Author: Chong Ser Jing

In 2011, Jeff Bezos, the founder and CEO of the US online retail giant Amazon.com, was interviewed by Wired. During the interview, he said (emphasis is mine):

“If everything you do needs to work on a three-year time horizon, then you’re competing against a lot of people. But if you’re willing to invest on a seven-year time horizon, you’re now competing against a fraction of those people, because very few companies are willing to do that.

Just by lengthening the time horizon, you can engage in endeavors that you could never otherwise pursue.”

What’s an edge?

I believe Bezos’s quote above applies to stock market investing too. By simply lengthening our time horizon when investing, we can gain an edge and eliminate our competition.

Investor John Huber from Saber Capital Management, who has an excellent – albeit relatively short – track record,  explained in a 2013 presentation that there are only three sources of edge: Informational; analytical; and time. I agree.

A difficult source of lasting edge

The informational edge refers to having access to information that most others do not have. In his 2013 presentation, Huber shared the story of how Buffett uncovered Western Insurance as an investment opportunity in the 1950s.

Western Insurance was a profitable, well-run insurance company and was selling at a price-to-earnings ratio of just 1. Buffett found the company by poring over Moody’s, a print magazine that listed financial statistics of stocks in the US. It would have been painstaking work in those days to look at every stock individually.

With the birth of the internet, the informational edge has mostly disappeared since information is now easily and cheaply available. The Internet – and the growth in software capabilities – have levelled the information playing field tremendously. This makes having access to information difficult to be a lasting investing edge for us.

Another difficult source of lasting edge  

The analytical edge is where you’re able to process information differently and come up with better insights compared to most. I believe, like Huber does, that this is still possible. Give two investors the exact same information about a company and it’s highly likely they will arrive at a different conclusion about its attractiveness as an investment opportunity.

As a great example, we can look at Mastercard and how investors Chuck Akre and Mohnish Pabrai think about the credit card company.

Akre runs the Akre Focus Fund, which has generated an impressive annual return of 16.8% from inception in August 2009 through to 30 September 2019. Over the same period, the S&P 500’s annual return was just 13.5%. Pabrai also has a fantastic long-term record. His fund’s annual return of 13.3% from 1999 to 30 June 2019 is nearly double that of the US market’s 7.0%.

At the end of September 2019, Mastercard made up 10% of the Akre Focus Fund. So clearly, Akre thinks highly of the company. Pabrai, on the other hand, made it very clear in a recent interview that he wouldn’t touch Mastercard with a 10-feet barge pool. In the October 2019 edition of Columbia Business School’s investing newsletter, Graham and Doddsville, Pabrai said:

“Is MasterCard a compounder? Yeah. But what’s the multiple? I can’t even look. Investing is not about buying great businesses, it’s about making great investments. A great compounder may not be a great investment.”

The fact that two highly accomplished stock market investors can have wildly differing views on the same company means that it is possible for us to develop an analytical edge. But it is not easy to achieve. In fact, I have a hunch that the ability to consistently produce differentiated insight may be an innate talent that some investors possess and others don’t.

A simple but lasting edge

Huber’s last source of edge, time, refers to our ability to simply adopt a long time horizon in the way we invest. It sounds simple, but it’s not easy to achieve. Because like Bezos said, not many people are willing or able to be patient. This makes time a lasting edge we can have in the market.

You may be surprised to know just how short-term minded many professional investors can be. A recent article from Huber showed how the hedge fund SAC Capital was predominantly focused on short-term stock price movements (emphasis is mine):

“The firm spent hundreds of millions of dollars they collectively spent on research [sic] was all designed to figure out if a stock was going to go up or down a few dollars in a short period of time, usually after an earnings announcement or some other significant event.

These traders were moving billions of dollars around with no concern for what the company’s long-term prospects were, other than how those prospects might be viewed by other traders in the upcoming days…

… The traders at SAC weren’t even discussing this type of edge [referring to the time-related edge]. It wasn’t even on their radar, because they had no interest in the long game.”

Another example can be seen in a story that Morgan Housel from the Collaborative Fund shared in a blog post (emphasis is mine):

“BlackRock CEO Larry Fink once told a story about having dinner with the manager of one of the world’s largest sovereign wealth funds.

The fund’s objectives, the manager said, were generational. “So how do you measure performance?” Fink asked. “Quarterly,” said the manager.

There is a difference between time horizon and endurance.”

Since many investors are more concerned with short-term price movements than long-term business value, this creates an opportunity for us if we’re focused on the latter. In the same article on SAC Capital, Huber explained:

“[T]he investor who is willing to look out three or four years will have a lasting edge because the more money that gets allocated for reasons other than a security’s long-term value, the more likely it is that the security’s price becomes disconnected from that long-term value.” 

The curse of patience, and a switch in mindset

Although having time on our side is a simple way for us to gain a lasting edge in the stock market, it is not easy to achieve, since we have to pay a price – of enduring short-term volatility. History bears this out: Even the biggest long-term winners in the stock market have also suffered painful short-term declines. 

Take the US-listed Monster Beverage for instance. I’ve written previously that from 1995 to 2015, Monster Beverage produced an astonishing total return of 105,000% despite its stock price having dropped by 50% or more from a peak on four separate occasions in that timeframe.

But a switch in our mindset can make the sharp swings over the short run easier to manage. “Fees are something you pay for admission to get something worthwhile in return. Fines are punishment for doing something wrong,” Morgan Housel once wrote. Most investors think of short-term volatility in the stock market as a fine, when they should really be thinking of it as a fee for something worthwhile – great long-term returns.

So, fee or fine? I love paying fees. Do you?

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.

Walter Schloss is one of my investing heroes. He’s not too well-known, which is a real pity, because he has a tremendous track record. He invested in US stocks for his fund and produced an astonishing annual return of 15.3% for 44 years from 1956 to 2000, far outstripping the US market’s annual gain of 11.5% over the same period.

There’s so much we can learn from Schloss. He never went to college. He was a one-man shop until his son Edwin joined in 1973 – and then they became a two-man shop till the fund was closed in the early 2000s. Schloss typically worked only from 9:30 am to 4:30 pm. Despite running a highly successful investment fund, he led very much a stress-free lifestyle. His office was also simple – it was a closet in a rented corner of a larger office. It seems like there’s no need for a fancy office to do well in investing! Schloss had no use for insider-connections and got his investment ideas mainly by reading the financial statements of companies. He’s a close friend of Warren Buffett, but invested in a completely different way, as we’ll see later.  

Unfortunately, it’s impossible for us now to learn directly from Schloss – he sadly passed away in 2012 at the ripe young age of 95. But the internet has given us the good fortune of being able to freely access a wonderful archive of materials on him. Within the archive is a fantastic investing speech Schloss once gave. 

Here are three great insights from him in that speech, along with my comments:

On investing in commodity-related stocks

Question: “Are you involved with commodities at all and if so…do you see silver as under-valued?”

Schloss: “You know, I have no opinion about any commodity or where it’s going to go and Asarco [a stock Schloss owned at the time of the speech] is a commodity company in copper. I have no idea if copper can keep going longer.

But I just think that the stock is cheap based upon its price, not necessarily because I know what’s going to happen to the price of the copper any more than silver. I have no opinion on any of those things. It saves me a lot of time.”

I love how Schloss had invested in a copper-related company not because he thought he knew where the price of copper’s heading to, but because he thought the stock was cheap. The difference between the two mindsets is very important for two reasons. 

First, the future movement of commodity prices is notoriously hard to pin down. In an article with Fool.com, Morgan Housel shared this fascinating nugget of information (emphasis is mine):

“[Economists Ron Acquits, Lutz Kilian, and Robert Vigfusson] showed that forecasts of the price of oil one year out made by the Energy Information Agency and survey firm Consensus Economics were no more accurate than just assuming whatever oil’s price is today is what it will be next year. Literally, not having any forecast was as accurate as a professional forecast.”

Second, a commodity-related company’s stock may not become a winner even if the price of the associated-commodity rises substantially. Here’s something on the topic that I shared in The Good Investors previously:

“Gold was worth A$620 per ounce at the end of September 2005. The price of gold climbed by 10% per year for nearly 10 years to reach A$1,550 per ounce on 15 September 2015. An index of gold mining stocks in Australia’s market, the S&P / ASX All Ordinaries Gold Index, fell by 4% per year from 3,372 points to 2,245 in the same timeframe.”

A high starting valuation. A weak balance sheet. Poor efficiency in production. Unscrupulous management. These are just some of the obstacles that stand between a positive macro-trend and higher stock prices.

The importance of knowing your own strengths and weaknesses

Question: “Buffett keeps talking about liking a handful of thick bets. It sounds like you don’t do that.”

Schloss: “Oh, no, we can’t. Psychologically I can’t, and Warren as I say, is a brilliant, he’s not only a good analyst, but he’s a very good judge of businesses and he knows, I mean my gosh, he buys a company and the guy’s killing himself working for Warren. I would have thought he’d retire.

But Warren is a very good judge of people and he’s a very good judge of businesses. And what Warren does is fine. It’s just that it’s not our – we just really can’t do it that way and find five businesses that he understands, and most of them are financial businesses, and he’s very good at it. But you’ve got to know your limitations.”

One of the most crucial skills we have to master as investors is knowing the limits of our knowledge and staying clear of the boundaries is. A failure to do so can be disastrous when investing. That’s because we may end up using strategies that are ill-suited to our psyche, and thus potentially result in us commiting stupid mistakes frequently.

Schloss understood this well, and invested in a manner that was well-suited to his own strengths and weaknesses. In his seminal 1984 essay on investing, The Superinvestors of Graham and Doddsville, Buffett shared the following about Schloss (emphasis is his):

“Walter has diversified enormously, owning well over 100 stocks currently. He knows how to identify securities that sell at considerably less than their value to a private owner. And that’s all he does.

He doesn’t worry about whether it’s January, he doesn’t worry about whether it’s Monday, he doesn’t worry about whether it’s an election year. He simply says, if a business is worth a dollar and I can buy it for 40 cents, something good may happen to me. And he does it over and over and over again.

He owns many more stocks than I do – and is far less interested in the underlying nature of the business; I don’t seem to have very much influence on Walter. That’s one of his strengths: no one has much influence on him.”

We need to evolve with the ever-changing market

Question: “Has your approach changed significantly?”

Schloss: “Yes, it’s changed because the market’s changed. I can’t buy any working capital stocks anymore so instead of saying well I can’t buy ‘em, I’m not going to play the game, you have to decide what you want to do.

And so we’ve decided that we want to buy stocks if we can that are depressed and are some book value and are not too, selling near to their lows instead of their highs and nobody likes them.

Well why don’t they like them? And then you might say there may be reasons why. It may simply be they don’t have any earnings and people love earnings. I mean that’s, you know, the next quarter that’s the big thing and of course we don’t think the net quarter is so important.”

I published an article recently in The Good Investors titled Sometimes, This Time Really Is Different. In the article, I shared that “it’s important for us to acknowledge that conditions in financial markets can change in permanent or near-permanent ways to severely blunt the usefulness of historical experience.”

Schloss was well aware of the need to keep up with the times, and he changed his investing approach when there was a paradigm shift. I think this is a severely underrated reason for his longevity in investing. 

But crucially, Schloss also knew what to retain. He continued (1) seeing stocks as partial ownership stakes in businesses, (2) to purchase stocks that were selling for far less than what their underlying businesses were worth, and (3) to be aware of his own limitations.

There are things about investing that are timeless. But markets do change, and so should we.

I highly recommend you to check out Schloss’s speech. It will be well worth your time. Here it is again.

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.

News broke earlier today that Iran has fired missiles at US troops stationed in Iraq, in retaliation for the death of a top Iraninan general at the hands of the US military. 

Could Iran’s latest move escalate into a full-blown war between itself and the US? I have no idea. My heart sinks at the thought of the human lives that could be painfully ended or maimed because of any potential large-scale armed conflict. May a war not happen. The human costs are too tragic. 

But what if tensions between Iran and the US erupt and a huge battle develops? What happens to the financial markets? In this uncertain time, it’s worth remembering that:

• The US experienced a recession in July 1990
• The US entered into war in the Middle East in August 1990. 
• The price of oil spiked in August 1990. 
• Ray Dalio said in early 1992 that “unfortunately… the current economic climate of low inflation and historically slow growth means that bonds will actually prove to be the better long-term performers.”

But from the start of 1990 to today, the US stock market is up nearly 800% in price alone (the chart below shows the price-change for the S&P 500 from the start of 1990 to early December 2019):

Every time I’m confronted with uncertainty in the markets, I turn to one of my favourite investing passages. It’s written by Warren Buffett in his Berkshire Hathaway 1994 shareholders’ letter:

“We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen.

Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%.

But, surprise – none of these blockbuster events made the slightest dent in Ben Graham’s investment principles. Nor did they render unsound the negotiated purchases of fine businesses at sensible prices.

Imagine the cost to us, then, if we had let a fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist.

A different set of major shocks is sure to occur in the next 30 years. We will neither try to predict these nor to profit from them. If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results.”

This too, shall pass. But again, may war not happen.

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.

In 2010, the US government interviewed Warren Buffett as part of its investigation on the causes of the 2007-09 financial crisis. 

The 103-page transcript of Buffett’s interview was released by the US government in March 2016, along with many other documents created during the investigation. The documents are a wonderful resource if you’re interested in gaining a deeper understanding of the worst economic meltdown seen in generations.

The transcript of Buffett’s interview is a fascinating treasure-trove of valuable insights from one of the best investors in the world today. Here are my favourite Buffett quotes from the transcript:

Spotting a great investment:

“And basically, the single-most important decision in evaluating a business is pricing power.

If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by a tenth of a cent, then you’ve got a terrible business. I’ve been in both, and I know the difference.”

Causes of a bubble:

“[T]he only way you get a bubble is when basically a very high percentage of the population buys into some originally sound premise and – it’s quite interesting how that develops – originally sound premise that becomes distorted as time passes and people forget the original sound premise and start focusing solely on the price action.”

More on the causes of a bubble (emphasis mine):

“[W]hat my former boss, Ben Graham, made an observation, 50 or so years ago to me that it really stuck in my mind and now I’ve seen evidence of it. He said, “You can get in a whole lot more trouble in investing with a sound premise than with a false premise.”

If you have some premise that the moon is made of green cheese or something, it’s ridiculous on its face. If you come out with a premise that common stocks have done better than bonds — and I wrote about this in Fortune article in 2001 – because there was a famous little book in 2001 by Edgar Lawrence Smith – in 1924 by Edgar Lawrence Smith that made a study of common stocks versus bonds.

And it showed – he started out with the idea that bonds would over-perform during deflation and common stocks would over-perform during inflation. He went back and studied a whole bunch of periods and, lo and behold, his original hypothesis was wrong.  He found that common stock always over-performed. And he started thinking about that and why was that.

Well, it was because there was a retained earnings factor. They sold – the dividend yield on stocks was the same as the yield on bonds, and on top of it, you had retained earnings.  So they over-performed. That became the underlying bulwark for the ‘29 bubble. People thought stocks were starting to be wonderful and they forgot the limitations of the original premise, which was that if stocks were yielding the same as bonds, that they had this going…

…So after a while, the original premise, which becomes sort of the impetus for what later turns out to be a bubble is forgotten and the price action takes over.”

Even more on the causes of a bubble:

“It’s a totally sound premise that houses will become worth more over time because the dollar becomes worth less. It isn’t because – you know, construction costs go up.  So it isn’t because houses are so wonderful, it’s because the dollar becomes worth less, and that a house that was bought 40 years ago is worth more today than it was then.

And since 66 or 67 percent of the people want to own their own home and because you can borrow money on it and you’re dreaming of buying a home, if you really believe that houses are going to go up in value, you buy one as soon as you can. And that’s a very sound premise.  It’s related, of course, though, to houses selling at something like replacement price and not far outstripping inflation.

So this sound premise that it’s a good idea to buy a house this year because it’s probably going to cost more next year and you’re going to want a home, and the fact that you can finance it gets distorted over time if housing prices are going up 10 percent a year and inflation is a couple percent a year.

Soon the price action – or at some point the price action takes over, and you want to buy three houses and five houses and you want to buy it with nothing down and you want to agree to payments that you can’t make and all of that sort of thing, because it doesn’t make any difference: It’s going to be worth more next year.

And lender feels the same way. It really doesn’t make a difference if it’s a liar’s loan or you know what I mean? …because even if they have to take it over, it’s going to be worth more next year. And once that gathers momentum and it gets reinforced by price action and the original premise is forgotten, which it was in 1929.” 

Detecting danger in financial institutions:

“Well, I didn’t know that they weren’t going to be good investments, but I was concerned about the management at both Freddie Mac and Fannie Mae, although our holdings were concentrated in Fannie Mac.

They were trying to – and proclaiming that they could increase earnings per share in some low double-digit range or something of the sort. And any time a large financial institution starts promising regular earnings increases, you’re going to have trouble, you know?

I mean, it isn’t given to man to be able to run a financial institution where different interest-rate scenarios will prevail on all of that so as to produce kind of smooth, regular earnings from a very large base to start with; and so if people are thinking that way, they are going to do things, maybe in accounting – as it turns out to be the case in both Freddie and Fannie – but also in operations that I would regard as unsound.”

There’s never just one problem:

“And, you know, there is seldom just one cockroach in the kitchen. You know, you turn on the light and, all of sudden, they all start scurrying around. And I wasn’t – I couldn’t find the light switch, but I had seen one.“

Having faith in the system:

“I was, in my own mind, I – there was only way both the financial world and the economy was going to come out of this situation of paralysis in September of 2008, and that was – I made the fundamental decision that we had really the right people in Bernanke and Paulson in there, where the President would back them up. That we had a government that would take the action and only the government could take the action to get an economic machine that had become stalled, basically, back into action.

And I didn’t know what they would do. I didn’t know what Congress would go – it really didn’t make much difference. The important thing was that the American public would come to believe that our government would do whatever it took. And I felt it would – it would have been suicide not to, but it hadn’t been done in the early ‘30s.

And therefore, I felt companies like General Electric or Goldman Sachs were going to be fine over time. But it was a bet essentially on the fact that the government would not really shirk its responsibility at the time like that, to leverage up when the rest of the world was trying to de-leverage and panicked.”

Understanding moral hazard:

Question to Buffett: “Would the American economy have been better off in the long run if there had been no exceptional government assistance to financial institutions? In other words, do you think we’ve increased the likelihood of moral hazard in the long run?”

Buffett’s response: “No, I think the moral hazard has been misunderstood in a big way. There is no moral hazard existing with shareholders of Citigroup, with Freddie Mac, with Fannie Mae, with WaMu, with Wachovia – you just go up and down the line. I mean, those people lost anywhere from 90 percent to 100 percent of their money, and the idea that they will walk away and think, “Ah, I’ve been saved by the federal government.”

I think just the companies that I’ve named there’s at least a half a trillion dollars of loss to common shareholders. Now, there’s another question with management, which we might get into later, but in terms of moral hazard, I don’t even understand why people talk about that in terms of equity holders.”

The difference between investing and speculating:

“It’s a tricky definition. You know, it’s like pornography, and that famous quote on that.

But I look at it in terms of the intent of the person engaging in the transaction, and an investment operation – though, it’s not the way Graham defines it in his book, but investment operation in my view is one where you look to the asset itself to determine your decision to lay out some money now to get some more money back later on.

So you look to the apartment house, you look to the stock, you look to the farm, in terms of what that will produce. And you don’t really care whether there is a quote on it at all. You are basically committing some funds now to get more funds later on, through the operation of the asset.

Speculation, I would define as much more focused on the price action of the stock, particularly that you, or the index future, or something of the sort. Because you are not really you are counting on for whatever factors, because you think quarterly earnings are going to be up or it’s going to split, or whatever it may be, or increase the dividend but you are not looking to the asset itself.” 

The dangers of using borrowed money:

“Anything that increased leverage significantly tends to make – it can’t even create a crisis, but it would tend to accentuate any crisis that occurs.

I think you that if Lehman had been less leveraged, there would have been less problem in the way of problems. And part of that leverage arose from the use of derivatives, and part of the – part of the dislocation that took place afterwards arose from that.

And there’s some interesting material, if you look at – if you look at – I don’t know exactly what Lehman material I was looking at – but they had a netting arrangement with the Bank of America, as I remember.

And, you know, the day before they went broke – and just are very, very, very rough figures, from memory – but as I remember, the day before they went broke, Bank of America was in a minus position of $600 million, or something like that, they had deposited with, I think, JPMorgan in relation to Lehman. And I think the day they went broke, it reversed to a billion and a half in the other direction. And those are big numbers. And I think the numbers – I think I’m right on just order of magnitude.

So when things like that exist in the system, you know, it’s under stress for other reasons, it becomes a magnifying factor how big of a one, you don’t know. But Lehman – Lehman would have had less impact on the system if they had not had the derivative book that they had. Now, they probably had bad real estate investments and a whole bunch of other things as well.” 

More on the dangers of using borrowed money:

“But it gets down to leverage overall. I mean, if you don’t have leverage, you don’t get in trouble.  That’s the only way a smart person can go broke, basically. And I’ve always said, “If you’re smart, you don’t need it; and if you’re dumb, you shouldn’t be using it.”” 

The risks of financial derivatives:

“I think it’s a terribly difficult problem because – well, it was so difficult a problem, I didn’t think I could solve it.

We bought Gen Re, which had 23,000 derivative contracts. I could have hired 15 of the smartest people – math majors, Ph.D.s, and I could have given them carte blanche to devise any reporting system to me, that would enable me to get my mind around what exposures I had, and it wouldn’t have worked. The only answer was to get out of it.

Can you imagine, 23,000 contracts with 900 institutions all over the world, probably 200 of them with names I can’t pronounce, you know? And all of these contracts extending years in the future, multiple variables. You know, all of these – you can’t – you can’t manage them, in my view. You know, I wouldn’t be able to manage something like that.

And if I read a 10K that’s 300 pages long and it describes notional values and all this – not to impugn anybody because probably one of the best managed, really large institutions around – but if I look at JPMorgan, I see two trillion of receivables, two trillion of payables, a trillion seven netted off on each side; of the 300 billion remaining, maybe 200 billion collateralized.

But that’s all fine, but I don’t know what these continuities are going to do to those numbers overnight. If there’s a major nuclear, chemical, or biological terrorist action that really is disruptive of the whole financial system here, who the hell knows what happens to those numbers on both sides or thousands of counterparties around?

So I don’t think it’s – I think it’s virtually unmanageable. It certainly is – it would be for me.” 

The causes of the housing crisis that led to the financial crisis:

“Well, I think the primary cause was an almost universal belief, among everybody and I don’t ascribe particular blame to any part of it – whether it’s Congress, media, regulators, homeowners, mortgage bankers, Wall Street — everybody — that houses prices would go up.  And you apply that to a $22 trillion asset class, that’s leveraged up, in many cases. And when that goes wrong, you’re going to have all kinds of consequences.

And it’s going to hit not only the people that did the unsound things, but to some extent the people that did the semi sound, and then finally the sound things, even, if it is allowed to gather enough momentum of its own on the downside, the same kind of momentum it had on the upside.

I think contributing to that — or causing the bubble to pop even louder, and maybe even to blow it up some, was improper incentives — systems and leverage. I mean, those — but they will contribute to almost any bubble that you have, you know, whether it’s the Internet or anything else.

The incentive systems during the Internet, you know, were terrible. I mean, you just — you formed a company, and you said, “I’m going to somehow deliver a billion eyeballs,” and somebody says, “Well, that’s $50 apiece,” or something. I mean, you get craziness that goes on there.

Leverage was not as much a factor in a bubble. But I think in this particular bubble, because leverage is so much a part of real estate, that once you loosened up on that, you’ve provided fuel that caused that bubble to get even bigger, and you made the pop even bigger, when it finally did pop.”

Accepting but not condoning fraud:

“Well, I mean, there was, obviously, a lot of fraud. There was fraud on the parts of the borrowers and there was frauds on the part of the intermediaries, in some cases. But you’d better not have a system that is dependent on the absence of fraud. I mean, it will be with us.”  

Here’s the link to download the transcript of Buffett’s interview. Take a look. Trust me – you’ll thoroughly enjoy it.

Photo source: Modified from Warren Buffett Caricature by DonkeyHotey under Creative Commons 2.0.

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

A friend of mine recently asked me: “How do you define risk when investing in stocks?” It’s a really good question that I think is worth fleshing out in an article.

In my opinion, there’s too much fuzzy thinking when the topic of risk in stocks pops up. It doesn’t help that the academic definition of risk in financial markets is simply price-volatility – I think this definition is wrong if you’re investing with a long time horizon. 

Responding

Here’s my reply to my friend’s question:

“To me, risk is the chance of permanent or near-permanent loss of capital. And that risk can come in a few ways:

1) Confiscation by government
2) Damage from war and/or natural catastrophes
3) Inflation and deflation
4) Extreme overvaluation
5) Management fraud”

I missed out on one more source of risk-according-to-my-definition, and that is companies going bankrupt. (I will be sending this article to my friend so that he gets the complete picture!)

Volatility is not risk

I want to first discuss why I think price-volatility is not the same as risk if you’re a long-term investor.

In his book Deep Risk: How History Informs Portfolio Design, the polymath investor William Bernstein categorised investing-risks into two forms. Here’s the Wall Street Journal’s Jason Zweig describing the first form of risk in an article:

“What Mr. Bernstein calls “shallow risk” is a temporary drop in an asset’s market price; decades ago, the great investment analyst Benjamin Graham referred to such an interim decline as “quotational loss.”

Shallow risk is as inevitable as weather. You can’t invest in anything other than cash without being hit by sharp falls in price. Shallow doesn’t mean that the losses can’t cut deep or last long – only that they aren’t permanent.”

Shallow risk is the type of risk that time can erase. It’s not permanent. And if we’re long-term investors – and everyone should be long-term investors! – I believe we need not be concerned about shallow risk.

In presentations on the market outlook for 2020 that I gave in December 2019, I played a game with my audience: 

“I’m going to share two stocks with you, and you’re going to tell me which you would prefer to invest in.

Stock ABC is the first. It was listed in 1997. From 1997 to 2018, the peak-to-trough decline in Stock ABC’s share price in each year had ranged from 12.6% to 83.0%. Put another way, Stock ABC had experienced a double-digit peak-to-trough decline every single year from 1997 to 2018.

Now let’s look at Stock DEF. It was also listed in 1997. And the chart shows Stock DEF’s share price growing by an astonishing 76,000% from $2 in 1997 to $1,500 in 2018. It’s obvious that Stock DEF has been an incredible long-term winner.

With this information, would you prefer to invest in Stock ABC or Stock DEF?”

I then revealed their identities:

“Here’s the kicker: They are the same stock. Stock ABC and Stock DEF are both Amazon, the US e-commerce giant.”

While building massive long-term wealth for its investors, Amazon’s stock had displayed shallow risk time and again.

I’ve owned Amazon’s shares since April 2014 and over the past five-plus years, I’ve experienced countless painful short-term falls – the peak-to-trough declines in Amazon’s stock price in 2016, 2017, and 2018 were more than 20% in each of those three years. But I was never worried. Amazon’s business was – and is – growing rapidly. From April 2014 to today, Amazon’s stock price is up by around 500%. The e-commerce giant’s shallow risk simply melted away with time and the growth of its business.

Permanent or near-permanent loss of capital

Zweig’s article also mentioned Bernstein’s second form of risk: 

“Deep risk,” on the other hand, is an irretrievable loss of capital, meaning that after inflation you won’t recover for decades – if ever.”

Bernstein’s deep risk is the same as my definition of what risk really is when investing in stocks. According to Bernstein, four things cause deep risk:

• Inflation: A runaway increase in prices, which eats away the purchasing power of money.  
• Deflation: A persistent drop in asset prices, which have been very rare occurrences throughout world history.
• Confiscation: When authorities seize assets, by onerous taxes or through sheer force.
• Devastation: Because of acts of war or anarchy (and I’ll add natural catastrophes to the mix too).

The sources of deep risk that Bernstein shared are the first three risk-factors that I mentioned in my answer to my friend’s question. My response also included my own sources of deep risk: Extreme overvaluation, management fraud, and company-bankruptcy.

Japan’s stock market is a classic case of extreme overvaluation. Today, the Nikkei 225 Index – a benchmark for Japanese stocks – is just below 24,000. That’s around 40% lower than the all-time high of nearly 39,000 that was reached in December 1989, more than 30 years ago.

At its peak, Japanese stocks had a CAPE ratio of more than 90, according to investor Mebane Faber. That’s an incredibly high valuation, which led to the Japanese stock market’s eventual collapse. The CAPE ratio – or cyclically-adjusted price-to-earnings ratio – is calculated by dividing a stock’s price with its average inflation-adjusted earnings over the past 10 years.

Management fraud involves cases such as Enron and Satyam in the US. Both companies saw their leaders fabricate financial and/or business numbers. When the shenanigans were exposed, both companies’ share prices effectively went to zero.

At home in Singapore’s stock market, there have been cases of fraud too. Some involve S-chips, which are Singapore-listed companies that are headquartered in China. An example is Eratat Lifestyle, a company that was supposedly manufacturing and distributing fashion and sports apparel.

In 2014, Eratat was discovered to have forged its bank statements. Instead of having RMB 577 million in the bank account of its main subsidiary at the end of 2013, as was claimed by the company, the account only had RMB 73,000 (that is 73 thousand) in cash. 

Eratat made its final official filing with Singapore Exchange – our local stock exchange operator and regulator – in June 2017, more than three years after the trading of its shares was stopped in January 2014. The final official filing stated that Eratat was “hopelessly insolvent” and “there will not be any distribution available to the shareholders of the Company.” Investors in Eratat lost their shirts.

The downfall of Eratat

I want to digress a little here and share more about what happened with Eratat. There are great lessons for us to be found in the episode. 

It turns out that there were two massive danger signs that appeared before all hell broke loose.

Firstly, there was the unusually low interest income earned by Eratat. In 2012, the company reported average cash holdings of around RMB 270 million. Yet it earned interest income of just RMB 1.4 million, which equated to an average interest rate of only 0.5%. RMB-denominated deposit rates in China were easily 3% during that period. 

Secondly, Eratat issued bonds with absurdly high interest rates despite having plenty of cash on its balance sheet. In July 2013, Eratat issued bonds with a total value of RMB 100.5 million to Sun Hung Kai & Co., a Hong Kong-based finance company. The bonds had short tenure of merely two years (meaning they had to be repaid after two years), but came with an effective annual interest rate of 16.7%. Interestingly, Eratat reported having RMB 545 million in cash and zero debt on its balance sheet just prior to issuing the bonds. Of course, we now know that the cash that Eratat claimed to have was fictitious.

The next time you see a company earn a pittance in interest income on its cash holdings and/or borrow at ridiculously expensive rates despite appearing to have lots of cash, be wary. You should check if there are any good reasons behind such things happening.

Circling back

Company-bankruptcy is another way for us to suffer a permanent loss of capital. And we should note that bankruptcies can happen even with management teams who are not fraudulent. Sometimes it’s a simple case of a business running into trouble because of high debt and an inability to generate cash.

Hyflux is a good example. The water-treatment company filed for bankruptcy protection in May 2018 but prior to that, the company was already laden with debt and was burning cash for a number of years. There are questions surrounding the competency of Hyflux’s long-time leader, Olivia Lum, but Hyflux’s case is a business-failure, and its collapse had nothing to do with fraud.

Protecting ourselves

After running through the concepts of shallow risk and deep risk, you may be left wondering: How can I protect myself from deep risk? Zweig’s aforementioned article also offered suggestions from Bernstein, which I will summarise [my additional inputs are in square brackets]:

• Inflation: Globally diversified portfolio of stocks; [also look for companies with pricing power, so that they can pass on cost-increases to customers].
• Deflation: Long-term government bonds; [also look for companies with pricing power, so that they can keep their selling prices intact in a deflationary environment].
• Confiscation: Own foreign assets; [or invest in markets where the government has a strong history of respecting the rule of the law and shareholder rights].
• Devastation: Nothing much we can do! ¯\_(ツ)_/¯

For the sources of deep risk that I put forth:

• Extreme overvaluation: Pay attention to the valuation of the stocks we invest in.
• Management fraud: Be vigilant about unusual transactions that a company has made; and build a diversified investment portfolio so that even if we unfortunately end up with a fraud case, our portfolios will not be ruined. 
• Bankruptcy: Invest in companies that are operating in industries with bright prospects and that have strong balance sheets and good ability to generate free cash flow.

Protecting ourselves from ourselves

The final few paragraphs of Zweig’s article on Bernstein’s thinking on risk is extremely noteworthy. They highlight the idea that our own behaviour is an important source of deep risk. Zweig wrote:

“Look back, honestly, at what you did in 2008 and 2009 when your stock portfolio lost half its value. Then ask how likely you are to hang on in a similar collapse. Your own behavior can turn shallow risk into deep risk in a heartbeat.”

I couldn’t agree more. Benjamin Graham once said that “The investor’s chief problem – and even his worst enemy – is likely to be himself.” Sometimes, we create our own headaches.

The CGM Focus Fund was the best-performing US stock mutual fund in the decade ended 30 November 2009 with an impressive annual return of 18.2%. But shockingly, its investors lost 11% per year over the same period. How did this tragedy happen?

It turns out that CGM Focus Fund’s investors would get greedy when it had a purple patch and pour money into it. But the moment the fund encountered temporary turbulence, its investors would flee because of fear. Shallow risk had turned into deep risk for CGM Focus Fund’s investors – all because they could not save themselves from themselves.

So when we’re thinking about risk when we’re investing, we should never forget the biggest source of deep risk: Our own behaviour.

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

I recently reconnected with a schoolmate of mine whom I’ve not seen for many years. He wanted to learn more about investing and I was happy to help. We had a wonderful time chatting in person and catching up with each others’ lives.

During our conversation, he asked a great question that I’ve never been asked before: “Why do investors lose money in the stock market?” I came up with two reasons, and I think they’re worth fleshing out in an article. 

Reason 1: Greed and fear

I think the theme of greed and fear in the market is best illustrated with the histories of the Fidelity Magellan Fund and the CGM Focus Fund, both of which invested in US stocks.

During his 13-year tenure running the Fidelity Magellan Fund from 1977 to 1990, Peter Lynch produced one of the greatest track records of all time: A 29% annualised return. That rate of return turns $1,000 into more than $27,000 in 13 years.

But what’s stunning is that Lynch’s investors earned far lower returns than he did. Spencer Jakab, a financial journalist with The Wall Street Journal, explained in his book Heads I Win, Tails I Win why that was so (emphasis is mine):

“During his tenure Lynch trounced the market overall and beat it in most years, racking up a 29 percent annualized return. But Lynch himself pointed out a fly in the ointment.

He calculated that the average investor in his fund made only around 7 percent during the same period. When he would have a setback, for example, the money would flow out of the fund through redemptions. Then when he got back on track it would flow back in, having missed the recovery.”

In essence, investors got greedy when Lynch had a purple patch and poured into the Fidelity Magellan Fund. But the moment Lynch’s fund hit some temporary turbulence, they fled because of fear. Greed and fear had led to investors buying high and selling low.

A similar tale befell the CGM Focus Fund. In the decade ended 30 November 2009, the CGM Focus Fund was the best-performing US stock mutual fund, with a gain of 18.2% annually. But shockingly, its investors lost 11% per year over the same period. How? CGM Focus Fund’s investors chased performance and bailed at the first whiff of trouble. That’s greed and fear, again.

It’s the same problem when it comes to investing in individual stocks. Some investors blindly chase a stock that has been rising (because of greed), only to sell at the first sign of temporary trouble (because of fear). What they don’t appreciate is that volatility is a feature of the stock market, not a bug. Even the best-performing stocks over the long run suffer from sickening short-term declines.

Reason 2: Not knowing what they’re investing in

The second reason is that many investors do not have a sound framework for investing. They buy a stock based on hot tips. Or they focus on superficial factors, such as a stock’s yield.

It’s dangerous to invest this way. If you’re investing based on a hot tip, you have no idea what will make or break the investment. You’re essentially gambling.

The risk of investing based on superficial factors can be illustrated with Hyflux. The water-treatment firm issued perpetual securities and preference shares in 2011 and 2016. They came with fat yields of 6% and attracted a large group of yield-hungry investors, many of whom focused on the yields. They did not notice Hyflux’s weak financial picture.

Back when Hyflux issued its 6% perpetual securities in May 2016, I wrote an article pointing out that the securities were risky. I said:

“According to data from S&P Global Market Intelligence, Hyflux has been generating negative cash flow from operations in each year from 2010 to 2015. Meanwhile, the company currently has a net-gearing ratio (net debt to equity ratio) of 0.98, which isn’t low.”

Hyflux ended up filing for bankruptcy protection in May 2018, and investors in the company’s perpetual securities and preference shares now face the prospect of suffering painful losses.

The Good Investors’ conclusion

The stock market can be a fantastic place for us to build lasting long-term wealth. But it can also be a money-burning pit if we’re not careful. Fortunately, the problems are easy to solve.

To tackle greed and fear, we can keep an investment journal that contains entries on our reasons for each investment we make. When we pen our thoughts down, we actually force ourselves to review our thought processes, thus improving our investment decision-making. And when the markets inevitably go through short-term declines, we can study our journal and determine with a cooler mind if our investment theses still hold.

The second big reason why investors lose money in the stock market that I see is ignorance. And here’s the balm to soothe this issue: We just need to understand what the stock market really is, and figure out a sound investment framework.

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.