System Thinking - A Comprehensive Guide to Earning Consistently
Unlock Proven Techniques for Profitable Investing, Risk Management, and Long-Term Wealth Building in the Stock Market
Question Everything
A common trait of beginner investors is accepting information at face value without questioning it.
An analyst's report indicates that the imbalance between supply and demand is fueling growth, with product prices expected to stay elevated in the near future – a strong signal to buy, buy, buy.
In 2022, U.S. analysts predicted energy stocks, particularly oil and gas, would skyrocket due to global supply shortages. Investors rushed to buy companies like ExxonMobil and Chevron, thinking prices would stay high. But as supply chain problems eased, prices fell, and some investors faced losses.
Look at the big picture at that moment:
ExxonMobil's Performance: ExxonMobil reported earnings of $55.7 billion and cash flow from operations of $76.8 billion in 2022, marking one of its best years in the last decade. The company also increased production in Guyana and the Permian Basin by over 30%.
Chevron's Success: Chevron achieved record earnings and cash flow in 2022, allowing for increased capital returns to shareholders.
Price Declines in 2023: As supply chain issues were resolved, oil and natural gas prices dropped significantly in 2023. Natural gas prices in the U.S. fell by 50% in Q1 2023, trading around $2/MMBtu by mid-April. In Europe, prices fell to approximately €36/MWh, a two-year low from record highs of €340/MWh in August 2022.
The company's financial report showed that profits were lower this quarter due to the costs of expanding their sales network and increased investments. They also spent a lot on research and development, which is expected to improve product competitiveness.
Consider Tesla in the early 2010s. It was investing heavily in building factories across the U.S. and Europe. Many investors bought in despite early losses, confident that the spending would lead to future dominance. Some profited, but others who entered late faced volatility.
The Tesla's Stock Performance and Financials
IPO Date: June 29, 2010
IPO Price: $17 per share
Shares Offered: 13.3 million shares
Total Raised: $226 million
IPO Split-Adjusted Price: Approximately $1.13 per share after two stock splits (5-for-1 in August 2020 and 3-for-1 in August 2022).
Recent Stock Price: Closed around $300 per share as of September 2022.
2010-2022 Growth: A $10,000 investment at the IPO would be worth approximately $2,643,178 today, representing a 26,332% increase over 12 years.
2010: Tesla went public; faced early production challenges but began ramping up Model S production.
2013: First profitable quarter; production issues resolved, leading to increased sales.
2020:
Recorded four profitable quarters in a row.
Market capitalization reached $206 billion, surpassing Toyota to become the largest automaker by market cap.
2021:
First annual profit reported for 2020.
Stock price peaked at around $410 before declining.
2022:
Delivered over 936,000 vehicles, a nearly 50% increase from the previous year.
Stock price fell by 65% overall throughout the year due to various factors, including supply chain disruptions and concerns over Musk's acquisition of Twitter.
An expert says that market competition is easing and a turning point is approaching, calling it "the darkness before dawn." Therefore, I plan to be patient and invest heavily, believing that time will validate my choice. However, it is not always true.
After facing significant losses, you learn how tough investing can be and realize that many companies' rosy forecasts don’t always come true. The key to successful investing is finding those few companies that consistently deliver and offer real certainty.
A perfect example of this mindset happened during the 2008 financial crisis. Some experts in Europe believed the worst was over, and investors piled into banking stocks like Barclays and Deutsche Bank. Unfortunately, the market continued to fall, and those who acted too soon lost even more.
January 2008:
Barclays shares open at £427.50 on January 1.
By January 31, the share price drops to approximately £400, reflecting growing concerns over the banking sector.
March 2008:
March 7: Barclays shares decline to £425.50 amid fears related to Bear Stearns' collapse.
March 17: Following Bear Stearns' acquisition by JPMorgan Chase, Barclays shares rise slightly to £450 as investors look for stability.
April 2008:
April 18: Barclays shares reach £496 as the Bank of England announces a £50 billion plan to support banks.
June 2008:
Some experts express optimism about the banking sector, leading to increased buying activity.
Barclays shares peak at around £550 during this period as investors anticipate recovery.
September 2008:
September 26: Barclays shares drop to £366.50 as Lehman Brothers files for bankruptcy, causing panic in the market.
October 2008:
October 10: Barclays shares fall to £207.50 as the market reacts negatively to ongoing financial instability.
October 31: The share price declines further to £179 after Barclays announces a costly fundraising effort, causing investor concern.
November 2008:
Following the announcement of significant losses, Barclays shares rebound slightly to £85 on November 26, reflecting renewed investor confidence after the bank reassures the market of its stability.
It's no surprise that companies like Coca-Cola in the U.S. and Nestlé in Europe are highly valued. They consistently meet expectations and rarely surprise investors. Even when companies like Apple or Volkswagen report disappointing results, investors stick with them due to their strong track record.
Looking back, I didn’t value certainty when I was younger. I focused on high-growth companies, believing that stable, slow-growth ones were overpriced and dull. I couldn’t see how they could generate significant returns.
Now, I’ve learned that a certainty-based investment strategy leads to steady profits over time.
Companies with high certainty, like Microsoft in the U.S. or L’Oréal in Europe, are best held long-term. Even if you pay 30% above their fair value, holding them for five years typically yields good returns. However, for companies with lower certainty, holding them for a year can be risky, and paying a high price might hurt your returns.
Once you grasp the importance of certainty, you reach a more mature stage in investing. You’ll recognize the value of sustainable business models, competitive advantages, and industry outlooks.
You can read this article. Why I want to buy Japanese Yen?
With this mindset, you start questioning everything about a company.
Is the company's revenue growth sustainable, or is it driven by temporary factors?
How does the company manage its debt, and what are the implications for its financial health?
Are there any potential regulatory or legal risks that could impact the company’s profitability?
How does the company’s innovation pipeline look, and is it sufficient to stay competitive?
What is the company's customer retention rate, and how does it affect long-term growth?
How effective is the company's supply chain management, and could disruptions impact its operations?
Will aggressively expanding distribution channels increase costs beyond what’s profitable?
What are the company’s major cost drivers, and are they under control?
How does the company compare to its competitors in terms of market share and profitability?
Can the company achieve its ambitious production goals?
Are there any recent or upcoming changes in leadership that could affect the company’s strategy?
Are price increases genuinely due to high demand, or are products accumulating unsold in warehouses?
How is the company addressing environmental, social, and governance (ESG) issues, and what impact might this have on its reputation and financial performance?
Amazon's competitive advantage comes from its dominance in the online marketplace, customer focus, and diverse revenue streams. The company leads in retail with nearly 50% of its products sold by third-party sellers, offering a wide range of items and flexibility for vendors. Its strong commitment to customer service, convenience, and a seamless shopping experience builds trust and loyalty. Amazon's revenue is spread across various segments, including online and physical stores, third-party seller services, subscriptions, and its profitable cloud computing division, AWS, which saw a 17% revenue increase in 2023. Despite these strengths, Amazon faces challenges like rising costs, supply chain issues, and regulatory hurdles, such as the blocked iRobot acquisition. The company's goal to achieve net-zero carbon emissions by 2040 and innovations like the AI-powered assistant Rufus aim to boost sustainability. To stay ahead, Amazon needs to keep innovating, manage costs, and address regulatory issues, all while competing with rivals like Microsoft and Walmart.
With this level of scrutiny, you'll likely focus on reliable blue-chip stocks. These stocks often trade at high prices and may even be overvalued because investors value certainty. Achieving extraordinary returns can be tough unless you're willing to buy during market downturns.
Even though understanding certainty is important, many investors eventually pursue more aggressive strategies to exploit market expectations.
What is Market Expectation Deviation?
You can read this article. what is the price mechanism.
Stock prices are influenced by market opinions, which can cause fluctuations when these opinions change. An expectation gap happens when you spot something others haven’t yet noticed. This gives you a chance to buy a stock before its price goes up and sell before it drops.
Tesla, Inc.
At the start of 2020, many analysts worried about Tesla's ability to maintain its rapid growth and profitability due to rising competition and production issues. However, some investors saw potential in Tesla's innovative technology and its capacity to scale production effectively.
By the end of 2020, Tesla's stock price skyrocketed over 700%, fueled by strong demand for electric vehicles and successful production scaling, proving the optimistic outlook of those who spotted the expectation deviation.
Many research reports today include a section that says, "The market is generally concerned about…", followed by, "Our differing view is…"
This represents the expectation deviation. To profit from it, you need to understand both the market's concerns about the company and where your insights differ. In contrast, making money with certainty simply involves studying the company itself.
In investing, "expected deviation" can be categorized into three types:
Performance deviation is the deviation between an investor's forecast for a company's revenue and profit versus market expectations, and it requires detailed analysis but is often more accurate.
Valuation deviation happens when a stock is seen as either undervalued or overvalued due to misunderstood aspects of the company's business or industry, and while it’s easier to spot, it’s less reliable.
Industry trend deviation involves evaluating broader industry trends and macro factors like policy changes, which requires a higher-level analysis but helps in balancing risk and reward.
Performance Deviation
When we analyzes a company, we need to have a profit model that focuses on 2 main aspects
Forecast the operating income in the 5 years by considering several key factors, including downstream demand, user retention rate, product pricing, production capacity, and capacity utilization across different business segments.
Predicting profits for the next 5 years by examining past data, such as the company’s cost structure, profit margins, and expense rates.
Let us analyzing Apple Inc’s profit model and cost structure
Profit Model
Profit Sales: Selling products like iPhones, iPads, Macs, and accessories. They set high prices for these products, which helps them earn higher profits.
Services: Apple also makes money from services like the App Store, Apple Music, iCloud, and Apple TV+. These services typically have better profit margins than their hardware.
Ecosystem Lock-in: Apple creates a connected ecosystem of devices and services that encourages customers to stick with their products and buy more.
Cost Structure
Cost of Goods Sold (COGS): This includes the costs of making and sourcing parts for their products.
Research and Development (R&D): Apple invests a lot in developing new technologies and products.
Marketing and Advertising: Apple spends a lot on marketing to promote its products and maintain its premium brand image.
Operational Expenses: These are costs for running the company, like administration, logistics, and customer support.
Securities information software platforms aggregate the average forecasts of multiple institutions, which directly shape market expectations. Analysts regularly update their revenue and earnings forecasts for companies like Apple, particularly after major events like new product announcements and strong quarterly results.
As analysts revise their forecasts upwards, the stock prices generally follow suit, reflecting investor optimism about the company's performance. This suggests that the stock price movements are driven by changes in expected performance rather than valuation adjustments.
If your independent analysis consistently predicted better-than-expected results for Apple, you would have capitalized on this performance expectation deviation as well. The fact that Apple's stock price has generally followed analyst forecast revisions suggests that the stock price movements are driven by changes in expected performance.
Performance prediction is the most reliable but difficult strategy because it requires in-depth knowledge of the company’s future production capabilities and market demand.
How well a company plans to expand its operation to meet the future demand?
How much of the company’s capacity will be used? Analyze production processes, past performance, and possible bottlenecks
Understand the industry’s competitive environment well such as consumer preferences, economic conditions, demand shift and competitor behavior.
Understand the structured process of fund managers managing their funds. Senior analysts, who have strong connections and deep insights, focus on analyzing blue-chip companies. It’s unlikely that our understanding would surpass theirs. Meanwhile, junior analysts dive into less well-known companies, doing detailed analysis on their financial health, business models, and competitive advantages.
We can easily find stocks that are not covered by these fund institutions, helping us spot potential performance gaps.
Also, we can easily find small-capped stocks that operating within major industry trends. When a breakthrough in product or business happens, their performance can often fall short of expectations.
C3.ai
Industry: Artificial Intelligence (AI) Software.
Platform: C3.ai offers a platform to develop and deploy AI applications for businesses, helping them make data-driven decisions.
Date: December 9, 2020.
IPO Price: $42 per share.
Peak: Rose to ~$180 in early 2021 due to high interest in AI.
Current Price: Trading between $15 to $20, with notable volatility since its peak.
Revenue Growth: 17% increase in fiscal year 2023, reaching $267 million.
Industries Served: Manufacturing, financial services, healthcare, utilities, and more.
Applications: Over 40 AI tools for various business needs, including demand forecasting and ESG performance.
Enterprise Focus: C3.ai is a leader in enterprise AI, helping companies integrate AI with their existing systems.
This company are positioned for significant growth due to subtle shifts in the AI industry.
Historically overlooked by major research institutions, either due to past poor performance or an unattractive industry outlook, they have seen little market attention.
They are first identified by long-term industry observers or influential commentators.
This performance gap attracts interest from private equity, speculative investors, and buy-side analysts, driving initial stock price increases. This momentum leads to broader coverage by research firms, sparking a second growth phase. As the companies meet performance expectations, a third wave of growth often follows.
Blue-chip stocks - Fewer opportunities and higher market expectations
Lesser-known - Present obvious performance gaps but requires you with deep industry knowledge and insight.
Valuation Deviation
The performance gap is harder to spot but tends to be more accurate, while the valuation gap is easier to find but less reliable.
A common misconception about the "valuation gap" is that it reveals hidden market inefficiencies or opportunities. In other words, the market doesn’t fully understand a company’s business model, competitive advantage or industry. In reality, the so-called gap often reflects nothing more than differing investor perspectives on future performance, rather than a true mispricing of the asset. In fact, for every stock, there are always both optimists and pessimists. The stock price represents the market’s overall perspective. Unless your perspective matches the market’s overall perspective, if not, you will likely think the stock is either overvalued or undervalued.
Sometimes, when a stock is called undervalued and then rises, it’s due to industry growth or better business performance, not a change in how it's valued.
Both performance gaps and valuation gaps disappear as soon as key factors change.
This is because many companies face uncertainties like hidden debts, complicated relationships, or management issues. To avoid these risks, some investors focus on a third kind of gap—industry trends.
Industry Trend Deviation
The performance gap and valuation gaps come from analyzing individual stocks (bottom-up research), while the industry trend gap focuses on studying industries as a whole (top-down research).
Profit opportunities emerge because different investors have varying perspectives on the future size of an industry, which can diverge from the prevailing market view.
To capitalize on these opportunities, you need to focus on industry-level changes and pay attention to macroeconomic factors, such as shifts in government policies, consumer preferences, and technological advancements.
In the early 2010s, Tesla was an innovator in the electric vehicle (EV) sector, while most automakers were still invested in internal combustion engine vehicles. Initially, the market did not fully appreciate Tesla's innovative products, vertical integration, and direct-to-consumer sales model.
However, as global adoption of EVs accelerated due to advancements in battery technology, stricter emissions regulations, and increasing consumer awareness, Tesla’s stock price soared. Investors who recognized the industry trend and Tesla’s leading role saw substantial returns. By 2021, Tesla had become the world’s most valuable automaker, with its stock price increasing over 1000% from its 2013 IPO price.
When dealing with 3 types of expectation gaps, you need to look at both the odds and the success rates. This involves assessing how big the gaps are and whether the risk is worth taking, which is a more quantitative approach.
You can read this article. Kelly's formula provides a framework for determining the optimal size of a series of bets or investments based on the probability of winning and the potential odd.
Investing in blue-chip stocks is based on the idea that the chances of success are higher than the risk involved. This is a qualitative approach, focusing more on understanding the business logic than on precise profit predictions. The goal is to make sound decisions rather than just accurate forecasts.
At the start of industry trends, certainty often comes from believing that broader economic policies are more reliable than industry trends, and industry trends are more reliable than the performance of individual stocks.
Broader economic policies > Industry trends > Performance of Individual stocks
When investing in blue-chip stocks, it’s often less important to focus on current valuations and industry trends. Instead, it's better to concentrate on the quality of the company’s decisions.
Eventually, many experienced investors eventually return to investing the blue-chip stocks after exploring the expectation gap-based investment styles.
Summary
Expectation Gap-based Investment Styles
Duration: Short-term, usually within one to three quarters.
Outcome: Profits if the market is wrong, losses if the market is right.
Returns: Potentially high but with average chances of success and the risk of significant losses.
Approach: Involves trying to be right when the market is wrong. As investment teams become more skilled and information is more readily available, these opportunities are decreasing, making it harder to outsmart other teams.
Buying into the blue-chip stock Investments:
Duration: Long-term, focusing on steady, compound growth.
Outcome: Relies on consistent returns from ongoing investments rather than quick gains.
Approach: Based on business experience and insight, focusing on long-term growth. This method doesn't require specialized knowledge or teamwork.
Many experienced investors who initially focused on expectation gap-based strategies have shifted back to blue-chip stock investments. They discovered that consistently beating the market is rare and prefer steady, reliable gains through safer investments. This approach emphasizes patience and consistent returns over chasing quick profits, marking a return to a more straightforward and disciplined investment style.
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