I’m extending a helping hand to those who are panicking or feeling stressed over the recent market volatility because of fears over COVID-19.
Freediving is the sport of diving underwater that relies on holding our breath without any breathing apparatus. Professional freedivers have been known to descend to depths of 100 metres or more on one single breath. It’s truly a sight to behold on what the human body can achieve.
I went to a freediving trial a few years ago in a deep swimming pool in Singapore. During the session, I was taught that when we hold our breath, a long gap actually exists between the time when our urge to breathe kicks in and the time when we actually do need to breathe. The information was interesting to me, so I’ve remembered it till now.
A few days ago, I went for a swim in the morning. While swimming, I tried extending the number of breast-stroke repetitions I could do while underwater. But try as I might, I couldn’t. I knew, logically, that my body would not be physically harmed even if I continued holding my breath for an extended period of time after the urge to breathe kicks in. But the urge was too strong. Each time it appeared, I gave in to it after a few short seconds. I couldn’t fight the visceral urge. After I stopped my swim, a light bulb went on in my head. I saw a link between investing and freediving.
Freediving requires us to fight the visceral urge to breathe when holding our breath. But it is difficult to do so, even if we have all the right analysis and understand the logic. I knew I would be fine and that my body did not have to breathe at that instant. But my body was screaming at me to surface from the water and take in some air.
Investing requires us to fight the visceral urge to capitulate when bear markets inevitably occur. But it is difficult to do so even if we have all the right analysis and understand the logic. Our brains will be screaming at us to sell when stocks are falling, even if we understand that we are going to be fine over the long run just leaving our portfolios as they are (assuming they were well-constructed from the start).
So what can we do?
We can train our bodies to hold our breath for long periods of time – there are well-documented methods.
I don’t know what the solution is for investing. But I’m hopeful that those of us who are susceptible to panic during bear markets can find some relief if someone can provide an empathetic listening ear and useful context when they occur. The current volatility in stocks – because of fears over the coronavirus, COVID-19 – means that many of us are likely enduring our brains screaming at us to sell. I want to help.
I have a long article sharing the useful context. The Singapore-based roboadvisor Endowus also put out a wonderful video recently sharing even more context. You can contact me at thegoodinvestors@gmail.com too. I cannot give financial advice, but I can perhaps help you deal with your investing-related emotions in a more constructive manner. You’re not in this alone.
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.
Amidst the market volatility and societal turmoil from the coronavirus, COVID-19, here are some important reminders for us as investors.
Stocks around the world have been incredibly volatile in recent weeks because of the new coronavirus, COVID-19. All over the world, business activity has slowed, large-scale gatherings of people have been cancelled, planes are grounded, hotels are empty, people are quarantined, and healthcare systems are pushed to their limits. Recessionary fears are also rampant.
Amidst the market and societal turmoil, I want to share some important investing-related reminders for all of us to provide context, soothe fraying nerves, and be a voice of calm, reason, and peace.
But before I get there, I want to stress this: COVID-19 or no COVID-19, recession or no recession, I am not changing the way I am investing. Regardless of how COVID-19 or the global economy develops, the stock market is still a place to buy and sell pieces of a business. This also means that a stock will do well eventually if its business does well. So I will continue looking for companies that excel according to my investing framework, and investing in their shares for the long run.
On to the update…!
1. Recessions are normal
The chart below shows all the recessions (the dark grey bars) in the US since 1871. You can see that recessions in the country – from whatever causes – have been regular occurrences even in relatively modern times. They are par for the course, even for a mighty economy like the US.
The following logarithmic chart shows the performance of the S&P 500 (including dividends) from January 1871 to February 2020. It turns out that US stocks have done exceedingly well over the past 149 years (up 46,459,412% in total including dividends, or 9.2% per year) despite the US economy encountering numerous recessions.If you’re investing for the long run, recessions can hurt over the short-term, but they’re nothing to fear.
Source: Robert Shiller data; National Bureau of Economic Research
2. The stock market has regularly seen serious short-term losses while on its way to earning great long-term returns
Between 1928 and 2013, the S&P 500 had, on average, fallen by 10% once every 11 months; 20% every two years; 30% every decade; and 50% two to three times per century. So stocks have declined regularly. But over the same period, the S&P 500 also climbed by 283,282% in all (including dividends), or 9.8% per year. Volatility in stocks is a feature, not a bug.
In fact, stocks have also experienced brutal one-day drops that – with the proper perspective – turn out to be blips.
Some market commentators have labelled 9 March 2020 as Black Monday because the S&P 500 fell by 7.6% that day. But that is nothing compared to the historical Black Monday – on 19 October 1987, the S&P 500 plunged by 20.5%. To make matters worse, the index was already down by 10.1% in the three days preceding 19 October 1987. So in four trading days – from the close on 13 October 1987 to 19 October 1987 – US stocks were down by 28.5% in all.
Black Monday (the historical one) was a harrowing experience for those who lived through it. But here’s the thing: From 13 October 1987 (before Black Monday happened) to 9 March 2020, the S&P 500 was up by 773% in total, or 6.9% per year. With dividends, the S&P 500 was up by around 2,100%, or 10.0% annually.
Source: Yahoo Finance
From an individual stock perspective, we can also look at the US e-commerce giant Amazon (NASDAQ: AMZN). The company (which is in my family’s investment portfolio) was a massive long-term winner from 1997 to 2018, with its share price rising by more than 76,000% from US$1.96 to US$1,501.97. But in the same timeframe, Amazon’s share price also experienced a double-digit top-to-bottom fall in every single year (the declines ranged from 13% to 83%).
Source: S&P Global Market Intelligence
One of my favourite finance writers is Morgan Housel. In an April 2019 blog post, he brilliantly articulated a concept that I’ve held in my mind for a long time: Instead of seeing short-term volatility in the stock market as a fine, think of it as a fee for something worthwhile. The stock market has produced good to great returns over the long-term. But it demands an admission fee. And the admission fee is what we’re currently experiencing.
3. Recessions and market crashes are inevitable
The late Hyman Minsky was an obscure economist when he was alive. 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 inevitable boom-bust cycles. According to Minsky’s then radical view, stability itself is destabilising. When an economy is stable and growing, people feel safe. And when people feel safe, they take on more risk, such as borrowing more. This leads to the system becoming fragile.
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 way 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 when stocks are priced for perfection, bad news will lead to lower stock prices.
4. There is always something to worry about
Peter Lynch, the legendary manager of the Fidelity Magellan Fund from 1977 to 1990, once said that “there is always something to worry about.” How true. The table below, constructed partially from Morgan Housel’s data, shows that the world had experienced multiple crises in every single year from 1990 to 2019.
But over the same period, US stocks were still up by nearly 800% after factoring in dividends and inflation.
COVID-19 is not the first deadly disease outbreak the world has faced. But global stocks have registered solid long-term gains despite multiple occurrences of epidemics/pandemics in the past. The chart below shows the performance of the MSCI World Index (a benchmark for global stocks) from 1970 to January 2020 against the backdrop of the various epidemics/pandemics we’ve experienced in the past 50 years.
5. Don’t invest in stocks with money that you will need within five years, at least; also, don’t use leverage
When I was helping to run the Motley Fool Singapore’s investment newsletters, my ex-colleagues and I repeated the same message over and over again: You should not invest with money that you need within the next five years.
The message is meant to prepare for days like we’ve seen over the past few weeks. The worst thing that can happen to us as investors is to be placed in a position where we’re forced to sell stocks. It doesn’t matter if we’re forced to sell when stock prices are high. But it can be disastrous to be forced to sell when stock prices are low.
To reap the rewards of long-term investing, we need to give ourselves holding power. And a very simple but effective thing we can do to gain holding power is to invest with money that we would very likely not need to touch for a good number of years.
Another simple but effective way we can have holding power in the financial markets is to not use leverage. Investing with leverage is to invest with borrowed capital. If we invest with leverage, we could very easily become forced-sellers when stocks fall. This becomes a severe headache during occasions when stocks fall sharply, such as over the past few weeks.
6. Volatility clusters
As mentioned earlier, the S&P 500 fell by 7.6% on 9 March 2020. The decline was so severe it triggered a circuit breaker in the process. On 10 March 2020, the prominent US market benchmark jumped 4.9%. A great day in the market followed a bad day.
This clustering of volatility is actually common. Investor Ben Carlson produced the table below recently (before March 2020) which illustrates the phenomenon.
The clustering means that it’s practically impossible to side-step the bad days in stocks and capture only the good days. This is important information for us, because missing just a handful of the market’s best days will destroy our returns.
Dimensional Fund Advisors, which manages more than US$600 billion, shared the following stats in a recent article:
$1,000 invested in US stocks in 1970 would become $138,908 by August 2019
Miss just the 25 best days in the market, and the $1,000 would grow to just $32,763
So it is important that we stay invested. But this does not mean we should stay invested blindly. Companies that currently are heavily in debt, and/or have shaky cash flows and weak revenue streams are likely to run into severe problems if there’s an economic downturn. If a global recession really happens this time (it looks increasingly likely that it will) and our portfolios are full of such companies, we may never recover. It’s good practice to constantly evaluate the companies in our portfolios, but I think there’s even more urgency to do so now.
7. Stick with high-quality businesses – don’t be attracted to a stock just because it has a low valuation
It’s easy for us to be lured by stocks that have low valuations after sharp declines in their prices. But it’s crucial that we also pay attention to the quality of the underlying businesses of the stocks we’re looking at. Low-quality businesses can’t compound in value. If we invest in them, our investments can’t grow over time. We may even lose money.
My friend Chin Hui Leong is a whip-smart investor and the co-founder of The Smart Investor, an investment education website. On 5 May 2009, he invested in American Oriental Bioengineering (AOB), a China-based pharmaceuticals company that was listed in the US. Chin was attracted to its low valuation – back then, AOB’s price-to-earnings ratio was only 7.
The S&P 500 reached a bottom during the Great Financial Crisis in March 2009 (it hit 677 points) and has nearly quadrupled since. So the timing of Chin’s investment in AOB was great. But he went on to effectively lose his entire investment in the company over a few short years because of its poor business performance subsequently. From 2009 to 2013, AOB’s revenue shrank from US$296 million to US$122 million while its US$41 million in profit became a loss of US$91 million. A cheap stock can easily become a big loser if its business does poorly.
Chin also has a fantastic and inspiring example of what can happen if we stick with high-quality businesses. He invested in Netflix (NASDAQ: NFLX) (my family also owns shares of Netflix) on 12 January 2007 at a share price of around US$3.20. On this occasion, his timing was poor. The S&P 500 closed at 1,431 on the day of his Netflix investment and reached a peak of 1,565 on 9 October 2007 before the Great Financial Crisis hit. But today, Netflix’s share price is around US$330, about 100 times higher than when he first invested.
8. Oil prices are low now, but we still shouldn’t buy oil & gas stocks indiscriminately
There are two widely-tracked prices for oil: West Texas Intermediate (WTI) crude and the international benchmark. Brent crude. Both shockingly fell by more than 30% each on 9 March 2020 at their respective low points.
WTI eventually closed the day with a 24.6% decline to US$31.13 per barrel while Brent crude settled with a 24.1% slide to US$34.36 per barrel. These prices were the lowest seen since February 2016. Some market observers have linked this sharp fall in oil prices to the recent turmoil in financial markets that we are seeing.
The lower oil prices have also caused the share prices of oil & gas stocks around the world to plummet. In the US market, Exxon Mobil (NYSE: XOM) plunged by 12.2% on 9 March 2020. Meanwhile, at our home in Singapore, Keppel Corporation (SGX: BN4) fell by 9.6% while Sembcorp Marine (SGX: S51) was down by 11.4%.
Oil prices are near multi-year lows now – they were around US$100 in 2014 and around US$32 at the moment. It could thus be tempting to pick up oil & gas stocks with the view that their share prices will tag along when oil prices rise. There are two problems here.
First, it’s practically impossible to forecast future oil prices. In 2007, Peter Davies gave a presentation titled What’s the Value of an Energy Economist? In it, he said that “we cannot forecast oil prices with any degree of accuracy over any period whether short or long.” Back then, Davies was the chief economist of British Petroleum, one of the largest oil & gas companies in the world.
Second, oil prices and oil & gas stocks can move in opposite directions. In mid-2014, oil prices started their rapid descent from around US$100. WTI reached a low of US$26.61 in February 2016. 10 months later (on 21 December 2016), WTI had doubled to US$53.53. But over the same period, 34 out of a group of 50 Singapore-listed oil & gas stocks saw their share prices fall. The average decline for the 50 companies was 11.9%.
There can be many obstacles that stand between a positive macrotrend and higher stock prices. In the case of oil & gas stocks, these include a weak balance sheet and deteriorating business fundamentals as a result of poor operational capabilities.
9. We will get through this
There are 7.8 billion individuals in our globe 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 motivation is ultimately what fuels the global economy and financial markets.
Miscreants and Mother Nature will occasionally wreak havoc. But we should have faith in the collective positivity of humankind. We should have faith in us. We can clean up the mess. To me, investing in stocks is the same as having faith in the long-term positivity of mankind. I continue and will continue to have this faith, so I continue and will continue to invest in stocks.
I want to leave the last words in this article to Morgan Housel. A few days ago he published a blog post with the most apt of titles: We’ll Get Through This. In it, he wrote:
“Remember that when progress is measured generationally, results and performance should not be measured quarterly.
It looks bad today.
It might look bad tomorrow.
But hang in there.
We’ll get through this.”
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 did a video chat with Reshveen Rajendran recently and talked about the coronavirus (COVID-19) situation, portfolio management, and so much more.
On Tuesday (10 March 2020), I recorded a video chat with Reshveen Rajendran who runs an investing education service (link goes to Resh’s Youtube channel). I first got to know Resh in 2013 or 2014 through a mutual friend.
Last week, Resh reached out to see if I would be interested to record a video with him to discuss a wide variety of investing topics. I love talking about such things so I readily agreed.
You can check out the video below. I had a wonderful time talking to Resh. He asked really good questions and we covered a lot of ground. Some of the topics include:
The importance of having a long-term perspective when investing
What’s going to happen next with the coronavirus (COVID-19) situation
What can you do when your stocks fall?
How should we approach investing in oil & gas stocks?
My investing mistakes
How I manage my portfolio allocations
Companies’ competitive advantages
How we can evaluate a company’s leaders
A company that still has bright long-term prospects despite being heavily affected in the short run by the COVID-19 situation (find out more about this company here)
The 3 stocks I will buy if I can only invest in 3 stocks
What Jeremy Chia and I are working on at the moment
I hope you will enjoy my conversation with Resh. All credit goes to him. Resh, thank you my friend!
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.
An investor’s first-hand account of what it was like to live through Black Monday, the worst 1-day crash in stocks in the US market.
Yesterday, I published Staying Calm Through The Recent Big Fall In Stocks. In the article, I shared how US stocks fell by a stunning 20.5% in one day on 19 October 1987. This event is now infamously known as Black Monday.
I used Black Monday as an example to show that incredibly sharp short-term declines have happened in the past. Yet, US businesses and the stock market as a whole have continued growing significantly. I thought Black Monday was an apt example, given the current climate – on Monday night (9 March 2020), US stocks declined by 7.6%.
In Staying Calm Through The Recent Big Fall In Stocks, I wrote that “when Black Monday occurred, it was likely an extremely stressful time for investors.” I could not find any data or anecdotes to illustrate how investors must have felt back then. As the market gods would have it, I just found one.
Ben Carlson once received a message from a reader who experienced Black Monday. Carlson is the Director of Institutional Asset Management at Ritholtz Wealth Management who blogs at A Wealth of Common Sense. This is what the reader wrote to him (italics are mine):
“As one who was actually invested in 1987 (and since 1973), I still have vivid memories of that market crash. It is oh-so-easy to look today at a long-term chart having a tiny blip and say “So what! . . . of course the market recovered . . . those who sold were fools.”
In 1987, market news was nothing like it is today. We had no Internet. We had the next day’s WSJ [Wall Street Journal] and Friday’s 30-minute Lou Rukeyser’s Wall Street Week; we subscribed to a few stock newsletters (delivered by snail mail) and Kiplinger and Money magazines . . . that’s about it.
Therefore, though I heard about the crash on the radio as I drove home from work on Black Monday, I was not prepared to find my wife in tears . . . her first words were “You’ve lost our retirement!” (Reading it does not convey the impact of hearing it.)
In real time, the crash was a VERY big event. Fear for a changed future was the natural response. Talking heads were saying “This worldwide event could last for years; our children will have a lower standard of living than we have.”
Long story short— she insisted we sell everything the next day (which was also a significant down day); we eventually re-entered the market.”
I can’t prove it, but I guarantee thatmany investors are today having similar thoughts as what I highlighted in the quote above. It was fortunate that Carlson’s reader eventually re-entered the market. Black Monday turned out to only be a painful blip in the short run (see chart below). From 13 October 1987 (before Black Monday happened, meaning stocks were at a higher price than after the 19 October 1987 crash) to 9 March 2020, the S&P 500 increased by 773% in total, or 6.9% per year. With dividends, the S&P 500 was up by around 2,100%, or 10.0% annually, according to data from Robert Shiller.
Source: Yahoo Finance
Black Monday was monumental for those who lived through it. But if those investors had the courage to stay invested, they would have been amply rewarded.
What we experienced on Monday night and for the past few weeks, feels similar to what Carlson’s reader described. But I also think the chances are very high that in five, 10, and 20 years from now, we will look back on our experiences in the past few weeks and think “What a time it was to live through. But I’m glad I stuck with stocks for the long haul!”
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.
Fear over the coronavirus, COVID-19, could be the biggest contributor to our investing-losses, even more than actual risks.
Yesterday night, the S&P 500 in the US swiftly fell by 7% when the market opened, triggering a circuit breaker that halted trading activity for 15 minutes. The index resumed trading, but eventually registered a drop of 7.6% for the day.
The decline in US stocks was sharp and it likely had hurt some investors, if not psychologically, then literally (because of fear-induced selling, or the activation of stop-losses). Some of you are also likely worried about what could happen next.
History is and will never be a perfect guide for the future. But a look at the past can give us context on what just happened and prevent us from committing emotion-driven mistakes.
19 October 1987 is known as Black Monday in the investing community. That’s because the S&P 500 fell by 20.5% on that day alone. What deepened the pain was that the US stock market index had already declined by 10.1% in the three days preceding Black Monday. So in the span of four trading days, from the close on 13 October 1987 to 19 October 1987, the S&P 500 sunk by a mighty 28.5% in total.
Source: Yahoo Finance
The chart above illustrates how brutal Black Monday was. But for another perspective, the chart below shows how the S&P 500 did from 13 October 1987 to 13 October 1992, a five-year period. It was up 30% in all. Not fantastic, but there was still a gain.
Source: Yahoo Finance
Let’s zoom out even further, with a chart that shows the performance of the S&P 500 from 13 October 1987 to today:
Source: Yahoo Finance
Turns out, the S&P 500 has climbed by 773% in total, or a solid 6.9% per year.
I have two points to make here. First, significant short-term declines in stocks have happened before. When Black Monday occurred, it was likely an extremely stressful time for investors [link added on 11 March 2020]. But the sun still rose and the world went on. According to Robert Shiller’s data, the S&P 500’s earnings per share (EPS) has also compounded at 6.9% per year from October 1987 to today. In fact, the S&P 500’s EPS in December 1987 was higher than it was in October 1987 (US$16.41 vs US$17.50). And if the S&P 500’s dividends were included, the index’s return from October 1987 to today would have been around 10% per year, based on Shiller’s data.
The second point is that we need to separate business performance – especially long-term business performance – from stock price movements when investing. As I just mentioned, US businesses were growing (in the form of higher EPS) despite Black Monday’s occurrence, and continued to grow over the long run. Yesterday night’s 7.6% fall in the S&P 500 was driven by a slew of factors, with one of them being fears related to the new coronavirus, COVID-19. I described some of the virus’s negative impacts on business conditions worldwide in a recent article:
“Global corporate giants such as Apple, Visa, and Mastercard have warned of pressures to their businesses because of COVID-19 (see here, here, and here). Airlines are some of the worst-hit groups of companies, with UK airline Flybe entering bankruptcy earlier this month; last week, Southwest Airlines in the US warned of a “very noticeable, precipitous decline in bookings.” In China, the PMI (purchasing managers’ index) for February 2020 came in at 35.7, the lowest seen since tracking began in 2004 (a reading below 50 indicates a contraction in factory activity). In 2008 and 2009, during the height of the Great Financial Crisis, China’s PMI reached a low of 38.8. ”
So yes, there’s a very real threat to the short-term health of many businesses because of COVID-19. But will the virus have any lasting negative consequences over the long run? It’s possible, but I think it’s unlikely. I’m not alone. During an interview with CNBC late last month, billionaire investor Warren Buffett shared his thoughts on how investors ought to be dealing with COVID-19. He said (emphasis is mine):
“Look, the tariff situation was a big question market for all kinds of companies. And still is to some degree. But that was front and center for a while. Now coronavirus is front and center. Something else will be front and center six months from now and a year from now and two years from now. Real question is — where are these businesses gonna be five and ten and 20 years from now? Some of them will do sensationally, some of them will disappear. And overall I think America will do very well — you know, it has since 1776…
…We’ve got a big investment in airline businesses and I just heard even more flights are canceled and all that. But flights are canceled for weather. It so happens in this case they’re gonna be canceled for longer because of coronavirus. But if you own airlines for 10 or 20 years you’re gonna have some ups and down in current. And some of them will be weather related and they can be all kinds of things. The real question is you know, how many passengers are they gonna be carrying 10 years from now and 15 years from now and what will margins be and– what will the competitive position be? But I still look at the figures all the time — I’ll admit that…
…[Coronavirus] makes no difference in our investments. There’s always gonna be some news, good or bad, every day. In fact, if you go back and read all the papers for the last 50 years, probably most of the headlines tend to be bad. But if you look at what happens to the economy, most of the things that happen are extremely good. I mean, it’s incredible what will happen over time. So if somebody came and told me that the global growth rate was gonna be down 1% instead of 1/10th of a percent, I’d still buy stocks if I liked the price at which — and I like the prices better today than I liked them last Friday…
… We’re buying businesses to own for 20 or 30 years. We buy them in whole, we buy them in part. They’re called stocks when we buy in part. And we think the 20- and 30-year outlook is not changed by coronavirus.”
But not every company is facing the same level of long-term risk because of COVID-19. Some companies are at higher risk of failing or having their health permanently impaired. These are companies with debt-laden balance sheets, lumpy revenues, and an inability to generate healthy free cash flows. Such companies have always faced a higher level of existential risk compared to companies with healthy balance sheets (that have minimal or reasonable levels of debt), recurring revenues, and strong free cash flows. But COVID-19 has raised even more questions on the survivability of the former group because of the intense short-term hit to business conditions worldwide.
We always need to tread carefully with the types of companies we invest in – more so today. But there’s no need to panic. Fear could be the biggest contributor to our investing-losses, even more than actual risks.
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 invest in stocks, I think there are 5 questions you should always ask yourself. But they are even more prominent now given the coronavirus.
I started a recent article with the sentence: “It’s an understatement to say that stocks have been volatile of late.”
From 14 February 2020 to 8 March 2020, the S&P 500 in the US has declined by 12.1%. I mention the US stock market because it is by far the largest in the world. I’ve never thought it makes sense to find reasons for the short-term movements of stock prices. But I think it’s pretty clear that the coronavirus, COVID-19, is the key reason for the declines seen in recent days.
The number of people who are infected with COVID-19 has been rising significantly, with the death toll tagging along. The virus is also making its way into more countries over time.
Source: World Health Organisation
Global corporate giants such as Apple, Visa, and Mastercard have warned of pressures to their businesses because of COVID-19 (see here, here, and here). Airlines are some of the worst-hit groups of companies, with UK airline Flybe entering bankruptcy earlier this month; last week, Southwest Airlines in the US warned of a “very noticeable, precipitous decline in bookings.” In China, the PMI (purchasing managers’ index) for February 2020 came in at 35.7, the lowest seen since tracking began in 2004 (a reading below 50 indicates a contraction in factory activity). In 2008 and 2009, during the height of the Great Financial Crisis, China’s PMI reached a low of 38.8.
We’re clearly in an environment now where stocks are volatile and the world is grappling with a public health crisis and recessionary fears. Many of you are likely wondering what you should be doing now with your investment portfolios. If you invest in stocks, I think there are five questions you should always ask yourself. But they are even more prominent now given the current situation:
What is my investing time horizon? If you’re investing in stocks with capital you need within the next five years, it’s always dangerous to do so. The danger is amplified given the current situation. Stocks are volatile over the short run, sometimes without reason. But over the long run, stock prices reflect business fundamentals and have delivered great returns.
Do I have a sound investment framework? An investment framework guides the way you select your investments. I have my own personal criteria to find businesses that can grow at high rates over a long period of time. It has served me well for nearly a decade. But that’s not the only way to invest. Do you have a framework that is based on sound investing logic? If you don’t, it’s always a dangerous time to invest – doubly so, now.
Do I have a sound investing plan? An investing plan is like an investing schedule – it guides us on when we put money to work in stocks. Some investors prefer a dollar-cost-averaging strategy, where a certain amount of capital is invested in stocks at regular intervals. That’s fine. Some prefer to be fully-invested at all times. There are also others who prefer to have a cash cushion that they will deploy depending on the magnitude of the market’s decline. These are all fine too. There are two crucial aspects to an investing plan: (1) Does it fit our temperament; and (2) does it make investing sense? If the first aspect fails, it does not matter how good our plan is – we will not stick to it. The second aspect is important for self-explanatory reasons.
Do I have a basic understanding of market history? Knowing what has happened in the past can give us context for what to expect next. It can also prevent us from panicking when stocks decline. Some critical information to know include: (1) How often do stocks decline? (2) How have stocks performed over the long-term through recessions? (3) Are short-term declines common even when stocks climb over the long run? I have shared these things before and they can be found here and here.
Do I understand my own investing temperament? How we react to market declines can have a tremendous impact on our returns as investors. The investors of legendary fund manager Peter Lynch made only 7% per year despite him producing an incredible annual return of 29% for 13 years; that’s because Lynch’s investors had poor temperament, selling quickly whenever there was a short-term decline in his fund. If you know you have a poor investing temperament, then set up an investing plan that can save you from yourself.
These questions won’t guarantee that you will come out ahead when the COVID-19 crisis blows over. But I’m sure they’ll greatly increase your chances of success.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
The late economist Hyman Minsky has an excellent framework for understanding why market crashes are bound to happen from time to time.
It’s an understatement to say that stocks have been volatile of late. This is what the S&P 500 in the US has done since last Monday:
24 Feb 2020: -3.4%
25 Feb 2020: -3.0%
26 Feb 2020: -0.4%
27 Feb 2020: -4.4%
28 Feb 2020: -0.8%
2 Mar 2020: +4.6%
3 Mar 2020: -2.8%
4 Mar 2020: 4.2%
And at the time of writing (10:00 pm, 5 Mar 2020 in Singapore), the S&P 500 is down by 2.8%. Deutsche Bank analyst Torsten Slok said last Friday that the speed of the S&P 500’s decline “is historic.” Many are surprised by the ferocity of the recent fall in US stocks.
It’s oh so common
Given the current state of affairs, I think it’s an apt time as any to revisit an important fact about stocks: Declines and volatility are common. I wrote recently:
“Between 1928 and 2013, the S&P 500 has, on average, fallen by 10% once every 11 months; 20% every two years; 30% every decade; and 50% two to three times per century.”
At this point, some of you may be wondering: Why are market crashes so common? This is what I want to discuss in this article too. For an answer, we’ll need to turn to the late Hyman Minsky.
Stability is destabilising
Minsky was an economist. He wasn’t well known when he was alive, but his views on why an economy goes through boom-bust cycles are thought-provoking and gained prominence after the 2008-2009 financial crisis.
In essence, Minsky theorised that for an economy, stability itself is destabilising. I first learnt about him, and how his ideas can be extended to the stock market, a few years ago after coming across a Motley Fool article written by Morgan Housel. Here’s how Housel describes Minsky’s framework:
“Whether it’s stocks not crashing or the economy going a long time without a recession, stability makes people feel safe. And when people feel safe, they take more risk, like going into debt or buying more stocks.
It pretty much has to be this way. If there was no volatility, and we knew stocks went up 8% every year [the long-run average annual return for the U.S. stock market], the only rational response would be to pay more for them, until they were expensive enough to return less than 8%. It would be crazy for this not to happen, because no rational person would hold cash in the bank if they were guaranteed a higher return in stocks. If we had a 100% guarantee that stocks would return 8% a year, people would bid prices up until they returned the same amount as FDIC-insured savings accounts, which is about 0%.
But there are no guarantees—only the perception of guarantees. Bad stuff happens, and when stocks are priced for perfection, a mere sniff of bad news will send them plunging.”
In other words, great fundamentals in the stock market (stability) can cause investors to take risky actions, such as pushing valuations toward the sky or using plenty of leverage. This plants the seeds for a future downturn to come (the creation of instability).
Why bother?
Some of you may now be thinking: if stocks are prone to exhibit boom-bust behaviour, why bother at all with long-term investing? Because of this:
I mentioned earlier that US stocks had frequently crashed from 1928 to 2013. The chart just above shows how the US market performed over the same period after adjusting for dividends and inflation. It turns out that the S&P 500 gained 21,000%, or 6.5% per year. Remember, that’s a 6.5% annual return, after inflation, for 85 years. Sharp short-term declines were seen, but there’s a huge long-term gain at the end.
Then there’s also this:
Source: S&P Global Market Intelligence
The US e-commerce giant Amazon (which is in my family’s investment portfolio) was a massive long-term winner from 1997 to 2018, with its share price rising by more than 76,000% from US$1.96 to US$1,501.97. But in the same timeframe, Amazon’s share price also experienced a double-digit top-to-bottom fall in every single year (the declines ranged from 13% to 83%). Again, sharp short-term declines were seen, but there’s a huge long-term gain at the end.
Missing the good times
Here’s another thought some of you may now have (I’m not psychic, trust me!): Why can’t we just side-step all the big downward moves and invest when the clouds have cleared? Wouldn’t this make the whole investing experience more comfortable?
Yes, you may be more comfortable, but you’re very likely going to earn much lower returns.
Dimensional Fund Advisors, a fund management company with more than US$600 billion in assets under management, shared the following stats in an article:
$1,000 invested in US stocks in 1970 would become $138,908 by August 2019
Miss just the 25 best days in the market, and the $1,000 would grow to just $32,763
So, missing just a handful of the market’s best days will absolutely decimate our return. Unfortunately, the market’s best and worst days tend to cluster, as seen in the table below from investor Ben Carlson. As a result, it’s practically impossible to side-step the bad days and capture only the good days. To earn good returns in stocks over the long run, we have to accept the inevitable bad times.
Source: Ben Carlson
Don’t be scared
Markets will crash from time to time. It’s something we have to get used to. Wharton finance professor Jeremy Siegel once said that “volatility scares enough people out of the market to generate superior returns for those who stay in.” So don’t be scared. And please don’t attempt to flit in and out of your shares – patience is what ends up paying in investing.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
First, Li Lu’s views on China’s economy are worth paying attention to. Many of you likely don’t know who he is, but he’s an excellent investor in China. I have never been able to find Li’s investment track record, but one piece of information that I’ve known for years convinces me of his brilliance: Charlie Munger’s an investor in Li’s fund, and Munger has nothing but praise for it. Munger himself is an incredible investor with a well-documented track record, and he’s the long-time right-hand man of Warren Buffett. In a May 2019 interview with The Wall Street Journal, Munger talked about Li:
“There are different ways to hunt, just like different places to fish. And that’s investing.
And knowing that, of course, one of the tricks is knowing where to fish. Li Lu [of Himalaya Capital Management LLC in Seattle] has made an absolute fortune as an investor using Graham’s training to look for deeper values. But if he had done it any place other than China and Korea, his record wouldn’t be as good. He fished where the fish were. There were a lot of wonderful, strong companies at very cheap prices over there…
…Now, so far, Li Lu’s record [at Himalaya] is just as good with a lot of money as it was with very little. But that is a miracle. It’s no accident that the only outside manager I’ve ever hired is Li Lu. So I’m now batting 1.000. If I try it one more time, I know what will happen. My record will go to hell. [Laughter.]”
Second, I think Li’s essay contains thought-provoking insights from him and Koo on the economic future of the Western world, Japan, and China. These insights are worth sharing with a wider audience. But they are presented in Mandarin, and there are many investors who have little or no knowledge of the language. I am fortunate to have sufficient proficiency in Mandarin to be able to grasp the content (though it was still painful to do the translation!), so I want to pay it forward. This also brings me to the third reason.
Google’s browser, Google Chrome, has a function to automatically translate Li’s Mandarin essay into English. But the translation is not the best and I spotted many areas for improvement.
Before I get to my translation, I want to stress again that it is my own self-directed attempt. So all mistakes in it are my sole responsibility. I hope I’ve managed to capture Li Lu’s ideas well. I’m happy to receive feedback about my translation. Feel free to leave a comment in this post, or email me at thegoodinvestors@gmail.com.
Translation of Li Lu’s essay
This year, the book I want to recommend to everyone is The Great Recession Era: The Other Half of Macroeconomics and The Fate of Globalisation, written by Gu Chao Ming.
The book discusses the biggest problems the world is currently facing. First: Monetary policy. In today’s environment, essentially all the major economies of today – such as Japan, the US, Europe, and China – are oversupplying currencies. The oversupply of these base currencies has reached astronomical levels, resulting in the global phenomena of low interest rates, zero interest rates, and even negative interest rates (in the case of the Eurozone). These phenomena have never happened in history. At the same time, the increase in the currency supply has contributed very little to economic growth. Except for the US, the economies of most of the developed nations have experienced minimal or zero growth. Another consequence of this situation is that each country’s debt level relative to its GDP is increasing; concurrently, prices of all assets, from stocks to bonds, and even real estate, are at historical highs. How long will this abnormal monetary phenomenon last? How will it end? What does it mean for global asset prices when it ends? No one has the answers, but practically all of our wealth is tied to these issues.
Second: Globalisation. The fates of many countries, each at different stages of development, have been intertwined because of the rising trend of globalisation over the past few decades. But global trade and capital flows are completely separate from the monetary and fiscal policies that are individually implemented in each country. There are two consequences to this issue. Firstly, significant conflicts have developed between globalisation and global capital flows on one end, and each country’s economic and domestic policies on the other. Secondly, international relations are increasingly strained. For instance, we’re currently witnessing an escalation of the trade conflict between the US and China. There’s also rising domestic unrest – particularly political protests on the streets – in many parts of the world, from Hong Kong to Paris and Chile. At the same time, far-left and far-right political factions are increasingly dominating the political scene of these countries at the expense of more moderate parties, leading to heightened uncertainties in the world. Under these circumstances, no one can predict the future for global trade and capital flows.
Third: How should each country’s macroeconomic and fiscal policies respond to the above international trends? Should there be differences in the policies for each country depending on the stage of development they are at?
The three problems are some of the most pressing issues the world is facing today. The ability to answer even just one of them will probably be an incredible scholarly achievement – to simultaneously answer all three of them is practically impossible. In his book, Gu Chao Ming provided convincing perspectives, basic concepts, and a theoretical framework with sound internal logic for dealing with the three big problems. I can’t really say that Gu has given us answers to the problems. But at the very least, he provides inspiration for us to think through them. His theories are deeply thought-provoking, whether you agree with them or not.
Now let’s talk about the author, Gu Chao Ming [Richard C. Koo]. He is the Chief Economist of Nomura Research Institute and has had a strong influence on the Japanese government over the past 30 years. I first heard of him tens of years ago, at a YPO international conference held in Japan. He delivered a keynote speech at the event, explaining Japan’s then “lost decade” (it’s now probably a “lost two decades” or even “lost three deacdes”). Gu Chao Ming explained the various economic phenomena that appeared in Japan after its bubble burst. These include zero economic growth, an oversupply of currency, zero interest rates, massive government deficit, high debt, and more. The West has many different views on the causes for Japan’s experience, but a common thread is that they resulted from the failure of Japan’s macroeconomic policies.
Gu Chao Ming was the first to provide a completely opposite viewpoint that was also convincing. He introduced his unique and new economic concept: A balance sheet recession. After the bursting of Japan’s asset-price bubble, the balance sheet of the Japanese private sector (businesses and households) switched from rapid expansion to a mode of rapid contraction – he attributed Japan’s economic recession to the switch. Gu provided a unique view, that driving the balance sheet recession was a radical change in the fundamental goal of the entire Japanese private sector from maximising profits to minimising debts. In such an environment, the first thing the private sector and individuals will do when they receive money is not to invest and expand business activities, but to repay debt – it does not matter how much currency is issued by the government. The sharp decline in Japanese asset prices at that time placed the entire Japanese private sector and households into a state of technical bankruptcy. Because of this, what they had to do, and the way they repaired their balance sheets, was to keep saving and paying off their debts. This scenario inevitably caused a large-scale contraction in the economy. The Japanese experience is similar to the US economic crisis in the 1930s. Once the economy begins to shrink, a vicious cycle forms to accelerate the downward momentum. During the Great Depression in the 1930s, the entire US economy shrank by nearly 46% within a few years.
The Japanese government dealt with the problem by issuing currency on a large scale, and then borrowing heavily to make direct infrastructure investments to digest the massive savings of Japanese residents. Through this solution, the Japanese government managed to maintain the economy at the same level for decades. There’s no growth, but the economy has not declined either. In Gu Chao Ming’s view, the Japan government’s macroeconomic policies were the only right choices. The policies prevented the Japanese economy from experiencing the 46% decline in economic activity that the US did in the 1930s. At the same time, the Japanese private sector was given the time needed to slowly repair their balance sheets. This is why Japan’s private sector and households have gradually returned to normalcy today. Of course, there was a price to pay – the Japanese government’s own balance sheet was hurt badly. Japanese government debt is the highest in the world today. Nonetheless, the Japanese government’s policies were the best option compared to the other choices. At that time, that was the most unique view on Japan that I had come across. Subsequently, my observations on Japan’s economy have also confirmed his ideas to a certain extent.
The Western world was always critical of Japan’s policies. Their stance on Japan started to change only after they encountered the Great Recession of 2008-2009. This is because the Western world’s experience during the Great Recession was very similar to what Japan went through in the late 1980s after its big asset-bubble burst. At the time, prices of major assets in the West were falling sharply, leading to technical bankruptcy for the entire private sector – this was why the subsequent experience for the West was eerily similar to Japan’s. To deal with the problem, the main policy implemented by the key Western countries was the large-scale issuance of currency, and they did so without any form of prior agreement. At the time, the experience of the Great Depression of the 1930s was the main influence on the actions of the central banks in the West. The consensus among the economic fraternity after evaluating the policies implemented to handle the Great Depression of the 1930s was based predominantly on Milton Friedman’s views, that major mistakes were made in monetary policies in that era. Ben Bernanke, the chairperson of the US Federal Reserve in 2008, is a strong proponent of this view. In fact, Bernanke thinks that distributing money from helicopters is an acceptable course of action in extreme circumstances. Consequently, Western governments started issuing currency at a large scale to deal with the 2008 crisis. But the currency issuance did not lead to the intended effect of a rapid recovery in economic growth. The money received by the private sector was being saved and used to repay debts. This is why economic growth remains sluggish. In fact, the economy of the Eurozone is bordering on zero growth; in the US economy, there are only pockets of weak growth.
The first response by Western governments to the problem is to continue with their large-scale currency issuance. Western central banks have even invented a new way to do so: Quantitative easing (QE). Traditionally, central banks have regulated the money supply by adjusting reserves (the most important component of a base currency). After implementing QE, the US Federal Reserve’s excess reserves have grown to 12.5 times the statutory amount. The major central banks in the West have followed the US’s lead in implementing QE, resulting in the selfsame ratio reaching 9.6 times in the Eurozone, 15.3 times in the UK, 30.5 times in Switzerland, and 32.5 times in Japan! In other words, under normal economic conditions, inflation could reach a similar magnitude (for example, 1,250% in the US) if the private sector could effectively deploy newly issued currency. Put another way, if the newly issued currency were invested in assets, it could lead to asset prices rising manifold to reach bubble levels or provide strong stimulus to GDP growth.
But the reality is that economic growth is anaemic while prices for certain assets have been rising. The greatest consequence of this policy is that interest rates are close to zero. In fact, the Eurozone has around US$15 trillion worth of debt with negative rates today. This has caused questions to be raised about the fundamental assumptions underpinning the entire capitalistic market system. At the same time, it has also not produced the hoped-for economic growth. Right now, the situation in Europe is starting to resemble what Japan experienced back then. People are starting to rethink the episode in Japan. Interest in Gu Chao Ming’s viewpoints on Japan and its fiscal policies are being reignited in the important Western countries.
Gu Chao Ming used a relatively simple framework to explain the phenomena in Japan. He said that an economy will always be in one of the following four regimes, depending on the actions of savers and investors:
Under normal circumstances, an economy should have savers as well as borrowers/investors. This places the economy in a positive state of growth. When an ordinary economic crisis arrives, savers tend to run out of capital but borrowers and investing opportunities are still present. In this scenario, it’s crucial that a central bank plays the role of supplier of capital of the last resort. This viewpoint – of the central bank having to be the lender and supplier of capital of the last resort – is the conclusion that the economic fraternity has from studying the Great Depression of the 1930s. Central banks provide the capital, which is then lent to the private sector.
But nobody thought about what happens to an economy when the third and fourth regimes appear. These regimes are unprecedented and characterised by the absence of borrowers (investors). For instance, there have been savers in Japan for the past few decades, but the private sector has no motivation to borrow for investments. What can be done in this case? In the 2008-2009 crisis, there were no savers as well as borrowers in the Western economies. Savers were already absent when the crisis happened. In the US, the private sector was mired in a state of technical bankruptcy because asset prices were falling heavily while there were essentially no savers. At the same time, there were no investment opportunities in Europe. Even after a few rounds of QE and the massive supply of base currencies, nobody was willing to invest – there were simply no opportunities to invest in the economy. When people got hold of capital, they in essence returned the capital to banks via negative interest rates. This situation was unprecedented.
The key contributions to the body of economic knowledge by Gu Chao Ming’s framework relates to a better understanding of what happens in the third and fourth regimes where borrowers are absent. Let’s take Japan for example. It is in the third regime, where there are savers but no borrowers. He thinks that the Japanese government should take up the mantle of being the borrower of last resort in this situation and use fiscal policy to conduct direct investments. A failure to do so will lead to a contraction in the economy, since the private sector is unwilling to borrow. And once the economy contracts, a vicious cycle will form, potentially causing widespread unemployment and economic activity to decline by half. The societal consequences are unthinkable. We know that Hitler’s rise to power in the 1930s and a revival in Japanese militarism in the same era both had direct links to the economic depression prevalent back then.
The fourth regime, one where savers and borrowers are both absent, describes the 2008-2009 crisis. When a fourth regime arises, the government should assume the roles of both provider of capital of last resort, and borrower of last resort. In the US during the 2008-2009 crisis, the Federal Reserve issued currency while the Treasury department used the TARP (Troubled Asset Relief Program) Act to directly inject capital into systematically important commercial and investment banks. The actions of both the Fed and the Treasury stabilised the economy by simultaneously solving the problems of a lack of savers and borrowers. Till this day, Western Europe is possibly still trapped in the third or maybe even the fourth regime. There are no savers or borrowers. Structural issues in the Eurozone make matters worse. Countries in the Eurozone can only make use of monetary policy, since they – especially the countries in Southern Europe – are restricted from using fiscal policy to boost domestic demand. These constraints within Europe could lead to catastrophic consequences in the future.
Gu Chao Ming used the aforementioned framework to analyse the unique problems facing the global economy today (the appearance of the third and fourth regimes). He also provided his own views on the current economic policies of developed nations.
He considered the following questions: Why did both Western Europe and the US lumber toward asset bubbles? In addition, why were they unable to discover the path that leads to a return to growth (the US did return to growth, but it is anaemic) after their asset bubbles burst? To answer these questions, Gu Chao Ming provided what I think is his second unique perspective, which is meaningful for the China of today. He shared that an economy will have three different stages of development under the backdrop of globalised trade.
Let me first introduce an important concept in development economics – the Lewis Turning Point. In the early days of urban industrialisation, surplus rural workers are constantly attracted by it. But as industrialisation progresses to a certain scale, the surplus of workers in the rural areas now becomes a shortage, leading to the economy entering a state of full employment. This is the Lewis Turning Point, which was first articulated by British economist W. Arthur Lewis in the 1950s.
Gu Chao Ming’s first stage of development refers to the early days of urban industrialisation, before the Lewis Turning Point is reached. The second stage happens when the economy has moved past the Lewis Turning Point and is in a phase where savings, investments, and consumption are all in a state of intertwined growth. This is also known as the Golden Era. In the third stage of development – a unique stage that Gu Chao Ming brought up – the economy enters a state of being chased, after it passes a mature growth phase and becomes an advanced economy. Why does this happen? That’s because investing overseas in developing countries becomes more advantageous as the cost of domestic production reaches a certain level. In the earlier days, the advantages of investing overseas in developing countries are not clear because of cultural and institutional obstacles. But as domestic production costs rises to a certain height, while other countries are simultaneously strengthening their infrastructure to absorb foreign investments, it becomes significantly more attractive to invest overseas compared to domestically. At this point, capital stops being invested in the country, and domestic wages start to stagnate.
In the first stage of development (the pre-Lewis Turning Point phase), owners of capital have absolute control. This is because rural areas are still supplying plenty of labour, and so the labour force is generally in a weak position to bargain and does not have much pricing power. Companies tend to exploit workers when there are many people looking for work.
In the second stage of development (when the economy is past the Lewis Turning Point and enters a mature growth phase), companies need to rely on investing in productivity to raise their output. At the same time, companies need to satisfy the demands of the labour force, such as increasing their wages, improving their working environment, providing them with better equipment, and more. In this stage, economic growth will lead to higher wages, because shortages are starting to appear in the labour supply. A positive cycle will form, where a rise in wages will lead to higher consumption levels, driving savings and investments higher, and ultimately higher profits for companies. During the second stage, nearly every member of society can enjoy the fruits of economic development. Meanwhile, a consumer society led by the middle class will be formed. Living standards for each level in society are improving – wages are rising even for people with low education levels. This is why the second stage of development is also known as the Golden Era.
Changes in society start to appear in the third stage of development. For the labour force, only those in highly-skilled roles (such as in science and technology, finance, and trade etc.) will continue to receive good returns from their jobs. Wages in traditional manufacturing jobs that require low levels of education will gradually decline. Wealth-inequality in society will widen. Domestic economic and investment conditions will deteriorate, and investors will increasingly look to foreign shores for opportunities. At this juncture, GDP growth will rely on continuous improvements in technology. Countries that excel in this area (like the US for example) will continue to enjoy GDP growth, albeit at a low pace; countries with a weaker ability to innovate (such as Europe and Japan) will experience poor economic growth, and investments will shift toward foreign or speculative opportunities.
Gu Chao Ming thinks that the Western economies had entered the third stage of development in the 1970s. Back then, they were being chased mainly by Japan and Asia’s Four Dragons. Fast forward to the 1980s and China had started to open itself to the international economy while Japan entered the phase of being chased. While being chased, a country’s domestic economic growth opportunities tend to decrease sharply. At the same time, any pockets of economic growth tend to form into frothy bubbles. It was the case in Japan, the US, and Western Europe. Capital flowed into real estate, stocks, bonds, and financial derivatives, forming massive bubbles and their subsequent bursting. Even after a bubble bursts, the country’s economic growth opportunities and potential remain extremely limited. As a result, the economy’s ultimate goal shifts from maximising profits to minimising liabilities. That’s because on one hand, the private sector has nowhere to invest domestically, while on the other, it wants to repair its balance sheet. In this way, predictions that are based on traditional economic theories will fail.
Gu Chao Ming pointed out that the functions of a government’s macro policies should change depending on what stage of development the economy is at. And so, different policy tools are needed. This view has meaningful implications for China today.
In the early phases of industrialisation, economic growth will rely heavily on manufacturing, exports, and the formation of capital etc. At this juncture, the government’s fiscal policies can play a huge role. Through fiscal policies, the government can gather scarce resources and invest them into basic infrastructure, resources, and export-related services etc. These help emerging countries to industrialise rapidly. Nearly every country that was in this stage of development saw their governments implement policies that promote active governmental support.
In the second stage of development, the twin engines of economic growth are rising wages and consumer spending. The economy is already in a state of full employment, so an increase in wages in any sector or field will inevitably lead to higher wages in other areas. Rising wages lead to higher spending and savings, and companies will use these savings to invest in productivity to improve output. In turn, profits will grow, leading to companies having an even stronger ability to raise wages to attract labour. All these combine to create a positive feedback loop of economic growth. Such growth comes mainly from internal sources in the domestic economy. Entrepreneurs, personal and household investing behaviour, and consumer spending patterns are the decisive players in promoting economic growth, since they are able to nimbly grasp business opportunities in the shifting economic landscape. Monetary policies are the most effective tool in this phase, compared to fiscal policies, for a few reasons. First, fiscal policies and private-sector investing both tap on a finite pool of savings. Second, conflicts could arise between the private sector’s investing activities and the government’s if poorly thought-out fiscal policies are implemented, leading to unnecessary competition for resources and opportunities.
When an economy reaches the third stage of development (the stage where it’s being chased), fiscal policy regains its importance. At this stage, domestic savings are high, but the private sector is unwilling to invest domestically because the investing environment has deteriorated – domestic opportunities have dwindled, and investors can get better returns from investing overseas. The government should step in at this juncture, like what Japan did, and invest heavily in infrastructure, education, basic research and more. The returns are not high. But the government-led investments can make up for the lack of private-sector investments and the lack of consumer-spending because of excessive savings. In this way, the government can protect employment in society and prevent the formation of a vicious cycle of a decline in GDP. In contrast, monetary policy is largely ineffective in the third stage.
For China’s current development, discussions on the use of macro policies are particularly meaningful. Although there are different viewpoints, the general consensus is that China had passed the Lewis Turning Point a few years ago and entered a mature growth phase. Over the past decade, we’ve seen accelerating growth in the level of wages, consumer spending, savings, and investments. But even when an economy has entered a new stage of development, the economic policies that were in place for the previous stage of development – and that have worked well – tend to remain for some time. The lag in the formulation and implementation of new policies that are more appropriate for the current stage of development comes from the inertia inherent in government bodies. This mismatch between macro policies and the stage of development the economy is at has happened in all countries and stages. For instance, Western economies are still stuck with macro policies that are more appropriate for the Golden Era (fiscal policy). Actual data show that the current policies in the West have worked poorly. Today, many Western countries (including Japan) are issuing currencies on a large scale and have zero or even negative interest rates. But even so, these countries are still facing extremely low inflation and slow economic growth while debt levels are soaring.
In the same vein, China’s government is still relying heavily on policies that are appropriate for the first stage of development even when the country’s economy has grown beyond the Lewis Turning Point. In the past few years, we have seen a series of measures for economic reforms. Their intentions are noble, meant to fix issues that have resulted from the industrialisation and manufacturing boom that occured in the previous development stage. But in practice, the reform measures have led to the closures and bankruptcies of private enterprises on a large scale. So from an objective standpoint, the reform measures have, at some level, produced the phenomenon of an advance in the state’s fortunes, but a decline for the private sector. More importantly, it has hurt the confidence of private enterprises and caused a certain degree of societal turmoil and loss of consumer-confidence. All of these have lowered the potential for economic growth in this stage.
Today, net exports contribute negatively to China’s GDP growth while consumption has a share of 70% to 80%. Private consumption is particularly important within the consumption category, and will be the key driver for China’s future economic growth. In the Golden Era, the crucial players are entrepreneurs and individual consumers. The focus and starting point for all policies should be on the following: (1) strengthening the confidence of entrepreneurs; (2) establishing market rules that are cleaner, fairer, and more standardised; (3) reducing the control that the government has over the economy; and (4) lowering taxes and economic burdens. Monetary policy will play a crucial role at this juncture, based on the experiences of many other developed countries during their respective Golden Eras.
During the first stage of development, China’s main financial policy system was based on an indirect financing model. It’s almost a form of forced savings on a large scale, and relied on government-controlled banks to distribute capital (also at a large scale) at low interest rates to manufacturing, infrastructure, exports and other industries that were important to China’s national interests. This financial policy was successful in helping China to industrialise rapidly.
At the second stage of development, the main focus should be this: How can society’s financing direction and methods be changed from one of indirect financing in the first stage to one of direct financing, so that entrepreneurs and individual consumers have the chance to play the key borrower role? We’ve seen such changes happen to some extent in the past few years. For instance, the area of consumer credit has started developing with the help of fintech. There are still questions worth pondering for the long run, such as whether property mortgages can be done better to unleash the potential for secondary mortgages. During this stage, some of the most important tools in macro policy include: Increasing the proportion of direct financing in the system; enhancing the stock market’s ability to provide financing for private enterprises; and establishing bond and equity markets. In addition, the biggest tests for the macro policies are whether the government can further reduce its power in the economy and switch its role from directing the economy to supporting and servicing it.
Over the past few years, the actual results of China’s macro policies have been poor despite the initial good intentions when they were implemented. This is because the policies were simply administrative means. The observation of the economic characteristics of China’s second stage of development also gives us new perspectives and lessons. During the Golden Era of the second stage of development, some policies could possibly have better results if they were adjusted spontaneously by market forces. In contrast, directed intervention may do more harm than good. These are the most important subjects for China today.
Currently, Japan, Western Europe and the US are all in the third stage of development while China is in the second. This means that China’s potential for future growth is still strong. China’s GDP per capita of around US$10,000 is still a cost-advantage for developed nations in the West. At the same time, other emerging countries (such as India) have yet to form any systemic competitive advantages. It’s possible for China to remain in the Golden Era for an extended period of time. China’s GDP per capita is around US$10,000 today, but there are already more than 100 million people in the country that have a per-capita GDP of over US$20,000. These people mainly reside in the southeast coastal cities of the country. China actually does not require cutting-edge technology to help its GDP per capita make the leap from US$10,000 to US$20,000 – all it needs is to allow the living standards and lifestyles of the people in the southeast coastal cities to spread inward throughout the country. The main driver for consumption growth is the “neighbour effect” – I too want for myself what others eat and possess. Information on the lifestyles of the 100 million people in China’s southeast coastal cities can be easily disseminated to the rest of the country’s 1 billion-plus population through the use of TV, the internet, and other forms of media. In this way, China’s GDP per capita can reach US$20,000.
In the years to come, the level of China’s wages, savings, investments, and consumption will all increase and create a positive cycle of growth. Investment opportunities in the country will also remain excellent. Attempts to unleash the growth potential in China’s economy would benefit greatly if China’s government can learn from the monetary policies of the Western nations when they were in their respective Golden Eras, and make some adjustments to the relationship between itself and the market. Meanwhile, Western nations (especially Western Europe) could learn from the positive experiences of the fiscal policies of Japan and China, and allow the government to assume the role of borrower of last resort and invest in infrastructure, education, and basic research at an even larger scale. Doing so will help developed nations in the West to maintain economic growth while they are in the third stage of development (of being chased).
The idea of adjusting policies and tools as the economy enters different stages of development is a huge contribution to the world’s body of economic knowledge. Economics is not physics – there are no everlasting axioms and theories. Economics requires the study of constantly-changing economic phenomena in real life to bring forth the best policies for each period. From this viewpoint, the theoretical framework found in Gu Chao Ming’s book is a breakthrough for economic research.
Earlier, I mentioned three big questions that the world is facing today and that the book is trying to answer. They are the most intractable and pressing issues, and it is unlikely that there will be perfect answers. Gu Chao Ming has a deep understanding of Japan, so the views found in his book stem from his knowledge of the country’s economic history. But is Japan’s experience really applicable for Europe and the US? This remains to be seen. QE, currency oversupply, zero and negative interest rates, high asset prices, wealth inequality, the rise of populist politics – these phenomena that arose from developed countries will continue to plague policy makers and ordinary citizens in all countries for a long period of time.
For China, it has passed the Lewis Turning Point and is in the Golden Era. The economic policies (particularly the fiscal policies) implemented by Japan and other developed countries in the West during their respective Golden Eras represent a rich library of experience for China to learn from. It’s possible for China to unleash its massive inherent economic growth potential during this Golden Era, so long as its policymakers know clearly what stage of development the country is at, and make the appropriate policy adjustments. China’s future is still promising.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
Fears related to the coronavirus (COVID-19) have caused stocks to fall. Economies are also at risk of facing a recession. What should investors do?
Stock markets around the world have fallen in recent times. For instance, the S&P 500 in the US was down by 6.6% from last Friday (21 February 2020) to Wednesday (26 February 2020). At our home in Singapore, the Straits Times Index has declined by 5.1% from 17 January 2020 to 26 February 2020.
I hate to attach reasons to short-term market moves. But this time, it’s pretty clear that fears related to COVID-19, the most recently discovered coronavirus that has infected humans on a large scale, are the culprits.
What scares us
These fears exist for good reasons – there could be a global economic downturn in the works. Already, businesses of many large companies around the world have been affected by COVID-19. In the US, these include Apple, Microsoft, and Booking Holdings (which is in my family’s investment portfolio) just to name a few. In Singapore, property giant CapitaLand, airline caterer SATS, and even Temasek Holdings (one of the Singapore government’s investment arms), have enacted pay cuts because of difficult business conditions.
Plenty of human suffering have happened because of COVID-19, and sadly no one knows how widespread the disease outbreak will be. And from an investing angle, I don’t think anyone knows the eventual effects that COVID-19 will have on the global economy and financial markets (you should run from anyone who claims he/she does!).
Lessons from the past
History is not, and will never be, a perfect guide for the future. But in an uncertain time like this, studying the past can give us context and soothe our nerves.
I’m looking mostly at the US stock market and economy, since there is good long-term data for me to work with.
The chart below shows all the recessions (the dark grey bars) in the US since 1871. You can see that recessions in the country – from whatever causes – have been regular occurrences even in relatively modern times. They are par for the course, even for a mighty economy like the US.
The following logarithmic chart shows the performance of the S&P 500 (including dividends) from January 1871 to February 2020. It turns out that US stocks have done exceedingly well over the past 149 years (up 46,459,412% in total including dividends, or 9.2% per year) despite the US economy having encountered numerous recessions. If you’re investing for the long run, recessions can hurt over the short-term, but they’re nothing to fear.
Source: Robert Shiller data; National Bureau of Economic Research
Having an idea of how often stocks have fallen – for whatever reasons – is also useful to put the current mini-meltdown in stocks into perspective. Between 1928 and 2013, the S&P 500 has, on average, fallen by 10% once every 11 months; 20% every two years; 30% every decade; and 50% two to three times per century. Over the same period, US stocks have climbed by 283,282% (including dividends), or 9.8% per year. Stocks frequently decline hard even while they’re in the process of earning good long-term returns for investors. So when stocks fall, it’s not a sign that something is broken – it’s just a natural part of the game.
It’s worth noting too that global stocks have registered solid long-term gains despite multiple occurrences of deadly disease outbreaks in the past. This is shown in the following chart:
Some of you might be thinking: Now that there’s a heightened risk of a global recession, should we try to time the stock market? I don’t think so. Why? Look at the chart below. The red line shows the return we could have earned from 1980 to today in the US stock market if we had sold stocks at the official start of a recession in the country and bought stocks at the official end. The black line illustrates our return if we had simply bought and held US stocks from 1980 to today. It turns out that completely side-stepping recessions harms our return significantly, so it could be better to stayinvested for the long run.
This does not mean we should stay invested blindly. Companies that currently are heavily in debt, and/or have shaky cash flows and weak revenue streams are likely to run into severe problems if there’s an economic downturn. If a global recession really happens, and our portfolios are full of such companies, we may never recover. It’s always a good time to re-evaluate the companies in our portfolios, but I think there’s even more urgency to do so now.
A sage’s wise words
I want to leave the final words in this article to Warren Buffett. In an interview with CNBC earlier this week, the Oracle of Omaha shared his thoughts on how investors ought to be dealing with COVID-19. He said (emphasis is mine):
“Look, the tariff situation was a big question market for all kinds of companies. And still is to some degree. But that was front and center for a while. Now coronavirus is front and center. Something else will be front and center six months from now and a year from now and two years from now. Real question is — where are these businesses gonna be five and ten and 20 years from now? Some of them will do sensationally, some of them will disappear. And overall I think America will do very well — you know, it has since 1776…
…We’ve got a big investment in airline businesses and I just heard even more flights are canceled and all that. But flights are canceled for weather. It so happens in this case they’re gonna be canceled for longer because of coronavirus. But if you own airlines for 10 or 20 years you’re gonna have some ups and down in current. And some of them will be weather related and they can be all kinds of things. The real question is you know, how many passengers are they gonna be carrying 10 years from now and 15 years from now and what will margins be and– what will the competitive position be? But I still look at the figures all the time — I’ll admit that…
…[Coronavirus] makes no difference in our investments. There’s always gonna be some news, good or bad, every day. In fact, if you go back and read all the papers for the last 50 years, probably most of the headlines tend to be bad. But if you look at what happens to the economy, most of the things that happen are extremely good. I mean, it’s incredible what will happen over time. So if somebody came and told me that the global growth rate was gonna be down 1% instead of 1/10th of a percent, I’d still buy stocks if I liked the price at which — and I like the prices better today than I liked them last Friday…
… We’re buying businesses to own for 20 or 30 years. We buy them in whole, we buy them in part. They’re called stocks when we buy in part. And we think the 20- and 30-year outlook is not changed by coronavirus.”
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
Mastercard has been in my family’s portfolio for a number years and it has done well for us. Here’s why we continue to own Mastercard.
Mastercard (NYSE: MA) is one of the 50-plus companies that’s in my family’s portfolio. I first bought Mastercard shares for the portfolio in December 2014 at a price of US$89 and subsequently made three more purchases (in February 2015 at US$85, in March 2017 at US$111, and in June 2019 at US$267). I’ve not sold any of the shares I’ve bought.
The purchases have worked out very well for my family’s portfolio, with Mastercard’s share price being around US$303 now. But it is always important to think about how a company’s business will evolve going forward. What follows is my thesis for why I still continue to hold Mastercard shares.
Company description
The US-headquartered Mastercard should be a familiar company to many of you who are reading this. Chances are, you have a Mastercard credit card in your wallet. But what’s interesting is that Mastercard is not in the business of issuing credit cards – it’s also not in the business of providing credit to us as consumers.
What Mastercard does is to provide the network on which payment transactions can happen. Here’s a graphical representation of Mastercard’s business:
Source: Mastercard 2019 annual report
Let’s imagine you have a Mastercard credit card and you’re buying an item in a NTUC supermarket. The transaction will involve five parties: Mastercard; the cardholder (you); the merchant (NTUC); an issuer (your bank that issued you the credit card); and an acquirer (NTUC’s bank). The transaction process will then take place in six steps:
Paying with your Mastercard credit card: You (cardholder) purchase your item from NTUC (the merchant) with your credit card.
Payment authentication: NTUC’s point-of-sale system captures your account information and sends it to NTUC’s bank (the acquirer) in a secure manner.
Submission of transaction: NTUC’s bank gets Mastercard to request an authorisation from your bank (the issuer).
Authorisation request: Mastercard sends information of your transaction to your bank for authorisation.
Authorisation response: Your bank authorises your transaction and pings the go-ahead to NTUC.
Payment to merchant: Your bank sends the payment for your transaction to NTUC’s bank, which then deposits the money into NTUC’s bank account.
Mastercard’s revenue comes from the fees it earns when it connects acquirers and issuers. In 2019, Mastercard earned US$16.9 billion in net revenue, which can be grouped into five segments:
Domestic assessments (US$6.8 billion): Fees charged to issuers and acquirers, based on dollar volume of activity, when the issuer and the merchant are in the same country.
Cross-border volume fees (US$5.6 billion): Charged to issuers and acquirers, based on dollar volume activity, when the issuer and merchant are in different countries.
Transaction processing (US$8.5 billion): Revenue that is earned for processing domestic and cross-border transactions and it is based on the number of transactions that take place.
Other services (US$4.1 billion): Includes services such as data analytics; consulting; fraud prevention, detection, and response; loyalty and rewards solutions; and more.
Rebates and incentives (-US$8.1 billion): These are payments that Mastercard pays to its customers. Revenues from domestic assessments, cross-border volume fees, transaction processing, and other services collectively make up Mastercard’s gross revenue. We arrive at Mastercard’s net revenue when we subtract rebates and incentives from gross revenue.
With the ability to handle transactions in more than 150 currencies in over 210 countries, it should not surprise you to find that Mastercard has a strong international presence. In 2019, the US accounted for just 32% of the company’s total revenue; no other individual country took up a revenue-share of more than 10%.
Investment thesis
I had previously laid out my six-criteria investment framework in The Good Investors. I will use the same framework to describe my investment thesis for Mastercard.
1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market
On the surface, Mastercard’s business already looks huge. The company processed 87.3 billion switched transactions in 2019, with a gross dollar volume of US$6.5 trillion; these helped to bring in US$16.9 billion in net revenue.
But the total market opportunity for Mastercard is immense. According to a September 2019 investor presentation by the company, the size of the payments market is US$235 trillion. From this perspective, Mastercard has barely scratched the surface.
Source: Mastercard September 2019 investor presentation
It’s worth noting too that around 80% of transactions in the world today are still settled with cash. So there are still plenty of cash-based transactions available for Mastercard to divert to its network.
Mastercard formed a JV with NetsUnion Clearing Corporation last year to conduct business in China. Earlier this month, the JV received in-principle approval from China’s central bank to operate in the country. Prior to this, Mastercard had no operations in China, so the regulatory approval could pave the way for a huge new geographical market for the company. NetsUnion Clearing Corporation’s stakeholders include China’s central bank, the People’s Bank of China. The JV will be able to apply for formal approval within a year.
2. A strong balance sheet with minimal or a reasonable amount of debt
At the end of 2019, Mastercard had US$7.7 billion in cash and investments on its balance sheet, against US$8.5 billion in debt. This gives rise to US$0.8 billion in net debt.
I generally prefer a balance sheet that has more cash than debt. But I’m not troubled at all in the case of Mastercard. That’s because the company has an excellent track record in generating free cash flow. The average annual free cash flow generated by Mastercard in 2017, 2018, and 2019 was US$5.0 billion, which compares well with the amount of net-debt the company has.
3. A management team with integrity, capability, and an innovative mindset
On integrity
Ajay Banga, 60, is Mastercard’s President and CEO. He has been CEO since July 2010, and I appreciate his long tenure. In 2018, Banga’s total compensation was a princely sum of US$20.4 million. But that is reasonable when compared with the scale of Mastercard’s business – the company’s profit and free cash flow in the same year were US$8.1 billion and US$5.5 billion, respectively. More importantly, his compensation structure looks sensible to me as a shareholder of the company. Here are the important points:
In 2018, 66% of Banga’s total compensation was from stock awards and stock options that vest over multi-year periods (three years and four years, respectively).
The stock awards are based on Mastercard’s revenue and earnings per share growth over a three-year period. I emphasised “per share” because Mastercard shareholders can only benefit from the company’s growth if there is per-share growth.
The value of the stock awards and stock options are nearly the same.
The lion’s share of the compensation of most of Mastercard’s other key leaders in 2018 also came from stock awards and stock options. This is illustrated in the table below.
Source: Mastercard 2019 proxy filing
It’s worth noting too that Mastercard’s management each have many years of experience with the company. Current CFO Sachin Mehra replaced Martina Hund-Mejean when the latter retired in April 2019; Mehra first joined Mastercard in 2010. The fact that Mastercard promotes from within is also a positive sign for me on the company’s culture.
There’s also a point I want to make on the alignment of interests between Banga and Mastercard’s shareholders: As of 26 April 2019, he controlled 1.859 million Mastercard shares which have a value of around US$563 million at the current share price. That’s a sizeable stake which likely places him in the same boat as other shareholders of the company.
On capability and innovation
Mastercard is a digital payment services provider. Some of the key business metrics that showcase the health of its network are: (1) Gross dollar volume, or GDV, of payments that flow through the network; (2) cross-border volume growth; (3) the number of processed transactions; and (4) the number of the company’s cards that are in circulation. The table below shows how the four metrics have grown in each year since 2007. I picked 2007 as the start so that we can understand how Mastercard’s business fared during the 2008-09 Great Financial Crisis.
Source: Mastercard annual reports and earnings updates
It turns out that Mastercard’s management has done a great job in growing the key business metrics over time. 2009 was a relatively rough year for the company, but growth picked up again quickly afterwards. As mentioned earlier, current CEO Ajay Banga had been leading the company since 2010, so the increases in the business metrics from 2007 to 2019 had happened mostly under his watch.
As another positive sign on Mastercard’s culture (I talked about the promotion from within earlier), we can look at Glassdoor, a website that allows a company’s employees to rate it anonymously. 96% of Mastercard’s employees who have submitted a review approve of Banga’s leadership, while 81% will recommend a job in the company to a friend. I credit Mastercard’s management, and Banga in particular, for building a strong culture.
Coming to innovation, Mastercard’s management has, for many years, been improving the payments-related solutions that it provides to consumers and organisations. This is aptly illustrated by the graphic below, which shows the changes in Mastercard’s business from 2012 to 2018:
Source: Mastercard September 2019 investor presentation
Here are some interesting recent developments by Mastercard:
Launched Mastercard Track in 2019; Mastercard Track is a B2B (business-to-business) payment ecosystem which helps to automate payments between suppliers and buyers.
Drove blockchain initiatives in 2019, in the areas of cross-border B2B payments and improving provenance-knowledge in companies’ supply chains.
Implemented AI-powered solutions to prevent fraudulent transactions and improve fraud detection.
In particular, the B2B opportunity is huge and worth tackling, because companies do encounter many pain-points that are related to payment issues. This is shown in the graphic below.
Source: Mastercard September 2019 investor presentation
4. Revenue streams that are recurring in nature, either through contracts or customer-behaviour
I think Mastercard is a great example of a company with recurring revenue from customer-behaviour. Each time we make a purchase and we pay with our Mastercard credit card, the company takes a small cut of the payment.
I showed earlier that the company handled trillions in dollars worth of payments in 2019, and processed billions in transactions. These numbers, together with the fact that no individual customer accounted for more than 10% of Mastercard’s revenues in 2019, 2018, and 2017, lend further weight to my view that the company’s revenue streams are largely recurring in nature.
5. A proven ability to grow
The table below shows Mastercard’s important financials from 2007 to 2019:
Source: Mastercard annual reports
A few key points about Mastercard’s financials:
Net revenue compounded decently at 12.6% per year from 2007 to 2019; over the last five years from 2014 to 2019, the company’s annual topline growth was similar at 12.3%.
The company also managed to produce net revenue growth in 2008 (22.7%) and 2009 (2.1%); those were the years when the global economy was rocked by the Great Financial Crisis.
Net profit surged by 18.2% per year from 2007 to 2019. Mastercard’s net profit growth from 2014 to 2019 was similarly healthy at 17.5%. Net profit was negative in 2008 because of large legal settlement expenses of US$2.5 billion incurred during the year, but it is not a cause for grave concern for me.
Operating cash flow grew in most years for the entire time frame I studied; increased markedly with annual growth of 21.8%; and had been consistently positive. The growth rate from 2014 to 2019 was still impressive at 19.2% per year.
Free cash flow, net of acquisitions, was consistently positive too and had stepped up from 2007 to 2019 at a rapid clip of 20.1% per year. The annual growth in free cash flow from 2014 to 2019 was 16.8% – not too shabby. It’s worth noting that Mastercard’s capital expenditure of US$2.6 billion in 2019 is significantly higher compared to the past primarily because of large acquisitions totalling US$1.4 billion. Without the acquisitions, Mastercard’s free cash flow in 2019 would be much higher at US$7.0 billion.
The net-cash position on Mastercard’s balance sheet was positive from 2007 to 2018 and had dipped into negative territory only in 2019. I mentioned earlier that I’m not troubled by Mastercard currently having more debt than cash, since the company has been adept at producing free cash flow and the amount of net-debt is manageable.
Mastercard’s diluted share count declined by 24% in total from 2007 to 2019, and also fell in nearly every year over the same period. This is positive for the company’s shareholders, since it boosts the company’s per-share earnings and free cash flow. For perspective, Mastercard’s free cash flow per share compounded at 20.0% per year from 2014 to 2019, which is higher than the annual growth rate of 16.8% over the same period for just free cash flow. Mastercard’s share price has also increased by a stunning amount of nearly 3,000% in total since the start of 2007. This means that the share buybacks conducted over the years by Mastercard’s management to reduce the share count have been excellent uses of capital.
In Mastercard’s 2019 fourth-quarter earnings conference call, management guided towards net revenue growth in the low-teens range for 2020. Growth in the first quarter of 2020 was expected to be around two percentage points lower than the whole year. But in late February, Mastercard updated its forecast for net revenue growth. The ongoing outbreak of COVID-19 has negatively impacted cross-border travel and cross-border e-commerce growth. As a result, Mastercard now expects its 2020 first-quarter net revenue growth to be “approximately 2-3 percentage points lower than discussed [during the earnings conference call].” Mastercard added:
“There are many unknowns as to the duration and severity of the situation and we are closely monitoring it. If the impact is limited to the first quarter only, we expect that our 2020 annual year-over-year net revenue growth rate would be at the low end of the low-teens range, on a currency-neutral basis, excluding acquisitions. We anticipate giving further updates on our first-quarter earnings call.”
No one knows what kind of impact COVID-19 will eventually have on the global economy. But I’m not worried about the long-term health of Mastercard’s business even though COVID-19 has already made its mark. My stance towards COVID-19 is that this too, shall pass.
6. A high likelihood of generating a strong and growing stream of free cash flow in the future
There are two reasons why I think Mastercard excels in this criterion.
First, the company has a long track record of producing strong free cash flow from its business. Moreover, its average free cash flow margin (free cash flow as a percentage of revenue) in the past five years from 2014 to 2019 was strong at 33.5%. In 2019, the free cash flow margin was 32.9%.
Two, there’s still tremendous room to grow for Mastercard in the entire payments space. The company has a strong network (the number of currencies it can handle; the number of countries it operates in; the sheer payment and transaction volumes it is processing; the billions in its self-branded credit cards that are circulating) as well as a capable and innovative management team that has integrity. These traits should lead to higher revenue for Mastercard over time. If the free cash flow margin stays fat – and I don’t see any reason why it shouldn’t – that will mean even more free cash flow for Mastercard in the future.
Valuation
I like to keep things simple in the valuation process. In Mastercard’s case, I think the price-to-earnings (P/E) ratio and price-to-free cash flow (P/FCF) ratio are suitable gauges for the company’s value. That’s because the company has been adept at producing positive and growing profit as well as free cash flow for a long period of time.
Right now, Mastercard carries trailing P/E and P/FCF ratios of around 38 and 56 at the current share price of US$303. These ratios look expensive, and are also clearly on the high-end (see chart below) when compared to their own histories over the past five years.
(Note: The chart above is from Ycharts and the P/FCF ratio excludes the impact of acquisitions. Using my own numbers for Mastercard, the company’s P/FCF ratio falls to 44 if I remove acquisition-related effects. My P/FCF ratio and that from YCharts are not the same, but they are similar enough. Moreover, I’m only relying on the P/FCF chart for general guidance.)
But I’m happy to pay up, since Mastercard excels under my investment framework. I also want to point out that Mastercard not only has a large market opportunity – the chance that it can win in its market is also very high, in my view. Put another way, Mastercard scores well in both the magnitude of growth and the probability of growth. For companies like this, I’m more than willing to accept a premium valuation. But the current high P/E and P/FCF ratios do mean that Mastercard’s share price could be volatile going forward. This is something I have to be – and I am – comfortable with.
The risks involved
There are a few key risks that I see in Mastercard.
First is a leadership transition. Mastercard announced earlier this month that long-time CEO Ajay Banga will become Executive Chairman on 1 January 2021. Current Chief Product Officer, Michael Miebach, will succeed Banga as CEO on the same date. Given the timeline involved, the transition seems planned. Miebach, who’s relatively young at 52 this year, joined Mastercard in June 2010. Again, this promotion from within is a positive thing in my view. Banga has high-praise for Miebach, commenting in the announcement:
“As the company moves into this next phase of growth, we have a deep leadership bench–with Michael at the helm–to take us to the next level. He has a proven track record of building products and running businesses globally.
Over his career, Michael has held leadership positions in Europe, the Middle East and Africa and in the U.S. across payments, data, banking services and technology. During the course of Michael’s 10 years at Mastercard, he has been a key architect of our multi-rail strategy–including leading the acquisition of Vocalink and the pending transaction with Nets–to address a broader set of payment flows. He’s also a visionary who kickstarted much of the work behind our financial inclusion journey.
I am excited to continue working closely with Michael and supporting Mastercard’s success when I become Executive Chairman.”
Miebach looks like a safe pair of hands and Banga will still continue to have a heavy say on Mastercard’s future given his upcoming role as Executive Chairman. But I will be keeping an eye on this leadership transition.
Competition is the second risk I’m watching. I mentioned in my investment thesis for PayPal (a digital payments services provider) that the payments space is highly competitive. There are larger payment networks such as that operated by Mastercard’s competitor, Visa (which processed US$11.6 trillion on its platforms in the 12 months ended 30 September 2019). In my PayPal thesis, I also said:
“Then there are technology companies with fintech arms that focus on payments, such as China’s Tencent and Alibaba. In November 2019, Bloomberg reported that Tencent and Alibaba plans to open up their payment services (WeChat Pay and Alipay, respectively) to foreigners who visit China. Let’s not forget that there’s blockchain technology (the backbone of cryptocurrencies) jostling for room too. There’s no guarantee that PayPal will continue being victorious. But the payments market is so huge that I think there will be multiple winners – and my bet is that PayPal will be among them.”
Just like PayPal, there are no guarantees that Mastercard will continue winning. But I do think the odds are in Mastercard’s favour.
Regulations are the third risk I’m watching. Payments is a highly regulated market, and Mastercard could fall prey to heavy-handed regulation. Lawmakers could impose hefty fines or tough limits on Mastercard’s business activities. In general, I expect Mastercard to be able to manage any new legal/regulatory cases if and when they come. But I’m watching for any changes to the regulatory landscape that could impair the health of Mastercard’s business permanently or for a prolonged period of time.
Lastly, there is the risk of recessions. Mastercard did grow its net revenue in 2009, but the growth rate was low. I don’t know when a recession in the US or around the world will hit. But when it does, payment activity on Mastercard’s network could be lowered. As I mentioned earlier, COVID-19 has already caused a softening in Mastercard’s business activity.
The Good Investors’ conclusion
To wrap up, Mastercard excels under my investment framework:
The payments market is worth a staggering US$235 trillion and Mastercard has barely scratched the surface.
The company currently has more debt than cash, but the net-debt level is manageable and the company has a strong history of producing free cash flow.
Mastercard’s management team has proved itself to be innovative and capable, but that’s not all – the company’s leaders also have sensible compensation structures that align their interests with shareholders.
Mastercard’s revenue streams are highly likely to be recurring in nature (each time we make a payment with a Mastercard service or product, the company gets a cut of the transaction).
The company has a long history of growing its net revenue, profit, and free cash flow, while keeping its balance sheet strong and reducing its share count.
There is a high likelihood that Mastercard will continue to be a free cash flow machine.
The company does have a high valuation – both in absolute terms and in relation to history. But I have no qualms with accepting a premium valuation for a high-quality business.
I’m also aware of the risks with Mastercard. I’m watching the leadership transition and also keeping an eye on risks that are related to competition, the regulatory landscape, and recessions.
But after weighing the pros and cons, I’m happy to allow Mastercard to continue to be in my family’s investment portfolio.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
