Tuesday, November 29, 2005

Three Questions about Charlie Munger

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:

  1. How some consultants in a small South American country helped eliminate corruption and turn the economy around?
  2. How Mr. Munger is way ahead of other experts in the principles of Mind control and why it works on Moonies?
  3. 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.

Sunday, November 27, 2005

Dr. Zen and His System

Text of Mail Sent to My Students at MDI

From: Sanjay Bakshi
Sent: Sat 26/11/2005 18:18
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…


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



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?

Brian Zen

Monday, November 21, 2005

Its all Greek to Me

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:


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...

Wednesday, November 09, 2005

Cheaters Causing Crashes?

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:
  1. 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.

  2. 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.”

  1. What happened next?

  2. 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.

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

  2. 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

  3. 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.

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.

Sunday, November 06, 2005

Billionaires' Wager With Loaded Dice

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 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:


Thanks Futile!

Saturday, November 05, 2005

One Valuation Rule, Two Paradoxes

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:

  1. 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;
  2. Average the past earning power (use cash flow from operations after deducting increase in working capital and maintenance capex).
  3. 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;
  4. Using data from the above two steps, work backwards to estimate the amount of interest expense that can easily be serviced by the company;
  5. Divide the interest expense arrived at in step 4. into the current interest rate to determine debt-capacity of the company;
  6. 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.”

Tuesday, November 01, 2005

The Boiler Room Lollapalooza

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.


I'm sorry, sir, I didn't realize...

I'm really busy, Seth.

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

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.

Ummm what?

Great. So tell me, Doc, are you working with a million dollars in the market right now?

Who is this again?

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]


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]

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 pushes the hold button. He pauses and then YELLS:


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.


Okay, his name's Dr. Jacobs and from the sound of it, I'd say he's

Whoa, whoa, I don't wanna hear it, kid.

Chris grabs the card from his hand and looks at it briefly.

Hi, Dr. Jacobs, this is Chris Marlin over at JT Marlin.


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.

So my associate tells me you're interested in one of our stocks.

Yes, MSC sounds like it might be interesting.

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]

Well, I still have to run it by my people.

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]

Well hold on a second. I didn't say that. I just wanted to talk more about it.

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.




Two thousand?! Whoa! That's way more than I was thinking about. Two
thousand, Jesus. (pause)


The brokers hold in their laughter.

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.

That sounds good. Give me two thousand shares.


You sure you can't do any better on this one?

No, I'm sorry, Dr. Jacobs.

Alright, let's start with this trade then.

Great. I promise we'll go big on the next one.

Now do you want the confirmation sent to your office or your mansion?

Very funny, Mr. Marlin.

Alright, let me put my secretary on. She'll take your info.

Chris hits the hold button and then...

Done and done.

The entire firm applauds when he gets off the phone. The crowd disperses. Chris sits down on Seth's desk.

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.

Why'd you put a max on his buy?

Didn't you tell him how it works?

He's still a trainee. He doesn't need to know about initial sell limits.

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.

That's great. Why don't you go back to little Italy now?

Greg points across the room.

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.
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.



I actually still don't know how it works.

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?

Seth, I showed you where Chris' desk is.

How does Michael afford that?

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.

Gotta bounce.

Seth stands there in awe. He sees the potential here.