Author: Jeremy Chia

Are stocks too expensive? On the surface, it certainly seems so.

The US economy declined by 32.9% on an annualised basis in the second quarter of 2020. Sequentially, it fell 9.5% from the first quarter, marking the fastest quarterly contraction on record. Worse still, many parts of the world are still in full or partial lockdowns and the travel industry is still effectively in a standstill.

And yet, the S&P 500 – the major US stock market benchmark – is roughly flat year-to-date. There is clearly a mismatch between the US stock index and the economy.

But if you think that the index is going to fall because of this mismatch, what are those invested missing? Are they all experiencing FOMO (fear of missing out) or are they all just plain dumb? I don’t have the answers, but I want to present some information as food for thought.

The key reasons

Based on my observation, there are two main reasons that market watchers point to for causing an expensive stock market. They are (1) Robinhood traders rushing to buy stocks and (2) the extra liquidity created by the Federal Reserve causing a rise in asset prices. Robinhood is a mobile app that provides commission-free trading for financial instruments such as stocks, exchange-traded funds, and more.

But Robinhood traders only make up a fraction of all market participants. There are market shorters, big hedge funds, and other professional investors that are participating in the market too. If stocks are too expensive because of exuberant demand from Robinhood traders, it is likely that there will be investors who will be shorting the market and keeping prices in check.

Second, the extra liquidity injected by the Federal Reserve is here to stay and is, therefore, rightly, an important determinant of stock prices.

Discerning

The fact of the matter is that everyone is seeing the same thing. Most of us are not special investors with special insights.

Yes, the stock market has reached bubble levels in the past but bubbles are rare. Most of the time, the stock market is fairly efficient. Could it be the case now?

If we take a closer look at the S&P 500, we can see a division in price performance between companies that are fundamentally sound and those that are not. For instance, technology stocks have made up the bulk of the market’s gains this year, while companies in sectors that have been hit the hardest have taken the brunt of the fall.

Year-to-date (as of 1 August 2020), the top-performing sector in the S&P 500 is Information Technology, which is up 21%. That’s backed by strong fundamentals. Many technology companies have seen a surge in revenue and profits in the most recent quarter. Amazon, Apple, Facebook and Netflix, for example, reported a year-on-year increase in revenue of 40%, 11%, 11%, and 25% respectively, for the second quarter of 2020.

At the other end of the spectrum, we have energy and financial stocks that are down 40% and 21% respectively as they are likely the hardest-hit from the current COVID-19-driven economic contraction. Airline stocks are also far below their pre-COVID-19 levels. Local flag carrier Singapore Airlines’ share price is down 62%, while the major US airlines are down between 40 and 70%.

All of which seems to indicate that market participants have been discerning about which stocks to sell down and which to price up.

The stock market and the economy

It can be easy to assume that the stock market and the economy are the same things. But there are actually big differences.

The S&P 500, a commonly used barometer to gauge the stock market in the US, only comprises around 500 companies. Within the index, the top five companies – Alphabet, Amazon, Apple, Facebook, and Microsoft – have a combined weight of around 22%.

A rise in the price of the top five companies can disproportionately impact the index. This is exactly what is happening. The big five, along with Netflix, have seen their share prices increase substantially this year. If we exclude the performances of just these six companies, the S&P 500 would be down substantially for the year so far.

Furthermore, being an index of just 500 companies, the S&P 500 does not take into account the rest of the 30 million-plus businesses in the US, many of which are SMBs (small, medium businesses). In fact, SMBs generate around 44% of the US’s economy activity, according to a recent study from The Office of Advocacy of the U.S. Small Business Administration. And unfortunately, SMBs are the most impacted businesses in the US during the COVID-19 pandemic.

Who knows?

Nobody knows how this will all play out. The ending’s not written yet. It is only with hindsight that we can tell if the stock market is currently making sense, or if it’s not.

But this is why investing is hard, and why beating the market is even harder.

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 have a vested interest in Alphabet, Amazon, Apple, Facebook, Microsoft and Netflix.

Psychological biases are the human tendency for us to make decisions in an illogical way. The concept was introduced by psychologists Daniel Kahneman, Paul Slovic, and Amos Tversky in the early 1970s. Kahneman later won a Nobel Prize for his work and went on to write the best-selling book Thinking, Fast and Slow.

In his book, Kahneman describes the “fast thinking” part of the brain as System 1. This way of thinking helps us make snap decisions, such as jumping away when we hear a loud noise.

Slower thinking, or System 2, is used to solve more complicated problems. Usually, Systems 1 and 2 work very well, but in some situations, System 1 may cause a person to jump to conclusions too quickly and lead to what we now know as psychological biases.

What is confirmation bias?

There are numerous psychological biases and one of the more common and well-known of them that affects us as investors is confirmation bias. Confirmation bias is our tendency to cherry-pick information that supports our existing beliefs.

It partly explains why two people with opposing views can come to very different conclusions when they see the same piece of information. It can also cause us to make bad investing decisions. Take the scenario below for an example.

A friend at a party whispers a hot investing tip to you. You get excited at the prospect of making money but realise that it is important to do your own research. When you reach home, you hastily search for more information. Unfortunately, because of your preconceived conception of the company, you unwittingly reject data that goes against your belief and only look for information that supports it. Thinking you did sufficient due diligence, you make your trade the next day.

This is a common phenomenon. You’ll be surprised how easy it is to interpret data and statistics to fit your preexisting view.  Shane Parish, in his Farnam Street blog, wrote:

“Confirmatory data is taken seriously, while disconfirming data is treated with scepticism.”

In his book, Six Thinking Hats, Edward De Bono wrote:

“There may be more danger in prejudices which are apparently founded in logic than in those which are acknowledged as emotions.”

Why do we suffer from confirmation bias?

If the above scenario sounds familiar, then you have suffered from confirmation bias.

There is an innate desire for us to want to have been right. In the book The Web of Belief, authors Willard V Quine and J.S Ullian wrote,

“The desire to be right and the desire to have been right are two desires, and the sooner we separate them the better off we are. The desire to be right is the thirst for truth. On all counts, both practical and theoretical, there is nothing but good to be said for it. The desire to have been right, on the other hand, is the pride that goeth before a fall. It stands in the way of our seeing we were wrong, and thus blocks the progress of our knowledge.”

Confirmation bias is so ingrained in our brains that knowing that we tend to suffer from confirmation bias is not enough. The act of seeking out other data is not the solution- the problem is not being open to an alternative view.

How do we overcome it?

The first thing we should do is to give ourselves time to make a decision. Giving ourselves time to conduct research, talk to people in the know, and look for a different point of view, can reduce the risk of confirmation bias. Darren Matthews wrote in an article:

“It seems logical to add time to making decisions, slowing things down. Time offers a perspective that brings with it the capacity to bring other steps into play.”

Second, actively search out opposing views. Find arguments that reject your initial view and dig into the other corner of the Internet. Further, be willing to change your opinion if you find sufficient evidence to do so. 

Third, acknowledge that changing our opinion can be extremely difficult. In The Little Book of Stupidity, Sia Mohajer wrote:

“Research has shown that attempts to “enlighten” believers can be either entirely useless or serve to bolster their current belief systems. This bolstering of belief is often referred to as entrenching. This is the idea that once you have invested mental energy into a habit or belief, you strongly reject any potential contradictory information.”

We, therefore, have to make a conscious effort to realise the challenge we face in changing our opinion.

Final words

“What the human being is best at doing is interpreting all new information so that their prior conclusions remain intact.”

Warren Buffett

Confirmation bias is part of our everyday life. It affects anything from our political views to our religious beliefs to our investing decisions.

The first step to overcoming confirmation bias is to acknowledge that it affects us. Only then can we take active steps to have safeguards to ensure that it does not negatively impact our lives – or in this case our investment returns.

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.

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

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

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

The two key factors

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

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

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

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

How to use this information?

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

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

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

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

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

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

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

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

Risks to growth

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

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

Final words

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

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

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

The ultimate goal of investing is simply to make money.

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

Companies that don’t pay dividends

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

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

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

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

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

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

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

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

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

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

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

Final words

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

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

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.

Just a glance at the price chart of a stock market index will tell you that stocks don’t go up in a straight line. Stocks go up in a zig-zag pattern, making peaks and troughs.

Wouldn’t it be wonderful if we could keep buying at troughs and selling at peaks? We’d all be extremely rich. But the reality is it’s impossible. Even the best investors will tell you that timing the market perfectly is a pipedream. Yet, time and again, I still hear novice investors who are trying to do exactly that.

“The market looks expensive now. Maybe I should wait for another day.”

This statement may seem innocuous and something that many investors are feeling now. It is also understandable. The S&P 500 in the US fell by more than 30% from 19 February 2020 to 23 March 2020, but has since recovered almost all of the losses. Meanwhile, COVID-19 cases continue to surge and lockdowns are still imposed in many parts of the world.

I’m not saying that I know for a fact that stocks will keep rising from here. However, trying to time the market over the long-term will likely do you more harm than good. According to asset management firm Franklin Templeton, missing just a few of the stock market’s best days will severely damage your returns:

Staying fully invested over the 20 years leading up to December 2019 would have given you a 6.06% total annual return. However, miss just the best 10 days and your return would fall to only 2.44% per year. Miss the best 20 days, and your return drops to a negligible 0.08%. Miss the 30 best days and you are looking at a -1.95% annual loss. That would be 20 wasted years of investing.

I can draw one simple conclusion from this: The risk of staying out of the market is huge. Because of this, I much prefer a way less risky, albeit boring, approach of staying invested. By doing this, I know that I will not risk missing out on the best trading days of the market.

Less stress

Timing the market is also extremely stressful. Even for investors who are able to get it right once in a while, do the extra returns justify the effort? You’ll need to constantly monitor the market, find opportunities to buy and sell and are likely to still end up messing things up (see above).

Imagine you sold your investments just before some of the best trading days occur and the index/stock you are investing in never goes back to where you sold it at. You’d have missed out on some gains.

And what would you do next? Would you be able to convince yourself to buy back in at a higher price than you sold? You will likely continue compounding your mistake by never investing again. That’s a big mistake as historically the stock market tends to keep making new highs.

Final words

Time is your greatest friend in investing. There will always be reasons not to invest in the market. 

The legendary investor Peter Lynch once said that “Wall Street makes its money on activity; you make your money on inactivity.” Investors who are tempted to time the market should remember these wise words.

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 S&P 500 index continues to defy gravity even as COVID-19 cases rise in the US. 

Investors whom I’ve been talking to are understandably getting nervous. Will the S&P 500 eventually come crashing down to reflect the recession the world is living in?

Distinguishing the S&P 500 index from the economy

The first thing I want to point out is that the S&P 500 is not an accurate representation of the US economy.

The S&P 500 represents a basket of 500 of the biggest companies listed in the US. Although it may be tempting to assume that this basket of stocks should rise and fall in tandem with the whole economy, reality looks different.

There are 32 million businesses in the US, so the S&P 500 is just a fraction of this. In addition, the S&P 500 is a market-cap-weighted index that is heavily weighted toward just a few big firms such as Apple, Amazon, Alphabet, and Facebook. These mega-cap tech companies have arguably thrived during the COVID-19-induced lockdown.

Amazon, for example, had a big jump in sales due to the need for social distancing. Facebook double-downed on investing its spare cash. With so much cash on their balance sheets, these tech giants can find bargains at a time when other businesses are struggling for cash.

If these mega caps rise in value, it can positively skew the S&P 500.

But should we invest at all-time highs?

Another concern is whether we should invest at all-time high prices? The reality is that the S&P 500 reaching new all-time high prices is actually not that uncommon.

Engaging-data.com has some interesting data related to this topic. Between 1950 to 2019, there were a total of more than 17,000 trading days. Of which, the S&P 500 reached an all-time high on 1,300 days. Interestingly, if you invested on days after the S&P 500 reached all-time highs, you’d be doing just as well as if you invested on any other day.

The chart below compares your returns if you bought at all-time high (ATH) prices vs if you bought at any other time.

If you bought the S&P 500 the day after it hit a new high, your mean return over five years was 53.7%. If you bought on any other time, your mean return was 50.0%. I checked the 10-year return data, and the numbers point to the same conclusion. The mean return after 10 years, if you bought at a high, was 103.2% compared to 114.7% if you bought on all trading days.

The data shows that investing during new market highs, contrary to popular belief, gives you very similar returns to if you invested at any other time.

If this is a market peak?

But what if this market high is a peak and stocks do come crashing down after this? In this case, your returns will most likely not be as good as if you invested before or after the crash. However, that doesn’t mean you will have poor returns per se.

Ben Carlson, a respected financial blogger and wealth manager wrote an insightful piece in 2014 on investing just before a market crash. 

In his article, Carlson wrote about a fictional investor who somehow managed to time his investments at all the worst times over a 40-year period. The investor invested in the S&P 500 just before the crash of 1973, before Black Monday of 1987, at the peak of the tech bubble in 1999, and at the peak before the start of the Great Financial Crisis of 2008.

Though this frictional investor was a terrible market timer, he was a long-term investor and never sold any of his positions. Despite his terrible luck in market timing, he ended up making a 490% return on his investment over his 40-year investing period.

This goes to show that even if you invest just before a crash, stocks tend to rebound and will eventually reach new peaks.

Final Takeaways

There are a few takeaways here:

1. It may be scary to invest in the stock market when it is at an all-time high. It is especially scary when the economy is in a recession, as we are seeing today. However, the S&P 500 is not the economy. 
2. Not all companies have businesses that live or die by the broad economy. Some thrive during times of crisis and investing in these “anti-fragile” companies can pay dividends down the road.
3. Whether the S&P 500 is at an all-time high or not shouldn’t make a difference to a long-term investor. The stock market tends to keep making new highs. 
4. Even if stocks were to fall dramatically tomorrow, if the past is anything to go by, investing in a broad index like the S&P 500 over the long-term will still provide a very decent return over a sufficiently long investing period.

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.

Much ink has been spilt about the great benefits of investing in the stock market. We constantly read about the power of compounding, how investing in stocks can help you beat inflation and the beauty of passive income from dividends.

But there’s a flip side to all this. Stock prices will fall every so often.

The size of the drawdowns can be big and they can happen frequently. It’s inevitable and will always be part and parcel of the stock market. 

That’s what makes long term investing so hard

Fundsmith is the UK’s largest fund by assets under management and also one of the country’s top-performing funds. Its annualised return since inception (from November 2010 to May 2020) is 18.2%, compared to the MSCI World Index’s gain of 11.2% per year.

Its investment philosophy is summed up by three simple but profound investing principles: (1) Buy good companies, (2) Don’t overpay, and (3) Do nothing.

But Fundsmith is quick to point out that though their investment philosophy may sound easy, it is anything but. In fact, Fundsmith says that the most difficult part is following its third principle – doing nothing.

As investors, we are so caught up in the day-to-day commentary about the market that doing nothing to your portfolio is so mentally difficult. One of the reasons why this is so because investors tend to try to avoid pain as much as possible. It’s human nature.

Infants enter the world with a natural instinct to avoid pain. Think of the time you touched a hot surface, and immediately retracted your hand. This is just one example of our bodies reacting to pain. 

In his book Thinking Fast and Slow, Daniel Kahneman refers to our instinct of avoiding pain as System 1 thinking, which is the automatic and fast-thinking part of the brain. But this instinct, though very useful in certain situations, can cause us to make very bad decisions in the stock market. Instead, we should force ourselves to think logically and more in-depth when it comes to investing, using the slow, logical thinking part of the brain- what Kahneman terms System 2.

Our human tendency to avoid pain

In his recent article Same As It Ever Was, Morgan Housel writes: 

“There are several areas of life where the best strategy is to accept a little pain as the cost of admission. But the natural reaction is to say, “No, no, no. I want no pain, none of it.”

The history of the stock market is that it goes up a lot in the long run but falls often in the short run. The falls are painful, but the gains are amazing. Put up with one and you get the other.

Yet a large portion of the investing industry is devoted to avoiding the falls. They forecast when the next 10% or 20% decline will come and sell in anticipation. They’re wrong virtually every time. But they appeal to investors because asking people to just accept the temporary pain of losing 10% or 20% – maybe more once a decade – is unbearable. The majority of investors I know will tell you that you will perform better over time if you simply endure the pain of declines rather than try to avoid them. Still, they try to avoid them.

The upside when you simply accept and endure the pain from market declines is that future declines don’t hurt as bad. You realize it’s just part of the game.”

Opportunities created

Yet, it is this same aversion to pain that creates opportunities in the stock market. My blogging partner, Ser Jing, wrote in an article of his:

“It makes sense for stocks to be volatile. If stocks went up 8% per year like clockwork without volatility, investors will feel safe, and safety leads to risk-taking. In a world where stocks are guaranteed to give 8% per year, the logical response from investors would be to keep buying them, till the point where stocks simply become too expensive to continue returning 8%, or where the system becomes too fragile with debt to handle shocks.”

In other words, the fact that stocks are so volatile is why stocks can continue to produce the kind of long-term returns it has done. Investors are put off by the volatility, which causes stocks to be frequently priced to offer premium returns.

Final words

Investing in the stock market is never going to be a smooth journey. Even investing legends have endured huge drawdowns that have resulted in their net worth moving up and down. Warren Buffett, himself, has seen billions wiped out from his net worth in a day. Yet, his ability to accept this pain and invest for the long-term makes him able to reap the long-term benefits of investing in stocks.

Morgan Housel perhaps summed it up best when he wrote: “Accepting a little pain has huge benefits. But it’ll always be rare, because it hurts.”

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.