Logical fallacies: representativeness bias

Decision making is science in its own right. I have seen very few people who are good decision makers in one field and very poor in others. Many people fail to realize this. If their investing decisions go often wrong then they would probably infer that
1. They don’t have the correct information
2. They have the correct information but They don’t have required skills to derive correct inferences from that information.

Their comments on their failures give away their beliefs.. “If only I had the insider information I would have made money”…. “If I had done MBA in finance I would have been able to analyze the stock and made money”

More often than not, the reason of their failure can be attributed to failure in making rational decisions. It has nothing to do with finance. It has nothing to do with the amount of information they get. In coming few weeks I would explain the fallacies in reasoning which cause erroneous decisions.

Suppose I tell you that in last one year, every Monday morning I wrote a BUY or SELL in my diary for Sensex. In past one year 69.2% of my weekly BUY decisions were correct. Would you be interested in buying a weekly newsletter from me?

Interesting question. Think about it before you jump to a conclusion. As I’ve already hinted I’m questioning your capability to take rational decisions.


Before you send me the mail confirming you decision, I would like you to know the secret behind my correct predictions. I tossed the coin every Monday to decide whether the market will rise or fall.

Number of weeks I gave a BUY signal : 26
Number of weeks the Sensex closed higher than previous week: 36
Number of weeks I gave a BUY signal and Sensex rose : 18
% of weeks where my BUY signal was correct = 18/26 => 69.2%

Now you can infer that if you succeeded in 69.2% of all your BUY decisions this year, you haven’t done better than a Buffett’s orangutan in coin flipping contest. Similarly if an analyst brags about his “in the bull’s eye” recommendations he hasn’t done great job either. In Behavioral finance this is known as representativeness bias.


The two envelopes problem

Many times the investors switch stocks with fallacious reasoning created by a flawed argument. I would show an example of one simple puzzle which leads into complex error of judgment.

Let's say you are given two indistinguishable envelopes, each of which contains a positive sum of money. One envelope contains twice as much as the other. You may pick one envelope and keep whatever amount it contains. You pick one envelope at random but before you open it you're offered the possibility to take the other envelope instead.

Now, suppose you reason as follows:

  1. I denote by A the amount in my selected envelope
  2. The probability that A is the smaller amount is 1/2, and that it's the larger also 1/2
  3. The other envelope may contain either 2A or A/2
  4. If A is the smaller amount the other envelope contains 2A
  5. If A is the larger amount the other envelope contains A/2
  6. Thus, the other envelope contains 2A with probability 1/2 and A/2 with probability 1/2
  7. So the expected value of the money in the other envelope is

V = ½ * 2A + ½ * A/2 = 5/4 *A

  1. This is greater than A, so I gain on average by swapping

Source- wikipedia

Your intuition would most probably realize that there is something wrong but you may find it difficult to spot flaw in the reasoning given above.

When you are calculating expected values using the equation in step 7, you are assuming that 50% of the time the other envelop would contain 2A and 50% of the time it would contain A/2. Its like saying that 50% of the time the envelops would be (A/2, A) and rest 50% of the time these would be (A, 2A). This is incorrect because the problem statement doesn’t say that. I can play the same game by giving (100$,200$) envelops repeatedly.

What you should see is that for any given set of envelops (A,2A), you would pick A 50% of the time and 2A, 50% of the time. If you are holding the 2A then you have conditional probability of 100% to lose by a swap. When your are holding A then you have conditional probability of 100% to gain by a swap. It is important to note that both his gain and loss are same as the smaller sum and the expected gain by swapping is zero.

V = 1/2 * 100% * A + 1/2 * 100% * (-A) = 0

When you are offered a chance to swap, you haven’t gained any extra information about the contents of another envelop, hence the probability of choosing the higher value envelop remains same. I’m as good as with the chosen envelop as I’m by swapping.

This situation can have real life equivalents with an additional twist. A transaction cost involved in swapping which makes swapping a losing proposition because the expected value is negative.

Another variation of the problem where the following 2 arguments lead to conflicting conclusions:

  1. Let the amount in the envelope you chose be A. Then by swapping, if you gain you gain A but if you lose you lose A/2. So the amount you might gain is strictly greater than the amount you might lose.
  2. Let the amounts in the envelopes be Y and 2Y. Now by swapping, if you gain you gain Y but if you lose you also lose Y. So the amount you might gain is equal to the amount you might lose.


Argument 2 has already been explained above so let us focus on argument one. When I lose I’m holding a sum twice as large as the sum I’m holding when I gain by swapping. So the A/2 in losing swap transaction is equal to A in the gaining swap transaction because A in both are not same.

PEG Stands for Purely Esoteric Garbage

PEG is completely worthless piece of information in analysing a stock. Its The relation to price and earning is non linear. First look at the DCF equations would tell you that. You would have used DCF models. Just plot a graph on the DCF valuation and different values of expected growth. Notice the curvature of the graph. You will see that any approximation of this curve using a straight line plot will lead you to huge errors.

PEG comes handy when you have to convince yourself to buy a stock which has cought your fancy. The decision has been made but the rational mind requires justification. In comes PEG. At stock growing at 20% available at PEG of only 1. Utter bullshit!

PEG would give you wrong result even if your growth estimation was correct. If you are ready to tolerate bit of maths then here is why I'm saying this.

Suppose PEG is a constant.

P = P/E * E
P/E = PEG * growth
P = PEG * growth * E

Suppose you have 3 companies with EPS, of Rs. 1 per year.

  1. Available at price 100, expected to grow at 3%
  2. Available at price 300, expected to grow at 9%
  3. Available at price 900, expected to grow at 27%

PEG of all these choices are same. Suppose you invest Rs. 9000 in each of these companies. Lets also assume that your prediction about growth was correct. Now see what happens in the 20th year from now.

  1. Earning 157.8, accumulated profit 2418.3
  2. Earning 154, accumulated profit 1534.8
  3. Earning 938, accumulated profit 4375

Earnings = EPS* no. of shares

In hindsight company C was obviously better choice than A but A was significantly better than B. Why did we get this bizarre result? This is because PEG is a variable. Its different for each combination of price and growth.

Mathematically PEG is a slope of the curve plotted between growth and P/E applicable for that growth. When you compare PEG of two different companies then you are assuming that linear relationship between growth and P/E and you would get wrong results here even when you correctly predict the growth.

Sourced from:

Mad rush for high growth

  1. If the investing public in general, anticipates growth then the prices move up. Many times this rise in prices negates any advantage that the investor would get if the growth did materialize
  2. If the prices are high you are essentially paying for a future which has not yet materialized. [compare this with paying for the assets which exist as of now]
  3. As the business conditions are subject to change there is a risk involved in paying for growth. Higher the expected growth, higher the risk.
    1. If you are expecting 27% per annum growth for 20 years and the company grows at 24.3% for 20 years, you have been amazingly accurate in your prediction. Your forecast is just 2.7%(0.1G) off the mark. But the accumulated profits in these 20 years would be 30% less than what you forecasted and the profit in the terminal year would be 35% less than your forecast. If you paid for this high growth you may end up loosing even after this stellar clairvoyance.
    2. For a 10% growth prediction the same 0.1G, i.e. 1% forecasting error would result in only 12% and 17% hit to accumulated profits and terminal year profits.
  4. Its easy to overrate growth expectations. If a company has grown at a rate of 50% p.a. in last 5 years and future looks bright, can I expect the CAGR of 27% p.a. for next 20 years. Its very difficult. If the company grows at CAGR of 27% for 20 years its profits would be 119 times current profits. Given that the company had grown 50% p.a. in last 5 years, the profits 20 years later would be staggering 904 times the profits it had 5 years ago. The question arises
    1. Does the company has management capacity and vision to achieve this? Scaling up 904 times in 25 years is almost impossible(except for startups which have low base).
    2. Even with 10% p.a. productivity enhancements, this would require 17.7 times resources. It can be capital or human resource. Can the company raise so many resources?
    3. If the future is indeed that bright many more competitors would join the fray. The margins would go down due to law of diminishing returns. Can you expect the revenues to grow more than 119 times?
    4. Suppose the company has 10% market share of the industry. If the industry grows at 15% in the same period the market share of this company would rise to 72.7%, almost a monopolistic level. What is the strength that makes you assume that this company would become a monopoly in 20 years.
  5. The more you look at these arguments the more you would realize the fallacy of the growth assumptions. When you do this you become averse to paying high for high growth. I would love to buy a growing company if I don’t have to pay an extra dime for that growth. The profits of M&M, Sterlite, Jindal have grown as fast as market favorites like Infosys, Wipro. But I paid P/E of 2-5 compared to p/E of 25-40 commanded by Infosys, Wipro. When the growth materialized I gained 20 to 30 times appreciation. If the companies were to fail and go bankrupt I would have got out without significant loss because the price paid was 50% less than the market value of the assets. Such valuations look highly improbable now but the markets have history of manic depressive syndromes. So its better to wait patiently when markets are in manic phases.
  6. Finally what makes you think that the underdogs wont turn the tables. In 2002 SAIL was deep in red. It reported loss of 1707 crs. You may have thought SAIL would go bankrupt, but it bounced back to profitability. In FY05 the profits were 6817 crs., in FY06 4013 crs. Needless to say stock price jumped through the roof.
  7. Growth is good. We all want our companies to grow. But we want them to grow more than the growth that’s already built into prices. Absolute growth number is meaningless and its pursuit has been one of main blunders, the money managers have made throughout the financial history[I’ll explain this some other day].

On Discounted Cash Flow Valuation

If we would have been able to reduce the stock valuation to a set of mathematical equations then equity investing wouldn’t have been fun. While I understand the utility of following a systematic approach to valuation, I give very little weightage(approx. 2.5%) to the results of my DCF models in my decision making process. The reason for that is simple. The process required so many assumptions that the probability of being right is very small. It is, however, important to do this exercise because it makes you aware of the risks you are taking and it can give you some clues about the upside.

I generally prefer doing sensitivity analysis on the results of these models. For example if valuation resulting from a set of assumptions is X then I would like to see how this changes if the variables change. For example what if the growth tapers off? What if the interest rates rise? This gives me some idea of the margin of safety I have, while making the investment decision.

Each long term investor must understand that at the bottom of it, he is a businessman. You may be owning smalls parts of many businesses but that doesn’t change the essential nature of the argument. When a businessman takes a decision, say to expand capacity, he would do rough calculation on the expected returns. He would analyze the output price levels which would be needed to make the breakeven. He would check the investments required, fixed costs, running costs to make an educated guess about profitability of the project. He would do an analysis of competitive advantages and disadvantages. He would analyze the market to see if there is room for expanded capacity. If the plan looks fine on paper, he would check if he has resources, expertise and capital to execute the plan. Finally he would think about fall back plans, exit options in case the things don’t go as planned.

To me it would look pretty odd to see a businessman basing his investment decision solely on the output of discounted cash flow valuation models. If this argument is correct then the utility of DCF model to for long term investors should not be overrated.

There is a difference in analyzing the expected returns from a mature business and analyzing the expected returns from a new project. The mature businesses tend to be more predictable but not predictable enough to e reduced to a set of mathematical equations.

La Warren Buffett

Butterfly Effect

"What happened? 13.2% down in 7 days. It's brutal. It didn't even give you time of adjust your expectations. And all for no obvious reasons. You tune into CNBC and the analysts talk about the correction that was long over due. Correction! all right..but why the **** you didn't tell me that it was incorrect."

I've seen it happening so many times that I've almost lost interest. But I want to answer the question that many people have asked me in past few days.Why did the markets fall?

Do you know about Butterfly Effect?


Ok…Do you know butterfly's wings might create tiny changes in the atmosphere that ultimately cause a tornado to appear (or, for that matter, prevent a tornado from appearing).

No jokes. It a concept from Chaos Theory. The butterfly effect is a phrase that encapsulates the more technical notion of sensitive dependence on initial conditions in chaos theory. Small variations of the initial condition of a dynamical system may produce large variations in the long term behavior of the system.

The concept becomes relevant in investing world because the valuation methods used to estimate value of a stock are ultra sensitive to the initial variable. On top of that we routinely indulge in oversimplification of valuation concepts so that they can be expressed in simple ratios.

Lets talk about P/E. Most of you would know that the ratio is calculated by diving price by earnings. But which year's earning are talking about. You would often see reports stating that the stock is quoting just 8 times its FY08 EPS! Cheap..isn't it?

Even if you calculate by taking the average earnings of last 3 years, as Graham suggested, how would you know if P/E 15 is expensive or not? What's the benchmark?

The benchmark is provided by the risk free interest rate and the estimate of risk premium.

The valuation process is known as Discounted cash flow method.

But the problem with the model is that it takes estimates of highly volatile variables as inputs. There is no way of predicting the growth rate of next 10 years. Nor can you ascertain the trends in risk free interest rates or the right level of risk premium. At best we go by our guesstimates which are susceptible to changes in general mood. When everything looks positive people find 1% risk premium enough to invest in blue chip stocks. At the same time they overestimate the expected growth rate. To see the effect lets take an example.

Suppose you were given a task for estimating these variables for 10 year period and here are the actual results


Interest rate

Risk premium









The interest rate rise a bit. Growth is a little lower and investors little more cautious. By all means you have performed very well. But the result.

You valuation model will show that the value of stock must be 75% of your initial estimate. Its shocking. and it's analogous to Butterfly Effect in chaos theory.

This minor change in initial estimates can cause the estimates of correct valuations to change. The impact is almost always coordinated. That means the changes in these variables impact the valuations in the same direction. For instance when the interest rates rise the estimates of growth are revised downward and risk premium shoots up. The combined effect can be disastrous.

To answer the question..Why did the markets fall? A butterfly flapped its wings, which, through complex chain of intermediate events, caused instability in the world financial system and well......Rest is history


Note: text in italics sourced from wikipedia

Sensex and Sensibility

In 2004 end I has posted a report Exclusive report on Sensex underperformance on the poor performance of Sensex and reason behind that. The summary of the report was that BSE has done rather too many changes in the index and has gone more ‘with the momentum‘ which has made it a speculative portfolio which can never beat a long term portfolio.

Though it is too early to say, but the Sensex has become more stable as a portfolio. The number of changes per year have come down and have become sensible. In last 2 years they made only 3 changes with Maruti, NTPC and TCS taking place of MTNL, HPCL and Zee tele.

The following stats would give you the idea about this.

1996 - 15 changes

1998 - 4 changes

2000 - 4 changes

2001 - 1 change

2002 - 4 changes

2003 - 5 changes

2004 - 1 changes

2005 - 2 changes

The results are showing up. I can bet that they wouldn’t have done any better by making more changes to the indices in last 2 years. In fact the number of changes in popular global indices is very low. Dow had 7 changes between 1999-2006. S&P 500 typically has 15-20 changes per year. If an index has to become worthy of tracking by the index funds then it should be like a long term portfolio.

Its very difficult to beat a well diversified index with minimal changes. Princeton University Professor Burton Malkiel found that the S&P 500 beat 70% of all equity managers retained by pension plans over the 1975–1994 20-year period. Another study by Robert Kirby, former Chairman of Capital Guardian, indicated that out of 115 U.S. equity mutual funds that were in business for 30 years or more, only 41 (36%) beat the S&P 500 by some margin, and only 23 of the funds (20%) beat the index by 1% per year or more. Report

But why should it be so difficult. For example if you want to beat S&P then all you have to do is to find JUST 1 stock which you think would perform worse than performance of S&P next year. Then you should divide the money in rest 499 stocks as per the index weightage. If you turn out to be correct then you will beat S&P 500 and you would be doing better than 70% well paid finance managers.

It looks good as a theory but in reality the only god damned stock which you removed turns out to be the stock which outperforms the index. (remember m&m’s expulsion from Sensex in 2002)

That’s why its such a fun to race against indices. I envy the pleasure Buffett gets while beating S&P 500 year after year. I hated Sensex because it could be beaten hands down with value investing approach. If it continues on the path of stability (buy and hold) and it would be fun to compete against it.

Comparing your performance

Comparing performace of 2 investment portfolios is not a matter of comparing 2 numbers. In this message I would describe what factors you should consider before comparing performance of your portfolio with anybody else's.

1. Performance of a portfolio on paper(on one web) is not comparable to the performance of your invested money. Many members have said that they were following the portfolio on paper. Paper portfolios are waste of time and create illusion of learning. This is because the two important psychological factors, fear and greed are absent when you operate without money.

2. Performance can be compared on equal timeframes. If you have beaten Sensex this year, it not a reason to be happy. Similarly if you failed to beat it(like me) you don't need to worried.

3. Performances on short time frames(less than 3 years) are not worth comparing.
[By my estimates, next 3 years be a disappointing for all those who are investing today by selecting top performing mutual funds. ]

4. Performances on dissimilar investing styles are not comparable. You can not compare value investing based portfolios with growth oriented portfolios. Similarly comparisons in mid cap vs. large caps, focused vs. diversified portfolios are equally meaningless. Each of these have different risk associated with them which doesn't show up in `Top 10' lists.

5. Performance which don't take into account the short term capital gain tax and brokerages are a delusion. Similarly for mutual fund investors what matters is the returns after subtracting loads/expenses. This factor alone makes indices difficult benchmark to beat because the indices are long term portfolios and have no fee(or minimal fee charged by ETF)

While ending this experiment I'm not proud because it gave 53% p.a returns. I'm proud because I got those returns by following my investment philosophy. This gives me confidence that I can reasonably hope to continue getting above average returns in future.

In investing the determining factor your maturity aren't your returns. Its your investment philosophy. Returns are byproducts of how you think. For new investors I think its OK to loose money on the way towards figuring out your investment philosophy. For mature investors its OK to under perform the markets in short/medium terms as long as you are following your investment philosophy(see Buffett's relatively poor performance in 1997-2000 period).

Hence I should extend my congratulations to all the members who didn't get good returns while following their well thought investment philosophy. We are all running a life time marathon. If you are right then the time will prove you right. If you are throwing darts then the laws of probability will catch up with you, sooner or later.

Posted: Apr 23, 2006


I would like to share a 'live' case from my personal portfolio on the subject of investment in holding companies.

On August 6th, 2004 I sold Sterlite and bought MALCO to take advantage to disparity in the prices.


When Sterlite came out with rights issue, I was concerned that MALCO would increase its debt to unsustainable levels(it later renoucned its right and pruned its debt). A month after the swap I reversed this transaction. Though we made 14% gain in this, the swap was a mistake because the LWB Special portfolio was not supposed to take risky bets for small arbitrage gains.


However in my personal portfolio I continued back and forth swap between Sterlite and MALCO depending upon which looked expensive relative to other. Over next year I completely swapped Sterlite with MALCO. MALCO became my single biggest investment and it was the only stock where my personal portfolio differed from LWB Special. Sterlite continued its rise and MALCO couldn't keep pace. Consequently I was underperforming compared to market.

Considering the fact that MALCO's market capitalization was less than the value of stake it owned in Sterlite, I had every reason to remain patient but as I've explained elsewhere holding companies test the limits of your patience.

The following table shows the movement of the stocks from starting value of 100. Its clear that although in long term the value of holdings is taken into account, it can take years. One might get frustrated and sell(or may be die in the meantime!). When the revaluation takes place its sudden and abrupt. MALCO gained 76% in 5 months in 2004. After this it became dormant while Sterlite continued to rise. On April 7th, 2006 Sterlite had risen by 353% whereas MALCO was up by only 127%. At this point MALCO's market capitalization was 625 crs. whereas the value of 4.61% stake it held in Sterlite was 1057 crs.
















View chart of relative price movements

I was obviously frustrated with this situation and broke my prudent limits on maximum exposure to single stock. To my pleasant surprise the price of MALCO rose 64% in last 10 days. Even today it was locked at upper circuit breaker at Rs.458. (consequently last 10 days turned out to be most profitable 10 days of my investing career)

Coming back to original question. Was I right about swapping Sterlite with MALCO? May be not. Sterlite rose from 416% since July 04 whereas MALCO rose only 272%.

I know what you are thinking! If I had swapped from Sterlite to MALCO on July,2004, back to Sterlite on Dec, 04, back to MALCO again on 7th April 06 then I would have made 920% gain. Such perfect timing works only in theory.

The reasons which compelled me to buy MALCO remained valid throughout the period from July 04 to date. So in such case if I did a swap it was logically correct decision. In spite of a correct decision I haven't made anything more than what I would have made by just sticking to Sterlite, the way we did in LWB Special.

To summarize, exploiting the inefficient valuation of holding companies remains a perennial attraction for many value investors. Many of us underestimate the complexities and timeline involved in correction of these inefficiencies. The purpose of holding company is to hold the stock..forever. Isn't it irrational to expect that `unlocking of value' in such cases?

On the other hand it is easy to get impatient in such cases and miss those 10 days when the inefficiencies are corrected. As a rule most value investors would be better of staying away from complicated situations like this.

This rule may not apply if you are willing to hold INDEFINITELY. In those cases its always advisable to swap as soon as you see a sizeable advantage. If you try to time your entries and exits you may end up getting returns lower than either of the stocks involved.


Do we learn from mistakes?

Not necessarily.

Our assumption that we learn from mistakes is one of many such fallacies that arise from confusing logical deduction with logical induction. Other such fallacies include "taking high risk for high returns".

Allow me to delve little deep here. Its happens to be my favorite subject. Logical deduction implies a guarantee that if the premise if true, the conclusion would be true.

Lets take a classic example. "If it rains the ground would be wet". If you know that it has rained today then you can deduce that the ground would be wet.

However when you see a wet ground in the morning and say that "it must have rained tonight", you are using inductive logic. In logical induction, a premise provides some degree of support for the conclusion but not a guarantee.

Nothing new..Right?? Just look around and you would find that this is THE MOST COMMON mistake we make regularly and we never learn from it.

A learning process requires assimilation of knowledge and putting it to practical use. When we venture out in open, with `less than perfect' knowledge, we make mistakes. It's a part of learning process. But its not the mistake, per se, which teaches you. It requires a rigorous amount of discipline and analysis to be able to figure out what went wrong. An Iranian saying goes like this "man is a donkey which falls twice in the same ditch" . Leaving aside the question "are women any better", I tend to agree with this saying. More often than not, you would find a pattern of mistakes getting repeated in your life. That's what you call your weaknesses.

Coming back to original question.

We commit mistakes in the learning process but committing mistakes doesn't teach us anything. It's the analysis and corrective measure that enables us to learn. Unless this feedback loop is established you can continue making the same mistakes forever.

My personal experience suggests that the costliest mistakes of my investing life didn't teach me anything worthwhile. Its like having a crush on someone as a teenager. You don't really learn anything. You aren't mature enough to be able to analyze otherwise you wouldn't have been in that situation in the first place. In the initial few years, I lost lot of money in trading but I didn't learn anything from that. You can argue that I learnt the lesson that you can't make money in trading. I use the same argument to justify that foolishness but the fact of the matter is, I was sowing seeds in an arid land. It was waste of time and money.

There is no correlation in the number of your own mistakes and learning. I've leant a lot by reading and analyzing mistakes made by other people. At this stage I don't need to commit a mistake to be able to learn.

So my advise to new investors is that unless you are sure that you have, what it takes to learn from mistakes, don't commit them. Stay away from direct equity investments. You don't have to be jack of all trades. You got to be good at what you doing for living.

This doesn't mean that you can't be master of all trades. You can(my mind is saying I am!). Its difficult, time consuming, complex and confusing task but not impossible.

Posted: Mar 21, 2006

Asset Allocation

In this message I would like to give my views on the question of "What assetclass should one look into and does the fund size matter?

You should invest in the areas which you know of. There are thousands
of areas where you can invest but if you don't know anything about
that field, stay away! For instance I don't invest in real estate even
though I know that it has given decent returns in past. I simply don't
know enough about it to take decisions. I know that many people would
say that they can invest with help of some financial advisors but it
takes a certain minimum knowledge to be able to decide whether the
financial advisor can be trusted to take investment decision on your

Having limited your asset classes in this manner you can evaluate the
risk/return profile of that asset class with your own risk appetite
and return expectations.

The asset allocation would be different if you had different amount of
investment money. An investment transaction has two aspects, the
investor and the investment. When you invest 10% of your total
networth(including cash, fixed income instruments, equity, real
estate, precious metals & other assets) then you can afford to take
higher risk because even a 100% equity portfolio mean that your
exposure to equities is just 10% of your networth.
Another aspect that comes into play is the effect of volatility of
the investment. If you have networth of 20 lacs and you invest 50% of
it in equities, then be ready to face few days in year when your
networth may be down by 2% or Rs 20,000. If you panic in such case and
loose you sleep then I would say that the asset allocation itself was
Finally the amount of investment matters in asset allocation because
of the time characteristics of assets. Liquid investments can be
encashed at your will but in other cases you can end up losing if you
liquidate your investment before maturity date. This is true not only
in debt but also in equity. If you plan for a long term equity
investment then you should know that in short term the prices may go
down. If you are forced to sell due to your needs then you have paid a
penalty. So you got to create a rough demand/supply schedule of your
funds. How much money you might need in less then a year, in 1-3 years
and how much of money you can safely park for future. In economic
terms this is called a demand schedule for funds. Similarly if you are
earning more than your immediate needs then you will be accumulating
funds which create your supply schedule for funds. Your aim should be
to avoid mismatch in requirement for your funds and availability of
liquid assets.

Having done all this homework yourself or with help of your financial
advisors, you are ready to ask specific questions about specific asset
class. There is no direct asnwsers for asset allocation problem.

Posted:Mar 7, 2006

My Investment philosphy

I don't have any academic background in finance and I don't miss it.
I've followed a unique way to train myself in this subject. The basic
tenets of my approach are.

1. Hear it straight from the Horse's Mouth: I don't like text books. I
would rather read Kenyes and Adam Smith, than reading a text book on
economics. Similarly in investing I've learnt more from the investors
like Graham, Ficher and Buffett. Here too I preferred reading all the
60 odd letters to shareholders rather than a cook book on Buffett.

2. Practice it: No matter how much you read theory you never learn
without applying the theory into practice. If you lack conviction to
put your money where your mouth is, then you haven't really learnt. At
various times 70 to 140% of my net worth has been in stocks and it has
given me a lot of impetus to learn, to avoid mistake. I can not afford
to speculate. I reserve my gambling instincts to card games.

3. When someone points to the moon, don't catch the finger: You got to
imbibe the essence of teachings and develop your own strategy. Time
and again people ask me that you buy commodity stocks and still say
that you follow Buffett's philosophy. I'm operating in a different
environment, with different fund size and with different level of
skill. I have much better chances of getting high returns following
myself than following Buffett. Just the same way as Buffett developed
his own strategy after learning from Graham, I have to develop my own
optimized for my operating environment.

I said that "Circle of competence is a fuzzy thing" because everyone
misjudges his competence level. You would remember the famous
experiment where people in the group were asked to judge their driving
skills on a scale of 1 to 10 relative to the group.
The average of their scores was 7.5 !

I'm no different. In 1994, when I was 18, I used to think that I know
a lot about stocks. Five years later I had lost a fortune, trading in
stocks and I still believed that I knew about investing. All that
changed after I read Buffett. Things have become much simpler and
pleasant fro that point on.

The differences between my approach 4 years ago and today have to do
with maturing of my strategies, more realistic assessment of risks
involved and increased confidence. Now I know that I can afford to sit
back for a while and still generate above average returns. I don't
have to outperform Sensex in each of its every mad rush.

Over the years I have become more circumspect in giving advise. The
quality of investment is just of facet of investment transaction. The
investor is the second facets. Suppose I give a long term `buy' advise
and you think that it will give you 100% in 2 month. It falls by 30%
that month and you sell it, then my advise is meaningless. I've come
to know that even sound advise can harm people. That's why you would
never see messages from me, with glossy titles like "million dollar
advise" even if I believe it is.

In spite of being in IT I find IT businesses very difficult to
predict. I like commodities because the equations are very simple
there. The next thing I like are branded businesses where revenues are

To summerize, investing is not about making great and accurate bets.
Its about being 100% sure in avoiding big mistakes. The amount of
effort it takes to be 100% sure automatically ensures that you end up
buying stakes into great businesses and returns usually follow.

Posted: Feb 5, 2006

Dividend yield

Low dividend yield can have different meanings for different people.
To me dividend is a very useful return provided by the company for
today's income needs while retaining sufficient cash to keep growth
engine humming. The future earning is like promise of a party later
in lieu of a starvation diet today. The investor who lives on
investment income needs dividend and has every right to consider 1.5%
dividend yield as low(compared to returns from fixed income). The
investor who is skeptical about the promise of party at a later
date(like me) would not like the starvation diet.

In the matter of dividends I belong to old schools(of Graham). I don't
like companies which pay very low dividend. I can't imagine such a
bright future which requires the management to keep every penny of the
cash the business is generating. The capacity to pay dividends lends
credibility to the assumption that the management expects the current
earning to grow from here.

My past experience in this field shows that dividend yield can be an
important parameter in judging the sustainability of earnings.
1. Most good companies have maintained their dividend at the same
levels even in the time of crisis(M&M 2000-01). This may be an
indicator that the management thinks that the lower earnings of that
years are temporary downturns.
2. Most good companies have increased the dividends as their profits
have grown, thereby maintaining the dividend payout ratio.
3. Many dishonest companies can be nailed down during analysis because
they show continuous rise in earnings but no change in dividend. Such
earnings are either fake or ephemeral.
4. The good companies which pay very little dividends(Software
Infy/TCS) haven't really achieved anything much by retaining the cash.
I would have been happier if these companies paid more liberal dividends.

I'm not convinced by the argument that you can get the same return due
to rise in the price of stock. In such cases I've to (1) make an
assumtion that such price rise is permanent (2) I've to liquidate a
part of my holding to satisfy my income needs.

I've reservations on both counts. Capital gain is not comparable to
dividend till the gain is booked. If I've to reduce my stake in a
company just to get enough cash for my current needs, then it doesn't
solve my purpose.

Posted: Nov 28, 2005

Deferred Revenue Expenditure

In last few years many Indian companies had adjusted their accumulated
deferred revenue expenditure against the security premium
account(SPA). Such write offs have helped the companies to escape the
reduction in profits due to amortization. In my analysis I try to
account for such things but I felt a need to have a broader discussion
on this subject. So here is the complete story. Do post your views and

Around 2001-03 the companies started the restructuring binge. The auto
companies were leading the pack. Here are some new items.

Tata Engineering set off Rs 1,180 crore against the share premium
account in 2001-02, Ashok Leyland is in the process of writing off Rs
160 crore the same way while Tata Steel had planned to set off a huge
Rs 1,550 crore now.

M&M wrote off around 500 Crs. from SPA.

While I understand that there is nothing wrong in deferring the
genuine product development expenditure which is going to pay off in
later years, I have 2 serious objections.

1. I'm skeptical about the type of expenditure being charged into
Deferred Revenue account. I read a document on guidelines for
accounting for such costs.
Monograph on Accounting for Research and Development Cost

Page 13 of this document sets out what can be termed as a Research and
Development cost. It further adds "The amount of the research and
development costs described above should be charged as an expense of
the period in which they are incurred except to the extent that
development costs are deferred in accordance with the following
paragraph" In page 14 it describes what can be deferred.

The essence of this document is that you can defer the costs only when
you can reasonably expect the costs to be recovered from future
revenues. However the trend I noticed in Indian companies is to treat
it as "when you can dream the costs to be recovered from future
revenues". All the new product developments are straight away being
deferred regardless of their commercial viability. You can see this by
looking at low R&D expenses of Indian Companies because they never
account for it in the year such costs are incurred but defer it for
later periods.

2. The second and most significant objection to this related to
avoiding amortization of such costs. You say that I've spent 100 crs.
this year on R&D and I'll recover that in future revenues and hence
you don't treat 100 crs. as expenditure but defer it. Next year you
write of 100 crs from balance sheet. Let's assume our R&D pays off and
you make 30 Crs. per year for next 10 years. As you have already
written off the costs you would report 30 Cr p.a. profit. Had you not
done, and amortized the costs over 10 years, your profits would have
been 20 crs. p.a.
And what if the product fails. If you write off your mistakes will
never be visible in the income statements and quarterly results. After
all in a world blinded by Q on Q growth who has the patience to read
balance sheets!!

The guidelines clearly say "If development costs of a project are
deferred, they should be allocated on a systematic basis to future
accounting period by reference either to the sale of use of the
product or process or to the time period over which the product or
process is expected to be sold or used"

It is clear that any such write offs will give incorrect picture of
the future earnings. Now coming back to Indian companies, I'm
surprised that the managements have lauded their decisions to resort
to such "deceptive" tricks.

An excerpt from Tata Motors report
`Telco has recently written off assets and expenses to the tune of Rs
1,180 crore from its balance sheet against its securities premium
account (SPA), thereby eroding its reserves by 40 per cent and net
worth by 36 per cent. The company has written off deferred revenue
expenses on account of product development and employee separation of
Rs 933 crore, accounting for the bulk of the write-off. The write-off
due to the fall in the value of investments and fixed assets is Rs 32
crore and Rs 215 crore respectively.
According to Mr Kadle: "The rightsizing of the balancesheet will give
a true reflection of the company in the future years. This is not the
end of the restructuring process. We are looking at further cost
reduction and the requirements of working capital." `
Other companies are no different in their description of "financial

As an analyst I don't care what the managements say but any deviation
from standard accounting practices makes my life difficult. I'm unable
to delegate my analysis process to my analytical models and I'm forced
to do a case by case analysis. The legalese used in notes to accounts
makes it even more difficult to understand what's happening.

let's take an example. Tata Motors had spent around 1400 Crs. on
development of Indica. Out of that they deferred 1000 Crs. and then
wrote it off by charging it to SPA. Now I should amortize it over a
period same as expected life time of the product. I'll to make a
guess here and take a random 10 year period. You would notice that the
write off has significant impact of jacking up profits. More than this
it gives very incorrect picture of the Return on Net Worth(RONW). The
numerator(Profit) is jacked up as there is no ammortization. The
denominator is braught down because the net worth is brought down by
write off. The results are obvious. In case of Tata Motors the RONW is
24.2% for FY03-04 and 30.16% for FY04-05. No auto company in the world
generates such returns on networth(GM -15.56%, Toyota 12.94%, Ford
13.49%, Daimler Chrysler 6.59%). If you adjust the book value and
account for amortization the RONW comes to more reasonable figures 15%
and 20% for last 2 years. Looking at the results of Tata Motors for
last 15 years you would realize that the CAGR of its book value(even
after adding back the 1180 crs) is ONLY 6.83%. Taking dividends into
account the returns come to 12.38% p.a. This shows to what extent the
write offs skew the real picture. (For detailed calculations refer to
the following file)

Some people go even farther to skew the reality using prism of their
wishful thinking and their ignorance of valuation concepts. If a
company has average RONW of r and has dividend retention ratio b then
the expected growth rate would be r*b. With the jacked up RONW of 30%
in case of Tata Motors and taking average retention ratio of 55% you
can get a Expected long term growth rate of 16.5%. The they calculate
FY07 EPS and multiply it with P/E based on 16.5% long term growth
rate. If you do this you can stretch the valuations like rubber band.
I see renowned analysts applying such faulty logic every day.

To summarize, analysts should make the adjustments for such write offs
because if you don't, you would end up with grossly incorrect picture
of company's profitability.

Posted: Nov 20, 2005

I would like to share some of the methods I use to quantify "Lack of
Corporate Governance". These simple and unorthodox methods may not
sound convincing but they work.

In 2003 I realized that most of my mistakes in past 2 years were
occurring due to inability to filter out dishonest managements. After
looking various texts I was unable to come out with anything concrete.
That year I started work on a Corporate (Mis)Governance Index.

I would admit that
1.The initial target was to create a Corporate Governance Index. After
failing on this I tried the reverse and created Corporate
(Mis)Governance Index.
2. Initially I was skeptical of any success in this project. But the
experience of last 3 years has shown that these homegrown tricks are
better than having no clue.

here is the methodology I use(Don't laugh at it till you try!!)
1. Check board composition.
variables :
a. Number of people of the same surname in the board i.e. no of
Ambani's in RIL board. With some knowledge you can also add related
surnames:). Check both absolute and percentage of total board strength
Interpretation: >3 or 16.66% means bad, >4 or >25% is too bad

b. Number of executive directors from the pervious set (point a)
Interpretation: Little fuzzy here. If the ratio is too high that means
they are paying all their uncles and nephews fat salaries. If its too
low it means they have added even 'Mataa jii' to the board.

c. Find number of non-working directors. (Mother's, sons, daughters of
main promotor who never attend a board meeting)
Criteria: people who skipped more than 1/3 of the board meetings. Give
AGM, EGMs extra weightage.
Interpretation: This is to find the how many of the family members are
there on board just for the heck of it. Sometimes it also points out
independent directors who are just pawns of promoters.

d. Total salaries + commissions + bonuses as a percentage of Net
profits (take average of last 3 year's profit because 100% jump in
profit shouldn't mean 100% hike in salaries)

e. Check the history of equity dilution. You can find this in any
financial website like IciciDirect.
Search for word preferential allotment. Can't find it use google!
Interpretation: Preferential allotment at low prices is the most
misused tool in the times of bearish markets.

f. Check history of mergers and acquisitions. If you find that there
are acquisitions of companies where promoters held 100% stake, you can
be sure that the parent company would have paid hefty price.

g. Similarly check for the divestment/ de-mergers /sellouts. Check the
price the company got out of them and who bought the assets.

h. You can also check the ratio of independant directors. In my tests
it hasn't helped in a single case(not sure why)

The data about points a -d is available on the annual reports. Don't
ignore the corporate communications that the companies send as
worthless crap. Atleast read the salary increases part!.

As for f, g, h experience helps. One reason why I never start with
high investment ina company is that it takes time to come to know
about a company. Once you hold some stake your eyes are on lookout for
news about the company and you would learn to see the instances of

Some interesting cases of high Corporate MisGovernance Index
1. Penta Media (scored on virtually every point)
2. Reliance group (scored very high on a-d)
3. Sah petroleum (small company which came out with IPO. The faily
members take 8.5% of profits home!!)

Some of the companies from LWb Special whose scrored were relatively
higher are Jindal Steel and Power & Sterlite.

The companies which scroed zero on Corporate MisGovernance Index
include HDFC, ITC, HLL, INFY. It just shows that this index is not
exhaustive enough to measure MisGovernance by professionals.

Surprisingly all PSU's scored low on Corporate MisGovernance Index.
may be that's becasue the index doesn't measure lack of
disclosures/lack of foresight etc.

Mutual Fund selection

"The dumbest reason in the world to buy a stock is because it's going
up" – Warren Buffett

I would say the next dumbest thing would be to buy a mutual fund
scheme just because it's NAV is going up. But that's exactly what the
investors do when they buy mutual funds on the basis of short term
performance. I read an artcile about the (in)consistency of mutual
fund performance.

EXCERPT: "The S&P's Mutual Fund Performance Persistence Scorecard
(link opens a PDF file) measured the consistency of top-performing
mutual funds over three and five consecutive years. As of May 31, only
10.7% of large-cap funds, 9.2% of mid-cap funds, and 11.5% of
small-cap funds maintained a top-quartile ranking for three
consecutive years. Which is to say that only one in every 10
top-performing funds in a given year stays in the top 25% for the next

This is a word of caution for the investors who think that they are
making intelligent decision than the people jumping directly into
markets. After all, if you fall from 10th floor it hardy matters if
fell from the window or you were inside a lift which fell 10 floors.

The article further goes on to suggest that you should carefully note
the expense ratio of the fund. As per the author, one of the golden
rule is "If you are investing in mutual funds, look for funds with an
expense ratio of less than 1%".
In India most of the equity funds have expenses ratio higher than 2%
which means that Indian investors have more reasons to worry.

Read the complete article at.
Beware of Dogs

If you want to know more about expense ration read the following post
Expense ratio : The indicator of Mutual fund costs

Posted:Oct 10, 2005

Investment vs Speculation

In every bull run the media reports are full of the references to the
return of the Small Investors to the equity markets. Lured by the
headlines of Sensex crossing 8000 and stories of neighbor making huge
money, otherwise intelligent people, decide to try their luck in the

I find the word Small Investor little misleading. The term is used for
the people who are really Small Speculator but think that they are
investing. It is very important to make the distinction between the
two. Any advise which is valuable to the investors, can be dangerous
for the speculators. Before I go on to explain this I want to put
forward the definition of investment as given by Benjamin Graham

"An investment operation is one which, upon thorough analysis promises
safety of principal and an adequate return. Operations not meeting
these requirements are speculative."
Graham and Dodd's Security Analysis (original 1934 edition)

Graham goes further to suggest that speculation is not wrong but
entirely different ball game and should not be confused with investment.

"Outright speculation is neither illegal, immoral, nor (for most
people) fattening to the pocketbook . . . There is intelligent
speculation as there is intelligent investing. But there are many ways
in which speculation may be unintelligent. Of these the foremost are:
(1) speculating when you think you are investing; (2) speculating
seriously instead of as a pastime, when you lack proper knowledge and
skill for it; and (3) risking more money in speculation than you can
afford to lose. . . everyone who buys a so-called "hot" common-stock
issue, or makes a purchase in any way similar thereto, is either
speculating or gambling. Speculation is always fascinating, and it can
be a lot of fun while you are ahead of the game. If you want to try
your luck, put aside a portion--the smaller the better--of your
capital in a separate fund for this purpose. Never add more money to
this account just because the market has gone up and profits are
rolling in. (That's the time to think of taking money out of your
speculative funds.) Never mingle your speculative and investment
operations in the same account, nor in any part of your thinking"

Benjamin Graham in The Intelligent Investor

When you speculate on a stock while thinking that you are investing,
the time tested principles of investing can do you more harm than
good. For instance take "Buy and Hold" approach. The investors who
have done property analysis can afford to hold the stock even if the
price goes down. If they are really sure about their reasoning they
can (and they should) increase their investment as the price goes
down. The same is not true for the speculator who is investing in a
penny stock. He can lose his entire amount just by waiting for the
time stock goes up.
The same goes with diversification. If you buy all slots of a
roulette, you have a 100% chance of losing money equal to the %
charged by the Casino. Similarly if you try to be a contrarian when
you know less than what market knows you would lose more that you
would by following the trend.

That brings me to the question I want you to answer for yourself. Are
you sure that you are not a speculator?
If you don't know the answer then you can get the answer the
following question.
(a) Do you know about the main products/business of the company you
have invested in?
(b) Can you tell , with (+-)50% accuracy, the revenues or profits of
the company.
(c)Have you ever checked the financials or results of the company?
(d) Do you have some reasonable expectation about the returns from the
money you have put in the stock and have you compared those
expectations with the returns available from other non-equity
(e) Do you have some estimate on risk that you are undertaking, e.g in
worst-case scenario how much you can lose.
(f) Have you done more than a day of homework per stock before forming
your expectations and risk estimates?

If you answer more than 4 of the above question as NO than you are
definitely an speculator irrespective of your opinion. If you have
answered at least one NO then you would be better of undertaking
investment under guidance from experts. Finally, if you have answered
all of this as yes it is difficult to guess whether you are an
investor but you are definitely on the way.

None of the points mentioned above are for discouraging or disparaging
speculation. Very few people in the group would know that I'm an
expert gambler but I never speculate in the markets….And I know, it
pays to be really sure when you are speculating.

Oct 19, 2005

Holding company structure

Holding companies are a tool used by promoters to retain management
control over companies with minimum amount of investment.

Assuming you want to retain management control of a company A which
has 100 Crs of paid up capital. You need to shell out 33 crs. to get
33% share which can give you control if no other shareholder hold that
much stake. Assuming you have a holding company B where you have
management control with 51% stake. If B holds 33% stake in A then B
gets management control over A.
Now think how much you will have to pay to get 51% of B ? Assuming B
the only asset of B is its holdings in A and its paid up capital is 33
crs. You will have to pay only 17.5 crores to get management control
over B and by virtue of its 33% stake in A you get management control
over A.

This is one of the many benefits promoters get using holding company
structure. You can create a pyramid of holding companies and get
management control over large companies with personal holdings as
small as 5 -10%.

Other benefits include fooling the creditors to supply loans of
disproportionate sizes. As a promoter your interest would lie in
retaining control with as minimum investment possible. If you get the
creditors to pay 100 cr loans on equity of 50 crs, you can get 33%
stake in a company with 150 crore assets , by paying just 17 crs.
Obviously no sane banker should pay loan as high as this but here the
holding company comes to rescue. For instance, Reliance paid loans
worth 12000 crs. to Reliance Infocomm when Reliance Infocomm's equity
was around 450 crs, that to at 8% interest rates.

That's another reason why its is unreasonable to expect the promoters
to unlock the value by resolving such structures even though the
holding companies remain undervalued for long periods of time. They
can keep increasing their stake in the holding company by creeping

In nutshell, the investors of the holding companies fund your
investment in the subsidiaries and help to getting top management
positions with fat pay checks as large as 1-2% of net profits of the

that's why the investors have to bee very cautious and very patient
when dealing with investments in holding companies. Its a complicated
business and should never be attempted unless you know enough abut
these tricks

In last weeks I had explained the fact that the
market capitalization of Indian equity markets seems on a higher side
in comparison to India's GDP. I've been able to get hold of some data
to support this claim. Here are the figures of market Cap to GDP
ratios of different countries(based on data from World bank on GDP for
FY 2004).

USA 132.2%
UK 132.1%
taiwan 87.0%
japan 80.3%
S. Koria 77.2%
India 64.9%
Russia 57.7%
Brasil 55.6%
China 22.7%

Please note that this ratio is not a single yardstick to measure the
relative valuations because the ratio depends following factors.

1. Ratio of listed companies compared to the unlisted companies (which explains why china's M.Cap/GDOP ratio is low)
2. ratio of contribution of unorganized sector to the organized sector.
3. Prospects of growth(higher the growth prospects the higher would be the ratio)
4. Interest rates (Low long term interest rates would result in higher valuations)
5. Risk premium (if the systematic risk are high the valuations would be low)

Even after accunting for expected growth I find it difficult to
justify assumtions that equities can yield 20%+ gains in coming years.
hence I believe that the markets are going to give returns of 11-13%
in next 5 years. While these returns are pretty good it implies a risk
premium of 3.5% to 5.5% over risk free rate. This may not be enough to
justify investment in stocks in general. This means that you should
concentrate your holdings into only those stocks where the prospects
of high returns justify the risk you are taking.

Posted: Aug 22, 2005

Why Diversify?

You may have heard of the oft repeated advise about not putting all
the eggs in a single basket. It is repeated so often that people want
to rebel against it. But I think diversification is a theory which has
sound mathematical basis.

Assume that you and me decide to gamble on 1 lack rupees on a toss of
a coin. Also assume that you have a special coin which churns out
head 70% of time and tail 30% of time and you have the liberty to pick
up your choice(head or tail). You can also choose how much you would
bet on 1 toss.. i.e that you can toss the coin 1 lack times by betting
1 rupee on each toss or you can put entire 1 lack rupees at stake in 1

What would be your strategy? How many times would you throw up the
coin? If you had read the chapter on probabilities well, you should
bet 1 lack times on getting head and you have assured chances of
winning approximately 40000 Rs. If you decide to bet 1 lack in a
single toss of coin you may lose up to 1 lack or win 1 lack.

Clearly the choice is yours. In equity investment, there are no risk
free bets just as there are no coins without a flip side.

In such cases diversification increases your probability adjusted returns.

Having said that diversification is necessary but not sufficient
condition to safer returns. This is because if there is any
correlation between returns of the stocks in which you have
diversified you may lose in all of them if things turn worse.

Also there are risk involved in over diversification because of the
transaction costs. Another reason is that it is difficult to find more
than a few stocks where you can get 70% chance of returns. This means
that the more you diversify, the closer you get to average performers.

My personal view is that an equity portfolio having less than 7 stocks
or more than 25 stocks is badly designed.

Posted: July 21, 2005

Last week I read an insightful article in The Economist on the Global
housing boom and the high probability of impending crash. I was quite
interested to get some information about real estate market which is
not my home turf. Though the analysis of housing market in India is
difficult task due to lack of information, lack of transparent legal
structure to support property rights and an inefficient market, I
would still like to initiate a discussion about housing prices in India.

To my mind investment in the Real Estate is like any other investment
with risk and rewards associated with it. But the majority of people
do not think about the risks in investing in real estate because they
think the prices will always go up. They usually base their arguments
on the fact that the supply of land is limited and the demand keeps
growing. However history doesn't back this argument. ( In the links to
the articles you would find some instances of sever crashes in real
estate prices and the reasons why it happened)

As an investment real estate investment has some interesting
characteristics. At least till your first house, the home acts both as
an investment and a consumable commodity. In that sense if you live in
a house you own you would not be in particular hurry to sell it just
because prices are falling.

But to reverse the argument would you buy a house just because you
have enough money to buy or enough cheap loan available to buy it.
Without giving any recommendations I would give you an interesting
scenario of my own rented flat. The rent is 14,000 p.a. with 5%
increase per year. If I want to purchase the house I'll have to pay
approx. 40 lacks.

If I use discounted cash flow model to determine how much time it
would take for me to break even with the rent saved at this price and
using risk free rate of 7.5%, it would be take me 36 years.

For obvious reasons I'm not interested to buy this house(or any house
for that matter, even though I afford one and I need one). So this
equation is simply not adding up. To make LHS= RHS one of the
following has to occur.
1. The rents will go up by more that 5%
2. The long term interest rates will come down
3. The price of the house comes down

The option 1 is rules out unless the prices in entire city move up. At
the rent I'm paying is on the higher side and I don't think that it
can go up further.

The long term interest rate are on the lower side now and will not
move down further unless there are structural changes in Indian Economy.

The last option seems more likely (I know you would disagree!). Two
years ago the prices were close to 28 lacs. In the last 2 years the
rents have moved up by 10-15% and the prices by 60%.

My case may be one off case. I want you to do the same analysis(or
send me data) and figure out for yourself if the house is worth buying.

Now the story is same globally. People are paying more price to buy
house than the returns they can get from them in their lifetime. the
argument is the same that the prices will go up and up.

I would leave you here with the following articles. Hope that you
would send your opinions even if you don't agree with me or The Economist.

The global housing boom: In come the waves

House prices : After the fall

Beware housing bubble: HDFC Chairman

Bonus shares - why bother?

The declaration of the bonus can be thought of as recognition of
additional equity capital provided by the investors by virtue of
agreeing to reinvest part of the profits. To understand this, let's
assume that a company X has a equity capital of Rs. 100 crs and no
accumulated profits. The company X earns 20 Crs and pays 5 Cr. as
dividends. Also assume that there is another company Y, which is
similar in all aspect to company X but gives entire 20 Crs as
dividend. Assuming that the profits and all other variables remain
same the company X would have a networth of Rs. 175 Crs. and Y would
have a networth of 100 Crs.

In the year 5 if both X and Y pay 20 Crs dividend which company has
higher payout ratio? same..they both have 100 Cr. equity and they both
pay 20 Crs. However we are ignoring the aspect that the shareholders
of company X have put additional 75 Crs. of capital in the company by
investing part of profits.

If the company X gives a bonus it is recognizing the fact that the
shareholders have provided additional capital by allowing the company
to deploy profits back to the business. This expanded capital base
need to be serviced through dividend and if a company recognizes the
contribution then it is highly likely to raise dividend payout.

All this may sound highly theoretical because the capital structure
doesn't change a bit through bonus. However, empirical evidence
suggests that bonus issues imply higher dividends in longer term. To
that extent the favorable opinion about bonus issues is logical up to
a certain limit.

The reaction of the market is many times exaggerated. Many analysts
seems to overvalue the advantages of more liquidity provided by the
bonus but I think it is of very limited long lasting value. The stock
splits serve the same purpose as bonus as far as liquidity is
concerned but they have no long term consequences.

In economics and finance, the expectation of change of variables is
more powerful factor than the change in variable. The variable in this
case happens to be the dividend. The bonus also raises expectation
that the profits are less likely to fall from current levels because a
conservative management would never like to reduce the dividend payout
even in bad times.

This subject has been nicely explained in the Intelligent Investor by Graham and
you can refer the book for more details.

Posted: Jul 1, 2005

Investing in holding companies

Holding companies make a good target for the value investors. I have
used this quite effectively in the past in case of M&M/Sterlite etc.
The principles I follow in these cases are as follows;

1.Analyze the companies independently to judge the prospects of
subsidiaries by themselves.

2.Find out the triggers of unlocking the value in the subsidiaries.
That may not necessarily mean that subsidiaries need to be made public
or sold. it simply means whether they would achieve the critical mass
to make the market realize their worth. In fact if a holding company
has stake in a strong subsidiary then by the value investing
principles it may not make sense to divest the stake.

3.Find out the pitfalls.
a.Figure out why such holding structure is created. Many times the
companies do this to hide debts in the books of subsidiaries. The
extreme example of this is pyramiding capital structure, a la Enron.
b.Check if the parent company is using transfer pricing to sell the
products at higher price then it can get in the markets and booking
profits whereas the subsidiary is suffering from losses.
c.Avoid complicated structures with substantial cross holding

4.Check if there are any synergies in the business of parent company
and the subsidiaries. History shows that diversified companies making
everything from steel to software are unable to remain focused in
disparate businesses.

5.Check if the managements of the subsidiaries have enough expertise
and freedom to shape the future of the subsidiary.

6.Having done all of the above mentioned analysis, evaluate the value
of the interest of the parent company in the subsidiary. You can get
this by looking into the consolidated accounts. Here a catch is that
the accounting norms do not force the company to consolidate the
accounts for the subsidiaries where the parent company holds less than
505 stake. Reliance Infocomm is the case to the point.

7.If you can determine with reasonable degree of confidence that that
the total value of the consolidated enterprise is more then what
market estimates buy it. But you got be very patient in such cases
because it may take years before market realizes that.

Posted: June 20, 2005

Oil Prices

I'm getting increasingly sceptical of macro economic forecasts made by
leading economic insttitutions and economic journals. Six months ago
when oil prices crossed the comfort zone, all analysts had said that
if oil remains at these levels the world economy will go into
recession. Well six months are over and oil prices have continued
their northward run but the global economic health seems as good as ever.

This not only raises doubts on capabilities to make such predictions
but also coroborates views of Buffett regarding giving low priority to
macro economic factors. He says "When investing, we view ourselves as
business analysts - not as market analysts, not as macroeconomic
analysts, and not even as security analysts. "

These variables are very difficult to predict and investors are better
of by ignoring them unless they themselves are very sure of the their

Having said that I'm not concluding that the high oil prices will have
no impact but we have to take the predictions of the extent of impact
and time with a pinch of salt.

Posted:Apr 5, 2005

In a perfect economic system, the changes in relative strength of a
currency should not affect the relative strength of any other 2
currencies. However, we live in an imperfect world. The currencies of
various economies are market driven to a different extent.

For instance, Chinese Yuan is pegged to dollar. Indian rupee in partly
market driven and any major move is scuttled by RBI through open
market operations. In such a case if the dollar loses strength it will
not only affect the trade equation between India and US but it will
have impact on trade equation between India and any other country.

If rupee appreciates against dollar but Yuan doesn't then the Indian
export will become less competitive in compared to Chinese exports.
These countries compete in many areas and dollar devaluation can
affect the economies quite a bit.

More specific impacts of weakening dollar are listed below:
1. Company's who have raised debt through ECBs denominated in dollars
would gain because they have to pay back fewer amounts in rupees.
2. Companies with dollar denominated exports will suffer exchange
losses. Such losses can amount to large figures unless company
actively manages exchange risk.
3. Companies which are importing dollar denominated goods/raw material
like capital goods/crude etc will benefit from lower cost.
4. Companies competing against countries like china will suffer due to
relative appreciation of their currency against an inflexible/pegged
5. India's 130bn $ forex reserves would lose their sheen but you will
never see forex loss reported in any financial statement from india.
6. A huge and unsustainable reserve position may force government to
open up some restrictions on convertibility, foreign investment by
Indian companies etc. This will be a beneficial impact.

To summarize I'm more worried about appreciation against competing
Asian currencies than against dollar.

Posted:Feb 8, 2005

Strength of Currency

Understanding the interplay of exchange rates and economic implication
is a complex subject. I would try to explain the things in layman's
terms and would refer serious economics enthusiasts to books
referenced at the end of this message.

Lets imagine a world without currencies and trade based on bartering
of goods. Assume that A deal produces only spices and country B
produces only silk. Thus these two items become their currency for
trade. if the spices are highly sought after items then the economy of
country A would be able to import more goods by forgoing a little part
of their own produce, that is silk. The country would afford a large
buying power for their produce.

Implication 1: Strong currency is helpful to the economy.
All the countries during the periods of their economic superiority
have had strong currencies. The rise of Dollar along with US economy
and fall of Rouble along with the fall of Russia are 2 examples

Now let's assume that there is another country C which produces only
spices. To compete agaist each other to sell their spices both A and C
will have to keep the prices of their spices at reasonable level. If
the country C starts under pricing its spices the trade between
country A and B will suffer and the economy of Country A be affected.

Implication 2: A strengthening currency not helpful to the exports. If
exports drive substantial portion of the GDP, a A strengthening
currency is not helpful economy.

The strength of economy is not directly correlated with the fortunes
of the capital markets which represent only organized corporate
sector. In the countries like India where FII investment is a
significant driver in the investment decisions of market participants
the exchange rate movement matters. This acts through the "expectation
of change in the exchange rate" rather than change itself. If the FIIs
think that they can generate 10% rupee returns and expect rupee to
depreciate by 5% their dollar return becomes only 5% and they would
rather invest in US Govt. treasuries.

If the strong currency is associated with expectation of weakening you
would see large FII/FDI investment. If the exchange rate is expected
to be stable it will not be a significant matter rupee trades at 40/$
or at 50/$.

The more complicated impacts from exchange rates come in form of the
changes in interest rates and inflation. For instance, if the dollar
inflows cause a rupee to appreciate the RBI will have to buy Dollars
and release rupee in the economy. This would cause inflation and rise
in interest rates. To counter this the central banks follow
neutralization tactics like selling Govt. bonds to mop up additional
liquidity. I don't think that I can explain(or even i understand) this
aspect in a message.

None the less I can answer any specific queries you have in this
subject and feel free to post your views.

The General Theory of Employment, Interest, and Money, by Keynes

Wealth of Nations , by Adam Smith

Posted: Feb 8, 2005


Diverfification beyond a point is meaningless. For
sure you don't need to put all the eggs in one basket but if all the
baskets are under one roof which may fall any day then you don't
achieve anything out of your planning.

Sometime back I wrote a Note on Over-Diversification. Posting the same

To explain let us assume that the funds are invested in 20 best
opportunities available. Had the investment been concentrated to 10
best opportunities and the results turn out to be in sync with the
estimation, the gains from a portfolio of top 10 companies would be
far higher than the one with 20 companies. The risk in the latter
would be lower but not significantly less because a substantial
portion of risk comes from the risks inherent in economy and capital

I seek to achieve an adequate level of diversification to achieve
`Safety of Principal' and high returns. The mutual funds due to large
size can not deploy all their funds in 10 companies. The results is
over diversification and lower returns. For example as of June 30th,
2004 Morgan Stanley Growth Fund had invested in 46 listed, 7 unlisted
and 3 ADRS. The results were obvious. In the 10 years since inception
the NAV of the fund increased from 10.00 to Rs. 18.47. The fund has
paid dividends of 4 Rs during this10 year period.I believe that the
mathematical odds are stacked heavily against such over diversified
portfolio. The managers of the fund did make money for themselves with
1-1.25% management fee and annual administrative expense not exceeding 3%.

The discussion on asset allocation has led us to an important topic
of inflation. I feel that inflation deserves a more detailed analysis
because of the complicated ways in which it affects businesses. I'll
try to explain this in this message.

During inflationary period the currency loses value which cause all
the securities denominated in that currency lose value. In case of
long term debt the impact may be even higher because the central
banks resort to increase in interest rates to check the inflation
which depresses bond prices.

The real assets like properties, plants etc are less vulnerable to
inflation because their nominal values rise along with inflation.
However the impact is not straightforward and can be detrimental to
the business in many ways.


Let's enumerate the beneficial effects of inflation on business.
B1) Inflation tends to increase the prices of assets like real
estate, plant and machinery etc which directly adds to the nominal
value of existing stock of capital.
B2) The rising asset prices make affect the supply of new investments
because rise in supply price. For example the increase in steel
prices would mean higher cost of setting up a plant which may or may
not provide enough returns to justify cost. This increases the
competitiveness of existing asset base.
B3) The fall in the value of currency decreases the indebtedness of
the company. If a company has taken a loan of Rs. 500 crs, the fall
in the real value of rupee will mean that the company can pay back
with less amount of real currency.

Let's enumerate the detrimental effects of inflation on business
D1) Inflation affects the consumer demand because of increased cost
of living which may not be offset by a rise in monetary wages.
D2) Any increase in monetary wages due to inflation can lead to rise
in operating cost which is risky because monetary wages tend to be
sticky and may not decline as situations change.
D3) Inflation increases the working capital requirements to manage
the same level of output. This affects working capital intensive
businesses like retail in a big way. This effect was explained by
Buffett in his letters to shareholders during inflationary period of
early 80's.
D4) In a competitive environment the businesses may not be able to
pass costs to the consumers. For example biscuit manufactures in
India have not been able to increase prices since last 6 years even
though the input costs have risen by more than 505 in the same period.
D5) If Central banks raise the interest rates the valuations based on
discounted cash flow suffer due to rise in risk free rates.
D6) The destabilization of economic system due to high inflation
leads to rise in risk premium.
D7) Although the nominal values of assets like real estate, plant and
machinery rises with inflation, the values of other assets like
cash, investment by company in bonds etc decline. (related to B3)


The asset prices react in different ways to the rise in inflations.
1. The hard cash has permanent loss equivalent to the inflation rate
2. Bonds may be affected more due to compounded effects of high
maturity and rising in interest rates. However there is a twist to
this. If the interest rates have already moved higher with inflation
and fall along with subsequent fall in inflations bonds may provide
higher returns considering the risk involved.
3. Stocks are the least affected in general. However the prices do
not always rise with rising inflation. The inflationary period due to
oil shock, in late 70's and early 80's in US, is a testimony
to this.
Between 1964 and 1981, Dow Jones remained at the same level i.e 875
because the Fed raised interest rates from over 4% at year-end 1964
to more than 15% by late 1981. A seventeen year bond bought in 1964
would have given a return of 4%. Similar observations
can be noted by comparing the performance of Indian equities in early
90's and govt. securities.

Higher inflation is typically a characteristic of over heated economy
which is associated with surplus liquidity, investment boom and low
interest rates. In such cases the overriding optimism and shift to
equities often results in high stock prices. As the effects of
inflations may not be all in favor of the business such high prices
may prove to be a temporary phenomenon.

4. If the conditions of runway inflation the real value of bonds and
cash would be almost wiped out as happened after breakup of USSR with
inflation crossing 1000% per year.


A general conclusion can be derived that equities, bought at fair
prices, are the best bet when you expect higher inflation. If the
inflation has already moved high the low bond prices may be more
attractive choice as inflated stock prices. The investor is faced
with a difficult choice of slow erosion of real value through
investment in debt on one hand and prospect of decline in asset
prices from current highs on the other. Like all another financial
situations, he need deal inflationary conditions with caution and he
should base his actions on his knowledge and understanding of current

Posted: Dec 13,2004

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