investing concepts Archives | Steady Compounding

Lessons from The Psychology of Money

By Steady Compounder | September 27, 2020 | Comments 4 comments

The Psychology of Money is one of the most highly anticipated books for finance enthusiasts in 2020. Morgan Housel has a knack for writing beautifully and a flair for capturing abstract concepts onto paper. This is not at all common for writings on the topic of finance.

Reading this book made me reflect a lot and helped fine-tune my thinking. It also made me think a lot about the problems many of my friends shared with me—keeping up with the Joneses, staying in a job that’s costing their health for the high paycheck, and worrying about stock market volatility.

I had a tough time choosing the key lessons from this book because it’s filled with great insights. After much deliberation, the following are my key takeaways which would be helpful both for my friends and I.

The price of success

Investing is simple, but not easy.

By simply investing in the S&P 500 index over a 20 year period, we could generate a return of 8% to 11% with dividends reinvested.

The S&P 500 increased 119-fold in the 50 years ending 2018. All you had to do was sit back and let your money compound. But, of course, successful investing looks easy when you’re not the one doing it.

Sounds simple?

In his book, Morgan presented the chart below where the shaded lines indicate at least a 5% decline below its previous all-time high.

*Chart taken from The Psychology of Money*

Since 1928, the S&P 500 has declined by 10% or more 91 times. Twenty-percent declines have occurred 22 times. It has declined more than 30% once every decade with more than 40% decline once every few decades.

Amidst the long backdrop of growth is drawdowns of multiple magnitudes. To enjoy the growth, investors must be able to stomach the sharp drawdowns which come every now and then.

To enjoy the reward, you need to pay the price — volatility.

Sensible optimism is a belief that odds are in your favor, and over time things will balance out to a good outcome even if what happens in between is filled with misery.

Between the start and the end, know that it will be filled with misery. Be optimistic that the long-term growth trajectory is up but the route to the prize is a tough one.

Beyond spreadsheets

Most people will agree that buying lottery is a mathematically unsound decision. It perplexes me when people I know routinely purchase lottery tickets 3 times a week. Especially when they are tight on cash.

Oftentimes the reasoning is “有买有希望希望，没买没希望。” Translated, this means “I’m buying hope, there’s no hope if I don’t buy.”

Few people make financial decisions purely with a spreadsheet. They make them at the dinner table, or in a company meeting. Places where personal history, your own unique view of the world, ego, pride, marketing, and odd incentives are scrambled together into a narrative that works for you.

Everyone has their own experience of how the world works. What I experienced is likely vastly different from what my parents experienced. All of us go through life anchored to our perception about how money works that vary widely from person to person.

Buying the lottery seems crazy to me but it made sense for others.

I’m certain that you and I have some version of ‘craziness’ ourselves, anchored by perceptions formed from our experiences. Strive to continuously read books, especially from authors with differing opinions and consider their propositions in totality.

Beware of learning solely from social media sites e.g. Youtube or Facebook/ Instagram posts. The algorithms works to reinforce your existing anchored views.

Tails drive everything

At a party given by a billionaire on Shelter Island, Kurt Vonnegut informs his pal, Joseph Heller, that their host, a hedge fund manager, had made more money in a single day than Heller had earned from his wildly popular novel Catch-22 over its whole history. Heller responds, “Yes, but I have something he will never have . . . enough.”

The case of Long Term Capital Management (LTCM) is an interesting one. They had 16 experienced professionals, including two Nobel prize winners. Collectively, the team probably had more than 350 years of experience in the investing business. They had an incredible amount of intellect and they invested most of their net worth into LTCM.

And then they went broke.

As Buffett says: “But to make money they didn’t have and didn’t need, they risked what they did have and did need. That is foolish. That is just plain foolish. It doesn’t make any difference what your IQ is. If you risk something that is important to you for something that is unimportant to you it just does not make any sense.“

There is no reason to risk what you have and need for what you don’t have and don’t need.

*Bloomberg Article on retail investors taking loans to invest*

Many take on leverage to invest in stocks, given that interest rates are at historical lows. As tempting as it is, I have abstained from doing so out of a respect for tail-end risks.

Long tails—the farthest ends of a distribution of outcomes—have tremendous influence in finance, where a small number of events can account for the majority of outcomes.

What will wipe most leveraged investors out is when the market swing 3 standard deviations to the left (the yellow zone).

Is it likely to happen? Rarely.

But if it does, leverage increase the probability of being wiped clean.

Charlie Munger says: “The first rule of compounding is to never interrupt it unnecessarily.”

Even if the odds looks favorable, the key to success in building up wealth is in avoiding ruin. Even with a 95% success rate, the 5% odds of being wrong means that we will certainly experience downside at some point. And if the cost of the downside is ruin, no amount of reward is worth the risk.

*Article from Bloomberg on 24 Mar 2020 at the market bottom*

As we look at what happened during the market bottom in March 2020, highly leveraged investors are more likely to cave in to volatility. When the market is soaring, risk appetite increases and leveraging up feels great.

During sharp drawdowns, your cash flows may be affected. Your emotions may viral out of control as you look at your family and your bills.

Over-leveraging, not having at least 6-months worth of emergency cash, and adequate insurance coverage all raises the probability of ruin—the risk of liquidating your positions at the worst possible time because you need to repay the money.

On the flip side, Peter Lynch’s famous quote “In this business, if you’re good, you’re right six times out of ten.” reflects the other spectrum of long tails. Where a handful of winners will propel bulk of your portfolio’s returns.

The Russell 3000 has increased more than 73-fold since 1980. That is a specular return. That is success. Forty percent of the companies in the index were effectively failures. But the 7% of components that performed extremely well were more than enough to offset the duds.”

Housel went on further to cite that not only do a few companies account for most of the market’s return, but within these companies are even more tail events.

In 2018, Amazon alone drove 6% of the S&P 500’s returns. And Amazon’s advancement was largely due to Prime and Amazon Web Services (AWS). Which itself are tail events whereby the company has experimented and failed hundreds of products (e.g. Fire Phone) before striking gold.

“It’s not whether you’re right or wrong that’s important,” George Soros once said, “but how much money you make when you’re right and how much you lose when you’re wrong.” You can be wrong half the time and still make a fortune.

Tail drives everything—don’t over-leverage your positions and appreciate that a handful of companies you own will deliver an outsize return for your portfolio, hold onto them.

The ultimate goal

Being able to wake up one morning and change what you’re doing, on your own terms, whenever you’re ready, seems like the grandmother of all financial goals. Independence, to me, doesn’t mean you’ll stop working. It means you only do the work you like with people you like at the times you want for as long as you want.

This is it.

Money’s greatest value is its ability to give you control of your time.

Plenty of studies have shown that splurging money provides only temporary relief. Life is miserable when we take up jobs we hate to sustain a lifestyle we do not need.

As Naval Ravikrant puts it “Looking forward to holidays takes the joy out of every day.”

What’s more important is having control over our lives. Independence means that your family is taken care of. That you are able to take controlled risks and pursue your dreams with a greater peace of mind.

Money in and of itself will not make you happy. But having the liberty to pursue your desired life might.

Independence, regardless of income bracket, is determined by how much you can save. Avoid lifestyle inflation upon landing your first job or from your promotion.

Most importantly, don’t fall into the trap of buying things we don’t need to impress people we don’t like.

The hedonic treadmill

The hardest financial skill is getting the goalpost to stop moving. Modern capitalism is a pro at two things: generating wealth and generating envy… Wanting to surpass your peers can be the fuel of hard work. But life isn’t any fun without a sense of enough. Happiness, as it’s said, is just results minus expectations.

As I reflect on the paragraph above, I’m reminded of a few of my close friends. They bring home a big paycheck but are never satisfied. Great earning power sometimes inflict a curse called the “hedonic treadmill.”

It continuously shift the goalpost of your financial dreams, extinguishing the joy you thought you would get from having more wealth, once you achieve it.

From observations, this is extremely pervasive in the sales industry. Where luxurious cars, condominiums and branded bags are deemed a ‘necessity’ for success.

“Someone will always be getting richer faster than you. This is not a tragedy.” says Munger.

Social comparison is the problem. In our minds, wealth is always relative and not absolute. You could be within the top 20% income bracket but if plagued by envy for your peers’ wealth, you’ll never be happy.

As Benjamin Franklin puts it “It is the eyes of others and not our own eyes that ruin us. If all the world were blind except myself I should not care for fine clothes or furniture.”

The role of luck

Investing, as with life, is like a game of poker, not chess. A novice chess player would stand no chance against Garry Kasparov.

In life, and investing, you can make all the right decisions and still end up losing.

Likewise, you can make all the wrong decisions and still come up a winner.

The cover of Forbes magazine does not celebrate poor investors who made good decisions but happened to experience the unfortunate side of risk. But it almost certainly celebrates rich investors who made OK or even reckless decisions and happened to get lucky.

The worrying part about this is that many of us try to study and emulate rich investors who made reckless decisions and got lucky.

*Forbes article on Bitcoin during the speculative period*

Be careful who you praise and admire. Be careful who you look down upon and wish to avoid becoming.

Realize that not all success is due to good decisions made or hard work, and not all poverty is due to poor decisions or laziness.

You’ll get closer to actionable takeaways by looking for broad patterns of success and failure. The more common the pattern, the more applicable it might be to your life.

Conclusion

Money is a relatively new tool and it is a subject that is very undertaught. Not understanding it caused many to bury themself in debt, sell at market bottoms, or become a tool for money. To better understand money, I strongly recommend The Psychology of Money, Dollars and Sense, and I Will Teach You to Be Rich.

For readers in Singapore, I would recommend you to follow Seedly.

Thank you for taking the time to read my blog.

In my next post, I will be back to writing on investment topics!

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Operating leverage – how it caused Gamestop (GME) to plunge into the red

By Steady Compounder | June 10, 2020 | Comments 4 comments

From the earlier post, we learned that not all growth is value-adding. Today, we are going to discuss an equally important concept – operating leverage. Not all sales growth has the same effect on profitability.

With these 2 articles, I wish to highlight to readers that sales growth, profit growth, and value creation are distinct. Growth in sales creates value only when a company earns a rate of return greater than its cost of capital. Furthermore, the percentage increase in profits may be vastly different than the increase in sales growth and vice versa as a result of operating leverage.

Operating leverage is a measurement of how an additional dollar of sales translates into operating profit. A 10% increase in sales may result in a 30% increase in net profits. Likewise, a 10% decline in sales may send a company’s ~~share price~~ earnings into oblivion. As we will see in Gamestop’s case study later.

How does operating leverage work?

Operating leverage is the most common in businesses which require a large amount of fixed assets investments. Theme parks are an example of a business with high operating leverage. Approximately 75% of their costs are fixed, with labor being the largest component. This means that if visitor numbers decline (i.e. sales), their operating profit will decline at a much larger magnitude.

Fixed costs are costs that a company must bear regardless of the sales level. For example, Starbucks must continue paying its rent, labor, and utilities regardless of the amount of coffee sold per store.

Variable costs are costs that are linked to the sales level. For Starbucks, this would be their coffee beans, whipped cream, etc. The more Frappuccinos they sell, the higher the amount of cost they would incur for the raw materials (i.e. coffee beans, etc).

The chart below from Credit Suisse illustrates nicely the impact on operating profit margin based on revenue changes and cost structure (fixed vs variable).

The concept of operating leverage is best explained with an example. ABC is a company with a higher operating leverage, 75% fixed expenses and 25% variable expenses. XYZ is a company with a lower operating leverage, 25% fixed expenses and 75% variable expenses.

Both of them are having sales of $10,000,000 and $8,000,000 in expenses. Giving them a profit of $2,000,000.

Assuming a 20% increase in sales from $10 million to $12 million would result in a proportional rise in variable expenses.

For ABC, variable cost would increase from $2 million to $2.4 million. And for XYZ, from $6 million to $7.2 million.

The fixed cost for ABC and XYZ would remain fixed at $6 million and $2 million respectively.

Net profits for ABC jumped 80% while XYZ’s increased by only 40%! This is operating leverage at work. For ABC, a larger proportion of their expenses are fixed. When expenses don’t grow as fast as sales, net profit will grow at a much higher rate.

Operating leverage cuts both ways. For a company with high operating leverage, a decline in sales would cause net profits to decline at a much larger magnitude as well.

When revenue declines by 20% to $8 million, variable cost would decline to $1.6 million and $4.8 million for ABC and XYZ respectively.

Net profits for ABC declined a whopping 80% while XYZ suffered a 40% decline. Fixed expenses still must be incurred when sales decline. When expenses do not decline as fast as sales, net profit will tumble at a much larger rate.

Case Study: GameStop Corp (NYSE: GME)

Errors in analyst forecasts tend to be larger in businesses that have high operating leverage. Likewise, investors are often caught by surprise when investing in businesses undergoing a secular decline that have high operating leverage. As the decline in sales inevitably resulted in a much larger decline in earnings (and share prices).

Briefly, GameStop (GME) is a video game retailer largely in the USA. With the internet, sales have plummeted as Amazon took up its market share and platforms such as Playstation and Xbox began selling digital games directly. Skipping a third-party retailer like GME altogether.

GME began to attract a lot of attention as ‘Big Short’ legend, Michael Burry, took a sizable stake in the company. The popular thesis was that the company has a ton of cash and a lot of value could be unlocked by GME repurchasing their shares. Creating a short squeeze on the short sellers (the stock was heavily shorted).

Many investors focused on the potential upside as Burry took a position. But many missed the important fact that a company in secular decline coupled with high operating leverage could be disastrous to earnings.

From their annual report, sales declined by 24%. However, it’s selling, general and administrative (SGA) expenses declined only 5%. This tells us that most of GME’s SGA expenses are fixed as reduced sales did not allow GME to save on SGA expenses. It still has to pay its employees and rent to run the business despite having fewer sales.

Adjusting for impairments, we are able to observe that operating earnings declined by a whopping 103%. From $453m to an operating loss of $14m. Despite only a 24% decline in revenue.

Likewise, investors who bought in 2017 at $25 were caught off guard with the sharp decline in earnings. The stock tumbled 80% as it lingers around $5 today.

Key lessons

Here I will summarize the key learning points I hope you can takeaway:

Operating leverage by itself is neither bad nor good.
It works both ways, a company with rising revenue could potentially see a much bigger increase in earnings and vice versa.
Companies with both high operating leverage and financial leverage will see greater swings in earnings.
Companies with high operating leverage and financial leverage are often the biggest gainers off a market bottom.
In the long run, all expenses are variable expenses.

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Focus on total returns, not income investing

By Steady Compounder | May 31, 2020 | Comments 0 Comment

This is a sequel to Getting Hurt Chasing Yields – Part 1. Apart from investing in instruments and companies that are unable to sustainably pay out interest and dividends based on their operating cash flow, investors are committing a mistake by solely focusing on investing for income.

Income investing means building a portfolio of interest or dividend-paying common stocks, preferred stocks, and bonds in an effort to generate sufficient income to maintain their desired lifestyle.

Investors should not be fixated on chasing yields. Rather, they should focus on the maximum total return they can derive from their investments. Total return includes both income and capital gains.

“The best way to approach this is to invest for the highest total return you can achieve and sell whatever shares or units you need to provide cash. However, I realise that for many investors, the idea of realising part of their capital to provide income is anathema.”
Terry Smith, CEO of Fundsmith

When investors focus on income-producing stocks, most are focused on stocks that have a high dividend yield. Generally, this would be limited to companies that pay out most of its earnings as dividends such as REITs or mature companies such as Singtel and Comfortdelgro.

These companies do not retain most of their earnings for reinvestment. Largely because they are unable to reinvest at high returns. Cash generated by the business will have to be deployed at other places (e.g. acquisitions) or returned to owners (e.g. via dividends or share buybacks).

Investors focusing on dividend yield alone would miss out on the great compounders – companies that are able to reinvest at a high rate of returns. Instead of paying out a dividend, they would retain most of their earnings for reinvestment. Growing the intrinsic value of their businesses.

Let’s look at an example comparing two businesses and understand which yield a higher total return. The first company, Compounding Corporation. It has the ability to reinvest all of its retained earnings at high returns due to its strong reinvestment moat. As a company that grows at a high ROIC, the market assigns it a higher multiple, at 20x earnings.

The second company, Dividend Corporation. It is a mature and steady business that pays out good dividend yield and trades at 10x earnings.

Assume that, over time, both companies will be valued approximately in line with the market, at 15x earnings. In this case, Compounding Corporation will suffer a multiple derating, while Dividend Corporation will enjoy a multiple expansion.

Let’s observe which company would provide shareholders with higher total returns:

By focusing on companies that provide a high dividend yield, investors would miss out on companies like Compounding Corporation. Although income investing would provide a decent result. The opportunity cost of doing so is huge (total returns of ~700% against ~300%).

The desperate search for yield has led to a number of people choosing to invest in income funds, or in mature companies providing a high dividend yield. On the surface, it might sound sensible, but it is erroneous. It may lead to investors underestimating the risk of investing in high yield instruments. Moreover, what is less obvious is the opportunity cost of focusing on yield only, as opposed to the total returns of a company that is able to compound at a high clip.