Category: General Investing

Positive returns in stocks are never a guarantee. Stay far, far away from anyone who tells you otherwise.

Company-specific risks, such as competition or regulatory risk, plus market-wide systemic risks, such as interest rates hikes and global recessions, pose risks to a stock’s long-term return. These risks result in what I call a wide distribution of outcome probabilities. 

And yet, in today’s stock market, it seems that more and more investors are starting to ignore these risks and go big or even all-in on just a single stock. Some argue that the large spread in returns between winners and laggards makes a concentrated portfolio more appealing.

But before diving headfirst into building a super-concentrated portfolio, consider the following risk.

What is the distribution of outcomes?

Let’s start with the basics.

When I talk about the distribution of outcomes, I am referring to the probability-distribution of the long-term returns of a stock. For example, a company can have a 20% chance to go to zero, a 60% chance to double up and another 20% chance to triple in value over five years (note that the probability percentages add up to 100%).

As such, there is a distribution of outcome possibilities, each with its own probability of occurring.

In the example above, over a five year period, investors in the company have a 20% chance to lose all their money, a 60% chance to double their money, and a 20% chance to triple their money.

Every stock has a different distribution of outcomes. The probabilities of returns and the range of returns will also differ drastically from stock to stock.

You found a great investment… now what?

Most stocks have a curve of different outcomes but for simplicity’s sake, let’s give the example of a stock that has just two possible outcomes.

This particular stock, let’s call it Company A, has a 30% chance to go bankrupt and a 70% chance to triple in value in five years. Simple mathematics will tell you that this is an amazing bargain. A gambler will take these odds any day.

We can calculate the average expected return we get from this stock by multiplying the probabilities with the outcomes. In this scenario, the expected return is 110%* (calculation below) in five years. Annualised, that translates to an excellent 15.9% return per year, which easily outpaces the returns of the S&P 500 over its entire history.

As such, any investor should happily take this bet. But don’t get too carried away. Even though this stock is a great investment, there is still a 30% possibility that we lose our entire investment in this stock. Would you be willing to take that risk?

Diversification reduces the risk

This is where diversification comes into play.

Instead of making a single bet on Company A, we can add another company into the portfolio.

Let’s say we find another company, Company B, that has slightly lower expected returns than Company A. Company B has a 35% chance of going broke and a 65% chance to triple in value, giving it an expected return of 95%**(calculation below).

The table below shows the probabilities of investing solely in Company A or Company B or investing half into each company.

	Company A Only	Company B Only	Half Each
Expected Annual Return	15.9%	14.3%	15.2%
Chance to Lose it All	30%	35%	10.5%

From the table above, we can see that the odds of losing your entire portfolio drops to 10.5% after splitting it between the two companies.

This seems counter-intuitive. Even though you are adding Company B into the portfolio, a stock that has a higher chance of going bust than Company A, the combined portfolio still ends up with a lower chance of going to zero.

The reason is that in order for the combined portfolio to go to zero, both companies need to go broke for you to lose your entire portfolio. The probability of both companies going bankrupt is much smaller than either of Company A or Company B going broke on its own. This is true if the two companies have businesses and risks that are not co-related.

What this shows is that we can lower our risk of suffering portfolio losses by adding more stocks into the portfolio.

Even though investors sacrifice some profits by adding stocks with lower expected returns, the lower risks make the portfolio more robust.

The sweet spot

This leads us to the next question, what is the sweet spot of portfolio diversification? Ultimately, this depends on the individual’s risk appetite and one’s own computation of an investment’s probability of outcomes. 

For instance, venture capital firms bet on startups that have a high chance of failing. It is, hence, not uncommon for venture capital funds to lose their entire investment in a company. But at the same time, the fund can still post excellent overall results.

For instance, venture investments in any single company may have a 95% chance of going to zero but have a small chance of becoming 100-plus-baggers in the future. A single winning bet can easily cover the losses of many failed bets. Given this, venture capital funds tend to diversify widely, sometimes betting on hundreds of companies at a time. This is to reduce the odds of losing all their money while increasing the odds of having at least some money on a spectacularly winning horse.

Similarly, in public markets, the same principle applies. Some early-stage companies that go public early have significant upside potential but have relatively high risks. If you are investing in these stocks, then wide diversification is key. 

Key takeaway

Many young investors today see the stock market as a place to get rich quick. This view is exacerbated by the raging bull of 2020 in some corners of the stock market across the world. 

They are, hence, tempted by the allure of making huge wins by concentrating their portfolio into just one or two companies. (You likely have heard stories of many Tesla shareholders becoming millionaires by placing their whole portfolio on just Tesla shares)

Although expected returns may be high, a concentrated portfolio poses substantial risks to one’s portfolio. 

I can’t speak for every investor, but I much rather sleep comfortably at night, knowing that I’ve built a sufficiently diversified portfolio to lower my risk of losing everything I’ve worked for

Nevertheless, if you insist on building a concentrated portfolio, it is important to learn the risks of such a strategy and make sure that you are financially and emotionally prepared with the very real possibility of losses.

*(0x0.3+300%x0.7-100%)=110%

**(0x0.35+300%x0.65-100%)=95%

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 any vested interest in the shares of any companies mentioned in this article. Holdings are subject to change at any time.

Investors often use the price-to-sales multiple to value a company. This makes sense as sales is a proxy for how much cash the company can generate for its shareholders (there’s no way to generate cash without sales). It is also more useful than price-to-earnings when a company is not yet profitable.

However, in the stock market, there is a disparity between the price-to-sales ratios that various companies have.

Take a look at the table below. It shows the price-to-sales multiples of some prominent “retail” companies around the world.

Company	Current price-to-sales multiple
Shopify Inc (NYSE: SHOP)	51.7
Alibaba Group Holdings Ltd (HKG: 9988)	8.9
Amazon.com Inc (NASDAQ: AMZN)	4.6
Costco Wholesale Corporation (NASDAQ: COST)	0.96

As you can see, these four companies trade at remarkably different sales multiples. Costco trades at the lowest price-to-sales multiple of less than 1. This means that if you buy Costco’s shares now, you are paying less than a $1 for every dollar of sales that the company earns.

On the other end of the spectrum is Shopify, which trades at a price-to-sales multiple of 51.7. For every dollar of revenue that Shopify generates, investors need to pay $51.70.

Just looking at this table, you will likely assume that the shares of Costco are much cheaper than Shopify’s. 

But the truth is that the price-to-sales multiple is just one part of the analysis. There are often good reasons why paying a premium multiple may make sense. In this article, I describe some of the main considerations and why you should never look at the price-to-sales multiple at face value without considering these other factors.

Growth

Perhaps the most obvious reason to pay a premium price-to-sales multiple is for growth. A company that is growing revenue quickly should command a higher multiple. 

For instance, take two companies that are generating $1 in sales per share. One company is growing at 50% over the next five years, while the other is growing at 10%. The table below shows their revenues over five years.

	Fast Grower Revenue per share	Slow Grower Revenue per share
Year 0	$1	$1
Year 1	$1.50	$1.10
Year 2	$2.25	$1.21
Year 3	$3.37	$1.33
Year 4	$5.06	$1.46
Year 5	$7.59	$1.61

In this scenario, even if you paid a price to sales multiple of 20 for the fast grower and a price-to-sales multiple of 10 for the slow grower, the fast-grower still ends up as the company with the better value for money. The table below illustrates this.

	Fast Grower Revenue per share	Price paid	Price-to-sales multiple	Slow Grower Revenue per share	Price Paid	Price-to-sales multiple
Year 0	$1	$20	20	$1	$10	10
Year 5	$7.59	$20	2.6	$1.61	$10	6.2

By the fifth year, the price-to-sales multiple based on your share price at cost is actually lower for the fast-grower than the slow grower, even though it started off much higher.

Let’s relate this back to the four companies mentioned earlier.

The table below shows their revenue growth in the last reported quarter.

Company	Current price-to-sales multiple	Year-on-year revenue growth rate for the last reported quarter
Shopify	51.9	96%
Alibaba	8.9	30%
Amazon	4.6	37%
Costco	0.96	17%

Based on the figures above, we can see that Shopify has the highest growth rate, while Costco has the slowest.

Margins

The next factor to consider is margins. Of every dollar in sales per share that a company earns, how much free cash flow per share can it generate?

The larger the margins, the higher the price-to-sales multiple you should be willing to pay.

As some companies are not yet profitable, we can use gross margins as an indicator of the company’s eventual free cash flow margin.

Here are the gross margins of the same four companies in the first table above.

Company	Current price-to-sales multiple	Gross Profit Margin
Shopify	51.7	53%
Alibaba	8.9	43%
Amazon	4.6	25%
Costco	0.96	13%

There is a clear trend here.

Based on current share prices, the market is willing to pay a higher multiple for a high margin business.

This makes absolute sense as the value of every dollar of revenue generated is more valuable to the shareholder for a high margin business.

Shopify is a software business that charges its merchants a subscription fee. It also provides other merchant services such as transactions and logistics services. As a software and services business, it has extremely high margins.

On the other end of the spectrum, Costco is a typical retailer that has its own inventory and sells it to consumers. It competes in a highly competitive retail environment and sells its products at thin margins to win market share. Due to the razor-thin margins, it makes sense for market participants to price Costco’s shares at a lower price-to-sales multiple.

Predictability of the business

Lastly, we need to look at other factors that impact the predictability of the business. Needless to say, a company with a more steady revenue stream that recurs every year should command a premium valuation.

There are many factors that can impact this. This includes the business model that the company operates, the company’s brand value, the presence of competition, the behaviour of customers, or any other moats that the company may have.

A highly predictable revenue stream will be valued more highly in the stock market.

Shopify is an example of a company that has a predictable revenue stream. The e-commerce enabler charges merchants a monthly subscription fee to use its platform. It provides the software to build and run an e-commerce shop. As such, it is mission-critical for merchants that built their websites using Shopify. Given this, it’s likely that many merchants will keep paying Shopify’s subscription fees month-after-month without fail. Investors are therefore willing to pay a premium for the reassurance of the predictability of Shopify’s existing revenue stream.

Final thoughts

There is no exact formula for the right multiple to pay for a company. As shown above, it depends on a multitude of factors. 

But the main takeaway is that we should never look at a company’s price-to-sales or price-to-earnings multiples in isolation.

Too often, I hear investors make general statements about a stock simply because of the high or low multiples that a stock is priced at.

These multiples may be a good starting point to value a company but it is only one piece of the puzzle. It doesn’t capture the nuances of a company’s business model, its growth, or its unit economics… Only by considering all these factors together can we make a truly informed decision.

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 the shares of Amazon, Costco Wholesale Corporation, and Shopify. Holdings are subject to change at any time.

The finance community often use the term “passive investing” to apply to investing in index funds. But is investing in an index fund really a “passive” strategy?

Actually not.

Most indexes actually have an active method of selecting their stocks. For example, the S&P 500 only includes the top 500 stocks by market capitalisation that are listed and headquartered in the USA. In addition, the stocks need to have at least four consecutive quarters of profitability.

The S&P 500 is also market-cap weighted. As such, bigger companies have a larger weight in the S&P 500 index, and their returns have a bigger impact on the index’s overall return.

I consider this method of selection and weighting as an active method of selecting stocks. Moreover, the selection criteria are determined by a committee and the committee also has the final say on whether a stock should be included in the index. This was the case for Tesla Inc (NASDAQ: TSLA), which was only included after it reported its fifth profitable quarter (instead of fourth).

Portfolio weighting

Ultimately, these active decisions made by a committee impact the index’s returns. For instance, the simple act of choosing to weight the index based on market cap has had a profound impact on the S&P 500 index over the last 10 years.

The table below shows the returns of the S&P 500 index against the S&P 500 equal-weighted index.

As you can see, the market-cap weighted index far outpaced the equal-weighted one. This is because larger stocks, which have a bigger weighting in the market-cap-weighted index, have outperformed their smaller counterparts over the last 10 years.

Choosing the right index 

All of which points to the fact that not all indexes are made equal.

Each index has specific selection criteria and a specific method of weighting its constituent stocks. Ultimately, these are active choices made by the committee building the index. 

As investors, we may think that “index investing” is a passive strategy.

But indexes are not completely passive. The stocks within an index have been picked based on criteria that are “actively” chosen.

Even in Singapore, the Straits Times Index (STI), which is a commonly used indicator of the health of Singapore’s stock market, may not be truly representative or passive.

The rules for inclusion into the STI are based on a stock’s market cap, liquidity, and a minimum amount of voting rights in public hands. As such, the stocks selected in the STI are actually picked by the committee based on a selection methodology that they have actively chosen.

Index investing is actually “active”

Ultimately, investing in any index is not a truly passive way to invest. The exposure you gain is based on active decisions made by the index committee that built the index.

In addition, with so many indexes available, choosing an index to invest in is also an active decision made by the investor. Within the US alone, there are funds that track the S&P 500, S&P 500 Equal Weight, MSCI USA, MSCI USA Equal Weighted Indexes, and many more. Each of these indexes has performed differently over the last 10 years.

Index investing is, hence, not truly “passive”.

By investing in any index, you are actually making an “active” decision that the “active” selection and weight criteria used in that particular index will work best for your investment needs.

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 the shares of any companies mentioned. Holdings are subject to change at any time.

Note: This article was first published in The Business Times on 25 November 2020; data as of 19 November 2020

On 9 November 2020, Pfizer announced a wonderful development for mankind. Trial results from the pharmaceutical giant’s COVID-19 vaccine candidate, developed together with Bio NTech, showed that it could be 90% effective in preventing infection.

A week later, Moderna revealed that its COVID-19 vaccine candidate was 94.5% effective in trials. This was followed by an update from Pfizer a few days later that its vaccine candidate was actually 95% effective .

COVID-19 is still a serious global health threat. Pfizer and Moderna’s vaccines have yet to pass regulatory approvals at the time of writing (19 November 2020). Both companies have said too that they can supply their respective vaccines at scale only in 2021. Pfizer’s vaccine candidate also poses a significant logistical challenge since it needs to be transported and stored at an extremely cold temperature of minus 70 degrees celsius .

But, we can at least see some light at the end of the tunnel now.

A celebration – for some

The stock market welcomed Pfizer’s announcement. In the USA, the S&P 500 index was up by as much as 3.9% in the next trading session following the release of Pfizer’s vaccine trial data, before closing with a 1.2% gain. Singapore’s stock market barometer, the Straits Times Index, climbed by 3.7%. But the warm reception did not extend to all corners of the market. The stock price of e-signature specialist DocuSign sank by 14.7% despite the S&P 500’s 1.2% gain.

There were also painful drops of 13.6% and 17.4%, respectively, in the stock prices of e-commerce software provider Shopify and video conferencing platform Zoom Video Communications. These are just some examples of the sharp stock price declines that many US-listed technology companies faced immediately after Pfizer shared the great news about its COVID-19 vaccine trial.

The future for tech stocks?

COVID-19 has led to restrictions on human movement in many countries around the world. Many technology companies benefitted as their products help people to live, work, play, and consume better from home. In late April this year, Microsoft’s CEO Satya Nadella famously said that he saw “two years’ worth of digital transformation happening in two months”.

As a microcosm of what happened with technology companies, DocuSign, Shopify, and Zoom saw their stock prices jump by between 133% and 577% from the start of 2020 to the end of October.

If Pfizer and Moderna’s vaccines are as effective as their trial results suggest, then COVID-19 could cease to be a worry for society in the near future.

Technology companies would then lose a powerful tailwind. This train of thought, along with the sharp difference in the movement of the broader market and technology stocks after Pfizer’s announcement, may prompt a question among many investors: Should we invest in technology stocks in the post-COVID world?

Better question

From my perspective, many of the tech companies whose stock prices were pummelled after Pfizer’s good news are creating or riding on powerful long-term trends.

For instance, before COVID-19, DocuSign was already providing e-signatures to a growing number of companies. Retail merchants were already flocking to Shopify in droves to create an online or omnichannel retail presence to meet consumer demand. A large and growing number of people and companies were already experiencing the joys of a well-built video conferencing app through Zoom.

From 2017 to 2019, DocuSign’s customer base increased by 57% from 373,000 to 585,000. Shopify’s merchant base jumped by two-thirds from 609,000 to over one million; and Zoom’s customers with more than 10 employees tripled from 25,800 to 81,900 . The trio, and many other tech companies, were growing before COVID-19 because their products and services are superior to how things are done traditionally.

When we’ve solved COVID-19, will the advantages that these technology companies have over the traditional ways still hold? I humbly suggest that this is the better question to ask, compared to whether we should we invest in tech stocks in the post-COVID world. This is because the question hones us in on a key driver of a company’s stock price over the long run: Its business performance. Answering this better question can help us determine if any particular technology company’s product or service will enjoy growing demand in the years ahead. With growing demand comes a higher chance of earning higher revenue, profit, and cash flow.

You will need to figure out your own answer to the better question, but my reply to it is “yes”. Will companies really stop their digital transformation and be content with or revert back to more archaic ways of conducting their business simply because the threat of COVID-19 has been removed? I doubt so.

What lies ahead

Some technology companies aren’t worth investing in because they already or will struggle to grow their businesses meaningfully over the long run. The trick lies in separating the wheat from the chaff.

Technology stocks could also be in for more pain in the months or even the next one or two years ahead. Short-term stock price movements are unpredictable. But as a long-term investor, I’m focused on what the businesses of technology stocks could look like five to 10 years from now. For me, the future looks bright, with or without COVID-19.

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 the shares of DocuSign, Microsoft, Shopify, and Zoom Video Communications. Holdings are subject to change at any time.

Ant Group’s massive initial public offering (IPO) was stopped cold in its tracks earlier this week.

Ant Group, a fintech company backed by Alibaba and its co-founder Jack Ma, was supposed to list its shares in the stock exchanges of Shanghai and Hong Kong today. The IPO was slated to raise a mammoth sum of at least US$34 billion for the company. What happened instead was the Shanghai Stock Exchange suspending Ant Group’s listing on Tuesday, followed shortly by the same action from the Hong Kong Stock Exchange.

Ostensibly, Ant Group’s IPO process was stopped after Jack Ma gave a speech during a financial conference in Shanghai in late October. In his comments, Ma had essentially labelled the Chinese financial system and regulations as antiquated. This presumably angered the Chinese government because Ma was quickly summoned for a meeting with the country’s financial regulators. And then came the news of the fintech firm’s stalled IPO.

I see Ant Group’s predicament as a manifestation of the risk of investing in China that investors need to contend with. I’m often being asked about my opinions on investing in Chinese companies. I think there are wonderfully innovative companies in China with tremendous growth prospects that can make for excellent investment opportunities. But will I want to make Chinese companies the majority of my portfolio? No. This is because I think that Chinese companies have to deal with unique political and regulatory risks that companies based in democratic environments do not. And these risks, if they flare up, could easily derail a Chinese company’s business.  

A recent Bloomberg article on the Ant Group IPO-debacle contained the following passage:

“The consequences came this week. On Monday, Beijing’s top financial watchdogs summoned Ma and dressed him down. Beijing also issued draft rules on online micro lending, stipulating stricter capital requirements and operational rules for some of Ant Group Co.’s consumer credit businesses.”

Based on Bloomberg’s reporting, the Chinese government has effectively made it more difficult for Ant Group to grow. But what’s more important is that the Chinese government has appeared to also pull the plug on Ant Group’s IPO for now. I just don’t see how something similar – where a company’s IPO process is killed at the very last minute because the company’s public-face had made some unflattering comments about its home country – can happen in a democratic environment. 

This article is not meant to discuss the investment merits of Ant Group. Instead, it’s simply meant to highlight what I think is a critical risk of investing in China that investors need to know: Chinese companies face unique politically-related risks that are not to be trifled with. And Ant Group just happens to be a prominent example.

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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 no vested interest in Ant Financial or Alibaba. Holdings are subject to change at any time.

One of the age-old questions in investing is how widely should we diversify. Unfortunately, it seems that even the best investors can’t seem to agree on this.

Legendary investor Charlie Munger is famous for being a supporter of a concentrated portfolio. He once said:

“The idea of excessive diversification is madness. Wide diversification, which necessarily includes investment in mediocre businesses, only guarantees ordinary results.”

In 2017, Munger said that he owned just three positions in his personal portfolio – Berkshire Hathaway, Costco, and an investment in Li Lu’s investment partnership (which itself is highly concentrated).

At the opposite corner, we have other renowned investors who practised wide diversification and yet still achieved stunning results. For example, there’s Peter Lynch, who earned a 29.2% annualised return in his 13-year tenure managing the Fidelity Magellan Fund from 1977 to 1990. In his later years managing the fund, Lynch held as many as 1,400 stocks in the portfolio. 

Concentration and the risks

I recently had a short conversation with a friend on this topic of diversification. My friend is a proponent of having a concentrated portfolio, believing that we should not dilute our best investment ideas.

I agree that a concentrated portfolio may give you the best chance of higher returns. If you manage to build a sizeable position in a stock that becomes a multi-bagger (meaning a stock with a return of 100% or more), your return will obviously be better than if you had diluted your portfolio with other companies that ended up with lousier gains.

But we shouldn’t ignore the fact that having a concentrated portfolio can also magnify our losses. If your concentrated portfolio included a large position in a “big loser”, or perhaps in a fraud case such as Luckin Coffee, your portfolio-level return will very likely lag a more diversified portfolio.

Higher concentration = Higher variance

According to research by Alex Bryan from Morningstar, there is no real significance between a fund’s portfolio-concentration and performance.

What Bryan’s research did conclude was that more concentrated funds had a wider variance of returns. This means that concentrated funds had a higher chance of “blockbuster” returns but also had a higher risk of ending up with very poor performance. Bryan explains (emphases are mine):

“The risk in manager selection actually increases with portfolio concentration. So, while we didn’t find a link on average between performance and concentration, the dispersion of potential outcomes increases with portfolio concentration. So, really highly concentrated managers can miss the mark by a really, really wide range.

I think the other point to remember is that more highly concentrated portfolios tend to have greater exposure to firm-specific risk, and on average, that’s not well-compensated. So, again, you really want to keep an eye on risk and make sure that the manager that you hire is taking adequate steps to try to manage that risk that comes with concentration.”

How does this relate to the individual investor?

At the end of the day, how concentrated our portfolios should be depends on our risk appetite, skill, goals and ability to take on risk.

The more concentrated our portfolios, the greater the possibility of extreme returns – both on the upside and the downside. Are you willing to take on this risk and can you mitigate the risks with your ability to select stocks? These are some questions to ask yourself.

Ultimately, thinking about your needs, investment expertise, and circumstance will help you decide what level of concentration works best for 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 currently have a vested interest in Costco.

Compounding is amazing, isn’t it? Just look at the graph below. It shows the nominal growth of the S&P 500, a prominent US stock market barometer, in the last 150 years.

What’s interesting about the chart is that the S&P 500’s growth accelerated over time. That’s exactly how compounding works. Nominal growth starts off slow but increases over time.

The chart below of the S&P500 over the last 150 years shows the same thing as above, but in logarithmic form. It gives a clearer picture of the percentage returns of the stock market over the same time frame.

The log-chart of the S&P 500 over the past 150 years is a fairly straight line up. What this tells us is that even though the return of US stocks have accelerated nominally, there was a fairly consistent growth in percentage terms over the time studied.

How do stocks compound?

This leads us to the next question. How?

In order to produce a 10% annual return for shareholders, a company that has a market value of $1 million needs to create $100,000 in shareholder value this year. The next year, in order to compound at the same rate, the company now needs to create $110,000 in shareholder value.

That figure grows exponentially and by year 30, the company now needs to create $1,586,309.30 to keep generating a 10% increase in shareholder value.

On paper, that seems outrageous and highly improbable. However, based on the historical returns of the stock market, we see that the S&P 500 has indeed managed to achieve this feat.

The reason is that companies can reinvest the capital they’ve earned. A larger invested capital base can result in larger profits. As long as they can keep reinvesting their earned capital at a similar rate of return, they can keep compounding shareholder value. 

But here’s the catch…

Although I’ve given an example of how a company can compound shareholder value over time, it really is not that simple.

Not all companies can create more shareholder value every year. In reality, corporations may find it hard to deploy their new capital at similar rates of return. Businesses that operate in highly competitive industries or are being disrupted may even face declining profits and are destroying shareholder value each year if they reinvest their capital into the business.

In fact, most of the returns from stock market indexes are due to just a handful of big winners. In 2014, JP Morgan released an interesting report on the distribution of stock returns. The report looked at the “lifetime” price returns of stocks versus the Russell 3000, an index of the biggest 3000 stocks in the US over a 35-year period.

What JP Morgan found was that from 1980 to 2014, the median stock underperformed the Russell 3000 by 54%. Two-thirds of all stocks underperformed the Russell 3000. The chart below shows the lifetime returns on individual stocks vs Russell 3000 from 1980 to 2014.

Moreover, on an absolute return basis and during the same time period, 40% of all stocks had a negative absolute return.

Even stocks within the S&P 500, a proxy for 500 of the largest and most successful US-listed companies, exhibited the same. There were over 320 S&P 500 deletions from 1980 to 2014 that were a consequence of stocks that failed, were removed due to substantial declines in market value, or were acquired after suffering a decline. The impressive growth you saw in the S&P 500 earlier was, hence, due to just a relatively small number of what JP Morgan terms “extreme winners”.

That’s why diversification is key

Based on JP Morgan’s 2014 report, if you picked just one random stock to invest in, you had a 66% chance to underperform the market and a 40% chance to have a negative return.

This is why diversification is key.

If historical returns are anything to go by, diversification is not just safer but also gives you a higher chance to gain exposure to “extreme winners.” Just a tiny exposure to these outperformers can make up for the relative underperformance in many other stocks.

Last words

Compounding is a game-changer when it works.

But the reality is that not all stocks compound in value over a long period of time. Many may actually destroy shareholder value over their lifetime. A useful quote from Warren Buffet comes to mind: “Time is the friend of the wonderful business, the enemy of the mediocre.”

Given the wide divergence of returns between winners and losers, we can’t take compounding for granted. By diversifying across a basket of stocks with a sound investment framework, or by buying a fund that tracks a broadly-diversified market index, we reduce our downside risk and increase our odds of earning positive returns.

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.

Note: An earlier version of this article was first published in MoneyOwl’s website. MoneyOwl is Singapore’s first bionic financial advisor and is a joint-venture between NTUC Enterprise and Providend (Singapore’s first fee-only financial advisor). This article is a collaboration between The Good Investors and MoneyOwl and is not a sponsored post.

The apparent disconnect between the stock market and the economy is one of the hottest topics of discussion in the finance community this year.

Let’s look at the USA, for example, since it’s home to the world’s largest economy and stock market (in terms of market capitalisation). Due to the ongoing restrictions on human movement to fight COVID-19, the country’s economy inched up by just 0.6% in the first quarter of 2020 compared to a year ago. The second quarter of the year saw the US’s economic output fall by a stunning 9.0%; that’s an even steeper decline compared to the worst quarter of the 2007-09 Great Financial Crisis. Yet the US stock market – measured by the S&P 500 – is up by 4.1% in price as of 30 September 2020 since the start of the year. 

Many are saying that this makes no sense, that stocks shouldn’t be holding up if the economy’s being crushed. But here’s the thing: The stock market and the economy are not the same things, and this has been the case for a long time. 

A walk down memory lane

Let’s go back 113 years ago to the Panic of 1907. It’s not widely remembered today but the crisis, which flared up in October 1907, was a period of severe economic distress for the USA. In fact, it was a key reason behind the US government’s decision to set up the Federal Reserve, the country’s central bank, in 1913.

Here are excerpts from an academic report published in December 1908 that highlighted the horrible state of the US economy during the Panic of 1907: 

“The truth regarding the industrial history of 1908 is that reaction in trade, consumption, and production, after the panic of 1907, was so extraordinarily violent that violent recovery was possible without in any way restoring the actual status quo.

At the opening of the year, business in many lines of industry was barely 28 per cent of the volume of the year before: by mid- summer it was still only 50 per cent of 1907; yet this was astonishingly rapid increase over the January record. Output of the country’s iron furnaces on January 1 was only 45 per cent of January, 1907: on November 1 it was 74 per cent of the year before; yet on September 30 the unfilled orders on hand, reported by the great United States Steel Corporation, were only 43 per cent of what were reported at that date in the “boom year” 1906.”

You can see that there were improvements in the economic conditions in the USA as 1908 progressed. But the country’s economic output toward the end of the year was still significantly lower than in 1907. 

Now let’s look at the US stock market in that same period. Using data published by Nobel-Prize-winning economist Robert Shiller, I constructed the chart below showing the S&P 500’s performance from 1907 to 1917.

It turns out that the US stock market fell for most of 1907. It bottomed out in November of the year after a 32% decline from January. It then started climbing rapidly in December 1907 and throughout 1908, even though 1908 was an abject year for the US economy. And for the next eight years, US stocks never looked back. What was going on in the US economy back then in 1908 was not the same as what happened to its stocks.

There’s no link

It may surprise you, but studies on the long-term histories of stock markets and economies around the world show that there’s essentially no relationship between economic growth and stock prices over the long run. One of my favourite examples comes from asset manager AllianceBernstein and is shown below:

Despite stunning 15% annual GDP growth in China from 1992 to 2013, Chinese stocks fell by 2% per year in the same period. Mexico on the other hand, saw its stock market gain 18% annually, despite anaemic annual economic growth of just 2%. A wide gap can exist between the performance of a country’s economy and its stocks for two reasons.

First, stocks are ultimately driven by per-share earnings growth as well as changes in valuations (how much investors are willing to pay for each dollar of earnings). On the other hand, a country’s economic growth is driven by the revenue growth of all its companies. There can be many obstacles between a company’s revenue growth and earnings growth. Some examples include poor cost-management, dilution (where a company issues more shares and lowers its per-share growth), and regulatory pressures (such as a company facing an increase in taxes). Second, the presence of revenue growth for all companies in aggregate does not mean that any collection of companies are growing. 

What this means is that if we’re investing in stocks, it’s crucial that we focus on companies and valuations instead of the economy. This brings us to the situation today.

Underneath the hood

We have to remember that when we talk about the stock market, we are usually referring to a stock market index, which reflects the aggregate stock price movements for a group of companies. For example, the most prominent index in the USA is the S&P 500, which consists of 500 of the largest companies in the country’s stock market. There are two things worth noting about the index:

1. The American economy has more than 6 million companies, so the S&P 500 – as large as it is with 500 companies – is still not at all representative of the broader picture.
2. The S&P 500’s constituents are weighted according to their market cap, meaning that the companies with the largest market caps have the heaviest influence on the movement of the index.

According to the Wall Street Journal, the S&P 500’s five largest companies in the middle of January 2020 – Apple, Microsoft, Alphabet, Amazon, and Facebook – accounted for 19% of the index then. Here’s how the five companies’ businesses performed in the first half of 2020:

Although the US economy did poorly in the first half of this year, the S&P 500’s five largest companies in mid-January 2020 saw their businesses grow relatively healthily. What’s happening in the broader economy is not the same as what’s happening at the individual company level, especially with the S&P 500’s largest constituents. From this perspective, the S&P 500’s year-to-date movement (the gain of 4.1%), even with the gloomy economy as a backdrop, makes some sense. 

In fact, the recent movement of stocks makes even more sense if we dig deeper. On 4 August 2020, Bloomberg published an article by investor Barry Ritholtz titled Why Markets Don’t Seem to Care If the Economy Stinks. Here are some relevant excerpts from Ritholtz’s piece:

“Start with some of 2020’s worst-performing industries: Year-to-date (as of the end of July), these include department stores, down 62.6%; airlines, off 55%; travel services, down 51.4%; oil and gas equipment and services, down 50.5%; resorts and casinos, down 45.4%; and hotel and motel real estate investment trusts, off 41.9%. The next 15 industry sectors in the index are down between 30.5% and 41.7%. And that’s four months after the market rebounded from the lows of late March…

…Consider how little these beaten-up sectors mentioned above affect the indexes.  Department stores may have fallen 62.3%, but on a market-cap basis they are a mere 0.01% of the S&P 500. Airlines are larger, but not much: They weigh in at 0.18% of the index. The story is the same for travel services, hotel and motel REITs, and resorts and casinos.” 

It turns out that the companies whose businesses have crashed because of COVID-19 have indeed seen their stock prices get walloped. But crucially, they don’t have much say on the movement of the S&P 500.

Conclusion 

Stock market indices are useful for us to have a broad overview of how stocks are faring. But they don’t paint the full picture. They can also move in completely different directions from economies, simply because they reflect business growth and not economic growth. The main takeaway is that when you’re investing in stocks, don’t let the noise about the economy affect you from staying invested as they don’t always move in the same direction. If you invest in stocks, look at companies and not the economy.

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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 the shares of Alphabet, Amazon, Apple, Facebook, and Microsoft. Holdings are subject to change at any time.

When we invest in a company’s shares, we are making a long-term bet that the share price will rise over time. But in investing, we never deal in absolutes but rather a range of probable outcomes.

This is where understanding the concept of a distribution of possible outcomes becomes useful. Using what we know now, we can build a simple distribution model of long-term returns. This will, in turn, guide us on whether a stock makes a good investment and if so, how much capital should we allocate to it. Here are some common distribution model graphs and how they impact our investing decisions.

Normal distribution

This is the most common probability distribution curve. Let’s assume that a stock is expected to double after 10 years. The distribution curve for a stock with a normal distribution of returns will look something like this:

In this scenario, the highest probability is for the stock to return 100%. There is also a chance that the stock can have lower or higher returns.

A narrower distribution of outcomes

There is also the possibility that a stock has a narrower distribution curve.

In this scenario, the variance of return for this stock is less. This means it is less likely to deviate from the expected 100% return over the time period.

We can say that this stock is less risky than the first one. Each stock may exhibit different degrees of the normal distribution curve. The thing to keep in mind here is that the taller the peak, the lower the variance and vice versa. So a very flat curve will mean the stock has a high variance of returns and is riskier. Bear in mind that these distribution curves are modelled based on our own analysis of the company.

Bimodal distribution

There are also stocks that have a bimodal distribution. This means that there are two peaks or two likely outcomes along with a range of other outcomes that cluster around the two peaks.

In the above example, the stock’s returns cluster around two peaks, -80% and +300%. The numbers are arbitrary and are just numbers I picked randomly. The point I am trying to make is that bimodal distribution can occur when there are two distinct possibilities that can either make or break a company.

A useful example is a biotech stock that requires FDA approval to commercialise its product. If it succeeds in getting FDA approval, the stock can skyrocket but if it is unable to get the regulatory green light, it may run out of money and the stock price can fall dramatically.

How to use probability distribution curves?

We can use a probability of outcomes distribution model to make investment decisions for our stock portfolio.

For instance, you may calculate that a stock such as Facebook Inc has a 10-year expected return of 200% and has a narrow normal probability curve. This means that the variance of returns is low and it is considered a less risky stock.

On the other side of the coin, you may think that a stock such as Zoom Video Communications can exhibit a normal distribution curve with a modal return over 10 years of 400%. But in Zoom’s case, you think it has a wider variance and a flatter distribution curve.

In these two scenarios, you think Zoom will give you better returns but it has a higher probability of falling short and a much fatter tail end risk.

With this mental model, you can decide on the allocation within your portfolio for these two stocks . It won’t be wise to put all your eggs into Zoom even though the expected return is higher due to the higher variance of returns. Given the higher variance, we need to size our Zoom position accordingly to reflect the bigger downside risk.

Similarly, if you want to have exposure in stocks with bi-modal distribution, we need to size our positions with a higher risk in mind. Some stocks that I believe have bimodal distribution curves include Moderna, Novocure, Guardant Health and other biotech firms that are developing novel technology but that have yet to achieve widespread commercialisation.

Portfolio allocation

As investors, we may be tempted to invest only in stocks with the highest expected returns (ER). This strategy would theoretically give us the best returns. But it is risky.

Even diversifying across a basket of such high variance stocks may lead to losses if you are unfortunate enough to have all these stocks end up below the ER you modelled for.

Personally, I prefer having a mix of both higher ER stocks and stocks that have slightly lower ER but lower variance profile. This gives the portfolio a nice balance of growth potential and stability.

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 Facebook Inc and Zoom Video Communications.

For non-software engineers like me, the topic of software can be extremely difficult to grasp. The mechanics and use case of a company’s software, where it is hosted, how the software is used or how it is different from the competition, can be complex. This is especially so for enterprise software that non-tech folks never have the chance to interact with.

Although I’ve read my fair share of IPO prospectuses and annual reports of software companies, many terms may still confuse me. But not investing in software companies because you don’t understand them can severely handicap your returns. Software companies today are highly prized due to their highly recurring revenue model, rapid growth, and expanding addressable markets.

As such, I occasionally turn to blogs and websites from experts who are able to explain the technicalities more clearly. Here are three such sites that I turn to understand software companies.

Site No.1

Software Stack Investing is a blog run and written by Peter Offringa. Peter has a rich history in the software space, leading software engineering teams for Internet-based companies for 20 years and serving as CTO at a number of companies.

His blog posts are long and highly technical but he tries to explain as much of it as simply as possible so that even the layperson can understand.

One of the highlights of his blog is his transparency. He states what stocks he bought and sold and he also incorporates his own personal views on companies and how he thinks they will perform five years out.

Peter does a thorough competitive analysis for every company he covers which gives the reader a better understanding of how one company’s software compares with another.

In his blog, he covers stocks such as Datadog, Alteryx, Fastly, Twilio, Cloudfare, MongoDB, Elastic, Okta and Docusign.

Most of these stocks offer enterprise software, which may be more technical than consumer software companies. As such, Offringa’s blog post helps fill a huge information gap for non-tech experts.

Site No.2

Stratechery is probably one of the more well-known blogs focused on technology and media businesses. It is run by Ben Thompson, who worked at Apple, Microsoft and Automattic.

His blog covers much more than pure-play software companies. But when he does cover software companies, he does a great job in breaking down what they do and how they match up to other software.

Some of his work requires a subscription. Nevertheless, the free content on his blog alone already provides great analysis and tools if you are looking for a place to read about tech and software companies.

Site No.3

The Investor’s Field Guide is a website run by Patrick O’Shaughnessy who is also the CEO of the asset management company, O’Shaughnessy Asset Management, that is founded by his father, Jim.

The website contains a collection of podcasts (and transcripts) on his interviews of some of the world’s top professionals in their respective fields. He has interviewed leaders of venture capital firms, CEOs of tech companies, psychologists and other business experts who provide deep insight into their area of expertise.

Naturally, software is one of the topics that he has covered. Some of the more recent podcasts on software include an interview with Eric Vishria, a partner at renowned venture capital firm Benchmark Capital, and joint interviews with Chetan Puttagunta, another partner at Benchmark Capital, and Jeremiah Lowin, the founder of Prefect, an open-source data engineering software company.

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 Datadog, Alteryx, Twilio, MongoDB, Okta and Docusign..