Chong Ser Jing, Author at The Good Investors : Page 22 of 23

Sometimes, This Time Really Is Different

The four most dangerous words in investing are “This time it’s different.” But investing is challening because sometimes, this time really is different.

Sir John Templeton, one of the true investing greats, once said that the four most dangerous words in investing are “This time it’s different.”

He wanted to warn us that if we ignore history, we’re doing so at our own peril. As French writer Jean-Baptiste Alphonse Karr once stated, “Plus ça change, plus c’est la même chose” (“the more things change, the more they stay the same”).

But what makes investing so challenging is that sometimes, this time really is different.

When dividend yields change permanently

There were two huge crashes in the US stock market in the early 20th century. One happened in 1929, during the infamous Great Depression, when US stocks fell by more than 80% at the 1932 bottom. The other, which is less well-known, occurred in the first decade of the 1900s and was known as the Panic of 1907.

Something interesting happened prior to both of these crises. In the first half of the 20th century, the dividend yield of US stocks were higher than the country’s bond yield most of the time. The only two occasions when the dividend yield fell below the bond yield were – you guessed it – just before the Panic of 1907 and the Great Depression.

Knowing what happened in the first half of the 1900s, it’s easy for us to think that US stocks would crash the next time the dividend yield fell below the bond yield. So guess what happened when the dividend yield of US stocks started once again to slip behind the bond yield in the late 1950s?

The bond yield ended up staying higher than the dividend yield all the way until it was late into the first decade of the 2000s!

If we were investing in the US in the 1950s and wanted to invest based on the historical relationship between dividend and bond yields in the first-half of the 1900s, we had no chance at all to invest for decades.

And yet from 1955 (before the dividend yield fell below the bond yield) to 2008 (when the dividend yield briefly became higher than the bond yield again), the S&P 500’s price increased by nearly 2,400%.

When a sign of cheapness stops working

Walter Schloss is one of my investing heroes, but he’s not too well-known among the general public. That’s a real pity because Schloss’s track record is astounding.

From 1956 to 2000, Schloss’s investment firm produced an annualised return of 15.3%, turning every $1,000 invested into more than $525,000. Over the same time frame, the US stock market, as a whole, had compounded at merely 11.5% per year – $1,000 would have become just $120,000.

In 1985, Schloss was interviewed by the investing publication Barron’s. During the interview, he recounted a story involving his one-time boss and fellow investing luminary, Benjamin Graham:

“Graham used to have this theory that if there were no working capital stocks around, that meant the market was too high…

… [That’s] because historically, when there were no working capital stocks, the market collapsed. That worked pretty well till about 1960, when there weren’t any working capital stocks, but the market kept going up. So that theory went out.”

Schloss provided an explanation of what a working capital stock is in the same interview:

“Suppose a company’s current assets are $10 million; the current liabilities are $3 million. There’s $7 million in working capital. And, they are, say, $2 million in debt. Take that off. So there’s $5 million of adjusted working capital. And say there are 100,000 shares, so they got $50 a share of working capital.

Now, if that stock were selling at 30 bucks a share, it would be kind of interesting.”

To put it simply, working capital stocks are stocks that are priced very cheaply compared to the assets they own. Graham’s theory was that if the market no longer has such cheap stocks, then a crash is imminent.

The model worked fine for a while, then it stopped working, as working capital stocks became scarce near-permanently from the 1960s onwards. In fact, Schloss had to change his investment strategy. During an interview with Outstanding Investors’ Digest in the late 1980s, Schloss said (emphasis is mine):

“Yes. I think it has – largely because of the situation in the market. Graham-Newman [Benjamin Graham’s investment firm] used to buy working capital stocks – which I thought was a great idea.

But by 1960, there were practically no working capital stocks. With the exception of 1974, at the very bottom of that market, there have been practically no working capital stocks.

A good way of seeing it is to look at Value Line’s [a business publication showing financial numbers of US stocks] list of working capital stocks. If you go back 15 years, you’ll see they have some on the list. Today, there are very few. And the ones that are on the list are really pretty bad – often with a lot of debt – especially in relationship to the equity.

With working capital stocks gone, we look next at book value.”

Schloss was right to have tweaked his strategy. The US stock market has been marching higher – much higher – since the disappearance of working capital stocks. From the start of 1960 to today, the S&P 500 has increased from 60 points to over 3,000. That’s more than a 50-fold jump in value.

Recognising when things are different

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.

The limits of using history can be applied to individual stocks too. For instance, it’s tempting for us to conclude that a stock is a bargain if it has lower valuations now compared to its own history. But we should also carefully consider if there’s anything that has permanently changed.

Bankruptcy risks. Industry obsolesce. Incompetent management. Absurdly high valuations in the past. These factors, and more, could render history useless as a guide for the future.

Many investors love to look at historical valuation data when studying the markets. I do too. But when doing so, it’s crucial to remember that things can change. What has worked in the past may no longer be valid in the future. We need to recognise that sometimes, this time really is different.

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.

3 Lessons From A 30% Annual Return In 3 Years

I picked six stocks three years ago in Singapore’s major newspaper, The Straits Times. The six stocks have done really well with a 30% annual return.

Three years ago on 18 December 2016, I was interviewed by The Straits Times for its “Me & My Money” column. During the interview, I mentioned six US-listed stocks that I thought would do well.

I believe that we can significantly improve our investing process if we score ourselves on our stock picks and on our forecasts – looking back, we can clearly see what went well and what went wrong. I also believe that three years is the bare minimum time-length we should use when analysing our investment decisions.

With three years having passed since my Straits Times interview, I checked how I fared, and picked up three lessons.

The stocks and my performance

Here are the six stocks and their returns (excluding dividends, and as of 15 December 2019) since the publication of my interview:

Facebook: +62%
Alphabet: +70%
Amazon: +132%
Activision Blizzard: +61%
MercadoLibre: +266%
Netflix: +140%
Average: +122%

The 122% average-return produced by the group of six over the past three years equates to an impressive annual return of 30%.

I think it’s crucial to also look at how the US stock market has performed. The reason why I’m investing in individual stocks is because I want to do better than the market. If I cannot beat the market, then I should be investing in passive funds instead, such as index-tracking exchange-traded funds. Finding stocks to invest in is a fun process, but it’s also hard work and requires discipline.

Over the past three years since my Straits Times interview was published, the S&P 500, including dividends, has increased by 49% in total, or 14% per year. All six stocks I was positive on have beaten the S&P 500 – and the group’s annual return is more than double the market’s. I think that’s not too shabby!

The 3 lessons

My first key takeaway is that my sextet were huge companies even when I talked about them during my interview. With the exception of MercadoLibre and Activision Blizzard, the six stocks were also highly visible and well-known companies across the world. You’ve probably used or at least heard about the services provided by Facebook, Alphabet (the parent of Google), Amazon, and Netflix.

Company	Market capitalisation on 18 December 2016
Facebook	US$345.5 billion
Alphabet	US$551.6 billion
Amazon	US$360.1 billion
Activision Blizzard	US$27.1 billion
MercadoLibre	US$6.8 billion
Netflix	US$53.3 billion

I’ve come across many investors who think that the only way to find good investment opportunities would be to look at stocks that are obscure and small. They ignore huge and well-known companies because they think that such stocks cannot be bargains due to high attention from market participants. But I think fantastic investment opportunities can come from companies of all sizes.

The second takeaway is that most of the stocks have inspirational and amazing leaders.

For example, at Facebook, there’s Mark Zuckerberg. Yes, there has been plenty of controversy surrounding him and his company in recent years. But in Facebook’s IPO prospectus, Zuckerberg included a shareholders’ letter (see page 80 of the document) that is a tour-de-force on building a company that has a purpose beyond profit. Here’s just one excerpt on the point:

“As I said above, Facebook was not originally founded to be a company. We’ve always cared primarily about our social mission, the services we’re building and the people who use them. This is a different approach for a public company to take, so I want to explain why I think it works.

I started off by writing the first version of Facebook myself because it was something I wanted to exist. Since then, most of the ideas and code that have gone into Facebook have come from the great people we’ve attracted to our team.

Most great people care primarily about building and being a part of great things, but they also want to make money. Through the process of building a team — and also building a developer community, advertising market and investor base — I’ve developed a deep appreciation for how building a strong company with a strong economic engine and strong growth can be the best way to align many people to solve important problems.

Simply put: we don’t build services to make money; we make money to build better services.”

I reserve the right to be wrong, but I believe in Zuckerberg’s letter.

At Alphabet, there’s Sergey Brin, Larry Page, and Sundar Pichai. Brin and Page, the founders of the company, recently stepped down from active management of Alphabet. But they had built an amazing firm that transformed the way the world accessed and searched for knowledge.

At Amazon, there’s Jeff Bezos. There’s also Marcos Galperin at MercadoLibre and Reed Hastings at Netflix. All three are innovative business leaders with tremendous track records. I also discussed Netflix’s management in greater depth in my investment thesis for the company. I think quality management is a key competitive advantage for a company and is a useful signal for picking long-term winners in the stock market. What do you think?

My last major takeaway is that I’ve held most of the six stocks for years before the interview was conducted (I still own them all!). From the time of my ownership to the publication of my interview with The Straits Times, they had performed pretty well – and then they continued to march higher. Peter Lynch once said that the best stock to buy may be the one you already own. How true!

Company	Date of my first investment	Return of company from the date of my investment to my *Straits Times* interview	Return of S&P 500 from the date of my investment to my *Straits Times* interview
Facebook	13 July 2015	33%	11%
Alphabet	29 February 2016	13%	19%
Amazon	15 April 2014	140%	30%
Activision Blizzard	26 October 2010	223%	117%
MercadoLibre	17 February 2015	18%	12%
Netflix	15 September 2011	414%	109%

I think there are two more points worth noting from my last major takeaway:

Stocks need time to perform. MercadoLibre is a good example. After nearly two years from my first investment (from February 2015 to December 2016), the company’s return was a mere 18%. But then MercadoLibre’s stock price proceeded to rise by 266% since December 2016.
There will always be things to worry about, but companies will still continue to grow and drive the stock market higher. Over the past three years since December 2016, we’ve had Brexit-related uncertainties, the US-China trade war, and interest rates rising and then falling. There are many more big issues the world has confronted and will have to continue to deal with. Throughout these episodes, the free cash flow of Facebook, Alphabet, and Amazon have increased by a total of 65%, 19%, and 121%. MercadoLibre and Netflix have seen their revenues grow by 167% and 131%, respectively.

A bonus takeaway

There’s also a bonus lesson here! In my interview with the Straits Times, I had identified two stocks as mistakes. Here they are and their returns (again, with dividends not included):

Ford: -27%
Dolby: +48%

I said in the interview that I rarely sell my stocks. This is for a good reason: I want to build and maintain the discipline of holding onto my winners for the long run. That’s how I believe that wealth can be built in the stock market and how an investment portfolio should be managed.

Yes, I recognise that holding onto the losers is not an optimal decision when investing. But if our investment framework is robust, then we’ll end up with winners that can more than make up for the losers. And selling our winners too early is a mistake in itself that we should aim to avoid as much as possible. A good way to avoid this mistake is to build the discipline to sell rarely. We have to train our discipline like how we train for physical fitness.

Sometimes not selling also works out in my favour. Look at Dolby’s return, which has matched the market. But I’m glad I identified both Dolby and Ford as mistakes because they’ve not been able to beat the returns of the S&P 500 and my group of six stocks.

The Good Investors’ conclusion

It’s been three years since my interview with the Straits Times. Three years is the shortest amount of time that I think we can use to form conclusions on investing. Ideally, we should be assessing our decisions over five years or longer.

The six stocks I mentioned in my interview, which I still own, have done well. There are instructive lessons we can gain from their performance. First, good investment opportunities can come from companies of all sizes. Second, having a great management team can be a useful signal in identifying long-term winners in the stock market. Third, we should be investing for the long run, even when there are things to worry about.

I will check back again at the five-year mark of my Straits Times interview, which will be in December 2021. Fingers-crossed that I’ll still have these handsome returns (or better) by then!

Why I Own Berkshire Hathaway Shares

I’ve owned Berkshire Hathaway shares for more than eight years. There are good reasons why I continue to hold shares of Warren Buffett’s conglomerate.

Berkshire Hathaway (NYSE: BRK-B) is one of the 50-plus companies that’s in my family’s portfolio. I first bought Berkshire shares for the portfolio in August 2011 at a price of US$70 and again in September 2015 at US$130. I’ve not sold any of the shares I’ve bought.

The first two purchases have performed well for my family’s portfolio, with Berkshire’s share price being around US$223 now. But it is always important to think about how a company’s business will evolve going forward. What follows is my thesis for why I still continue to hold Berkshire shares.

Company description

Berkshire is one of the most fascinating companies I have come across.

The story starts in 1965, when Warren Buffett took over the company because of anger. Back then, Buffett was a hedge fund manager. He had bought Berkshire shares a few years prior because they were cheap compared to the company’s assets.

In 1964, Berkshire’s then-leader, Seabury Stanton, offered to buy Buffett’s shares for US$11.50 each. Buffett agreed to sell. But Stanton’s official offer was slightly lower, at US$11.375 per share. Buffett was livid about being lied to, to the extent that he amassed a controlling stake in Berkshire to fire Stanton.

Berkshire was merely a struggling textile manufacturer when Buffett became its leader. But over the years, Buffett has thoroughly transformed the company through numerous inspired acquisitions and deft stock market investments.

Charlie Munger joined Berkshire in 1978. But for many years prior, he and Buffett were already collaborating. In fact, Munger helped Buffett to refine his already formidable investing prowess.

Today the 88-year old Buffett and 95-year old Munger continue to lead Berkshire as chairman and vice-chairman, respectively. The company can also be rightfully described as a truly diversified conglomerate, with more than 60 subsidiaries across a wide range of industries. Here’s a sample of the companies under Berkshire’s umbrella:

Berkshire Hathaway Reinsurance Group – provider of insurance products to other reinsurers and property, casualty, life, and health insurers globally
GEICO – second largest insurer in the US auto insurance market (share of 13% at end-2018)
Burlington Northern Santa Fe – one of the North American continent’s largest railroad companies
Berkshire Hathaway Energy – one of the largest energy utilities in the US, and the second-largest residential real estate brokerage firm in the same country
IMC International Metalworking Companies – among the top three manufacturers of consumable precision carbide metal cutting tools in the world
Precision Castparts – manufacturer of metal parts and components that go into aircraft
Borsheim’s – fine-jewellery retailer
Nebraska Furniture Mart – furniture retailer (as its name suggests)
See’s Candies – chocolate and confectionary producer

Berkshire’s reach extends beyond its subsidiaries. It also has a massive investment portfolio that is worth more than US$220 billion as of 30 September 2019. The portfolio consists of shares of more than 40 publicly traded companies that are mostly listed in the US. Some of them are also in my family’s portfolio, such as Apple, Amazon.com, and Mastercard. The investment portfolio is overseen by Buffett, Munger, Todd Combs, and Ted Weschler.

Investment thesis

I had previously laid out my investment framework in The Good Investors. I will use the framework, which consists of six criteria, to describe my investment thesis for Berkshire.

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

Berkshire is already a massive company, with US$247.8 billion in revenue in 2018. But I believe there’s still plenty of room to run for the conglomerate, although I’m not expecting rapid growth.

I think a growth rate in the high single-digit or low double-digit percentage range for Berkshire is reasonable. This is because Berkshire’s diversified collection of US stocks and high-quality subsidiaries puts it in a great position to ride on the US’s long-term economic growth.

There are a few points I want to expand on. First is regarding the US economy. Over the years, Buffett has not been shy in sharing his enthusiasm about the US . In Berkshire’s 2018 shareholders’ letter, Buffett wrote:

“Charlie and I happily acknowledge that much of Berkshire’s success has simply been a product of what I think should be called The American Tailwind.

It is beyond arrogance for American businesses or individuals to boast that they have “done it alone.” The tidy rows of simple white crosses at Normandy should shame those who make such claims.

There are also many other countries around the world that have bright futures. About that, we should rejoice: Americans will be both more prosperous and safer if all nations thrive. At Berkshire, we hope to invest significant sums across borders.

Over the next 77 years, however, the major source of our gains will almost certainly be provided by The American Tailwind. We are lucky – gloriously lucky – to have that force at our back.”

(Do read the “The American Tailwind” section of Buffett’s 2018 letter.)

To build on Buffett’s American Tailwind idea, I want to highlight that the working-age population in the US is estimated to increase by 13% from today to 2050. That’s one of the brightest demographics among developed economies across the world. Here’s a chart from Morgan Housel showing this:

The second point I want to expand on is the quality of Berkshire’s subsidiaries. If you’re a long-time observer of Berkshire, you’ll know that a durable competitive advantage is one of the key qualities that Buffett seeks when making acquisitions.

There are numbers to prove this point: Berkshire’s manufacturing, service, and retailing businesses earn healthy after-tax returns on net tangible assets while holding plenty of cash and using very little debt. The table illustrates this from 2012 to 2016 (the last year that Buffett reported the after-tax return on net tangible assets employed by this group of businesses).

*Source: Berkshire Hathaway annual reports*

A last note from me on Berkshire’s room for growth: Buffett and Munger are, in my eyes, two of the best investors in the world today, and they’re still constantly looking for bargains in the stock market and private businesses to acquire to strengthen Berkshire’s portfolio.

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

As of 30 September 2019, Berkshire’s balance sheet has US$102.2 billion in borrowings – that’s a fair amount of debt.

But Berkshire also has a massive cash hoard of US$128.2 billion, including US$53.4 billion in short-term investments in US Treasury bills, which can be considered as cash for liquidity purposes. So Berkshire does have tremendous resources to invest for growth as well as withstand shocks.

There are huge insurance businesses within Berkshire. So I think it’s also important for me to watch the company’s ability to payout huge insurance claims from time to time.

Buffett believes that “the annual probability of a US mega-catastrophe causing [US]$400 billion or more of insured losses is about 2%.” For perspective, a US$400 billion insured-loss is nearly four times the highest amount that the US has seen since 1980. This is illustrated in the chart below (the dark blue bars indicate insured losses in each year):

*Source:* *Insurance Information Institute*

In the event that US$400 billion of insured losses happen in a year, Berkshire’s share would be just US$12 billion or so. This is a huge sum of money. But it is far less than the annual earnings the company expects from its non-insurance businesses. For context, Berkshire’s non-insurance businesses generated US$20.8 billion in pre-tax income in 2018, up 24% from 2017. Although Berkshire will be bruised by a US$400 billion mega-catastrophe event in the insurance industry, most other insurers would go bust according to Buffett.

The diversification present in Berkshire adds another layer of financial resilience. I mentioned earlier that the conglomerate controls over 60 subsidiaries across many industries. This is also true of Berkshire’s investment portfolio. The 40-odd stocks in the portfolio belong to technology, banking, media, consumer products, and more.

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

On integrity

Buffett’s overall reputation, in business and in life, is pristine. The excerpt below, taken from Berkshire’s latest official proxy statement released in March 2019, will also shine tremendous light on the integrity of Buffett and Munger (emphases are mine):

“Due to Mr. Buffett’s and Mr. Munger’s desire that their compensation remain unchanged, the Committee has not proposed an increase in Mr. Buffett’s or Mr. Munger’s compensation since the Committee was created in 2004. Prior to that time, Mr. Buffett recommended to the Board of Directors the amount of his compensation and Mr. Munger’s.

Mr. Buffett’s annual compensation and Mr. Munger’s annual compensation have been [US]$100,000 for more than 25 years and Mr. Buffett has advised the Committee that he would not expect or desire such compensation to increase in the future…

...Mr. Buffett will on occasion utilize Berkshire personnel and/or have Berkshire pay for minor items such as postage or phone calls that are personal. Mr. Buffett reimburses Berkshire for these costs by making an annual payment to Berkshire in an amount that is equal to or greater than the costs that Berkshire has incurred on his behalf.

During 2018, Mr. Buffett reimbursed Berkshire [US]$50,000. Berkshire provides personal and home security services for Mr. Buffett. The cost for these services was approximately [US]$290,000 in 2018. Berkshire’s Board of Directors believe that in light of Mr. Buffett’s critical role as Berkshire’s CEO and given that Mr. Buffett spends a significant amount of his time while at home on Berkshire business matters that such costs represent bona fide business expenses.

None of Berkshire’s named executive officers use Company cars or belong to clubs to which the Company pays dues. It should also be noted that neither Mr. Buffett nor Mr. Munger utilizes corporate-owned aircraft for personal use.”

Buffett and Munger earn their riches predominantly from their ownership of Berkshire shares. As of 6 March 2019, Buffett controlled Berkshire shares that are worth around US$90 billion at the current price; Munger’s stake also makes him a billionaire (around US$1.5 billion). These high ownership stakes give me comfort that their interests are aligned with mine.

Although Buffett and Munger’s philanthropic actions are not directly-related to investing, I think they speak volumes about the characters of the two elder statesmen of business. The actions also inspire me, so I want to include a brief discussion. In 2006, Buffett pledged to donate more than 99% of his wealth to charitable causes during his lifetime or at his death. Since then, Buffett has already given more than US$34.5 billion to charities. Munger, meanwhile, has given hundreds of millions of dollars over the past 30 years toward the building of school facilities.

On capability

On the topic of capability, Berkshire’s track record of growth since 1965 has been nothing short of stunning. More on this soon.

On innovation

For a long time, Buffett was averse to technology stocks because he couldn’t understand them (he first broke the duck by investing in IBM in 2011, and of course Berkshire now has a big stake in Apple). So it’s no surprise that Berkshire is not the first name that comes to mind if we mention the word “innovation.”

But what Berkshire lacks in technological innovation, it makes up for with a unique mindset in business.

Let’s first talk about Buffett’s view toward acquiring companies. I want to discuss this because acquisitions will be one of Berkshire’s key growth drivers in the years ahead. The excerpts below from Berkshire’s 2008 shareholders’ letter are instructive (emphases are mine):

“Our long-avowed goal is to be the “buyer of choice” for businesses – particularly those built and owned by families. The way to achieve this goal is to deserve it. That means we must keep our promises; avoid leveraging up acquired businesses; grant unusual autonomy to our managers; and hold the purchased companies through thick and thin (though we prefer thick and thicker).

Our record matches our rhetoric. Most buyers competing against us, however, follow a different path. For them, acquisitions are “merchandise.” Before the ink dries on their purchase contracts, these operators are contemplating “exit strategies.” We have a decided advantage, therefore, when we encounter sellers who truly care about the future of their businesses.

Some years back our competitors were known as “leveraged-buyout operators.” But LBO became a bad name. So in Orwellian fashion, the buyout firms decided to change their moniker. What they did not change, though, were the essential ingredients of their previous operations, including their cherished fee structures and love of leverage.

Their new label became “private equity,” a name that turns the facts upside-down: A purchase of a business by these firms almost invariably results in dramatic reductions in the equity portion of the acquiree’s capital structure compared to that previously existing.

A number of these acquirees, purchased only two to three years ago, are now in mortal danger because of the debt piled on them by their private-equity buyers. Much of the bank debt is selling below 70¢ on the dollar, and the public debt has taken a far greater beating. The private equity firms, it should be noted, are not rushing in to inject the equity their wards now desperately need. Instead, they’re keeping their remaining funds very private.”

I believe that Buffett’s mindset of wanting to be long-term (eternal?) owners when acquiring companies, alone, is a competitive advantage in the private markets that is not easily replicable. Berkshire has walked the talk of being a responsible long-term owner of businesses and implementing decentralised management – these traits have made the conglomerate a preferred buyer when owners of good private family-built businesses are looking to sell. In his 2018 shareholders’ letter, Buffett again emphasised that Berkshire wants to be a long-term owner of the businesses that it acquires:

“You may ask whether an allowance should not also be made for the major tax costs Berkshire would incur if we were to sell certain of our wholly-owned businesses. Forget that thought: It would be foolish for us to sell any of our wonderful companies even if no tax would be payable on its sale. Truly good businesses are exceptionally hard to find. Selling any you are lucky enough to own makes no sense at all.”

Some of you reading this may be wondering, “Is Buffett’s competitive advantage in acquiring companies really so simple? Isn’t that easy to replicate?” My response will be something Munger once said: “It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”

Next, Buffett also does not push for short-term gains at the expense of Berkshire’s long-term business health. A great example can be seen in Berkshire’s excellent track record in the insurance industry: Its property and casualty (P/C) insurance business has recorded an underwriting profit for 15 of the past 16 years through to 2018. In contrast, the P/C industry as a whole often operates at a significant underwriting loss; in the decade ended 2018, the industry suffered an underwriting loss in five separate years.

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

There are two main components to Berkshire’s operating businesses: Insurance, and non-insurance companies.

The insurance part consists primarily of GEICO, Berkshire Hathaway Reinsurance Group, and Berkshire Hathaway Primary Group. Insurance is a service that organisations and individuals require on an ongoing basis, so there’s high levels of recurring activity there. GEICO, in particular, focuses on auto insurance, and that’s something drivers need every year.

For the non-insurance portion, two big entities are Burlington Northern Santa Fe (BNSF) and Berkshire Hathaway Energy. The former runs railroads in North America and the latter is an energy utility. Physical products will regularly need to be transported across the continent while energy (such as natural gas and electricity) is something that organisations and individuals require daily.

5. A proven ability to grow

Buffett is quite possibly the best capital allocator the world has seen to-date. The table below is taken from Berkshire’s 2018 annual report, and it shows the incredible 18.7% annual growth in the company’s book value per share since 1965, the year Buffett assumed control. ‘Nuff said.

*Source: Berkshire Hathaway* *2018 annual report*

In my explanation of this criterion, I mentioned that I’m looking for “big jumps in revenue, net profit, and free cash flow over time.” So why the focus on Berkshire’s book value per share? That’s because Berkshire’s main assets for many decades were public-listed stocks. Although, it’s worth pointing out that the company’s book value per share is increasingly losing its relevance as a measure of the company’s intrinsic economic worth – Berkshire’s main value now resides in its subsidiaries.

It must also be said that Berkshire’s no slouch when it comes to free cash flow. The table below shows the record of the conglomerate’s annual growth in free cash flow of 11% going back to 2007. I picked 2007 as the starting point to show that Berkshire was still gushing out cash even during the Great Financial Crisis of 2008-2009.

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

Berkshire has excelled in producing free cash flow from its businesses for a long time and has The American Tailwind on its back. So, I don’t see any reason to believe that Berkshire’s ability to generate cash from its businesses will change any time soon.

Valuation

In Berkshire’s 2018 shareholders’ letter, Buffett wrote:

“I believe Berkshire’s intrinsic value can be approximated by summing the values of our four asset-laden groves and then subtracting an appropriate amount for taxes eventually payable on the sale of marketable securities.”

The four groves Buffett mentioned refers to Berkshire’s (1) insurance operations, (2) non-insurance businesses, (3) ownership stakes in a quartet of companies – Kraft Heinz, Berkadia, Electric Transmission Texas, and Pilot Flying J – that it shares control with other parties, and (4) treasury bills, cash, and fixed-income investments.

I like to keep things simple in the valuation process, so I’m going to use an even simpler but sound heuristic to value Berkshire: Its price-to-book (P/B) ratio.

Earlier, I mentioned that Berkshire’s book value per share is losing relevance in being a proxy for the company’s true economic worth, so there’s a contradiction. I believe the contradiction can be resolved by simply allowing Berkshire to be seen as a bargain even if its PB ratio is significantly higher than 1. Buffett’s recent actions suggest this makes sense too.

For several years, Buffett had a standing order for Berkshire to repurchase shares if its P/B ratio fell below 1.2. But the order was amended by Buffett in July 2018: Now Berkshire can repurchase its shares at any time when he and Munger believe that the share price is “below Berkshire’s intrinsic value.”

Buffett publicly stated in his 2018 shareholders’ letter that over time, Berkshire is likely “to be a significant repurchaser of its shares, transactions that will take place at prices above book value but below our estimate of intrinsic value.” From the third quarter of 2018 to the third quarter of 2019, Berkshire has spent a total of US$3.48 billion to repurchase 2,744 Class A shares and 12.04 million Class B shares. These buybacks have happened when the company’s PB ratio was clearly higher than 1.2 and averaging around 1.4.

The risks involved

Succession is the biggest risk I’m watching with Berkshire. Buffett and Munger are both getting on in years – I will be truly sad the day they are no longer around.

Berkshire has very capable senior leaders who are supporting Buffett and Munger, including Ajit Jain (head of all insurance operations), Greg Abel (head of all non-insurance operations), and the investing duo of Todd Combs and Ted Weschler. All four are much younger too, with ages ranging from 46 to 67. Buffett has also tasked his son, Howard Buffett, to assume a non-executive chairman role in Berkshire when Buffett-senior eventually departs. The younger Buffett would be responsible for protecting and nurturing Berkshire’s culture.

I am confident in Buffett and Munger’s succession plan. But it remains to be seen whether Berkshire’s dealmaking prowess, competitive advantages, and culture will diminish when the octogenarian and nonagenarian leave the scene.

A massive catastrophe is another key risk I’m watching. I mentioned earlier that Berkshire is able to brush off a US$400 billion industry-wide catastrophe event in the US. It will take a huge disaster to result in insured losses of US$400 billion. For context, the sum is nearly four times the highest amount that the US has suffered since 1980, as I already mentioned. But there’s no upper limit to Mother Nature’s wrath, especially given the alarm bells that scientists have been ringing in recent years on climate change.

The Good Investors’ conclusion

Berkshire is not the fastest-growing company around, and its rapid-growth days are clearly over. But what it lacks in pace, it makes up for in stability. The conglomerate excels against my investment framework by having (1) the American Tailwind behind its back; (2) a diverse collection of excellent businesses; (3) a robust balance sheet and finances; (4) strong recurring revenues; (5) a great track record of growth; and (6) two brilliant leaders at its helm who have been there for decades – Warren Buffett and Charlie Munger – and who are as safe a pair of business-hands as anyone can find.

Every investment has risks, and so does Berkshire. Succession (because of the advanced age of Buffett and Munger) and major disasters (because a big part of Berkshire’s business is in insurance) are two big risks for the conglomerate that I’m watching.

But on balance, I believe that Berkshire is one of the lowest risk stocks there are in the world for producing a long-term annual return in the low-teens range.

6 Things I’m Certain Will Happen In The Financial Markets In 2020

Investing is a game of probabibilities. But there are still six things I’m certain will happen in 2020 that investors should watch.

There are no guarantees in the world of investing… or are there? Here are six things about investing that I’m certain will happen in 2020.

1. There will be something huge to worry about in the financial markets.

Peter Lynch is the legendary manager of the Fidelity Magellan Fund who earned a 29% annual return during his 13-year tenure from 1977 to 1990. He once said:

“There is always something to worry about. Avoid weekend thinking and ignore the latest dire predictions of the newscasters. Sell a stock because the company’s fundamentals deteriorate, not because the sky is falling.”

Imagine a year in which all the following happened: (1) The US enters a recession; (2) the US goes to war in the Middle East; and (3) the price of oil doubles in three months. Scary? Well, there’s no need to imagine: They all happened in 1990. And what about the S&P 500? It has increased by nearly 800% from the start of 1990 to today, even without counting dividends.

There will always be things to worry about. But that doesn’t mean we shouldn’t invest.

2. Individual stocks will be volatile.

From 1997 to 2018, the maximum peak-to-trough decline in each year for Amazon.com’s stock price ranged from 12.6% to 83.0%. In other words, Amazon’s stock price had suffered a double-digit fall every single year. Meanwhile, the same Amazon stock price had climbed by 76,000% (from US$1.96 to more than US$1,500) over the same period.

If you’re investing in individual stocks, be prepared for a wild ride. Volatility is a feature of the stock market – it’s not a sign that things are broken.

3. The US-China trade war will either remain status quo, intensify, or blow over.

“Seriously!?” I can hear your thoughts. But I’m stating the obvious for a good reason: We should not let our views on geopolitical events dictate our investment actions. Don’t just take my words for it. Warren Buffett himself said so. In his 1994 Berkshire Hathaway shareholders’ letter, Buffett wrote (emphases are mine):

“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.”

From 1994 to 2018, Berkshire Hathaway’s book value per share, a proxy for the company’s value, grew by 13.5% annually. Buffett’s disciplined focus on long-term business fundamentals – while ignoring the distractions of political and economic forecasts – has worked out just fine.

4. Interest rates will move in one of three ways: Sideways, up, or down.

“Again, Captain Obvious!?” Please bear with me. There is a good reason why I’m stating the obvious again.

Much ado has been made about what central banks have been doing, and would do, with their respective economies’ benchmark interest rates. This is because of the theoretical link between interest rates and stock prices.

Stocks and other asset classes (bonds, cash, real estate etc.) are constantly competing for capital. In theory, when interest rates are high, the valuation of stocks should be low, since the alternative to stocks – bonds – are providing a good return. On the other hand, when interest rates are low, the valuation of stocks should be high, since the alternative – again, bonds – are providing a poor return.

But if we’re long-term investors in the stock market, I think we really do not need to pay much attention to what central banks are doing with interest rates.

There’s an amazing free repository of long-term US financial market data that is maintained by Robert Shiller. He is a professor of economics and the winner of a Nobel Prize in economics in 2013.

His data includes long-term interest rates in the US, as well as US stock market valuations, going back to the 1870s. The S&P 500 index is used as the representation for US stocks while the cyclically adjusted price earnings (CAPE) ratio is the valuation measure. The CAPE ratio divides a stock’s price by its inflation-adjusted average earnings over a 10-year period.

The chart below shows US long-term interest rates and the CAPE ratio of the S&P 500 since 1920:

Contrary to theory, there was a 30-plus year period that started in the early 1930s when interest rates and the S&P 500’s CAPE ratio both grew. It was only in the early 1980s when falling interest rates were met with rising valuations.

To me, Shiller’s data shows how changes in interest rates alone can’t tell us much about the movement of stocks. In fact, relationships in finance are seldom clear-cut. “If A happens, then B will occur” is rarely seen.

Time that’s spent watching central banks’ decisions regarding interest rates will be better spent studying business fundamentals. The quality of a company’s business and the growth opportunities it has matter far more to its stock price over the long run than interest rates.

Sears is a case in point. In the 1980s, the US-based company was the dominant retailer in the country. Morgan Housel wrote in his recent blog post, Common Plots of Economic History :

“Sears was the largest retailer in the world, housed in the tallest building in the world, employing one of the largest workforces.

“No one has to tell you you’ve come to the right place. The look of merchandising authority is complete and unmistakable,” The New York Times wrote of Sears in 1983.

Sears was so good at retailing that in the 1970s and ‘80s it ventured into other areas, like finance. It owned Allstate Insurance, Discover credit card, the Dean Witter brokerage for your stocks and Coldwell Banker brokerage for your house.”

US long-term interest rates fell dramatically from around 15% in the early-to-mid 1980s to 3% or so in 2018. But Sears filed for bankruptcy in October 2018, leaving its shareholders with an empty bag. In his blog post mentioned earlier, Housel also wrote:

“Growing income inequality pushed consumers to either bargain or luxury goods, leaving Sears in the shrinking middle. Competition from Wal-Mart and Target – younger and hungrier – took off.

By the late 2000s Sears was a shell of its former self. “YES, WE ARE OPEN” a sign outside my local Sears read – a reminder to customers who had all but written it off.”

If you’re investing for the long run, there are far more important things to watch than interest rates.

5. There will be investors who are itching to make wholesale changes to their investment portfolios for 2020.

Ofer Azar is a behavioural economist. He once studied more than 300 penalty kicks in professional football (or soccer) games. The goalkeepers who jumped left made a save 14.2% of the time while those who jumped right had a 12.6% success rate. Those who stayed in the centre of the goal saved a penalty 33.3% of the time.

Interestingly, only 6% of the keepers whom Azar studied chose to stay put in the centre. Azar concluded that the keepers’ moves highlight the action bias in us, where we think doing something is better than doing nothing.

The bias can manifest in investing too, where we develop the urge to do something to our portfolios, especially during periods of volatility. We should guard against the action bias. This is because doing nothing to our portfolios is often better than doing something. I have two great examples.

The first is a paper published by finance professors Brad Barber and Terry Odean in 2000. They analysed the trading records of more than 66,000 US households over a five-year period from 1991 to 1996. They found that the most frequent traders generated the lowest returns – and the difference is stark. The average household earned 16.4% per year for the timeframe under study but the active traders only made 11.4% per year.

Second, finance professor Jeremy Siegel discovered something fascinating in the mid-2000s. In an interview with Wharton, Siegel said:

“If you bought the original S&P 500 stocks, and held them until today—simple buy and hold, reinvesting dividends—you outpaced the S&P 500 index itself, which adds about 20 new stocks every year and has added almost 1,000 new stocks since its inception in 1957.”

Doing nothing beats doing something.

6. There are 7.7 billion individuals in the world today, and the vast majority of us will wake up every morning wanting to improve the world and our own lot in life.

This motivation is ultimately what fuels the global economy and financial markets. There are miscreants who appear occasionally to mess things up, but we should have faith in the collective positivity of humankind. We should have faith in us. The idiots’ mess will be temporary.

To me, investing in stocks is the same as having the long-term view that we humans are always striving collectively to improve the world. What about you?

Why I Like This Unique Bank As An Investment Opportunity Now

HDFC Bank from India looks like a really good investment opportunity, given its track record of growth, and strong macroeconomic tailwinds.

I recently appeared in an episode of the Investing Ideas podcast series that is created by my friend, Stanley Lim from Value Invest Asia.

In the episode, I shared why I thought the India-based HDFC Bank looks like an attractive investment opportunity to me. I also prepared a short presentation deck: Download here

The following are some of the points I mentioned in the podcast about HDFC Bank:

The bank has been growing every single year from 1996 to 2019.
The bank is very conservatively managed, with even lower leverage than Singapore’s local banking stalwarts, DBS, OCBC, and UOB.
The bank has a fanatical focus on the customer experience.
India has amazing population tailwinds that many developed economies will envy – the working-age population of the country is expected to increase by 30% from today to 2050. China, in contrast, is expected to have a 20% decline in the working-age population over the same period.

Check out the podcast (and video) below!

“How Can We Avoid Hyflux-Like Disasters”

Although Hyflux has found a white knight, its investors still don’t have much to smile over. Here are the important lessons we can learn from Hyflux.

News broke yesterday that the embattled water treatment firm Hyflux has finally signed a S$400 million rescue deal with Utico, a utilities company based in the Middle East.

Although Hyflux has now been given a lifeline with Utico injecting capital, shareholders and creditors of the water treatment company don’t have much to smile over. There are important lessons we can learn from Hyflux’s experience.

Painful lifeline

Hyflux and Utico’s agreement came after months of talks between the two. It had also been over a year since Hyflux filed for bankruptcy protection in May 2018 and suspended the trading of its ordinary shares, preference shares, and perpetual securities.

The rescue deal will see Utico take a 95% stake in Hyflux at a value of S$300 million. This means that all of Hyflux’s existing owners of ordinary shares will emerge holding 5% of the company, with a value of merely S$15.8 million. Just prior to the May 2018 trading suspension, Hyflux had a total market value (or market capitalisation) of S$165 million. In other words, Hyflux’s ordinary shareholders are now facing a haircut of around 90%.

Meanwhile, there are 34,000 individuals who hold Hyflux’s preference shares and/or perpetual securities that collectively have a face value of S$900 million. Utico’s rescue deal will see these 34,000 individuals receive total payment ranging from only S$50 million to S$100 million. Even at a S$100 million payout, the owners of Hyflux’s preference shares and perpetual securities are still staring at a loss of 89%.

Avoiding disasters

It’s great timing that a user of the community forums of personal finance portal Seedly asked a question yesterday along the lines of “How can we avoid Hyflux-like disasters?” I answered, and I thought my response is worth sharing with a wider audience, hence me writing this article. Parts of my answer are reproduced below (with slight tweaks made for readability):

“I’m not a pro, nor will I wish anyone to follow my investing thoughts blindly. But I used to write for The Motley Fool Singapore, and I wrote a piece on Hyflux in May 2016 when the company issued its S$300 million, 6% perpetual securities [the offering was eventually upsized to S$500 million].
The Fool SG website is no longer available, but there’s an article from The Online Citizen published in June 2018 that referenced my piece.

Back then, I concluded that Hyflux’s perpetual securities were risky after looking through the company’s financials. That was because the company had a chronic inability to generate cash flow and its balance sheet was really weak. Those risks sadly flared up in 2018 and caused pain for so many of the company’s investors.
What I wrote was this: “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.””

What I shared was the financial traits I found in Hyflux that made me wary about the company. The great thing about those traits are that they can be applied to most situations in investing.

Simple rules

In my response to the Hyflux question in Seedly, I also mentioned (emphasis is added now):

“There are many things about a company to look at when investing. But I believe there are some simple rules that can help us avoid trouble. The rules are not fool-proof and nothing is fool-proof in investing, but they do work in general. The rules are: (1) Be careful when a company is unable to produce cash flow from its business consistently; and (2) be careful when the company’s balance sheet is burdened heavily by debt.”

The parts in italics above are rules that I believe are simple, yet incredibly effective. They also form part of my investment framework. Those rules are sometimes meant to be broken, as is the case with my decision to stay invested in Netflix, which has trouble generating cash flow and a heavy debt load for a good reason. But if we stick to the two rules with discipline, I believe we can keep ourselves out of trouble in the stock market most of the time.

Why I Own Netflix Shares

My family’s portfolio has owned Netflix shares for eight years, and this is why we continue to own it.

Netflix (NASDAQ: NFLX) is one of the companies that’s in my family’s portfolio. I first bought Netflix shares for the portfolio in September 2011 at a price of US$26, again in March 2012 at US$16, and yet again in August 2017 at US$170. I’ve not sold any of the shares I’ve bought.

The company has done really well for my family’s portfolio, with its share price rising to around US$300 now. But it is always important to think about how a company’s business will evolve going forward. What follows is my thesis for why I still continue to hold Netflix’s shares.

Company description

Netflix is based and listed in the US. When it IPO-ed in 2002, Netflix’s main business was renting out DVDs by mail. It had 600,000 subscribers back then, and had an online website for its members to access the rental service.

Today, Netflix’s business is drastically different. In the first nine months of 2019, Netflix pulled in US$14.7 billion in revenue, of which 98% came from streaming; the remaining 2% is from the legacy DVD-by-mail rental business. The company’s streaming content includes TV series, documentaries, and movies across a wide variety of genres and languages. These content are licensed from third parties or produced originally by Netflix.

Many of you reading this likely have experienced Netflix’s streaming service, so it’s no surprise that Netflix has an international presence. In the first nine months of 2019, 48% of Netflix’s revenue came from the US, with the rest spread across the world (Netflix operates in over 190 countries). The company counted 158.3 million subscribers globally as of 30 September 2019.

Investment thesis

I will describe my investment thesis for Netflix according to the investment framework (consisting of six criteria) that I previously laid out in The Good Investors.

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

Netflix already generates substantial revenue and has a huge base of 158.3 million subscribers. But there’s still plenty of room for growth.

According to Statista, there are 1.05 billion broadband internet subscribers worldwide in the first quarter of 2019. Netflix has also been testing a lower-priced mobile-only streaming plan in India. The test has done better-than-expected and Netflix is looking to test mobile-only plans in other countries too. Data from GSMA showed that there were 3.5 billion mobile internet subscribers globally in 2018.

I’m not expecting Netflix to sign up the entire global broadband or mobile internet user base – Netflix is not in China, and I doubt it will ever be allowed into the giant Asian nation. But there are still significantly more broadband and mobile internet subscribers in the world compared to Netflix subscribers, and this is a growth opportunity for the company. It’s also likely, in my view, that the global number of broadband as well as mobile internet users should continue to climb in the years ahead. This grows the pool of potential Netflix customers.

For another perspective, the chart immediately below illustrates clearly that cable subscriptions still account for the lion’s share of consumer-dollars when it comes to video entertainment. This is again, an opportunity for Netflix.

Subscribers to online subscription video services across the world has also exploded in the past few years. This shows how streaming is indeed a fast-growing market – and in my opinion, the way of the future for video entertainment.

As a last point on the market opportunity for Netflix, as large as the company already is in the US, it still accounts for only 10% of consumers’ television viewing time in the country, and even less of their mobile screen time.

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

At first glance, Netflix does not cut the mustard here. As of 30 September 2019, Netflix’s balance sheet held US$12.4 billion in debt and just US$4.4 billion in cash. This stands in sharp contrast to the end of 2014, when Netflix had US$900 million in debt and US$1.6 billion in cash. Moreover, Netflix has lost US$9.3 billion in cumulative free cash flow from 2014 to the first nine months of 2019.

But I’ll explain later why I think Netflix has a good reason for having so much debt on its balance sheet.

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

On integrity

Netflix is led by CEO Reed Hastings, 58, who also co-founded the company in 1997. The long-tenure of Hastings in Netflix is one of the things I like about the company.

Although Hastings is paid a tidy sum to run Netflix – his total compensation in 2018 was US$36.1 million – his pay has reasonably tracked the company’s revenue growth. From 2014 to 2018, Netflix’s revenue nearly tripled from US$5.5 billion to US$15.8 billion. This matches the 326% jump in Hastings’ total compensation from US$11.1 million to US$36.1 million over the same period.

Hastings also owns 5.56 million Netflix shares as of 8 April 2019, along with the option to purchase 4.50 million shares. His ownership stake alone is worth around US$1.7 billion at the current share price, which will very likely align his interests with other Netflix shareholders.

On capability and innovation

Netflix was an early pioneer in the streaming business when it launched its service in 2007. In fact, Netflix probably wanted to introduce streaming even from its earliest days. Hastings said the following in a 2007 interview with Fortune magazine:

“We named the company Netflix for a reason; we didn’t name it DVDs-by-mail. The opportunity for Netflix online arrives when we can deliver content to the TV without any intermediary device.”

When Netflix first started streaming, the content came from third-party producers. In 2013, the company launched its first slate of original programming. Since then, the company has ramped up its original content budget significantly.

The table below shows Netflix’s total content cash spending from 2014 to 2018. There are two things to note. First, total content spending has been increasing each year and has jumped by around 340% for the entire time frame. Second, around 85%, or US$11 billion, of Netflix’s content spending in 2018 was for original content. Netflix’s content budget for 2019 is projected to be around US$15 billion, most of which is again for original content.

All that content-spending has resulted in strong subscriber growth, which is clearly seen from the table below. Netflix’s decade-plus head start in streaming – a move that I credit management for – has also given the company a tremendously valuable asset: Data. The data lets Netflix know what people are watching, and in turn allows the company to predict what people want to watch next. This is very helpful for Netflix when producing original content that keeps viewers hooked.

And Netflix has indeed found plenty of success with its original programming. For instance, in 2013, the company became the first streaming provider to be nominated for a primetime Emmy. In 2018 and 2019, the company snagged 23 and 27 Emmy wins, respectively. From a viewership perspective, the third season of Stranger Things (I love the show!), launched in the third quarter of 2019, had 64 million households tuning in within the first month of its release. Adam Sandler’s comedy film, Murder Mystery, welcomed views from over 73 million households in the first month of its release in June this year.

The move into originals by management has also proved to be prescient. Netflix’s 2019 second quarter shareholders’ letter name-dropped nine existing and would-be streaming competitors – and there are more that are unnamed. I think Netflix’s aforementioned data, and its strong library of original content, should help it to withstand competition.

I also want to point out the unique view on Netflix’s market opportunity that management has. Management sees Netflix’s competition as more than just other streaming providers. In Netflix’s Long-Term View letter to investors, management wrote:

“We compete for a share of members’ time and spending for relaxation and stimulation, against linear networks, pay-per-view content, DVD watching, other internet networks, video gaming, web browsing, magazine reading, video piracy, and much more. Over the coming years, most of these forms of entertainment will improve.

If you think of your own behavior any evening or weekend in the last month when you did not watch Netflix, you will understand how broad and vigorous our competition is.

We strive to win more of our members’ “moments of truth”.”

Having an expansive view on competition lessens the risk that Netflix will get blindsided by competitors, in my view.

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

Netflix’s business is built entirely on subscriptions, which generate recurring revenue for the company. As I already mentioned, nearly all of Netflix’s revenue in the first nine months of 2019 (98%) came from subscriptions to its streaming service, while subscriptions to the DVD-by-mail service accounted for the remaining small chunk of revenue.

But just having a subscription model does not equate to having recurring revenues. If your business has a high churn rate (the rate of customers leaving), you’re constantly filling a leaky bucket. That’s not recurring income. According to a recent estimate from a third-party source (Lab42), Netflix’s churn rate is just 7%, and is much better than its competitors.

5. A proven ability to grow

2007 was the year Netflix first launched its streaming service. This has provided the impetus for the company’s stunning revenue and net income growth since, as the table below illustrates. It’s good to note too that Netflix’s diluted share count has actually declined since 2007.

In my explanation of this criterion, I mentioned that I’m looking for “big jumps in revenue, net profit, and free cash flow over time.” I also said that “I am generally wary of companies that (a) produce revenue and profit growth without corresponding increases in free cash flow.” So why am I holding Netflix shares when its free cash flow has cratered over time and is deeply in red at the moment?

This is my view on the situation. Netflix has been growing its original content production, as mentioned earlier, and the high capital outlay for such content is mostly paid upfront. But the high upfront costs are for the production of content that (1) could have a long lifespan, (2) can be delivered to subscribers at minimal cost, and (3) could satisfy subscribers who have high lifetime value (the high lifetime value is inferred from Netflix’s low churn rate). In other words, Netflix is spending upfront for content, but has the potential to reap outsized rewards over a long period of time at low cost. The shelf-life for good content could be decades, or more – for instance, Seinfeld, a sitcom in the US, is still popular 30 years after it was produced.

In Netflix’s Long-Term View shareholder’s letter, management wrote (emphases are mine):

“People love movies and TV shows, but they don’t love the linear TV experience, where channels present programs only at particular times on non-portable screens with complicated remote controls. Now streaming entertainment – which is on-demand, personalized, and available on any screen – is replacing linear TV.

Changes of this magnitude are rare. Radio was the dominant home entertainment media for nearly 50 years until linear TV took over in the 1950’s and 1960’s. Linear video in the home was a huge advance over radio, and very large firms emerged to meet consumer desires over the last 60 years. The new era of streaming entertainment, which began in the mid-2000’s, is likely to be very big and enduring also, given the flexibility and ubiquity of the internet around the world. We hope to continue being one of the leading firms of the streaming entertainment era.”

I agree with Netflix’s management that the company is in the early stages of a multi-decade transition from linear TV to internet entertainment at a global scale. With this backdrop, along with what I mentioned earlier on Netflix’s business model of spending upfront to produce content with long monetisable-lifespans, I’m not troubled by Netflix’s negative and deteriorating free cash flow for now. Netflix’s management also expects free cash flow to improve in 2020 compared to 2019, and “to continue to improve annually beyond 2020.”

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

I understand that Netflix’s free cash flow numbers look horrible at the moment. But Netflix is a subscription business that enjoys a low churn rate. It is also spending plenty of capital to pay upfront for long-lived assets (the original content). I believe that these provide the potential for Netflix to generate high free cash flow in the future, if it continues to grow its subscriber base.

Valuation

“Cheap” is definitely not a good way to describe Netflix’s shares. The company has trailing earnings per share of US$3.12 against a share price north of US$300. That’s a price-to-earnings (PE) ratio of around 100. But Netflix has the tailwinds of expanding margins and revenue growth. The company is currently on track to achieve its goal of an operating margin of 13% in 2019, up from just 4% in 2016. It is targeting an operating margin of 16% in 2020.

Let’s assume that in five years’ time, Netflix can hit 300 million subscribers worldwide paying US$12 per month on average. The lowest-tier plan in the US is currently US$9 per month, and Netflix has managed to grow its average revenue per user at a healthy clip, as shown in the table below.

With the assumptions above, Netflix’s revenue in five years would be US$43 billion. If we apply a 20% net profit margin, the company would then earn US$8.6 billion in net profit. With an earnings multiple of just 30, Netflix’s market capitalisation in five years would be US$258 billion, nearly double from the current market capitalisation of US$134 billion. This equates to an annualised return of 14%. I think my assumptions are conservative. Higher subscriber numbers, higher average revenue per user, and fatter margins will lead to much higher upside.

The risks involved

There are three key risks that I see in Netflix.

First, Netflix’s cash burn and weak balance sheet is a big risk. I think Netflix’s strategy to produce original content is sound. But the strategy necessitates the spending of capital upfront, which has led to debt piling up on the balance sheet. I will be watching Netflix’s free cash flow and borrowing terms. For now, Netflix depends on the kindness of the debt markets – that’s a situation the company should be getting itself out of as soon as possible.

Second, there’s competition. Tech giant Apple and entertainment heavyweight Disney recently launched their streaming offerings, and the space is getting more crowded as we speak. As I mentioned earlier, I think Netflix should be able to withstand competition. In fact, I think the real victims will be cable TV companies. This is not a case of Netflix versus other streaming options – this is a case of streaming services versus cable. Different streaming services can co-exist and thrive. And even if the streaming market has a shakeout, Netflix, by virtue of its already massive subscriber base, should be one of the victors. But I can’t know for sure. Only time will tell. Netflix’s subscriber numbers in the future will show us how it’s dealing with competition.

Third, there’s key-man risk. Reed Hastings has been a phenomenal leader at Netflix, but he’s not the only important member of the management team. Ted Sarandos, 54, Netflix’s Chief Content Officer, is also a vital figure. He has been leading Netflix’s content team since 2000, and was a driving force in Netflix’s transition into original content production that started in 2013. If Hastings and/or Sarandos were to leave Netflix for whatever reason, I’ll be concerned.

The Good Investors’ conclusion

Despite already having more than 158 million subscribers worldwide, Netflix still has a large market opportunity to conquer. The company also has an excellent management team with integrity, and has an attractive subscription business model with sticky customers. Although Netflix’s balance sheet is currently weak and it has trouble generating free cash flow, I think the company will be able to generate strong free cash flow in the future.

There are certainly risks to note, such as a high debt-burden, high cash-burn, and an increasingly competitive landscape. Key-man departures, if they happen, could also significantly dent Netflix’s growth prospects.

But in weighing the risks and rewards, I think the odds are in my favour.

“What Should I Do With My Sembcorp Marine Shares That Are In The Red?”

The price you had initially purchased Sembcorp Marine’s shares at is irrelevant in deciding whether you should hold or sell the shares now.

I participate in Seedly’s community forums by answering investing-related questions. Recently, there was a question along the lines of “What should I do with my Sembcorp Marine shares that are in the red?” I thought my answer is worth sharing with a wider audience. It is reproduced below (with slight tweaks made for readability).

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Hello! The price you had initially purchased Sembcorp Marine’s shares at is irrelevant in deciding whether you should hold or sell the shares now.

When it comes to any stock, we should constantly be assessing what its future business prospects look like and compare it to the current stock price. At any point in time, if you realise that the current stock price reflects a bright future whereas the actual future business prospects look relatively dimmer to you, then that’s a good time to sell.

I wish I could give you a holistic framework to assess the future prospects of Sembcorp Marine. But I don’t have one. Right now, the company’s revenue depends heavily on the level of oil prices. I don’t have any skill in determining how a commodity’s price will move in the future, so I’ve largely stayed away from stocks whose revenues rely on commodity prices.

When you make your decision about what to do with your Sembcorp Marine shares, you’ll have to make a judgement on how the company’s business will fare five to 10 years from now. This judgement will in turn depend on your views on how the price of oil changes in that timeframe.

There’s another wrinkle to the equation. Sometimes a stock’s price can still fall even when there’s a positive macro-economic change. In the case of the oil & gas industry, a company’s stock price could still decline despite rising oil prices, if said company’s balance sheet is very weak and it has significant trouble in generating positive free cash flow.

Right now (as of 30 September 2019), Sembcorp Marine’s balance sheet holds S$468 million in cash, but S$4.15 billion in total debt. These numbers give rise to net-debt (total debt minus cash) of S$3.68 billion, which is significantly higher than the company’s shareholders’ equity of $2.25 billion. In fact, the net-debt to shareholders’ equity ratio of 164% is uncomfortably high in my view.

If I look at data from S&P Global Market Intelligence, Sembcorp Marine’s free cash flow has also been negative in every year from 2014 to 2018, with the exception of 2016. There has been no improvement detected so far in 2019. The first nine months of this year saw the company produce negative operating cash flow and free cash flow of S$17 million and S$290 million, respectively.

A weak balance sheet and inability to generate free cash flow could be a toxic combination for a company. That’s because the company’s lenders may be concerned with the situation and demand even tougher borrowing terms in the future. This starts a vicious cycle of pricier debt leading to an even weaker ability to service and repay borrowings, resulting in even pricier debt.

Sembcorp Marine is fortunate because it has the backing of Sembcorp Industries (Sembcorp Industries owns the majority of Sembcorp Marine’s shares), which has the relatively more stable utilities business to act as a buffer. It’s worth noting too that Temasek Holdings, one of our local government’s investment arms, is a major shareholder of Sembcorp Industries. But it’s anybody’s guess as to how much support Sembcorp Industries is ultimately willing to provide Sembcorp Marine.

I hope what I’ve shared can give you useful context in making a decision with your Sembcorp Marine shares.

The ETF Checklist: 8 Key Points To Avoid The Pitfalls

Not every exchange-traded fund, or ETF, is built the same. Some can be dangerous. We can avoid th common pitfalls if we know where to look.

Exchange-traded funds, or ETFs, are rising in popularity. According to ETF.com, assets under management by US ETFs crossed the US$4 trillion mark earlier this year. That’s huge, to say the least.

It’s not hard to see why the investment vehicle is appealing. You can get wide diversification instantly with most ETFs. Expense ratios are typically low as well, enabling you to keep most of the returns generated.

But not all ETFs are the same. Before you invest in any ETF, you may want to take note of these eight key points.

1. What is an ETF

An ETF is a fund that is traded on a stock exchange, and it can be bought and sold just like any other stock on a stock exchange. An ETF can invest in all kinds of shares depending on the purpose of the fund, and there are many ETFs that aim to track the performance of a stock market index.

Singapore’s main stock market index is the Straits Times Index. There are two ETFs that track its performance, namely, the SPDR Straits Times Index ETF, and the Nikko AM Singapore STI ETF.

2. Mind the gap

The gap between a positive macro-economic trend and stock price returns can be a mile wide.

For example, gold was worth A$620 per ounce at the end of September 2005 and the price climbed by 10% annually for nearly 10 years to reach A$1,550 per ounce on 15 September 2015. But 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.

In another example, you can refer to the chart below on the disparity between the stock market returns and economic growth for China and Mexico from 1992 to 2013. Despite stunning 15% annual GDP growth in that period for China, Chinese stocks actually fell by 2% per year. Mexico on the other hand, saw its stocks gain 18% annually, despite its economy growing at a pedestrian rate of just 2% per year.

So when finding themes to invest in via ETFs, make sure that the macro-economic theme you’re betting on can translate into commensurate stock market gains.

3. Replication method

ETFs can mimic the performance of a stock market index through two broad ways: Synthetic replication, or direct replication.

Synthetic replication involves the use of derivatives without directly investing in the underlying assets. It is the less ideal way to build an index-tracking ETF, in my view, because there is more complexity involved and hence a higher risk that a large proportion of the underlying index’s performance can’t be captured.

Direct replication has two sub-categories: (a) Representative sampling, where the ETF holds only a sample of the stocks within an index; and (b) full replication, which involves an ETF buying the same stocks in nearly identical proportions as the weights of all the stocks that make up an index.

You should try to invest in ETFs that use full replication if possible.

4. Reputation matters

Look for an ETF that is managed by a reputable fund management company. Vanguard, SPDR, iSHAREs, and Blackrock are just some examples of reputable ETF managers.

5. Track record

An ETF should ideally have a listing history of at least a few years, so that we can see how the ETF has actually done, instead of relying on the performance of the underlying index.

6. Watch your costs

The expense ratio (essentially all of the fees that you have to pay to the ETF’s manager and service providers) should be low. There’s no iron-clad rule on what “low” is, but I think anything less than 0.3% for the expense ratio deserves a thumbs-up.

Having a low expense ratio puts an ETF on the right side of the trend of investment dollars flowing toward low-cost index-tracking funds. This lowers the risk of an ETF’s manager closing the ETF down for commercial reasons.

7. The assets that are managed

An ETF’s assets under management (AUM) should be high – ideally more than US$1 billion. Having sizable AUM would also lower the chance that an ETF will close in the future. It’s not uncommon for ETFs to close. When a closure happens, it creates hassle on our part to find new ETFs to invest in.

8. Performance tracking

Lastly, you should look for a low tracking error. An ETF’s returns should closely match the returns of its underlying index. If the tracking error has been high in the past, there’s a higher chance that the ETF can’t adequately capture the performance of its underlying index in the future.

Taming Our Ego When Investing

Preventing ego from getting into our heads is of utmost importance. Without ego, we can invest in a safer manner by not falling prey to overconfidence.

In his book Open Heart, Open Mind, the Tibetan Buddisht educator Tsoknyi Rinpoche recounted a conversation he had with his late father, Tulku Urgyen Rinpoche.

The younger Rinpoche was about to visit the US for the first time to deliver teachings on Buddhism. He wanted advice from his father on how he should approach educating a new audience. Tulku Urgyen Rinpoche responded:

“Don’t let the praise go to your head. People will compliment you. They’ll say how great you are, how wonderful your teachings are… Whatever compliments your students give you have nothing to do with you… How you teach is not important. What you teach is.”

The elder Rinpoche also said that he had observed many Buddhist teachers develop a mistaken notion – that they are special because their ways of imparting Buddhist lessons are popular with students. Tulku Urgyen Rinpoche gently reminded his son: “What’s really special, is the teaching itself.”

The investing analogy

If we invest soundly in the stock market with a long-term, business-focused mindset, it’s likelier than not that investing success will knock on our doors. When we taste success, it’s easy for ego to enter the picture. We may look into the mirror often and proclaim, “I’m a special investor!”

But the entrance of ego plants the seeds of failure. My friend, the fund manager Goh Tee Leng, recently wrote in his website Investing Nook that Pride, or Ego, is one of the seven sins of investing.

If we have done well in investing using the underlying framework that stocks represent a piece of a business and that the value of the stock is a reflection of the value of the underlying business, we’re not special. This framework was already fleshed out thoroughly by Benjamin Graham 85 years ago in his 1934 book, the first edition of Security Analysis. We may each have our own unique interpretations and applications of Graham’s then-groundbreaking ideas. But what’s really special, is the framework itself.

Conclusion

Preventing ego from getting into our heads is of utmost importance. Without ego, we can invest in a safer manner. That’s because we won’t fall prey to overconfidence. When overconfident, we think we know more than we actually do, and we may end up doing risky things, such as borrowing to invest or overly concentrating our portfolios.

This post will serve as a constant reminder to myself, a barrier that keeps my ego at the door. I hope it can serve the same purpose for you too.