Endowus’s Fight To Give A Better Retirement For Singaporeans

We recently spoke to Singapore-based roboadvisor Endowus and learnt about its desire to solve Singapore’s retirement problem and so much more.

On 13 March 2020, Jeremy and I met Samuel Rhee and Chiam Sheng Shi from Endowus for a long, lovely chat. Sam is Endowus’s Chief Investment Officer, while Sheng Shi is the company’s Personal Finance Lead.

(From left to right in the photo above: Jeremy, myself, Sam, and Sheng Shi)

Endowus is one of the roboadvisors participating in Singapore’s burgeoning fintech landscape. I first came across Endowus about a year ago and was interested to learn more. That’s because the roboadvisor was (and still is) partnering Dimensional Fund Advisors, a fund management company I have long admired for its investing discipline and overall conduct.

Sheng Shi came across The Good Investors recently and reached out to Jeremy and I to find out more. This led to the in-person meeting on 13 March 2020.

Jeremy, Sam, Sheng Shi, and I covered a lot of ground during our conversation. We talked about Endowus’s founding, its investment philosophy, the company’s strong desire to solve the retirement problem for Singaporean investors, the obstacles it had to overcome to build low-cost investment solutions for investors, and more.

I came away from the meeting impressed by Endowus’s team as well as their passion and actions to help investors in Singapore. Jeremy did too. We are all fighting the same good fight. Below is a transcript of our conversation (edited for length and clarity). This is NOT a sponsored post by Endowus. Jeremy and I hope you will enjoy Sam and Sheng Shi’s wisdom and candid sharing as much as we did.


Introduction of Sam and Endowus

Ser Jing:
Could you please give an introduction about yourself?

Samuel:
Okay. I’m Sam. I’ve been working 25 years in the finance industry on the institutional side. I was at Morgan Stanley for 17 years. And the last job I had was at Morgan Stanley Investment Management Asia where I was CEO and CIO and I was there for 13 years. I worked in London and then Hong Kong for about seven years and I’ve now been in Singapore for 15+ years. When I was on the buyside, I did macro, asset allocation, portfolio construction in public equities and mostly Asia and emerging markets. I became the Chief Investment Officer and ran the money in Singapore. Singapore is the headquarters so we ran about 45 billion total. The portfolio that I personally managed was about US$10 billion to US$15 billion, depending on how markets were and I became the CEO for the last four years I was there.

I am the Chief Investment Officer in Endowus. We have this fancy title called Chairman that was bestowed upon me that I don’t really use but it’s there just because I’m the oldest by far.

Ser Jing:
You look really young actually.

Samuel:
Yeah, I’m turning 48. So the next youngest guy is 11 years younger than me in the office.

Ser Jing: You look 40, at most!

Samuel:
I have a babyface (laughs)! I call it the gift of immaturity. I started in ‘94. So I’ve seen many crises. ‘94 was a bad year. ‘97 was the Asian financial crisis. In ‘99 I saw the tech bubble bursting. 2008 was the financial crisis. Then the 2011 Euro crisis. Now we’ve come here and in the midst of another bear market, and we are experiencing 30% falls, which is unprecedented in nature.

Ser Jing:
In terms of the speed, right?

Samuel:
Yeah, we’re at the very early stages of the unfolding of this bear market but it’s unprecedented in speed and that’s because of the nature of the external shock we are facing. We don’t really know how this goes.

Anyway, back to the introduction! I am in charge of the investment office. I strategize the overall investment framework, the investment philosophy, how we execute on that through the best products. So we’re completely product agnostic – we use whatever product is most suitable and cost efficient for our clients, whether it’s unit trusts or ETFs. We are an independent fee-only financial advisor. That’s the constraint that we have put upon ourselves because we don’t want to be paid by anybody else other than the client.

When you define yourself as a fee-only independent financial advisor, the products that are available to you are tremendous. We went with the best passive or passive-plus product, which was Vanguard and Dimensional Fund Advisors. Vanguard was a strategic partner. We were supposed to do work together, but they pulled out of Singapore a few months before we launched. So that was the story. We were excited to launch with Dimensional as it can only be made available through the IFA (independent financial advisory) channel. On the fixed income side we did not like any existing solutions and there were no decent passive products because of the small SGD fixed income market here so we chose the best manager which was PIMCO, which is very well known by institutional clients but not readily available to retail investors. 

Ser Jing:
Not even Dimensional for the bonds portion? Because I think MoneyOwl uses them.

Samuel:
They have a short duration and short fixed income product, which is not globally diversified. We want a globally diversified core fixed income product. Dimensional products are suited for what they’re supposed to do, which is short term or short duration and they have other great products that we are trying to bring in.

Ser Jing:
Close to a money market fund?

Samuel:
I think it’s exactly what it is. Short duration and ultra high quality, you know, AA, AAA, treasuries, and sovereigns. And so I think there’s not much credit, not much high yield or emerging markets. I don’t think there’s any, and the term is just really short duration, so short fixed income products. Not global or through the duration spectrum.

We talked to Dimensional about requirements for a core fixed income product and they introduced a fund for us – a global quality bond fund. Unfortunately, their track record is really short. They just launched it last year with a Singapore dollar share class and we are looking to bring that into our portfolio so we are excited about that. 

To be honest, in fixed income, active management is not as sinful as equities. Even in equities, I’ve been an active manager so I know that if you do it well you can do well. It’s just that for the average Singaporean investor, can you do it well? If you are a really long term investor, especially with your CPF money, can you do it well and with the transaction costs and limitations involved?

That’s the elephant in the room: Are there enough guys that are delivering consistent returns over the long run net of fees, for CPF and SRS/cash investment? I have outperformed for eight consecutive years as an active manager. I know it can be done. I’ve seen many people around me do it.

We talk about Warren Buffett, Soros, Julian Robertson, and all these guys. They’ll say it’s possible but net of fees, it is difficult. And most retail investors don’t have access. Last year the top five hedge fund managers in the world got paid over a billion. Four of them underperformed the index I think. This doesn’t make sense, this kind of concept. Warren Buffett is actually supportive of the strategy of just buying an index fund. Passive low cost works over the long term. So why fix something that’s not broken?

Endowus’s investment philosophy and how Endowus is different from the rest

Ser Jing:
All good! So next question: What is your investment philosophy like and has it evolved across the years?

Samuel:
Let’s talk about the Endowus investment philosophy. We are trying to build an investment product that is suitable for 90%-plus of Singapore’s population and suitable for investors’ CPF money, long term, for their retirement goals. That’s the primary raison d’etre. The reason for our existence is to solve this generational problem, the retirement pension shortfall. And if you try to do that in Singapore, you can’t do that without CPF cause it’s such a big piece. It’s 37% of your gross monthly income. We can invest that better for Singaporeans. What we want to do is find and build an investment that is suitable for that particular problem.

We want to build a core investment product suitable to everyone, where they can invest 90-100% of their wealth conveniently, securely and in a low cost manner. When I say core, I mean the product that will build upon your long term sustainable returns based on equities and bonds, equities being the riskier growth asset class, which gives you the long term returns. And bonds being your diversifier and stable returns over time.

People compare us with other robo advisors/online platforms and they say we’re active managers and they criticize us for it. I would say that asset allocation (across different asset classes) take precedence over fund choices. The asset allocation has to be strategic and passive. That’s our philosophy. The problem with a lot of robo guys here is that they’re active asset allocators. As an institutional investor, I know that asset allocation represents 80% to 90% of your returns historically depending on the period. You need a strategic long term passive asset allocation and these guys are doing active management based on their whitepapers with backtested numbers which are not real track records. Fundamentally our asset allocation investment philosophy diverges.

The second thing is that we are really focused on the advice piece. We’re not building a product ourselves like the other Robos. We have lots of product guys (fund managers) like Dimensional or Vanguard and so many thousands of managers out there building great products and they have scale. They have expertise and they can build up much better than us.

So for us, we don’t want to focus on the product. We’re not building a product, we’re not competing with any fund managers. So later on, if those (active allocation) guys do fantastically well, they can be on the Endowus platform and they can build it into a portfolio or offer it as a DIY solution. 

It has to be strategic asset allocation. And in the execution of that asset allocation, we find the best product and we are agnostic to the structure. It can be an ETF or mutual fund. It doesn’t matter. It’s still the same funds that Vanguard has, say the S&P 500 fund, and Irish domiciled so it is tax efficient. It is the same product. The ETF and the fund are largely the same and we choose the more cost efficient and provide SGD funds as investors should match their assets and liabilities to SGD which is the home currency without taking unnecessary FX risk.

So basically ETFs are just listed and mutual funds are not but they have the same open-ended structure, same fund and cost structure. So this misunderstanding in the market that ETFs are the only way to be low cost, passive, and indexed is wrong. You can be none of those things for ETFs.

An ETF can be actively managed, high cost, and not indexed. So it doesn’t matter that it’s an ETF. You have to look at the underlying fund, what you’re investing in, right? Is it indexed? Is it passive, is it low cost? That’s what we apply. And sometimes ETFs are more expensive than accessing the mutual fund and mutual funds at institutional rates.

As an institutional investor, I know there’s access to funds at a lower cost. If you are an institution you don’t pay all the fees that people talk about. So what Endowus is doing is saying that as an institution we can group-buy for you.

How Endowus chooses the best investment products for investors

Ser Jing:
Why do you choose the funds that you do and not some of the ETFs in the US?

Samuel:
Now one of the problems with the US ETF fund is US dollars. That’s a problem for Singapore investors. Finance 101 is you need to match your assets with liabilities, including your FOREX liability. You should not be taking needless FX transactions when you invest, especially if the FX transaction cost is high like it is in Singapore for a retail investor.

When you convert SGD to USD, taking a hit there in terms of cost and then investing in USD, being exposed to that, and then later on having to bring it back at whatever exchange rate you don’t know. Then you go to the US and you have withholding tax and other things like inheritance tax issues. Bid-ask spreads on certain ETFs, you know, are another 5-10 basis points, which means you lose some when you hit the offer to buy and then again when you hit the bid to sell. This compares to mutual funds that will always be bought and sold on the same NAV [net asset value] and so no spread and no transaction cost, whereas ETFs have brokerage and transaction costs.

So we looked at all these things and concluded that US ETFs are really expensive and are not competitive for non-US investors. SGX-listed ones are in USD too and have huge bid-ask spreads. So for me after assessing the situation and products, we decided to go with Dimensional and PIMCO for our cash products. And for CPF products, we got the first passive Vanguard funds in there. Two of them exclusive to Endowus clients. Being agnostic to products is really important for us to change products if we find better, more efficient products.

We sourced for the best products most suitable for Singaporeans that are tax-efficient. It’s in SGD or in the case of fixed income, it is hedged to the SGD. For example, we are the ones that actually brought in the Dimensional World Equity product into Singapore. They didn’t have a World Equity Fund here, they didn’t have an SGD fund. We seeded and funded it. Before, it wasn’t available.

We also went to PIMCO and said, “Look, you have a global emerging market fund, but there’s no institutional share class and it is not SGD-hedged. Launch it for us and we’ll seed it and we’ll bring it our platform. We want to give it to Singaporean investors” They gave us some conditions and we know we want to do whatever it takes to bring the best product that we ourselves want to invest in. Within three, four weeks it was done. We seeded the SGD-hedged, institutional share class ourselves, and made it available to our clients on our advised portfolios.

So those are the kinds of solutions that we bring to the table, which is very different from everybody else. This is very different from trying to copy the US Robo model, which is to just buy US ETFs, pick off the list, try to get a tax refund later. In our view, this model is very, very fin-light. We pride ourselves in not only being Deep Tech, but also Deep Fin.

Endowus’s bootstrapping and employee-ownership mindset

Ser Jing:
How did Endowus gain the necessary initial capital to work with PIMCO and Dimensional Fund Advisors to seed the funds?

Samuel:
Okay. So the company is partner-funded and employee-owned. So everybody who’s an employee has the opportunity to invest in the company and they do. All of the employees are shareholders and we don’t have any external shareholders now. No VCs or PEs. The partners put up the money to begin the company. Employees put money in too. And the last round that we did, we didn’t even have room for all advisors who want to invest because employees take precedence. That’s how we structured the company. Its called bootstrapping and we’re bootstrapping not only in reality but in terms of our culture as well. That’s how we like it.

Endowus’s partnership with fund managers to bring the best products for investors to investors

Samuel:
And when we go to fund management companies, there is a language most people don’t know how to speak but I do. Fund managers actually are in a tough spot today because passive is taking over active. It’s a hugely competitive space as well. Think about the number of fund managers out there. They’re not future-proofed or prepared for the future. But if you go to them and make a proposition of what Endowus is about, why our values are aligned. We tell them that we’re going to gather assets and then we’re going to put it into the best products like theirs. Their response is immediately “Great. We’d love to work with you. What do you need?” Because for them, we are a digital asset gatherer and we’re free.

But we’re not a Fundsupermart. We’re not just going to put it on the platform. We’re actually gonna screen and go and get the best funds and provide the best-in-class funds at the lowest cost achievable by working with the fund managers directly.

Protecting investors’ interests, and Endowus’s unique cost-rebates to investors

Ser Jing:
You also direct the money into specific funds and don’t charge a trailer fee.

Samuel:
Yes. I mean the trailer fee, the fund manager doesn’t get, we don’t get it, so in our business model everyone’s interest is completely aligned. It’s the distribution guys like the traditional banks and brokers and platforms like iFast who take all of that. It should go to the client but these distribution and platform guys are taking it and lining their pocket. And the fund managers have to pitch and sell to the banks and platforms and brokers – the traditional distribution channels. It’s precisely why Vanguard gave up and left Singapore as they don’t pay trailer fees and it was impossible to get distributed.

The worst problem though is that it is in the end, the investors who get screwed because the best-in-class funds are often under the radar or not available. Vanguard’s best low cost passive funds are not available to retail investors! So the best funds are funds who are not willing to pay high or any trailer fees. Dimensional and Vanguard by philosophy would never pay trailer fees. And we as a philosophy would never take any. Unlike the iFast, Dollardex, DBSs of the world.

Ser Jing:
And I think Dimensional recently struck a deal with Finexis Advisory.

Samuel:
Actually they supply to a bunch of FAs [financial advisors] offline. They have no problem. They just distribute through financial advisors and not directly to retail or through traditional channels. So they have their own model, which is unique.

Vanguard doesn’t do the FA model. Dimensional started and really grew through FAs in the US. It works here as well although it’s not a huge pool but it’s still decent. So Dimensional is slightly different from Vanguard and that’s why they didn’t pull out.

But good fund managers, in general, are very happy to work with us. They don’t want to pay trailer fees anyway. Especially if you are the best quality or best performing. And so it’s perfectly aligned. So we go to them, we speak their language, we tell them why and we tell them there’s nothing in it for us and they just give us the best funds. We partner strategically with all the major fund managers. We have a great relationship with everybody.

We don’t carry everybody’s product. We don’t carry Aberdeen, Standard Life. You know, we don’t carry Wellington, GMO, Pinebridge. All these guys reach out to me and we keep a good relationship because we are always searching for best-in-class products, the most suitable product for Singapore. We will also provide more funds in the future through new services that we have in plan. It will really help investors with better choice, better advice and better price too! 

If someone can come up with a better product, we’ll work with them. Amundi for example. We’re doing some work, looking for products – even on the ETF side as they are a leader in ETF cost. That’s the Endowus investment philosophy. Fund due-diligence, fund manager due-diligence, that’s like a lot of the work. We have to screen for the best funds. We have to creatively think about what product is best suited to represent. So if you do an asset allocation and you allocate to a different market, geographically, Global, DM [developed markets], EM [emerging markets], then you try to find the best fit and we don’t want to do specific things like China and Malaysia funds, but more like big blocks that make sense. And you bring it up to an asset allocation that is passive and strategic.

Endowus’s efforts to lower costs for investors

Jeremy:
Is there a criteria that you use to select funds? For instance do the funds you select have a maximum management fee?

Samuel:
So we target all-in fees of 1% or less including our own advice access fee. Our fees are fixed. So for cash, it is 60 basis points [0.60%] going down to 0.25% depending on how much you invest with us. For the CPF and SRS it’s 0.4%. We said from the get-go, “Look, this is retirement, this is helping people’s future and therefore let’s try to start at the lowest possible.” And also it was influenced by the fact that CPF had already announced that their wrap fees are going to go down to 40 basis points by October 2020 and it was at 70 basis points at the moment and 1% before. So we moved way ahead of the curve last year. They delayed that announcement, but we still went with 0.4%. You don’t know if they’re going to execute, but hopefully, they will. But even if they don’t, that’s fine. Then everybody can invest through Endowus!

So 40 basis points. We started with a flat 40 basic fee and we target only an additional 60 basis points total expense ratio for the portfolio. But we couldn’t get them for CPF. There weren’t enough products because CPF has to include the funds and you have to go through a consultant, Mercer, in the process. It takes at least like six, nine months to go through that. And strict definitions of three-year track record, first quartile performance, et cetera, and bonds, even more onerous. And so there are only like 80 funds left on the CPF list and we couldn’t build a very high quality globally diversified low-cost portfolio. So we fixed the low-cost part by thinking creatively again.

Would you believe CPF doesn’t have a single passive fund or global ETF you can access?

Ser Jing:
I did not realise that.

Samuel:
You can only access the Singapore local ETF. And so it’s STI [Straits Times Index] and ABF Singapore Bond ETF and that’s it. So you can’t build a globally diverse portfolio. How do we fix this?

So we went to Vanguard and met with the CEO Charles Lin at the time, and Gerard Lee the CEO of Lion Global. I asked them to help solve the retirement problem here in Singapore together. We gotta fix the CPF issues of high cost, lack of passive product,  and we can do it together. So they already have a product. Vanguard supplies and manages the Infinity Series S&P500 and global equities and so we worked together to get it into the CPF-IS included fund list.

The problem though was that the cost of that fund was too high. The headline expense ratio was like 80 basis points and which included a trailer fee and the distribution was charging a sales charge on top of like 1% or more. We felt that that was ridiculous. We wanted to get it cheaper. They initially offered a standard rebate but we needed to get lower to achieve the lowest cost for CPF members and long term investors. So we pushed them until they agreed to get to a really low number. So in the end Vanguard gave us access at 10bps [basis points] and Lion Global’s wrap went down to just 20bps. We are so grateful for their support. They’ve been very value-aligned and tried really hard to get there with us. So total all-in management and wrap were 30 basis points and including expense ratio, gets to closer to 40bps. Compared to the 80bps and 1% sales charge, it’s a meaningful difference to give people a better chance of succeeding in investing. They denominated it in SGD, locally registered, and also put into CPF-IS. And you can’t get that with even cash ETF access, you know? If you look at it from a total all-in cost angle, it’s certainly so much cheaper than US ETFs.

Ser Jing:
This is off the track but I am actually a little bit confused. Why would Lion Global’s wrap services be needed? There seems to be a more elegant solution where Vanguard could just supply it directly?

Samuel:
Well, first of all they pulled out of Singapore. So the plan was for them to do that. In order to do that they have to be qualified for two things. One is they have to be a locally registered licensed retail fund manager, RLFMC, right? So they have to be a registered licensed fund manager. Secondly, they have to be an approved fund manager on the CPF Investment Scheme. So that’s the second step and the third step is you have to get your fund onto the CPF approved list. So there’s three steps and the moment Vanguard pulls out, they can’t do that.

So Lion Global is locally registered as a retail licensed fund manager. They’re approved by CPF as a CPF Investment Scheme fund manager. And the only thing that was left was for them to put it (the Vanguard S&P 500 fund) onto the CPF system. Because they were no longer there, so we needed to put it back and then fix the cost issue. Also, the underlying Vanguard funds do not have an SGD fund. This is the only SGD fund available.

So there was a new guideline that was introduced by CPF Board just as the first passive fund went in that there will be a cap of 50 basis points. That’s the total expense ratio. We are hoping that the total expense ratio will be a single digit fee expense ratio, so our total expense ratio (including the fund management fee) will be 40 or below 50, all in.

So now it’s in, but it’s only allowed and falls below the 50bps guideline because Endowus introduced the industry-first of giving back 100% rebate of trailer fees. So technically the product is still 57.5, but we give 27.5 rebate to get to that 30 basis point management and 40 TER. So it’s well below 50 and a second passive fund that we just put in is the Global Equities fund. So the Vanguard Global Equities. Similarly 18 basis points that Vanguard takes, 20 for Lion Global, and expense ratio of single digit, so all in its less than 48bps TER. So again below 50. So we’re the only ones who can distribute these as the official TER is higher and no one else rebates 100% of the trailer. So that’s the elegant solution. We looked into getting the institutional ones in but we couldn’t. So we tried to still solve it intelligently by putting another product in at low cost.

So those are the things that we could do to improve the product. So those two funds are passive. They are the first two passive funds in CPF and it is part of our portfolio. The only way to access it (for your CPF) is through Endowus. It (the two index funds) makes up the bulk of the equities allocation, which brings down cost dramatically from what we had before and it’s also available for Cash and SRS if you want to at that lower cost too.

Jeremy:
So for the two indexed funds, your clients are paying a 0.9% total expense ratio?

Samuel:
No, the total expense ratio is a concept that exists at the fund level. So that TER is 0.4% and 0.48% for the two funds – below 0.5%. So we’ve included both funds into our globally diversified portfolio. The whole list of funds will be allocated based on your risk appetite. Whether its 100% equity or 60% equity and 40% bonds, or whatever, we will build our globally diversified portfolio. The portfolio fund level fees (the TERs I mention above) vary depending on the risk level you choose, but effectively your all in total cost of investing in Endowus is less than 1%. For CPF and SRS it’s 0.4% to Endowus for all of our advice and access. Then the fund level underlying fee is 50~60bps. Yeah. So especially if you consider the fact that if you try to build that yourself, like right now through iFAST, everything, it’s probably closer to 2%-3% because you have the platform fee and the trailer fee that they take.

Sheng Shi:
We are definitely the lowest cost platform. Even if you get through Fund Supermart, they charge a platform fee. I looked up the cost of buying the same Infinity fund on iFast and they charge 35bps of platform fees on top of the trailer fees they receive which should be at least 27.5bps. So they are getting 62.5bps of fees for just selling a Vanguard passive fund.

Endowus’s founding and how the founders built the team

Ser Jing:
So the next question is how did you and the rest of Endowus’s founding team meet? Tell us more about the conversations that led to Endowus.

Samuel:
It was a pretty simple story. Basically I left Morgan Stanley. I retired from the firm on the condition that I don’t join a competitor, completely retired. And then I took a year out. So it was a sabbatical for me and I worked 23 years straight without a break and Morgan Stanley was 17 years of that. Within Morgan Stanley, I moved a couple of times.

So I’m very unique in the sense that I moved within the same company and any large financial institution is about joining the same department and doing it for the rest of your life. Like investment banking, research, or whatever. I was lucky that Morgan Stanley gave me the opportunity to move around. Anyway after 17 years I left and took the sabbatical. I needed to restore relationships with my wife, my kids, friends, cause I was so busy doing CEO and CIO.

It’s a role that in asset management very rarely is taken together. And it was forced upon me because of circumstances. It was supposed to be a temporary gig, but in reality it ended up being four years. I enjoyed it as it was a new challenge and made me learn a lot more about being a CEO and running a business more holistically. I think it was fun at times but very challenging at the same time as there were a lot of changes from a regulatory perspective, and we had to beef up governance and oversight and risk management. We had to revamp the whole trading team and other changes that were needed. But it was too much and I finally was able to negotiate a very amicable exit.

During my sabbatical, I went to a theological seminary to study theology, especially workplace ministry and things like the biblical interpretation of money. I find these things fascinating and that was really, really fun. And then I took a Stanford NUS International Management course to learn cutting edge management and other skills and during this time I had set up a vehicle to invest in fintech companies, so I had multiple fintech investments across the region. I stopped doing that once I joined Endowus full-time. But my idea was that I wanted to disrupt the pieces of the financial services landscape through the application of technology and innovative new services. The focus was on the biggest pools of financial assets and potential business opportunities that were not being disrupted.

One was, well it was Wealth Tech. The other one is pieces of the investment banking business. So those two verticals are by definition very relationship driven and very old school. There’s not much innovation, there’s nothing new really happening. There’s no technology being applied. And so those two were the space. I thought wealth was like true to my heart. I have a passion for solving retirement issues. The pension problem is the single biggest generational challenge. It’s like a major problem, not only in Singapore but Korea and other major aging countries.

So I was driven by this mission and I looked at all the robo guys, including the ones in Singapore at the time. There were also four guys in Korea. Hong Kong, Taiwanese, Australia, etc. I actually didn’t want to invest in any of them. And the reason is simple: They’re all product guys. They all have fund management licenses and were building product but just using ETFs instead of underlying securities so you have double layer of fees and inefficient structures. And I wanted to focus more on the value added piece, which I felt was going to be the advice piece and especially retirement related.

That is the more value-added piece and I believe long-term, advice wins. So we need to build an advice company and there are a few guys in the US that were doing robo retirement – like Bloom and some of these guys. So I wanted to do something in that space, retirement and advice. And I was thinking about starting my own company. The biggest one in Korea actually offered me to build that in Asia Pacific. They wanted to back me and give me the freedom to own it and build it. But the values and the ways you were looking at their investments just were not aligned. They will try to build algorithms to outperform. Right? So it’s product again. That was when a friend who runs a VC fund introduced me to You Ning and he said, “Oh Sam, you’re doing fintech. I have a guy who is doing fintech, you guys should meet.” That was it.

So I met You Ning first and we have common connections. So we hit it off from the get go. We were excited that we were so similar in the way we were thinking about things and how it should be different from the simple roboadvisors out there. He had incorporated the company with Greg and started Endowus and had focused on the CPF piece which was the catch for me as CPF is about retirement – or should be.

You Ning’s background was at Goldman Sachs investment banking. He did private equity, was at a hedge fund for a little bit, and then he ran the family office of Mr. Kuok, the founder of Wilmar. But a lot of it was private investments, so he thought my public market background would be a great fit. And then Greg did fund structuring and distribution at UBS, for private equity and venture cap. He also began the payment service at Grab when it was Grabtaxi and only cash!

So they didn’t have that public market expertise, which was what they needed. They wanted to get a CIO, they wanted to get my advice or mentorship kind of thing. And it kind of all came together. So my thing was, “Do I just become an investor or become an entrepreneur and join full time?” And that’s when I thought this group makes a good fit for me to be the older balance and the investment person for the team. Greg, who’s done Grab and payments and who’s actually built product was focused on the COO role. So he’s the product guy. And then You Ning brings the type of market expertise and private markets knowledge but is also meticulous, so You Ning has the CFO role. And then I was a CIO. So functionally those were the three divisions and it was a great fit to build out the company in a robust way. And I really build the investment side of the business. Whether it’s partnerships with FMCs [fund management companies], due diligence on the funds themselves, and building out portfolios to express the strategic asset allocation. So we all had like very defined contributions, very defined roles. And it was a perfect fit and personality wise and we work really well together. So that’s how we came together.

Ser Jing:
Thanks for sharing that. Because when I was looking through the founding team, I was just thinking you have these two seemingly very experienced investors, so how do you decide who gets to do what?

Samuel:
The fourth important piece of the founding team was Sin Ting. So I met them at the end of ‘17 beginning of ‘18. And I officially joined in February of ‘18. Sin Ting joined just before me in November of ‘17. Sin Ting is the other partner – I guess, cofounder as well. We came together as a team and we were licensed in January of 2018 and we started managing money from April and launched our platform in August of 2018 and our retail launch was April 2019.

She has a private banking background. So she was at Morgan Stanley in private banking and then she worked in Nomura private banking. So the other piece is the wealth piece, right? So I’m institutional, we’re all institutional. COO, CIO, so Sin Ting is the Chief Client Officer with private banking experience. Sin Ting fits that bill. Client Facing, client interaction, what clients want, how they should be served. The client experience is very important.

Ser Jing:
So she has a lot of input on how the product should be for the client.

Samuel:
Yeah, she’s the client advocate. So she faces the client and runs the client team where we have 6 registered reps and then she gives feedback to the investment product and tech product and feeds into how the product should be structured.

Obviously, it’s a group thing. You get everybody’s contributions and now Sheng Shi is also on board. He is a rep and he is client-facing, but he also reaches out to the community and videos and blogs and he’s our personal finance lead. He does a lot of wonderful grassroots work in the community and interfaces and partners with CPF Board for example. 

Sin Ting leads the more high net worth kind of private banking. We have another person, Lean Sing who was from Citi Gold, so more mass-wealth kind of expertise. And he is great with our clients at the mass wealth all the way up to high net worth clients and really provides value-added advice to clients. He worked in finance and also went for a few years to study Theology and served at a church and came back to finance with us at Endowus as he believed in our values and vision. So we have really been very purposeful in building out the team and filling the gaps.

When you’re building a tech product, you can’t just build a financial services tech product. You’ve got to have deep financial services expertise. So the domain knowledge is very deep. You have to know the trade flows, you know exactly how things are executed, what investment products actually do, how they should be. How to find the best products. Think about tax, FX, and costs and things that others don’t know or don’t think about. So you need to rely on people who’ve had experience and are capable of doing that.We all have a wealth of knowledge and experience in the field that we are in and the clients that we are serving.

So our tech team is actually, it’s like the Avengers, it’s like guys who know finance, guys who know tech, and can build products. We don’t need superfluous stuff or a humongous team. We just need a dedicated team that has the expertise, like 10 people that can do it. Execute. That’s it. We built all the technology in-house and our team has really deep expertise and experience in building out our tech team. Our CTO Joo was at Goldman Sachs Asset Management and UBS and a few other financial firms building trading systems and complex tech platforms. He also built the backend of Stashaway. He has grown into an amazing CTO now leading the team for us. John and Jay, the front and back end leads, are amazing as is our Dev Ops CY. We brought in our Chief Product Officer from Silicon Valley – Jx Lye – amazing guy with great experience and will help take our product to the next level. So we are excited about our tech and product too.

Ser Jing:
So you have your own in-house software development.

Samuel:
Completely. Yeah. That’s why they are called the A team, the Avengers team and we are the B team, the business team. We are confident we have built the most cutting edge and flexible WealthTech platform in not just Singapore but all of Asia. It’s an amazing product.

Endowus’s greatest challenge

Ser Jing:
I’m mindful of time, I’m sorry. So maybe I’ll just ask two or three more questions. I think this one can be very important for individual investors in Singapore. What do you think is Endowus’s greatest challenge in trying to become a lasting investing institute for investors?

Samuel:
There’s a purpose for why we wanted to go in specifically with the goal of trying to to help solve retirement. Helping people secure their financial future, helping people to save and invest, to prepare for their life better. All those things, right? Grand phrases and captions but hollow words unless we can really help people’s lives in a meaningful way.

The most important thing is that I think clients need to buy into the idea of investing their CPF. And that’s a tough challenge. And the reason is that historically people have been told, your CPF is for this and this and it’s not just a retirement solution. It’s really a total social security system. And OA is always for housing, right? That’s what people instinctively think. OA is for housing. You have a retirement piece (retirement account). You have SA [Special Account], MediSave (medical cover) so it solves everything.

But the problem is that housing, I mean really as an investor, and I don’t know if you agree, but housing is probably a poor asset allocation to me at this point in time in this cycle. And equities have corrected 30% but housing has not even begun. So if you look at the opportunity for capital gains, if you look at the fact that it’s a low yielding asset class, and if you look at the fact that if you use your OA, especially for an HDB 99-year lease, it is not an efficient investment.

What you should do with your OA, because your SA is giving 4% to 5%, you should think of this piece as your bond allocation. And use your OA which is giving you just 2.5% (which by the way is not really guaranteed long term) and barely above inflation. Rather than using that for a house, you should really try to invest as much of it as your long term equities allocation. Build returns over the long run and build that for retirement. And it’s perfect for that purpose as it’s locked away and you cannot touch it for 20, 30, 40 years and you save regularly into it as a regular savings plan and it’s a meaningful enough chunk of it. The recent market correction is the right time to start thinking and using this. The problem has been that the costs have been too high and so outcomes have been poor or you get suckered into terrible ILP products. But now with Endowus you can get a globally diversified portfolio for the long term at really low cost which raises your chances of success.

The other reason is that your retirement adequacy is not enough. Even the enhanced retirement sum under CPF is not enough. It’s probably gonna be around $1,500 to $2,000 a month. So it’s just basically not enough to live in Singapore with the inflation rate that exists. So you need to do more and if your retirement account is not enough, your OA (ordinary account) is basically your backup plan, right? And so you need to build it up in a meaningful way. My friend Loo Cheng Chuan talks about 1M65 alot but together with his wife, he thinks if he uses Endowus and invests his OA then he can get to 4M65, that’s 4 million by the time he is 65, which is amazing. That’s the power of investing your CPF.

But the problem is no one knows of this fact and it takes time to change long-held beliefs. That’s the education piece and that’s the biggest challenge that we face. We do a lot of financial literacy and education, and hold events and webinars, but it takes time. And the incumbent banks and platforms are not helping much. Even if we fail, if we can change the way these guys run their business so they lower fees and improve access to individual investors and provide better advice because of the competition we bring then we would have done our job. We are David and they are Goliath in this fight.

But we know it is the right thing. We’re up for the challenge and we’ll do it, but it’s a long haul and it’s going to be a tough ask and it’s going to take a long time. But we’re fine. Time is on our side and we’re patient entrepreneurs, so we’ll keep at it because we know we’re doing the right thing. 

Ser Jing:
Fantastic! I guess this is a really good point to end the conversation. Thank you for your time.


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.

Why I Own Alteryx Shares

Alteryx has only been in my family’s portfolio for a short time, but it has not done well for us. Here’s why we continue to own Alteryx.

Alteryx (NYSE: AYX) is one of the 50-plus companies that’s in my family’s portfolio. I first bought Alteryx shares for the portfolio in September 2019 at a price of US$118 and I’ve not sold any of the shares I’ve bought.

The purchase has not worked out well for my family’s portfolio thus far, with Alteryx’s share price being around US$98 now. But we’ve not even owned the company’s shares for a year, and it is always important to think about how the company’s business will evolve going forward. What follows is my thesis for why I still continue to hold Alteryx shares.

Company description

Alteryx provides a self-service subscription-based software platform that allows organisations to easily scrub and blend data from multiple sources and perform sophisticated analysis to obtain actionable insights.

The company’s platform can interact with nearly all data sources. These include traditional databases offered by the likes of IBM, Oracle, and SAP, as well as newer offerings such as those from MongoDB, Amazon Web Services, Google Analytics, and even social media.

Once data from different sources are fed into Alteryx’s platform, it cleans and blends the data. Users can easily build configurable and sophisticated analytical workflows on the platform through drag-and-drop tools. The workflows can be easily automated and shared within the users’ organisation, and the results can be displayed through Alteryx’s integrations with data-visualisation software from companies such as Tableau Software and Qlik. Here’s a chart showing the various use cases for Alteryx’s data analytics platform:

Source: Alteryx June 2019 investor presentation

At the end of 2019, Alteryx had around 6,100 customers, of all sizes, in more than 90 countries. These customers come from a wide variety of industries and include more than 700 of the Global 2000 companies. The Global 2000 is compiled by Forbes and it’s a list of the top 2,000 public-listed companies in the world ranked according to a combination of their revenue, profits, assets, and market value. With thousands of customers, it’s no surprise that Alteryx does not have any customer concentration – no single customer accounted for more than 10% of the company’s revenue in the three years through 2019. The graphic below illustrates the diversity of Alteryx’s customer base:

Source: Alteryx 2019 fourth-quarter earnings presentation

Despite having customers in over 90 countries, Alteryx is currently still a US-centric company. In 2019, 71% of its revenue came from the US. The UK is the only other country that accounted for more than 10% of Alteryx’s revenue in 2019 (10.7%).

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 Alteryx.

1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market

Alteryx earned US$417.9 million in revenue in 2019. This is significantly lower than the US$73 billion addressable market that the company is currently seeing. It comprises two parts:

  1. US$49 billion in the global big data and analytics software market (according to a July 2017 IDC report) which includes the US$28 billion global analytics and business intelligence market (according to a January 2019 Gartner report) 
  2. A US$24 billion slice, based on Alteryx’s estimate of the spend associated with 47 million spreadsheet users worldwide who worked on advanced data preparation and analytics in 2018 (according to an April 2019 IDC report)
Source: Alteryx 2019 fourth-quarter earnings presentation

I believe that better days are ahead for Alteryx for a few reasons:

  • I mentioned earlier that the company’s data analytics platform can interact with nearly all data sources. This interactivity is important. A 2015 Harvard Business Review study sponsored by Alteryx found that 64% of organizations use five or more sources of data for analytics.
  • Market researcher IDC predicted in late 2018 that the quantity of data in the world (generated, captured, and replicated) would compound at an astounding rate of 61% per year, from 33 zettabytes then to 175 zettabytes in 2025. That’s staggering. 1 zettabyte equals to 1012 gigabytes.
  • A 2013 survey on more than 400 companies by business consultancy group Bain found that only 4% of them had the appropriate human and technological assets to derive meaningful insights from their data. In fact, Alteryx’s primary competitors are manual processes performed on spreadsheets, or custom-built approaches. These traditional methods for data analysis involve multiple steps, require the support of technical teams, and are slow (see chart below).
  • Crucially, Alteryx’s self-service data analytics platform is scalable, efficient, and can be mastered and used by analysts with no coding skill or experience. I think this leads to a few good things for Alteryx. First, it democratises access to sophisticated data analytics for companies, and hence opens up Alteryx’s market opportunity. Second, it places Alteryx’s platform in a sweet spot of riding on a growing trend (the explosion in data generated) as well as addressing a pain-point for many organisations (the lack of resources to analyse data, and the laborious way that data analysis is traditionally done).

(Traditional way to perform data analysis)

Source: Alteryx IPO prospectus

2. A strong balance sheet with minimal or a reasonable amount of debt

As of 31 December 2019, Alteryx held US$974.9 million in cash, short-term investments, and long-term investments. This is comfortably higher than the company’s total debt of US$698.5 million (all of which are convertible notes).

3. A management team with integrity, capability, and an innovative mindset

On integrity

Alteryx was listed in March 2017, so there’s only a short history to study when it comes to management. But I do like what I see.

The company was founded in 1997. One of its co-founders, Dean Stoecker, 63, has held the roles of CEO and chairman since its establishment. Another of Alteryx’s co-founders is 57-year-old Olivia Duane Adams, the company’s current chief customer officer. The third co-founder, Ned Harding, 52, was a key technology leader in the company and left in July 2018; he remains an advisor to Alteryx’s software engineering teams. The company’s chief technology officer role is currently filled by Derek Knudsen, 46. He stepped into the position in August 2018  after Harding’s departure. Knudsen had accumulated over 20 years of experience working with technology in companies in senior leadership positions before joining Alteryx.

Stoecker and Duane Adams collectively controlled nearly 10 million Alteryx shares as of 31 March 2019. These shares are worth around US$980 million at the company’s current share price of US$98. That’s a large stake and it likely aligns the interests of Stoecker and Duane Adams’ with Alteryx’s other shareholders.

Alteryx has two share classes: (1) The publicly-traded Class A shares with 1 voting right per share; and (2) the non-traded Class B shares with 10 voting rights each. Stoecker and Duane Adams’ Alteryx shares were mostly of the Class B variety. So, they controlled 47.9% of the voting power in the company despite holding only 16% of the total shares. Collectively, Alteryx’s key leaders controlled 54.1% of the company’s voting rights as of 31 March 2019.

Source: Alteryx proxy statement

Having clear control over Alteryx means that management can easily implement compensation plans that fatten themselves at the expense of shareholders. The good thing is that the compensation structure for Alteryx’s management looks sensible to me.

In 2018, 70% to 79.7% of the compensation of Alteryx’s management team came from long-term incentives. These incentives include restricted stock units (RSUs) and stock options that vest over multi-year periods. There is room for some misalignment to creep in though – as far as I can tell, there is no clear description given by Alteryx on the performance metrics that management must meet in order to earn their compensation. But I don’t see this as a dealbreaker. Because of the multi-year vesting period for the RSUs and stock options, Alteryx’s management will do well over time only if the share price does well – and the share price will do well only if the business does well. From this perspective, the interests of management and shareholders are still well-aligned.

On capability and innovation

Alteryx’s business has changed dramatically over time since its founding. In its early days, the company was selling software for analysing demographics. Alteryx’s current core data analytics software platform was launched only in 2010, and a subscription model was introduced relatively recently in 2013. I see Alteryx’s long and winding journey to success as a sign of the founders’ ability to adapt and innovate.

I also credit Alteryx’s management with the success that the company has found in the land-and-expand strategy. The strategy starts with the company landing a customer with an initial use case, and then expanding its relationship with the customer through other use cases. The success can be illustrated through Alteryx’s impressive dollar-based net expansion rates (DBNERs). The metric is a very important gauge for the health of a SaaS (software-as-a-service) company’s business. It measures the change in revenue from all the company’s customers a year ago compared to today; it includes positive effects from upsells as well as negative effects from customers who leave or downgrade. Anything more than 100% indicates that the company’s customers, as a group, are spending more.

Alteryx’s DBNER has been more than 120% in each of the last 20 quarters – that’s five years! The chart below illustrates Alteryx’s DBNER going back to 2017’s first quarter.

Source: Alteryx 2019 fourth-quarter earnings presentation

Alteryx’s management has also led impressive customer-growth at the company. The company’s customer count has more than quadrupled from 1,398 at the end of 2015 to 6,087 at the end of 2019.

But there is a key area where Alteryx’s management falls short: The company’s culture. Alteryx has a 3.5-star rating on Glassdoor, and only 65% of reviewers will recommend Alteryx to friends. Stoecker only has an 85% approval rating as CEO. SAP, a competitor of Alteryx, has 4.5 stars on Glassdoor, and recommendation and CEO-approval ratings of 93% and 97%, respectively. Alteryx has managed to post impressive business-results despite its relatively poor culture, but I’m keeping an eye on things here.

4. Revenue streams that are recurring in nature, either through contracts or customer-behaviour

Alteryx’s business is built nearly entirely on subscriptions, which generate recurring revenue for the company. The company sells access to its data analytics platform through subscriptions, which typically range from one to three years. In 2019, 2018, 2017, and 2016, more than 95% of Alteryx’s revenue in each year came from subscriptions to its platform; the rest of the revenue came from training and consulting services, among others. 

5. A proven ability to grow

There isn’t much historical financial data to study for Alteryx, since the company was listed only in March 2017. But I do like what I see.

Source: Alteryx IPO prospectus and annual reports 

A few key points to note:

  • Alteryx has compounded its revenue at an impressive annual rate of 61.6% from 2014 to 2019. The astounding revenue growth of 92.7% in 2018 was partly the result of Alteryx adopting new accounting rules in the year. Alteryx’s revenue for 2018 would have been US$204.3 million after adjusting for the impact of the accounting rule, representing slower-but-still-impressive top-line growth of 55.2% for the year. 2019 saw the company maintain breakneck growth, with its revenue up by 64.8%.
  • Alteryx started making a profit in 2018, and also generated positive operating cash flow and free cash flow in 2017, 2018, and 2019.
  • Annual growth in operating cash flow and free cash flow from 2017 to 2019 was strong at 33.8% and 21.4%, respectively.
  • The company’s balance sheet remained robust throughout the timeframe under study, with significantly more cash and investments than debt.
  • At first glance, Alteryx’s diluted share count appeared to increase sharply by 22.1% from 2017 to 2018. But the number I’m using is the weighted average diluted share count. Right after Alteryx got listed in March 2017, it had a share count of around 57 million. This means that the increase in 2018 was milder (in the mid-teens range) though still higher than I would like it to be. The good news is that the diluted share count inched up by only 6% in 2019, which is acceptable, given the company’s rapid growth. I will be keeping an eye on Alteryx’s dilution.

6. A high likelihood of generating a strong and growing stream of free cash flow in the future

Alteryx has already started to generate free cash flow. Right now, the company has a poor trailing free cash flow margin (free cash flow as a percentage of revenue) of just 5.4%.

But over the long run, Alteryx expects to generate a strong free cash flow margin of 30% to 35%. I think this is a realistic and achievable target. There are other larger SaaS companies such as Adobe, salesforce.com, and Veeva Systems (my family’s portfolio owns shares in all three companies too) with a free cash flow margin around that range or higher.

Source: Companies’ annual reports and earnings updates

Valuation

You should get some tissue ready… because Alteryx’s shares have a nosebleed valuation. At a share price of US$98, Alteryx carries a trailing price-to-sales (P/S) ratio of 16.1. This P/S ratio is in the middle-range of where it has been since Alteryx’s IPO in March 2017 (see chart below). But the P/S ratio of 16.1 is still considered high. For perspective, if I assume that Alteryx has a 30% free cash flow margin today, then the company would have a price-to-free cash flow ratio of 54 based on the current P/S ratio (16.1 divided by 30%). 

But Alteryx also has a few strong positives going for it. The company has: (1) a huge addressable market in relation to its revenue; (2) a large and rapidly expanding customer base; and (3) very sticky customers who have been willing to significantly increase their spending with the company over time. I believe that with these traits, there’s a high chance that Alteryx will continue posting excellent revenue growth – and in turn, excellent free cash flow growth – in the years ahead.

The current high valuation for Alteryx does mean that its share price is likely going to be more volatile than the stock market as a whole (I’m also keeping in mind that stocks have been very volatile of late because of COVID-19 fears). But the potential volatility is something I’m very comfortable with.

The risks involved

I see a few key risks in Alteryx, with the high valuation being one. Besides introducing volatility (which I don’t see as a risk), Alteryx’s high valuation means that the market has high expectations for the company’s future growth. If Alteryx stumbles along the way, its share price will be punished. With COVID-19 causing widespread slowdowns in business activity across the world, there may be a global recession in the works. Should it happen, Alteryx may find it tough to grow its business.

Competition is another important risk. I mentioned earlier that Alteryx’s primary competitors are spreadsheets, or custom-built approaches. But the company’s data analytics platform is also competing against services from other technology heavyweights with much stronger financial resources, such as International Business Machines, Microsoft, Oracle, and SAP. Providers of data visualisation software, such as Tableau, could also decide to move upstream and budge into Alteryx’s space. To date, Alteryx has dealt with competition admirably – its quarterly DBNERs and growth in customer numbers are impressive. I’m watching these two metrics to observe how the company is faring against competitors.

Two other key risks deal with hacking and downtime in Alteryx’s services. The company’s platform is important for users, since it is used to crunch data to derive actionable insights; it is also likely that Alteryx’s platform is constantly fed with sensitive information of its users. Should there be a data breach on the platform, and/or if the platform stops working for extended periods of time, Alteryx could lose the confidence of its customers.

Then there’s also succession risk with Alteryx. Dean Stoecker, the company’s co-founder and CEO, is already 63. Should he step down in the future, I will keep an eye on the leadership transition.

Lastly, the following are all yellow-to-red flags for me regarding Alteryx: (1) The company’s DBNER comes in at less than 100% for an extended period of time; (2) it fails to increase its number of customers; and (3) it’s unable to convert revenue into free cash flow at a healthy clip in the future.

The Good Investors’ conclusion

Summing up Alteryx, it has:

  1. A valuable self-service data analytics platform that addresses customers’ pain-points and is superior to legacy methods for data analysis;
  2. high levels of recurring revenue;
  3. outstanding revenue growth rates;
  4. positive profit and free cash flow, with the potential for much higher free cash flow margins in the future;
  5. a large and mostly untapped addressable market;
  6. an impressive track record of winning customers and increasing their spending; and
  7. capable leaders who are in the same boat as the company’s other shareholders

The company does have a premium valuation, so I’m taking on valuation risk. There are also other risks to note, such as tough competition and succession. But after analysing all the data on Alteryx’s pros and cons, I’m happy for my family’s portfolio to continue owning the company’s shares.

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.

Freediving & Investing

I’m extending a helping hand to those who are panicking or feeling stressed over the recent market volatility because of fears over COVID-19.

Freediving is the sport of diving underwater that relies on holding our breath without any breathing apparatus. Professional freedivers have been known to descend to depths of 100 metres or more on one single breath. It’s truly a sight to behold on what the human body can achieve.

I went to a freediving trial a few years ago in a deep swimming pool in Singapore. During the session, I was taught that when we hold our breath, a long gap actually exists between the time when our urge to breathe kicks in and the time when we actually do need to breathe. The information was interesting to me, so I’ve remembered it till now.

A few days ago, I went for a swim in the morning. While swimming, I tried extending the number of breast-stroke repetitions I could do while underwater. But try as I might, I couldn’t. I knew, logically, that my body would not be physically harmed even if I continued holding my breath for an extended period of time after the urge to breathe kicks in. But the urge was too strong. Each time it appeared, I gave in to it after a few short seconds. I couldn’t fight the visceral urge. After I stopped my swim, a light bulb went on in my head. I saw a link between investing and freediving.

Freediving requires us to fight the visceral urge to breathe when holding our breath. But it is difficult to do so, even if we have all the right analysis and understand the logic. I knew I would be fine and that my body did not have to breathe at that instant. But my body was screaming at me to surface from the water and take in some air.

Investing requires us to fight the visceral urge to capitulate when bear markets inevitably occur. But it is difficult to do so even if we have all the right analysis and understand the logic. Our brains will be screaming at us to sell when stocks are falling, even if we understand that we are going to be fine over the long run just leaving our portfolios as they are (assuming they were well-constructed from the start).

So what can we do?

We can train our bodies to hold our breath for long periods of time – there are well-documented methods.

I don’t know what the solution is for investing. But I’m hopeful that those of us who are susceptible to panic during bear markets can find some relief if someone can provide an empathetic listening ear and useful context when they occur. The current volatility in stocks – because of fears over the coronavirus, COVID-19 – means that many of us are likely enduring our brains screaming at us to sell. I want to help.

I have a long article sharing the useful context. The Singapore-based roboadvisor Endowus also put out a wonderful video recently sharing even more context. You can contact me at thegoodinvestors@gmail.com too. I cannot give financial advice, but I can perhaps help you deal with your investing-related emotions in a more constructive manner. You’re not in this alone.

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

9 Key Reminders For The Recent Market Turmoil

Amidst the market volatility and societal turmoil from the coronavirus, COVID-19, here are some important reminders for us as investors.

Stocks around the world have been incredibly volatile in recent weeks because of the new coronavirus, COVID-19. All over the world, business activity has slowed, large-scale gatherings of people have been cancelled, planes are grounded, hotels are empty, people are quarantined, and healthcare systems are pushed to their limits. Recessionary fears are also rampant.

Amidst the market and societal turmoil, I want to share some important investing-related reminders for all of us to provide context, soothe fraying nerves, and be a voice of calm, reason, and peace.

But before I get there, I want to stress this: COVID-19 or no COVID-19, recession or no recession, I am not changing the way I am investing. Regardless of how COVID-19 or the global economy develops, the stock market is still a place to buy and sell pieces of a business. This also means that a stock will do well eventually if its business does well. So I will continue looking for companies that excel according to my investing framework, and investing in their shares for the long run.

On to the update…!

1. Recessions are normal

The chart below shows all the recessions (the dark grey bars) in the US since 1871. You can see that recessions in the country – from whatever causes – have been regular occurrences even in relatively modern times. They are par for the course, even for a mighty economy like the US.

Source: National Bureau of Economic Research

The following logarithmic chart shows the performance of the S&P 500 (including dividends) from January 1871 to February 2020. It turns out that US stocks have done exceedingly well over the past 149 years (up 46,459,412% in total including dividends, or 9.2% per year) despite the US economy encountering numerous recessions. If you’re investing for the long run, recessions can hurt over the short-term, but they’re nothing to fear.

Source: Robert Shiller data; National Bureau of Economic Research

2. The stock market has regularly seen serious short-term losses while on its way to earning great long-term returns

Between 1928 and 2013, the S&P 500 had, on average, fallen by 10% once every 11 months; 20% every two years; 30% every decade; and 50% two to three times per century. So stocks have declined regularly. But over the same period, the S&P 500 also climbed by 283,282% in all (including dividends), or 9.8% per year. Volatility in stocks is a feature, not a bug.

In fact, stocks have also experienced brutal one-day drops that – with the proper perspective – turn out to be blips.

Some market commentators have labelled 9 March 2020 as Black Monday because the S&P 500 fell by 7.6% that day. But that is nothing compared to the historical Black Monday – on 19 October 1987, the S&P 500 plunged by 20.5%. To make matters worse, the index was already down by 10.1% in the three days preceding 19 October 1987. So in four trading days – from the close on 13 October 1987 to 19 October 1987 – US stocks were down by 28.5% in all.

Black Monday (the historical one) was a harrowing experience for those who lived through it. But here’s the thing: From 13 October 1987 (before Black Monday happened) to 9 March 2020, the S&P 500 was up by 773% in total, or 6.9% per year. With dividends, the S&P 500 was up by around 2,100%, or 10.0% annually.

Source: Yahoo Finance

From an individual stock perspective, we can also look at the US e-commerce giant Amazon (NASDAQ: AMZN). The company (which is in my family’s investment portfolio) was a massive long-term winner from 1997 to 2018, with its share price rising by more than 76,000% from US$1.96 to US$1,501.97. But in the same timeframe, Amazon’s share price also experienced a double-digit top-to-bottom fall in every single year (the declines ranged from 13% to 83%).

Source: S&P Global Market Intelligence

One of my favourite finance writers is Morgan Housel. In an April 2019 blog post, he brilliantly articulated a concept that I’ve held in my mind for a long time: Instead of seeing short-term volatility in the stock market as a fine, think of it as a fee for something worthwhile. The stock market has produced good to great returns over the long-term. But it demands an admission fee. And the admission fee is what we’re currently experiencing.

3. Recessions and market crashes are inevitable

The late Hyman Minsky was an obscure economist when he was alive. But his ideas flourished after the Great Financial Crisis of 2007-09.

That’s because he had a framework for understanding why markets and economies go through inevitable boom-bust cycles. According to Minsky’s then radical view, stability itself is destabilising. When an economy is stable and growing, people feel safe. And when people feel safe, they take on more risk, such as borrowing more. This leads to the system becoming fragile.

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

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

4. There is always something to worry about

Peter Lynch, the legendary manager of the Fidelity Magellan Fund from 1977 to 1990, once said that “there is always something to worry about.” How true. The table below, constructed partially from Morgan Housel’s data, shows that the world had experienced multiple crises in every single year from 1990 to 2019.

But over the same period, US stocks were still up by nearly 800% after factoring in dividends and inflation.

Source: Robert Shiller data

COVID-19 is not the first deadly disease outbreak the world has faced. But global stocks have registered solid long-term gains despite multiple occurrences of epidemics/pandemics in the past. The chart below shows the performance of the MSCI World Index (a benchmark for global stocks) from 1970 to January 2020 against the backdrop of the various epidemics/pandemics we’ve experienced in the past 50 years.

Source: Marketwatch

5. Don’t invest in stocks with money that you will need within five years, at least; also, don’t use leverage

When I was helping to run the Motley Fool Singapore’s investment newsletters, my ex-colleagues and I repeated the same message over and over again: You should not invest with money that you need within the next five years.

The message is meant to prepare for days like we’ve seen over the past few weeks. The worst thing that can happen to us as investors is to be placed in a position where we’re forced to sell stocks. It doesn’t matter if we’re forced to sell when stock prices are high. But it can be disastrous to be forced to sell when stock prices are low.

To reap the rewards of long-term investing, we need to give ourselves holding power. And a very simple but effective thing we can do to gain holding power is to invest with money that we would very likely not need to touch for a good number of years.

Another simple but effective way we can have holding power in the financial markets is to not use leverage. Investing with leverage is to invest with borrowed capital. If we invest with leverage, we could very easily become forced-sellers when stocks fall. This becomes a severe headache during occasions when stocks fall sharply, such as over the past few weeks. 

6. Volatility clusters

As mentioned earlier, the S&P 500 fell by 7.6% on 9 March 2020. The decline was so severe it triggered a circuit breaker in the process. On 10 March 2020, the prominent US market benchmark jumped 4.9%. A great day in the market followed a bad day.

This clustering of volatility is actually common. Investor Ben Carlson produced the table below recently (before March 2020) which illustrates the phenomenon.

The clustering means that it’s practically impossible to side-step the bad days in stocks and capture only the good days. This is important information for us, because missing just a handful of the market’s best days will destroy our returns.

Dimensional Fund Advisors, which manages more than US$600 billion, shared the following stats in a recent article:

  • $1,000 invested in US stocks in 1970 would become $138,908 by August 2019
  • Miss just the 25 best days in the market, and the $1,000 would grow to just $32,763

So it is important that we stay invested. But this does not mean we should stay invested blindly. Companies that currently are heavily in debt, and/or have shaky cash flows and weak revenue streams are likely to run into severe problems if there’s an economic downturn. If a global recession really happens this time (it looks increasingly likely that it will) and our portfolios are full of such companies, we may never recover. It’s good practice to constantly evaluate the companies in our portfolios, but I think there’s even more urgency to do so now.

7. Stick with high-quality businesses – don’t be attracted to a stock just because it has a low valuation

It’s easy for us to be lured by stocks that have low valuations after sharp declines in their prices. But it’s crucial that we also pay attention to the quality of the underlying businesses of the stocks we’re looking at. Low-quality businesses can’t compound in value. If we invest in them, our investments can’t grow over time. We may even lose money.

My friend Chin Hui Leong is a whip-smart investor and the co-founder of The Smart Investor, an investment education website. On 5 May 2009, he invested in American Oriental Bioengineering (AOB), a China-based pharmaceuticals company that was listed in the US. Chin was attracted to its low valuation – back then, AOB’s price-to-earnings ratio was only 7.

The S&P 500 reached a bottom during the Great Financial Crisis in March 2009 (it hit 677 points) and has nearly quadrupled since. So the timing of Chin’s investment in AOB was great. But he went on to effectively lose his entire investment in the company over a few short years because of its poor business performance subsequently. From 2009 to 2013, AOB’s revenue shrank from US$296 million to US$122 million while its US$41 million in profit became a loss of US$91 million. A cheap stock can easily become a big loser if its business does poorly.

Chin also has a fantastic and inspiring example of what can happen if we stick with high-quality businesses. He invested in Netflix (NASDAQ: NFLX) (my family also owns shares of Netflix) on 12 January 2007 at a share price of around US$3.20. On this occasion, his timing was poor. The S&P 500 closed at 1,431 on the day of his Netflix investment and reached a peak of 1,565 on 9 October 2007 before the Great Financial Crisis hit. But today, Netflix’s share price is around US$330, about 100 times higher than when he first invested. 

8. Oil prices are low now, but we still shouldn’t buy oil & gas stocks indiscriminately

There are two widely-tracked prices for oil: West Texas Intermediate (WTI) crude and the international benchmark. Brent crude. Both shockingly fell by more than 30% each on 9 March 2020 at their respective low points.

WTI eventually closed the day with a 24.6% decline to US$31.13 per barrel while Brent crude settled with a 24.1% slide to US$34.36 per barrel. These prices were the lowest seen since February 2016. Some market observers have linked this sharp fall in oil prices to the recent turmoil in financial markets that we are seeing.

The lower oil prices have also caused the share prices of oil & gas stocks around the world to plummet. In the US market, Exxon Mobil (NYSE: XOM) plunged by 12.2% on 9 March 2020. Meanwhile, at our home in Singapore, Keppel Corporation (SGX: BN4) fell by 9.6% while Sembcorp Marine (SGX: S51) was down by 11.4%.

Oil prices are near multi-year lows now – they were around US$100 in 2014 and around US$32 at the moment. It could thus be tempting to pick up oil & gas stocks with the view that their share prices will tag along when oil prices rise. There are two problems here.

First, it’s practically impossible to forecast future oil prices. In 2007, Peter Davies gave a presentation titled What’s the Value of an Energy Economist? In it, he said that “we cannot forecast oil prices with any degree of accuracy over any period whether short or long.” Back then, Davies was the chief economist of British Petroleum, one of the largest oil & gas companies in the world.

Second, oil prices and oil & gas stocks can move in opposite directions. In mid-2014, oil prices started their rapid descent from around US$100. WTI reached a low of US$26.61 in February 2016. 10 months later (on 21 December 2016), WTI had doubled to US$53.53. But over the same period, 34 out of a group of 50 Singapore-listed oil & gas stocks saw their share prices fall. The average decline for the 50 companies was 11.9%.

There can be many obstacles that stand between a positive macrotrend and higher stock prices. In the case of oil & gas stocks, these include a weak balance sheet and deteriorating business fundamentals as a result of poor operational capabilities.

9. We will get through this 

There are 7.8 billion individuals in our globe today, and the vast majority of us will wake up every morning wanting to improve the world and our own lot in life – COVID-19 or no COVID-19. This motivation is ultimately what fuels the global economy and financial markets.

Miscreants and Mother Nature will occasionally wreak havoc. But we should have faith in the collective positivity of humankind. We should have faith in us. We can clean up the mess. To me, investing in stocks is the same as having faith in the long-term positivity of mankind. I continue and will continue to have this faith, so I continue and will continue to invest in stocks.

I want to leave the last words in this article to Morgan Housel. A few days ago he published a blog post with the most apt of titles: We’ll Get Through This. In it, he wrote:

“Remember that when progress is measured generationally, results and performance should not be measured quarterly.

It looks bad today.

It might look bad tomorrow.

But hang in there.

We’ll get through this.” 

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

Investing Through The Coronavirus Crisis; Portfolio Management; Evaluating A Company’s Leaders; And More

I did a video chat with Reshveen Rajendran recently and talked about the coronavirus (COVID-19) situation, portfolio management, and so much more.

On Tuesday (10 March 2020), I recorded a video chat with Reshveen Rajendran who runs an investing education service (link goes to Resh’s Youtube channel). I first got to know Resh in 2013 or 2014 through a mutual friend.

Last week, Resh reached out to see if I would be interested to record a video with him to discuss a wide variety of investing topics. I love talking about such things so I readily agreed.

You can check out the video below. I had a wonderful time talking to Resh. He asked really good questions and we covered a lot of ground. Some of the topics include: 

  • The importance of having a long-term perspective when investing
  • What’s going to happen next with the coronavirus (COVID-19) situation
  • What can you do when your stocks fall?
  • How should we approach investing in oil & gas stocks?
  • My investing mistakes
  • How I manage my portfolio allocations
  • Companies’ competitive advantages
  • How we can evaluate a company’s leaders
  • A company that still has bright long-term prospects despite being heavily affected in the short run by the COVID-19 situation (find out more about this company here)
  • The 3 stocks I will buy if I can only invest in 3 stocks
  • What Jeremy Chia and I are working on at the moment

I hope you will enjoy my conversation with Resh. All credit goes to him. Resh, thank you my friend!

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

What It Was Like To Live Through The Greatest 1-Day Market Crash In History

An investor’s first-hand account of what it was like to live through Black Monday, the worst 1-day crash in stocks in the US market.

Yesterday, I published Staying Calm Through The Recent Big Fall In Stocks. In the article, I shared how US stocks fell by a stunning 20.5% in one day on 19 October 1987. This event is now infamously known as Black Monday.

I used Black Monday as an example to show that incredibly sharp short-term declines have happened in the past. Yet, US businesses and the stock market as a whole have continued growing significantly. I thought Black Monday was an apt example, given the current climate – on Monday night (9 March 2020), US stocks declined by 7.6%.

In Staying Calm Through The Recent Big Fall In Stocks, I wrote that “when Black Monday occurred, it was likely an extremely stressful time for investors.” I could not find any data or anecdotes to illustrate how investors must have felt back then. As the market gods would have it, I just found one.

Ben Carlson once received a message from a reader who experienced Black Monday. Carlson is the Director of Institutional Asset Management at Ritholtz Wealth Management who blogs at A Wealth of Common Sense. This is what the reader wrote to him (italics are mine):

“As one who was actually invested in 1987 (and since 1973), I still have vivid memories of that market crash. It is oh-so-easy to look today at a long-term chart having a tiny blip and say “So what! . . . of course the market recovered . . . those who sold were fools.”

In 1987, market news was nothing like it is today. We had no Internet. We had the next day’s WSJ [Wall Street Journal] and Friday’s 30-minute Lou Rukeyser’s Wall Street Week; we subscribed to a few stock newsletters (delivered by snail mail) and Kiplinger and Money magazines . . . that’s about it.

Therefore, though I heard about the crash on the radio as I drove home from work on Black Monday, I was not prepared to find my wife in tears . . . her first words were
“You’ve lost our retirement!” (Reading it does not convey the impact of hearing it.)

In real time, the crash was a VERY big event. Fear for a changed future was the natural response. Talking heads were saying “This worldwide event could last for years; our children will have a lower standard of living than we have.”

Long story short— she insisted we sell everything the next day (which was also a significant down day); we eventually re-entered the market.”

I can’t prove it, but I guarantee that many investors are today having similar thoughts as what I highlighted in the quote above. It was fortunate that Carlson’s reader eventually re-entered the market. Black Monday turned out to only be a painful blip in the short run (see chart below). From 13 October 1987 (before Black Monday happened, meaning stocks were at a higher price than after the 19 October 1987 crash) to 9 March 2020, the S&P 500 increased by 773% in total, or 6.9% per year. With dividends, the S&P 500 was up by around 2,100%, or 10.0% annually, according to data from Robert Shiller.

Source: Yahoo Finance

Black Monday was monumental for those who lived through it. But if those investors had the courage to stay invested, they would have been amply rewarded.

What we experienced on Monday night and for the past few weeks, feels similar to what Carlson’s reader described. But I also think the chances are very high that in five, 10, and 20 years from now, we will look back on our experiences in the past few weeks and think “What a time it was to live through. But I’m glad I stuck with stocks for the long haul!”

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

Staying Calm Through The Recent Big Fall In Stocks

Fear over the coronavirus, COVID-19, could be the biggest contributor to our investing-losses, even more than actual risks.

Yesterday night, the S&P 500 in the US swiftly fell by 7% when the market opened, triggering a circuit breaker that halted trading activity for 15 minutes. The index resumed trading, but eventually registered a drop of 7.6% for the day.

The decline in US stocks was sharp and it likely had hurt some investors, if not psychologically, then literally (because of fear-induced selling, or the activation of stop-losses). Some of you are also likely worried about what could happen next.

History is and will never be a perfect guide for the future. But a look at the past can give us context on what just happened and prevent us from committing emotion-driven mistakes.

19 October 1987 is known as Black Monday in the investing community. That’s because the S&P 500 fell by 20.5% on that day alone. What deepened the pain was that the US stock market index had already declined by 10.1% in the three days preceding Black Monday. So in the span of four trading days, from the close on 13 October 1987 to 19 October 1987, the S&P 500 sunk by a mighty 28.5% in total.

Source: Yahoo Finance

The chart above illustrates how brutal Black Monday was. But for another perspective, the chart below shows how the S&P 500 did from 13 October 1987 to 13 October 1992, a five-year period. It was up 30% in all. Not fantastic, but there was still a gain. 

Source: Yahoo Finance

Let’s zoom out even further, with a chart that shows the performance of the S&P 500 from 13 October 1987 to today:

Source: Yahoo Finance

Turns out, the S&P 500 has climbed by 773% in total, or a solid 6.9% per year.

I have two points to make here. First, significant short-term declines in stocks have happened before. When Black Monday occurred, it was likely an extremely stressful time for investors [link added on 11 March 2020]. But the sun still rose and the world went on. According to Robert Shiller’s data, the S&P 500’s earnings per share (EPS) has also compounded at 6.9% per year from October 1987 to today. In fact, the S&P 500’s EPS in December 1987 was higher than it was in October 1987 (US$16.41 vs US$17.50). And if the S&P 500’s dividends were included, the index’s return from October 1987 to today would have been around 10% per year, based on Shiller’s data.

The second point is that we need to separate business performance – especially long-term business performance – from stock price movements when investing. As I just mentioned, US businesses were growing (in the form of higher EPS) despite Black Monday’s occurrence, and continued to grow over the long run. Yesterday night’s 7.6% fall in the S&P 500 was driven by a slew of factors, with one of them being fears related to the new coronavirus, COVID-19. I described some of the virus’s negative impacts on business conditions worldwide in a recent article:

“Global corporate giants such as Apple, Visa, and Mastercard have warned of pressures to their businesses because of COVID-19 (see herehere, and here). Airlines are some of the worst-hit groups of companies, with UK airline Flybe entering bankruptcy earlier this month; last week, Southwest Airlines in the US warned of a “very noticeable, precipitous decline in bookings.” In China, the PMI (purchasing managers’ index) for February 2020 came in at 35.7, the lowest seen since tracking began in 2004 (a reading below 50 indicates a contraction in factory activity). In 2008 and 2009, during the height of the Great Financial Crisis, China’s PMI reached a low of 38.8. ”

So yes, there’s a very real threat to the short-term health of many businesses because of COVID-19. But will the virus have any lasting negative consequences over the long run? It’s possible, but I think it’s unlikely. I’m not alone. During an interview with CNBC late last month, billionaire investor Warren Buffett shared his thoughts on how investors ought to be dealing with COVID-19. He said (emphasis is mine):

“Look, the tariff situation was a big question market for all kinds of companies. And still is to some degree. But that was front and center for a while. Now coronavirus is front and center. Something else will be front and center six months from now and a year from now and two years from now. Real question is — where are these businesses gonna be five and ten and 20 years from now? Some of them will do sensationally, some of them will disappear. And overall I think America will do very well — you know, it has since 1776…

…We’ve got a big investment in airline businesses and I just heard even more flights are canceled and all that. But flights are canceled for weather. It so happens in this case they’re gonna be canceled for longer because of coronavirus. But if you own airlines for 10 or 20 years you’re gonna have some ups and down in current. And some of them will be weather related and they can be all kinds of things. The real question is you know, how many passengers are they gonna be carrying 10 years from now and 15 years from now and what will margins be and– what will the competitive position be? But I still look at the figures all the time — I’ll admit that…

…[Coronavirus] makes no difference in our investments. There’s always gonna be some news, good or bad, every day. In fact, if you go back and read all the papers for the last 50 years, probably most of the headlines tend to be bad. But if you look at what happens to the economy, most of the things that happen are extremely good. I mean, it’s incredible what will happen over time. So if somebody came and told me that the global growth rate was gonna be down 1% instead of 1/10th of a percent, I’d still buy stocks if I liked the price at which — and I like the prices better today than I liked them last Friday…

We’re buying businesses to own for 20 or 30 years. We buy them in whole, we buy them in part. They’re called stocks when we buy in part. And we think the 20- and 30-year outlook is not changed by coronavirus.”

But not every company is facing the same level of long-term risk because of COVID-19. Some companies are at higher risk of failing or having their health permanently impaired. These are companies with debt-laden balance sheets, lumpy revenues, and an inability to generate healthy free cash flows. Such companies have always faced a higher level of existential risk compared to companies with healthy balance sheets (that have minimal or reasonable levels of debt), recurring revenues, and strong free cash flows. But COVID-19 has raised even more questions on the survivability of the former group because of the intense short-term hit to business conditions worldwide.

We always need to tread carefully with the types of companies we invest in – more so today. But there’s no need to panic. Fear could be the biggest contributor to our investing-losses, even more than actual risks.

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

Coronavirus Outbreak: 5 Questions To Ask Yourself If You’re Investing In Stocks

If you invest in stocks, I think there are 5 questions you should always ask yourself. But they are even more prominent now given the coronavirus.

I started a recent article with the sentence: “It’s an understatement to say that stocks have been volatile of late.”

From 14 February 2020 to 8 March 2020, the S&P 500 in the US has declined by 12.1%. I mention the US stock market because it is by far the largest in the world. I’ve never thought it makes sense to find reasons for the short-term movements of stock prices. But I think it’s pretty clear that the coronavirus, COVID-19, is the key reason for the declines seen in recent days.

The number of people who are infected with COVID-19 has been rising significantly, with the death toll tagging along. The virus is also making its way into more countries over time.

Source: World Health Organisation

Global corporate giants such as Apple, Visa, and Mastercard have warned of pressures to their businesses because of COVID-19 (see here, here, and here). Airlines are some of the worst-hit groups of companies, with UK airline Flybe entering bankruptcy earlier this month; last week, Southwest Airlines in the US warned of a “very noticeable, precipitous decline in bookings.” In China, the PMI (purchasing managers’ index) for February 2020 came in at 35.7, the lowest seen since tracking began in 2004 (a reading below 50 indicates a contraction in factory activity). In 2008 and 2009, during the height of the Great Financial Crisis, China’s PMI reached a low of 38.8.

We’re clearly in an environment now where stocks are volatile and the world is grappling with a public health crisis and recessionary fears. Many of you are likely wondering what you should be doing now with your investment portfolios. If you invest in stocks, I think there are five questions you should always ask yourself. But they are even more prominent now given the current situation:

  1. What is my investing time horizon? If you’re investing in stocks with capital you need within the next five years, it’s always dangerous to do so. The danger is amplified given the current situation. Stocks are volatile over the short run, sometimes without reason. But over the long run, stock prices reflect business fundamentals and have delivered great returns.
  2. Do I have a sound investment framework? An investment framework guides the way you select your investments. I have my own personal criteria to find businesses that can grow at high rates over a long period of time. It has served me well for nearly a decade. But that’s not the only way to invest. Do you have a framework that is based on sound investing logic? If you don’t, it’s always a dangerous time to invest – doubly so, now.
  3. Do I have a sound investing plan? An investing plan is like an investing schedule – it guides us on when we put money to work in stocks. Some investors prefer a dollar-cost-averaging strategy, where a certain amount of capital is invested in stocks at regular intervals. That’s fine. Some prefer to be fully-invested at all times. There are also others who prefer to have a cash cushion that they will deploy depending on the magnitude of the market’s decline. These are all fine too. There are two crucial aspects to an investing plan: (1) Does it fit our temperament; and (2) does it make investing sense? If the first aspect fails, it does not matter how good our plan is – we will not stick to it. The second aspect is important for self-explanatory reasons. 
  4. Do I have a basic understanding of market history? Knowing what has happened in the past can give us context for what to expect next. It can also prevent us from panicking when stocks decline. Some critical information to know include: (1) How often do stocks decline? (2) How have stocks performed over the long-term through recessions? (3) Are short-term declines common even when stocks climb over the long run? I have shared these things before and they can be found here and here.
  5. Do I understand my own investing temperament? How we react to market declines can have a tremendous impact on our returns as investors. The investors of legendary fund manager Peter Lynch made only 7% per year despite him producing an incredible annual return of 29% for 13 years; that’s because Lynch’s investors had poor temperament, selling quickly whenever there was a short-term decline in his fund. If you know you have a poor investing temperament, then set up an investing plan that can save you from yourself.

These questions won’t guarantee that you will come out ahead when the COVID-19 crisis blows over. But I’m sure they’ll greatly increase your chances of success.

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

Why Market Crashes Are Inevitable

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:

Source: Robert Shiller data

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.

China’s Future: Thoughts From Li Lu, A China Super Investor

Li Lu is a brilliant investor and recently shared his thoughts on China’s future through a Mandarin essay. This is a translation of his work.

This post is my self-directed attempt to translate a Mandarin essay penned by Li Lu that was published in November 2019. The topic of the essay is Li’s review and thoughts on the book The Other Half of Macroeconomics and the Fate of Globalization written by economist Richard C. Koo (Gu Chao Ming).

I want to do this translation for three reasons. 

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.