The late economist Hyman Minsky has an excellent framework for understanding why market crashes are bound to happen from time to time.
It’s an understatement to say that stocks have been volatile of late. This is what the S&P 500 in the US has done since last Monday:
24 Feb 2020: -3.4%
25 Feb 2020: -3.0%
26 Feb 2020: -0.4%
27 Feb 2020: -4.4%
28 Feb 2020: -0.8%
2 Mar 2020: +4.6%
3 Mar 2020: -2.8%
4 Mar 2020: 4.2%
And at the time of writing (10:00 pm, 5 Mar 2020 in Singapore), the S&P 500 is down by 2.8%. Deutsche Bank analyst Torsten Slok said last Friday that the speed of the S&P 500’s decline “is historic.” Many are surprised by the ferocity of the recent fall in US stocks.
It’s oh so common
Given the current state of affairs, I think it’s an apt time as any to revisit an important fact about stocks: Declines and volatility are common. I wrote recently:
“Between 1928 and 2013, the S&P 500 has, on average, fallen by 10% once every 11 months; 20% every two years; 30% every decade; and 50% two to three times per century.”
At this point, some of you may be wondering: Why are market crashes so common? This is what I want to discuss in this article too. For an answer, we’ll need to turn to the late Hyman Minsky.
Stability is destabilising
Minsky was an economist. He wasn’t well known when he was alive, but his views on why an economy goes through boom-bust cycles are thought-provoking and gained prominence after the 2008-2009 financial crisis.
In essence, Minsky theorised that for an economy, stability itself is destabilising. I first learnt about him, and how his ideas can be extended to the stock market, a few years ago after coming across a Motley Fool article written by Morgan Housel. Here’s how Housel describes Minsky’s framework:
“Whether it’s stocks not crashing or the economy going a long time without a recession, stability makes people feel safe. And when people feel safe, they take more risk, like going into debt or buying more stocks.
It pretty much has to be this way. If there was no volatility, and we knew stocks went up 8% every year [the long-run average annual return for the U.S. stock market], the only rational response would be to pay more for them, until they were expensive enough to return less than 8%. It would be crazy for this not to happen, because no rational person would hold cash in the bank if they were guaranteed a higher return in stocks. If we had a 100% guarantee that stocks would return 8% a year, people would bid prices up until they returned the same amount as FDIC-insured savings accounts, which is about 0%.
But there are no guarantees—only the perception of guarantees. Bad stuff happens, and when stocks are priced for perfection, a mere sniff of bad news will send them plunging.”
In other words, great fundamentals in the stock market (stability) can cause investors to take risky actions, such as pushing valuations toward the sky or using plenty of leverage. This plants the seeds for a future downturn to come (the creation of instability).
Why bother?
Some of you may now be thinking: if stocks are prone to exhibit boom-bust behaviour, why bother at all with long-term investing? Because of this:
I mentioned earlier that US stocks had frequently crashed from 1928 to 2013. The chart just above shows how the US market performed over the same period after adjusting for dividends and inflation. It turns out that the S&P 500 gained 21,000%, or 6.5% per year. Remember, that’s a 6.5% annual return, after inflation, for 85 years. Sharp short-term declines were seen, but there’s a huge long-term gain at the end.
Then there’s also this:
Source: S&P Global Market Intelligence
The US e-commerce giant Amazon (which is in my family’s investment portfolio) was a massive long-term winner from 1997 to 2018, with its share price rising by more than 76,000% from US$1.96 to US$1,501.97. But in the same timeframe, Amazon’s share price also experienced a double-digit top-to-bottom fall in every single year (the declines ranged from 13% to 83%). Again, sharp short-term declines were seen, but there’s a huge long-term gain at the end.
Missing the good times
Here’s another thought some of you may now have (I’m not psychic, trust me!): Why can’t we just side-step all the big downward moves and invest when the clouds have cleared? Wouldn’t this make the whole investing experience more comfortable?
Yes, you may be more comfortable, but you’re very likely going to earn much lower returns.
Dimensional Fund Advisors, a fund management company with more than US$600 billion in assets under management, shared the following stats in an article:
$1,000 invested in US stocks in 1970 would become $138,908 by August 2019
Miss just the 25 best days in the market, and the $1,000 would grow to just $32,763
So, missing just a handful of the market’s best days will absolutely decimate our return. Unfortunately, the market’s best and worst days tend to cluster, as seen in the table below from investor Ben Carlson. As a result, it’s practically impossible to side-step the bad days and capture only the good days. To earn good returns in stocks over the long run, we have to accept the inevitable bad times.
Source: Ben Carlson
Don’t be scared
Markets will crash from time to time. It’s something we have to get used to. Wharton finance professor Jeremy Siegel once said that “volatility scares enough people out of the market to generate superior returns for those who stay in.” So don’t be scared. And please don’t attempt to flit in and out of your shares – patience is what ends up paying in investing.
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.
DKAM Capital Ideas Fund may not be that well-known in this part of the world. However its 17.2% annual return since 2008 is definitely worthy of attention.
Actively-managed funds have had a bad reputation in recent years. High fees and poor performance have resulted in the outflow of money from active funds to passive funds. But that’s not to say that there are no active funds that can outperform the market.
DKAM Capital Ideas Fund, run by Donville Kent Asset Management, is one such fund. From its inception in 2008 to 31 January 2020, the North American-focused fund has delivered a compound annul return of 17.2%, compared to the S&P 500’s 11.7%.
For a fund, even outpacing its relevant index by a few percentage points can be hugely rewarding for its investors. This can be seen in the huge difference between DKAM Capital Ideas Fund’s total return and the S&P 500’s. Cumulatively, the fund’s total return since inception is 503.7%, compared to the S&P 500’s 251.9% over the same 12-year period.
With such an impressive track record of growing shareholder wealth, I decided to take a look at some of DKAM Capital Ideas Fund’s materials to see what is the secret behind its success.
It looks for compounders
Some funds invest in “value stocks” and wait for these stocks to rise to their true value before selling. While this is a decent strategy, it requires active management of capital once these “value stocks” hit what the fund managers believe is their true value.
DKAM Capital Ideas Fund, on the other hand, invests in true compounders. Compounders are companies that can grow their value multiple-fold over the long term. True compounders have much higher upside potential and investors need not move in and out of positions to reap the gains.
A broad approach to screening
To look for these compounders, DKAM Capital Ideas Fund uses a broad approach to screening and idea generation.
The first step the fund manager takes is to screen for companies that have a high return on equity, typically more than 15%. A high return on equity suggests that a company is making good use of its shareholders’ equity to generate returns.
On top of that, the fund manager also sources for potential new ideas through the use of other basic screens, communication with industry contacts, the media, and publications.
This broad approach to idea generation has enabled the fund to unearth lesser-known companies.
For instance, as of 31 January 2020, 25 of DKAM Capital Ideas Fund’s positions are not in any major indices.
Long-short but with with a bias towards long
As a long-short fund, DKAM Capital Ideas Fund goes both “long” and “short” equities. (To go long means to invest in stocks with the view that they will appreciate in price; to go short means to invest in stocks with the view that they will decline in price.) The table below shows the fund’s exposure as of January 2020.
The short position covers some of the market’s downside risk while the long position is able to leverage up due to hedges from the shorts.
But overall, the net exposure of the fund is still 100.5% long.
DKAM Capital Ideas Fund short strategy is based on factor analysis and consists of companies that are essentially an inverse of its investment framework.
Bias toward small caps
Donville Kent Asset Management also believes that the small caps universe provide a unique opportunity.
Companies with small market capitalisations are less well-known and hence may have a good risk-reward profile. In a recent article, the fund noted that the top-performing stocks in Canada over the past decade started with an average market cap of C$796 million in 2009. The article explained:
“This is definitely on the small side and many of these stocks would not have met the minimum size requirements for most investors in 2009. We think this is where a lot of the opportunities are, hence why it is important to be open to investing in small companies. Every big company was at one point a small company. Looking back over the trajectories of these companies over the last 10 years shows that strong growth is definitely possible.”
The Good Investors’ view
DKAM Capital Ideas Fund is a fund that stands out in an industry that is gaining a bad reputation in recent years. Its long-term performance is driven by an approach that has enabled them to find gems that other investors have yet to uncover.
If you wish to read more of their investing insights, you can head to the ROE Reporter (the name of its newsletter) segment of the fund’s website.
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.
First, Li Lu’s views on China’s economy are worth paying attention to. Many of you likely don’t know who he is, but he’s an excellent investor in China. I have never been able to find Li’s investment track record, but one piece of information that I’ve known for years convinces me of his brilliance: Charlie Munger’s an investor in Li’s fund, and Munger has nothing but praise for it. Munger himself is an incredible investor with a well-documented track record, and he’s the long-time right-hand man of Warren Buffett. In a May 2019 interview with The Wall Street Journal, Munger talked about Li:
“There are different ways to hunt, just like different places to fish. And that’s investing.
And knowing that, of course, one of the tricks is knowing where to fish. Li Lu [of Himalaya Capital Management LLC in Seattle] has made an absolute fortune as an investor using Graham’s training to look for deeper values. But if he had done it any place other than China and Korea, his record wouldn’t be as good. He fished where the fish were. There were a lot of wonderful, strong companies at very cheap prices over there…
…Now, so far, Li Lu’s record [at Himalaya] is just as good with a lot of money as it was with very little. But that is a miracle. It’s no accident that the only outside manager I’ve ever hired is Li Lu. So I’m now batting 1.000. If I try it one more time, I know what will happen. My record will go to hell. [Laughter.]”
Second, I think Li’s essay contains thought-provoking insights from him and Koo on the economic future of the Western world, Japan, and China. These insights are worth sharing with a wider audience. But they are presented in Mandarin, and there are many investors who have little or no knowledge of the language. I am fortunate to have sufficient proficiency in Mandarin to be able to grasp the content (though it was still painful to do the translation!), so I want to pay it forward. This also brings me to the third reason.
Google’s browser, Google Chrome, has a function to automatically translate Li’s Mandarin essay into English. But the translation is not the best and I spotted many areas for improvement.
Before I get to my translation, I want to stress again that it is my own self-directed attempt. So all mistakes in it are my sole responsibility. I hope I’ve managed to capture Li Lu’s ideas well. I’m happy to receive feedback about my translation. Feel free to leave a comment in this post, or email me at thegoodinvestors@gmail.com.
Translation of Li Lu’s essay
This year, the book I want to recommend to everyone is The Great Recession Era: The Other Half of Macroeconomics and The Fate of Globalisation, written by Gu Chao Ming.
The book discusses the biggest problems the world is currently facing. First: Monetary policy. In today’s environment, essentially all the major economies of today – such as Japan, the US, Europe, and China – are oversupplying currencies. The oversupply of these base currencies has reached astronomical levels, resulting in the global phenomena of low interest rates, zero interest rates, and even negative interest rates (in the case of the Eurozone). These phenomena have never happened in history. At the same time, the increase in the currency supply has contributed very little to economic growth. Except for the US, the economies of most of the developed nations have experienced minimal or zero growth. Another consequence of this situation is that each country’s debt level relative to its GDP is increasing; concurrently, prices of all assets, from stocks to bonds, and even real estate, are at historical highs. How long will this abnormal monetary phenomenon last? How will it end? What does it mean for global asset prices when it ends? No one has the answers, but practically all of our wealth is tied to these issues.
Second: Globalisation. The fates of many countries, each at different stages of development, have been intertwined because of the rising trend of globalisation over the past few decades. But global trade and capital flows are completely separate from the monetary and fiscal policies that are individually implemented in each country. There are two consequences to this issue. Firstly, significant conflicts have developed between globalisation and global capital flows on one end, and each country’s economic and domestic policies on the other. Secondly, international relations are increasingly strained. For instance, we’re currently witnessing an escalation of the trade conflict between the US and China. There’s also rising domestic unrest – particularly political protests on the streets – in many parts of the world, from Hong Kong to Paris and Chile. At the same time, far-left and far-right political factions are increasingly dominating the political scene of these countries at the expense of more moderate parties, leading to heightened uncertainties in the world. Under these circumstances, no one can predict the future for global trade and capital flows.
Third: How should each country’s macroeconomic and fiscal policies respond to the above international trends? Should there be differences in the policies for each country depending on the stage of development they are at?
The three problems are some of the most pressing issues the world is facing today. The ability to answer even just one of them will probably be an incredible scholarly achievement – to simultaneously answer all three of them is practically impossible. In his book, Gu Chao Ming provided convincing perspectives, basic concepts, and a theoretical framework with sound internal logic for dealing with the three big problems. I can’t really say that Gu has given us answers to the problems. But at the very least, he provides inspiration for us to think through them. His theories are deeply thought-provoking, whether you agree with them or not.
Now let’s talk about the author, Gu Chao Ming [Richard C. Koo]. He is the Chief Economist of Nomura Research Institute and has had a strong influence on the Japanese government over the past 30 years. I first heard of him tens of years ago, at a YPO international conference held in Japan. He delivered a keynote speech at the event, explaining Japan’s then “lost decade” (it’s now probably a “lost two decades” or even “lost three deacdes”). Gu Chao Ming explained the various economic phenomena that appeared in Japan after its bubble burst. These include zero economic growth, an oversupply of currency, zero interest rates, massive government deficit, high debt, and more. The West has many different views on the causes for Japan’s experience, but a common thread is that they resulted from the failure of Japan’s macroeconomic policies.
Gu Chao Ming was the first to provide a completely opposite viewpoint that was also convincing. He introduced his unique and new economic concept: A balance sheet recession. After the bursting of Japan’s asset-price bubble, the balance sheet of the Japanese private sector (businesses and households) switched from rapid expansion to a mode of rapid contraction – he attributed Japan’s economic recession to the switch. Gu provided a unique view, that driving the balance sheet recession was a radical change in the fundamental goal of the entire Japanese private sector from maximising profits to minimising debts. In such an environment, the first thing the private sector and individuals will do when they receive money is not to invest and expand business activities, but to repay debt – it does not matter how much currency is issued by the government. The sharp decline in Japanese asset prices at that time placed the entire Japanese private sector and households into a state of technical bankruptcy. Because of this, what they had to do, and the way they repaired their balance sheets, was to keep saving and paying off their debts. This scenario inevitably caused a large-scale contraction in the economy. The Japanese experience is similar to the US economic crisis in the 1930s. Once the economy begins to shrink, a vicious cycle forms to accelerate the downward momentum. During the Great Depression in the 1930s, the entire US economy shrank by nearly 46% within a few years.
The Japanese government dealt with the problem by issuing currency on a large scale, and then borrowing heavily to make direct infrastructure investments to digest the massive savings of Japanese residents. Through this solution, the Japanese government managed to maintain the economy at the same level for decades. There’s no growth, but the economy has not declined either. In Gu Chao Ming’s view, the Japan government’s macroeconomic policies were the only right choices. The policies prevented the Japanese economy from experiencing the 46% decline in economic activity that the US did in the 1930s. At the same time, the Japanese private sector was given the time needed to slowly repair their balance sheets. This is why Japan’s private sector and households have gradually returned to normalcy today. Of course, there was a price to pay – the Japanese government’s own balance sheet was hurt badly. Japanese government debt is the highest in the world today. Nonetheless, the Japanese government’s policies were the best option compared to the other choices. At that time, that was the most unique view on Japan that I had come across. Subsequently, my observations on Japan’s economy have also confirmed his ideas to a certain extent.
The Western world was always critical of Japan’s policies. Their stance on Japan started to change only after they encountered the Great Recession of 2008-2009. This is because the Western world’s experience during the Great Recession was very similar to what Japan went through in the late 1980s after its big asset-bubble burst. At the time, prices of major assets in the West were falling sharply, leading to technical bankruptcy for the entire private sector – this was why the subsequent experience for the West was eerily similar to Japan’s. To deal with the problem, the main policy implemented by the key Western countries was the large-scale issuance of currency, and they did so without any form of prior agreement. At the time, the experience of the Great Depression of the 1930s was the main influence on the actions of the central banks in the West. The consensus among the economic fraternity after evaluating the policies implemented to handle the Great Depression of the 1930s was based predominantly on Milton Friedman’s views, that major mistakes were made in monetary policies in that era. Ben Bernanke, the chairperson of the US Federal Reserve in 2008, is a strong proponent of this view. In fact, Bernanke thinks that distributing money from helicopters is an acceptable course of action in extreme circumstances. Consequently, Western governments started issuing currency at a large scale to deal with the 2008 crisis. But the currency issuance did not lead to the intended effect of a rapid recovery in economic growth. The money received by the private sector was being saved and used to repay debts. This is why economic growth remains sluggish. In fact, the economy of the Eurozone is bordering on zero growth; in the US economy, there are only pockets of weak growth.
The first response by Western governments to the problem is to continue with their large-scale currency issuance. Western central banks have even invented a new way to do so: Quantitative easing (QE). Traditionally, central banks have regulated the money supply by adjusting reserves (the most important component of a base currency). After implementing QE, the US Federal Reserve’s excess reserves have grown to 12.5 times the statutory amount. The major central banks in the West have followed the US’s lead in implementing QE, resulting in the selfsame ratio reaching 9.6 times in the Eurozone, 15.3 times in the UK, 30.5 times in Switzerland, and 32.5 times in Japan! In other words, under normal economic conditions, inflation could reach a similar magnitude (for example, 1,250% in the US) if the private sector could effectively deploy newly issued currency. Put another way, if the newly issued currency were invested in assets, it could lead to asset prices rising manifold to reach bubble levels or provide strong stimulus to GDP growth.
But the reality is that economic growth is anaemic while prices for certain assets have been rising. The greatest consequence of this policy is that interest rates are close to zero. In fact, the Eurozone has around US$15 trillion worth of debt with negative rates today. This has caused questions to be raised about the fundamental assumptions underpinning the entire capitalistic market system. At the same time, it has also not produced the hoped-for economic growth. Right now, the situation in Europe is starting to resemble what Japan experienced back then. People are starting to rethink the episode in Japan. Interest in Gu Chao Ming’s viewpoints on Japan and its fiscal policies are being reignited in the important Western countries.
Gu Chao Ming used a relatively simple framework to explain the phenomena in Japan. He said that an economy will always be in one of the following four regimes, depending on the actions of savers and investors:
Under normal circumstances, an economy should have savers as well as borrowers/investors. This places the economy in a positive state of growth. When an ordinary economic crisis arrives, savers tend to run out of capital but borrowers and investing opportunities are still present. In this scenario, it’s crucial that a central bank plays the role of supplier of capital of the last resort. This viewpoint – of the central bank having to be the lender and supplier of capital of the last resort – is the conclusion that the economic fraternity has from studying the Great Depression of the 1930s. Central banks provide the capital, which is then lent to the private sector.
But nobody thought about what happens to an economy when the third and fourth regimes appear. These regimes are unprecedented and characterised by the absence of borrowers (investors). For instance, there have been savers in Japan for the past few decades, but the private sector has no motivation to borrow for investments. What can be done in this case? In the 2008-2009 crisis, there were no savers as well as borrowers in the Western economies. Savers were already absent when the crisis happened. In the US, the private sector was mired in a state of technical bankruptcy because asset prices were falling heavily while there were essentially no savers. At the same time, there were no investment opportunities in Europe. Even after a few rounds of QE and the massive supply of base currencies, nobody was willing to invest – there were simply no opportunities to invest in the economy. When people got hold of capital, they in essence returned the capital to banks via negative interest rates. This situation was unprecedented.
The key contributions to the body of economic knowledge by Gu Chao Ming’s framework relates to a better understanding of what happens in the third and fourth regimes where borrowers are absent. Let’s take Japan for example. It is in the third regime, where there are savers but no borrowers. He thinks that the Japanese government should take up the mantle of being the borrower of last resort in this situation and use fiscal policy to conduct direct investments. A failure to do so will lead to a contraction in the economy, since the private sector is unwilling to borrow. And once the economy contracts, a vicious cycle will form, potentially causing widespread unemployment and economic activity to decline by half. The societal consequences are unthinkable. We know that Hitler’s rise to power in the 1930s and a revival in Japanese militarism in the same era both had direct links to the economic depression prevalent back then.
The fourth regime, one where savers and borrowers are both absent, describes the 2008-2009 crisis. When a fourth regime arises, the government should assume the roles of both provider of capital of last resort, and borrower of last resort. In the US during the 2008-2009 crisis, the Federal Reserve issued currency while the Treasury department used the TARP (Troubled Asset Relief Program) Act to directly inject capital into systematically important commercial and investment banks. The actions of both the Fed and the Treasury stabilised the economy by simultaneously solving the problems of a lack of savers and borrowers. Till this day, Western Europe is possibly still trapped in the third or maybe even the fourth regime. There are no savers or borrowers. Structural issues in the Eurozone make matters worse. Countries in the Eurozone can only make use of monetary policy, since they – especially the countries in Southern Europe – are restricted from using fiscal policy to boost domestic demand. These constraints within Europe could lead to catastrophic consequences in the future.
Gu Chao Ming used the aforementioned framework to analyse the unique problems facing the global economy today (the appearance of the third and fourth regimes). He also provided his own views on the current economic policies of developed nations.
He considered the following questions: Why did both Western Europe and the US lumber toward asset bubbles? In addition, why were they unable to discover the path that leads to a return to growth (the US did return to growth, but it is anaemic) after their asset bubbles burst? To answer these questions, Gu Chao Ming provided what I think is his second unique perspective, which is meaningful for the China of today. He shared that an economy will have three different stages of development under the backdrop of globalised trade.
Let me first introduce an important concept in development economics – the Lewis Turning Point. In the early days of urban industrialisation, surplus rural workers are constantly attracted by it. But as industrialisation progresses to a certain scale, the surplus of workers in the rural areas now becomes a shortage, leading to the economy entering a state of full employment. This is the Lewis Turning Point, which was first articulated by British economist W. Arthur Lewis in the 1950s.
Gu Chao Ming’s first stage of development refers to the early days of urban industrialisation, before the Lewis Turning Point is reached. The second stage happens when the economy has moved past the Lewis Turning Point and is in a phase where savings, investments, and consumption are all in a state of intertwined growth. This is also known as the Golden Era. In the third stage of development – a unique stage that Gu Chao Ming brought up – the economy enters a state of being chased, after it passes a mature growth phase and becomes an advanced economy. Why does this happen? That’s because investing overseas in developing countries becomes more advantageous as the cost of domestic production reaches a certain level. In the earlier days, the advantages of investing overseas in developing countries are not clear because of cultural and institutional obstacles. But as domestic production costs rises to a certain height, while other countries are simultaneously strengthening their infrastructure to absorb foreign investments, it becomes significantly more attractive to invest overseas compared to domestically. At this point, capital stops being invested in the country, and domestic wages start to stagnate.
In the first stage of development (the pre-Lewis Turning Point phase), owners of capital have absolute control. This is because rural areas are still supplying plenty of labour, and so the labour force is generally in a weak position to bargain and does not have much pricing power. Companies tend to exploit workers when there are many people looking for work.
In the second stage of development (when the economy is past the Lewis Turning Point and enters a mature growth phase), companies need to rely on investing in productivity to raise their output. At the same time, companies need to satisfy the demands of the labour force, such as increasing their wages, improving their working environment, providing them with better equipment, and more. In this stage, economic growth will lead to higher wages, because shortages are starting to appear in the labour supply. A positive cycle will form, where a rise in wages will lead to higher consumption levels, driving savings and investments higher, and ultimately higher profits for companies. During the second stage, nearly every member of society can enjoy the fruits of economic development. Meanwhile, a consumer society led by the middle class will be formed. Living standards for each level in society are improving – wages are rising even for people with low education levels. This is why the second stage of development is also known as the Golden Era.
Changes in society start to appear in the third stage of development. For the labour force, only those in highly-skilled roles (such as in science and technology, finance, and trade etc.) will continue to receive good returns from their jobs. Wages in traditional manufacturing jobs that require low levels of education will gradually decline. Wealth-inequality in society will widen. Domestic economic and investment conditions will deteriorate, and investors will increasingly look to foreign shores for opportunities. At this juncture, GDP growth will rely on continuous improvements in technology. Countries that excel in this area (like the US for example) will continue to enjoy GDP growth, albeit at a low pace; countries with a weaker ability to innovate (such as Europe and Japan) will experience poor economic growth, and investments will shift toward foreign or speculative opportunities.
Gu Chao Ming thinks that the Western economies had entered the third stage of development in the 1970s. Back then, they were being chased mainly by Japan and Asia’s Four Dragons. Fast forward to the 1980s and China had started to open itself to the international economy while Japan entered the phase of being chased. While being chased, a country’s domestic economic growth opportunities tend to decrease sharply. At the same time, any pockets of economic growth tend to form into frothy bubbles. It was the case in Japan, the US, and Western Europe. Capital flowed into real estate, stocks, bonds, and financial derivatives, forming massive bubbles and their subsequent bursting. Even after a bubble bursts, the country’s economic growth opportunities and potential remain extremely limited. As a result, the economy’s ultimate goal shifts from maximising profits to minimising liabilities. That’s because on one hand, the private sector has nowhere to invest domestically, while on the other, it wants to repair its balance sheet. In this way, predictions that are based on traditional economic theories will fail.
Gu Chao Ming pointed out that the functions of a government’s macro policies should change depending on what stage of development the economy is at. And so, different policy tools are needed. This view has meaningful implications for China today.
In the early phases of industrialisation, economic growth will rely heavily on manufacturing, exports, and the formation of capital etc. At this juncture, the government’s fiscal policies can play a huge role. Through fiscal policies, the government can gather scarce resources and invest them into basic infrastructure, resources, and export-related services etc. These help emerging countries to industrialise rapidly. Nearly every country that was in this stage of development saw their governments implement policies that promote active governmental support.
In the second stage of development, the twin engines of economic growth are rising wages and consumer spending. The economy is already in a state of full employment, so an increase in wages in any sector or field will inevitably lead to higher wages in other areas. Rising wages lead to higher spending and savings, and companies will use these savings to invest in productivity to improve output. In turn, profits will grow, leading to companies having an even stronger ability to raise wages to attract labour. All these combine to create a positive feedback loop of economic growth. Such growth comes mainly from internal sources in the domestic economy. Entrepreneurs, personal and household investing behaviour, and consumer spending patterns are the decisive players in promoting economic growth, since they are able to nimbly grasp business opportunities in the shifting economic landscape. Monetary policies are the most effective tool in this phase, compared to fiscal policies, for a few reasons. First, fiscal policies and private-sector investing both tap on a finite pool of savings. Second, conflicts could arise between the private sector’s investing activities and the government’s if poorly thought-out fiscal policies are implemented, leading to unnecessary competition for resources and opportunities.
When an economy reaches the third stage of development (the stage where it’s being chased), fiscal policy regains its importance. At this stage, domestic savings are high, but the private sector is unwilling to invest domestically because the investing environment has deteriorated – domestic opportunities have dwindled, and investors can get better returns from investing overseas. The government should step in at this juncture, like what Japan did, and invest heavily in infrastructure, education, basic research and more. The returns are not high. But the government-led investments can make up for the lack of private-sector investments and the lack of consumer-spending because of excessive savings. In this way, the government can protect employment in society and prevent the formation of a vicious cycle of a decline in GDP. In contrast, monetary policy is largely ineffective in the third stage.
For China’s current development, discussions on the use of macro policies are particularly meaningful. Although there are different viewpoints, the general consensus is that China had passed the Lewis Turning Point a few years ago and entered a mature growth phase. Over the past decade, we’ve seen accelerating growth in the level of wages, consumer spending, savings, and investments. But even when an economy has entered a new stage of development, the economic policies that were in place for the previous stage of development – and that have worked well – tend to remain for some time. The lag in the formulation and implementation of new policies that are more appropriate for the current stage of development comes from the inertia inherent in government bodies. This mismatch between macro policies and the stage of development the economy is at has happened in all countries and stages. For instance, Western economies are still stuck with macro policies that are more appropriate for the Golden Era (fiscal policy). Actual data show that the current policies in the West have worked poorly. Today, many Western countries (including Japan) are issuing currencies on a large scale and have zero or even negative interest rates. But even so, these countries are still facing extremely low inflation and slow economic growth while debt levels are soaring.
In the same vein, China’s government is still relying heavily on policies that are appropriate for the first stage of development even when the country’s economy has grown beyond the Lewis Turning Point. In the past few years, we have seen a series of measures for economic reforms. Their intentions are noble, meant to fix issues that have resulted from the industrialisation and manufacturing boom that occured in the previous development stage. But in practice, the reform measures have led to the closures and bankruptcies of private enterprises on a large scale. So from an objective standpoint, the reform measures have, at some level, produced the phenomenon of an advance in the state’s fortunes, but a decline for the private sector. More importantly, it has hurt the confidence of private enterprises and caused a certain degree of societal turmoil and loss of consumer-confidence. All of these have lowered the potential for economic growth in this stage.
Today, net exports contribute negatively to China’s GDP growth while consumption has a share of 70% to 80%. Private consumption is particularly important within the consumption category, and will be the key driver for China’s future economic growth. In the Golden Era, the crucial players are entrepreneurs and individual consumers. The focus and starting point for all policies should be on the following: (1) strengthening the confidence of entrepreneurs; (2) establishing market rules that are cleaner, fairer, and more standardised; (3) reducing the control that the government has over the economy; and (4) lowering taxes and economic burdens. Monetary policy will play a crucial role at this juncture, based on the experiences of many other developed countries during their respective Golden Eras.
During the first stage of development, China’s main financial policy system was based on an indirect financing model. It’s almost a form of forced savings on a large scale, and relied on government-controlled banks to distribute capital (also at a large scale) at low interest rates to manufacturing, infrastructure, exports and other industries that were important to China’s national interests. This financial policy was successful in helping China to industrialise rapidly.
At the second stage of development, the main focus should be this: How can society’s financing direction and methods be changed from one of indirect financing in the first stage to one of direct financing, so that entrepreneurs and individual consumers have the chance to play the key borrower role? We’ve seen such changes happen to some extent in the past few years. For instance, the area of consumer credit has started developing with the help of fintech. There are still questions worth pondering for the long run, such as whether property mortgages can be done better to unleash the potential for secondary mortgages. During this stage, some of the most important tools in macro policy include: Increasing the proportion of direct financing in the system; enhancing the stock market’s ability to provide financing for private enterprises; and establishing bond and equity markets. In addition, the biggest tests for the macro policies are whether the government can further reduce its power in the economy and switch its role from directing the economy to supporting and servicing it.
Over the past few years, the actual results of China’s macro policies have been poor despite the initial good intentions when they were implemented. This is because the policies were simply administrative means. The observation of the economic characteristics of China’s second stage of development also gives us new perspectives and lessons. During the Golden Era of the second stage of development, some policies could possibly have better results if they were adjusted spontaneously by market forces. In contrast, directed intervention may do more harm than good. These are the most important subjects for China today.
Currently, Japan, Western Europe and the US are all in the third stage of development while China is in the second. This means that China’s potential for future growth is still strong. China’s GDP per capita of around US$10,000 is still a cost-advantage for developed nations in the West. At the same time, other emerging countries (such as India) have yet to form any systemic competitive advantages. It’s possible for China to remain in the Golden Era for an extended period of time. China’s GDP per capita is around US$10,000 today, but there are already more than 100 million people in the country that have a per-capita GDP of over US$20,000. These people mainly reside in the southeast coastal cities of the country. China actually does not require cutting-edge technology to help its GDP per capita make the leap from US$10,000 to US$20,000 – all it needs is to allow the living standards and lifestyles of the people in the southeast coastal cities to spread inward throughout the country. The main driver for consumption growth is the “neighbour effect” – I too want for myself what others eat and possess. Information on the lifestyles of the 100 million people in China’s southeast coastal cities can be easily disseminated to the rest of the country’s 1 billion-plus population through the use of TV, the internet, and other forms of media. In this way, China’s GDP per capita can reach US$20,000.
In the years to come, the level of China’s wages, savings, investments, and consumption will all increase and create a positive cycle of growth. Investment opportunities in the country will also remain excellent. Attempts to unleash the growth potential in China’s economy would benefit greatly if China’s government can learn from the monetary policies of the Western nations when they were in their respective Golden Eras, and make some adjustments to the relationship between itself and the market. Meanwhile, Western nations (especially Western Europe) could learn from the positive experiences of the fiscal policies of Japan and China, and allow the government to assume the role of borrower of last resort and invest in infrastructure, education, and basic research at an even larger scale. Doing so will help developed nations in the West to maintain economic growth while they are in the third stage of development (of being chased).
The idea of adjusting policies and tools as the economy enters different stages of development is a huge contribution to the world’s body of economic knowledge. Economics is not physics – there are no everlasting axioms and theories. Economics requires the study of constantly-changing economic phenomena in real life to bring forth the best policies for each period. From this viewpoint, the theoretical framework found in Gu Chao Ming’s book is a breakthrough for economic research.
Earlier, I mentioned three big questions that the world is facing today and that the book is trying to answer. They are the most intractable and pressing issues, and it is unlikely that there will be perfect answers. Gu Chao Ming has a deep understanding of Japan, so the views found in his book stem from his knowledge of the country’s economic history. But is Japan’s experience really applicable for Europe and the US? This remains to be seen. QE, currency oversupply, zero and negative interest rates, high asset prices, wealth inequality, the rise of populist politics – these phenomena that arose from developed countries will continue to plague policy makers and ordinary citizens in all countries for a long period of time.
For China, it has passed the Lewis Turning Point and is in the Golden Era. The economic policies (particularly the fiscal policies) implemented by Japan and other developed countries in the West during their respective Golden Eras represent a rich library of experience for China to learn from. It’s possible for China to unleash its massive inherent economic growth potential during this Golden Era, so long as its policymakers know clearly what stage of development the country is at, and make the appropriate policy adjustments. China’s future is still promising.
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.
Fears related to the coronavirus (COVID-19) have caused stocks to fall. Economies are also at risk of facing a recession. What should investors do?
Stock markets around the world have fallen in recent times. For instance, the S&P 500 in the US was down by 6.6% from last Friday (21 February 2020) to Wednesday (26 February 2020). At our home in Singapore, the Straits Times Index has declined by 5.1% from 17 January 2020 to 26 February 2020.
I hate to attach reasons to short-term market moves. But this time, it’s pretty clear that fears related to COVID-19, the most recently discovered coronavirus that has infected humans on a large scale, are the culprits.
What scares us
These fears exist for good reasons – there could be a global economic downturn in the works. Already, businesses of many large companies around the world have been affected by COVID-19. In the US, these include Apple, Microsoft, and Booking Holdings (which is in my family’s investment portfolio) just to name a few. In Singapore, property giant CapitaLand, airline caterer SATS, and even Temasek Holdings (one of the Singapore government’s investment arms), have enacted pay cuts because of difficult business conditions.
Plenty of human suffering have happened because of COVID-19, and sadly no one knows how widespread the disease outbreak will be. And from an investing angle, I don’t think anyone knows the eventual effects that COVID-19 will have on the global economy and financial markets (you should run from anyone who claims he/she does!).
Lessons from the past
History is not, and will never be, a perfect guide for the future. But in an uncertain time like this, studying the past can give us context and soothe our nerves.
I’m looking mostly at the US stock market and economy, since there is good long-term data for me to work with.
The chart below shows all the recessions (the dark grey bars) in the US since 1871. You can see that recessions in the country – from whatever causes – have been regular occurrences even in relatively modern times. They are par for the course, even for a mighty economy like the US.
The following logarithmic chart shows the performance of the S&P 500 (including dividends) from January 1871 to February 2020. It turns out that US stocks have done exceedingly well over the past 149 years (up 46,459,412% in total including dividends, or 9.2% per year) despite the US economy having encountered numerous recessions. If you’re investing for the long run, recessions can hurt over the short-term, but they’re nothing to fear.
Source: Robert Shiller data; National Bureau of Economic Research
Having an idea of how often stocks have fallen – for whatever reasons – is also useful to put the current mini-meltdown in stocks into perspective. Between 1928 and 2013, the S&P 500 has, on average, fallen by 10% once every 11 months; 20% every two years; 30% every decade; and 50% two to three times per century. Over the same period, US stocks have climbed by 283,282% (including dividends), or 9.8% per year. Stocks frequently decline hard even while they’re in the process of earning good long-term returns for investors. So when stocks fall, it’s not a sign that something is broken – it’s just a natural part of the game.
It’s worth noting too that global stocks have registered solid long-term gains despite multiple occurrences of deadly disease outbreaks in the past. This is shown in the following chart:
Some of you might be thinking: Now that there’s a heightened risk of a global recession, should we try to time the stock market? I don’t think so. Why? Look at the chart below. The red line shows the return we could have earned from 1980 to today in the US stock market if we had sold stocks at the official start of a recession in the country and bought stocks at the official end. The black line illustrates our return if we had simply bought and held US stocks from 1980 to today. It turns out that completely side-stepping recessions harms our return significantly, so it could be better to stayinvested for the long run.
This does not mean we should stay invested blindly. Companies that currently are heavily in debt, and/or have shaky cash flows and weak revenue streams are likely to run into severe problems if there’s an economic downturn. If a global recession really happens, and our portfolios are full of such companies, we may never recover. It’s always a good time to re-evaluate the companies in our portfolios, but I think there’s even more urgency to do so now.
A sage’s wise words
I want to leave the final words in this article to Warren Buffett. In an interview with CNBC earlier this week, the Oracle of Omaha shared his thoughts on how investors ought to be dealing with COVID-19. He said (emphasis is mine):
“Look, the tariff situation was a big question market for all kinds of companies. And still is to some degree. But that was front and center for a while. Now coronavirus is front and center. Something else will be front and center six months from now and a year from now and two years from now. Real question is — where are these businesses gonna be five and ten and 20 years from now? Some of them will do sensationally, some of them will disappear. And overall I think America will do very well — you know, it has since 1776…
…We’ve got a big investment in airline businesses and I just heard even more flights are canceled and all that. But flights are canceled for weather. It so happens in this case they’re gonna be canceled for longer because of coronavirus. But if you own airlines for 10 or 20 years you’re gonna have some ups and down in current. And some of them will be weather related and they can be all kinds of things. The real question is you know, how many passengers are they gonna be carrying 10 years from now and 15 years from now and what will margins be and– what will the competitive position be? But I still look at the figures all the time — I’ll admit that…
…[Coronavirus] makes no difference in our investments. There’s always gonna be some news, good or bad, every day. In fact, if you go back and read all the papers for the last 50 years, probably most of the headlines tend to be bad. But if you look at what happens to the economy, most of the things that happen are extremely good. I mean, it’s incredible what will happen over time. So if somebody came and told me that the global growth rate was gonna be down 1% instead of 1/10th of a percent, I’d still buy stocks if I liked the price at which — and I like the prices better today than I liked them last Friday…
… We’re buying businesses to own for 20 or 30 years. We buy them in whole, we buy them in part. They’re called stocks when we buy in part. And we think the 20- and 30-year outlook is not changed by coronavirus.”
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.
ARK Innovation ETF has an annualised return of 21.7% since its inception in 2015, far outpacing the S&P 500. Here are some things we can learn from it.
ARK Innovation ETF is an actively managed exchange-traded fund run by ARK that focuses on US stocks. As of December 2019, the tech-focused fund boasts a 21.7% annualised return since its inception in late 2014, making it one of the top-performing funds globally. Its performance is also well ahead of its comparative benchmark, the S&P 500, which returned just 11.7% annualised over the same time frame.
So how did ARK Innovation ETF do it?
I took a look at some of the blog posts from ARK’s investing team and its investing principals to find out what is driving the ARK Innovation ETF’s market-beating performance.
It invests for the long-term
Benjamin Graham was one of the pioneers of long-term investing. He once said that “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
What this means is that stocks can get mispriced in the stock market simply because of the whims of investors. Over the long run, though, a stock will tend to gravitate towards its true value.
ARK invests with this principle in mind. It explains:
“The market easily can be distracted by short-term price movements, losing focus on the long-term effect of disruptive technologies. We believe there is a time arbitrage ARK can take advantage of. We seek opportunities that offer growth over 3-5 years that the market ignores or underestimates.”
It doesn’t mind going against the grain
ARK is not your typical Wall Street fund manager. In fact, many of its views go against the traditional beliefs of Wall Street.
For example, Wall Street often likes to categorise different types of innovation. But ARK believes that innovation “cannot be boxed into sectors, geographies or market caps.”
It also doesn’t mind having vastly different opinions from the rest. For instance, ARK is famous for being one of the most bullish funds about Tesla, which is also one of the most heavily shorted stocks in the market today.
It goes big on high-conviction stocks
A truly exceptional opportunity does not come around often. And Charlie Munger is famous for saying that the important thing when you find one is to “use a shovel, not a teaspoon.”
I think ARK abides by the principle, betting big on stocks that it believes in.
For instance, 10% of ARK Innovation ETF’s portfolio is in Tesla. ARK is one of the vocal supporters of Elon Musk’s brainchild. So far, the concentrated position has worked well for ARK with Tesla’s stock price up four-fold over the past five years and nearly doubling so far this year.
Open-source approach to research
Instead of relying solely on its own in-house research, ARK is open to new ideas from the public. It frequently publishes its research and encourages readers to provide more insight and comments. ARK believes that its “open research ecosystem allows for an organised exchange of insights between portfolio managers, director of research, analysts and external sources”.
The Good Investors’ conclusion
ARK’s unique approach has certainly worked well for it. The ARK Innovation ETF is now one of the top-performing and most respected funds in the market.
I also have a feeling that year ARK Innovation ETF will extend its winning streak in 2020 due to the recent surge in Tesla’s share price.
Investors who want to learn more about ARK’s research can head here.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.
Hint: The US market’s rise may not have much to do with the frequently-heard accusations of the Federal Reserve artificially inflating stock prices.
Since the start of 2010, the US stock market – as measured by the S&P 500 – has nearly tripled, from 1,124 points to more than 3,300. This meteoric rise in US stock prices has prompted plenty of commentary within the investment community on its underlying drivers.
A frequent “culprit” cited is the Federal Reserve in the US. Many investors and market commentators have blamed the US central bank for driving stock prices higher because of its interest rate policy (of keeping rates low) and quantitative easing (the act of pumping money into the economy via the purchase of mostly government-related financial assets).
The chart above is plotted with data from Nobel Prize-winning economist, Robert Shiller. It shows changes in the S&P 500’s price, dividends, and earnings since the start of 2010. Over the past decade, all three numbers have basically increased hand-in-hand. Put another way, the meteoric rise in the S&P 500 I mentioned earlier could be explained by a similarly big jump in the fundamentals of American businesses.
I was inspired to plot my chart after I came across the following tweet by Morgan Housel, one of my favourite finance writers:
Housel’s chart showed that the S&P 500’s price and its dividends have climbed in lock-step since 2010. This suggests that the US market had been driven higher because of improvements in its underlying business fundamentals. But I was curious to know if the increase in dividends is sustainable. This is why I plotted my own chart which included earnings growth. Turns out, there has been a commensurate increase in earnings for the US market. The S&P 500 has done what Warren Buffett wrote in his 2018 Berkshire Hathaway shareholders’ letter:
“On occasion, a ridiculously-high purchase price for a given stock will cause a splendid business to become a poor investment – if not permanently, at least for a painfully long period. Over time, however, investment performance converges with business performance.”
None of the above is meant to say that the S&P 500 will continue climbing over the next year, or the next 10 years. Over the short run, sentiment can change on a dime; a rise in investors’ pessimism over the future – whether warranted or unwarranted – will drag stock prices lower. Over the long run, if the rise in earnings for US businesses in the past was unsustainable, then there could be a collapse in the S&P 500 in the future.
But what we do know now is that there is a very good reason why US stocks prices have grown so much over the past decade – their businesses have done very well too.
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 investors think that it’s easy to figure out when stocks will hit a peak. But it’s actually really tough to tell when a bear market would happen.
Here’s a common misconception I’ve noticed that investors have about the stock market: They think that it’s easy to figure out when stocks will hit a peak. Unfortunately, that’s not an easy task at all.
In a 2017 Bloomberg article, investor Ben Carlson showed the level of various financial data that were found at the start of each of the 15 bear markets that US stocks have experienced since World War II:
The financial data that Carlson presented include valuations for US stocks (the trailing P/E ratio, the cyclically adjusted P/E ratio, and the dividend yield), interest rates (the 10 year treasury yield), and the inflation rate. These are major things that the financial media and many investors pay attention to. (The cyclically-adjusted P/E ratio is calculated by dividing a stock’s price with the 10-year average of its inflation-adjusted earnings.)
But these numbers are not useful in helping us determine when stocks will peak. Bear markets have started when valuations, interest rates, and inflation were high as well as low. This is why it’s so tough to tell when stocks will fall.
None of the above is meant to say that we should ignore valuations or other important financial data. For instance, the starting valuation for stocks does have a heavy say on their eventual long-term return. This is shown in the chart below. It uses data from economist Robert Shiller on the S&P 500 from 1871 to 2019 and shows the returns of the index against its starting valuation for 10-year holding periods. It’s clear that the S&P 500 has historically produced higher returns when it was cheap compared to when it was expensive.
But even then, the dispersion in 10-year returns for the S&P 500 can be huge for a given valuation level. Right now, the S&P 500 has a cyclically-adjusted P/E ratio of around 31. The table below shows the 10-year annual returns that the index has historically produced whenever it had a CAPE ratio of more than 25.
If it’s so hard for us to tell when bear markets will occur, what can we do as investors? It’s simple: We can stay invested. Despite the occurrence of numerous bear markets since World War II, the US stock market has still increased by 228,417% (after dividends) from 1945 to 2019. That’s a solid return of 11.0% per year. Yes, bear markets will hurt psychologically. But we can lessen the pain significantly if we think of them as an admission fee for worthwhile long-term returns instead of a fine by the market-gods.
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.
There are six investing mindsets that have helped me in my activities in the stock market, both on a personal as well as professional basis.
Having a good framework to find investment opportunities in the stock market is important. But it’s equally important – perhaps even more important – to have the right mindsets. Without them, it’s hard to be a successful investor even if you have the best analytical mind in the world of finance.
There are six key mindsets that have served me well in my investing activities in the stock market, both on a personal as well as professional basis. I want to share them in this article.
The first mindset
Here’s a chart showing the maximum peak-to-trough decline for Amazon’s share price in each year from 1997 to 2018:
Source: S&P Global Market Intelligence
It turns out that Amazon’s share price had experienced a double-digit top-to-bottom fall (ranging from 13% to 83%) in every single year from 1997 to 2018. Looks horrible, doesn’t it?
Now here’s a chart showing Amazon’s share price from 1997 to 2018:
Source: S&P Global Market Intelligence
The second chart makes it clear that Amazon has been a massive long-term winner, with its share price rising by more than 76,000% from US$1.96 in 1997 to US$1,501.97 in 2018. Amazon does not look so horrible now, does it?
The experience of the e-commerce giant is why Peter Lynch, the legendary fund manager of Fidelity Magellan Fund, once said:
“In the stock market, the most important organ is the stomach. It’s not the brain.”
We need the stomach to withstand volatility, the violent ups-and-downs of share prices. As Amazon has shown, even the best long-term winners in the stock market have suffered from sharp short-term declines.
This is why accepting that volatility in share prices is a feature of the stock market and not a bug isa very important mindset for me. When stocks go up and down, it’s not a sign that something is broken. In fact, there’s actually great data to prove that volatility in share prices do not tell us much about how the underlying businesses are doing.
Robert Shiller is an economist who won the Nobel Prize in 2013. In the 1980s, Shiller looked at how the US stock market performed from 1871 to 1979. He compared the market’s actual performance to how it should have rationally performed if investors had hindsight knowledge of how the dividends of US stocks would change. Here’s the chart Shiller plotted from his research:
The solid black line is the stock market’s actual performance while the black dashed line is the rational performance. The fundamentals of American businesses – using dividends as a proxy – was much less volatile than American share prices.
The second mindset
We cannot run from the fact that we humans are emotional creatures. When share prices fall – even with the knowledge that volatility is merely a feature in the stock market – it hurts. And when it hurts, that’s when we make stupid mistakes.
From 1977 to 1990, Peter Lynch earned an annual return of 29% for Fidelity Magellan Fund, turning every thousand dollars invested with him into $27,000. It is this performance that made Lynch a legend in the investing business. But shockingly, the average investor in his fund made only 7% per year – $1,000 invested with an annual return of 7% for 13 years would become just $2,400.
In his book Heads I Win, Tails I Win, Spencer Jakab, a financial journalist with The Wall Street Journal, explained why this big performance-gap happened:
“During his tenure Lynch trounced the market overall and beat it in most years, racking up a 29 percent annualized return. But Lynch himself pointed out a fly in the ointment.
He calculated that the average investor in his fund made only around 7 percent during the same period. When he would have a setback, for example, the money would flow out of the fund through redemptions. Then when he got back on track it would flow back in, having missed the recovery.”
In essence, investors in Fidelity Magellan Fund had bought high and sold low. That’s a recipe for poor returns, born out of our emotional reactions to the stock market’s volatility.
I think there’s a great way for us to frame how we think about volatility so that we can minimise its damage. This was articulated brilliantly by Morgan Housel in a recent blog post of his (emphasis his):
“But a reason declines hurt and scare so many investors off is because they think of them as fines. You’re not supposed to get fined. You’re supposed to make decisions that preempt and avoid fines. Traffic fines and IRS fines mean you did something wrong and deserve to be punished. The natural response for anyone who watches their wealth decline and views that drop as a fine is to avoid future fines.
But if you view volatility as a fee, things look different.
Disneyland tickets cost $100. But you get an awesome day with your kids you’ll never forget. Last year more than 18 million people thought that fee was worth paying. Few felt the $100 paid was a punishment or a fine. The worthwhile tradeoff of fees is obvious when it’s clear you’re paying one.
Same with investing, where volatility is almost always a fee, not a fine.
Returns are never free. They demand you pay a price, like any other product. And since market returns can be not just great but sensational over time, the fee is high. Declines, crashes, panics, manias, recessions, depressions.”
This is why my second mindset is this: Instead of seeing short-term volatility in the stock market as a fine, think of it as a fee for something worthwhile – great long-term returns.
You might be thinking: Is the fee really worth paying? We saw the case of Amazon earlier, where the fee was definitely worth it. Thing is, the point I made about Amazon can actually be applied to the broader US market too.
A few years ago, Housel wrote an article for The Motley Fool that showed how often the US stock market – represented by the S&P 500 – had fallen by a certain percentage from 1928 to 2013. Here’re the results:
It’s clear that US stocks have declined frequently. But data from Robert Shiller also showed that the S&P 500 was up by around 21,000% from 1928 to 2013 after factoring in dividends and inflation. That means every $1,000 invested in the S&P 500 in 1928 would become $210,000 in 2013 after inflation. The S&P 500 has charged investors an expensive entry fee (in the form of volatility) for a magical show.
Source: Robert Shiller data
The third mindset
A common misconception I encounter about the stock market is that what goes up must come down. Yes it’s true that there’s cyclicality with stocks. But an important point is missed: Stocks go up a lot more than they go down. We’ve seen that with Amazon and with the S&P 500. Now let’s see it with stocks all over the world.
Source: Credit Suisse Global Investment Returns Yearbook 2014
The chart above plots the returns of the stock markets from both developed and developing economies over more than 110 years from 1900 to 2013. In that timeframe, stocks in developed economies (the blue line) produced an annual return of 8.3% while stocks in developing economies (the red line) generated a return of 7.4% per year. There are clearly bumps along the way, but the long run trend is crystal clear.
So the third key mindset I have when investing in the stock market is that what goes up, does not always come down permanently. But there is an important caveat to note: Diversification is crucial.
The fourth mindset
Devastation from war or natural disasters. Corrupt or useless leaders. Incredible overvaluation at the starting point. These are factors that can cause a single stock or a single country’s stock market to do poorly even after decades.
We can study a company’s or country’s traits to understand things like valuations and the quality of the leaders. But there’s pretty much nothing we can do when it comes to catastrophes caused by mankind or Mother Nature.
This is why my fourth mindset is the importance of diversifying our investments across both geographies and companies.
The fifth mindset
We’re living in uncertain times. Toward the end of 2019, China alerted the World Health Organisation (WHO) about cases of pneumonia amongst its citizens that were caused by an unknown virus. That was the start of what we know today as COVID-19. Many countries in the world – including our home in Singapore – are currently battling to keep their citizens safe from the disease. When faced with uncertainty, should we still invest?
How do you think the US stock market will fare over the next five years and the next 30 years if I tell you that in this year, the price of oil will spike, and the US will simultaneously go to war in the Middle East and experience a recession? We don’t need to guess, because history has shown us.
The events I mentioned all happened in 1990. The price of oil spiked in August 1990, the same month that the US went into an actual war in the Middle East. In July 1990, the US entered a recession. Turns out, the S&P 500 was up by nearly 80% from the start of 1990 to the end of 1995, including dividends and after inflation. From the start of 1990 to the end of 2019, US stocks were up by nearly 800%.
What’s also fascinating is that the world saw multiple crises in every single year from 1990 to 2019, as the table below – constructed partially from Morgan Housel’s data – illustrates. Yet, the S&P 500 has steadily marched higher.
Earlier, I talked about COVID-19. I think it would be appropriate to also show how global stocks have done after the occurence of deadly epidemics.
My blogging partner, Jeremy, included the chart just above in a recent article. It illustrates the performance of the MSCI World Index (a benchmark for global stocks) since the 1970s against the backdrop of multiple epidemics/pandemics that have happened since. He commented:
“As you can see from the chart… the world has experienced 13 different epidemics since the 1970s. Yet, global stocks – measured by the MSCI World Index – has survived each of those, registering long term gains after each outbreak.”
So I carry this important mindset with me (the fifth one): Uncertainty is always around, but that does not mean we should not invest.
The sixth mindset
We’ve seen in the data that market crashes and recessions are bound to happen periodically. But crucially we don’t know when they will occur. Even the best investors have tried to outguess the market, only to fail.
So if we’re investing for many years, we should count on things to get ugly a few times, at least. This is completely different from saying “the US will have a recession in the third quarter of 2020” and then positioning our investment portfolios to fit this view.
The difference between expecting and predicting lies in our behaviour. If we merely expect downturns to happen from time to time while knowing we have no predictive power, our investment portfolios would be built to be able to handle a wide range of outcomes. On the other hand, if we’re engaged in the dark arts of prediction, 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 only in a narrow range of situations – if things take a different path, our portfolios will be on the road to ruin.
Here’s an interesting thought: If we can just somehow time our stock market entries and exits to coincide with the end/start of recessions, surely we can do better than just staying invested, right?
The chart below is from investor Michael Batnick. The red line shows the return we could have earned from 1980 to today in the US stock market if we had sold stocks at the official start of a recession in the country and bought stocks at the official end. The black line illustrates our return if we had simply bought and held US stocks from 1980 to today. It turns out that completely side-stepping recessions harms our return significantly.
This is why my sixth mindset is that we should expect bad things to happen from time to time, but we should not try to predict them.
In conclusion
To recap, here are the six mindsets that have been very useful for me:
First, volatility in stocks is a feature, not a sign that something is broken
Second, think of short-term volatility in the stock market as a fee, not a fine
Third, what goes up does not always come down permanently
Fourth, it is important to diversify across geographies and companies
Fifth, uncertainty is always around, but we should still invest
Sixth, we should expect bad things to happen from time to time in the financial markets, but we shouldn’t try to predict them
They have helped me to be psychologically comfortable when investing. Without them, I may become flustered when things do not go my way temporarily or when uncertainties are rife. This could in turn result in bad investing behaviour on my part. I hope these mindsets can benefit you too.
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 life and investing principles of Warren Buffett are laid bare in the book “Tap dancing to Work”. Here are some of the best bits from the book.
I recently read the book Tap Dancing to Work. Compiled by Carol Loomis, Tap Dancing to Work is a collection of articles published on Fortune magazine between 1966 and 2012 that are on Warren Buffett or authored by himself.
Even though some of these articles were penned more than 50 years ago, they hold insights that are still relevant today. With that, here’s a collection of some of my favourite quotes from the book.
On why buying mediocre companies at a cheap price is not ideal
“Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original ‘bargain’ probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces- never is there just one cockroach in the kitchen.
Second, any initial advantage you secure will be quickly eroded by the low returns that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realise a high return. But the investment will disappoint if the business is sold for $10 million in 10 years and in the interim has annually earned and distributed only a few percents on cost. Time is the friend of the wonderful business, the enemy of the mediocre.”
In his 1989 annual letter to Berkshire Hathaway shareholders, Buffett outlined some of the mistakes he made over his first 25 years at the helm of the company. One of those mistakes was buying control of Berkshire itself. At that time, and being trained by Ben Graham, Buffett thought that buying a company for a cheap price would end up being a good investment.
However, such bargain-priced stocks may take years to eventually trade at their liquidation value. This can result in very mediocre returns, even after paying a seemingly low price for the company and its assets.
Buffett later reasoned that “it’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
On why Berkshire does not leverage more
“In retrospect, it is clear that significantly higher, though still conventional, leverage ratios at Berkshire would have produced considerably better returns on equity than the 23.8% we have actually average. Even in 1965, we could have judge there to be a 99% probability that higher leverage would lead to nothing but good. Correspondingly, we might have seen only a 1% chance that some shock factor, external or internal, would cause a conventional debt ratio to produce a result falling somewhere between temporary anguish and default.
We wouldn’t have liked those 99:1 odds- and never will. A small chance of distress or disgrace cannot, in our view, be offset by a large chance of extra returns. If your actions are sensible, you are certain to get good results; in most such cases, leverage just moves things along faster.”
It is often tempting to invest on margin (in other words, borrowing to invest) as it can accelerate your gains. However, using leverage to invest can also result in distress and bankruptcy, both for the individual investor and companies alike.
Take the 2008 crisis for instance. The S&P 500 – the US’s stock market benchmark – lost approximately 50% of its value. An investor who invested on a 50% margin would have faced a margin call and his entire portfolio would be wiped out.
Although cases like this are infrequent, as Buffett believes, it is always better to err on the side caution.
On the simple economics of valuing a financial asset
“A financial asset means, by definition, that you lay out money now to get money back in the future. If every financial asset was valued properly, they would all sell at a price that reflected all of the cash that would be received from them forever until judgement day, discounted back to the present at the same interest rate.”
In 1998, Buffett and Bill Gates spoke at the University of Washington, answering any questions that students threw at them. One of the students questioned whether the traditional way of valuing companies was still relevant at that time.
Buffett’s simple method of valuation can be applied to any financial asset. For a stock, it involves coming up with a prediction of the company’s future free cash flows and discounting them back to the present. This simple method of valuation is the ideal method of valuing a stock and is still used by numerous investors today.
On risk
“The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the popularity- the reasoned probability- of that investment causing its owner a loss of purchasing power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see (he goes on to describe gold), a nonfluctuating asset can be laden by risk.”
In his 2011 Berkshire letter to shareholders, Buffett addressed the topic of risk. Investors are often concerned about the possibility of making a paper loss in their investments.
However, volatility should not be misconstrued as risk. Buffett instead defines risk as the chance of suffering a permanent loss or the inability of the investment to produce meaningful growth in purchasing power.
On being thankful and giving back…
Buffett is not just a brilliant investor but also a terrific human being. His humility and generosity are clearly demonstrated by his philanthropic pledge to donate 99% of his wealth to charity.
“My luck was accentuated by my living in a market system that sometimes produces distorted results, though overall it serves our country well. I’ve worked in an economy that rewards someone who saves the lives of others on a battlefield with a medal, rewards a great teacher with thank-you notes from parents, but rewards those who can detect mispricings of securities with sums reaching into the billions. In short, fate’s distribution of long straws is wildly capricious.
The reaction of my family and me to our extraordinary good fortune is not guilt, but rather gratitude. Were we to use more than 1% of my claim checks on ourselves, neither our happiness nor our well-being would be enhanced. In contrast, the remaining 99% can have a huge effect on the health and welfare of others. That reality sets an obvious course for me and my family. Keep all we can conceivably need and distribute the rest to society, for its needs. My pledge starts us down that course.”
The Good Investors’ Conclusion
Tap Dancing to Work is a priceless collection of articles describing Warren Buffett as a person, a business owner, and an investor. The articles that Warren Buffett penned himself, many of them excerpts from his own annual Berkshire shareholders’ letters, hold immense insights into the global economy and investing. There are many more insights in the book and I encourage all Buffett fans to find the time to read it.
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.
Good capital allocation is the key to compounding shareholder wealth. Here are some ways a company can use capital and how investors should assess them.
Capital allocation is one of the most important decisions a company’s leaders have to make. Good capital allocation will enable the company to grow profits and maximise shareholder returns.
In this article, I will share what are some common uses of capital and how I assess whether management has made good capital allocation decisions.
The different uses of capital
I will start of by describing some of the ways that companies can make use of their financial resources.
1. Reinvesting for organic growth
First, companies can invest their capital to expand the business. This can take multiple forms. For instance, a restaurant chain can spend money opening new stores, while a glove manufacturer may spend cash increasing its annual production capacity. Companies can also spend on research and development for new products or improving an existing product.
A company should, however, only spend on organic growth when there are opportunities to expand its business at good rates of return.
2. Acquisitions and mergers
Big companies with substantial financial strength might decide to acquire a smaller company. An acquisition can help a company by (1) removing a competitor, (2) gaining intellectual property and technology, (3) achieving vertical integration, or (4) increasing its market share and presence.
Ultimately, acquisitions should lead to long-term financial gain for the company and shareholders.
3. Pay off debt
Another way that a company can use its financial resources is to pay down existing debt. This is most effective when interest rates on its debt are high and paying off the debt provides a decent rate of savings.
This is true for a company that has taken on a lot of debt to grow and needs to reduce its debt burden to keep its cost of capital low. Reducing overly high leverage may also be necessary for a company to survive an economic crisis.
4. Share buybacks
A company can also choose to buy back its own shares in the open market. This reduces the number of outstanding shares. What this does is that it increases the size of the pie that each shareholder owns. Share buybacks can create shareholder value if the stocks are bought back below the true value of the company.
5. Pay dividends
Lastly, a company may choose to reward shareholders by returning the excess cash it has to shareholders as dividends. A company may also pay a dividend if there’s no other effective way to use its cash; in such an instance, returning cash may be more beneficial for a company’s shareholders than it hoarding cash.
What’s the best way to use its financial resources?
With so many different ways for a company to use cash, how do investors tell if management is making the best use of a company’s resources to maximise shareholder returns?
Unfortunately, there is no one-size-fits-all solution. Shareholders need to assess manager-decisions individually to see if each makes sense.
That being said, there is one useful metric that investors can use to gauge roughly how well capital has been allocated. That is the return on equity (ROE).
A firm that has been making good capital allocation decisions will be able to maintain a high ROE over the long term. It is also important to see that the company’s shareholder equity is growing, rather than being stagnant (a stagnant shareholder equity implies that a company is simply returning capital to shareholders).
Facebook is an example of a company that has been using its capital effectively to grow its business. The social network’s ROE has grown from 9% in 2015 to 28% in 2018. Furthermore, even after accounting for a US$5 billion fine, Facebook still managed to post a 20% ROE in 2019, demonstrating how efficiently the company is at maximising its resources. Facebook’s high ROE is made even more impressive given that the company has no debt and has not paid a dividend yet.
The best capital allocator
While we are on the subject, I think it is an appropriate time to pay tribute to one of the best capital allocators of all time- Warren Buffett. He has compounded the book value per share of his company, Berkshire Hathaway, at 18.7% per year from 1965 to 2018.
That translates to a 1,099,899% increase in book value per share over a 53-year time frame.
If you invest in Berkshire, you are not merely investing in a business. You are also banking on one of the best money managers of the past half-century.
Buffett’s success in picking great investments to grow Berkshire’s book value per share has, in turn, led to the company becoming one of the best-performing stocks of the last half-century in the US.
The Good Investors’ conclusion
Too often, investors overlook the importance of companies having good capital allocators at the helm. Unfortunately, Singapore is home to numerous listed companies that seem to consistently make poor capital allocation decisions.
These decisions have led to poor returns on equity and in turn, stagnant stock prices. It is one of the reasons why some stocks in Singapore trade at seemingly low valuation multiples.
Knowing this, instead of merely focusing on the business, investors should put more emphasis on the manager’s ability and how capital is being allocated in a 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.
