Why Your Portfolio Isn’t Growing: The Painful Truth

IMPORTANT: Please read the disclaimer before continuing.

After investing for a while, it is important to question the concepts that we have learnt from books or other investors that we have met.

No matter how great some investors are, it is important to understand how they derive their knowledge. Without doing that, you will not be able to consistently outperform the market.

Over time, you need to refine your investing framework by continually reviewing your mental model by reflecting on what has worked for you.

The only true wisdom is in knowing you know nothing.

by Socrates

This process led me to realise some observations that may sound controversial about investing in the stock market. To some of us, reading this may feel like a rude awakening.

Despite that, my purpose is to allow you to see a different dimension of thinking. I am not making any assertion that I am correct.

To start off, let me explain how I define if something is working for you. For lack of a better measurement, I will be looking at portfolio returns.

So far, after becoming a growth and software investor many years ago, my returns improved dramatically.

(RELATED: The Hedgehog Portfolio Reports 64% Returns YTD)

Now, I will list down a few controversial reflections about investing in the stock market.

1. Book Value is Dead

What is book value? It is shareholders’ equity or total assets minus total liabilities. This is taken from a company’s balance sheet.

In short, what your net worth is to you, is what shareholders’ equity is to shareholders of a listed company.

In the past, we often use book value to value the company.

For example, if you are buying a company with a book value per share of $1 for $0.50. You are purchasing it at a Price-to-Book ratio of 0.5x. This means you are getting a steal! Excited?

I kid you not, I used to have these identical thoughts! However, when I researched deeper, I found a few flaws with this method.

Firstly, we are assuming that the business is able to liquidate everything and realise its book value.

But is this realistic? A company may have old machinery, inventory or trade receivables. During a liquidation process, the value of the mentioned items will be significantly lower.

Secondly, when you buy a company, you are not buying the assets.

You are buying the ability of the management to utilise their assets to generate significant returns for shareholders. For example, Real Estate Investment Trusts (REITs) are very popular in the country where I come from. Most investors tend to use Price-to-Book ratio to evaluate the price to pay for a REIT. While that method seems okay, I feel that the dividend yield of the REIT is a much better measurement.

Simply said, there is no point purchasing an asset worth $2 for $1 if it does not generate good cash flows. You feel good for buying something cheap, but it means nothing.

In comparison, if you had paid a higher price for a quality asset that is generating a good cash flow, wouldn’t that be better?

The most important thing is the earnings generated out of the asset, and not in the asset value itself.

Some assets look cheap but they do not generate strong earnings.

An investor who is focused on looking at book value may fall into some deep traps. That’s why I stopped using P/B and my returns improved multi-fold.

2. Don’t Read Investment Books Only

As new investors, we probably would have read books like One Up on Wall Street, Common Stocks and Uncommon Profits, The Essays of Warren Buffett or The Education of a Value Investor.

You cannot hope to become a better investor without reading any of these books.

During my army days, I had little money. Even so, whenever I received my allowance, I would spend a big portion of it on investment books. Investment books are important because they teach us how to evaluate businesses through three different aspects, such as business, management and valuation.

If there is something you should not be scrimping on, it would be investing in your own knowledge. I recall purchasing “The Winning Investment Habits of Warren Buffett & George Soros” back then. While it probably cost me less than SGD $50, I generated over $10,000 in profits from what I had learnt.

Till today, I still invest with knowledge from the book.

However, the content you get from books alone may become repetitive after a while. Your growth starts to plateau although you’re looking for your next growth curve. With every new investment book, you start feeling disappointed because you are just reading content that is packaged differently.

I had my biggest breakthrough when I shifted away from investment books and I focused on business strategy books. I picked up business books like Competition Demystified, Predictable Revenue, The Business of Software, and Zero Marginal Cost Society.

I even started consuming articles written by thought leaders from different industries. For example, when I wanted to learn about software, I picked up a book called Subscribed by Tien Tzuo.

When you understand competitive advantages better and have the ability to bridge what businesses are doing with their current financials, you would become a lot better than most investors out there. That’s where the edge is being created.

If you wish to have book recommendations, check out Monish Pabrai’s list.

3. Be Very Skeptical About Low P/E Stocks

Before I go on, I must qualify that looking at share price alone is meaningless. As prudent investors, we should look at valuations.

In short, we cannot conclude whether a company with a $20 share price is expensive compared to a company with a $5 share price. If you look carefully, you might find that the company with a $5 share price is actually more expensive.

(RELATED: Share Price Alone is Meaningless)

Here’s why. Let’s give names to our companies too. Funfair and Growth Monster.

If FunFair Inc has a $20 share price and it is earning $2 per share, the P/E ratio is 10x.

If GrowthMonster Inc with a $5 share price and it is earning $0.2 per share, the P/E ratio is 25x.

In this scenario, GrowthMonster Inc with a $5 share price is more expensive.

The conventional truth that most of us understand is that we want to buy at a low P/E ratio because it represents good value.

Increasingly, I am starting to doubt this truth.

Companies with low P/E ratio tend to have weak businesses, are prone to massive disruptions, weak corporate governance and lack growth aspects.

The key is never to buy businesses just because it is cheap. Never focus on price alone.

If GrowthMonster Inc is growing its earnings at 50% every year and FunFair Inc isn’t growing, which would you rather purchase?

I would purchase shares of GrowthMonster Inc instead.

Focus on quality. You have to buy a good business at a good price.

4. Loss-Making Companies?

Traditionally, we frown upon loss-making companies and avoid them at all costs.

In recent years, more investors are puzzled over why companies such as e-commerce enabler Shopify, e-commerce platform Sea Group and app monitoring Datadog kept growing despite their mounting losses.

Instead of dismissing this situation quickly, it makes sense to find out what causes them to be loss-making.

I have to qualify this statement before everyone jumps at me: Are their business models loss-making by choice or are their business models broken?

Amazon was loss-making for several years by choice. Many investors could not understand why. But by linking business strategy and financial numbers, Chris Mayer explained Amazon was operating near break-even intentionally.

How so?

The market opportunity was so huge that it did not make sense for Amazon to be profitable. To be profitable was to lose sight of the prize. So to speak, Amazon could be profitable but Jeff Bezos chose to invest instead, so that he could gain more market share rapidly.

They spent more money than any of their competitors on research and development costs in order to lower prices for their customers. While their competitors were busy thinking about their profits, Jeff Bezos was busy winning and locking customers’ loyalty. Soon, Amazon won the battle. Customers found great value through Amazon’s Prime membership and faster delivery. All these would not be possible if Amazon did not first invest aggressively into platform infrastructure.

Similarly for Datadog: it has a great product and it works. It has an excellent product-market fit. Should Olivier Pomel, the CEO of Datadog, care about showing up profits or should he care about investing its sales and marketing expenses to win more customers? It’s clearly about winning the customers.

That is why, for Datadog and Amazon, it is about sowing the seeds first then harvesting massive profits later. There are clear paths to profitability for these business models, but their leaders are delaying it by outspending and investing more aggressively to win more market share.

This kind of aggression is not what most investors are used to. Some CEOs are not comfortable seeing losses in their financial reports too.

Most of them are even frightened by this situation.

For me, I learned to embrace loss-making businesses once I am clear about their strategic objective. A business model with a proven product should win as many customers as possible and create an ecosystem to encourage repeat purchases.

Once the businesses have captured a huge pie of the market share, they have the option of lowering their sales and marketing expenses. By doing so, you will start to see their underlying profitability. By then, they have more customers than any of their competitors AND they are profitable too.

Many investors balk at loss-making companies with a common question: when will they ever stop burning money? One way is to identify the unit economics of their business. With positive unit economics, you should never worry about such issues anymore.

Also, when investing in software companies, it is important to note that they tend to incur huge sales and marketing expenses upfront, but the revenue of a customer is earned repeatedly over many years. You have an unfair situation where sales expenses are recognised upfront while revenues are recognized throughout the years.

This is where understanding unit economics is very powerful!

Investing is about buying into an eventual winner. It is not about buying into a profitable company now that it is slowly losing customers. Who cares whether you are profitable at the moment? It is more important to care about future outcomes.

5. Most Singaporeans Prefer “Safe” Names

When you read this, you might feel offended. However, I rather tell the hard truth now instead of sugar-coating my content. As I was investing incorrectly for a long time, it drastically slowed down my earnings, and I don’t want you to go through it either.

Firstly, a lot of Singaporeans prefer well-known names.

We invest in companies like CapitaLand, Hyflux, Jumbo Group, or UnUsUal. We tend to have a mentality that well-known companies are good companies. That mentality does not serve us – in fact, it is extremely dangerous.

Jumbo Group suffers from high labour and rental costs while Hyflux had to deal with low-profit margins and high capital expenditures.

Some places where you can gather more opinions before buying shares of companies are like Seedly that provides a forum. I also build a paid community where we uncover hidden gems in the stock market.

Secondly, Singaporeans prefers dividend stocks because it feels good to receive dividends. With a small capital size, the dividend-paying companies won’t compound your money towards your financial freedom goal.

Let’s assume that a young Singaporean builds a portfolio of 6% yielding stocks worth $10,000 – he would receive $600 per share. Even by reinvesting his $600 into his portfolio, it would take a painfully long time to grow his portfolio. When you are young, you should focus on eliminating all kinds of dividends stocks. Focus on growth stocks that pay no dividends.

While it may not be true all the time, dividend-paying companies may be in the “maturity” stage of its business life cycle. This is where earnings are starting to plateau. You would not want to invest in a company like that. It is like squeezing whatever is left of the company before it starts being disrupted by a hungrier competitor.

Why?

If a company pays out most of its earnings to its shareholders, it might not have anything left to invest back to grow its operations.

For example, if the management of a listed company is able to demonstrate his ability to grow $1 of retained earnings into $1.5 of future earnings, the debate is over. The company should retain its earnings instead of distributing the earnings as dividends.

Illustrating using another analogy, imagine you have one store of McDonald’s. After the first year, you have two choices. Either you take your profits out as dividends or utilise the profits to grow another store.

A smart capitalist like you would take the money and grow another store.

By year 2, you would have 2 stores.

By year 3, you would have 4 stores.

Once you have finished expanding all your stores, you have 4 stores that are able to pay out their earnings to you. Isn’t that better? You are getting more dividends too.

A business that owns 4 stores instead of 1 store is likely to be 4 times more valuable too.

In short, invest in a growth company instead of a dividend-paying company if you’re young. But if you’re in your late 40s or 50s, that is where dividends are going to be very important to supplement your income as you look towards retirement.

Conclusion

The world is changing rapidly. We have to update our firmware to learn from global investors. Do not stick to people we know, expand our social circles to include learning from people who are total strangers. You may dislike a person but if he/she is having consistent out-performance, learn from him/her.

Instead of being closed-minded, be open-minded to learn new things. Don’t hold on to your beliefs too strongly, and always approach new concepts with a learner’s mindset.