Friday, December 07, 2007

Re: free cash from ops


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...


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?

Tuesday, December 04, 2007

What Should Infy Do to Restore its Honor?

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?

Monday, December 03, 2007

Quiz: If IFC buys into IFCI, then what?

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:

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?

Sunday, December 02, 2007

The Mystery Behind Mastek's Buyback

On 29 October, Mastek made the following announcement:


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.


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

From: Sanjay Bakshi [
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:
  1. 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. 
  2. 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. 
  3. 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.
  4. 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. 
  5. 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. 
  6. 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. 
  7. 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." :-)
  8. 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?
Best Regards
Ashutosh Datar

Tuesday, November 27, 2007

Incentive-caused Bias in the Medical Profession

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...

Monday, November 26, 2007

Quiz for Students on LGB

---------------------------- Original Message ----------------------------
Subject: Analyze This
Date: Mon, November 26, 2007 11:13 pm

How would you analyze this?

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:

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

--------------- Original Message ---------------- 
Subject: Fraud Analysis
Date: Mon, November 26, 2007 10:51 pm

How would you approach this disclosure?

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.

Friday, November 02, 2007

Competitive Project on a Deep Value Stock

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.



Thursday, November 01, 2007

Class Group Project Competition

This was sent to my class students today...

---------------------------- Original Message ----------------------------
Subject: Group Project Competition
Date: Thu, November 1, 2007 1:18 pm

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.



Thursday, September 20, 2007

Memo to Students: Bob Hamman Video

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:

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:

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

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

List of topics discussed in Tuesday's class:
  1. Graham, Buffett, and Rubin suggested as role models for learning risk arb and the fermat/pascal way of probabilistic thinking.
  2. Case on Arcata Corporation from the Buffett letters was discussed at length to illustrate the idea behind risk arb
  3. 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)
  4. 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.
  5. 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.
  6. Extended discussion of the the GE Shipping spinoff deal, the twists and turns in that deal
  7. 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.
  8. Fermat/Pascal system of thinking, the necessity of developing an expected value frame of mind (Fermat/Pascal letters can be seen from here.
  9. 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.
  10. 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.
  11. 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).
  12. 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.
  13. 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.
  14. 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)
  15. 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...
  16. 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

Wednesday, September 19, 2007

Memo to Students: Ben Franklin's Prudential Algebra

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


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...

Monday, September 17, 2007

Memo to Students: Robert Rubin as a Role Model

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:

  1. Rubin's page at Wikipedia;
  2. The first three minutes and fourteen seconds of Rubin's interview with Charlie Rose;
  3. Rubin's commencement address at Harvard;
  4. Rubin's interview with Carol Loomis;
  5. 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.
  6. This article on Rubin in the New York Times Magazine and this letter about that article; and
  7. This press release issued by Rubin's office when he was Treasury Secretary.

Just do it!

Saturday, September 15, 2007

Mindmaps in Investing

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.

Friday, September 14, 2007

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

Topics covered in today's class:

  1. 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.
  2. 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.
  3. Diseconomies of scale, bureaucracy, eventual decline of all great corporations inevitable.
  4. 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.
  5. 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.
  6. 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.
  7. 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.
  8. 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.
  9. 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...

Thursday, September 13, 2007

Lecture 01: Introduction to Mental Models & Mental Tricks

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!)

  1. Mental models: definition, utility, Herb Simon's and Charlie Munger's idea of using checklists, the man-with-a-hammer syndrome.
  2. 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.
  3. The necessity of "jumping jurisdictional boundaries" and the futility of using a single tool like Microsoft excel to make decisions.
  4. 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).
  5. Inherent contradictions between some mental models e.g. Adam Smith's invisible hand and Garrett Hardin's invisible foot.
  6. 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....)
  7. 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.
  8. 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.
  9. 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.
  10. 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.

Sunday, September 09, 2007

Two Nights Before...

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

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

Sunday, July 08, 2007

Interview with Capital Ideas Online

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.

Thursday, June 21, 2007

Going, Going, Gone!

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!

Monday, June 11, 2007

My Recent Investment Operations

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

Friday, April 13, 2007

Schemes of Derangement

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...

Wednesday, March 21, 2007

Essar Shipping's Delisting Sinks, Drowns Prisoned Stockholders

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...

Sunday, March 11, 2007

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

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!