Weekend Reading

Stephen Clapham in his blog behindthebalancesheet.com has come up with ten reasons why the investment landscape in the western world will be different in post-Covid19 virus world. His points are worth pondering over by all investors.

1 Fortress balance sheets: One legacy of the pandemic may be a culture of greater conservatism and risk aversion. Boards are likely to adopt a more conservative approach – the shock we have just experienced will make even the less risk-averse Director appreciate having more cash and more facilities, just in case. Boards will likely want some security against another pandemic.

2   Onshoring supply chains: Businesses are likely to shift to from lean ‘just in time’ to bigger ‘just in case’ inventories. Businesses will be warier of single sources of supply or demand, allowing for a greater ability to switch activities or locations. Clearly there is an associated cost. The risk inherent in just-in-time and diverse supply chains has become more apparent and companies will surely want higher stocks, more diversity of supply and will onshore more production as a protection against a recurrence. Again this will have two implications: Production costs will rise and Returns will fall as inventory and working capital increase.

3 Working capital unwind: Unwinding of working capital will occur on both sides of the balance sheet. A number of industrial companies which have improved working capital tremendously over the last 10-15 years. But many have done this predominantly by failing to pay suppliers on time – unless their supply chains are extraordinarily robust, these companies will be hit by the need for increased inventory (see 2 above) and by the need to start paying suppliers more quickly.

4  Interest rates may stay low for some time: It seems highly likely that interest rates will stay low for an extended period. Clapham’s base case assumption is that as with the situation post the GFC, inflation will remain subdued (this may well be the surprise of the decade as inflation returns as in the mid-1960s, but not for a while). This should, in theory, continue to fuel the valuation of growth stocks. With growth scarcer, this becomes an even more attractive feature.

5 Pension deficits to increase significantly: Assets have gone down significantly for those with higher exposure to equity, less so for those funds with a larger exposure to bonds and. And funds with heavy exposure to alternatives may find that the lack of a mark to market doesn’t help if the private equity portfolio companies sink under the weight of their dent. Liabilities have gone up significantly because the liabilities are discounted to present value based on bond yields which have collapsed. This means that pension deficits will have increased significantly for most quoted companies. This is almost a straight subtraction from equity values.

We will continue with the remaining five on Sunday 3^rd May.

Charles Schwab built a Fortune 500 company whose value compounded at an average rate of 19% a year since IPO in 1987; twice the growth rate of the S&P500. The customer was at the heart of everything Schwab did. He entered a race that for fear of revenue loss, the large incumbent brokers didn’t want to be involved with, a lucrative niche providing customers with cut-price stock transactions which he exploited and expanded with new technologies. Charles Schwab tells his story in a recent book, ‘Invested – Changing forever the way Americans invest’.

Following are his views on the Stock Market & Investing

“With the stock market, there are no guarantees. You can guarantee service, costs, quality, and certainly integrity. But you can’t guarantee performance; Risk is just part of the deal.”

“I don’t think human nature deals very well with the patience and strong stomach investing requires. We’re wired for fight or flight.”

“I have now seen nine crashes in my life, and it still troubles me that investors react this way [sit on the sidelines], because it always ends the same. The market roars back and leaves too many investors sitting on the sidelines missing out. Sometimes I wish I could just tie them to their chairs to help them ride out the temporary storm. To this day our advice is the same: ‘Panic is not a strategy, stick with your investment plan, and don’t let emotions get the better of you.’ Heeding that advice when you’re in full panic mode is just not easy. People aren’t wired to be good investors.”

“The most natural instinct is to run for the door. To sell. Sell everything,’ I said [in 2008 when reaching out to clients]. ‘You’ve got to fight that emotion because you want to be able to hang on for the recovery. Which has happened every time we have had an experience like this in my career and that goes back now some 40 years … nine different cracks in the market like this. Smart investing is about taking it year by year. It is a little bit of a nightmare, but we handle those by living through them and looking forward to better days.’ Did I get the timing right with my advice? Not exactly. You never do. And that’s exactly the point… Timing the market is impossible. As the saying goes, it’s not timing the market that counts, but time in the market.”

“Successful investing is not easy, that’s the bottom line. It involves so much of your emotions, your sense of self-worth, your ego.”

source: http://mastersinvest.com/

Howard Marks, a renowned investor answers the important question, “Should I wait for the bottom?” In short, the answer is no. Since bottoms are only found out after the fact, buying on the downswing offers more opportunities than the alternative — waiting for some “all clear” signal.

Jon reminds us on his website that the old saying goes, “The perfect is the enemy of the good.” Likewise, waiting for the bottom can keep investors from making good purchases. The investor’s goal should be to make a large number of good buys, not just a few perfect ones. Think about your normal behaviour. Before every purchase, do you insist on being sure the thing in question will never be available lower? That is, that you’re buying at the bottom? I doubt it. You probably buy because you think you’re getting a good asset at an attractive price. Isn’t that enough? And I trust you sell because you think the selling price is adequate or more, not because you’re convinced the price can never go higher. To insist on buying only at bottoms and selling only at tops would be paralyzing…

The bottom line for Jon is that he is not at all troubled saying (a) markets may be considerably lower sometime in the coming months and (b) we’re buying today when we find good value. He doesn’t find these statements inconsistent.

With as fast as the market’ moved in the past two weeks, the question might be updated to: “Did I miss the bottom?” Arguments can be made for both yes and no. The correct answer is it’s impossible to know today. Besides, not holding tight to opinions on this is more important than having one. Jan –March quarter earnings, over the next few weeks, will offer some insight into the impact. But April –June quarter numbers will tell the tale. The best-case scenario is we won’t find out the real hit to companies — revenues, earnings, etc. — until sometime in July, at the earliest. Duration is still the biggest unanswered question right now. How long will it last? How will the market react to companies that report no revenues for a month? Two months? A quarter?

Investing is about understanding potential risks, placing bets based on those possibilities, but also being prepared for alternative outcomes. That’s why investing is a tradeoff. Finding the perfect balance between attack and defend in your portfolio is never easy. But if you go all-in thinking the market bottomed in an attempt to not miss the recovery, and you’re wrong, then you lose.  But if you’re all-out and wrong, you miss out on gains and also lose. Investment survival is a necessity. So finding a good enough balance, that you’re comfortable with, is key.

Jon concludes that the only guarantee is that when all this blows over, everyone will wish they had more cash to invest, that they bought more stocks, and at a better time. That’s the painful lesson with risk — not all risks are realized but we still need to prepare for it just in case.

Robert P. Seawright writes on his blog that investors have to face fear every day, more so on some days than others. To quote Jason Zweig paraphrasing Mike Tyson, “investors always have a plan until the market punches them in the face.” Every investor got punched in the face during 1Q 2020. Over and over. What’s an investor to do? The obvious temptation is to sell and maybe hide, but betting against the market is a dangerous business. Peter Lynch famously said that more money has been lost trying to avoid bad markets than in the bad markets themselves.

We humans don’t handle the stress well. As Laurence Gonzales explained in Deep Survival, “it’s easy to demonstrate that many people (estimates run as high as 90 per cent), when put under stress, are unable to think clearly or solve simple problems. They get rattled. They panic. They freeze.”

Our quite natural reaction to market volatility, to fear, is to bail. Trying to time the market in that way comes with a crazy-high degree of difficulty. Market-timing successfully means making many immensely difficult and complicated decisions and being consistently right. There is no reason to expect anyone to be able consistently to navigate difficult markets without losses.

On the other hand, staying in the market has significant advantages. Studies concluded that an average of just three days per year generated 95 per cent of all the market gains. Long-term returns accrue in bunches, and, in the markets as in the lottery, you’ve got to be in it to win it (although the market offers an exponentially greater chance of success). Moreover, the majority of the market’s best days occur within two weeks of the worst days (as we’ve seen recently), meaning that if you could somehow avoid the worst days, you would almost surely miss a lot of best days. It generally pays to stay invested.

Trying to “go to cash” at opportune times and, equally importantly, buying back in at the right time, is a loser’s game. Market timing strategies are frequently tried, rarely, if ever, successfully. Stocks are worth their volatility, the necessary price you pay for the much higher expected returns of stocks as compared with other investment choices. Accordingly, the longer the time frame we use for reference, the more powerful stocks become.

That’s why truly long-term investors shouldn’t worry about market volatility, which raises what is likely the crucial question: Are you a long-term investor? Those who recognize that fear will get the better of them might consider a portfolio mechanism like a pressure relief valve to try to help manage their fears. A decent portfolio that you can stick with is far better than a perfect portfolio you can’t. [Quick Check: How often did you check your portfolio last week? If your answer is something like, “A lot,” Seawright may well be talking about you]

Seawright concludes that despite the current turmoil, the difficulties of which should not be underestimated, the probabilities still favour investment. By a lot. Our brains all echo with fearful thoughts, whispers, and imprecations. For most of us, most of the time, we’d do well to ignore them about our investment choices.

Joe Wiggins writes on his blog that it is at times of severe market stress that our worst behavioural impulses come to pass. Whilst the recent losses in the value of portfolios are undoubtedly painful; the poor decisions that we will make as a result of the torrid environment will likely prove more damaging to our long-term outcomes. Against such a turbulent market backdrop, which behavioural issues should we be most concerned about?

Myopic Loss Aversion: Short-term losses are difficult, but they are also an inevitable feature of investing in risky assets.  Indeed, the high long-term returns from equity investment are a consequence of their volatility and the potential for severe losses – to enjoy the benefit you must be behaviorally disposed to bearing exacting periods.  For most investors (particularly younger ones) it makes sense to reframe the issue – rather than markets falling precipitously we should think about the likelihood that long-term expected returns from risky assets are now materially higher.

Recency: Our obsession with recent and salient issues means that they overwhelm our thinking.   Whether it is trade wars, Brexit or coronavirus.   This is not to say that such issues are not important but from a long-term investment perspective they are less vital than we think and feel they are at the time.  Try to make investments on the basis that we have to leave them untouched and unseen for the next ten years.

Risk Perception We are poor at judging risks.  We are prone to ignoring certain threats whilst hugely overstating others.  Our judgement about the materiality of risk tends to be driven by its availability (how aware we are of it) and its emotional impact on us.  The coronavirus is a particularly harmful risk for investors both because the magnitude of the impact is highly uncertain and it is deeply salient.  We also need to be clear about what risks we are considering when making an investment decision – is it the risk of short-term losses, the risk of being whipsawed by volatile markets, or the risk of failing to meet our long-term objectives?

Overconfidence In the past three months everyone has become an expert in virology, despite having no previous grounding in the subject.  It is okay to have an opinion, but the vast majority of people are guessing, and nobody knows the near term market or economic impact of the virus.  We shouldn’t make investment decisions that suggest we do.  In these environments making sensible long-term investment decisions is highly likely to leave us looking foolish in the short-term.  This doesn’t mean, however, we should not make them.  The advantage of being able to invest for the long-term is at its greatest when it is the hardest thing to do.  The only way to benefit from this is to have a sensible investment plan that is clear about objectives and the decision-making process.

This is a summary of a couple of articles that I read over the weekend. Investors all over the world are worried about the volatility and spread of COVID 19 virus. Here are some sobering thoughts.

The Evidence-based Investor website reminds us that crashes and corrections are a feature of equity investing, but when they happen they can be hugely unsettling. At the time of writing, exchanges around the world have rallied after the worst day for markets for 33 years. But don’t be fooled. We could be in for plenty more stomach-churning volatility in the days and weeks ahead.

The problem is, no one can predict the future with any accuracy. It’s impossible to say quite how serious coronavirus will be, or what impact it will have on the economy, let alone the markets. And markets may rise or fall sharply from here for reasons that have nothing to do with COVID-19. Yes, there’s lots of bad news out there. And there’s bound to be more to come. But life goes on, and there should be rich rewards for investors who keep their long-term focus, diversify, control their costs and carry on investing what they can. Stay calm, wash your hands and don’t touch your face. Or your portfolio

Michael Batnick reminds investors that it is hard to stay calm and ignore the movement day after day and week after week, especially if the market keeps going lower. But, when this thing finally does end, there will be a rally so fast and so furious that it will leave the people who sold like a deer in the headlights. They won’t know what to do. The idea that people who sell out of fear will buy out of greed is misguided at best.

Batnick warns us that if you’re making drastic changes to your retirement fund, just stop. There is too much on the line. What you’re really doing is ensuring you’ll have less money in the future because you’re uncomfortable today. It’s OK to be uncomfortable, in fact, it is guaranteed that over the course of your investing life, you will feel this very same emotion half a dozen times, maybe many more. You can be worried about lower prices tomorrow and still confident in higher returns in the future. That should be the default setting right now.

Jonathan Clements reminds us that here’s the least surprising thing you’ll read this week: you can’t control the financial markets. They’re driven by the news — and we simply don’t know what news we’ll get in the weeks and months ahead, whether it’s about the spread of the coronavirus, its impact on the global economy or something else entirely.

But don’t despair. There’s also much that we can control, including how much we save and spend, the amount of investment risk we take, how much we pay in investment costs, our portfolio’s tax efficiency and — most critically at a time like this — our own emotional reaction to market ups and downs.

Recency bias. In 2019, the S&P 500 stocks were up an impressive 28.9%, excluding dividends. This year, they’re down a fairly modest 7.8%. Which number are we focused on? You already know the answer. Instead of celebrating the huge gains enjoyed over the past decade, investors are fretting about the relatively modest losses suffered this year. Our thinking, alas, tends to be heavily influenced by whatever’s happened most recently.

Extrapolation. The S&P 500 has given up 12% over the past six trading days. The temptation is to take the past week’s losses and extrapolate them into the future. But that would be a classic investor mistake: We imagine we can forecast returns simply by looking at past performance.

Unstable risk tolerance. Will those big investment bets involve stashing more in stocks or bailing out? Which way folks jump will likely depend, in part, on how recent market action has affected their tolerance for risk. In theory, we’re supposed to figure out how much risk we can stomach and then build a portfolio that reflects that. In practice, our appetite for risk tends to rise and fall with the financial markets — and right now a lot of investors are likely discovering they aren’t nearly as brave as they imagined.

The illusion of control. Faced with danger, often our instinct is to act. That can make us feel more in control of our destiny — but it may not be good for our financial future. Most of us hold a portfolio built to help us pay for retirement and other goals in the decades ahead.

Clements concludes by asking should we mess with that investment mix simply because of a few rough days in the market? To ask the question is to answer it.

Nick Maggiulli writes on his blog about “Winning the Loser’s Game” a book written by Charles Ellis.  In the book, Ellis describes what he calls “winners’ games” and “losers’ games”: In a winner’s game, the outcome is determined by the correct actions of the winner.  In a loser’s game, the outcome is determined by the mistakes made by the loser. Ellis then goes on to explain that investing is a loser’s game because most investors who attempt to beat the market (i.e. those who try to win) typically underperform in the long run.  For example, using excessive leverage or paying high fees for expected outperformance are two common ways in which would-be winners become definite losers.

The better strategy for investors then is not to try and win, but to not lose.  Too many people in the financial community obsess over the “optimal” way to invest when their time would be better spent steering clear of actions that could lead to ruin. Warren Buffett said it best in his 2005 Berkshire Hathaway letter to shareholders: Over the years, a number of very smart people have learned the hard way that a long string of impressive numbers multiplied by a single zero always equals zero.

The warning from Ellis and Buffett alike is crystal clear: avoid the zeros.  Avoid them at all costs. Why?  Because the zeros are those things that can set you back years or decades in an instant.  What are “the zeros” exactly? In the investment world, the zeros are usually things associated with high costs (i.e. fees, taxes, extravagant spending, etc.) or high risks (i.e. leverage, concentration, etc.).  All of these things, if not managed properly, can wreak havoc on your finances.

As the saying goes, “Play stupid games, win stupid prizes.”  So don’t play.  Not even once.

Ben Carlson reminds us on his blog that regardless of the start date, this bull market in US equities has been relentless. Agreeing on the start date may be semantics, but we can all agree that pinpointing when it ends is impossible to do in advance. Until that day comes, here are some reminders about investing during bull markets.

Bull markets make you feel smarter the general direction of the market can toy with emotions by magnifying how we feel about our investing abilities. When stocks are going up it can make you feel like a genius just as when stocks are going down it can make you feel inept. Legendary investor Bernard Baruch offered some advice on this point: “Become more humble as the market goes your way.” Confusing brains with a bull market can be a costly mistake because bear markets don’t care how well you did when markets were going up.

Two things to remember Bull markets can last longer than you imagine. Secondly, even bull markets aren’t easy. They don’t keep going up in one direction. There can be a significant decline in share prices before the bullishness returns testing an investor’s patience and resolve.

Bull markets can lull investors to sleep Bull and bear market volatility in the stock market tends to look very different. You would assume bull markets are overflowing with big up days while bear markets consist of mainly big down days but that’s typically not how it works. Bear markets are full of both big down and big up days as volatility tends to cluster. When markets are going down volatility goes up, but it does so in both directions. Bull markets, on the other hand, are slow and methodical.

The methodical nature of bull markets is one of the biggest reasons we see overreactions during the inevitable bear market to follow. Markets that slowly go up blind investors to the fact that sometimes they also go down. And those overreactions are amplified by the fact that no one knows how long the music will continue to play.

Carlson advises investors to enjoy the bull market while it lasts. Just know it will take a pause at some point and when that happens many investors will sell first and ask questions later.