Is stock investing a zero-sum game?

This question has puzzled me for a long period of time since I started my journey on learning about investing. Different people hold different views to this question. Some say stock investing is a zero-sum game while others say that it is not. Is stock investing a zero-sum game?

The idea of zero-sum game implies that in every stock investment transaction, one party must benefit at the expense of another party who is making a loss. It seems that during every transaction of a stock in the stock exchange, the proponents in support of investing as a zero-sum game hold the view that one party must always benefit from the transaction from another party who is making a loss. 

For example, buyer buys a stock at a particular price from a seller who sells at a loss to him. This seems true during a bear market when a seller might be selling a stock at a loss due to a down-trending market to a buyer who buys the stock at a cheaper price which later rises in price resulting in a profit for the buyer. This also seems true when a seller sells a stock at profit at a particular price to a buyer after which the stock price goes down resulting in a loss for the buyer. 

However, do stock prices always behave in a zero-sum game fashion? Is it always necessarily true that one party must make a profit from a transaction at the expense of another party who is making a loss? 

Through my own experience with investing so far, I noticed that any stock investment transaction on the stock exchange may not necessarily follow a zero-sum game fashion. For instance, when I sold off a stock at a particular stock price making a profit, the buyer of my stock did not make a loss thereafter as the stock price continued its climb further. In this case, both parties made profits on their transactions. In another case, when I sold off a stock at a loss, the buyer of my stock did not make a profit as the stock price continued to decline further. In this case, both me the seller and the buyer made losses together on our transactions.

Thus, it is not always in a stock transaction that one party will make a profit at the expense of another party making a loss. This is the randomness of the stock market as described by Benjamin Graham, the father of value investing that in the short-term, the stock market is a voting machine, but in the long term, it is a weighing machine.

In the long term, stocks belonging to businesses with good fundamentals may grow their value over time rewarding their investors with appreciating stock price. For example, one cannot imagine a small company that has grown over time to become a large enterprise generating larger amount of revenue, income and cash flow to be still trading at the same share price when it was once in its infancy stage of growth. Unless this company keeps issuing more outstanding shares enlarging its equity at a faster rate than the growth of its earnings to dilute its earnings per share. Then, we might see a stock price that has not grown over a long period of time as the earnings per share remains the same due to dilution effects of more shares issued over time.

Thus, the company that can steadily grow its earnings per share over time, while growing and managing well its other tangible and intangible fundamentals such as revenue, income, cash flow, margins, branding, market share, corporate governance, debt loads, debt servicing, working capital need, etc. will generate appreciating stock value over time. This is why the stock market is a weighing machine over time as time will tell the difference between a good company and a lousy one. 

An investor can invest in a company at its early stage of growth and exit from the company by selling off his shares at a profit to another investor after the company has grown into a medium size enterprise. The latter investor can also benefit by staying invested with the same company which grows into a large enterprise similarly seeing the share price of the company continue its appreciation over time and making also a profit on his investments. Both investors, the earlier and latter one derive benefits by staying invested with the company that grows in value. No one benefits at the expense of the other as both made their profits on their investments. 

If one is a good value investor, there is no concern over whether stock investing is a zero-sum game or not. This is because no matter which period of time he has bought his shares (assuming he always tries his best to buy at lower than his estimated intrinsic value per share of a good company securing a margin of safety), he will be rewarded with an appreciating share price over a period of time. Thus, stock investing will never be a zero-sum game for any investor as no matter at which stage of growth in the company, as long as an investor rides on the growth, he will be seeing the share price of his invested company appreciate over time as the company grows. This is on the assumption that he has invested in a good company at a reasonable share price that grows its fundamentals steadily over a long period of time. 

Is stock investing a zero-sum game? By the looks of it, it is not. A company can grow over time and an investor who has invested in a good company that grows in value over time will see his shares in the company appreciate over time. Thus, stock investing is not a zero-sum game as it will reward any patient and astute investor who rides along the growth of a good company, seeing his invested shares grow in their share price over time. This is only so true of a company that grows in value instead of destroying value for its shareholders over time.

Stock investing is not a zero-sum game. 

Any investor can derive value from a good company by participating at different points of its growth.

Reflections on my investing journey so far - "It is still cash flow that triumphs".

As I reflect on my past three years plus of investing in stocks and shares, I learnt many lessons, some slightly bitter ones and some are good ones. So far, I am glad to say that I have not made any realised losses from the stock market yet. In fact, I have made steady returns of approximately 13% per annum over the past 3 years plus of investing mainly through recurring cash flows from dividends received from my stocks investments and some gains through selling of shares (a lesser amount though compared to dividends received). This figure of returns may not be exceptionally significant, but it is already better than most other alternative forms of investments. Also, I have not made a single realised loss on my investments so far.

I have learnt through my humble experience in investing so far that it is better to have the mindset of building assets that return stable continuous cash flow than to invest for quick returns. Even if one is going for an accelerated way of investing by investing for appreciation in value of assets (be it paper assets like stocks and shares or physical assets like real estate properties), one must still own an increasing amount of assets through the years that provides recurring and increasing cash flow that can beat inflation over the years.

Getting positive cash flow through owning assets is really everything about successful investing. Appreciation in value of assets is an icing on the cake. Even after one sells off an asset that has appreciated in value and made a gain, he is still faced with the decision to reinvest his gains and original capital into another asset. If he does not reinvest his cash, then cash will depreciate in value over time. By not investing one's cash, one is getting poorer by the days.

Ultimately, I believe the distinction between rich and poor people is just in the mentality of how they view money. The rich becomes financially educated and invests to control or own assets that provide them recurring and increasing cash flow that fights inflation. Of course, any appreciation in value of the assets is also welcomed. The poor views investing as risky or is just ignorant of the merits of doing proper investments. The simple key to successful investing is just to continue learning how to invest and just do it and really learn from mistakes and successes whenever investment decisions are made.

The more learning and experience one gains through own research and learning from mentors, the better it becomes as one matures in his investing journey. As I have already expressed in an earlier post quite sometime ago, my view on successful investing has not changed now. Building up the amount of high quality assets one can have the most control (be it paper assets - this tends to have lesser control for the investor as shares are just meager part-ownership of an invested company unless one is a major shareholder, physical assets or business) over time and getting increasing recurring cash flow which beats inflation will allow one to reach financial freedom sometime in life. Cash flow received from assets is further plough back to reinvest in more quality assets which further increases cash flow. This is a virtuous cycle of increasing cash flow over time (by compounding), cash flow that further feeds more cash flow.

Patience and endurance to resist instant gratification in seeing immediate gains is important. Surprisingly, I learnt through these three years plus of investing that money goes to the one who is not greedy for it. The more one is not greedy for money, the more rational and composed one is when it comes to long term financial planning and constantly making the right investment decisions. It is all about the mindset of the investor. The success and failure of investing is not so much affected by the economy, but often it is the wrong emotions of greed and fear that causes the investor to make unwise investing decisions.

I will continue to look out first and foremost for quality assets (be it in paper or physical assets or business) to invest for good quality cash flow while secondly welcoming the idea of appreciation in value of invested assets. Building cash flow through owning and controlling more and more quality assets over time that beat inflation heads down is the crux of successful investing that will enable one to reach financial freedom. Better yet is that the quality assets one has owned can appreciate in value over time. This simple rule of successful investing has not changed through the ages. I believe it will not in future too.

Are you into building more and more positive cash flow (by owning and controlling more quality assets) or "building" more and more negative cash flow over time (by spending more than one's income, chalking up bad debts or making unwise investment not in cash flow producing assets but in investments that may lose their value in the end resulting in a loss)? If 'cash' thinks that it is really king, 'cash flow' will be laughing his heads off at 'cash'. Perhaps, the mindset of wanting cash flow is probably better than the mindset of wanting cash when it comes to successful investing?

Think of cash flow investing as installing more and more taps that can be opened to provide more and more cash inflows. The choice of the right taps to install is important so that the right taps (quality cash flow positive assets) can continually provide more and more cash inflows over a long period of time to build one's passive income.

How to know whether an investor has succeeded??

It is known to many that one looks at investment success in terms of rate of return on investment. If an investor can receive consistent annual high rates of returns on his original capital, he is deemed to be successful. The higher the annual rate of returns and the more consistent he can keep receiving the high rate of returns on investment, the more successful he is.

This brings us to the question of whether this long held belief is a good measure of investment success or not. I believe there is no harm in challenging every beliefs in life, and that includes investment beliefs as well. By challenging beliefs, one is not trying to be difficult and go against the beliefs but rather to seek the truth, to see whether the belief in question is really the ideal truth or not.

Is annual rate of returns on investment a good measure of investment success? Let's look at two separate fictitious people, Alan and Jane who did their investments differently. Alan is an investor who goes for high annual rate of return on his investments. He recognises the need to invest long term in good dividend stocks that provide a high yield. He also recognises the need to go for high capital gain every year, so he carefully selects some stocks that he thinks have good potential to grow their share price in any year. Alan has been doing well so far, getting reasonably good average annual rate of return (around 18%) on his original capital though his rate of return may change every year.

The only thing about Alan is that he reinvested little of his earnings from investments, so his investment capital value has not grown much throughout the years even though he continues to receive dividends and capital gains yearly which he spends away most of these earnings. When Alan talked to his friends about his investments, he always smiled with pride that he managed to get consistently good average annual rate of returns.

Jane another investor shares the same investment thoughts as Alan carefully selecting good dividend stocks with high yield to invest for the long term. She also looks out to invest in good growth companies that show potential to increase their share price be it on short term or longer term. In doing so, she is also hoping for good capital gain on her investments apart from receiving cashflows from dividend stocks. She is not as good as Alan in getting a high annual rate of returns on her investments. She managed to receive on average around 11% annual rate of return  on her investments. She diligently reinvest her earnings from investments throughout the years during opportunate times when valuations of companies are cheap.

Alan started with $100,000. After 20 years, his portfolio investment value has grown to $300,000. Jane started also with $100,000. After the same 20 years, her portfolio investment value has grown to $800,000. So, at the earlier part of both their investing journeys, Alan seems to be the better investor getting a higher average annual rate of return on his investments than Jane. However, he only reinvested little amount of his earnings from investments and mostly spends the rest of his earnings. He was thinking to himself all along that he was successful at getting a high average annual rate of returns on his investments.

Jane recognised the value of compound interest growth, so she delays her immediate gratification on spending her earnings from investments and instead plough back her earnings from investments to work on the principle of compound interest growth. Her efforts are finally realised only after a sufficient long period of consistent and diligent reinvesting, greatly increasing her original capital sum.

She has a higher capital value in investments than Alan after 20 years even though she made lesser average annual rate of returns on her investments throughout this period. In doing so, she managed to have a higher rate of accumulation of capital compared to Alan over the same period of time for the same start-up capital, since she has accumulated a capital sum through investing which is much higher than Alan.

I shall leave you with a final question. Is annual rate of returns on investments really a good measure of eventual investment success or maybe it is time to relook at this long held belief and consider another possible measure, the annual rate of accumulation of investment capital?

Investing is a long distance journey of discipline and hard work in putting financial resources to good use.

I have been two and a half years into the business of stock investing. I admit that it is not an easy journey. I have learnt to put in hard work by doing research into acquiring sound knowledge in investing. Even though learning about investing is hard work, I find that it is also interesting as it opens up my mental realm and horizon to allow me to gain new perspectives in life.

Investing is not about having some short-cut way to amassing riches. It is the discipline of training oneself to put in hard work to be a good steward of whatever financial resources one is given. With greater financial resources being managed as one grows the financial resources under one's charge through sound investing, one should also put the financial resources to good use. As a christian, putting financial resources to good use means using my financial resources wisely according to God's way whatever amount of financial resources He has provided for me by His grace.

Since investing to me is a disciplined journey of putting in hard work to see the results, I will be careful not to avoid the needed discipline and hard work in this investing journey. There is no short-cuts, just a disciplined focus and hard work to make sure one is doing sound investing, slowly building up good cashflow generating assets that can continue to generate sustainable cashflows over time. One should also consider carefully how to put the cashflows generated to good use which by itself is also a mark of sound investing.

I shall leave you my reader with a quote from Thomas Alva Edison, the famous inventor and businessman, and also a video clip which I believe can be applied to the journey of investing. Do consider carefully also how one's financial resources can be put to good use even as one is successful in this journey of investing for what is the use of having financial resources if one does not consider how to put the financial resources to good use. In all things, I believe God is watching.

The first requisite for success is to develop the ability to focus and apply your mental and physical energies to the problem at hand - without growing weary. Because such thinking is often difficult, there seems to be no limit to which some people will go to avoid the effort and labor that is associated with it.... - Thomas Alva Edison

The Amazing Pipe Line Story - Pablo & Bruno

Investment Learning Points

Dear readers,
I am shifting all the investment learning points from the sidebar of my blog into this dedicated post so as not to overcrowd the sidebar of my blog. This is also to allow further updating and expansion of my investment learning points in this post as my investment experience grows. Please return periodically to this post for updates on my investment learning points. I wish all readers a fruitful investing journey!

INVESTMENT LEARNING POINTS

Investment techniques

Focused investing:- Invest heavily in only a few stocks (10 stocks or lesser) that are perceived to be most promising.

Value investing:- Invest in stocks only when their price is below their intrinsic value to pay less than what the shares of a company is worth, and achieve greater returns.

Cut loss:- Short-term investors should adopt a strict cut-loss measure to sell out shares that have decreased by a certain pre-determined amount in price to prevent incurring huge loss.

Emotions kill at investing.  

Never catch a falling knife.

It is difficult if not impossible to accurately time a market bottom.

It is always prudent to analyse business fundamentals underlying a stocks before purchasing the stocks.

Average down only when stock prices are already significantly undervalued. Never average down on a free falling bear market to prevent catching a falling knife.
 
Cheap price may not mean value buy. Always check for any permanent problems with underlying business of stocks to make sure one is not inheriting a failing business.

For a diversified investment approach, an investor can consider exchange traded funds (ETFs).


An investor should live out an investment philosophy suitable to his personality so as to make investment decisions based on his philosophy and not emotions.

Avoid rebalancing of one's portfolio. Have the courage to ride the winners and weed out losers constantly.

Avoid high turnover in trading one's portfolio. Transaction costs is a drag to investment returns.

Value investing provides a protective margin of safety.


An investor may misjudge a company's intrinsic worth, so he should always seek to invest at share prices below the estimated intrinsic value per share of a company to gain a margin of safety to account for possible error in overestimating intrinsic worth of a company.

Buy-and-hold strategy can work well if an investor has applied it properly knowing when to buy, when to hold and when to sell a stock or investment product.

Compounding is an amazing effect that serves to grow an initial investment many times over in value through reinvestments. The higher the compounded annual rate of returns and the longer the time period of compounding, the higher will be the final value of an initial investment.

The stock market is not always efficient. Prices of stocks can be traded at ridiculously low or high valuations at times.

The stock market is random. Stock prices may not always follow through trends and can change suddenly. Make use of market price fluctuations to one's advantage.

Valuation techniques
 
Hunt for stocks with high current and future projected yields on investment:-
Take current EPS divide by current share price and multiply by 100% to calculate current yield. Take future projected EPS (after certain number of years) divide by current share price and multiply by 100% to calculate future yield. That will be the future yield of returns on an investor's investment dollars.

One can estimate the intrinsic value of a company by using the discounted cashflow method (DCF method). This valuation technique assumes that a business is worth the present value of all it's future projected cashflows. A note when using the DCF method is that future cashflows are only estimates and the estimated intrinsic value per share of a company using DCF is ONLY an estimate at best. Thus, value investors should invest at a margin of safety below the estimated intrinsic value per share of a company.

Fundamental Analysis

Free cashflow = Net cash from operating activities - Capital expenditure

Look for companies that shows consistent growth in net cash from operating activites while maintaining low capital expenditure, and has consistent high return on equity (ROE).

Ability to consistently generate high free cashflows from a business allows the cash to be reinvested in the business or to be paid as dividends to shareholders.

Return on equity (ROE) is an important metric for measuring a company's profitability. Consistently high ROE (15% or more) for many years of a company's operating history is desirable. An investor should also take note of a company's financial leverage when using ROE to make sure a company is not risky by taking on excessively high amounts of debts.

It is important to examine trends in the financial statements of companies over a period of time (e.g. last 5 to 10 years) to uncover any consistency or inconsistency in the economics of a business. A one-off recent spectacular performance by a company may not necessarily indicate consistency to perform in future. Similarly, a one-off recent underperformance may not necessarily indicate permanent deterioration in business fundamentals. Be aware of non-recurring exceptional items in any financial statements that may undermine or overestimate a business's true economics. Always look for possible consistency in the business fundamentals and make sure the consistency is still intact.

Net asset value (NAV) per share also known as book value per share or equity value per share is the value of a company's assets less the value of its liabilities.

Net asset value (NAV) = Total assets - Total liabilities
It is a misconception that shareholders of a company should get back the NAV per share worth of compensation upon winding up a company. This is because assets of a company may be sold at lower firesale prices than its carrying price stated in financial statement upon winding up the business. Shareholders may get back lower than NAV per share value of compensation or even no compensation upon winding up of a company after it has paid off all liabilities.

One should consider the liquidity of a company to evaluate it's short-term financial health. To do so, one can consider the types and proportion of current assets held by the company such as cash and cash equivalents, short-term investments (e.g. equities held for trading), account receivables and inventory. Cash and cash equivalents are the most liquid current assets that can be readily converted into cash while inventory are the least liquid current asset that is most difficult to convert into cash. The company that can readily convert it's current assets into cash will be able to meet it's current liabilities ensuring good short-term financial health. 

To assess the short-term financial health of a company whether it has current assets able to meet it's current liabilities, one can look at a few financial ratios and calculations such as current ratio, quick ratio and cash conversion cycle.

REITs investing

When investing in REITs, do not just focus on annualised distribution yield alone which can be misleading since it changes according to the REIT's traded unit price which can fluctuate. Instead focus on core fundamentals such as:-
- performance of trends of growth over the years in the amount of income distribution to unitholders, rental revenue and net property income.
- average income yield of properties in the REIT,
- occupancy rates over the years,
- track record in refinancing loans on time,
- gearing of less than 40 plus %,
- diversified rental income sources from different types of tenants,
- built-in rental escalation,
- security deposits on rental,
- long average rental lease period to expiry,
- no large number of rental leases (expressed as % of gross rental income) expiring over any single year,
- no significant overcontribution from a single tenant,
- honest and capable management that are shareholder friendly,
- interest coverage ratio of more than 1.5,
- low interest rate on borrowings, 
- consistent growth in EPU and DPU (examine carefully the reason if there is a dip in EPU and DPU for a particular year).
Also seek to invest significantly below the NAV of the REIT to gain a margin of safety.

Rights issue

Rights issue is an invitation by a company to it's shareholders or other investors to purchase more shares in the company at a discounted price to the current market price of it's shares.

Look for rights issues that are supported by full underwritting from an investment bank. This ensures that the company / REIT raising the rights issue can obtain it's funding regardless of whether the rights shares/ units are eventually undersubscribed or oversubscribed.

Theoretical ex-rights price is an estimated stock price after factoring in the effect of the rights issue. One can use the theoretical ex-rights price to compare with one's eventual average holding price after purchasing new shares through the rights issue to make sure one's eventual average holding price is not too steep above the theoretical ex-rights price.

Check carefully whether a rights issue consists of renounceable or non-renounceable rights. Renounceable rights offer existing shareholders the choice to sell their rights entitlement to other investors during the nil-paid rights trading period should they not want to hold the rights to purchase the new offered shares. This is so that existing shareholders that do not want to exercise their rights to purchase new shares can receive some compensation for the eventual dilution of their investment in the company.

To determine how much is the rights entitlement worth, take the difference between the theoretical ex-rights price per share and the rights issue price per share. An existing shareholder (who does not want to purchase new shares) should seek to sell his rights entitlement above this calculated rights entitlement value during the nil-paid rights trading period. On the other hand, a new investor (who wants to purchase new shares) should seek to buy at below the rights entitlement value for a bargain.

Be careful of companies that frequently raise rights issue only for paying down debts. This may signal problems with the financial health of the company. Rights issue is preferred for reasons such as fulfiling acquisition and growth plans. This ensures potentially increased future shareholders' earnings from yield accretive ventures.

Cash conversion cycle

Cash conversion cycle measures how fast a company sells its goods (inventory), how fast it collects payments from goods sold (receivables), and how long it can hold on to the goods before it has to pay its suppliers of goods (payables).

Cash conversion cycle = Days in Inventory + Days in Receivables - Days Payable Outstanding

Red flags to look at when assessing the cash conversion cycle include increasing days in inventory, low inventory turnover, high number of days in receivables and low number of days in payable outstanding, all these escalating for prolonged period of time which may damage the business resulting in significant losses.

One should compare the cash conversion cycle for similar competitive businesses in same industries and sectors to have a fair comparison on which business has a better cash conversion cycle than its competition, since cash conversion cycle may differ widely if comparing businesses in very different industries and sectors.

Generally, lower number of days for the cash conversion cycle is preferred over a higher number of days.

Industry analysis

There are five competitive forces driving industry competition. These forces drive returns in an industry to a perfectly competitive level, thus constraining any companies in an industry from achieving supernormal returns. These five competitive forces are:-
1. Bargaining power of buyers (customers)
2. Bargaining power of suppliers
3. Threat from potential entrants
4. Threat from substitutes of products or services
5. Intense competition among existing companies in an industry

It is important to check whether a company has both strong bargaining powers as buyers of goods/ services and suppliers of goods/ services before investing in the company. Bargaining powers as buyers and suppliers affect the competitiveness and margins of the company.

To deal with the threat from potential entrants into an industry, existing companies engage in two strategies:
1. Sending clear message to the new entrants that if they cross over a certain tolerance line they will be subjected to strong retaliatory attack until they are driven out of the industry.
2. Putting different types of barriers in the path of new entrants.

An investor has to consider in his assessment of a company whether it is facing much intense competition with rival companies in an industry based on different possible factors promoting competition. Intense competition reduces returns in an industry.

An investor needs to consider any potential threat from substitutes of products or services to an existing company to see whether the company has downside pressure to it's margins due to such threats.