Six Common Misconceptions About Buying Stocks, with Extensive Quotes from Duan Yongping

A month ago, to get more work done, I uninstalled Douyin and Zhihu and turned off WeChat Moments. I could still post, but I couldn’t scroll. Xueqiu was the only feed left on my phone. I also spent a lot of that month talking about stocks with friends. By the end of it, I had a deeper understanding of what Duan Yongping meant by “Only invest in what you understand,” and a rough idea of why most retail investors lose money trading stocks.

Duan Yongping:

Steer clear of anything you don’t understand! That’s the basic principle of investing: only invest in what you understand. (2011-03-02)

Duan Yongping:

Steer clear of anything you don’t understand! If you ultimately can’t find a single business you understand and decide to leave them all alone, your investing performance will put you in the top 10–15% worldwide. But if you insist on buying things you don’t understand, you’ll at least learn a few lessons sooner or later. That might do you some good in life. (2011-09-21)

Duan Yongping:

Buying things they don’t understand is how 85% of people manage to lose money in both bull and bear markets. There’s no more absurd reason to buy a stock than the fact that it’s gone up a lot. (2015-06-26)

Here are some common ways retail investors think. I trust readers will see what’s absurd about them. There’s no need to take any of it personally.

Misconception 1: I liked or disliked the product, so the stock will rise or fall.

Whenever the conversation over dinner turns to investing in a company, someone immediately holds forth about their experience with its products. Maybe they loved the latest Huawei phone, admired the finish on a Vanke apartment, or had a terrible experience shopping on Taobao. The mistake is to treat a good product as sufficient, though unnecessary, for a company to be valuable. Only two fundamental factors actually determine long-term value: the business model and corporate culture.

Duan Yongping:
Good companies invariably have some good products. But even good products have a very limited lifespan. A good business model can extend that lifespan considerably. (2010-04-03) Good companies invariably have some good products. But even good products have a very limited lifespan. A good business model can extend that lifespan considerably. (2010-04-03)

Duan Yongping: Strong products are a prerequisite. What I care about most is the business model and corporate culture.

Related reading from Zhou Zhewu’s WeChat account: Why Did Panasonic Make Countless Products Without Becoming a Great Company?

A good product that consumers love doesn’t guarantee a good business model. To assess a business model, look at pricing power and how well the company can defend its position. A good business model gives a company control over its prices and lets it sit out a price war.

Didi and Uber offer an excellent experience, yet they went a long time without making a profit. A fleeting quarter of profit was down to financial engineering. Airline tickets routinely sell for 10–20% of the full fare and passengers get a great experience, but airlines generally fail to make money. There’s a joke that if investors ever invented a time machine, they’d go back and stop the Wright brothers from inventing the airplane. The combined losses of aircraft manufacturers and airlines in the century since would be too big to count.

When I see 75-year-old Konosuke Matsushita come out of retirement and put on a headband that says “Keep going!” to rally the sales staff, or Ctrip CEO James Liang return to the front lines after 19 years as a public company and sell tickets on livestreams, or Dong Mingzhu, who hadn’t taken a single day of annual leave in 30 years, sell air conditioners herself on Douyin, I suspect their companies have good products and weak business models.

(I admire all three entrepreneurs. They’ve worked hard for years and created a great deal of value for society. I’m discussing their business models here and intend no disrespect.)

What makes a good investment?

In Peter Thiel’s formulation, if a business creates X in value for society and can capture Y% of that value (a percentage of the value it creates, separate from market share), the business is worth X × Y%.

Most internet companies create less value for society than traditional industries like healthcare and education. Network effects and technological barriers, however, can make Y large enough. A good investment has both a large X and a large Y.

Take Twitter and email. Both have a large X because they create a lot of value for society. That value doesn’t translate into a good enough business model, so Y is tiny, making them poor investments. Tencent, on the other hand, has built an unparalleled monopoly with WeChat. You could say its Y is close to 100%, making it an exceptionally good investment.

From Demystifying Venture Capital: How Do You Resist the Hype Around False Trends?

The bike-sharing business I worked on was much the same. We had a great product, but we never managed to build a business model.

Every time I see people using the quality of a product to predict whether the company’s shares will rise or fall, I sigh. This is what trips up small investors.

Reader: Duan, can an investor with a small amount of capital afford to be less strict when choosing a business model?

Duan Yongping: That’s actually a pretty effective way to keep your capital small. (2017-08-27)

Misconception 2: The company's dividends and buybacks tell me whether the stock is worth buying.

On Xueqiu I keep seeing retail investors use dividend yields and buybacks to judge the quality of a stock. Here’s one example:

Now look at the dividend yields. After a 10% tax, the three banks yield 6.71%, 7.76%, and 6.42%, respectively. Put HK$1 million into each bank and your annual after-tax dividend income is HK$67,100 + HK$77,600 + HK$64,200 = HK$208,900. That’s HK$3 million in exchange for HK$208,900 a year in passive income. I doubt anyone would declare themselves financially independent on HK$3 million. What about HK$6 million? That brings in about HK$410,000 a year. With HK$9 million, you get HK$630,000 a year. Remember, that’s after tax. To earn HK$630,000 a year after tax from a job, you’d need to make roughly HK$700,000 to HK$750,000 before tax. Even in a city as expensive as Hong Kong, that much passive income is enough for financial independence if you live modestly.

We all know we shouldn’t borrow money to invest or invest the money we need for living expenses. The same logic applies to planning our spending around investment returns.

Dividends are a secondary effect of fundamental factors like the business model and corporate culture. Management also has plenty of room to maneuver and may have its own ideas about how to influence the share price.

Does a company have any value if it pays no dividends?

Reader: Over the long run, a stock’s return is the company’s profit growth rate. Most of the income from Coca-Cola now comes from dividends, and without buybacks it won’t show up in the share price. Dan Bin is right to ask about it. If you think it through, the answer becomes clear.

Duan Yongping: What would happen to Coca-Cola’s share price if it stopped paying dividends and buying back shares today?

Reader T: Yes, the money would go into net assets and still lift the share price. Reader A: If KO paid no dividends and did no buybacks, I think it could triple in 10 years or rise to nine times its current price in 20 years. That’s roughly a 12% annual return. In other words, KO would still be a great stock.

Reader S: I agree with art’s analysis. KO is much better than long-term government bonds. Buffett even buys railroads, let alone KO.

Duan Yongping: Doing better than long-term government bonds is the most basic definition of investing. (2010-10-21)

Misconception 3: A high or low P/E ratio means the company is overvalued or undervalued.

The P/E ratios you see on websites are based on the previous quarter or year. Forward P/E is based on management’s guidance. For someone who doesn’t understand the business, both are merely reference points.

Reader: How much weight do you give to a company’s price-to-earnings ratio when you invest?

Duan Yongping: I look at it, but I don’t give it much weight. P/E is historical data. What we buy is future cash flow. Unless the past tells you something about the future, it’s meaningless. I’m more likely to use E/E to assess a company. (Author’s note: The first E stands for enterprise value, meaning equity plus debt here.) (2010-06-01)

Buying a stock means buying a business. The stock’s intrinsic value is the present value of its future cash flows. To estimate those cash flows, we’re back to the business model and corporate culture.

Duan Yongping: Enterprise value is meant to express how much it would really cost to buy the company.

Duan Yongping: When I say P/E is historical data, I mean you’ll get burned if you rely on it alone to estimate future earnings. GM, for instance, always had a low P/E, often around five. It also had a lot of debt and went bankrupt. (2010-04-04)

Duan Yongping: The price-to-earnings ratio is a rearview mirror. It can’t tell you whether to invest. What matters is the ability to earn money in the future. If you don’t understand the business, leave it alone however low the ratio is. (2019-09-16)

Duan Yongping: Don’t let P/E mislead you. It’s historical data and may tell you nothing about the future. When I talk about P/E, I usually mean the price relative to actual long-term future profits, as distinct from the usual P/E in financial reports. The multiple you’re willing to pay depends entirely on your own ability, or the opportunity cost of your capital. The market has nothing to do with it. (2011-10-01)

Reader: There are quite a few stocks in the US market with extremely low P/E ratios of one to three. Many are Chinese stocks, and some trade for less than their cash or short-term investments. What do you make of them? Are they worth investing in?

Duan Yongping: Generally, companies with very low P/E ratios are quite likely to have problems. Unless you understand the business, it’s best to steer clear. (2011-06-17)

Reader: I was reviewing this today and finally noticed your explanation of P/E. Suddenly I understood why there’s no need to watch the market, and why it wouldn’t matter if the market closed for five years.

Reader: There are quite a few stocks in the US market with extremely low P/E ratios of one to three. Many are Chinese stocks, and some trade for less than their cash or short-term investments. What do you make of them? Are they worth investing in?

Duan Yongping: Generally, companies with very low P/E ratios are quite likely to have problems. Unless you understand the business, it’s best to steer clear. (2011-06-17)

Misconception 4: Whether a company is publicly listed determines how much it's worth.

Subscribing to IPOs and buying pre-IPO shares are highly speculative. The basic rule of investing is to invest only in what you understand. If you haven’t figured out the company’s business model and culture or made even a rough estimate of its discounted future cash flows, and you’re buying simply to sell to someone else, you’re bound to get burned.

Buffett once said, “If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.”

Reader: Some interesting news. Alibaba has decided to postpone its subsidiaries’ listings indefinitely. For a company that holds a lot of private equity stakes, whether those businesses are about to list hardly makes a difference to its value. Just look at Berkshire’s share price over the long run. Buffett has taken many public companies private.

Duan Yongping: I hadn’t heard they planned to list, so I don’t know why it’s called a postponement. Our companies (author’s note: BBK, OPPO, vivo, OnePlus phones, and Xiaotiancai smartwatches) still haven’t gone public. I guess you could say we’ve postponed it indefinitely, too. A listing has no bearing on intrinsic value, though it often affects the price. (2011-01-28)

Reader: If a company like Taobao never goes public, for instance, would that make it worth less?

Duan Yongping: The value stays the same. It may just take a little longer for the price to reflect it. Over 20 or 30 years, there’s really no difference. (2010-03-30)

Duan Yongping: In investing, it’s important to be able to think about a public company as though it were private and then decide rationally what to do. (2012-11-11)

Buying a stock means buying a business. The listing just makes it easier to exit.

Duan Yongping: Are private companies worth anything? Go back to the most basic definition of investing. Buying a stock means buying a business, regardless of whether it is listed. (2010-04-26)

Duan Yongping: Imagine this were a private company without a fluctuating share price and you’ll understand. Most people probably can’t do that. The fact is, most investors who can’t think about a company as if it were private will end up losing money. (2012-04-13)

Duan Yongping: Suppose Coca-Cola stopped growing forever, earned five billion a year, and had a market cap of three billion. Would you buy it? Wouldn’t you make a fortune simply by buying the company and taking it private? (2011-02-14)

Misconception 5: An employee's positive or negative account tells me whether the company is good or bad.

We keep coming back to two things when assessing a company’s long-term performance: the business model and corporate culture. Can an employee’s public account give us a window into that culture?

I don’t think so. First, everyone wants a shortcut, hoping to figure out the whole picture from a single clue. But a shortcut can turn out to be the longest route. When you know only one part of the story, you may be like one of the blind men feeling an elephant.

Second, employees who go public tend to have a partial view, and much of what they say can come from anger or dissatisfaction. Former employees in particular can also have conflicts of interest. My understanding of the Alibaba sexual assault case was that the allegation ultimately proved false. Alibaba certainly handled the matter poorly, but I don’t take it as evidence that the company’s once-excellent culture has lost its luster.

Corporate culture primarily shapes whether a company pursues long-term compounding, what it’s willing to give up in short-term profits, and how it evolves over time. Leaders with integrity can correct many short-term mistakes if they take a long view.

There’s also an English saying, “Pressure makes diamonds.” Steve Jobs’s team worked punishing hours and held itself to exacting quality standards. When I read a long account by a Pinduoduo employee describing poor benefits and questionable management practices, what came through to me was enormous pressure and inexperienced middle managers. Complaints about pressure from rank-and-file staff can be read as signs of strained labor relations or of a company with high ambitions, ideals, and goals.

The employee accounts that really matter tell you whether management is honest and upright. China Europe International Business School followed many companies over several years and found a single common factor determining whether they succeeded or failed: integrity. Integrity is nonnegotiable. Take the long road, make lasting friends, and steer clear of people who cut corners.

Misconception 6: The company's past stock price tells me where it will go next.

When value investors are buying a stock, a falling price should make them happier and more willing to buy. My wife used to agonize over whether to place a market order or a limit order. If the price had already touched a particular level, she was especially likely to anchor on it and expect it to come back.

In fact, poring over stock charts and trend lines is as absurd as trying to read something into the last few spins of a roulette wheel. (There’s no conditional probability at play. Each random event is independent.)

Past prices can’t predict future prices, which will fluctuate around the company’s intrinsic value.

Horse-racing bettors study racing guides, lottery players read lottery magazines, and stock traders stare at charts. All three are making the same mistake about how things work.

Duan Yongping: My view on when to sell a stock is that, whatever you do, you shouldn’t tie the decision to what you paid. There may be plenty of reasons to sell. The one reason you shouldn’t use is that you’ve already made money. Otherwise, it’s all too easy to sell a good company you worked hard to find at a low price. The same applies when you buy. There can be many reasons to buy, but it’s best to leave the price the stock once reached out of your reasoning.

Duan Yongping: Whenever you sell, don’t tie it to what you paid. There may be many reasons to sell. The one reason you shouldn’t use is “I’ve already made money.” Otherwise, it’s easy to sell a good company you worked hard to find at a low price, or to hang on to a loser when you should sell. The same goes for buying. There are plenty of reasons to buy, but it’s best to leave the price the stock once reached out of your reasoning. I make the decision based on value. That’s how I managed to hold NetEase for eight or nine years. My earliest purchases averaged about 1 a share, equivalent to 0.25 now. I sold most of it at around 30–35 in today’s prices. Every day of those eight or nine years, I could have been tempted by the price I could sell at. This was how I resisted the temptation. (2010-03-27)

Reader: Mr. Duan, when a stock already offers a margin of safety but market sentiment could still push it to new lows, what do you do?
Duan Yongping: I don’t know how to factor in market sentiment. (2010-06-21)

Reader: There have been a lot of reports lately about insurance money entering the stock market. This kind of news has often come with a bull run in the past. What do you make of it, Mr. Duan?

Duan Yongping: 🙄 (eye roll) (2011-06-09)

Reader T: That’s what the analogy about the voting machine and the weighing machine is about. You’re still thinking about the voting machine when you should give more thought to the weighing machine.

Duan Yongping: 😄 (grin) (2011-06-09)

Reader: Value investing requires three things: knowing yourself, knowing what you buy, and understanding the logic of the market.

Duan Yongping: What you understand about a business is objective and doesn’t vary from person to person. What do you mean by the logic of the market? In fact, the most important thing about investing is being able to ignore the market. (2012-02-14)

Reader: Why do you say there’s an element of speculation in the saying “Knowing when to sell makes you a master”?

Duan Yongping: Value investors buy and sell based on value. What you paid, for example, has no bearing on the decision to sell. The saying about being a master at selling is really about the relationship between the market price and what you paid. People who think that way focus on what the market thinks of the stock and lose sight of the business itself. It’s all guesswork. When you really understand a company, deciding to buy and deciding to sell are about equally hard. (Author’s note: If you understand it, both decisions are easy.) (2012-07-04)

Reader (about Apple): I really want to buy more at today’s price, but I already bought some at 330, and that earlier price keeps getting in the way. What should I do, Dadao? You said trying to buy at the very bottom can leave you buying too little. I think I’m starting to see what you mean. Is this the feeling you were talking about?

Duan Yongping: Ha, after you’ve bought at a lower price, it’s easy to get hung up on it when you want to buy again. The most important thing is to stay rational. Imagine you just came out of hibernation today. Get up, see what stocks are worth buying, then make your decision. Selling works much the same way. (2012-01-30)

Duan Yongping: It’s easy to get burned trying to catch a falling knife because people usually focus on where the stock used to trade and forget to ask what the company is worth. Any time you buy a stock, I think you should imagine you’ve just arrived on Earth from another planet and calmly ask whether it’s worth buying at this price. That applies to falling knives, too. (2013-02-01)

Duan Yongping: Keep a clear head and treat each buy or sell as an independent decision. If you know what you’re waiting for, of course you can wait. (2013-07-04)

Reader: How do you tell whether a stock is cheap?
Duan Yongping: That’s a question for someone focused on the short term and watching the market. I don’t think about it. I focus on the long term and leave alone anything I don’t understand. Any attempt to read the market or time it may be misguided. I look at the business and ignore the market. You say a stock is expensive. How do you know? If you look back ten years from today, almost everything probably looked expensive at the time. Imagine looking back on today from ten years in the future. If you find a company you understand and it looks cheap, buy it. (2018-09-30)

Original article: https://mp.weixin.qq.com/s/Y19HBWpUHv-CJdqF4icTvg