Category: General Investing

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..

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!

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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. 

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.

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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. 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.

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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. 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.