On Target Newsletter

In this issue: 

  • Start-ups
  • Investing in shares
  • Go defensive now!
  • Over-regulation in America
  • Europe warning
  • Energy trends
  • Canada

The Essential Elements of a Good Marriage

Our Diamond Wedding, which Liz and I have just commemorated, got me thinking about what are the factors that make for a happy marriage… in this case for 60 years.

Love obviously heads the list. But there needs to be much more to sustain and strengthen a marriage partnership.

Here are the elements that I identified in a speech I made to family and friends at a celebratory meal at David’s Kitchen, the world-class-ranked fine-dining venue near our home in Chiangmai, Thailand, where Liz and I now live in retirement…

► Personalities should be complementary. In our case Liz is the extrovert, I am the introvert. Different but matching characteristics provide the needed balance in life, within a partnership, and in relation to others.

► Values / moral codes / religious beliefs should be the same, similar, or at least compatible. That’s more likely if you come from similar backgrounds. (In our case we were raised in the English middle class; our fathers both had small businesses; we both went out to work when we were young – 15 and16 years old).

► Attitudes towards sex, money, material possessions, raising children, dealing with others, must be the same, similar or compatible.

► The same applies towards lifestyles, towards work, home, leisure, personal tastes, relocation. (We have moved to and lived happily on three continents, embracing three very different cultures in Europe, Africa, Asia.)

► Common interests are important. In our case those have been animals (especially cats and horses), politics, family business, reading (non-fiction), and international travel.

There must be no secrecy about important matters… while allowing for personal privacy.

Other essential characteristics of a strong marriage partnership are tolerance, complete trust, and unconditional support for one’s spouse in all circumstances.

Tips for Start-ups from a Master

These days the model for those who are ambitious to succeed in business is the unicorn – a start-up so successful that it soars in a handful of years from tiny beginnings to a billion-dollar market valuation.

Peter Thiel, an American venture capitalist who breeds unicorns – PayPal and Palantir being among the best-known – has written a book on how to initiate start-ups and invest in them: Zero to One.

Here are some of the interesting pieces of advice and comments that he offers…

The seven key questions that every start-up must answer, he says, are:

► Can you create breakthrough technology – not incremental improvements?

► Is now the right time to start your particular business?

► Are you starting with a big share of a small market? (eBay began offering an auction place for tiny intense-interest groups such as Beanie Baby collectors).

► Do you have the right team?

► Do you have a way to distribute your product?

► Will your market position be defensible ten, 20 years into the future?

► Have you identified a unique opportunity that others don’t see? (For example, start-ups that harnessed widespread but ignored spare capacity, such as Airbnb, Uber).

Start small, Thiel advises. “Small groups of people bound together by a sense of mission have changed the world for the better.” It’s hard to develop new things in big organizations. But it’s even harder to do so entirely on your own. You need a small team… “a tribe of like-minded people fiercely devoted to the company’s mission.”

It’s important to identify a niche market that everyone has ignored — one that you can monopolize, as competition is the enemy of success in business. You need to find a target market that you can make your own, offer a product that is unique, and then prevent competition by “making your company so good at what it does that no other firm can offer a close substitute.”

The perfect target market for a start-up is a small group of particular people concentrated together and served by few or no competitors. Any big market is a bad choice, and a big market already served by competing companies is even worse.

Expect to lose money for the first few years, especially in the technology sector. To build a valuable business means delaying revenue to focus on growth. When Twitter went public in 2013 it was losing money, but the stock-market valued it at $24 billion, or more than 12 times the New York Times, which had annual earnings of $133 million. What matters is not current profitability but the present value of FUTURE cash flows.

Start-up managers/entrepreneurs shouldn’t be paid well. “In no case should a CEO of an early-stage, venture-backed start-up receive more than $150,000 per year in salary.” He/she should be incentivized by the prospect of part ownership of the business. “A cash-poor executive… will focus on increasing the value of the company as a whole.” Low CEO pay also sets the standard for everyone else.

Boards of directors should be limited to three people, never five, unless the firm is publicly held.

“For a company to be valuable it must grow and ENDURE,” Thiel says. “But many entrepreneurs focus only on short-term growth. They have an excuse: growth is easy to measure, but durability isn’t. Those who succumb to measurement mania obsess about weekly active user statistics, monthly revenue targets and quarterly earnings reports. However, you can hit those numbers and still overlook deeper, harder-to-measure problems that threaten the durability of your business.”

The key to large, growing cash flows far into the future is to be a near-monopoly in the market in which the business operates. Such companies usually share some combination of these characteristics: proprietary technology, network effects, economies of scale, branding.

“As a good rule of thumb, proprietary technology must be ten times better than its closest substitute in some important dimension to lead to a real monopolistic advantage. The clearest way to make a 10x improvement is to invent something completely new.” Other ways are to radically improve an existing solution, and superior integrated design (as Apple did when it introduced its iPad).

Network effects can be powerful, but you’ll only reap the benefits if your product is valuable to its very first users when the network is necessarily small. Facebook started with just Harvard students – Mark Zuckerberg’s first product was designed to get all his classmates signed up, not to attract all the Earth’s people.

Economies of scale can be especially dramatic for software start-ups because the marginal cost of producing another copy of a product is close to zero. Many businesses gain only limited advantages as they grow to large scale. It’s especially difficult for service business to acquire monopoly characteristics.

Long-term planning is one of the keys to success. Steve Jobs “saw that you can change the world through careful planning, not by listening to focus group feedback or copying others’ successes.”

A small handful of companies will always radically outperform the others. This is the “power law.” One market will probably be better than all others. One distribution strategy usually dominates all others. “You should focus relentlessly on something you’re good at doing.”

But Thiel says that, even if you’re extraordinarily talented, it’s not necessarily the wise decision to start your own company. Very few start-ups survive. It could be better to join the very best company there is while it’s growing fast.

Zero to One, by Peter Thiel. Pub. by Currency.


Share Markets: Why Experts Get Them Wrong

People are usually disappointed about how poor are the returns on their investments even when stock markets have been doing well, as they generally have been in recent years. How could the fund managers they use to manage their savings, and/or the professional advisers to whom they turn for guidance, seem to be so unable to achieve acceptable results?

One important reason, I believe, is a lack of a sense of history. Because investment markets followed a predictable cyclical pattern for decades, analysts were insensitive to the emergence of major secular change – in this case, brought about by globalization, disinflation, the computer chip revolution and the emergence of economic giants in Asia.

Even now, few of the experts seem to have adjusted their investment planning to a world where profits are narrowly focused on a handful of relatively new corporate superpowers based on social media and infotech, deflation is a greater threat than inflation, and nations are being destabilized by terrorism, the failures of political classes and social disintegration. A world likely to favour lower-risk investments whether tangible or intangible.

Another reason for the poor performance of almost all professional investment managers is their herd instinct. They operate in an environment which rewards conformity more than success and punishes individuality and unconventional thinking, even when proved correct.

A third reason is that we’ve been educated to believe that investment is a hard science rather than a human one; a process that can be reduced to mathematical formulae and repetition of historical precedents. The reality is very different, which is why the stock market makes fools of the experts on a grand scale.

However, an increasing number of investors able to think for themselves are recognizing the importance of emotion in distorting decisionmaking (their own and their advisers’/fund managers’), and learning how to take advantage of the instincts of the herd by pursuing contrarian strategies.

Why investors make mistakes

James Montier, the well-known global equity strategist who is currently a member of GMO’s Asset Allocation team, says in his book Behavioural Finance: Insights into Irrational Minds and Markets that investors don’t act in the rational way but make mistakes in a predictable way. If you know what those mistakes are, you can profit from them.

Here are some of the biases or misperceptions that he identifies:

Over-optimism and over-confidence. These are “a potent combination” that “lead investors to over-estimate their knowledge, understate the risk, and exaggerate their ability to control the situation”. One consequence is that investors – especially men — manage too actively, even though it’s been shown by research that as turnover rises, net profits tend to fall.

Resistance to unwelcome facts. Investors tend to look for information that agrees with their beliefs or assumptions, and to refuse to accept evidence that conflicts with them. They tend “to cling tenaciously to a view or a forecast – once a position has been stated, most people find it very hard to move away from that view. When movement does occur it is only very slow (this creates under-reaction to events)”.

Conforming to what others suggest. When asked to make a quantitative assessment, people are too influenced by suggestion – called “anchoring”. Analysts “anchor” their discounted cashflow valuations to within 5 per cent of those that would seem to be justified by market prices, rather than calculate their own figures independently.

Trend-following. Investors tend to believe that because a company has had many periods of good earnings growth, that’s likely to continue. In fact “earnings have a habit of mean-reverting, such that ‘good companies’ are likely to become average – and so are ‘poor companies’”.

Familiarity bias. People give too much weight to things with which they’re familiar. One researcher “investigated the relationship between stock returns and press coverage; he found that stocks with very high levels of press coverage underperformed in the subsequent two years!”

The other side of the coin is that people “are exceptionally afraid of financial situations involving ambiguity… This translates into extreme caution on the part of investors with regard to stocks they think they don’t know”. An important consequence is under-diversification. Investors show massive bias in favour of their own country’s bourses. Fund managers “are consistently more optimistic about their home markets than they are about foreign markets”.

Unbalanced risk sensitivity. Research has shown that people feel losses 2 to 2½ times more than they feel gains, so they overstate downside risk and understate upside potential. They tend to hold on to losers in the hope of recovering their losses and to sell winners too soon.

Montier has some other interesting points to make:

► Investors get selection wrong by focusing on earnings rather than cashflow. Earnings are cashflow plus accruals, but accruals are poor-quality earnings. One study showed that an investment portfolio of firms with low accrual components in their earnings outperformed those with high accruals in 28 out of 31 years and delivered an annual excess profit of more than 10 per cent.

► Classical finance theory teaches that one asset cannot sell at different prices, after taking transaction and information costs into account. In practice, it doesn’t work that way.

► Investment styles, such as favouring value against growth stocks, or small companies against large ones, have life cycles. Switching from one style to another at the right time “holds the key to maximizing returns”.

► Research shows that investment selection is based too much on old information, such as established earnings trends. This produces under-reaction to earnings changes and over-reaction to unreliable information such as analysts’ long-term growth forecasts.

“Amongst value stocks (low price-to-book, low volume, long history of earnings disappointments) we should be searching for stocks that have just started to deliver good news. Amongst glamour stocks (high price-to-book, high volume, long history of exceeding earnings expectations) we should be hunting out those stocks that have just started to deliver disappointing results”.

Montier’s book was written for professionals, but contains many insights of value to individual investors.

‘A Slowdown, Not Armageddon’

The switch by governments from monetary stimulus (ultra-low credit and suppression of bond yields) to fiscal stimulus (more state spending) will be better for stimulating economic activity than it will be for capital markets, says KKR, the New York private equity specialist.

Governments will seek not only to spur economic growth but also to combat inequality. That will be a major policy reversal from policies that have mainly benefited elites and the rich, increasing inequality.

“US savers have now been asked to absorb at least an additional $360 billion in Federal Reserve balance sheet liquidity, and around a $400 billion increase in the US [fiscal] deficit, at a time when other global central banks and other foreign investors are reducing their ownership of US government bonds.”

KKR has switched towards more defensive investments, away from momentum stocks, investment-grade credit and “parts of core real estate.”

However, the bank’s models suggest that what we’re now experiencing is “a slowdown, not economic Armageddon.”

Globally the best additional sources of fiscal stimulus will be Germany, China and Brazil.

If the coming recession is “normal,” as KKR expects, the stock-market will bottom well before the recession ends. So now is the time to develop a shopping list.

If the dollar continues to fall, as it has been doing for several months, “that is likely to be particularly beneficial for emerging markets, particularly those with growth-minded administrations like India, Indonesia and Brazil.”

Gold and gold mining companies “are also among the most under-owned assets right now and continue to firm.”

Planning for Success

If you want to succeed as an investor, you must have a plan; an organized approach to buying and to selling.

That approach should be based on a particular style that appeals to you, such as value, growth or contrarian investing.

You need to stick to the discipline of a system – but only if it works for you. If it doesn’t, scrap it and try a different one.

Benjamin Graham, the founder of securities analysis, changed his stock-picking criteria several times.

He warned both that investment theories that seem to have worked, often cease to do so, and that even good theories do not work in all market conditions.

Pick a system that plays to your strengths. After a few years of experimentation, you’ll discover what you’re reasonably good at – and what kinds of investing you should avoid because you don’t have the skill, knowledge or intuition for them.

Most successful investors place great emphasis on avoiding loss. Once you have taken a significant loss, you’ve tipped the risk/reward balance against yourself. If you’re in a stock that loses half its value, you then have to double its price just to get back to your starting-point.

There a several different approaches to risk avoidance. Graham believed that if you buy a company cheaply enough, you won’t lose money even if your expectations of profit aren’t fulfilled.

One thing all experts agree on is: Never invest in a share or a fund that you don’t understand.

Over-Regulation Damages Investors’ Judgment

The world’s most successful private investor, Warren Buffett, says the latest accounting rule imposed by regulators on American companies will “severely distort” the net income figures published by his Berkshire Hathaway firm and “very often mislead commentators and investors.”

The new rule says that the net change in unrealized investment gains and losses in stock holdings must be included in all net income figures reported to shareholders.

This requirement will produce some “truly wild and capricious swings” in figures calculated according to GAAP principles because of big fluctuations from one reporting period to the next – easily as much as $10 billion a quarter. Gyrations of such magnitude “will swamp the truly important numbers that describe our operating performance. For analytical purposes, Berkshire’s ‘bottom line’ will be useless.”

Buffett says the new requirement compounds the longstanding communication problem relating to accounting rules insisting that realized gains and losses are included in net income figures. They also fluctuate randomly.

A Warning About Europe

Market strategist Russell Napier is predicting another global financial crisis as the ratio of non-financial debt to economic activity is now 234 per cent compared to 210 per cent, the level it reached in December 2007, just before the last credit crisis.

The key consequence of the coming collapse will be “the destruction of the euro. The expected success of the Far-Right and Far-Left in the European parliamentary election in May augurs the beginning of the end for the currency union.” Both favour policies that are incompatible with a single currency.

The collapse of the euro is likely to begin with the imposition of capital controls by key Eurozone countries.

Napier says: “In the financial, political and social maelstrom of a Eurozone dissolution, investors should not expect property rights to be respected.”

However “the UK, where democracy and the rule of law will remain largely unchallenged, will become an attractive safe haven investment for European investors facing increasingly authoritarian regimes and property sequestration” on the Continent.

In the next global financial crisis, risks will be highest in Europe.

Coal and Gas Still Dominate

Five trends for investors in the energy sector to watch for this year, reports Ed Crooks, are:

►There will continue to be huge global demand for coal. In China, which accounts for half of it, provincial authorities have issued permits that could lead to a surge in construction of new coal-fired power stations.

►The US is an increasingly important supplier of natural gas. Project start-ups this year are set to make it the third largest exporter of LNG after Qatar and Australia.

►Costs of renewable electricity and energy storage will continue to fall.

►Sales of electric cars, which reached 2.1 million last year, will continue to expand, with Tesla launching its Model 3 in Europe and China and new models coming from Porsche, Mercedes, Audi, Hyundai.

►Developments in the world economy are likely to dominate trends in the oil market; many forecasters expect lower prices.

Made in China Can Be Good News

Foreigners see the Chinese government’s plan to force-feed ten leading-edge industries such as next-generation information technology, high-tech machine tools and robotics, aerospace equipment, to achieve global dominance by 2025, as a threat. But it’s more of an opportunity for multinationals with China-based operations, argues investment bank CLSA’s strategist Haixu Qiu.

China needs them to stay and contribute to growth as they currently control the most advanced intellectual property in the priority areas targeted by the plan. China may seek to improve protection for foreign companies for its own purposes as well as to meet US demands.

Qui points out that over the past 12 months the Chinese government has already eased ownership restrictions on foreign investment to allow BASF, Exxon Mobil and Tesla to build new, wholly-owned plants. 100 per cent ownership removes the risk of “forced technology transfer.”

Canadians Turn Against PC

It’s interesting to see how damaging politically-correct but unpopular policies are becoming for global elites. Latest news on this front comes from Canada, the country whose rulers have even made it an offence to use supposedly incorrect gender pronouns in conversation.

Its carbonatics have been trying hard to close down the fossil fuels industry, particularly the important oil sands sector. Thanks to their efforts, it’s proving impossible to build more pipeline capacity for exports. Consequent losses have become massive.

But voters are awakening. A new poll reveals that 53 per cent both major pipeline projects (Trans Mountain and Energy East) while only 19 per cent oppose them.

Some nasty populist voting shocks would seem likely to be coming down the track.

China Reverts to Some Bad Old Ways

President Xi Jinping has scrapped the policy that has been the basis of China’s spectacular economic growth over the past 35 years, argues Nicholas Lardy of the American think-tank Peterson Institute.

Deng Xiaoping triggered the growth explosion by allowing private enterprise to flourish. Xi instead favours state companies, even though they’re hopelessly inefficient. In the industrial sector, for example, the productivity of private companies is three times that of the state enterprises. Two-fifths of state companies persistently rack up losses.

Xi has pushed through policies that reduce competition, weakening innovation and cost control. Banks are encouraged to pour credit into the state behemoths. Those focused on lending to private firms have been squeezed. The share of bank lending to the private sector has shrunk by 80 per cent since 2013. The absolute amount of bank lending to private companies has also fallen sharply, reversing a long-term trend.

The state has also failed to protect private property rights, undermining many entrepreneurs’ trust and confidence in the system. “Declining investment by private companies is dragging down China’s average annual growth by an estimated two percentage points,” Lardy says.


Another migration headache: There are now more illegal migrants crossing the Mediterranean and entering Spain than Italy, and it’s starting to have major political consequences. The populist Far Right is a rising force. In Andalucia the upstart party Vox, which opposes Muslim and “irregular” immigration, has been asked and agreed to provide enough support to put a conservative/liberal coalition into power in the regional government.

Across Europe all mainstream parties have refused to seek the support of Far Right groups to achieve coalition voting majorities, but this anathema is eroding as the growing voter support for the populists makes them key to achieving power.

Spain has become the destination of choice for African migrants as its Leftist government has been less hostile than other European countries to illegal inflows.

Still too expensive: Even after the major falls in tech shares last year, their values remain excessive, says the FT’s Michael Mackenzie, “and the news that Softbank [the Japanese venture capital mega-fund] is scaling back its investment plans for WeWork is an important and bearish signal.

“The funding backstop for private tech groups does have limits. That means more listings for tech unicorns and I suspect they will struggle to validate their lofty private valuations.”

Wall Street remains expensive with the Shiller cyclically-adjusted price/earnings ratio, on a multiple of 29 times, still “in lofty territory.” The rating has only been as high twice before, ominously at time immediately preceding stock-market collapses, as in 1929.

Propaganda avalanche: As America’s 2020 presidential election race gets under way, energy companies and fossil fuels will become targets for “relentless attacks,” predicts consultant Allen Brook of PPHB.

“Expect a steady stream of climate change articles arguing for the immediate replacement of fossil fuels by clean energy in what is referred to as the New Green Deal by Democrat politicians. These calls carry little credibility… but they will generate lots of headlines.”

Prospering in China: Despite increasingly bearish stock-market sentiment about its economy, and the likelihood of continued weakening in the early part of this year, it’s important to remember China’s many positive fundamentals.

Chinese families still enjoy buoyant incomes and a high rate of personal savings. Real per capita disposable income rose at an annual rate of 6.6 per cent in the first three quarters of 2018. Household savings are running at 32 per cent of disposable income.

The pound: A surge in “break-evens” – the differences between nominal yields on British government bonds and rates on index-linked securities – suggests that some investors are expecting a sharp fall in sterling “because of the likelihood that the UK will crash out of the EU at the end of March without a transition deal,” says the FT’s Kate Allen.

Infrastructure: It’s a sector that is increasingly popular with international investors as it offers low-risk relatively high income yields. Last year inflows into infrastructure funds rose by $10 billion to $85 billion. This year is expected to be even better.

Pot luck: Tesla has sold a debt security with a minimum subscription amount set at a curious level… $420,000. The company’s officials claim the unusual figure was set by independent consultants. It was just a coincidence that “420” is a slang term for smoking marijuana. As the firm’s boss, Egon Musk, was caught doing when interviewed for a podcast recently.

Wise words: 

You can’t do well investing unless you think independently. You are neither right nor wrong because people agree with you. You’re right because your facts and reasoning are right. 

Warren Buffett.

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