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.
Hint: The US market’s rise may not have much to do with the frequently-heard accusations of the Federal Reserve artificially inflating stock prices.
Since the start of 2010, the US stock market – as measured by the S&P 500 – has nearly tripled, from 1,124 points to more than 3,300. This meteoric rise in US stock prices has prompted plenty of commentary within the investment community on its underlying drivers.
A frequent “culprit” cited is the Federal Reserve in the US. Many investors and market commentators have blamed the US central bank for driving stock prices higher because of its interest rate policy (of keeping rates low) and quantitative easing (the act of pumping money into the economy via the purchase of mostly government-related financial assets).
The chart above is plotted with data from Nobel Prize-winning economist, Robert Shiller. It shows changes in the S&P 500’s price, dividends, and earnings since the start of 2010. Over the past decade, all three numbers have basically increased hand-in-hand. Put another way, the meteoric rise in the S&P 500 I mentioned earlier could be explained by a similarly big jump in the fundamentals of American businesses.
I was inspired to plot my chart after I came across the following tweet by Morgan Housel, one of my favourite finance writers:
Housel’s chart showed that the S&P 500’s price and its dividends have climbed in lock-step since 2010. This suggests that the US market had been driven higher because of improvements in its underlying business fundamentals. But I was curious to know if the increase in dividends is sustainable. This is why I plotted my own chart which included earnings growth. Turns out, there has been a commensurate increase in earnings for the US market. The S&P 500 has done what Warren Buffett wrote in his 2018 Berkshire Hathaway shareholders’ letter:
“On occasion, a ridiculously-high purchase price for a given stock will cause a splendid business to become a poor investment – if not permanently, at least for a painfully long period. Over time, however, investment performance converges with business performance.”
None of the above is meant to say that the S&P 500 will continue climbing over the next year, or the next 10 years. Over the short run, sentiment can change on a dime; a rise in investors’ pessimism over the future – whether warranted or unwarranted – will drag stock prices lower. Over the long run, if the rise in earnings for US businesses in the past was unsustainable, then there could be a collapse in the S&P 500 in the future.
But what we do know now is that there is a very good reason why US stocks prices have grown so much over the past decade – their businesses have done very well too.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
Many investors think that it’s easy to figure out when stocks will hit a peak. But it’s actually really tough to tell when a bear market would happen.
Here’s a common misconception I’ve noticed that investors have about the stock market: They think that it’s easy to figure out when stocks will hit a peak. Unfortunately, that’s not an easy task at all.
In a 2017 Bloomberg article, investor Ben Carlson showed the level of various financial data that were found at the start of each of the 15 bear markets that US stocks have experienced since World War II:
The financial data that Carlson presented include valuations for US stocks (the trailing P/E ratio, the cyclically adjusted P/E ratio, and the dividend yield), interest rates (the 10 year treasury yield), and the inflation rate. These are major things that the financial media and many investors pay attention to. (The cyclically-adjusted P/E ratio is calculated by dividing a stock’s price with the 10-year average of its inflation-adjusted earnings.)
But these numbers are not useful in helping us determine when stocks will peak. Bear markets have started when valuations, interest rates, and inflation were high as well as low. This is why it’s so tough to tell when stocks will fall.
None of the above is meant to say that we should ignore valuations or other important financial data. For instance, the starting valuation for stocks does have a heavy say on their eventual long-term return. This is shown in the chart below. It uses data from economist Robert Shiller on the S&P 500 from 1871 to 2019 and shows the returns of the index against its starting valuation for 10-year holding periods. It’s clear that the S&P 500 has historically produced higher returns when it was cheap compared to when it was expensive.
But even then, the dispersion in 10-year returns for the S&P 500 can be huge for a given valuation level. Right now, the S&P 500 has a cyclically-adjusted P/E ratio of around 31. The table below shows the 10-year annual returns that the index has historically produced whenever it had a CAPE ratio of more than 25.
If it’s so hard for us to tell when bear markets will occur, what can we do as investors? It’s simple: We can stay invested. Despite the occurrence of numerous bear markets since World War II, the US stock market has still increased by 228,417% (after dividends) from 1945 to 2019. That’s a solid return of 11.0% per year. Yes, bear markets will hurt psychologically. But we can lessen the pain significantly if we think of them as an admission fee for worthwhile long-term returns instead of a fine by the market-gods.
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.
There are six investing mindsets that have helped me in my activities in the stock market, both on a personal as well as professional basis.
Having a good framework to find investment opportunities in the stock market is important. But it’s equally important – perhaps even more important – to have the right mindsets. Without them, it’s hard to be a successful investor even if you have the best analytical mind in the world of finance.
There are six key mindsets that have served me well in my investing activities in the stock market, both on a personal as well as professional basis. I want to share them in this article.
The first mindset
Here’s a chart showing the maximum peak-to-trough decline for Amazon’s share price in each year from 1997 to 2018:
Source: S&P Global Market Intelligence
It turns out that Amazon’s share price had experienced a double-digit top-to-bottom fall (ranging from 13% to 83%) in every single year from 1997 to 2018. Looks horrible, doesn’t it?
Now here’s a chart showing Amazon’s share price from 1997 to 2018:
Source: S&P Global Market Intelligence
The second chart makes it clear that Amazon has been a massive long-term winner, with its share price rising by more than 76,000% from US$1.96 in 1997 to US$1,501.97 in 2018. Amazon does not look so horrible now, does it?
The experience of the e-commerce giant is why Peter Lynch, the legendary fund manager of Fidelity Magellan Fund, once said:
“In the stock market, the most important organ is the stomach. It’s not the brain.”
We need the stomach to withstand volatility, the violent ups-and-downs of share prices. As Amazon has shown, even the best long-term winners in the stock market have suffered from sharp short-term declines.
This is why accepting that volatility in share prices is a feature of the stock market and not a bug isa very important mindset for me. When stocks go up and down, it’s not a sign that something is broken. In fact, there’s actually great data to prove that volatility in share prices do not tell us much about how the underlying businesses are doing.
Robert Shiller is an economist who won the Nobel Prize in 2013. In the 1980s, Shiller looked at how the US stock market performed from 1871 to 1979. He compared the market’s actual performance to how it should have rationally performed if investors had hindsight knowledge of how the dividends of US stocks would change. Here’s the chart Shiller plotted from his research:
The solid black line is the stock market’s actual performance while the black dashed line is the rational performance. The fundamentals of American businesses – using dividends as a proxy – was much less volatile than American share prices.
The second mindset
We cannot run from the fact that we humans are emotional creatures. When share prices fall – even with the knowledge that volatility is merely a feature in the stock market – it hurts. And when it hurts, that’s when we make stupid mistakes.
From 1977 to 1990, Peter Lynch earned an annual return of 29% for Fidelity Magellan Fund, turning every thousand dollars invested with him into $27,000. It is this performance that made Lynch a legend in the investing business. But shockingly, the average investor in his fund made only 7% per year – $1,000 invested with an annual return of 7% for 13 years would become just $2,400.
In his book Heads I Win, Tails I Win, Spencer Jakab, a financial journalist with The Wall Street Journal, explained why this big performance-gap happened:
“During his tenure Lynch trounced the market overall and beat it in most years, racking up a 29 percent annualized return. But Lynch himself pointed out a fly in the ointment.
He calculated that the average investor in his fund made only around 7 percent during the same period. When he would have a setback, for example, the money would flow out of the fund through redemptions. Then when he got back on track it would flow back in, having missed the recovery.”
In essence, investors in Fidelity Magellan Fund had bought high and sold low. That’s a recipe for poor returns, born out of our emotional reactions to the stock market’s volatility.
I think there’s a great way for us to frame how we think about volatility so that we can minimise its damage. This was articulated brilliantly by Morgan Housel in a recent blog post of his (emphasis his):
“But a reason declines hurt and scare so many investors off is because they think of them as fines. You’re not supposed to get fined. You’re supposed to make decisions that preempt and avoid fines. Traffic fines and IRS fines mean you did something wrong and deserve to be punished. The natural response for anyone who watches their wealth decline and views that drop as a fine is to avoid future fines.
But if you view volatility as a fee, things look different.
Disneyland tickets cost $100. But you get an awesome day with your kids you’ll never forget. Last year more than 18 million people thought that fee was worth paying. Few felt the $100 paid was a punishment or a fine. The worthwhile tradeoff of fees is obvious when it’s clear you’re paying one.
Same with investing, where volatility is almost always a fee, not a fine.
Returns are never free. They demand you pay a price, like any other product. And since market returns can be not just great but sensational over time, the fee is high. Declines, crashes, panics, manias, recessions, depressions.”
This is why my second mindset is this: Instead of seeing short-term volatility in the stock market as a fine, think of it as a fee for something worthwhile – great long-term returns.
You might be thinking: Is the fee really worth paying? We saw the case of Amazon earlier, where the fee was definitely worth it. Thing is, the point I made about Amazon can actually be applied to the broader US market too.
A few years ago, Housel wrote an article for The Motley Fool that showed how often the US stock market – represented by the S&P 500 – had fallen by a certain percentage from 1928 to 2013. Here’re the results:
It’s clear that US stocks have declined frequently. But data from Robert Shiller also showed that the S&P 500 was up by around 21,000% from 1928 to 2013 after factoring in dividends and inflation. That means every $1,000 invested in the S&P 500 in 1928 would become $210,000 in 2013 after inflation. The S&P 500 has charged investors an expensive entry fee (in the form of volatility) for a magical show.
Source: Robert Shiller data
The third mindset
A common misconception I encounter about the stock market is that what goes up must come down. Yes it’s true that there’s cyclicality with stocks. But an important point is missed: Stocks go up a lot more than they go down. We’ve seen that with Amazon and with the S&P 500. Now let’s see it with stocks all over the world.
Source: Credit Suisse Global Investment Returns Yearbook 2014
The chart above plots the returns of the stock markets from both developed and developing economies over more than 110 years from 1900 to 2013. In that timeframe, stocks in developed economies (the blue line) produced an annual return of 8.3% while stocks in developing economies (the red line) generated a return of 7.4% per year. There are clearly bumps along the way, but the long run trend is crystal clear.
So the third key mindset I have when investing in the stock market is that what goes up, does not always come down permanently. But there is an important caveat to note: Diversification is crucial.
The fourth mindset
Devastation from war or natural disasters. Corrupt or useless leaders. Incredible overvaluation at the starting point. These are factors that can cause a single stock or a single country’s stock market to do poorly even after decades.
We can study a company’s or country’s traits to understand things like valuations and the quality of the leaders. But there’s pretty much nothing we can do when it comes to catastrophes caused by mankind or Mother Nature.
This is why my fourth mindset is the importance of diversifying our investments across both geographies and companies.
The fifth mindset
We’re living in uncertain times. Toward the end of 2019, China alerted the World Health Organisation (WHO) about cases of pneumonia amongst its citizens that were caused by an unknown virus. That was the start of what we know today as COVID-19. Many countries in the world – including our home in Singapore – are currently battling to keep their citizens safe from the disease. When faced with uncertainty, should we still invest?
How do you think the US stock market will fare over the next five years and the next 30 years if I tell you that in this year, the price of oil will spike, and the US will simultaneously go to war in the Middle East and experience a recession? We don’t need to guess, because history has shown us.
The events I mentioned all happened in 1990. The price of oil spiked in August 1990, the same month that the US went into an actual war in the Middle East. In July 1990, the US entered a recession. Turns out, the S&P 500 was up by nearly 80% from the start of 1990 to the end of 1995, including dividends and after inflation. From the start of 1990 to the end of 2019, US stocks were up by nearly 800%.
What’s also fascinating is that the world saw multiple crises in every single year from 1990 to 2019, as the table below – constructed partially from Morgan Housel’s data – illustrates. Yet, the S&P 500 has steadily marched higher.
Earlier, I talked about COVID-19. I think it would be appropriate to also show how global stocks have done after the occurence of deadly epidemics.
My blogging partner, Jeremy, included the chart just above in a recent article. It illustrates the performance of the MSCI World Index (a benchmark for global stocks) since the 1970s against the backdrop of multiple epidemics/pandemics that have happened since. He commented:
“As you can see from the chart… the world has experienced 13 different epidemics since the 1970s. Yet, global stocks – measured by the MSCI World Index – has survived each of those, registering long term gains after each outbreak.”
So I carry this important mindset with me (the fifth one): Uncertainty is always around, but that does not mean we should not invest.
The sixth mindset
We’ve seen in the data that market crashes and recessions are bound to happen periodically. But crucially we don’t know when they will occur. Even the best investors have tried to outguess the market, only to fail.
So if we’re investing for many years, we should count on things to get ugly a few times, at least. This is completely different from saying “the US will have a recession in the third quarter of 2020” and then positioning our investment portfolios to fit this view.
The difference between expecting and predicting lies in our behaviour. If we merely expect downturns to happen from time to time while knowing we have no predictive power, our investment portfolios would be built to be able to handle a wide range of outcomes. On the other hand, if we’re engaged in the dark arts of prediction, then we think we know when something will happen and we try to act on it. Our investment portfolios will thus be suited to thrive only in a narrow range of situations – if things take a different path, our portfolios will be on the road to ruin.
Here’s an interesting thought: If we can just somehow time our stock market entries and exits to coincide with the end/start of recessions, surely we can do better than just staying invested, right?
The chart below is from investor Michael Batnick. 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.
This is why my sixth mindset is that we should expect bad things to happen from time to time, but we should not try to predict them.
In conclusion
To recap, here are the six mindsets that have been very useful for me:
First, volatility in stocks is a feature, not a sign that something is broken
Second, think of short-term volatility in the stock market as a fee, not a fine
Third, what goes up does not always come down permanently
Fourth, it is important to diversify across geographies and companies
Fifth, uncertainty is always around, but we should still invest
Sixth, we should expect bad things to happen from time to time in the financial markets, but we shouldn’t try to predict them
They have helped me to be psychologically comfortable when investing. Without them, I may become flustered when things do not go my way temporarily or when uncertainties are rife. This could in turn result in bad investing behaviour on my part. I hope these mindsets can benefit you too.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
My family’s portfolio has held Booking Holdings shares for a few years and it has done well for us. Here is why we continue to own Booking Holdings shares.
Booking Holdings (NASDAQ: BKNG) is one of the 50-plus companies that’s in my family’s portfolio. I first bought Booking shares for the portfolio in May 2013 at a price of US$765 and subsequently made three more purchases (in December 2014 at US$1,141, in February 2016 at US$1,277, and March 2017 at US$1,771). I’ve not sold any of the shares I’ve bought.
The first three purchases have worked out pretty well for my family’s portfolio, with Booking’s share price being around US$1,990 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 Booking shares.
Company description
Booking, formerly known as Priceline, was listed in March 1999, right in the middle of the dotcom bubble. When the bubble met its sudsy end, Booking’s share price collapsed by over 99% from peak-to-trough. But like a phoenix rising from the ashes, Booking’s share price then embarked on an incredible climb of more than 30,000% from the bottom (reached in October 2002) to where it is today.
At the beginning of its life as a public listed company, Booking was in the online travel business. Today it is still in the online travel business. The difference between now and then is that Booking was an unproven business with significant losses in the days of yore. Now, it is the world’s largest online travel company, and very profitable. Some of you may have booked hotels online with Agoda or Booking.com – that’s Booking, the company, in action!
In the first nine months of 2019, Booking pulled in US$11.7 billion in revenue. These came primarily from the following brands the company has:
Booking.com – one of the world’s largest, if not the largest, online service for booking accommodation reservations
KAYAK – an online service for users to search and compare prices for air tickets, accommodations, and car rentals from hundreds of travel websites
priceline – an online travel agent in North America for reservations of hotels, rental cars, air tickets, and vacation packages
Agoda – a website for accommodation reservations, with a focus on consumers in the Asia-Pacific region
Rentalcars.com – an online worldwide rental car reservation service
OpenTable – allows consumers to make restaurant reservations online, and provides restaurant reservation management and customer acquisition services to restaurant operators.
Booking.com, which is based in the Netherlands, is Booking’s largest brand – it accounted for 77% of the company’s total revenue in the first nine month of 2019. Because of the location of Booking.com’s headquarters, Booking counts the Netherlands as its largest geographical market (a 77% share of the pie). The US is Booking’s next largest country, with a 10% share of total revenue.
Each time you make a hotel reservation, Booking earns either the entire room rate as revenue, or earns a referral fee. This is because the company runs two different business models:
There is the merchant model, where Booking earns the entire room rate when rooms are booked through its platforms. It is a more complex model as the company has to negotiate room prices and allocations with the operator of the property. Ensuring parity between the company’s room-rate and the operator’s room-rate is likely also a tricky problem.
Then there is the agency model, which is a lot simpler. It allows hoteliers to set their own price and room allocations. Under this model, Booking is the agent that passes customer reservations to hotels and it collects a commission fee for each reservation made. Guests also pay only on checkout, compared to the merchant model where guests have to pay when the reservation is made (so now you know why certain travel websites require you to pay upfront, while some don’t!).
In the first nine months of 2019, 68% of Booking’s total revenue of US$11.7 billion came from its agency business, while 25% was from the merchant model. Advertising and other types of services accounted for the rest. Nearly all of Booking’s agency revenue came from Booking.com.
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 Booking.
1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market
I’m confident that online travel is a huge and growing market because of a few data points.
First, according to statistics from travel research firm PhocusWright that were cited by travel review site TripAdvisor, the global travel market was estimated to be US$1.3 trillion in 2016, with online travel spend accounting for US$492 billion (38%). The latest data from PhocusWright that was cited by TripAdvisor in the latter’s November 2019 investor presentation showed that the global travel market had expanded to around US$1.7 trillion for 2019.
Second, Allied Market Research released a report in mid-2019 that contained a forecast for the online travel market to grow by 11.1% annually from 2016 to 2022 to reach US$1.1 trillion.
Third, aircraft manufacturer Airbus expects air travel traffic to grow by 4.3% annually from 8.7 trillion RPK in 2018 to 20.3 trillion RPK in 2038, driven by a rising middle class population across the globe (from 3.95 billion individuals in 2018 to 5.94 billion in 2038). Air travel traffic has been remarkably resilient in the past, and had grown by around 5.5% annually in the 30 years from 1988 to 2018. The chart just below shows the growth of global air travel traffic, in terms of RPK (RPK stands for revenue passenger-kilometres, which is the number of fare-paying passengers multiplied by the distance travelled), since 1978.
Source: Airbus Global Market Forecast 2019-2038
The following chart shows the sources for the expected global air travel traffic growth of 4.3% per year from 2019 to 2038:
Source: Airbus Global Market Forecast 2019-2038
For context, Booking’s revenue is only US$14.9 billion over the last 12 months, suggesting a long runway for growth for the company.
2. A strong balance sheet with minimal or a reasonable amount of debt
Booking has a strong balance sheet right now, with slightly more cash and investments than debt as of 30 September 2019 (US$8.8 billion in cash and investments against US$8.5 billion in debt).
Note: Booking’s cash and investments of US$8.8 billion excludes US$2.9 billion in strategic investments that the company has in Trip.com (a China-focused travel agent), Meituan Dianping (a China-based e-commerce platform for services), Didi Chuxing (China’s leading ride hailing platform), and other private companies, such as Grab, the Singapore-based version of Didi Chuxing.
The company also has an excellent track record in generating free cash flow. I’ll discuss this later.
3. A management team with integrity, capability, and an innovative mindset
On integrity
Glenn Fogel, 57, is currently Booking’s CEO. He joined the company in February 2000 and was promoted to his current role in January 2017. Prior to being CEO, Fogel was already a key leader in Booking since 2009. I appreciate his long tenure with the company. Seeing Booking promote from within is also a positive sign on its culture.
Fogel’s total compensation was US$20.5 million for 2018, which is a tidy sum of money. But it is a reasonable amount when we consider that Booking’s profit and free cash flow in 2018 were US$4.0 billion and US$4.6 billion, respectively.
68% of Fogel’s total compensation for 2018 came from long-term stock awards that depend on the performance of Booking’s stock price and adjusted EBITDA (earnings before interest, taxes, depreciation, and amortisation) over a three year period. I’m not the biggest fan of EBITDA and would much prefer the use of earnings per share or free cash flow per share. I also typically frown upon compensation plans that are linked to a company’s stock price. But there are strong redeeming factors in Booking’s overall compensation structure:
The adjusted EBITDA excludes any positive impacts from acquisitions as well as the sale of loss-making subsidiaries; so, the performance of the adjusted EBITDA will have to depend on the growth of Booking’s core businesses.
The changes to adjusted EBITDA and the stock price are measured over three years, which is a sufficiently long time period (although I wouldn’t mind an even longer time frame!).
Fogel’s base salary and cash bonus is designed to be below the market rate, to incentivise him to lead Booking towards strong long-term business performance in order to earn his attractive stock awards.
In all, I think that Booking’s compensation structure for Fogel aligns his interests with mine as a shareholder of the company. I want to point out too that Booking’s other key leaders, including CFO David Goulden (59 years old) and General Counsel Peter Millones Jr. (49 years old), also have similar compensation structures as Fogel’s. In addition, Booking’s compensation plan for its leaders has been substantially similar for many years – that’s another plus-point for me on the integrity of the company’s management team.
I also want to mention Jeffrey Boyd, 62. He has been the Chairman of Booking’s board of directors since January 2013, and was CEO of the company from November 2002 to December 2013. He also became interim CEO from April 2016 to December 2016 (more on this in the Risk section of this article). As Chairman of the board, Boyd’s compensation was just US$491,399 in 2018. It is an extremely low sum compared to the scale of Booking’s business, and I think it’s another testament to the integrity that Booking’s leaders have.
On capability and innovation
Earlier, I mentioned that Booking’s key brand is Booking.com. In 2005, Booking acquired the Netherlands-based Booking.com for merely US$133 million. In just the first nine months of 2019, Booking.com produced around US$9 billion in revenue, representing 77% or so of Booking’s overall top-line. These stunning figures make the acquisition price-tag of US$133 million look like one of the greatest business deals of all time. Jeffrey Boyd, the company’s current Chairman of the Board, was Booking’s CEO at the time of the acquisition.
As a platform for online travel reservations, I believe Booking’s business exhibits a classic network effect, where having more accomodation properties on its platform leads to more visitors, which in turn leads to more accommodation properties. Booking’s management has done a fantastic job in growing its accommodations network over the years. The table below shows this, along with the growth in the number of room nights booked by travellers, demonstrating the power of Booking’s network effect.
Source: Booking annual reports and earnings updates
The company’s growth in unique accommodations is noteworthy. Online travel is a massive and growing market, so I think there is room for multiple winners. But I still see AirBnB, with more than 6 million listings in early 2019, as one of the main threats to Booking’s business. (Note: The definition of listings by AirBnB is different from Booking’s property-count in the table above, but the key point is that AirBnB also has a wide network.) I’m sure most of you reading this have used, or at least heard of, AirBnB’s online platform that provides travellers with alternative accommodation options to hotels. Booking has amassed a sizable inventory of unique accommodations of its own, to management’s credit – and this part of the business is growing faster than Booking’s main hotel business.
There’s an aspect of Booking’s accommodations network that I think is underappreciated by investors: The supplier- and customer-support that is provided by the company. Booking is able to provide 24/7 support in nearly 50 languages – small, independent hotels and owners of alternative accommodations are unable to provide that for travellers. This is why Booking believes its services enable this group of accommodation-providers to reach a wider audience than they otherwise could by themselves. To be clear, Booking believes that its services are valuable to large hotel chains too. It is worth noting that independent hotels make up around 40% to 50% of the total hotel supply in Asia Pacific, Middle East, Africa, Europe, and Latin America; in the US, it is 72%.
Bookiing’s leaders have also proven to be quick to adapt, in my view. I want to bring up two points on the matter.
First, the company had produced significant growth in agency revenue from 2007 to 2017, with merchant revenue being relatively flat (especially from 2011 to 2017). But when the agency business started facing growth headwinds in 2018 and the first nine months of 2019, the merchant business helped to pick up the slack with significant growth. These are shown in the table just below.
Source: Booking annual reports and earnings updates
Second, the company had traditionally been big spenders on performance marketing, which are marketing expenses on online search engines (primarily Google) and other travel-related websites to drive traffic to Booking’s own websites. But after experiencing a decline in the return on investment in performance marketing, Booking started to place heavier emphasis on brand marketing in the past few years.
I believe that brand advertising will be a net benefit to the long-term health of Booking’s business – if the brand advertising efforts are a success, travellers will flock to Booking’s websites without the need for the company to advertise online. The changes in the growth of Booking’s performance marketing spend and brand marketing spend over the past few years is shown in the table below. The early signs are mixed. On one hand, Booking’s direct channel (where customers head to the company’s websites directly) is growing faster than its paid channel (where customers visit the company’s websites because of performance-marketing adverts). On the other hand, management had expected its brand advertising results to be better. I have confidence that Booking’s management will work things out in the end.
Source: Booking annual reports and earnings updates
Booking’s culture can be described as decentralized, empowered, and innovative. According to a 2014 interview of Booking’s former CEO, Darren Huston, the company operates in small teams that are no larger than eight people, and runs more than 1,000 concurrent experiments on its products every day. Booking’s current CEO, Glen Fogel, was interviewed in 2018 by Skift and revealed that constant testing is still very much in the company’s DNA.
Perhaps the greatest feather in the cap of Booking’s management is the fact that the company has handily outpaced its rival Expedia over the long run. In 2007, Expedia’s revenue was almost twice of Booking’s. But Booking’s revenue over the last 12 months was significantly higher than Expedia’s.
Source: Expedia and Booking earnings updates
Being a travel-related technology company, it’s no surprise to learn that Booking also has an innovative streak. The company is working with machine learning and artificial intelligence to improve people’s overall travel experience. In particular, Booking’s highly interested in the connected trip, where a traveller’s entire travel experience (from flights to hotels to ground-transport to attraction-reservations, and more) can be integrated on one platform. Another nascent growth area for Booking is payments, which the company started investing in only in recent years. Here’s CFO David Goulden describing the purpose of the company’s payments platform during Booking’s 2018 third-quarter earnings conference call:
“[The payments platform] does a number of great things for us, for our customers and our partners. For our customers, it gives them many more choices to how they may want to pay for their transactions in advance or closer to the stay, it gives them more opportunities to pay with the payments product of their choice, it may not necessarily be a credit card, it could be something like an Ally pay for example.
For us, it lets us basically provide our customers with a more consistent service, because we’re in charge of exactly how that payment flow works.
And then for our partners, again, we offer them more ability to access different payment forms from different customers in different parts of the world, because we can basically pay them the partner in the form of whatever they like to take even though we may have taken the payment in on the front end, there are different payment mechanisms.”
I also think management’s investments in a number of Asia-focused tech start-ups are smart moves. As I mentioned earlier, Booking has stakes in Meituan Dianping, Didi Chuxing, and Grab. These investments aren’t just passive. Booking is actively collaborating with some of them. Here’s Booking’s CEO Glenn Fogel in the aforementioned interview with Skift describing how the company is working with Didi Chuxing to improve the experience of travellers in China:
“Now until recently by the way, DiDi only had a Chinese app. Kind of hard for most of the people who go to China to use it. Recently now, they have an English language one. But still, we have a lot of customers, English isn’t their language, right? So what we’ve done is this deal is so wonderful.
One, our customers, they go onto the Booking.com or they go to the app and you’ll be able to get that ground transportation from Didi app in the language that they were doing the work with Booking or Agoda. Really good. Nice, seamless, frictionless thing. Second thing is, we’re going to work with them so we can help make sure all those Didi customers know about Booking.com and Agoda. You need a place to stay, that’s where you can go and get a great deal, a great service in Chinese.”
4. Revenue streams that are recurring in nature, either through contracts or customer-behaviour
I believe that Booking’s revenue streams are highly recurrent because of customer-behaviour. Each time you travel, you’ll need to reserve accommodations and arrange for transport options. Moreover, I think it’s highly likely that Booking does not have any customer-concentration – I showed earlier that 654 million room-nights were reserved through Booking’s platforms in the first nine months of 2019.
5. A proven ability to grow
The table below shows Booking’s important financials from 2007 to 2018:
Source: Booking annual reports
A few key points about Booking’s financials:
Revenue has compounded impressively at 23.6% per year from 2007 to 2018; over the last five years from 2013 to 2018, the company’s annual topline growth was slower but still strong at 16.4%.
The company also managed to produce strong revenue growth of 33.8% in 2008 and 24.0% in 2009; those were the years when the global economy was rocked by the Great Financial Crisis.
Net profit has surged by 35.7% per year from 2007 to 2018. Like revenue-growth, Booking’s net profit growth from 2013 to 2018 is slower, but still healthy at 16.1%.
Operating cash flow has not only grown in each year from 2007 to 2018. It has also increased markedly with annual growth of 37.9%, and been consistently positive. The growth rate from 2013 to 2018 was considerably slower at 18.3% per year, but that is still a good performance.
Free cash flow, net of acquisitions, has consistently been positive too and has also stepped up from 2007 to 2018 at a rapid clip of 38.9% per year. The annual growth in free cash flow from 2013 to 2018 was 19.7% – not too shabby. Booking’s free cash flow fell dramatically in 2014 because it acquired OpenTable for US$2.4 billion during the year.
The net-cash position on Booking’s balance sheet was mostly positive. I include Booking’s investments in bonds and debt as part of its cash, but I exclude the company’s strategic investments.
Dilution has also been negligible for Booking’s shareholders from 2007 to 2018 with the diluted share count barely rising in that period.
2019 has so far been a relatively tough year for Booking. Revenue was up by just 3.7% to US$11.7 billion in the first nine months of the year. Adverse currency movements and a decline in the average room-rate had dented Booking’s top-line growth. Profit inched up by just 0.9% year-on-year to US$3.28 billion after stripping away non-core profits. Booking has strategic investments in other companies and some of them are listed; accounting rules state that Booking has to recognise changes in the stock prices of these companies in its income statement. A 9.4% reduction in the company’s diluted share count to 43.9 million resulted in adjusted earnings per share for the first nine months of 2019 climbing by 11.4% to US$74.52 from a year ago. Operating cash flow declined by 11.0%, but was still healthy at US$3.8 billion. Free cash flow was down 6.9% to US$3.5 billion. The balance sheet, as mentioned earlier, remains robust with cash and investments (excluding the strategic investments), slightly outweighing debt.
Booking has an impressive long-term track record of growth, so I’m not concerned with the slowdown in 2019 thus far. The market opportunity is still immense, and Booking has a very strong competitive position with its huge network of accommodations spanning large hotel chains to unique places to stay.
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 Booking excels in this criterion.
Firstly, the company has done very well in producing free cash flow from its business for a long time. In the past five years from 2013 to 2018, its average free cash flow margin (free cash flow as a percentage of revenue) was strong at 26.5%. Booking’s free cash flow margin was 29.8% in the first nine months of 2019.
Secondly, there’s still tremendous room to grow for Booking. This should lead to higher revenue for the company 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 Booking in the future.
Valuation
I like to keep things simple in the valuation process. In Booking’s case, I think the price-to-free cash flow (P/FCF) ratio is a suitable gauge for the company’s value for two reasons: (1) The online travel company has a strong history of producing positive and growing free cash flow; and (2) the company’s net profit is muddied by the inclusion of changes in the stock prices of its strategic investments.
Booking carries a trailing P/FCF ratio of around 20 at a share price of US$1,990. This ratio strikes me as highly reasonable when we look at the company’s excellent track record of growth, strong network of accommodation options across its websites, and opportunities for future expansion in its business. Moreover, this P/FCF ratio is low when compared to history. The chart below shows Booking’s P/FCF ratio over the past five years.
The risks involved
Every company has risks, and Booking is no exception. There are a few key ones that I see.
The first is management turmoil. I have confidence in the quality of Booking’s current leaders. But the company has seen some management shake-ups in recent years.
Earlier, I mentioned that current Chairman Jeffrey Boyd had to become interim CEO in April 2016 (till December 2016). That’s because the then-CEO of both Booking and Booking.com (Booking.com is the main brand of Booking the company), Darren Huston, stepped down from his roles in the same month after he was caught in a relationship with an employee. He was promoted to CEO of Booking only in January 2014. Gillian Tans, a long-time Booking employee, assumed the position of CEO for Booking.com right after Huston’s departure. But she was replaced by Glenn Fogel after just over three years (Fogel is now the CEO of both Booking.com and Booking the company). Booking’s current CFO, David Goulden, stepped into his current role only in January 2018 after long-time CFO Daniel Finnegan announced his retirement in 2017. The good thing is that Booking can still benefit from Boyd’s experience, and Fogel has a long tenure with the company. I will be keeping an eye on leadership transitions at Booking.
The second risk involves downturns in travel spending. Travellers could tighten their purse strings in the face of a global recession or slowdown in economic growth, for instance, since travel can be considered a discretionary activity. The good thing here is that Booking managed to post significant growth during the Great Financial Crisis. But the company’s much larger today, so it may not be able to outrun a future recession as it has in the past.
Another potential important reason for consumers to travel less will be outbreaks of contagious diseases. The world – particularly China – is currently battling COVID-19. If the situation worsens, Booking’s business could be hurt. The good thing with such cases is that the idea of “This too, shall pass” applies. Natural disasters could also dent travel spending. In 2010, the Icelandic volcano Eyjafjallajökull erupted. Many flights that involved Europe were disrupted for a period of time, and the episode was a speed bump for Booking. The clouds eventually cleared for the company, but there could be similar instances in the future.
The last important risk I see with Booking relates to competition. In 2018, Google launched Google Hotels, its search product that focuses on – you guessed it – hotels. As a result, travel websites such as Expedia and TripAdvisor started feeling the heat from Google. This is what Skift reported in a November 2019 article:
“The fact that Google is leveraging its dominance as a search engine into taking market share away from travel competitors is no longer even debatable. Expedia and TripAdvisor officials seem almost depressed about the whole thing and resigned to its impact…
… Both Okerstrom [Expedia CEO] and Kaufer [TripAdvisor CEO] complained that their organic, or free, links are ending up further down the page in Google search results as Google prioritizes its own travel businesses.”
This is where Booking’s huge spending on performance marketing and pivot toward brand marketing comes into play. Booking has been spending billions of dollars on performance marketing, most of it likely on Google Search – this stands in contrast to Expedia and TripAdvisor, which have relied more heavily on free search results from Google. So I believe that Google and Booking currently have a frenemy type of relationship – both rely on each other for business but are also somewhat competitors. But if Booking is successful in building its brand and mindshare among travellers through its brand marketing initiatives, there will be a lot less reliance on Google, thereby lessening the threat of the online search giant.
AirBnB, with its focus on alternatives to hotels, could also be a formidable threat for Booking. Moreover, AirBnB has been making inroads into the hotel-reservations business, such as its acquisition of HotelTonight in March 2019. But like I mentioned earlier, Booking has its own huge and growing supply of hotel-alternatives for travellers to choose from. Ultimately though, I believe that online travel is such a huge pie that multiple winners can exist – and Booking is likely to be one of those.
Meanwhile, in Booking’s latest quarterly earnings report, it also listed other internet giants besides Google – the list includes Apple, AliBaba, Tencent, Amazon, and Facebook – as potential competitors with significant resources to mount a serious assault on the company’s business. So far, Booking has held its own. But it is always possible that another company might build a better mousetrap in the future.
A smaller risk that I perceive relates to Booking’s multi-billion stakes in the Chinese companies, Meituan Dianping, Trip.com, and Didi Chuxing. Booking’s investments in them are based on a variable interest entity (VIE) structure, which is considered to be common with Chinese internet companies. But there’s a risk that China’s government may someday view the VIE structure as a violation of China’s laws.
The Good Investors’ conclusion
I think the online travel market holds immense opportunities for companies, especially for an organisation with a wide network of hotels and alternative accommodations, such as Booking, for instance.
Furthermore, Booking has a robust balance sheet, a proven ability to generate strong free cash flow, high levels of recurring revenues, and an excellent management team whose interests are aligned with shareholders. Booking’s P/FCF ratio is also low in relation to its own history.
Every company has risks, and I’m aware of the important ones with Booking. They include recent management turmoil, competition from Google and other tech players, and a few factors that could dampen travel spending. But after weighing the risks and rewards, I’m more than happy for my family’s investment portfolio to continue flying high with Booking.
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 human tragedies of the novel coronavirus (2019 n-CoV) are painful. But as investors, there’s no need to panic if we’re investing for the long run.
As I write this, the novel coronavirus (2019-nCoV) has infected 43,103 people globally and caused the deaths of 1,018 people. China has been the hardest-hit country, accounting for the lion’s share of the infected cases (42,708) and deaths (1,017).
This disease outbreak has already caused plenty of human suffering, especially in China. No one knows how widespread the 2019-nCoV will become around the world. The eventual impact of the virus on the global economy is also impossible to determine. If you’re an investor in stocks in Singapore and/or other parts of the world, it’s understandable to be worried.
A look at the past
But in times like these, we can look at history to soothe our fraying nerves. This is not the first time the world has fought against epidemics and pandemics. If you’re curious about the difference, this is the definition given by the CDC (Centres for Disease Control and Prevention) in the US:
“Epidemic refers to an increase, often sudden, in the number of cases of a disease above what is normally expected in that population in that area… Pandemic refers to an epidemic that has spread over several countries or continents, usually affecting a large number of people.”
My blogging partner, Jeremy, included the chart below in a recent article. The chart illustrates the performance of the MSCI World Index (a benchmark for global stocks) since the 1970s against the backdrop of multiple epidemics/pandemics. He commented:
“As you can see from the chart… the world has experienced 13 different epidemics since the 1970s. Yet, global stocks – measured by the MSCI World Index – has survived each of those, registering long term gains after each outbreak.”
The chart does not show what happened to stocks in the 1910s and 1920s. In 2009, the H1N1 pandemic arose (this is covered in the chart), but it was not the first time the virus had reared its ugly head. The first H1N1 pandemic lasted from 1918 to 1920. The first outbreak infected 500 million people worldwide, of whom 50 million to 100 million died. It was a dark age for mankind.
A tragedy for us, a normal time for investing
But from an investing perspective, it was a normal time. Data from Robert Shiller, a Nobel Prize-winning economist, show that the S&P 500 rose 10% (after dividends and inflation) from the start of 1918 to the end of 1919. From the start of 1918 to the end of 1923 – a six-year period – the S&P 500 rose 48% in total (again after dividends and inflation), for a decent annual gain of 6.8%. There was significant volatility between 1918 and 1923 – the maximum peak-to-trough decline in that period was 30% – but investors still made a respectable return.
I wish I had more countries’ stock market data from the 1910s and 1920s to work with. But the US experience is instructive, since some historical accounts state the country to be the source of the 1918-1920 H1N1 pandemic.
I’m not trying to say that stocks will go up this time. Every point in history is different and there’s plenty of context in the 1910s and 1920s that’s missing from today. For example, in December 1917, the CAPE ratio for the S&P 500 was 6.4; today, it’s 32. (The CAPE ratio – or cyclically-adjusted price-to-earnings ratio – is calculated by dividing a stock’s price with its average inflation-adjusted earnings over the past 10 years.) The interest rate environment was also drastically different then compared to now.
There are limits to the usefulness of studying history. But by looking at the past, we can get a general sense for what to expect for the future. And history’s verdict is that horrific pandemics/epidemics have not stopped the upward march of stocks around the world.
The Good Investors’ take
The human tragedies of a virus outbreak like what we’re experiencing now with the 2019 n-CoV are painful. But as investors, there’s no need to panic if we’re investing for the long run – which is what investing is about, in the first place – and assuming our portfolios are made up of great companies.
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.
A paradigm shift may be happening soon in the financial markets, according to Ray Dalio. But there’s one thing that won’t change.
Ray Dalio published an article in July 2019 that captured plenty of attention from the investment industry. When Dalio speaks, people listen. He is the Founder, Chairman, and Co-Chief Investment Officer of Bridgewater Associates, an investment firm that is currently managing around US$160 billion.
The times they are a-changin’
In his article, Dalio shared his view that a paradigm shift will soon occur in financial markets. He defines a paradigm as a long period of time “(about 10 years) in which the markets and market relationships operate in a certain way.”
The current paradigm we’re in started in late 2008/early 2009, according to Dalio. Back then, the global economy and stock market reached their troughs during the Great Financial Crisis. The paradigm was driven by central banks around the world lowering interest rates and conducting quantitative easing. The result is we’re now in a debt-glut, and a state of “relatively high” asset prices, “low” inflation, and “moderately strong” growth.
Dalio expects the current paradigm to end soon and a new one to emerge. The new paradigm will be driven by central banks’ actions to deal with the debt-glut. Dalio thinks that central banks will be doing two key things: First, they will monetise debt, which is the act of printing money to purchase debt; and second, they will depreciate currencies. These create inflation, thus depressing the value of money and the inflation-adjusted returns of debt-investors. For Dalio, holding gold is the way for investors to navigate the coming paradigm.
Plus ça change (the more things change)…
I don’t invest based on paradigm shifts, and I’m definitely not abandoning stocks. In fact, I prefer stocks to gold. Stocks are productive assets, pieces of companies that are generating cash flows. Meanwhile, gold is an unproductive asset which just sits there. Warren Buffett explained this view better than I ever can in his 2011 Berkshire Hathaway shareholders’ letter:
“Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.
What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth – for a while…
… Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At [US]$1,750 per ounce – gold’s price as I write this – its value would be [US]$9.6 trillion. Call this cube pile A.
Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about [US]$200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than [US]$40 billion annually). After these purchases, we would have about [US]$1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with [US]$9.6 trillion selecting pile A over pile B?
Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about [US]$160 billion. Buyers – whether jewelry and industrial users, frightened individuals, or speculators – must continually absorb this additional supply to merely maintain an equilibrium at present prices.
A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.
Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the [US]$9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.”
…plus c’est la même chose (the more they remain the same)
But Dalio’s opinion on a coming paradigm shift led me to an inverted thought: Are there things that don’t change in the financial markets? Inverting is a powerful concept in both business and investing. Here’s Jeff Bezos, founder and CEO of US e-commerce giant Amazon, on the topic (emphases are mine):
“I very frequently get the question: “What’s going to change in the next 10 years?” And that is a very interesting question; it’s a very common one. I almost never get the question: “What’s not going to change in the next 10 years?” And I submit to you that that second question is actually the more important of the two — because you can build a business strategy around the things that are stable in time…
…[I]n our retail business, we know that customers want low prices, and I know that’s going to be true 10 years from now. They want fast delivery; they want vast selection. It’s impossible to imagine a future 10 years from now where a customer comes up and says, “Jeff, I love Amazon; I just wish the prices were a little higher.” “I love Amazon; I just wish you’d deliver a little more slowly.” Impossible.
And so the effort we put into those things, spinning those things up, we know the energy we put into it today will still be paying off dividends for our customers 10 years from now. When you have something that you know is true, even over the long term, you can afford to put a lot of energy into it.”
My inverted-thought led me to one thing that I’m certain will never change in the financial markets: A company will become more valuable over time if its revenues, profits, and cash flows increase faster than inflation. There’s just no way that this statement becomes false.
But there’s a problem: Great companies can be very expensive, which makes them lousy investments. How can we reconcile this conflict? This is one of the hard parts about investing.
The tough things
Investing has many hard parts. Charlie Munger is the long-time sidekick of Warren Buffett. In a 2015 meeting, someone asked him:
“What is the least talked about or most misunderstood moat? [A moat refers to a company’s competitive advantage.]”
Munger responded:
“You basically want me to explain to you a difficult subject of identifying moats. It reminds me of a story. One man came to Mozart and asked him how to write a symphony. Mozart replied: “You are too young to write a symphony.” The man said: “You were writing symphonies when you were 10 years of age, and I am 21.” Mozart said: “Yes, but I didn’t run around asking people how to do it.””
I struggle often with determining the appropriate price to pay for a great company. There’s no easy formula. “A P/E ratio of X is just right” is fantasy. Fortunately, I’m nothelpless when tackling this conundrum.
“Surprise me”
David Gardner is the co-founder of The Motley Fool and he is one of the best investors I know. In September 1997, he recommended and bought Amazon shares at US$3.21 apiece, and has held onto them since. Amazon’s current share price is US$2,079, which translates into a mind-boggling gain of nearly 64,700%, or 33% per year.
When David first recommended Amazon, did it ever cross his mind that the company would generate such an incredible return? Nope. Here’s David on the matter:
“I assure you, in 1997, when we bought Amazon.com at $3.21, we did not imagine any of that could happen. And yet, all of that has happened and more, and the stock has so far exceeded any expectations any of us could have had that all I can say is, no one was a genius to call it, but you and I could be geniuses just to buy it and to add to it and to hold it, and out-hold Wall Street trading in and out of these kinds of companies.
You and I can hold them over the course of our lives and do wonderfully. So, positive surprises, too. Surprise.”
There can be many cases of great companies being poor investments because they are pricey. But great companies can also surprise us in good ways, since they are often led by management teams that possess high levels of integrity, capability, and innovativeness. So, for many years, I’ve been giving my family’s investment portfolio the chance to be positively surprised. I achieve this by investing in great companies with patience and perseverance (stocks are volatile over the short run!), and in a diversified manner.
It doesn’t matter whether a paradigm change is happening. I know there’s one thing that will not change in the stock market, and that is, great companies will become more valuable over time. So my investing plan is clear: I’m going to continue to find and invest in great companies, and believe that some of them will surprise me.
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.
