Tuesday, March 31, 2015

Relative valuation & why anchoring is dangerous

One of the big problems I was having earlier was that I was rejecting a company with similar economics at a valuation of 10 times earnings and thinking of buying another company with similar economics at 15 times earnings. It took a while before I realized what was happening. The problem does not lie in valuation methodology as much as it does in psychology. Robert Cialdini in his book about the psychology of influence talks about real estate dealers who have a couple of houses listed at an exorbitant price which are in horrible state. These are shown to buyers before showing them the actual house they want to sell. It drives people to say yes to the actual house because relatively it looks like better value.

Monday, March 30, 2015

Behavioural finance: Psychology of the astute value investor

“All of humanity's problems stem from man's inability to sit quietly in a room alone.”
- Blaise Pascal

Charlie Munger espouses a concept called the latticework of mental models. This section is my understanding of that concept applied to value investing. Robert Cialdini’s book “The psychology of influence” is also a wonderful read and probably encapsulates most of what one needs as the basis of behavioural finance. I already had this book on my bookshelf somehow and then started seriously reading it when I heard Munger recommend it on his 1995 lecture on "The psychology of human misjudgement". The psychological element of value investing is the most important advantage that you have. There are several intelligent investors who do not raise capital to manage for others for the simple reason that they don’t want their investors to liquidate at exactly the wrong time.

Wednesday, March 25, 2015

Dalal Street (or Wall Street) Research coverage: Bait for the sharks

We have already learnt in the article about why it might be best to stay away from IPOs that IPOs are a massive section of a bank’s fees. Now let’s think about why a client picks a bank?

One of the principal agent problems that an investment bank has is that they typically have a research coverage team that is not explicitly paid for by anyone. Their trading clients (typically mutual funds, hedge funds, insurance companies, portfolio management companies, etc.) use the research to help them make investment decisions. Now the principal agent problem comes in where the IPO or secondary offering side of the business is pitching to raise capital for a company. At this point do you believe it is easy for the bank to give a negative rating to the stock of this company?

Tuesday, March 24, 2015

Getting conviction: Management quality factors

High conviction positions are the holy grail of portfolio management. The basics of this judgement have been covered in the judging the quality of management chapter in the principles section. Management matters a lot but not as much as business quality. Typically it is the most important factor after the business quality in the world of portfolio management. The idea here is the focus on the factors that need to be graded. I have to thank the Valuepickr forum and its contributors (especially Donald Francis) for helping me with this thinking. Typically I would give equal weight age to each of these 6 factors.

Monday, March 23, 2015

Brokerage fees & the art of delaying activity

“We don't get paid for activity, just for being right. As to how long we'll wait, we'll wait indefinitely.”
- Warren Buffet

Brokerage fees sound like a pittance when you are trading, but if you trade too often then you end up hitting your returns. If the brokerage fee is 0.3% (including trading taxes assuming you're trading on Dalal Street) you end up giving up a good 0.6% if you turn over 100% of your portfolio and 1.2% if you turn over 200%. Now your broker wants you trade as often as possible so you will keep getting calls to trade out of what you bought last month and trade into the new fad. But does that really enhance return?

Leverage: The fastest & most likely way to go bankrupt

“If you're smart you don't need it, and if you're dumb, you got no business using it."
- Warren Buffet

Leverage is used by many funds (hedge fund more than mutual funds) as a financial tool to improve returns. Now in the value investing world of equities leverage can be a very dangerous thing. Leverage increases your chances of going bankrupt rapidly. A portfolio management strategy with 1:1 leverage that moves down 50% will be out of the money and the game will be over for the investor. Typically in the value investing world a market move downwards of 50% is a wonderful thing as it provides many opportunities to the intelligent investor. Value investing should then require you to hold a minimum percentage of cash (arbitrarily let’s say 5%) so that in the extreme “six sigma” event you can attend the buying party. For the uninitiated a six sigma event should mathematically occur 0.00034% of the times but in the markets when the going is good the markets find it very unlikely that a 30% fall will happen. And every time it does happen some people start (wrongly) calling it a “six sigma” event. This so called six sigma even seems to happen once or sometimes even more times a decade. So in the value investing communities a “six sigma” event is a buying party!

Sunday, March 22, 2015

Verdict Log: Systematized learning from failure (and successes)

“I’ve learnt so much from mistakes that I am thinking of making a few more.”
- Unknown

The verdict log is a tool I developed when I heard many people in the investment community talk about it. Even in my professional investing experience (with investment banks or a hedge fund) I have seen the stark difference in the clarity of thought of investors who keep a verdict log and those who don’t. The verdict log maybe kept in one form or another.

So what is the verdict log? A verdict log, in my definition, is a two column table with dates and verdict notes. Verdict notes are the bottom line opinion in 3 lines or less of the analysis and data collected up to that point on a company. I maintain a separate verdict log for each company.

The biggest advantage is that with 20/20 hindsight one can very easily analyse the thought process that went into the investment and how it could have been improved. The things that were right are stark and so are the things that are wrong. It is absolutely fine if you are not one hundred percent sure of what is going to happen to a stock – in fact if you are a hundred percent sure the verdict log will create doubt as it forces you to think about all the aspects of the investment.

Other methods I have seen to achieve this are to maintain an investment thesis history, or financial model versions for those who rely on them. How the log is maintained and kept is not important. What is important is for you to be able to look back and understand how you thought about a particular situation and how you think about it now.

Several professional funds (read highly successful ones - mutual funds and even a hedge fund) use this tool in many forms. Some have traders do a write-up which is signed off by risk before the trade happens. Yes – all funds are not cowboys saying yeehaw before each trade. Some are actually systematic. Some of these funds might not create massive returns in a single year but over time the systematic approach definitely yields better results.

The bottom line is that all these tools are there to remove your biases and reduce your reliance on your memory. There is too much information that is going to be running through your mind during the process of value investing and it is very difficult to remember everything. The intelligent investor knows what to tune out as noise and what to listen to as music.

Saturday, March 21, 2015

Proprietary positions, front running & being a pig

“Bulls make money, bears make money, pigs get slaughtered”
- Old adage

Imagine a sales representative trying to sell you a latest stock which he or she claims is going to run up in the coming months. You are told about the wonders of this company and how bright the future is. Now at this point if I told you that his bank holds a large position on it and is on the other side of the trade would you buy it? It would probably surprise you to know that even professional investors at a hedge fund or at mutual funds sometimes fall prey to this situation. These large positions are taken by a portfolio manager within the bank working on a 'prop desk'. After the sub-prime crisis several banks shut down these portfolio management desks and focussed on their core business but you can be sure that something akin to this will be back within the decade.

Every time the brokerage arm of an investment bank is selling you something how do you know they are not selling out their own position? On the flip side how would you know if the brokerage arm was telling you to sell when they were buying for their own proprietary desk?

There is supposed to be regulation in most countries that suggests this to not be allowed. Proprietary desks are on the other side of the ‘Chinese wall’. But do you believe it? Proprietary desks often have the highest paid traders on the firm's payroll on them. They typically yield lots of power within the institution.

Front running is when your brokers respect your investment decision so much that when you tell them to buy something for your they go ahead and buy it for themselves first. With small amounts of capital this may not be a big deal but when funds are buying large percentages of a company then this becomes a very big deal - a big enough deal to be illegal in most countries. Several people I know who trade for hedge funds say that they don’t want large investment banks like Goldman as they have a significant proprietary trading business. This has lead to many a fund to trade with smaller firms. The internet world has democratized the business of stock trading and made it a technology play from an old boys club.

One way to stay away from this problem is to research whether the bank has a position in the company via filings, but filings are only quarterly and they maybe at the start of an operation. Also they could be invested via various legal entities so it may not show up on filings. Some jurisdictions require large financial institutions to club their holdings in their reports. But why not just stay away from buying anything that is being suggested by a large brokerage or investment bank?

The science behind capital allocation & how to make sense of concentrated positions

“Diversification may preserve wealth, but concentration builds wealth.”
- Warren Buffet

Position sizing is the biggest determinant of overall portfolio return. At a 10000 foot level the following table summarizes the allocation concept:

Conviction Level
Discount to fair value
Position size
Very small or zero

Thursday, March 19, 2015

Against all odds: IPOs and why you should fear them

"It's almost a mathematical impossibility to imagine that, out of the thousands of things for sale on a given day, the most attractively priced is the one being sold by a knowledgeable seller (company insiders) to a less-knowledgeable buyer (investors)."
- Warren Buffet

Typically an investment bank (on wall street, dalal street, or other financial hubs) will make anywhere from 3% to 7% of IPO proceeds as fees. Brokerage fees are typically very small (below 0.15%). This should make it very clear that financial intermediaries make the bulk of the money via initial or follow on public offerings by listed companies. When the bank is going to get such a large percentage of the proceeds as fees they are naturally motivated to drive the price up as much as possible. This is why many a seasoned investor will tell you not to buy into IPOs as most of them are overpriced by the banks via their massive marketing and sales channels.

Wednesday, March 18, 2015

Financial intermediaries & the principal agent problem on Dalal Street

 "Stay away from anything that an investment bank is selling. Their bread and butter depends on their sales skills not their investment skills."

- Rephrased Buffet saying

    Financial intermediaries are typically compensated in a manner that drives their interest contrary to investors. Let’s think about how most financial intermediaries make money:
  • Proprietary positions - Would you like to buy something the bank wants to sell from its own portfolio?
  • Investment banking fees - If you know that the bank was paid 6% of IPO proceeds then you essentially at least loose 6%, and because the bank puts its best salesmen at IPOs you can be sure that its not just 6%.
  • Brokerage fees - Doesn't take a rocket scientist to figure out that a broker wants you to trade in and out as often as possible irrespective of the return.
  • Research coverage - If a company promises an investment bank its market offering or other business isn't it more likely to give it a high rating on research? If not why don't sell side research analysts clearly state their investment performance.
  • Leverage given to investors - The bank makes money on money lent to you. Wouldn't they want to lend as much as possible as long as they know they can liquidate your portfolio fast enough to not loose the entire capital?
  • Sales commission for distributing financial products - If you know that 1% of the mutual fund you buy goes to the broker and then there are entry, exit loads and several fees. Would you still buy it?
  • Asset management (Mutual funds, hedge funds, etc.) - If you are being pitched a fund and that is the only fund that the asset manager runs and it has a great track record maybe you could consider it. If the asset manager runs 20 funds of which 2 are outperforming the market how does that tell you that the asset manager is generating alpha?
  • New financial products - This is the highest risk and most fun. I am going to cover how people have been fooled in the past - even sophisticated investors and asset managers by financial products innovation. As a rule of thumb financial products innovation is designed to increase the EPS of the innovating investment bank not your net worth.
The primary principle that I am trying to drive home is that never buy any equity that is being sold by Wall Street or Dalal Street or any bank or financial intermediary. These institutions are selling machines. They run through several training programs that try to sell you several financial products which might sound excellent to you but when you do the analysis they might not sound as good. Now I am not saying you ignore what your trust broker of the last 2 decades says or that you cannot find a good and honest broker. But before you bring the broker into your circle of trust please evaluate the value of the ideas presented forth in an unbiased manner. I will run through each of these scenarios to describe how they are not very good for investors in the next few articles.

The IGValue magazine on Flipboard

I don't know if you are as big of a Flipboard fan as me but I find the easiest form of reading on Flipboard. For the uninitiated Flipboard is an app for an iPad, tablet, smart phone or even the web that can turn any content into a digital magazine that you can literally flip.

Please do check out the IGValue flipboard magazine at:

I would be obliged if you could tell me whether you like the content in the Flipboard format.

Monday, March 16, 2015

How to get started with Value investing - Step 1: Finding the first investment

If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you'd need. If you're driving a truck across a bridge that says it holds 10,000 pounds and you've got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it's over the Grand Canyon, you may feel you want a little larger margin of safety...” – Warren Buffet

Finding the first investment is always the hardest. This is primarily because there are over 55,000 listed companies globally and literally gigabytes of data available on and off the internet on each. These businesses directly employ millions of people and indirectly probably deal with a large part if not a hundred percent of the world’s population. Each one of these people can have perspectives on the businesses you are looking at. I hope by now I have convinced you that knowing everything there is to know about all the listed businesses and then making the first investment would never lead to that first investment!

Rules of the game

  Here are a few simple rules that I use to kind of keep on track. A few of them were borrowed from Guy Spier's book, The Education of a Value Investor: My Transformative Quest for Wealth, Wisdom, and Enlightenment. Would love to hear your feedback on these and if you agree with them.
  1. Never sell for 2 years after you have bought: This does multiple good things for you. Firstly if you know this you will always think a lot before you become a partner in the business. Secondly it eliminates all biases and gives you enough time to do in depth research before you sell out your interest in the business. This by no way means that you should stop thinking about the business or reading or doing research during the two years. On the contrary it means that you do highly diligent research during those two years in order to affirm or dispute your thesis.

Friday, March 13, 2015

How to get started with Value investing

Many times I am asked: This is all very good but how can it benefit me? And I was planning to cover this in a short few articles but I was chatting with a friend of mine who said 

“All this motherhood stuff is great but I will only read your stuff if it can benefit me!” 

And this is coming from a guy who has lots of experience in various business fields in various countries for decades. He has probably read more business books than I have seen in libraries and bookstores. This probably means what he is saying might actually have a tiny bit of weight to say the least. You can thank him (or not if you don’t like this section) for this factor being covered over several articles.

Saturday, March 7, 2015

Long short & the myth of market neutrality

“The market can stay irrational far longer than you can stay solvent”
-      John Maynard Keynes

Long short strategies when right can produce wonderful returns as well but the risk associated with these is far higher than you think. On paper these strategies look wonderful. Imagine if you can make the market return without the downside because your longs and shorts offset each other. Many funds claim to be market neutral but in reality they have massive amounts of implicitly leverage. When you short a stock the most you can make is 100% but the most you can lose is infinite.

Tuesday, March 3, 2015

Why focus on equities?

You can generate much larger and outsized returns with minimal riskusing arbitrage strategies. There are several arbitrage opportunities available to investors in warrants, Rights, Options, Futures & forwards to name a few. These are typically wonderful opportunities especially if the capital you are running is small. The annualized returns from these can be much larger than buy and hold on good companies. So then why should you even look at at equities?

Monday, March 2, 2015

Volatility: Friend or foe of the value investor?

Volatility is the variation in stock prices. Mathematically it is the square root of the variance. The more a stock moves up and down the higher the volatility. Investors typically fear volatility and are much happier in lower volatility environments as it is perceived is lower risk. But image if you know that you have the opportunity to buy something at various prices every 365 days at prices that differ by over 50%? Wouldn't this be very exciting for you if you knew the value of the underlying security?