It is not uncommon to see stock prices gyrate wildly during earnings season. A small earnings beat and the stock goes up 10% or even 20%. An earnings miss and the stock is down double digits after hours.

Are these stock price movements justified? Has the intrinsic value of the stock really changed that much? In this article, I look at how a change in assumptions about a company’s cash flow can affect the intrinsic value of the stock.

I take a look at what effects changing assumptions to a company’s cash flow have on the intrinsic value of the stock.

When long-term assumptions are slashed

Let’s start by analysing a stock that has its long-term assumptions slashed. This should have the biggest impact on intrinsic value compared to just a near-term earnings miss.

Suppose Company A is expected to dish out $1 in dividends every year for 10 years before it closes down in year 10 and liquidates for $5 a share. The liquidation value is paid out to shareholders as a special dividend in year 10. The table below shows the dividend schedule and the calculation of the intrinsic value of the stock today using a 10% discount rate.

The intrinsic value in this case is $8.07.

But what if expectations for Company A are slashed? The dividend schedule is now expected to drop 10% to 90 cents per share for the next 10 years. The liquidation value is also cut by 10% to $4.50. The table below illustrates the new dividend expectation and the new intrinsic value of the stock.

Understandably, the intrinsic value drops 10% to $7.27 as all future cash flows are now 10% less. In this case, if the stock was trading close to the initial $8.07 per share intrinsic value, then a 10% decline in the stock price can be considered justified.

When only short-term cash flows are impacted

But most of the time, expectations for a company should not change so drastically. An earnings miss may lead to expectations of lower dividends for the next couple of years but does not impact dividend projections for later years.

For instance, let’s say the dividend projection for Company A above is cut by 10% for Year 1 but returns to $1 per share in Year 2 onwards and the liquidation value at the end of Year 10 is still $5. The table shows the new expected dividend schedule and the intrinsic value of the stock.

In this case, the intrinsic value drops to $7.98 from $8.07. Only a small decline in the stock price is warranted if the stock was initially trading close to its $8.07 intrinsic value since the decline in intrinsic value is only minimal. 

Delaying cash flows to the shareholder

Expectations can also change about the timing of cash flows paid to shareholders. This will also impact the intrinsic value of a stock.

For the same company above, instead of dividends per share declining, the dividends are paid out one year later than expected. The table below shows the new expected dividend schedule and the present value of the cash flows.

As you can see this has a bigger impact on intrinsic value. The intrinsic value of the stock drops to $5.24 from $8.07. But this is a pretty extreme example. We have delayed all future cash flows by one year. In most cases, our expectations may not change so drastically. For instance, Year 1’s dividend may just be pushed to Year 2. The table below illustrates this new scenario.

In this case, the intrinsic value only drops by a few cents to $7.99.

Conclusion

A change in expectations for a company has an impact on intrinsic value. But unless the expectations have changed dramatically, the change in intrinsic value is usually small.

Fluctuations in stock prices are more often than not overreactions to new information that the market is prone to make. Most of the time, the new information does not change the expectations of a company drastically and the stock price movements can be considered unjustified. This is the case if the stock price is trading close to its original intrinsic value to begin with.

But bear in mind, this works both ways. Stock price pops can also be considered unjustified depending on the situation. As investors, we can use any mispricing of stocks to earn a good long-term return.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I have no vested interest in any companies mentioned. Holdings are subject to change at any time.

Investors often talk about profits and free cash flow. I’m no exception. If you look at the archive of articles on this blog, you will find that I have written about both of these subjects numerous times.

So why am I saying that profits and free cash flow are not what really matter and that dividends are what ultimately matters most?

Well, that’s because an asset should be valued based on the cash flow that the asset can produce for the asset holder. In the case of stocks, dividends are the only cash flow you receive as a long-term shareholder.

Business profits may not end up in our pockets 

Although profits or free cash flow that a business earns can theoretically be returned to the shareholder, the truth is that, more often than not, they aren’t. Companies may want to retain a portion or all of that cash flow for reinvestment in the business, acquisitions, or buybacks. 

Let’s take a look at a simple example.

Company A is a profitable business. It generates $1 in free cash flow in year one. The company does not want to pay a dividend. Instead, it reinvests that $1 to generate 10% more cash flows the subsequent year. It keeps reinvesting its profits each year for 5 years. Only after Year 5 does Company A decide that it will start to return all its free cash flow to shareholders as dividends. Its free cash flow per year stagnates after Year 5. Here is what Company A’s annual free cash flow and dividend per share look like:

Company B, on the other hand, produces $0 in free cash flow in Years 1 to 5. But in Year 6, it starts to generate $1.61 in free cash flow per share and pays all of that out as dividends each year. Like Company A, its growth stagnates after Year 5.

Here is what Company B’s annual free cash flow and dividend per share look like:

Which company is worth more? Neither. They are worth the same. That is because the cash flow received by the shareholders is equal.

Free cash flow and profits do not reflect all costs

If the above example left you slightly confused, maybe you can think of it like this. A company may be generating free cash flow but uses all that cash to grow through acquisitions or conduct share buybacks. Another company may be using its cash from operations to build more capacity to drive growth. The cash spent here are capital expenses which lower free cash flow*.

The first company may appear to be generating a lot of free cash flow but that cash is being spent on buybacks and acquisitions. The second company has no free cash flow but that’s because its investments are deducted before calculating free cash flow. Both these companies end up with no cash that year that can be returned to shareholders even though one is generating free cash flow and the other one is not. The difference lies in where these expenses/investments are recorded.

Capital expenses are deducted in the calculation of free cash flow but cash acquisitions of another company or buybacks usually are not. Correspondingly, a company that is spending heavily on marketing for growth may show up with no operating cash flow at all and consequently no free cash flow. Ultimately, it does not matter how the company invests or whether free cash flow appears on the financial statements. What really matters is how much cash the company can eventually return to shareholders as dividends, now or in the future.

Although it is true that dividends will eventually come from the free cash flow that a company produces, it is not always true that the free cash flow produced in any given year will lead to dividends.

A brief comment on buybacks

This discussion would not be complete without a short discussion on where buybacks fit into the grand scheme of things. Companies often declare that they have “returned” cash to shareholders through buybacks. 

However, this cash is only returned to shareholders who actually sell their stock to the company. What do long-term shareholders who do not sell their shares to the company get? They certainly do not receive any cash. 

I count buybacks as a form of investment that the company makes. Buybacks increase a company’s free cash flow per share by reducing the outstanding share count. Long-term shareholders benefit as future dividends are now split among fewer shares.

Given this, I do not count buybacks as cash that is “returned” to the long-term shareholder. Instead, I count it as an investment that drives free cash flow per share growth, and eventually, dividend per share growth.

What ultimately matters to long-term shareholders is, hence, dividends. Dividends is the only cash flow that a long-term shareholder receives. And this is what should drive the value of the stock price.

Final word

Don’t get me wrong. I’m not saying that investors should only invest in companies that are paying dividends. Far from it. I personally have a vested interest in many companies that currently don’t pay a dividend.

However, as a long-term shareholder, I’m cognizant of the fact that the value of the stock is dependent on the dividends that the company will pay eventually. Companies that don’t pay a dividend now or even in the near future can still be valuable if they ultimately start paying dividends.

And while cash flows and profits may not always result in dividends, it is the backbone of where dividends come from. As such, it is still important to keep in mind the future cash-generative profile of a company that will ultimately lead to dividend payments.

*Free cash flow is usually calculated as operating cash flow minus any capital expenses such as the purchase of property, plant and equipment or capitalised software costs

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I have no vested interest in any companies mentioned. Holdings are subject to change at any time.

This March has been a wild month in the world of finance. So far, three banks in the USA have collapsed, including Silicon Valley Bank, the 16th largest bank in the country with US$209 billion in assets at the end of 2022. Meanwhile, First Republic Bank, ranked 14th in America with US$212 billion in assets, has seen a 90% month-to-date decline in its share price. Over in Europe, the Swiss bank Credit Suisse, with a market capitalization of US$8.6 billion on the 17th, was forced by regulators to agree to be acquired by its national peer, UBS, for just over US$3 billion on the 19th.

The issues plaguing the troubled banks have much to do with the sharp rise in interest rates seen in the USA and Europe that began in earnest in the third quarter of 2022. For context, the Federal Funds Rate – the key interest rate benchmark in the USA – rose from a target range of 1.5%-1.75% at the end of June 2022 to 4.5%-4.75% right now. Over the same period, the key interest rate benchmarks in the European Union rose from a range of -0.5% to 0.25%, to a range of 3.0% to 3.75%. Given the aforementioned banking failures, it’s clear that rising interest rates are already a big problem for banks. But there could be more pain ahead for banks who fail to understand a lesson from an old banking crisis in the USA.

A blast from the past

The Savings & Loan (S&L) crisis started in the early 1980s and stretched into the early 1990s. There were nearly 4,000 S&L institutions in the USA in 1980; by 1989, 563 of them had failed. S&L institutions are also known as thrift banks and savings banks. They provide similar services as commercial banks, such as deposit products, loans, and mortgages. But S&L institutions have a heavier emphasis on mortgages as opposed to commercial banks, which tend to also focus on business and personal lending.

In the early 1980s, major changes were made to the regulations governing S&L institutions and these reforms sparked the crisis. One of the key changes was the removal of caps on the interest rates that S&L institutions could offer for deposits. Other important changes included the removal of loan-to-value ratios on the loans that S&L institutions could make, and the relaxation on the types of assets that they could own.

The regulatory changes were made to ease two major problems that S&L institutions were confronting. First, since the rates they could offer were limited by the government, S&L institutions found it increasingly difficult to compete for deposits after interest rates rose dramatically in the late 1970s. Second, the mortgage loans that S&L institutions made were primarily long-term fixed rate mortgages; the rise in interest rates caused the value of these mortgage loans to fall. The US government thought that S&L institutions could cope better if they were deregulated.

But because of the relaxation in rules, it became much easier for S&L institutions to engage in risky activities. For instance, S&L institutions were now able to pay above-market interest rates on deposits, which attracted a flood of savers. Besides paying high interest on deposits, another risky thing the S&L institutions did was to make questionable loans in areas outside of residential lending. For perspective, the percentage of S&L institutions’ total assets that were in mortgage loans fell from 78% in 1981 to just 56% by 1986.

Ultimately, the risks that the S&L institutions had taken on, as a group, were too high. As a result, many of them collapsed.

Learning from the past

Hingham Institution of Savings is a 189-year-old bank headquartered in Massachusetts, USA. Its current CEO, Robert Gaughen Jr, assumed control in the middle of 1993. Since then, the bank has been profitable every single year. From 1994 (the first full-year where the bank was led by Robert Gaughen Jr) to 2022, Hingham’s average return on equity (ROE) was a respectable 14.2%, and the lowest ROE achieved was 8.4% (in 2007). There are two things worth noting about the 1994-2022 timeframe in relation to Hingham: 

• The bank had – and still has – heavy exposure to residential-related real estate lending.
• The period covers the 2008-09 Great Financial Crisis. During the crisis, many American banks suffered financially and US house prices crashed. For perspective, the US banking industry had ROEs of 7.8%,  0.7%, and -0.7% in 2007, 2008, and 2009, while Hingham’s ROEs were higher – at times materially so – at 8.4%, 11.1%, and 12.8%.

Hingham’s most recent annual shareholder’s meeting was held in April 2022. During the meeting, its president and chief operating officer, Patrick Gaughen, shared an important lesson that banks should learn from the S&L crisis (emphasis is mine):

“We spent some time talking in the past about why bankers have misunderstandings about the S&L crisis in the ’80s, with respect to how a lot of those banks failed. And that was in periods when rates were rising, there were a lot of S&Ls that looked for assets that had yields that would offset the rising price of their liabilities, and those assets had risks that the S&Ls did not appreciate. Rather than accepting tighter margins through those periods where there were flatter curves, they resisted. They tried to protect those profits. And in doing so, they put assets on the balance sheet that when your capital’s levered 10x or 11x or 12x or 13x to 1 — they put assets on the balance sheet that went under.”

In other words, the S&L institutions failed because they wanted to protect their profits at a time when their cost of deposits were high as a result of rising interest rates. And they tried to protect their profits by investing in risky assets to chase higher returns, a move which backfired.

A better way

At Hingham’s aforementioned shareholder’s meeting, Patrick Gaughen also shared what he and his colleagues think should be the right way to manage the problem of a high cost of deposits stemming from rising interest rates (emphases are mine):

“And I think it’s important to think and maybe describe the way that I think about this is that we’re not protecting profits in any given period. We’re thinking about how to maximize returns on equity on a per share basis over a long time period, which means that there are probably periods where we earn, as I said earlier, outsized returns relative to that long-term trend. And then periods where we earn what are perfectly satisfactory returns. Looking back over history, with 1 year, 2 years exceptions, double-digit returns on equity. So it’s satisfactory, but it’s not 20% or 21%.

And the choices that we’ve made from a structural perspective about the business mean that we need to live with both sides of that trade as it occurs. But over the long term, there are things we can do to offset that. So the first thing we’re always focused on regardless of the level and the direction of rates is establishing new relationships with strong borrowers, deepening the relationships that we have with customers that we already have in the business. Because over time, those relationships as the shape of curve changes, those relationships are going to be the relationships that give us the opportunity to source an increasing volume of high quality assets. And those are the relationships that are going to form the core of the noninterest-bearing deposits to allow us to earn those spreads. And so that’s true regardless of the direction of rates.”

I find the approach of Hingham’s management team to be sensible. By being willing to accept lower profits when interest rates (and thus deposit rates) are high, management is able to ensure Hingham’s longevity and maximise its long-term returns.

In our current environment, interest rates are elevated, which makes the cost of deposits expensive for banks. If you’re looking to invest in the shares of a bank right now, you may want to determine if the bank’s management team has grasped the crucial lesson from the S&L crisis of old. If there’s a bank today which fails to pay heed, they may well face failure in the road ahead.

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

On 12 March 2023, Signature Bank, which was based in New York, was closed by banking regulators in the USA. Its closure happened in the wake of Silicon Valley Bank’s high-profile collapse just a few days prior. Silicon Valley Bank was dealing with a flood of deposit withdrawals that it could not handle. After regulators assumed control of Silicon Valley Bank, it was revealed that depositors tried to withdraw US$42 billion – around a quarter of the bank’s total deposits – in one day. 

Signature Bank was by no means a behemoth, but it was definitely not small. For perspective, the US’s largest bank by assets, JPMorgan Chase, had total assets of US$3.67 trillion at the end of 2022; Signature Bank, meanwhile, reported total assets of US$110 billion. But what is fascinating – and shocking – about Signature Bank’s failure is not its size. It has to do with its board of directors, one of whom is Barney Frank, a long-time politician who retired from American politics in 2012.

During his political career, Frank was heavily involved with reforming and regulating the US banking industry. From 2007 to 2011, he served as Chairman of the House Financial Services Committee, where he played an important role in creating a US$550 billion plan to rescue American banks during the 2008-2009 financial crisis. He also cosponsored the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was signed into law in July 2010. The Dodd-Frank act was established in the aftermath of the 2008-2009 financial crisis, which saw many banks in the USA collapse. The act was created primarily to prevent banks from engaging heavily in risky activities that could threaten their survival.

Although Signature Bank was able to tap on Frank’s experience for the past eight years – he has been a director of the bank since June 2015 – it still failed. An argument can be made that Signature Bank was  engaging in risky banking activities prior to its closure. The bank started taking deposits from cryptocurrency companies in 2018. By 2021 and 2022, deposits from cryptocurrency companies made up 27% and 20%, respectively, of Signature’s total deposit base; the bank was playing with fire by having significant chunks of its deposit base come from companies in a highly speculative sector. The key takeaway I have from this episode is that investors should never be complacent about the capabilities of a company’s leaders, even if they have a storied reputation. Always be vigilant.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I do not have a vested interest in any stocks mentioned. Holdings are subject to change at any time. 

A book I read recently is Edward Chancellor’s The Price of Time, published in July 2022. The book traces the history of interest rates from ancient Mesopotamia (a civilisation that dates back to 3100 B.C.) to our current era. One of the thought-provoking collection of ideas I gleaned from the book involves China and the growing problems with its economy over the past two to three decades.

Jeremy and I have investments in China, so I want to document these facts for easy reference in the future. Moreover, given the size of China’s economy – the second largest in the world – I think anyone who’s interested in investing may find the facts useful. To be clear, none of what I’m going to share from The Price of Time is meant to be seen as a commentary on the attractiveness (or lack thereof) of Chinese stocks or the growth prospects of the Chinese economy. Instead, Jeremy and I merely see them as providing additional colour in the mosaic we have collected over time about how the world works and where the world is going. With that, here’re the fascinating new details I picked up about China’s economy from The Price of Time (bolded emphases are mine):

The state of China’s property bubble in 2016

Quote 1

“In parts of Shanghai and neighbouring Suzhou, empty development plots sold for more than neighbouring land with completed buildings – a case of ‘flour more expensive than bread’. By late 2016, house prices were valued nationwide at eight times average Chinese incomes, roughly double the peak valuation of US housing a decade earlier.”

Quote 2

“A study released in 2015 by the National Bureau of Economic Research found that rental yields in Beijing and Shanghai had fallen below 2 per cent – in line with the discount rate. However, rental yields of less than 2 per cent implied a payback of nearly seven decades – roughly the same length of time as residential land leases, after which title reverted to the state… But, as the NBER researchers commented, ‘only modest declines in expected appreciation seem needed to generate large drops in house values.’”

Quote 3

“By late 2016 total real estate was valued at [US]$43 trillion, equivalent to nearly four times GDP and on a par with the aggregate value of Japanese real estate (relative to GDP) at its bubble peak. Like Japan three decades earlier, China had transformed into a ‘land bubble’ economy. The French bank Société Générale had calculated back in 2011 that over the previous decade China had built 16 billion square metres of residential floor space. This was equivalent to building modern Rome from scratch every fourteen days, over and over again. A decade after the stimulus more than half of the world’s hundred tallest buildings were under construction in the People’s Republic, and more than a quarter of economic output was related, directly or indirectly, to real estate development.”

The stunning growth of debt in China in the 21st century

Quote 4

“In ten years to 2015, China accounted for around half the world’s total credit creation. This borrowing binge constituted ‘history’s greatest Credit Bubble’. Every part of the economy became bloated with debt. Liabilities of the banking system grew to three times GDP. At the time of Lehman’s bankruptcy, households in the People’s Republic carried much less debt than their American counterparts. But, since the much-touted ‘rebalancing’ of the economy never occurred, consumers turned to credit to enhance their purchasing power.

Between 2008 and 2018, Chinese households doubled their level of debt (relative to income) and ended up owing more than American households did at the start of the subprime crisis. Over the same period, Chinese companies borrowed [US]$15 trillion, accounting for roughly half the total increase in global corporate debt. Real estate companies borrowed to finance their developments – the largest developer, Evergrande, ran up total liabilities equivalent to 3 per cent of GDP. Local governments set up opaque financing vehicles to pay for infrastructure projects with borrowed money. Debt owed by local governments grew to [US]$8.2 trillion (by the end of 2020), equivalent to more than half of GDP.”

How China concealed its bad-debt problems in the 21st century and the problems this concealment is causing

Quote 5

“Although they borrowed more cheaply than private firms, state-owned enterprises nevertheless had trouble covering their interest costs. After 2012 the total cost of debt-servicing exceeded China’s economic growth. An economy that can’t grow faster than its interest costs is said to have entered a ‘debt trap’. China avoided the immediate consequences of the debt trap by concealing bad debts. What’s been called ‘Red Capitalism’ resembled a shell game in which non-performing loans were passed from one state-connected player to another.

The shell game commenced at the turn of this century when state banks were weighed down with nonperforming loans. The bad loans weren’t written off, however, but sold at face value to state-owned asset management companies (AMCs), which paid for them by issuing ten-year bonds that were, in turn, acquired by the state-owned banks. In effect, the banks had swapped uncollectible short-term debt for uncollectible long dated debt. When the day finally arrived for the AMCs to redeem their bonds, the loans were quietly rolled over. Concealing or ‘evergreening’ bad debts required low interest rates. China’s rate cuts in 2001 and 2002 were partly intended to help banks handle their debt problems. Over the following years, bank loan rates were kept well below the country’s nominal GDP growth, while deposit rates remained stuck beneath 3 per cent. Thus, Chinese depositors indirectly bailed out the banking system.

After 2008, cracks in the credit system were papered over with new loans – a tenet of Red Capitalism being that ‘as long as the banks continue to lend, there will be no repayment problems.’ But it became progressively harder to conceal problem loans. In 2015, an industrial engineering company (Baoding Tianwei Group) became the first state-owned enterprise to default on its domestic bonds. The trickle of defaults continued. One could only guess at the scale of China’s bad debts. Bank analyst Charlene Chu suggested that by 2017 up to a quarter of bank loans were non-performing. This estimate was five times the official figure.

As Chu commented: ‘if losses don’t manifest on financial institution balance sheets, they will do so via slowing growth and deflation.’ Debt deflation, as Irving Fisher pointed out, occurs after too much debt has accumulated. At the same time, excess industrial capacity was putting downward pressure on producer prices and leading China to export deflation abroad – for instance, by dumping its surplus steel in European and US markets. Corporate zombies added to deflation pressures. Despite the soaring money supply after 2008, consumer prices hardly budged. By November 2015, the index of producer prices had fallen for a record forty-four consecutive months.

If China’s investment had been productive, then it would have generated the cash flow needed to pay off its debt. But, for the economy as a whole, this wasn’t the case. So debt continued growing. Top officials in Beijing were aware that the situation was unsustainable. In the summer of 2016, President Xi’s anonymous adviser warned in his interview with the People’s Daily that leverage must be contained. ‘A tree cannot grow to the sky,’ declared the ‘authoritative person’; ‘high leverage must bring with it high risks.’ Former Finance Minister Lou Jiwei put his finger on Beijing’s dilemma: ‘The first problem is to stop the accumulation of leverage,’ Lou said. ‘But we also can’t allow the economy to lose speed.’ Since these twin ambitions are incompatible, Beijing chose the path of least resistance. A decade after the stimulus launch, China’s ‘Great Wall of Debt’ had reached 250 per cent of GDP, up 100 percentage points since 2008.”

The troubling state of China’s shadow banking system in 2016

Quote 6

“By 2016, the market for wealth management products had grown to 23.5 trillion yuan, equivalent to over a third of China’s national income. Total shadow finance was estimated to be twice as large. Even the relatively obscure market for debt-receivables exceeded the size of the US subprime market at its peak. George Soros observed an ‘eery resemblance’ between China’s shadow banks and the discredited American version. Both were driven by a search for yield at a time of low interest rates; both were opaque; both involved banks originating and selling on questionable loans; both depended on the credit markets remaining open and liquid; and both were exposed to real estate bubbles.”

China’s risk of facing a currency crisis because of its expanding money supply

Quote 7

“As John Law had discovered in 1720, it is not possible for a country to fix the price of its currency on the foreign exchanges while rapidly expanding the domestic money supply. Since 2008 China’s money supply had grown relentlessly relative to the size of its economy and the world’s total money supply. Those trillions of dollars’ worth of foreign exchange reserves provided an illusion of safety since a large chunk was tied up in illiquid investments. Besides, cash deposits in China’s banks far exceeded foreign exchange reserves. If only a fraction of those deposits left the country, however, the People’s Republic would face a debilitating currency crisis.” 

China’s problems of inequality, financial repression, and tight control of the economy by the government

Quote 8

“From the early 1980s onwards, the rising incomes of hundreds of millions of Chinese workers contributed to a decline in global inequality. But during this period, China itself transformed from one of the world’s most egalitarian nations into one of the least equal. After 2008, the Gini coefficient for Chinese incomes climbed to 0.49 – an indicator of extreme inequality and more than twice the level at the start of the reform era.

The inequality problem was worse than the official data suggested. A 2010 report from Credit Suisse claimed that ‘illegal or quasi-legal’ income amounted to nearly a third of China’s GDP. Much of this grey income derived from rents extracted by Party members. The case of Bo Xilai, the princeling who became Party chief of Chongqing, is instructive. As the head of this sprawling municipality, Bo made a great display of rooting out corruption. But after he fell from grace in 2012 it was revealed that his family was worth hundreds of millions of dollars. Premier Wen’s family fortune was estimated at [US]$2.7 billion.

The richest 1 per cent of the population controlled a third of the country’s wealth, while the poorest quartile owned just 1 per cent. The real estate bubble was responsible for much of this rise in inequality. Researchers at Peking University found that 70 per cent of household wealth was held in real estate. A quarter of China’s dollar billionaires were real estate moguls. At the top of the rich list was Xu Jiayin, boss of property developer China Evergrande, whose fortune (in 2018) was estimated at [US]$40 billion. Many successful property developers turned out to be the offspring of top Party members. Local government officials who drove villagers off their land to hand it over to developers acted as ‘engines of inequality’.

Financial repression turned back the clock on China’s economic liberalization. Throughout its history, the Middle Kingdom’s progress ‘has an intermittent character and is full of leaps and bounds, regressions and relapses’. In general, when the state has been relatively weak and money plentiful, the Middle Kingdom has advanced. Incomes were probably higher in the twelfth century under the relatively laissez-faire Song than in the mid-twentieth century when the Communists came to power. But when the state has shown a more authoritarian character, economic output has stagnated or declined. The mandarins’ desire for total monetary control contributed to Imperial China’s ‘great divergence’ from Western economic development.

In recent years, China has experienced an authoritarian relapse. Paramount leader Xi Jinping exercises imperial powers. An Orwellian system of electronic surveillance tracks the citizenry. Millions of Uighurs are reported to have been locked up in camps. Private companies are required to place the interests of the state before their own. The ‘China 2025’ economic development plans aim to establish Chinese predominance in a number of new technologies, from artificial intelligence to robotics. A system of social credits, which rewards and punishes citizens’ behaviour, will supplement conventional credit. A digital yuan, issued by the People’s Bank, will supplement – or even replace – conventional money. These developments are best summed up by a phrase that became commonplace in the 2010s: ‘the state advances, while the private [sector] retreats.’

Financial repression has played a role in this regressive movement. The credit binge launched by the 2008/9 stimulus enhanced Beijing’s sway over the economy. As the state has advanced, productivity growth has declined. Because interest rates neither reflect the return on capital nor credit risk, China’s economy has suffered from the twin evils of capital misallocation and excessive debt. Real estate development, fuelled by low-cost credit, delivered what President Xi called ‘fictional growth’. By 2019 Chinese GDP growth (per capita) had fallen to half its 2007 level.

The Third Plenum of the Eighteenth Chinese Communist Party Congress, held in Beijing in 2013, heralded profound reforms to banking practices. The ceiling on bank deposit rates was lifted, and banks could set their own lending rates. Households earned a little more on their bank deposits, but interest rates remained below nominal GDP growth. The central bank now turned to managing the volatility of the interbank market interest rate. The People’s Bank still lacked independence and had to appeal to the State Council for any change to monetary policy.

Allowing interest rates to be set by the market would have required wrenching changes. Forced to compete for deposits, state-controlled banks would suffer a loss of profitability. Bad loans would become harder to conceal. Without access to subsidized credit, state-owned enterprises would become even less profitable. Corporate zombies would keel over. Economic planners would lose the ability to direct cheap capital to favoured sectors. The cost of controlling the currency on the foreign exchanges would become prohibitively expensive. Beijing would no longer be able to manipulate real estate or fine-tune other markets.

The Party’s monopoly of power has survived the liberalization of most commercial prices and many business activities, but the cadres never removed their grip on the most important price of all. The state, not the market, would determine the level of interest. The legacy of China’s financial repression was, as President Xi told the National Congress in 2017, a ‘contradiction between unbalanced and inadequate [economic] development and the people’s ever-growing needs for a better life’, which, in turn, provided Xi with a rationale for further advancing the role of the state.”

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I do not have a vested interest in any stocks mentioned. Holdings are subject to change at any time.

What happens to stocks when risk-free rates are high? Theoretically, when risk-free rates are high, stocks should fall in price – why would anyone invest in stocks if they can earn 8%, risk-free? But as Yogi Berra was once believed to have said, “In theory, there is no difference between practice and theory. In practice, there is.”

Ben Carlson is the Director of Institutional Asset Management at Ritholtz Wealth Management. He published a blog post recently, titled Will High Risk-Free Rates Derail the Stock Market?, where he looked at the relationship between US stock market returns and US government interest rates. It turns out there’s no clear link between the two.

In the 1950s, the 3-month Treasury bill (which is effectively a risk-free investment, since it’s a US government bond with one of the shortest maturities around) had a low average yield of 2.0%; US stocks returned 19.5% annually back then, a phenomenal gain. In the 2000s, US stocks fell by 1.0% per year when the average yield on the 3-month Treasury bill was 2.7%. Meanwhile, a blockbuster 17.3% annualised return in US stocks in the 1980s was accompanied by a high average yield of 8.8% for the 3-month Treasury bill. In the 1970s, the 3-month Treasury bill yielded a high average of 6.3% while US stocks returned just 5.9% per year. 

Here’s a table summarising the messy relationship, depicted in the paragraph above, between the risk-free rate and stock market returns in the USA:

So there are two important lessons here: (1) While interest rates have a role to play in the movement of stocks, it is far from the only thing that matters; (2) one-factor analysis in finance – “if A happens, then B will occur” – should be largely avoided because clear-cut relationships are rarely seen.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I do not have a vested interest in any stocks mentioned. Holdings are subject to change at any time.

In my December 2021 article, The Need For Patience, I shared two of my favourite investing stories. The first involved Warren Buffett’s experience with investing in The Washington Post Company in 1973 and the second was about the recommendation of Starbucks shares by the brothers, David and Tom Gardner, during a TV show in the USA in July 1998. 

The thread tying the two stories together was that both companies saw sharp declines in their stock prices while on their way to delivering massive returns. Washington Post’s stock price fell by more than 20% shortly after Buffett invested, and then stayed in the red for three years. But by the end of 2007, Buffett’s investment in Washington Post had produced a return of more than 10,000%. As for Starbucks, its stock price was down by a third a mere six weeks after the Gardners’ recommendation. When The Need For Patience was published, the global coffee retailer’s stock price was 30 times higher from where the Gardners recommended the company.

I recently learnt that Walmart, the US retail giant, had walked a similar path. From 1971 to 1980, Walmart produced breath-taking business growth. The table below shows the near 30x increase in Walmart’s revenue and the 1,600% jump in earnings per share in that period. Unfortunately, this exceptional growth did not help with Walmart’s short-term return. Based on the earliest data I could find, Walmart’s stock price fell by three-quarters from less than US$0.04 in late-August 1972 to around US$0.01 by December 1974 – in comparison, the S&P 500 was down by ‘only’ 40%. 

But by the end of 1979, Walmart’s stock price was above US$0.08, more than double what it was in late-August 1972. Still, the 2x-plus increase in Walmart’s stock price was far below the huge increase in earnings per share the company generated. This is where the passage of time helped – as more years passed, the weighing machine clicked into gear (I’m borrowing from Ben Graham’s brilliant analogy of the stock market being a voting machine in the short run but a weighing machine in the long run). At the end of 1989, Walmart’s stock price was around US$3.70, representing an annualised growth rate in the region of 32% from August 1972; from 1971 to 1989, Walmart’s revenue and earnings per share grew by 41% and 38% per year. Even by the end of 1982, Walmart’s stock price was already US$0.48, up more than 10 times where it was in late-August 1972. 

What’s also interesting was Walmart’s valuation. It turns out that in late-August 1972, when its stock price was less than US$0.04, Walmart’s price-to-earnings (P/E) ratio was between 42 and 68 (I couldn’t find quarterly financial data for Walmart for that time period so I worked only with annual data). This is a high valuation. If you looked at Walmart’s stock price in December 1974, after it had sunk by 75% to a low of around US$0.01 to carry a P/E ratio of between 6 and 7, the easy conclusion is that it was a mistake to invest in Walmart in August 1972 because of its high valuation. But as Walmart’s business continued to grow, its stock price eventually soared to around US$3.70 near the end of 1989. What looked like a horrendous mistake in the short run turned out to be a wonderful decision in the long run because of Walmart’s underlying business growth. 

This look at a particular part of Walmart’s history brings to mind two important lessons for all of us when we’re investing in stocks:

• Even when you’ve found the best company to invest in, it’s likely that there will be pain before gain; don’t give up on the company’s stock just because its price has fallen
• Paying a high valuation can still work out really well if the company’s underlying business can indeed grow at a high clip for a long time 

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. Of all the companies mentioned, I currently have a vested interest in Starbucks. Holdings are subject to change at any time.