Many people assume diversification is good because it minimizes risks…
The headlines are everywhere – China’s stock market is collapsing.
It’s been a very roller coaster year so far, and with news like how some investors have committed suicide because of the recent drops, it’s bound to get the jitters out of the investors. Everything was so rosy just a couple of months ago, when everything was rising rapidly.
A few quick words on volatility – it is something you shouldn’t be fearful of! Time and time again, media and ‘so called’ experts from financial institutions say volatility is bad because it’s easy to lose a lot of money. Note however that the definition of volatility isn’t when things are going bad, it’s when things are changing rapidly. When something is volatile, it means it is easy to go up just as it is easy to go down. To illustrate my example, imagine flipping a coin and earning HKD 5,000 when its heads, and losing HKD 5,000 when its tails. In the second example, imagine the same situation, except that you only earn HKD 10 when its heads, and lose HKD 10 when its tails. Does the first example suggest the game is worse? Absolutely not. Volatility and bad conditions are not the same, its only that the first example would imply higher fluctuations to your cash flow. Now if you are those investors where you invest all your savings and even leverage it, and the market drops, the fault is on you only and not the market’s. You should only invest enough so that even if you lose most of it, you would still live adequately and sleep soundly at night.
Now it would be too easy to say that the Mainland Chinese people are like that in the way they ‘play’ with their money – go big or go home. A trip to Macau and sitting at a Baccarat table and you will be amazed just how loosely they are with money. HKD 100,000 per turn? Not even surprising. Play at a poker table and you will notice in general the play is much more loose. Seems that the fortunes of casino have now been eroded as they have cashed out from casinos and are now treating the stock markets as the new casinos. And in typical retail investor fashion, as the market starts to decline, some retail investors sell fast so they can still earn a profit, and those losing money tend to hold until their tolerance gives up, and once their tolerance gives up is when the market goes up again. This is predictable human nature, but an illogical method of investing. Imagine you find a company that is worth HKD 100 per share conservatively. Its price is HKD 60, and you originally bought a share at HKD 20. Do you sell it because it’s going down? Duh no! You buy! This, of course, requires you to do a bit of your homework. But like I said, blaming it on the culture of ‘go big or go home’ is way too simple.
Now that the market has retreated almost 20%, the bear analysts are storming in and justifying this is right and that is right. Read an article from Jake Van Der Kamp on South China Morning Post saying how there was no fundamental reason for this growth – slowing economy, oversupplied property market, rising bad debt, export demand is slack. (By the way, China’s market hasn’t been doing very well at all since financial crisis in 2008. Its growth is still higher than that of many developed countries but only recently has the stock market started to surge, whereas some developed countries’ markets like US have gone up a lot since 2011 after the Greek bailout).
So what is the real reason you ask? To be frank, I don’t know. To be even more frank, I don’t really give a shit. Sure I agree, some of these companies are posting at ridiculous prices. I mean movie production / distribution companies with P/Es of 200x? Companies with incredibly high P/E usually don’t have a growth rate that can justify this type of P/E, and even if they do, it’s usually unsustainable. Back in high school, I learned about the growth-share matrix, and that stars are companies that market shares are high and growth rate is high, and cash cows are companies with high market share and low growth. Now usually I’m guessing the high P/E companies are stars, but as the company grows and number of new customers start to dwindle, the growth rate becomes unsustainable and they generally fall back into becoming a cash cow. Of course sometimes cows become stars again, but I’m speaking in general. Companies that start growing too big start becoming harder to manage and the marginal utility would start to decline. This is the nature of companies – they undergo a business cycle.
To be honest, it’s hard to ever pinpoint a single factor contributing to a bearish or bullish market except for some exceptional cases. When a person says he’s absolutely sure of the reason, be wary. There is really nothing you can do to pinpoint to one reason, and it’s pointless to even try. How can I guess when government will decrease interest rates again? Raise interest rates again? Do this, do that? We always want to try to find reasons or guess reasons so we can market time, but it’s impossible. Sometimes it may just be market sentiment is extremely bad and that is hard to predict. I bet you I can find a monkey that so happens by chance to randomly type up Hamlet faster than for you to find a person who can time the market perfectly every time.
So why am I saying all this? What’s with this rebellious, “I don’t give a shit” attitude? OK, I do give a shit, but those factors don’t worry me. Time and time again I’ve stated that what’s more important is that you find companies that are great (OK fine, Warren Buffett said that). Find companies that have a healthy balance sheet, sustainable growth, and that consumers have a need for it (I find B2C companies generally become bigger companies than B2B). Find those companies, and you can worry less about rising bad debt, because the company would have little debt if at all. Find those companies, and the fear of oversupplied properties would not be a concern for them as they do not have property used in collateral, nor do they engage in mainly property investing but in their own core operations. And luckily for you, because investors who start to panic will sell everything so they can look like they earned a buck or two or lose less, usually all companies’ stocks decline, bringing down even the good companies who have little to do with it, and still has improving business conditions, which allows you to buy at ever cheaper prices. This is the way to invest.
There are some key areas I am aware of. The changing economy into becoming an urbanized country is one declared by Xi Jinping, and I believe China is gradually getting there. In an urbanized country, the industries will be mainly composed of tertiary sectors, not so much primary or secondary sectors such as manufacturing. Warren Buffett has stated Berkshire to be one of his worst purchases, because it was in a textile industry that was cheap but offered weak economic prospects, and eventually he had to leave the textile business behind. Similarly, I believe China is entering this stage, and so textile business would only have worsening economic prospects in this country. I don’t care how cheap it is, I would not be interested in investing. It’s like trying to buy Blockbuster shares because it’s cheap when clearly everyone is streaming or downloading movies online. This is the kind of stuff I would think about. How does urbanization affect the country? Which companies would benefit? Easy example – more cars.
I know all this investing talk is unsexy, so let me give you a metaphor to make it in layman terms. There is a t-shirt on sale at HKD 10, but once you wash it the first time it will shrink and rub its color off on to other clothes. It also doesn’t fit very well with you and isn’t comfortable to wear. In fact, it might have holes in it. There is another t-shirt at HKD 200 on sale. It’s a classic t-shirt, its something durable and you can wash it however many times you like, and it is comfortable to wear. Which t-shirt would you buy? Obviously the second one right? The same is true for companies.
Since I’m on about t-shirts, let me give you an example of ‘trend investing’. So you see an industry and that is the trend to buy. Think about it this way. A t-shirt costs HKD 200 because it’s the trend right now to wear. Another t-shirt costs HKD 200 and it’s a classic t-shirt. Which one would you rather buy if you could only buy one? Once the first t-shirt is out of style, you may just leave it in the closet forever. For the second t-shirt, you can still keep wearing it. Investing in trends is just like that too – sure you can be a bandwagoner and join the ride, but you never know when the trend will just disappear.
Going back to the previous example with the HKD 10 t-shirts, some of these t-shirts may be well placed and have a nice appearance. You would think they are extremely cheap and good looking… only until you buy then you realize how many problems there are. That’s why it’s so important to do your homework. Companies are like that. They dress up their financial statements well to present to their investors, “Hey guys, don’t worry, we are absolutely doing well here.” Buy a share then, fuck, you realize that the company is that HKD 10 t-shirt. Don’t buy company stocks that are cheap just because they are cheap. Buy because they are cheap relative to their supposed value and that they are durable and can last long. Always make sure the companies have a healthy balance sheet.
Also, given China’s many interest rate cuts these past couple of months, it only makes even more sense to invest in stocks. What not to invest? Bonds. As volatile as it is right now, bonds are not good when interest rates decline. Cuts in interest rates usually means less bond yield. Instead, benefactors of interest rate declines are companies. The ‘underlying’ of stocks are companies. Companies benefit from inflation as they can raise their prices to earn more. Companies with debt can pay less of their variable interest rates. Companies can borrow money easier. And because companies benefit, their intrinsic value increases, meaning stocks will benefit too.
Because the market is going through some turbulence, it may continue to go down. Like I said, I’m not interested in market timing. It’s near impossible, and I can better spend my time doing something else rather than that. Time better allocated. But despite all the twists and turns, invest in great companies, and you in turn shall be rewarded.
*Image from South China Morning Post