HEDERA THOUGHTS
To the reader:
It's been half a decade since I made my first stock purchase back in 2018. As
Mark Twain aptly put it, history doesn't repeat itself, but it rhymes. In 2018,
we witnessed a series of macroeconomic events. Notably, Donald Trump ignited
the US-China trade war, and guided by Yellen, the Federal Reserve commenced a
new phase of interest rate hikes and Quantitative Tightening (QT) - a course
correction following a decade of near-zero interest rates stemming from the
subprime mortgage crisis in 2008, though eventually threw the towel due to the
unexpected turmoil in repo markets in the end of that year.
In a notable parallel, 2023 saw the most rapid interest rate hikes since the
1980s, following the Federal Reserve's misjudgment on inflation triage in 2022.
Fortunately, they appeared to successfully tame inflation, avoiding a
recurrence of the stagflation witnessed four decades ago. Nevertheless, the
overall market demonstrated considerable fluctuations, swinging dramatically
from one extreme to another (It currently anticipates an interest rate decrease
of over 150 basis points before the end of 2024!).
Over the course of the year, investors have consistently raised the well-known
question about inflation and economic outlook: is this time different from
2018 (or 1990, 1980s, ...)? While the answer to it has not been revealed by NBER
yet, the one about my investment portfolio performance is at least satisfying.
Year Pre-tax SPY QQQ
2018 (25.64%) (8.07%) (10.73%)
2019 7.28% 28.65% 37.27%
2020 21.54% 15.09% 45.14%
2021 58.53% 28.79% 28.63%
2022 (12.33%) (20.28%) (34.16%)
2023 30.92% 25.13% 55.59%
Total 176% 175% 234%
1) It's worth noting that the marginal tax rate, hovering between 40% and 60%
before 2021, experienced a reduction to 0% to 20% since then. This shift is
attributed to the majority of securities sales falling into the long-term tax
bracket or tax-delayed mediums such as IRA and 401(k). Details on this will
be explored further in this letter. Additionally, all new contributions are
assumed to be made in the initial days of each year. While this might
slightly impact the actual return rate, this difference can be disregarded when
assessing the long-term performance.
2) All returns for the baseline are pre-tax and do not account for dividends.
3) First purchased were made on 07/01/2028.
This year, I made fewer than 20 transactions involving less than 7
companies-namely TLT, Google, BAC, SCHW, and SARK. Most of my profits came from
TLT (explained later in the macroeconomic-based investment section) and Google.
While I did gain 40% on SCHW thanks to Mr Market's gloomy outlook, I ended up
losing half of it on BAC for tax harvest and capital re-allocation. Overall, it
was a decently fortunate performance, but I see all these moves as mistakes,
though not as bad as those in 2018. The luckiest (and probably also smartest?)
thing I did in the past year was that engaging in conversations with various
masters in the investment field through reading their books. And this led me to
discover the right path within the investment domain. Most of what follows
reflects their ideas more than mine, and you might have come across them
elsewhere.
In the words of Robert Benchley, "Having a dog teaches a boy faithfulness,
perseverance, and to turn around three times before lying down." Such lessons
capture the flaws of experience. Still, it's a good idea to look back at past
blunders before making new ones. Let's review what I've learnt in the last 5
years.
Market Fluctuations and the Efficient Market Theory
Markets are filled with noise, stemming from two sources: the multitude of
events that can influence how the public perceives the future of a particular
company or the overall market, and the internal chatter within ourselves. Let's
delve into each dimension.
Over the past five years, the question I've encountered most frequently is: Why
do the stock prices of GOOGLE/META/BABA/SPY/QQQ experience significant
fluctuations before/during/after market hours today? In the aftermath, someone
in the crowd of market watchers often ventures a guess, sparking subsequent
discussions. Initially, I, too, would join the ranks of the curious and turn to
financial media outlets like Bloomberg and YahooFinance for answers. However,
it didn't take long for me to realize that most information is simply noise
from the view of a long-term investor. (On the bright side, these fluctuations
may present opportunities to acquire shares at more reasonable prices for those
good companies.) The crucial task is discerning whether the original long-term
outlook for the company will change. The most gratifying results often stem
from a stock purchase involving a sound company experiencing price drops due to
inconsequential news. Buffett successfully accumulated initial capital through
three key investments: American Express, Washington Post, and GEICO. All
purchases were made when the overall market has a gloomy outlook over the
company due to some scandals or temporary tight cash flow.
In the last century, academia introduced the efficient market theory, which, in
essence, proposes that all factors influencing a company's outlook will always
be immediately reflected in its stock price. Consequently, the theory suggests
that investors can only achieve beta returns since catching up with Mr. Market
is deemed impossible. However, I remain strong suspicious about this theory,
especially in light of my observations of the market's response to COVID-19 in
2020 and the overall anticipation of stagflation in 2023. Much like the beta theory,
these concepts appear more like only make sense in textbook and fall significantly
short of capturing the complexities of reality. Echoing Graham's insight, he
aptly notes that in the short run, the market operates as a voting machine, but
in the long run, it transforms into a weighing machine. The inherent human
nature of participants in this game inevitably leads to voting results marked
by overreaction in most cases.
The second source of noise arises internally, from within ourselves. I've
observed numerous retail investors who complain that institutional investors
control stock prices, especially during periods of extremely low or high
volatility. They consistently devise theories to explain market movements or
justify their portfolio's performance. Besides, when stock prices hover
slightly below the cost, they often start seeking evidence to support biased
buy or sell actions. In my humble opinion, these behaviors stem from a lack of
understanding of the businesses they hold. The uncertainty of their holdings'
return continually generates a voice in their minds, amplified by the whims of
Mr. Market: "Buy it, or you will earn much less than you should," or "Sell it,
or you will lose much more than you could." The only solutions to mitigate this
internal noise: Invest in index funds or own businesses that you thoroughly
understand.
What Defines a Good Company?
This question matters a lot for security investors, job seekers, and anyone
aspiring to venture into a new business. Initially, I thought good companies
are those showing solid growth in net income, dividends, or other financial
metrics.
Later, I learned that good companies are those with high returns on equity,
assets, or can make good money with little capital investment. Yet, I realized
the answer is simpler: The key lies in understanding the supply-demand
relationship behind the business.
There are two types of businesses in the world: economic franchises and general
businesses. An economic franchise arises from a product or service that is
needed or desired, thought by customers to have no close substitute, and
isn't subject to price regulation. A classic example is Coca-Cola. Such
businesses often face minimal competition, don't rely on cost-cutting or low
prices to attract customers, and require little capital investment to
generate earnings. Their success hinges on the uniqueness and quality of their
products or services.
The other type of business earns exceptional profits either by being the
low-cost operator or if the supply of its product or service is scarce.
However, scarcity in supply typically doesn't last long. (Few people can
imagine oil prices going below zero in 2020 but rising higher than 2019 levels
just three years later!)
I currently prefer to invest more in the first type of business, albeit
challenging to find. Once purchased at a reasonable price and held for a
long duration, the returns are consistently satisfying in the long term.
As for the second type of business, consideration is given only if the return
is exceptionally attractive, such as when the market undervalues it
significantly-like the banking sector in late 2023. However, once it's priced
fairly, it's off the table.
Macro-Based Investment
My journey into macroeconomic-based investment began with superficial studies of
different fundamental economic and valuation theories while preparing for the
CFA exam. Concepts like the Phillips curve, beta theory, and covered interest
rate parity were like a financial bible guiding my investment decisions.(I owe
a big thank you to my ex-girlfriend, who steered me away from starting with
memorizing candlestick patterns and insisted on a more robust knowledge
foundation. Her approach turned out to be a good call!)
Initially, I believed these theories could navigate me through the complexities
of investment. However, my perspective shifted when I faced my largest
unrealized loss in mid-2023 due to my steadfast adhering to these theories and
bet on a long-term interest rate expectation. It turned out to be fortunate
that I didn't suffer significant losses this year (in fact, I earned a 40%
return). It made me realize that relying solely on macroeconomic indicators
isn't a sound investment approach, especially when the long-term prospect is my
primary focus.
If I discover a good business, concentrating my bets on it is actually a
low-risk strategy. Putting all my bets on my own speculative macro predictions,
on the contrary, poses significant risks. What if there's a paradigm shift in
the future, e.g. a ten-year stagflation in 1980s, even if it doesn't manifest
this time? Even Warren Buffett made an incorrect call on future inflation rate in
the early 1980s, despite he did acknowledge Paul Volcker's determination to
tame the inflation.
On the basis of the above, forming macro opinions or listening to the macro or
market predictions of others is a waste of time. Indeed, it's dangerous because
it may blur your vision of the facts that are truly important.As a result, I've
decided not to make any predictions on the market, interest/inflation rates,
and the like in the future. Instead, my emphasis will be on identifying
businesses that I'd be content owning. In the meanwhile, any opportunities that
align with the long-term return will see a modest allocation of capital. For
instance, the expectations on long-term interest rates in May and November this
year serve as examples of instances where I might make such small allocations.
Tax
Since 2020, I've given considerable attention to the tax implications in my
investments, particularly for retail investors in the United States. The
estimated tax rates are as follows:
Short-term capital gain: 40%~50%
Long-term capital gain: 20%~30%
401K and IRA: 0% on gains or losses.
The weighty tax burden acts as a restraint for investors who engage in frequent
trading, be it on a daily, monthly, or even yearly basis. A simple calculation makes
it evident that such investors cannot fully enjoy the benefits of compound
returns.
Initially, this was my perspective, and I considered it a critical aspect.
However, I made a significant mistake by the end of 2022. I sold off
substantial holdings in good companies like Nvidia, ASML, and Costco with the
intention of tax harvesting. The realization that this was a mistake struck me
immediately after I submitted the order, standing on the streets in
Honolulu. Despite the realization, the fear of sunk costs discouraged me from
buying back in. This isn't hindsight bias; it's an acknowledgment of a genuine
error.
This experience reinforced my belief that value investing is perhaps the only
viable approach for retail investors aiming for "alpha" returns. While tax
considerations are crucial, they aren't the sole determinants. The primary
objective remains achieving a robust long-term return on the portfolio.
Consequently, decisions to buy or sell should consider multiple factors, and
it's silly to sell off good companies solely for the sake of saving a few
thousand dollars in taxes.
Capital Allocation
While I've explicitly stated my decision to steer away from macroeconomic-based
investment, I want to underscore my openness to various investment mediums.
Whether it's stocks, arbitrage, short-term bonds, long-term bonds or any other
viable option that may have a decent long-term return, I'm willing to explore
it. However, my primary emphasis still remains on the long-term ownership of
sound companies, with a modest 5-10% allocation to those speculative endeavors.
It's essential to note that this flexibility also extends to the prospect of
owning my own business if a compelling opportunity arises, offering superior
returns compared to the general industry. In general the allure of
entrepreneurship is attractive for its potential to expedite capital
accumulation faster than the current W2-based approach (or risk losing).
Nevertheless, in the short term, this seems unlikely given the challenge of
finding a business that boasts exceptional returns without requiring
substantial capital (beyond just dollars) investment.
Lastly, despite the advantages leverage has offered me in the past five years,
I've decided to avoid utilizing it in future investments. This decision isn't
primarily driven by the side effects of leverage, such as time decay, but
rather stems from my view of this as a long-term game. I'm not inclined to risk
being ousted from the board simply because I want to sprint in the early
phases. Additionally, recognizing that most companies employ operational
leverage to some extent, I prefer delegating this aspect to astute management
rather than incorporating it into my personal investment strategy.
Corporate Management
The essence of a good investment rests on three pillars: 1) the company's
quality, 2) a reasonable price, and 3) effective management. While I'm still
refining my understanding of what constitutes effective management, I've
gleaned two naive ideas about pool management pattern from my experiences over
the past five years:
1) Irresponsible Decision-Making in Corporate Actions: An example of this is
when a company's management makes decisions about acquisitions, mergers, or
other corporate actions, they solely consider their own career growth and
sacrifice shareholders' benefits by e.g. an unreasonable valuation of acquiree.
This is commonly referred to as the acquisition curse. If such decisions
trigger a market overreaction, it typically raises a red flag.
2) Irresponsible Industry-Related Decision: Consider the Silicon Valley crisis
as an example. When a management team places the blame for business failures on
external factors like the Federal Reserve raising interest rate, failing to
reflect on their own poor decisions, it is indicative of poor management.
While I continue learning about effective management principles, these observations
serve as valuable markers for evaluating the competence and responsibility of
leadership in the companies I consider for investment.
Miscellaneous
There are several topics I've intentionally left unexplored here, reserving them
for contemplation at the close of 2024. These include the question of
allocating capital to emerging markets, determining the right time to sell a
stock, and delving into the theories of risk and beta.
In 2023, I successfully completed the OKR of reading ten financial textbooks,
surpassing my initial expectations. Looking ahead to 2024, I have a lineup of
pending candidates for reading, including "The Farmer from Merna"
, "Principles of Marketing." etc. Hopefully I can make the same progress next
year.
An exciting event on the horizon is my attendance at the Berkshire Hathaway
annual stockholder meeting in Omaha in early May next year. This marks my first
participation, and I hope it won't be the last. If you share an interest in
connecting and sharing insights (I genuinely enjoy hearing great thoughts!),
feel free to reach out via email at zhaopq77@gmail.com
As the journey in the financial realm continues, these future considerations and
milestones will shape my evolving perspective and approach to investment.
Hedera
Dec 29, 2023
* Thanks to ChatGPT for polishing the whole letter.