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:

Source: Robert Shiller

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?

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

Why I 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:

  1. The bank has been growing every single year from 1996 to 2019.
  2. The bank is very conservatively managed, with even lower leverage than Singapore’s local banking stalwarts, DBS, OCBC, and UOB.
  3. The bank has a fanatical focus on the customer experience.
  4. 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!

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.

“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.

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

Why I Own 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. 

Source: MPAA 2018 THEME report

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. 

Source: MPAA 2018 THEME report

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.

Source: Netflix earnings

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. 

Source: Netflix earnings

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. 

Source: Netflix annual reports

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. 

Source: Netflix earnings

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. 

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

“What 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).

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. 

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

The 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.

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.

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.

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.

“Should I Buy Mapletree North Asia Commercial Trust Now?”

Investors are fearful of Mapletree North Asia Commercial Trust right now. Should we buy its shares? The answer is surprisingly complicated.

Yesterday, a wise and kind lady whom Jeremy and I know asked us: “Buying when there is blood on the street is a golden rule in investing. So should I buy Mapletree North Asia Commercial Trust now?” 

I responded to her query, and I thought my answer is worth sharing with a wider audience. But first, we need a brief introduction of the stock in question.

The background

Mapletree North Asia Commercial Trust is a REIT (real estate investment trust) that is listed in Singapore’s stock market. It currently has a S$7.7 billion portfolio that holds nine properties across Beijing, Shanghai, Hong Kong, and Japan.

Festival Walk is a retail mall and is the REIT’s only property in Hong Kong. It also happens to be Mapletree North Asia Commercial Trust’s most important property. In the first half of FY19/20 (the fiscal year ending 31 March 2020), Festival Walk accounted for 62% of the REIT’s total net property income. 

Hong Kong has been plagued by political and social unrest for months. On 12 November 2019, protestors in the special administrative region caused extensive damage to Festival Walk. Mapletree North Asia Commercial Trust’s share price (technically a unit price, but let’s not split hairs here!) promptly fell 4.9% to S$1.16 the day after. At S$1.16, the REIT’s share price had fallen by nearly 20% from this year’s peak of S$1.43 (after adjusting for dividends) that was reached in July. 

For context on Mapletree North Asia Commercial Trust’s sliding share price over the past few months, consider two things.

First, the other REITs under the Mapletree umbrella have seen their share prices rise since Mapletree North Asia Commercial Trust’s share price peaked in July this year – the share prices of Mapletree Industrial Trust, Mapletree Logistics Trust, and Mapletree Commercial Trust have risen by 13%, 5%, and 12%, respectively (all after adjusting for dividends). Second, Mapletree North Asia Commercial Trust’s results for the second quarter of FY19/20 was released on 25 October 2019 and it was decent. Net property income was up 1.3% from a year ago while distribution per unit inched up by 0.6%. And yet, the share price has been falling.

To me, it seems obvious that fears over the unrest in Hong Kong have affected investors’ sentiment towards the REIT.

The response

My answer to the lady’s question is given in whole below (it’s lightly edited for readability, since the original message was sent as a text):

“Buying decisions should always be made in the context of a portfolio. Will a portfolio that already has 50% of its capital invested in stocks that are directly linked to Hong Kong’s economy (not just stocks listed in Hong Kong) need Mapletree North Asia Commercial Trust? I’m not sure. But in a portfolio that has very light exposure to Hong Kong, the picture changes. 

Mapletree, as a group, has run all its REITs really well. But most of the public-listed REITs are well-diversified in terms of property-count or geography, or both. Mapletree North Asia Commercial Trust at its listing, and even today, is quite different – it’s very concentrated in geography and property-count. But still, the properties seem to be of high quality, so that’s good.


Buying when there’s blood on the streets makes a lot of sense. But statistics also show that of all stocks ever listed in the US from 1980 to 2014, 40% have fallen by at least 70% from their peak and never recovered. So buying when there’s blood on the streets needs a caveat: That the stock itself is not overvalued, and that the business itself still has a bright future.

Mapletree North Asia Commercial Trust’s valuation looks good, but its future will have to depend on the stability of Hong Kong 5-10 years from now. I’m optimistic about the situation in Hong Kong while recognising the short-term pain. At the same time, I won’t claim to be an expert in international relations or the socio-economic fabric of Hong Kong. So, diversification at the portfolio level will be important.

With all this being said, I think Mapletree North Asia Commercial Trust is interesting with a 2% to 3% weighting in a portfolio that does not already have a high concentration (say 20%?) of companies that do business in Hong Kong.”

Perspectives

I mentioned earlier that Mapletree North Asia Commercial Trust’s valuation looks good and that it owns high-quality properties. 

The chart below shows the REIT’s dividend yield and price-to-book (PB) ratio over the last five years. Right now, the PB ratio is near a five-year low, while the dividend yield – which is nearly 7% – looks favourable compared to history. 

Source: S&P Capital IQ

On the quality of the REIT’s property portfolio, there are two key points to make: First, the portfolio has commanded a high occupancy rate of not less than 98.5% in each of the last six fiscal years; second, the properties in the portfolio have achieved healthy rental reversion rates over the same period.

Source: Mapletree North Asia Commercial Trust earnings presentation

Mapletree North Asia Commercial Trust also scores well at some of the other traits that could point us to good REITs:

  • Growth in gross revenue, net property income, and distribution per unit – The REIT’s net property income has grown in each year from FY14/15 to FY18/19, and has increased by 9.4% per year. Distribution per unit also climbed in each year for the same period, and was up by 4.1% annually.
  • Low leverage and a strong ability to service interest payments on debt – The REIT has a high leverage ratio. As of 30 September 2019, the leverage ratio is 37.1%, which is only a small distance from the regulatory leverage ratio ceiling of 45%. But its interest cover ratio for the quarter ended 30 September 2019 is 4.2, which is fairly safe.
  • Favourable lease structures and/or a long track record of growing rent on a per-area basis – At the end of FY18/19, nearly all of Festival Walk’s leases included step-up clauses in base rent. Small portions of the respective leases for the other properties in the REIT’s portfolio also contain step-up clauses. In addition, the REIT has been able to produce strong rental reversions over a multi-year period, as mentioned earlier.

Conclusion

Mapletree North Asia Commercial Trust currently has an attractive valuation in relation to history. It’s also cheaper than many other REITs in Singapore – for example, its sister REITs under the Mapletree group have dividend yields ranging from only 4% to 5%. It also has other attractive traits, such as a strong history of growth, a safe interest cover ratio, and favourable lease structures. 

On the other hand, Mapletree North Asia Commercial Trust has high concentration risk since Festival Walk accounts for more than half its revenue. Moreover, Festival Walk’s prospects depend heavily on the stability of Hong Kong’s sociopolitical fabric. I don’t think anyone can be certain about Hong Kong’s future given the current unrest (which seems to have escalated in recent weeks). These increase the risk profile for the REIT in my view. 

To balance both sides of the equation on Mapletree North Asia Commercial Trust, I think my point on portfolio-level diversification given in my answer to the lady’s question is critical. 

I’m often asked if a certain stock is a good or bad buy. The question is deceptively difficult to answer because it depends on your risk appetite and your investment portfolio’s composition. A stock that makes sense for one portfolio may not make sense for another. Keep this in mind when you’re assessing whether Mapletree North Asia Commercial Trust is suitable for your portfolio.

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

The Best Investing Speech, And 5 Lessons

Timeless investing lessons and wisdom were shared in an investing speech delivered 38 years ago in 1981.

Surprise! The best investing speech I’ve ever come across is not from Warren Buffett or other well-known investing legends such as Peter Lynch, Benjamin Graham, or John Neff. It’s from the little-known Dean Williams. 

The speech, Trying Too Hard, was delivered 38 years ago in 1981, when Williams was with Batterymarch Financial Management. But its content remains as relevant as ever. Here are five gems I took away from Williams’ timeless speech.

1.  Confidence and accuracy

“Confidence in a forecast rises with the amount of information that goes into it. But the accuracy of the forecast stays the same.”

Keep this in mind the next time you come across a market forecaster who is highly confident just because he’s backed by mountains of data. Bad data, however much the amount, can lead to bad forecasts. A poor understanding of how markets work (such as assuming that price movements in the financial markets follow a normal distribution) will also lead to toxic outcomes even when there’s plenty of data involved.

In fact, research by Philip Tetlock, a psychologist at Berkeley, brings this Dean Williams quote one step further by suggesting that confidence and accuracy in a forecast can often be inversely correlated.

2. Don’t just do something, stand there!

“The title Marshall mentioned, “Trying Too Hard”, comes from something that happened to me a few years ago. I had just completed what I thought was some fancy footwork involving buying and selling a long list of stocks. The oldest member of Morgan’s trust committee looked down the list and said, “Do you think you might be trying too hard?” At the time I thought, “Who ever heard of trying too hard?” Well, over the years I have changed my mind about that.”

Finance professors Brad Barber and Terry Odean published a paper in 2000 that looked at the trading records of more than 66,000 US households over a five-year period from 1991 to 1996. The research was astonishing: The households who traded the most generated the lowest returns. The average household earned 16.4% per year for the timeframe under study, while the most frequent traders only earned 11.4% per year.

Investor William Smead once said that “Your common stock portfolio is like a bar of soap. The more you rub it, the smaller it gets.” How true.

3. We know less than we think we do

“Here are the ideas I’m going to talk about: the first is an analogy between physics and investing… The foundation of Newtonian physics was that physical events are governed by physical laws. Laws that we could understand rationally. And if we learned enough about those laws, we could extend our knowledge and influence over our environment. 

That was also the foundation of most of the security analysis, technical analysis, economic theory and forecasting methods you and I learned about when we first began in this business. There were rational and predictable economic forces. And if we just tried hard enough… If we learned every detail about a company. . . .If we discovered just the right variables for out forecasting models… Earnings and prices and interest rates should all behave in rational and predictable ways. If we just tried hard enough.

In the last fifty years a new physics came along. Quantum, or subatomic physics. The clues it left along its trail frustrated the best scientific minds in the world. Evidence began to mount that our knowledge of what governed events on the subatomic level wasn’t nearly what we thought it would be. Those events just didn’t seem subject to rational behavior or prediction. Soon it wasn’t clear whether it was even possible to observe and measure subatomic events, or whether the observing and measuring were, themselves, changing or even causing those events.

What I have to tell you tonight is that the investment world I think I know anything about is a lot more like quantum physics than it is like Newtonian physics. There is just too much evidence that our knowledge of what governs financial and economic events isn’t nearly what we thought it would be.”

Investing involves human psychology, which is incredibly hard to model. The great physicist Richard Feynman apparently once said “Imagine how much harder physics would be if electrons had emotions.” That’s the problem we as investors have to deal with. 

Investing is not always a case of “if X, then Y.” According to a study done in 2004, South Africa’s economy expanded by 6.5% annually from 1900 to 2002, but saw its stock market rise by less than 1%. The Federal Reserve in the US started its bond-purchase programme, Quantitative Easing, in 2008. Investors thought back then that interest rates would rise when QE stopped since the Fed’s massive presence would be gone. QE officially ended in late 2014 but the Fed had stopped and restarted QE on a number of occasions. Morgan Housel showed that, contrary to the general idea, interest rates rose each time the Fed stopped QE between the beginning of 2008 and April 2013.

The good thing is you and I need not be helpless. We can work with sound investing principles that are backed by strong logical reasoning and evidence, and we can invest with humility by diversifying. 

4. The power of simplicity and consistency

“You are familiar with the periodic rankings of past investment results published in Pension & Investment Age. You may have missed the news that for the last ten years the best investment record in the country belonged to the Citizens Bank and Trust Company of Chillicothe, Missouri.

Forbes magazine did not miss it, though, and sent a reporter to Chillicothe to find the genius responsible for it. He found a 72 year old man named Edgerton Welsh, who said he’d never heard of Benjamin Graham and didn’t have any idea what modern portfolio theory was. “Well, how did you do it?” the reporter wanted to know.

Mr. Welch showed the report his copy of Value-Line and said he bought all the stocks ranked “1” that Merrill Lynch or E.F. Hutton also liked. And when any one of the three changed their ratings, he sold. Mr. Welch said, “It’s like owning a computer. When you get the printout, use the figures to make a decision–not your own impulse.”

The Forbes reporter finally concluded, “His secret isn’t the system but his own consistency.” EXACTLY. That is what Garfield Drew, the market writer, meant forty years ago when he said, “In fact, simplicity or singleness of approach is a greatly underestimated factor of market success.””

I’ve previously shared in The Good Investors about how a simple portfolio of US stocks, international stocks, and global bonds have bested even the best-performing endowment funds of US colleges that invests in incredibly complex ways. Here’s another good one, according to Morgan Housel: “Someone who bought a low-cost S&P 500 index fund in 2003 earned a 97% return by the end of 2012… Meanwhile, the average equity market neutral fancy-pants hedge fund lost 4.7% of its value over the same period, according to data from Dow Jones Credit Suisse Hedge Fund Indices.”

5. Investing without forecasts

“And when it comes to forecasting—as opposed to doing something—a lot of expertise is no better than a little expertise. And may even be worse.

The consolation prize is pretty consoling, actually. It’s that you can be a successful investor without being a perpetual forecaster. Not only that, I can tell you from personal experience that one of the most liberating experiences you can have is to be asked to look over your firm’s economic outlook and to say, “We don’t have one.”

Successful investing can be done without paying attention to economic forecasts. I have been investing for more than 9 years, and have never depended on outlooks on the economy. My focus has always been on a stock’s underlying business fundamentals. It’s the same when I was with the Motley Fool Singapore’s investing team – the prospects of a stock’s business was our primary concern. In his speech, Dean Williams also said “Give life a try without forecasts.” I have tried, and it’s been great

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

Why Value Investing Has Worked – and Some Key Takeaways

Insights on why value investing (essentially investing in stocks with low valuations) has worked in the stock market over long periods of time but has struggled in the last decade or so.

Around 1.5 years ago, I read a piece of fascinating research from O’Shaughnessy Asset Management (OSAM) and the pseudonymous financial blogger, Jesse Livermore. The research provided insights on why value investing (essentially investing in stocks with low valuations) has worked in the stock market over long periods of time but has struggled in the last decade or so. 

I want to share the paper’s main findings and my takeaways, because value investing is popular among many stock market participants. 

Value’s success

The research found that stocks in the value category saw their earnings fall in the short run. The market was somewhat correct in giving such stocks a low valuation in the first place. I say “somewhat correct” because the market was excessively pessimistic. Value stocks eventually outperformed the market because their earnings recovered to a point where their initial purchase prices looked cheap – it was the initial excessively-pessimistic pricing and subsequent recovery in earnings that led to the value factor’s ability to deliver market-beating returns.

So the market was right in the short run, in the sense that value stocks will see a downturn in their businesses. But the market was also wrong in the sense that it was too pessimistic on the long-run ability of the businesses of value stocks to eventually recover. OSAM and Livermore’s research also showed that the value factor’s poor performance in the last decade or so can be attributed to the disappearance of the subsequent recovery in earnings of value stocks. The reason for the disappearance of the earnings-recovery was not covered in the paper.

My takeaways

First, investors can gain an enormous and lasting edge over the market simply by adopting a longer time horizon and having the courage and optimism to see past dark clouds on the horizon. The Motley Fool’s co-founder and chairman, David Gardner, spoke about the concept of “Dark Clouds I Can See Through” in an insightful podcast of his. The idea behind seeing past dark clouds on the horizon is that if you’re able to look past the prevailing pessimism about a situation, and if you’re right in your optimism, there’s success to be found on the other side when the clouds clear. OSAM and Livermore showed this empirically when they broke down the exact drivers behind the past successes of the value factor – investors who had the ability to “see” the subsequent recovery in earnings of value stocks were able to profit from the market’s short-term pessimism.

Second, I think it’s now more important than ever for investors to not buy value stocks blindly. The underlying mechanism behind the value factor’s past successes has been shown to be the initial overly-pessimistic pricing and the subsequent earnings recovery of value stocks. The recent struggles of the value factor, however, has been due to the inability of value stocks to produce an earnings recovery. To succeed with value stocks, I think investors should have a robust framework for analysing companies in the value category and think carefully about the probability of their businesses’ abilities to produce growth in the future.

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.