General investing articles archive : Page 25 of 25

Can We Really Do Good While Investing?

Here’s how investors can make the world a better place through good investing decisions.

Are we really able to do good while investing?

This question irked me at the time I was thinking of making a career switch to investing. I wanted a career that was both fulfilling and enabled me to make a difference to the world at the same time.

Thankfully, through further reading, I can say the answer to that question is an emphatic yes.

As investors, we are a small cog in the financial markets that help make the world a better place.

Every drop counts

So how do we do good when we invest? Well, let’s start at the very beginning.

When a start-up that is looking to improve the world develops an idea, it needs funding. Venture capitalists help to fund these ideas.

In turn, these venture capitalists invest because they know that there is a stable public market system behind them.

Along the way, these startups enrich the lives of numerous stakeholders, including employees, customers, and shareholders.

At its initial public offering, the company then raises more funds through a public offering of shares.

Those who invest in initial public offerings do so because of the assurances of the liquidity of the public market and the ability to sell shares at a future date, which is when we (stock market investors, or public market investors) usually come in.

The final piece of the jigsaw

All of which means that we, public market investors, are a small but important piece of the jigsaw that helps drive innovation and the improvement of society through capitalism.

As you can see, by participating in the stock market as investors, we are indirectly part of the reason why startups are able to raise much-needed funds in the first place.

Impact investing

Besides simply being part of the financial markets, we can also choose to invest in companies that are actively improving the world.

One way is to invest in companies that are building a better future for tomorrow through innovative technologies such as Google. We can also invest in companies that uphold a high standard of corporate social responsibility by giving back to society or through actions that help reverse climate change.

The more investors embrace Impact investing, the more firms are likely to embrace the need for a strong corporate social responsibility to enrich the lives of other stakeholders and the world.

Recently, the Singapore government set aside US$2 billion in funds to participate in public market investment strategies that have a strong green focus. Singapore Education Minister, Ong Ye Kuang, described how investments help to shape the world saying, “Finance fuels the economy and business. It determines investment decision and it drives action.”

Enriching others

As you can see, investing is certainly not a zero-sum game. The injection of much-needed capital into companies that are improving the world aids numerous stakeholders along the way.

Even if we solely invest in the secondary market (the public stock market), we are still an important – albeit small – part of the financial markets that is essential in capitalism and the betterment of the world.

Further, by focusing our investing efforts on responsible companies that are not solely profit-driven but have a strong corporate social responsibility to do good, we can mold the way investment decisions are made and help to prod business towards socially responsible investment decisions.

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 Best Investing Speech, And 5 Lessons

Timeless investing lessons and wisdom were shared in an investing speech delivered 38 years ago in 1981.

Surprise! The best investing speech I’ve ever come across is not from Warren Buffett or other well-known investing legends such as Peter Lynch, Benjamin Graham, or John Neff. It’s from the little-known Dean Williams.

The speech, Trying Too Hard, was delivered 38 years ago in 1981, when Williams was with Batterymarch Financial Management. But its content remains as relevant as ever. Here are five gems I took away from Williams’ timeless speech.

1. Confidence and accuracy

“Confidence in a forecast rises with the amount of information that goes into it. But the accuracy of the forecast stays the same.”

Keep this in mind the next time you come across a market forecaster who is highly confident just because he’s backed by mountains of data. Bad data, however much the amount, can lead to bad forecasts. A poor understanding of how markets work (such as assuming that price movements in the financial markets follow a normal distribution) will also lead to toxic outcomes even when there’s plenty of data involved.

In fact, research by Philip Tetlock, a psychologist at Berkeley, brings this Dean Williams quote one step further by suggesting that confidence and accuracy in a forecast can often be inversely correlated.

2. Don’t just do something, stand there!

“The title Marshall mentioned, “Trying Too Hard”, comes from something that happened to me a few years ago. I had just completed what I thought was some fancy footwork involving buying and selling a long list of stocks. The oldest member of Morgan’s trust committee looked down the list and said, “Do you think you might be trying too hard?” At the time I thought, “Who ever heard of trying too hard?” Well, over the years I have changed my mind about that.”

Finance professors Brad Barber and Terry Odean published a paper in 2000 that looked at the trading records of more than 66,000 US households over a five-year period from 1991 to 1996. The research was astonishing: The households who traded the most generated the lowest returns. The average household earned 16.4% per year for the timeframe under study, while the most frequent traders only earned 11.4% per year.

Investor William Smead once said that “Your common stock portfolio is like a bar of soap. The more you rub it, the smaller it gets.” How true.

3. We know less than we think we do

“Here are the ideas I’m going to talk about: the first is an analogy between physics and investing… The foundation of Newtonian physics was that physical events are governed by physical laws. Laws that we could understand rationally. And if we learned enough about those laws, we could extend our knowledge and influence over our environment.

That was also the foundation of most of the security analysis, technical analysis, economic theory and forecasting methods you and I learned about when we first began in this business. There were rational and predictable economic forces. And if we just tried hard enough… If we learned every detail about a company. . . .If we discovered just the right variables for out forecasting models… Earnings and prices and interest rates should all behave in rational and predictable ways. If we just tried hard enough.

In the last fifty years a new physics came along. Quantum, or subatomic physics. The clues it left along its trail frustrated the best scientific minds in the world. Evidence began to mount that our knowledge of what governed events on the subatomic level wasn’t nearly what we thought it would be. Those events just didn’t seem subject to rational behavior or prediction. Soon it wasn’t clear whether it was even possible to observe and measure subatomic events, or whether the observing and measuring were, themselves, changing or even causing those events.

What I have to tell you tonight is that the investment world I think I know anything about is a lot more like quantum physics than it is like Newtonian physics. There is just too much evidence that our knowledge of what governs financial and economic events isn’t nearly what we thought it would be.”

Investing involves human psychology, which is incredibly hard to model. The great physicist Richard Feynman apparently once said “Imagine how much harder physics would be if electrons had emotions.” That’s the problem we as investors have to deal with.

Investing is not always a case of “if X, then Y.” According to a study done in 2004, South Africa’s economy expanded by 6.5% annually from 1900 to 2002, but saw its stock market rise by less than 1%. The Federal Reserve in the US started its bond-purchase programme, Quantitative Easing, in 2008. Investors thought back then that interest rates would rise when QE stopped since the Fed’s massive presence would be gone. QE officially ended in late 2014 but the Fed had stopped and restarted QE on a number of occasions. Morgan Housel showed that, contrary to the general idea, interest rates rose each time the Fed stopped QE between the beginning of 2008 and April 2013.

The good thing is you and I need not be helpless. We can work with sound investing principles that are backed by strong logical reasoning and evidence, and we can invest with humility by diversifying.

4. The power of simplicity and consistency

“You are familiar with the periodic rankings of past investment results published in Pension & Investment Age. You may have missed the news that for the last ten years the best investment record in the country belonged to the Citizens Bank and Trust Company of Chillicothe, Missouri.

Forbes magazine did not miss it, though, and sent a reporter to Chillicothe to find the genius responsible for it. He found a 72 year old man named Edgerton Welsh, who said he’d never heard of Benjamin Graham and didn’t have any idea what modern portfolio theory was. “Well, how did you do it?” the reporter wanted to know.

Mr. Welch showed the report his copy of Value-Line and said he bought all the stocks ranked “1” that Merrill Lynch or E.F. Hutton also liked. And when any one of the three changed their ratings, he sold. Mr. Welch said, “It’s like owning a computer. When you get the printout, use the figures to make a decision–not your own impulse.”

The Forbes reporter finally concluded, “His secret isn’t the system but his own consistency.” EXACTLY. That is what Garfield Drew, the market writer, meant forty years ago when he said, “In fact, simplicity or singleness of approach is a greatly underestimated factor of market success.””

I’ve previously shared in The Good Investors about how a simple portfolio of US stocks, international stocks, and global bonds have bested even the best-performing endowment funds of US colleges that invests in incredibly complex ways. Here’s another good one, according to Morgan Housel: “Someone who bought a low-cost S&P 500 index fund in 2003 earned a 97% return by the end of 2012… Meanwhile, the average equity market neutral fancy-pants hedge fund lost 4.7% of its value over the same period, according to data from Dow Jones Credit Suisse Hedge Fund Indices.”

5. Investing without forecasts

“And when it comes to forecasting—as opposed to doing something—a lot of expertise is no better than a little expertise. And may even be worse.

The consolation prize is pretty consoling, actually. It’s that you can be a successful investor without being a perpetual forecaster. Not only that, I can tell you from personal experience that one of the most liberating experiences you can have is to be asked to look over your firm’s economic outlook and to say, “We don’t have one.”

Successful investing can be done without paying attention to economic forecasts. I have been investing for more than 9 years, and have never depended on outlooks on the economy. My focus has always been on a stock’s underlying business fundamentals. It’s the same when I was with the Motley Fool Singapore’s investing team – the prospects of a stock’s business was our primary concern. In his speech, Dean Williams also said “Give life a try without forecasts.” I have tried, and it’s been great.

Why Value Investing Has Worked – and Some Key Takeaways

Insights on why value investing (essentially investing in stocks with low valuations) has worked in the stock market over long periods of time but has struggled in the last decade or so.

Around 1.5 years ago, I read a piece of fascinating research from O’Shaughnessy Asset Management (OSAM) and the pseudonymous financial blogger, Jesse Livermore. The research provided insights on why value investing (essentially investing in stocks with low valuations) has worked in the stock market over long periods of time but has struggled in the last decade or so.

I want to share the paper’s main findings and my takeaways, because value investing is popular among many stock market participants.

Value’s success

The research found that stocks in the value category saw their earnings fall in the short run. The market was somewhat correct in giving such stocks a low valuation in the first place. I say “somewhat correct” because the market was excessively pessimistic. Value stocks eventually outperformed the market because their earnings recovered to a point where their initial purchase prices looked cheap – it was the initial excessively-pessimistic pricing and subsequent recovery in earnings that led to the value factor’s ability to deliver market-beating returns.

So the market was right in the short run, in the sense that value stocks will see a downturn in their businesses. But the market was also wrong in the sense that it was too pessimistic on the long-run ability of the businesses of value stocks to eventually recover. OSAM and Livermore’s research also showed that the value factor’s poor performance in the last decade or so can be attributed to the disappearance of the subsequent recovery in earnings of value stocks. The reason for the disappearance of the earnings-recovery was not covered in the paper.

My takeaways

First, investors can gain an enormous and lasting edge over the market simply by adopting a longer time horizon and having the courage and optimism to see past dark clouds on the horizon. The Motley Fool’s co-founder and chairman, David Gardner, spoke about the concept of “Dark Clouds I Can See Through” in an insightful podcast of his. The idea behind seeing past dark clouds on the horizon is that if you’re able to look past the prevailing pessimism about a situation, and if you’re right in your optimism, there’s success to be found on the other side when the clouds clear. OSAM and Livermore showed this empirically when they broke down the exact drivers behind the past successes of the value factor – investors who had the ability to “see” the subsequent recovery in earnings of value stocks were able to profit from the market’s short-term pessimism.

Second, I think it’s now more important than ever for investors to not buy value stocks blindly. The underlying mechanism behind the value factor’s past successes has been shown to be the initial overly-pessimistic pricing and the subsequent earnings recovery of value stocks. The recent struggles of the value factor, however, has been due to the inability of value stocks to produce an earnings recovery. To succeed with value stocks, I think investors should have a robust framework for analysing companies in the value category and think carefully about the probability of their businesses’ abilities to produce growth in the future.

The Power of Compounding

Compounding works best the longer the investment timeframe.

Compounding is a well-publicised concept in investment. Essentially, it refers to the returns that an investor gets when he reinvests his earnings each year.

Albert Einstein was said to have referred to compounding as the eighth wonder of the world. The power of compounding is also well illustrated by Warren Buffett’s own investment journey. Despite starting his investment journey at the ripe age of eleven, 99% of Buffett’s wealth was earned after his fiftieth birthday.

How you can compound your wealth

So how can the retail investors compound wealth over time?

Ser jing and I have formed a list of criteria that can help us find stocks that can compound meaningfully over the long term.

For instance, one of the characteristics we look out for is companies that operate in an industry that is growing. These companies tend to grow along with the industry. But that’s not all. We also want to pinpoint companies that can capitalise on the growing market, whilst increasing their market share at the same time.

Take Amazon.com for example. Well before the company reached its current size, shrewd investors could have identified Amazon as the next big thing. Jeff Bezos was a visionary entrepreneur who was focused on customer satisfaction. He realised the importance of a great customer experience, which enabled Amazon to dominate the growing e-commerce space. The signs back then were telling.

Even if you had bought in at the peak of the dot com boom, you would have made a 16% annualised return over 20 years. That’s a 2000% gain in just 20 years.

In addition, we also look for disruptors who can win market share in an already large industry or even create a whole new market on its own.

For instance, in the past customer relations management was not a big industry nor did companies truly identify it as a problem that needed solving. However, software such as salesforce has completed changed the way companies manage their customer relations. Nowadays, many companies cannot go a day without a customer relations tool. It has become an important software in some of the largest companies in the States.

Although much more prominent now, Salesforce is still small in relation to the potential addressable global market.

Time is your friend

Compounding is certainly a powerful investing concept. But, perhaps the biggest takeaway of all of this is that compounding works best the longer it is allowed to grow. Consider the example below.

If you have an investing life span of twenty years and are able to compound your wealth at 10% per year, your eventual returns will be 570% at the end of the investment cycle. Not too shabby. However, by adding just another five years to the investment time frame, you would have made a 980% return, 410% more in the extra five years. As you can see, time is indeed your friend when it comes to investing.

If you are thinking of investing but have not started yet, remember that the earlier you start, the more rewards you will reap in the future.

Hopefully, this post encourages readers to start their investment journey as soon as possible. With that, Happy compounding and invest on!

My Investment Framework

This investing framework has helped me produce significant market-beating returns since October 2010.

The very first stock market in the world was established in Amsterdam in the 1600s. A few hundred years have passed since, and a stock exchange today looks very different even from just 20 years ago. But one thing has remained constant: A stock market is still a place to buy and sell pieces of a business.

Having this basic but important understanding of the stock market leads to the next observation, that a stock’s price movement over the long run then depends on the performance of the underlying business. In this way, the stock market becomes something easy to grasp: A stock’s price will do well over time if the underlying business does well too. The next logical question then follows: Is there a way to find companies with businesses that could do well in the years ahead? From experience and logical reasoning, I believe the answer is “Yes!”

I’ve been investing for my family since October 2010, and over the past nine years, I’ve developed a framework for picking companies that have a good chance of growing at high rates for long periods of time. I focus on finding companies that meet all or most of the following six criteria.

My investment framework

1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market.

This criterion is important because I want companies that have the capacity to grow. Being stuck in a market that is shrinking – such as print-advertising for instance, which has shrunk by 2.3% per year from 2011 to 2018 – would mean that a company faces an uphill battle to grow.

An example of a company with smaller revenue in relation to a fast-growing market is, believe it or not, Facebook, a company I own shares of. Facebook’s revenue over the last 12 months is US$66.5 billion, of which most come from digital advertising. The company’s revenue, as large as it is, is still just a fraction of the global digital advertising market, which was US$283 billion in 2018 and expected to grow to US$518 billion in 2023. In turn, the global digital advertising market was less than half of the global advertising spend of US$617 billion in 2018. An example of a company that I own shares of with large revenues in relation to a fast-growing market is Intuitive Surgical, maker of robotic surgery systems. Intuitive Surgical’s revenue over the last 12 months is US$4.2 billion, while the worldwide robotic surgical market is forecast to jump from US$4.1 billion in 2015 to nearly US$10 billion by 2020. Intuitive Surgical’s systems handled 1.04 million surgical procedures in 2018, which seems like a large number, but only 5% or so of surgeries worldwide are done with robots today.

2. A strong balance sheet with minimal or a reasonable amount of debt.

A strong balance sheet enables a company to achieve three things: (a) Invest for growth, (b) withstand tough times, and (c) increase market share when its financially-weaker companies are struggling during periods of economic contraction. I typically want a company to have more cash than debt. If there are significant levels of debt, then I will want the debt to be a low multiple of free cash flow. If I’m looking at a bank, the level of cash and debt is inconsequential, so my attention will be on the leverage ratio, which is the ratio of the bank’s total assets to shareholders’ equity.

3. A management team with integrity, capability, and an innovative mindset.

A management team without capability is bad for self-explanatory reasons. Without an innovative mindset, a company can easily be overtaken by competitors. Meanwhile, a management team without integrity can fatten themselves at the expense of shareholders. There are a few things we can look at to understand how a company’s management team fares on these fronts.

On integrity:

How has management’s pay changed over time relative to the company’s business performance? It’s not a good sign if management’s pay has increased or remained the same in periods when the company’s business isn’t doing well.
How is management compensated? Ideally, we want management to be compensated based on metrics that make sense to us as a company’s shareholders. PayPal, another company I own shares of, excels in this regard, in my view. In 2018, the lion’s share of the compensation of PayPal’s key leaders came from the following: (a) Stock awards that vest over a three-year period; (b) restricted stock awards that depend on growth in the company’s revenue and free cash flow over a three-year period; and (c) which applies specifically for the CEO, stock awards that depend on the performance of PayPal’s share price over a five-year period.
Are there high levels of related-party transactions (RTPs)? RTPs are business transactions made between a company and organisations that are linked to said company’s management. A good example will be the famous hotpot restaurant operator, Haidilao. In 2018, Haidilao’s top five suppliers accounted for 38.4% of the company’s total purchases of RMB 10 billion, and four of the top five suppliers were linked to management. The presence of high levels of RTPs in a company could mean that management is using said company to enrich entities that are linked to them – that’s not ideal for the company’s other shareholders. In the case of Haidilao, it appears that management has been treating shareholders fairly; the company’s net profit margin has been at a healthy level (for a restaurant operator) of at least 9% going back to 2016.

On capability:

Does the company have a good culture? Some clues on a company’s culture can be found on Glassdoor, a website that allows a company’s employees to rate it anonymously. Unfortunately, Glassdoor’s coverage mostly extends to only US companies for now.
Has the company managed to successfully grow its important business metrics over time? Going back to Intuitive Surgical, the number of surgical procedures worldwide performed with the company’s robots has increased significantly from 68,000 in 2007 to 1.04 million in 2018. Meanwhile, the installed base of Intuitive Surgical’s robotic surgery systems worldwide has jumped from 795 in 2007 to 5,406 today.

On innovation:

It requires some judgement in assessing a management team’s ability to innovate. There are three companies that I think are great examples of having innovative management.
First is US e-commerce and cloud computing giant Amazon, which I own shares of. Amazon started selling just books online when it was founded in 1994 but expanded its online retail business into an incredible variety of product-categories over time. In 2006, the company launched its cloud computing business, AWS (Amazon Web Services), which has since grown into the largest cloud computing service provider in the world.
Second is the international video streaming provider Netflix, which I also own shares of. Netflix’s co-founder and CEO Reed Hastings said in 2007: “We named the company Netflix for a reason; we didn’t name it DVDs-by-mail. The opportunity for Netflix online arrives when we can deliver content to the TV without any intermediary device.” This shows that Netflix’s leaders were already thinking about building a video streaming business right from the very beginning, back when video streaming wasn’t even a widely used term.
Third is MercadoLibre, another company that I have a stake in. MercadoLibre started life in the late 1990s operating online marketplaces in Latin America that connects buyers and sellers. In the early 2000s, MercadoLibre started an online payments service, MercadoPago, that now also includes online-to-offline (O2O) payments services. In addition, the service helps facilities online payments for merchants and consumers that are outside of the company’s online retail platform. In the third quarter of 2019, off-platform payment volume on MercadoPago exceeded on-platform payment volume in Brazil (the company’s largest market), for the first time ever. Then in 2013, MercadoLibre launched its shipping solution, MercadoEnvios. MercadoLibre’s service-innovations all help to drive further growth in the company’s marketplace business, and in some cases, even create new growth areas outside of the company’s main platform.

4. Revenue streams that are recurring in nature, either through contracts or customor-behaviour.

Having recurring business is a beautiful thing because it means a company need not spend its time and money looking to remake a past sale. Instead, past sales are recurring, and the company is free to find brand new avenues for growth.

A company in my portfolio, Adobe, provides subscription services for software used in many different areas including digital marketing and creation of digital content. The subscriptions provide recurring revenue for Adobe and accounted for 88% of the company’s US$9.0 billion in revenue in its fiscal year ended 30 November 2018.

Recurring revenue from customer behaviour is embodied by the digital payments company, Mastercard, another stock-holding of mine. Each time you swipe your Mastercard credit card, the company earns a fee; in 2018, Mastercard processed US$5.9 trillion in payments (that’s a lot of swiping!). Intuitive Surgical is also another good example of a company with high-levels of recurring revenue from customer behaviour due to its razor-and-blades business model. The company generates revenue from the one-time sale of its surgical robot systems. But it also supplies the accessories that are used with the robots and provides the necessary maintenance services. The accessories and maintenance services generate recurring revenues for Intuitive Surgical and accounted for 70% of the company’s total revenue of US$3.7 billion in 2018.

5. A proven ability to grow.

It’s important that a company has shown that it’s able to grow so that the chances of future growth are higher. And by growth, I’m looking at big jumps in revenue, net profit, and free cash flow over time. Sometimes, just revenue and free cash flow are good enough. I am generally wary of companies that (a) produce revenue and profit growth without corresponding increases in free cash flow, or (b) produce revenue growth but suffer losses and/or negative free cash flow. But I will be happy to make exceptions for some relatively young SaaS (software-as-a-service) companies that produce strong revenue growth but currently still generate losses and/or negative free cash flow.

A company’s track record is important, because it is easy for anyone to promise the sky – delivering on the promise is another matter, and it’s not easy to do. Amazon is a good example of a company with a strong history of growth. From 2013 to 2018, revenue tripled from US$74 billion to US$233 billion, while free cash flow jumped nearly nine times from US$2 billion to US$17 billion. PayPal Holdings is another good instance. From 2013 to 2018, revenue more than doubled from US$6.7 billion to US$15.5 billion, profit rose from US$1 billion to US$2 billion, and free cash flow increased from US$1.6 billion to US$4.7 billion.

6. A high likelihood of generating a strong and growing stream of free cash flow in the future.

The actual value of a company, in general, is the amount of cash it can generate over its entire life. So, the more free cash flow a company can produce, the more valuable it is. It’s important to note that free cash flow is not a relevant metric to use when assessing banks – the book value per share will be more appropriate.

A good example of a company that embodies this criterion, in my view, is Alphabet, the parent of the internet search giant Google (I own shares of Alphabet). Alphabet has a strong history of generating free cash flow, and it likely can continue doing so in the future, since the advertising business of Google is so lucrative. From 2013 to 2018, Alphabet’s free cash flow increased from US$11.3 billion to US$22.8 billion, while the free cash flow margin (free cash flow as a percentage of revenue) only slipped slightly from 20% to a still-strong 17%.

Conclusion

Companies that excel in all six criteria may still turn out to be poor investments. It’s impossible to get it right all the time in the investing game, so I believe it is important to diversify. And believe me, there are stocks in my family’s portfolio that are big losers (down 50% or more). But by sticking with companies that meet most or all of the six criteria above, I believe that the winners can more than make up for the losers. This is something that has happened to my family’s portfolio.

Another important point to note is that patience is needed in investing. Even the best winners in the market suffer painful declines from time to time. From 1997 to 2018, the peak-to-trough decline for Amazon’s stock price in each year ranged from 12.6% to 83.0%, meaning to say that Amazon’s stock price had experienced a double-digit peak-to-trough fall every year. Over the same period, Amazon’s stock price climbed from US$1.96 to US$1,501.97, for an astonishing gain of over 76,000%. My family’s portfolio still holds many of the stocks bought in 2010, 2011 and 2012 (we first bought Amazon shares in 2014 and are still happy owners). By having patience, we allow the underlying businesses of the companies we own shares in to shine and carry our portfolio to new heights over time.

24 Things Every Investor Should Know About Investing (To Become Better)

24 lessons learnt from a decade of investing.

I started investing in October 2010 and have learnt a lot along the way. Here are 24 evergreen lessons so that you, dear reader, can become a better investor.

Market facts

1. There are many hucksters out there. Always ask for their track record. How many “students” they have, how long they have been in the business, or much money they are managing does not matter. The key is, how have they done over a long period of time (five years and more)?

2. Stocks represent part ownership of a living, breathing business.

3. If a business does well over time, its stock price will too, eventually; if a business does poorly, so too will its stock price.

4. According to the Credit Suisse Global Investment Returns Yearbook 2019 report, Developed economy stocks have climbed by 8.2% per year from 1900 to 2018 – this turns $1,000 into $10.9 million. Emerging economy stocks have climbed by 7.2% per year rom 1900 to 2018 – this turns $1,000 into $3.7 million.

5. But stocks have been volatile over the short run – it happens to even the best of stocks.

6. From 1997 to 2018, the peak-to-trough decline for Amazon.com’s share price in each year ranged from 12.6% to 83.0%, meaning to say that Amazon’s share price had experienced a double-digit peak-to-trough fall every year. Over the same period, Amazon has seen its stock price climb from $1.96 to $1,501.97, for an astonishing gain of over 76,000%.

7. It makes sense for stocks to be volatile. If stocks went up 8% per year like clockwork without volatility, investors will feel safe, and safety leads to risk-taking. In a world where stocks are guaranteed to give 8% per year, the logical response from investors would be to keep buying them, till the point where stocks simply become too expensive to continue returning 8%, or where the system becomes too fragile with debt to handle shocks. Thing is, there are no guarantees in the world. Bad things happen from time to time. And when stocks are priced for perfection, any whiff of bad news will lead to tumbling prices.

8. Investing in stocks allows you to be a silent partner to some of the best businessmen and investors on the planet.

Investing psychology

9. There are always things to worry about and the future is always uncertain. But that does not mean we shouldn’t invest.

10. The past 53 years from 1965 to 2018 included the Vietnam War, the Black Monday stock market crash (when US stocks fell by more than 22% in a day), the “breaking” of the Bank of England (when the UK was forced to allow the pound to have a floating exchange rate), the Asian Financial Crisis, the bursting of the Dotcom Bubble, the Great Financial Crisis, Brexit, and the US-China trade war. But in those 53 years, the book value of Warren Buffett’s Berkshire Hathaway grew by 18.7% per year while its stock price increased by 20.5% per year. An 18.7% input has still led to a 20.5% output despite all these things to worry about.

11. Loss aversion is a psychological bias most people have where a loss feels twice as painful as an equivalent gain. Put in place systems to help you deal with the psychological pain when stocks fall from time to time.

12. The most important organ for investing is not the brain, but the stomach. We must not be scared off by short-term declines.

How to invest

13. The most sensible investment philosophy should be built on the idea that stocks represent part ownership of a living, breathing business. And there are times when a stock has a price that’s significantly lower than the value of its underlying business – investing is about identifying these instances!

14. There are many different ways to invest with the philosophy above. The three broad categories are: (a) Finding a large group of stocks that are cheap based on their financial statements; (b) Finding a handful of stocks that are cheap based on their financial statements and appraisal of their current business conditions; and (c) Finding stocks that are cheap based on how well their businesses may do in the future.

15. There are three financial statements every listed company must report: (a) Income statement; (b) Balance sheet; and (c) Cash flow statement.

16. The income statement measures how much sales a company makes, and how much profit the company makes; the balance sheet tells us what a company owns, and what it owes; the cash flow statement tells us how much cash a company brings in. It’s important to have basic accounting knowledge so you can track the progress of a company. Each financial statement has many important things to look at, but there are a few that are critical.

17. Critical things for the income statement:

Revenue (how much sales a company makes)
Gross profit margin
Operating profit margin
Net profit margin
Net profit (what’s left from sales after deduction of all expenses)
We typically want fat gross margins, fat operating margins, and fat net profit margins.

18. Critical things for the balance sheet:

Level of cash and level of debt; we typically want cash to be significantly higher than debt
Slightly less important things are total assets (what the company owns), total liabilities (what the company owes), and total equity (total assets minus total liabilities).

19. Critical things for the cash flow statement:

Operating cash flow (the cash flow generated from the company’s normal business operations)
Capital expenditure (what the company has spent to maintain its business at the current state)
We typically want high operating cash flow and low capital expenditure; the difference between operating cash flow and capital expenditure is free cash flow – the higher the better.

20. Going back to point 14, in this article I will focus mainly on the third broad category on how to invest: Finding stocks that are cheap based on how well their businesses may do in the future. A few quick words on the first and second broad categories of investing first…

21. Finding a large group of stocks that are cheap based on their financial statements: It focuses on finding a large group of stocks with share prices that are low in relation to their net profit and/or their total equity, and buying an entire basket of them. This basket is typically held for anywhere from a quarter to two-years, and the search-and-investing process is then repeated.

22. Finding a handful of stocks that are cheap based on their financial statements and appraisal of their current business conditions: It focuses on the analysis of a company’s business and financials to determine its underlying intrinsic value (nearly always how much cash it can generate from now to eternity, discounted back to the present), and then buying only a small handful of stocks with share prices that are much lower than their underlying intrinsic values.

23. The third broad category – finding stocks that are cheap based on how well their businesses may do in the future – is where I have found the most success in, and find the most intellectually stimulating. To do well in this area requires two very important things: (a) Patience, because share prices need time to reflect the strengths of the business, and because compounding takes time, and (b) a strong stomach to withstand volatility.

24. I find stocks with all or most of the following characteristics: (1) Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market; (2) Strong balance sheets with minimal or reasonable levels of debt; (3) Management teams with integrity, capability, and an innovative mindset; (4) Revenue streams that are recurring in nature, either through contracts or customer-behaviour; (5) A proven ability to grow; (6) A high likelihood of generating a strong and growing stream of free cash flow in the future. For a more thorough take on the six criteria, head here.

Note: An earlier version of this article was published at The Smart Investor, an investing website run by my friends.

My Family’s Portfolio

Here’s how my family’s investment portfolio has performed since October 2010.

I have been investing for my family since October 2010. The portfolio that I manage consists of US-listed stocks, so I track my returns against the most widely-followed US stock market benchmark, the S&P 500.

The portfolio contains over 50 stocks, and its return is net of trading fees and does not include dividends. The S&P 500 return does not include any hypothetical trading commissions but does include dividends.

I’m sharing my family’s investing journey to serve as inspiration for what’s possible by applying a long-term, business-focused mindset to investing in the stock market.