Category: General Investing

My article Surprising Facts About Oil Prices (And The Questions They Raise) was published last week. In it, I mentioned that “the price of oil has experienced at least five major crashes over the past four decades despite demand for the commodity being higher than supply in every year.” When Vision Capital’s Eugene Ng – who’s a friend of both Jeremy and myself – read it, he was intrigued by what I discovered about oil prices and wanted to find out more. 

Eugene noticed that the U.S. Energy Information Administration (EIA) maintained its own database for long-term global oil consumption and production. After plotting a chart of EIA’s data, he obtained similar results to what I got from BP (NYSE: BP) (the BP data was shown in my aforementioned article). Eugene and I talked about this and he decided to ask the EIA how it is possible for oil consumption to outweigh production for decades. 

The EIA kindly responded to Eugene, who shared the answers with me. It turns out that there could be errors within EIA’s data. The possible sources of errors come from incomplete accounting of Transfers and Backflows in oil balances: 

• Transfers include the direct and indirect conversion of coal and natural gas to petroleum.
• Backflows refer to double-counting of oil-streams in consumption. Backflows can happen if the data collection process does not properly account for recycled streams.

The EIA also gave an example of how a Backflow could happen with the fuel additive, MTBE or methyl tert-butyl ether (quote is lightly edited for clarity):

“The fuel additive MTBE is an useful example of both, as its most common feedstocks are methanol (usually from a non-petroleum fossil source) and Iso-Butylene whose feedstock likely comes from feed that has already been accounted for as butane (or iso-butane) consumption. MTBE adds a further complexity in that it is often exported as a chemical and thus not tracked in the petroleum trade balance.”

Thanks to the EIA, I now appreciate that the BP data I cited in Surprising Facts About Oil Prices (And The Questions They Raise) might contain errors, and how those errors could have appeared. This answers the third question I had in the article, but the first two questions remain unanswered. Even after knowing that there could be years between 1980 and 2021 where production came in higher than consumption, I can’t tell what the actual demand-and-supply dynamics of oil were during the five major crashes in oil prices that happened in that period.

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

Warren Buffett has recently been investing billions in shares of oil & gas companies such as Occidental Petroleum (NYSE: OXY) and Chevron (NYSE: CVX). I’ve also seen articles and podcasts from oil & gas investors talking about the current supply-and-demand dynamics in the oil market that could lead to sustained high prices for the energy commodity, (the price of WTI Crude is currently around US$93 per barrel). These piqued my interest and led me to research the history of oil prices and what influences it.

What I found was surprising. First, here’s a brief history on major crashes in the price of oil (WTI Crude) over the past four decades:

• 1980 – 1986: From around US$30 to US$10
• 1990 – 1994: From around US$40 to less than US$14
• 2008 – 2009: From around US$140 to around US$40
• 2014 – 2016: From around US$110 to less than US$33
• 2020: From around US$60 to -US$37 

As a commodity, it’s logical to think that differences in the level of oil’s supply-and-demand would heavily affect its price movement – when demand is higher than supply, prices would rise, and vice versa. But data from BP (NYSE: BP) – one of the largest oil-producing companies in the world, so there’s no reason to doubt the validity of the data – show otherwise.

BP’s dataset goes back to 1965 and from then to 1980, the consumption of oil (demand) was lower than the production of oil (supply) in every year. From 1981 onwards, the relationship flipped, with demand being higher than supply in every year since. This is shown in Figure 1. What this means is the price of oil has experienced at least five major crashes over the past four decades despite demand for the commodity being higher than supply in every year. 

These surprising facts about the oil market bring up three important questions in my mind: 

• Are there way more important factors than demand-and-supply dynamics that can move the price of oil?
• What do the facts imply about the future movement of oil prices, given the widely-held view (at least from what I’ve gathered) that oil prices would remain elevated – or climb higher from here – based on the current environment where demand far outstrips supply, and where supply is not able to be increased easily?
• How is it physically possible that consumption of oil can outweigh production for four decades?

I currently don’t have answers to these questions. But if any of you reading this have thoughts to share, please reach out to me – I’ll be happy to discuss!

Note: A follow-up article addressing one of the questions was published on 9 September 2022. Read it here.

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

Note: An earlier version of this article was first published in The Business Times on 26 July 2022

Lately, the dreaded “R” word has been making its rounds. Yes, I’m talking about a recession, a risk that is not confined to any specific country. In fact, in early July, the chief of the International Monetary Fund, Kristalina Georgieva, warned that a global recession cannot be ruled out. 

The thing is, recessions are not within our control. Yet, as investors, we are affected by it. This begs the question, what should stock market investors do now that the possibility of a recession looms in the background? 

I don’t have a panacea, but what I can offer are historical perspectives – truths, if you will – about stocks and recessions. The US stock market is a great case study. According to the Visual Capitalist, the USA accounts for nearly a quarter of global economic output while its stocks make up around 40% of the total global stock market capitalisation based on data from the Securities Industry and Financial Markets Association.

1. What happened to stocks in past recessions

A common refrain I’ve heard over the years is that stock prices are bound to fall during a recession. But the data says otherwise.

Ben Carlson is the Director of Institutional Asset Management at Ritholtz Wealth Management. According to his research shown in his recent blog post titled Timing a Recession vs. Timing the Stock Market, there have been 12 recessions in the USA since World War II (WWII). 

The average return for the S&P 500 – a broad barometer for US stocks – when all these recessions took place was 1.4%. A positive number. Of course, there were some horrible returns within the average. For example, the recession that stretched from December 2007 to June 2009 saw the S&P 500 fall by 35.5%. On the other end, there were some decent returns. For the recession between July 1981 and November 1982, the S&P 500 gained 14.7%.

Hence, it’s not a given that stocks will definitely fall during a recession.

2. What happened if you stayed invested in stocks through past recessions

If you are thinking of selling your stocks during a recession, you may want to think again.  

Carlson’s research showed that If you had invested in the S&P 500 six months prior to all of the 12 recessions since WWII and held on for 10 years after each of them, you would have earned a positive return on every occasion. Furthermore, the returns were largely rewarding.

The worst return was a total gain of 9.4% for the recession that lasted from March 2001 to November 2001. The best was the first post-WWII recession that happened from November 1948 to October 1949, a staggering return of 555.7%. After taking away the best and worst returns, the average was 257.2%. Not too shabby!

In short, holding onto stocks in the lead up to, through, and in the years after a recession, has historically produced good returns most of the time.

3. What happened if you avoided stocks during past recessions

Some of you reading this may also wonder: What if I tried to side-step a recession? What if I had perfect knowledge of when a recession would start and end, and I simply sold stocks at the start of a recession and bought back in at the end? The answer: You would do poorly. 

Michael Batnick, the Director of Research at Ritholtz Wealth Management, has the facts to prove it. In his October 2019 blog post titled 12 Charts You Ought to See Before the Next Recession, Batnick showed that a dollar invested in US stocks at the start of 1980 would be worth north of $78 around the end of 2018 if you had simply held the stocks and did nothing. 

But if you invested the same dollar in US stocks at the start of 1980 and expertly side-stepped the ensuing recessions to perfection, you would have less than $32 at the same endpoint. 

Said another way, avoiding recessions flawlessly would have caused your return to drop by more than half.

4. What bottomed first in past recessions – stocks or the economy?

I know it’s tempting to sell your stocks if you think the economy has room to fall further. But this idea is flawed.

Here’s what the data shows: Stocks tend to bottom before the economy does. Let’s go back to the three most recent recessions in the USA prior to 2020’s pandemic. These would be the recessions that lasted from July 1990 to March 1991, from March 2001 to November 2001, and from December 2007 to June 2009.

During the first recession in this sample, data on the S&P 500 from Yale economist Robert Shiller showed that the US S&P 500 bottomed in October 1990. In the second episode, the S&P 500 found its low 15 months after the end of the recession, in February 2003. This phenomenon was caused by the aftermath of the dotcom bubble’s bursting. For the third recession, the S&P 500 reached a trough in March 2009, three months before the recession ended. 

In summation, even if you are right today that the economy would be in worse shape in the months ahead, stocks may already have bottomed or be near one. Only time will tell. 

5. Did companies manage to grow in past recessions?

A recession is a period of time when a country’s economy is in decline. And when the economy is in poor health, it’s easy to think that all businesses are either suffering or are at best stagnating. But this isn’t always true for all companies. Some businesses can thrive. 

The recession that lasted from December 2007 to June 2009 was one of the worst in the USA’s modern history. The country’s real gross domestic product fell by 4.3% from a peak in the fourth quarter of 2007 to a bottom in the second quarter of 2009. The unemployment rate also spiked from 5% in December 2007 to 10% in October 2009.

But while the US economy was in trouble, the revenue of software-as-a-service pioneer Salesforce grew by 51% in FY2008 (fiscal year ending January 2008), 44% in FY2009, 21% in FY2010, and 27% in FY2011. Salesforce is not the only one. iPhone manufacturer Apple saw its revenue rise by 27% in FY2007 (fiscal year ending September 2007), 53% in FY2008, 14% in FY2009, and 52% in FY2010. Booking Holdings, the owner of Booking.com and Agoda.com, enjoyed revenue growth of 26% in 2007, 34% in 2008, 24% in 2009, and 32% in 2010.

Hence, investors in these three US-based companies had nothing to worry about even during one of the worst recessions for the country in modern history. Their businesses kept growing at an admirable clip, which meant that their underlying economic values were increasing rapidly too.

Parting words

When we’re on the precipice of a recession, it may feel like tomorrow will never get better. But brighter days eventually do come. As one of my favourite finance writers, Morgan Housel, once wrote: “Every five to seven years, people forget that recessions occur every five to seven years.” Recessions are normal. Par for the course.

Now we circle back to the question I posed at the beginning: “What should stock market investors do now with the possibility of a recession looming in the background?” You have history’s responses. The next step is up to 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. I have an interest in Apple and Salesforce. Holdings are subject to change at any time.

Last week, I spent a few days in Malaysia for a friend’s wedding and for a short drive around the country’s western coast. This was my first time in Malaysia since the start of the COVID pandemic.

Although the purpose of my trip was primarily for leisure, I couldn’t help but notice the interesting dynamic of Malaysia’s evolving payment ecosystem.

Card penetration is still low and will likely remain so

The first thing I noticed was that many small merchants still do not accept card payments. Although card payments are convenient for both merchants and consumers, there is a frictional cost involved with card payments for merchants.

The cost of accepting card payments includes a fixed transaction fee per transaction and a variable fee based on the size of the payment which can add up to 3% of the total amount collected. In addition, merchants need to pay for the hardware to be able to accept card payments, which is another extra cost that some merchants may be unwilling to bear.

Card companies trumpet the fact that a large percentage of payments made globally are still done in cash, implying that there’s a vast addressable market to be won. This is true but there are large amounts of cash transactions made today that will likely never transition to card payments.

In Malaysia, there are still a large number of mom-and-pop businesses that depend on low-margin, small-sized transactions. The frictional cost of card payments makes accepting such payments too costly for these merchants. Moreover, as cash is still dominant in Malaysia and with the nature of these businesses dealing with relatively small transactions, cash is still a relatively convenient solution.

I am bullish on the prospects of card payments growing globally. But I believe card penetration for certain types of businesses will remain low for the foreseeable future.

Other digital payment methods gaining steam

Although card payment is not widely accepted at small merchants, I noticed that local or regional digital payment methods such as Grabpay, Shopee Pay, and Touch and Go are much more common.

I believe that merchants are more inclined to adopt these payment solutions as they are cheaper to set up and have lower transaction fees. Grabpay and Shopee Pay, for example, require neither the installation of a card reader nor a dedicated point of sale system. Merchants only need to download the app to start accepting payments.

Besides the low set-up cost, these solutions currently levy merchants a lower fee than cards. Some solutions like Touch and Go are not even charging any transaction fees to smaller merchants. This naturally makes merchants more willing to accept these payment solutions.

At the other end of the transaction, consumers are inclined to use these digital payment methods as they are more convenient than cash and there is occasionally a reward system tied to these payment solutions. 

My observations about paying as a traveller

Making payments overseas is becoming increasingly frictionless and cheaper. For my trip to Malaysia, I paid in cash when necessary (which was mostly the case) but when card payment methods were accepted, I used a debit card linked to my Wise account. 

Wise is an app that makes sending money overseas or paying money in a foreign currency convenient and cheap.

To set up, all I had to do was top up my Wise account and apply for a debit card. When paying with the Wise debit card in Malaysia, the Wise app would automatically deduct the amount from my Wise balance. Even though I kept the cash in my Wise balance in Singapore dollars, I could still make payments in Malaysian ringgit as the app would automatically deduct the appropriate amount of Singapore dollars at a competitive rate. 

Wise markets itself as a company that provides very competitive rates and low commission fees for transfers and payments made using its solutions.

Travellers today can use apps like Wise or Revolut for more competitive foreign exchange rates than standard credit cards.

Final thoughts

The payment ecosystem in each country is unique. Countries such as Malaysia are still highly reliant on cash but are fast transitioning to other forms of digital payment methods.

And with companies such as Wise, travellers are getting cheaper ways to pay for goods overseas. All of these developments are great for merchants and consumers as it decreases the fractional cost of transactions, enabling more commerce to occur seamlessly.

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 Wise. Holdings are subject to change at any time

JPMorgan Chase (NYSE: JPM) is currently the largest bank in the USA by total assets. Because of this status, JPMorgan is naturally able to feel the pulse of the country’s economy. The bank’s latest earnings conference call – for the second quarter of 2022 – contained useful insights on the state of American consumers and businesses. The bottom-line is that while there are risks on the horizon, consumer spending in the USA is still healthy and the leaders of companies there think that their businesses are currently doing fine. What’s shown between the two horizontal lines below are quotes from JPMorgan’s management team that I picked up from the call. 

1. Credit is still healthy and loan volumes continued to grow

Credit is still quite healthy and net charge-offs remain historically low. And there continue to be positive trends in loan growth across our businesses, with average loans up 7% year-on-year and 2% quarter-on-quarter.

2. Provision for credit losses were much higher than a year ago (when there was a release of previous credit loss charges) to account for a slightly weaker economic outlook

And credit costs were $1.1 billion, which included net charge-offs of $657 million and reserve builds of $428 million, reflecting loan growth as well as a modest deterioration in the economic outlook.

3. Consumer spending is still healthy, across both debit and credit cards, but there’s clear impact from inflation and higher non-discretionary spending; this said, there’s no pullback seen yet on discretionary spending

Spend is still healthy with combined debit and credit spend up 15% year-on-year. We see the impact of inflation and higher nondiscretionary spend across income segments. Notably, the average consumer is spending 35% more year-on-year on gas and approximately 6% more on recurring bills and other nondiscretionary categories. At the same time, we have yet to observe a pullback in discretionary spending, including in the lower income segments, with travel and dining growing a robust 34% year-on-year overall.

4. Consumer deposit balances are down, although cash buffers are still high

And with spending growing faster than incomes, median deposit balances are down across income segments for the first time since the pandemic started, though cash buffers still remain elevated.

5. Auto loan originations fell sharply

And in auto, originations were $7 billion, down 44% from record levels a year ago due to continued lack of vehicle supply and rising rates while loans were up 2%.

6. Loan growth outlook of high single digit for 2022, but no view on 2023 yet

Yes. So we’ve talked, as you know, Steve, about sort of a mid — high single digits loan growth expectation for this year. And that outlook is more or less still in place. Obviously, we only have half the year left. We continue to see quite robust C&I growth, both higher revolver utilization and new account origination. We’re also seeing good growth in CRE. And of course, we continue to see very robust card loan growth, which is nice to see. Outlook beyond this year, I’m not going to give now.

7. Lower income segments are where cash buffers are getting thinner, but they are still above pre-pandemic levels; JPMorgan’s management is also not sure if this is just simply normalisation or an early warning sign of deterioration

[Question] Okay. Great. And then just maybe on credit. It continues to look, I guess, very good, whether it’s on the consumer side or commercial side. Are you — we don’t really see it, but are you starting to see any initial cracks in credit or strains in the system?

[Answer] But if you really want to kind of turn up the magnification on the microscope and look really, really, really closely, if you look at cash buffers in the lower-income segments and early delinquency roll rates in those segments, you can maybe see a little bit of an early warning signal to the effect that the burn-down of excess cash is a little bit faster there. Buffers are still above what they were pre-pandemic, but coming down. And that absolute numbers for the typical customer are not that high. And you do see those early delinquency buckets still below pre-pandemic levels, but getting closer in the lower-income segment. So if you wanted to try to look for early warning signals, that’s where you would see it. But I think there’s really still a big question about whether that’s simply normalization or whether it’s actually an early warning sign of deterioration. And for us, as you know, our portfolio is really not very exposed to that segment of the market. So not really very significant for us.

8. JPMorgan’s CEO, Jamie Dimon, said a few months ago that a hurricane is coming, but he acknowledges that in the long-term, the economy will be fine; current economic conditions also look good

[Question] Could you help me reconcile your words with your actions? After Investor Day, Jamie, you said a hurricane is on the horizon. But today, you’re holding firm with your $77 billion expense guidance for 2022. I mean, it’s like you’re acting like there’s sunny skies ahead. You’re out buying kayaks, surfboards, wave runners just before the storm. So is it tough times or not?

[Answer] Now let me — we run the company. We’ve always run the company consistently, investing, doing this stuff through storms. We don’t like pull in and pull out and go up and go down and go into markets, out of markets through storms. We manage the company, and you’ve seen us do this consistently since I’ve been at Bank One. We invest, we grow, we expand, we manage through the storm and stuff like that.

And so — and I mentioned to all of you on the media call, but there are very good current numbers taking place. Consumers are in good shape. They’re spending money. They have more income. Jobs are plentiful. They’re spending 10% more than last year, almost 30% plus more than pre-COVID. Businesses, when you talk to them, they’re in good shape, they’re doing fine. We’ve never seen business credit be better ever like in our lifetimes. And that’s the current environment.

The future environment, which is not that far off, involves rates going up maybe more than people think because of inflation, maybe deflation, maybe a soft — there might be a soft landing. I’m simply saying, there’s a range of potential outcomes, from a soft lending to a hard lending, driven by how much rates go up; the effect of quantitative tightening; the effect of volatile markets; and obviously, this terrible humanitarian crisis in Ukraine and the war, and then the effect of that on food and oil and gas.

And we’re simply pointing out, those things make the probabilities and possibilities of these events different. It’s not going to change how we run the company. The economy will be bigger in 10 years. We’re going to run the company. We’re going to serve more clients. We’re going to open our branches. We’re going to invest in the things. And we’ll manage through that.

We do — if you look at what we do, our bridge book is way down. That was managing certain exposures. We’re not in subprime fundamentally. That’s managing your exposures. So we’re quite careful about how we run the risk of the company. And if there was a reason to cut back on something, we would. But now that we think it’s a great business that’s got great growth prospects, it’s just going to go through a storm.

And in fact, going through a storm, we will — that gives us opportunities, too. I always remind myself, the economy will be a lot bigger in 10 years, we’re here to serve clients through thick or thin, and we will do that…

…But that’s — yes, that’s very performance-based, too. And again, Mike, the way I look at it a little bit, in 15 years, the global GDP — or 20 years, the global GDP, global financial assets, global companies, companies over $5 billion will all double. That’s what we’re building for. We’re not building for like 18 months.

9. JPMorgan sees technology investments as being really helpful during recessions

[Question] So clearly running the company for the next 5 to 10 years. If we have a recession in the next 5 to 10 months, how does technology help you manage through that better? Whether it’s credit losses, managing for less credit losses, expenses, more flexibility, more revenues, maybe gaining market share. What’s the benefit of all these technology investments if we have a recession over the next…

[Answer] Mike, I think we gave you some examples at Investor Day. For example, AI, which we spend a lot of money on. We gave you a couple of examples, but one of them is we spent $100 million building certain risk and fraud systems so that when we process payments on the consumer side, losses are down $100 million to $200 million. Volume is way up. That’s a huge benefit. I don’t think you’d want to stop doing that because there’s a recession. And so — and plus, in a recession, certain things get cheaper, branches are enormously profitable, bank is enormously profitable. We’re going to keep on doing those things. And we’ve managed through recessions before, we’ll manage it again. And I’m quite comfortable we’ll do it quite well. We’re stop-starting on recruiting or training or technology or branch, right? That’s crazy. We don’t do that. We’ve never done that. We didn’t do it in ’08 and ’09. [ And it puts us in quite good stead ] in terms — yes.

10. From JPMorgan’s vantage point, consumers are in great shape

And the consumer, I feel like a broken record. The consumer right now is in great shape. So even we go into a recession, they’re entering that recession with less leverage, in far better shape than they’ve been — did in ’08 and ’09, and far better shape than they did even in 2020. And jobs are plentiful. Now of course, jobs may disappear. Things happen. But they’re in very good shape. And obviously, when you have recessions, it affects consumer income and consumer credit. Our credit card portfolio is prime. I mean, it’s exceptional. But again, we’re adults in that. We know that if you have a recession, losses will go up. We prepare for all that, and we’re prepared to take it because we grow the business over time. We’re not going to just immediately run out of it. And so I think it’s great the consumer’s is in good shape. And it sounds excellent that — I like the fact that wages are going up for people at the low end. I like the fact that jobs are plentiful. I think that’s good for the average American, and we should applaud that. And so they’re in good shape right now.

11. When responding to a question about the market pricing in rate cuts for next year, Jamie Dimon said forward curves have been wrong all the time

[Question] I guess just one for — a couple of follow-ups, Jeremy. In terms of the markets have gone very quickly from pricing in a ton of rate hikes to potentially pricing in rate cuts next year…

…[Answer] And I should just point out, the forward curve has been consistently wrong in my whole lifetime. We don’t necessarily make investments based on the forward curve.

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 don’t have a vested interest in any company mentioned. Holdings are subject to change at any time.

What is a stock? A stock is a small stake in a company. But what does that really mean?

First Principles Thinking

Elon Musk recently popularised the term first principle thinking which in layman’s terms refers to questioning assumptions until you get down to the bare bones of the matter.

This can apply to defining a stock too. A stock represents part-ownership of a company. But what does being a part-owner of a company mean? Let’s dig deeper.

As a  part-owner of a company, you are entitled to receive dividends from the company. The company can choose to pay dividends to shareholders when there is excess cash on the balance sheet. As such, we can say that if you own a stock, you are entitled to a stream of future cash based on the profitability of the company.

This is one of the main reasons investors buy stock in a company. But that’s not all. In a well-oiled stock market, investors can buy and sell stocks to each other.

As such, not only are stockholders entitled to future dividends, but they can also sell the stock – or in other words, this “entitlement to future cash” – to other investors in the stock market. 

So why do stock prices fluctuate so wildly?

Once we understand what a stock really is, we realise that the value of a stock should be tied to cash that the stock owner can get. 

In theory, the value of a stock is all of the stock owner’s future cash flows discounted to the present day. But if stocks have a very easily defined value, which in theory, should not fluctuate on a day-to-day basis, why do stock prices still gyrate wildly?

There are many reasons for this. First, the cash flows of a company may be hard to predict and may depend on many factors. When situations change, the company’s cash flow outlook can change too, which means the present value of the company’s stock can fluctuate.

Also, investors may make different assumptions about a company which also causes market participants to value a company differently. All of which can lead to fluctuations in the stock price as investors are willing to pay different amounts for a stock.

The discount rate that is applied to value a company is also highly dependent on numerous factors such as the inherent risk in the business and the risk-free rate which is set by central banks. Investors may apply different discount rates to future cash flows based on how they perceive the risks to that cash flow materialising.

The discount rate is also affected by the risk-free rate. Usually, central bankers will meet a few times a year to decide on what the risk-free rate will be. When the rate changes, the value of a stock should change too.

There are also investors in the stock market who simply don’t care about value. All they care about is being able to sell a stock at a higher price to someone else. 

These traders simply buy and sell a stock in the hopes that the stock price goes in the “correct” direction for them to make a profit. 

Even if a stock seems very overvalued compared to the potential future cash flows of the business, these traders are still willing to buy the stock in anticipation that someone else will buy it from them at an even higher price.

The gravitational pull of value

While stock prices can fluctuate wildly, over time they tend to gravitate toward the intrinsic value of a company.

Benjamin Graham, mentor to Warren Buffett and the author of classic investing texts such as The Intelligent Investor, once said that in the short run, the stock market is like a voting machine but in the long run it is like a weighing machine.

This makes sense as eventually, a stock should trade close to the present value of its future cash flows. For instance, if a stock is too cheap, investors can simply buy the stock at a discount and make an outsized profit from the actual cash flows paid to shareholders.

This basic principle should be music to the ears of long-term investors, especially in today’s bear market. Although it may feel unpleasant when your stock price falls, it is important to take a step back and realise the true meaning of being a shareholder. 

When you do so, you can properly assess the actual value of your stock.

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.

I find that earnings seasons always provide important insights to investors. This is especially so in today’s climate, when there is so much uncertainty over macroeconomic conditions and stock prices have fallen hard.

With this in mind, here are the key themes I’ll be keeping an eye out for during the upcoming earnings season which will start in a few weeks.

Spending trends

The Federal Reserve’s tightening of monetary policy will likely impact consumer spending and company budgets. I will be keeping an eye on managements’ commentary about the business environment that they are in and the spending trends that they are seeing.

In the first quarter of 2022, it was heartening to see mission-critical software companies continue to post excellent results amid the wider market slowing down. I’ll also be looking for other companies that can come out of this environment stronger than they were before.

If these companies can continue to buck the trend, it will be another sign of their resilience.

Stock-based compensation

Lower stock prices could result in more heavy dilution for companies that depend heavily on stock-based compensation. This is because such companies need to offer employees more shares to make up for the shortfall in stock prices to attract the best talent.

With some companies seeing up to an 80% drop in their stock prices, it will be interesting to watch the dilutive impact of stock-based compensation. While the true impact will likely only be felt much later in the future, I’ll be keeping an eye on managements’ commentary on this subject.

Leadership changes and employee turnover

DocuSign and Pinterest recently reported that their respective CEOs have stepped down from their roles. It is not uncommon to see leadership shuffles in times such as these.

In the coming earnings season, we should also get a better picture of what companies are doing about retaining employees and the employee turnover trends. Investors of companies who have seen the loss of key personnel should also hope to get clarity on the reasons for any C-suite shuffling.

Updates on cost-cutting initiatives

There has also been a host of companies that have tightened their belts for the year. Sea Ltd, Tesla, and Netflix have all announced layoffs. With interest rates rising and capital becoming more expensive, companies will need to be more prudent in their spending.

In the coming earnings reports, I’ll be looking for additional colour on the impact cost-cutting initiatives have on their businesses going forward and how the initiatives have panned out.

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 Docusign, Tesla, Netflix, and Sea Ltd. Holdings are subject to change at any time

If you could go back in time to the start of this year, which of the following groups of real-life companies would you be interested to invest in? 

Table 1 below shows the historical revenue and free cash flow for the two companies in Group 1, namely, Company A and Company B. It’s clear that Company A has not grown its revenue much over the past four years and its free cash flow has also not been steady. Meanwhile, Company B’s revenue has barely budged and although its free cash flow has improved in every year, there’s only so much juice that can be squeezed from improving the free cash flow margin*.

Next we have Table 2 below, which shows the historical revenue and free cash flow for Group 2 consisting of Company C and Company D. Both companies have displayed excellent revenue growth for 2017 to 2021, with Company C quadrupling its revenue and Company D increasing its topline by nearly five times. Both companies have also experienced consistent and impressive growth in free cash flow over the period. 

So would you prefer to invest in Group 1 or Group 2 when you take your time-machine back to the start of this year? It’s clear that Group 2 contains the superior businesses – not only do they have fat free cash flow margins, their revenues have also been growing rapidly. If you’re a business-focused investor – like me – you likely would have picked Group 2. But if you did, you would now be nursing a big loss of around 50% for both companies in the group. On the other hand, the stock prices for the companies in Group 1 have been about flat. Table 3 shows the identities of the companies in the two groups, and their year-to-date stock price performances.

But interestingly, over the past five years, Trade Desk’s stock price is up by 823% whereas Kellogg’s and Coca-Cola’s stock prices have delivered much poorer returns of -7% and 31%. Adyen was listed only on 13 June 2018 and from then to today, its stock price is up by 175%; in this time period, Trade Desk, Kellogg and Coca-Cola’s returns are 404%, 4%, and 34%, respectively.

What this fun exercise shows are a few important traits of the stock market: 

• In the short run, business fundamentals and stock prices can move in completely opposite directions in unpredictable ways. 
• But in the long run, business fundamentals are what dominates stock prices 

The stock market has been really rough in the past few months, especially for higher-growth companies. Keeping the aforementioned traits of the stock market in mind should help you make better decisions in, and react better to, the volatile stock market we’re all experiencing right now. 

*The free cash flow margin refers to a company’s free cash flow as a percentage of revenue

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 Adyen and The Trade Desk. Holdings are subject to change at any time