Author: Chong Ser Jing

Dangerous Stock Market Myths For Any Market 

Myths about the stock market that are dangerous because they can harm your long-term investing returns by influencing your investing behaviour negatively.

This morning, I gave a presentation for iFAST Global Markets’ Virtual Symposium – Strategies to Build Wealth During the Bear Market event. I would like to thank the iFAST Global Markets team, in particular Ko Yang Zhi, for their invitation. The title of my presentation is the same as the title of this article you’re reading. You can check out the slide deck for my presentation by hitting this orange button:

Download my presentation deck

You can also find my speech, along with the accompanying slides, below!

Presentation

[Slide 2] Hi everyone, I’m Ser Jing. I launched Compounder Fund, a global equities investment fund, July 2020 together with my friend Jeremy Chia. The both of us also run an investment blog called The Good Investors, with the URL (www.thegoodinvestors.sg). Prior to Compounder Fund and the blog, I was with The Motley Fool Singapore from Jan 2013 – Oct 2019. For those of you who may not know, The Motley Fool Singapore was an investment website and we specialised in selling investment research online.

[Slide 2] During this presentation, I’ll be sharing myths regarding the stock market that I commonly read or hear about. These myths are dangerous if they’re not debunked because they can harm your long-term investing returns by influencing your investing behaviour in negative ways. During the presentation, I’ll need your participation. There will be a few questions I’ll be asking, and I need your help to answer them. I’ll be covering nine myths in all, and there will be some time for a Q&A at the end. With each myth that I debunk – with factual data – I’ll also discuss a key lesson that we can learn from each of them. 

[Slide 3] Before I dive into the presentation, nothing I say should be taken to be investment advice or a recommendation to act on any security or investment product. I may also have a vested interest in the stocks mentioned during this presentation

[Slide 4] Let’s start with the first myth. Imagine that you’re now back in 1992 and you found a country that had a GDP (gross domestic product) of US$427 billion. You also have a perfect crystal ball that’s telling you that this country’s GDP would go on to compound by 13.7% per year till 2021, ending the year with US$17.7 trillion in GDP. Take a second to think if you would want to invest in the stock market of this country in 1992? Note that these are all real figures.

[Slide 5] The country I’m talking about here is China and if you said yes to my question, a dollar that you had invested in the MSCI China Index – a collection of large and mid-sized companies in the country – in late-1992 would have become roughly… a dollar by October this year. You heard that correctly: Chinese stocks have been flat for 30 years despite a 13.7% annualised growth in GDP over the same period. The reason is because stocks ultimately go up if their underlying businesses do well.

[Slide 6] And in the case of China, you can see that the earnings per share of the MSCI China Index was basically flat from 1995 to 2021.

[Slide 7] So the first myth I want to debunk is that a country’s stock market will definitely do well if its economy is growing robustly. And the lesson here is that the gap between a favourable macroeconomic event and the movement of stock prices can be a mile wide. 

[Slide 8] Now for the second myth. Let’s go back in time again, this time to September 2005 – in case you’re wondering, we’ll be doing quite a bit of time travelling in today’s presentation. You’re in September 2005 now and you can see that gold is worth A$620 per ounce. The perfect crystal ball you had in Myth 1 is now telling you that the price of gold would climb by 10% per year to A$1,550 in September 2015. The golden question facing you now in September 2005 is this: Do you want to invest in Australian gold mining stocks for the next 10 years?

[Slide 9] If you said yes, you would be sitting on a loss of more than 30%. The S&P / ASX All Ordinaries Gold index, an index of gold-mining stocks in Australia’s stock market, fell by 4% annually from 3,372 points in September 2005 to 2,245 in September 2015.

[Slide 10] So the second myth is this: You should definitely invest in a commodity-producer’s stock if you’re sure that the price of the commodity will rise. The lesson here is the same as the first myth’s: The gap between a favourable macroeconomic event and the movement of stock prices can be a mile wide. In that mile are things like the quality of the business, the capability of the management team, the balance sheet strength of the company, and so on.

[Slide 11] Moving on to the third myth, I need your help to choose between two groups of real-life US-listed companies that you would prefer to invest in if you could go back in time to 2010.

[Slide 12] The first group comprises Company A, Company B, and Company C. This chart shows their stock prices from the start of 2010 to the end of 2021 – Company A is the purple line, Company B is orange, and Company C is blue. More specifically, the chart shows the percentage declines from a recent high that each company’s stock price had experienced in that timeframe. The chart looks brutally rough for all three companies. Their stock prices declined by 20% or more on multiple occasions from 2010 to 2021. In fact, Company B’s stock price had fallen by 40% from a recent high on four separate occasions, and Company C even suffered an 80% drop in 2011. Moreover, their stock prices were much more volatile than the S&P 500; the S&P 500 is a major stock market index in the USA and it experienced a decline of 20% or more from a recent high just once in early 2020. 

[Slide 13] The second group of companies are Company D, Company, E, and Company F. This table illustrates their stock prices and revenue growth from the start of 2010 to the end of 2021, along with the S&P 500’s gain. The second group has generated tremendous wealth for their investors, far in excess of the S&P 500’s return, because of years of rapid business growth.

[Slide 14] This chart is a pictorial representation of the stock price gains that Company D, Company E, Company F, and the S&P 500 have produced.So take a second to think about which group you would like to invest in. As a quick recap: The first group had experienced severe volatility in their stock prices in the 2010-to-2021 time frame, often falling by huge percentages.

[Slide 15] I’m guessing that most of you would prefer to invest in the second group. But here’s what’s interesting: Both groups refer to the same companies! Company A and Company D are Amazon; B and E are MercadoLibre, and C and F are Netflix. Amazon and Netflix are likely to be familiar to all of you watching this, but MercadoLibre is not – it is an e-commerce and digital payments giant that focuses on Latin America.

[Slide 16] The third myth is that great long-term winners in the stock market will make you feel comfortable on their way up. But this myth couldn’t be further from the truth. Even the market’s best winners will make you feel like throwing up as they climb over time and there are two lessons here: (1) Volatility in the stock market is a feature and not an anomaly, and (2) The route to huge gains in the stock market will feel like a sickening roller-coaster.

[Slide 17] We’re now at the fourth myth, and it relates to something interesting about the stock price returns and business growth of Amazon, MercadoLibre, and Netflix. This table shows the revenue growth and stock price movement for all three companies in each year from 2010 to 2021. You will notice that the trio have each: (1) exhibited excellent revenue growth in each year for the period; (2) underperformed the S&P 500 in a few calendar years, sometimes significantly; and (3) seen their stock prices and business move in completely opposite directions in some years. But yet, all three of them have produced excellent business growth with matching stock price returns, as I discussed in Myth 3.

[Slide 18] The experience of Amazon, MercadoLibre, and Netflix are not isolated examples. In fact, Nobel-prize-winning economist Robert Shiller once published research in the 1980s that looked at how the US stock market performed from 1871 to 1979. Shiller compared the market’s performance to how it should have rationally performed if investors had perfect knowledge on the future changes in its dividends. The result is the chart you’re looking at now. The solid line is the stock market’s actual performance while the dashed line is the rational performance. Although there were violent fluctuations in US stock prices, the fundamentals of American businesses – using dividends as a proxy – was much less volatile. The legendary investor Ben Graham has a beautiful analogy for the stock market, that it is a voting machine in the short run but a weighing machine in the long run. Plenty of shorter-term voting had taken place in the US stock market over the course of history. But importantly, the weighing scale did function beautifully. From 1871 to 1979, historical data on US stocks maintained by Shiller show that the S&P 500’s dividend and price had increased by 2,073% and 2,328%, respectively. 

[Slide 19] So the fourth myth is this: If a stock’s underlying business does well every year, the stock’s price will also do well each year. In fact, and this is the lesson: A company’s stock price can exhibit stomach-churning short-term volatility even when its underlying business is performing well, but in the long run, business fundamentals and stock prices do match up nicely.

[Slide 20] We’re at the fifth myth now, and I need your help to quickly think about this question: We’re now at the start of the year 1990 – how do you think the US stock market will fare over the next five years and the next 30 years, if I tell you that all three of the following will happen during the year: In July, the USA will enter a recession and a month later, the country will fight in a war in the Middle East and the price of oil will spike?

[Slide 21] Turns out, the S&P 500 was up by nearly 80% from the start of 1990 to the end of 1995, including dividends and after inflation. 

[Slide 22] From the start of 1990 to the end of 2019, US stocks were up by nearly 800%.

[Slide 23] What’s also fascinating is that the world saw multiple crises in every single year from 1990 to 2019, as the table here illustrates. Yet, the S&P 500 had steadily marched higher in that period.

[Slide 24] The myth here is that stocks can only do well during peaceful times. But the truth – and the lesson – is that uncertainty is always around, and disasters are always happening, but that does not mean we should not invest as stocks can still do well even in the face of trouble.

[Slide 25] For Myth No. 6, let’s consider the importance that some of the best investors in the world place in trying to predict the short-term movement of stock prices. We can use Peter Lynch and Warren Buffett as examples. But first, I’ll quickly run through why the both of them are widely considered to be investing greats. Lynch was the manager of the US-focused Fidelity Magellan Fund from 1977 to 1990. During his 13-year tenure, he produced an annual return of 29%, nearly double that of the S&P 500. Meanwhile, Buffett has been in control of his investment conglomerate Berkshire Hathaway since 1965. From then to 2018, he grew the book value per share of Berkshire by 18.7% per year by using its capital to invest in stocks and acquire companies with outstanding businesses. Over the same period, the S&P 500 compounded at less than 10% annually. 

[Slide 26] So how do Lynch and Buffett incorporate short-term predictions on the stock market in their investing process? They don’t. In an old interview with PBS, Lynch said: “What the market’s going to do in one or two years, you don’t know. Time is on your side in the stock market. It’s on your side. And when stocks go down, if you’ve got the money, you don’t worry about it and you’re putting more in, you shouldn’t worry about it. You should worry what are stocks going to be 10 years from now, 20 years from now, 30 years from now.”

[Slide 27] Then there’s Buffett, who wrote a famous op-ed for The New York Times in October 2008, at the height of the Great Financial Crisis. In it, Buffett shared: “Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month or a year from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.”

[Slide 28] Myth No.6 is something I hear often, and that is that great stock market investors know exactly what’s going to happen to stock prices in the next month or year ahead. But as I’ve discussed, even the best in the business have no clue what stocks would do in the short run, and yet that did not prevent them from clocking incredible long-term returns. So the lesson here is that we can still achieve great long-term investing results even if we have no idea what the market’s going to do over the short run. 

[Slide 29] The seventh myth involves stocks and recessions. What do you think will happen if you have perfect clairvoyance and are able to tell when the US economy will enter and exit a recession and thus sell stocks just before a recession hits and buy them back just before a recession ends?

[Slide 30] If you had this clairvoyance from 1980 to 2018, you would wish you did not have the special ability. According to research from Michael Batnick, a dollar invested in US stocks at the start of 1980 would be worth north of $78 around the end of 2018 if you had simply held the stocks and did nothing. This is the black line in the chart. But if you invested the same dollar in US stocks at the start of 1980 and expertly side-stepped the ensuing recessions to perfection, you would have less than $32 at the same endpoint. This is the red line.

[Slide 31] The seventh myth is that it is important for stock market investors to side-step recessions. But the data shows us an important lesson: Trying to side-step recessions can end up harming our returns, so it’s far better to stay invested and accept that recessions are par for the course when it comes to investing.

[Slide 32] Moving to Myth No. 8, when we’re in an economic downturn, I think it’s natural to assume that it’s safer to invest when the coast is clear. But the reality is that the stock market tends to recover before good news about the economy arrives. For example, if we go back to the most recent recession in the USA prior to COVID, that would be the recession that lasted from December 2007 to June 2009. In that episode, the S&P 500 reached a trough in March 2009 of around 680 points. Back then, the unemployment rate in the country was around 8%. But by the time the unemployment rate reached  a peak in late 2009 at 10%, the S&P 500 was already around 50% higher than where it was in March 2009 and it has never looked back.

[Slide 33] So the myth here is that we should only invest when the coast is clear. But as the data shows – and to borrow a Warren Buffett quote I mentioned earlier, “if you wait for the robins, spring will be over.”

[Slide 34] And last but not least, we’re at Myth No.9, where it’s about interest rates and stocks. There’s plenty of attention being paid to interest rates because of its theoretical link with 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 bonds, being an alternative to stocks, 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. And falling valuations for stocks would then lead to falling stock prices. But the real relationship between interest rates and stocks is nowhere near as clean as what’s described in theory.

[Slide 35] Ben Carlson’s research has shown that the S&P 500 climbed by 21% annually from 1954 to 1964 even when the yield on 3-month Treasury bills (a good proxy for the Fed Funds rate, which is the key interest rate set by the USA’s central bank, the Federal Reserve) surged from around 1.2% to 4.4% in the same period. In the 1960s, the yield on the 3-month Treasury bill doubled from just over 4% to 8%, but US stocks still rose by 7.7% per year. And then in the 1970s, rates climbed from 8% to 12% and the S&P 500 still produced an annual return of nearly 6%.

[Slide 36] Meanwhile, data from Robert Shiller show that the US 10-year Treasury yield was 2.3% at the start of 1950. The yield reached a peak of 15.3% in September 1981. In that same period, the S&P 500’s price-to-earnings (P/E) ratio moved from 7 to…  8. That’s right, the P/E ratio for the S&P 500 increased slightly despite the huge jump in interest rates.

[Slide 37] It’s worth noting too that the S&P 500’s P/E ratio of 7 at the start of 1950 was not a result of earnings that were temporarily inflated, as can be seen by the trend for the index’s earnings per share in preceding and subsequent five-year periods.

[Slide 38] Then we have this chart, which illustrates the historical relationship that the S&P 500’s price-to-earnings (P/E) ratio has had with 10-year Treasury yields. It turns out that the S&P 500’s P/E ratio has historically and – noticeably – peaked when the 10-year bond yield was around 5%, and not when the 10-year bond yield was materially lower at say 3% or 2%.

[Slide 39] The ninth myth is this: Rising interest rates are definitely bad for stock valuations and thus stock prices. But what the evidence shows is that stock valuations and prices have risen over time even when interest rates have soared. So there are two important lessons here: (1) While interest rates have a role to play in the movement of stocks, it is far from the only thing that matters; (2) one-factor analysis in finance – “if A happens, then B will occur” – should be largely avoided because clear-cut relationships are rarely seen.

[Slide 40] I’ve come to the end of my presentation today and I’m happy to take questions!

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in Amazon, MercadoLibre, and Netflix shares mentioned. Holdings are subject to change at any time.

What Warren Buffett Saw In See’s Candy

See’s Candy taught Warren Buffett and Charlie Munger invaluable lessons about investing.

See’s Candy, a simple chocolate manufacturer, was a transformative acquisition for Warren Buffett. 

Through the company, Buffett and his long-time partner, Charlie Munger, gained lessons that have shaped the fortunes of their investment conglomerate, Berkshire Hathaway, for the better. Here’s Buffett, from Berkshire’s 2014 shareholder’s letter:

“The year 1972 was a turning point for Berkshire (though not without occasional backsliding on my part – remember my 1975 purchase of Waumbec). We had the opportunity then to buy See’s Candy for Blue Chip Stamps, a company in which Charlie, I and Berkshire had major stakes, and which was later merged into Berkshire.

See’s was a legendary West Coast manufacturer and retailer of boxed chocolates, then annually earning about [US]$4 million pre-tax while utilizing only [US]$8 million of net tangible assets. Moreover, the company had a huge asset that did not appear on its balance sheet: a broad and durable competitive advantage that gave it significant pricing power. That strength was virtually certain to give See’s major gains in earnings over time. Better yet, these would materialize with only minor amounts of incremental investment. In other words, See’s could be expected to gush cash for decades to come.

The family controlling See’s wanted [US]$30 million for the business, and Charlie rightly said it was worth that much. But I didn’t want to pay more than $25 million and wasn’t all that enthusiastic even at that figure. (A price that was three times net tangible assets made me gulp.) My misguided caution could have scuttled a terrific purchase. But, luckily, the sellers decided to take our [US]$25 million bid.

To date, See’s has earned [US]$1.9 billion pre-tax, with its growth having required added investment of only [US]$40 million. See’s has thus been able to distribute huge sums that have helped Berkshire buy other businesses that, in turn, have themselves produced large distributable profits. (Envision rabbits breeding.) Additionally, through watching See’s in action, I gained a business education about the value of powerful brands that opened my eyes to many other profitable investments.”

The US$25 million that Buffett and Munger paid in 1972 to acquire See’s gave them a company that had generated a collective US$1.9 billion in pre-tax earnings by 2014. But that’s not at all. See’s provided cash flow for Buffett and Munger to make other profitable investments; through first-hand observation of See’s operations and results, they also learnt about the true value of businesses with powerful brands.

I recently came across an old annual report of See’s from a tweet made by a Twitter user with the username of Turtle Bay. The report, which showed See’s financials from 1960 to 1971 (see Table 1 below), is possibly the last annual report the chocolate maker published before its acquisition by Buffett and Munger. Given the importance of See’s in the folklore of Berkshire, I wanted to study See’s historical financials to better understand what Buffett and Munger saw in the company.

Table 1; Source: Turtle Bay tweet 

Here’s what I gathered from Table 1:

  • See’s revenue was not growing rapidly, but the growth profile was smooth
  • Its gross margin was respectable throughout and had increased from 47% to 54%; the same goes for its operating margin
  • The chocolate manufacturer’s net profit, much like its revenue, showed consistent growth, and the net profit margin climbed from 5.1% to 7.8% (see Table 2 below)
  • See’s did not dilute its shareholders as its shares outstanding did not change in any year from 1960 to 1971
  • See’s steadily increased its dividend while keeping its payout ratio sustainable (never crossing 74%)
  • The balance sheet was rock-solid throughout the entire time frame as See’s debt was either minimal (in 1960) or zero
  • The company had a healthy return on equity in every year – never falling below 13.3%, and averaging at 15.8% – as shown in Table 2
Table 2; Source: Turtle Bay tweet

See’s success after Buffett’s purchase was by no means a guarantee. A fascinating 1972 letter Buffett sent to See’s then leader, Charles Huggins, after the acquisition closed detailed the tenets that Buffett wanted See’s to adhere to:

  • Maintain strict control over merchandising conditions, with a focus on creating an image in consumer’s minds that See’s Candy products are special
  • Educate consumers on the unique legacy of See’s Candy (this also helps with fostering the positive impression on consumers that Buffett wants)
  • Creation of product scarcity in terms of timing and geography, again to maintain the quality of See’s image with consumers

If See’s had failed to follow Buffett’s inputs, its chocolates could easily have become just another commodity as time progressed. See’s subsequent results after 1972 could thus have been far less spectacular than what was actually produced. 

The next time you find any company with similar characteristics as See’s in the 1960s and ‘70s, it’s not a given that it would be a great investment. But at the very least, it would be a company that’s worth a deeper look.  

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I don’t have a vested interest in any company mentioned. Holdings are subject to change at any time.

What The USA’s Largest Bank Thinks About The State Of The Country’s Economy In Q3 2022

Insights from JPMorgan Chase’s management on the health of American consumers and businesses in the third quarter of 2022.

JPMorgan Chase (NYSE: JPM) is currently the largest bank in the USA by total assets. Because of this status, JPMorgan is naturally able to feel the pulse of the country’s economy. The bank’s latest earnings conference call – for the third quarter of 2022 – contained useful insights on the state of American consumers and businesses. The bottom-line is this: (1) Consumer spending is still healthy, but there are risks on the horizon; (2) Leaders of small businesses are getting concerned about the macro-economic environment; and (3) Businesses and consumers are still in good financial health.  

What’s shown between the two horizontal lines below are quotes from JPMorgan’s management team that I picked up from the call.

1. Consumer spending and consumer cash levels are still strong

Nominal spend is still strong across both discretionary and nondiscretionary categories, with combined debit and credit spend up 13% year-on-year. Cash buffers remain elevated across all income segments.

2. But consumer spending is growing faster than income, so deposits continue to fall, especially for lower income groups

However, with spending growing faster than income, we are seeing a continued decrease in median deposits year-on-year, particularly in the lower income segments. 

3. Small businesses are increasingly worried about the macro environment

And not surprisingly, small business owners are increasingly focused on the risks and the economic outlook.

4. Auto-loan originations fell sharply

And in Auto, originations were $7.5 billion, down 35%, due to lack of vehicle supply and rising rates.

5. Card delinquencies remain well below pre-COVID levels, but are creeping up

Card delinquencies remain well below pre-pandemic levels, though we continue to see gradual normalization.

6. There’s just no crack in credit performance that JP Morgan’s management is seeing; but they do see some strain on future numbers that are coming from well-known current macro-economic issues

[Question] Would appreciate any perspective in terms of are you beginning to see cracks, either be it commercial, real estate, consumer where it feels like the economic pain from inflation, higher rates is beginning to filter through to your clients?

[Answer] The short answer to that question is just no. We just don’t see anything that you could realistically describe as a crack in any of our actual credit performance. I made some comments about this in the prepared remarks on the consumer side. But we’ve done some fairly detailed analysis about different cohorts and early delinquency bucket entry rates and stuff like that. And we do see, in some cases, some tiny increases. But generally, in almost all cases, we think that’s normalization, and it’s even slower than we expect…

…[Answer] I think we’re in an environment where it’s kind of odd, which is very strong consumer spend. You see it in our numbers. You see it in other people’s numbers, up 10% prior to last year, up 35% pre-COVID. Balance sheets are very good for consumers. Credit card borrowing is normalizing, not getting worse. You might see — and that’s really good. So you go in to recession, you’ve got a very strong consumer. However, it’s rather predictable if you look at how they’re spending and inflation. So inflation is 10% reduces that by 10%. And that extra cap — money they have in the checking accounts will deplete probably by sometime midyear next year. And then, of course, you have inflation, higher rates, higher mortgage rates, oil volatility, war. So those things are out there, and that is not a crack in current numbers. It’s quite predictable. It will strain future numbers.

7. JPMorgan’s CEO, Jamie Dimon, thinks conditions today are the same compared to a few months ago, when he commented that a “hurricane” was coming 

[Question] Let’s just cut to the chase. So where are you versus 3 months ago? I mean, is it — you certainly got headlines with the hurricane comment and all that. And it’s — look, like as you said, you have Fed tightening, QT, tighter capital rules for banks. You have like the trifecta of tightening by the Fed and then you have wars and everything else. So I don’t think that even stock market supports your view and about all the risks out there, but are things better or worse or the same as they were 3 months ago?

[Answer] They’re roughly the same. We’re just getting closer to what you and I might consider bad events. So — in my hurricane, I’ve been very consistent, but looking at probabilities and possibilities. There is still, for example, a possibility of a soft wind. We can debate. We think that percentage of yours might be different than mine, but there’s a possibility of a mild recession. Consumers are in very good shape, companies are in a very good shape. And there’s possibility of something worse, mostly because of the war in Ukraine and oil price and all things like that. Those — I would not change my possibilities and probabilities this quarter versus last quarter for me…

8. Mortgages and auto loans expected to decline further

I mean look at the volumes and mortgage have dropped and cars quota have dropped and stuff like that. And that’s already in our numbers, and we would expect that to continue that way.

9. Jamie Dimon summarising the state of things: The overall picture looks good, but dark clouds are gathering on the horizon

In the U.S., consumers continue to spend with solid balance sheets, job openings are plentiful and businesses remain healthy. However, there are significant headwinds immediately in front of us – stubbornly high inflation leading to higher global interest rates, the uncertain impacts of quantitative tightening, the war in Ukraine, which is increasing all geopolitical risks, and the fragile state of oil supply and prices. While we are hoping for the best, we always remain vigilant and are prepared for bad outcomes so we can continue to serve customers even in the most challenging of times.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I don’t have a vested interest in any company mentioned. Holdings are subject to change at any time.

Quality Thoughts From A Quality Investor

I’ve read about the investment firm First Eagle Investments and its legendary portfolio manager, Jean-Marie Eveillard, many years ago. But I was not familiar with Matthew McLennan, currently an important leader in First Eagle’s stock market investment team, until I came across his interview with William Green for the Richer, Happier, Wiser podcast series on The Investor’s Podcast Network.

During their nearly two-hour conversation, McLennan and Green covered plenty of high–quality ground and I had many takeaways that I wish to share. Here goes!

Using gardening as an analogy for the importance of having a long-term mindset in stock market investing

McLennan: I mentioned that my grandfather was a gardener and he passed that skill on to my mother and this little home that we built, she was an ardent gardener in this home. As a child, I always wondered why she went to the effort because there was always some issue. There were drought conditions or the bamboo root would spread to somewhere where it wasn’t meant to be or there was some weird fungus or virus. She was always having troubles.

Whereas, there’s a gentleman who lived next to us who mow his lawn every week and it just looked pristine and clean. We had another house behind us at the bottom of the rainforest where he just lived amidst the rainforest. I didn’t realized the wisdom of my mother’s long-term strategy when I came back to the house some 20 years later with children, my children. The garden had really grown into this resplendent beautiful space. It had been selectively curated over time. Whereas, the house next to me was still being mowed. The lawn was still being mowed every week. But there was nothing to show for all of this activity. He was like the active manager turning over the portfolio once a week.

The gentleman who’d had his house down the hill behind us had some fire damage I heard at some point. The passive strategy of just letting the forest go around you wasn’t necessarily the safe strategy my mother had worked in all of these fire buffers and things. Selectively curating something and letting time take its course is something that doesn’t seem like a very well-rewarded activity in the short term. When you step back and let time play out, it can be very rewarding.

The scientific principle of entropy is a useful framework for thinking about the longevity of companies

McLennan: Entropy is probably one of the few absolute truths. It’s a second law of the thermodynamics that any form of order is essentially transient. And perhaps it’s the fight against entropy that’s sort of gotten me interested in old master art or great wine that can survive for generations, from vineyards that have been planted for generations, or a business that has a slow fade rate relative to the typical business.

But if you think about the economy as an ecosystem, rather than as machine, productivity happens every year, productivity growth, and over the last century, we’ve grown productivity close to 2% a year. But the dark symmetry of productivity is that the existing pool of companies won’t control a future profit pool in perpetuity. New businesses get created that chip away at the margins at existing incumbency. And so entropy is a fundamental principle and investing. And when you go through business school and learn about asset pricing, you’re really only taught to think about beta risk or systemic risk. But idiosyncratic risk is interesting to think about as well.

And in fact, entropy is a form of systemic risk because change in the economy and the overall improvement in the economy imputes that existing companies will grab a smaller share of the future pie given enough time. And so I’ve focused a lot on this question. And the paradox of it is that buying businesses that have been around for a long period of time, that have demonstrated persistence, in some ways, can be a safer strategy than trying to buy a business that’s growing a lot today because many of the businesses that are growing a lot today are in industry verticals where market share positions move around a lot. And so by definition, your ability to capitalize their terminal earnings at any given period of time is low because easy come, easy go, as it would relate to market share shifts.

And so we do like to try and focus on businesses that have a stickiness to their market share over time, high customer retention rates, to try and slow the curve of entropy. And we approach it with a great deal of humility and respect, and we recognize that even our favorite ideas are going to get disrupted at some point or another.

Digital wealth could co-exist with financial assets

McLennan: Most wealth before the industrial revolution was stored in real assets, land, art, precious metals, livestock. And then we created all these financial assets which were essentially the crypto of the time. They were virtual claims. The original companies were beneficial claims of trusts on underlying assets. And so this was kind of arcane and abstract at the time, but financial assets came to coexist alongside real assets. They didn’t disrupt totally, they coexisted.

And if digital assets are another concentric circle around financial assets and real assets, it doesn’t mean that real assets will disappear and it doesn’t mean that all financial assets will disappear. I think what we’re going to see is the emergent coexistence.

Emerging economies often don’t “emerge”; the problems with China’s economy today

McLennan: Well, it’s not clear to me that China will become, and even if it does sustain its position as the world’s largest economy. And I think a lot of people are presuming that will happen, but it’s not clear to me that happens. I think one of the things that’s interesting is if you look at a list of emerging markets and of 50 years ago and look at a list today, very few emerging markets actually emerge.

And there’s a whole host of reasons for this and there’s, in fact, there was an interesting book on this called Why Nations Fail by Robinson and I think Acemoglu MIT economist. And one of the tells of a country that’s managed to sort of grow and benefit from capitalism and the spread of property rights and all those sorts of things. There’s an inherent pluralism and a political process that gives voice to multiple constituencies. And historically at least if you haven’t had that, it’s been difficult to sustain growth to develop market levels. And ultimately if you have some form of authoritarian regime, it’s impeding to the very notion of creative destruction because if there’s a rent seeking regime, it has to retard at some point in time, creative destruction to preserve its own existence.

And so I think if you were to ask if Hayek still lived and you were to ask him, will China become and sustain its position as the world’s largest economy? I think he’d be very weary of making that prediction. And so I think that China is set with quite a few problems right now despite the fact that there are opportunities, this self-inflicted wound with the COVID policy response and the lockdowns. There is dramatic adjustment going on in the real estate sector and that market is very overbuilt. And they had a clamp down on the entrepreneurial class and which has really led to sort a derating of that sector.

Through a study of history, there’s a risk of China and the USA coming into conflict

Green: And you seem pretty concerned as a fan of Thucydides and his views on history, you seem pretty concerned about some kind of mounting inevitability to a conflict between the US and China sort of echoing the Spartan Athenian kind of conflict that we saw thousands of years ago.

McLennan: Well I think if you read Thucydides what’s compelling about it is that it was written before 400 BC and a lot’s changed since then. Obviously technology is dramatically different today from what it was back then. On the other hand, human behavior and human wiring hasn’t changed that much. And I get the analyst on our team to read the book because it shows you the common mistakes that people make. Hubris, dogma, acting with haste. And I use that as a template to get people to think about doing the opposite with their temperament, having humility to accept uncertainty, being a patient investor, being flexible, not dogmatic about just investing in one particular part of the world or one particular industry. 

And so I think there’s a lot we can learn from Thucydides and I think what he showed us is that the fear of war is often the cause of war, and especially when you have two competing regimes. And I certainly hope we don’t see that emerge, but Nancy Pelosi’s visit to Taiwan and the response is clearly flashing some warning signs here that I think we can’t ignore in totality.

How to improve your thinking

McLennan: So I think the first thing is you have to create time to reflect. And it’s easier said than done. We all have busy schedules. We could all spend all of our time doing a subset of our jobs. And so first you just have to, in the mental hierarchy of things, acknowledge that some time spent on reflection is important. And in fact, as I think about it, what, if I were a client? What would I want Matt or any of the team members to be spending their time on? And I’d want them to be spending some meaningful amount of their time on reflection so that they’re seeing the world through a different prism.

The second thing is that it doesn’t happen linearly. Even though I try to religiously schedule some time for reflection on certain days of the week or certain times of the day, reality intervenes frequently. And so you have to squeeze it in while you can but, and it’s not even linear in that context.

So I might go through some years where I’m reading voraciously, I read many books in a year. And then I go through other years where I get into four or five books but I don’t complete any. And I’m actually spending most of my time to your point before raking the zen garden, and trying to order my thoughts. And I do keep many notes that essential attempts to sort distill what I’ve learned from different works and tying it together in a philosophy that makes sense. And sometimes I’ll wake up at five o’clock in the morning and I’ll just spend two hours trying to refine one element of a mental model. And so part of it is creating time to absorb new ideas, many of which have come from great people that you never got the chance to meet, but you can at least read their books.

And the other part that’s equally important is to synthesize. And it’s the same notion if you’re going to visit a company that you, you’re going to Tokyo and visiting a bunch of companies, you have to spend the time preparing for it and the time to make sense of what you’ve learned after the fact. And so it’s not enough just to read a lot. You have to try and think about it and distill it and it’s both of those things.

And then sometimes you just get stuck. You feel like you’re not necessarily making a leap forward in your understanding. I don’t know if you’ve gone through the process of learning another language, often it feels like you get this window of stasis and then all of a sudden in a non-linear way you take a stair step function up and you’re seeing things in a new light.

And so I think often when you’re feeling stuck, it makes sense to do something different, to travel somewhere, to do something physical. I like to play backgammon against the computer from time to time and sometimes it takes doing something different. A friend of mine, Josh Waskin said sometimes the ember needs to withdraw before the flame comes back up. And so I think it’s a combination of all those things, prioritization of reflection, realizing that it’s not just about reading but equal measure must be spent to synthesis and making sense. And then the final thing, recognizing that it’s a kind of step function process where you need time to step outside.

And Lord Dening, one of the great English judges said, “Let not our vision be clouded by the dust of the arena”. Sometimes you’re just too much in the thick of something to make sense of it all and sometimes you’ve got to leave the snow globe, let it settle and then come back. And so those are the ways I try to do it and it feels rather imperfect. I’ve been at this for decades now and I feel like I’m just beginning and I feel like I’m so far behind in so many dimensions that it’s humbling.

How to deal with living in a world of complexity

McLennan: If we go back to Wolfram and complexity theory, something that was just a blinding revelation to me when I read that his book, A New Kind of Science was that he was studying deterministic systems. So what I mean by that, think of an Excel spreadsheet where a cell could be different colors based on the behavior of cells around it, but there’s an underlying formula. And he did thousands and thousands of simulations of what the patterns would be for different formulas.

And what he found was really interesting, which was that only a small fraction of the formulas produced linearity. And most of science is built on regression and looking for linear relationships, but this is the minority of reality. And then there was a bigger subset but still small where there was some sort of nested cyclicality to the patent but not a hundred percent neat.

So I think the business cycle, we know it, there’s an ebb and flow, but we can’t call it precisely. And then the vast majority of the patents of these cellular automata in these spreadsheets were effect, They looked like they were random but they were driven by a given formula. And what’s interesting is if something as linear, you can predict it in the future with a small number of observations. If something has a nested cyclicality with more observations, you can kind of predict the skew in it, but not necessarily exactly where it will be.

But if something’s truly complex, it would take you more observations than actually exist in reality playing out to backwards induce the formula. And he came up with this notion of the computational irreducibility that basically, even though there’s a formula behind the patent, it’s effectively random unless the formula because it would take you more steps to observe it than to figure it out. And so the reason I mentioned this upfront is that number one, there’s a realization that there’s a lot that we can’t know unless you actually know. 

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I don’t have a vested interest in any company mentioned. Holdings are subject to change at any time.

Talking About Investing On Radio 

A chat about investing in technology stocks and investing during recessions.

Yesterday, I was invited onto Money FM 89.3, Singapore’s first business and personal finance radio station, for a short interview. My friend Willie Keng, the founder of investor education website Dividend Titan, was co-hosting a segment for Money FM 89.3 and we covered a few topics including:

  • My view on technology stocks going forward, given their recent well-publicised slowdown in hiring
  • Whether technology companies are experiencing a structural change, post-COVID
  • Should investors wait to invest before the bottom is in?
  • Investing in stocks during recessions
  • My criteria for evaluating stocks

You can check out the recording of our conversation 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. Of all the companies mentioned, I currently have a vested interest in Datadog, DocuSign, Microsoft, MongoDB, and Zoom. Holdings are subject to change at any time.

How Warren Buffett Analysed Lehman Brothers

Warren Buffett rejected Lehman Brothers’ request for financing help during the Great Financial Crisis – here’s how he analysed Lehman back then

A friend of Jeremy and I recently shared a tweet with us from Andrew Kuhn, a partner at the investment firm Focused Compounding, that I found fascinating. It mentioned an interview Warren Buffett did with the Wall Street Journal in 2018 where he explained his reasons for rejecting Lehman Brothers’ plea for financing during the 2008-09 Great Financial Crisis.

Prior to its bankruptcy in September 2008, Lehman Brothers was a storied investment bank that was founded more than a century ago in 1847. Lehman first approached Buffett for help in March 2008. After studying Lehman’s then-latest 10-K – for the financial year ended 30 November 2007 (the 10-K is the annual report that US-listed companies have to file) – Buffett discovered multiple red flags and decided to turn the bank down.

During his interview with the Wall Street Journal, Buffett showed a physical copy of Lehman’s 10-K that he read and made notes on. I managed to find a copy of Buffett’s 10-K and thought it would be an interesting exercise to run through all the pages he marked out as red flags to understand how he analysed Lehman Brothers in 2008.

Before I continue, here are some important things to note:

  • What I’m about to share are merely my interpretations and I make no claim that they accurately portray Buffett’s actual thought process.
  • This is the most complex set of financial statements that I’ve seen since I started investing in 2010 so I might be getting some of the details wrong (it’s also a great reminder for me to proceed with extreme caution when investing in banks!).
  • Kuhn created a video with his colleague, Geoff Gannon, that featured their analysis of Buffett’s copy of Lehman’s 10-K. I watched it while reading the document and it was really helpful for my own understanding of the red flags that Buffett noted.

Buffett’s mark ups: Page 106 & 107

These pages contain Figure 1 below, which shows the high yield bonds held by Lehman in FY2007 and FY2006.

Figure 2; Source: Buffett’s Lehman 10-K

Three things stood out to me: 

  • The high yield bond positions increased significantly by 137% from US$12.8 billion in FY2006 to US$30.4 billion in FY2007. 
  • The increase was a result of Lehman being unable to offload these positions, an indication that perhaps these assets were of poor quality. Per Lehman’s 10-K (emphasis is mine): “The increase in high-yield positions from 2006 to 2007 is primarily from funded lending commitments that have not been syndicated.”
  • The high yield bond positions need to be seen in relation to Lehman’s shareholder’s equity of merely US$22.5 billion in FY2007. If these high yield positions – US$30.4 billion – were to decline sharply in value, Lehman’s shareholder’s equity, and thus financial health, would be in serious trouble.

Pages 106 and 107 also mentioned that Lehman was authorised to buy back up to 100 million shares of itself “for the management of our equity capital, including offsetting dilution due to employee stock awards.” I’m guessing this did not sit well with Buffett from a capital allocation perspective because buying back shares merely to offset dilution is not an intelligent nor prudent use of capital.

Buffett’s mark ups: Page 115

This page is linked to the following passages (empahses are mine): 

“We enter into various transactions with special purpose entities (“SPEs”). SPEs may be corporations, trusts or partnerships that are established for a limited purpose. There are two types of SPEs— QSPEs and VIEs.

A QSPE generally can be described as an entity whose permitted activities are limited to passively holding financial assets and distributing cash flows to investors based on pre-set terms. Our primary involvement with QSPEs relates to securitization transactions in which transferred assets, including mortgages, loans, receivables and other financial assets, are sold to an SPE that qualifies as a QSPE under SFAS 140. In accordance with SFAS 140 and FIN-46(R), we do not consolidate QSPEs. We recognize at fair value the interests we hold in the QSPEs. We derecognize financial assets transferred to QSPEs, provided we have surrendered control over the assets.”

What these passages effectively mean is that Lehman had off-balance sheet entities (the QSPEs) that housed certain assets so that they would not show up on Lehman’s own balance sheet. But it was exceedingly difficult to know (1) the value of these assets, (2) what these assets were, and (3) Lehman’s liabilities that were associated with these assets. Buffett might have been worried about the damage these unknowns could wrought on Lehman if trouble manifested in them.

Buffett’s mark ups: Page 125

This page is linked to the following passages (emphases are mine):

“Derivatives are exchange traded or privately negotiated contracts that derive their value from an underlying asset. Derivatives are useful for risk management because the fair values or cash flows of derivatives can be used to offset the changes in fair values or cash flows of other financial instruments. In addition to risk management, we enter into derivative transactions for purposes of client transactions or establishing trading positions. The presentation of derivatives in our Consolidated Statement of Financial Position is net of payments and receipts and, in instances where management determines a legal right of offset exists as a result of a netting agreement, net-by-counterparty. Risk for an OTC derivative includes credit risk associated with the counterparty in the negotiated contract and continues for the duration of that contract.

The fair value of our OTC derivative assets at November 30, 2007 and 2006, was $41.3 billion and $19.5 billion, respectively; however, we view our net credit exposure to have been $34.6 billion and $15.6 billion at November 30, 2007 and 2006, respectively, representing the fair value of OTC derivative contracts in a net receivable position after consideration of collateral.”

Lehman had OTC (over-the-counter) derivative assets of US$41.3 billion in FY2007. These assets were problematic because (1) it’s hard to tell what’s in them and thus if Lehman had any counterparty risk, (2) it’s hard to tell what their actual values were since they were traded over-the-counter, and (3) they had more than doubled in value from FY2006 to FY2007. Moreover, Lehman’s shareholder’s equity in FY2007 was just US$22.5 billion, as mentioned earlier. This meant the investment bank did not have much cushion to absorb any significant declines in the value of its OTC derivative assets if they were to occur. 

Buffett’s mark ups: Page 173 & 175

These pages are linked to Figure 2, which shows all the financial instruments and inventory owned by Lehman in FY2007 and FY2006:

Figure 2; Source: Buffett’s Lehman 10-K

I think what troubled Buffett here would be the owned derivatives and other contractual agreements of US$44.6 billion in FY2007. The number was double that of FY2006 and as Figure 3 below illustrates, all of these assets were traded over-the-counter and thus had values that could not be easily determined. Let’s not forget too, that Lehman’s shareholder’s equity – US$22.5 billion in FY2007 – would provide only a thin buffer if any large decline in value for the owned derivatives and other contractual agreements happened. 

Figure 3; Source: Buffett’s Lehman 10-K

Buffett’s mark ups: Page 180

This page is linked to a description of the way Lehman groups its assets based on how their values are derived. Per the 10-K (emphases are mine):

“Level I – Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date. The types of assets and liabilities carried at Level I fair value generally are G-7 government and agency securities, equities listed in active markets, investments in publicly traded mutual funds with quoted market prices and listed derivatives.

Level II – Inputs (other than quoted prices included in Level I) are either directly or indirectly observable for the asset or liability through correlation with market data at the measurement date and for the duration of the instrument’s anticipated life. Fair valued assets and liabilities that are generally included in this category are non-G-7 government securities, municipal bonds, certain hybrid financial instruments, certain mortgage and asset backed securities, certain corporate debt, certain commitments and guarantees, certain private equity investments and certain derivatives.

Level III – Inputs reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model. Generally, assets and liabilities carried at fair value and included in this category are certain mortgage and asset-backed securities, certain corporate debt, certain private equity investments, certain commitments and guarantees and certain derivatives.”

Put simply, Lehman had three types of assets: Level I assets had values that were determined simply by publicly-available prices while Level II and Level III assets had values that were determined using management’s inputs. Page 180 is also linked to Figure 4 below:

Figure 4; Source: Buffett’s Lehman 10-K

What Figure 4 shows is that one of Lehman’s single-largest asset categories – mortgage and asset-backed securities – were nearly all Level II and Level III assets. They are thus assets whose prices were not easily determinable by third-parties at that point in time. And their collective value was US$89.1 billion, four times higher than Lehman’s shareholder equity of US$22.5 billion. Buffett might have been worried that Lehman would be wiped out if these assets were to fall by just 25% in value – a distinct possibility given that the US housing market was already shaky back then.

Another aspect of Lehman’s financials linked to Page 180 of its 10-K that might have troubled Buffett is shown in Figure 5: Lehman’s Level III mortgage and asset-backed positions had surged threefold from just US$8.6 billion in FY2006 to US$25.2 billion in FY2007. 

Figure 5; Source: Buffett’s Lehman 10-K

Buffett’s mark ups: Page 184

This page is linked to the following paragraphs (emphases are mine):

“The Company uses fair value measurements on a nonrecurring basis in its assessment of assets classified as Goodwill and other inventory positions classified as Real estate held for sale. These assets and inventory positions are recorded at fair value initially and assessed for impairment periodically thereafter. During the fiscal year ended November 30, 2007, the carrying amount of Goodwill assets were compared to their fair value. No change in carrying amount resulted in accordance with the provisions of SFAS No. 142, Goodwill and Other Intangible Assets. 

Additionally and on a nonrecurring basis during the fiscal year ended November 30, 2007, the carrying amount of Real estate held for sale positions were compared to their fair value less cost to sell. No change in carrying amount resulted in accordance with the provisions of SFAS No. 66, Accounting for Sales of Real Estate, SFAS No. 144, Accounting for Impairment or Disposal of Long Lived Assets, and other relevant accounting guidance. The lowest level of inputs for fair value measurements for Goodwill and Real estate held for sale are Level III.”

It turns out that Lehman’s real estate held for sale of US$21.9 billion in FY2007 – first shown in “Buffett’s mark ups: Page 173 & 175” – could have been Level III assets. So the stated value of US$21.9 billion may not have been anywhere close to what these assets could fetch in an open transaction, since the US housing market was already in trouble at that point in time.

Final word

Buffett’s marked-up copy of Lehman’s 10-K contained more pages that he noted down as red flags, such as pages 188, 199, 209, and more. But when I read them, there was nothing that jumped out at me as being highly unusual so I’ve not included them in this article.

Again, everything I’ve shared earlier are merely my interpretations and I make no claim that they accurately portray Buffett’s actual thought process when he studied Lehman’s 10-K. Nonetheless, I found it to be an interesting exercise for myself and I hope you find my takeaways useful too. The biggest lesson I have is that if I were to research a bank, I need to study its footnotes and I should be extremely wary of banks with complex balance sheets that contain a significant amount of assets with questionable values.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently do not have a vested interest in any companies mentioned. Holdings are subject to change at any time. Holdings are subject to change at any time.

Questions on Oil Prices Partially Answered

I had questions on the history of oil consumption, production, and prices and I managed to find some answers for them.

My article Surprising Facts About Oil Prices (And The Questions They Raise) was published last week. In it, I mentioned that “the price of oil has experienced at least five major crashes over the past four decades despite demand for the commodity being higher than supply in every year.” When Vision Capital’s Eugene Ng – who’s a friend of both Jeremy and myself – read it, he was intrigued by what I discovered about oil prices and wanted to find out more. 

Eugene noticed that the U.S. Energy Information Administration (EIA) maintained its own database for long-term global oil consumption and production. After plotting a chart of EIA’s data, he obtained similar results to what I got from BP (NYSE: BP) (the BP data was shown in my aforementioned article). Eugene and I talked about this and he decided to ask the EIA how it is possible for oil consumption to outweigh production for decades. 

The EIA kindly responded to Eugene, who shared the answers with me. It turns out that there could be errors within EIA’s data. The possible sources of errors come from incomplete accounting of Transfers and Backflows in oil balances: 

  • Transfers include the direct and indirect conversion of coal and natural gas to petroleum.
  • Backflows refer to double-counting of oil-streams in consumption. Backflows can happen if the data collection process does not properly account for recycled streams.

The EIA also gave an example of how a Backflow could happen with the fuel additive, MTBE or methyl tert-butyl ether (quote is lightly edited for clarity):

“The fuel additive MTBE is an useful example of both, as its most common feedstocks are methanol (usually from a non-petroleum fossil source) and Iso-Butylene whose feedstock likely comes from feed that has already been accounted for as butane (or iso-butane) consumption. MTBE adds a further complexity in that it is often exported as a chemical and thus not tracked in the petroleum trade balance.”

Thanks to the EIA, I now appreciate that the BP data I cited in Surprising Facts About Oil Prices (And The Questions They Raise) might contain errors, and how those errors could have appeared. This answers the third question I had in the article, but the first two questions remain unanswered. Even after knowing that there could be years between 1980 and 2021 where production came in higher than consumption, I can’t tell what the actual demand-and-supply dynamics of oil were during the five major crashes in oil prices that happened in that period.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently do not have a vested interest in any companies mentioned. Holdings are subject to change at any time. Holdings are subject to change at any time.

Surprising Facts About Oil Prices (And The Questions They Raise)

The history of oil prices, and what drives them.

Warren Buffett has recently been investing billions in shares of oil & gas companies such as Occidental Petroleum (NYSE: OXY) and Chevron (NYSE: CVX). I’ve also seen articles and podcasts from oil & gas investors talking about the current supply-and-demand dynamics in the oil market that could lead to sustained high prices for the energy commodity, (the price of WTI Crude is currently around US$93 per barrel). These piqued my interest and led me to research the history of oil prices and what influences it.

What I found was surprising. First, here’s a brief history on major crashes in the price of oil (WTI Crude) over the past four decades:

  • 1980 – 1986: From around US$30 to US$10
  • 1990 – 1994: From around US$40 to less than US$14
  • 2008 – 2009: From around US$140 to around US$40
  • 2014 – 2016: From around US$110 to less than US$33
  • 2020: From around US$60 to -US$37 

As a commodity, it’s logical to think that differences in the level of oil’s supply-and-demand would heavily affect its price movement – when demand is higher than supply, prices would rise, and vice versa. But data from BP (NYSE: BP) – one of the largest oil-producing companies in the world, so there’s no reason to doubt the validity of the data – show otherwise.

BP’s dataset goes back to 1965 and from then to 1980, the consumption of oil (demand) was lower than the production of oil (supply) in every year. From 1981 onwards, the relationship flipped, with demand being higher than supply in every year since. This is shown in Figure 1. What this means is the price of oil has experienced at least five major crashes over the past four decades despite demand for the commodity being higher than supply in every year. 

Figure 1; Source: BP

These surprising facts about the oil market bring up three important questions in my mind: 

  • Are there way more important factors than demand-and-supply dynamics that can move the price of oil?
  • What do the facts imply about the future movement of oil prices, given the widely-held view (at least from what I’ve gathered) that oil prices would remain elevated – or climb higher from here – based on the current environment where demand far outstrips supply, and where supply is not able to be increased easily?
  • How is it physically possible that consumption of oil can outweigh production for four decades?

I currently don’t have answers to these questions. But if any of you reading this have thoughts to share, please reach out to me – I’ll be happy to discuss!

Note: A follow-up article addressing one of the questions was published on 9 September 2022. Read it here.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently do not have a vested interest in any companies mentioned. Holdings are subject to change at any time. Holdings are subject to change at any time.

The Truths About Investing In Stocks During Recessions

How stocks have historically performed during a recession.

Note: An earlier version of this article was first published in The Business Times on 26 July 2022

Lately, the dreaded “R” word has been making its rounds. Yes, I’m talking about a recession, a risk that is not confined to any specific country. In fact, in early July, the chief of the International Monetary Fund, Kristalina Georgieva, warned that a global recession cannot be ruled out. 

The thing is, recessions are not within our control. Yet, as investors, we are affected by it. This begs the question, what should stock market investors do now that the possibility of a recession looms in the background? 

I don’t have a panacea, but what I can offer are historical perspectives – truths, if you will – about stocks and recessions. The US stock market is a great case study. According to the Visual Capitalist, the USA accounts for nearly a quarter of global economic output while its stocks make up around 40% of the total global stock market capitalisation based on data from the Securities Industry and Financial Markets Association.

1. What happened to stocks in past recessions

A common refrain I’ve heard over the years is that stock prices are bound to fall during a recession. But the data says otherwise.

Ben Carlson is the Director of Institutional Asset Management at Ritholtz Wealth Management. According to his research shown in his recent blog post titled Timing a Recession vs. Timing the Stock Market, there have been 12 recessions in the USA since World War II (WWII). 

The average return for the S&P 500 – a broad barometer for US stocks – when all these recessions took place was 1.4%. A positive number. Of course, there were some horrible returns within the average. For example, the recession that stretched from December 2007 to June 2009 saw the S&P 500 fall by 35.5%. On the other end, there were some decent returns. For the recession between July 1981 and November 1982, the S&P 500 gained 14.7%.

Hence, it’s not a given that stocks will definitely fall during a recession.

2. What happened if you stayed invested in stocks through past recessions

If you are thinking of selling your stocks during a recession, you may want to think again.  

Carlson’s research showed that If you had invested in the S&P 500 six months prior to all of the 12 recessions since WWII and held on for 10 years after each of them, you would have earned a positive return on every occasion. Furthermore, the returns were largely rewarding.

The worst return was a total gain of 9.4% for the recession that lasted from March 2001 to November 2001. The best was the first post-WWII recession that happened from November 1948 to October 1949, a staggering return of 555.7%. After taking away the best and worst returns, the average was 257.2%. Not too shabby!

In short, holding onto stocks in the lead up to, through, and in the years after a recession, has historically produced good returns most of the time.

3. What happened if you avoided stocks during past recessions

Some of you reading this may also wonder: What if I tried to side-step a recession? What if I had perfect knowledge of when a recession would start and end, and I simply sold stocks at the start of a recession and bought back in at the end? The answer: You would do poorly. 

Michael Batnick, the Director of Research at Ritholtz Wealth Management, has the facts to prove it. In his October 2019 blog post titled 12 Charts You Ought to See Before the Next Recession, Batnick showed that a dollar invested in US stocks at the start of 1980 would be worth north of $78 around the end of 2018 if you had simply held the stocks and did nothing. 

But if you invested the same dollar in US stocks at the start of 1980 and expertly side-stepped the ensuing recessions to perfection, you would have less than $32 at the same endpoint. 

Said another way, avoiding recessions flawlessly would have caused your return to drop by more than half.

4. What bottomed first in past recessions – stocks or the economy?

I know it’s tempting to sell your stocks if you think the economy has room to fall further. But this idea is flawed.

Here’s what the data shows: Stocks tend to bottom before the economy does. Let’s go back to the three most recent recessions in the USA prior to 2020’s pandemic. These would be the recessions that lasted from July 1990 to March 1991, from March 2001 to November 2001, and from December 2007 to June 2009.

During the first recession in this sample, data on the S&P 500 from Yale economist Robert Shiller showed that the US S&P 500 bottomed in October 1990. In the second episode, the S&P 500 found its low 15 months after the end of the recession, in February 2003. This phenomenon was caused by the aftermath of the dotcom bubble’s bursting. For the third recession, the S&P 500 reached a trough in March 2009, three months before the recession ended. 

In summation, even if you are right today that the economy would be in worse shape in the months ahead, stocks may already have bottomed or be near one. Only time will tell. 

5. Did companies manage to grow in past recessions?

A recession is a period of time when a country’s economy is in decline. And when the economy is in poor health, it’s easy to think that all businesses are either suffering or are at best stagnating. But this isn’t always true for all companies. Some businesses can thrive. 

The recession that lasted from December 2007 to June 2009 was one of the worst in the USA’s modern history. The country’s real gross domestic product fell by 4.3% from a peak in the fourth quarter of 2007 to a bottom in the second quarter of 2009. The unemployment rate also spiked from 5% in December 2007 to 10% in October 2009.

But while the US economy was in trouble, the revenue of software-as-a-service pioneer Salesforce grew by 51% in FY2008 (fiscal year ending January 2008), 44% in FY2009, 21% in FY2010, and 27% in FY2011. Salesforce is not the only one. iPhone manufacturer Apple saw its revenue rise by 27% in FY2007 (fiscal year ending September 2007), 53% in FY2008, 14% in FY2009, and 52% in FY2010. Booking Holdings, the owner of Booking.com and Agoda.com, enjoyed revenue growth of 26% in 2007, 34% in 2008, 24% in 2009, and 32% in 2010.

Hence, investors in these three US-based companies had nothing to worry about even during one of the worst recessions for the country in modern history. Their businesses kept growing at an admirable clip, which meant that their underlying economic values were increasing rapidly too.

Parting words

When we’re on the precipice of a recession, it may feel like tomorrow will never get better. But brighter days eventually do come. As one of my favourite finance writers, Morgan Housel, once wrote: “Every five to seven years, people forget that recessions occur every five to seven years.” Recessions are normal. Par for the course.

Now we circle back to the question I posed at the beginning: “What should stock market investors do now with the possibility of a recession looming in the background?” You have history’s responses. The next step is up to 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. I have an interest in Apple and Salesforce. Holdings are subject to change at any time.

What The USA’s Largest Bank Thinks About The State Of The Country’s Economy

Insights from JPMorgan Chase’s management on the health of American consumers and businesses.

JPMorgan Chase (NYSE: JPM) is currently the largest bank in the USA by total assets. Because of this status, JPMorgan is naturally able to feel the pulse of the country’s economy. The bank’s latest earnings conference call – for the second quarter of 2022 – contained useful insights on the state of American consumers and businesses. The bottom-line is that while there are risks on the horizon, consumer spending in the USA is still healthy and the leaders of companies there think that their businesses are currently doing fine. What’s shown between the two horizontal lines below are quotes from JPMorgan’s management team that I picked up from the call. 

1. Credit is still healthy and loan volumes continued to grow

Credit is still quite healthy and net charge-offs remain historically low. And there continue to be positive trends in loan growth across our businesses, with average loans up 7% year-on-year and 2% quarter-on-quarter.

2. Provision for credit losses were much higher than a year ago (when there was a release of previous credit loss charges) to account for a slightly weaker economic outlook

And credit costs were $1.1 billion, which included net charge-offs of $657 million and reserve builds of $428 million, reflecting loan growth as well as a modest deterioration in the economic outlook.

3. Consumer spending is still healthy, across both debit and credit cards, but there’s clear impact from inflation and higher non-discretionary spending; this said, there’s no pullback seen yet on discretionary spending

Spend is still healthy with combined debit and credit spend up 15% year-on-year. We see the impact of inflation and higher nondiscretionary spend across income segments. Notably, the average consumer is spending 35% more year-on-year on gas and approximately 6% more on recurring bills and other nondiscretionary categories. At the same time, we have yet to observe a pullback in discretionary spending, including in the lower income segments, with travel and dining growing a robust 34% year-on-year overall.

4. Consumer deposit balances are down, although cash buffers are still high

And with spending growing faster than incomes, median deposit balances are down across income segments for the first time since the pandemic started, though cash buffers still remain elevated.

5. Auto loan originations fell sharply

And in auto, originations were $7 billion, down 44% from record levels a year ago due to continued lack of vehicle supply and rising rates while loans were up 2%.

6. Loan growth outlook of high single digit for 2022, but no view on 2023 yet

Yes. So we’ve talked, as you know, Steve, about sort of a mid — high single digits loan growth expectation for this year. And that outlook is more or less still in place. Obviously, we only have half the year left. We continue to see quite robust C&I growth, both higher revolver utilization and new account origination. We’re also seeing good growth in CRE. And of course, we continue to see very robust card loan growth, which is nice to see. Outlook beyond this year, I’m not going to give now.

7. Lower income segments are where cash buffers are getting thinner, but they are still above pre-pandemic levels; JPMorgan’s management is also not sure if this is just simply normalisation or an early warning sign of deterioration

[Question] Okay. Great. And then just maybe on credit. It continues to look, I guess, very good, whether it’s on the consumer side or commercial side. Are you — we don’t really see it, but are you starting to see any initial cracks in credit or strains in the system?

[Answer] But if you really want to kind of turn up the magnification on the microscope and look really, really, really closely, if you look at cash buffers in the lower-income segments and early delinquency roll rates in those segments, you can maybe see a little bit of an early warning signal to the effect that the burn-down of excess cash is a little bit faster there. Buffers are still above what they were pre-pandemic, but coming down. And that absolute numbers for the typical customer are not that high. And you do see those early delinquency buckets still below pre-pandemic levels, but getting closer in the lower-income segment. So if you wanted to try to look for early warning signals, that’s where you would see it. But I think there’s really still a big question about whether that’s simply normalization or whether it’s actually an early warning sign of deterioration. And for us, as you know, our portfolio is really not very exposed to that segment of the market. So not really very significant for us.

8. JPMorgan’s CEO, Jamie Dimon, said a few months ago that a hurricane is coming, but he acknowledges that in the long-term, the economy will be fine; current economic conditions also look good

[Question] Could you help me reconcile your words with your actions? After Investor Day, Jamie, you said a hurricane is on the horizon. But today, you’re holding firm with your $77 billion expense guidance for 2022. I mean, it’s like you’re acting like there’s sunny skies ahead. You’re out buying kayaks, surfboards, wave runners just before the storm. So is it tough times or not?

[Answer] Now let me — we run the company. We’ve always run the company consistently, investing, doing this stuff through storms. We don’t like pull in and pull out and go up and go down and go into markets, out of markets through storms. We manage the company, and you’ve seen us do this consistently since I’ve been at Bank One. We invest, we grow, we expand, we manage through the storm and stuff like that.

And so — and I mentioned to all of you on the media call, but there are very good current numbers taking place. Consumers are in good shape. They’re spending money. They have more income. Jobs are plentiful. They’re spending 10% more than last year, almost 30% plus more than pre-COVID. Businesses, when you talk to them, they’re in good shape, they’re doing fine. We’ve never seen business credit be better ever like in our lifetimes. And that’s the current environment.

The future environment, which is not that far off, involves rates going up maybe more than people think because of inflation, maybe deflation, maybe a soft — there might be a soft landing. I’m simply saying, there’s a range of potential outcomes, from a soft lending to a hard lending, driven by how much rates go up; the effect of quantitative tightening; the effect of volatile markets; and obviously, this terrible humanitarian crisis in Ukraine and the war, and then the effect of that on food and oil and gas.

And we’re simply pointing out, those things make the probabilities and possibilities of these events different. It’s not going to change how we run the company. The economy will be bigger in 10 years. We’re going to run the company. We’re going to serve more clients. We’re going to open our branches. We’re going to invest in the things. And we’ll manage through that.

We do — if you look at what we do, our bridge book is way down. That was managing certain exposures. We’re not in subprime fundamentally. That’s managing your exposures. So we’re quite careful about how we run the risk of the company. And if there was a reason to cut back on something, we would. But now that we think it’s a great business that’s got great growth prospects, it’s just going to go through a storm.

And in fact, going through a storm, we will — that gives us opportunities, too. I always remind myself, the economy will be a lot bigger in 10 years, we’re here to serve clients through thick or thin, and we will do that…

…But that’s — yes, that’s very performance-based, too. And again, Mike, the way I look at it a little bit, in 15 years, the global GDP — or 20 years, the global GDP, global financial assets, global companies, companies over $5 billion will all double. That’s what we’re building for. We’re not building for like 18 months.

9. JPMorgan sees technology investments as being really helpful during recessions

[Question] So clearly running the company for the next 5 to 10 years. If we have a recession in the next 5 to 10 months, how does technology help you manage through that better? Whether it’s credit losses, managing for less credit losses, expenses, more flexibility, more revenues, maybe gaining market share. What’s the benefit of all these technology investments if we have a recession over the next…

[Answer] Mike, I think we gave you some examples at Investor Day. For example, AI, which we spend a lot of money on. We gave you a couple of examples, but one of them is we spent $100 million building certain risk and fraud systems so that when we process payments on the consumer side, losses are down $100 million to $200 million. Volume is way up. That’s a huge benefit. I don’t think you’d want to stop doing that because there’s a recession. And so — and plus, in a recession, certain things get cheaper, branches are enormously profitable, bank is enormously profitable. We’re going to keep on doing those things. And we’ve managed through recessions before, we’ll manage it again. And I’m quite comfortable we’ll do it quite well. We’re stop-starting on recruiting or training or technology or branch, right? That’s crazy. We don’t do that. We’ve never done that. We didn’t do it in ’08 and ’09. [ And it puts us in quite good stead ] in terms — yes.

10. From JPMorgan’s vantage point, consumers are in great shape

And the consumer, I feel like a broken record. The consumer right now is in great shape. So even we go into a recession, they’re entering that recession with less leverage, in far better shape than they’ve been — did in ’08 and ’09, and far better shape than they did even in 2020. And jobs are plentiful. Now of course, jobs may disappear. Things happen. But they’re in very good shape. And obviously, when you have recessions, it affects consumer income and consumer credit. Our credit card portfolio is prime. I mean, it’s exceptional. But again, we’re adults in that. We know that if you have a recession, losses will go up. We prepare for all that, and we’re prepared to take it because we grow the business over time. We’re not going to just immediately run out of it. And so I think it’s great the consumer’s is in good shape. And it sounds excellent that — I like the fact that wages are going up for people at the low end. I like the fact that jobs are plentiful. I think that’s good for the average American, and we should applaud that. And so they’re in good shape right now.

11. When responding to a question about the market pricing in rate cuts for next year, Jamie Dimon said forward curves have been wrong all the time

[Question] I guess just one for — a couple of follow-ups, Jeremy. In terms of the markets have gone very quickly from pricing in a ton of rate hikes to potentially pricing in rate cuts next year…

…[Answer] And I should just point out, the forward curve has been consistently wrong in my whole lifetime. We don’t necessarily make investments based on the forward curve.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I don’t have a vested interest in any company mentioned. Holdings are subject to change at any time.