Bull Cycle Lessons From The Time Of COVID
Lessons learned from the 2020-2021 bull market
Over the past few years, I’ve learned a lot regarding how I think about the market, and how the market thinks about stocks. If you’d paid close attention, you'd learn many great lessons. These teachings will stay with me forever and make me a better investor for the rest of my life.
Although these lessons are time agnostic, but it’s important to freshen ourselves up on them. Always remind yourself of the mistakes the market makes. By inversion, staying clear of these mistakes will increase your returns. Let’s get to it!
If there is one lesson that every investor has learned is that valuations matter. Buying company A because it's "only trading at 45x revenues" is not smart investing. Always remember the contrast-misreaction tendency:
We contrast things in relation to other things in relative terms rather than absolute terms
If you are comparing 2 overpriced companies, it doesn't matter that one is cheaper than the other. The simple conclusion is that they're both expensive, and your lowest risk move is to steer clear of both. Keep it simple.
If you want examples of this in real life, look at Cathie Wood's ARK Innovation Fund. On June 28th, 2021, it was valued at $128.15. Today it's $44.09. That's a -65.6% drawdown. Out of her top 10 holdings (~60%), only 5 are profitable. So comparing that fund with another fund that has 6 profitable holdings in its top 10, or 4 isn’t going to save you from the damage that happened in 2022. They’re all overpriced.
If you want a portfolio that won't get destroyed by downswings, don't chase momentum. Find high-quality businesses that will compound intrinsic value. Are there some high-quality names in ARKK? Sure, but not enough to make me even consider investing.
The markets were on a tear in 2020-2021. This was due to the fact that certain names were getting over-extended. They were bound to regress to the mean. For instance SNAP in the past year is down 75%. Revenues were up about 61% from 2020 to 2021, yet they were still losing hundreds of millions of dollars.
If you held these hot names, you would be riding the wave of irrationality. But when the market came to its senses, it realized some of the errors it was making. This resulted in punishing these zero-profit companies' share prices. The sad thing is, even when you look at some of the companies that have had 50% plus of their price deleted, they still don't look cheap.
Outsized returns over the short-term result in pain during downturns.
This section is a continuation of the previous one. There are a few extra points I'd like to make.
Many of the best performing funds during COVID got there because the value of their stocks soared past intrinsic value.
COVID didn't wave its wand and increase intrinsic value at the same rate as many stocks appreciated. Sure there were some names where revenues were pulled forward (PayPal comes to mind). Many of these tailwinds have now been confirmed as being very short-term. Regression to previous growth patterns has caused share prices to come down to reasonable levels.
Stocks can't provide 30%, 40%, or 50% returns without major drawdowns. Remember that over the long run, share price appreciation tracks earnings growth. Companies cannot grow at the rates above for decades. If they could they'd be worth an ungodly amount of money.
Market psychology has a short memory
I remember reading some John Kenneth Galbraith, where he discussed the short memory of markets. Now that I've lived through a bull market, I appreciate his point even more. In the mid-2020s, the market was so high on growth names. The stock prices were insane, 5%, or even 10% increases in a day occurred often.
The market was "buy, buy, buy." The market couldn't get enough expensive tech stocks that were booming due to the rise of eCommerce. It was obvious to me that these companies were vastly overpriced. The odds of making a good return were extremely low
And then the FED changed its course, interest rates rose, and free money became less free. Now the market thinks the world is going to end; the free world is going to go up in flames, and inflation will NEVER slow down again. Mr. Market is bipolar.
Now the key is to look at how short these current memories will last. I have no crystal ball into the future, but I can imagine that when recession fears end, the ride will continue. Current negativity will be forgotten, only to be brought up once again in the not-so-distant future. The market is one giant cycle.
Short-term regulatory flexing doesn’t break a hypothesis
Let’s examine some of the largest tech names in China as an example here. I have three holdings there: Tencent, Alibaba, and 360 Digitech. All three of these companies are doing just fine fundamentally, yet their share prices have been pummeled.
Let's use Alibaba in this example. Since I purchased my first $BABA shares its revenues have gone up 53.4% while net income has dropped 45.8%. The price has plummeted by over 50%. Their last quarter was pretty ho-hum compared to previous growth. But when you consider how bleak the economy has been due to Zero-Covid, it's a clear win in my books.
Once China reopens, and it's business as usual, we’ll see some incredible growth. Alibaba has been the target of regulatory bodies, they had their ANT IPO canceled, and they've been forced to "donate" to the common prosperity movement. And through all this, they keep on generating free cash. If that isn't a moat, then I don't know what is.
As I discussed above regarding sentiment: many of these Chinese companies were not super cheap. They were emerging large caps with long runways, they were going up in price. After the regulatory beating, sentiment changed. As the regulatory issues subside, my guess is capital will once again flow to China.
The lesson I learned from this is that regulatory bodies in China are powerful. I knew this going in. I also knew that they could execute regulatory rulings very quickly compared to the West. This is what happened. Unfortunately, many Western investors didn't research the regulatory frameworks of China and were caught off guard once regulations were enforced.
So even though I lost money on my Chinese investments so far, I don't see them as being poor decisions. If my company's earnings have been reduced due to regulation in the next 3-4 years, then I know that I made an error.
Don’t fall for fads
There has been a decades-long shift of cash moving into publicly-traded companies with zero earnings. A recent Bloomberg article pointed out that over the last 50 years the percentage of zero-earnings companies trading publicly has more than tripled.
This feeds into the fact that people will pile money anywhere they think they can generate a profit. It's important to remember that over history people have piled money into things such as tulip bulbs as an investment. Don't be one of these people. Look at the fundamentals of the asset you are buying then ask yourself if its intrinsic value is likely to increase.
If the herd is doing something, you are better off grabbing some popcorn and watching from the sidelines. You don't have to participate in everything. There will always be opportunities in the future that you can take part in without the downside risk. Do not fall for FOMO!
I want to end this section by discussing Howard Marks' points on second-level thinking. This is a great tool to help you make better decisions, particularly based on how the market is acting.
The majority of market participants use first-level thinking: "First-level thinking is simplistic and superficial, and just about everyone can do it." - Howard Marks
- Everyone is buying XYZ, so I should buy it too.
- This company's stock price keeps going down, I need to sell so I don't lose more money.
First-level thinking solves an immediate problem, without giving consideration to the consequences. The problem with first-level thinking is that it often gives you the wrong answer. You can spot the issue with the examples above.
Using second-level thinking, we have to ask what the consequences are likely to be. If we have a deeper understanding of those consequences, our decision-making improves. If we analyze the problems using second-level thinking, our solutions would be different.
- If everyone is buying stock XYZ, it's because greed is showing its face. This means it will drop in price. I'll wait for that event to happen before buying!
- This company I own is dropping in price, but they keep generating greater and greater profits. It doesn't look like anything will stop them from generating more profits far into the future. So I'll keep buying more as the price comes down and get even higher rates of return.
You can see the contrast in what our actions would be in response to an event. If you look at problems using second-level thinking, you will have an edge on the market. Think long and hard about specific problems to determine what action you should take. The first solution you come up with could be completely wrong.
There were many great lessons from the Covid bull market and subsequent decline we are going through now. The timeless lessons you can glean from the above:
Valuation will always matter
Don’t mistake short-term tailwinds for the long-term
When stock prices exceed earnings growth, the price will regress to the mean
Markets have a short memory
Remember that price and value are two separate entities
If you like making money, don’t fall for fads