illustration by Tim Sheaffer
Mike Tyson famously said, “Everyone has a plan until they get punched in the mouth.”
The brutal “punch in the mouth” brought on by Covid-19 caused markets worldwide to collapse and the repercussions sent shock waves throughout our daily lives. It’s changed how we work, learn, shop, eat, interact and generally how we live.
Having a plan is one thing (and albeit it a very important thing) but being able to stick to a well-thought-out plan is equally important, as Iron Mike Tyson’s quote implies.
If you were not sure before 2020, markets are volatile and can move extremely fast. It's best to think that we will get punched in the face from time to time and plan accordingly.
So how do we make sure our emotions don’t get in the way of our best judgement when we are getting punched in the face? The best time to build a resolute plan is prior-to, not during the barrage. A plan that anticipates getting punched in the face.
Why do we want to do this? Because our minds can be our own worst enemy under duress and we don't want to change our plan when getting punched in the face.
Several years ago Daniel Kahneman, the 2002 Nobel prize winning economist wrote about System 1 and System 2 thinking in his seminal book, “Thinking, Fast and Slow.” He describes how System 1 thinking helps us make everyday decisions and react quickly when we need to, while System 2 thinking helps us make more purposeful decisions and work on more complicated tasks. For both System 1 and System 2 thinking, our minds try to save energy by using heuristics to make decisions more efficiently. And most of the time this works fine, but biases can pop up which can lead us astray - these biases can do real damage when we don't even realize they are behind the scenes causing havoc. The challenge is to understand the biases we may have, the even bigger challenge is understanding the biases we don’t even know we have that are influencing us.
Psychologists and behavioral scientists have researched and documented well over a hundred and fifty different biases that can lead us astray when making decisions. We’ll discuss just a few biases that are particularly damaging when it comes to investing.
If you said yes, you are not alone. 90% of all drivers in a famous study of everyday people said they were above-average drivers - myself included. Unfortunately, basic math tells us this isn't possible. This is overconfidence bias. We all tend to be unrealistically optimistic about our chances of success and our abilities. When it comes to making investing decisions, this can result in investors thinking they can outsmart the market. This type of thinking leads people to believe they have a superior edge when in reality they do not.
Quickly Putting It All Together:
Here are a few things you can do to help make the best (System 2) decisions possible and overcome those nasty biases and unrelenting emotions.
Cheers to an emotional and bias free investing future!
-Paul R. Rossi, CFA
What is an IPO?
An IPO (Initial Public Offering) is when a private company transitions from being a private company to public company and it's at this point in time that Joe and Jane public can for the first time invest and own shares of the company.
By nature, IPOs are risky. Why? Well investors have relatively limited financial history on the company going public. Why? Because many private companies are smaller and don't have a long track record and prior to "going public," the private companies are not required to have audited financial statements.
So how does anyone know which companies are good buys and which ones will turn out to be bad investments? Good question...and a very tough question.
What should you look for when evaluating a new IPO?
Interestingly enough, similar analysis should go into an IPO and a company that is already public. Things like understanding their financial situation by analyzing their balance sheet, income statement, and cash flow statement. You should know the various financial ratios (Quick Ratio, Debt/Equity Ratio, Conversion Ratio, ROE, etc.) and how these ratios have been trending over time. Are they getting better or worse? You should understand the various drivers that will impact the company - both good and bad. What is the company's (TAM) Total Addressable Market? Who are their biggest competitors? What is the company's advantage and is their advantage sustainable? What Warren Buffett calls this a company's "durable competitive advantage."
And after you've thoroughly read through the company's prospectus (including the foot notes), answered an additional 101 questions or so, you can then move on to trying to value the company. While there are several ways, from Price/Sales, Price/Earnings, Price/EBITDA, to name a few, generally the most robust way is to do a comprehensive discounted cash flow analysis (DFC). A DFC is a process that uses the projected future cash flows of the company into perpetuity and discounting them back based upon current risk and interest rate levels. Once you have this DFC you can then stress the results by changing various assumptions, like initial cash flows, growth rates, and discount rates to see how the valuation changes.
So build a DCF, then take these various DFC valuations and compare this with the IPO valuation to see if buying into this company make sense.
What makes buying an IPO even more difficult to evaluate is the fact that many of them don't have positive cash flow. So how do you value a company that doesn't make money? Again, another great question and another difficult one. The big driver will be the assumptions used in what the company might look like in several quarters or even several years down the road. So playing fortune teller becomes a necessary requirement. Something, I'm typically not a fan of. Uggg.
So having read all this, while history is never an accurate forecast of the future, sometimes it can provide valuable sign posts with which to gain some insight. If you have a high tolerance for taking big risks then maybe allocating a portion of your investment portfolio to IPO's might be for you. However it would be prudent to understand and recognize that buying IPO's is the quintessential, "buyer beware" transaction.
-Paul R. Rossi, CFA
The Stock Market is Volatile.
It's volatile on a daily basis. It's volatile on a monthly basis. And it's volatile on a yearly basis.
Take a look at the first two charts below which show the 20-year period of monthly and yearly returns respectively for:
As the 10 time World Series champion New York Yankees catcher Yogi Berra famously said, "You can observe a lot just by watching."
So let's do that, the "average" monthly return for the stock market (orange line and number) is 0.68%, yet it's not uncommon for the stock market to experience negative monthly returns of -10% and even -15%. Most recently we experienced a -8% drop in February of 2020 followed by a -12% drop in March of 2020, to then rebound with +18% return in April and an almost +8% return in May.
Notice the lines of both the orange (stock market) and purple (large company growth index) vacillate quite frequently between positive and negative monthly returns, meaning it's been very common for there to be many negative months. Conversely, if you look closely at the blue line (bond market), you'll notice the volatility is substantially lower than the orange and the purple line. As the graph and number show the bond index has averaged a monthly return of 0.35% over the last 20 years and has been substantially less volatile than the stock market.
When we look at the yearly returns of these same 3 indexes you'll notice the less frequent negative returns for both the stock market and the large cap growth indexes. In fact, the last 20 years has been pretty average in terms of the number of yearly negative returns. We've had 5 years with negative returns in the stock market (2000, 2001, 2002, 2008, and 2018), so said another way, we've had 15 years of positive returns. Notice the average yearly returns for the 3 indexes, the large company growth average 9.46%, the stock market averaged 7.51%, and the bond market averaged 4.25%. Keep these return percentages in mind when you look at the third and last chart.
As mentioned above, 25% of the time the stock market has experienced negative calendar returns. Yet, despite the stock market posting negative returns once every 4 years (on average), investors who were able to stomach the volatility, were rewarded handsomely. An initial $10,000 grew to over $50,000 in the stock market, while the bond market index grew to just over $20,000. What's utterly amazing is the growth of the large company growth index (QQQ), which turned every $10,000 into over $100,000. A 10x return on every dollar invested - this is truly remarkable.
It's important to understand your goals and know your ability to withstand market volatility, because, "If you don't know where you are going, you'll end up someplace else," as Yogi Berra also said. Without a rock solid plan and your ability to stick to it, you might end up in a place that you didn't imagine.
-Paul R. Rossi, CFA
Paul R. Rossi, CFA