Investing in Index funds and exchange-traded funds (ETFs) resolves the common blindspots in stock investing which can make you lose lots of money.
What are the blindspots, you asked?
Here I explain in detail.
Why invest in ETFs #3: Value investing analysis blindspot of ignoring technology advancement/obsolescence
Why invest in ETFs #1: The problem with using DCF method to evaluate a company stocks
The discounted cash flow (DCF) model is the touted valuation method to determine if a stocks is undervalued or overvalued at its current price.
However, in practice, it is often very difficult to use it. Besides the challenges of estimating all the future cash flows, it is also hard to say what discount rate or cost of capital is considered as “fair” when we try to estimate the intrinsic value.
*Intrinsic value is calculated by taking a discount to future cash flows.
Value investors use a discount rate relative to the current risk-free rate when using DCF model. Risk-free rate can be Cash Deposit rate It seems to be reasonable since investors of equity asset should require a premium over risk-free asset. So if 10 years government bond yields 3%, and you require 5% more yield as the premium to hold a more risky asset like stocks, you might use 8% as your discount rate.
But in reality, this does NOT work unless you are investing in a vacuum.
Risk-free rate changes over time in a dramatic way. Cash deposit rate in Malaysia, for example, used to be circa 10% in the early 80’s , but today it is only less than 4%. Therefore, whatever discount rate you use for stocks, the fair value computed from that discount rate will also change over time, if that discount rate is based on the risk-free rate.
Besides, it is near impossible to speculate what the interest rate (which correlate to risk-free rate) will be in the future.
Consider the situation of emerging market countries – Brazil and Russia, where the inflation rate and bank deposit can yield 10%, stocks with 10 times P/E (Price to Earnings ratio) certainly don’t look cheap in this context. However, if some kind of hyperinflation indeed happens later for one of them, the value of any cash deposit (denominated in that currency) will be reduced dramatically when it stays at 10% per annum.
On the contrary, the real business value of a business will suffer a much lesser impact. By definition, inflation means the prices of goods go up in general, this change may not be evenly distributed, as some businesses/industries like consumer staples have more pricing power than others, say, luxury goods.
But in general and in average, a business’s value is hedged by the corresponding changes of prices, while the bond is not.
But what if a company is in a business where it has no pricing power, and its cash flow does not naturally grows at inflation rate?
Using DCF method to value a stock’s intrinsic value is useless in this sense.
The stuff taught in value investing courses – such as reading annual reports or historical financial statements of a company and analyzing the various financial ratios is equally useless if you…
- Never care about what business/sector has pricing power, and which one has not
- How a business prospect is going to be 10 or 20 years from now by understanding local & global macro-economy
Why invest in ETFs #2: Value investing fundamental analysis tend to ignore the macroeconomy
In reality, investors almost always have a portfolio instead of a single stock, so the value of any additional investment is relative to the other existing positions in that portfolio in terms of risk-adjusted returns.
For example, if the financial sector (typically acts as the bellwether of business cycle) is under stress, you might find a lot of cheap financial stocks. However, the value of another cheap financial stock is much less to a portfolio that is already more than 50% weighted in the financial sector than to another portfolio that has no financial stocks at all.
Furthermore, you should also consider these looming risky aspects, which value investing never teach you but you have to read the news to know:
- You are over-exposing to 1 sector only, financial sector in this case. That is a risk by itself – concentration risk
- You fail to consider that the plunge of stocks in financial sector is limited to itself while other sectors like consumer staples maybe still doing fine.
- The business cycle is not heading into recession, so it may be a value trap in the financial sector.
In other words, while each individual stock has its own value and risk, the real risk and value investors should care about is on the entire portfolio. Just because your best idea is 3 times more attractive than your 3rd best idea, it doesn’t mean you should keep adding the former, and completely ignore the latter.
Why invest in ETFs #3: Value investing analysis blindspot of ignoring technology advancement/obsolescence
This is from Andreessen Horowitz, simplified. A historical lesson for all value investors.
Times are changing — the destructive power of technology is starting to break down companies faster than ever.
The classic case is Research in Motion (RIM). In January 2007, RIM was trading at a high 55x PE multiple. Over in Cupertino, a computer company called Apple had reinvented itself as an MP3 player company and was now unveiling a new phone set to launch in the summer.
By the end of December 2009, market share for Apple’s iPhone iOS as a percentage of US smartphone OS was 25% while RIM had increased from 28% to 41% in that same period. Though RIM had grown market share, fears of iOS growth had toppled the PE multiple to ~17x.
U.S. Smartphone market share by OS
Many traditional, value investors sat back and thought, “Well, RIM is holding up pretty well compared to the iPhone, yet their PE multiple is getting destroyed.” It’s trading at near the historical average S&P 500 PE multiple of 15x. Apple hasn’t historically been strong in the enterprise, so maybe iPhone will just be a consumer phenomenon that doesn’t break through to business users. Android is irrelevant with 5% market share. The smartphone market is growing rapidly and RIM is the clear leader. RIM is still growing north of 35% and generating nearly $2.5B in net income. I think RIM looks cheap!
Two years later, RIM was trading at a 3.5x PE multiple and topline growth had screeched to a halt. Market share for RIM had contracted to 16% while iOS and Android combined for 77% market share. In fact, in 2012, RIM posted a net income loss of $847mm. Investors lost a ton of cash and were left scratching their heads.
How did this happen so quickly? Why did net income fall off a cliff? Why now?
In 1962, Everett Rogers presented his thesis on the diffusion of innovation.
One reason: Technology Adoption is Accelerating
Innovation adoption lifecycle
The idea is that the adoption of new technologies follows a bell curve comprised of innovators (2.5%), early adopters (13.5%), early majority (34%), late majority (34%) and laggards (16%).
The cumulative adoption of technology over time generates what is known as the S-curve. Over the last 100 years, technology adoptions have always followed this same S-curve leading to market saturation.
What has significantly changed is the rate of adoption. New technologies are being adopted much faster than ever before. While technologies from the early part of the century like electricity, automobiles and the telephone took well over 50 years to reach 50% adoption, newer technologies like Internet, PCs, smartphones and tablets are being adopted much faster.
There are several factors that go in to how fast the technology gets adopted, including how discontinuous the innovation is and the per capita income, but the reality is adoption pace is accelerating. The flip side of this is when new technologies get adopted faster, incumbent solutions die faster. Quicker adoption leads to quicker destruction of old technologies.
For example, no longer do people have the need to print out paper and file documents away in those ugly green folders; they store all their documents in a cloud service like DropBox. Printers, fax machines, paper, pens and notebooks are all items that were central to the office 15 years ago but aren’t relevant in the digital office.
Software doesn’t just challenge businesses through direct competition; they can upend businesses through a systematic digitization of the world, rendering goods and service that a company is offering obsolete.
With technology upending markets, remaining a traditional value investor is a death sentence. In the case of RIM, the company thought that their scale was defensible and stopped innovating on the operating system, favoring battery life instead. Apple’s iPhone operating system and associated software was an order of magnitude better than RIM and attracted consumers.
While there may still be opportunities for value investing, you need to be cautious of businesses that appear to be on a slow decline. With the rate of technology adoption accelerating, Internet being a way of life and software consuming the world, businesses who refuse to embrace or adapt don’t just slowly decline; they fall off a cliff and take their cash flows with them.
Here’s a personal example of making this mistake. I invested in RIMM using Value Investing principles in 2010 yet I still lose money. But I manage to recover my losses using sophisticated investing method.
It is a classic example where a value investor can get burnt by value traps and therefore claim that value investing doesn’t work at all.
Why invest in ETFs #4: Simply buy-and-hold principle in value investing is flawed on itself
Buffett’s successes in the past can’t realistically be repeated today as the dynamic has shifted permanently.
Let me explain.
Firstly, although value investors are supposed to hold a long-term view, as Buffett said,
“You shouldn’t hold a stock for 10 minutes if you don’t like to have it for 10 years.”,
…that doesn’t mean value investors should always hold onto a stock for 10 years. It is just that the reason for buying it should be for its long-term value.
In fact, many value investors always hope to close the value gap as soon as possible. That is why many value investors emphasize on “catalysts”.
Do you agree?
Another way to think this is that considering investing as a business, the return on investment capital is closely related to “asset turnover”. If the stock can close a 50% value gap within a year, it can be better than another stock that closes a 100% value gap in 5 years.
In other words, a stocks with catalysts might be worth a lot more than another stock without any catalysts even when they all have the same valuation on the DCF basis.
And secondly, ponder over this deeply – why do stocks have catalysts for growth, on a macro level?
An oft-disregarded fact that aided Warren Buffett’s ascendency is the unparalleled growth of the US economy from the 50s to the 90s. In a slow-growing, mature or stagnant economy, it’s much tougher to achieve outsized returns at an annual rate of 20% compounded for decades.
Size counts as well – the U.S. economy grew to be the largest economy in the world, the runway for growth is huge for American companies operating within the States itself without having to venture overseas.
One can’t realistically expect a company based in smaller country like Malaysia or Singapore that only sells its services/products locally to make one a billionaire. Most countries’ economy, even the emerging ones as we speak, have matured and the runway for growth highly limited.
Whenever you try to forecast economic growth for a certain country, simply ask yourself this:
Why invest in ETFs #5: Stocks price can be manipulated by ‘pump & dump’ activities
[source: Focus Malaysia July 2016]
Seasoned investors know that logic does not necessarily prevail in stocks investment. Fundamentally weak stocks can see steep rises in prices while those with good prospects can experience price slides.
The invisible hands, aka Market syndicates doing Pump & Dump activities.
They push stocks prices up and down in a relatively short period of time.
Commonly happen to, but not limited to, penny stocks and their warrants.
For retail investors, a pump-and-dump strategy can make you feel like a fool for learning value investing.
A example: Comintel Corp (ComCorp) on 21 June 2016.
28.88% drop in the last 20 minutes of trading.
Do you know that a 28.88% drop needs a 41% gain just to break-even?
The syndicates pushed the stocks up for ‘false breakout’ to the upside with a break above the recent high of 97.5 cents to 99 cents before slamming it down to 66.5 cents.
The fundamentals are sound, its P/E ratio was 8.31 times while its net profit for Q4/2016 jumped to RM 6.11 mil Y-O-Y from RM 708k previously.
Fundamental analysis in value investing would have been useless in this classic scenario. Retail investors are at the mercy of market syndicates.
The fact is, manipulation will still exist in the market no matter how tight is the regulation. Nothing much you as retail investors can do, caveat emptor.
Possessing holding power and using average-down method is not ideal solution – they are false sense of security. Knowledge of technical analysis, however, will help a bit.
Why invest in ETFs #6: The Stock Market has become more Efficient
Markets today are way more efficient than the markets before mid 90’s. There was no Bloomberg, spreadsheet software, trading platform nor the Internet. Most analysis were literally done on paper with a calculator and pen. Buy/sell was done by calling your broker-remisier. Public information was available, but it was scarce as there was no Google to index information and keep it available at a few keystroke.
On the flip-side, global markets have never been more accessible today, you can invest into any companies or sectors globally without even stepping out of your room. This makes life easier (or tougher) for the budding value investor.
On top of that, there are tens of thousands of funds using highly complex (or simple) strategies to hunt inefficiencies in the markets. We can easily find any company’s annual reports thanks to Google and can analyse its financial data using Excel, we can also use various free stock screeners to screen for “value” plays. And have you heard of HFT – high frequency trading?
If you think you are are ‘fast’, there are people and machines which are even faster to capitalize on inefficient market opportunities.
Even Warren Buffett himself no longer invests in public equities as aggressively as before as Berkshire Hathaway has grown too large to have a small company move its needle. He now hunts the big game – buying out companies private-equity style to expand the Berkshire holdings.
Evidence #1 stock market is becoming more efficient
Even the largest asset management company in the world, Blackrock concur to this fact and that is why it is shifting to ETFs / index funds
In March 2017, Blackrock, the company behind the many ETFs above, BlackRock laid out an ambitious plan to consolidate a large number of actively managed mutual funds with peers that rely more on algorithms and models to pick stocks.
Some $30 billion in assets (about 11 percent of active equity funds) will be targeted, with $6 billion rebranded BlackRock Advantage funds. These funds focus on quantitative and other strategies that adopt a more rules-based approach to investing.
“The democratization of information has made it much harder for active management,”
Founder, Chairman and CEO of Blackrock, Laurence D. Fink said in an interview.
“We have to change the ecosystem — that means relying more on big data, artificial intelligence, factors and models within quant and traditional investment strategies.”
The casualty from the restructuring?
7 of BlackRock’s 53 stock pickers are expected to step down from their funds. At least 36 employees connected to the funds are leaving the firm.
Now the biggest fund companies are Vanguard, the indexing pioneer, and BlackRock, which together oversee close to $10 trillion in assets.
“The old way of people sitting in a room picking stocks, thinking they are smarter than the next guy — that does not work anymore,”
“These are stormy seas for active managers, but we at BlackRock are an aircraft carrier, and we are going to chart our way through these seas.”
Evidence #2 stock market is becoming more efficient
Andrew Hallam, author of the globe trotting Millionaire Teacher was–and continue to be–a fanatic fan of Warren Buffett. But in January 2011, he sold every share. At the time, they were worth almost $400,000. He channeled the proceeds into Vanguard’s Total Stock Market Index ETF.
He admitted that such move might sound crazy for most people. After all, Berkshire Hathaway had long outperformed the U.S. market.
In 2010 something dawned upon him while he was researching for his first book Millionaire Teacher. At the time, his portfolio consisted of individual stocks and index funds. But the research was clear. Few people beat the market over time. It was easier in the past, when fundamental techniques were far less refined.
According to Hallam, Larry Swedroe and Andrew L. Berkin explained this in their 2015 book, The Incredible Shrinking Alpha: And What You Can Do To Escape Its Clutches. The authors have a lot of respect for history’s great investors. “They were decades ahead of their time. They learned that you could beat the market by picking small stocks or value stocks or quality stocks with increasing price momentum.”
But today, most active managers know that. Swedroe and Berkin say the market has changed. “Today, professional investors account for as much as 90 percent of stock market trading. And each decade, they get better and more sophisticated.”
Why invest in ETFs #7: Black Swan event can befall to a single stock or sector
Let me give you an excellent example of a black swan event other than Brexit and Trumponomics.
Imagination Technologies Group plc is a British-based technology R&D company, focusing on semiconductor and related intellectual property licensing.
However, shares in Imagination were in free-fall on 4 April 2017 morning after Imagination confirmed it would lose its biggest customer by 2019. In a press statement, it said “Apple is of a view that it will no longer use the group’s intellectual property in its new products in 15 months to two years time, and as such will not be eligible for royalty payments under the current license and royalty agreement,”
There is no way anyone could have seen that coming
Roughly half the company’s revenue derives from a licensing deal with Apple.
Apple told the company that it is “working on a separate, independent graphics design” so as it can ditch Imagination Technologies and take more control of its products
Shares in Imagination were down 65 percent following confirmation of Apple’s decision to rip up its contract with the firm. In 2016, Apple paid nearly £60.7 million (about $75.8 million) in royalties to the British company, which reported total sales of £120 million (about $150 million) for the 12-month period.