Mary Mary, Not Quite Contrary!

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Prof. Bruce Greenwald's Talk on Value Investing

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

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

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

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


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

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

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

Here are a few photographs covering the function:

Fooled by a Percentage Into Catching Falling Knife!

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

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

About 70% of the students raise their hands.

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

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

I hardly see a hand raised.

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

What is going on here?

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

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

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

Isn’t a penny saved a penny earned,?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

And that, you will agree, can hurt.

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


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

Re: free cash from ops

Pat, 

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

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

Best,

Sanjay

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

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

What Should Infy Do to Restore its Honor?

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

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

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

What could explain an outcome like that???

Has the company's earnings declined?

NO! See the chart below:

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

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

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

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

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

What should Infy do?

Quiz: If IFC buys into IFCI, then what?

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

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

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

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

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

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

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

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

The Mystery Behind Mastek's Buyback

On 29 October, Mastek made the following announcement:

http://tinyurl.com/ynu79f

Text:

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

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

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

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

END

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

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

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

Mr. Buffett's Model of Circle of Competence

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

 

Hi Ashutosh,

 

Hope all is well.

 

Here are my comments on your mail:

 

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?

 

Thanks

 

Best Regards

 

Ashutosh Datar

http://1skeptic.blogspot.com

http://snoopy-pixs.blogspot.com

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...

Quiz for Students on LGB

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

How would you analyze this?

http://tinyurl.com/33tt6v

Text Follows:

August 7, 2007

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

And this:

http://tinyurl.com/2da6br

Text Follows:

November 26, 2007

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

Quiz for Students: Fraud Analysis

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

Subject: Fraud Analysis

From: sbakshi@mdi.ac.in

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

To: bfbv@mdi.ac.in

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

How would you approach this disclosure?

http://tinyurl.com/yodgmp

Text follows:

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

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

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

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

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

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

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

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

Competitive Project on a Deep Value Stock

Sent to my class just now:

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

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

Which stock is it?

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

Rgds

==SB

Class Group Project Competition

This was sent to my class students today...


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

Ok here is the deal...

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

Which group can find this opportunity?

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

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

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

Rgds

==SB

Memo to Students: Bob Hamman Video

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

Wikipedia Page:

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

Company Site:

http://www.scapromotions.com/

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

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

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

http://tinyurl.com/3bfjpl

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

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

http://tinyurl.com/nsad

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

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
    marketplace.

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

END

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

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

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

Memo to Students: Robert Rubin as a Role Model

Hi,

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

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

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

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

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!

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.

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...

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.

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...