Second-Order Systems and Their Implications

And how I try to outperform

Author's Avatar
Mar 24, 2022
Summary
  • How would you approach the stock market if you could predict future events?
  • I outline one reason why prediction helps little, and its implications for investors.
  • As a more enterprising investor, I list a few key elements of my approach with the aim to outperform the system without predicting the future.
Article's Main Image

While writing this piece at the moment on March 16, 2022, I easily feel an empty street through the window, even during the rush hour of this late afternoon. My city is nearly in lockdown, alongside many peer cities in the world’s second-largest economy, in combat with the pandemic. Globally, our health care systems have been under pressure for the last two years, seeing no light at the end of the tunnel yet. Still, most of our daily life continues to be impacted (think travel and dining out here). De-globalization appears to become a global theme (both physically and mentally, I would say). Business managers across regions and sectors are commonly facing supply-chain disruption and labor shortages. “Antitrust” and “inflation” (if not “stagflation”) have become frequent words in news headlines over many major markets. And indeed, the list would be by no means near completion without mentioning the war going on in Ukraine.

Now take a minute to imagine that at the start of 2020, you were able to predict all these – at that point, how would you, for the next two years, plan to approach the stock market, which was then hitting all-time highs? It may look logical for investors to stay as far away as possible. Nonetheless, stocks turned out to have great years in 2020 and 2021. At the time of this writing, even after recent sell-offs, the broadly diversified MSCI ACWI All-cap Index (ACWI) has delivered a solid 21.5% total net return in USD since 2020. So, what were those investors missing there?

The stock market is a second-order system: it is not the future events but the consensus view regarding the events that matters in determining the short-term share price movement. Since it is extremely difficult (if not impossible) to gauge other market participants’ perception with consistent accuracy, the optimal approach for most investors (although being counterintuitive to some degree) is to allocate long-term money to participate in the future prosperity of this planet and make every attempt to ALWAYS stay in the game, in my view.

As a more enterprising investor, I aim to do a little better over time than average participants who always stay in the game. It is worth noting that those "average participants" (i.e., passive investors buying low-cost, diversified index funds) have a reasonably high chance to do better over time than most other investors (including many well-educated Wall Street professionals).

Given the uselessness to predict future events, I guess that the remaining portion of this article can be better spent to explain how I try to beat hard-to-beat average Joe with their passive index funds (without predicting the future). I am going to take this opportunity to elaborate in the context of the companies that I have been dealing with.

For one, I exclusively look for the high-quality companies which generate consistently superior cash returns on capital with a healthy balance sheet – this applies to my companies of focus.

I prefer to partner with shareholder-oriented, entrepreneurial-minded capital allocators with skin in the game – most of my favorite companies are still led by their founders, all of whom tie the majority of their lifetime wealth to the prospect of their businesses.

I get excited by “boring” businesses, which tend to go under-noticed – for example, Kato (HK) Holdings (

HKSE:02189, Financial) is the leading elderly home services provider generating software-like profitability and facing consistently unmet demand in the aging society of Hong Kong.

Instead of trying to “predict” future winners, I concentrate on those who have already won – for example, Integrated Diagnostics (LSE:IHDC) owns more than 50% of the private-sector diagnostics market in Egypt; LaCroix, a sparkling-water brand owned by National Beverage (

FIZZ, Financial), has become the most Instagram-able beverage among millennials in the United States.

I appreciate under-appreciated market leadership – for example, being lesser-known to the investing community, Plover Bay (

HKSE:01523, Financial) is the world’s top player in the wireless SD-WAN space that has been rapidly developing due to the 5G rollout; Kaspi.kz is the super-app that dominates almost every vertical of people’s daily life in Kazakhstan, which is best known for its energy resources;

I watch the downside in the first place – most of my investments do not have any debt and generate repeatable/recurring sales. I like to deal with businesses that do not need investors' money – all of my companies require low capital expenditure to sustain and even grow their operations while producing predictable, abundant cash-flows onto their balance sheets;

I favor secular growth – all of my investments enjoy one or more major industry tailwinds, such as digitalization (e.g., Check Point (

CHKP, Financial), Plus500 (LSE:PLUS, Financial)), aging population (e.g., Bioventix (LSE:BVXP, Financial), premiumization (e.g., a2 Milk (ASX:A2M, Financial)), etc.

Despite the high quality, I strive to avoid paying a premium for shares – opportunities may emerge thanks to market biases/under-appreciation as mentioned above, fire sales in special situations (e.g., liquidity of some Eastern Europe funds) and intense market panic (e.g., March 2020).

Concerning expected total return, I would like to have a fairly high hurdle rate compared to most investors – this is possible thanks to a larger-than-average investable universe across market caps and geographies.

I tend to ignore market/macro noises – economic downturns and market crashes would actually benefit my companies in terms of creating shareholder value in the end (in the sense that they can gain market shares from struggling peers and repurchase shares at lower prices).

Lastly, I attempt to be inactive in the market – investors are their own worst enemy (by acting too much).

When it comes to stocks, discussions usually prevail regarding near-term projections (think “price target” here), which could be seen as a fool’s errand, in my opinion. Although being unable to offer any insight into the stock market for the next 12 months (or even a bit longer), I know for sure that lower share prices can lead to higher-return opportunities and that stocks tend to go up over the long term (that is, the only term that counts for investors).

Happy investing!

Disclosures

I am/ we are currently short the stocks mentioned. Click for the complete disclosure
Rating:
5 / 5 (3 votes)
2 Comments
Load More

GuruFocus Screeners

Related Articles