Author: Chong Ser Jing

My girlfriend is currently taking online courses on financial analysis for her own personal development. The content can be really dry for her at times. To spice up her learning, I recently suggested that she watch the movie, The Big Short.

The film came out in 2015 and is based on the 2010 book by renowned author Michael Lewis, The Big Short: Inside the Doomsday Machine. Both the movie and book depict the real-life experience of a few groups of investors who foresaw the 2008-09 US housing and financial crisis and profited from it.

When the movie first came out, I was so excited that I helped organise an outing to watch it with a group of friends who are also keen investors. I remember being captivated by the film.

After recommending The Big Short to my girlfriend (she loves the movie too – yay!), I decided to rewatch it last weekend. It was the first time I did so, five years after I initially saw the film. In my second run, I experienced the same captivation I did as on my first. But this time, I also came away with investing lessons that I want to share – perhaps a by-product of me having this investment blog that I love writing for.

Lesson 1: The market can remain irrational longer than you can remain solvent

The characters in The Big Short mostly used leveraged instruments – credit default swaps (CDSs) – to make their bets that the housing market and the financial instruments tied to the housing market would fall. This is a simplified explanation, but the financial instruments that were tied to the housing market were essentially bonds that were each made up of thousands of mortgage loans from across the US.

The CDSs are like insurance contracts on the bonds. If you own a CDS, its value will rise significantly, or you will receive a big payoff, if the value of the bonds fall or go to zero. But before the decline happens, you have to pay regular premiums on the swaps as long as you own it. Moreover, you have to meet margin calls on the CDS if the value of the bonds increase. 

The investors depicted in The Big Short suffered temporary but painful losses to their portfolios because of the premiums and margin calls they had to pay prior to the flare up of the housing and financial crisis. Their experience reminded me of a great quote that is commonly attributed to the legendary economist John Maynard Keynes, but that is more likely to have originated from financial analyst Gary Shilling: 

“The market can remain irrational longer than you can remain solvent.”

If the housing and financial crisis did not erupt when they did, the investors in The Big Short may have suffered debilitating losses if they held onto their CDSs long enough. This is a key reason why I do not short financial assets nor use leverage. Some investors can do it very successfully – the ones in The Big Short certainly did – but it’s not my game. 

Lesson 2: Investing can be a lonely affair

One of the real-life investors profiled in the movie and book is Dr Michael Burry. The movie did not explore much of Burry’s earlier life before he invested in the CDSs, but his real backstory is amazing. 

Growing up, Burry was somewhat of a loner. But he managed to excel academically and eventually graduated with a medical degree. He worked in a hospital for some time, but found that his real interest was in stock market investing. When he was a doctor, he spent his free hours researching stocks and writing about them on the internet. His sharing was excellent and attracted the attention of the well-known investor Joel Greenblatt (the character Lawrence Fields in the movie is based on him). Burry eventually left medicine to establish his investment firm, Scion Capital, with Greenblatt’s seed capital. 

Burry’s reputation was built on his uncanny ability to pick stocks mostly through bottoms-up, fundamental analysis. In Scion’s early days, he posted tremendous returns for a few years by shorting overvalued stocks and investing in undervalued ones. But in 2005, after he discovered the house of cards that the US housing market was built on and decided to invest in CDSs, his investors started turning on him. They had no faith in his ability to find investment opportunities outside of the stock market. They wanted him to stick to his knitting. 

The Big Short depicted the intense emotional loneliness that Burry felt when his investors turned their backs on him. Some even threatened to sue. Burry was vindicated in the end. In 2007, the US housing market started to collapse and the bonds that were built with the mortgage loans failed. Burry’s CDSs soared as a result. But he was so burnt out by the experience that he decided to close Scion Capital after cashing in the profits.

What was even sadder is that even though Burry made a lot of money for his investors in Scion Capital – the fund gained 489% in total, or 27% annualised, from its inception in November 2000 to June 2008 – the relationships he had with his investors, including his mentor Greenblatt, had mostly soured beyond repair. 

At times in investing, we may be the only ones who hold a certain view. This could be a lonely and draining experience (although it’s probably unlikely that we will face the same level of isolation that Burry did) so we have to be mentally prepared for it.

Lesson 3: Famous investors can be very wrong at times too

This is related to Lesson 2. Joel Greenblatt produced a 40% annualised return for 20 years with his investment fund, Gotham Capital, that he co-founded in 1985. That’s an amazing track record. But Greenblatt got it wrong when he butted heads with Dr Michael Burry’s decision to invest in CDSs.

It’s very important for us as investors to know what we don’t know. As I mentioned earlier, Burry started his investing career by being a very successful stock picker who did bottoms-up fundamental analysis. Being a good stock picker does not mean that you will automatically be good at other types of investments. I believe this was Greenblatt’s concern and I sympathise with him. This is because it was a legitimate worry that Burry may have ventured into an area where he had zero expertise when he shorted the US housing market through CDSs.

This is not meant to be a criticism of Greenblatt in any way. His results are one of the best in the investing business. I would have been worried about Burry’s investment actions too if I were in Greenblatt’s shoes. What I’m trying to show is just how difficult investing in the financial markets can be at times, and that even the best of the best can get it wrong too. 

Lesson 4: Luck can play a huge role in our returns

One of the central characters in the movie and the book is hedge fund manager Steve Eisman (named Mark Baum in the film) who first heard of the CDSs trade from a bond trader at Deutsche Bank, Greg Lippmann (named Jared Vennett in the film). What is amazing is that Eisman only knew about the idea because of a mistake that Lippmann made.

Lippmann wanted to introduce his idea of shorting the housing market with CDSs to hedge funds that had a certain characteristic. One hedge fund Lippmann discovered that fit his bill was Frontpoint. Eisman’s hedge fund was named Frontpoint – but the problem was Eisman’s Frontpoint was not the Frontpoint Lippmann was looking for. Lippmann only realised his mistake when he met Eisman in person. Nonetheless, Eisman saw the logic in Lippmann’s idea. He made the trade for his Frontpoint, and the rest as they say, is history.

This goes to show how important luck can be to our investment returns. Eisman only knew about the idea because Lippmann suffered a case of mistaken identity. Sure, Eisman may have eventually discovered the same idea independently. But this is a counterfactual that is impossible for us to ever know. What we do know is that Lady Luck had smiled on Eisman, and to his credit, he acted on 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.

Here’s an excerpt of a speech by the leader of the Federal Reserve, the central bank of the US, warning of danger in stocks in the country:

“Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past.

But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy?

We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy.

But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.”

Trouble ahead?

Are you worried about the implications of the speech? Don’t be. That’s because the speech was delivered on 6 December 1996 – more than 23 years ago – by Alan Greenspan, who was the chairperson of the Federal Reserve at the time. Greenspan’s speech has since become well-known for the phrase “irrational exuberance” because it happened only a few short years before the infamous Dotcom bubble in the US imploded in late 2000. 

But what’s really interesting is that the S&P 500, the major benchmark for the US stock market, has gained 526% in total including dividends, from December 1996 to today. That’s a solid annual return of 8%. This reminds me of two important things about investing.

Worries, worries

The first thing is, to borrow the words of the legendary fund manager Peter Lynch, “there is always something to worry about.”

The content of Greenspan’s speech could well be used to describe the financial markets we’re seeing today. The S&P 500 has bounced 36% higher (as of 28 May 2020) from its 23 March 2020 low after suffering a historically steep coronavirus-driven decline of more than 30% from its 19 February 2020 high. Moreover, the S&P 500 has a price-to-earnings (P/E) ratio of 22 today, which is not far from the P/E ratio of 19 seen at the start of December 1996.

Yet anyone who got scared out of the US stock market back then by Greenspan’s speech, and crucially, failed to reinvest, would have missed out on more than 23 years of good returns. Some individual stocks in the US have delivered significantly higher returns, so the opportunity costs for anyone who stayed out would have been immense.

Time heals

The second thing is, time can wash away plenty of mistakes in the financial markets.

The past 23-plus years from 1996 to today contained plenty of jarring episodes for the economies and the financial markets of the US and many other countries. Here’s a short and incomplete list: The 1997 Asian Financial Crisis; the bursting of the Dotcom bubble in late 2000 that I already mentioned; the 2008-09 Great Financial Crisis; Greece’s debt crisis in 2015; Italy’s banking troubles in 2015; and the US-China trade war in 2018. 

Yet, investors who stayed invested have been rewarded, as Corporate America grew steadily over the years.

Words of caution

I’m not saying that the US stock market will be higher 1 or 2 years from now. Nobody knows. When the Dotcom bubble burst after Greenspan gave his famous “irrational exuberance” speech, the S&P 500 fell by nearly half. It recovered, only to then get crushed again during the 2008-09 Great Financial Crisis. The chart below shows this.

What I want to illustrate is that it makes sense to invest even when the world is mired in trouble, if we have a long time horizon for our investments. 

Now, I want to stress that having a long time horizon is not a magical panacea. 

If our portfolio is filled with stocks that have lousy underlying businesses, staying invested for the long run will destroy our return. This is because such a portfolio becomes riskier the longer we hold onto it, since value is being actively eroded.

If we invest in stocks at ridiculous valuations, staying invested can’t save us too. Japan’s a great example. Its main stock market barometer, the Nikkei 225 index, is today more than 40% lower than the peak seen in late 1989. This is because Japanese stocks were valued at nearly 100 times their inflation-adjusted 10-year average earnings near the late-1989 high. The good thing is Japan-level bubbles are rare. It’s the exception, not the norm. 

So, if the stocks we own today have reasonable valuations and have decent-to-great underlying businesses, we can afford to be patient. In such cases, time can be a great healer of stock market wounds.

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 word “analogy” is defined by the Cambridge Dictionary as a “comparison between things that have similar features, often used to help explain a principle or idea.” It is a useful way for us to understand a topic that’s complicated or new to us.

One topic that is often made overly complex is investing in stocks. Fortunately, I have three analogies – sourced from greater minds – that can help us cut through the fluff and get to the point about the core of stock market investing.

Watching the right thing

The first analogy is from Ralph Wagner, who ran the US-based Acorn Fund from 1970 to 2003. During his tenure, he led Acorn Fund to an impressive annual gain of 16.3%. This is also significantly better compared to the S&P 500’s return of 12.1% per year over the same period. 

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.”  

In Wagner’s terminology, the stock price is the pooch, while the underlying business of the stock is the owner. Instead of watching the dog (the stock price), we should be focusing on the owner (the business).

My favourite example of this is Warren Buffett’s investment conglomerate, Berkshire Hathaway. 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%.

In all, Berkshire’s book value per share increased by 18.7% per year from 1965 to 2018. Meanwhile, its share price was up by 20.5% annually over the same period. An input of 18.7% had led to a similar output of 20.5% over the long run despite wide differences at times during shorter timeframes. 

Predictions are hard

Dean Wlliams is the owner of the second analogy. There are only two things I know about Williams. I couldn’t find anything else about him online – if you know more about him, please reach out to me! First, he’s an investor who was part of Batterymarch Financial Management. Second, he wrote one of the best investment speeches I’ve ever come across. The speech, delivered in 1981, is titled Trying Too Hard.

Here’s the analogy:

“The foundation of Newtonian physics was that physical events are governed by physical laws. Laws that we could understand rationally. And if we learned enough about those laws, we could extend our knowledge and influence over our environment.

That was also the foundation of most of the security analysis, technical analysis, economic theory and forecasting methods you and I learned about when we first began in this business. There were rational and predictable economic forces. And if we just tried hard enough… Earnings and prices and interest rates should all behave in rational and predictable ways. If we just tried hard enough.

In the last fifty years a new physics came along. Quantum, or subatomic physics. The clues it left along its trail frustrated the best scientific minds in the world. Evidence began to mount that our knowledge of what governed events on the subatomic level wasn’t nearly what we thought it would be. Those events just didn’t seem subject to rational behavior or prediction. Soon it wasn’t clear whether it was even possible to observe and measure subatomic events, or whether the observing and measuring were, themselves, changing or even causing those events.

What I have to tell you tonight is that the investment world I think I know anything about is a lot more like quantum physics than it is like Newtonian physics. There is just too much evidence that our knowledge of what governs financial and economic events isn’t nearly what we thought it would be.”

Newtonian physics – the laws of nature governing our daily life – is neat and tidy. You can calculate gravity, air resistance, motion etc. with precision. This is how NASA managed to calculate precisely how long it would take for a spacecraft to travel from Earth to Pluto. In January 2006, NASA launched the New Horizons spacecraft, which reached Pluto in July 2015. The five billion kilometre journey “took about one minute less than predicted when the craft was launched,” according to NASA.

Quantum physics – the laws of nature governing atomic or subatomic particles – is far messier. When I first learnt about quantum physics in school, I was fascinated by the idea that it is impossible to simultaneously measure a particle’s position and velocity. In fact, the act of measuring a particle itself can change the thing you’re trying to probe.

What Williams is trying to bring across in his analogy is that investing is messy, just like quantum physics. Investing does not lend itself easily to tidy predictions, such as those common in Newtonian physics. This is shown clearly in the tweet below by investor Ben Carlson.

The case for long-term thinking

The third analogy comes from Jeremy Grantham, the co-founder and investment strategist of the asset management firm GMO. At the end of 2014, GMO managed US$116 billion in assets.

Financial journalist Maggie Mahar shared the following quote from Grantham in her excellent book Bull: A History of the Boom and Bust, 1998-2004:

“Think of yourself standing on the corner of a high building in a hurricane with a bag of feathers. Throw the feathers in the air. You don’t know much about those feathers. You don’t know how high they will go. You don’t know how far they will go. Above all, you don’t know how long they will stay up…

…Yet you know one thing with absolute certainty: eventually on some unknown flight path, at an unknown time, at an unknown location, the feathers will hit the ground, absolutely guaranteed. There are situations where you absolutely know the outcome of a long-term interval, though you absolutely cannot know the short-term time periods in between. That is almost perfectly analogous to the stock market.”

Making sense of short-term events in the stock market is practically impossible – just like how it’s impossible to tell how a feather will travel when it’s in the air. But over the long run, it’s easier to make sense of what’s going on in the stock market. Over time, richly valued stocks and stocks with poor business results tend to come down to earth, while stocks with underlying businesses that do well tend to rise significantly. This is similar to how a feather will hit the ground eventually.

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.  

It’s now nearly 10 years since I first started investing in stocks for my family in October 2010. During this period, I also helped pick stocks professionally (from May 2016 to October 2019) while I was at The Motley Fool Singapore.

I’ve developed 7 personal investing rules for the stock market throughout these years that I think are timeless. I also think these rules are worth sharing now, since there’s so much uncertainty about the future with the world living under the shadow of COVID-19. In no particular order, here they are:

Rule 1: Focus on business fundamentals, not geopolitical and macroeconomic developments

Peter Lynch, the legendary manager of the Fidelity Magellan Fund from 1977 to 1990, once said: 

“If you spend more than 13 minutes analyzing economic and market forecasts, you’ve wasted 10 minutes.”

Focus on business fundamentals to find great companies because it is great companies that produce great long-term stock market returns.

Warren Buffett’s investment conglomerate, Berkshire Hathaway, saw its book value per share increase by 18.7% per year from 1965 to 2018. In those 53 years, there was the Vietnam War, the Black Monday stock market crash in 1987, the “breaking” of the Bank of England, the Asian Financial Crisis, the bursting of the Dotcom Bubble, the Great Financial Crisis, Brexit, and the US-China trade war, among many other important geopolitical and macroeconomic developments. Over the same period, Berkshire’s share price increased by 20.5% per year – the 18.7% input led to a similar 20.5% output. 

Rule 2: Think and act long-term

I believe that the stock market has a fundamental identity: It is a place to buy and sell pieces of a business. This also means that a stock will do well over time if its business does well. So to excel in investing, we need to identify companies that can grow strongly over the long run.

Jeff Bezos once said:

“If everything you do needs to work on a three-year time horizon, then you’re competing against a lot of people. But if you’re willing to invest on a seven-year time horizon, you’re now competing against a fraction of those people, because very few companies are willing to do that. Just by lengthening the time horizon, you can engage in endeavors that you could never otherwise pursue.”

I believe Bezos’s quote applies to investing too. The simple act of having a long-term mindset gives us an advantage in the market. 

Investing for the long run also lowers the risk of investing in stocks. In a column for The Motley Fool, Morgan Housel shared the chart below. It uses data for the S&P 500 from 1871 to 2012 and shows the chance that we will earn a positive return in US stocks for various holding periods, ranging from 1 day to 30 years. Essentially, the longer we hold our stocks, the higher the chance that we will earn a positive return.

The caveat here is that we must be adequately diversified, and we must not be holding a portfolio that is full of poor quality companies. Such a portfolio becomes riskier the longer we stay invested, because value is being actively destroyed.

Rule 3: Don’t obsess over valuation – instead, focus on business quality

I think it’s far more important to be right about the quality of a business than it is to fret over its valuation. Yes, overpaying for a stock doesn’t make sense. But I think many investors don’t realise that certain stocks can carry what seems like high valuations and still do very well over a long period of time. 

Terry Smith is an investor I respect greatly. He is the founder, CEO, and CIO (Chief Investment Officer) of Fundsmith, a fund management company based in the UK. In his 2013 letter to Fundsmith’s investors, Smith wrote:

“We examined the relative performance of Colgate-Palmolive and Coca-Cola over a 30 year time period from 1979-2009. Why 30 years? Because we thought it was long enough to simulate an investment lifetime in which individuals save for their retirement after which they seek to live on the income from their investment. Why 1979-2009? We wanted a recent period and in 1979 it so happens that Coca-Cola was on exactly the same Price Earnings Ratio (“PE”) as the market – 10 and Colgate was a little cheaper on 7x.

The question we posed is what PE could you have paid for those shares in 1979 and still performed in line with the market, which we took as the S&P 500 Index, over the next 30 years?

We found the answer rather surprising – it was 36x in the case of Coke and 34x in the case of Colgate when the market was on 10x. Another way of looking at it is that you could therefore have paid a PE of 3.6x the market PE for Coke and 4.9x the market PE for Colgate in 1979 and still matched the market performance over the next 30 years.

The reason is the differential rate of compound growth in the share prices (to a large extent driven by growth in the earnings) of those companies over the 30 years. They compound at about 5% p.a. faster than the market. You may be surprised that this differential can have such a profound effect upon the outcome. It’s the magic of compounding.”

Rule 4: Don’t use leverage

The stock market can move in surprising ways more often than we imagine.

On 12 August 2019, Argentina’s key stock market benchmark, the Merval Index, fell by a stunning 48% in US-dollar terms. That’s a 48% fall in one day.

According to investor Charlie Bilello, the decline was a “20+- sigma event.” Mainstream finance theories are built on the assumption that price-movements in the financial markets follow a normal distribution. Under this statistical framework, the 48% one-day collapse in the Merval Index should only happen once every 145,300,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000 years. For perspective, the age of the universe is estimated to be 13.77 billion years, or 13,770,000,000 years.

If we invest using leverage, we may be ruined whenever stocks lurch violently in their unpredictable yet more-frequently-than expected manner.

Rule 5: Volatility is normal

Volatility in stock prices is a feature of the stock market and not a bug. I say this because even the stock market’s best winners exhibit incredible volatility. We can see this in Monster Beverage, an energy drinks maker listed in the US. 

Monster Beverage’s share price was up by 105,000% from 1995 to 2015, making it the best-performing stock in the US market in that timeframe. In another column for the Motley Fool, Morgan Housel shared how often Monster Beverage had experienced sickening drops in its share price: 

“The truth is that Monster has been a gut-wrenching nightmare to own over the last 20 years [from 1995 to 2015]. It traded below its previous all-time high on 94% of days during that period. On average, its stock was 26% below its high of the previous two years. It suffered four separate drops of 50% or more. It lost more than two-thirds of its value twice, and more than three-quarters once.”

Wharton finance professor Jeremy Siegel once said that “volatility scares enough people out of the market to generate superior returns for those who stay in.” There really is nothing to fear about volatility. It is normal.

Rule 6: Expect, but don’t predict

The financial markets are incredibly hard to predict. So it’s important to me to stay humble. What I do to handle the uncertain future is to expect. The difference between expecting and predicting lies in our behaviour. 

A look at history will make it clear that bad things – bear markets, recessions, natural disasters, diseases, wars – happen frequently. But they’re practically impossible to predict in advance. How many people six months ago even thought that a virus would end up crippling the global economy today? 

If we merely expect bad things to happen from time to time while knowing we have no predictive power, our investment portfolios would be built to be able to handle a wide range of outcomes. On the other hand, if we’re engaged in the dark arts of prediction, then we think arrogantly that we know when something will happen and we try to act on it. Our investment portfolios will thus be suited to thrive only in a narrow range of situations – if things take a different path, our portfolios will be on the road to ruin.

Rule 7: Be rationally optimistic over the long run

There are 7.8 billion individuals in our globe today, and the vast majority of people will wake up every morning wanting to improve the world and their own lot in life. This is ultimately what fuels the global economy and financial markets.

Miscreants and Mother Nature will wreak havoc from time to time – we’re currently living through one such episode of Mother Nature’s wrath in the form of a coronavirus that mutated and became capable of infecting humans. But I have faith in the collective positivity of humanity. When things are in a mess, humanity can clean it up. This has been the story of mankind’s and civilisation’s long histories. And I won’t bet against 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.

Note: This article was first published in The Business Times on 13 May 2020.

Our lives have been upended. 

Where once we could walk freely and gather in groups, we’re now huddled at home and have adapted to social distancing. 

Where once parents would send their kids to school in the morning before heading to work, they now have to assume the tough twin-roles of educator and working-professional at home. 

Where once malls and businesses were open, we now see shuttered stores all over town. 

COVID-19 has brought tremendous changes to our lives. 

And there’s a massive ongoing debate about how investors should be investing because of these changes. 

Interest rates are at generational lows, and even negative in some instances. Central banks are racing to keep their financial systems – particularly the credit markets – humming. 

Governments are handing out cash to save their economies and many are taking on tremendous amounts of debt to do so. Unemployment has increased sharply in some cases, or are expected to rise significantly.

Adding to the confusion is the massive rally that US stocks have experienced after suffering a historically steep decline of more than 30% in February and March. In Singapore, the Straits Times Index has also bounced 16% higher after falling by 32% from its peak this year in January. 

What should investors do? 

Plus ça change (the more things change)… 

I will humbly suggest one thing. 

Instead of focusing on positioning their portfolios to handle the things that are changing, investors should focus on the things that are not changing. This inverted thinking has tremendous value for investors. 

Jeff Bezos is the founder and CEO of Amazon.com, the e-commerce and cloud computing giant based in the US. He once said:

“I very frequently get the question: “What’s going to change in the next 10 years?” And that is a very interesting question; it’s a very common one.

I almost never get the question: “What’s not going to change in the next 10 years?” And I submit to you that that second question is actually the more important of the two — because you can build a business strategy around the things that are stable in time.” 

Similarly, we can build a successful investment strategy around things that don’t change in the financial markets.

…plus c’est la même chose (the more they remain the same) 

I believe that investors should only invest in things they understand. I only understand stocks well, so they are my focus in this article.

The first stock market in the world was created in Amsterdam in the 1600s. Many things have changed since. But stock markets around the world still share one fundamental attribute today: They are still places to buy and sell pieces of a business. 

Having this understanding of the stock market leads to the next logical thought: A stock will typically do well over time if its underlying business does well too. That’s because a company will become more valuable over time if its revenues, profits, and cash flows increase faster than inflation. There’s just no way that this statement becomes false.  

The fundamental attribute makes the stock market become something simple to understand. 

But it also means that we have to be investing for the long run (with an investing time horizon measured in years) for us to take advantage of the relationship between businesses and stock prices. 

Over the short run, the stock market is governed by the collective emotions of millions of investors. That’s not something that can be easily divined. 

But over the long run, business-strength prevails.

An enduring investment framework 

How then can we find businesses that can grow well over a long period of time, to utilise the unchanging long-run relationship between stock prices and business performances? 

I cannot speak for everyone. But what I do is to reason from first principles. What characteristics do I want if I can design my ideal business from scratch? 

There are six traits I have come up with, and they have served me well through my years of investing in both a professional and personal capacity. The six traits in a company are: 

1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market.
2. A strong balance sheet with minimal or a reasonable amount of debt.
3. A management team with integrity, capability, and an innovative mindset.
4. Revenue streams that are recurring in nature, either through contracts or customer-behaviour.
5. A proven ability to grow.
6. A high likelihood of generating a strong and growing stream of free cash flow in the future.

A word of caution is necessary. Companies that excel in all my six criteria may still turn out to be poor investments. It’s impossible to get it right all the time in the investing game. So I believe it is important to diversify, across companies, industries, and geographies.

Don’t put your eggs in one basket

The concept of geographical diversification is particularly important for Singapore investors. 

Look at the stocks in our local stock market benchmark, the Straits Times Index. There’s no good exposure to some of the important growth industries of tomorrow, such as cloud computing, DNA analysis, precision medicine, e-commerce, digital advertising, and more.

Chuin Ting Weber, the CEO of bionic financial advisor MoneyOwl, made a great point recently about global diversification. She said that as people who live in Singapore, we already have heavy economic exposure to our country through our jobs. If our investment portfolios also have a high proportion of Singapore stocks, we are taking on significant levels of concentration-risk.

The risks involved 

Every investment strategy has risks, mine included. 

A key risk is that companies that excel according to my investment criteria tend to carry high valuations. Even the best company can be a lousy investment if its share price is too high. So it’s important to weigh a company’s growth prospects with its valuation. 

What’s not changing

The emergence of COVID-19, and the responses that countries around the world have mounted to combat the virus, may have caused huge changes to the growth prospects of many industries. 

Travel-related companies, for instance, may suffer for some time until countries reopen their borders to accept international travellers at scale.

But crucially, I think that COVID-19 does not change the fundamental identity of the stock market as a place to buy and sell pieces of a business. So, I don’t think that the presence of COVID-19 changes the long-term relationship between stock prices and business performances in any way.

Most importantly, I don’t see COVID-19 changing humanity’s ability to innovate and solve problems. 

There are 7.8 billion individuals in the world today, and the vast majority of us will wake up every morning wanting to improve the world and our own lot in life – COVID-19 or no COVID-19. 

This is ultimately what fuels the global economy and financial markets. Miscreants and Mother Nature will occasionally wreak havoc. But I have faith in the potential of humanity – and to me, investing in stocks is ultimately the same as having this faith. 

Unless stocks become wildly overvalued, I will remain optimistic on stocks for the long run so long as I continue to believe in humanity.

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.

One of the most confusing things in the world of finance at the moment is the rapid recovery in many stock markets around the world after the sharp fall in February and March this year.

For instance, in the US, the S&P 500 has bounced 28% higher (as of 15 May 2020) from the 23 March 2020 low after suffering a historically steep decline of more than 30% from the 19 February 2020 high. In Singapore, the Straits Times Index has gained 13% (as of 15 May 2020) from its low after falling by 32% from its peak this year in January.

The steep declines in stock prices have happened against the backdrop of a sharp contraction in economic activity in the US and many other countries because of COVID-19. Based on news articles, blog posts, and comments on internet forums that I’m reading, many market participants are perplexed. They look at the horrible state of the US and global economy, and what stocks have done since late March, and they wonder: What’s up with the disconnect between Main Street and Wall Street? Are stocks due for another huge crash?

I don’t know. And I don’t think anyone does either. But I do know something: There was at least one instance in the past when stocks did fine even when the economy fell apart.

A few days ago, I chanced upon a fascinating academic report, written in December 1908, on the Panic of 1907 in the US. The Panic of 1907 flared up in October of the year. It does not seem to be widely remembered now, but it had a huge impact. In fact, the Panic of 1907 was one of the key motivations behind the US government’s decision to set up the Federal Reserve (the US’s central bank) in 1913.  

I picked up three sets of passages from the report that showed the bleak economic conditions in the US back then during the Panic of 1907.

This is the first set (emphasis is mine):

“Was the panic of 1907 what economists call a commercial panic, an economic crisis of the first magnitude?..

… The panic of 1907 was a panic of the first magnitude, and will be so classed in future economic history…

… The characteristics which distinguish a panic of that character from those smaller financial convulsions and industrial set-backs which are of constant occurrence on speculative markets, are five in number:

First, a credit crisis so acute as to involve the holding back of payment of cash by banks to depositors, and the momen- tary suspension of practically all credit facilities.

Second, the general hoarding of money by individuals, through withdrawal of great sums of cash from banks, thereby depleting bank reserves, involving runs of depositors on banks, and, in this country, bringing about an actual premium on currency.

Third, such financial helplessness, in the country at large, that gold has to be bought or borrowed instantly in huge quantity from other countries, and that emergency expedients have to be adopted to provide the necessary medium of exchange for ordinary business.

Fourth, the shutting down of manufacturing enterprises, suddenly and on a large scale, chiefly because of absolute inability to get credit, but partly also because of fear that demand from consumers will suddenly disap- pear.

Fifth, fulfilment of this last misgiving, in the shape of abrupt disappearance of the buying demand through- out the country, this particular phenomenon being pro- longed through a period of months and sometimes years…

…For the panic of 1907 displayed not one or two of the characteristic phenomena just set forth, but all of them…

Here’s the second set:

“During the first ten months of 1908, our [referring to the US] merchandise import trade  decreased [US]$319,000,000 from 1907, or no less than 26 per cent, and even our exports, despite enormous shipment of wheat to meet Europe’s shortage, fell off US$109,000,000.”

This is the third set, which laid bare the stunning declines in industrial activity in the US during the crisis:

“The truth regarding the industrial history of 1908 is that reaction in trade, consumption, and production, after the panic of 1907, was so extraordinarily violent that violent recovery was possible without in any way restoring the actual status quo.

At the opening of the year, business in many lines of industry was barely 28 per cent of the volume of the year before: by mid- summer it was still only 50 per cent of 1907; yet this was astonishingly rapid increase over the January record. Output of the country’s iron furnaces on January 1 was only 45 per cent of January, 1907: on November 1 it was 74 per cent of the year before; yet on September 30 the unfilled orders on hand, reported by the great United States Steel Corporation, were only 43 per cent of what were reported at that date in the “boom year” 1906.”

Let’s now look at how the US stock market did from the start of 1907 to 1917, using data from economist Robert Shiller.

The US market fell for most of 1907. It bottomed in November 1907 after a 32% decline from January. It then started climbing rapidly in December 1907 and throughout 1908 – and it never looked back for the next nine years. Earlier, we saw just how horrible economic conditions were in the US for most of 1908. Yes, there was an improvement as the year progressed, but economic output toward the end of 1908 was still significantly lower than in 1907. 

April-May 2020 is not the first time that we’re seeing an apparent disconnect between Wall Street and Main Street. I don’t think it will be the last time we see something like this too.

Nothing in this article should be seen as me knowing what’s going to happen to stocks next. I have no idea. I’m just simply trying to provide more context about what we’re currently experiencing together. The market – as short-sighted as it can be on occasions – can at times look pretty far out ahead. It seemed to do so in 1907 and 1908, and it might be doing the same thing again today.

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.