Category: General Investing

Warren Buffett is one of my investing heroes. 

He’s well known for producing incredible long-term returns at Berkshire Hathaway since assuming leadership of the company in 1965. What is less well-known is that he ran his own investment fund from 1957 to 1969 and achieved a stunning annualised return of 29.5%; the US stock market, in comparison, had gained just 7.4% per year over the same period.

Buffett has given numerous speeches and interviews throughout his long career. My favourite is a 1984 speech he gave titled The Superinvestors of Graham-and-Doddsville. I want to share three great lessons I have from the speech.

On what works in investing

Buffett profiled nine investors (including himself) in the speech. These investors invested very differently. For example, some were widely diversified while others were highly concentrated, and their holdings had no significant overlap. 

There were only two common things among the group. First, they all had phenomenal long-term track records of investment success. Second, they all believed in buying businesses, not tickers. Here’re Buffett’s words:

“The common intellectual theme of the investors from Graham-and-Doddsville is this: they search for discrepancies between the value of a business and the price of small pieces of that business in the market.”

I firmly believe that there are many roads to Rome when it comes to investing in stocks. A great way is to – as Buffett pointed out – look at stocks as part-ownership of a real business. This is what I do too. 

On risk and rewards

I commonly hear that earning high returns in stocks must entail taking on high risks. This is not always true. Buffett commented:

“It’s very important to understand that this group had assumed far less risk than average; note their record in years when the general market was weak.”

A stock becomes risky when its valuation is high. In such an instance, the potential return of the stock is also low because there’s no exploitable gap between the stock’s price and its intrinsic value. On the other hand, a stock becomes less risky when it’s priced low in relation to its intrinsic value; this is also when its potential return is high since there’s a wide exploitable-gap. So instead of “high risk / high return,” I think a better description of how investing works is “low risk / high return.” 

It’s worth noting that a stock’s valuation is not high just because it carries a high price-to-earnings (P/E) or price-to-sales (P/S) ratio. What is more important here is the stock’s future business growth in relation to the ratios. A stock with a high P/E ratio can still be considered to have a low valuation if its business is able to grow significantly faster than average.

On why sound investing principles will always work

Will sharing the ‘secrets’ to investing cause them to fail? Maybe not. This is what Buffett said (emphasis is mine):

“In conclusion, some of the more commercially minded among you may wonder why I am writing this article. Adding many converts to the value approach will perforce narrow the spreads between price and value. I can only tell you that the secret has been out for 50 years, ever since Ben Graham and David Dodd wrote “Security Analysis”, yet I have seen no trend toward value investing in the 35 years I’ve practiced it. There seems to be some perverse human characteristic that likes to make easy things difficult.”

Surprisingly, it seems that human nature itself is what allows sound investing principles to continue working even after they’re widely known. Investing, at its core, is not something difficult – you buy small pieces of businesses at a price lower than their value, and be patient. So let’s not overcomplicate things, for there’s power in simplicity.

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

The S&P 500 index continues to defy gravity even as COVID-19 cases rise in the US. 

Investors whom I’ve been talking to are understandably getting nervous. Will the S&P 500 eventually come crashing down to reflect the recession the world is living in?

Distinguishing the S&P 500 index from the economy

The first thing I want to point out is that the S&P 500 is not an accurate representation of the US economy.

The S&P 500 represents a basket of 500 of the biggest companies listed in the US. Although it may be tempting to assume that this basket of stocks should rise and fall in tandem with the whole economy, reality looks different.

There are 32 million businesses in the US, so the S&P 500 is just a fraction of this. In addition, the S&P 500 is a market-cap-weighted index that is heavily weighted toward just a few big firms such as Apple, Amazon, Alphabet, and Facebook. These mega-cap tech companies have arguably thrived during the COVID-19-induced lockdown.

Amazon, for example, had a big jump in sales due to the need for social distancing. Facebook double-downed on investing its spare cash. With so much cash on their balance sheets, these tech giants can find bargains at a time when other businesses are struggling for cash.

If these mega caps rise in value, it can positively skew the S&P 500.

But should we invest at all-time highs?

Another concern is whether we should invest at all-time high prices? The reality is that the S&P 500 reaching new all-time high prices is actually not that uncommon.

Engaging-data.com has some interesting data related to this topic. Between 1950 to 2019, there were a total of more than 17,000 trading days. Of which, the S&P 500 reached an all-time high on 1,300 days. Interestingly, if you invested on days after the S&P 500 reached all-time highs, you’d be doing just as well as if you invested on any other day.

The chart below compares your returns if you bought at all-time high (ATH) prices vs if you bought at any other time.

If you bought the S&P 500 the day after it hit a new high, your mean return over five years was 53.7%. If you bought on any other time, your mean return was 50.0%. I checked the 10-year return data, and the numbers point to the same conclusion. The mean return after 10 years, if you bought at a high, was 103.2% compared to 114.7% if you bought on all trading days.

The data shows that investing during new market highs, contrary to popular belief, gives you very similar returns to if you invested at any other time.

If this is a market peak?

But what if this market high is a peak and stocks do come crashing down after this? In this case, your returns will most likely not be as good as if you invested before or after the crash. However, that doesn’t mean you will have poor returns per se.

Ben Carlson, a respected financial blogger and wealth manager wrote an insightful piece in 2014 on investing just before a market crash. 

In his article, Carlson wrote about a fictional investor who somehow managed to time his investments at all the worst times over a 40-year period. The investor invested in the S&P 500 just before the crash of 1973, before Black Monday of 1987, at the peak of the tech bubble in 1999, and at the peak before the start of the Great Financial Crisis of 2008.

Though this frictional investor was a terrible market timer, he was a long-term investor and never sold any of his positions. Despite his terrible luck in market timing, he ended up making a 490% return on his investment over his 40-year investing period.

This goes to show that even if you invest just before a crash, stocks tend to rebound and will eventually reach new peaks.

Final Takeaways

There are a few takeaways here:

1. It may be scary to invest in the stock market when it is at an all-time high. It is especially scary when the economy is in a recession, as we are seeing today. However, the S&P 500 is not the economy. 
2. Not all companies have businesses that live or die by the broad economy. Some thrive during times of crisis and investing in these “anti-fragile” companies can pay dividends down the road.
3. Whether the S&P 500 is at an all-time high or not shouldn’t make a difference to a long-term investor. The stock market tends to keep making new highs. 
4. Even if stocks were to fall dramatically tomorrow, if the past is anything to go by, investing in a broad index like the S&P 500 over the long-term will still provide a very decent return over a sufficiently long investing period.

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

A few days ago, I was mucking around with historical data on Alphabet, the parent company of the internet search engine of our time, Google. I found some interesting data on this company that led to me writing this short but hopefully thought-provoking article. 

Alphabet was listed in August 2004 and closed its first trading day at a share price of US$50. By 31 January 2005, Alphabet’s share price had risen to US$98, and it carried an astronomical price-to-earnings ratio of 250. On 31 January 2005, Alphabet’s revenue and profit were respectively US$2.67 billion and US$222 milion, giving rise to a profit margin of 8.3%. 

Today, Alphabet’s share price is US$1,418, which represents an annualised return of 19% from 31 January 2005. Its P/E ratio has shrunk to 29, and the company’s revenue and profit are US$166.7 billion and US$34.5 billion, respectively, which equate to a profit margin of 21%.

Today, many software companies – especially the young ones categorised as software-as-a-service (SaaS) companies – carry really high price-to-sales ratios of 30 or more (let’s call it, 35). Those seem like extreme valuations, especially when we consider that the SaaS companies are mostly loss-making and/or generating negative or meagre free cash flow. If we apply a 10% net profit margin to the SaaS companies, they are trading at an adjusted P/E ratio of 350 (35 / 0.10).

But many of the SaaS companies today – the younger ones especially – have revenues of less than US$2.7 billion, with huge markets to conquer. The mature SaaS companies have even fatter profit margins, relative to Alphabet, of 30% or more today. So, compared to Alphabet’s valuation back then on 31 January 2005, things don’t seem that out-of-whack now for SaaS companies, does it? Of course, the key assumptions here are:

1. The young SaaS companies of today can go on to grow at high rates for a long period of time;
2. The young SaaS companies can indeed become profitable in the future, with a solid profit margin.

Nobody can guarantee these assumptions to be true. But for me, looking at Alphabet’s history and where young SaaS companies are today provides interesting food for thought.

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.

Much ink has been spilt about the great benefits of investing in the stock market. We constantly read about the power of compounding, how investing in stocks can help you beat inflation and the beauty of passive income from dividends.

But there’s a flip side to all this. Stock prices will fall every so often.

The size of the drawdowns can be big and they can happen frequently. It’s inevitable and will always be part and parcel of the stock market. 

That’s what makes long term investing so hard

Fundsmith is the UK’s largest fund by assets under management and also one of the country’s top-performing funds. Its annualised return since inception (from November 2010 to May 2020) is 18.2%, compared to the MSCI World Index’s gain of 11.2% per year.

Its investment philosophy is summed up by three simple but profound investing principles: (1) Buy good companies, (2) Don’t overpay, and (3) Do nothing.

But Fundsmith is quick to point out that though their investment philosophy may sound easy, it is anything but. In fact, Fundsmith says that the most difficult part is following its third principle – doing nothing.

As investors, we are so caught up in the day-to-day commentary about the market that doing nothing to your portfolio is so mentally difficult. One of the reasons why this is so because investors tend to try to avoid pain as much as possible. It’s human nature.

Infants enter the world with a natural instinct to avoid pain. Think of the time you touched a hot surface, and immediately retracted your hand. This is just one example of our bodies reacting to pain. 

In his book Thinking Fast and Slow, Daniel Kahneman refers to our instinct of avoiding pain as System 1 thinking, which is the automatic and fast-thinking part of the brain. But this instinct, though very useful in certain situations, can cause us to make very bad decisions in the stock market. Instead, we should force ourselves to think logically and more in-depth when it comes to investing, using the slow, logical thinking part of the brain- what Kahneman terms System 2.

Our human tendency to avoid pain

In his recent article Same As It Ever Was, Morgan Housel writes: 

“There are several areas of life where the best strategy is to accept a little pain as the cost of admission. But the natural reaction is to say, “No, no, no. I want no pain, none of it.”

The history of the stock market is that it goes up a lot in the long run but falls often in the short run. The falls are painful, but the gains are amazing. Put up with one and you get the other.

Yet a large portion of the investing industry is devoted to avoiding the falls. They forecast when the next 10% or 20% decline will come and sell in anticipation. They’re wrong virtually every time. But they appeal to investors because asking people to just accept the temporary pain of losing 10% or 20% – maybe more once a decade – is unbearable. The majority of investors I know will tell you that you will perform better over time if you simply endure the pain of declines rather than try to avoid them. Still, they try to avoid them.

The upside when you simply accept and endure the pain from market declines is that future declines don’t hurt as bad. You realize it’s just part of the game.”

Opportunities created

Yet, it is this same aversion to pain that creates opportunities in the stock market. My blogging partner, Ser Jing, wrote in an article of his:

“It makes sense for stocks to be volatile. If stocks went up 8% per year like clockwork without volatility, investors will feel safe, and safety leads to risk-taking. In a world where stocks are guaranteed to give 8% per year, the logical response from investors would be to keep buying them, till the point where stocks simply become too expensive to continue returning 8%, or where the system becomes too fragile with debt to handle shocks.”

In other words, the fact that stocks are so volatile is why stocks can continue to produce the kind of long-term returns it has done. Investors are put off by the volatility, which causes stocks to be frequently priced to offer premium returns.

Final words

Investing in the stock market is never going to be a smooth journey. Even investing legends have endured huge drawdowns that have resulted in their net worth moving up and down. Warren Buffett, himself, has seen billions wiped out from his net worth in a day. Yet, his ability to accept this pain and invest for the long-term makes him able to reap the long-term benefits of investing in stocks.

Morgan Housel perhaps summed it up best when he wrote: “Accepting a little pain has huge benefits. But it’ll always be rare, because it hurts.”

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

The three legendary investors I’m talking about here are Warren Buffett, Benjamin Graham, and Shelby Davis. 

Buffett is perhaps the most well-known investor in the world today, so he does not need an introduction. Meanwhile, his late mentor, Benjamin Graham, is revered as the father of the discipline of value investing. The last investor, Davis, is less known. In a recent article, The Greatest Investor You’ve Never Heard Of, I introduced him this way:

“I first learnt about Shelby Cullom Davis sometime in 2012 or 2013. Since then, I’ve realised that he’s seldom mentioned when people talk about the greatest investors. This is a pity, because I think he deserves a spot on the podium alongside the often-mentioned giants such as Warren Buffett, Benjamin Graham, Charlie Munger, and Peter Lynch.

Davis’s story is well-chronicled by John Rothchild in the book, The Davis Dynasty. Davis started his investing career in the US with US$50,000 in 1947. When he passed away in 1994, this sum had ballooned to US$900 million. In a span of 47 years, Davis managed to grow his wealth at a stunning rate of 23% annually by investing in stocks.”

The stock mentioned in the title of this article is GEICO, an auto insurance company that was fully acquired by Buffett’s investment conglomerate, Berkshire Hathaway, in 1995. In 1976, Buffett, Graham, and Davis all owned GEICO’s shares.

The GEICO link

Back in 1975, GEICO was in serious trouble due to then-CEO Ralph Peck’s decision to relax the company’s criteria for offering insurance policies. GEICO’s share price reached a high of US$61 in 1972, but by 1976, the share price had collapsed to US$2. The auto insurer lost US$126 million in 1975 and by 1976, the company had ousted Peck and was teetering on the edge of bankruptcy. Davis and Graham both had invested capital in GEICO way before the problems started and had suffered significant paper losses at the peak of GEICO’s troubles.

 After Jack Byrne became the new CEO of GEICO in 1976, he approached Buffett to come up with a rescue plan. Byrne promised Buffett that GEICO would reinstate stringent rules for offering insurance policies. Buffett recognised the temporal nature of GEICO’s troubles – if Byrne stayed true to his promise. Soon, Buffett started to invest millions in GEICO shares.

The rescue plan involved an offering of GEICO shares which would significantly dilute existing GEICO shareholders. Davis was offended by the offer and did not see how GEICO could ever return to profitability. He promptly sold his shares. It was a decision that Davis regretted till his passing in 1994. This was because Byrne stayed true to his promise and GEICO’s share price eventually rose from US$2 to US$300 before being fully acquired by Berkshire Hathaway.

The GEICO lessons

Davis’s GEICO story fascinated me, and it taught me three important lessons that I want to share.

First, even the best investors can make huge mistakes. Davis’s fortune was built largely through his long-term investments in shares of insurance companies. But he still made a mistake when assessing GEICO’s future, despite having intimate knowledge on the insurance industry. There are many investors who look at the sales made by high profile fund managers and think that they should copy the moves. But the fund managers – even the best ones – can get things wrong. We should come to our own conclusions about the investment merits of any company instead of blindly following authority.

Second, it pays to be an independent thinker. Davis stood by his view on GEICO’s future, even though Graham and Buffett thought otherwise. Davis turned out to be wrong on GEICO. But throughout his career, he prized independent critical thinking and stuck by his own guns.

Third, it is okay to make mistakes in individual ideas in a portfolio. Davis missed GEICO’s massive rebound. In fact, he lost a huge chunk of his investment in GEICO when he sold his shares. But he still earned a tremendous annual return of 23% for 47 years in his portfolio, which provided him and his family with a dynastic fortune. This goes to show that a portfolio can withstand huge mistakes and still be wildly successful if there’s a sound investment process in place. In The Greatest Investor You’ve Never Heard Of, I wrote:

“The secret of Davis’s success is that he started investing with a sound process. He was an admirer of Benjamin Graham, Buffett’s revered investing mentor. Just like Graham, Davis subscribed to the discipline of “value investing”, where investors look at stocks as part-ownership of businesses, and sought to invest in stocks that are selling for less than their true economic worth. Davis’s preference was to invest in growing and profitable companies that carried low price-to-earnings (P/E) ratios. He called his approach the ‘Davis Double Play’ – by investing in growing companies with low P/E ratios, he could benefit from both the growth in the company’s business as well as the expansion of the company’s P/E ratio in the future.

Davis also recognised the importance of having the right behaviour. He ignored market volatility and never gave in to excessive fear or euphoria. He took the long-term approach and stayed invested in his companies for years – even decades, as you’ll see later – through bull and bear markets. Davis’s experience shows that it is a person’s behaviour and investing process that matters in investing, not their age.”

Breaking the rules

There’s actually a bonus lesson I want to share regarding GEICO. This time, it does not involve Davis, but instead, Graham. In Graham’s seminal investing text, The Intelligent Investor, he wrote (emphases are mine): 

“We know very well two partners [Graham was referring to himself and his business partner, Jerome Newman] who spent a good part of their lives handling their own and other people’s funds on Wall Street. Some hard experience taught them it was better to be safe and careful rather than to try to make all the money in the world. They established a rather unique approach to security operations, which combined good profit possibilities with sound values. They avoided anything that appeared overpriced and were rather too quick to dispose of issues that had advanced to levels they deemed no longer attractive. Their portfolio was always well diversified, with more than a hundred different issues represented. In this way they did quite well through many years of ups and downs in the general market; they averaged about 20% per annum on the several millions of capital they had accepted for management, and their clients were well pleased with the results.

In the year [1948] in which the first edition of this book appeared an opportunity was offered to the partners’ fund to purchase a half-interest in a growing enterprise [referring to GEICO]. For some reason the industry did not have Wall Street appeal at the time and the deal had been turned down by quite a few important houses. But the pair was impressed by the company’s possibilities; what was decisive for them was that the price was moderate in relation to current earnings and asset value. The partners went ahead with the acquisition, amounting in dollars to about one-fifth of their fund. They became closely identified with the new business interest, which prospered.

In fact it did so well that the price of its shares advanced to two hundred times or more the price paid for the half-interest. The advance far outstripped the actual growth in profits, and almost from the start the quotation appeared much too high in terms of the partners’ own investment standards. But since they regarded the company as a sort of “family business,” they continued to maintain a substantial ownership of the shares despite the spectacular price rise. A large number of participants in their funds did the same, and they became millionaires through their holding in this one enterprise, plus later-organized affiliates. Ironically enough, the aggregate of profits accruing from this single investment decision far exceeded the sum of all the others realized through 20 years of wide-ranging operations in the partners’ specialized fields, involving much investigation, endless pondering, and countless individual decisions.”

Graham’s investment in GEICO broke all his usual investing rules. When there was usually diversification, he sank 20% of his fund’s capital into GEICO shares. When he usually wanted to buy shares with really cheap valuations, GEICO was bought at a price “much too high in terms of the partners’ own investment standards.” When he usually sold his shares after they appreciated somewhat in price, he held onto GEICO’s shares for an unusually long time and made an unusually huge gain. So the fourth lesson in this article, the bonus, is that we need to know our investing rules well – but we also need to know when to break them.

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.

A few months back, the US Federal Reserve slashed its benchmark interest rates to between 0% and 0.25%. The last time it was this low was in late 2008, during the throes of the Great Financial Crisis. Now, with the near-term economic impact of the COVID-19 crisis still unknown, there’s also the possibility that the benchmark interest rate in the US could move into unprecedented negative territory.

This gives us investors a dilemma. In this low rate environment, should we invest in higher-returning but riskier asset classes, or stick to lower-risk but ultra-low-yielding investments?

The search for higher returns

Interest rates are an important determinant in the long-term returns of most asset classes. In a low-interest-rate environment, corporate bonds and treasuries naturally have low yields. Holding cash is an even less attractive proposition, with bank interest rates almost negligible.

In a bid to get higher returns, stocks may be the best option for investors.

How much is enough?

According to Trading Economics, interest rates in the US had averaged at 5.59% from 1971 to 2020. Meanwhile, the S&P 500 returned approximately 9.3% annually during that time. In other words, investors were willing to invest in stocks to make an additional 4% per year more than the risk-free rate.

This makes sense, given that stocks are also more volatile and are considered a riskier asset. Investors, therefore, will require a return-premium to consider investing in stocks.

But interest rates then were much higher than they are today. With the benchmark interest rate in the US now at 0% to 0.25%, what sort of expected returns must the stock market offer to make it an attractive option?

I can’t speak for everyone but considering the options we have, I think that as in the past 50 years, a 4% spread over the risk-free rate makes stocks sufficiently attractive.

The big question

So that naturally leads us to the next question. Can investing in the S&P 500 index at current prices give me a 4% premium over the current risk-free rate.

Sadly, I don’t have the answer to that. The S&P 500 is a basket of 500 stocks that each have their own risk-reward profile. With so many moving parts, it is difficult to quantify how the index will do over the long run. Similarly, other indexes are difficult to predict too.

However, I know that there are individual companies listed in the global stock markets today that could provide an annual expected return of much more than 4% over the risk-free rate.

By carefully building a portfolio out of such stocks, I think investors can navigate safely through the current low-interest environment and still come up with decent returns over the long term.

A few months ago, my blogging partner, Ser Jing, shared his investment framework that helped him build a portfolio of stocks that compounded at a rate that is meaningfully higher than 4% a year (19% to be exact) from October 2010 to May 2020. 

Using a sound investment framework, such as his, to build a portfolio may be all you need to navigate through this low-interest-rate climate.

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

The glove manufacturing industry has been one of the few beneficiaries of the Covid-19 outbreak. Share prices of glove manufacturers have skyrocketed in the past few months (some are up more than 100%!) with many of them touching record highs earlier this month.

The share price performance is backed by solid business results as shown by the table below.

The four glove manufacturers I’ve studied – Riverstone, Top Glove, Hartalega, and Supermax – have seen sharp increases in revenue. These companies have not only benefited from a rise in sales volumes, but also an increase in the average selling prices of their gloves. The increase in demand has also resulted in their factories operating closer to full capacity, which have resulted in greater economies of scale and fatter margins. 

Growth to continue for the next few quarters

Although the spread of Covid-19 is slowing down in parts of the world, demand for rubber gloves is expected to remain high as authorities place greater emphasis on hygiene and prevent a rapid spread of the virus.

In its earnings results for the quarter ended 31 May 2020, Top Glove said: 

“The Group’s extraordinary performance was attributed to unparalleled growth in Sales Volume, on the back of the global COVID-19 pandemic. Monthly sales orders went up by some 180%, resulting in long lead times, which went up from 40 days to around 400 days, whereby orders placed now would only be delivered over a year later.

However, Top Glove has endeavoured to allocate capacity to as many countries as possible, to ensure its life-saving gloves reach those most in need, while also prioritising its existing customers. It also accommodated requests from various governments of hard-hit countries who approached the Group directly to procure gloves.”

Will the growth last?

The near-term outlook for glove manufacturers looks distinctly positive but the question is: How long will it last?

Based on comments made by Top Glove, the glove manufacturing industry as a whole probably has a large backlog of orders. This will provide them with steady revenue streams and high margins for the next few quarters. However, what happens after this? 

It is likely that this current spike in orders is a one-off occurrence. Some countries are stocking up in case there is a second wave of Covid-19, while others that have yet to feel the full effects of the pandemic are preparing for the worst. But when this blows over, glove demand could fall- maybe not to pre-pandemic levels – but likely below the current unsustainably high levels.

Frothy valuations

As mentioned earlier, glove manufacturers have seen their share prices skyrocket recently.

The table below illustrates the price-to-annualised earnings ratios of the same four glove manufacturers I had mentioned. I used the most recent quarterly earnings to calculate the annualised earnings for these companies.

As you can see, each of these companies have an annualised P/E ratio of close to 30 or higher. Although I understand the optimism surrounding glove manufacturers, to me, their share prices have surged to what seems like rich valuations.

There is also the risk that if demand falls, the glove manufacturers will see average selling prices drop to more normal levels leading to lower gross margins.

I also want to point out that part of the expansion in the glove manufacturers’ profit margins was the lower price of butadiene, a key raw material used in the production of nitrile-based gloves. As glove manufacturers have little control over the price of this commodity, there is an additional risk that if butadiene prices return to previous high levels, profit margins will decline.

Final words

The stars seem to have aligned for glove manufacturers. Not only has demand increased, but gross margins have also been boosted by lower raw material prices. It is also likely that the demand for rubber gloves will continue to be high for an extended period of time. And with the large backlog of orders, glove manufacturers will have their hands full for the next few quarters.

However, there are still risks worth noting. Current fat profit margins may not be sustainable over the longer term. When capacity eventually catches up to demand, average selling prices are likely to fall and margins will normalise. 

On top of that, the glove manufacturers’ share prices have surged to all-time highs and they are currently sitting on extremely rich valuations. To me, it seems that much of the upcoming profit growth of glove manufacturing companies has already been priced in.

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.

When I first started investing, the “deep value” style of investing resonated with me. This style involves buying shares in a company that is trading at a discount to its net cash. It seemed like a sensible thing to do.

Buying a dollar for less than a dollar sounded like a common-sense approach that couldn’t go wrong.

But the net cash is just one aspect of a company. The company could be burning cash at unsustainable rates and destroying shareholder value. In this case, buying said company below its net cash will still turn out to be a bad investment.

Given this, investing in a company should not be based purely on its net cash but on the future cash flows that the company can generate. 

How can a company be worth less than the cash it owns?

This is why I believe that it may even be possible for a company to be worth less than the net cash on its balance sheet.

If a company is burning money every year and management does not make any changes, it will eventually run out of cash. Shareholders will then be left with nothing. In other words, a company with a lot of cash but a terrible business model that does nothing but destroy shareholder value should very reasonably trade less than its net cash. The example below can illustrate my point.

Company ABC has $10 million in cash and no debt. However, it is going to burn cash at a rate of $1 million a year over the next 10 years. How much should this company be worth?

Using the discounted free cash flow method and an 8% discount rate on future cash flows, the company is worth only $3.29 million. That’s a 67% discount to its net cash.

Valuation screens only tell half the story

So how should we apply this to our investment decisions? I think the key takeaway is that we should not base our investment decisions solely on the valuation of a company.

A company may look cheap using traditional valuation metrics, but in reality, it may not be cheap if you take into account the future cash flow of the company.

For example, even the trailing price-to-earnings ratio may not be a good indicator of a company’s cheapness. “Trailing earnings” is a historical figure. John Huber of Saber Capital Management brought up a great point in a recent video interview.

In the past, trailing earnings for many companies were a good guidepost for future earnings. This was why the price-to-earnings multiple was used to value a company.

However, the divergence today between future earnings and past earnings is huge. There are numerous companies being disrupted, while well-run technology companies are building new and rapidly growing markets for themselves. In today’s world, past earnings may not be a good representation of future earnings for many companies anymore.

How to apply this principle?

As investors, our goal is to buy companies at a discount to their real value. But that value can no longer be derived largely from using metrics such as the price-to-book or price-to-trailing earnings ratios. We need to look at the company’s likelihood in generating future free cash flow.

Instead of focusing my energy looking at historical ratios, I try to dig deep into a company’s business, its competitive moat, market opportunity, and the ability of management to grow or at the very least maintain said company’s cash flow. By doing so, I get a better understanding of how much free cash flow a company could generate in the future and the probability it can achieve these projections.

These factors will eventually determine the real value of a company in the long-term, and not its historical earnings nor book value.

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.

Healthy is not the best word to describe the condition of the US right now. 

The US accounts for around 28% of all the COVID-19 cases in the world, despite making up just 4% of the global population. Its economy – the world’s largest – officially entered a recession in February this year, and its current unemployment rate of 13.3% is significantly higher than what it was during the depths of the Great Financial Crisis of 2008-09. The US is also currently in conflict with the world’s second largest economy, China, over multiple issues. Making matters worse for America, the unfortunate death of George Floyd in May while in police custody has sparked large-scale civil unrest across the country over racism.

And yet, the NASDAQ index closed at a record high on 10 June 2020. Meanwhile, the S&P 500 is today just a few percentage points below its record high seen in February 2020 after bouncing more than 37% from its coronavirus-low reached in March. 

This massive disconnect between what’s going on in the streets of America and its stock market has left many questioning the sustainability of the country’s current stock prices. Nobody has a working crystal ball. But I know for sure that this is not the first time the US has stumbled.   

1968 is widely recognised as one of the most turbulent years in the modern history of the US. During the year, the country was in the throes of the Vietnam War, prominent civil rights activist Martin Luther King Jr and presidential hopeful Robert F. Kennedy were both murdered, and massive riots were taking place. It was a dreadful time for America. 

How did the US stock market do? The table below shows the S&P 500’s price and earnings growth with January 1968 as the starting point. I have a few time periods: 1 year; 5 years; 10 years; 20 years; and 30 years. You can see that growth in the earnings and price of US stocks over these timeframes have been fair to good.

The following are charts of the S&P 500’s performance over the same time periods, for a more detailed view:

It’s worth noting too that the S&P 500’s CAPE (cyclically-adjusted price-to-earnings) ratio in January 1968 was 21.5. This means that the rise in US stocks in the time periods we’ve looked at were not driven by a low valuation at the starting point. Today, the S&P 500’s CAPE ratio is 28.5, which is higher, but not too far from where it was in January 1968. (The CAPE ratio divides a stock’s price by its inflation-adjusted 10-year-average earnings)

I’m not trying to say that US stocks will continue to rise from here. A new bear market may start tonight, for all I know. I’m just trying to show two things.

First, stocks can rise even when the world seems to be falling apart. What we’re seeing today – the huge disconnect between Main Street and Wall Street – is not unique. It has happened before. In fact, I’ve written about similar episodes that occurred in 1907 and 2009. Second, we should approach the future with humility. Let’s assume we can travel back in time to the start of 1968. If I told you then about the mess the US would be entering, would you have guessed that, with a starting CAPE ratio of 21.5, US stocks would be (a) 11% higher a year later and (b) 46% higher five years later? Be honest.

No one knows what’s going to happen next. All past crashes look like opportunities, but every future one seems like a risk. There are also always reasons to sell. The best way we can deal with an uncertain future in our investing activities is to adopt a long time horizon, and have a sound investment process in place.

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.