Monthly Archives: February 2020

Thursday Trivia ~ My Notes from Lecture of Superstar Investor Prof. Sanjay Bakshi!

Prof. Bakshi is one of most revered names in the investment industry. He doesn’t speak about investment returns nor does he engage with business media. On the contrary, a student of stock market attending his lecture often is enlightened with learnings from Warren Buffet, Charlie Munger, Ben Graham, Philip Fisher and other great investors around the World. It’s the uncanny ability to apply those learnings and making them super easy for audience to understand those learnings that leaves a lasting impression.

The lecture was titled – The Evolution of a Value Investor that took place on Sunday, February 23, 2020. Prof. Bakshi spoke about his 25 years and constant evolving value investment framework. The focus was on 2 names that redefined his investment ideology whose ideas most of us are following in some way or other.

  1. Ben Graham
  2. Philip Fisher

Prof. Bakshi started his session by speaking about Ben Graham where he highlighted his learnings from Special Situations and Bargain Securities. 

In the 3rd edition of Securities Analysis, Ben Graham has written an essay about Special Situations which entails as betting on happening or non-happening of a corporate event such as merger/demerger, bonus, rights issue, etc.

Features of Investment in Special Situations

  • Great Returns 

There is a possibility of getting a 40 to 50% return in less than 1 year by investing in such news based activities.

  • Uncorrelated Returns

In a normal investment framework, one is worried about market risk. Whereas in Special Situations framework, event risk is far more important than market risk.

  • No need for predicting future fundamental performance
  • Lots of fun

It’s definitely a lot of fun when there is a chance of making a quick buck in a limited time frame. Kind of gives a dopamine effect to the brain.

Since these situations seem like a low hanging fruit on a tree for most investors. It’s very easy to copy and replicate an almost similar performance. Hence, over the years a lot of things happened.

  • Competition Caught Up

The arrival of arbitrage funds in the mutual fund category was a game changer in the industry. These funds were created for exactly the same purpose. With more money pouring in, prices shot up quickly and the returns on these special situations came down.

Another reason was that there were no entry barriers to invest in such kind of events. Not as if one needed an intellect or patience of Warren Buffet. These were just low hanging fruits which everyone could see how to make money from.

  • Patsy in the Game

Patsy is made in reference to a dumb guy who doesn’t know what’s happening. As Warren Buffet says, in the game of bridge – if you can’t figure out who is the patsy in the game then it’s probably you. 

Special Situations are all about information asymmetry, where one person has a little more information about the company than the other. Since, this little edge can give huge rewards but being on the wrong end, might also make you a patsy in the game.

  • High IRRs, Low Wealth Creation

To create sustainable wealth, money should remain invested in the business for long periods of time. Investing in such situations may result in high internal rate of returns (IRRs) but since cash remains idle for most part of the year, it results in low wealth creation for investors.

  • Trying to predict the behavior of other investors

In the subject of Behavioral Finance, we learn that it’s impossible to predict the behavior of masses or crowds.  Most investors have lost a lot of money doing the same. However, the paradox of investing in special situations is that constantly we are trying to predict the behavior of other people.

Rumors spread around quickly which affects our conviction. Other than investors, sometimes even regulators or governments play some spoil sport. This drives down our profits. It’s a struggle to accurately predict the behavior of others accurately, all the time.

  • Errors of Omission

There are a lot of moving parts in the deal. Such as some court cases going on a particular project, some corporate governance issue which has not come to light as yet but can come into news anytime, etc. These sort of issues are very hard to focus on from a 6 month to 1-year perspective and hence it removes our focus on compounding our capital for long periods of time.

What Ideas should be discarded from Special Situations

  1. Short Term Thinking
  2. Dependence of Returns on the Behavior of Other People.

Ideas to be implemented

  1. The Idea of Upside Potential v/s Downside Risk

In certain special situations, there is a tremendous upside potential with limited downside risk. This happens when a company demerges or spins off a non-profitable unit or sells it to someone which unlocks hidden value of the company.

  • Taking Advantage of Market Over-reaction to Adverse Events

Demonetization is an adverse event where markets over-reacted to a lot of things. When money comes back into banks as deposits, it makes a bank healthy which is good for the economy in the long term. But in the short term, markets tanked giving pockets of opportunities.

  • Importance of Reinvestment Risk

In special situations, cash is lying idle to wait for the next big idea to jump in. There is little chance for that reinvestment to work in exactly the same way or even better. There can be times where money is lost which brings down the overall return on investment for the year.

Prof. Bakshi then went on to speak about Bargain Securities, something that Ben Graham is famous for and which even Warren Buffet used to practice in his early days.

Features of Bargain Securities of Ben Graham 

  • Low Price as your friend

Earning power yield which is the opposite of price to earnings multiple should be more than prevailing bond rate. Using this multiple, Graham would figure out whether the price is low or expensive.

  • Low price in relation to average past earnings power

There can be situations where current earnings are low but the average past earnings are higher. The reason for low current earnings could be some short term bad situations. In such a scenario, usually price is down due to disappearance of earnings. Bet here is that the earnings will one day go up.

  • High Dividend Yield
  • Low Price in Relation to Asset Value
  • Low Priced Common Stock
  • High Cost Producers & Leverage

A way to think about this is a stretch rubber band that comes back to normal shape once it’s released. When commodity prices go up, Graham advocates investing in high cost producing companies. 

For example, when steel prices go up buy a high cost producer of steel. When the cycle turns, there is a disproportionate impact on profits. Because revenue numbers go up, while input costs remain same. So there are good operating profits generated which help in paying out interest costs on debt. This pushes the Net profits upwards and so does Earnings per Share (EPS) hence the rubber band was stretched with low EPS which is now coming back to normal.

  • Relatively Unpopular Large Companies

Problems in Bargain Investing

  • Value Traps

Investors should always keep in mind the golden rule – stocks are sometimes cheap for very good reasons. Such as bad management quality, shady promoter activity, bad balance sheet quality, etc.

  • Errors of Omission

Since, the focus is too much on bargains, an investor tends to miss out on compounders. Sometimes they just don’t pay up for quality businesses looking for bargains. Charlie Munger changed this behavior of Warren Buffet in the late 1980s after which Berkshire bought a good stake in Coca Cola.

  • Selling a good business too early

As there is no effort to work on quality of the business. An investor tends to exit the stock once the bargain is over. This is a lot more painful when the stock continues to climb upwards even though there is no perceivable bargain in the framework.

  • Need for constant monitoring

80 to 100 stocks are difficult to monitor. Especially with so many moving parts. The constant buying and selling often disrupts the long term wealth creation aspect.

Common Factor in Graham’s Stock Philosophy 

Mean Reversion (Apna Time Aayega)

Bad periods will be followed by good periods.

Other Aspects of Graham’s Philosophy

  • Relatively Small Holding Periods
  • High Degree of Diversification

Looking for statistical good bargains. Hence, the portfolio is diversified upto 80 to 100 stocks in such situations.

  • Earnings Power Growth as a Speculative factor
  • Protection v/s. Prediction

Pain won’t last forever. Hence, protection from volatility is countered by wide diversification.

After an extensive discussion on Graham’s philosophy, Prof. Bakshi spoke about the second most influence in his life as a value investor – Philip Fisher. As he had spent a lot of time focusing on Graham’s philosophy, he went through a few things about Fisher very quickly. Fisher is completely opposite to Graham. He loves good companies that keep on compounding at decent rates for long periods of time. The idea of concentrated portfolio emerges from Fisher’s philosophy which our readers will discover further.

Key Features of Fisher’s Investment Philosophy

  • Growth

Contrary to bargain companies whose prices are low for a specific period of time, Fisher speaks about investing growth companies that will compound its earnings over long periods of time.

  • Innovation

Companies that innovate in various production processes that are usually hidden from its competitors are companies that possess strong growth over long periods.

  • Low Dividends

Companies that use money in good IRR projects rather than distributing them as dividends.

  • High Profitability
  • Self-Funding Growth

EPS of the company that keeps on growing.

  • Entry Barriers
  • Management Quality
  • Paying up for Quality 

Price in relation to future expected earning power of the company. Graham pays for price in relation to current earnings of the company. Another opposite feature.

  • Low Diversification

Less than 10 stocks which is completely opposite to 80 to 100 stocks of Graham.

  • Very Long Holding Periods

Common Factor in Fisher’s Investment Philosophy

Fundamental Momentum (Abhi toh party shuru hui hai!)

Things are good, they are going to get better.

Benefits of following Fisher’s Philosophy

  1. Slowing down by making fewer decisions
  2. Appreciation of qualitative factors
  3. Freeing up time

Downside of following Fisher’s Philosophy

  1. Overconfidence was costly.
  2. You could go wrong as management quality may change after purchase of stock or you can go wrong about the future earnings power
  3. No return for 10 years
  4. Business maybe very good when purchased but then story changes.

Ideas from Fisher to accepted in the portfolio

  1. Fundamental Momentum
  2. Paying up for quality with a caveat

Discarding ideas from Fisher

  1. Very long holding periods: As business cycles are getting shorter due to tech disruptions
  2. Extremely concentrated portfolios

Adding more ingredients by Prof. Bakshi on his portfolio

  • Different perspective on diversification

Having a focused portfolio of 15 stocks at max. in the portfolio.

  • Anti-fragility (Desirable)

Pain of others is a blessing for you. Because they did some dumb things which you didn’t.

  • Earnings power v/s Reported Earnings and Owner Earnings v/s Reported Earnings

Graham v/s. Fisher

Both ideologies are right but the tools are different. People get into trouble when they mix up both these ideologies. Example, Graphite story was of Mean Reversion and people confused it for Fundamental Momentum.

Synthesis between Graham and Fisher

  • Mean Reversion: In the long term, it’s a very powerful force.
  • AAA Bond Yield as a key mental construct

Suppose if the AAA bond purchased for Rs. 100 yields 10% interest, then an investor makes Rs. 10 (pre-tax) each year. This should be seen as an indicator of business’s earnings growth that should happen more than AAA Bond Yield so that the investor is better off purchasing equities of a business.

  • Earning Power Growth as a speculative component

The approach here is for an earnings power growth of a stock is when the market thinks it will shrink and all it has to do is not shrink. And then when it grows, it makes a lot of money for investors. Return on investment will come from growth.

Benefits of treating Earnings Power Growth

  1. No longer required to make elaborate projections about quantum and timing of growth.
  2. As multiple re-ratings are not in our control.
  3. If a large part of an excellent return has come from P/E multiple expansion as opposed to earnings power growth, then at some point stock will get vulnerable.
  4. Because you are reasonably diversified, hopefully you won’t get it wrong in every security in the portfolio.
  5. Protection v/s Prediction
  6. Focus on Portfolio’s Earnings Power Growth and not individual stocks.
  7. Buy high growth, high P/E stocks with moderation of risk.

The closer you are at the portfolio level to a AA Bond Yield Earnings, the more protected your portfolio will be from value impairment.

Discarding Ideas

  1. Low price can compensate for poor quality
  2. Too much diversification

End of Presentation

Then came the Question and Answer session where Prof. Bakshi was very open about his views on NBFCs and PSUs. He sees pockets of opportunities there. To a peculiar question of a largest private bank, Prof. Bakshi candidly mentioned that there are several ways of making money but very few ways blowing it up. An investor should study of how businesses blow up as there are hidden markers everywhere before such an event unfolds.

We thoroughly enjoy such knowledge sessions from veteran investors. Investment industry pays its deepest respect to investors such as Prof. Bakshi who come out and pour gold to others by sharing their knowledge, wisdom and practical application without having any second thoughts. It’s our constant endeavor to spread such pearls of wisdom with our readers, this Thursday Trivia is dedicated to Prof. Bakshi.

– Jinay Savla

Thursday Trivia ~ Mimetic Theory and How it impacts your Financial Future!

Rene Girard was a French historian and literary critic. He’s famous for Mimetic Theory, which forms the worldview of many of greatest entrepreneur’s and investors of our generation. One of whom is Peter Thiel, co-founder of Pay Pal and one of the early investor in Facebook. Thiel studied under Girard as an undergraduate at Stanford in the late 1980s. Their relationship stretched beyond the walls of Palo Alto classrooms and became a lifelong friendship. 

Mimetic Theory rests on the assumption that all our cultural behaviours, beginning with the acquisition of language by children are imitative. He sees the world as a theatre of envy, where, like mimes, we imitate other people’s desires. 

Mimetic conflict emerges when two people desire the same, scarce resource. Like lions in a cage, we mirror our enemies, fight because of our sameness, and ascend status hierarchies instead of providing value for society. Only by observing others do we learn how and what to desire. When it goes right, imitation is a shortcut to learning. But when it spirals out of control, Mimetic imitation leads to envy, violence, and bitter, ever-escalating violence. 

Mimesis is the Greek word for imitation. Imitation is not the childish, low-level form of behavior that many people think it is. Since humanity would not exist without it, humans aren’t as independent as they think they are. Early psychologists like Sigmund Freud didn’t take imitation seriously enough. In one essay, Thiel described human brains as “gigantic imitation machines.” 

How the Mimetic Theory impacts your financial future?

It’s no secret that the generation of 50s and 60s were absolute savers. They were raised differently; India’s economy wasn’t opened up to provide for a lot of opportunities. The way a millennials go about their lives, it wouldn’t even be in their imagination. Equity Markets weren’t as transparent as they are today, hence Banks fulfilled most of their needs. Information which is now freely available was once upon a time a scarce resource. Data analytics as a profession is something nobody would have thought of in 70s that one person sitting in front of a laptop or computer has the ability to access tons of data around the world. 

However, one thing doesn’t change between both the generation is the tendency to imitate their peers when it comes to life decisions especially financial ones. That’s why we tend to see mutual funds becoming an important conversation during 2016-2017 when equity markets gave good returns and by 2018-2019, these conversations now turned to having a fixed deposit being the better option. Yet the World’s Biggest Investor – Warren Buffet advises investors to do the opposite which is Be greedy when everyone is fearful and be fearful when everyone is greedy. Yet, almost always it never happens.

The reason is our capacity for imitation is unconscious. We tend to look at our peers such as family, friends, co-workers or relatives making certain financial decisions of their lives which in our rat race are unconsciously imbibed by us.

Our Mimetic nature is simultaneously our biggest strength and biggest weakness.

We tend to get inspired to do great work when we hear about someone who has accomplished so much. Sachin Tendulkar is the greatest influence on the game of cricket. Sehwag first and now Prithvi Shaw have their batting style which identical to the great man. In the world of badminton, PV Sindhu and Saina Nehwal have made a whole bunch of youngsters go out to play a serious badminton game. The world of Investments pays its respect to the dynamic duo of Warren Buffet and Charlie Munger. For starting great businesses, a whole generation is inspired by Steve Jobs and Elon Musk, so much so that they take pride in dropping out of college. 

The motivation to do great work often results in huge monetary gains as well. Higher aspirations right from the childhood combined with almost identical education amongst a circle of friends can result in an impactful career choice. For instance, students pursuing commerce are often interested in CA, CFA, CS or LLB, while students in science tend to pursue engineering. MBA these days has become a cult as a post-graduation degree, regardless of where a student has pursued graduation. 

However, there is another side to this as well. Our Mimetic nature often interferes with our peace when the tendency to match up our lifestyle with others takes the centre stage.

Take for example, the newly purchased or furnished home of your relative or a fancy new car or bike your co-worker brought to office. Looks great isn’t it? They must have made the right financial decision to afford it and we are being too conservative with our finances. For some there could a plethora of thoughts such as they could have also bought a similar house or bike, if only their investments would have grown at a faster rate. The tendency to take investment risk rises in such situations . And it’s this tendency where people tend to fall for tips from star fund managers or investors coming on television or reading about their recommendations over the internet to make quick money. The primary feeling behind this sort of behaviour is to not feel left out especially when the stock moves up.

Competition distracts us from things that are more important, meaningful, or valuable. We buy things we don’t need with money we don’t have to impress people we don’t like. 

These days we tend to see a new dimension to children’s birthday parties. Spending a good amount on parties by giving them in good restaurants are seen as a very important expense by parents just so that their children gain peer acceptance in school. Otherwise, there is a fear of a child becoming lonely or being seen in a poor way. The days of house parties with one large cake, wafers, samosa or vada pav followed with pav bhaji and soft drink are a thing of past now. 

Hence, in many ways spending has seen a rise. So has the need to start budgeting. Yet, it’s often ignored in the hunt for instant gratification. Any new mouth-watering deal that offers 50% discount but not really a necessity is often purchased resulting in over spending for things that we don’t really need.

With the rise in spending, especially discretionary expenses the ability of a family to save is decreasing. Since, imitating our peers make us short sighted, we tend to ignore our future goals of life such as retirement. Will we have enough financial resources to support our life when we are no longer working? Okay, that’s too much into the future. What about having some money aside if in-case there is a lay off and no job is available for the next 1 year? Do we have some money set aside to support us in those times?

We aren’t trying to be pessimistic here, just being cautious. When driving on a highway, it’s better to use a seatbelt which doesn’t mean that there is a chance of an accident.

Due to our Mimetic nature, cons often outweigh the pros. This tendency to imitate often takes away our originality. 

Hence, first and foremost we should ask ourselves whether are we really falling prey to this Mimetic Theory of imitating others? If yes, then specifically which areas of life? Is it to do with having a big house because some relative has it or a fancy car or generating best investment returns even while putting our money at greater risk?

And if you are actively countering your mimetic behaviour then please do share with us your success story. We eagerly await your reply.

– Jinay Savla