Investing 201: Conventional Investing
In this post, I will primarily discuss conventional investing¹. In the US and many developed markets², with the exception of real estate³, stocks and bonds (in addition to cash or saving accounts, which we will not discuss here) make up most of people’s investments.
Let’s look at what looks like a bubble in equities first.
Pundits have been calling the P/E multiples too high to be sustainable for a while now. Some even silently saw a silver lining in Covid-19 — assuming what Fed (soft land the market by gradually raising the interest rates, for example) or market forces (bust the bubble) could not do, Covid-19 would. Yet, here we are — S&P 500 has soared more than 50% in 2 years, and 15% just in the last year alone, when the Main Street was largely shut down.
It is ludicrous to believe that asset bubbles can only be recognized in hindsight — Michael Burry
The primary justification for the “irrational exuberance” is of course that the interest rates are historically low and expected to stay so for the short-term, and there are not many alternate attractive options to invest (bond yields are extremely low for example). Moreover, when interest rates are so low, businesses can borrow cheap money to boost their growth, thus potentially providing a good reason for growth in stock prices. Last but not least, price of a stock is nothing but a sum of discounted cash flows (DCF), all the way through its lifetime⁴: Lower the interest rates, greater the valuation.
What central banks typically would do in such times is gradually raise interest rates to force “soft landing” — that is, avoiding a bubble bust by deflating it gradually. That’s what Greenspan’s Fed started doing in mid 90’s, without much success however — even with rising interest rates that went up to more than 5% — stocks frenzy continued unabated, indeed until we saw the bubble bust in 1999 and 2000. However, given the state of unemployment and larger economy today, the Fed essentially does not have the opportunity to raise the interest rates and slow down the market.
There are a few compelling arguments that favor the idea that we are not in quite the bubble yet.
The big tech firms, have largely benefited from Covid-19 as more and more users rely on technology to carry on with their lives. Big tech stocks now have increasingly big share of major indices.
The most compelling argument I have seen so far is that the stock market should be seen in the light of “Excess CAPE Yield”, as opposed to traditional metrics such as P/E. When seen from this new lens, the market seems frothier than it was in 2000, but less frothier when compared to the one in the days of 2007–08 financial crisis.
This is not to say that you can’t make money off the bubble.
If you can set aside some money, and would not mind losing a major chunk of it in the short to medium term, invest away. That may help assuage your FOMO, while not cause much hurt if the bubble bursts.
What helps everyone is getting in somewhere that’s going up, and it just carries you along without much talent or work — Charlie Munger
We’re in very uncharted waters. Nobody has gotten by with the kind of money printing now for a very extended period without some kind of trouble. We’re very near the edge of playing with fire — Charlie Munger highlighting the dangers of unprecedented monetary easing and aggressive fiscal spending in recent months.
Be fearful when others are greedy, and greedy when others are fearful. — Warren Buffet
In theory, when interest rates are high, it is a good time to buy bonds, and sell stocks — and when interest rates are low, it may be a good time to buy stocks, and sell bonds. Ideally you want to lead the herd — as in, enter (or exit) the market (stocks or bonds) before most people do. In other words, fear cycles (recessions) are the most risky and least profitable times for purchasing bonds., while greed cycles (Bull Markets) are the least risky and most profitable times for purchasing bonds.
More generally, of course, you should compare your expected return of a stock to the expected return of a long-term bond, and buy the one with the higher return.
Alas, we are in strange times — bond yields are low making them a relatively unattractive investment for most people, and stock market seems like it’s in a bubble.
The basic principle of being fearful when others are greedy and vice versa still applies in other ways, however, even when it does not apply to stocks vs bonds. For example, it may help to look at stocks that are overlooked, or are an underdog. You will of course want to have a good reason behind why you think a stock is undervalued.
OK, I know how to make money “off” the bubble, but how do I make money “in” the bubble (or not).
The good news is that bubble or bust (which by definition are very difficult to foresee), you can always find “value stocks”. Value investors (e.g. Warren Buffet) tend to over-perform growth investors in the long term. The bad news is picking value stocks is incredibly hard. A few metrics can help you make a determination⁵.
The late nineties almost forced me to identify myself as a value investor, because I thought what everybody else was doing was insane. — Michael Burry
There is all this opportunity, but so few active managers looking to take advantage. — Michael Burry, highlighting the money to be made in unloved assets⁶ during the current passive-investing “bubble”
In general, try to avoid the urge of buying stocks that are too popular, or stocks of companies whose products you love. You may want to look for companies up or downstream from popular stocks, however — for example, if electric vehicles sales are going to take off, look for companies that make essential components for those cars and their manufacturers.
Growth stocks lie on the other end of the spectrum, and especially do well in the times of a bubble. Broadly speaking, growth investors look for the next big thing. It should not mean that you disregard value metrics for example, however often this seems to be the case. A not so atypical example of growth investing would be if you bought Tesla shares earlier last year, for example, which increased in value by more than 700% — despite weak fundamentals. Of course, in hindsight, some of these stocks would appear cheaper in the past, and the argument for would be that the multiple one should be looking for is for forward earnings, which are incredibly difficult to forecast.
When the tide turns (or the bubble bursts), you can bet that growth stocks would lead the trend, and fall in value quicker than value stocks.
Whether you are picking value or growth stocks, try to come up with a simple model or hypothesis⁷.
It is all too complicated, and I do not have time to the analyses.
If modeling or value analysis sounds too complicated, you should consider dollar-cost-averaging⁸ methodology, which essentially assumes one make periodic stock (or bond) purchases despite how the market is doing. The underlying philosophy is that timing a market is close to impossible, and while you could have lost more than 50% of your value in equity markets in the financial crisis of 2008, if you kept investing and held on to your investments, you’d have recovered or exceeded your original positions by now⁹. Of course, this is also why, you should increase the percentage of bond positions in your basket as you grow older, since you may not have a decade before retirement to make up for a bust in stocks. Dollar-cost averaging can work with either value or growth investing, and like value investing it generally favors buy and hold pattern.
Mutual funds or low-cost index-tracking ETFs are other ways to tap into the market with relatively low skill or work. That said, I am personally not in favor of actively managed mutual funds for at least the following reasons:
- Historically they tend to under-perform passively managed, low cost funds, and therefore do not justify the management costs.
- Open-ended mutual funds fall victims to the herd mentality — when investors are scared, they tend to sell their holdings, thus making it very difficult for the managers to take advantage of low valuations.
Index-tracking funds have pitfalls of their own — the primary one being that most indices are not that well diversified after-all: For example, “the six” (or MFAANG — Microsoft, Facebook, Apple, Amazon, Netflix, and Google) account for nearly 25% of the index and over 70% of its gains over the 12 months through September.
Automated investing (or robo investing) is yet another trend to watch out for, and one that I strongly recommend. Automated investing platforms such as Betterment use sophisticated algorithms to arrive at an “efficient portfolio” — something that is incredibly hard to do at least manually, and when combined with dollar-cost-averaging can offer superior returns in the long run. You can also take advantage of tax-loss harvesting via these platforms — once again something that isn’t easy to do on your own.
While I have not talked about short-selling, options, or leverage here, I will discuss them in the context of alternate investing (though arguably these concepts very well apply to conventional investing — but are not common for most conventional investors). Stay tuned for rest of the posts in the series.
¹ Typically, stocks and bonds are considered forms of conventional investments, while a few folks consider real estate to be part of conventional investing as well, as opposed to alternate investing. In my opinion, real estate is a big enough asset class to be considered as a bucket on its own, and hence I will write a separate post that will focus just on real estate.
² While my experience has mostly been with investing via US brokerages, similar principles should apply for most countries — though of course market dynamics usually differ. If you live in an emerging economy such as Pakistan — where most people typically do not at least directly invest in stocks (or bonds), I will encourage you to explore this universe more. Personally, I feel more comfortable investing in markets where I have ready access to data and research, and the process of trading online is seamless. Unfortunately, in Pakistan for example, it is difficult to get up to date financials and other relevant data and whatever information is available, is less reliable. This poses an opportunity for those few that have asymmetric information at their disposal. I do have a small exposure at KSE, which by the way has soared an incredible 27% in the last few months!
If you want to invest in global equity markets, opening a brokerage account in the US may be the easiest, and should give you access to equities and markets beyond US, as most brokerages offer funds that invest in other developed or emerging economies. Moreover, many US companies have significant exposure to international markets — so you may just be investing in Apple, but as a result get exposed to markets in most of the rest of the world where Apple generates revenue. This gives you more diversification, however, financial contagion may evaporate much of that advantage— i.e. — if Apple does not do well in China, but sells very well in the US even to compensate for the dip in China, the stock price may still get a big hit.
You can also trade directly in non US exchanges through some brokers — this gives you a direct exposure to a stock exchange in Shanghai for example, as opposed to investing in ADRs that trade in a US stock exchange but represent companies elsewhere like China.
³ In many emerging economies, real estate is still the most popular asset class. See below for a break up of global investment universe.
⁴ For simplicity sake, let’s say, business A earns $100 in year 1, $110 in year 2, and then shuts down — assuming interest rates of zero, A’s valuation is simply $210. You can see why company valuations can go high in times of low interest. If interest rates were higher, the A’s valuation would be discounted by the cost of capital.
⁵ There are multiple ways of evaluating value stocks. I mention only a few here.
- Look for stocks that issue dividends — ideally 3% or greater. Of course, most growth stocks offer no dividends.
- Look for companies that have a Debt/Equity ratio below 0.50
- Current ratio should be above 1.0
- When P/BV is 1.5 or less and P/E is 15 or less for example, you’ll get the following result: 1.5 * 15 = 22.5. Look for P/BV * P/E < 22.5.
- Look for ROE > 5%.
These are only rules of thumb and have to be taken into consideration with other factors including your risk tolerance, and expectations of forward earnings. Moreover, as you can see from the values above, these numbers would preclude companies that do not have profits yet. `
⁶ There is nothing fundamentally wrong with buying large cap stocks —however, large cap stocks tend to be oversubscribed by institutional investors, who in order to keep their portfolios more manageable have to go after a few large cap stocks as opposed to many small cap stocks.
⁷ A very simple example of a model could be as follows. Let’s say you are evaluating Spotify, and your hypothesis is that it’d become the Netflix of audio. You could find out price of Netflix’s stock to its active users ratio, and compare it with Spotify’s. If you see that Spotify’s ratio is much smaller, there may be an opportunity to long Spotify. Of course you will need to make several other considerations — for example, how the audio dynamics are very different than those of video, how entrenched Apple Music is etc.
⁸ Imagine that you bought a stock for $10. If the value goes down to $9, wouldn’t you want to buy more of it ? Since if if you thought $10 was a good buy, $9 could be even better! Conversely, if the stock price increased to $11, it may seem that the stock is gaining momentum (not to be confused with momentum investing — whereby you’d buy more of the same stock if its value is increasing, and sell short if the price is decreasing¹⁰) — why not hold it?
⁹ Here is a fascinating article that talks about why short-term losses are an integral part of long-term gains. See how many losses an investor would have to have endured in order to take full advantage of what was unprecedented rise in value for the decade.
¹⁰ Momentum investing is yet another, but not a sophisticated, way of automating trades, whereby you can put stop or limit orders in place to take advantage of the market momentum.