How to generate insights

“…when it came to real-world complexities, the elegant equations and the fancy mathematics he’d spent so much time on in school were no more than tools – and limited tools at that. The crucial skill was insight, the ability to see connections.”

Taken from Complexity by Waldrop Mitchell, the quote described W. Brian Arthur, a pioneer in complexity economics.

Similar to Arthur, investors want insights. They want to know something that others do not. The most competitive institutional investors pursue insights in the form of differentiated data. Gabriel Plotkin, the owner of Melvin Capital (of GameStop short-selling fame), was an early user of credit card data when picking consumer stocks. Many investors interview vendors, employees, and product experts to uncover unique data.

If the puzzle of above-market returns is a walled castle, pursuing differentiated data is similar to a head-on attack. Accumulate armies of analysts and differentiated data, and swarm the castle’s defenses with sheer intellectual brilliance.

Yet a head-on attack is not without risk. Casualties abound (high turnover in analysts and data). The castle walls have to be re-built to prevent others from attacking (differentiated data is discounted by the market, demanding even more differentiated data sets for returns).

A better tactic would be to understand the needs of the town within the walls, and negotiate with its leaders for a surrender. No casualties. Nothing destroyed.

I label the alternative tactic as differentiated understanding.

The path to differentiated understanding begins with a hypothesis, which is tested against real-world data. Even when data is supportive, the hypothesis is never fully accepted. Statisticians use the term “cannot be rejected”. This means that other data, not yet considered or available, may reject the hypothesis. The analysis leaves room for further exploration, which, when repeated, leads to correct and deep understanding.

Compare what I just describe to the opposite. Start with differentiated data (instead of a hypothesis), determine patterns, then attempt to understand. This is what investors commonly do, and it leaves plenty of room for error instead of exploration. The patterns are likely to reflect correlation. Mistaking correlation for causation results in erroneous understanding, which is often expensive to correct in investing.

Yet data is often used as the starting point because it is relatively easier to obtain than a hypothesis. A credible hypothesis is abstract and creative, because it hasn’t been fully proven by data, isn’t known by others, and isn’t discounted by the market (hence containing the potential for profit).

More difficult than coming up with a hypothesis is refining it. The process demands more creativity and abstraction, more grounding by real-world data, and sometimes long feedback cycles. This is diametrically different from the touch-and-go nature of the typical data analysis process, in which analysts move quickly from one data set to another without proper understanding (hence creating an industry for more and more differentiated data).

Differentiated understanding is wisdom, whereas differentiated data is still data, just with unique sources. Dee Hock (founder of Visa) describes it best:

“Data, on one end of the spectrum, is separable, objective, linear, mechanistic, and abundant. Wisdom, on the other end
of the spectrum, is holistic, subjective, spiritual, conceptual, creative, and scarce.”

That statement is as profound as it is useful. The modern scientific pursuit is reductionistic. It distills the world to the few factors that mostly explains the observed phenomena. The resulting theory is thus indisputable and mechanical. Yet the theory only works in the defined environment, and can hardly be extended to the real-world containing more variables and complexity.

What wisdom attempts to achieve is results in the real-world. It discards the elegance and simplicity of reductionistic theories for utility. It sees the world not as linear cause-and-effect, but as a system comprising myriad interrelated nodes. Changes in a single node would reverberate through countless others.

Perhaps an example would aid in solidifying concepts. Say theory and experience have proven that mean reversion works in investing. Buy cyclical companies at trough valuations, sell them at peak valuations, repeat. Wisdom would require asking “and then what”. What happens when more and more investors realize and practice this strategy? Trough valuations would no longer be low when more investors buy. Peak valuations would no longer be high when more investors sell. What happens when more and more cyclical companies realize what investors are doing? They might adjust their business models to maintain stable valuations, which would aid as a currency for M&A and employee stock incentives. The entire game would evolve.

In another example, research has consistently proven that rising EPS is the key determinant of rising stock prices. Linear cause-and-effect logic would dictate one look for stocks with rising EPS and stagnant or declining prices.

This simple dynamic leads to complex behaviors. Consider that one should buy the stock before EPS rises. How early should investors be? Perhaps wait for indicators such as rising operating earnings that precedes rising EPS? If the market knows about rising operating earnings, the wise investor would have to look for earlier indicators yet to be discounted.

Here’s the kicker. What happens to the original linear cause-and-effect logic? The market has evolved such that actual rising EPS forms a weak (but not impossible) case for rising stock prices. When the market is looking for earlier and earlier indicators for rising EPS and yet ignores actual rising EPS (when it shouldn’t be), the market is strongly signalling that the rising EPS won’t last.

To achieve wisdom is to understand how the world really works. The real world evolves, but an experimental one does not. Little changes result in enormous shifts in the real-world, but are unlikely to be demonstrated as such in a controlled setting (it would make the setting uncontrollable).

This is not to say scientific inquiry is useless. If anything, wisdom recognizes both the utility and limits of scientific inquiry.

Every investor begins with a scientific mindset. There is no starting if you cannot count and theorize. But achieving great returns requires leaps beyond, and many non-scientific subjects would aid that effort. Dee Hock said it best again:

“Science has traditionally operated in the provinces of data … where measurement, particularity, specialization and rationality are most useful. It has often blithely ignored the provinces of understanding and wisdom.

Theology, philosophy, literature, and art have traditionally operated in the provinces of understanding and wisdom, where subjectivity, spirituality, and values are most useful. It has often blindly opposed the scientific way of knowing.

Data moves at the speed of light today (quite literally). Data, no matter how differentiated, is quickly discounted. Wisdom is difficult to gain but also hard for the market to discount quickly, and should henceforth be the insight upon which investors rely.

How to miss life-changing opportunities, again and again

How can anyone miss once-in-a-lifetime opportunities? Missing it once is unimaginable. Twice, ludicrous. Thrice, plain stupid.

How about missing it one thousand eight hundred times?

My dentist did exactly that.

His dental practice, built over three decades, is popular and profitable. The wait list to get an appointment is long. His success motivated his sons to be dentists as well. He makes enough for a million-dollar home, country club membership, and private schools for his kids.

These are nothing compared to what he missed.

20 years ago, he attended a farewell party. His cousin’s startup was acquired by Company X. As part of the acquisition, his cousin had to move to Nevada to work for X.

The cousin was a robotics engineer by trade. His startup owned two patents and had no revenue. He was thrilled that X appreciated the intellectual property enough to acquire it. What was better, in his mind, was that 98% of the acquisition price was paid in X’s stock, with more on the way as part of his employment agreement with X. Suffice to say, he was optimistic on X’s prospects.

X is the most amazing company. You all have to buy its stock, the cousin said at the party.

Out of 30 family members present, my dentist was the sole buyer of X’s stock. He had never owned stocks before. He had no idea what a stock is. But he trusted his cousin. X traded at $5 per share then.

As business at the dental practice picked up, my dentist almost forgot about his tiny stake in X. He checked his portfolio bi-annually, if at all.

To his surprise, X increased six-fold after two years. He was thrilled. He had never bought a stock before X, yet his first purchase was wildly profitable. He called the cousin to ask about X.

Everything is going great because of our proprietary advances in precision robotics and biomedical engineering. Do not worry about the litigation matters. You should continue to own X, the cousin said.

My dentist, perplexed by the conversation, promptly sold his stake at $30 per share.

For the next five years, my dentist had conversations about X with his cousin at least once annually, before they lost touch. At every conversation, his cousin touted the milestones at X. Every major regulatory approval, significant purchase order, and successful R&D outcome reinforced the cousin’s confidence in X (These were all public information). At their final meeting before losing touch, my dentist insisted that he was satisfied with the six-fold return, and could do without owning X’s stock.

Shortly after the final meeting, the United States faced its worst financial crisis since the Great Depression.

My dentist felt justified in not owning stocks at all, and perhaps even more justified in selling X’s stock five years earlier.

Fast-forward to 2020. It has been 12 years after the financial crisis, a little over 12 years since the final conversation my dentist had about X with his cousin, 17 years since my dentist sold X at $30 per share, and 19 years since the cousin began working for X and recommended X at $5 per share.

The cousin invited his entire family to a 4-day, all-expense-paid trip at an exclusive ranch in California. The occasion was his retirement. After 19 years of service at X, he retired as a senior executive. Adjusted for stock splits, X was trading near $700 per share.

The cousin never sold a single share of X in his 19 years of employment.

The cousin was wealthy. How wealthy? If he had sold his startup at $1.5 million (estimated, the price was never disclosed), of which 98% was paid in X’s stock, his stake in X would be worth $206 million, a staggering 140-fold return.

And $206 million is the minimum estimate of his stake. Because about 30% of his compensation was paid in stock annually.

My dentist invested $50,000 in X and sold his position for $300,000. Had he held until his cousin retired, his stake would have been worth almost $7 million.

My dentist missed the boat for a 23-fold return ($30 to $700 per share). Not once. Not twice. Arguably for five years (between selling X and losing touch with his cousin), my dentist had direct access to an executive with intimate knowledge of X and keen enthusiasm for the business. Every day in those five years was a chance to buy X again. He missed all of them.

All 1,800 days.

A few takeaways:

1 – Missing life-changing opportunities happens more often than you think.

Between 1952 and 1962, Warren Buffett taught investing at the Municipal University of Omaha (now the University of Nebraska Omaha, or UNO). It was a non-credit class because Buffett disliked giving bad grades.

A photo showed 16 students in Buffett’s class. In 10 years, Buffett perhaps taught 160 students. Guess how many invested with Buffett?

One.

Less than one percent of 160 students felt that the Oracle of Omaha was good enough for them to invest in. Every student listened to hours of insights, taught directly by the Oracle, yet almost every student thought he won’t be good enough.

You probably think that you won’t behave like those students or my dentist.

But you probably would.

We are inclined to perceive things as “normal” because that is the easy way to understand things. Perceiving things as extraordinary requires a leap of faith and more mental effort.

Ergo, the human instinct is unable to spot the outstanding early. The outstanding, by definition, is different. The human mind is inclined to dismiss the differentiating elements, and explains them as similar to everything else. The outstanding has to be prove itself, again and again and again, for the human mind to believe.

For the purposes of investing, this innate quality is not helpful. The cat is out of the bag by the time the outstanding has proven itself to be outstanding. As more investors learn about the outstanding, they would bid its price up to a point that curtails the potential for it to appreciate further.

The point is to spot the outstanding early. To buy and hold X at $5 per share before it becomes $700. To invest in a young Buffett before he becomes the Oracle.

I know one way to do so.

2 – All you need is context, a lot of it.

If you have $122 billion in a checking account, how would you look for an investment?

Most would rely on hordes of lawyers, consultants, bankers, accountants, analysts, and of course, endless meetings. This is the gold standard of corporate due diligence.

Berkshire Hathaway has exactly that in cash and equivalents. Its owners prefer this way:

We really can tell you in five minutes whether we’re interested in something.” – Warren Buffett

Five minutes is all he needs, because he has context. A lot of it.

Within 5 minutes, he analyzes the investment relative to others and knowledge accumulated over 70 years (Buffett started investing at 11 years old. He is 90 now), during which he spent 80% of his days reading.

In an average day, Buffett spends almost 13 out of 16 waking-hours reading (assuming 8 hours of sleep). How much does he read? 500 pages.

Per day.

Todd Combs did that and more. He is now the CEO of Geico, arguably Berkshire’s most valuable asset.

Knowledge provides context. You can identify the outstanding early with context.

To be clear, what you want is not just any knowledge. You want the right set of knowledge, which provides what I term the complete context.

To determine whether X is a good investment, you have to know not only about X, but also everything else that surrounds it and came before it. Knowing all three and seeing their connections provide complete context.

Think about the complete context as a three-dimensional perspective (x-y-z planes, if you recall high school geometry).

The first dimension is a single plane (x-axis). Your knowledge of X per se, no matter how much, is just one plane. It is a start, but not helpful in forming a complete picture.

The second dimension comprises two planes (x and y axes). The additional plane is akin to knowledge of X’s peers, industry, market size etc. In this dimension, you can draw lines to connect your knowledge of X to its comparable peers, industry, market size etc.. A better picture emerges.

So what else is missing? The time element.

The third dimension (x, y, and z axes) includes the historical perspective – the knowledge of X and its peers, industry, market size etc in their past.

Complete context is only possible when you combine knowledge of X (first dimension), knowledge of peers, industry, market size etc surrounding X (second dimension), and the corresponding historical knowledge (third dimension).

Combining all three creates unique knowledge when you see connections among the three. Therefore, the combination of the three is greater than the sum of its parts.

Think back to my dentist and his cousin. Who had the more complete context of X and significantly more success?

Recall that my dentist sold X after his cousin mentioned complex engineering terms and litigation matters. He feared about his lack of understanding, which, in all likelihood, is not because of the inherent complex nature of X.

It is because he did not work hard enough to attain the complete context of X.

And that is the problem with this method. To most people, it takes too much effort.

And the reason it works is because most people won’t do it.

“Read 500 pages every day. That’s how knowledge works. It builds up, like compound interest. All of you can do it, but I guarantee not many of you will do it.” – Warren Buffett

What will you do?

The investor who crashed but ended wealthy

I have a large extended family. My mother has ten siblings. My father, six. Out of eighteen people (including my parents), only two are financially well-off.

The first arrived in the United States without knowing a word of English. She was not a bright student. She struggled in a work-study program paying below-minimum wages. She eventually built a significant manufacturing operation employing near fifty.

Yet it is the second relative with the more interesting story. I’ll call him V.

V was expelled from school because he got into one too many fights. He then worked in his father’s (my grandfather’s) small hardware store, and later delivered eggs for a farm. His fortunes turned after his tiny startup capitalized on the explosive growth of jeans. He supplied the then-unique fabric to manufacturers. He even timed the sale of his controlling stake at peak valuations. By any measure, V was no longer poor.

This was when his problems began.

Armed with abundant capital for the first time, V started “investing”. He speculated in currencies, stocks, and derivatives, with a rudimentary understanding of finance. His frequent and enormous trades summed to hundreds of millions in turnover, attracting brokers of all sizes. The more shrewd and cunning suggested trades that he could never understand. They explained that the trades were exclusive to a select few, and that profits were virtually certain, but not when and how. V never stood a chance against Wall Street.

V took five years to build and sell his startup. His account took less than half that time to be down 120%.

V should have been in utter financial ruins. An otherwise tepid transaction, suggested by his wife, not only saved V from ruin, but also generated profits enough to make him a millionaire many times over.

His eldest son was born shortly before the sale of his startup. In planning for the family’s future, his wife suggested that they plant roots in the neighboring country of Singapore. This was the late 1970s, when the majority of Singapore was rural and unsewered (I urge readers to learn what unsewered is to appreciate the miracle that is the modern sewage sanitation system). V was flabbergasted. To leave the familiar for a wasteland (pun intended) was absurd. His wife was insistent, believing that the public school system in Singapore, however undeveloped, was better than what her country offered. V, with little formal education, did not understand her perspectives, but gave in out of respect. The young family eventually migrated to Singapore. V used some proceeds from the startup sale to purchase land and real estate in the new developing country, and allocated the balance to his trading account.

In 1978, Singapore’s GDP per capita was about $3,200, roughly a third of the United States’. In 2018, the same measure for Singapore had grown 20-fold and exceeded the USA by about 3% (The USA grew the measure by about 6-fold in the same period).

So how did real estate in Singapore performed? About a 22-fold increase. V’s returns are likely much higher because of leverage and favorable exchange rates. By rough calculations, his returns were at least 60-fold in USD terms, considering a 50% down-payment (interest rates exceeded 10% in the late 1970s, so buyers tend to place large down-payments to reduce interest payments) and a 70% appreciation of Singapore versus US dollars (meaning that one Singapore dollar today buys 70% more US dollars than it did).

A few takeaways:

1 – Success is not transferable. What made you successful in one game does not directly make you win in another.

V was a sharp operator before indulging in securities. He knew exactly how machines are running, and what his suppliers, customers, and employees expect. His skills did not translate directly to trading. Only his confidence and ego did.

As an operator, constant action was the norm. V was always on his feet, inspecting machinery and talking to people. He thought he had to do the same in trading. He could, but he didn’t have to. His skills may had worked if he were a tape-reader (ie the quintessential intuitive trader), but results certainly showed he wasn’t.

You have to understand your strengths at their core, in order to know what to work on and how to work in the unique way that caters to your strengths.

To work in a certain way, just because your peers do or some successful person says so, ensures disappointment.

2 – When you have capital, the right thing to do mostly is nothing.

Warren Buffett once quipped “I make mistakes when I get cash. Charlie tells me to go to a bar instead. Don’t hang around the office.”

Investing is akin to a baseball game with infinite pitches. You only have to swing at those which assure home-runs. You have to know your sweet spots. Every investor has unique backgrounds, knowledge, and by extension, sweet spots.

Home-runs are rare by definition, so the investor should behave similar to the batter who watches many pitches pass and does not swing. Yet the batter must always be prepared to swing at a moment’s notice.

Wall Street gets paid when the batter hits the baseball. Every hit on the bat is a commission, so WS throws as many pitches as possible in as many ways as possible to entice investors to swing their bats. WS does not care whether the batter hits a dud or a home-run.

WS makes it difficult to do nothing when you have capital, but nothing is exactly what you mostly have to do.

To be fair, real estate in Singapore is not V’s sweet spot. However, V is likely to understand where and how to buy a home for his family, more so than when to buy and sell complex securities. V’s home-run in real estate obscures an important but subtle point, which brings us to the next takeaway:

3 – Home-runs are not short-term large returns, but are really long-term moderate returns.

A 60-fold return is significant. Over 40 years, it equates to 10.8% per year. The annual returns do not appear significant relative to equity indices. The S&P 500 reached a bottom in March 2009, and returned 16.5% per year between then and now (with dividends reinvested).

The secret is not in the annual returns. It is in the duration.

Over a long-enough time frame, even moderate returns can achieve astonishing results. Committing to the investment, through large and small downturns, is essential but counter-intuitive. It is a characteristic that V had help on, which leads to the final takeaway.

4 – Marry the right person, and have reasonable expectations.

Investors take pride in sticking to cold, hard facts. But investing is predominantly a human activity. The cold, hard facts underpinning decisions are selected by bias, which contains an emotional element. Trading algorithms, designed to be emotionless, are designed by emotional humans.

This means that human psychology matters.

Just knowing about home-runs is insufficient. You have to know how to emotionally stick to the strategy producing the home-run.

Judging from V’s trading, I am certain that he wanted to sell the real-estate in Singapore after a certain level of appreciation. One who trades in minutes and hours does not have the patience to invest for months and years, let alone decades.

I am almost certain that every discussion V had with his wife about selling, he was persuaded otherwise. His wife loved the home that was built from scratch, the large yard, its polite neighbors, proximity to great schools and public transportation etc. On top of those, the home and land values appreciated almost every year.

In all fairness, V’s wife knew next to nothing about investing. Singapore real estate was certainly not her sweet spot. However, that she could stick to a home and its surroundings for more than 40 years is telling of her reasonable expectations (she does not want or need a bigger house) and stable sense of contentment. The average American, contrary to V’s family, moves 11.7 times in a lifetime (Singaporeans about a third as often).

Reasonable expectations allows one to stick to a strategy, through thick and thin, for the long-term. It is not the same as being ignorant. Quite the opposite. It is being aware of the facts, and the understanding of the futility of reaching for the very best returns when the present works fine.

Contentment, the act of not reaching for more, is the paradoxical key to get more, because it results in long-term duration that underpins astonishing returns.

Marrying the right person can do wonders for the psychology of contentment. After V saw his trading account wiped clean, he never traded again for short-term profit, likely at the behest of his wife. His wife constantly reminded him to appreciate the present, which offered a higher standard of living by any measure relative to their lives before moving to Singapore. V’s appreciation for the present grew gradually. As his brokers pay less attention to him, he eventually sold all his luxury jewelry and watches, and traded his Mercedes for a beat-up Honda van. The less he owned, the more contented he became.

The Oracle of Omaha said the following about reasonable expectations. It is no wonder that he achieved the rare combination of being wealthy, contented, and in all likelihood, happy.

I was going to do the same things when I had a little bit of money as when I had a lot of money. If you think of the difference between me and you, we wear the same clothes basically (SunTrust gives me mine), we eat similar food—we all go to McDonald’s or better yet, Dairy Queen, and we live in a house that is warm in winter and cool in summer. We watch the Nebraska (football) game on big screen TV. You see it the same way I see it. We do everything the same—our lives are not that different. The only thing we do is we travel differently. What can I do that you can’t do?” -Warren Buffett

Tech boom or bubble?

The strength of technology stocks in 2020 is indisputable. The five largest companies – Google, Amazon, Apple, Facebook, Microsoft – are all in technology. Their dominance is increasing. Their market values make up more of the S&P 500 than their counterparts did at the dotcom bubble peak 20 years ago.

Yet such strength often precedes bubbles that end with painful crashes. History contains many examples – conglomerates in the 70s, thrifts and semiconductors in the 80s, “tiger” economies in Southeast Asia in the 90s, TMT in early 2000s, and financials before the GFC in 2008.

All bubbles begin as booms, but not all booms become bubbles. Sometimes a boom is deflated by timely contractionary policies or gradual loss of investor interest. The boom to worry about is the one with a self-reinforcing character. It starts with good fundamentals, leading to rising valuations, high investor interest, and pressure on companies to show improving fundamentals. Companies venture into less-profitable activities that are disguised as sound decisions to support valuations. Rising stock prices discourage investors from prudent due diligence and encourage them to use impractical assumptions to justify increasing valuations, which further increases pressure on companies. The self-reinforcing frenzy results in a bubble that would inevitably end after companies meet the limits of expansion and show deteriorating fundamentals.

History shows that two factors are essential for a boom to become a bubble:

  1. Excessive valuations
  2. Abundance of overly simplistic elements as key drivers of value

Is the boom in tech stocks actually a bubble?

1. The largest tech companies do not appear to be excessively valued relative to past bubbles and long-term interest rates.

The conglomerate bubble in the 70s involved the then-largest companies, while the dotcom bubble in 2000 involved TMT companies. These bubbles are used as proxies because they relate to the current largest tech companies in size and sector respectively.

The reader should also understand the concept of equity yield and its relation to long-term interest rates. The equity yield is the underlying company’s earnings and dividends relative to its stock price. Another way to put the equity yield in context is to view a stock as a bond. Earnings and dividends of a stock are akin to coupons of a bond (except that earnings are not distributed like coupons are, but are left for management to allocate).

Compared to the yield on treasury bonds, the equity yield of a stock should be higher. This is because a stock’s risk is higher than treasuries’ (ie risk-free), so it should almost always offer higher yields than treasuries to entice investors. Higher risk, higher yields; lower risk, lower yields.

During the 1970s, the conglomerate bubble saw large-cap stocks yielding less than 2%, while 10-year treasuries yield more than 6%. This discrepancy was evident of a bubble. Equity investors accepted yields lower than treasuries!

Put in a different way, investors accepted low yields that implied excessively high valuations (PE ratios range 70-80), and could had accepted higher yields in treasuries with much lower risk.

The tech bubble in 2000 saw even lower equity yields. The 100-200x PE ratios of Nasdaq stocks implied yields of 0.5-1.0%, which were much lower than the 6.5% yield on 10-year treasuries.

Today, with the exception of Amazon, the four large tech companies trade near 32x forward PE, which translates to 3.1% yield (inverse of 32). Only Microsoft and Apple in the group pay dividends in the 0.7-1.0% range. Hence 4.0% can be used as an appropriate proxy for the equity yield of the group.

Relative to 10-year treasuries yielding 0.7%, the group isn’t expensive. Even if the 10-year yielded 1%, PE ratios of the group have to triple to match.

This method shows that only Amazon is expensive relative to long-term rates. Amazon sports 108x forward pe, which translates to 0.9% yield, just slightly above the yield on the 10-year.

2. There is little evidence of overly simplistic elements as key drivers of valuations.

During the late 1960s and early 1970s, conglomerates relied on M&A for high growth rates that were rewarded with increasing multiples. Their success attracted imitators, which went on acquisition sprees. M&A activity eventually involved the most mundane businesses with stagnant or even contracting revenues, such as metal scrapping. At the peak of the bubble, companies were rewarded with high multiples as long as they promised fervent M&A.

In the late 1990s and early 2000s, any business related to the Internet, whether it be laying fiber-optic cables or selling pet products online, had high multiples based on projected revenues. No attention was paid to earning, cash flows, and other traditional indicators of the sustainability of business models.

As shown by history, bubbles are formed by the lack of investor discrimination.

Current trends favor SaaS (software-as-a-service), IaaS (infrastructure-as-a-service), and similar business models with strong customer loyalty, platforms with network effects, and subscription components that support recurring revenues. However, investors are selective about the quality of business models. Most importantly, they discriminate to an extent that a company cannot market itself as “something-as-a-service” to achieve high multiples.

Take Grubhub as an example. The company was once a high-flyer, whose stock increased 22% in a single session after Yum Brands (the parent of Taco Bell, KFC, and Pizza Hut) bought a small stake. The stock crumbled after competition from Uber, Postmates, and Amazon intensified (Amazon has shut down its food delivery business) and revealed that high margins were unsustainable because of expensive customer acquisition cost. As with airlines and autos, consolidation to achieve scale is the solution to the problem of costs outpacing revenue growth. Uber is merging with Postmates, and Just Eat Takeaway is acquiring Grubhub.

Another example is lesser-known Alteryx. The company pioneered data analytics SaaS, increased revenue by 12x in 6 years, and oversaw near 13-fold returns from its IPO. Despite its excellent history, AYX was punished with a 53% decline in its stock when it provided earnings and an outlook that missed expectations. Investors were unforgiving despite the SaaS nature of the business and the company’s excellent track record.

Even Intel faced the wrath of the market when it failed to deliver. After announcing a delay in its next-generation chips, the stock of the technology stalwart fell 23% in 3 days.

Investors are (still) careful, so the current tech boom is not a bubble (yet).

Despite the lack of a tech bubble, technology stocks are still prone to large and small declines. It is hard to tell what the market would focus on. At one moment, it is revenue growth rates, no matter the cost. At another, it is liquidity and cash flows., no matter the business model. The investor must be ready for the market to do anything, and has to prepare accordingly. Investors, especially those in technology, would do well to heed Ben Graham’s advice:

“You can get in more trouble with a sound premise than an unsound premise because you’ll just throw out the unsound premise” -Ben Graham, father of value investing and mentor to Warren Buffett

How to invest during Covid-19

Anything can happen in the markets. Events that historically took many months or years to unfold happened in weeks in 2020. The S&P 500 declined by 30% in a record 22 days. The only event that surprised investors more was the recovery. The S&P recovered to its 2020 starting point within months.

Yet many households could not afford rent and mortgage payments in July, and millions are out of work. Consumer spending, the engine of growth in the United States, is likely to stall. How is the market not at lower levels?

These are confusing times. I attempt to offer a few guidelines, as a response to the barrage of questions received.

To start, nobody knows what the market is going to do.

Warren Buffett frequently says the same. So does Seth Klarman. Perhaps Matthew McConaughey says it best in the movie Wolf of Wall Street:

“Number 1 rule of Wall Street. Nobody … I don’t care if you’re Warren Buffett or Jimmy Buffett … Nobody knows if the stock is going to go up, down, sideways, or in f****** circles” (scroll to 1:48 in this clip)

How are you suppose to invest not knowing where the market is going?

There are 4 things to do:

1. Believe in the long-term potential of the American economic expansion

Earlier in March 2020, I wrote:

“Stocks reflect the long-term earnings potential of their underlying businesses. The American economy is contracting because of necessary measures to contain the virus, but the long-term potential of the American economic expansion is intact. In the past 100 years, America, backed by relentless dynamism, has survived a flu epidemic; the Great Depression; costly World Wars and numerous conflicts; an assassination and a resignation of her Presidents; hyperinflation and oil shock; Black Monday; savings-and-loans implosion; September 11; the dot-com crash; defaults of major economies; the Lehman and mortgage crisis; and the Eurozone sovereign crisis. Yet the S&P 500 increased from 18 to 3,231. There is little doubt that major corporations in the United States would set record earnings 10, 20 and 30 years from today.”

2. Invest in passive index funds

For the 99% of readers who believe in #1, you should invest in index funds designed to mirror the broad economic performance of the United States***.

3. Have a long-term orientation

Not a day, a month, or even a year. Years. Decades is even better.

Compounding takes time. Decent returns take time. Give your investing the time it needs.

4. Do not use excessive leverage

There are bold investors. There are old investors. There are no bold and old investors.

To have decent returns, the investor must first survive.

Leverage increases both returns and losses. What is the point of having 10 years of fantastic returns before losing it all in the 11th year? Some funds did exactly that.

The guidelines above are easy to follow, only if you live in a world without Wall Street and the media.

In recent memory, Morgan Housel perhaps summarized the challenge best:

“Investing isn’t an IQ test; it’s a test of character.”

The conviction to follow simple rules in investing for decades, without undue influence from family/friends/CNBC/Wall Street/that smart analyst, is extremely rare.

***The remaining 1% may attempt to invest in active managers such as myself. However, it is a wild ride for the uninitiated. Most of my peers under-perform passive benchmarks.

Bet your own money, not OPM, to learn and win

I was excited to attend my first class on investing principles in graduate school. I was finally with like-minded individuals who share my pursuit of investing excellence.

My first conversation with a classmate dulled my spirits.

We discussed everything about a stock that we both liked. Our knowledge on its business model, finances, history, management, and competitors overlapped yet complemented. I have a substantial portion of my net worth in the stock. Yet the classmate said:

Classmate: I have a little invested in the stock. I would never have much invested in it.

I was in disbelief. For heaven’s sake, why?

Classmate: I know a lot about this stock to prepare for a job interview at a [insert well-known company] fund. Why bet your own money when you can bet OPM (other people’s money), take a large salary, and avoid losing your own money if you’re wrong?

My classmate would be a highly-paid employee at a large fund. Yet it is unlikely that he would become an outstanding investor.

Investing one’s own hard-earned capital and investing OPM have subtle yet important differences. Capital fuels life in capitalistic societies. It pays for food, water, shelter, and education. It supports families, relationships, and self-esteem (to an extent, arguably). Investing one’s own capital is an undertaking of personal risk. Enormous stress is an understatement. Investing OPM reduces personal risk significantly.

Yet investing one’s own capital confers huge advantages to the bearer of risk. Because the drive to protect and profit from one’s capital is strong and tangible, one starts to learn the exacting means to do so. One inevitably begins to see the irrational practices of the market. Does the business value of the strong company fluctuates as much as its stock price volatility or market commentaries suggest? The investor of own capital would find the answer, struggle with it, lose money, choose to believe in it more, lose money again, believe in it enough to make it part of one’s being, practice it right, and finally survive price volatility. Repeat the grueling journey for other investing principles enough, and one finally profits.

By taking significant personal risk with own capital, the investor learns from a journey that the OPM investor would not. The OPM investor has a large salary and bonus (yes, bonus is due even in a losing year) which guarantees a high standard of living. There is little incentive to take personal risk by betting personal capital. Being a good employee would suffice.

Humans are conditioned to seek security now. Now, not in the long-run. The majority of “investors” would seek the stable paycheck of a large fund. What the majority is giving up in exchange is significant – the opportunity to go through near-term grueling self-doubt and learning to achieve long-term life-changing profits.

As an illustration, consider the stock of The Trade Desk (NASDAQ: TTD). As a provider of advertising technology, its IPO was unpopular. Predecessors have risen and fallen. The Rubicon Project (now Magnite MGNI after merging with Telaria) was a high-flying SSP (supply-side platform) before crashing because it missed out on the crucial transition to header-bidding technology. The pace of technology change was so fast that even a leader could not keep pace. Why would TTD do any different? To top it all off, large competitors include Google and Facebook, which owned more than half of the digital advertising market with their walled gardens. How likely would a newly IPO company win against the titans?

If the investors of OPM did not give up on TTD pre-IPO, they would have post-IPO. TTD stock popped 60% on day 1 and declined 20% in the next two months. In the next four months, the stock did nothing from its day-one pop (see chart below). To avoid explaining why the stock didn’t perform (while the S&P was up 6%) and how TTD could compete with Google and Facebook, investors of OPM would likely replace TTD with a stock that can be easily explained to clients and bosses.

If one had focused on business value, one would have understood the value of TTD as a leading DSP riding the CTV wave, armed with a technically-savvy founder-CEO with a 50% stake proven by a previous successful exit to Microsoft. I’ll leave the competition with Google/Facebook for another day (or for the reader to find out). Even with the knowledge of business value, one has to suffer multiple significant declines, ranging from 5% to 50%, to profit from TTD (see chart below for multiple rises and declines. Yet TTD returned about 15x from day-one close to now over about 4 years). Those who profit have taken to heart the lessons from multiple rounds of grating mistakes and missing out on other profitable opportunities, driven by their investing of personal capital and taking of great personal risk.

To AT&T and Comcast: take your head out of the sand

Fans of Roku and Amazon Fire might have been surprised when AT&T-owned HBO Max – the almighty channel featuring Game of Thrones and Southpark – would not be directly available to them (there is a workaround, albeit cumbersome). They might be shocked again upon realizing that Comcast-owned Peacock would likely be unavailable too. Roku and Amazon Fire reach 80 million households. Why would the media giants give up this reach if their objective is to reach as many subscribers as possible?

Their decisions appeared to be motivated by the fear of accelerating loss of cable subscribers. The rise of TV streaming and cord-cutting have caused the permanent loss of millions of cable subscribers. AT&T owns Time Warner Cable (now Spectrum) and Comcast owns cable assets under Xfinity. The cable business has historically been very profitable, producing north of 30% net margins. AT&T and Comcast are motivated to protect their cable business and stem the loss of subscribers by limiting streaming access to their most popular content.

However, the restrictions are akin to a shack in front of an enormous tidal wave. There is no way to prevent TV streaming from disrupting the cable industry (I argued in a previous article that cable was ripe for disruption). Hence little can be done to stop the outflow of cable subscribers. AT&T and Comcast are merely slowing down the inevitable with content restrictions and customer-hostile tactics, which would ironically accelerate the demise of the cable business in the long run by increasing the relative appeal of user-friendly streaming channels.

If it is impossible to stop customers from moving to streaming, it would be rational for AT&T and Comcast to position for and profit from streaming. Allowing Roku and Amazon Fire easy access to HBO Max and Peacock is a step in the right direction, yet is still insufficient to assure success in attracting and retaining subscribers. AT&T and Comcast are light-years behind streaming stalwarts like Netflix. Large content libraries, owned by the media giants, alone are not enough. The success of streaming champions (Netflix, Roku channel, Hulu etc) depend on both content and sophisticated technology. For example, Netflix has at least a decade lead in its recommendation engine technology that pairs users with content that they otherwise would not discover. The recommendation engine, named Cinematch, uses machine learning algorithms, so advanced and refined that it does not require users to rate content in order to recommend content (for more on this fascinating topic, read chapter 11 of this book). The Cinematch algorithm retains customers by facilitating discoveries of hidden gems. Therefore, it would be unwise for AT&T and Comcast to rely solely on large libraries of premium content for success in streaming. They would also have to consider matching the user experience and back-end technology of competitors. This is a formidable undertaking whose difficulty is compounded by constantly-improving competitors. Yet AT&T and Comcast are squandering precious time and resources over squabbles concerning content access.

Streaming is the future. Netflix is already worth more than AT&T and Comcast. Roku would eventually be recognized as the premier platform for streaming. The sooner that AT&T and Comcast position for streaming, the sooner they can start competing for a future that is increasingly likely to cast them aside.

How to generate extreme returns (Part 2) – The market exists to serve, not to guide.

In ground rules, I stated that “Your manager seeks to avoid permanent losses, but not quotational losses. A security can trade at any price, hence price volatility can never be avoided.”

That a security can trade at any price should be both seductive and intimidating. The stock bought at $10 yesterday can trade at multiples higher today or $1 the day after. Any price is possible. Many investors have this principle seared into their psyches during the Covid-19 downturn.

If volatility is threatening, one is looking to the market for guidance. A large decline from purchase triggers fear, which activates the human instinct to abandon self-thinking and follow a higher order, in this case the crowd and the market, for guidance. Succumbing to these instincts is a grave mistake. Investors should look to the market for opportunities, not for guidance, and embrace volatility as a provider of opportunities.

But doesn’t the market know more than any individual? Isn’t the wisdom of crowds worth following? In truth, the market may not know more than the individual. The market price is the product of many buyers and sellers who are not always motivated by fundamentals. They may transact based on emotions such as fear and greed or on technical factors such as portfolio rebalancing.

Therefore, the investor who keeps a cool head and has conviction in the right fundamental perspective may actually know more than the market. He looks to the market for opportunities, not for guidance.

To have conviction in the underlying fundamentals of a stock is to follow the rules outlined in part 1. Practice investing based on cash flows and avoid speculation; avoid excessive leverage; know the boundaries of your knowledge; have processes that guard against destructive human instincts.

Following the aforementioned rules effectively leads to a focus on the asset and business, not price, resulting in an evaluation of the stock’s fundamentals relative to price, not an evaluation of price alone. A stock does not exist in a vacuum. It is an ownership stake in a business. Even experienced investors forget this during extreme bouts of volatility.

Volatility that feels intimidating functions as a feedback mechanism. It is the market’s way of informing investors that they lack conviction and understanding of fundamentals. Investors who heed the warning would exit and reflect. Those who don’t will eventually succumb to destructive instincts and look to the market, instead of independent thought, for guidance, suffering losses as a result. Yet this is the brutal fate for the majority of investors, providing the minority that keeps a cool head with opportunities.

How to generate extreme returns (Part 1) – an introduction

First published on 2/29/20. Revised on 4/11/20.

My goal as an active investor is to out-perform standard stock indices by a large margin over an extended period.

A standard stock index is a formidable opponent, as the vast majority of active investors would attest. Most generate returns insufficient to beat a passive investment in a diversified index in a single year. Those who do are unlikely to repeat the performance in other years. However, those who maintain sustainable market-bearing returns exist, albeit in small numbers.

Achieving extreme returns can be a complex study weaving disparate topics from finance to psychology. Yet, similar to complex phenomena in the physical sciences, simple rules, governed by constraints, underlie chaos. Simple does not imply that the rules are easy to learn or execute. Rather it means that the rules are clearly defined and hence possible, though difficult and unintuitive, to learn. This series of studies attempts to explain the simple rules underlying the complex, oftentimes disorderly, achievement of extreme returns.

First, avoid permanent loss.

 “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” -Albert Einstein

It is perhaps counterintuitive to introduce the topic of extreme returns in the form of loss avoidance. It is akin to telling a new driver that the point of driving is, not to travel from A to B, but to avoid accidents. Yet the practice of defensive driving to avoid accidents inevitably leads to safe travel. Similarly, the practice of avoiding losses eventually results in returns.

Loss avoidance unleashes the power of compounding to produce extreme, if not downright mind-boggling, returns over time. A $10,000 investment generating 10% per annum provides $1.7 million profits in 30 years. However, a single year of loss can cost years of profits. In the previous example, a 50% loss in the 30th year is equivalent to losing all profits in the prior 7 years. Consecutive 50% losses in the 29th and 30th year wipe out profits accumulated over the prior 15 years.

Second, to avoid permanent losses, one must invest, not speculate. Investments are decided based on cash flows, and speculations on anything else.

Investors perceive a business having two values: the observable market price, and the unobservable yet conceivable intrinsic price. Investors establish the intrinsic value of a business on an absolute basis, meaning it is based on the sum of future cash flows discounted by appropriate interest rates. Speculators have little consideration for intrinsic values. Their chief concern is future price movements based, not on fundamentals, but on predictions of the behavior of others. Some assets, such as collectibles, can only be speculated and never invested because they do not generate cash flows. Hence they can only be priced based on past transactions. Their values are based on circular reasoning, that is they are bought because they were bought in the past. This increases their prices, attracting more buyers, further increasing prices, and repeating the cycle. The speculative logic can collapse any time.

To further differentiate investors and speculators, one distinguishes absolute valuation from relative valuation. Believing that a business should trade at 20x earnings because its peers do is an example of relative valuation. However, such speculative logic quickly collapses with second-order thinking. If one purportedly buys the business in question at lower than 20x peer earnings, the purchase would increase the peer group multiple higher than 20x, which is the impetus for further purchases. Circular reasoning inherent in relative valuation means that the logic can collapse at any time.

Third, stay away from excessive leverage.

Investors have to be ready for the markets to do anything. It is challenging to tell what will cause a crisis, so investing with a plan to defend against crises is absolutely necessary. The more leverage is used, the lower the ability to ride through temporary quotational losses, the weaker the defense against crises.

Fourth, define your circle of competence and stay within it.

“Real knowledge is knowing the extent of one’s ignorance.” -Confucius

“There is nothing wrong with a know-nothing investor who realizes it. The problem is when you are a know-nothing investor but you think you know something.” -Warren Buffett

“It ain’t what you don’t know that kills you. It’s what you know for sure that just ain’t so.”-Mark Twain

To avoid losses, you have to avoid what you don’t know. The successful investor does not have to know everything, but has to be certain of the boundaries of his knowledge.

To evaluate a business, the investor has to know the factors that are important and knowable. The intelligent can identify the important elements, but only the wise can tell whether they are knowable. The wise is aware of the limits of understanding.

For example, it is easy to identify oil prices as a primary determinant of revenues for an energy exploration business, but it is utterly unwise to believe that one can forecast oil prices with certainty. Oil prices are important but unknowable. Forecasting customer retention for a software subscription business that has maintained consistent retention for 20 years is relatively more certain. Retention rates are important and likely to be knowable in this example.

For some businesses, the important factors are never knowable. Their prospects can never be predicted with certainty. Hence these businesses can never be wise investments. Buffett places them in the “too-hard” pile. Why leap over 7-foot hurdles when you can step over 1-foot hurdles?

Fifth, maintain a process that guards against destructive instincts.

“If the Earth formed at midnight and the present moment is the next midnight, 24 hours later, modern humans have been around since 11:59:59pm – 1 second. And if human history itself spans 24 hours from one midnight to the next, 14 minutes represents the time since Christ.” -waitbutwhy.com

The implicit mathematics shows that the existence of modern humans occupies one-tenth of 1% of 1% of time since the formation of the Earth, and the existence of civilization (crudely defined as time after the birth of Christ) is one-thousandth of that. In short, humans have not existed that long, and human civilization occupies a tiny part of that short history.

Hence, the human instinct has mostly evolved in environments before civilization. The important implication is that instincts useful during pre-civilization may not be so now.

Consider the human instinct to follow crowds. Pre-civilization, humans lived in hazardous environments with dangerous predators, and lacked sufficient food, water, and shelter. A tribe offered better protection against hazards and more resources than the individual. There was safety in numbers. The tribe was so essential to human survival that following others became a basic instinct. Fast forward to today, investors are unlikely to live in conditions similar to those their ancestors did. There is no pressing need to live closely with others in a tribe to protect against hazards or obtain necessities, but the instinct to follow others still exerts itself because our instincts are mostly shaped during pre-civilization.

Following the crowd in investing is detrimental. If one buys and sells stocks when the crowd does, one would buy high (the crowd buying increases prices) and sell low (the crowd selling lowers prices).

To weed out destructive instincts, investors require a systematic process that provides fair treatment to all analytical thoughts. Any thought has to be properly judged and given due process. The lack of due process is akin to a court with only one attorney. The sole attorney may present an excellent argument, but a judge can never find it valid without weighing other perspectives.

Along the lines of the same analogy, the investor takes the role of an attorney (when presenting his own perspective), listens to opposing attorneys (when considering the perspective of others), and finally arrives at a conclusion, whether presented or not (when weighing all, available and unavailable, perspectives as a judge).

The complexity of achieving extreme returns is proportional to its rewards. Identifying simple, clear rules is akin to locating a lighthouse, essential in pointing the right direction amid the perplexing, inundating, and stormy sea of investing.

“It [referring to investing and achieved outsized returns] is not supposed to be easy. Anyone who thinks is easy is stupid.”-Charlie Munger

Buy stocks now

Special deal sign in the shopping mall in Asia. Bali.

The headlines appear more threatening every day. Increasing infections and deaths from Covid-19 are forcing quarantines at an unprecedented scale. The economic fallout is certain to be bad, and the timing of the recovery uncertain. Almighty corporations such as Boeing and Delta are seeking state-backed bailouts reminiscent of AIG and General Motors in the Lehman crisis.

Yet the one thing to do, neither intuitive nor obvious, is to buy stocks now.

Stocks reflect the long-term earnings potential of their underlying businesses. The American economy is contracting because of necessary measures to contain the virus, but the long-term potential of the American economic expansion is intact. In the past 100 years, America, backed by relentless dynamism, has survived a flu epidemic; the Great Depression; costly World Wars and numerous conflicts; an assassination and a resignation of her Presidents; hyperinflation and oil shock; Black Monday; savings-and-loans implosion; September 11; the dot-com crash; defaults of major economies; the Lehman and mortgage crisis; and the Eurozone sovereign crisis. Yet the S&P 500 increased from 18 to 3,231. There is little doubt that major corporations in the United States would set record earnings 10, 20 and 30 years from today.

So why now?

How do we know that stocks have bottomed? The truth is that there is no way to tell, despite what you hear from Goldman Sachs and CNBC. Steve Jobs said that “you can never connect the dots forward. You can only connect the dots backwards”, which means that we will only know the bottom with hindsight. Because you can’t be certain to buy at the bottom, you should only buy when you expect reasonable returns. Using 90-year averages for the S&P 500 as a benchmark, the investor can expect roughly 7% returns per year in the next 10 years (see Appendix at end of article for calculation), a reasonable return.

Why now when investors are hungry for cash and appear to be selling assets from stocks to bonds to commodities for cash? Cash pays next-to-nothing and loses value in an inflationary economy. The Federal Reserve and the ECB, the two most significant central banks, set policies to target positive inflation every year. You don’t want to bet against that. Yet investors demand cash now because of a lack of confidence in assets, even when cash is a depreciating asset. Stocks are almost certain to beat cash in returns over the next 10 years. So buy stocks before others regain confidence, as long as you are buying at levels that are likely to offer reasonable returns.

The case for owning a piece of the American economic expansion now is clear, yet there are other obstacles – psychological, economic or otherwise – for investors to pull the trigger. I do not purport to convince every person to own stocks and hold them for a sufficient duration for significant returns. Perhaps JP Morgan said it best – in bear markets, stocks return to their rightful owners.

Appendix

S&P 500
EPSPEPrice
19281.1814.8917.57
2019139.5323.153,230.78
CAGR5.4%0.5%5.9%
To keep calculations straightforward, CAGR is not total return because it excludes the reinvestment of dividends. The reinvestment of dividends adds roughly 3.5%/y, meaning that the total return between 1928-2019 is 9.4% per annum. As a side note, the S&P 500 was created in 1957, but one can “create” the index before that year.

Table above shows that S&P returned 5.9%/y for the past 90 years, comprising mostly EPS growth (5.4%) and a little PE expansion (0.5%). As of March 20, 2020, the S&P 500 traded at 13.3x forward PE. Using the 90-year averages as a benchmark, if the investor expects PE at 20x in 2030 (20x is the 1928-2019 average), this means that PE will grow from 13.3x now to 20x within 10 years, providing 4.2% return per year. Let’s assume that the return is reduced to 3.0% because of damage to confidence from the Covid-19 fallout. To estimate returns from EPS, the investor can use 5.4%, which is the 90-year average. Let’s assume that EPS returns almost halved to 3.0% because of the damage from virus containment. Summing the returns from PE (3.0%) and EPS (3.0%) result in 6.0% returns without the reinvestment of dividends. Say if we assume dividends add another 1% return conservatively (current dividend yield is about 2%), total return becomes 7%.