Mistakes in the Market
There is no doubt that markets across the globe have left investors scratching their heads It’s odd seeing so much economic destruction and yet seeing markets continue to rise, and while we’ve touched on why this might not be as irrational as people think in previous blogs, there is no doubt that current market conditions are not easy (although – are they ever?). During the last few weeks we’ve had a number of conversations with clients, potential clients, friends and other investors to understand how they are navigating these markets and putting capital to work (or not putting capital to work). Through these conversations we’ve noticed a few mistakes that market participants (including us) might be making with regards to the current investing environment. Now certain points below we know to be mistakes but most we simply think are mistakes, so obviously these are open to debate, but whether you agree with them or not, hopefully they give you good food for thought.
Chart-based decision making:
Looking at some stock graphs these days is more like looking at rocket reaching escape velocity rather than one of a company’s value over time. Stocks charts of companies such as Tesla, Wayfair, and Carvana have gone nearly parabolic and at a speed so fast that it would make even the most aggressive momentum investors think twice. While we have no real opinion of these three companies (although we are a bit suspect of Wayfair’s unit economics), there are companies in our and our clients’ portfolios that even though they have risen 3x,4x,5x since March we are still keen to buy and have been recommending as such. Now when we speak to clients about this, there is quite some hesitance, because one of the first things market participants naturally do, is to look at the chart and see what has happened recently. When they see massive moves in the stock, the ‘overvalued’ bell starts ringing in their head and they worry there is more downside than upside remaining. Now, don’t get us wrong, there are a lot of sub-par businesses (in our opinion) that have reached unthinkable highs, but this is certainly a time to separate the wheat from the chaff. The problem with looking at the chart is that it immediately influences your decision making, and even seasoned investors we know fall trap to this. The reality is, we must separate price from value, and to do this, we have a useful thought experiment we use to get over this bias. Let’s say you have some money to invest in a world where stock markets don’t exist. One day, someone comes along and offers you a stake in a business that you know a lot about (otherwise why invest in it?), and they tell you what the price is. Since there is no stock market, you have no idea what the business was worth before and obviously you can’t be sure what the business will be worth after, so, what would you do? Let’s play this out. Let say someone says that they have a great company to offer you which is the absolute leader in US online sales at a time where online sales only make up ~20% of total retail sales which is a market of over 5 trillion dollars. This company also has amazing businesses in cloud computing (which will be its own trillion dollar industry), music, video, and in most cases is the top or top 3 player. A stake in this company is yours today if you want it for a total value of $1.5 trillion– would you want it? Now, we’re not saying the answer is obvious, but certainly it’s much easier to think through value without wondering about the stock’s recent movements.
Thinking complexity is required:
Luckily, our client portfolios have done well over the past few weeks, but success and growth of AUMs somehow seems to cause investors to think that they need to make their portfolios more complex. This perceived need from complexity manifests in two ways; either a desire to do more and diversify further (i.e. own more assets) or to take profits and wait for better marketing timing. We’ve never quite understood either tactic. The reality is that, on the whole, a portfolio of $100,000 does not have to look very much different than a portfolio worth a billion dollars. We’ve found that beyond 15-20 total assets you start to do very little to improve your returns, but instead diversify your attention and lower your returns (as Buffet says… pretty sure it was him). Some of the struggle we’ve seen here is with HNI’s who have spent most of their careers as traders in bulge-bracket firms/hedge funds, where their returns targets are based in absolute dollars. There, managing $100k and managing $100 million are vastly different endeavours. However, when managing your own money, if you instead think in percentage terms your decision making process becomes a lot simpler. Put it this way, say you have a $100 million portfolio; thinking about a 2% position is much easier than thinking about a $2 million investment.
Further, while profit taking can be a reasonable strategy if you think your investment’s future is less exciting than other opportunities you might have available, in general, a profit taking strategy usually adds a lot of complexity to your investment process. In this way, you’re forced to make more decisions, and as we know well, more decisions do not imply better decisions. For example, let’s play out two different strategies, and assume that in neither scenario is there is any change to the business or any adverse news.
Long-Term holding of solid business:
Action/Decision
- Stock goes up: No decision required
- Stock goes down: Buy more
Profit Taking of a solid business:
Action/Decision
- Stock goes up: When to take profits? How much profit to take?
- Stock goes down (once profit taken): When to buy again? How much to buy? What happens if it doesn’t reach my target level? If not this stock, what else to invest in?
As you can see, one strategy requires very few decisions, and the other requires quite a few. As much as we can, we highly recommend investors actively lower the amount of decisions they need to make. Trust us, you’ll have a much simpler time investing.
Total concentration on tech:
Tech investing is certainly in vogue and has been for a number of years. With FAANGM stocks making up 25% of the S&P 500 and business models which allow for companies to scale infinitely at very little cost, it’s hard not to be attracted to the sector. However more and more often we keep hearing market participants say “I focus only on tech” or “I’m a tech investor” and we’re unclear if they have become that way only because of recent returns or if they truly have a deep understanding of tech business models. Either way, we think it’s a mistake for portfolios to only have tech companies in them. The reasons here are simple, the first is valuation driven. While there are some great companies that are worth buying even after this run-up (see our first point above), in general we see valuations of the Nasdaq at the highest they have been since the 2001 dot com boom. Second, as we mentioned in our previous blog, if investors aren’t thinking of an environment of zero revenue for a tech company is possible, they’re probably not thinking hard enough. We won’t rehash those ideas here but let’s just say AI, computer viruses, and hackers/internal sabotage (see what happened to Jack Dorsey’s company Square and Twitter recently) all pose the same kind of risks to tech as Covid has to the travel industry. If you think we’re kidding – read the book “Sandworm” by Andy Greenberg (thanks to RV Capital’s investor letter for the suggestion) to learn how fragile our tech infrastructure really is.
Holding too much cash:
The swift market-run up has caused investors to either cash-out or refrain from jumping in. Market participants are waiting for a pull-back for better opportunities to jump-in. Now, don’t get us wrong, holding some cash is usually a prudent idea as it gives you optionality, and in fact all of our clients are either holding a bit of cash or have the ability to generate cash quickly if required. However we have been speaking to market participants who are holding 20-40% of their assets in cash right now, and we think they might be making a mistake here. There are two main reasons for this. The first is that by holding this much cash can be a huge drag on your returns and if the market continues to run, your opportunity cost will just increase. Dennis Hong of ShawSpring partners put this into perspective using another thought experiment in this interview. He explains it this way. Say you have an opportunity to buy a business for $1 million, and this business gives off $250K in cash earnings/year. Now in a recession, you could buy this business for 30% off (so $300k in savings) so you decide to wait. But now assume a recession only happens every 10 years (which is roughly accurate), and you get to year 9 and the recession still hasn’t come – you’ve given up millions in cash earnings just to save $300K. If you think through cash holdings using this lens, you can see why the opportunity cost can be quite huge.
The second reason against cash holding is there seems to be lots of liquidity sloshing around the market. There is close to $4.5 trillion in money-market funds, which is up ~25% YTD[1]. According to UBS, during March-May 2020 44% of family offices increased cash significantly while only 19% lowered it (and cash allocation was already higher than usual going into 2020),[2] and it seems like the Fed has spent very little of its $2.6trillion lending facilities so far[3]. All this leads us to believe if there is a correction in the market driven by bankruptcies or election surprise, we don’t think it will last too long (or go too deep), as all the money on the side-lines will come pouring into markets. So if you’re waiting for a March-type opportunity to deploy your cash, you might be waiting for a very long time.
There are a few other mistakes we are seeing market participants make (Singapore investors' over-reliance on Temasek/Gov support, value traps, etc), but for the sake of brevity we might save these discussions for another day. We hope the above has given you a few things to think about, and help you adjust your investing strategy for the better.
As usual, happy investing and stay safe out there!