Popular (but wrong) beliefs about investing – Part 1

This article series is here to poke holes in certitudes regarding investments. So, without too much rambling, let’s dive in:

« The stock market is a casino »

Let me start with a disclaimer: yes, the stock market can be a casino. It certainly feels like that. You bet money on a series of letters – the ticker (which represent the shares on a company) – and the next day, it might be worth 2% more. Or 20% more. Or 70% less. So, how is it different than a game of roulette?

Obscure company losing 37% yesterday. Yes, that happens every day.

To make things simple, yes, the stock market is a giant game of roulette… in the short-term. There is no valid reason why the value of a company changes by 10, 5, or even 1% from one day to the other. In the short-term, price variations are a gamble. Some clever people are able to take advantage of that: traders. Because they have access to an infinite amount of information and because they are supported by algorithms which act at the speed of light, they can buy share for 100 and sell them 5 minutes later (or 5 nanoseconds later) for 101.

In a way, traders are like professional poker players: they rely on chance but they have the odds on their side because they know the game very well. I might know the rules of poker but I wouldn’t stand a chance against a pro. I might win a few hands because of luck but a pro will eventually win because he knows when it is worth betting and how much. If a trader makes enough bets with good odds, he will be successful on the long term. He won’t win every time but on average he will earn money.

But we aren’t traders neither should we try to be, so, we can’t play the game of short-term variations. But weirdly enough, the game of long-term variations is easier to grasp.

The famous investor Benjamin Graham explained this concept by saying that:

In the short run, the stock market is like a voting machine – tallying up which companies are popular and unpopular. But in the long run, the stock market is like a weighing machine – assessing the substance of a company.

Benjamin Graham

Successful companies

Over the long term, the most successful companies are the companies which earn the most money. Plain and simple. If you aren’t convinced, ask yourself the following question: would you rather own the entirety of Apple Inc. and earn around 30% of the price of each iProduct sold in the world between now and Judgement Day, or, the entirety of the local gas station, which earns 0.7% of all the fuel they sell ? Since more people want to own Apple Inc. than the local gas station, Apple is worth more money. But it’s not simply a popularity contest because the popularity is backed by real earnings, customers, margins, etc.. If the local gas station made 100% profit and sold 372 gigatons of gas every day, you bet that it would be popular (and pricey) too.

So we’ve established that the most successful companies are the ones which earn or will earn the most money. That sounds simple enough, right? Buy the companies that are going to be successful and hold for the long term, and all will be well.

The problem is that it’s nearly impossible to know which companies are going to be successful in the long term (I wrote “the long term game is easier”, not easy). Imagine telling your dad in the 80s to buy an obscure IT company named after a fruit because by the year 2021 everybody will have a personal computer (which fits in a thick A4 envelope) AND a mini-computer that fits in your hand that you can activate with touch on a glass screen. Nobody could predict that Apple would become the largest traded company in history. Most people predicted that it would go bankrupt, which it nearly did in 1997.

Most companies aren’t very successful. Did you know that more than half of the companies listed in 1977 produced negative returns. That means: if you had picked a company at random in 1977 and sold today, there are more than 50% chance that you would have lost money. Isn’t that crazy?

Inherent truths of the human race

There are two things we know almost for sure though:

1. Capitalism isn’t stopping anytime soon. Even the Chinese Communist Party adopted it.
2. Most people want to improve their standard of living.

Since most people on this planet will want to get an even bigger, more high-def TV, every few years, and since a free market economy will be there to offer them one, companies are going to keep making money. Since people who are currently travelling on horse back might want the comfort of a car, and since people who already have a car might want a Porsche or a Tesla, companies are going to make more money in the future than they do now.

Notice that I wrote: companies. It’s hard to know which ones are going to be successful because it’s hard to predict the future, but it’s relatively straightforward to guess that companies in general are going to be more successful in 30 years than they are today, unless WWIII occurs or the Black Plague makes a mutated comeback, but at that point money will be the least of our concerns. No one knows what will happen a year from now but it’s almost certain that 30 years from now, the entirety of South-East Asia will have air conditioning, because it’s hot and humid there and, in general, people don’t like sweating. Who is going to sell them air conditioning in 30 years? No one has a clue. But someone will. That someone will most likely make money doing that. And if you’re a shareholder of that company, you will make money too.

But, what do we buy if we don’t know which company it is going to be?

The sure way to win the lottery

It’s essentially the same question as: what is the sure way to win the lottery? Which ticket to buy if I don’t know which ticket will win? Well, you buy all of them. Buying all the tickets of the lottery is the sure way to have the winning number. The same way, how to be sure to hold the companies who will be successful in 30 years? You buy all of them. And contrary to the lottery, it is a profitable strategy.

Buying all the companies in the American stock market in 1977 would have produced a x16 return on investment, and that’s accounting for inflation. 1977 isn’t a particular year, it just happens to match the year of the article mentioned above, so it’s easier to compare.

So, how can it be that picking one company at random has had more than 50% chance of negative returns and yet all companies produced a very positive return? Well, that’s the cruelty of capitalism: losers go bankrupt and disappear while winners win big. Microsoft started trading at 7 cents a share (adjusting for both splits and dividends, but not inflation). It’s at $246 today. I don’t even want to calculate the returns on that.

Owning Philip Morris in the 80s, which wasn’t exactly a start-up at the time, would have produced x18 returns without reinvesting the dividends.

Those returns are spectacular but rare. Sometimes big successful companies fail miserably. For instance, Kodak in the 80s was THE stock to own. This is how the pitch sounded like: “people like taking pictures and it won’t be long before everyone in the world owns a camera (that Kodak makes and sells for a profit). But that’s not the best part: every picture is printed on film and guess who has a duopoly on film production and sales? Yep, Kodak.” It was a convincing pitch. Unfortunately, the film sales part of the business disappeared with the invention of digital cameras (that Kodak first developed, talking about shooting yourself in the foot) and the company nearly disappeared. Same for Polaroid. Big market capitalization in the 70s; went bankrupt in 2001. Don’t get me started on the internet companies of the end of the 90s, I’m keeping those for an article on Bitcoin.

The only way to capture the huge winners is to cast a wide net; the wider, the safer. But that also means that the net will catch losers and a whole bunch of them. But that’s OK, because their relative value will shrink every year and you will end up owning less and less of them. On the other hand, the winners will grow and you will earn more and more of them.

How on earth am I supposed to own all the companies on the planet? I don’t even know all the companies on the planet!

You, probably.

Well, the finance industry has heard you and created a wonderful tool

These tools are the exchange-traded funds or ETFs. They allow you to buy and sell one shares of a fund that itself owns multiple companies. That way, you don’t have to worry about finding the companies and buying shares of them, the fund manager will do that for you, for a small fee. There are hundreds of ETFs out there, but some track all the companies in the world and require very small fees (One example, not an affiliated link). I will stop there with the discussion of ETFs because they deserve their own article.

So what have we learned today?

The “The stock market is a casino” belief is probably 90% true. It is for sure a casino in the short-term, because it’s impossible to predict the variations. And it is sometimes a casino in the long term, because although some companies might be successful now, there is no reason the believe that they will be also successful in the future. The only way to use the stock market not like a casino is to bet on a wide range of companies (the wider, the safer) and hold them for at least 20 years. That is the only way to tap into the very real trend of people wanting to earn and spend more money, while companies capture part of this money as profit for shareholders (that’s you).