Category: General Investing

If the price of a company’s stock went up, it’s more expensive, right? Well, not exactly. Stocks are not something static. Stocks represent part-ownership of an actual and ever-changing company.

Because the underlying company changes, its value may go up or down. If a company’s share price rises slower than its intrinsic value, the stock may have actually gotten cheaper even after the price increase.

What determines intrinsic value?

Most investors agree that a company’s intrinsic value is determined by the company’s cash on hand and the future free cash flows that it can generate. This cash can be used to grow the company or returned to shareholders through buybacks or dividends.

Investors often use historical price-to-earnings and price-to-free cash flow ratios as a proxy to gauge how cheap or expensive a company is.

Facebook shares

Facebook is an example of a stock whose price has risen, but that has actually gotten cheaper based on its earnings and free cash flow multiples.

The chart below shows Facebook’s stock price against its price-to-earnings (P/E) and price-to-free cash flow (P/FCF) multiples over the last five years.

The blue line is Facebook’s stock price. In the last five years, Facebook’s stock price has climbed 220% from US$88.26 to US$282.73.

The red and orange lines show the social media giant’s P/E and P/FCF ratios over the years. As you can see, the P/E ratio has trended downwards, while the P/FCF flow ratio has remained largely flat. This is because the growth in Facebook’s earnings and free cash flow over the last five years has outran and kept pace, respectively, with the rise in the company’s share price. As such, based on these valuation multiples, Facebook shares can actually be considered cheaper today than they were five years ago, even though the price is higher.

Buying stocks with high valuations

The Facebook example highlights that buying a stock at a high P/E ratio may still reap good returns for investors.

In the past, Facebook shares traded at much higher P/E ratios than they do today. Yet buying shares then, still resulted in solid returns.

What this tells us is that if we buy into a quality company that can grow its free cash flow and earnings at a fast rate, even a compression in the stock’s valuation ratios will still lead to strong share price performance.

Final words

Investors often confuse stock price movements as a change in the relative cheapness of a company. If the price of a stock rises, we assume it has become more expensive and vice versa. However, that completely misses the bigger picture.

The difference between a company’s stock price and future intrinsic value is what makes a company cheaper or more expensive.

We should, therefore, put more emphasis assessing whether the company can grow its earnings and free cash flow and the longevity of their growth runway, rather than looking at the recent price movement of a stock.

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.

Accounting scandals have been in the spotlight in recent months. Companies such as Wirecard and Luckin Coffee are two of the more recent high profile cases that have cost investors billions of dollars.

Worryingly, both companies were given a pass from reputable auditors before their respective cases blew up. As investors, we rely on external auditors to give us a sense of the company’s financial well being. But with the latest scandals, can we truly trust an auditor’s stamp of approval?

Nothing new

There have been many high profile accounting scandals over the past few decades. 

One major example that comes to mind is the accounting scandal of Waste Management Inc. In 1998, the company was revealed to have faked over US$1.7 billion in earnings from 1992 to 1997. Then CEO, A. Maurice Meyers was eventually found guilty along with other top executives and the SEC (Securities & Exchange Commission) fined Arthur Anderson, the company’s auditor, over US$7 million.

But the case that truly shocked the world came a few years later in 2001- Enron. Enron was a US energy, commodities, and services company. In that year, it was discovered that the company had been using accounting loopholes to hide billions of dollars of bad debt, while inflating earnings. Within a year, Enron lost US$74 billion in market capitalisation. Its auditor was again Arthur Anderson, which by then had lost so much of its reputation that it was forced to dissolve.

Recent scandals 

You would thought that the demise of Arthur Anderson would have brought a swift change to the industry. And yet, more than two decades later, we still hear of major scandals rocking the financial world.

Earlier this year, the China-based but US-listed coffee chain, Luckin Coffee, admitted that at least US$310 million of its sales over the previous three quarters were fabricated.

Today, Luckin Coffee’s shares have been delisted from the NASDAQ exchange where they were previously listed, and the company’s survival is in serious doubt. One of the company’s major shareholders is none other than GIC, one of the Singapore government’s investment arms, owned 5.37% of the Chinese company as recently as March 2020.

The other big-name scandal this year was Wirecard, a high flying payment solutions company that is headquartered and listed in Germany. It was considered one of Germany’s tech success stories and was briefly included in the country’s main stock market bellwether, the DAX index.

However, on 25 June this year, Wirecard filed for insolvency after revealing that €1.9 billion in cash was missing from its coffers. One of the company’s largest investors is Softbank, which injected €900  million cash in 2019. Softbank has since joined efforts with Wirecard’s other investors to pursue legal action against the company’s auditor, EY.

Worrying for investors

Although the vast majority of companies are free from accounting fraud and investors can fully trust whatever they see on the financial statements, these recent accounting scandals cast a shadow of doubt for investors.

Both Wirecard and Luckin Coffee were audited by reputable auditors and yet both managed to distort their financial statements. Even professional investors such as GIC and Softbank were badly burnt.

Most worryingly, Wirecard reportedly managed to hide the missing cash from auditors for years. As investors, we often look at the cash statement as the most reliable piece of information because cash is traditionally the hardest to manipulate. And yet, Wirecard was able to mislead investors that they had more than US$2 billion in cash, which they didn’t.

What other steps can we take

As investors, we usually look to the auditor’s report as the source of truth. They are supposed to be our neutral insiders. Yet, the past few scandals have shown that sometimes an auditor’s stamp of approval is simply not enough.

So what more can we as investors do?

I think as investors, it is difficult to sniff out whether a company’s financial statements are legitimate. Even big-name investors may end up betting on the wrong horse. The best we can do is to look at trends and market data. For instance, investors should look at the past track record of the company, the background of the managers, and where the company is audited and listed.

If anything seems amiss or too good to be true, our danger-radar should be up.

Portfolio sizing is also important to try to reduce the risk of accounting scandals. Having a sufficiently diversified portfolio and sizing down a position that you think has a greater risk of fraud ensures that if you are unfortunate enough to bet on a fraudulent company, your portfolio as a whole will still not be severely impacted. 

A call for change

Based on recent scandals, we can see the clear conflicts of interest for auditors. Auditing firms are paid by the company that they are auditing, and these contracts may be worth millions of dollars. 

To protect their nest egg, auditors could be under pressure to turn a blind eye on accounting malpractice, as was the case in the Enron scandal.

Changes, therefore, need to be made in the way companies are audited. The conflicts of interest create an unnecessary incentive and can be the reason why accounting fraud may take such a long time to be detected.

Regulatory bodies need to find a way to reduce these conflicts of interest to prevent accounting scandals that not only hurt investors but the integrity of the financial markets as a whole.

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.

Warren Buffett is one of my heroes, not just in investing, but also in life. On 30 August 2020, he turned an amazing 90 years old. But as his dear friend Bill Gates notes, Buffett still “has the mental sharpness of a 30-year-old, the mischievous laugh of a 10-year-old, and the diet of a 6-year-old.”

To celebrate Buffett’s extraordinary life, I want to share a few of my favourite stories about him.

Story 1: Philanthropy and the meaning of wealth

In August 2014, Buffett, together with his friends Bill and Melinda Gates, created The Giving Pledge, a movement that encourages society’s wealthiest individuals to pledge the majority of their immense wealth to philanthropic causes. The Giving Pledge started with 40 of America’s wealthiest people and today includes more than 200 families from 23 countries. The Giving Pledge has its roots in Buffett’s decision in 2006 to gradually give all of his wealth to philanthropic foundations. As part of The Giving Pledge, Buffett has committed to giving more than 99% of his wealth to philanthropy during his lifetime or at his death. According to a July 2020 New York Times article, Buffett has donated at least US$37 billion to philanthropic causes since his 2006 pledge. 

For me, the admirable actions of Buffett and the Gateses are a reminder to myself that the accumulation of wealth gains meaning only if it’s used to better the lives of others and not for purely hedonistic personal enjoyment. 

Story 2: Trust

In 1983, Buffett acquired 90% of The Nebraska Furniture Mart from the then-89 year-old Rose Blumkin (popularly known as Mrs B) for US$55 million. When he made the acquisition, he did not request for an audit of Nebraska Furniture Mart’s business, take an inventory, verify the receivables, nor check the company’s property titles. The contract was just over one page long. 

Buffett had full trust in Blumkin’s character. It’s easy to see why. In 1950, Blumkin was sued by competitors who complained that she was engaging in unfair trading by offering low prices for furniture to consumers. This is how she responded: 

“I went to Marshall Field in Chicago. I tell them I need 3,000 yards of carpet for an apartment building — I got, actually, an apartment building. I buy it from Marshall Field for $3 a yard, I sell it for $3.95 a yard. Three lawyers from Mohawk take me into court, suing me for unfair trade — they’re selling for $7.95. Three lawyers and me with my English. I go to the judge and say, ‘Judge, I sell everything 10 percent above cost, what’s wrong? I don’t rob my customers?’ He throws out the case. The next day, he comes in and buys $1,400 worth. I take out an ad with the whole case and put it in the Omaha World-Herald: ‘Here’s proof how I sell my customers.” 

I have a firm belief that it’s hard to make a bad deal with a good person no matter how poorly-written the contract is. I also believe it’s equally hard to make a good deal with a bad person, no matter how strong the contract is. Buffett’s experience with Mrs B taught me so.

Story 3: Patience   

In July 2020, I published the article, The Fascinating Facts Behind Warren Buffett’s Best Investment. It discusses Buffett’s investment in The Washington Post Company (WPC), now known as Graham Holdings Company, in the 1970s. 

It’s one of my favourite Buffettt stories for two reasons. First, Buffett’s WPC shares gained over 10,000% from the 1970s to 2007, making it one of the best – if not the best – investments he has ever made. Second, WPC’s share price actually fell by more than 20% shortly after Buffett invested, and then stayed there for three years.

To achieve great returns in stock market investing, patience is almost always a necessity. Buffett’s investing results show exactly why.  

This article will never be seen by Warren Buffett, but I hope my birthday wishes for him can still be received by him in some way or another. Happy 90th birthday, Mr Buffett! Stay healthy and strong, always!

---

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. 

Many tech companies nowadays use stock-based compensation to reward managers and employees. Some even pay as much as 80% of executive pay in stocks or options. I’m personally a fan of stock-based compensation for a few reasons.

A fan

For one, stock-based compensation is not a cash expense. Cash is the lifeblood of a company and is vital for a fast-growing business.

Second, stock-based compensation aligns management’s interests with shareholders. Executives and employees become shareholders themselves who are incentivised to see the stock perform well.

In addition, companies may pay executives through stock options or restricted stock units that vest over a few years. With a multi-year vesting period, executives are incentivised to see the stock do well over a multi-year period, which aligns their interests with long-term shareholders.

All these being said, stock-based compensation does create a headache for analysts: It leads to a mismatch between the company’s profit/loss and its cash flow.

Stock-based compensation is recorded as an expense in the income statement but is not a cash expense. As such, companies who use stock-based compensation end up with higher cash flow than profits.

Why adjusted earnings is not good enough

To account for the difference, some companies may decide to provide adjusted earnings. This is a non-GAAP accounting method that adjusts earnings to add back the stock-based compensation and other selected expenses.

The adjusted earnings figure is closer to the company’s actual cash flow. But I don’t think this is the best method to measure the impact of stock-based compensation.

Adjusted earnings do not take into account the dilutive impact from stock-based compensation.

Free cash flow per share may be the best metric to use

So how do we best measure the impact of stock-based compensation? Amazon.com’s founder, Jeff Bezos once said,

“Percentage margins are not one of the things we are seeking to optimize. It’s the absolute dollar free cash flow per share that you want to maximize.”

I completely agree. With the growing use of stock-based compensation, earnings per share is no longer the most important factor. Free cash flow per share has become the more important determinant of what drives long term shareholder value.

This takes into account both non-cash expenses and the dilutive impact of share-based compensation. By comparing a company’s free cash flow per share over a multi-year period, we are able to derive how much the company has grown its free cash flow on a per-share basis, which is ultimately what shareholders are interested in.

Ideally, we want to see free cash flow growing much faster than the number of shares outstanding. This would lead to a higher free cash flow per share.

Conclusion

To sum up, stock-based compensation is a good way to incentivise managers to act on the interests of shareholders.

However, it creates a challenge for analysts who need to analyse the performance of the company on a per-share basis.

In the past, earnings used to be the best measure of a company’s growth. But today, with the growing use of stock-based compensation, free cash flow per share is probably a more useful metric to measure a company’s per-share growth.

By measuring the year-on-year growth in free cash flow per share, we can derive the actual growth of a company for shareholders after accounting for dilution and any other non-cash expenses.

---

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. We have a vested interest in Amazon.com shares.

There are two kinds of problems in this world: puzzles and mysteries. Puzzles can be solved by collecting information. Mysteries, on the other hand, require insight – they can’t be solved simply with more information.

Here’s writer Malcolm Gladwell explaining the difference between a puzzle and a mystery in a 2007 article:

“The national-security expert Gregory Treverton has famously made a distinction between puzzles and mysteries. Osama bin Laden’s whereabouts are a puzzle. We can’t find him because we don’t have enough information. The key to the puzzle will probably come from someone close to bin Laden, and until we can find that source bin Laden will remain at large.

The problem of what would happen in Iraq after the toppling of Saddam Hussein was, by contrast, a mystery. It wasn’t a question that had a simple, factual answer. Mysteries require judgments and the assessment of uncertainty, and the hard part is not that we have too little information but that we have too much. The C.I.A. had a position on what a post-invasion Iraq would look like, and so did the Pentagon and the State Department and Colin Powell and Dick Cheney and any number of political scientists and journalists and think-tank fellows. For that matter, so did every cabdriver in Baghdad.”

I believe investing is a mystery, and not a puzzle. There are seldom clear-cut answers in the financial markets. 

Investing is a mystery-problem to me because you can have billionaire investor Bill Ackman invest in a company (formerly Valeant Pharmaceuticals, now Bausch Health Companies) after conducting such deep research that he had to sign confidentiality agreements and yet have the company’s share price do this:

The slide below shows the extent of the due-diligence that Pershing Square (Ackman’s investment firm) conducted on Valeant:

I’m not trying to have a dig at Ackman. I have immense respect for his long-term accomplishments as an investor. I’m using his experience with Valeant because I think it is a wonderful example of the puzzle/mystery dichotomy in investing. Having a mountain of information on Valeant had no use in the eventual outcome that Pershing Square had with the company. 

Investing is a mystery-problem to me because you can give two great investors the exact same information about a company and they can arrive at wildly different conclusions about its investment merits. 

Credit card company Mastercard currently has 39 analysts covering its stock, according to its own website. Its market capitalisation is more than US$330 billion right now and it was never below US$200 billion at any point over the past year. It’s very likely that the investing community knows all there is to know about Mastercard’s business. 

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

At the end of September 2019, Mastercard made up 10% of the Akre Focus Fund. So Akre clearly thought highly of the company. Pabrai, on the other hand, did not want to touch Mastercard even with a 10-feet barge pool. In the October 2019 edition of Columbia Business School’s investing newsletter, Graham and Doddsville, Pabrai said:

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

Investing is a mystery-problem to me because even the tiniest investment firms can beat the most well-staffed ones.

I once spoke to an employee of a US college endowment fund with an excellent history of investing in fund managers who go on to produce stellar long-term results. During our conversation, I asked him what was the most surprising thing he found about the best fund managers his endowment fund had worked with. He said that the fund managers with the best results are the one or two-man shops. If investing is a puzzle-problem – meaning that collecting information is the key to success – there is simply no way that the two-man-shop fund manager can beat one with 50 analysts. But if investing is a mystery-problem – where insights matter the most – then you can have David triumph over Goliath.   

So what are the key implications for investors if investing is a mystery and not a puzzle? I have one. 

Investing can never be fully taught. There are the technical aspects of investing – such as how to read financial statements and the workings of the financial markets – that can be learned. But there will come a point in the research process where the collection of more information will not help us, where insight is necessary. And the development of insights, unfortunately, can’t be transmitted from teacher to student. Insights depend on an individual’s life experiences and knowledge-base. The books I’ve read are different from the ones you have. Even for the same books, our takeaways can be wildly different.

I believe one can become a competent investor by following rote methods. But to become a great investor, I don’t think there’s any manual that can be followed, because investing is a mystery, not a puzzle.

---

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. We have a vested interest in Mastercard shares.

Are stocks too expensive? On the surface, it certainly seems so.

The US economy declined by 32.9% on an annualised basis in the second quarter of 2020. Sequentially, it fell 9.5% from the first quarter, marking the fastest quarterly contraction on record. Worse still, many parts of the world are still in full or partial lockdowns and the travel industry is still effectively in a standstill.

And yet, the S&P 500 – the major US stock market benchmark – is roughly flat year-to-date. There is clearly a mismatch between the US stock index and the economy.

But if you think that the index is going to fall because of this mismatch, what are those invested missing? Are they all experiencing FOMO (fear of missing out) or are they all just plain dumb? I don’t have the answers, but I want to present some information as food for thought.

The key reasons

Based on my observation, there are two main reasons that market watchers point to for causing an expensive stock market. They are (1) Robinhood traders rushing to buy stocks and (2) the extra liquidity created by the Federal Reserve causing a rise in asset prices. Robinhood is a mobile app that provides commission-free trading for financial instruments such as stocks, exchange-traded funds, and more.

But Robinhood traders only make up a fraction of all market participants. There are market shorters, big hedge funds, and other professional investors that are participating in the market too. If stocks are too expensive because of exuberant demand from Robinhood traders, it is likely that there will be investors who will be shorting the market and keeping prices in check.

Second, the extra liquidity injected by the Federal Reserve is here to stay and is, therefore, rightly, an important determinant of stock prices.

Discerning

The fact of the matter is that everyone is seeing the same thing. Most of us are not special investors with special insights.

Yes, the stock market has reached bubble levels in the past but bubbles are rare. Most of the time, the stock market is fairly efficient. Could it be the case now?

If we take a closer look at the S&P 500, we can see a division in price performance between companies that are fundamentally sound and those that are not. For instance, technology stocks have made up the bulk of the market’s gains this year, while companies in sectors that have been hit the hardest have taken the brunt of the fall.

Year-to-date (as of 1 August 2020), the top-performing sector in the S&P 500 is Information Technology, which is up 21%. That’s backed by strong fundamentals. Many technology companies have seen a surge in revenue and profits in the most recent quarter. Amazon, Apple, Facebook and Netflix, for example, reported a year-on-year increase in revenue of 40%, 11%, 11%, and 25% respectively, for the second quarter of 2020.

At the other end of the spectrum, we have energy and financial stocks that are down 40% and 21% respectively as they are likely the hardest-hit from the current COVID-19-driven economic contraction. Airline stocks are also far below their pre-COVID-19 levels. Local flag carrier Singapore Airlines’ share price is down 62%, while the major US airlines are down between 40 and 70%.

All of which seems to indicate that market participants have been discerning about which stocks to sell down and which to price up.

The stock market and the economy

It can be easy to assume that the stock market and the economy are the same things. But there are actually big differences.

The S&P 500, a commonly used barometer to gauge the stock market in the US, only comprises around 500 companies. Within the index, the top five companies – Alphabet, Amazon, Apple, Facebook, and Microsoft – have a combined weight of around 22%.

A rise in the price of the top five companies can disproportionately impact the index. This is exactly what is happening. The big five, along with Netflix, have seen their share prices increase substantially this year. If we exclude the performances of just these six companies, the S&P 500 would be down substantially for the year so far.

Furthermore, being an index of just 500 companies, the S&P 500 does not take into account the rest of the 30 million-plus businesses in the US, many of which are SMBs (small, medium businesses). In fact, SMBs generate around 44% of the US’s economy activity, according to a recent study from The Office of Advocacy of the U.S. Small Business Administration. And unfortunately, SMBs are the most impacted businesses in the US during the COVID-19 pandemic.

Who knows?

Nobody knows how this will all play out. The ending’s not written yet. It is only with hindsight that we can tell if the stock market is currently making sense, or if it’s not.

But this is why investing is hard, and why beating the market is even harder.

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 a vested interest in Alphabet, Amazon, Apple, Facebook, Microsoft and Netflix.

Note: This article was first published in The Business Times on 29 July 2020.

It may feel like a lifetime has passed, but it’s only been around seven months since COVID-19 emerged and upended the lives of people all over the world. 

Given the short span of time, I don’t think there can be many definitive investing lessons that we can currently draw from the crisis.  But I do think there are already key lessons we can learn from. At the same time, we should be wary of learning the wrong lessons. 

A mistaken notion

As of 21 July 2020, the S&P 500 index – a broad representation for US stocks – is flat year-to-date. Meanwhile, the Nasdaq – a tech-heavy index of US-listed companies – is up by more than 17% in the same period. Even more impressive is the BVP Nasdaq Emerging Cloud Index’s 55.5% year-to-date gain. The BVP Nasdaq Emerging Cloud Index is created by venture capital firm Bessemer Venture Partners and it is designed to track US-listed SaaS (software-as-a-service) companies.

The huge gap between the performances of the S&P 500 and the Nasdaq and Bessemer’s cloud index is not surprising. 

Large swathes of the physical economy have been shut or slowed down because of measures that governments have put in place to stamp out COVID-19. Meanwhile, companies operating in the digital economy are mostly still able to carry on business as usual despite lockdowns happening across the world. In fact, COVID-19 has accelerated adoption of digital technologies.

Given this, it’s easy to jump to the following conclusion: A key investing lesson from COVID-19 is that we should invest a large portion of our portfolios into technology stocks. But I think that would be the wrong lesson.

We have to remember that crises come in all kinds of flavours, and they are seldom predictable in advance. It just so happened that COVID-19 affected the physical world.  There could be crises in the future that harm the digital realm. For instance, a powerful solar flare – an intense burst of radiation from the sun – could severely cripple our globe’s digital infrastructure.

I think there are two key investing lessons from COVID-19.

In the face of adversity

First, we should invest in companies that are resilient – or better yet, are antifragile – toward shocks. Antifragility is a term introduced by Nassim Taleb, a former options trader and the author of numerous books including Black Swan and Antifragile. Taleb classifies things into three groups: 

• The fragile, which breaks when exposed to stress (like a piece of glass, which shatters when dropped)
• The robust, which remain unchanged when stressed (like a football, which does not get affected much when kicked or dropped)
• The antifragile, which strengthens when exposed to stress (like our human body, which becomes stronger when we exercise)

Companies too, can be fragile, robust, or even antifragile. 

The easiest way for a company to be fragile is to load up on debt. If a company has a high level of debt, it can crumble when facing even a small level of economic stress. On the other hand, a company can be robust or even antifragile if it has a strong balance sheet that has minimal or reasonable levels of debt.

During tough times (for whatever reason), having a strong balance sheet gives a company a high chance of surviving. It can even allow the company to go on the offensive, such as by hiring talent and winning customers away from weaker competitors, or having a headstart in developing new products and services. In such a scenario, companies with strong balance sheets have a higher chance of emerging from a crisis – a period of stress – stronger than before. 

Expect – don’t predict  

Second, when investing, we should have expectations but not predictions. The two concepts seem similar, but they are different. 

An expectation is developed by applying past events when thinking about the future. For example, the US economy has been in recession multiple times throughout modern history. So, it would be reasonable to expect another downturn to occur over the next, say, 10 years – I just don’t know when it will happen. A prediction, on the other hand, is saying that a recession will happen in, say, the third quarter of 2025. 

This difference between expectations and predictions results in different investing behaviour.

If we merely expect bad things to happen from time to time while knowing we have no predictive power, we would build our investment portfolios to be able to handle a wide range of outcomes. In this way, our investment portfolios become robust or even antifragile.

Meanwhile, if we’re making predictions, then we think we know when something will happen and we try to act on it. Our investment portfolios will thus be suited to thrive in only a narrow range of situations. If things take a different turn, our portfolios will be hurt badly – in other words, our portfolios become fragile.

It should be noted too that humanity’s collective track record at predictions are horrible. And if you need proof, think about how many people saw the widespread impact of COVID-19 ahead of time.

Conclusion

There will be so much more to come in the future about lessons from COVID-19.  We’re not there yet, but I think there are already important and lasting ones to note. 

My lessons rely on understanding the fundamental nature of the stock market (a place to buy and sell pieces of actual businesses) and the fundamental driver of stock prices (the long run performance of the underlying business). 

COVID-19 does not change the stock market’s identity as a place to trade pieces of businesses, so this is why I think my lessons will stick. 

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.

Psychological biases are the human tendency for us to make decisions in an illogical way. The concept was introduced by psychologists Daniel Kahneman, Paul Slovic, and Amos Tversky in the early 1970s. Kahneman later won a Nobel Prize for his work and went on to write the best-selling book Thinking, Fast and Slow.

In his book, Kahneman describes the “fast thinking” part of the brain as System 1. This way of thinking helps us make snap decisions, such as jumping away when we hear a loud noise.

Slower thinking, or System 2, is used to solve more complicated problems. Usually, Systems 1 and 2 work very well, but in some situations, System 1 may cause a person to jump to conclusions too quickly and lead to what we now know as psychological biases.

What is confirmation bias?

There are numerous psychological biases and one of the more common and well-known of them that affects us as investors is confirmation bias. Confirmation bias is our tendency to cherry-pick information that supports our existing beliefs.

It partly explains why two people with opposing views can come to very different conclusions when they see the same piece of information. It can also cause us to make bad investing decisions. Take the scenario below for an example.

A friend at a party whispers a hot investing tip to you. You get excited at the prospect of making money but realise that it is important to do your own research. When you reach home, you hastily search for more information. Unfortunately, because of your preconceived conception of the company, you unwittingly reject data that goes against your belief and only look for information that supports it. Thinking you did sufficient due diligence, you make your trade the next day.

This is a common phenomenon. You’ll be surprised how easy it is to interpret data and statistics to fit your preexisting view.  Shane Parish, in his Farnam Street blog, wrote:

“Confirmatory data is taken seriously, while disconfirming data is treated with scepticism.”

In his book, Six Thinking Hats, Edward De Bono wrote:

“There may be more danger in prejudices which are apparently founded in logic than in those which are acknowledged as emotions.”

Why do we suffer from confirmation bias?

If the above scenario sounds familiar, then you have suffered from confirmation bias.

There is an innate desire for us to want to have been right. In the book The Web of Belief, authors Willard V Quine and J.S Ullian wrote,

“The desire to be right and the desire to have been right are two desires, and the sooner we separate them the better off we are. The desire to be right is the thirst for truth. On all counts, both practical and theoretical, there is nothing but good to be said for it. The desire to have been right, on the other hand, is the pride that goeth before a fall. It stands in the way of our seeing we were wrong, and thus blocks the progress of our knowledge.”

Confirmation bias is so ingrained in our brains that knowing that we tend to suffer from confirmation bias is not enough. The act of seeking out other data is not the solution- the problem is not being open to an alternative view.

How do we overcome it?

The first thing we should do is to give ourselves time to make a decision. Giving ourselves time to conduct research, talk to people in the know, and look for a different point of view, can reduce the risk of confirmation bias. Darren Matthews wrote in an article:

“It seems logical to add time to making decisions, slowing things down. Time offers a perspective that brings with it the capacity to bring other steps into play.”

Second, actively search out opposing views. Find arguments that reject your initial view and dig into the other corner of the Internet. Further, be willing to change your opinion if you find sufficient evidence to do so. 

Third, acknowledge that changing our opinion can be extremely difficult. In The Little Book of Stupidity, Sia Mohajer wrote:

“Research has shown that attempts to “enlighten” believers can be either entirely useless or serve to bolster their current belief systems. This bolstering of belief is often referred to as entrenching. This is the idea that once you have invested mental energy into a habit or belief, you strongly reject any potential contradictory information.”

We, therefore, have to make a conscious effort to realise the challenge we face in changing our opinion.

Final words

“What the human being is best at doing is interpreting all new information so that their prior conclusions remain intact.”

Warren Buffett

Confirmation bias is part of our everyday life. It affects anything from our political views to our religious beliefs to our investing decisions.

The first step to overcoming confirmation bias is to acknowledge that it affects us. Only then can we take active steps to have safeguards to ensure that it does not negatively impact our lives – or in this case our investment 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.

It’s only natural for us to believe that individual investors don’t stand a chance against professional investors. After all, the pros have access to research capabilities, analytical support, and technology that individuals don’t. 

But if you’re an individual investor, you can still beat professional investors at their game. The trick is part patience, and part something else.

Long term investing

In Board Games, Coffee Cans, and Investing, I shared investment manager Robert Kirby’s Coffee Can Portfolio article that was penned in the 1980s. Here’s what I wrote in my piece: 

“In The Coffee Can Portfolio, Kirby shared a personal experience he had with a female client of his in the 1950s. He had been working with this client for 10 years – during which he managed her investment portfolio, jumping in and out of stocks and lightening positions frequently – when her husband passed away suddenly. The client wanted Kirby to handle the stocks she had inherited from her deceased husband. Here’s what happened next, according to Kirby:

“When we received the list of assets, I was amused to find that he had secretly been piggy-backing our recommendations for his wife’s portfolio. Then, when I looked at the total value of the estate, I was also shocked. The husband had applied a small twist of his own to our advice: He paid no attention whatsoever to the sale recommendations. He simply put about $5,000 in every purchase recommendation. Then he would toss the certificate in his safe-deposit box and forget it.

Needless to say, he had an odd-looking portfolio. He owned a number of small holdings with values of less than $2,000. He had several large holdings with values in excess of $100,000. There was one jumbo holding worth over $800,000 that exceeded the total value of his wife’s portfolio and came from a small commitment in a company called Haloid; this later turned out to be a zillion shares of Xerox.”

The revelation that buying and then patiently holding shares of great companies for the long-term had generated vastly superior returns as compared to more active buying-and-selling helped Kirby to form the basis for his Coffee Can Portfolio idea. He explained:

“The Coffee Can portfolio concept harkens back to the Old West, when people put their valuable possessions in a coffee can and kept it under the mattress. That coffee can involved no transaction costs, administrative costs, or any other costs. The success of the program depended entirely on the wisdom and foresight used to select the objects to be placed in the coffee can to begin with.””

The twist

In his article, Kirby also shared how he would use the Coffee Can Portfolio concept to build an actual portfolio. His solution: (1) Select a group of 50 stocks with desirable investment-qualities, (2) buy them all in equal proportions, and then (3) simply hold the shares for a decade or more. Kirby’s reasoning that such a portfolio will do really well has two legs: 

“First, the most that could be lost in any one holding would be 2% of the fund. Second, the most that the portfolio could gain from any one holding would be unlimited.”

But here’s the twist. Kirby did not put his solution into action, even when he thought it was a brilliant idea. There were two big problems. First, Kirby thought that the hurdles involved with assembling a team of investment professionals who can excel in constructing a long-term portfolio is too high to overcome. Second, there was massive career risk for him. “Who is going to buy a product, the value of which will take 10 years to evaluate,” Kirby wrote. 

The latter problem holds the huge edge that individual investors have over professional investors: There is zero career risk. After all, you can’t fire ourselves, can you? This means that individual investors can use the best portfolio management idea they have.

Earlier, I said that the trick to beat professional investors at their game consists of part patience and part something else. The patience bit involves the necessity of investing for the long run. The something else refers to individual investors not having to face career risk.

Stacking the odds

I first came across Kirby’s The Coffee Can Portfolio article a few years ago. I remember I was stunned to learn that Kirby was unable to act on a great investing strategy due to something (the career risk) that was not at all related to the effectiveness of the strategy. Individual investors have the luxury of not having to worry about this.

It is true that professional investors have a certain edge over individual investors in parts of the investing game. But not all hope is lost. Being able to invest for the long-term – a wise investing strategy, I should add – without career risk is a huge advantage that individual investors have over the pros.

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.

David Gardner is the co-founder of The Motley Fool, and he’s one of the best stock market investors I know. 

There’s a fascinating short story involving David that can be found in a 2016 Fool.com article written by Morgan Housel titled Two Short Stories to Put Successful Investing Into Context.

In the article, Morgan shared a conversation he had with David. Once, Morgan spotted David playing video games at the Fool’s office and asked him in jest: “If you had to give up board games, video games, or stocks, which would you quit?” (For context, David is a huge fan of board games.)

David’s response surprised Morgan: He would choose to quit stocks rather than board games or video games. Here’s Morgan recounting David’s brilliant explanation in Two Short Stories to Put Successful Investing Into Context: 

“Games are hands-on by design. They are meant to be played, not left alone.

But a good portfolio can prosper for decades with minimal intervention. A basket of stocks is not a board game with turns and rounds. It’s something that should be mostly hands-off. After a proper allocation is set up, one of the biggest strengths of individual investors is what they don’t do. They don’t trade. They don’t fiddle. They don’t require daily monitoring. They let businesses earn profit and accrue to shareholders in uneven ways. 

David’s point was that he could be happy never touching his investments again, because he currently owns a big, diverse set of companies whose long-term future he’s bullish on.”

David’s response echoes one of my favourite investing articles, The Coffee Can Portfolio, written by investment manager Robert G. Kirby in the 1980s.

In The Coffee Can Portfolio, Kirby shared a personal experience he had with a female client of his in the 1950s. He had been working with this client for 10 years – during which he managed her investment portfolio, jumping in and out of stocks and lightening positions frequently – when her husband passed away suddenly. The client wanted Kirby to handle the stocks she had inherited from her deceased husband. Here’s what happened next, according to Kirby:

“When we received the list of assets, I was amused to find that he had secretly been piggy-backing our recommendations for his wife’s portfolio. Then, when I looked at the total value of the estate, I was also shocked. The husband had applied a small twist of his own to our advice: He paid no attention whatsoever to the sale recommendations. He simply put about $5,000 in every purchase recommendation. Then he would toss the certificate in his safe-deposit box and forget it.

Needless to say, he had an odd-looking portfolio. He owned a number of small holdings with values of less than $2,000. He had several large holdings with values in excess of $100,000. There was one jumbo holding worth over $800,000 that exceeded the total value of his wife’s portfolio and came from a small commitment in a company called Haloid; this later turned out to be a zillion shares of Xerox.”

The revelation that buying and then patiently holding shares of great companies for the long-term had generated vastly superior returns as compared to more active buying-and-selling helped Kirby to form the basis for his Coffee Can Portfolio idea. He explained:

“The Coffee Can portfolio concept harkens back to the Old West, when people put their valuable possessions in a coffee can and kept it under the mattress. That coffee can involved no transaction costs, administrative costs, or any other costs. The success of the program depended entirely on the wisdom and foresight used to select the objects to be placed in the coffee can to begin with.”

Doing nothing is one of the most important actions we can take as stock market investors, and it has served me immensely well. It is also one of the hardest things to do. But I hope those of you reading this article can achieve this. Don’t just do something – sit there!

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.