Fundoo Professor

Fundoo Professor is Moving

2008-10-13T16:00:00.003+05:30

Fundoo Professor is moving to a new location. Here is the link.

Thanks

Sanjay Bakshi

BFBV Page

2008-10-11T15:36:00.002+05:30

BFBV course page can now be viewed from here.

Thanks

Sanjay Bakshi

Articles in Outlook Profit

2008-09-19T16:23:00.006+05:30

These can be viewed from here.

Thanks

Sanjay Bakshi

The Snowball Effect as a Positive Feedback Loop

2008-09-12T06:03:00.005+05:30

Subject: RE: The Snowball Effect

From: sbakshi@mdi.ac.in

Date: Fri, September 12, 2008 6:17 am

To: "Ajay Singh Bhati"

Dear Ajay,

In my view, its not correct to always view positive feedback loops in business as destructive, though they well might be. For example a run on a bank can bring it down on its knees in a very short time period and it can spread (systemic risk) to other banks. Similarly stock market bubbles can be thought of positive feedback loops - high prices feed optimism which feeds high prices - it does not last for ever, but it can last for a long long time.

I think you're on the right track when you visualize a positive feedback loop as a mechanism which is nested inside a negative feedback loop. To illustrate, why do bear markets follow bull markets? Because over the long run, markets operate inside a negative feedback loop with built-in corrective mechanisms. When prices run too far away from underlying values, there are forces that pull them back. For example, when stocks become too cheap in relation to the replacement cost of the underlying assets, there is no incentive to create new capacity and industry consolidation is likely to take place wherein the strong players in an industry, instead of creating new capacity, buy out competitors.

Conversely, when stock prices rise so high that they become much more than the replacement cost of the underlying assets, strong incentives are created by those high prices, to create fresh capacity. So shortages follow gluts follow shortages.... - hence a negative feedback loop.

But what caused the speculative bubble in the first place? Why do people suddenly become euphoric about an industry or a sector and invest in it in unison? That part of the answer is better explained by positive feedback loops.

Its also important to view positive feedback loops as means of explaining some of the extreme business successes. I gave two examples in class of the dominant newspaper, and Wal-Mart. But one can think of others. For example, in some industries, the first mover has a big advantage. He goes and captures a very large part of the market and obtains scale economics. And once he's done that, it becomes very difficult to dislodge him. Airtel is one example which comes to mind. There are, I am sure, several other examples...

Rgds

==SB

Sir,

Can it assumed that snowball effects (positive feedback) constitute a small alternate parts of negative feedback loop? (Since in a negative feedback loop, balancing acts take place after increase in one of the aspects -- may be a result of snowball effect -- of the process. Also snowball effect generally ends with destruction resulting in the onset of the reverse process.)

Regards,

Ajay Singh Bhati

-----Original Message-----

From: sbakshi@mdi.ac.in [mailto:sbakshi@mdi.ac.in]

Sent: Wednesday, September 10, 2008 7:34 AM

To: bfbv@mdi.ac.in

Subject: The Snowball Effect

Shareholder: You've acknowledged that it's a more difficult investment and business environment today than it was when you first started out. If you were starting out again today in your early thirties, what would you do differently or the same in today's environment to replicate your success? In short, how can I make $30 billion?

Buffett: Start young. As Charlie's always said, the big thing about it is we started building this little snowball on top of a very long hill. We started at a very early age in rolling the snowball down. And of course, the nature of compound interest is that it behaves like a snowball in sticky snow. The trick is to have a very long hill - which means either starting very young or living to be very old.

If I were doing it in the investment world, I would do it exactly the same way. If I were getting out of school today and I had $10,000 to invest, I'd start with the A's.. (The companies whose names begin with the letter "A") And I probably would focus on smaller companies - because I'd be working with smaller sums and there would be a greater chance that something would be overlooked in that arena.

Buffett: As Charlie said earlier it won't be like doing that in 1951 when you could leaf through and find all kinds of things that just leapt off the page at you. But that's the only way to do it. You have to buy businesses - or little pieces of businesses called stocks. You have to buy 'em at attractive prices. And you have to buy into good businesses. That advice will be the same 100 years from now. That's what investing is all about.

And you can't expect anybody else to do it for you. People will not tell you about wonderful, little investments. It's not the way the investment business is set up.

Buffett: When I first visited GEICO back in January of 1951, I went back to Columbia the rest of that year; but I subsequently went down to Blythe & Company, and actually to one other firm . that was a leading analyst of insurance. I thought I'd discovered this wonderful thing - so I'd see what these great investment houses that specialized in insurance stocks said. And they said I didn't know what I was talking about. It wasn't of any interest to them.

You've got to follow your own ideas - with the caveat that you've got to learn what you know and what you don't know. And within the arena of what you know, you have to pursue it very vigorously and act on it when you find it. You can't look around for people to agree with you. You can't look around for people to even know what you're talking about. You have to think for yourself. If you do, you'll find things. Charlie?

Munger: The hard part of the process for most people is the first $100,000. If you have a standing start at zero. Getting together $100,000 is a long struggle for most people. I'd argue that the people who get there relatively quickly are helped if they're passionate about being rational, very eager and opportunistic, and steadily under spend their income grossly. I think those three factors are very helpful.

Behavioral Finance & Business Valuation

2008-09-10T07:53:00.002+05:30

My course at MDI started yesterday. The course outline can be downloaded from:

http://tinyurl.com/5ttus5

Thanks!

Seven Documentaries To Watch

2008-06-11T08:33:00.002+05:30

Here are seven documentaries I loved watching. They can be viewed from:

SEBI Eliminates Gimmickry in Buybacks

2008-05-16T13:52:00.003+05:30

In December 2007, I wrote about a stock buyback announcement made by Mastek (MAST@IN). See "The Mystery Behind Mastek's Buyback."

In that post, I had written:

"Why did the company give a maximum price of Rs 750 per share for its buyback, even though the current market price is Rs 280 per share? Indeed, adjusted for stock splits and bonus issues, this company has not seen its stock price hit Rs 750 in the last seven years."

That post attracted many comments some of which dealt with the possible gimmickry in buyback announcements when buybacks are to be conducted thru open market purchases.

Fast forward to today when Mastek published an important notice in The Financial Express (page 11, New Delhi edition dated may 16, 2008). The company disclosed that SEBI has directed it to:

1. place orders for buying back shares from the market "at least once a week at market related prices during the periods when the market price is lower than the maximum buy-back price such that the amount of buy-back is exhausted expeditiously"; and

2. not to close the buyback without completing it except under exceptional circumstances, with prior approval of SEBI.

Wow!

That will put a stop to some of the gimmickry.

Good work SEBI.

Bongy's Mating Dance with IOC

2008-05-07T19:35:00.009+05:30

Bongaigaon Refinery (BRPL@IN) whom I fondly call Bongy, has been engaged with Indian Oil (IOC@IN) since November 2006.

On November 29, 2006, Bongy announced her intention to get married to IOC. As per the terms of the marriage, the stockholders of Bongy were to get 4 shares of IOC for every 37 shares they were holding on the record date. They are still waiting for the marriage to take place...

Marriage is a very serious business in India. There is lots of planning to do, arrangements to make. And so, since that date in November of 2006, Bongy is still waiting to mate with IOC because her parents, and those of IOC, have yet to give their assent. Interestingly, both Bongy and IOC have the same parents, so I guess, this is going to be an incestuous marriage, which is even more complicated than an Indian arranged marriage:-)

A long engagement period has made Bongy quite restless, as you can see from the chart below (click on it to get a better view):

Since 37 shares of Bongy are to be exchanged with 4 shares of IOC, Bongy should sell for 4/37th or 10.81% of IOC. The red line in the chart above depicts this steadfast relationship.

The red line is the marital bed from which Bongy must not wander too far away.

But its hard to keep Bongy waiting for her groom. She likes to wander away from the marital bed to return only occasionally. The blue line in the chart depicts Bongy's behavior since she got engaged- since then, her life has been volatile, and eventful.

Bongy's mischievous behavior presents opportunities to opportunists like me - arbitrageurs who bet on the outcome of marital events.

For instance, in early March of 2007, when Bongy was found to be somewhere under the marital bed, and not on it, people like me could either think of this as an opportunity to buy OIL cheaply thru Bongy, or we could simply buy Bongy and short IOC in the hope that Bongy will ultimately return to her marital bed, at which time, happy with the outcome, we would reverse our trades.

Then, sometime in June of 2007, Bongy decided to rise above the marital bed (see chart above), and she rose, and rose. Now why would Bongy do something like that? Could she justify her behavior? I asked her and she told me she can explain anything.

She said take a look at my assets, my productive capacity, my ability to generate cash, and compare them with my market value. She said, on a stand-alone basis, that is, if I call off this marriage, I am worth a lot more than the measly 10.81% of IOC. I checked this out, I compared her with other similar girls like Chennai Petro (MRL@IN), and I could not agree more with Bongy. She could indeed explain everything.

But a marriage is a contract we Indians take very seriously. Once Bongy had agreed to merge into IOC, it was not going to be easy for her to walk away. At least that's what some arbitrageurs must have bet, when in November 2007, they could effectively go long IOC at 534, and simultaneously go short Bongy at 98. This trade would have enabled a shrewd arbitrageur, to create Bongy shares thru IOC at a cost of Rs 57 and immediately sell them in the futures market at 98. Of course, this smart arbitrageur (not me) would have to carry forward his positions until March 24, 2o08 because on that date Bongy closed at 46.55 and IOC closed at 432.80. Bongy was now close to 10.81% of IOC, where she belonged. Grudgingly, she had returned to her marital bed. The arb could now reverse his trades and derive pleasure not only from his profits, but also from his successful enforcement of Indian traditions.

But Bongy is hardly traditional. Soon after her momentary visit to the marital bed, she decided to move away again (see chart). She now trades at 13.3% of IOC instead of 10.81%.

How long will it be before she returns to where she belongs?

Indian Overseas Bank Tries its Hand in The Alchemy of Finance

2008-05-07T08:40:00.003+05:30

I was amused today while reading a story in the Business Standard titled, "Indian Overseas Bank cashes in on Realty."

The paper reports that the Bank plans to "sell" some of its real estate to a "special purpose vehicle (SPV)."

The sale, at current market price, will produce a "profit" for the bank because the real estate is valued in its books at cost which is much below its current market value. This "profit" will increase the bank's capital adequacy ratio. Moreover, the bank will then lease the real estate back from the special purpose vehicle!

There is no mention of the SPV paying cash to the Bank for the acquisition of the real estate assets.

In other words, without actually selling the real estate (in economic, not legal terms), the bank will magically increase its capital adequacy!

Brilliant!

A simple revaluation of real estate wouldn't have worked. So, we now have this new attempt at financial alchemy. Reminds me of John Galbraith's words:

"The world of finance hails the invention of wheel over and over again, often in a slightly more unstable version. All financial innovation involves, in one form or another, the creation of debt, secured in greater or lesser adequacy by real assets."

How Weak is this Oily Chain?

2008-05-06T09:30:00.004+05:30

Today's Finanical Express carries an interesting column by Vikram Mehta, Chairman of the Shell Group in India.

The following passage caught my eye:

"Success in the exploration and production of oil & gas requires a company to overcome three interlocking sets of probabilities. The probability that a given geologic structure contains hydrocarbons [let's call this Event A]; the probability that hydrocarbons will be located [lets call this Event B], and the probability that once located, the find can be commercially exploited [let's call this Event C]."

Vikram's statement has vast practical implications for security analysts.

The market value of an asset is the present value of its expected future cash flows. Cash flows from an oil exploration company can be derived only out of hydrocarbons which can be commercially exploited. And for that to happen ALL of the above three events must happen.

Suppose that the probability of Event A happening is 40%, that of Event B happening is 20%, and that of Event C happening is 25%.

Then the probability of seeing cash flow which is valuable is 0.40 x 0.20 x 0.25 or 0.02. That comes to just 2%!

I wonder if the market participants think in those terms before valuing oil exploration stocks.

The man who said that "a chain is only as strong as its weakest link" was wrong.

He should have said "a chain has to be weaker than its weakest link."

Mary Mary, Not Quite Contrary!

2008-04-21T18:07:00.002+05:30

A few months ago, in August 2007, Mary Meeker, Morgan Stanley’s famous internet analyst published a bullish report on Google.

Google had just announced that its video web site, YouTube, would soon begin displaying video ads. In her report, Mary initially projected that YouTube’s video ads would result in incremental revenues of $720 million next year. But, while doing the number crunching for her report, Mary made a serious mistake. She took the price of the ads as “$20 CPM” to mean price per ad impression, and not per thousand ad impressions, which is what “CPM” means. In other words, she overstated projected revenues by a factor of 1,000. The actual projected incremental revenues, based on Mary’s corrected model were only $720,000, an insignificant number when compared with Google’s total revenues.

What’s interesting for us, however, is to observe what happened next. When Henry Blodget, another famous internet stock analyst, pointed out Mary’s mistake, on a public forum, she acknowledged her error.

However, instead of revising her overoptimistic conclusions, Mary left them intact! She rationalized them by revising yet another assumption in her model which resulted in much higher projected revenues for Google than would have been the case, had she not made this second revision, In her report update, Mary wrote: “In fixing the error, we also took the opportunity to dig deeper into our assumptions and.... we provide an updated scenario analysis of the opportunity.”

Mary Meeker’s response was not quite contrary to what most of us do, when we are presented with evidence which proves that our previous conclusions may be wrong. When we face such situations, our first reaction, almost always, is to discredit the new piece of evidence which proves us wrong. If we can’t do that, for example when the evidence is solid, we tend to invent other, new reasons, which would keep our prior conclusions intact.

Consider how a chain smoker, who smokes two packs of cigarettes a day behaves when he is first informed by his doctor that smoking causes lung cancer.

His first reaction is that of extreme discomfort arising out of two inconsistent pieces of information - that he smokes and that he was just informed by his doctor that smoking causes lung cancer. The chain-smoker, could, of course, eliminate the feeling of discomfort by quitting smoking immediately, but we know that is not going to be easy at all. Even the great Mark Twain, tried to give up smoking, and after having failed, once remarked, “Its not difficult to quit smoking, I’ve done it hundreds of times!”

One option before our chain smoking friend is to first discredit the medical evidence linking smoking and lung cancer. He could do that by questioning the validity of the medical research behind that finding, or, perhaps, by citing a silly the fact that he once knew a chain-smoking man who lived to a hundred years. Or, he will find other reasons for convincing himself that smoking isn’t really harmful, or that it helps him relax, prevents him from gaining weight etc.

The above example shows that we are capable of going to extremes in order to fool ourselves into believing that we’re right about things about which we are really wrong.

Contrary to the belief of most economic theorists, we’re really not rational animals. Rather, we are rationalizing ones. There are obvious lessons here for the readers.

Take the idea behind what is called as the “sunk-cost fallacy.” We’re obsessed with what it cost us to buy an investment. The cost of our investment is not just a financial commitment made by us - its also an emotional decision about ourselves. We like to think we were right. If the price of a stock moves up after we buy it, we take it as evidence of our intelligence and investing skills.

However, if it falls well below our cost, we tend to overlook negative developments about the company which we learn about subsequent to our purchase - or we tend to under-weigh such information, for example, by deluding ourselves into believing that the adversity our company is facing is only of a short term nature, and that its only a matter of time when our stock will soar.

We consciously ignore other alternative investment opportunities that become available to us, because we don’t want to buy them from cash realized from the sale of a dud investment. We fear that if we sell, we will suffer a loss, not realizing that the loss happened the day we made the wrong decision. We forget a fundamentally sound economic principle that, with a few exceptions, sunk costs i.e. what it cost us to buy a stock, are irrelevant in the sell decision.

Here’s an experiment I would recommend to all of you. Take a look at your portfolio without considering what it cost you to buy those investments. All you have is the name of each stock, the number of shares you own, the current stock price of each investment, and its current market value. Total up the last column to estimate the liquidation value of your portfolio. Notice, you’ve no idea about the cost of the individual investment, or of the entire portfolio.
Now, as objectively as you possibly can, ask yourself this question: “If I did not own all these stocks, but instead had the cash equal to their current market value, then would I buy them today?” Ask this question about every stock that is present in your portfolio. Sometimes the answer will be overwhelmingly “yes”. But when the answer is overwhelmingly “no”, you’ve to ask yourself as to why is the stock in your portfolio in the first place!

The reason why this experiment is useful is because it forces you to forget about the cost. It also forces you to start from a clean slate. When you start from a clean slate, your old past decisions will often appear to be silly, especially when they are compared with other, better alternatives. When you leave the baggage of past decisions behind, and start from a clean slate, you tend to become more rational.

The “sunk cost fallacy” is often reinforced by what is called as the “endowment effect” which shows that once you own something, you value it higher than before you owned it even though there is no rational reason for it.

Somehow, in our minds, our ownership of something wrongly increases its value. For example, just after placing bets, bettors at the racetrack become much more confident about their horse’s chance of winning the race. And lottery ticket buyers tend to buy more frequently if they are allowed to choose their own lottery tickets than when they are not. They also value their lottery tickets more highly if they personally chose them.

In a fascinating experiment, two groups of people were sold lottery tickets with identical chance of winning. Members of one group were allowed to choose their own tickets, while members of the other group were given randomly selected tickets. Immediately after the sale of tickets, but well before the results of the lottery were to be announced, members of both groups were individually asked to quote a price at which they would be willing to sell their tickets. The average quoted price for first group - those who were allowed to select their own tickets - was four times the average quoted price of the second group! Clearly, the act of buying the lottery tickets, when combined with the act of choosing the tickets themselves, magically increased their value to the first group.

There are vast practical implications of these simple experiments for you, dear reader. For you’re going to make mistakes. It’s inevitable that you will make mistakes in your buying decisions. You will face tremendous pressures that will tempt you rationalize your mistakes and not correct them. Your will tend to protect the status quo by inventing new reasons to hold on to a dud investment. This will be especially true when your original buying decision is known to many other people who are important to you. For it will hurt you to acknowledge to them, and to yourself, that you made a mistake, and it will be difficult for you to correct it because, ironically, you will attach more importance to saving face by appearing to be consistent with your past commitments, than trying to become a rational investor.

Contrary to what we may choose to believe, the functional equivalent of Mary Meeker is there in all of us.

Note:
The above piece was published in Outlook Profit, a new fortnightly magazine published by the Outlook group. Reproduced with permission.

Prof. Bruce Greenwald's Talk on Value Investing

2008-04-03T08:36:00.009+05:30

On January 8, I had the privilege of co-hosting (along with Dhananjay Lodha of Anagram and Chetan Parikh of Jeetay Investments) a talk on value investing delivered by Prof. Bruce Greenwald of Columbia Business School.

The talk, titled, "Value Investing Frameworks and Business Analytics" was delivered by Prof. Greenwald to an audience of 220 guests from the Indian investment community at Hotel Taj President in Mumbai.

Enrin Bellissimo, Director, Heilbrunn Center for Graham & Dodd Investing, and her colleague, Indira Almadi, gave us their enormous co-operation in organizing this function. Many thanks to both! Many of my ex-students helped me as well - I thank all of you.

Its interesting to know that Prof. Greenwald said that the Indian markets were over valued and due for a correction on the very day the market hit its all time high. On 8 Jan, Nifty closed at 6,287.85 points. As of the date of this writing, Nifty sands at 4,754.20. Thats a decline of 24%.

Since Prof. Greewald's talk, Nifty Midcap 50 Index has declined by 39%.

Over the same period, Nifty's P/E has fallen from 28 to 21 and Nifty Midcap 50's P/E has fallen from 24 to 14.

Prof Greenwald's presentation can be seen from here. (Uploaded with permission).

Here are a few photographs covering the function:

Fooled by a Percentage Into Catching Falling Knife!

2008-04-01T18:39:00.005+05:30

One of my favorite experiments in class involves asking my students the following question:

“Suppose that you visit a furniture store in a mall to buy a lamp for your bedroom. You find a lamp you like and it has a list price of Rs. 5,000. Happy with this deal, when you approach the sales representative ready to buy the lamp you picked, she informs you that one of their stores which is just a ten-minute walk from there is closing down and you can buy the same lamp over there for Rs 1,000 less. Please raise your hand if the 20% discount is sufficient incentive for you to walk ten minutes to the other store to buy your lamp.”

About 70% of the students raise their hands.

My next question is then addressed to only those who raised their hands. I ask them:

“Suppose that you visit a car showroom to buy a car and after checking out many models, you find one you like. It costs Rs. 500,000, you are told by the sales representative. However, she also informs you that one of their showrooms which was just a ten-minute walk from there is closing down and you can buy the same car over there for Rs. 499,000 or Rs. 1,000 less. How many of you would like to walk ten minutes to go over to the other showroom to save Rs. 1,000?”

I hardly see a hand raised.

Somehow, students who were happy to walk ten minutes to save Rs 1,000 on a lamp are reluctant to walk ten minutes to save Rs. 1,000 on a car!

What is going on here?

Indeed, when I reframe both questions again, in a different form, students appeared puzzled:

“Would you walk ten minutes to increase your net worth by Rs. 1,000?”

Why would a man decline to save Rs 1,000 in one situation, and gladly accept it in another, with the same effort required in both situations?

Isn’t a penny saved a penny earned,?

To most people, apparently not, suggests research in behavioral economics. Part of the reason is a bias arising out of a phenomenon called the “contrast effect” which deals with how we treat multiple pieces of information presented to us one after the other.

If you put something sweet in your mouth immediately after tasting a lemon, it will taste much sweeter than it really is. The contrast between sweet and sour gets accentuated if one experiences one taste immediately after the other.

If you meet someone very attractive at a party, and immediately after that you are introduced to someone who, in contrast, is merely average looking, then the average person would appear to be more unattractive to you than would have been the case had you not met the very attractive person beforehand.

Similarly, a saving of Rs. 1,000 looks much bigger than it really is when it is contrasted with a purchase price of Rs 5,000 for a lamp, (a 20 percent saving!) but looks much smaller than it really is when it is contrasted with a purchase price of Rs 500,000 for a car (only 0.2 percent saving).

It does not matter to a man that a Rs 1,000 saving will have the same effect on his net worth whether he saves it on a lamp or a car. Somehow the presence of a 20 percent reduction triggers an irrational response in his brain.

The brain, operating at the subconscious level, is often influenced by the presence of false “anchors”. Anchors are pieces of information to which a mind tends to latch on to while making a decision. And the human mind will often latch on to false anchors created by various influences like availability or contrast.

In a classic experiment, researchers asked a group of people if the Mississippi River in the US is longer or shorter than 500 miles (the anchor). Most people responded that it was longer than 500 miles. They were then asked to estimate the length of that river. The average answer was about 1,000 miles.

A second group, in contrast, was asked if the Mississippi River is longer or shorter than 5,000 miles and were then asked to estimate its length. Most people responded that it was shorter than 5,000 miles but the average length of the River in this group was about 2,000 miles!

The actual length of the Mississippi River is 2,348 miles but false anchors of 500 miles or 5,000 miles tend to pull the average answers towards them!

In the lamp vs. car experiment, students who chose to walk ten minutes to save Rs 1,000 while buying a lamp but who refused to walk ten minutes to save the same amount of money while buying a car, were suffering from “anchoring bias”. Their minds were latching on to the wrong anchor of a large percentage savings on a list price, instead of latching on to the right anchor of their personal net worth.

Anchors are important, of course, but one has to be careful when deciding if an anchor is valid or not. A man who feels miserable because he dropped Rs. 500 from his pocket which had only Rs. 1,000 in it even though his personal net worth is Rs. fifty lacs is suffering from an anchoring bias. He incorrectly identifies the money in his pocket as a valid anchor as opposed to his net worth. He is also suffering from bias arising out of contrast effect because Rs 500 lost out of Rs 1,000 in his pocket looks very big to him in percentage terms.

In contrast, a rational investor who practices wide diversification, knows that its inevitable that some of his picks will turn out to be duds. He does, not, however, let such outcomes make him miserable because he has trained himself to latch on to the right anchors such as the size of his portfolio, and not the percentage lost in a single position.

A stock may have fallen 50 percent from its all-time peak in a market crash, may have gone below its 52-week low price, may have fallen below the price at which its shares were offered in a hot IPO, or may have fallen below par value. None of these things mean that the stock is cheap. A stock is cheap only if its price has fallen well below than what the company is rationally worth on a per-share basis.

In contrast with underlying value which is the right anchor to latch on to, all time peak prices, 52-week low price, IPO price, and par value are all false anchors. If you blindly buy stocks merely because they have fallen well below some false anchors, thereby allowing contrast effect to make you feel that they are much cheaper than they really might be, then you are functionally equivalent to the man who is trying to catch a falling knife.

And that, you will agree, can hurt.

Sanjay Bakshi is a Visiting Professor at Management Development Institute, Gurgaon. www.sanjaybakshi.net

Note:
The above piece was published in Outlook Profit, a new fortnightly magazine published by the Outlook group. Reproduced with permission.

Re: free cash from ops

2007-12-07T09:44:00.001+05:30

Pat,

Averaging the past in a growing economy will: (1) force you to be more sanguine than a guy who takes more recent data, becomes over-optimistic and projects it into the future stupidly assuming that all trends are destiny, thereby making many errors of commission; and (2) make you ultra-conservative because many things will now start looking too expensive, which will inevitably lead you to make errors of omission.

So its a tradeoff between errors of commission and errors of omission. You know which error I'd rather make...

Best,

Sanjay

On 06-Dec-07, at 11:21 PM, pratik gandhi wrote:

Question that has troubled me for some time - should one always take the average of the past few years? Or should any leeway be given for a smaller fast growing company as opposed to a large company not growing by as much?

What Should Infy Do to Restore its Honor?

2007-12-04T07:36:00.001+05:30

Take a look at the chart below. It shows something very very interesting. This is the stock price chart (adjusted for splits, bonus issues etc) of Infosys, one of India's most admired companies.

The fellow who bought the stock in March 2000 (the peak of the tech bubble) and held on to the shares in Infosys for more than seven years, essentially did not make any money!

One of the most-admired companies in one of the world's fastest growing economies - a company which is debt-free, earns super returns on capital, and is run by a management team which is renowned for its operating skills as well as integrity. And the stock earns nothing in the biggest bull market India has ever seen!

What could explain an outcome like that???

Has the company's earnings declined?

NO! See the chart below:

Infosys's earnings have grown consistently ever since it went public. Moreover, the earnings growth rate has always been well in excess of India's GDP growth rate.

Now see the chart below - it shows what really happened to Infy.
As the above chart shows, Infy's P/E Multiple chart resembles that of a speculative bubble -and indeed it was a speculative bubble.

At the peak of the tech bubble, the investment (speculative?) community was so optimistic about Infy's prospects, that every rupee of earnings was thought to be worth Rs 350 or so. Today, markets are so pessimistic about Infy that every rupee of its earnings is thought by Mr. Market to be worth no more than Rs 23.

Ben Graham's "Security Analysis" starts with Horace's observation: "Many shall be restored that are now fallen and many shall fall that are now in honor."

What can Infy do to restore its honor, given its current market value, its competitive position, and its financial strength?

What should Infy do?

Quiz: If IFC buys into IFCI, then what?

2007-12-03T22:39:00.000+05:30

The stock price of IFCI (IFCI@IN) shot up by 13% today, presumably on rumors that International Finance Corporation (IFC) may buy a strategic stake in IFCI. See, for example, the following:

http://sify.com/finance/fullstory.php?id=14570297

http://www.reuters.com/article/bankingfinancial-SP/idUSBOM23903720071203

Suppose that the rumor was true. I have no clue, but let's just suppose that it was true.

That is, suppose that IFC bought a strategic stake in IFCI.

Further suppose that the stake was in excess of 15%.

Further suppose that the stake was bought at a premium to today's closing price of 106.80 at NSE, which incidentally is the highest price the stock has seen in more than a decade.

Then, under India's Takeover Code, what will (or won't) happen and why?

The Mystery Behind Mastek's Buyback

2007-12-02T19:04:00.000+05:30

On 29 October, Mastek made the following announcement:

http://tinyurl.com/ynu79f

Text:

Mastek Ltd has informed BSE that the members of the Company will consider to approve the following Special Resolution by way of Postal Ballot:

- Approval of Board of Directors (which expression shall Include a Committee of Directors of the Company constituted for the purpose) for the purchase of the Company's fully paid up Equity shares each of a face value of Rs 5/- to the extent not exceeding 25% of the Company's paid up Equity Share Capital at a price not exceeding Rs 750 Per equity share from the Open Market through Bombay Stock Exchange Ltd and National Stock Exchange of India Ltd and the total aggregate amount to be expended by the Company for the Buy-back not exceeding Rs 65 crores, i.e. within 25% of the Company's fully paid-up Equity Share Capital and Free Reserves as per audited Balance Sheet as on June 30, 2007, subject to necessary provisions & approvals.

The Board of Directors has appointed Mr. V V Chakradeo, Practicing Company Secretary as the Scrutinizer for conducting the Postal Ballot process in a fair and transparent manner.

The Postal Ballot form duly completed and signed, should reach the scrutinizer not later than the close of working hours on November 26, 2007. The results will be announced on November 27, 2007.

END

Why did the company give a maximum price of Rs 750 per share for its buyback, even though the current market price is Rs 280 per share. Indeed, adjusted for stock splits and bonus issues, this company has not seen its stock price hit Rs 750 in the last seven years.

So, could this be gimmick? How can we ascertain this? (Hint: The company has done a buyback before. What happened then?)

Does the buyback make sense at a small premium to current stock price? Why? Why not?

Mr. Buffett's Model of Circle of Competence

2007-12-02T16:51:00.000+05:30

From: Sanjay Bakshi [mailto:sanjay@tacticacapital.com]
Sent: Sunday, December 02, 2007 8:39 AM
To: Ashutosh Datar
Subject: Re: Circle of competence - what is it?

Hi Ashutosh,

Hope all is well.

Here are my comments on your mail:

Mr. Buffett's "circle of competence" has several meanings. One is simply the need to not stray outside an area of one's own skills. The probability of success is much greater if one's does not stray outside one's circle. Mr. Buffett likes to say he has a very large "too tough" basket where most of the things go. But occasionally, he comes across something compelling which he really understands.
Risk: Mr. Buffett's framework of risk has the circle of competence model at its heart. In his 1993 letter, in which he wrote about his thoughts on risk (defined as probability of permanent capital loss, as opposed to mere quotational losses), he mentioned that risk depends to a large degree on one's ability to accurately predict the future about the situation being examined. He connects the circle of competence model to his idea of risk by relating it to the certainty with which the long-term prospects of the business, the operating skills, the capital-allocation skills, and the integrity of the management can be ascertained by an investor. So, the same investment, may carry different levels of risk for different investors. This, as you know, is contrary to what academic finance teaches. Mr. Buffett, however, believes, that risk comes from not knowing what one is doing.
I don't think the circle of competence model is industry specific. For example, I consider my own circle of competence in the deep value space and within that space, I have sort of found my calling in the field of special situations. Over the years, I have accumulated a substantial experience in those fields. I think its possible to find deep value in a sector which you do not have to understand to the degree required of a sell-side research analyst.
My own view is that sell-side analysts often go wrong because they know too much - they have too much information to work with and as a result they often miss the obvious, which can easily, perhaps, be observed by a generalist, who maintains a distance from the noise that surrounds sell-side research. There is a very famous experiment in psychology called the "fire hydrant" experiment. A class of students is divided into two equal groups and each group is separately shown a very blurry image of a fire hydrant which is unrecognizable. Then, the image is brought into focus and the process is stopped at a point well before the image is totally clear to anyone. However, for one group, the image is brought into focus in ten increments, while in the other group its brought into focus in five increments. Note that both groups start with the same image and end with the same image. Surprisingly to many, the group which had more information (ten increments) take much longer to recognize the fire hydrant than the group which had less information. The chief reason is that the members of group which was exposed to more increments come to initial judgments (first conclusions) derived from the pattern-seeking human brain, and then in subsequent information it tend to under-weigh disconfirming evidence and over-weigh confirming evidence of their initial notions (confirmation bias). The second group, on the other hand, does not suffer from these biases. They see no relation between the first image and the next and the next and suddenly they see something that resembles a fire hydrant. The second group - the one with less information - identifies the fire hydrant- much more quickly than the first group which had too much information. The analogy with sell-side research is obvious, in my view.
Cost of capital - Circle of competence has much to do with cost of capital. The opportunity of cost an investment is the expected return of the next best investment which is available to me. The key phrase is "available to me". Now, most of the things that happen in the stock market and fall outside my circle of competence, are not "available to me" so they must not influence my thinking about opportunity costs. This is fundamentally logical, in my view, and is totally at odds with Markowitz's model of portfolio optimization.
This means that there will always be some strategy which will be doing far better that what I know and understand. Does that mean that I must run after that strategy? No! So long as my own strategy, derived out of my own circle of competence, has delivered me satisfactory results and is expected to do so in the future as well, I don't have to be envious (envy being the deadliest of the seven deadly sins), I should be contended. This is consistent with the Herb Simon's idea of satisficing as an application of his theory of bounded rationality.
One's own circle of competence expands over time through personal and vicarious experience - the latter one obtained primarily through careful reading of extreme successes and failures - the lollapalooza outcomes - and relating them to the causal factors (mental models) which combined to produce those outcomes. In this respect, vicarious experience is terribly important, according to Mr. Munger, for "you do not have to to do it to learn not to pee on an electrified." :-)
You really have to choose a field that you feel passionate about - it could be a sector, it could be a strategy (deep value, special situations, growth, momentum - whatever), it could be top-down or it could be bottoms up - It does not matter. What does matter is that you have real passion for it, and you have determination to build a circle of competence in that space and to expand it over time through the accumulation of experience - both direct and vicarious.

I'd like to blog this thread because there may be other people who may benefit from this exchange. If you prefer, I can protect your identity from being revealed when I post it. Do let me know.

Thanks and best wishes

Sanjay Bakshi

On 25-Nov-07, at 11:27 AM, Ashutosh Datar wrote

Hello Sir

I am struggling with this concept for the past few weeks and so writing to you to get your perspective.

Circle of competence is a good and a fairly intuitive concept but I am not clear what it means in actual sense…

If by it we mean knowing one particular sector inside out, then the typical sell side analyst should be the best guy. He covers a particular sector, does not go beyond it and pretty much knows every small thing that is happening in it. But then he doesn’t seem to produce good results – what’s the problem there? Does he know too much? Or does he not know the right stuff

WB talks about buying businesses that he understands, buying businesses that are simple, what does it mean? I mean Coca-cola is a simple business but Petrochina I guess is a whole lot complicated than that… add the political risk of dealing with ppl as opaque as Chinese and it seems kinda odd to me.
Is circle of competence necessarily a sector thing? I mean someone could say I can call the interest rate cycle or politics for that matter, so he could use it for a wide range of sectors which are affected by that…
Lastly, how does one go about developing his/her own circle/niche? Is it just a natural process driven by time?

Could you help?

Thanks

Best Regards

Ashutosh Datar

http://1skeptic.blogspot.com

http://snoopy-pixs.blogspot.com

Incentive-caused Bias in the Medical Profession

2007-11-27T00:43:00.000+05:30

Mr. Charlie Munger would surely have enjoyed reading this superb article in New York Times Magazine published on 25 November.

The piece titled, "Dr. Drug Rep", is a moral story of Dr. Daniel Carlat, a medical man, who learnt how to deal with one of Mr. Munger's favorite mental models: Incentive-Caused Bias which Mr. Munger likes to describe as "whose bread I eat, his song I sing."

Every professional should read Dr. Carlat's story. It has powerful lessons for professions outside of medicine...

Mr. Munger likes to talk about incentive-caused bias as a very powerful psychological tendency, which makes, "a decent man, driven both consciously and subconsciously, by incentives, drift into immoral behavior in order to get what he wants."

Its fascinating to me to see what happens once incentive-cause bias sets in.

After his immoral behavior has started, the victim would come under the influence of several more psychological tendencies. For example, Operant Conditioning (It feels good, so I want more), Social Proof (everyone is doing it, so it must be OK), bias from Commitment and Consistency principle (I have to be consistent with my earlier, taken stand), and Low contrast effect (If I said yes to x, then saying yes to 1.01 x is no big deal) would combine together to produce rationalized immoral behavior. ("Man is not a rational animal, but a rationalizing one.")

It takes a lot of courage for a professional to speak out against the incentive caused bias spreading like cancer in his profession, which is exactly why such stories deserve to be recommended for reading...

For example, the accounting profession could do with more Dr. Carlats...

Quiz for Students on LGB

2007-11-26T23:15:00.000+05:30

---------------------------- Original Message ----------------------------
Subject: Analyze This
From: sbakshi@mdi.ac.in
Date: Mon, November 26, 2007 11:13 pm
To: bfbv@mdi.ac.in
--------------------------------------------------------------------------

How would you analyze this?

http://tinyurl.com/33tt6v

Text Follows:

August 7, 2007

LG Balakrishnan & Bros Ltd has informed BSE that the Board of Directors of the Company at its meeting held on July 30, 2007, has intended to reduce the paidup capital of the Company by extinguishing 5,658,000 equity shares of Re 1 each held by Trustees LGB Shareholding Trust allotted to them by virtue of scheme of amalgamation as approved by the High Court of Madras, subject to the approval of the shareholders and the High Court.

And this:

http://tinyurl.com/2da6br

Text Follows:

November 26, 2007

LG Balakrishnan & Bros Ltd has informed BSE regarding the order for confirmation by the High Court of Madras under Section 101 and 102 and other applicable provisions of the Companies Act, 1956, for the reduction of the existing fully paid up Share Capital of the Company from Rs 84,139,034 divided into 84,139,034 Equity Shares of Re 1/- each to Rs
78,481,034 divided into 78,481,034 equity shares of Re 1/- each so as to reflect the true paid up capital of the Company by cancellation of 5,658,000 equity shares of Re 1/- each amounting to Rs 5,658,000 in the Company standing in the name of Sri. B Vijayakumar, Sri. P S Balasubramanian and Sri. S Sivakumar, Trustees of LGB Shareholding Trust, which represents the own capital of the Company.

Quiz for Students: Fraud Analysis

2007-11-26T22:51:00.000+05:30

--------------- Original Message ----------------

Subject: Fraud Analysis

From: sbakshi@mdi.ac.in

Date: Mon, November 26, 2007 10:51 pm

To: bfbv@mdi.ac.in

----------------------------------------------

How would you approach this disclosure?

http://tinyurl.com/yodgmp

Text follows:

Hexaware Technologies Ltd on November 26, 2007 reported that its Board of Directors has appointed a special committee to conduct an internal investigation and make recommendations for changes to its foreign exchange management practices. This action is due to certain actively concealed and potentially fraudulent foreign exchange Option transactions conducted by one Hexaware official. The Hexaware official, who exercised unauthorised fiduciary powers, has been immediately suspended, pending Investigation. Hexaware plans to provision between US$ 20-25 million to cover any potential exposure as a result of these transactions.

The series of forex transactions in question were initiated over the last few months. These transactions were unauthorised and outside the Company's normal hedging program. The information regarding these transactions was intentionally withheld from the senior management and the Board of Directors and was not included in internal reports. The first transaction came to light on November 22, 2007. Preliminary investigations conducted
over Friday, Saturday and Sunday led to uncovering of more such transactions.

"The need for provisioning is because or direct actions of one individual which were actively concealed," said Rusi Brij, Vice Chairman and CEO.

A meeting of the Board of Directors was called on November 26, 2007, where it was decided to appoint a Special Committee comprising the following independent directors, to conduct a thorough investigation into the transactions:

- Mr. Shailesh Haribhakti, Chairman of the Audit Committee
- Ms. Preeti Mehta, Partner, Kanga & Co.
- Mr. L S, Sarma, Member of Audit Committee

"As immediate steps, an embargo has been placed on all Option deals; future forex deals will necessarily have to be transacted jointly by two signatories out of the designated four from amongst the top management; the Company's authorised dealers are being informed about this procedure and the internal auditors (KPMG) are being asked to conduct a thorough audit of the function. The Company will continue to maintain the normal hedging strategy to protect against the rupee appreciation," said Shailesh Haribhakti, Chairman of the Audit Committee.

The Company will take all measures and actions as advised by the Special Committee of the Board of Directors, Statutory Auditors (Deloitte) and Legal Advisers, to mitigate the impact or the transactions and prevent recurrence of similar situations in the future.

"The Company's business remains robust and its future growth trajectory unaffected. Our order book, as of September 30, 2007, stands at over US$300 million. We will continue to build on that," added Rusi Brij.

Competitive Project on a Deep Value Stock

2007-11-02T05:18:00.000+05:30

Sent to my class just now:

There is a stock out there which, even in this so-called raging bull
market, is offering a dividend yield in excess of AAA bond yield (remember
Graham loved stocks that yielded more than 2/3rd of AAA bond yield).

The unique thing about this stock is that the company to which it belongs
is essentially debt-free. This combination of debt-free status and a high
dividend yield is very attractive, in my view.

Which stock is it?

The group which identifies it first and sends me a report on it, with not
just the name of the stock, but clear demonstration of its cheapness won't
have to submit a project for this term.

Rgds

==SB

Class Group Project Competition

2007-11-01T22:00:00.000+05:30

This was sent to my class students today...

---------------------------- Original Message ----------------------------
Subject: Group Project Competition
From: sbakshi@mdi.ac.in
Date: Thu, November 1, 2007 1:18 pm
To: bfbv@mdi.ac.in
--------------------------------------------------------------------------

Ok here is the deal...

There is a special situation opportunity available in the market today
which promises a return of at least 35% p.a.pretax (the max return in my
view is in the range of 50% p.a. pretax) with very low risk of loss.
Moreover, the deal is suited for debt financing, and is also liquid.

Which group can find this opportunity?

Hint 1: The announcement of the transaction which led to the creation of
this special situation opportunity was made on BSE sometime in the last
ten days.

Hint 2: The operation involves buying a security from the stock market and
thats it. You don't have to sell. You don't have to tender.

This is a competitive project competition. All class groups are invited to
compete. However, only the first TWO GROUP PROJECT REPORTS with the
correct answer and reasoning will be considered towards completion of
group project component for term 5.

Rgds

==SB

Memo to Students: Bob Hamman Video

2007-09-20T09:19:00.001+05:30

Bob Hamman is considered to be one of the best bridge players in the world. He runs a very interesting company called SCA Promotions.

Wikipedia Page:

http://en.wikipedia.org/wiki/Bob_Hamman

Company Site:

http://www.scapromotions.com/

Warren Buffett is a fan of Bob Hamman. Buffett and Ajit Jain (the genius who runs BRK's super-catastrophe insurance operation) often do things similar to what Bob does. Here is what Buffett wrote in this connection in his 1995 letter:

"Ajit Jain is the guiding genius of our super-cat business and writes important non-cat business as well. In insurance, the term "catastrophe" is applied to an event, such as a hurricane or earthquake, that causes a great many insured losses. The other deals Ajit enters into usually cover only a single large loss. A simplified description of three transactions from last year will illustrate both what I mean and Ajit's versatility. We insured: (1) The life of Mike Tyson for a sum that is large initially and that, fight-by-fight, gradually declines to zero over the next few years; (2) Lloyd's against more than 225 of its "names" dying during the year; and (3) The launch, and a year of orbit, of two Chinese satellites. Happily, both satellites are orbiting, the Lloyd's folk avoided abnormal mortality, and if Mike Tyson looked any healthier, no one would get in the ring with him."

You can view a very interesting video of Bob in which explains what he does i.e. how he sets odds in a risky situation. You can view this video from:

http://tinyurl.com/3bfjpl

The Bob Hamman video can be seen by clicking the link titled "Risky Business"

The video may play only if you have an older version of Real Player installed on your comp. You can get an older version - the Real Player 8 from

http://tinyurl.com/nsad 

Lectures 03 & 04: Risk Arbitrage, Fermat-Pascal, and Life

2007-09-20T07:41:00.001+05:30

List of topics discussed in Tuesday's class:

Graham, Buffett, and Rubin suggested as role models for learning risk arb and the fermat/pascal way of probabilistic thinking.
Case on Arcata Corporation from the Buffett letters was discussed at length to illustrate the idea behind risk arb
Risk arb defined, Buffett's four questions on risk arb deal analysis (probability of deal going thru, time to consummation, chances of icing on the cake, and worst case scenario)
Graham's framework on special situations from the appendix of the 3rd edition of Security Analysis, Walter Schloss on that appendix, and how my own career was deeply influenced by it.
Robert Rubin's philosophy on risk arb (students were asked to do substantial reading on Rubin prior to class), Graham-Newman's arbitrage results over a long time, Buffett's own results in the field.
Extended discussion of the the GE Shipping spinoff deal, the twists and turns in that deal
Discussion of some old deals from my experience involving bailouts, mutual fund arbitrage, creating cheap shares in schemes of arrangements, tender offers, buybacks, going-private transactions, merger arb, dividend capture, and recapitalizations.
Fermat/Pascal system of thinking, the necessity of developing an expected value frame of mind (Fermat/Pascal letters can be seen from here.
Rubin's four principles of decision-making - the uncertainty principle, probabilistic thinking, decisions and actions being different (includes the ideas of preserving optionality and sometimes having to choose the least worst option), and the importance of process over outcomes.
Process vs. Outcome- bad process will inevitably produce bad long term outcomes, but bad short-term outcomes do not necessarily imply a bad process, importance of luck in success.
Frequency-Magnitude framework of expected value, how the world focuses on frequencies and not magnitudes and expected values, the jellybean experiment, how people give up an idea because they think its too tough without thinking thru the consequences of success, how long term-success almost never comes from the first idea, how conviction in oneself and cumulative learning produce good long-term outcomes even though they are improbable (you only have to get rich once), the venture cap model (low chance of success, high magnitude of success in a few cases), how someone can be wrong most of the time, and be right just a few times (Taleb's bleed strategy).
Preserving optionality - the deep simplicity behind black-scholes - options have value even when they are out-of-the-money because of time and volatility, the more the volatility, the more the value of the option, the importance of not making a decision i.e. deferring it, particularly in a dynamic situation, allowing new information to come in which changes the odds, Graham's idea of never converting a convertible, how risk arb teaches the benefits of keeping options open till the last possible moment ("stuff happens"), we will cross the bridge when we come to it.
Contrary viewpoint - when to burn bridges, when to close options and make decisions, how often big decisions in life often involve burning bridges, while generally the preserving optionality model is very useful, particularly in investing.
Probability Blindness, how people make big mistakes when they estimate probabilities, denominator blindness (an example of anchoring bias), the monty hall problem, believing that trends are destiny, wrong perceptions of risk because some bad event has not happened for a long time (people assume its become safe when the exact opposite is true e.g. some earthquake-prone areas which have not experienced an earthquake for a long time), conjunction fallacy, mistakes in interpreting causal chains (a chain cannot be stronger than its weakest link)
Why is risk arb fun apart from the money? Forces you to think rationally using expected value framework which is dynamic requiring frequent calibration of thinking in response to new information and new interpretation of old information, forces you to think about
opportunity cost, requires multi-disciplinary thinking (e.g. probability, psychology particularly game theory, law particularly corporate and securities law, and finance), and of course the availability of un-co-related to market opportunities arising out of corporate actions, giving the arbitrageur plenty of very interesting things to do...
How the expected value framework, so well-taught by practicing risk arbitrage, can also be be used in regular straight value investing, Buffett's case on investing in Wells Fargo, how he estimated worst case scenario and exploited the perception-reality gap in the
marketplace.

Memo to Students: Ben Franklin's Prudential Algebra

2007-09-19T08:46:00.001+05:30

Benjamin Franklin wrote this to a friend in 1772:

To Joseph Priestley

Dear Sir, London Sept. 19. 1772 In the Affair of so much Importance to you, wherein you ask my Advice, I cannot for want of sufficient Premises, advise you what to determine, but if you please I will tell you how. When these difficult Cases occur, they are difficult chiefly because while we have them under Consideration all the Reasons pro and con are not present to the Mind at the same time; but sometimes one Set present themselves, and at other times another, the first being out of Sight. Hence the various Purposes or Inclinations that alternately prevail, and the Uncertainty that perplexes us. To get over this, my Way is, to divide half a Sheet of Paper by a Line into two Columns, writing over the one Pro, and over the other Con. Then during three or four Days Consideration I put down under the different Heads short Hints of the different Motives that at different Times occur to me for or against the Measure. When I have thus got them all together in one View, I endeavour to estimate their respective Weights; and where I find two, one on each side, that seem equal, I strike them both out: If I find a Reason pro equal to some two Reasons con, I strike out the three. If I judge some two Reasons con equal to some three Reasons pro, I strike out the five; and thus proceeding I find at length where the Ballance lies; and if after a Day or two of farther Consideration nothing new that is of Importance occurs on either side, I come to a Determination accordingly. And tho' the Weight of Reasons cannot be taken with the Precision of Algebraic Quantities, yet when each is thus considered separately and comparatively, and the whole lies before me, I think I can judge better, and am less likely to make a rash Step; and in fact I have found great Advantage from this kind of Equation, in what may be called Moral or Prudential Algebra. Wishing sincerely that you may determine for the best, I am ever, my dear Friend, Yours most affectionately, B Franklin

END

Note the underlying wisdom in the Franklin system of decision making. By making a list of things that would go in favor of, as well as, a list of things that would go against, a potential decision, he prevented his mind from jumping to conclusions (first conclusion bias as a subset of availability bias). This procedure also ensured that Franklin did not over-weigh any particular factor which could mis-influence his decision (availability bias). Further, his insistence on not making sudden decisions without reflecting over them for a few days ensured that he "preserved optionality" allowing new information to come in which could change the odds (Robert Rubin's idea of preserving optionality is valid here). Finally, his roughly-right system of dealing with trade-offs works way better, in my view, than the "optimization systems" you see in the modern world.

Keynes had it right when he said, "its better to be roughly right than to be precisely wrong."

Btw, I love doing "Prudential Algebra" on my mind maps...

Memo to Students: Robert Rubin as a Role Model

2007-09-17T15:05:00.000+05:30

Hi,

The next two classes will deal with the Fermat/Pascal way of thinking.

In my view, the best way to understand Fermat/Pascal thinking style, from an investment viewpoint, is to see how risk arbitrage works. And one of the best ways to learn the dynamics of risk arb is to study the experiences of Graham, Buffett, Greenblatt, and Rubin.

As the course progresses, we will be talking about all of these experts. At this time, however, I'd like you to do some work on Robert Rubin.

Rubin learnt risk arb at Goldman Sachs. And the lessons he learnt, he says, served him very well in his life. Risk arb teaches a lot of things about life, as you are about to find out. So, please make the effort of reading/viewing the following:

Rubin's page at Wikipedia;
The first three minutes and fourteen seconds of Rubin's interview with Charlie Rose;
Rubin's commencement address at Harvard;
Rubin's interview with Carol Loomis;
The following pages from Rubin's book "In an Uncertain World": A note from the author, pages 7-8, Chapter 2 (A Market Education), Chapter 3 (Inside and Outside Goldman Sachs), pages 173-176, Chapter 10 (Hitting Bottom), pages 340-350, and page 382.
This article on Rubin in the New York Times Magazine and this letter about that article; and
This press release issued by Rubin's office when he was Treasury Secretary.

Just do it!

Mindmaps in Investing

2007-09-15T08:16:00.001+05:30

As mentioned in my class yesterday, I frequently use Mindmaps for my investment thinking.

Here are two mindmaps - one is historic and one is current.

You will need mindjet viewer to be able to see the maps which you can download from here.

Lecture 02: Introduction to Mental Models & Mental Tricks- II

2007-09-14T22:41:00.001+05:30

Topics covered in today's class:

Surfing as a mental model, There's a tide in the affairs of men, which taken at the flood, leads on to fortune - Shakespeare, example of Sunil Mittal who rode the GSM wave and because one of India's richest men. A lot of business fortunes are made because someone happened to be in the right place at the right time - i.e. luck.
Two views of the world - Bell curve world, and the Power Law world, Scalability in the Power Law World, Winner-takes-all model, importance of scale in valuation.
Diseconomies of scale, bureaucracy, eventual decline of all great corporations inevitable.
Mental Trick: Importance of using checklists in dealing with availability bias, first conclusion bias, and confirmation bias, the pleasure of exploiting other people's availability bias, examples.
Mental Trick: Effects have effects, Peltzman effect, Carol Loomis on The Risk that Wont Go Away, Need to think like a chess grandmaster, unintended consequences, America's futile war on drugs, Price controls, Jim Roger's Law (you can control the price, or the supply but not both), examples of Licence Raj, Ration Shops, Smuggling and Arbitraging. Need to do "second step analysis" as Buffett did in shutdown of textile operations, how price changes everything (in stock market crashes), how people respond to changes in tax policies and how markets tend to assume that tax changes are permanent, how Indian companies became more profitable and not less after opening up of Indian markets to competition in 1990, How Y2k did not end Indian IT Industry, how in cyclical businesses are influenced by effects of effects, the inability of excel to capture the power of the human sprit to fight and bounce back.
Mental Trick: Backward thinking, proof by contradiction, its utility in security analysis, expectations investing, how to find absurd valuations using backward thinking, the removal of need to make elaborate predictions when using backward thinking, using backward thinking in risk arbitrage and in option markets (implied volatility), the need to falsify first conclusions, negative empiricism, the asymmetry between proving something and disproving it.
Mental Trick: Zooming in - the need to focus on what is going on at the detailed level e.g. segment data of Microsoft and ITC reveals something very interesting which is camouflaged when one looks at overall financial performance.
Mental Trick: Zooming out - Need to step back and look at a situation, e.g. Buffett's decision to shutdown textile operations, need to think like an allocator of capital and not as someone married to a business.
Mental Trick: Be creative: use mind maps, creative whack pack, innovative whack pack - examples of creativity in investment thinking e.g. changing viewpoints, asking what if, using metaphors and Aesop's fables (e.g. the rabbit runs faster than the fox because the fox is running for his dinner but the rabbit is running for his life), the need to invert, the need to check your timing (e.g. instead of asking is this attractive at this price, asking how can I make money in this deal, corporate event etc), the need to be aware of unintended consequences, the need to be very curious about things around us, the need to see the opposite viewpoint, and the need to kill your own best loved ideas, the need to be charmed by randomness...

Lecture 01: Introduction to Mental Models & Mental Tricks

2007-09-13T09:15:00.000+05:30

Here is a list of topics covered in my BFBV class (in which I had an opportunity of discussing Charles Munger and Charles Ponzi together!)

Mental models: definition, utility, Herb Simon's and Charlie Munger's idea of using checklists, the man-with-a-hammer syndrome.
Warren Buffett's decision to shut down textile operations of BRK (students were given his essay in his 1985 letter as pre-reading material). Dissection of Buffett's textile experience into multiple mental models - competition from microeconomics, return on capital from accounting, opportunity cost from microeconomics, prisoners' dilemma from game theory, contrast effect from psychology and bias from commitment and consistency from psychology.
The necessity of "jumping jurisdictional boundaries" and the futility of using a single tool like Microsoft excel to make decisions.
The mental model framework - the Lollapalooza effect, the need to look at extreme outcomes and working backwards to mental models and also to see how mental models work together to produce lollapalooza effects (thinking forwards).
Inherent contradictions between some mental models e.g. Adam Smith's invisible hand and Garrett Hardin's invisible foot.
Feedback loops from engineering, their application in other disciplines, positive feedback loops (spiral, runaway, vicious circles) and negative feedback loops (self correcting e.g. business cycles). Examples of bank runs and stock market crashes and successful business models with embedded positive feedback loops (e.g. Buffett's example of dominant newspapers wherein circulation and advertising feed on each other, and Wal-Mart where low-prices create high volumes, which creates scale economics for the company which are passed on to customers in the form of low prices which create high volumes....)
Regression to the mean from statistics - applicable in a gaussian bell curve world, Buffett on markets performance regressing to underlying business performance over time, the Graham voting machine weighing machine metaphor, mean reversion strategies, all trends are not destiny.
Creative Destruction by Schumpeter and its relation to extinction in evolution - Sometimes trends ARE destiny, examples of digital cameras vs analogue cameras, mobile phones vs fixed line telephony etc - fascination about observing what goes on inside the heads of entrenched player in a industry who is about to be dislodged by an upstart who has made a better mousetrap, the light at the end of the tunnel coming from an oncoming train metaphor.
Ponzi scheme from mathematics - importance of thinking in terms of Munger's "functional equivalents" i.e. in this case embedded ponzi schemes in RIETS, business models like Amway, venture capital, greater fool theory in IPOs, chain letters, pension funds etc.
As a follow up reading, students were asked to read Charlie Munger's essay on S&Ls in Wesco Financial's annual report for 1990. They were asked to analyze his marvelous decision to get out of the S&L business when he could see the threat from money market funds and Freddie Mac (oncoming train), and how not only he got out of the way of that metaphorical train, he jumped on to it and made a billion dollars for his investors in the process.

Two Nights Before...

2007-09-09T20:29:00.000+05:30

.
My course - Behavioral Finance and Business Valuation (BFBV) starts on 9/11. Two more nights to go. Been busy preparing a revised course outline (I like to change my course every year otherwise it gets too boring to put the same slides again and again).

I will have a total of 30 contact sessions with 70-odd students. I wish I could have more contact sessions - there is so much material to cover! Soon, the students will be tormented by an avalanche of mails and assignments etc from me :-)

I have prepared a list of topics I want to add and those I want to delete. There is a list of movies to show, stories to tell, video scenes to play. There is a list of appropriate quotes to insert at the right moment. Its like writing a screenplay!

I am increasing the scope of behavioral finance component this year and hopefully students will like that. I have also incorporated many changes triggered by Nassim Taleb and his influence on my thinking. His latest book- Black Swan - is very good and I can relate what he has written to a huge number of real-cases which would be suitable for classroom discussions.

The photo at the top was taken by my wife while I was deeply engrossed with my friends i.e. my books. Two more nights and miles to go before I sleep...

My Bookshelf at Shelfari

2007-09-09T08:22:00.000+05:30

You can see my bookshelf here which I am in the process of updating. I recommend this site to you.

Interview with Capital Ideas Online

2007-07-08T18:20:00.000+05:30

11 June 2007

Chetan Parikh of Capital Ideas Online, who had hosted a talk for me in 2002, came to Delhi on 22 March, 2007 to interview me. The transcript of the 2002 talk can be seen from here. And the transcript of the 2007 interview can be seen from here.

Update on 8 July 2007

The full version of the 2007 interview can now be viewed from here. Uploaded with permission of CIO.

Going, Going, Gone!

2007-06-21T22:56:00.000+05:30

Finally, I found an auditor with a sense of humor!

Here is a notice filed by a listed company with NSE today:

Madras Fertilizers Ltd has informed the Exchange that "With regard to Auditor's opinion that the Company is not a 'GOING CONCERN' but a 'GONE CONCERN', it is stated that the Company has represented to the GOI that the policy on pricing of NPK since Apr 2002 and on Urea from Apr 2003 have adversely affected its profitability. Consequently, the Company has been making huge losses. The networth has been fully eroded on 31.3.2004. The Company has been urging the GOI to make suitable corrections in the Pricing Policies. The DOF referred the Company to BRPSE. BRPSE recommended certain relief measures for revival of the Company. A Financial Restructuring package aimed at making the operations of the Company commercially viable is under the consideration of Government".

Thank you Ankur for pointing it out to me!

My Recent Investment Operations

2007-06-11T00:00:00.000+05:30

I have uploaded a pdf file on my recent investment operations on my site which can be seen from here.

Schemes of Derangement

2007-04-13T08:25:00.000+05:30

One of my colleagues, Ankur, brought this one to my attention.

There is this company - Shivam Autotech- which was recently listed on the stock exchanges. This company emerged out of a scheme of arrangement proposed by Munjal Auto Industries.

Here is the stock price chart of the Shivam Autotech since it listed:

As the above chart shows, the stock price has fallen significantly post-listing - this is a very common phenomenon.

Anyway, while going through the scheme of arrangement, Ankur came across the following text:

"All the equity shareholders of the transferor company shall be issued 1(one) equity share in transferee company and 1(one) equity share in transferor company in lieu and substitution of 2 (two) equity shares held by them in the transferor company as on the record date fixed by the transferor company. Those shareholders holding the Shares in physical form shall get shares in the physical form and those holding in Demat shall be credited in Demat form. Fractional entitlements arising out of the aforesaid shall be consolidated and sold through market operations and proceeds will be donated to the Prime Minister Relief Fund." [Emphasis mine]

Unbelievable, isn't it?

If you owned odd number of shares in the transferor company, the sale proceeds of your fractional entitlements ended up with India's Prime Minister. Neither did you get the shares, nor did you get the sale proceeds! A wonderful example of altruism isn't it?

I am reminded of another scheme of derangement which was implemented several years ago. Godrej Industries, with the help of very helpful lawyers (whose bread I eat, his song I sing) drafted a scheme which enabled the company to buy back shares from minority stockholders at Rs 18 per share - a rather low price in relation to underlying value, as subsequent events would prove.

The interesting thing about this scheme of derangement was that it had negative consent embedded in it - if you were a minority stockholder in Godrej Industries on record date, the company would take away your shares and send you a check for Rs 18 per share, unless you opted out of the scheme by a specified date. And if you were holidaying on date or forgot to open your mail, or opened it a bit late? Well, thats just too bad!

The Godrej Industries case went all the way to India's Supreme Court and the Court ruled that one share is one vote and if the body of shareholders has passed the scheme, then the court sees no reason for intervention. The company, backed by the Court judgment went ahead with the buyback. That same stock today quotes at Rs 976 (after adjusting for a stock split).

So much for shareholder democracy i.e. all shares are created equal. But, as these schemes of derangement show, some shares are "more equal" than other shares...

Essar Shipping's Delisting Sinks, Drowns Prisoned Stockholders

2007-03-21T07:43:00.002+05:30

Essar Shipping's stock sank yesterday on news of the failure of the tender offer to take the company private under SEBI's Delisting Regulations.

In a cryptic-sounding message, the company informed the following to the Mumbai stock exchange:

"Essar Shipping & Logistics Ltd has informed the Company pursuant to the approval of the shareholders for delisting of equity shares of Essar Shipping Ltd ("Target Company") from Bombay stock Exchange Ltd ("BSE") pursuant to SEBI (Delisting of Securities) Guidelines, 2003, The Essar Shipping & Logistics Ltd had made a Public Announcement for making an offer to the Public Shareholders of the Target Company in terms of the Guidelines.

The Reverse Book Building Process ("RBB") closed on March 16, 2007. As the aggregate number of shares tendered by the Public Shareholders was less than the number required to reduce the public shareholding of the Target Company to fall below minimum public shareholding determined as per the provisions of the Listing Agreement, the Delisting Offer has failed in terms of the Guidelines and no securities can be acquired pursuant to such Delisting Offer.

In light of the facts and law stated above, the Target Company will continue to remain listed on BSE. The shares deposited in the Special Depository Account of the trading members during the RBB will be returned to the respective public shareholders in accordance with the Guidelines."

If you were a shareholder in Essar Shipping, your situation was analogous to that of one of the prisoners in the famous game of prisoners' dilemma. You could either sell your shares in the market, or you could tender them to the offerer.

If you tendered, then the offerer would return your shares if the total number of shares received were less than the minimum required (this is what happened in this case) or if the book-built price arrived at after the tender was over was rejected by the offerer as too high. (this is what happened in the Blue Dart case a few months ago).

Both these outcomes take place AFTER the tender offer is over, by which time its too late to sell the tendered shares in the market (in the absence of futures trading) because you don't have them with you. So, a failed offer, typically results in a crash, as the above chart depicts.

Viewed from your own perspective, the correct strategy is to sell the stock in the market rather than tendering it - the above chart shows that those investors who followed this advice would have fared well.

The problem, of course, is that if everyone follows this advice, then the tender offer must fail!

A nice little prisoners' dilemma embedded inside the SEBI's Delisting Regulations...

The Journey from "Value" to "Glamour": Two Examples

2007-03-11T08:56:00.000+05:30

In October 2001, SRF (SRF@IN) appeared on my radar screen as a deep-value stock. At that time, the stock price of the company was Rs 14 per share. The company was deeply out of favor in the stock market for many reasons.

First, the company was in the business of making CFC gases many of which were required to be phased out under the Montreal Protocol.

Second, the company was also in the business of making Nylon Tire Cords (NTC), an input required for making cross-ply tires as opposed to radial tires. Cross-ply tires need much more NTC than radial tires. As India was expected to move from cross-ply tires towards radial tires just like other developing countries had in the past, the SRF's NTC business was perceived to be a declining one.

Third, a family whose record in matters of corporate governance was nothing to write home about, controlled the company.

Fourth, the company was highly leveraged due to over expansion with debt in the past and was perceived as risky because of this reason.

So, there were many things going against the company and the stock: sunset industries, poor management, leverage.

However, a few things intrigued me. At Rs 14 per share, the market cap of the company was Rs 910 million. Debt was Rs 3.4 billion. So the enterprise value was Rs 4.3 billion. Over the previous three years the company’s operations had generated cash of Rs 1.9 billion a year. The enterprise value was 2.3 times cash flow. Moreover, the average cash flow from operating activities (after payment of interest) over the same period was a hefty Rs 1 billion a year so the shares of the company were selling at less than one times cash flow! Simple backward thinking showed, that for this valuation to be correct, the company must go extinct very soon. How likely was that? Extremely unlikely, I figured. For many reasons.

First, the company was de-leveraging its balance sheet and the stock price was highly sensitive to debt-reduction (which is the most sensible allocation of capital decision in such cases).

Second, even though the company was in business activities perceived by markets as sunset industries, the company would continue to be around for a long long time. In my view, the markets had over-discounted the negative aspect of a declining industry and under-recognized the benefits that go with such cases (low competition, high returns on capital, plenty of free cash flow since depreciating productive capacity wont be replaced).

Third, the company had acquired a NTC plant from Du-Pont for a song. Du-Pont was exiting the business, and sold it to SRF at a ridiculously low price in relation to the amount it had spent to build that plant. Moreover, along with the low-priced plant came accumulated losses, which SRF could use for shielding its profits from taxes. And SRF could, and did, turn around the plant with little effort and expense (by changing it to make a product that was in high demand as opposed to continue to making a product for which there was little demand and for which the plant that originally been erected by Du-Pont).

Fourth, the company was receiving compensation under the Montreal Protocol, for phasing out the production of some CFC gases. Indeed, what astonished me was that the amount of money to be received was more than the then prevailing market cap of the company! Such was the negative perception of the market that it was unwilling to see how cheap the stock had become.

Fifth, at Rs 14 per share, the company was paying a dividend of Rs 2 per share. The dividend yield was an unbelievable 14%. Normally in such cases when one sees such a high historic dividend yield, the future dividend is cut. I figured that given the healthy cash flows and the low amount of cash required to maintain dividend, this was extremely unlikely to be the case. With the benefit of hindsight, I can now say I was right.

Convinced that I had identified an extremely cheap stock, I bought it in large quantities.

Fast forward to 2006. See chart below:The chart above gives a vivid description of what happens to a stock when it moves from “value” to “glamour”.

By March 2006 – less than five years after I identified it as a deep value stock – the stock price had soared to Rs 360 per share – a twenty-five bagger (ignoring dividends which would make it look even better).

I sold off my shares long before it hit Rs 360 because when it moved out of my “value” range I no longer understood it. I sold and moved on to what I thought were greener pastures.

What’s more interesting for this discussion is that by time the stock hit Rs 360 it had become a “carbon credit story” which in early 2006 was considered as “glamour”. The company was in possession of carbon credits and more were in the pipeline and the markets were seduced into putting a very high market value on these credits. As the carbon credit story melted soon after, the stock has since declined to Rs 120 indicating the risk of investing at high prices in glamour stocks as opposed to the risk of investing in deep value stocks at non-glamorous prices.

In August 2004, I added to my holdings in Heritage Foods (HTFI@IN) because the stock had declined from Rs 70 to Rs 50 level for what I thought were wrong reasons.

At Rs 50 per share the market cap of the company was Rs 500 million. Total debt was very low at Rs 230 million. The stock was yielding 5.5%, which was very attractive because in India dividends received by investors are treated as tax-free income.

Heritage makes packaged milk, a product where penetration rates are low because most of the milk in India is sold in loose form. Given that India is the largest milk producing country in the world, the potential for growth in this business is huge.

However the stock price of the company, at Rs 50, per share, did not reflect this. In effect, at that price, one was getting the future potential growth for nothing.

Over the previous 10 years, Heritage’s revenues had grown at 35% p.a. and EBITDA had grown at 36% p.a. Moreover the reported earnings of the company were real earnings, which showed up in discretionary cash instead of fixed assets, inventory, or receivables.

I also liked the management of the company, which was focused on growth without sacrificing stockholders’ interests. For example, the company had completed a stock buyback program recently.

Despite having a good business (with superb returns on capital), excellent growth prospects, a solid balance sheet (low debt in relation to cash generating ability), an owner-oriented management, a low price in relation to underlying value, the stock had declined from Rs 70 to Rs 50. The chief reason for this, in my view, was the poor recent showing of the company.

Heritage buys milk from farmers, processes it in its milk processing plants, packages and sells it under its brand. Milk procurement prices had recently increased due to shortfall of rains (less rains means less fodder which results in less milk supply) as well as intervention of state governments in fixing prices of milk to be paid to farmers. In addition, the state governments also control the retail prices of milk and they were kept low, which forced the company to absorb cost inflation. As a result, the company’s margins had fallen dramatically from their long-term average.

I thought this to be a temporary phenomenon. I have strong faith in “reversion to the mean” mental model. If you flip a coin ten times, you may easily end up with eight heads and two tails. If you flip it twenty times, the proportion of total number of heads to total flips should reduce from eighty percent. If you flip it a thousand times, the proportion of total number of heads of total flips will almost certainly revert to fifty percent, which is the probability of landing a heads if you flip a coin.

In the above example, the mean of fifty percent acts as a strong magnet pulling the average towards it.

What works in coin flips works in a whole lot of other things around us. For example stock returns are mean reverting but stock prices are not. In the case of stock returns, the magnet that pulls the returns towards it is the underlying return on equity. Hence the truism of that famous quote by Mr. Buffett: “Bull markets and bear markets can obscure mathematical laws but they cannot repeal them.”

I figured that reversion to the mean was the appropriate model to use in the case of Heritage for many reasons.

First, the company had staying power to ride out temporary adversity. A strong balance sheet and a high cash generating ability of the business indicated this staying power. Second, the rise in milk procurement prices would produce the incentives for farmers to direct more capital towards production and sale of milk. And third, the politicians had reduced the sale prices of milk in retail markets to gain some temporary political mileage, which was needed by them to win some elections.

All in all, I figured that the reversion to mean in Heritage would, in all probability, restore normal earning power of the company and deliver me with more than satisfactory returns.

Did I get those satisfactory returns? The chart below shows that I did.But, did the returns come because of the mean reversion? No, they did not. Over the next two years, even though the company’s revenues grew significantly, the margins did not grow. Then what caused the stock to rise from Rs 50 in August 2004 to Rs 440 in February 2007 – a nine bagger in just two and half years?

The company announced its intentions to go into real-estate development. Since the company was in possession of some real estate, and real estate was “glamorous” in late 2006 and early 2007, the markets became excited and lifted the valuation of the company in a very short while. By the time the stock hit Rs 440, the company was more of a real-estate company, which also sold milk, rather than the other way round!

I had long ago sold my holdings before the stock hit Rs 440. As was the case with SRF, when the stock went above Rs 170, I could not understand it anymore. It was no longer a value stock but was about to become a glamour stock. (The stock has since fallen to Rs 225 as markets have become a bit more sanguine towards the real estate sector).

I can give you more examples of similar transformation of value stocks into a glamour stocks. But that would be unnecessary I think. What I want to do here is to list out the similarities in such situations.

Almost certainly, the near-term outlook in such cases looks horrible. And markets assume that recent trend is destiny. More often than not, markets are proven wrong. So, betting against the market in such cases is likely to be a winning strategy.

In a famous academic paper, the authors De Bondt and Thaler explained that investors tend to extrapolate past earnings growth too far into the future, assume a trend in stock prices, over-react to good or bad news, or simply equate a good investment with a well-run company regardless of price.

For any or all of these reasons, some investors get over-excited about stocks that have done very well in the past and they buy them and then these “glamour” stocks become over-priced.

Similarly, many investors over-react to stocks that have done very badly, and they become excessively pessimistic about them and sell them at lower and lower prices and as a result these out-of-favor stocks become under-priced.

According to De Bondt and Thaler, contrarian investment strategies work because contrarian investors invest disproportionately in stocks that are under-priced, and under-invest in stocks that are over-priced.

My own experience shows that De Bondt and Thaler were right. When you buy a value stock, lots of good things can happen to you- things, which will deliver you more than satisfactory returns. Even though your original thesis of buying into a value situation may prove to be somewhat inaccurate, the chance that more good things are likely to happen to you than bad things becomes a real friend. In contrast, when you buy a glamour stock, you run major risk of a permanent and sudden loss of capital because by its very nature glamour is a fair-weather friend – here today, gone tomorrow!

My Course, My Mac, and Some Recent Investments

2007-01-23T10:29:00.000+05:30

My course at MDI is over for the year! What a relief!

Here is a presentation, made on my new Mac (If you don't have one, then get one - if you have a windows PC, then switch - its easy), on some of my recent investments (many of which were discussed as cases in the class):

http://www.sanjaybakshi.net/Recent_Investments.zip

You will need Apple's Quicktime to view it. Get it from:

http://www.apple.com/quicktime/download/win.html

Arjya @ MDI

2007-01-16T07:35:00.000+05:30

On a cold Sunday morning, Arjya Chattoraj, an ex-student who is presently Senior Manager at SBI Mutual Fund, delivered an excellent talk to 20 students at MDI . The talk was titled "10 Things I Wish I Knew Before I Entered The Equity Markets".

You can see Arjya delivering the talk from here.

The presentation can be downloaded from here.

Hips don't Lie

2006-12-21T04:47:00.000+05:30

Dear Sir,

This is with reference to the ‘Hips Don’t Lie’ lecture. There are a few doubts I have about this…

Firstly, this is what I understand about the two approaches (please correct me where I’m wrong):

An investment is ‘good’ if the present value of future cash-flows is greater than the price paid for it (the basic economic concept). Since future cash-flows have to be estimated, there is a risk that we may overestimate these cash-flows. To deal with this risk, we keep a margin of safety in the price that we are willing to pay for an investment. These points are common for both ‘value’ and ‘growth’ approaches.

Now, on the one hand, in the value approach, we keep a margin of safety by mainly relying on the current economic value of the firm’s assets and not so much on its future growth. We mainly try to value the existing assets of the firm and see if we can get an ‘interest’ in them at a cheap price. Graham’s 10 rules of return and risk largely point in this direction.

On the other hand, in the growth approach, we keep a margin of safety by mainly relying on the future growth prospects of the firm and not so much on current economic value of its assets. We try to estimate the future cash-flows of the firm based on our strong expectations of growth and see if we can get an ‘interest’ in these cash-flows at a cheap price.

The ‘value’ approach relies on cash-flow value of assets while the ‘growth’ approach relies on the cash-flow value of growth. Therefore, in using Graham’s approach, the nature or quality of a company’s business is not of critical importance but the quality of its assets is. On the other hand, using Fisher’s approach, the nature and quality of the business (including the management) is of prime importance and not the quality of its assets.

Now my question: when you say that the two approaches are ‘joined at the hip’, do you mean that they CAN be integrated into a better investment philosophy or they SHOULD be integrated to have any sort of philosophy at all?

To my mind, the two approaches are separate and can be effectively used separately. Even if someone is able to integrate them, at some point of time, there would have to be tradeoffs between the two approaches. When I say this, I’m thinking similar to Michael Porter’s model of basic strategic orientation of firms: Low Cost OR Differentiation. A firm cannot be both: a low-cost operator as well as a differentiator, at the same time. It has to make a trade-off and focus on one approach as a provider of ‘sustainable competitive advantage’ this is because the two approaches are mutually exclusive. This does not mean that a low cost operator should completely ignore differentiation and vice-versa. What it only means that in the end, a firm can focus on only one approach from which to derive its competitive advantage.

Similarly, can an investor, psychologically and intellectually, handle the diverse demands of the ‘growth’ approach and the ‘value’ approach? Will he not have to eventually make trade-offs, in his investment philosophy, towards one approach, at the expense of the other? The expertise required to pick a good value stock and a good growth stock are probably very different. Should one try to achieve both? It is certainly desirable to be able to do both.

But is it feasible?

Sincerely yours,

K.K

_____________________________________________________________________________________

Dear K.K,

I think it is feasible to have your cake and eat it too :-)

You made some excellent points.

Graham's approach - often called the value approach was based on “protection” instead of “prediction”. He was never a believer in forecasting financial statements beyond a year or two. Rather, he focused on getting something that was cheap today based either on asset valuation, or on earning power valuation, WITHOUT making optimistic growth projections about that future earning power.

The key thing to remember is that Graham never really valued a business or a stock. Rather he insisted on a large margin of safety i.e. proof that the price was he was paying was much less than the value that he was receiving, whatever that value may be. Moreover, his extreme diversification took care of mistakes of commission.

In the modern context, many Grahamites, including me, have evolved Graham's approach to incorporate growth expectations in our investment process. Basically, we are so spoilt by Graham that we like getting free lunches and having our cakes and eating them too :-)

Seriously, we DON'T pay for growth. We are aware that some businesses have a great growth potential but we don't want to PAY for that growth. So we like to buy growth stocks at prices which imply low or negative earnings growth.

Read the following very interesting document which will hopefully resolve your questions. If not, please revert.

http://tinyurl.com/y9h252

SB

___________________________________________________________________________________

Dear Sir,

The speech you sent does indeed explain the ‘have your cake and eat it too’ approach. In essence what you and Mr. Nygren are saying is: take Graham’s value approach and apply another ‘filter’ of growth to these value stocks. The ones which emerge out of this double selection criterion are good stocks for investment.

So the approach is essentially value investing with an additional safety buffer called growth. You are not looking for high-growth stocks and buying them almost regardless of the price because the high internal rate of return will make up for a steep valuation today, given sufficient time.

So, I’m probably beginning to understand the idea behind value and growth approaches being ‘joined at the hip’.

K.K

Are CFO's Men with Hammers?

2006-11-09T11:31:00.000+05:30

The following is the text of an article I wrote recently for a publication meant for CFOs. The article was withdrawn before publication.

Are CFO's Men with Hammers?

I often ask my students the following question:

You are the CFO of a textile company which makes commodity yarn. The industry in which you operate is extremely competitive beset with excess capacity.

A leading textile machinery manufacturer’s marketing agent approaches you with a proposal to sell you a new loom which is more efficient than any other loom available in the market. He informs you that the new invention is far more efficient and that it will save your company a substantial sum of money every year, so that it will pay for itself in a very short span of time. To justify his claims, he presents you with the following figures: (1) Cost of machine: $100 million.; (2) expected life = 10 years; (3) annual savings in operating costs for the next 10 years = $25 million. p.a.; (4) expected residual value of the machine = $10 million.

You have verified the numbers presented to you and find them to be accurate. Your company’s pre-tax hurdle rate is 15% p.a.

Should your company place orders to buy these looms?

Using their newly-acquired skills in DCF analysis, the students quickly determine the NPV, which is large and positive, and conclude that the loom should be purchased and installed as soon as possible.

The main problem with this approach is that it often leads to wrong conclusions arising out of over-use of the DCF model in finance and ignorance of appropriate models from other disciplines such as microeconomics, game theory, and psychology.

Warren Buffett, the world’s most respected investor and Chairman of Berkshire Hathaway Inc., and his partner, Charlie Munger, call this “the man with a hammer syndrome”: To a man with a hammer everything looks like a nail. If all you have is one tool, you’re going to end up overusing it.

How can one deal with the man with a hammer syndrome? Well, the best way, according to Mr. Munger, is to train oneself to “jump jurisdictional boundaries” and grab the most appropriate models from multiple disciplines that best solve the problem at hand.

The present problem requires a two-step analysis drawing on models from multiple disciplines before drawing any conclusions.

The first step involves using DCF analysis, which my students have no problem with. That part of the analysis has already been done and described above.

It’s the second part of the analysis which they miss. They miss it because they are not yet trained to think in a multi-disciplinary manner.

That second part of the analysis requires them to answer the following question: How much of the cost savings that the new loom will deliver be kept by the company and how much of it will be passed on to the company’s customers?

Ah ha! Now it gets a bit tricky, doesn’t it? It gets tricky because to answer that question one has to grab models from microeconomics – such as the model of competition. And, of course, when you look at it from that angle, its obvious, that given the nature of textile industry’s competitive nature, arising out of surplus capacity and commodity attributes of the product, most of the cost-savings from the new loom will go to the customers of the company, and not to its owners.

This will happen because once a textile company acquires the new loom and achieves the promised cost savings, it will tend to either lower its prices to gain market share, or keep prices unchanged to earn higher margins.

Sooner or later either of these two actions would get noticed by the company’s competitors and they would naturally rush to make the same investments in new, efficient looms, in order to regain lost market share or to earn higher margins. Ironically, the very salesman who sold the loom to your textile company will rush to sell it to your second competitor and then the third one and so on, citing your own cost saving experience as reason for your competitors to buy his company’s new invention. After all, he is not in the business to make your production process more efficient. He is in the business of making money for his company (“Whose bread I eat, his song I sing”).

In our problem, competition i.e. the absence of a cartel will ensure that almost all of the efficiency gains end up in the pockets of the buyers of textiles, and not in the pockets of the owners of the textile companies.

Another irony arises out of the fact that this tragic outcome would occur even though all of the promised efficiency gains materialized. It’s not that the new looms aren’t any good. In fact they are so good that any advantage for the early buyers will prove to be a temporary illusion because sooner or later everyone has to have one or risk being perished.

Such is the nature of certain businesses where you have to keep on putting more and more money in just to stay where you are. (It's like running up on an escalator which is moving down - lots of investment, zero progress). You keep on investing money in projects which have positive NPVs and high IRRs and still end up earning substandard returns on capital that destroy shareholder value.

On the other hand, if we were dealing with India's largest tobacco company like ITC, a virtual monopoly where the buyers of its cigarettes are price-insensitive addicts – if someone sold it a more efficient machine to make its cigarettes - then the cost savings from this new wonderful invention will not be passed on to the customers. Rather, much of the post-tax cost savings would accrue to the benefit of ITC’s shareholders.

So, without jumping over the jurisdictional boundary of finance where DCF resides, into the jurisdictional boundary of microeconomics where the model of competition resides, you cannot solve the problem at hand in a satisfactory manner.

In early 1980s, Mr. Buffett faced a similar dilemma in the management of the unprofitable textile business of Berkshire Hathaway. He knew that the US textile industry was going to become increasingly uncompetitive, primarily due to its high, and impossible to reduce, labor costs. He also knew that he had other opportunities in which he could invest capital where the prospects of earning superior returns were excellent, given the fundamental economics of those businesses then available.

Long before most capitalists would even consider the possibility, in 1985, Mr. Buffett decided to shut down the textile operations of Berkshire and redeploy the capital in great businesses. It proved to be one of the best business decisions he ever made. In a letter written to the shareholders of Berkshire in 1985, Mr. Buffett reasoned:

“The promised benefits from these textile investments were illusory. Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industry wide. Viewed individually, each company’s capital investment decision appeared cost effective and rational; viewed collectively; the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic.”

Mr. Buffett utilized the metaphor of a parade to illustrate a well-known problem in game theory called “Prisoner’s Dilemma.”

Prisoner’s dilemma involves two suspects, A and B, who have been arrested by the police. The police have insufficient evidence for a conviction, and, after separated both prisoners, offer each the same deal: if one testifies for the prosecution against the other and the other remains silent, the betrayer goes free and the silent accomplice receives the full 10-year sentence. If both stay silent, the police can sentence both prisoners to only six months in jail for a minor charge. If each betrays the other, each will receive a two-year sentence. Each prisoner must make the choice of whether to betray the other or to remain silent. However, neither prisoner knows for sure what choice the other prisoner will make. So the question this dilemma poses is: What will happen? How will the prisoners act? The dilemma is summarized in the following table:

The dilemma arises when one assumes that both prisoners only care about minimizing their own jail terms. Each prisoner has two options: to cooperate with his accomplice and stay quiet, or to defect from their implied pact and betray his accomplice in return for a lighter sentence. The outcome of each choice depends on the choice of the accomplice, but the player must choose without knowing what their accomplice has chosen to do.

Let's assume prisoner A is working out his best move. If his partner stays quiet, his best move is to betray as he then walks free instead of receiving the minor sentence. If his partner betrays, his best move is still to betray, as by doing it he receives a relatively lesser sentence than staying silent. At the same time, the other prisoner's thinking would also have arrived at the same conclusion and would therefore also betray.

If reasoned from the perspective of the optimal outcome for the group (of two prisoners), the correct choice would be for both prisoners to cooperate with each other, as this would reduce the total jail time served by the group to one year total. Any other decision would be worse for the two prisoners considered together. When the prisoners both betray each other, each prisoner achieves a worse outcome than if they had cooperated.

In other words, actions that appear to be rational from an individual’s perspective sometimes become foolish, when viewed from a group’s perspective. The functional equivalent of the prisoner’s dilemma in our problem creates miserable choices but would we have discovered that unless we had jumped over into the jurisdictional boundary of game theory? I think not.

So, we grabbed DCF from finance, and then jumped over its jurisdictional boundary into the territory called microeconomics, where we grabbed competition. Then we jumped over the fence again and grabbed prisoner’s dilemma from game theory.

We need one more jump into the jurisdiction of psychology. And then we can stop jumping around and solve the problem.

One model we will grab from psychology is what Mr. Munger calls “bias from commitment and consistency.” When you have already made prior commitments to pet projects, you may find it hard, even impossible, to reverse your position and change course. If old reasons are no longer valid to support the original decision, new ones shall be invented. Man, after all, is not a rational animal, but a rationalizing one.

Another model we will grab from psychology is called the “contrast effect”. One version of the contrast effect makes small, incremental escalations in commitments go un-noticed, particularly when these escalations are carried out over a long period of time.

It works in Chinese brainwashing techniques. It also contributes to foolish business decisions.

If you’ve already sunk in $1oo million in a bad capital investment project, an additional investment of $10 million will look very small in contrast to the much bigger total commitment already made and will therefore tend to go un-noticed.

This version of contrast effect is also called the "boiling frog syndrome": If you put a frog in boiling hot water, it will jump out instantly, but if you put a frog in room-temperature water and then slowly heat it, it will boil and die.

The story about the boiling frog isn’t true. That metaphor, however, is highly appropriate because the human equivalent of the boiling frog is there in all of us.

Mr. Buffett could see that bias from commitment and consistency and the boiling frog syndrome from psychology often combine with the prisoners’ dilemma model from game theory, making many a businessman take foolish decisions by continuing to sink more and more money in a lousy business instead of taking money out and re-deploying it more productively elsewhere. He realized that in some industries the chief problem is that if you continue to remain in the game then “you can’t be a lot smarter than your dumbest competitor”.

And, so, Mr. Buffett wisely refused to play this game and withdrew his capital from the textile business and re-invested the proceeds in businesses with much better fundamental economics like Coke, Gillette, Capital Cities, See’s Candies, and Nebraska Furniture Mart. Over time, his decisions to shut down the textile operations of Berkshire and to re-allocate the released capital elsewhere have made its shareholders richer by tens of billions of dollars.

Mr. Buffett’s multi-disciplinary mind helped him solve a complex business problem. I see no reason why CFOs cannot apply the same thinking style in solving complex business problems they face.

Otherwise, they are destined to remain as “men with hammers”.

Project Libra Revealed

2006-10-26T20:01:00.000+05:30

In 2001, I and one of my great friends Nalin, were working on a secret project. We decided to call it "Project Libra". The Project involved exploring ideas for unlocking value from a company which I thought was highly undervalued.

While preparing for a lecture today, I came across the transcript of a chat I had with Nalin on Project Libra. This chat took place on 19 May, 2001. I reproduce here the transcript of that chat. I decided not to edit anything out or make any corrections whatsoever.

At the end of the transcript, I have placed a stock price chart of the company from around the time of that chat till recently. It became a 35-bagger. The company's name is Lakshmi Machine Works.

Chat
Date: May 19 2001 - 11:58am

Sanjay says:
Hi Nalin, will try to send Libra comments thru MSN

Nalin says:
Okay - send

Waiting for Nalin to accept the file "Libra Comments.htm" (4 Kb, less than 1 minute with a 28.8 modem). Please wait for a response or Cancel (Alt+Q) the file transfer.

Transfer of file "Libra Comments.htm" has been accepted by Nalin. Starting transfer...

Transfer of "Libra Comments.htm" is complete.

Nalin says:
Okay got it. Tell me when you send the Libra stuff. Bye
Sanjay says:
Wait
Nalin says:
waiting
Sanjay says:
is the file legible. it may not be i am sending a text version
Nalin says:
okay send

Waiting for Nalin to accept the file "Libra comments.txt" (4 Kb, less than 1 minute with a 28.8 modem). Please wait for a response or Cancel (Alt+Q) the file transfer.

Transfer of file "Libra comments.txt" has been accepted by Nalin. Starting transfer...

Transfer of "Libra comments.txt" is complete.

Sanjay says:
will SMS u when ready with Taurus comments
Nalin says:
Got it thanx. Actually I don't remember myself if Rieter was under hostile takeover. Remember I told you in Delhi about a Swiss activist investor. Do you remember which company he was trying to acquire - why is Rieter or some other ?
Sanjay says:
That guy sold stake a pharma co to another pharma co
Nalin says:
Okay - anyway I had already deleted the hostile takeover reference.
Sanjay says:
OK spend a couple of minuts reading my note. I'm waiting
Nalin says:
Okay
Nalin says:
I'm still reading it - but I have one question - maybe you can answer while I continue reading - why should normal dep be 50% of dep charged ?
Nalin says:
Also, on the financial engineering thing - if you took out Rs 100 Crore from the company (by replacing it with debt) it won't earn 45 Cr of discretionary profit a year.
Nalin says:
I agree, in general, that financial engineering can add value. But only when cash earnings. (They may already be stable - but we're not sure of that yet). Also, financial engineering in India is a very difficult task - and an acquirer would not want to pay now for benefits of financial engineering which he'll do post acquisition.
Sanjay says:
Take a look at the gross block and the accumulated depreciation. Gross block is 603 cr and acc dep is 407 cr. They are definitely overproviding depreciation. The amount of money that would be required to replace this gross block is definitely a lot more than the net block figure of 196 cr
Nalin says:
Sorry I missed a work in that message. I meant to say "But only when cash earnings are stable"
Nalin says:
If you feel that they are overproviding dep, then that is an additional upside which we will find out in detailed due diligence (if we are ever allowed to do that ) - at this stage its just a guess - we can't expect someone to pay top dollar for a guess.
Nalin says:
For all we know their assets might need a major revamp - which they have been delaying. Also in cash earnings we must deduct their increasing need for working capital
Sanjay says:
I am quite confident of the overprovision. Take a look at all the cash they have squandered away thru stupid diversification over all these years. THow did they finance it? not from new issue of shares, but from debt and internal accruals. Basically they had too much cash and insteadd of returning it to stockholders they simply threw it away
Nalin says:
You are right they might have overprovided depreciation. Do you want to base our presentation on that premise. Are you sure enough to make it a KEY assumption ?
Nalin says:
I'd rather just make it an additional upside
Sanjay says:
Not at all. What I want is to inform our investor group that this is classic case of massive misallocation of cash generated from operations. And that a rational person in control will have an opportunity to correct that misallocation and create value
Sanjay says:
Fine, you'can make it an additional upside but I should be in the document
Nalin says:
Okay - so we make that an upside that an acquirer gets - when he gains control. But I don't think we should ask him to pay for an upside - that we have no way of proving at this stage.
Nalin says:
Then the strategy remains more or less unchanged ?
Sanjay says:
Please also notice that my additional debt of Rs 100 cr requires an annual interest outgo of only Rs 15 cr and I have assumed c discretionary cash earnings of 45 cr p.a. at least until TUF benefits are available for the next three years. Even if the discretionary earnigns come to less than 45 cr, I can still pay a Rs 100 cr dividend financed out of from borrowed funds because the company is hugely
Sanjay says:
underleveraged.
Sanjay says:
Therefor I can bring my effecive cost of acqusition to Rs 18 cr for a 40% stake
Nalin says:
Like I said earlier - financial engineering is not something an acquirer will pay for up front
Sanjay says:
Why not? I would if I was certain of the benefits. If we get more info on the company's cash generating abilites then I would very gladly pay for financial engerring value
Nalin says:
In some cases it makes sense to go to the hilt in paying. In this case it makes sense to pay as little as possible - and not factor in too many upsides
Nalin says:
How do you get certain of the benefits ?
Sanjay says:
I agree with the conservatinve approach u are taking but putting a value equal to 100% of adjusted book value is too conservative, I feel.
Sanjay says:
We go to Coimbatore on a fact finding mission. we can control costs by travelling by train
Nalin says:
Its conservative - but in this case, paying more doesn't achieve much additional advantage - it disproportionately increases our downside risk. If we stick to market price in our bids - we have almost zero risk of loss - and a considerable upside.
Nalin says:
Even getting control of this company is very difficult - with labour, politics etc involved. Also, it probably has liabilities we haven't even dreamed off - such as corp guarantees for the steel project. Its a mess we don't want.
Sanjay says:
Ok think of it this way. Suppose, the amount of cash that can be taken out of this company without hurting it is only Rs 35 cr p.a. for the next three years and we are use a discolunt rate of 20% p.a. Then the present value of the next three year cash flows alone comes to Rs 650 per share.
Nalin says:
Its pure GM - with controlled downside risks
Sanjay says:
Nalin how can we do a successful GM when we are delaing with promoters who are not cash rich? I thought u did that cash rich promoters
Nalin says:
Listen - the way the industry is going - the company may need to get cash negative - to be able to emerge a strong player
Sanjay says:
But we'll be out well before that happens
Nalin says:
How do you get out ?
Sanjay says:
Leveraged recap can esnure that our cost is negligible. Then whatever we sell the company for is profit
Nalin says:
You can't do a leveraged re-cap if we fear uncertain cash flows - because of a recession + competition. Depending only on the TDF is not enough.
Sanjay says:
To quote u, "I agree to disagree!"
Nalin says:
But what strategy do we put in the book
Sanjay says:
I guess it would be best if we were to fix the meeting for wednesday and I come to mumbai on Monday and we spend 2 days on it
Sanjay says:
Im ust tell u that I am enjoying working with u
Nalin says:
Thats good.
Nalin says:
Lets give one last attempt at coming to consensus now.
Nalin says:
Tell me why is my strategy flawed. Let me defend it for a change.
Sanjay says:
It all comes down to valuation. You are being unlta conservative in valuing this company. A company that produces a cash profit of 70 cr cannot be worth less than the book value of 117 cr. This is true even if a large part of those earnings are not discretionary.
Nalin says:
I'm not saying its not worth more - I'm just saying we shouldn't pay more - what's wrong with sticking to a low price ?
Sanjay says:
Your views on valuation in the presentation are so pessimistic that the whole project will turn off investors
Sanjay says:
and I thought u were an investment banker!
Nalin says:
I WAS an investment banker. Now I think more like a value investor.
Nalin says:
My views on valuation were given on the next page - where I said that it could be worth Rs 1800
Nalin says:
Did you get the presentation ?
Sanjay says:
LOL! i agree we sohuld pay less if we can get away with it but how to achieve it is the issue here. We cannot do this deal unless we convince investors that this is a sitting duck
Nalin says:
But did you get the presentation - I hope you aren't refering only to my initial note
Sanjay says:
That 1800 is based on relative valuation with peers, something that may be difficut to sell to our investors.
Nalin says:
Before I proceed I need to know if you got the presentation
Sanjay says:
I got the presentation. Also, our strategy shoudl reflect the illiquidity of the stock for exit. We cannot sell a deal to investor on the basis that one of the exit routes will be thru the market when dailty volume is 15 shares. We cannot also tell them to hold it as a value stock. Our investors want to make a quick buck.
Nalin says:
I mentioned exit through the market only when the deal is on (and only to a very limited extent). I mentioned illiquidity when I said only 32,000 shares were traded last year.
Nalin says:
Holding on to the stock is a worst case scenario. I think we shouldn't proceed unless we have an investor who is willing to take that risk. Because its a real risk. I can think of no other approach which has a lower risk.
Sanjay says:
The stock is so illiquid that mkt operations after Public Annoucement will not be feasible. under such circumstances, why not have a conditional two-tiered tender offer which guarantees either control or exit thru tender in their counter offer?
Nalin says:
Let me think about this for a minute ?
Sanjay says:
Say a 7% toehold at 850, a 21% offer at 1500 subject to minumum level of acceptance of 20% with a lower offer price of 850 if shares tendered are less than 21%
Nalin says:
I think the problem again will be return on investment. We did this exercise in Taurus. The return on investment was just too low
Nalin says:
What should be the offer size ?
Sanjay says:
The toehold will cost only Rs 7 cr. A 21% offer will cost 38 cr., 50% of which or 19 cr will be cash escrow
Nalin says:
You are saying a 21% conditional offer, with 20% minimum acceptance ?
Sanjay says:
yes
Nalin says:
But in terms of risk - how is this different from what I said. You still run the risk of getting stuck with acceptances in your offer at Rs 850 ? But the downside is that return on investment goes for a toss. It was bad enough under my option at only 50% annualised.
Nalin says:
You also run the risk of actually getting 21% at Rs 1500
Nalin says:
Are you saying the only problem with my plan is that we won't get an investor willing to take the risk of a residuary holding at Rs 850 ?
Sanjay says:
I am unable to explain. Either we have to meet or I have prepare a note on bidding strategy explaining why I think that a conditional offer may make sense. The main reason is that a conditional offer is a hedge. But it imposes an ban on market purchases. But mkt purchases are not going to happen in any case in this stock/
Nalin says:
Okay - we'll discuss conditional offers later. Lets go back to why my plan is flawed ?
Sanjay says:
Look at pg 18. What if they don't buy us out? What if they go to instutions and get them to not tender to us because of lack of significant premium to market offer fro us. There are 100 shares. 13+21+33 (rieter,promoter,instutions) or 67 will not come. 20 shares are are missing. therefore 87 will not come. we already have say 7%. so we'll get only 6% if institutions do not tender.
Sanjay says:
they can simply ignore us and just get institutions to not tender.
Sanjay says:
so we end up with 13% at 850 and no control just apin in their necks
Sanjay says:
in order to get the institutions to tender we have to offer a significant premium to market otherwise they will have an excuse for not tendering. I saw this in Gesco case
Sanjay says:
If institutions do not tender and they don't make a counter offer we are fucked
Nalin says:
There is only a small chance that FIs will pre-agree not to tender. I think FIs will keep quiet about their intentions - therefore LIBRA will be forced to act. Also Rieter may want to ext. I don't think Libra will ignore us because they will not want to take any chances of losing control.
Nalin says:
But assuming this happens (its only a 2% chance) then our max downside is we are stuck with a 15% stake at 850. In other options there are worse risks.
Sanjay says:
In case of Gesco, the institutions made it very clear that they will not tender unless they got book value. In Gesco the book value was 54 and return on equity was less than 5%. So we told them that the stock is not worth book value because ROI is so poor. Thay told us to fuck off and come back with a 54 offer.
Sanjay says:
In LIBRA book value is 2000 even though a lot of it is water, but it does give a huge excuse to institutions to not tender. Also there is a history of this stock which at one tiem sold for Rs 10,000
Nalin says:
FIs will certainly want to put pressure on LIbra to give a better counter offer. They won't want to give them guaranteed comfort - and suggest they don't need to counter offer. Rieter will also want a higher counter offer - so there won't be any guarantees from that end eithre
Nalin says:
Anyway - we are talking about the same flaw - the chance (in my opinion small) of a residuary stake at Rs 850 ? Is there any other flaw ?
Sanjay says:
Precisely the point. In order to put this company in play we have to make institutions the sellers. Once we do that with our offer then our offer is the minimum they would get and they would demand higher from promoters or Rieter.
Sanjay says:
Unless we induce instutions to sell, we cannot succeed. becasue in any proxy contrest tyhey would side with management
Nalin says:
Okay - but we have to be careful not to introduce higher risks just to eliminate that risk - also be careful not to dilute returns too much. If you can come up with such a plan good. If we can't - we scrap this project.
Sanjay says:
My basic difference with you on this is that u are approaching it as a GM operation, whereas I am appraoching it as an acqusition prior to a leveraged recap, but which could also become a GM operation.
Sanjay says:
Hopefully it will be the later
Nalin says:
I strongly feel that we should not acquire this company - but stick to GM
Sanjay says:
But even if it turns out to be the former, I can do a recap to get my cost to negligible levels
Nalin says:
Do you want to discuss GM vs acquisition a little more ?
Sanjay says:
OK
Sanjay says:
Let's talk about promoters. GM is done with cash rich guys not poor ones
Sanjay says:
thesze guys are leveraging to creep up. OK, chola may be a white knight in which case our probability of GM is that much higher
Nalin says:
Overgeneralisations are dangerous. Every situation is different. In this case, we keep the cash required to buy us out low - so that they can actually buy us out - therefore a low bid
Sanjay says:
u do have a point there
Nalin says:
If Cholamandalam is appears as a white knight and gives a counter offer without buying us out - we lose - but hopefully without a loss.
Nalin says:
Also please note if we start a bidding match, Cholamandalam can still come in - in that case our losses would be even higher
Sanjay says:
now u're making sense
Sanjay says:
what 2 do?
Sanjay says:
OK, here;s a plan, we go with your presentation with John and ASit and see how they feel about it. Do u want to talk to Asit about Libra?
Sanjay says:
On pg 19 of your presentation u mention, "If promoters do not give counter offer - we become largest shareholder". I don't agree with this because we will not have significant tenders at a low price offer if institutions are not participating
Nalin says:
Listen I don't want to steamroll you into this. So you keep thinking. I'll keep working on the presentation. Overall, I think we should give both plans to Asit and John, just to show that we have more ideas where Taurus came from. On whether the plan is good or not - we can decide tomorrow
Nalin says:
Okay - I'll take care of that
Sanjay says:
Just think about this aspct
Nalin says:
Yes - this requires a lot of thinking - I agree
Nalin says:
Earlier when I said we should give both plans to Asit _ I meant both projects not both plans
Nalin says:
Someone has just sent me an email from gescocorp. Should I check and see ?
Sanjay says:
WHATTT????
Nalin says:
Wait I'm checking
Nalin says:
A friend of mine has just joined Gesco Corp. He's coming to visit tomorrow. How wierd.
Sanjay says:
Don't tell him about me!
Nalin says:
I have this feeling that destiny is just a game played for God's perverse amusement
Nalin says:
I won't.
Sanjay says:
I wanna live
Nalin says:
Okay.
Sanjay says:
ask him what's happening in the company
Nalin says:
Any more detailed comments on Libra - such as page 19 ?
Nalin says:
I'll work on another draft of the presentation and send it to you - in the meantime you think strategy. But hurry up with Taurus. Because I need to print the presentation today
Sanjay says:
OK Give me 2 hours on Taurus. I agree with most of your work there, just a few points I want to add/amend
Nalin says:
Okay talk to you later then ?
Sanjay says:
In libra disagreement is on valuation, and accoringly on strategy, but i see your point that a alow priced offer will enable the promoters to buy us out at a lower cost
Sanjay says:
Bye?
Nalin says:
It was a stimulating discussion anyway. Bye.
Sanjay says:
bye

SUBSEQUENT DEVELOPMENTS:

Adventures of a Risk Arbitrageur- The Case of Matrix Laboratories

2006-10-22T20:28:00.000+05:30

From: Sanjay Bakshi
Sent: Sun 22/10/2006 20:22
To: BFBV
Subject: Adventures of a Risk Arbitrageur

Dear Students,

Some time ago, I had told you about a deal on which I was working. This was the deal involving the acquisition of Matrix Laboratories by Mylan. I had, at that time said, that there are multiple ways of looking for opportunities in this deal. I had disclosed one such way to you. This involved taking a long position in the stock and simultaneously selling the shares expected to be received back (due to over-tendering) in the futures market. The second leg of that trade would have involved selling the surplus shares as and when received in the spot market and simultaneously squaring up the short futures position. These trades, if they had been initiated, soon after announcement of the deal, had an expected pre-tax, hedged return of more than 25% p.a. after considering trading and hedging costs. For details of this trade see the text of a note prepared by Ankur Jain, one of my colleagues, who is three years senior to you. The note is at the bottom of this mail.

Such returns are considered to be mouth-watering by many hedge fund managers primarily because of low correlation to overall market.

However, this very fact, attracts more capital in this game which makes returns in the strategy described above less attractive for new capital. That brings me to the second way of looking at this deal.

Given that (1) this is a large transaction involving a liquid stock; and (2) the stock is trading in futures market, it was clear to me that much capital will enter this trade. One way of validating this is to see what happened to the November futures contract, which was the relevant contract for hedging purposes in this deal (assuming no delays - wrong assumption - more about that later). A few days after the announcement of the deal, sure enough, the November futures contract started to trade below the spot price and the gap kept on increasing progressively and at one time reached more than Rs 15 per share. That is, the November futures were trading Rs 15 below the spot in September. Why would that happen? All of you know the mathematical relationship between spot and futures prices. Futures are supposed to trade a premium not discount to spot. Why were November futures trading at a discount to spot?

Well part of the answer is that too much money was chasing this deal. The strategy of buying shares in the spot market and selling them in the futures market for November delivery depressed the price of November contract for technical reasons. Such technical reasons often create very interesting anomalies for exploitation by the alert investors. Let me explain. (I am listening to Sarah Brightman as I type this - I love this girl's voice :) - so I am in the mood to share some of my secrets with you :)

Well this offer was to open on 20 October 2006 and close on 8 November 2006 and the surplus shares and money for shares accepted would have reached us by 23 November. This means that the November contract was the relevant contract because its settlement date was after 23 November. And that's exactly why the November contract went to discount to the spot price.

One of the key risks in risk arb is that of unexpected delays. Well, in this case a delay did take place. See the following news reported on 19th October.

http://www.business-standard.com/common/storypage.php?leftnm=lmnu1&subLeft=1&autono=262276&tab=r

What did the delay mean? Well in this case it means that the November contract was no longer the relevant contract for hedging because by the time the surplus shares would come back after the delay, it would be past the settlement date for the November contract (futures contracts are settled on the last Thursday of every month.) Now what that that imply?

If November is no longer the right contract for hedging then people who were selling November contracts for hedging would now have to shift to December. That required them to buy back the November contract which would create demand for this contract on the long side. Looked another way, there was no logic anymore for the November contract to trade at a discount to the spot price. So how does one make money in this? One way is to go long November contract and short December contract. Another way is to just go long November contract in the expectation that the discount will vanish.

And vanish it did- It HAD to didn't it? The market may be foolish for a while but it does not remain foolish forever. This window of opportunity was available for just a few hours - too little for the unaware investor -but just right for the alert one.

Total pre-tax realized return came to 15% flat on invested capital over just a few hours - the annualized returns need not be computed as they would look obscene :)

SB

P.S.: "The answer is out there, Neo, and it's looking for you, and it will find you if you want it to." - Trinity in "The Matrix"

Text of Note prepared on 6 September 2006

MATRIX LABS

On August 28, 2006, Mylan Labs announced the acquisition of 51.5% stake of Matrix Laboratories through a Share Purchase Agreement between Mylan (acquirer) and Mr N Prasad (Promoter of Matrix Labs) and the other Persons Acting in Concert.

The acquisition of 51.5% stake in the Indian company triggered the SEBI Takeover Code, 1997 which required the acquirer, Mylan Labs to come out with an open offer to buy at least 20% of the outstanding equity from the public shareholders of the acquired company, Matrix Labs. Also, post acquisition 5% of the outstanding shares are going to continue remain with Mr. N Prasad.

On August29, 2006, Mylan Labs came out with an open offer to buy 20% of the outstanding shares of the company from the public shareholders (except the parties to the Share Purchase Agreement).

Date of opening of offer: October 20, 2006

Date of closing of offer: November 08, 2006

Last date by which cash will be received: November 23, 2006

Investment Rationale

The excel sheet shows the shareholding pattern of the company. 51.5% has been acquired by Mylan. Also 5% is going to remain with Mr N Prasad. Thus, for the open offer of 20%, the % of eligible shares for tendering is (100-51.5-5) = 43.5%.

In our view, there might be some "brain dead" investors which in turn might increase the acceptance ratio during the open offer. Even if there are 3-4% investors who do not tender their shares during the open offer, the acceptance ratio will be 50%.

For 100 shares that we buy at Rs 274/ share, 50 might be accepted in the open offer at Rs 306/share and the rest 50 shares will be returned to us.

To hedge the risk of the price of the returned shares falling down, we can hedge our position using the availability of the Matrix Labs stock in the F & O Market.

The calculations have been taken for 6 F&O contracts because the deal will take 3 months and we will have to take 3 pairs of buy-sell.

The calculations show that for a fully hedged position in this trade, over a 78 day period ( Sep 07,2006- Nov 23, 2006) , the annualised returns after all costs of trading is close to 25.22%.

The Case of Neyveli Lignite

2006-07-08T22:58:00.000+05:30

The following is the account of a fictional meeting which took place between Dr. Manmohan Singh,

India

’s Prime Minister (PM) and M. Karunanidhi, Tamil Nadu’s Chief Minister (CM). Tamil Nadu is a state governed by DMK, a political party with socialist leanings and a partner in the coalition of parties supporting the central government led by the PM.

The meeting’s agenda was to discuss the central government’s plans to sell 10% of the shares of Neyveli Lignite, India’s largest lignite-based power generation company based in Tamil Nadu. The government owns 93.56% of the shares of Neyveli and the balance shares are actively traded in India’s stock markets.

The Prime Minister had invited the CM to consult him on various issues related to the plan. A consultation paper had been forwarded to the CM prior to the meeting. The CM was totally opposed to the idea of selling shares in Neyveli. He became very upset after reading the consultation paper and was intending to deliver a “take it or leave it” threat to the PM in the meeting. The PM, a wise man, was quite aware of the hostile reaction he was likely to receive from the CM.

The PM was prepared…

Venue: Prime Minister’s Office

Date: 7 July 2006

PM (standing up and welcoming the CM into his room and pointing him to a sofa): Ah, welcome sir, please be seated here. I will be with you in just a moment.

PM then calls his secretary and informs him not to allow any calls in his room during this meeting. Then he goes around his table and takes a seat right next to the sofa at which the CM is seated.

PM: Thank you sir for taking the time to come to my office for this meeting.

CM (angry and tense): I have read your consultation document and as you may be aware, I and my party are totally opposed to your plan to sell shares in Neyveli. If you persist in going ahead with your plan, then my party will withdraw support from your government. Also, we have full plans to involve all the other left-wing parties supporting your government to join with us. Without our combined support, you government will fall. Please announce cancellation of your plan to sell the shares in Neyveli immediately.

PM (takes a deep breath): Sir, you are right.

CM (totally surprised): Huh? What do you mean? You mean you will not sell the shares? You don’t want to argue with me on this subject? You know, you are not supposed to do this. You are the one of the architects of India’s reforms who believes in privatization and flexible labor markets. Are you sure you are feeling ok?

PM (smiling): I am just fine sir. I just wanted to take your advice on this matter, that’s all. While I don’t have plans to sell shares in Neyveli, I do have some other thoughts on this matter which I will discuss later. But before that, may I ask you for the reasons for your opposition to the sale?

CM: Well, you know the party from which I come. You know my constituents. You know my background. All my life I have been a socialist. I simply cannot agree to your proposal of selling government's shares in profitable companies like Neyveli. And even more important, I cannot be seen to be agreeing with you on this either. I know you are a good man. But in this matter, my hands are tied.

PM: Sir, why don’t we look at the problem in a different light? Instead of getting caught in a face to face confrontation, why don’t we do side-by-side problem solving as collaborators? After all you have tremendous experience in negotiations. I just want to consult you. What are your chief interests in this matter?

CM: Well, I have already told you. My chief interest is to not allow this proposed sale. You simply cannot be allowed to jeopardize the employment prospects of my state's workers by selling shares in Neyveli.

PM: Sir, I have already agreed with you on this. I have done some thinking. I need your support. I am not asking you to support a sale. I have a much better plan.

CM (now a bit more relaxed): Well then, in that case let’s hear about your interests and your plan.

PM (smiling): Sir, my chief interest is not to sell shares of Neyveli, but to reduce the budget deficit for which I need your help and support. You see this is not a zero-sum game. We should look for ways to expand the pie. We don’t want your constituents or the nation to think I will sell the cream of India’s public sector for a song. We should try to make this a win-win deal for all of us – for you and your party, for Neyveli’s employees, and for its shareholders including my government. In fact, we want this to be a vote-winning proposition for you because it involves a substantial payment to all the workers at Neyveli with no risk of any job losses.

CM: Well I appreciate your concern for my interests. But where in the world will the money to pay the workers come from?

PM: From Neyveli itself.

CM: Huh? I told you that you cannot sell your shares in the company. And don't try to bribe my workers!

PM: Sir, I am not offering to bribe your workers and I am not proposing to sell the company’s shares either. Sale of Neyveli’s shares is not the only way to raise funds for reducing the budget deficit. We should try to be a bit more creative, isn’t it?

CM: Huh? Look you are confusing me here. I am an old man. Don’t do this to me. Please explain to me how your plan works. Where will the money for workers come from? How will it win votes for me so that I remain CM as long as I live?

PM: Sir, allow me to explain the concept of a leveraged recapitalization.

CM: Huh? Leveraged what? What are you talking about?

PM: I will try to make it as simple as possible. Neyveli is a very strong company, thanks mostly to the tireless efforts of the workers of Tamil Nadu. It’s highly profitable and is also debt free. Indeed it has in its possession substantial cash. I am told that currently it should have about Rs 40 billion in cash, net of all debt. If I were to sell 10% of the company’s shares at say Rs 70 per share, I would raise about Rs 12 billion which is a lot of money. However I can do even better- not just for me but for everyone. By making Neyveli undertake a leveraged recapitalization transaction, I can end up with lots more money to reduce my government's budget deficit, with money left over for distribution to the workers of Neyveli, without any need for me to sell any shares.

Most importantly, post leveraged recapitalization, Neyveli will remain a very strong company in which the government will continue to hold 93.56% stake. And its other shareholders will benefit too by receiving a substantial amount of cash and a fairer market price for their shares in the stock market.

CM: Tell me more…

PM: Sir, although I have no personal interest in the stock market, I am told by my financial advisors that Neyveli’s stock is selling in the stock market at a very low price.

CM: What do I care about its value in the stock market? We socialists have nothing to do with the stock market.

PM: Sir, market value matters. Why should I sell Neyveli’s shares in the market if they are quoting at an unduly low price? Why should I sell the family silver for a song? I won’t. Not when I have a much better plan.

CM: Ok. So market value is important. Tell me how your plan will work.

PM: Sir, the total market capitalization of Neyveli is presently about Rs 100 billion. It’s a debt free company already in possession of Rs 40 billion in cash. It can easily borrow Rs 30 billion. Let's see how.

At current interest rates of about 10% p.a., the annual cost of debt will come to Rs 3 billion. And during the last five years, the company has generated cash of more than Rs 15 billion per annum. Putting a debt of Rs 30 billion on the balance sheet of Neyveli will not jeopardize the company’s solvency or its future growth plans because of its ability to generate cash of about 5 times its annual interest requirements. Indeed, I am told, that should Neyveli raise this debt, it will enjoy a very high credit rating.

Now let’s see we already have Rs 40 billion in net cash. The company borrowes an additional Rs 30 billion by selling 10% bonds. That makes it Rs 70 billion of cash. Of this, I propose to distribute Rs 5 billion to the workers of the Neyveli in appreciation of their contribution to the company. Neyveli has 19,000 workers. Each of them will receive for his/her valuable contribution, one years’ salary as bonus out of the money raised by the company.

I propose to distribute the rest of the Rs 65 billion to its shareholders as a special dividend. The company has 1.67 billion shares outstanding so the dividend per share will come to about Rs 39 per share. Of the Rs 65 billion dividend distribution, the government will receive 93.56%, or Rs 60 billion. Without selling a single share, this is five times the Rs 12 billion I would have realized by selling 10% of the company’s shares!

The leveraged recap will go a long way to generate much needed cash for the development of the infrastructure of the country. It will also satisfy the interest of all stakeholders. It’s a win-win deal for everyone.

CM: But how can this be? It’s too good to be true is it not? How can I enrich my workers without taking money from the owners?

PM (smiling): Sir, trust me on this. I am an economist trained to understand the concepts of valuation and its distribution amongst stakeholders, zero-sum games, and pie expansion. This proposal, if blessed by you, will become the role model for providing the much-needed funds for the growth of India. The best thing about this plan- the Karunanidhi Plan – is that it does not require the government to sell shares in well-capitalized, profitable, public-sector companies.

CM (smiling): You are indeed a wise man, Manmohan. No wonder you are the PM! You have found a way to have your cake and eat it too! You are getting five times more money through your leveraged recap than through the sale which I would have opposed tooth and nail. I would have said no to the sale but I am happy to say that we agree to my plan. Because this new plan of ours does not require any sale but only a leveraged recap, I will be able to sell it to my constituents.

PM: Sale or Leveraged recap? What’s in a name? That which we call a rose by any other word would smell as sweet!

Thank you sir! I have taken the liberty to draw up the draft press release of the “Karunanidhi Plan”. Let’s sit here and read it together and see if we need to make any changes.

CM: Yes, let’s do this now. I want to announce it to the media myself.

Draft Press Release

Jointly issued by the office of the Chief Minister of Tamil Nadu and the office of the Prime Minister of India

Date: 7 July 2006

The Chief Minister of Tamil Nadu is pleased to announce the salient features of the “Karunanidhi Plan on Neyveli Lignite” prepared by him in consultation with India’s Prime Minister, Dr. Manmohan Singh.

There shall be no sale of the company’s shares by the central government.
The company shall, against the security of its assets and cash flow, borrow Rs 30 billion.
After the completion of the borrowing, the company shall distribute a sum of Rs 5 billion to all the 19,000 workers in proportion of their existing wages, as special bonus for their valuable services to the company and the nation.
After the payment of the special bonus, the company shall pay its stockholders, a special dividend of Rs 65 billion. Since the government of India owns 93.56% of the company’s shares, it will receive Rs 60 billion as dividends plus dividend tax. The existing cash resources with the company in addition to the recently borrowed funds, shall be sufficient to fund this large, dividend payout.
The central government has undertaken that out of Rs 60 billion it expects to receive as dividend, it will spend at least Rs 20 billion towards the development of infrastructure of Tamil Nadu.

The Prime Minister welcomed the “Karunanidhi Plan on Neyveli Lignite” with the following words: “I congratulate Mr. Karunanidhi for showing the nation a path to achieve significant growth by raising resources from the markets, without having the need to sell government’s shares in profitable, public sector companies at unduly low prices. This model is likely to be adopted by the government in cases other than Neyveli Lignite.”

The Chief Minister commented: “I am grateful to the Prime Minister to endorse my plan for the transformation of financing the government’s deficits. My plan fully ensures that the ownership pattern of profitable, public sector companies does not change, that the employment at such companies remains unchanged, that workers are rewarded suitably for their valuable contribution to their company, and the central government can raise substantial resources, a significant part of which shall be allocated to the development of this state.”

The BOC Special Situation

2006-04-30T20:03:00.000+05:30

For details see my company's blog post.

Nothing Ventured, Something Gained: The Titan Industries Special Situation

2006-04-02T19:05:00.000+05:30

On August 31, 2005, Titan Industries made the following announcement to the exchanges:

Titan Industries Ltd. has informed the Exchange that at the meeting of BODs of the company held on August 31,2005, the directors have approved the issue of Partly Convertible Debentures(PCDs) of Rs.600 each on a rights basis in the ratio of one PCD for every twenty equity shares held in the company to the shareholders of the company as on a record date to be fixed by the board or by a duly constituted committee thereof. The duly constituted committee of the board for the Rights Issue will also decide on matters incidental to the Issue. The PCD will comprise of:a)Part 'A' will be converted into one equity share(Face value of Rs.10/-) in a price band of Rs.325/- to Rs.375/- which shall be fixed closer to the record date by the BODs of the company.b)Part 'B' will be one Non-Convertible Debenture(NCD),of the face value of the balance amount out of the Rs.600/- on due appropriation of the amount of equity shares priced as per 'a' above. The NCDs will be carrying a coupon rate of 6.75% per annum payable annually and redeemable at the end of 5 years. The total issue size is calculated to be around Rs.126.83 crores comprising of 21,13,813 PCDs of Rs.600 each.

On December 26, 2005, another announcement was made by the company:

Titan Industries Ltd. has informed the Exchange that at the 'Rights Issue Committee Meeting' of the Board held on December 26, 2005, the Members after deliberations on the subject have finalised the price of the equity shares comprised in the Partly Convertible Debentures (PCD) (forming Part A of the PCD) to be issued on allotment, at Rs.350 per equity share of a face of Rs.10 per share and inclusive of premium of Rs.340 per equity share and within the price band of Rs.325 - Rs 375 per equity share, as approved by the Board in their earlier Meeting. The price of the Non-Convertible Debenture (NCD) comprised in Part B has been fixed at Rs.250 per NCD carrying an annual interest of 6.75% p.a. and redeemable at par at the end of 5 years from the date of allotment.

On January 3, 2006, the company filed the draft offer document with the Securities and Exchange Board of India (SEBI).

On February 3, 2006, the company fixed March 06, 2006 as the record date for the purpose of the rights issue.

One of the key aspects of the offer was the buyback arrangement made by the company for the Part B of the PCD. Called the "Khokha buyback scheme" (see page 288 of the offer document), the applications had the option to sell the Part B of the PCD, having a face value of Rs 250, at a small discount.

Given that the stock price of the company was around Rs 800 per share, this looked like a very interesting idea. The investment operation would have involved buying 20 shares at Rs 800 on cum-rights basis, selling all of them ex-rights basis, and acquiring a the right to subscribe for the PCD at a low, or zero cost. The reasoning was that given the low dilution, the market would virtually ignore the dilution factor. Moreover, once the Rs 600 PCD was bought, a sum of slightly less than Rs 250 could be recovered by opting for the Khokha buyback scheme. In effect, the operation, if successful would have resulted in the acquisition of one share of this company at a price slightly more than Rs 350, even though its prevailing market price was Rs 800.

Not bad, eh?

Even more interesting was the fact that Titan stock was traded in futures and options segment. This meant that it was possible to buy 20 shares in the spot market on cum-rights basis and sell 21 shares in the futures market on ex-rights basis, locking in a handsome profit. However, the NSE decided make the necessary adjustments for the rights issue in the outstanding futures and options contracts. See this notice, and this one and this one.

So what happened exactly?

On 24 February - the last date on which the stock traded on a cum-rights basis, Titan stock closed at Rs 799 and had an average price of Rs 792 for that day. So one could easily have bought 20 shares @ Rs 792 costing a total of Rs 15,840.

On 27 February - the first date on which the stock traded on ex-rights basis, Titan stock closed at Rs 780 and had an average price of Rs 785. However, by March 1 the price had increased to Rs 792 which was the same as the cum-rights price. The market had, as expected, ignored the dilution.

I did not do this transaction though. Why? There were several reasons.

One was the capital intensity of the operation. The maximum spread, ignoring all costs, was Rs 442 (Rs 792 less Rs 350 effective cost of one new equity share). To get this gross maximum spread, one had to invest Rs 15,840 initially which was 35 times the gross maximum spread.

The second reason was to do with costs. In order to get one rights share, one had to buy and sell 20 equity shares in the spot market. In addition, the operation would have involved selling 21 shares in the futures market, and then squaring up that position later. The transaction costs of doing business in the spot market for 20 shares, and the futures market for 21 shares, must be loaded on to the cost of the one share to be acquired in the rights issue. Simple calculation showed that once when this was factored in the gross spread of Rs 442 was reduced very substantially. This made the operation less profitable and even more capital intensive than before.

In risk arbitrage, transaction costs matter - they matter a lot.

The third reason killed it. To generate the capital to do the deal would have involved substantial sales of the existing portfolio, resulting in significant taxes, which should correctly be counted as the cost of this operation.

All in all, nothing was ventured, but something was gained - knowledge - and that's what I am sharing here with you tonight...

Creating Free Warrants: The Case of JSW Steel

2006-04-02T18:06:00.000+05:30

On January 20, 2006, JSW Steel gave the following notice to the exchanges:

JSW Steel Limited has informed the Exchange that the Board at its meeting held on Jaunary 20,2006 has pursuant to section 81(1) of the Companies Act, 1956 has approved the issue of Equity Shares with Warrants on Rights basis to the existing shareholders of the Company. The total amount proposed to be raised by Rights issue of equity shares (excluding the amount of equity issue pursuant to conversion of warrants) shall not exceed a sum of Rs. 400 crores. The said Rights issue proceeds shall be utilized for part financing the Cold Rolling Mill Project of one million tpa capacity proposed to be set up at the Company's manufacturing unit at Village Toranagallu, Bellary Dist, Karnataka at an estimated project cost of Rs. 1000 crores. The principal terms and conditions governing the issue of equity shares with warrants on rights basis are as under: The equity shares and warrants will be offered for subscription for cash on a record date (to be decided later) as under: (a) (1) Equity shares for every (8) Equity Shares held as on the Record Date and (1) Series A and (1) Series B Warrants for every fully paid up Equity Share being subscribed and allotted on Rights basis under this issue. (b) Each equity share shall be offered at a price to be determined (including the warrant conversion price) later by a Committee of Directors formed for this purpose. (c) Each warrant will entitle the holder thereof to apply for 1 (one) equity share of Rs. 10/- each at a price and on terms set forth below (i) Warrant Conversion Period for Series A Warrants shall be the period commencing after 18months from the Date of Allotment upto 36 months from the Date of Allotment. The Warrant Conversion Period for Series B Warrants shall be the period commencing after 24 months from the Date of Allotment upto 48 months from the Date of Allotment.

On January 30, 2006, the company filed the draft offer document with Securities and Exchange Board of India (SEBI) for the rights issue.

On February 27, 2006, the stock price of JSW Steel closed at Rs 203.55. That's the date on which I wrote a note on a potential opportunity to acquire free warrants in the company.

Given that the current stock price of JSW Steel is Rs 303 per share, and the expected terms of the forthcoming rights issue, its now quite likely that the warrants would be free for investors who bought on or around the date of the note.

Here is the text of the note:

Note on JSW Steel Opportunity
By Sanjay Bakshi
February 27, 2006

JSW Steel Limited is planning a rights issue. Depending on the exact terms of the issue, we believe there may be a lucrative opportunity to acquire a zero-cost, or very low-cost, long-term warrants in this company.

When a company wishes to issue new shares to raise equity capital, it has to first offer them proportionately to its current shareholders. This “pre-emptive right” is granted to shareholders of all Indian companies by law. If the company wishes to issue shares to a different body of shareholders than its existing shareholders, this law requires the company to take prior approval from its current shareholders to waive off their pre-emptive right.

Obviously, like all options, this pre-emptive right to buy shares has value. So, when warrants are issued by a company, that action takes away the value of this pre-emptive right and transfers it to a separate certificate. Therefore, the value of the shares before issue of the warrants must equal the sum of (1) the value of the shares after such issue; and (2) the value of the warrants. At least that’s what the theory says.

Well, in practice, things don’t work out as the theory says. That’s because the theory assumes that markets are efficient and there is no difference between price and value. But the reality is quite different. Price and value often diverge by a large margin. And when value of a stock exceeds its price, the act of separating something valuable from that stock typically does not result in a compensating reduction in its price after the separation.

In the context of warrants this means that when the stock is cheap, the package of stock and warrants will tend to command a better price in the market than would the stock alone. This means that, under certain circumstances, it is possible to buy shares on cum basis, and sell them on ex basis at a price which implies acquisition of warrants at zero cost, or very low cost.

Before we return to warrants, however, we would offer two more applications of the above rule which we have profitably employed in the past. We want to do this to demonstrate the practical utility of the rule.

Dividend stripping

Cheap stocks often offer high dividend yields. If dividend cover is sufficient and its highly likely that the past dividend will be continued, then it’s possible to buy the stock on cum-dividend basis, and subsequently sell it on an ex-dividend basis at the same price, and strip the dividend for free. This approach has worked in spades in the past. The package of dividend plus ex-dividend stock price is worth more than the stock price before dividend.

Spin offs

When a cheap conglomerate company spins off a business division, then it is often possible to buy the stock of the conglomerate on a cum-deal basis, and subsequently sell it on an ex-deal basis, and get the shares of the newco for free, or almost free. There are plenty of examples of this working in the past. The package of newco and oldco shares commands a better price than the price of oldco alone.

JSW Steel Opportunity

This company is planning to raise a maximum of Rs 4 billion by offering shares to its existing shareholders. For every 8 shares held in the company, 1 share will be offered to the current shareholders at a price which is yet to be determined. And for every share subscribed, the company will allot 2 warrants. One of these warrants could be converted into one equity share 18 to 36 months from allotment. The other warrant could be converted into one equity share 24 to 48 months from allotment. The conversion price for both warrants will be at a discount to the stock price prevailing at the time of conversion. The extent of discount is yet to be determined. The warrants are adequately protected from corporate actions like stock splits, bonus issues, and further equity dilution. Moreover, the warrants shall be listed for trading soon after they have been allotted.

The exact terms of the right issue – in particular the price at which one share will be offered for every eight shares held, and the exact discount for pricing of warrants, will be announced shortly. Of the two, it’s the discount for pricing the warrants which is very important for the profitability of this operation. We expect the discount to be a minimum of 15%.

Assuming a discount of 15% and a stock price of Rs 300 at the time of conversion of the warrants (which is about 31 months from date of issue), the expected present value of two warrants allotted for every eight shares acquired comes to Rs 60 (assuming an opportunity cost of 15% p.a.).

The operation will involve the act of buying eight shares at Rs 205 on a cum-deal basis, selling nine shares on an ex-deal basis, at cost, and ending up owning the warrants for nothing. The basic assumption is that when the stock trades on ex-rights basis, the market would ignore the dilution factor caused by warrants. That is, nine shares in the company (eight bought from the market and one directly from the company) would sell for their cost, and two warrants would come for free. The reasoning behind this assumption has already been stated above. Specifically in this case, we expect the market to ignore the dilution factor due to warrants because of the following reasons:

The underlying stock is ultra-cheap and the principle (when value of a stock exceeds its price, the act of separating something valuable from that stock typically does not result in a compensating reduction in its price after the separation) stated earlier is applicable.
The warrants are of a long duration and uncertain subscription price.
Only two warrants will be issued for every nine shares, so the extent of dilution is relatively small.
If the stock price on ex-rights basis takes into account the value of the warrants also, then the stock will become ultra-cheap relative to current earning power, which will induce buying.

There are two ways this opportunity can be exploited. One would be from a pure arbitrage point of view. The other would be from an arbitrage plus straight equity viewpoint.

From the straight-equity-plus-arbitrage viewpoint, our recommendation is to buy the stock now. This will allow us to participate in the possible run-up of the stock price just before the stock turns ex-rights. Of course, this strategy also exposes us to market risk, which we believe, is worth taking in this case, given the inherent cheapness of the stock. If we are willing to take a market risk of about one month, then not only do we have a good change of getting the warrants for nothing, we are also likely to end up with a handsome profit on the straight equity component of the operation.

From a pure arbitrage viewpoint, we should buy just before the stock trades on ex-rights basis and sell it just after it turns ex-rights. Under this strategy, our intention will be to basically acquire the warrants at a zero-cost, or low cost basis. The chief advantage of the pure arbitrage approach over the other approach is that even in the worst case scenario i.e. even if the warrant dilution factor is factored in the pricing of stock on ex-rights basis, its hard to lose money.

This is just a preliminary note which will be updated as soon as the pricing information about the stock and warrants becomes available.

Reflections on Indian Stock Market Levels Revisited

2006-04-02T12:42:00.000+05:30

John Galbraith once famously said:

"There are two classes of forecasters. Those who don’t know and those who don’t know they don’t know."

Claiming that I belong to the former class, I, nevertheless, wrote a blog on July 30, 2005, when the widely-tracked Nifty (Indian stock market index) had hit an all-time high of 2,312. Providing historical data pertaining to relative values over time, I concluded, by borrowing Mr. Buffett’s quote:

“Stocks are high, they look high, but they're not as high as they look.”

During the eight months that elapsed since I wrote that blog, Nifty rocketed upwards and on March 31, 2006, stood tall at 3,402.

That’s a rise of 47% in eight months.

The obvious question that I am being asked now is: “What do you feel now about where the Indian stock market is headed?”

Still believing that I belong to the former class of Galbraith’s forecasters, my answer is: I don’t know.

Not knowing what lies ahead does not have to result in paralysis, however. So let me go out on a limb and give my views on the current state of the Indian stock market, and their implications for investment policy.

The chart below traces Nifty’s P/E multiple over time. On March 30, 2006, Nifty’s P/E was 20.35. Although the P/E is much lower than the peak of 28 times observed in Feb 2000, it’s not very far from other previous peaks as can be seen from the chart.

Here is another chart which portrays an even bleaker picture (for bulls). This one traces Nifty’s Price-to-book value ratio over time.

On March 30, 2006 Nifty’s P/B stood at 5.17 which is an all-time high. The previous peak was in the tech bubble market of 1999-2000 when it hit a level of 5.07 in February 2000.

A simple look at the P/B ratio chart can easily lead one to conclude that Indian stock market levels are expensive, in comparison to the past. However, one must also see how well corporate India is doing in comparison to the past. The following table gives some clues:

All figures in the above table pertain to Nifty.

The table clearly shows that the rise in the P/B value is justified because corporate India is doing exceptionally well both on earnings growth and on return on equity. The important question is whether these trends are sustainable or will they reverse? If they reverse, for example, if return on equity falls to 20% level, P/B ratio will fall to perhaps 3 times. On the other hand, if earnings growth rate and return on equity continue to remain high, we can expect an even higher price-to-book value – perhaps 6 times.

The future, in other words, is uncertain.

Given this uncertainty, what is one to do? Here are some preliminary conclusions about investment policy going forward:

Invest in companies that are significantly cheaper than the Nifty stocks.
Identify stocks which are much more expensive than Nifty – for shorting. This will be necessary and desirable to protect the long positions in deep-value shares in the event of a market decline.
Don’t leverage for straight equity investing (this was ok when markets collapsed in May 2004 – they have risen by 150% since then) but doing so in special situations is ok provided market risk is minimal.
Allocate more capital towards special situations – probably 50% and keep the rest in deep-value shares.

Quiz on "The Letters of Warren E. Buffett" - Preliminary Round

2005-12-21T11:28:00.000+05:30

As part of their course, my students at MDI were recently asked to participate in a quiz titled "The Letters of Warren E. Buffett."

The quiz was administered in two rounds. The class, consisting of 84 students, was asked to read all the letters written by Mr. Buffett to the shareholders of Berkshire Hathaway Inc.

The preliminary round was a written quiz consisting of forty questions, to be answered by each student individually.

The final round was an oral quiz consisting of thirty six questions. Six teams of four students each qualified to participate in the final round.

Ankur Jain, my colleague and ex-student, and who is also a quiz enthusiast, spent several days in the preparation of the question bank for both rounds. He also did an excellent job of administering the quiz - written as well as oral.

Ankur and I were also helped by Saroni Ray, our colleague. My thanks to both Ankur and Saroni!

I am posting the questions that were asked in the preliminary round. I will post the questions asked in the final round in a later post.

Management Development Institute

Post-Graduate Programme in Management (2004-2006)

Behavioural Finance & Business Valuation (BFBV)

20 December 2005

Quiz on The Letters of Warren E. Buffett

INSTRUCTIONS

This quiz contains three sections and a total of forty questions.
Read the instructions carefully, given at the beginning of every section.
Total time allowed: 60 minutes.
The acronyms, “BRK” & “WEB” stand for Berkshire Hathaway and Warren E. Buffett respectively.

Your Name: __________________________________________

Your Roll No: __________________________________________

SECTION A
(Questions 1-10)

• Each statement in this section is either true or false.
• No reasoning is required.
• Each answer carries two marks.
• Negative marking for every wrong answer is (-1) mark.

1. The long term economic goal of BRK is to maximize the average annual rate of gain in the reported earnings on a per share basis. True/False

2. Both Mr. Graham and WEB insist on investing in companies run by exceptionally talented managers. True/False

3. In WEB’s view, because stock options are hard to value and they are not dollars out of a company’s coffers, their costs should be ignored in calculation of a company’s earnings. True/False

4. WEB believes that taxes unnecessarily reduce returns for investors and therefore he likes companies which have low tax/profit ratios. True/False

5. Stock splits create enormous value for the shareholders. True/False

6. According to WEB, businesses should borrow money only when they need it for immediate deployment in a business opportunity which promises a rate of return which is significantly higher than the promised rate of interest on the funds borrowed. True/False

7. WEB believes that treasury bonds should be treated as risk free securities. True/False

8. WEB advocates usage of stock options because they align the interests of the managers with those of the company’s stockholders. True/False

9. WEB pays special attention to political and economic forecasts made by the experts in these fields before deciding upon an investment. True/False

10. WEB favors highly liquid markets because high-volume, active trading produces low bid-offer spreads which makes the markets more efficient. True/False

SECTION B
(Questions 11-30)

• Each of the following questions is a multiple choice one having one correct answer. Tick the correct one.
• Each answer carries two marks.
• Negative marking for every wrong answer is (-0.50) mark.

11. According to WEB, the appropriate measure of managerial economic performance is:

A high operating profit margin.
A high return on capital.
A low debt/equity ratio.
A high level of growth in EPS.

12. The term “look-through earnings” refers to:

BRK’s operating earnings plus dividends received by BRK from its investee companies.
Earnings from the lingerie business of BRK.
Earnings computed by looking through vast amount of financial and other data relating to the business and its managers.
BRK’s operating earnings plus BRK’s share of retained operating earnings in its investee companies less taxes that would have been payable had these investee earnings been paid out to BRK.

13. BRK’s long term economic goal is to:

Maximize the market cap of the company over the very long term.
Maximize economic earnings on a per-share basis.
Maximize dominance of markets in which it operates.
Maximize the average annual rate of gain in intrinsic business value on a per-share
basis.

14. When WEB wrote, “If corporate pregnancy is going to be the consequence of corporate mating, the time to face that fact is before the moment of ecstasy,” he was referring to:

The need to be aware of the possibility/need of a spin off of a business division after acquiring a company.
The need to factor in expansion of equity capital in mergers before the merger takes place.
The need to not count one’s chickens before they hatch i.e. to wait for post-merger integration to take place before deciding as to whether or not it was successful.

15. When WEB wrote, “If you've a harem of forty women, you’ll never get to know any of them very well,” he was referring to:

The need to control one’s sexual urges.
The need to maintain good memory especially when in the company of women.
The need to burn the midnight oil in order to understand all the businesses in one’s portfolio.
The need to diversify very little.

16. A jump in reported earnings from $10 million to $30 million is good news when:

The capital employed in the business increased by a lot more than the increase in reported earnings.
The number of shares outstanding has increased significantly.
The growth in reported earnings is due to exceptional reasons not likely to be repeated.
The company used untapped pricing power to achieve a permanent jump in earnings i.e. it increased prices of its products which have inelastic demand curves.

17. According to WEB, a business with historic and prospective high returns on capital, and having capital expenditure potential should:

Distribute large part of its earnings as dividends.
Retain much or all of its earnings for reinvestment in the business.
Use its stock currency to acquire other businesses.
Use its earnings to build a treasury.

18. When WEB wrote “If you want to shoot rare, fast moving elephants, you should always carry a loaded gun,” he was referring to:

The need to by fully prepared when going to Kenya for a jungle safari.
The need to be fully prepared for unexpected events while underwriting risks in the insurance business.
The need to have ample cash available for deployment in attractive investment opportunities as and when they arise.
The need to have ample unutilized debt capacity to take advantage of opportunities in leveraged buyouts.

19. When WEB asked, “Why should the time taken by a planet to circle the sun synchronize precisely with the time taken for business actions to pay off?” he was referring to:

The futility of focusing on one years’ financial data while evaluating a business.
The futility of focusing on the annual budgets made by managers of many businesses.
The occurrence of leaps years making it difficult for managers of certain businesses to plan ahead.

20. The term “float” refers to:

Insurance premiums received by BRK from insuring floating, seaworthy ships.
Interest paid by BRK on floating rate bonds issued by it as part of its opportunistic financing operations done in anticipation of a drop in interest rates over the next few years.
Money held by BRK in its insurance operations but not owned by it because premiums are prepaid and there is a lag between receipt of premiums and payment of claims, if any.

21. While making investments in marketable securities, WEB believes in very little diversification. However, BRK is one of the largest diversified conglomerates in the world. How would you resolve this paradox?

The rules for diversification in marketable securities are different than the rules for diversification into operating businesses.
Insurance company rules require that BRK to own substantial liquid investments in large-cap stocks.
There is no paradox here- WEB promises not to diversify by buying operating businesses at prices that are higher than values BRK’s shareholders can obtain through direct purchases in the stock market.

22. Buffett talks of “Rip Van Winkle” in the context of which one of the following:

The fact that the top few holdings of BRK hardly change.
The fact that the management hardly changes in any BRK companies.
The nick name given to Charlie Munger by WEB.
The nick name given to WEB by Charlie Munger.

23. BRK once borrowed funds at 10% p.a. and parked it in short-term debt securities earnings 6.25%. WEB justified it on the which of the following grounds:

He did not justify it. He admitted it was a foolish mistake.
That you should take advantage of tax arbitrage opportunities e.g. when interest on the debt is tax deductible but dividends received from the investments in debt mutual funds are tax free.
That you should borrow money when it is cheap and available and deploy it only when there are lucrative investment opportunities available and since these two events do not always go together, it makes sense to borrow long-term funds and wait for the right opportunity to come by.

24. When WEB wrote that “It has been far safer to steal large sums with a pen than small sums with a gun”, he was:

Comparing the success rate of bank robbers with those of bank check forgers.
Lamenting about accounting fraudsters getting away with their crimes.
Advocating gun control to curb violent crime in the United States.

25. In 1996, BRK split its stock into two classes – class A and class B. The primary motive behind this transaction was:

To increase the liquidity of BRK’s stock so that the stock sells at a higher price.
To defeat the plans of some opportunistic people who wanted to profit from BRK’s high stock price by creating and selling mini BRKs.
To make the stock more affordable to the small investors because class B is 1/30th of class A.
To comply with new NYSE listing regulations.

26. WEB believes that an intelligent investor in shares will do better in the secondary market than he will do in buying new issues (IPO’s). This is because:

Long-term returns on IPOs tend to be much less than those earned by broad market indexes.
There are so few IPOs in a year but there are thousands of companies to choose from in the secondary market.
Investment bankers allocate shares in hot IPOs to favored clients and it’s unlikely that a typical investor will get sufficient number of shares in such IPOs.
The price-setting mechanism of the secondary market is conducive to the occasional emergence of bargains while this is very unlikely in the IPO market.

27. The exceptional profitability of Nebraska Furniture Mart and Geico is attributable to:

Low margins with high turnover
High margins with low turnover
Frequent stock buybacks which reduced capital employed
Extremely conservative accounting

28. The exceptional profitability of See’s Candy is primarily attributable to:

Pricing power arising out of brand loyalty
Low-cost operations in an extremely competitive market
Frequent stock buybacks which reduced capital employed
Extremely conservative accounting

29. Property-casualty insurance business has two income streams.

Underwriting profits and unpaid claims.
Underwriting profits and float income.
Float income and unpaid claims.
Premiums and capital gains on investments.

30. In WEB’s framework of risk analysis, there are five primary factors to consider. Four of these are: (1) The certainty with which the long-term economic characteristics of the business can be evaluated; (2) The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows; (3) The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself; (4) The levels of taxation and inflation that will be experienced by the investors over his/her prospective holding period. The fifth one is:

The purchase price of the business.
The expected annual future returns from the stockmarket over the next several years.
The extent to which the operations of the business are financed with debt as opposed to equity.
The return on invested capital earned by the business - both historic as well as prospective.

SECTION C
(Questions 31-40)

• This section contains direct questions. Write your answer in just a few words.
• Each answer carries four marks.
• There is no negative marking.

31. Fill in the blank: “In a business selling a commodity-type product, it’s impossible to be a lot smarter than your __________________.”

32. If your stock is deeply undervalued, then the most intelligent allocation of capital decision is likely to be _______________.

33. According to WEB, producers of relatively undifferentiated goods in capital intensive businesses will earn inadequate returns except when _______________________.

34. According to WEB, BRK will issue shares only if its shareholders receive _________________________.

35. According to WEB, while estimating the fair swap ratio in a merger transaction between two companies, its silly for the would-be purchaser to focus on current earnings of the target company when the prospective acquiree has

different prospects,
a different mix of operating and non-operating assets, or
______________________.

36. WEB likes to think of businesses on a continuum on which at one extreme are bullet proof franchises. At the other extreme are _________________.

37. Two conditions, when they exist together, contribute towards WEB’s favoring a zero-dividend policy. One is the presence of large returns on capital employed. The other is ____________________________.

38. WEB talks a lot about the advantages of scale in many of the businesses in which it has an interest. But there is one exception i.e. there is one business in BRK’s portfolio where going for a large scale i.e. a dominant market share is not a good idea. The managers of this business are perfectly willing to accept reduced volume by refusing to lower prices in response to competition, and let its competitors take away business. WEB is referring to the _______________________ business of BRK.

39. WEB advises investors to seek answers to four questions while evaluating risk arbitrage opportunities. These are:

How likely is it that the promised event will indeed occur?
How long will your money be tied up?
What chance is there that something still better will transpire- a competing takeover bid, for example? and
The fourth one is _______________

40. WEB once used a famous Aesop’s fable to describe the process of DCF valuation. The fable is “_________________________________________.”

END OF QUIZ

To Burn a Bridge? Or to Cross it Only When You Come to it? Lessons from Black-Scholes Options Pricing Model

2005-12-03T21:08:00.000+05:30

When the Spanish explorer Cortez landed at Veracruz, the first thing he did was burn his ships. Then he told his men: “You can either fight, or you can die.” Burning his ships removed a third alternative: giving up and returning to Spain. [from Creative Whack Pack Card # 55]

In 1334, Hochosterwitz Castle was besieged by the Duchess of Tyrol. As time wore on, the defenders became desperate: their last food was an ox. The Duchess’ situation was also severe: her troops had become unruly, and she had urgent matters elsewhere. Then, the castle’s commander had an idea that must have seem utter folly to his men. He had the last ox slaughtered and thrown over the wall in front of the enemy. The Duchess interpreted this scornful message to mean that the defenders had so much food that they could waste it. At this, the discouraged Duchess quit her siege. [Creative Whack Pack Card # 59]

Two truck drivers driving their trucks at breakneck speed towards each other on a narrow road. One of them has to go off the road to avoid a collusion. Then, one of the drivers yanks out the steering wheel of his truck and throws it out of the window leaving the other truck's driver with no choice but to go off the road to avoid getting both of them killed.

These examples show how the “burning your bridges” strategy involving deliberate elimination of one’s options is sensible under certain circumstances. In war, for example, when you need to invoke the powerful psychological influence of extreme commitment [Read chapter on Commitment and Consistency in Cialdini’s Influence] by your troops to achieve a desirable goal which appears, to most people, impossible, this strategy clearly makes sense. Great Generals like George Patton knew this. So do great business leaders.

Why does the burning your bridges strategy work?

When a man burns his bridges, there is no more turning back for him and that realization changes his attitude towards the only two choices now available to him– one which will lead to sure failure and disgrace, and another one which requires him to achieve something, which, at present, appears impossible to accomplish, but if accomplished, will lead to success and glory. The act of destroying some of his options drives the man to accomplish the impossible.

So, the burn-your-bridges tool is a good tool. Like any tool, however, its prone to be over-used by men who are afflicted by what Mr. Charlie Munger calls the man-with-the-hammer syndrome: “To a man with a hammer, everything looks like a nail”.

How does one avoid falling victim to the man-with-the-hammer syndrome in this case? Well, one way would be to invert the problem and ask the following question:

Are there situations where the burn-your-bridges tool will not work, but it’s opposite i.e. keeping-your-options-open tool, will? And once you think about the problem in this manner, the answer is obviously a “yes”.

To see how, let's go inside the guts of Black-Scholes Option Pricing Model.

Options - puts as well as calls - have value for all sorts of reasons. The elegant Black-Scholes Option Pricing Model, shows, that there are six factors that determine the value of options : (1) the stock price; (2) the exercise price; (3) risk-free rate of interest; (4) dividends; (5) time to maturity of the option; and (5) volatility.

For the purpose of this essay, two of these are important- time to maturity and volatility.

Time to Maturity: A key reason why options - calls as well as puts - have value is that there is time before which the option holder has to decide whether to exercise it or not. Options with longer lives are more valuable than options with shorter lives, other things remaining the same. This is true for both calls as well as puts.

Volatility: Another reason is volatility. An option on a volatile stock is more valuable than an identical option on a less volatile stock. This is true for call, as well as, put options.

What works in finance also works in much of life.

In rapidly changing situations (think high volatility), buying time before making a decision (think increasing time to maturity) will improve the quality of the decision, other things remaining unchanged. Dynamic situations have a high likelihood of the emergence of new, material, information. That is, stuff happens.

Therefore, sometimes it makes sense to keep your options open, to buy time, to delay decisions and wait for new information, before making decisions. In other words, you should cross a bridge only when you come to it.

Robert Rubin called this “preserving optionality”.

Mr. Rubin, who is currently chairman of Citigroup, developed his philosophy of preserving optionality while doing risk arbitrage at Goldman Sachs. In risk arbitrage, one bets money on the happening or non-happening of a corporate event such a merger. By definition, such events are dynamic i.e. they display a large degree of volatility because the chances of new developments (e.g. the emergence of a competing bid, regulatory or financial glitches etc.) is significant. While practicing risk arbitrage, Mr. Rubin learnt that preserving optionality is very often a good idea. He successfully applied the same idea in his hugely successful career as the US Treasury Secretary under President Clinton. Clearly multi-disciplinary thinking helped him a lot.

One can learn much about Mr. Rubin’s thoughts on preserving optionality and his philosophy of decision making from his excellent book, “In an Uncertain World”.

In July 1998, the New York Times Magazine published an article on Mr. Rubin. Jacob Weisberg, who wrote the article, had talked to Lawrence Summers about Mr. Rubin. An excerpt:

Rubin is someone who loves to examine and reexamine his options -- a tendency the academically minded Summers refers to as “his preference for optionality.”

One thing Summers says he has learned from Rubin is the value of not always choosing among the available options. “Rubin ends half the meetings with - 'So we don't have to make a decision on this today, do we?' Summers says. New information will evolve.”

“What so many people have a tendency to do is to lock into a scenario,” Summers says. “What Rubin will say, at times to the frustration of others, is that some questions don't have answers - which is to say that just because a problem is terrible, we don't have to act. It may not be the right time.”

In November 2003, Carol Loomis wrote a wonderful article on Mr. Rubin for a Fortune magazine cover story. An excerpt:

Part of Rubin's approach to decisions at the Treasury was to put them off as long as possible. Some people might call that procrastination; Rubin called it getting that one last fact or well-judged opinion, from whoever at the table might offer it, that might make a decision the right one. Geithner says the young members of the Treasury staff would on occasion rush into Rubin's office, imploring him for a decision about something consequential. Rubin's first question would often be, “How much time do we have before we have to decide?” Summers tabs this Rubin's habit of “preserving his optionality.”

Another person who agrees with Mr. Rubin is Steven Sample, the author of the excellent book, “The Contrarian's Guide to Leadership”. In this book, which was once recommended by Mr. Munger, Sample states one of his contrarian rules of leadership:

“Never make a decision today that can be reasonably put off till tomorrow.”

Mr. Sample gives the example of Harry Truman that reminds me of Mr. Rubin.

“Whenever a staff member would come to him with a problem or opportunity requiring a presidential decision, the first thing Truman would ask was, “How much time do I have?" Was it essential that he make the decision in thirty seconds, in an hour, in a day, sometime next week, in a month, within a year.”

Of course, Benjamin Graham, the father of value investing also knew about the idea of preserving optionality. In his book, Security Analysis, Mr. Graham discussed the wisdom of the principle:

“Never convert a convertible”.

Suppose that a bond issued by a sound company, having a face value of $100 is convertible into 2 shares of the company at a fixed price of $50 per share. The option to convert is available to the bondholder for the next 3 years, and the stock price of the underlying company is $60 per share.

Such a bond should sell for $100 plus some premium reflecting the value of the option to convert. The option to convert itself is worth $20 plus some additional value due to the long period of 3 years till conversion.

Suppose this bond is selling in the market for $150. Should the bondholder convert?

Mr. Graham suggested that he should not convert. Why so? Because by converting his bond which can be sold in the market for $150, the bond holder will get two shares having an aggregate market value of $120, a loss of $30.

So, the bond holder should not convert because doing so will result in the loss of the time value embedded in the option to convert. If the bondholder is bullish on the company, he should continue holding the convertible and if he is bearish on the company he should sell the convertible, but he must not convert it because doing so will destroy the time value of the option.

Conclusion: So, after much deliberation over the creative whack pack, the option pricing model, the wisdom of Robert Rubin, Steven Sample, Benjamin Graham, and others, what's my conclusion?

My conclusion is that sometimes it makes sense to burn a bridge after crosssing it, so that there is no turning back, and at other times it makes sense to cross a bridge only when you come to it.

The trick, of course, is to know, when to do what.

If I look back at my own life and identify key decisions I took that explain my current situation, I find that most of those decisions required burning bridges. On the other hand, in my day-to-day affairs including investment-related affairs, I find that preserving optionality has helped me in making better decisions.

Three Questions about Charlie Munger

2005-11-29T07:03:00.000+05:30

Bryan Kelleher, a CPA from Ohio, who is fascinated by Mr. Munger's teachings, sent me a mail in which he asked me three questions. I am listing here, Bryan's questions, and my response:

In one of his most recent speeches on Academic Economics, he posed several issues and questions I have been pondering:

How some consultants in a small South American country helped eliminate corruption and turn the economy around?
How Mr. Munger is way ahead of other experts in the principles of Mind control and why it works on Moonies?
How a slot machine receives better results than other machines based on the same payouts, same locations, same design, etc?

My reply:

Thank you for your mail . . .

I have read the Munger speech you referred to in your mail. If you have not already got this book, I recommend that you buy it. It contains lots of Munger wisdom:

Now, here are my responses to your questions:

1. South American Company - the publishers of the above book (see page 448) asked Mr. Munger the same question you have asked. And his response was:

"Oh yes - I ran across that fascinating story not in an economics book, but in a psychology paper. I could take it out of my files for you, but its too much effort, so I wont."

The editor noted: "Sometimes we remain in the dark."

2. Moonies:
If you read the talk by Mr. Munger on psychology - "The Psychology of Human Misjudgment- you will have your answer. The earlier version of this talk can be seen from here.

The greatly updated version of this talk is in the book mentioned earlier.

Basically, Reverend Moon used a combination of psychological mental models which produce the effect desired by him. Some of them were Authority, Social Proof, Stress, and Reciprocation.

3. Slot Machines - this is an example of deprival super-reaction - for meaning read the talk on psychology. The difference between the two slot machines is this : even though the overall probability of winning or losing is the same in both, one machine has a lot more "near misses" than the other one. This triggers the deprival super-reaction in the gambler who now tends to play more, which translates into more collections for the casino from the "doctored" machine.

The psychology of a near miss is a very powerful influence. You can learn more about it from here.

Dr. Zen and His System

2005-11-27T08:29:00.001+05:30

Text of Mail Sent to My Students at MDI

From: Sanjay Bakshi
Sent: Sat 26/11/2005 18:18
To: BFBV
Cc:
Subject: Dr Zen and his System

Dr. Brian F. Zen, who runs the ZenWay program, claims that as a Zen student he is “used to simple life-style” and that he has “no desire for material luxury.” And yet, when asked about his passion for the ZenWay program, he says “It's what I love to do, and you know, the money doesn't suck.”

Dr. Zen wrote to me recently and made me an offer.

It is, to put it mildly, a very generous offer.

He wants me to recommend to you, as my student, his online investment course which has helped “people with limited means to become millionaires and multi-millionaires.”

Dr. Zen will charge you $800 to sign up. He promises to pay me $400, if you do.

You will, I hope, recall the connection between Dr. Zen’s offer and Mr. Charlie Munger’s example of “bribing the purchasing agent”. I had used this wonderful example as an illustration of the power of incentives and the need for multi-disciplinary thinking in one of my earlier lectures. I was quoting Mr. Munger, who in this speech, said:

“I have posed at two different business schools the following problem. I say, “You have studied supply and demand curves. You have learned that when you raise the price, ordinarily the volume you can sell goes down, and when you reduce the price, the volume you can sell goes up. Is that right? That’s what you’ve learned?” They all nod yes. And I say, “Now tell me several instances when, if you want the physical volume to go up, the correct answer is to increase the price?” And there’s this long and ghastly pause. And finally, in each of the two business schools in which I’ve tried this, maybe one person in fifty could name one instance. They come up with the idea that occasionally a higher price acts as a rough indicator of quality and thereby increases sales volumes. . .

. . . But only one in fifty can come up with this sole instance in a modern business school – one of the business schools being Stanford, which is hard to get into. And nobody has yet come up with the main answer that I like. Suppose you raise that price, and use the extra money to bribe the other guy’s purchasing agent? (Laughter). Is that going to work? And are there functional equivalents in economics – microeconomics – of raising the price and using the extra sales proceeds to drive sales higher? And of course there are zillion, once you’ve made that mental jump. It’s so simple. One of the most extreme examples is in the investment management field. Suppose you’re the manager of a mutual fund, and you want to sell more. People commonly come to the following answer: You raise the commissions, which of course reduces the number of units of real investments delivered to the ultimate buyer, so you’re increasing the price per unit of real investment that you’re selling the ultimate customer. And you’re using that extra commission to bribe the customer’s purchasing agent. You’re bribing the broker to betray his client and put the client’s money into the high-commission product. This has worked to produce at least a trillion dollars of mutual fund sales. This tactic is not an attractive part of human nature, and I want to tell you that I pretty completely avoided it in my life. I don’t think it’s necessary to spend your life selling what you would never buy. Even though it’s legal, I don’t think it’s a good idea.” [Emphasis mine]

Dr. Zen claims to teach Graham-Buffett system of value investing. Here’s what he claims at his site:

“At Zenway.com, we only deploy proven methods developed and tested by proven superinvestors. And in terms of proven investment methods, nothing is more so than the analytical methods introduced in the 1934 classic, Security Analysis, widely recognized as the Bible of Wall Street. Benjamin Graham, the father of security analysis, introduced the idea that stocks should be viewed as small parts of a business that's for sale. He developed a system for identifying the real value of a business based on measurable data. This system was later modified and further developed by Warren Buffett, the greatest investor in the world. Our Zenway investment system is based on the Old Testament written by Benjamin Graham and the New Testament written by Warren Buffett.”

I checked the price of the “old testament” from here. It costs $31.50. And I checked the price of the “new testament” from here. It’s free. Yes, the single most valuable source of knowledge about investing – the Warren Buffett letters – are available for free to anyone who has access to the internet, which I believe, all potential customers of Dr. Zen, do.

So, all it costs is $31.50 to get access to the collective wisdom of two of the greatest minds on Wall Street that ever existed.

How, then, does one go about selling a high-priced product derived out of something so cheap? That’s simple. One uses, the reward super-response tendency and the associated incentive-caused bias (whose bread I eat, his song I sing) which it produces– Mr. Munger’s terms - by pricing the product high and offering a very significant part of the sales proceeds to people like me having access to “captive audience” like you.

There is nothing illegal about Dr. Zen designing his business model in this manner. After all, seeking profits is the essence of capitalism, isn’t it? But I doubt it very much – if the fathers of value investing – Mr. Graham and Mr. Buffett - would approve of the marketing strategies used by Dr. Zen, for promoting products created out of their knowledge, which they generously shared with the world, without any profit motive involved.

When Wal-Mart pushes its suppliers to lower their prices, and then passes on these low prices to its customers, and yet is able to earn a respectable return on capital, it’s an example of a positive-sum game which benefits civilization as a whole. Wal-Mart does not make money off its customers – it makes money with them. But when someone pushes a high-priced product using as ammunition, mouth-watering commissions offered to people who are in a position to influence others, it largely becomes, at least in my view, a zero-sum game. You’re not making money with your clients anymore- you’re making money off them. And, this aspect of capitalism is not very good for civilization.

There is another aspect of Dr. Zen’s philosophy of life which I find rather interesting. He claims to know how to make money in the stock market using the principles of investing he says he learnt from Mr. Graham, Mr. Buffett, and others. And yet, he chooses to run a for-profit venture which sells this very knowledge.

If he is so sure about his system, why is he selling it to others, at any price? After all, the money he can make from his system, if it really works, will be far more, than money he is likely to make by selling that system. By selling the very system which, he believes, works, is he not killing the goose that lays the golden eggs?

Moreover, if he is selling it to others for $800, using 50% commissions to increase volumes, what does that imply about his own rational assessment about the value of his product to its buyers? Would he agree to put his own money in something like this, knowing that 50% of what he pays will go, not to the seller, but to the person who recommended it to him?

These are controversial questions, but logical ones, in my view. In the investment business, we should address these questions in the following manner: If we really know how to do it, we should not sell the “how to do it” for any price. But, if we still want to share our knowledge, then we should give it away – for free.

Prof. Graham knew this. So do Mr. Buffett and Mr. Munger.

I hope you do too…

Regards

Sanjay Bakshi

25 March, 2008:

Dr. Zen has requested that I post this on my blog:

Dear Prof: Bakshi:

I respect your work and your suspicion about any online courses charging a fee for teaching and coaching. I apologize that I did not explain our program too well that made you think that the up-to-50% commission is a "bribe" to you. It is not. By taking a 50% payout, you will have to personally coach whoever you referred into our online coaching and mentoring program. We are actually paying for you coaching work for a one year period. That's why we believe we are providing a extremely valuable service for a very low fee. I happen to believe that personalized coaching is the missing link towards success for all the college kids who went to good schools.

I respect your noble idea of teaching for free. But I have one question: If we follow your advice, how could our tutors and teachers

make a living and bring food to their family table? Also, how could we set up our classroom and the computers to facilitate our coaching? Would you, our noble professor, consider donating a few million dollars so we can provide value investing university courses for free? Without any pay, how can we recruit talented teachers.

By the way, I happen to believe that a commercial coaching business could benefit people more than a non-profit organization because we have an opportunity to create wealth for our trainees and tutors.

Further more, could you please do what you preach and come to New York to coach all our students for free? Also, would you take in students into your classes for free? How much your students would have to pay to take your courses? How much do you get paid by giving your lectures? The last time I checked, it seems your students pay a much higher tuition to learn from you. Our guys pay a lot less and get much more personal guidance from us.

You and I belong to the same church of Graham-Buffett Value Investing. I am somewhat disappointed and hurt that a fellow believer would attach a brother for offering personalized coaching and mentoring for a meager fee. If we don't offer the guidance ourselves, would you rather hope that we push all the naive investors into those $2,000 per day online trading courses or expensive conferences?

I also want to make another point. I fully understand that smart guys like you can just hit the books, synthesize all the conflicting

information, and figure out the map and the puzzle all by yourself. But less talented people may need some coaching. Coaching can also dramatically speed up the learning curve. Even Warren Buffett paid a lot more than $800 to attend Ben Graham's lectures. I firmly believe there is value in what you do and what I do. We all have noble motives while pursuing commercial interests by designing different compensation systems. I don't see any reason to belittle other's work. Yes, Buffett and Graham taught a lot. But I believe their teachings can be better structured and better organized.

Besides, all the math and language books are already on sale in bookstores, should we just banish all the schools and universities and ask all the kids to read the books themselves?

There is also some flaw in the notion that those who know don't teach, those who teach don't know. Do you know that one of world's best swimming coach did not know how to swim himself? Yet he coached many Olympic gold medalists. The coaches are not necessarily the fastest athletes. But they know how to provide guidance. So there is value in what I do even if I am not as good as Buffett. I also believe there is a lot of value in what you teach and you did not choose to keep all the secrets for yourself.

Again, I respect your work. I think your misunderstanding of our program is mainly due to the 50% commission. I am sorry that I did not explain the work involved upfront. Had you showed an interest, you would have to sign an agreement with us where you would take up the obligation to coach whoever you refer into our online training program.

I hope you could remove your comments from your blog due to the misunderstanding of the work involved behind the 50% commission and tutoring fee. Otherwise, please kindly post my response right on top of your posting to prevent mischaracterization of our coaching program.

Respectfully yours,

Brian Zen

BRIAN F. ZEN, CFA

http://www.zenway.com - from wisdom to wealth

wealth management • estate tax planning

Midtown: 330 W. 38 St. Ste 238, New York, NY 10018

Downtown: 211 N End Ave, New York, NY 10282

phone: 212.786.3018

fax: 212.786.1859

cell: 646.388.0887

29 November, 2005:

Requested by Dr. Zen:

Please post the following response to your blog and correct some
mistakes or misunderstandings in your blog comments. Please post this
as a formal response from me:

Dear Prof. Bakshi:

There seems to some huge philosophical misunderstandings between two teachers of value investings.

1) Had you decided to be part our Zenway tutoring and mentoring network,you would have to tutor, teach and mentor your team members and students inorder to EARN your 38% fee. The 12% deferred compensation would be based on your performance as a mentor and researcher in our network of enlightened investors. We think the work of teaching and mentoring is noble. It's really a lot of good work for a low fee. We prefer not to label it as a "bribe".

2) The $800 tuition to get one-year's worth of trainings, tutorings, mentorings and research stock picks is really cheap compared to someother not-for-profit investment courses at many universities. Would you care to share with us how much your students pay to enroll in your classes. Further more, would you be willing to return all your teaching compensation to your school?

3) Great investors like Benjamin Graham have come out to teach for a small sweat fee. To say that "if someone is willing to teach and therefore his system must be worthless" is perhaps not reasonable. I bet Warren Buffett paid more than $800 to take Benjamin Graham courses.

4) If we use your logic, we would perhaps close all the schools and universities in the world. You can buy all the cheap math books and physics books, why pay the huge tuition to get tutors, mentors, and instructors from all the not-for-profit universities? It seems a for-profit organization of zenway.com is charging less than some not-for-profit universities.

5) You can always read Newton and Einstein. Then why all the high-priced textbooks, high-tuitioned university courses, why all the reorganization, repackaging, and representation of all the materials from Newton and Einstein. Our simplification and reorganization work at zenway.com is aimed to make value investing so intuitive that even a kid would understand. To say our work is worthless is perhaps an attack on your own teaching work.

6) If we follow your noble advice to make our courses free to all,would Prof. Bakshi be willing to donate $2 million so we can pay the rent of our classroom?

Respectfully,
Brian Zen
http://www.zenway.com/

Its all Greek to Me

2005-11-21T20:23:00.000+05:30

One of my students, Atul Kumar Tiwari, recently forward a link to a marvellous article which appeared in the Harvard Business Review. In my view, everyone interested in value investing should read this article. Here's the link:

http://www.ederman.com/new/docs/beware.hbr.pdf

You will also find references to "physics envy" in this talk by Mr. Charlie Munger (see page 7).

Of course, the desire to be precise in economics and its subset, security analysis, is an example of Mr. Munger's availability misweighing tendency whereby overemphasis on useless numbers that are easily available (beta, for example), and underemphasis of factors that cannot be precisely measured but are, nevertheless, critical for rational decision making, results in much avoidance of the practise of Keynes' wise advice that its better to be approximately right than to be precisely wrong...

Cheaters Causing Crashes?

2005-11-09T19:24:00.000+05:30

Once upon a time there was a village in which there lived many married couples. There were certain qualities about this village, though, that made this village unique:

Whenever a man had an affair with another man’s wife, every woman in the village got to know about the affair, except his own wife. This happened because the woman who he had slept with talked about their affair with all the other women in the village, except his wife. Moreover, no one ever told his wife about the affair.

The strict laws of the village required that if a woman could prove that her own husband had been unfaithful towards her, then she must kill him that very day before midnight. Also, every woman was law-abiding, intelligent, and aware of the intelligence of other women living in that village.

You and I know that exactly twenty of the men had been unfaithful to their wives. However, as no woman could prove the guilt of her husband, the village life proceeded smoothly.

Then, one morning, a wise old man with a long, white beard came to the village. His magical powers, and honesty was acknowledged by all and his word was taken as the gospel truth.

The wise old man asked all villagers to gather together in the village compound and then announced:

“At least one of the men in this village has been unfaithful to his wife.”

Questions:

What happened next?

And what this got to do with stock market crashes?

Answer 1:
After the wise old man has spoken, there shall be 19 peaceful days followed by a massive slaughter before the midnight of the 20th day when twenty women will kill their husbands.

Proof:
We will use backward thinking for the proof. Indeed, the very purpose of this post is to demonstrate the utility of the backward thinking style.

Let’s start by assuming that there is only one unfaithful man in the village – Mr. A. Later, we shall drop this assumption.

Every woman in the village except Mrs. A knows that he is unfaithful. However, since no one has told her anything, and she remains blissfully ignorant. But only until the old man speaks the words, “At least one of the men in this village has been unfaithful to his wife.”

The old man’s words are news only for Mrs. A, and mean nothing to the other women. And because she is intelligent, she correctly reasons that if any man other than her own husband was unfaithful, she would have known about it. And since she has no such knowledge in her possession, it must mean that it’s her own husband who is unfaithful. And so, before the midnight of the day the old man spoke, she must execute her husband.

Now, let’s assume that there were exactly two unfaithful men in the village – Mr. A and Mr. B.

The moment the old man speaks the words, “At least one of the men in this village has been unfaithful to his wife,” the village’s women population gets divided as follows:

Every woman other than Mrs. A and Mrs. B knows the whole truth;

Mrs. A knows about philanderer Mr. B, but, as of now, knows nothing about her own husband’s unfaithfulness, so she assumes that there is only one unfaithful man - Mr. B – who will be executed by Mrs. B that night; and

Mrs. B knows about philanderer Mr. A, but, as of now, knows nothing about her own husband’s unfaithfulness, so she assumes that there is only one unfaithful man - Mr. A – who will be executed by Mrs. A that night.

As the midnight of day one approaches, Mrs. A is expecting Mrs. B to execute her husband, and vice versa. But, and this is key, none of them do what the other one is expecting them to do!

The clock is ticking away and passes midnight and day 2 starts. What happens now is sudden realization on the part of both Mrs. A and Mrs. B, that there must be more than one man who is unfaithful. And, since none of them had prior knowledge about this other unfaithful man, then it must be their own respective husbands who were unfaithful!

In other words, the inaction of one represents new information for the other.

Therefore, using the principles of inductive logic requiring backward thinking, both Mrs. A and Mrs. B will execute their respective husbands before the midnight of day 2.

Now, let’s assume that there are exactly three unfaithful men in the village- Mr. A, Mr. B., and Mr. C. The same procedure can be used to show that in such a scenario, the wives of these three philandering men will kill them before the midnight of day 3.

Using the same process, it can be shown that if exactly twenty husbands are unfaithful, their wives would finally be able to prove it on the 20th day, which will also be the day of the bloodbath.

Answer 2: Connection with Stock Market Crashes
If you replace the announcement of the old man with that provided, by say, the SEC, the nervousness of the wives with the nervousness of the investors, the wives’ contentment as long as their own husbands weren’t cheating on them with the investors’ contentment so long as their own companies were not indulging in fraud, the execution of twenty husbands with massive dumping of stocks, and the time lag between the old man’s announcement and the killings with the time lag between the old man’s announcement and the market crash, the connection between the story and market crashes becomes obvious.

Information Asymmetry
One of the most interesting aspects about the story is the role of information asymmetry.

You and I knew that there were exactly twenty unfaithful men in the village. We had complete information about the number of unfaithful men in that village but not their identity.

On the other hand, every woman in the village knew the identity of at least nineteen unfaithful men. For example, if you were Mrs. A, you would have known about nineteen unfaithful men, but not about your own husband’s unfaithfulness. And, if you were one of the women whose husband was faithful, then you’d know the identity of twenty unfaithful men.

But the old man did not say that there were twenty unfaithful men in the village. All he said was that there was at least one unfaithful man in the village. So, his statement, did not add anything to the knowledge of any individual woman because each of them knew of at least nineteen unfaithful men!

And yet, his statement caused the bloodbath after twenty days!
.
The lesson is simple: It’s not necessary for any new information to cause havoc in the stock market. Sudden realizations about the stupidity of gross overvaluations and dubious accounting practices followed by some companies in bubble markets can and do occur simultaneously in the minds of the crowd. And that sudden realization can cause markets to crash.

Note:
The above village story was adapted from John Paulos’ excellent book, Once Upon a Number and was repeated in his, other, also excellent, book, A Mathematician Plays the Stock Market.

Billionaires' Wager With Loaded Dice

2005-11-06T14:23:00.000+05:30

In 1996, Bill Gates wrote a review of Roger Lowenstein's book, "Buffett: The Making of an American Capitalist".

Gates' review, which was titled, "What I Learnt from Warren Buffett" was published by Harvard Business Review in early 1996 and later by the Fortune magazine. In that review, Gates wrote a small passage on his and Buffett's love of mathematics, which I am reproducing below:

"One area in which we do joust now and then is mathematics. Once Warren presented me with three unusual dice, each with a unique combination of numbers (from 1 to 12) on its six sides. He proposed that we each choose one of the dice, discard the third, and wager on who will roll the highest number most often. He gratiously offered to let me choose the die first.

"Okay," Warren said, "because you get to pick first, what kind of odds will you give me?"

I knew something was up. "Let me look at those dice," I said.

After studying the numbers on their faces for a moment, I said, "This is a losing proposition. You choose first."

Once he chose a die, it took me a couple of minutes to figure out which remaining die to choose in response. Because of the careful selection of the numbers on each die, they were nontransitive. Each of the three dice could be beaten by one of the others: die A would tend to beat die B, die B would tend to beat die C, and die C would tend to beat die A. This means that there was no winning first choice of a die, only a winning second choice. It was counter-intuitive, like a lot of things in the business world."

Then, in January 1997, Time magazine did a cover story titled "In Search of the Real Bill Gates" for which Buffett gave the magazine an interview. He spoke about the game-of-dice incident. However, his account was slighly different from that of Gates. Here is the relevant extract:

"He loves games that involve problem solving," Buffett says. "I showed him a set of four dice with numbers arranged in a complex way so that any one of them would on average beat one of the others. He was one of three people I ever showed them to who figured this out and saw the way to win was to make me choose first which one I'd roll." (For math buffs: the dice were nontransitive. One of the others who figured it out was the logician Saul Kripke.)

Three dice or four, it does not matter. What matters is: (1) how the numbers were arranged on those dice; and (2) what general lesson can be drawn from the wager?

There are several ways in which numbers on nontransitive dice can be arranged. Here are two ways involving four dice:

Take a look at the upper deck of four dice. A will tend to beat B. Why? Because four out of six times die A will land the number 4 and two out of six times it will land on the number 0. However, die B will land 3 on every roll because all its six sides carry the number 3. So, two-thirds of the time A will beat B and one thirds of the time B will beat A.

Similar analysis shows that B will beat C two-thirds of the time and C will beat D two-thirds of the time. The nontransitive property of the dice, however, also means that D will beat A two-thirds of the time.

So the trick lies in making your opponent choose first. If she chooses A, you must choose D. If she chooses B, you must choose A. If she chooses C, you must choose B, and if she chooses D, you must choose C.

Similar analysis will work with the lower deck of dice.

The general lesson from the wager is that blind faith in "first mover advantage" is often misplaced. Sometimes, the odds of the business game are such, that it is advantageous for you to allow your opponents to make the first move and then decide your own move (including whether you want to move at all or not).

SUBSEQUENT CLARIFICATION FROM FUTILE FRANCE

Subsequent to my posting of the above blog post, Futile France wrote to me and clarified that Buffett-Gates wager involved four dice and not three.

I had relied on an old paper version of the HBR article (which mentioned three dice - I reconfirmed), whereas, Futile not only looked up his (corrected) electronic copy of the same article, he also checked out the Fortune article. He also gave two links which I'd like to share here:

http://tinyurl.com/7fmja
http://tinyurl.com/dluoh

Thanks Futile!

One Valuation Rule, Two Paradoxes

2005-11-05T22:12:00.000+05:30

In his book, Security Analysis, Benjamin Graham gives an elegant rule on valuation of equities which I call as the rule of minimum valuation. This rule states that:

"An equity share representing the entire business cannot be less safe and less valuable than a bond having a claim to only a part thereof."

The wisdom of the rule of minimum valuation arises out of the fact that it allows you to use elementary math to prove the cheapness of a stock. To see how, let me use the very example that Graham used in the 1934 edition of Security Analysis. It’s the example of the American Laundry Machinery.

American Laundry Machinery
In early 1933, the stock of this debt-free company was quoting at $7 per share. The company had 614,000 shares outstanding. The market cap came to $4.3 mil. Graham gave the following additional information about the company:

Cash assets: $ 4.13 mil
Other current assets: $ 17.4 mil
Current liabilities: $ 0.20 mil
Average 10 years earnings before interest: $ 3.15 mil
Average earnings per share: $ 5.13

At $7 per share, the stock of this company was selling for less than 2 times average earnings. Moreover the company classified as a net-current-asset bargain. So, it was a cheap stock. But Graham wanted to prove it mathematically. How did he do that?

Graham Plays a Mental Game
He played a mental game. He said that let us make this debt-free company issue 45,000 hypothetical bonds of $100 each and let us make this company distribute these hypothetical bonds to its shareholders without taking any cash from them. Since the hypothetical bonds were to carry an interest rate of 5% p.a., they would represent an annual interest expense of $ 225,000 to the company. This was not a problem at all since the company’s average annual earnings of $3.15 million were 14 times annual (hypothetical) interest. With such a healthy interest coverage ratio, the bonds deserved to be classified as high-grade bonds. Because market interest rates were slightly higher than the 5% interest which these bonds were paying, Graham valued these bonds at $94 each.

So, the total market value of the 45,000 bonds came to approximately $4.3 million, which, not co-incidentally, was the same as the market value of the entire company before it issued the bonds!

The interesting thing is that shareholders of American Laundry Machinery did not have to pay anything to receive the bonds distributed by the company. If you owned 1% of its equity shares, you'd automatically recieve 1% of its bonds. Moreover, the shareholders did not have to surrender their shares in exchange of the bonds. Even so, the insersion of a prior claim reduced the fair value of the equity shares of the company. However, since the market value of the bonds received was the same as the market value of all the shares in the un-leveraged American Laundry Machinery, the shareholders who receieved the bonds had no cause for complaint. They now simply held two pieces of paper – one representing ownership stake in the corporation and the other a claim against its assets and earning power. And the combined market value of two pieces of paper they now held in the leveraged American Laundry Machinery was bound to be significantly more than the market value of the shares in the unleveraged American Laundry Machinery they held earlier.

This process of creating and distributing bonds, which we now call as leveraged recapitalization, proved that the stock of the unleveraged American Laundry Machinery simply cannot be less than the value of the 45,000 bonds issued by the leveraged American Laundry Machinery. Graham explained:

“The purpose of this analysis is to show that at $7 per share for American Laundry Machinery stock in early 1933- equivalent to only $4,300,000 for the entire business- the purchaser was getting as much safety of principal as would be required of a good bond, and in addition he was obtaining all the profit opportunities attaching to common stock ownership.

Our contention is that if American Laundry Machinery had happened to have outstanding a $4,500,000 bond issue, this issue would have been considered adequately secured by the standards of fixed-value investment.

There would have been no question about the continuance of interest payments, in view of the powerful cash position revealed by balance sheet. Nor could the investor fail to be impressed by the fact that the net current assets alone were nearly five times the amount of the bond issue.

If a $4,500,000 bond issue of American Laundry Machinery would have been safe, then the purchase of the entire company for $4,300,000 would also have been safe. For a bondholder can enjoy no right or protection which the full owner of the business, without bonds ahead of him, does not also enjoy. Stated somewhat fancifully, the owner (stockholder) can write out his own bonds, if he pleases, and give them to himself.”

Debt Capacity Bargains
Over the last ten years, I have frequently used the rule of minimum valuation to identify stocks for further research that appear to be ridiculously cheap. I call this theme of deep value investing as debt capacity bargains. The process used to identify stocks using this theme, is derived from Graham’s rule of minimum value. It's a very simple process but it requires one to do a bit of backward thinking, which is Mr. Charlie Munger’s favorite thinking style (more on this thinking style in a future blog post).

Before I lay down the process of how I use the debt capacity bargains theme, let me restate the rule of minimum valuation, in Graham’s own words, this time, from his other book, The Intelligent Investor:

“There are instances where an equity share may be considered sound because it enjoys a margin of safety as large as that of a good bond. This will occur, for example, when a company has outstanding only equity shares that under depression conditions are selling for less than the amount of the bonds that could safely be issued against its property and earning power. In such instances the investor can obtain the margin of safety associated with a bond, plus all the chances of larger income and principal appreciation inherent in an equity share.”

Here is the process I use to identify stocks for further research which are cheap under my debt capacity bargains theme of deep value investing:

Look for debt-free companies which have displayed stable earning power in the past and are expected to continue to do the same in the future as well;
Average the past earning power (use cash flow from operations after deducting increase in working capital and maintenance capex).
Use a desired interest coverage ratio of 3x to 5x, depending on the character of the industry – Use 3x for highly stable businesses, 5x for cyclical businesses;
Using data from the above two steps, work backwards to estimate the amount of interest expense that can easily be serviced by the company;
Divide the interest expense arrived at in step 4. into the current interest rate to determine debt-capacity of the company;
Compare this debt-capacity with the current market cap, and if the market cap is less than debt-capacity, consider buying the stock.

An example would explain. Suppose that the past annual average cash flow from operations of a debt-free company after adjusting for working capital changes and maintenance capex is $100 million. Assuming that its business operations are fairly stable, by using the desired interest coverage ratio of 4x, we estimate that this company can easily afford to carry debt which would require payment of $25 million ($100 million/4) of interest payments every year. Given that the current rate of interest for such companies is 5% p.a., the company’s comfortable debt capacity comes to $500 million ($25 million/0.05). In other words, if this company had bonds in issue having a face value of $500 million, then these bonds would easily classify as high-grade bonds with little credit risk, worthy of investment-grade credit rating, and worthy of selling in the market at near $500 million value.

Now, if the market cap of this company is less than $500 million it means that the stock is selling for less than this debt-free company's debt-capacity – making it similar to Graham’s American Laundry Machinery. That is, if you buy the stock of this unleveraged company for less than a total value of $500 million, you’re, in effect, acquiring a high-grade bond having a market value of $500 million, plus you're getting equity stake for free. In other words, a free lunch!

Basically, by buying the stock at that ridiculously low price, you're exploing the deep truth in the rule of minimum valuation, which is that hidden inside every stock of a debt-free company is a high-grade bond which can easily be valued.

Paradox # 1: The Bond Fund Manager
This brings me to the first paradox which is:

A bond fund manager will refuse to buy shares of a debt-free company quoting at a price implying a market value of the company to be less than its debt-capacity and yet, he’d gladly buy the bonds of this very company created thru the process of a leveraged recapitalization.

This irrational behavior on the part of the fund manager would, to a very substantial degree, be due to the ignorance of the fundamental truth in the principle of minimum value. And even if the bond fund manager understood the principle, he’d rationalize his unwillingness to buy the stock and his willingness to buy the bond by stating that he is not allowed to buy stocks for his bond fund. And if he gave you that rationalization, he’d display his ignorance of Shakespeare’s famous quote from Romeo and Juliet:

“What’s in a name?
That which we call a rose by any other word would smell as sweet."

His third argument rationalizing his behavior could be that the act of buying bonds entitles him to receive contractual interest payments, but if he had bought the stock instead, he’d get a right to receive only discretionary dividends. This silliness of this argument is obvious from the fact that its not contractual rights, but the cash generating ability of a corporation which overwhelmingly determines its value and investment merit.

Paradox # 2: The Miracle of Financial Engineering
The second related paradox is this:

A banker will refuse to lend money to an uncreditworthy, speculative company (think “dotcoms”) whose stock may be selling at a ridiculously high price, but the same banker will gladly advance loans to the shareholders of that very company against the security of its highly liquid shares!

This “miracle” of financial engineering which makes the owners of a corporation creditworthy, even though the corporation is anything but, has its roots in: (1) the incorrect treatment of difference between the market price of the shares given as collateral and the loan advanced as genuine margin of safety; and (2) almost blind faith in liquidity of the stock market which will presumably allow the banker to offload the shares when needed (he forgets Keynes’ acute observation that “of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of "liquid" securities. It forgets that there is no such thing as liquidity of the investment for the community as a whole.”)

Mr. Charlie Munger knows this paradox very well. It was him, after all, who brought it to my attention a few years ago when dotcoms were the rage. At that time he had said:

“What’s fascinating . . .is that you could now have a business that might have been selling for $10 billion where the business itself could probably not have borrowed even $100 million. But the owners of that business, because its public, could borrow many billions of dollars on their little pieces of paper- because they had these market valuations. But as a private business, the company itself couldn’t borrow even 1/20th of what the individuals could borrow.”

This example of a "miracle" of financial engineering is by no means the only example. There are others but their discussion will have to wait for another day.

Let me end, though, by quoting Michael Aronstein, who, in the excellent book, Five Eminent Contrarians, pretty much agreed with my own views on the subject, by saying:

“Of the many advances in the long history of commerce, the advent of sausage stands out as one of the greatest. The idea of taking something which, in pure form, would be repellent to potential customers, and by thorough grinding, mixing, reshaping and adulterating, creating an entirely new entity that could be marketed free from the taint of its original ingredients, marked a milestone in the annals of business thought. . . Sausage making is the prototype for an entire class of merchandising technique that has become particularly common in modern finance . . . The financial marketer who uses commingling as an approach is responding to the same general conditions that drive the sausage stuffer: an abundance of lower grade ingredients along with hungry and credulous public.”

The Boiler Room Lollapalooza

2005-11-01T11:54:00.000+05:30

How can a prosperous man take one phone call from someone he never met or even talked to before, and over the course of the next few minutes agree with the request of the caller to make a foolish “investment” in a company he never heard of before?

Obviously greed is a reason. Greed is associated with reward superresponse tendency which is a mental model from psychology. In this case, its the greed of the broker, induced by huge commissions, which drives his behaviour, and its the greed of the customer, whose desire to get rich quick, contributes to his mental malfunction.

But is greed the only reason which produced this outcome, or is there something else?

There has to be something else, isn’t it? Lollapalooza outcomes are never due to only one reason. It’s a combination of many mental models, all working in the same direction, which produce lollapalooza outcomes.

So which models combined to produce this lollapalooza outcome?

The above story was taken from the film Boiler Room, an awesome movie which I screened in my class recently to students who had earlier read Mr. Munger’s talks on psychology. Members of the audience enjoyed the film, I think, because they could easily relate the Munger mental models from the talks to the scenes in the film.

My favorite scene is a lollapalooza. In this scene, Seth (played by Giovanni Ribisi) is a broker dealer working for a boiler room operation under the name of J.T Marlin Associates. Seth and his mentor, Chris (played by Vin Diesel) talk to Dr. Jacobs (played by Peter Maloney) on the phone, and by the end of the conversation, which lasts just a few memorable minutes, they basically get him to foolishly hand over his hard-earned money to them.

How did Seth and Chris do it? I think it’s very interesting to see how the pair used several mental models from psychology in combination to achieve the desired outcome - for them, not for Dr. Jacobs (boiler room operations are zero-sum games, which, incidentally, is also a mental model with enormous applicability – more about that one in a future blog post.)

An excellent way to identify the mental models embedded in the scene is to read its script, which I am reproducing below, while having the Munger Mental Model Checklist from psychology in front of you.

This is the procedure I followed, and was amused, though not surprised, to find the presence of multiple models in Munger's checklist in that memorable scene.

Read the script of the scene below along with my comments[IN CAPITALISED BOLD LETTERS IN BRACKETS] and I think you'll arrive at the same conclusion as mine.

INT. BOILER ROOM - DAY

SETH (O.S.)
I'm sorry, sir, I didn't realize...

DR. JACOBS
I'm really busy, Seth.

Seth looks over towards Michael's office and sees Greg and three other team leaders coming out.

SETH
I understand. I'm real busy here myself, Doctor. Look, we're going to come back to you in a month with one idea and one idea only. If you like what we have to say, great, we'll do business. Worst case scenario you'll hear yourself a new business idea. Chat about it with your golfing buddies and we'll part as friends. That's fair, right? [ONE IDEA AND ONE IDEA ONLY - SETH INVOKES THE SCARCITY MODEL HERE]

A nurse is asking the Doctor a question and he loses focus.

DR. JACOBS
Ummm what?

SETH
Great. So tell me, Doc, are you working with a million dollars in the market right now?

DR. JACOBS
Who is this again?

SETH
Tell me something, you're a doctor. Have you ever heard of a drug called Fenamul? It's being manufactured by MSC pharmaceuticals. [INFLUENCE FROM MERE-ASSOCIATION TENDENCY I.E. ASSOCIATION OF DRUG WITH DOCTOR]

DR. JACOBS
No.

SETH
Well it's in the third stage of FDA approval right now. Word is, it's going to get approved in the next three months. Could be tomorrow for all I know. Anyway, I'm getting ahead of
myself. And you're real busy over there. Why don't I send you out the info you requested about the firm and a senior broker will call you next month with that one idea. [AUTHORITY MISINFLUENCE TENDENCY - FDA AS AUTHORITY HERE. ALSO SCARCITY - SCARCE, VALUABLE INSIDE INFORMATION PRESENTED EXCLUSIVELY]

DR. JACOBS
Wait, wait, wait, hold on a second, forget the info, let's talk about this now. What was the name of the drug again? [DEPRIVAL SUPERREACTION TENDENCY - DR JACOBS REACTS TO THE POTENTIAL LOSS OF AN OPPORTUNITY BY DISPENSING WITH THE NEED TO BE DILIGENT]

Seth begins to smile.

SETH
You know what, sir, let me pass you on to a senior broker who's more involved with this particular stock. Hold on a second. [AUTHORITY MISINFLUENCE TENDENCY - SENIOR BROKER AS AN AUTHORITY FIGURE WHO IS SUPPOSED TO KNOW MORE, HE WILL NOT SAY ANYTHING INCONSISTENT WITH WHAT THE JUNIOR BROKER SAID - THE WHOLE THING IS PART OF THE ELABORATE GAME DESIGNED TO GAIN THE CUSTOMER'S CONFIDENCE]

Seth pushes the hold button. He pauses and then YELLS:

Reco!!

Everything and everyone in the room stops. There is a slight
pause and then CHAOS. About 20 brokers BOLT toward Seth.

Chris is closest. Another broker JUMPS onto the table separating him from Seth and clambers over it. Chris puts on the steam and gets there first. The other broker runs straight into Seth, unable to stop.

Chris regains his composure wiping the smile off his face.

CHRIS
Card.

SETH
Okay, his name's Dr. Jacobs and from the sound of it, I'd say he's
definitely...

CHRIS
Whoa, whoa, I don't wanna hear it, kid.

Chris grabs the card from his hand and looks at it briefly.

CHRIS (CONT'D)
Hi, Dr. Jacobs, this is Chris Marlin over at JT Marlin.

DR. JACOBS
Marlin?

CHRIS
Right. He's my father.

Another broker connects a wire to a jack on the back of the phone and the conversation is now heard on the PA system.

CHRIS (CONT'D)
So my associate tells me you're interested in one of our stocks.

DR. JACOBS
Yes, MSC sounds like it might be interesting.

CHRIS
Might be? Might be doesn't sell stock at the rate MSC is going, Dr. Jacobs. We're talking about very high volume here. [SOCIAL PROOF TENDENCY - VERY HIGH VOLUME IMPLIES THAT THERE ARE MANY OTHERS WHO APPROVE OF THE IDEA WHICH AUTOMATICALLY MUST MEAN THAT IT'S A GOOD IDEA]

DR. JACOBS
Well, I still have to run it by my people.

CHRIS
That's great, Doc. If you want to miss yet another opportunity here and go watch your colleagues get rich doing clinical trials, then don't buy a share and hang up the phone. [DEPRIVAL SUPERREACTION TENDENCY, AND ENVY/JEALOUSY TENDENCY INVOKED TOGETHER IN JUST TWO SENTENCES RESULT IN TOTAL SUPRESSSION OF THE DESIRE TO QUESTION ANYTHING]

DR. JACOBS
Well hold on a second. I didn't say that. I just wanted to talk more about it.

CHRIS
Honestly Doc, I don't have the time. This stock is blowing up right now. The whole firm is going nuts. Let me open the door to my office.

Chris holds the phone up to the 100 brokers standing there silently. They begin talking loudly and screaming "Buy, Sell". Chris makes a hand motion and they stop.

You hear that? That's my trading floor, Doc. Now I have a million calls to make to other doctors who are already in the know. I can't walk you through this right now. I'm sorry.

Huge pause. Everyone looks on waiting to hear what he'll do. Chris doesn't even look mildly concerned. Then... [DEPRIVAL SUPERREACTION TENDENCY I.E. TIME IS RUNNING OUT DR JACOBS + SOCIAL PROOF TENDENCY I.E. JUST HEAR HOW PEOPLE ARE NUTS OVER THIS STOCK + ENVY I.E. OTHER DOCTORS ARE GOING TO GET RICHER = BUY NOW! IT HAS TO WORK NOW ISN'T IT?]

DR. JACOBS
Okay, okay. Let's do this. [MISSION ACCOMPLISHED! - THEY GOT HIM - HOOK, LINE, AND SINKER]

CHRIS
Now, since you're a new account I cannot go any higher than two thousand shares. I'd love to but I just can't do it. [AVAILABILITY MISINFLUENCE TENDENCY - CHRIS VERY CLEVERLY NOW MENTIONS A FIGURE OF 2,000 SHARES WHICH IS PROBABLY MORE THAN WHAT DR. JACOBS WOULD HAVE BOUGHT - HE CREATES AN AVAILABLE ANCHOR IN THE MIND OF DR. JACOBS - ANCHORING BIAS AS A SPECIAL CASE OF AVAILABILITY BIAS COMBINES WITH DEPRIVAL SUPERREACATION TENDENCY]

DR. JACOBS
Two thousand?! Whoa! That's way more than I was thinking about. Two
thousand, Jesus. (pause)

I'm just curious, why can't you sell me more than that? [THE STRATEGY IS WORKING! DEPRIVAL SUPER-REACTION TENDENCY COMBINES WITH REWARD SUPERRESPONSE TENDENCY TO MAKE DR. JACOBS TO WANT MORE SHARES!]

The brokers hold in their laughter.

CHRIS
Well, we like to establish a relationship with our clients on something small before we get to the more serious trades. Let me show you several percentage points on this small trade and then we'll talk about doing future business.

DR. JACOBS
That sounds good. Give me two thousand shares.

CHRIS
Done.

DR. JACOBS
You sure you can't do any better on this one?

CHRIS
No, I'm sorry, Dr. Jacobs.

DR. JACOBS
Alright, let's start with this trade then.

CHRIS
Great. I promise we'll go big on the next one.

Now do you want the confirmation sent to your office or your mansion?

DR. JACOBS
(laughs)
Very funny, Mr. Marlin.

CHRIS
Alright, let me put my secretary on. She'll take your info.

Chris hits the hold button and then...

CHRIS (CONT'D)
Done and done.

The entire firm applauds when he gets off the phone. The crowd disperses. Chris sits down on Seth's desk.

CHRIS (CONT'D)
I love doctors, man. All that money and not a clue what to do with it. Fucking rollovers. Hold onto your ankles, Doc, here comes the love.

SETH
Why'd you put a max on his buy?

CHRIS
Didn't you tell him how it works?

GREG
He's still a trainee. He doesn't need to know about initial sell limits.

CHRIS
Right, right. Make sure he shows you the ropes. He's too busy calling his bookie. You fucking Hebrews, man. Always looking out for yourselves, never the trainees.

GREG
That's great. Why don't you go back to little Italy now?

Greg points across the room.

CHRIS
Why don't you go make a latke dreidel boy.
(back to Seth)
The reason I capped him is in case he's a piker. See, we're going to go ahead and front the money for this sale. If he doesn't send the check, I'm the one holding the bag.
(whispers)
Last commission month a kid on Jim's team wrote a million dollar ticket.
Stock was down three and a half points by settlement. Fucking kid took a one quarter million dollar hit. Besides, first sale just whets the appetite. If he's a whale, which it looks like he
is, then I'll get him on a day when there's a real rip.

SETH
Rip?

CHRIS
(surprised)
Rip. Commission. That's why we work here. We get huge rips. [REWARD SUPERRESPONSE TENDENCY- INCENTIVES AS SUPERPOWERS - GIVEN SUFFICIENT INCENTIVES AND YOU CAN BE VIRTUALLY SURE THAT THE PRODUCT/SERVICE WILL GET PUSHED TO THE CUSTOMER, NO MATTER HOW TOXIC IT MAY BE ]

SETH
(quietly)
I actually still don't know how it works.

CHRIS
A two dollar rip, which is unheard of anywhere on Wall Street, means you're walking away with two dollars for every share you sell. Real money. Jesus Greg, you tell him where the bathroom is yet?

GREG
Seth, I showed you where Chris' desk is.

SETH
How does Michael afford that?

CHRIS
I don't know, but if he's doing it, he's making money on it. Point is, don't worry about selling small on the first trade. You service the client right and he'll be back for more. Bide your time. Show him a three percent return and he'll trust you to watch his kids for the weekend. If he's serviced correctly it's not a matter of whether he's making a second trade with you, it's a matter of how much.

Chris' secretary calls out from across the room.

CHRIS
Gotta bounce.

Seth stands there in awe. He sees the potential here.

Creative Whack Pack Teaches Charlie Munger's Way of Thinking

2005-10-09T22:58:00.000+05:30

My favorite creativity tool is the Creative Whack Pack written by Roger Von Oech.

This pack of cards was designed by Oech to enable its users to practice creative thinking, which, in my view, is one extremely useful ingredient of investment success.

I recommend the purchase and extensive use of the Creative Whack Pack. For less than $11, it’s a great investment.

Given below are the brief contents of a few cards I selected from the pack, along with their connections with Mr. Munger’s way of thinking:

Card # 2 (“Ask Why?”) states:

“Leonardo Da Vinci “I roamed the countryside searching for answers to things I did not understand. Why shells exist on the top of mountains along with imprints of plants usually found in the sea . . . Questions like these engaged my thought throughout my life.””
[Connection with curiosity and the need to ask why? why ? why?]

Card # 3 (“Get Out Of Your Box”) states:

“Each culture has its own way of looking at the world. Often the best ideas come from cutting across disciplinary boundaries and looking into other fields . . ."
[Connection with multidisciplinary thinking]

Card # 15 (“Let Your Mind Wander”) states:

“Much of our thinking is associative. One idea makes you think of another - no matter how logical the connections. Use this ability to generate new ideas . . .”
[Connection with Pavlovian Association]

Card # 27 (“Reverse”) states:

“Reversing how you look at a situation can open up new possibilities and dislodge assumptions . . .”
[Connection with backward thinking (Jacobi's "Invert, always invert"), and first conclusion bias]

Card # 25 (“Combine Ideas”) states:

“The time has come, the Walrus said, “to talk of many things – of shoes and ships – and sealing wax – and of cabbages – and kings. Combining unusual ideas is at the heart of creative thinking."
[Connection with Munger framework of mental models]

Card # 42 (“Beware the Unintended”) states:

“In preparing for the Olympics, the coach of a leading new team invited a meditation instructor to teach awareness techniques to his crew. He hoped that such training would enhance their rowing effectiveness. As the crew learnt more about meditation, they became more synchronized, there was less resistance, and their strokes got smoother. The irony is that they went slower. It turned out that the crew became more interested in being in harmony than winning.”
[Connection with “effects have effects”]

Card # 45 (“Don’t Fall in Love with Ideas”) states:

“If you fall in love with an idea, you won’t see the merits of alternative approaches and will probably miss an opportunity or two. One of life’s great pleasures is the letting go of a previously cherished idea. Then you’re free to look for new ones”.
[Connection with the need to look for disconfirming evidence, first conclusion bias, and bias from commitment and consistency]

Card # 63 (“Learn from Mistakes”) states:

“On his way to creating the light bulb, Edison discovered 1,800 ways not to make one. One of Madam Curie’s failures was radium. Columbus was looking for India. Errors are one of life’s primary learning vehicles. That’s because success reinforces the way you do things. When you fail however, you learn what’s not working, and you get the opportunity to try new approaches.”
[Connection with the need to examine one’s own mistakes as well as those of others, and learning from them].

Feeds for this Blog

2005-10-09T11:37:00.000+05:30

Got this idea from Shai's blog.

http://feeds.feedburner.com/blogspot/yRcA

http://fundooprofessor.blogspot.com/atom.xml

Thanks Shai!

Lollapalooza from Insider Trading

2005-10-08T08:55:00.000+05:30

Once upon a time, a friend of mine knew someone, who knew someone in a big, listed company. And through this chain, he got reliable, price sensitive, inside information about the company.

The information was this: In two weeks, there would be an announcement about the settlement of a major legal dispute in which the company was involved. The settlement was going to be hugely in favor of the company.

The sums involved were large and my friend estimated that when the news becomes public information, the stock should soar by a minimum of 150%. His computations were conservative.

And so, my friend concluded that this was a once in a lifetime opportunity to become richer than he already was. This was his chance to be free.

He decided to back up the truck. He quickly liquidated his entire stock portfolio, worth a substantial sum, and all his other assets, and used the entire proceeds to buy his favorite stock. And then, he borrowed more money and trebled his position in the stock.

And in a matter of two weeks, he went bust. And he went bust despite the inside information he was betting so heavily on, being correct.

What happened?

This is what happened: Just before the announcement my friend was betting on, a massive earthquake hit the only plant of the company and completely destroyed it and its associated future earning power. The stock fell 40% despite the announcement of the positive news. The market ignored the positive news my friend had bet everything on and focused on the new development instead.

The banks, who had lent money to my friend, asked him to put up more money or securities in his account. But he didn’t have any more money or securities. All of his wealth was in this one stock. And so, the bank liquidated his stock in a fire sale, and he lost every penny he had earned and saved. He went bankrupt. The irony, of course, is that he was right about the information, but he still went bust. Now, that's a lollapalooza.

What created this lollapalooza outcome?

This is a very interesting question.

Lollapalooza outcomes do not happen for just one reason. There has to be a combination of several mental models, all working in the same direction, which produces lollapalooza outcomes.

Which mental models combined to produce this horrible outcome for my friend? There were four:

Tendency to overweigh scarcity;
Excessive self-regard tendency;
Over-optimism; and
Availability-misweighing tendency.

Of these four tendencies, the first one is described very well in Robert Cialdini’s great book, Influence. The other three tendencies were described by Mr. Charlie Munger in his essay titled “The Psychology of Human Misjudgment” included in his biography.

Under the scarcity principle, we tend to overvalue something that is scarce. The tendency that makes us rush and buy things we do not need in discount sales that will end in a few hours is the same tendency that makes us put a high value on useless information when it is put under censorship. The very same tendency makes investment opportunities available to us seem more valuable when they are not available to others.

My friend had access to privileged, and valuable, information. This automatically led him to over-weigh the value of the information in his possession.

In his essay, Mr. Munger talked about excessive self-regard tendency leading to what he called as the “endowment effect”. Man has an automatic tendency to over-weigh something in his possession. That includes himself, his family members and friends, and his material possessions. If you suffer from this tendency, then if you own something, you’ll value it more highly than you would have, if you did not own it. If asked to sell it, you’d tend to ask for a substantially higher price than its true worth. This tendency makes someone, who has bought a stock, even more bullish about it than before, immediately after he bought it.

My friend suffered from the endowment effect. Not only the information was valuable because it was scarce, the endowment effect made it even more valuable to him immediately after he possessed it. And that, of course, led to over-optimism which led him to bet everything he had (and more through borrowed money) on one stock.

There is one more tendency which contributed towards my friend's gamble. This is the availability-misweighing tendency. To quote Mr. Munger:

“Man’s imperfect, limited-capacity brain easily drifts into working with what’s easily available to it. And the brain can’t use what it can’t remember or when it’s blocked from recognizing because it is heavily influenced by one or more psychological tendencies bearing strongly on it. . .”

In my poor friend’s situation, the tendency to overweigh scarcity and excessive self-regard tendency combined to produce over-optimism tendency, and the combined power of these three tendencies made him totally blind as to the possibility of some event that could make his excessive investment in the company, wrong.

The availability heuristic is the source of one of the most common biases we all suffer from– the availability bias. As Tversky and Kahneman explained in 1973, we assess the frequency, probability, or likely causes of an event by the degree to which instances or occurrences of that event are readily “available” in memory.

And, of course, if something is not available in our memory, we simply cannot assign a weight to it so we leave it out of our decision-making process, leading us to make bad judgment calls, like in my friend’s case.

My friend forgot to ask the simple question: “Despite my possession of this wonderful, and scarce, information, are there factors that could possibly make my decision a bad one?” He did not seek evidence that disconfirmed his much-loved notion. And that, in my view, destroyed him.

If he has asked this simple question, he would have come to the correct conclusion that Mr. Munger gave in his essay: “An idea or a fact is not worth more merely because it’s more available to you.”

So, that's how these four psychological tendencies combined together and impaired the cognition of my friend, thereby ensuring that he lives miserably ever after. . .

Explaining Mr. Munger's "Kantian Fairness Tendency"

2005-09-30T19:51:00.000+05:30

Arpan Ranka, a student at MDI, recently asked me to explain Mr. Charlie Munger's mental model titled "Kantian Fairness Tendency". This model was mentioned by Mr. Munger in the revised version of his essay titled "The Psychology of Human Misjudgment". This essay is one of several essays contained in "Poor Charlie's Almanac".

I believe Mr. Munger was referring to man's overlove of fairness for all, often resulting in bad outcomes for humanity. Earlier, he had made a reference to this subject in his UCSB talk in which he said:

"It is not always recognized that, to function best, morality should sometimes appear unfair, like most worldly outcomes. The craving for perfect fairness causes a lot of terrible problems in system function. Some systems should be made deliberately unfair to individuals because they’ll be fairer on average for all of us. I frequently cite the example of having your career over, in the Navy, if your ship goes aground, even if it wasn’t your fault. I say the lack of justice for the one guy that wasn’t at fault is way more than made up by a greater justice for everybody when every captain of a ship always sweats blood to make sure the ship doesn’t go aground. Tolerating a little unfairness to some to get a greater fairness for all is a model I recommend to all of you. But again, I wouldn’t put it in your assigned college work if you want to be graded well, particularly in a modern law school wherein there is usually an over-love of fairness-seeking process."

I see a connection between the above quote and the "law of the higher good" which I discovered in Machiavelli's "The Prince". Last year, I had written a note on the law of the higher good to my students. Here's a revised version of that note:

Machiavelli's "The Prince" is a great book and should be made compulsory reading for all MBA students.

To many people, The Prince is an evil book. But Joseph L. Badaracco, who teaches a hugely popular course titled "The Moral Leader" at the Harvard Business School uses this book to teach ethics. And he teaches ethics by telling students to follow Machiavelli's advice in The Prince. In an interview, Badaracco has said that four different takes on The Prince usually emerge in classroom discussions of The Prince at HBS:

Version 1 : "This book is a mess. It was written by a guy who hoped to get to the center of things, was there briefly, offended some of the wrong Medicis, was exiled, was tortured, and wanted to get back in." It’s "a scholar’s dream because you can find anything you want in it and play intellectual games. But just put it aside."

Version 2 : "Now wait a minute. There’s some good common sense in there. Machiavelli is basically saying that if you want to make an omelet you have to break some eggs... To do some right things, you may have to not do some other right things."

Version 3 : Other students believe the book is still around because it’s so evil. Why is it evil? "If you look closely at The Prince," he said, "it’s quite interesting what isn’t in the book. Nothing about religion. Nothing about the Church. Nothing about God. There’s nothing about spirituality. Almost nothing about the law. Almost nothing about traditions. You’re out there on your own doing what works for you in terms of naked ambition."

Version 4 : "A fourth Prince that other students uncover is the most interesting one, in Badaracco’s mind. Students find that the book reveals a kind of worldview, he says, and it’s not an evil worldview. This version goes: "If you’re going to make progress in the world you’ve got to have a clear sense, a realistic sense, an unsentimental sense, of how things really work: the mixed motives that compel some people and the high motives that compel some others. And the low motives that unfortunately captivate other people." Students who claim the fourth Prince, Badaracco said, believe that if they're going to make a difference, it’s got to be in this world, "and not in some ideal world that you would really like to live in."

One of my favourite mental models comes from The Prince. I call this model, the "law of the higher good". Before I read The Prince, I read an excellent book called, "The Contrarian Guide to Leadership" by Steven Sample. In this book, which was recommended by Mr. Munger, Sample's thoughts on the law of the higher good from The Prince resonated very well with what Mr. Munger has been advocating for years. I reproduce here an extract from Sample's book which deals with the law of the higher good:

"Let me clarify the most fundamental misunderstanding. Machiavelli was not an immoral or even an amoral man; as mentioned earlier, he had a strong set of moral principles. But he was driven by the notion of a higher good: an orderly state in which citizens can move about at will, conduct business, safeguard their families and possessions, and be free of foreign intervention or domination. Anything which could harm this higher good, Machiavelli argued, must be opposed vigorously and ruthlessly. Failure to do so out of either weakness or kindness was condemned by Machiavelli as being contrary to the interests of the state, just as it would be contrary to the interests of a patient for his surgeon to refuse to perform a needed operation out of fear that doing so would inflict pain on the patient."

The law of the higher good is a terribly useful model for leaders because it forces them to think about things from a totally different perspective. Here's a hypothetical situation to ponder about:

You are in charge of running a retail store and one of your cashiers, an elderly woman, is caught committing a minor embezzlement. Fearing that she might be dismissed, she approaches you to plead forgiveness. She tells you that this is the first time she embezzled money from the company and promises that she'll never do it again. She tells you about her sad situation, namely that her husband is very ill and that she was going to use the money to buy medicines for him. She becomes extremely emotional and your heart is melting. What do you do?

Something similar to the above situation was described by Mr. Munger in a talk given by him. He used two models to produce his answer. The first model was probability. Mr. Munger implores you to reduce the problem to the mathematics of Fermat/Pascal by asking the question: How likely is it that the old woman's statement, "I've never done it before, I'll never do it again" is true?

Note that this question has nothing whatsoever to do with the circumstances in this particular instance of embezzlement. Rather, Munger is relying on his knowledge of the theory of probability. He asks: "If you found 10 embezzlements in a year, how many of them are likely to be first offences?"

The possible actions are: (1) She is lying and you fire her (good outcome - because it cures the problem and sends the right signals); (2) She is telling the truth and you fire her (bad outcome for her but good outcome for system integrity); (3) She is lying and you pardon her (bad outcome for system integrity); and (4) She is telling the truth and you pardon her (bad outcome for system integrity because it will send the wrong signal that its ok to embezzle once).

Weighed with probabilities, and after considering signaling effects of your actions on other people's incentives and its effect on system integrity, its clear that the woman should be fired.

Looked this way, this is not a legal problem or an ethical problem. Its an arithmetical problem with a simple solution. This extreme reductionism of practical problems to a fundamental discipline (in this case mathematics), is, of course, the hallmark of the Munger way of thinking and living.

So, from a leader's perspective, it's more important to have the right systems with the right incentives in place, rather than trying to be fair to one person - even if that person is the leader or someone close to the leader.

The logic is that leaders must look at such situations from their civilization's point of view rather than the viewpoint of an individual. If we create systems which encourage embezzlements, or tolerate such systems, we'll ruin our civilization. If we don't punish the woman, the idea that its ok to do minor embezzlement once in a while, will spread because of incentive effects, and social proof (everyone's doing it so its ok). And we cannot let that idea spread because that will ruin our civilization. Its that simple.

A New Blog Takes Shape

2005-09-10T11:01:00.000+05:30

My colleagues and I have started a new blog for Tactica Capital Management, our company.

This blog will focus on my professional side. Over time, we would put up for sharing with the world, some of the investment ideas that worked out very well for us, and the reasoning behind those ideas [Process more important than outcome].

We will also talk about our investment mistakes (yes we have them) and sort of rub our noses in them.

Sanjay Bakshi

Carol Loomis, Risk, and the Law of Conservation of Energy

2005-09-09T07:18:00.000+05:30

Carol Loomis is a legend. Her columns in Fortune are a collector's item and I have been a collector since 1994 – the year in which I started out my career in investments.

In March 1994, Loomis wrote an article on derivatives in Fortune titled "The Risk that Won't Go Away". I was totally blown away after I read that article. At that time, derivatives were the talk of the town. There was an explosion in the usage of derivatives, particularly, non-traded ones, which ostensibly enabled companies to “manage risk” at a low cost.

Loomis however took the opposite view and predicted trouble ahead. And sure enough, trouble followed soon after, when several derivatives-related financial fiascos like those at Bankers Trust, Gibson Greetings, Orange County, and P&G emerged. These were covered by Loomis a year later in March 1995 in a column titled "Untangling the Derivatives Mess" which essentially said “I told you so”.

What is the connection between the law of conservation of energy and the concept of risk in financial markets?

In my view, there’s a big connection. I feel that they are essentially the same – an insight I got after reading the above Loomis’ columns although she herself did not talk about the connection.

The law of conservation of energy states that the total inflow of energy into a system must equal the total outflow of energy from the system, plus the change in the energy contained within the system. In other words, energy can be converted from one form to another, but it cannot be created or destroyed.

Simply change “energy” for “risk” and you’ll have the law of conservation of risk.

The law of conservation of risk states that the total inflow of risk in a system must equal the total outflow of risk from the system, plus the change in the risk contained within the system. In other words, risk can be converted from one form to another, but it cannot be created or destroyed.

Take the simple example of a hedging operation involving shorting index futures. The hedger who shorts the index futures is trying to protect herself from a market decline. Should the market decline, the value of her stock portfolio will also decline, but this decline is expected to be offset by the profit she will make on the short futures position. So far, so good. But, is it?

Is it really that simple? Has the risk to the hedger been reduced? Of course not. The risk of the decline in the price has merely been transferred to the buyer (counter-party) of the index futures. But that’s not the whole story. There is more to it.

By selling the index futures, the hedger has transferred the price risk to the buyer of the index futures but has assumed another risk. That risk is credit risk i.e. the risk that the counter-party may default.

While it’s true that with the presence of organized futures markets with margin requirements and other risk mitigation measures in place, credit risk is much lower at the individual level, this does not mean that the risk in the entire system has been reduced. At the individual level, risk may be reduced but not at the system level.

Risk can be sliced and diced. Risk can be transferred from one person to another. And one form of risk might replace another form, but at the end of the day, the total risk in the system is not going to change.

In other words, just like energy, risk can be converted from one form to another, but it cannot be created or destroyed.

And that’s one insight that has paid me well over the last eleven years…

Jared Diamond's "Dam Fools"

2005-09-05T19:45:00.000+05:30

Jared Diamond is one hell of a thinker. I really like the way he thinks. The ideas described by him in his talks and in his wonderful books are also portable i.e. their lessons can be applied in other fields like investments.

His book, "Guns, Germs, and Steel: The Fates of Human Societies" contains highly useful ideas about how to think correctly. It's no wonder that Mr. Charlie Munger has been recommending Diamond's book for years. Diamond's way of thinking is highly multidisciplinary, which I think, is exactly what Mr. Munger likes about him.

I've yet to start reading Diamond's other famous book, "Collapse: How Societies Choose to Fail or Succeed". However, a couple of days ago, I started watching the recently released DVD on Guns, Germs, and Steel. If you do not have the time or the inclination to read the book, watch the DVD.

You will also enjoy reading the transcripts of two of Diamond's talks from here and here.

The earlier of these two talks titled "How to Get Rich?" beautifully illustrates the role of competition in wealth creation rather than wealth destruction. This talk also wonderfully explains how innovation really works.

The second talk titled "Why Do Some Societies Make Disastrous Decisions?" could actually have easily been titled "Why Do Some Investors Make Disastrous Decisions?" In this talk, I loved Diamond's discussion of "Psychological Denial" one of the several mental models from psychology used by Mr. Munger. Here's a wonderful quote on psychological denial from that talk:

"Consider a narrow deep river valley below a high dam, such that if the dam burst, the resulting flood of water would drown people for a long distance downstream. When attitude pollsters ask people downstream of the dam how concerned they are about the dam's bursting, it's not surprising that fear of a dam burst is lowest far downstream, and increases among residents increasingly close to the dam.

Surprisingly, though, when one gets within a few miles of the dam, where fear of the dam's breaking is highest, as you then get closer to the dam the concern falls off to zero! That is, the people living immediately under the dam who are certain to be drowned in a dam burst profess unconcern. That is because of psychological denial: the only way of preserving one's sanity while living immediately under the high dam is to deny the finite possibility that it could burst."

How can the idea of psychology denial as explained by Diamond be applied to another field like investments? Diamond's example of what I call "dam fools" has a close parallel to what happens to most investors, the media, and the politicians at the peak of an asset price bubble. The most recent example was that of the dotcom bubble where most people were victims of sheer psychological denial. They were blissfully ignorant of the trouble ahead.

Another application of psychological denial which I have observed is when I meet with, or read the interviews of, the managements of some companies. For example, Steel executives were bullish when prices were at their peak. Why does this happen? I think part of the reason why it happens is that people are too close to the scene of the action, just like the "dam fools" in Diamond's example.

I think one the traits one needs to learn is the ability to "zoom out" and look at the big picture which is not easy when you are too close to the scene of the action.

Yet another example of psychological denial is seen when management is over-confident of its own abilities and under-confident of the abilities of its competition. Recently, I met with the management of a profitable Indian company which manufactures a commodity product at a low cost. However, a much bigger competitor is creating new capacity in China. If this new capacity comes on stream, it can destroy the profitability of the most of the players in the industry. The management of the company I met, however, feels that the Chinese player will not be able to stabilise the plant. When I come across such responses from managements, the "Dam Fool" example of Diamond pops up in my mind!

Why would a fellow who is spending hundreds of millions of dollars to build capacity in a growing industry not be able to stabilise a plant? Sure, it would cost money to poach some of the smartest engineers and technicians, but for a person who has already made that large size commitment, the incremental cost required to get the right people to get the job done will be really small, isn’t it? [Commitment and Consistency - Psychology, Contrast Effect - Psychology]

It's such a simple question, but the management of the Indian company would not like to ask it. Now that's psychological denial. So, psychological denial operates at a subconsious level in the minds of investors as well as company managers.

A marvelous example of psychological denial at both levels was depicted in the movie "Other People's Money". In this fantastic film, which I recommend watching, "Larry the Liquidator", played by the giant of American cinema, Danny DeVito, is trying to convince the shareholders of New England Wire & Cable Company to vote him into power so that he can liquidate the company because in his view it deserves to be liquidated. You can hear the speech of the incumbent manager, Andrew Jorgenson, played by Gregory Peck, from here and that of DeVito from here.

Here's a quote from DeVito's speech which beautifully illustrates psychological denial, both at the corporate as well as the investor level:

"This company is dead. I didn't kill it. Don't blame me. It was dead when I got here. It's too late for prayers. For even if the prayers were answered, and a miracle occurred, and the yen did this, and the dollar did that, and the infrastructure did the other thing, we would still be dead. You know why? Fiber optics. New technologies. Obsolescence. We're dead alright. We're just not broke.

And you know the surest way to go broke? Keep getting an increasing share of a shrinking market. Down the tubes. Slow but sure. You know, at one time there must've been dozens of companies makin' buggy whips. And I'll bet the last company around was the one that made the best goddamn buggy whip you ever saw. Now how would you have liked to have been a stockholder in that company? You invested in a business and this business is dead. Let's have the intelligence, let's have the decency to sign the death certificate, collect the insurance, and invest in something with a future."

Revisiting Oxford Book Club Talk Given in July 2002

2005-09-04T20:07:00.000+05:30

In July 2002, I was invited to give a talk on value investing at the famous Oxford Bookstore in Mumbai. The talk was attended by about forty fund managers and analysts.

Today, I found that presentation on my computer and was reading it. I was fascinated to find how well some of the stocks that I had spoken about in 2002 have performed since then.

Gesco Corporation has gone from Rs 11 in June 2000 to Rs 204 now. Trent has gone from Rs 60 in August 2001 to Rs 875. Gujarat Mineral Development Corporation has gone from Rs 45 in January 2002 to Rs 436 now. Zodiac Clothing has gone from Rs 43 in October 2001 to Rs 535 now. Blue Star Infotech has gone from Rs 35 in August 2001 to Rs 150 now. SRF has gone from Rs 26 in July 2002 to Rs 314 now (excluding the value of shares of a company spun off from SRF). Hindustan Motors has gone from Rs 9 in July 2002 to Rs 46 now. And Himatsingka Seide has gone from Rs 97 in July 2002 to Rs 556 now. All of these stocks have outperformed the market handsomely.

The only disappointment has been Regency Ceramics which has not gone anywhere in the last four years.

All of the above stocks were identified using very simple hueristics derived from Graham's philosophy of deep value investing.

Behavioural Finance and Business Valuation: Course Outline

2005-08-29T12:43:00.000+05:30

Uploaded the outline for my course on Behavioural Finance and Business Valuation. It can be downloaded from here.

A nine-year old dreams up a M&A Deal

2005-08-04T06:45:00.000+05:30

Last night, over dinner, I was telling my family about Adidas' plans to buy Reebok.

Gauri, my younger daughter who is nine years old thought about what I had said and then blurted:

"I think Subway should buy Big Chill (her favourite restaurant in Khan Market, New Delhi)".

Highly amused, I asked Gauri, "Tell me three reasons why Subway and Big Chill should merge."

Gauri is highly familiar with the term "merge" because when we play Monopoly, two players often merge when they find synergies (complimentary properties, cash and properties combo etc.)

Its extremely fascinating to discuss stuff like this over the dinner table with kiddos.

Gauri thought about my question for a while and then giggled, in substance, the following reasons:

Subway Sandwich outlets have awesome smell and if Subway merges with Big Chill, then more customers will come to eat in the merged entity;
Big Chill makes the best desserts in the world and Subway makes the best sandwiches in the world, and therefore, if the best of both are offered under the same roof, the revenues of the combined entity will be more than the revenues of the two outlets on a stand-alone basis; and
People who can't eat subway sandwiches (like Gauri's elder sister Garima, because she got braces installed recently) can eat the Big Chill food, while other members of the family freak out over both. So, there will be more reasons for such families to visit the combined entity.

Not bad at all!

Keep it up Gauri, you've all the hallmarks of becoming a fundoo M&A player...

When the promoter goes to jail, the projections go out of the window

2005-08-03T07:37:00.000+05:30

In June 2005, Provogue came out with an IPO priced at Rs 150 per share. The IPO was subscribed 67 times (social proof, deprival super-reaction) the number of shares offered. The stock opened for trading at Rs 250 and closed at Rs 205 on 2 August.

At Rs 205, the company's market cap comes to Rs 331 cr. Add debt of Rs 33 cr. and the enterprise value comes to Rs 364 cr. Is this valuation justified by the current fundamentals (the future will be hazy now, isnt it?)?

For FY 2004-05, the company reported revenues of Rs 115 cr., EBITDA of Rs 14 cr., and PAT of Rs 7.2 cr. So, the current enterprise value of Rs 364 cr. is 3.2 times revenues and 26 times EBITDA. The P/E comes to 46 times. Nifty's P/E is 14.58 times.

Sadly, the stock is not traded on futures and options. Sigh...

One interesting aspect of the IPO is the innovative application of Mr. Munger's "backward thinking" wherein the seller of shares approaches the intermediaries and tells them "I want Rs xyz per share, for selling z% of my company and now its up to you to justify this valuation by making projections about the future of my company." And so, given the nature of competition in the intermediateries market, there are strong incentives to apply backward thinking by taking the price being asked as correct, and working backward to figure out what the future of the company should be (on paper, of course), to justify that price.

When the promoter goes to jail, the projections go out of the window. Remember MS Shoes' Pavan Sachdeva and Mesco's Rita Singh? Where are their companies?

How can it be otherwise?

After all, pavlovian association works both ways. Fardeen Khan, who endorses the company's brand, and popular retail chains like Shoppers' Stop, Westside, Pyramyd, Pantaloon, and Lifestyle who sell Provogue apparel, will be doing some very serious thinking.

It will be interesting to watch what the insiders do with their stock.

Models:
Social Proof
Deprival Super Reaction
Incentives
Pavlovian Association

Mental Trick:
Backward Thinking

Here's looking at you kid!

2005-08-01T07:10:00.000+05:30

Why should a 40-year old finance professor cum investment professional draw inspiration from an undergrad finance student roughly half his age?

Well, why not?

Shai Dardashti is 21 years old and is doing a wonderful job on his new blog.

All Grahamites should bookmark Shai's blog.

Drawing inspiration from Shai, I will be a bit more active on my blog now!