factors, such as a stock’s yield.

It’s dangerous to invest this way. If you’re investing based on a hot tip, you have no idea what will make or break the investment. You’re essentially gambling.

The risk of investing based on superficial factors can be illustrated with Hyflux. The water-treatment firm issued perpetual securities and preference shares in 2011 and 2016. They came with fat yields of 6% and attracted a large group of yield-hungry investors, many of whom focused on the yields. They did not notice Hyflux’s weak financial picture.

Back when Hyflux issued its 6% perpetual securities in May 2016, I wrote an article pointing out that the securities were risky. I said:

“According to data from S&P Global Market Intelligence, Hyflux has been generating negative cash flow from operations in each year from 2010 to 2015. Meanwhile, the company currently has a net-gearing ratio (net debt to equity ratio) of 0.98, which isn’t low.”

Hyflux ended up filing for bankruptcy protection in May 2018, and investors in the company’s perpetual securities and preference shares now face the prospect of suffering painful losses.

The Good Investors’ conclusion

The stock market can be a fantastic place for us to build lasting long-term wealth. But it can also be a money-burning pit if we’re not careful. Fortunately, the problems are easy to solve.

To tackle greed and fear, we can keep an investment journal that contains entries on our reasons for each investment we make. When we pen our thoughts down, we actually force ourselves to review our thought processes, thus improving our investment decision-making. And when the markets inevitably go through short-term declines, we can study our journal and determine with a cooler mind if our investment theses still hold.

The second big reason why investors lose money in the stock market that I see is ignorance. And here’s the balm to soothe this issue: We just need to understand what the stock market really is, and figure out a sound investment framework.

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.

I gave two small-group presentations in December 2019 at the request of friends. The presentations were on the 2020 market outlook. I kept the presentations nearly identical too, since there were important things I wanted both groups of attendees to know, and I knew both events had completely different audiences. 

I prepared a speech and a slide-deck for the presentations. They are meant to be viewed together. You can download the slide-deck here. The speech is found below; for a PDF version, you can find it here. 

——

Introduction

[Slides: 1 to 2]

Thank you for having me today. The topic of my presentation will be on the market outlook for 2020. Before I start, allow me to quickly introduce myself. I’m Chong Ser Jing. I joined the Motley Fool Singapore in January 2013 as an investment writer, and I became a co-leader of the company’s investing team from May 2016 till my departure in October 2019.

Now I run an investing blog called The Good Investors together with my long-time friend Jeremy Chia. Jeremy and I are also in the midst of setting up an investment fund with the primary objectives of building wealth for Singapore investors through long-term investing in the stock market, and giving back to society.

So first, a quick disclaimer: Nothing I say tonight should be taken to be financial advice. The information I’m sharing is purely educational. 

Big predictions for 2020

[Slide: 3]

I’m going to start with my bold predictions for 2020. A warning though: It’s ugly.

First, the US will go to war in the Middle East. It’s unfortunate to see countries at war, but I see this happening. Second: The price of oil will spike. We know that oil prices started crashing in mid-2014 and have stayed low since, but do watch out in 2020. Third: The US will enter a recession. It has been a long, long time since the US has seen a recession, but I think it will soon. Fourth: Stocks are in for a rough time, according to Ray Dalio:

“Unfortunately… the current economic climate of low inflation and historically slow growth means that bonds will actually prove to be the better long-term performers.”

If you’re unaware, Ray Dalio is the founder of Bridgewater, one of the largest fund management companies in the world. Bridgewater’s assets under management are around US$160 billion today.

A confession

[Slides: 4 to 8]

Are you worried now? I have a confession to make. My predictions are not predictions at all. Let me say again: I’m not trying to make any prediction. I’m just stating actual events that happened many years ago in the past to make an important point.

The first and second “predictions” took place in August 1990. The third “prediction” occurred in July 1990. The last are comments Ray Dalio gave in February 1992.

How has the market done since 1990, knowing that the picture was bleak? Turns out the market has done very well. From 1990 to today, the S&P 500 has increased by nearly 800%, without even counting dividends.

Interestingly, the world has seen multiple crises in every single year from 1990 to today, as the table, courtesy of data from Morgan Housel, illustrates.

And that is the important point I want to make: Uncertainty is always around, but that does not mean we should not invest. This is one key takeaway for you from today’s presentation.

Yes, the market has its ups and downs, but there’s still a clear upward bias.

Market outlooks

[Slides: 9 to 10]

Okay, next I want to talk about market outlooks. I think it’s a very important topic to discuss. We’re at the time of the year where you’ll be bombarded by market outlooks.

I want to play a simple game with you. Make a guess as to who will win in a contest of predicting the return of the US stock market every year. In one corner, we have the blue team, which consists of market strategists from the most prestigious financial institutions in the US. On the other side of the ring is the green team, with a sole member. This person is a simple guy who thinks the US stock market just goes up by 9% every year.

Based on real-world data from 2000 to 2014, it is the green team that wins. In that period, the blue team’s forecasts were off by an average of 14.7 percentage points per year. For the green team, his forecast was off by an average of 14.1 percentage points per year.

This chart shows how bad the strategists’ forecasts were, compared to the US market’s actual returns. The blue bars are the forecasts, while the red bars show the market’s actual performance.

Frequency of market crashes

[Slide: 11]

So I think no one really knows how the market is going to do next year. It could crash – or it may not. But one thing I know for sure: Market crashes are common.

Morgan Housel, again, provides great data. This table shows how often the US market has fallen by a certain percentage going back to 1928. We can see that 10% declines happen nearly once a year; 20% falls, once every two years; 30% drops, once every decade; and 50% collapses, two to three times per century.

Let’s not forget that from 1990 to today, the US market is up by nearly 800% despite stocks having fallen by 50% or more, twice.

Morgan’s data show that it is perfectly normal for us to experience market crashes multiple times throughout our entire investing career. This is another key point I hope you’ll take away from my presentation today.

Why do crashes happen?

[Slide: 12]

You may ask, rightfully: Why are market crashes so common? For this, we have to visit the theories of the late Hyman Minsky. When Minsky was alive, he was an obscure economist. But his ideas flourished after the Great Financial Crisis of 2007-09.

That’s because he had a framework for understanding why markets and economies go through ups and downs. According to Minsky, stability is destabilising. If the economy does not suffer a recession for a long time, people feel safe. This causes people to take more risk, such as borrowing more, which leads to the system becoming fragile.

The same goes for stocks. Let’s assume that stocks are guaranteed to grow by 9% per year. The only logical result would be that people would keep paying up for stocks, till the point that stocks become too expensive to return 9% a year. Or people will take on too much risk, such as taking on debt to buy stocks.

But bad things happen in the real world. And they happen often. And if stocks are priced for perfection, bad news will lead to lower stock prices. 

Feature, not a bug

[Slides: 13 to 15]

Let’s play another game now. I’m going to share two stocks with you, and you’re going to tell me which you would prefer to invest in.

Stock ABC is the first. It was listed in 1997. From 1997 to 2018, the peak-to-trough decline in Stock ABC’s share price in each year had ranged from 12.6% to 83.0%. Put another way, Stock ABC had experienced a double-digit peak-to-trough decline every single year from 1997 to 2018.

Now let’s look at Stock DEF. It was also listed in 1997. And the chart shows Stock DEF’s share price growing by an astonishing 76,000% from $2 in 1997 to $1,500 in 2018. It’s obvious that Stock DEF has been an incredible long-term winner.

With this information, would you prefer to invest in Stock ABC or Stock DEF? Here’s the kicker: They are the same stock. Stock ABC and Stock DEF are both Amazon, the US e-commerce giant.

This leads me to another key takeaway for you: Volatility in stocks is a feature, not a bug. Even the best long-term winners in the stock market also suffer from sharp short-term declines.

Expect, don’t predict

[Slide: 16]

Another thing I want to talk about is the importance of expecting but not predicting. We know for sure that market crashes happen periodically. But we don’t know when they will occur. And the track record of people who give precise forecasts on such matters is horrible, to put it mildly.

So if we’re investing for many years, we should count on things to get ugly a few times at least. This is different from saying “The US will have a recession in the third quarter of 2020” and then positioning our investment portfolios to fit this view.

The difference between expecting and predicting lies in our behaviour. If we merely expect downturns to happen from time to time, we won’t be surprised when they come. Our portfolios would also be built to handle a wide range of outcomes.

If we’re trying to predict, then we think we know when something will happen and we try to act on it. Our portfolios may thus be suited to thrive only in a narrow range of situations – if a different outcome happens, then our portfolios will be on the road to ruin.

How to prepare

[Slide: 17]

This leads me to the next logical question: How can we prepare our portfolios to thrive in a wide range of outcomes? I believe the answer lies in how we view the stock market by reasoning from 1st principles.

The first stock market was created in Amsterdam in the 1600s. Many things have changed since. But one thing has remained constant: A stock market is still a place to buy and sell pieces of a business.

Having this understanding of the stock market leads to the next logical thought: That a stock will do well over time if its underlying business does well too. Warren Buffett’s Berkshire Hathaway is a great example. From 1965 to 2018, Berkshire Hathaway’s book value (which is assets less liabilities) grew by 18.7% per year while its share price climbed by 20.5% per year. An input of 18.7% led to an output of 20.5%.

Growing businesses

[Slides: 18 to 19]

I have an investment framework that I believe can lead us to companies that can grow their businesses at high rates over a long period of time. I have an article on my blog, thegoodinvestors.sg, that explains my investment framework. I’ll run through it quickly.

First, I want companies with revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market.

The first criterion is important because I want companies that have the capacity to grow. Being stuck in a market that is shrinking would mean that a company faces an uphill battle to grow. Print-advertising is an example of a shrinking market – it has shrunk by 2.3% per year across the globe from 2011 to 2018.

Second, I want companies with a strong balance sheet that has minimal or reasonable levels of debt.

A strong balance sheet enables a company to achieve three things: (a) Invest for growth, (b) withstand tough times, and (c) increase market share when its financially-weaker companies are struggling during economic downturns.

Third, I want management teams with integrity, capability, and an innovative mindset.

A management team without integrity can fatten themselves at the expense of shareholders. A company can’t grow if the management team is weak. And without an innovative mindset, a company can easily be overtaken by competitors or run out of room to grow.

We can look at a company’s history to get a sense for the third criterion. Areas we can look at include (a) how management’s pay has changed over time in relation to the company’s business; (b) whether there are huge amounts of related party transactions; and (c) the company’s past actions to grow its business.

Fourth, I want revenue streams that are recurring in nature, either through contracts or customer-behaviour.

I think this is a crucial trait in a company that many investors don’t pay attention to. Having recurring business is a beautiful thing because it means a company need not spend resources to remake a past sale. Instead, past sales are recurring, and the company is free to find brand new avenues for growth.

Fifth, I want companies with a proven ability to grow.

Companies with a proven track record have a higher chance of being able to grow in the future. I’m looking for strong historical growth in revenue, profit, and free cash flow.

Lastly, I want companies with business models that give a high likelihood of generating a strong and growing stream of free cash flow in the future.

That’s because the more free cash flow a company can produce, the more valuable it is.

I believe that companies that excel in all or most of these six criteria could be worthwhile investments for the long run.

But companies that excel in all six criteria may still turn out to be poor investments. It’s impossible to get it right all the time in investing, so I believe it is important to diversify. This is another key takeaway for you.

Protecting the portfolio

[Slides: 20 to 21]

I’ve been using my investment framework for my family’s portfolio for over nine years. In that period, I’ve managed to produce a return of around 18% per year without counting dividends. This is far ahead of the 13.7% annual return of the S&P 500 with dividends.

The investment framework also guided my investment process in my time at The Motley Fool Singapore.

I used my framework to help pick stocks from around the world for the company’s flagship investment newsletter. We recommended two stocks per month, one from Singapore, and one from international markets, including the US, UK, Malaysia, and Hong Kong. The newsletter nearly doubled the global stock market’s return over a 3.5 year period.

Some of you may wonder: How can the framework protect your portfolio? Let me be clear. The framework cannot protect my portfolio from short-term declines in stock prices. Market downturns happen from time to time. They are inevitable.

The framework protects my portfolio by guiding me towards companies with strong balance sheets, strong free cash flow, and high levels of recurring revenue. These traits should enable a company to survive tough economic conditions relatively unharmed. They might even still be able to thrive. 

Putting the framework into action 

[Slides: 22 to 23]

Now I want to quickly run through how I use my investment framework by discussing a stock I bought for my family’s portfolio, PayPal. I bought PayPal shares three times, in June 2016 November 2018, and June 2019. The June 2016 purchase was at US$38, and I’ve done very well on that.

PayPal runs a mobile and digital payment work that spans the globe. It can handle transactions in more than 200 markets, and its customers and receive, hold, and withdraw money in a wide range of currencies. PayPal has other payment brands under its umbrella including Braintree, Venmo, and more.

The company was first listed in February 2002. But it was acquired by online-auction platform eBay only a few months later. Over the years, PayPal started to outgrow eBay. In mid-2015, eBay spun off PayPal as a new listing.

How PayPal meets the six criteria

[Slides: 24 to 32]

The first criterion of my investment framework is on PayPal’s market opportunity. The global digital and mobile payments market is worth a staggering US$110 trillion. Moreover, around 80% of the transactions conducted in the world today are still settled with cash.

For perspective, the total payment volume flowing through PayPal’s platform over the last 12 months is US$676 billion (or US$0.676 trillion). The company earned US$17 billion in revenue from this volume.

Next, is on PayPal’s balance sheet. The company’s balance sheet is rock solid with nearly US$7 billion in cash and just US$5 billion in total debt.

The picture may change soon though, as PayPal will be acquiring Honey for US$4 billion in the coming months. Honey helps consumers in the US discover discounts while shopping online. But I’m not worried, as PayPal has a solid track record in generating free cash flow, which I will talk about shortly.

The third criterion is on PayPal’s management. In 2018, PayPal’s leaders were paid mostly with stock awards that vest over three years; restricted stock awards that depended on the company’s revenue and free cash flow growth over three years; and stock awards that are based on PayPal’s share price movement over a five year period. The last factor is specifically for PayPal’s CEO, Dan Schulman.

I think PayPal’s compensation structure aligns my interests closely with management’s. There is an emphasis on the company’s free cash flow and long-term share price movement. 

Regarding the capability of PayPal’s management team, there are two clues. First, PayPal’s network has grown impressively since the separation from eBay. Transactions, payment volume, and the number of active accounts have all enjoyed double-digit annual growth.

Second, PayPal has been striking up strategic partnerships with many parties since the spin-off. The chart on the left shows the partners PayPal had when it was still with eBay – there were no partners! The chart on the right was shared by management in 2018 – there are many partners.

The fourth criterion is on the level of recurring revenue. PayPal excels here. Around 90% of PayPal’s revenue comes from the small fees that it takes from each transaction that it processes. In the first nine months of 2019, PayPal processed 8.9 billion transactions from 295 million accounts. These are transactions that likely occur repeatedly.

It’s also worth noting that PayPal has no customer concentration, as no single customer accounted for more than 10% of its revenues in the past three years.

Next, I’m looking at PayPal’s ability to grow. The company’s track record is impressive, with a strong balance sheet throughout, and growing revenues, profits, and free cash flow. From 2012 to 2018, revenue and profit both compounded at 18% annually. PayPal’s free cash flow compounded at an even stronger rate of 28%.

I also think that PayPal’s business exhibits a network effect, where its platform becomes more valuable when there are more users. I want to pay special attention to Venmo too, PayPal’s digital wallet. Venmo is highly popular with millennials in the US, and has more than 40 million accounts. The annualised revenue from Venmo has also exceeded US$400 million, double from a year ago.

Lastly, it’s about PayPal’s free cash flow. The company has excelled in producing free cash flow from its business for a long time, and has huge growth opportunities ahead. So there’s no reason to believe that the company’s ability to generate free cash flow will change any time soon.

PayPal’s valuation and risks

[Slides: 33 to 34] 

Now, let’s look at valuation. I believe in using simple techniques for valuation. Since PayPal has been excellent in generating free cash flow, the price-to-free cash flow ratio, or PFCF ratio, is useful. Right now, PayPal’s PFCF ratio is 34, which is on the high side compared to the past. But I’m always happy to pay up for a quality company.

Lastly, we also need to talk about the risks.

The payments market is highly competitive, with many larger players. For example, Mastercard and Visa processed trillions in transactions over the past year, much more than PayPal. Then there are fintech players and also cryptocurrencies all fighting for room. The good thing is that the payments market is so huge that I think there can be multiple winners. 

PayPal’s soon-to-be-expiring deal with eBay is a risk. But eBay’s business is declining. And in the latest quarter, PayPal’s overall payment volume grew by 27% despite the portion from eBay falling by 3%.

Since payments is a highly regulated space, there’s also a risk of regulators stepping in and lowering what PayPal can take per transaction.

Then there’s recessions. If they happen – and we don’t know when! – consumer activity could be lowered. This could lead to lesser transactions on PayPal’s platform.

The purchase of Honey for US$4 billion that I mentioned earlier is also something to note. It will be PayPal’s largest acquisition to date. The valuation of Honey is also steep, at around 20 times its projected revenue for this year. I think the acquisition will work. Honey has 17 million users. It can strengthen PayPal’s value proposition to merchants by telling merchants what shoppers are looking for.

The last risk is succession. PayPal’s CEO, Dan Schulman, is already 61 years old this year. The good thing is, the company’s senior leaders are younger – they are in their mid-fifties or less.

Conclusion

[Slides: 35 to 36]

I’ve reached the end of my presentation. I just want to quickly remind all of you the four key takeaways. 

First, uncertainty is always around, but that does not mean we shouldn’t invest. Second, it is perfectly normal for us to experience market crashes multiple times throughout our entire investing career. Third, volatility in stocks is a feature, not a bug. Fourth, it is important to diversify!

With that, I thank you for your time. You can reach me through my blog, thegoodinvestors.sg, or through my email, thegoodinvestors@gmail.com

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 global economy is made up of nearly 7.8 billion people. According to the World Federation of Exchanges, an association for exchanges and clearing houses, there are over 48,000 companies listed in the stock markets around the world.

With so many moving parts, what should we really be watching to invest well in stocks? Two great investors, Ralph Wagner and Warren Buffett, have shown us the way through two fun analogies. 

Dog on a leash

From my personal observations, the US fund manager Ralph Wagner isn’t very well-known to the public. But he’s one of the real investing greats. From 1970 to 2003, Wagner’s Acorn Fund produced an annual return of 16.3%, which was significantly better than the S&P 500 index’s gain of 12.1% per year over the same period.

But what makes Wagner unique was his wit. A case in point: His 1997 book about his investing adventures is titled A Zebra in Lion Country. According to a Google Books summary, this is the reason for the book’s name:

“Investors are like zebras in lion country: They must settle for meager pickings by sticking in the middle of the herd, or seek richer rewards at the outer edge, where hungry lions lurk.”

Coming back to the main topic of this article, here’s what Wagner once said:

“There’s an excitable dog on a very long leash in New York City, darting randomly in every direction. The dog’s owner is walking from Columbus Circle, through Central Park, to the Metropolitan Museum. At any one moment, there is no predicting which way the pooch will lurch.

But in the long run, you know he’s heading northeast at an average speed of three miles per hour. What is astonishing is that almost all of the dog watchers, big and small, seem to have their eye on the dog, and not the owner.”

If you missed Wagner’s analogy, stock markets are the dog while the underlying businesses of stocks are the dog-owner. As investors, we should really be watching businesses (the owner), and not the dog (stock prices).

No matter how the dog is leaping and where it’s darting to, it will still end up at the Metropolitan Museum at three miles per hour – because that’s the owner’s pace, and where he’s walking to.

Winning the game

Warren Buffett is one of the best investors the world has seen. His long-term track records with his investment fund and his conglomerate, Berkshire Hathaway, are astonishing. In his 2013 shareholders’ letter, Buffett wrote:

“Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.”

Buffett’s message is similar to Wagner’s: The playing field (businesses) is the important thing to watch, not the scoreboard (stock prices).

Berkshire’s experience is a fantastic example. The chart below shows the percentage change in Berkshire’s book value per share and its share price for each year from 1965 to 2018. There were years when the two percentages match closely, but there were also times when they diverged wildly. A case of the latter is 1974, when Berkshire’s book value per share grew by 5.5% even though its share price fell sharply by 48.7%.

But through the 53 years from 1965 to 2018, the book value of Berkshire grew by 18.7% per year while its share price increased by 20.5% annually. An 18.7% input over the long run has resulted in a closely-matched output of 20.5%.

Focusing on businesses

It’s not a coincidence that Wagner and Buffett are saying the same thing. To really do well in the stock market, we should be watching businesses, not stock prices. After all, investment performance converges with business performance over the long run.

I want to end off with a quote from Peter Lynch, himself another legend in the investing business. During his entire tenure as the manager of the Fidelity Magellan Fund from 1977 to 1990, Lynch produced an annual return of 29%. In a 1994 lecture (link leads to a video; see the 14:20 min mark), he said:

“I’m trying to convince people there is a method. There are reasons for stocks to go up. This is very magic: it’s a very magic number, easy to remember. Coca-cola is earning 30 times per share what they did 32 years ago; the stock has gone up 30 fold. Bethlehem Steel is earning less than they did 30 years ago – the stock is half its price 30 years ago.

Stocks are not lottery tickets. There’s a company behind every stock – if the company does well, the stock does well. It’s not that complicated.”

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.

If you thought that professional investors can easily beat an unmanaged basket of stocks, think again.

According to an article on CNBC, 64.49% of large-cap funds lagged the S&P 500 in 2018. It marked the ninth consecutive year that actively managed funds trailed the broad US-market index.

Over a 10-year period, 85% of large-cap funds underperformed the S&P 500. Over 15 years, that figure increases to 92%.

Given how such few funds consistently beat the market, I tend to take notice when one does.

Two funds, in particular, have caught my eye. They are the Fundsmith Equity Fund and the Mawer Global Equity Fund. Both funds have global investment mandates and have beaten their respective indexes by a wide margin.

Fundsmith has an impressive annualised return of 18.3% as of 31 October 2019 since its inception nine years ago. It is well ahead of the annualised 11.7% return of the global equities market. 

The Mawer Global Equity Fund has also done really well since its inception in 2009. As of 30 September, it has a compounded annual return of 13.1%, compared to an 11.4% return from the global equity benchmark.

So what is the secret behind their success? 

Low portfolio turnover

Needless to say, careful selection of high-quality stocks is one of the key ingredients to their success. 

But another thing that stands out is that both Fundsmith and Mawer Global Equity Fund have extremely low portfolio turnover. Portfolio turnover is a way to measure the average holding period for a stock in a fund.

In 2018, Fundsmith and the Mawer Global Equity Fund had an annualised portfolio turnover of 13.4% and 16% respectively. In essence, that means the average holding period for stocks in their portfolios was more than 6 years each.

So why is this important? Terry Smith, founder and manager of Fundsmith, explained in his annual letter to shareholders that a low portfolio turnover “helps to minimise costs and minimising the costs of investment is vital contribution to achieving a satisfactory outcome as an investor.”

Besides reducing the costs of transactions, staying invested in high-quality stocks gives investors the opportunity to participate in the immense compounding effect of the stock market. 

Morgan Housel, currently a partner in Collaborative Fund, wrote in one of his past columns for the Motley Fool:

“There have been 20,798 trading sessions between 1928 and today (2011). During that time, the Dow went from 240 to 12,500, or an average annual growth rate of 5% (this doesn’t include dividends). If you missed just 20 of the best days during that period, annual returns fall to 2.6%. In other words, half of the compounded gains took place during 0.09% of days.”

Hence, a low portfolio turnover not only reduces transaction fees but increases the chance that investors do not miss out on the best trading sessions, which form a large portion of the market’s returns.

Low management fees

Actively managed funds have been known to charge notoriously high fees. This is one of the reasons why active funds find it difficult to outperform their low-cost index-tracking counterparts.

However, both Fundsmith and Mawer Global Equity Fund buck this trend. Both funds have relatively low management fees and do not have a performance fee. Fundsmith’s management fee ranges from 0.9% to 1.5%, while Mawer Global Equity Fund has a management expense ratio of around 1.3%.

The Good Investors’ Conclusion

When Warren Buffett was the manager of the Buffett Partnership some 50 years ago, he noted that earning a few percentage points more than the market average per year can be hugely rewarding. He said:

“It is always startling to see how a relatively small difference in rates add up to very significant sums over a period of years. That is why, even though we are shooting for more, we feel that a few percentage points advantage over the Dow is a very worthwhile achievement. It can mean a lot of dollars over a decade or two.”

Actively-managed funds that can consistently outperform the market over a long time frame are a dime a dozen. But if you find one, it definitely pays to invest in it.

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.

Many people may not know this. Before Warren Buffett became CEO of Berkshire Hathaway, he was a fund manager.  

And his track record was, unsurprisingly, phenomenal.

According to his fund’s investor letter in 1969, his partnership produced an annual compounded return of 31.6%, compared to the Dow’s 9.1%. 

Net of fees, limited partners (investors in the fund) gained a cumulative return of 1,403% in just 12 years, or 25.3% per year. Not bad.

Despite being written more than 50 years ago, Buffett’s teachings in his fund’s investor letters are still relevant today.

Here are five things I learnt from the great man’s writings.

Don’t time the market

The market will swing in the short term. But over a long time frame, you can bet your last dollar that it will be up. Buffett wrote:

“I am certainly not going to predict what general business or the stock market are going to do in the next year or two since I don’t have the faintest idea. I think you can be quite sure that over the next ten years there are going to be a few years when the general market is plus 20% or 25%, a few years when it is minus on the same order, and a majority when it is in between. I haven’t any notion as to the sequence in which these will occur, nor do I think it is of any great importance for the long-term investor.”

Today, many hedge funds and financial advisors try to manage their clients’ money to reduce near-term volatility. But timing the market is a fool’s game.

Buffett’s right-hand man, Charlie Munger certainly agrees, saying, “Time in the market is more important than timing the market.”

It is notoriously difficult to beat the stock market index

When Buffett started his fund, he set the goal of beating the Dow Jones Industrial Average, which at that time was the most widely followed stock market index in the US.

If you thought this was easy to achieve, think again. In his 1961 annual letter, Buffett noted that out of 70 funds listed in Arthur Wiesenberger’s book with a continuous record since 1946, only seven outperformed the Dow. And those that did were superior by just a few percentage points.

Today the story is no different. Bob Pisani, wrote in an article on CNBC earlier this year that 64.49% of large-cap funds lagged the S&P 500 in 2018. It marked the ninth consecutive year that actively managed funds trailed the index.

Over a 10-year period, 85% of large-cap funds underperformed the S&P 500. Over 15 years, that figure increases to 92%.

The joys of compounding

A few percentage points can really add up when compounding. Buffett observed:

“It is always startling to see how relatively small difference in rates add up to very significant sums over a period of years. That is why, even though we are shooting for more, we feel that a few percentage points advantage over the Dow is a very worthwhile achievement. It can mean a lot of dollars over a decade or two.”

Buffett added the table below to show how much more you would make if you compounded a $100,000 investment at 15% instead of 10% or 5%. The results were indeed staggering, and also demonstrates that the difference in absolute returns mushrooms the longer the investment compounds.

Individual thinking is important

In his annual letter in 1962, Buffett warned that it is not safe to simply follow what others are doing. Individual thinking is essential. He wrote:

“You will not be right simply because a large number of people momentarily agree with you. You will not be right simply because important people agree with you.

In many quarters the simultaneous occurrence of the two above factors is enough to make a course of actions meet the test of conservatism.”

He added:

“You will be right, over the course of many transactions, if your hypotheses are correct, your facts are correct, and your reasoning is correct. True conservatism is only possible through knowledge and reason.”

Making bigger bets on high-conviction stocks

While modern portfolio theory suggests ample diversification, Buffett had a somewhat less conventional style. His fund had the mandate to invest up to 40% of its assets in a single stock!

In his 1965 letter, Buffett reasoned:

“Frankly, there is nothing I would like better than to have 50 different investment opportunities, all of which have a mathematical expectation of achieving performances surpassing the Dow by, say, fifteen percentage points per annum.”

But he adds:

“It doesn’t work that way. We have to work extremely hard to find just a few attractive investment situations. Such a situation by definition is one where my expectation of performance is at least ten percentage points per annum superior to the Dow.”

Because of that, Buffett does not mind allocating a larger chunk of his portfolio to stocks that he expects to outperform the index and has a very low probability of loss.

Based on his track record, its clear this strategy has done really well for him.

The Good Investors’ Conclusion

Even at a young age (he was just 25 when he started), Warren Buffett was already a great investor. His performance as manager of the Buffett Partnership all those years ago speaks for itself.

More importantly, for investors today, his writings back then are still relevant today. If you want to read more of Buffett’s annual letters during his time at Buffett Partnership, you can head here.

Photo source: Modified from Warren Buffett Caricature by DonkeyHotey under Creative Commons 2.0.

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.

Risk management is essential when building a stock portfolio. But it is impossible to remove risk completely. Instead, we should find ways to reduce risk in our investment portfolio, while maintaining a good chance for high returns.

With that in mind, here is a simple framework for picking low-risk stocks.

How to find low-risk businesses?

A low-risk business should have a strong balance sheet and an ability to consistently generate cash. Ideally, I look for companies with six qualities that should indicate it has a resilient business.

1. A manageable debt load and low-interest expenses

The company should be able to easily service its interest expense and to pay back its debts when they’re due. The company should have both a high-interest coverage ratio (how easily it can pay back its interest expenses using profits or free cash flow) and a low debt-to-equity ratio.

2. Consistent free cash flow generation

Cash is the lifeblood of a company. It is what the company needs to pay its creditors and suppliers. A company that is able to generate cash after paying off all its expenses and capital requirements (free cash flow to equity) is then able to reward shareholders through dividends, share buybacks, or reinvesting in the business.

3. Predictable and recurring sales

In order to generate cash consistently, a company needs recurring sales. A low-risk business should have recurring and fairly predictable revenue. This can come in the form of repetitive customer behaviour or long-term contracts. 

4. Low customer concentration

The business should also have a varied pool of customers. A high customer concentration might cause wild fluctuations in sales and profits.

5. A diversified business

Similarly, the business should ideally not rely on a single revenue source. A business that has multiple revenue streams is more resistant to technological changes disrupting a single core focus.

6. A long track record

Finally, a low-risk business should have a reasonably long track record of all the above qualities. The track record should ideally span years, if not, decades. Businesses that have such an admirable track record demonstrate resilience and management’s adaptability to technological disruptions.

How to find stocks that will not suffer from valuation compression?

Besides investing in stocks that have resilient businesses, we should also consider the risk of valuation-compression.

A valuation compression occurs when a company’s market value declines permanently despite sustained earnings growth. This happens usually because the starting valuation is too high. If the purchase price is too steep, a good business may still end up becoming a bad investment.

The most common metrics that are used to value a stock are the earnings, cash flow, and book value.

Another metric that I like to use is the enterprise value to EBITDA (earnings before interest, tax, depreciation, and amortisation). The metric is also known conveniently as EV-to-EBITDA.

The enterprise value, or EV, strips out the company’s net cash from its market cap. Companies whose cash make up a large proportion of their market caps are prime acquisition targets. In addition, the net cash balance could also act as a support for which the company’s market cap will likely not fall under.

I also look for companies whose earnings are likely to grow faster or longer than the market expects. This requires a reasonable amount of judgment. But stocks that eventually exhibit such sustained growth are unlikely to see a compression in their valuation.

The Good Investors’ Conclusion

If you’ve been avoiding stocks because of the fear of the risk of loss, don’t.

Warren Buffett says that “risk comes from not knowing what you are doing.”

If we pick stocks wisely, the risk of permanent loss becomes small. On top of investing in stocks that exhibit low-risk qualities, investors should also consider diversifying their portfolio. Diversification reduces the risk that a single mistake or an unforeseen circumstance will be detrimental to our overall 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.

Sir John Templeton, one of the true investing greats, once said that the four most dangerous words in investing are “This time it’s different.” 

He wanted to warn us that if we ignore history, we’re doing so at our own peril. As French writer Jean-Baptiste Alphonse Karr once stated, “Plus ça change, plus c’est la même chose” (“the more things change, the more they stay the same”). 

But what makes investing so challenging is that sometimes, this time really is different.  

When dividend yields change permanently

There were two huge crashes in the US stock market in the early 20th century. One happened in 1929, during the infamous Great Depression, when US stocks fell by more than 80% at the 1932 bottom. The other, which is less well-known, occurred in the first decade of the 1900s and was known as the Panic of 1907. 

Something interesting happened prior to both of these crises. In the first half of the 20th century, the dividend yield of US stocks were higher than the country’s bond yield most of the time. The only two occasions when the dividend yield fell below the bond yield were – you guessed it – just before the Panic of 1907 and the Great Depression.

Knowing what happened in the first half of the 1900s, it’s easy for us to think that US stocks would crash the next time the dividend yield fell below the bond yield. So guess what happened when the dividend yield of US stocks started once again to slip behind the bond yield in the late 1950s?

The bond yield ended up staying higher than the dividend yield all the way until it was late into the first decade of the 2000s!

If we were investing in the US in the 1950s and wanted to invest based on the historical relationship between dividend and bond yields in the first-half of the 1900s, we had no chance at all to invest for decades. 

And yet from 1955 (before the dividend yield fell below the bond yield) to 2008 (when the dividend yield briefly became higher than the bond yield again), the S&P 500’s price increased by nearly 2,400%.

When a sign of cheapness stops working

Walter Schloss is one of my investing heroes, but he’s not too well-known among the general public. That’s a real pity because Schloss’s track record is astounding.  

From 1956 to 2000, Schloss’s investment firm produced an annualised return of 15.3%, turning every $1,000 invested into more than $525,000. Over the same time frame, the US stock market, as a whole, had compounded at merely 11.5% per year – $1,000 would have become just $120,000.

In 1985, Schloss was interviewed by the investing publication Barron’s. During the interview, he recounted a story involving his one-time boss and fellow investing luminary, Benjamin Graham:

“Graham used to have this theory that if there were no working capital stocks around, that meant the market was too high…

… [That’s] because historically, when there were no working capital stocks, the market collapsed. That worked pretty well till about 1960, when there weren’t any working capital stocks, but the market kept going up. So that theory went out.”

Schloss provided an explanation of what a working capital stock is in the same interview:

“Suppose a company’s current assets are $10 million; the current liabilities are $3 million. There’s $7 million in working capital. And, they are, say, $2 million in debt. Take that off. So there’s $5 million of adjusted working capital. And say there are 100,000 shares, so they got $50 a share of working capital.

Now, if that stock were selling at 30 bucks a share, it would be kind of interesting.”

To put it simply, working capital stocks are stocks that are priced very cheaply compared to the assets they own. Graham’s theory was that if the market no longer has such cheap stocks, then a crash is imminent.

The model worked fine for a while, then it stopped working, as working capital stocks became scarce near-permanently from the 1960s onwards. In fact, Schloss had to change his investment strategy. During an interview with Outstanding Investors’ Digest in the late 1980s, Schloss said (emphasis is mine):

“Yes. I think it has – largely because of the situation in the market. Graham-Newman [Benjamin Graham’s investment firm] used to buy working capital stocks – which I thought was a great idea.

But by 1960, there were practically no working capital stocks. With the exception of 1974, at the very bottom of that market, there have been practically no working capital stocks.

A good way of seeing it is to look at Value Line’s [a business publication showing financial numbers of US stocks] list of working capital stocks. If you go back 15 years, you’ll see they have some on the list. Today, there are very few. And the ones that are on the list are really pretty bad – often with a lot of debt – especially in relationship to the equity.

With working capital stocks gone, we look next at book value.”

Schloss was right to have tweaked his strategy. The US stock market has been marching higher – much higher – since the disappearance of working capital stocks. From the start of 1960 to today, the S&P 500 has increased from 60 points to over 3,000. That’s more than a 50-fold jump in value.

Recognising when things are different

It’s important for us to acknowledge that conditions in financial markets can change in permanent or near-permanent ways to severely blunt the usefulness of historical experience. 

The limits of using history can be applied to individual stocks too. For instance, it’s tempting for us to conclude that a stock is a bargain if it has lower valuations now compared to its own history. But we should also carefully consider if there’s anything that has permanently changed.

Bankruptcy risks. Industry obsolesce. Incompetent management. Absurdly high valuations in the past. These factors, and more, could render history useless as a guide for the future.

Many investors love to look at historical valuation data when studying the markets. I do too. But when doing so, it’s crucial to remember that things can change. What has worked in the past may no longer be valid in the future. We need to recognise that sometimes, this time really is different. 

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.  

Three years ago on 18 December 2016, I was interviewed by The Straits Times for its “Me & My Money” column. During the interview, I mentioned six US-listed stocks that I thought would do well.

I believe that we can significantly improve our investing process if we score ourselves on our stock picks and on our forecasts – looking back, we can clearly see what went well and what went wrong. I also believe that three years is the bare minimum time-length we should use when analysing our investment decisions. 

With three years having passed since my Straits Times interview, I checked how I fared, and picked up three lessons.

The stocks and my performance 

Here are the six stocks and their returns (excluding dividends, and as of 15 December 2019) since the publication of my interview:

• Facebook: +62%
• Alphabet: +70%
• Amazon: +132%
• Activision Blizzard: +61%
• MercadoLibre: +266%
• Netflix: +140%
• Average: +122% 

The 122% average-return produced by the group of six over the past three years equates to an impressive annual return of 30%. 

I think it’s crucial to also look at how the US stock market has performed. The reason why I’m investing in individual stocks is because I want to do better than the market. If I cannot beat the market, then I should be investing in passive funds instead, such as index-tracking exchange-traded funds. Finding stocks to invest in is a fun process, but it’s also hard work and requires discipline.

Over the past three years since my Straits Times interview was published, the S&P 500, including dividends, has increased by 49% in total, or 14% per year. All six stocks I was positive on have beaten the S&P 500 – and the group’s annual return is more than double the market’s. I think that’s not too shabby!

The 3 lessons

My first key takeaway is that my sextet were huge companies even when I talked about them during my interview. With the exception of MercadoLibre and Activision Blizzard, the six stocks were also highly visible and well-known companies across the world. You’ve probably used or at least heard about the services provided by Facebook, Alphabet (the parent of Google), Amazon, and Netflix.

Company	Market capitalisation on 18 December 2016
Facebook	US$345.5 billion
Alphabet	US$551.6 billion
Amazon	US$360.1 billion
Activision Blizzard	US$27.1 billion
MercadoLibre	US$6.8 billion
Netflix	US$53.3 billion

I’ve come across many investors who think that the only way to find good investment opportunities would be to look at stocks that are obscure and small. They ignore huge and well-known companies because they think that such stocks cannot be bargains due to high attention from market participants. But I think fantastic investment opportunities can come from companies of all sizes.

The second takeaway is that most of the stocks have inspirational and amazing leaders.

For example, at Facebook, there’s Mark Zuckerberg. Yes, there has been plenty of controversy surrounding him and his company in recent years. But in Facebook’s IPO prospectus, Zuckerberg included a shareholders’ letter (see page 80 of the document) that is a tour-de-force on building a company that has a purpose beyond profit. Here’s just one excerpt on the point:

“As I said above, Facebook was not originally founded to be a company. We’ve always cared primarily about our social mission, the services we’re building and the people who use them. This is a different approach for a public company to take, so I want to explain why I think it works.

I started off by writing the first version of Facebook myself because it was something I wanted to exist. Since then, most of the ideas and code that have gone into Facebook have come from the great people we’ve attracted to our team.

Most great people care primarily about building and being a part of great things, but they also want to make money. Through the process of building a team — and also building a developer community, advertising market and investor base — I’ve developed a deep appreciation for how building a strong company with a strong economic engine and strong growth can be the best way to align many people to solve important problems.

Simply put: we don’t build services to make money; we make money to build better services.”

I reserve the right to be wrong, but I believe in Zuckerberg’s letter.

At Alphabet, there’s Sergey Brin, Larry Page, and Sundar Pichai. Brin and Page, the founders of the company, recently stepped down from active management of Alphabet. But they had built an amazing firm that transformed the way the world accessed and searched for knowledge.

At Amazon, there’s Jeff Bezos. There’s also Marcos Galperin at MercadoLibre and Reed Hastings at Netflix. All three are innovative business leaders with tremendous track records. I also discussed Netflix’s management in greater depth in my investment thesis for the company. I think quality management is a key competitive advantage for a company and is a useful signal for picking long-term winners in the stock market. What do you think?

My last major takeaway is that I’ve held most of the six stocks for years before the interview was conducted (I still own them all!). From the time of my ownership to the publication of my interview with The Straits Times, they had performed pretty well – and then they continued to march higher. Peter Lynch once said that the best stock to buy may be the one you already own. How true!

Company	Date of my first investment	Return of company from the date of my investment to my Straits Times interview	Return of S&P 500 from the date of my investment to my Straits Times interview
Facebook	13 July 2015	33%	11%
Alphabet	29 February 2016	13%	19%
Amazon	15 April 2014	140%	30%
Activision Blizzard	26 October 2010	223%	117%
MercadoLibre	17 February 2015	18%	12%
Netflix	15 September 2011	414%	109%

I think there are two more points worth noting from my last major takeaway:

• Stocks need time to perform. MercadoLibre is a good example. After nearly two years from my first investment (from February 2015 to December 2016), the company’s return was a mere 18%. But then MercadoLibre’s stock price proceeded to rise by 266% since December 2016.
• There will always be things to worry about, but companies will still continue to grow and drive the stock market higher. Over the past three years since December 2016, we’ve had Brexit-related uncertainties, the US-China trade war, and interest rates rising and then falling. There are many more big issues the world has confronted and will have to continue to deal with. Throughout these episodes, the free cash flow of Facebook, Alphabet, and Amazon have increased by a total of 65%, 19%, and 121%. MercadoLibre and Netflix have seen their revenues grow by 167% and 131%, respectively.

A bonus takeaway

There’s also a bonus lesson here! In my interview with the Straits Times, I had identified two stocks as mistakes. Here they are and their returns (again, with dividends not included): 

• Ford: -27%
• Dolby: +48%

I said in the interview that I rarely sell my stocks. This is for a good reason: I want to build and maintain the discipline of holding onto my winners for the long run. That’s how I believe that wealth can be built in the stock market and how an investment portfolio should be managed.

Yes, I recognise that holding onto the losers is not an optimal decision when investing. But if our investment framework is robust, then we’ll end up with winners that can more than make up for the losers. And selling our winners too early is a mistake in itself that we should aim to avoid as much as possible. A good way to avoid this mistake is to build the discipline to sell rarely. We have to train our discipline like how we train for physical fitness.

Sometimes not selling also works out in my favour. Look at Dolby’s return, which has matched the market. But I’m glad I identified both Dolby and Ford as mistakes because they’ve not been able to beat the returns of the S&P 500 and my group of six stocks.

The Good Investors’ conclusion

It’s been three years since my interview with the Straits Times. Three years is the shortest amount of time that I think we can use to form conclusions on investing. Ideally, we should be assessing our decisions over five years or longer. 

The six stocks I mentioned in my interview, which I still own, have done well. There are instructive lessons we can gain from their performance. First, good investment opportunities can come from companies of all sizes. Second, having a great management team can be a useful signal in identifying long-term winners in the stock market. Third, we should be investing for the long run, even when there are things to worry about.

I will check back again at the five-year mark of my Straits Times interview, which will be in December 2021. Fingers-crossed that I’ll still have these handsome returns (or better) 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.