Category: General Investing

If you thought that professional investors can easily beat an unmanaged basket of stocks, think again.

According to an article on CNBC, 64.49% of large-cap funds lagged the S&P 500 in 2018. It marked the ninth consecutive year that actively managed funds trailed the broad US-market index.

Over a 10-year period, 85% of large-cap funds underperformed the S&P 500. Over 15 years, that figure increases to 92%.

Given how such few funds consistently beat the market, I tend to take notice when one does.

Two funds, in particular, have caught my eye. They are the Fundsmith Equity Fund and the Mawer Global Equity Fund. Both funds have global investment mandates and have beaten their respective indexes by a wide margin.

Fundsmith has an impressive annualised return of 18.3% as of 31 October 2019 since its inception nine years ago. It is well ahead of the annualised 11.7% return of the global equities market. 

The Mawer Global Equity Fund has also done really well since its inception in 2009. As of 30 September, it has a compounded annual return of 13.1%, compared to an 11.4% return from the global equity benchmark.

So what is the secret behind their success? 

Low portfolio turnover

Needless to say, careful selection of high-quality stocks is one of the key ingredients to their success. 

But another thing that stands out is that both Fundsmith and Mawer Global Equity Fund have extremely low portfolio turnover. Portfolio turnover is a way to measure the average holding period for a stock in a fund.

In 2018, Fundsmith and the Mawer Global Equity Fund had an annualised portfolio turnover of 13.4% and 16% respectively. In essence, that means the average holding period for stocks in their portfolios was more than 6 years each.

So why is this important? Terry Smith, founder and manager of Fundsmith, explained in his annual letter to shareholders that a low portfolio turnover “helps to minimise costs and minimising the costs of investment is vital contribution to achieving a satisfactory outcome as an investor.”

Besides reducing the costs of transactions, staying invested in high-quality stocks gives investors the opportunity to participate in the immense compounding effect of the stock market. 

Morgan Housel, currently a partner in Collaborative Fund, wrote in one of his past columns for the Motley Fool:

“There have been 20,798 trading sessions between 1928 and today (2011). During that time, the Dow went from 240 to 12,500, or an average annual growth rate of 5% (this doesn’t include dividends). If you missed just 20 of the best days during that period, annual returns fall to 2.6%. In other words, half of the compounded gains took place during 0.09% of days.”

Hence, a low portfolio turnover not only reduces transaction fees but increases the chance that investors do not miss out on the best trading sessions, which form a large portion of the market’s returns.

Low management fees

Actively managed funds have been known to charge notoriously high fees. This is one of the reasons why active funds find it difficult to outperform their low-cost index-tracking counterparts.

However, both Fundsmith and Mawer Global Equity Fund buck this trend. Both funds have relatively low management fees and do not have a performance fee. Fundsmith’s management fee ranges from 0.9% to 1.5%, while Mawer Global Equity Fund has a management expense ratio of around 1.3%.

The Good Investors’ Conclusion

When Warren Buffett was the manager of the Buffett Partnership some 50 years ago, he noted that earning a few percentage points more than the market average per year can be hugely rewarding. He said:

“It is always startling to see how a relatively small difference in rates add up to very significant sums over a period of years. That is why, even though we are shooting for more, we feel that a few percentage points advantage over the Dow is a very worthwhile achievement. It can mean a lot of dollars over a decade or two.”

Actively-managed funds that can consistently outperform the market over a long time frame are a dime a dozen. But if you find one, it definitely pays to invest in 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.

Many people may not know this. Before Warren Buffett became CEO of Berkshire Hathaway, he was a fund manager.  

And his track record was, unsurprisingly, phenomenal.

According to his fund’s investor letter in 1969, his partnership produced an annual compounded return of 31.6%, compared to the Dow’s 9.1%. 

Net of fees, limited partners (investors in the fund) gained a cumulative return of 1,403% in just 12 years, or 25.3% per year. Not bad.

Despite being written more than 50 years ago, Buffett’s teachings in his fund’s investor letters are still relevant today.

Here are five things I learnt from the great man’s writings.

Don’t time the market

The market will swing in the short term. But over a long time frame, you can bet your last dollar that it will be up. Buffett wrote:

“I am certainly not going to predict what general business or the stock market are going to do in the next year or two since I don’t have the faintest idea. I think you can be quite sure that over the next ten years there are going to be a few years when the general market is plus 20% or 25%, a few years when it is minus on the same order, and a majority when it is in between. I haven’t any notion as to the sequence in which these will occur, nor do I think it is of any great importance for the long-term investor.”

Today, many hedge funds and financial advisors try to manage their clients’ money to reduce near-term volatility. But timing the market is a fool’s game.

Buffett’s right-hand man, Charlie Munger certainly agrees, saying, “Time in the market is more important than timing the market.”

It is notoriously difficult to beat the stock market index

When Buffett started his fund, he set the goal of beating the Dow Jones Industrial Average, which at that time was the most widely followed stock market index in the US.

If you thought this was easy to achieve, think again. In his 1961 annual letter, Buffett noted that out of 70 funds listed in Arthur Wiesenberger’s book with a continuous record since 1946, only seven outperformed the Dow. And those that did were superior by just a few percentage points.

Today the story is no different. Bob Pisani, wrote in an article on CNBC earlier this year that 64.49% of large-cap funds lagged the S&P 500 in 2018. It marked the ninth consecutive year that actively managed funds trailed the index.

Over a 10-year period, 85% of large-cap funds underperformed the S&P 500. Over 15 years, that figure increases to 92%.

The joys of compounding

A few percentage points can really add up when compounding. Buffett observed:

“It is always startling to see how relatively small difference in rates add up to very significant sums over a period of years. That is why, even though we are shooting for more, we feel that a few percentage points advantage over the Dow is a very worthwhile achievement. It can mean a lot of dollars over a decade or two.”

Buffett added the table below to show how much more you would make if you compounded a $100,000 investment at 15% instead of 10% or 5%. The results were indeed staggering, and also demonstrates that the difference in absolute returns mushrooms the longer the investment compounds.

Individual thinking is important

In his annual letter in 1962, Buffett warned that it is not safe to simply follow what others are doing. Individual thinking is essential. He wrote:

“You will not be right simply because a large number of people momentarily agree with you. You will not be right simply because important people agree with you.

In many quarters the simultaneous occurrence of the two above factors is enough to make a course of actions meet the test of conservatism.”

He added:

“You will be right, over the course of many transactions, if your hypotheses are correct, your facts are correct, and your reasoning is correct. True conservatism is only possible through knowledge and reason.”

Making bigger bets on high-conviction stocks

While modern portfolio theory suggests ample diversification, Buffett had a somewhat less conventional style. His fund had the mandate to invest up to 40% of its assets in a single stock!

In his 1965 letter, Buffett reasoned:

“Frankly, there is nothing I would like better than to have 50 different investment opportunities, all of which have a mathematical expectation of achieving performances surpassing the Dow by, say, fifteen percentage points per annum.”

But he adds:

“It doesn’t work that way. We have to work extremely hard to find just a few attractive investment situations. Such a situation by definition is one where my expectation of performance is at least ten percentage points per annum superior to the Dow.”

Because of that, Buffett does not mind allocating a larger chunk of his portfolio to stocks that he expects to outperform the index and has a very low probability of loss.

Based on his track record, its clear this strategy has done really well for him.

The Good Investors’ Conclusion

Even at a young age (he was just 25 when he started), Warren Buffett was already a great investor. His performance as manager of the Buffett Partnership all those years ago speaks for itself.

More importantly, for investors today, his writings back then are still relevant today. If you want to read more of Buffett’s annual letters during his time at Buffett Partnership, you can head here.

Photo source: Modified from Warren Buffett Caricature by DonkeyHotey under Creative Commons 2.0.

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.

Risk management is essential when building a stock portfolio. But it is impossible to remove risk completely. Instead, we should find ways to reduce risk in our investment portfolio, while maintaining a good chance for high returns.

With that in mind, here is a simple framework for picking low-risk stocks.

How to find low-risk businesses?

A low-risk business should have a strong balance sheet and an ability to consistently generate cash. Ideally, I look for companies with six qualities that should indicate it has a resilient business.

1. A manageable debt load and low-interest expenses

The company should be able to easily service its interest expense and to pay back its debts when they’re due. The company should have both a high-interest coverage ratio (how easily it can pay back its interest expenses using profits or free cash flow) and a low debt-to-equity ratio.

2. Consistent free cash flow generation

Cash is the lifeblood of a company. It is what the company needs to pay its creditors and suppliers. A company that is able to generate cash after paying off all its expenses and capital requirements (free cash flow to equity) is then able to reward shareholders through dividends, share buybacks, or reinvesting in the business.

3. Predictable and recurring sales

In order to generate cash consistently, a company needs recurring sales. A low-risk business should have recurring and fairly predictable revenue. This can come in the form of repetitive customer behaviour or long-term contracts. 

4. Low customer concentration

The business should also have a varied pool of customers. A high customer concentration might cause wild fluctuations in sales and profits.

5. A diversified business

Similarly, the business should ideally not rely on a single revenue source. A business that has multiple revenue streams is more resistant to technological changes disrupting a single core focus.

6. A long track record

Finally, a low-risk business should have a reasonably long track record of all the above qualities. The track record should ideally span years, if not, decades. Businesses that have such an admirable track record demonstrate resilience and management’s adaptability to technological disruptions.

How to find stocks that will not suffer from valuation compression?

Besides investing in stocks that have resilient businesses, we should also consider the risk of valuation-compression.

A valuation compression occurs when a company’s market value declines permanently despite sustained earnings growth. This happens usually because the starting valuation is too high. If the purchase price is too steep, a good business may still end up becoming a bad investment.

The most common metrics that are used to value a stock are the earnings, cash flow, and book value.

Another metric that I like to use is the enterprise value to EBITDA (earnings before interest, tax, depreciation, and amortisation). The metric is also known conveniently as EV-to-EBITDA.

The enterprise value, or EV, strips out the company’s net cash from its market cap. Companies whose cash make up a large proportion of their market caps are prime acquisition targets. In addition, the net cash balance could also act as a support for which the company’s market cap will likely not fall under.

I also look for companies whose earnings are likely to grow faster or longer than the market expects. This requires a reasonable amount of judgment. But stocks that eventually exhibit such sustained growth are unlikely to see a compression in their valuation.

The Good Investors’ Conclusion

If you’ve been avoiding stocks because of the fear of the risk of loss, don’t.

Warren Buffett says that “risk comes from not knowing what you are doing.”

If we pick stocks wisely, the risk of permanent loss becomes small. On top of investing in stocks that exhibit low-risk qualities, investors should also consider diversifying their portfolio. Diversification reduces the risk that a single mistake or an unforeseen circumstance will be detrimental to our overall portfolio.

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.

Sir John Templeton, one of the true investing greats, once said that the four most dangerous words in investing are “This time it’s different.” 

He wanted to warn us that if we ignore history, we’re doing so at our own peril. As French writer Jean-Baptiste Alphonse Karr once stated, “Plus ça change, plus c’est la même chose” (“the more things change, the more they stay the same”). 

But what makes investing so challenging is that sometimes, this time really is different.  

When dividend yields change permanently

There were two huge crashes in the US stock market in the early 20th century. One happened in 1929, during the infamous Great Depression, when US stocks fell by more than 80% at the 1932 bottom. The other, which is less well-known, occurred in the first decade of the 1900s and was known as the Panic of 1907. 

Something interesting happened prior to both of these crises. In the first half of the 20th century, the dividend yield of US stocks were higher than the country’s bond yield most of the time. The only two occasions when the dividend yield fell below the bond yield were – you guessed it – just before the Panic of 1907 and the Great Depression.

Knowing what happened in the first half of the 1900s, it’s easy for us to think that US stocks would crash the next time the dividend yield fell below the bond yield. So guess what happened when the dividend yield of US stocks started once again to slip behind the bond yield in the late 1950s?

The bond yield ended up staying higher than the dividend yield all the way until it was late into the first decade of the 2000s!

If we were investing in the US in the 1950s and wanted to invest based on the historical relationship between dividend and bond yields in the first-half of the 1900s, we had no chance at all to invest for decades. 

And yet from 1955 (before the dividend yield fell below the bond yield) to 2008 (when the dividend yield briefly became higher than the bond yield again), the S&P 500’s price increased by nearly 2,400%.

When a sign of cheapness stops working

Walter Schloss is one of my investing heroes, but he’s not too well-known among the general public. That’s a real pity because Schloss’s track record is astounding.  

From 1956 to 2000, Schloss’s investment firm produced an annualised return of 15.3%, turning every $1,000 invested into more than $525,000. Over the same time frame, the US stock market, as a whole, had compounded at merely 11.5% per year – $1,000 would have become just $120,000.

In 1985, Schloss was interviewed by the investing publication Barron’s. During the interview, he recounted a story involving his one-time boss and fellow investing luminary, Benjamin Graham:

“Graham used to have this theory that if there were no working capital stocks around, that meant the market was too high…

… [That’s] because historically, when there were no working capital stocks, the market collapsed. That worked pretty well till about 1960, when there weren’t any working capital stocks, but the market kept going up. So that theory went out.”

Schloss provided an explanation of what a working capital stock is in the same interview:

“Suppose a company’s current assets are $10 million; the current liabilities are $3 million. There’s $7 million in working capital. And, they are, say, $2 million in debt. Take that off. So there’s $5 million of adjusted working capital. And say there are 100,000 shares, so they got $50 a share of working capital.

Now, if that stock were selling at 30 bucks a share, it would be kind of interesting.”

To put it simply, working capital stocks are stocks that are priced very cheaply compared to the assets they own. Graham’s theory was that if the market no longer has such cheap stocks, then a crash is imminent.

The model worked fine for a while, then it stopped working, as working capital stocks became scarce near-permanently from the 1960s onwards. In fact, Schloss had to change his investment strategy. During an interview with Outstanding Investors’ Digest in the late 1980s, Schloss said (emphasis is mine):

“Yes. I think it has – largely because of the situation in the market. Graham-Newman [Benjamin Graham’s investment firm] used to buy working capital stocks – which I thought was a great idea.

But by 1960, there were practically no working capital stocks. With the exception of 1974, at the very bottom of that market, there have been practically no working capital stocks.

A good way of seeing it is to look at Value Line’s [a business publication showing financial numbers of US stocks] list of working capital stocks. If you go back 15 years, you’ll see they have some on the list. Today, there are very few. And the ones that are on the list are really pretty bad – often with a lot of debt – especially in relationship to the equity.

With working capital stocks gone, we look next at book value.”

Schloss was right to have tweaked his strategy. The US stock market has been marching higher – much higher – since the disappearance of working capital stocks. From the start of 1960 to today, the S&P 500 has increased from 60 points to over 3,000. That’s more than a 50-fold jump in value.

Recognising when things are different

It’s important for us to acknowledge that conditions in financial markets can change in permanent or near-permanent ways to severely blunt the usefulness of historical experience. 

The limits of using history can be applied to individual stocks too. For instance, it’s tempting for us to conclude that a stock is a bargain if it has lower valuations now compared to its own history. But we should also carefully consider if there’s anything that has permanently changed.

Bankruptcy risks. Industry obsolesce. Incompetent management. Absurdly high valuations in the past. These factors, and more, could render history useless as a guide for the future.

Many investors love to look at historical valuation data when studying the markets. I do too. But when doing so, it’s crucial to remember that things can change. What has worked in the past may no longer be valid in the future. We need to recognise that sometimes, this time really is different. 

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.  

Three years ago on 18 December 2016, I was interviewed by The Straits Times for its “Me & My Money” column. During the interview, I mentioned six US-listed stocks that I thought would do well.

I believe that we can significantly improve our investing process if we score ourselves on our stock picks and on our forecasts – looking back, we can clearly see what went well and what went wrong. I also believe that three years is the bare minimum time-length we should use when analysing our investment decisions. 

With three years having passed since my Straits Times interview, I checked how I fared, and picked up three lessons.

The stocks and my performance 

Here are the six stocks and their returns (excluding dividends, and as of 15 December 2019) since the publication of my interview:

• Facebook: +62%
• Alphabet: +70%
• Amazon: +132%
• Activision Blizzard: +61%
• MercadoLibre: +266%
• Netflix: +140%
• Average: +122% 

The 122% average-return produced by the group of six over the past three years equates to an impressive annual return of 30%. 

I think it’s crucial to also look at how the US stock market has performed. The reason why I’m investing in individual stocks is because I want to do better than the market. If I cannot beat the market, then I should be investing in passive funds instead, such as index-tracking exchange-traded funds. Finding stocks to invest in is a fun process, but it’s also hard work and requires discipline.

Over the past three years since my Straits Times interview was published, the S&P 500, including dividends, has increased by 49% in total, or 14% per year. All six stocks I was positive on have beaten the S&P 500 – and the group’s annual return is more than double the market’s. I think that’s not too shabby!

The 3 lessons

My first key takeaway is that my sextet were huge companies even when I talked about them during my interview. With the exception of MercadoLibre and Activision Blizzard, the six stocks were also highly visible and well-known companies across the world. You’ve probably used or at least heard about the services provided by Facebook, Alphabet (the parent of Google), Amazon, and Netflix.

Company	Market capitalisation on 18 December 2016
Facebook	US$345.5 billion
Alphabet	US$551.6 billion
Amazon	US$360.1 billion
Activision Blizzard	US$27.1 billion
MercadoLibre	US$6.8 billion
Netflix	US$53.3 billion

I’ve come across many investors who think that the only way to find good investment opportunities would be to look at stocks that are obscure and small. They ignore huge and well-known companies because they think that such stocks cannot be bargains due to high attention from market participants. But I think fantastic investment opportunities can come from companies of all sizes.

The second takeaway is that most of the stocks have inspirational and amazing leaders.

For example, at Facebook, there’s Mark Zuckerberg. Yes, there has been plenty of controversy surrounding him and his company in recent years. But in Facebook’s IPO prospectus, Zuckerberg included a shareholders’ letter (see page 80 of the document) that is a tour-de-force on building a company that has a purpose beyond profit. Here’s just one excerpt on the point:

“As I said above, Facebook was not originally founded to be a company. We’ve always cared primarily about our social mission, the services we’re building and the people who use them. This is a different approach for a public company to take, so I want to explain why I think it works.

I started off by writing the first version of Facebook myself because it was something I wanted to exist. Since then, most of the ideas and code that have gone into Facebook have come from the great people we’ve attracted to our team.

Most great people care primarily about building and being a part of great things, but they also want to make money. Through the process of building a team — and also building a developer community, advertising market and investor base — I’ve developed a deep appreciation for how building a strong company with a strong economic engine and strong growth can be the best way to align many people to solve important problems.

Simply put: we don’t build services to make money; we make money to build better services.”

I reserve the right to be wrong, but I believe in Zuckerberg’s letter.

At Alphabet, there’s Sergey Brin, Larry Page, and Sundar Pichai. Brin and Page, the founders of the company, recently stepped down from active management of Alphabet. But they had built an amazing firm that transformed the way the world accessed and searched for knowledge.

At Amazon, there’s Jeff Bezos. There’s also Marcos Galperin at MercadoLibre and Reed Hastings at Netflix. All three are innovative business leaders with tremendous track records. I also discussed Netflix’s management in greater depth in my investment thesis for the company. I think quality management is a key competitive advantage for a company and is a useful signal for picking long-term winners in the stock market. What do you think?

My last major takeaway is that I’ve held most of the six stocks for years before the interview was conducted (I still own them all!). From the time of my ownership to the publication of my interview with The Straits Times, they had performed pretty well – and then they continued to march higher. Peter Lynch once said that the best stock to buy may be the one you already own. How true!

Company	Date of my first investment	Return of company from the date of my investment to my Straits Times interview	Return of S&P 500 from the date of my investment to my Straits Times interview
Facebook	13 July 2015	33%	11%
Alphabet	29 February 2016	13%	19%
Amazon	15 April 2014	140%	30%
Activision Blizzard	26 October 2010	223%	117%
MercadoLibre	17 February 2015	18%	12%
Netflix	15 September 2011	414%	109%

I think there are two more points worth noting from my last major takeaway:

• Stocks need time to perform. MercadoLibre is a good example. After nearly two years from my first investment (from February 2015 to December 2016), the company’s return was a mere 18%. But then MercadoLibre’s stock price proceeded to rise by 266% since December 2016.
• There will always be things to worry about, but companies will still continue to grow and drive the stock market higher. Over the past three years since December 2016, we’ve had Brexit-related uncertainties, the US-China trade war, and interest rates rising and then falling. There are many more big issues the world has confronted and will have to continue to deal with. Throughout these episodes, the free cash flow of Facebook, Alphabet, and Amazon have increased by a total of 65%, 19%, and 121%. MercadoLibre and Netflix have seen their revenues grow by 167% and 131%, respectively.

A bonus takeaway

There’s also a bonus lesson here! In my interview with the Straits Times, I had identified two stocks as mistakes. Here they are and their returns (again, with dividends not included): 

• Ford: -27%
• Dolby: +48%

I said in the interview that I rarely sell my stocks. This is for a good reason: I want to build and maintain the discipline of holding onto my winners for the long run. That’s how I believe that wealth can be built in the stock market and how an investment portfolio should be managed.

Yes, I recognise that holding onto the losers is not an optimal decision when investing. But if our investment framework is robust, then we’ll end up with winners that can more than make up for the losers. And selling our winners too early is a mistake in itself that we should aim to avoid as much as possible. A good way to avoid this mistake is to build the discipline to sell rarely. We have to train our discipline like how we train for physical fitness.

Sometimes not selling also works out in my favour. Look at Dolby’s return, which has matched the market. But I’m glad I identified both Dolby and Ford as mistakes because they’ve not been able to beat the returns of the S&P 500 and my group of six stocks.

The Good Investors’ conclusion

It’s been three years since my interview with the Straits Times. Three years is the shortest amount of time that I think we can use to form conclusions on investing. Ideally, we should be assessing our decisions over five years or longer. 

The six stocks I mentioned in my interview, which I still own, have done well. There are instructive lessons we can gain from their performance. First, good investment opportunities can come from companies of all sizes. Second, having a great management team can be a useful signal in identifying long-term winners in the stock market. Third, we should be investing for the long run, even when there are things to worry about.

I will check back again at the five-year mark of my Straits Times interview, which will be in December 2021. Fingers-crossed that I’ll still have these handsome returns (or better) by then!

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.

Taking control of your own finances can be hugely rewarding. But it is also permeated with investing mine traps that could potentially derail your returns. 

Even seasoned investors and professional portfolio managers are not immune to these pitfalls.

Many of these are innate behavioral human tendencies that create delusions and lead to investment errors.

Jason Zweig, the author of the best selling book, Your Money and Your Brain, said, “Humankind evolved to seek rewards and avoid risks, but not to invest wisely. To do that. You’ll have to outwit your impulses – especially the greedy and fearful ones.”

With that said, here are three common human tendencies that may impact our investing.

Making gross generalisations

The human brain makes sense of the world by recognising patterns. But when it comes to investing, assuming a pattern when there really isn’t one could be detrimental.

Carolyn Gowen, a well-respected financial advisor, recently wrote in her blog that “in investing, we often mistake random noise for what appears to be a non-random sequence.”

To lower the chance that we mistake a random sequence for a pattern, we should look for real economic reasons behind a correlation.

Second, never rely on short-term data. Investing should be viewed in decades, rather than months or years.

Herd mentality

Humans are social creatures. We want to be included and accepted. It is, therefore, not surprising that herd instinct is a common phenomenon in investing.

Investors need positive reinforcement to make decisions. We want to be verified by advice and what others are doing.

The end result is an investment decision that is not the result of individual choice. The tulip mania is a classic example of herd mentality. Towards the end of the 16th century, the demand for Dutch tulips skyrocketed. Investors, eyeing a quick buck, flocked in to buy tulip futures. The price of tulips skyrocketed before the bubble finally burst in 1937.

John Huber, manager of the Saber Capital Fund said, “My observation is that independent thought is extremely rate, which makes it valuable… Understanding this reality and being aware of our own human tendencies is probably a necessary condition to investment success in the long run.”

Self-serving bias

The self-serving bias is a common cognitive bias that distorts an investor’s thinking. In essence, the self-serving bias leads us to credit ourselves for successes but blame failures on other causes.

This delusion perpetuates poor investing decisions and limits our ability to learn. Not knowing what you don’t know is probably the single most dangerous flaw in investing.

The best defense against this cognitive bias is to review each investment decision and see if your investment thesis had played out in the first place. Were your investment successes built around solid fundamental reasoning or was it pure luck?

Keeping an investing journal can help us keep track and review our investing decisions.

The Good Investors’ Conclusion

Billionaire hedge fund manager, Seth Klarman, once observed:

“So if the entire country became security analysts, memorized Ben Graham’s Intelligent Investor, and regularly attended Warren Buffett’s annual shareholder meetings, most people would, nevertheless, find themselves irresistibly drawn to hot initial public offerings, momentum strategies, and investment fads.

Even if they somehow managed to be long-term value investors with a portion of their capital, people would still find it tempting to day-trade and perform technical analysis of stock charts. People would, in short, still be attracted to short-term, get-rich-quick schemes.”

Being rational is easier said than done. We humans are built in a way that has helped us survive for thousands of years by making decisions based on fear and greed. So going against these human emotions is innately difficult.

But to be good investors, we need to appreciate and overcome these human emotions and biases. By overcoming our emotions and biases in investing, we are more likely to make sound investing decisions that give us the best chance of long-term investing success.

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 no guarantees in the world of investing… or are there? Here are six things about investing that I’m certain will happen in 2020.

1. There will be something huge to worry about in the financial markets.

Peter Lynch is the legendary manager of the Fidelity Magellan Fund who earned a 29% annual return during his 13-year tenure from 1977 to 1990. He once said:

“There is always something to worry about. Avoid weekend thinking and ignore the latest dire predictions of the newscasters. Sell a stock because the company’s fundamentals deteriorate, not because the sky is falling.”

Imagine a year in which all the following happened: (1) The US enters a recession; (2) the US goes to war in the Middle East; and (3) the price of oil doubles in three months. Scary? Well, there’s no need to imagine: They all happened in 1990. And what about the S&P 500? It has increased by nearly 800% from the start of 1990 to today, even without counting dividends.

There will always be things to worry about. But that doesn’t mean we shouldn’t invest.

2. Individual stocks will be volatile.

From 1997 to 2018, the maximum peak-to-trough decline in each year for Amazon.com’s stock price ranged from 12.6% to 83.0%. In other words, Amazon’s stock price had suffered a double-digit fall every single year. Meanwhile, the same Amazon stock price had climbed by 76,000% (from US$1.96 to more than US$1,500) over the same period.

If you’re investing in individual stocks, be prepared for a wild ride. Volatility is a feature of the stock market – it’s not a sign that things are broken. 

3. The US-China trade war will either remain status quo, intensify, or blow over.

“Seriously!?” I can hear your thoughts. But I’m stating the obvious for a good reason: We should not let our views on geopolitical events dictate our investment actions. Don’t just take my words for it. Warren Buffett himself said so. In his 1994 Berkshire Hathaway shareholders’ letter, Buffett wrote (emphases are mine):

“We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen.

Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%.

But, surprise – none of these blockbuster events made the slightest dent in Ben Graham’s investment principles. Nor did they render unsound the negotiated purchases of fine businesses at sensible prices.

Imagine the cost to us, then, if we had let a fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist.

A different set of major shocks is sure to occur in the next 30 years. We will neither try to predict these nor to profit from them. If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results.”

From 1994 to 2018, Berkshire Hathaway’s book value per share, a proxy for the company’s value, grew by 13.5% annually. Buffett’s disciplined focus on long-term business fundamentals – while ignoring the distractions of political and economic forecasts – has worked out just fine.

4. Interest rates will move in one of three ways: Sideways, up, or down.

“Again, Captain Obvious!?” Please bear with me. There is a good reason why I’m stating the obvious again.

Much ado has been made about what central banks have been doing, and would do, with their respective economies’ benchmark interest rates. This is because of the theoretical link between interest rates and stock prices.

Stocks and other asset classes (bonds, cash, real estate etc.) are constantly competing for capital. In theory, when interest rates are high, the valuation of stocks should be low, since the alternative to stocks – bonds – are providing a good return. On the other hand, when interest rates are low, the valuation of stocks should be high, since the alternative – again, bonds – are providing a poor return.

But if we’re long-term investors in the stock market, I think we really do not need to pay much attention to what central banks are doing with interest rates.

There’s an amazing free repository of long-term US financial market data that is maintained by Robert Shiller. He is a professor of economics and the winner of a Nobel Prize in economics in 2013. 

His data includes long-term interest rates in the US, as well as US stock market valuations, going back to the 1870s. The S&P 500 index is used as the representation for US stocks while the cyclically adjusted price earnings (CAPE) ratio is the valuation measure. The CAPE ratio divides a stock’s price by its inflation-adjusted average earnings over a 10-year period.

The chart below shows US long-term interest rates and the CAPE ratio of the S&P 500 since 1920:

Contrary to theory, there was a 30-plus year period that started in the early 1930s when interest rates and the S&P 500’s CAPE ratio both grew. It was only in the early 1980s when falling interest rates were met with rising valuations. 

To me, Shiller’s data shows how changes in interest rates alone can’t tell us much about the movement of stocks. In fact, relationships in finance are seldom clear-cut. “If A happens, then B will occur” is rarely seen.

Time that’s spent watching central banks’ decisions regarding interest rates will be better spent studying business fundamentals. The quality of a company’s business and the growth opportunities it has matter far more to its stock price over the long run than interest rates. 

Sears is a case in point. In the 1980s, the US-based company was the dominant retailer in the country. Morgan Housel wrote in his recent blog post, Common Plots of Economic History :

“Sears was the largest retailer in the world, housed in the tallest building in the world, employing one of the largest workforces.

“No one has to tell you you’ve come to the right place. The look of merchandising authority is complete and unmistakable,” The New York Times wrote of Sears in 1983.

Sears was so good at retailing that in the 1970s and ‘80s it ventured into other areas, like finance. It owned Allstate Insurance, Discover credit card, the Dean Witter brokerage for your stocks and Coldwell Banker brokerage for your house.”

US long-term interest rates fell dramatically from around 15% in the early-to-mid 1980s to 3% or so in 2018. But Sears filed for bankruptcy in October 2018, leaving its shareholders with an empty bag. In his blog post mentioned earlier, Housel also wrote:

“Growing income inequality pushed consumers to either bargain or luxury goods, leaving Sears in the shrinking middle. Competition from Wal-Mart and Target – younger and hungrier – took off.

By the late 2000s Sears was a shell of its former self. “YES, WE ARE OPEN” a sign outside my local Sears read – a reminder to customers who had all but written it off.” 

If you’re investing for the long run, there are far more important things to watch than interest rates.

5. There will be investors who are itching to make wholesale changes to their investment portfolios for 2020.

Ofer Azar is a behavioural economist. He once studied more than 300 penalty kicks in professional football (or soccer) games. The goalkeepers who jumped left made a save 14.2% of the time while those who jumped right had a 12.6% success rate. Those who stayed in the centre of the goal saved a penalty 33.3% of the time.

Interestingly, only 6% of the keepers whom Azar studied chose to stay put in the centre. Azar concluded that the keepers’ moves highlight the action bias in us, where we think doing something is better than doing nothing. 

The bias can manifest in investing too, where we develop the urge to do something to our portfolios, especially during periods of volatility. We should guard against the action bias. This is because doing nothing to our portfolios is often better than doing something. I have two great examples. 

The first is a paper published by finance professors Brad Barber and Terry Odean in 2000. They analysed the trading records of more than 66,000 US households over a five-year period from 1991 to 1996. They found that the most frequent traders generated the lowest returns – and the difference is stark. The average household earned 16.4% per year for the timeframe under study but the active traders only made 11.4% per year.

Second, finance professor Jeremy Siegel discovered something fascinating in the mid-2000s. In an interview with Wharton, Siegel said:

“If you bought the original S&P 500 stocks, and held them until today—simple buy and hold, reinvesting dividends—you outpaced the S&P 500 index itself, which adds about 20 new stocks every year and has added almost 1,000 new stocks since its inception in 1957.”

Doing nothing beats doing something. 

6. There are 7.7 billion individuals in the world today, and the vast majority of us will wake up every morning wanting to improve the world and our own lot in life.

This motivation is ultimately what fuels the global economy and financial markets. There are miscreants who appear occasionally to mess things up, but we should have faith in the collective positivity of humankind. We should have faith in us. The idiots’ mess will be temporary.

To me, investing in stocks is the same as having the long-term view that we humans are always striving collectively to improve the world. What about you?

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

John Huber is one of the top-performing fund managers of the decade. His Saber Investment fund has achieved a gross annualised return of 20.66% since 2014. That puts his fund well ahead of the S&P 500 which has annualised at 10.89%.

I spent my weekend studying some of Huber’s letters to shareholders and blog posts. Here are three investing lessons from his writings.

Time is a valuable edge

Fund managers often get asked the question, “what is your edge”? The two main responses that institutional investors look for are some sort of “information” or “analytical” edge.

However, Huber believes that in an era of easily-accessible information, both these edges do not exist anymore. Huber explains:

“I’ve observed over the years that whatever information an investor believes to be unique is almost always understood by many other market participants, and thus is not valuable.

The mispricing is not in the stock itself, but in the investor’s own perception of the value of information: it’s worth far less than they believe it is. Information is now a commodity, and like the unit price of computing power that provides it, the value has steadily fallen as the supply and access to it has skyrocketed.”

But the absence of an “informational” or “analytical” edge does not mean stock pickers cannot outperform the market. Huber believes that the “time horizon” edge is still alive and kicking.

The “time horizon” edge is formed because today’s market participants are more interested in short-term gains over the long-term. Huber notes that many investment firms today make investing decisions based entirely on short-term stock price movements. These decisions have nothing to do with long-term value. 

This creates a huge pricing mismatch between a stock’s long-term value and the current stock price. In turn, it creates a massive opportunity for long-term investors to outperform the market.

But the “time horizon” edge does come with its price. Huber explains:

“The price of gaining this edge is the volatility that could occur in the near term. You have to be willing to accept the possibility that your stock will go down before it goes up. Very few investors are willing to pay that price, which is why even large-cap stocks can become disconnected from their long term fair values.”

Don’t be afraid to say, “I don’t know”

Huber wrote a great article on one of Warren Buffett’s underrated investment attributes: His ability to recognize when a situation is outside of his well-defined circle of competence.

Buffett has been able to do extremely well in the stock market simply by focusing on more-certain bets and resisting everything else.

The ability to say “no” has enabled Buffett to have very few major mistakes on his record.

More impressively, Buffett is also humble enough to admit when he is wrong. For example, his ability to realise his mistakes led him to make smart investment exits in IBM, Tesco, and Freddie Mac. Huber wrote:

“I think the vast majority of investment mistakes can be traced back to the inability to be honest about your own knowledge or level of understanding about a subject matter.

It’s hard for smart people who have spent their lives being right far more often than they are wrong to admit to themselves that something is too challenging.

It is even harder to admit that their original assessment was completely wrong. So I think intellectual honesty can be a source of a powerful edge for those who can harness it to their advantage.”

Individual thought is essential

Huber also explains that one of the biggest risks in investing is allowing others to indirectly make your investment decisions.

Too often investors rely on outside advisors to make an investment decision. But the advice may be based on different economic interests, investment horizons, or goals. 

Investors also tend to copy high-profile investors. However, high-profile investors can also occasionally make mistakes. 

Theranos, one of the most high profile fraud cases of the decade, managed to secure billions in funding before it was eventually found out. Its early investors were some of the most respected business people of our time. They included the likes of Carlos Slim, Robert Kraft, Larry Ellison, Rupert Murdoch, and the Walton family. Huber notes:

“My observation is that independent thought is extremely rare, which makes it very valuable.

On the other hand, outsourced thinking appears to be pervasive in the investment community, and because of how we’re wired, this dynamic is unlikely to change. Regardless of how convincing the facts are, we are just more comfortable if we can mold our opinion around the opinion of others.

Understanding this reality and being aware of our own human tendencies is probably a necessary condition to investment success in the long run.”

Ser Jing and I started The Good Investors as a platform to raise awareness on how investors can invest well for themselves while doing good for the world. These two objectives are by no means mutually exclusive. 

Driving growth

In his book Sapiens: a Brief History of Humankind, Yuval Noah Harari devoted a whole chapter to how capitalism contributed to the modernisation and growth of the world’s economy. He wrote:

“Capitalism distinguishes ‘capital’ from mere ‘wealth’. Capital consists of money, goods, and resources that are invested in production. Wealth, on the other hand, is buried in the ground or wasted on unproductive activities.”

Capitalism is, hence, one of the driving forces of real economic growth over the last five centuries.

But free markets that are solely after profits can be detrimental to society. The slave trade, for example, was the product of free-market capitalism. Harrari wrote, “When growth becomes a supreme good, unrestricted by any other ethical considerations, it can easily lead to catastrophe.”

To prevent this, investors should focus on ethical investing, rather than simply chasing after profits. Investing responsibly can not only fuel economic growth but can also help drive innovation, promote good practices, and reverse climate change, among others.

Investors today are much more conscious of how they can do well while doing good. With that said, I have compiled a list of five ways investors can invest for the greater good.

1. Avoiding sin stocks

Tim Nash, the founder of Good Investing, describes negative screening as doing less evil. By avoiding sin stocks, capital allocators force companies to rethink their strategy and discourage entrepreneurs from moving into the controversial sector in the first place.

Each of us may have a different definition of sin stocks depending on our personal values. However, some commonly cited “sin stocks” include weapons, fossil fuels, and cigarette companies.

2. Investing in green technology

We can also actively invest in companies that are striving to make the world a better place.

Climate change is one of the biggest challenges of the world today. It is, therefore, no surprise that investors are now prioritising green technology more than ever. But the success of green technology can only be achieved if both investors and consumers are willing to back it.

Some examples of green technology include solar power, electric vehicles, water purification, and LED lights. 

Thankfully, it seems that the world is moving in the right direction when it comes to green technology. In November 2019, the Singapore government announced that it will invest US$2 billion in funds that have a strong green focus. 

3. Investing in necessities

In Singapore, we take clean water for granted. However, unsafe sanitation is still a massive problem in Africa. Unsanitary water contributes to more than 1,200 deaths of children under five years old per day.

The Bill & Melinda Gates Foundation has taken massive steps to alleviate the problem, through education and waste treatment technology. 

Investors can contribute too. We can play our part by funneling our capital to companies that are helping to alleviate the sanitisation problem.

Besides water, investors can also consider supporting companies that champion basic human rights, promote education, enable sustainable farming, and others.

4. Innovative companies

Some companies are improving the lives of millions of people simply through innovative technologies.

Take Alphabet Inc, for example. The parent company of Google has increased its focus away from merely “organising information”. Today, the tech conglomerate has investments in healthcare and autonomous vehicles, and even provides the world with faster Internet access through fiber networks.

Many of us also probably also use some of Google’s other applications that make our lives much easier, like Google Maps, Gmail, Google Photos, and even Google Translate.

Alphabet is certainly not the only company making a difference to the world. Today, there are more tech companies than ever that are coming up with innovative solutions that are not only financially feasible but improving the lives of millions.

5. Healthcare

Another way we can invest for the greater good is by investing in healthcare companies. The pharmaceutical sector, for instance, is responsible for the innovation of numerous drugs that have saved the lives of millions.

However, pharmaceutical companies require bucketloads of cash to fund research and clinical trials.

While the biggest pharmaceutical companies are self-sustainable through the money earned from earlier blockbuster drugs, many are still in their infant stages. Such firms are desperately in need of capital.

Investors can help to fund research by investing in these companies. There is also the potential of profit should one of the pipeline drugs get commercialised.

Doing well while doing good

Contrary to popular belief, investing need not be solely for enriching yourself. By selectively investing in companies that are doing good for the world, we not only stand to profit but can also improve the world in the process.

My hope is that more investors use their capital not only as a means to enrich themselves but also for the greater good of the world.

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.