The Monotony of sensible Investing

This is not another article about rubber ducks

There’s something glamorous about investing in the stock market that perhaps no other type of investing possesses; you can make a fortune on selling rubber ducks (Roman Abrahmovich made his first million selling rubber ducks) or ice-cream (Duncan Bannantyne made his first million from the back of an ice-cream van) but somehow, it doesn’t have the same caché.

It’s as if there’s something smart about stock investing that other areas don’t quite have, that appeals to us. Maybe it’s because when someone who works in stocks and shares says something with authority, we listen. Who doesn’t want the ability to hold someone’s attention, for them to highly regard your opinion on areas as serious as the economy and put their money where your mouth is?

Go back a step.

When you’re investing in the stock market, you’re looking to get a return on an investment. The rest is window dressing. Holding someone’s attention, those blue shirts with the white collars and all the rest of the trimmings have nothing to do with good investment and it’s important not to lose sight of that. An industry has been built around the actual business of sensible investing to distract you.

The best offices in London are held by investment banks. Here’s a little secret: you’re paying for the office as soon as you walk in the door to talk to them. Nobody is going to tell you that they’re not successful. They’re very successful – at betting on the right way stocks that are going some of the time and convincing clients to pay out large fees all of the time.

If proof of this were needed, all you have to do is look at the offices of Warren Buffett, widely regarded as the best investor of all time. Rather than the shiny metal and glass wonder in the heart of Manhattan that you might expect, it instead stands as an ugly 1970s monolith in Omaha, Nebraska – a part of the American Midwest that would be unknown to most were it not for his investing prowess.

Berkshire Hathaway Headquarters

He did it all, first from an office in his house attic and then in a plain office building in his hometown where the rents were low (again, showing a focus on investment and nothing else). What Buffett understood – and is constantly at pains to point out – is the difference between price and value: “Price is what you pay. Value is what you get.”

Enter the Media

The media are often accused of spinning political stories and it’s probably justified. Strangely, rarely are they accused of spinning economic stories. To be fair, they don’t do it intentionally – we all do it. But headlines like, “stocks to watch out for in 2015,” “2015 could be a good year for stocks” (note: the heading said “could be”), and “where are the next growth industries?” are commonplace.

In the same way that the media convinces some people through home design shows that a house can be bought, refurbished and flipped for a 15% profit in three months, they often, unwittingly do the same with the stock market. It goes with the territory – if you’re writing an article, it’s easier to start with, “here are ten hot tips,” than, “this one is tricky to call – I’m really not sure.”

If you are investing in anything, should it be shares, bonds, real estate or other physical assets, use the media by all means; but use it for information. Good investors trade on good information. Don’t use it as your shepherd. When the Sunday Times tells you in its Money section that it has found the best shares to invest in for next year, pinch yourself and think that 800,000 other people bought the same newspaper that day. If 1% of the people listen to the paper’s advice, 8,000 people will go out on Monday morning and buy the stock.

Oh, it will go up in price alright.

This is what we mean by not using the media as a shepherd. It should be looked at (and hopefully will remain as) a source of timely, relevant and accurate information. Beyond this, you will have to use the information wisely in tandem with specifics of each company, fund or index that you wish to invest in. That doesn’t make a particularly good headline, but it’s true.

Fund Management

The civil service offer better value for money than most fund managers. And at least the civil service provide us with reliable data on their (sometimes impressive) performance. Fund managers invest in shares on your behalf, warning you beforehand, “shares can go up as well as down.” Think about that for a moment. The shares can go up as well as down. And they’re getting paid for that nugget.

There is a trick in the fund management industry whereby funds of shares that aren’t performing well are killed off. Therefore, we have what is known as “survivorship bias:” every one of the funds is doing well, because all of the ones that weren’t doing well were killed off. This is the finance equivalent of showing someone you got an “A” in an exam as proof that you got “A”s in all of your exams.

The most bizarre thing of all is that they get handsomely paid for this. Again, the shiny office comes out. The ads for fund management firms appear daily and weekly on reputable publications like The Economist and The Financial Times (even as the pages inside the covers slate the industry), and the process goes on. You would think it couldn’t last but it’s already lasted so long that it seems to have its own momentum.

Investing in shares is not exciting

Investing in shares is not exciting. It’s worth repeating the sub-heading. One of the images that trading on the stock market is of a man or woman looking intently at a computer screen when somebody calls and says, “Buy! Buy! Buy!” He or she subsequently buys the shares and makes a million on the trade. In fact, that is so unrealistic that it has probably happened about five times in Hollywood films.

Most stock market investing is a case of buying under-valued shares in sound companies and waiting a few years to see the return on the investment. And before that return comes, there may be a bad year – or a year with no dividend return – where you begin to think you made a bad choice. But if it was a good choice in the first place, then it makes sense to wait.

The NYU Professor and investor, Aswath Damodaran, spoke to students about the value of waiting. He gave the example of an economic crash in an emerging market (which are almost always more volatile). In each of those countries, there are companies that depend almost entirely on the country’s wellbeing (such as, say, domestic supermarket chains) and those that don’t (such as those that have a lot of international trade).

Damodaran gave his students the case of Embraer as an example of the latter. Embraer is the largest airplane producer in Brazil and 95% of its output goes to the United States. So what happens if the Brazilian economy goes belly up tomorrow? Hopefully, it doesn’t come to pass as people would suffer. Embraer would be shielded better than most though – 95% of its money comes from the United States. Effectively, it’s depending more on the well-being of the US economy than the Brazilian economy!

So, when the economy crashes, all the international funds get out of Brazil (at the same time as telling their clients they saw this coming), pushing down the value of the stock market. The price of Embraer goes down as well. But its cash flow was just the same as it was before, because Americans are still buying their airplanes. It’s a good example of using the media for information rather than as a shepherd.

Damodaran notes that for a while (maybe up to a year or slightly more), the share behaves erratically but after waiting a few years, he says he did well on trades like this. Again, even in a situation where there was a world-class professor and sometimes investor involved waiting it out paid off. The company retained its cash flow and its shareholders were rewarded.

Cash Flow

At the beginning of this document, we stated that investment is about getting a return. The cash flows are the return. Not the revenue. Not the EBITDA or even the net income. These are effectively accounting tricks. In fact, accounting can tell us that a business is still a going concern when it has no cash flows. EBITDA and net income can be doctored. Try doctoring how much cash a business has.

It is worth hammering home the difference between revenue and cash flow again and again. Revenue is the sales of a business – the headline figure. Bizarrely, everyone is more familiar with the revenue than the cash flow of most companies. When people say, “Google made X billion dollars last year,” they’re almost always talking about revenue.

Well, what Google actually made was the cash flow (also, incidentally, not a small amount for Google but even for them, always smaller than the revenue). The cash flow is what’s left after everything else has been paid: salaries, tax and all the rest of it. As an investor, it’s the figure you should be looking for; the faster you get to the cash, the faster you will see a return on your investment.

The importance of cash flow was underlined recently when the debt of Twitter was given a junk rating. Ratings agencies – paid to value debt – said that a company as well-known as Twitter, with how ever many daily users were unlikely to give your money back if you borrowed it to them. Why? The reason given was that they aren’t generating enough cash flows. Nothing else – just the cash flows.

Risk

We commonly think of companies as large stable non-risky entities that have been and will be around forever. In our collective defence, they’re happy for us to think this – it’s in their interest. Why? Because companies pay for risk on the money they loan, just like everyone else does. The more stable they can appear, the cheaper the money they borrow will be.

But companies aren’t stable. Incredibly, Coca Cola lurched towards bankruptcy in the 1980s. The term “Kodak moment” might be with us forever but the company that the term is based on certainly won’t be – they went bankrupt a few years ago. They were world leaders in their industry for almost a century. Most children these days wouldn’t know what a film is, never mind how to reel one. So much for stability.

The Encyclopaedia Britannica was a feature in rich people’s houses for decades as they sought to educate their young. It stopped selling when Microsoft put Encarta Encyclopaedia on a CD in the early 1990s. Who could topple an encyclopaedia on a disc? Well, it lasted about ten years. Wikipedia came along and now Encarta is a distant memory.

This is not a parable for the sake of it. The stock market is constantly asking you to invest in firms, which are market leaders, have a seemingly unassailable lead over their rivals or an industry monopoly. And yet, firms always fall. And with them, they take investors’ money and the vast majority of their creditors’ money (who clearly undervalued the debt).

The risk is ever present. Even if companies don’t fail, they can make bad investments, which kill money. They make the wrong choices – who would have bet on Facebook taking over when MySpace had a clear lead? At a price of $580m, Rupert Murdoch called it one of his best ever purchases. In 2011, he sold it for $30m. Murdoch generally isn’t one to throw away money.

Shares are risky and anyone looking to invest in them should be very aware of that.

Past Performance

We have purposely left the biggest downfall of new stock market investors to last. There’s something about an upward sloping curve that we all love. It says success, money, good investment. Well, actually, it doesn’t say good investment. It says well invested. The difference being that the performance was in the past. The one thing all stock charts have in common is that they’re all in the past.

It’s startlingly obvious but it catches so many people out and despite hundreds of years now of stock market existence, people are still falling for it. Looking at an upward sloping chart and thinking that it’s a sign that the share is a good investment is like putting a bet on Nottingham Forest to win the Champions League because they won it twice at the end of the 1970s.

Remind yourself again and again that the graph of a share shows the investor expectation at any one point in time about what the future performance (i.e. the future cash flows) of that share will be. It’s constantly going up and down because nobody can say with 100% certainty how cash flows will be, but it means that the current price is about as good a guess as we can make.

That means that the current share price – in as much as we can tell – is accurate. It’s worth no more and no less. If you think it’s undervalued, go ahead and buy it. But you’re effectively saying that everyone else in the market is wrong about the price and you’re right. And you could be right. But at the other side of the trade, the guy selling you the share will be wrong about the price. So, really, it’s not easy.

Conclusion

The purpose of this article was not to scare anyone away from investing in the stock market. We don’t think we could, anyway. Rather, it was a call to sensible investing and to be aware of the dangers and pitfalls of investing on the stock market – not just for novice investors, but for everyone. And even armed with good information, sensible investors with good intentions have been badly burned.

The massive industry that has grown around the stock market (including the companies that make up the stock market themselves) doesn’t get paid if you don’t invest on the stock market. So bad news is often short on the ground. This article is just an antidote to that. We have attempted to play the role of devil’s advocate and not just for the sake of it.

The stock market can still be a highly worthwhile investment, when you are armed with the right knowledge. Put aside emotions, biases and narratives that you want to be true and look at investments with cold, unemotional rationality. Anyone who has made money on the stock market over a sustained period has done it this way. Forewarned is forearmed. We wish you successful investing!