ICICI Bank's profit shoots up by 21%.. Wow!!

A classic example of how the headlines of corporate results can be misleading. ICICI bank reported 21% jump in profits which would make a good impression on an untrained eye but the reality is quite different.

If you go to the following link, you would find 3 documents http://www.icicibank.com/pfsuser/aboutus/resultsann/webcast.htm

The first Performance Review gives the management's version of story. It talks about growth in profits, strong net interest margins, falling cost of deposits due to higher portion of CASA deposits. It paints a rosy picture,

If you just ignore the text and read the numbers in second document, audited financial results you would see this very clearly in last 1 year
• Deposits fell by 11%
• Advances fell by 11.6%.
• NPAs rise to 4.63% at gross level and 2.33% at net level

It's not surprising that if you search 'NPA' in the 'Performance Review', you won't find any mention of it. You won't find mention of falling deposits and advances.
Now another statement copied verbatim from 'Performance Review'..along with its font size and style!! Current and savings account (CASA) ratio increased to 30.4% at June 30, 2009 from 27.6% at June 30, 2008.

Banking is all about gathering low cost funds and generating good returns by managing a portfolio of good quality advances. The Current and savings accounts give lower interests compares to fixed term deposits which helps a bank keep its cost of funds low. It's a key variable tracked by analysts.

In June 2008, the bank had deposits of 234,461 crores out of which 27.6% was CASA. This means they had 64,711 crores of CASA deposits and 169,749 crores of term deposits. In June 2009, the total deposits fell to 210,236 crores and percentage of CASA deposits rose to 30.4%. This means the CASA deposits in June 2009 were 63,911 crores and term deposits were 146234 crores.

This implies, CASA deposits fell by 1.24% and term deposits fell by whopping 13.8% in one year. This is a fact we know because last year when the rumors about health of the bank were spreading, people shifted their fixed deposits from ICICI to PSU banks.
Hence ratio of CASA deposits didn't rise because of good performance of the bank but due to drastic fall in the term deposits with the bank.

Management's attempt to highlight it as an achievement is tantamount to assuming that the people can't do this simple math.

The bank reported 21% increase in standalone profit after tax to Rs. 878 crore for the quarter ended June 30, 2009 from Rs. 728 crore for the quarter ended June 30, 2008 . Look out the details in the document. The net interest income fell by 5%, fee based income fell by 32.6%. The treasury operations showed a profit of 714 crores compared to loss of 594 crores in the same quarter last year. This shows that the rise in Profit after Tax was mostly due to treasury gains which are highly volatile. A small rise in interest rates can result in huge treasury losses due to fall in prices of govt securities held by bank in 'available for sale' category.

The bank also reported 68% increase in consolidated profit after tax. But they haven't filed their consolidated results with stock exchanges. The result document gives no details!

The results clearly show that ICICI Bank's honeymoon period is over. It has to do serious efforts to get bank on growth track. The performance review by the management reflects at best an ostrich like mentality to deny the obvious and at worst, it's a attempt to mislead investors.

The investors can take a lesson from this. The numbers reported in the corporate results can be misleading. They have to look at foot notes, analyze the details, slice and dice the documents to find the true picture. If you have to find oil, don't scratch the surface. You got to dig deep.

A prudent portfolio

[Many people told me that they are "kind of getting the hang of things" that matter in investing but they don't know where to start and how to start. They are afraid of losing their capital in their maiden attempt. While sharing the knowledge, data and analysis helps people, sharing real life examples is a real morale booster. That's why I'm sharing with you a story of a small portfolio]

Four months ago, I created a portfolio for Seema partly as a token gift to her for her excellent work as editor of Unfair Value and partly to prove to her that value investing works, even during slowdown. Women are a difficult lot. They need proof. They need constant reinforcement even for the things they keep in a jar labeled "Truth". So you can guess that the odds were stacked against me.

As I have said in the past, the investor is a key variable in the equation of investing. It is impossible to give a specific advice without knowing whom you are advising. After discussion with her, I listed down the things that were important to her. (1) Capital Protection (2) Regular Income (3) Investments in domains within her circle of competence (4) Scope of long term appreciation (5) Low volatility

The investment characteristics you would look for in candidate companies for such a portfolio will include companies which are financially strong and entrenched in their respective industry segments. They have a healthy cash flow and low capital requirement enabling them to pay liberal dividends. For capital protection, they should be quoting at discount to their real support levels like book value and discounted cash flow value. Volatility is something that is beyond an investor's control and the only thing you can do is to diversify. At the same time, I wanted to keep the portfolio limited to things she knew about, i.e., regular day to day use products and services.

The interesting aspect was that the list of her objectives was different from mine. Low volatility and regular income don't rank high in my personal list. Also, I can choose from a much broader field due to my understanding of various industries based on the knowledge accumulated over many years. Then the size of the portfolio was small which meant that I could invest in much smaller companies than I usually do. (I limit myself to only large companies, typically top 200, because I don't feel comfortable putting large sums into small companies and I want to limit the number of companies in my portfolio to less than 20).

During the editing of previous issues, we have had discussions about Castrol and Gujarat Gas, which made her comfortable with the sectors these companies operated in. I chose Indraprastha Gas for her due to her familiarity with the company and the dividend payout being higher. At that time, banks were selling at really dismal valuations with doubts about solvency of some large private banks. So I chose a PSU bank, Oriental Bank of Commerce, with high dividend yield, low NPAs and low price to book value. Then I added 3 small companies, Mahindra Finance, Venky's and Hawkins. These 3 companies were interesting in their own ways and met the criteria I had set forth.

Hawkins is a 50-year-old brand of pressure cookers which has sold 3.59 crore pressure cookers since its inception. It is very well entrenched in the market. They sold 20.6 lakh pressure cookers last year. The company earned a return on networth of a whopping 56.33% in 2008 (which rose to 81.8% in 2009). Its dividend payout ratio (dividend/EPS) had been in the range of 47% to 66% which showed that the company needed very little additional cash for growth. It was easy to analyze the company. If you have ever bought a Hawkins pressure cooker, you know the company. Interestingly, a pressure cooker as a product is immense value for money. It can pay for its cost within months by saving fuel. Not surprisingly, it is usually the first big ticket purchase for a very poor family when their lot improves (a cycle comes next).

Venky's is a company I got interested in during the times of the bird flu. Contrarian that I am, I was happily relishing roasted chicken when flu fear stricken denizens of the mortal world chickened out. I wanted to buy Venky's below cash but I failed. In the process I read about hatcheries, broilers, production of eggs and emerging trends in packaged meat. Their pathetic looking website (worse than Berkshire Hathaway's) had loads of interesting facts if you can find tem (like nine of every ten eggs consumed in India are laid by BV 300, a layer developed by Venky's. A layer is a hen, bred specially for laying eggs). The company pays good dividends and it was selling at a discount to book value.

Mahindra Finance is an NBFC which is quite strong in rural finance. The workings of rural finance are very different and banks lack the infrastructure and will to tap the opportunities. A Mahindra Finance employee has to ride his bicycle for miles before he reaches a village to collect EMI. At times the EMI is paid in one rupee coins. Defaulting on the loans is a matter of losing pride in the village and that keeps the NPAs low. The company also piggybacks on the growth in vehicle sales of its parent, providing financing of tractors, jeeps, autos and yes, Scorpios and Xylos.

Now the results of the portfolio. The outcome is quite satisfactory so far. The portfolio gave her a dividend yield of 6.06% which is the same as the after tax yield available on fixed deposits. The only source of volatility for the portfolio has been its rapid advance. It never went below the invested capital.


Price PaidDividend (Rs)Div. YieldCurrent Price


Oriental Bank of Commerce997.37.4%16769.4%
Castrol Ltd29515.05.1%38530.4%
Indraprastha Gas Ltd964.04.2%13843.8%
Venkey’s Ltd883.54.0%11732.6%
Mahindra Finance2055.52.7%26227.5%
Aggregate 6.06% 53.86%

For the long term analysis, the short term capital gain can be safely ignored. The 53.86% gain in four months was a result of excessively depressed prices and is unlikely to be repeated. What is certain is that her portfolio will give a yield better that 6% in the coming years. As the years pass the prices of these companies will keep pace with growth in business and that in the long run will yield a return in excess of 15%.

I have strong reasons to believe that investors can get good results by sticking to conservative investing principles and by focusing on things which are real like dividends, networth, strength of brand, familiarity with the company's products and services. You don't need to be able to predict the future. If you can trace the history of a company on how it reached to its present strength, you are better off than those using fancy algorithmic models

P.S.: If the approach seems too simplistic to your intelligent brain, there are enough ways in the world to get lousy returns using sophisticated methods. For one such example, you can read about Religare's Agile fund. Agile stands for Alpha Generated from Industry Leaders.

Show me the dividend!

In the years before the 1950s, all the texts about equity investment laid a clear emphasis on dividend. Benjamin Graham said that a conservative investor should consider only those companies that have been paying uninterrupted dividends for the last 20 years. The emphasis was evident not only on the presence of dividends. The quantum was considered important too. The Dividend Discount Model[1] was based upon the theory that a stock is worth the discounted sum of all of its future dividend payments.

Then came the era of growth companies. Companies like IBM and Xerox funneled all the returns from business back to it to fuel growth and paid little or no dividends. The only returns from such companies were from capital gains. It is important to note that this trend was a result of change in the mindset of investors, not the cause of it. The perception of investors has a bearing upon dividend policies of companies. The promoters want the price of their listed company to be higher than its value. A higher price enables them to raise extra capital when needed, raises a bulwark against hostile takeovers and gives a stronger currency to trade in during acquisitions. So what caused this shift in perception towards dividends?

If a company can earn higher returns on incremental capital addition than the rates investors can get in fixed income instruments, then lower dividends are better for investors. For example, Castrol generates 55.82% return on networth. If it pays dividends to me and I invest them in Fixed Deposits, I can get only 7%. Why should Castrol pay dividends and taxes upon it instead of deploying the cash into its highly profitable business? The answer depends on whether Castrol needs more capital or not. If it doesn't need more capital for business, even the company can't get high returns on idle cash. So it makes sense to pay out dividends.

At the same time, all the classic arguments in favor of dividends remain in force. As a matter of practice, companies maintain or increase dividend rates over the years. The declaration of dividend is an indication that the company expects the future earning per share to exceed the dividend per share. Dividends are harder to fake. Dividends also avoid bloated corporate structures with unprofitable diversification into non core areas. Dividends give the right to a shareholder to decide whether he wants to put the returns from capital into the same business or invest elsewhere (or consume). Finally, dividends remove the risk that the retained earnings will be blown away by some future act of foolishness (Citi Bank) or mischief by the management (Satyam). A bird in hand is worth two in the bush.

For a shareholder friendly board (!), it should be pretty easy to decide upon dividend. They know about the current capital requirements of business and available resources. They know about the future plans. If they have funds left after taking into account the capital required to handle contingencies and growth requirements they should release the money. If the company has high cost debt in its books, the debt should be paid first before paying out dividends. The earnings should not be retained unless there is a reason to do so.

Reality is very different, though. At least in India, I can see a whole lot of companies following dividend policies which are detrimental to the interests of shareholders. A few examples: Infosys Ltd, cash more than 2 billion dollars, produces 250 million dollars every quarter in free cash flow, zero debt, EPS 101.65 and dividend?? A paltry Rs 23.5 per share. They have no plans to invest this cash profitably and hence no reason to hoard but they do. Moser Baer, at the other extreme, is nose deep in debt with debt to equity ratio 1.32, interest cost 273 crores, loss per share Rs 21.6 and yet dividend Rs 0.6 per share. How much more stupid could one get?`The bottom line is this. The investors should analyze the company's profitability in conjunction with growth plans and outstanding debt to decide what percentage of profits they should get as dividend. If they get significantly more or significantly less than that percentage, the attractiveness of the company as a long term investment is questionable.


1. Dividend Discount Model

To hell with liquidity

Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of 'liquid' securities. [1]

These words of John Maynard Keynes ring in my ears every time I hear the term 'liquidity'. Yes, fetish is the right word. To someone uninitiated to finance, the persistent talk of terms like volumes, flows, depth and liquidity will make him feel as if he is sitting in a fluid dynamics class.

Had I been an MBA, I would have been fluent with these fluid terms, but the engineer in me revolts against pseudo scientific talk which uses terms that can't be defined or measured. Liquidity is one such term. Keynes made an important assertion that "there is no such thing as liquidity of investment for the community as a whole". He meant that the capital already deployed in production of goods and services can't be pulled back at will. A new steel plant cannot be liquidated just because the steel prices have gone down. The investor of that steel company may liquidate his investment and turn it into cash but for that, there must be other investor who is willing to part with his cash and invest it into the steel company.

Keynes correctly questions the rationale behind organizing the markets to promote liquidity.
When I say that the investors should think like the owner of a business, what should be their view to liquidity? Before I build my argument further, let's see when do you need liquidity. You need liquidity at the time of sale and only to the extent of the stocks owned by you. If I to sell hundred stocks, does it matter if there are thousand stocks traded a day of a million? If I'm not planning to sell, does it matter if the stock is traded at all?

Liquidity drives down the spread between bid and ask price of a stock which reduces the transaction cost. That's a definite virtue. And then there are other questionable virtues. A liquid stock attracts more participation from institutional investors. It is also said that the liquid stocks are less volatile. The participation from institutional investors is a virtue if they act like long term investors. It's a virtue if they stand up against any actions of management which are detrimental to the interests of minority shareholders. Both these aspects are questionable. The volatility of the highly liquid stocks raises doubts on the credibility of the notion that liquidity reduces volatility.

The long term investors do not share the high opinion about liquidity with the rest of the investing community. Charlie Munger said, "I think the notion that liquidity of a tradable common stock is a great contributor to capitalism is mostly twaddle". Warren Buffett's Berkshire Hathaway is one of the most illiquid stocks in the US. At a price of $90,000 per share, it's out of the reach of most investors. Once when he was asked about splitting the stock to increase liquidity, Buffett quipped, "Over my dead body". In the letter to shareholders in 1983[2], he has described the reasons behind the no- split policy.

Now let me speak from my personal experience. I've never rated liquidity as a virtue in my investment decisions. In fact, about 20% of my equity portfolio consists of stocks which have been delisted and a further 20% is bordering on illiquid. This is not by design but it so happens that the investor apathy which is the reason behind low volumes, sometimes brings the prices down to the bargain basement levels which they find me waiting. It is also true that value I can see so clearly in those stocks, won't go unnoticed by the promoters. The net result is that promoters have either raised the stake so high that the stock has become illiquid or they have delisted the companies. Pretty scary state to be in! Right??

Well not quite. Here are the records from 3 such illiquid companies where I chose to invest a significant portion of my portfolio.

CompanyMALCOEicher LtdNovaritis Ltd
Avg. Purchase price21.3279.85289.45
Purchase DatesJuly-04 to Sep-04Aug-05 to June-06Mar-08
Exit Offer 1 Price48265351
Exit Offer 1 DateMar-05Dec-06Mar-09
Exit Offer 2 Price115354.37450
Exit Offer 2 DateMar-09Jul-09May-09
Current StatusHolding onExitedHolding on
Returns(No. of times)5.394.441.55

As you can see, I have been rewarded handsomely for foregoing the liquidity. In case of Eicher Ltd, I opted to remain a private shareholder when they delisted the company. Later, I exercised the option to convert into preferred stock, which I redeemed at a price 33% above the delisting price. In case of MALCO, I not only refused to exit at a price of 115 but invested more money before delisting. In case of Novartis, I did not participate in their two open offers and bought more.

These seemingly counter- intuitive actions can be explained by a simple principle that when I own a stock, I own a part of a business. Whether someone else is willing to buy out doesn't matter to me as long as my business grows. If you own something valuable, rest assured, you will find buyers. You can't say so about a piece of junk that's a regular entrant in the list of highly traded stock.

None of this will impress those who offer daily prayers to the Goddess of liquidity. Nor will they pay heed to Charlie Munger's advice to study carefully the example of the English economy which continued to do well despite the ban on trading of stocks after the South Sea Bubble in 1720.

For those who invest on leverage, liquidity assumes paramount importance. The same can be said about the institutions that attract hot capital by promises of high short term returns. They have a sword hanging over their neck. Liquidity is important to them but all the long term investors can safely say, "To hell with liquidity".


  1. The General Theory of Employment, Interest, and Money
    John Maynard Keynes
  2. Stock Splits and Stock Activity
    Warren Buffett, Letter to Shareholders

Indian Budget 2009

The studio was full. Analysts came dressed up for the budget, in their three-piece suits. Industrialists came with a list full of demands, sops...more sops, tax cuts, more tax cuts. Then there were economists with a list of reforms, more reforms. I was feeling lonely…watching from the sidelines. The budget speech was little more than an hour but the drama continued long after. Why wouldn't it? After all it had begun 3 months ago when the Sensex did a pole vault of 2110 points in a single day. There was talk of a new India. A new secular bull run.
It's 4:00 PM now. 'We' are down by 869 points. Markets have given a thumbs down to the budget. Traders with long positions have got long faces. TV channels are busy asking 'experts' questions on how they rate the budget on a scale of one to ten.

Why this expectation? How much can change in one quarter? You didn't even have a government change. It's the same Congress. It's the same finance minister. I'm not buying the sentiment that there is anything fundamentally wrong with this budget. There is no reason to be disappointed. The expectations were wrong. There are no quick fixes to the structural economic issues that we face today. If the government is expected to stimulate the economy back to the growth track, it's going to have a deficit. You can't expect the government to embrace austerity and profligacy at the same time. You can't expect the government to sell strategic stakes in the PSUs to meet the fiscal deficit. If buy and hold is a good strategy for investors, the government would be foolish to sell just because its finances are strained. I agree that the government has no business to be in business but given that the government is already in business, that too in a big way, it shouldn't sell stakes at fire sale prices.

Those who ask for oil price decontrol should think what they are asking for. From January 2004, it took crude oil less than 4.5 years to move from 30$ to 150$ a barrel and it was back at 30$ at the end of last year. It's gone back to the 60$-70$ range. Are we ready to take such volatility in our stride? No, we aren't. But we, as a nation, are already paying the cost for all the subsidies that we get. We are in fact paying more than the cost of subsidies because the user group that benefits from subsidies is different from those who pay for the subsidies and such a system is bound to be inefficient. The government has to reduce subsidies but in such a manner that it doesn't spark a violent over-reaction. In a democracy, such a reaction can lead to the rise of populist parties that can reverse the course of reforms. I'm happy that the finance minister has acknowledged the need to reduce subsidies, need to decontrol oil prices and the need to disinvest. What he has not done is to make promises that can make good headlines but can't get implemented. Haven't we seen in the past, how loft disinvestment targets were forgotten soon after the budget?

When someone is making promises for the sake of doing so, he needs no time. The fact that the government sought more time on various reforms, sounded more sincere to me than any 'dream budget' would have. I sincerely hope that the government gives serious thought to various reform measures that are long overdue and takes an action that doesn't need to be rolled back or held in abeyance due to protest from stakeholders whose short term interests get affected. We don't want to hear the Finance Ministry announcing something and then, he ministry which has to implement the reform requesting a rollback. The government must reach to a decision on issues of vital economic importance and then act decisively on those.

The finance minister did well by not raising taxes and by sticking to the date of implementation of GST. He did well to abolish the FBT and 10% surcharge on income tax. I'm happy that he increased the MAT to 15%. There is no reason why tax sops to some favored industries should continue for decades at the expense of other industries. Such tax sops, although important for nascent industries, tend to cause oversupply in mature industries like IT.

The dream of going back to the 9% growth level and maintaining it there is unrealistic unless we remove constraints. We need to go full throttle on providing easy capital, infrastructure and skilled manpower. These are the areas where there would be no political opposition. I was disappointed that the budget didn't contain enough provisions on these aspects. All the measures announced in this budget are welcome but we need more. The foreign direct investment is a welcome source of capital. We need to get rid of sectoral constraints on this. The physical infrastructure and skilled manpower take time to build. We need to take radical steps in these areas.

The thrust on rural development and poverty alleviation is good. We cannot afford to raise the income inequality any further. The political unrest, consequent disruption of economic activity and breakdown of law and order in poverty stricken areas are the factors that convince me that it is impossible for a democratic country to grow at a fast pace in the long term unless it sets all sections of population on the growth path. To that end the talk of increasing the efficiency of delivery mechanisms of subsidies is welcome. If we can plug in the loopholes, the money going from the government to the poor will boost the demand in the real economy. The money that is lost to corruption ends up in a parallel economy of back money which reduces the multiplier effects of public investments.

There were certain things in the budget which create genuine fear in the mind of anyone who likes to see more reforms. The praise for Indira Gandhi's nationalization of banks was uncalled for. The talk of government planning to retain 51% stake in PSUs is a sure shot way to fritter away public wealth. As a general case, the divestments should be to a strategic partner who brings in expertise to run the business well. The government must let go of control. If the government sells 25% to the public and retains control, then (a) It will fetch a lower price for its stake, (b) It will not improve the business (c) and it will be cheating those 25% minority shareholders by imposing its will on them (imagine the pain of shareholders of HPCL, BPCL and the like)

Overall, there are things in the budget to raise hope for higher growth in the long term. The key lies in implementation of the plans. The high disappointment levels of the market participants are as irrational as their hopes of one-night reforms were. You can shrug it off.

Performance of Indian Mutual Funds

It would be an understatement to say that the past 3 years have been interesting for investors. What a roller coaster ride! From 10,573 (3 years ago), the Sensex went to an all-time high of 21,113 on 9-Jan-08, touched a low of 7,697 on 27-Oct-08 and it has gone back up to 13,887. Overall, the Sensex gave 9.5% compounded return in the past 3 years which is not bad because long term capital gains are tax free. On top of it, you would have got from 1% to 2% as dividends per annum which makes the returns more than those available in fixed deposits.

The period is interesting to analyze because such sharp movements are a rule rather than an exception in the equity markets. These are the periods which separate men from the boys. When the market is showing what folks at CNBC call a secular uptrend, the investors who bought, with our without reason, perform better. When the markets are falling, your grandmom with all her savings under her carpet will outperform you.

In the Indian context, the period is even more important. When the Sensex crossed 10000, it became a topic of front page headlines in the national dailies. There was nothing sexier than the Sensex and many investors, who had so far resisted the lure of a forbidden fruit, entered the market. These new investors weren't the ones who should invest in equities in the first place because their definition of long term coincides with that of the Indian tax department…One year! [This is amazing because I can't think of any business whose projects have a gestation period less than one year…except may be the booming Indian business of procreation]

From the shady bylanes of Bharuch to sparkling tech parks in Bangalore, stocks became a topic of discussion. I'm not saying that investing in stocks is bad. After all, if the inhabitants of the country won't participate in their country's march towards prosperity, foreigners will and soon every profitable corporation will be owned by foreign investors. But what these investors need to invest in is the right advice.

In all countries (including India), mutual funds play a big role in channelizing the investments from investors into good businesses. India too has a booming mutual funds industry. They have a mandate to make the investors prosperous and they claim they will… in no time.

The results, however, are saying something else. In the last 3 years, 78.44% equity mutual funds underperformed the 9.5% p.a. return from the Sensex. The median return was 5.28%. In the balanced funds, 78.78% funds underperformed the Sensex and 81.12% debt funds gave returns lower than 10% of what was available from Fixed Deposits during this period[1].

If you invested in mutual funds, you've got to get angry. These MFs charged you 2-3% of the money invested per annum and what a lousy result.But your anger is unjustified. You should have known better. You were screwed the day you bought the mutual fund. The world knows it. Forty years ago, when people collated decades of performance data, they found that more than 70% of fund managers underperformed the indices like S&P 500. This shocking result led to the rise of low cost Index funds and a highly costly Efficient Market Hypothesis (EMH).

The former relied upon a passive investing approach by investing in stocks in the same proportion as the weight of the stock in the benchmark index and thereby reducing the 2-3% fund management costs to close to zero. It was a huge success.The latter, i.e. EMH, theorized the empirical observations. Efficient Market Hypothesis claimed that it's not possible to beat the indices consistently because the markets, always, price the stocks efficiently. Forty years on, the investors like Buffett have proved the theory wrong with a simple common sense approach to investing but that doesn't stop the bogus hypothesis to be in curriculum, in analysis models and in the investing strategies of mutual funds.

There are two things which are very clear about the mutual funds. (1) They charge exorbitant cost ranging from 2-3% of the money for delivering this lousy performance. (2) The very structure of the mutual fund prohibits them from being able to outperform the general market.First, on the cost part. If a fund is delivering 30% per annum compounded and charges 4.5% per annum, you still make 25.5% compounded. The fee is well earned. If the fund makes only 13% and charges 2.5% p.a. for this, you are getting only 10.5% per annum. That's not enough incentive to subject yourself to market risk. You are better off by investing solely in fixed deposits. You are better off by investing in Index funds.

Secondly, the inevitability of underperformance. In 1997, when I had less than 3 years of experience in investing, I read an article by Paul Krugman: ‘No Free Lunch; Seven Habits Of Highly Defective Investors' [2]. These habits, as per him, are

  1. Think short term
  2. Be greedy
  3. Believe in the greater fool
  4. Run with the herd
  5. Over-generalize
  6. Be trendy
  7. Play with other people's money
I really liked what he wrote. I realized that mutual funds have all these habits and some more. In my life, I never invested in mutual funds (except making a killing by buying close ended funds quoting at deep discounts close to their maturity date). But I didn't sit quiet either, sucking my thumb, quoting EMH profs., "you know, it's impossible to beat markets". Looking back, I feel happy that I did what I did. (In 2008, Paul Krugman won Nobel Memorial Prize in Economics).

In addition to Krugman's list, the structural problem with mutual funds is that they get the highest amount on inflows when the markets are at their peak and they face huge redemption pressures when the markets are close to bottom. In sector specific funds, they mop highest amount of funds for the sectors that have given huge returns in the past few years and that are overheated. This is recipe for disastrous performance. (That being said, I must note that in India, during last 3 years, all closed ended mutual funds and 21 out of 25 tax saving funds underperformed the Sensex. The more free hand you give to them, the more they underperform).

There is also a problem of incentives. From the point of view of an asset management company, the most successful mutual fund is the one which makes maximum money for them. You are incidental. The size of the fund is the key concern for the fund manager, because the expenses are charged on the invested amount. The mutual fund investors usually rank the mutual funds and invest in those with highest returns. This means that a fund manager has to focus on being among the top ranking during the upmove of the market because that's when the deluge of funds begins. You don't have to care about safety because no investor likes to exit at loss. This makes the whole proposition speculative and that's the reason why the mutual funds under-perform in the long run. In fact a careful look at the data will show that the performance of past few years does not guarantee above average returns in future.

What are the options for investors who don't know enough to invest themselves? Invest in index funds? I can't answer this in affirmative. The indices in India are heavily concentrated into few stocks and they are highly volatile. There is no index like S&P 500, because the quality of companies rapidly degrades as you go towards bottom of the pyramid. That's why you would see that Nifty Junior is even more volatile index.I've a simple advice for new investors. If you have to invest in equities, directly or indirectly, you have to learn few basic things about investing. Devote the next 5 years of your life to learn investing. You don't have to quit your job for it. You don't have to devote more than an hour to it, reading newspapers, business magazines and books. Don't worry about discounted cash flow valuation. Learn how to analyze the strengths and weaknesses of the businesses around you. Observe how powerful HULs brands are. Observe how ITC is investing heavily in FMCG and how long has it taken for the company to break even. Guess what will happen in the next 5 years. Analyze the results. This is what investing in stocks takes because a stock represents part ownership of a business. Your percentage returns in stocks of a company are not different from the majority owner. Then why should people think about stocks differently?

Theoretically, beating a leading index like Sensex isn't difficult. If you allocate your portfolio to same stocks as in Sensex, in same proportion as the weightage of each stock, you can match the returns from market. To beat that, all you have to do is to allocate a little less to a company that you think is below average and allocate that extra money to a company that you think is above average. That simple change will put you ahead of 78% mutual funds. But in reality, it's not that easy. Those very companies whose weight you reduced may outperform the index. That's why you need some bit of business knowledge so be able to make informed changes. Even if you never reach the confidence level to invest on your own, you will be able to at least check the portfolios of your mutual funds and check if they are taking unnecessary risk. Remember, if you don't know about investing, you can never judge whether your fund manager knows anything about investing. In such a case, every rupee you invest is stamped with "In God we trust" like the one US dollar bill.


1. Mutual Fund Performance Data

2. No Free Lunch; Seven Habits Of Highly Defective Investors
PAUL KRUGMAN, Fortune 12/29/1997

Actionable Information

They call him Jesus. He must be a God to win five World Series of Poker bracelets with his live tournament winnings exceeding 7.3 million dollars. You would expect him to be an astute reader of faces who can look at your face and tell if you are holding an ace. But he is very different.

Chris Ferguson(Jesus), is a PHD in computer science(on virtual network algorithms). His game is purely mathematical and strongly based on game theory. That must have made his dad, a game theory professor, a proud father. He is not to leave his mom unimpressed for he can cut bananas, carrots and water melon with playing cards!.

I’m telling you about Chris due one very important difference in his game. All good poker players(counting myself in!) know how to make an intelligent guess on the cards their opponents are holding. They can read situations, thoughts and yes, faces. At the same time, their own face doesn’t give any clue on what’s going on in their mind. They have what you call a poker face. Chris, however, doesn’t like to look at his opponents. He wears a big hat, keeps his head down and watches only the cards and bets.

That’s surprising because one would think he is missing out on an important source of information. But his record speaks for him. He says that at the highest level of poker, no player would give you a reliable tell. (A tell in poker is a subtle but detectable change in a player's behavior or demeanor that gives clues to that player's assessment of his hand. Examples include leaning forward or back, placing chips with more or less force, fidgeting, direction of gaze etc). Most of the times, the opponent is deliberately giving a tell to confuse you. Chris relies solely on mathematics and his game theoretic analysis of the game. What he is essentially saying is that although you can try to guess, the information you get from the tell is not actionable.

Let’s come back to investing.

May 14th 2009. Most exit polls in India are predicting a hung parliament and weeks of uncertainty while political parties cobble together a weak coalition. You know that such a thing will be a sure disaster for the markets reeling under constant flow of bad news on economic front.

You know that the markets have been extremely volatile in recent past and all the gains of past 3 months can be wiped out in few days. What do you about the stocks you are holding? Why not sell now and wait for clear picture to emerge. After all, the markets don’t look that cheap at this juncture as they were few months ago?

Many analysts suggested this course of action. Many investors sold in a hope to buy back later at half the price. I would never think along these lines. The reason is that the information coming out from the exit polls is not actionable.

Figuring out which information is actionable and which is not, is a key part in decision making under uncertainty. Investing in stocks is a problem that involves decision making under uncertainty and investors will do well to understand this concept.

Actionable information means that you have got an information which has (a) reasonably high chance of being true and (b) reasonably high chance of affecting your interest if it turns out to be true. There is a cost involved in taking action in a hurry and that cost plays an important role in deciding what to act upon and what to ignore.

To give you an example, I ignored the news from exit polls completely because

  1. The information was unreliable. I’ve seen more exit polls going wrong about the results than those hitting the bulls eye.
  2. Even if the information is correct and there is a hung parliament, there is no direct impact on the worth of businesses I’m invested in.

There are many scenarios where the exit poll results, even when they turn out to be true, may not affect me. For example

  1. Given the era of political opportunism we live in, there can be unlikely alliances which can result in a majority government.
  2. Even if a minority government is in place, it may remain stable until some parties are willing to go to the polls again.
  3. Even if government is weak, it may still be good for the economy by letting the free markets decide the right course of action.
  4. Even if the economy is hit, my business may not suffer that much.
  5. Even if my business is hit in short term, the stock price of my companies may not fall because the investors see the bright long term prospects.

As you can see, there is a long and uncertain casual chain between the hung parliament and my stocks falling in value. At each step there is an uncertainty whether the cause will have the effect you are worried about. This reasoning has a mathematical basis. If a fact p implies another fact q and q implies r and r implies s, then you can deduce that s is true if you know the fact p is true. This information is actionable.

However if the causality is uncertain, you have to put a confidence factor. For example, suppose I’m planning to host an event, outdoors, on an evening in July. My friend who works at Indian Met department tells "You know that in any given day in July, there is 60% chance that it would rain in Bangalore. And in a rainy day, there is 40% chance that it will rain the evening. Are you sure you want to do it outdoors?"

I know that hosting the event indoors will be costlier but I’m scared of rain playing a party pooper. Are my fears justified? Think about it.

I don’t need to tell you about reliability of the Met department. On top of that my friend may not be having correct data or may just be spicing up his advice with data to show of his knowledge. Even if he’s correct, there is only 24% chance that it will rain on the same evening that I plan to host the event.

His information is not actionable given the cost of acting upon it. I’ll ignore the rains.

Coming back to elections. Results are out. We are heading for another stable government. It’s business as usual. I own the same stocks that I have been owning for years. For those, who sold their stocks, there may not be another chance on Monday to catch the same bus again.

The Three Musketeers

You are counting. It's probably 10th time in this hour when you have heard him say “I don't want to lose money”. If it was any other old man you would say "Now shut up and stay away from stocks. If you want to make money, you got to be mentally prepared to lose money. No risk, no gain!"
But then you get to know, this is no ordinary old man. He is Walter Schloss, one of The Superinvestor of Graham-and-Doddsville. He produced a 16% total return after fees during five decades as a stand-alone investment manager, versus 10% for the S&P 500.

And the realization strikes that the only option left is to shut up and listen.

Walter J. Schloss
Presentation at "The Ben Graham Center for Value Investing"
Richard Ivery Schools of Business, Feb 12, 2008

Warren Buffett, doesn't need the weight of his 37billion dollars to impress you. He is not only the richest but his wit and wisdom has turned him into the most respected and most popular investor of our times. In this video, he gives valuable insights into his thinking on investing and life in general.

Warren Buffett addresses students at the University of Florida
October 15th , 1998

Charlie is simply magnificent. He is master of brevity. He can bulldoze a never ending argument with just one word and he doesn't mind offending you if it can put some sense in your brain. To give you an example, once in a shareholder meeting a guy asked him "what is the dumbest thing you ever did in your life". Charlie looked around the auditorium sizing the viewers and then said "I'm not going to answer it here".
You get the first hand taste of his wit and brevity in his conversation with Tom Tombrello, at Caltech. He acknowledges "In terms of humility, I frequently say that when they passed it out, I didn't get my full share. It was a serious problem when I was young but I cured it partially by becoming very rich"

He doesn't even hesitate to take a swipe on his host, Tom Tombrello, chair of Caltech's Division of Physics, Math and Astronomy. When Charlie says "I'm going to touch on my favorite subject, common sense". Tom interjects "which isn't so common" and pat comes reply "See"…and a roar of laughter

DuBridge Distinguished Lecture: A Conversation with Charlie Munger
March 11th, 2008

Introduction to April Issue

How would you feel if you make a doomsday prediction and the real doomsday arrives? You can't be happy for sure. When I wrote about Brokelyn Ltd, in Anatomy of a Debt Trap, I got many queries on the real identity of the fictitious company I had analyzed. People asked me, "Is it Aurobindo Pharma?". The next issue of Unfair Value detailed the issue of excessive leverage in Leverage Explained and I took the example of Workhardt. Again I got queries on whether Wockhardt is the next Brokelyn?

I had used a fictitious name because this was a systematic problem with many high-flying companies having dug their own grave by taking excessive debt. In last six months, the fonts in the epitaphs are becoming bolder: "Here lies a company that thought it can acquire the world on borrowed money." The debt burden is becoming increasingly heavier due to depreciation of the rupee, hardening of interest rates and the sorry state of capital markets. When the foreign currency debt matures, these companies will have to repay the principal amount of debt plus the premium plus the mark-to-market losses. Together these factors will erode the networth so drastically that no fresh loans can be taken because the debt to equity ratios on outstanding debt will rise to unheard levels. Without being able to raise fresh loans, these companies are effectively crippled. Some will sell their assets, some will be able to rollover the loans at sky high interest rates and others will simply go under the creditors' control. BIFR, the dirty word of 90s, will be back with a bang.

The government understands this. It has issued a notification dated 31 March 2009 to amend AS 11 "The Effects of Changes in Foreign Exchange Rates". As per the amendment, companies would be allowed as an alternative treatment to amortize/capitalize foreign exchange differences arising on long-term monetary items. To me, this amendment is equivalent to delivering a bad news softly, over the years, but that doesn't change the nature and enormity of the problem. It will surely reduce the volatility of reported earnings but this will create excellent value traps. Investors who are trying to do bottom fishing may end up investing in a company which is sitting on a pile of unamortized foreign exchange losses.

But debt explains only a part of the problem. The other problem is derivatives. In the article The Great Hedging Hogwash I explained how the corporates are indulging in rampant speculation in the name of hedging their currency risk. I had explained that for the companies who are working on huge net profit margins (like IT companies), hedging serves only one purpose, to smoothen the profits. I was not wrong to accuse the mighty software companies of trying to smoothen their results. They were short on dollars and as it appreciated, you got hundreds of crores of foreign exchange losses. It was simply not required.

Infosys, the most conservative among the IT lot, changed its hedging policy this year. It reduced exposure to hedging in the currency market to $576 million from $932 million. It played safe by taking a short term view on the dollar-rupee variation, while others like TCS, Wipro and HCL continued to hedge their receivables for more than a year. Another difference is that Infosys deals only in range forward options. The exposure of the company is limited to the range of the option. For instance, if the range is 1.3-1.6 for a dollar-euro contract, then the company will get the spot exchange rate as long as it falls within the range. If on the settlement day, the spot rate falls below 1.3, it gets the lower rate of 1.3 and if the rate moves above 1.6, it gets a higher rate. The results are quite clear. While Infosys escaped unhurt, other companies reported huge exchange losses. More on this in SNAFU.

The coming years are going to be stock pickers' paradise and a nightmare for casual investors (!) who don't do their homework. The coming years will separate men from boys, both in business and in investments. The balance sheets of banks give the early indications. ICICI Bank, for example, reported Gross NPAs at 4.32% of advances. BusinessLine reports: "Gross non-performing assets of the banking sector are likely to touch 5 per cent by 2011, from 2.3 per cent in 2008." Rather than jumping on to the wrong conclusion, "Let's avoid the banking sector", you have to see where these NPAs are coming from. You have to avoid being an investor in companies that may default on their debt. The shareholders are the last ones to get their share of spoils when the companies go bankrupt.

Many corporates are coming out with fixed deposits in their desperate bid to raise resources. Do not invest into these, thinking that these instruments are as safe as Fixed Deposits of the banks. They are not and that's what explains the high interest rates. Do the analysis of these like your analyze bonds or else stay away.

GOI Notification on The Effects of Changes in Foreign Exchange Rates

Who will gain from AS-11 change?
BusinessLine Apr 12, 2009


Situation Normal, All Fucked Up.
That's what describes the financial condition of significant number of large, well respected Indian companies. To me it seems as if some bad April Fool prank has been played on the investors. Derivative losses are burning holes in the books of companies. It wasn't unexpected yet the scale of damage from derivative and hedging losses has spooked investors.

TCS reports foreign exchange loss of 781.3 Cr. You won't find it mentioned in their press release. You will have to literally dissect the reported result to find it. An innocuous looking note says: "Other income (consolidated) for the year ended March 2009 includes foreign exchange loss of 78,136 lakhs."Ranbaxy reports a Rs 918.8 Cr loss, "arising on account of change in fair value of foreign currency options determined to be ineffective cash flow hedge". No, it's not all. Its result contains two more items: 'Foreign Exchange loss' of 56 Cr and 'Foreign Exchange Loss on Loans' of 124.2 Cr. A total of 1,098.4 Cr.

"While these three items were non-cash in nature, they primarily contributed to the overall loss of Rs. 9,146 Mn (USD 198 Mn) for the year"

Wockhardt, reports MTM losses of Rs 581 Cr. They do not take into account the already booked losses of Rs 489.5 Cr. Their press release says:

"Some of the banks, based on the early termination clause in the agreement had terminated certain forex contracts and claimed an amount of Rs. 4895.24 million. The Board is of the view (that) the forex transactions were unilaterally cancelled by the banks and the mark to market losses had arisen on account of counter positions advised by the banks. The Company has obtained a legal opinion that these contracts can be disputed, and accordingly no provision for the same has been made"

To put this not-so-grand total of 1,070 Cr losses in perspective, the company's consolidated networth in the year ended Dec 2007 was 1,065 Cr.

Habil Khorakiwala is unashamed. "We have had an exceptional year in all ways, both in terms of sales revenues and operating profits".

HCL Technologies reports forex losses of Rs 201.3 Cr for the third quarter. It reported forex losses of 300 Cr in March 2008, 141.9 Cr in Sept. 2008, 67 Crores in Dec 2008. Total losses in 4 quarters comes to 710.2 Cr.

"Our investments are not only delivering business results but with heightened employee engagement and a global recognition of HCL's 'Bold' business strategy, HCL is today geared to lead the industry well through this difficult time", said Shiv Nadar, Chairman and Chief Strategy Officer, HCL Technologies.

Haven't we had enough of 'boldness' already? How do these idiots claim to have delivered good business results when their networth is being wiped out through their outlandish bets on currency movements? How can they not admit that they did a foolish thing and they are paying up for it?

The companies I've mentioned aren't mom and pop businesses. They are among the top companies in their sectors. If investors get this performance from leading companies, what else can they expect from laggards?

I'm not only angry, I'm feeling sick. This is no way to run a business. Financing growth though optimal capital structures and managing risks is part and parcel of business. You cannot say we had an exceptional year in terms of revenues but the profitability was impacted due to non cash charge. MTM losses are a future cash charge. There is no currency god they can pray to. When these derivative positions are unwound (by the companies or by their banks, forcibly), these companies will have to pay a huge cost for their stupidity and pay though a bleeding nose.

This reminds me of the story of a bird which fell on the ground in a storm and lay there dying in the cold. A passing cow deposited a pile of dung on him. The warmth of dung brought a new lease of life in the bird and soon he started singing. A passing cat heard the song. He dragged the bird out of dung and ate him.

The story has 3 lessons.

  1. Not all shit is bad for you
  2. The one who takes you out of shit, is not necessarily being good to you
  3. When you are in deep shit, you should not sing songs about it.

Corporate India focused solely on lesson one from this story. They lapped up all kind of derivative while claiming 'We do not hold or issue derivative financial instruments for trading or speculative purposes. The company actively hedges it's foreign currency exposure as a part of its risk management policy'. It was bullshit but to them, the lesson number one overruled the objections.

It's imperative that they learn the other two as well. That is – beware of banks selling complex derivative products that you don't understand. The banks want their share of these exotic financial products. They will claim that 'exchange rate volatility will kill you. If rupee appreciates further, you would be in deep shit. Let us help you'. Remember lesson no 2.

Finally, when the mistake is made, own it, don't sing songs about performance at the operational level. When a company makes some money though other income, extraordinary profits, they include it in the full page adds in financial dailies screaming "Revenue up 27%, profits up 68%". Now everyone is talking about 'EBITDA', Profit before gain/loss due to exchange fluctuations'. You can't have it both ways. If you fucked up, say it. A person, who persistently tries to fool others, ends up fooling himself. The applies to organizations. It's time for corporate India to wake up and take corrective measures to get out of the mess they have gotten themselves in. No point suing banks for your own blunders. It's time to stop fooling investors otherwise the ire of investors will raze the billion dollar market capitalizations to ground zero much before you've had a chance to do any restructuring.

Why do some people always lose money

The simple answer is that they are unlucky.
Everyone comes into this universe with a destiny set in stone. We just live the script.

Ha ha…I was kidding. There is no such thing as luck.

Years ago, when I was a speculator with the mistaken belief that I was investing, I used to go to my broker's office quite often. In his office, there were always some day-traders who used to sit there the whole day and 'invest' in stocks on margin. Among these people was an old man with thick spectacles, a septuagenarian. I liked him because among this boastful gang of traders, he was a quiet guy. One day he asked me, what is the price of Reliance (He couldn't even read the prices blinking on the screen due to poor eye sight)? I said "124". He placed an order with the broker to buy 500 Reliance stocks and then turned to me and said, "ab ye neeche jaayega" [now this will go down]. I was a little shocked at the air of inevitability in his words yet I remained quiet. Later that day when Reliance fell to Rs 112, he smiled at me and said "dekhaa!" [See, I told you so!]. The stock kept falling and fell to Rs 107 and the old man asked the broker to book losses and sell the stocks. He turned to me and said, "Ab bech diya, ab ye upar jaayega" [Now that I've sold it, it will shoot up]. It happened. The old man muttered, "hum to gawaane ke liye hi baithe hain" [I sit here all day simply to lose money].

It was an unnerving experience for me. I was a novice yet I could see something disastrously wrong with the way people invest. Their investing strategies were suicidal. The probability of them winning was significantly less than 50%.

Over the years, I have understood why some people always lose. In primary markets, they lose because the promoters know more about their business than the small investors. They sell stocks in an IPO when they know that they will be able to sell at a price higher than the intrinsic value. The small investor doesn't have the courage or foresight to hold on to these stocks for the long term. When the prices correct, the small investors sell. That is the time when you see buybacks, open offers and delisting proposals. It's an unfair game and the investors have significant chances of losing money. The 'conservative' small investors, who invest only in IPOs, lose money mainly due to this reason.

In secondary markets, the big problem is that most investors lack the capability to make decisions under uncertainty. Such decision making involves attaching probabilistic weightage to possible outcomes. This is part of high school arithmetic, the only prerequisite for you to invest safely. Probability is full of some very counter intuitive results. Try out few simple problems, guess the correct answer before you calculate, and calculate before you read on.

Q1 : What is the chance that there at least two kids in a class of 40 whose birthday will fall on the same day. Make a guess.(a) 0.6% (b) 90% (c) 12% (d) 1.1%

Q2 : Every day a 1,000 lottery tickets, of Rs 100 each, are sold which have unique 3 digit numbers from 000 to 999. The ticket matching the randomly generated 3 digit number gets a prize money of Rs 1 lakh. You have Rs 1 lakh of savings (and no other assets) and you decide to buy one ticket daily till you win the lottery. What are the chances that you will go bankrupt?
(a) 36.7% (b) 0.4% (c) 9% (d) 50%

The answers (given later in this article) will surprise you when you try them for the first time .
If you are not able to grasp the risk and to analyze the attractiveness of returns while keeping the risks in mind, you are ill equipped to invest. The markets are much more complicated than the simple mathematical problems I gave you. You may get yourself in situation where loss becomes a mathematical certainty.

Consider this.I give you a bet where you need to put some money on the table and you'll have to roll a dice marked with numbers 1 to 6 on 6 faces. If you get 1 or 6, your money will be tripled. If you get 2, 3, 4 or 5, your money will be halved. Would you play this bet?
You should. The odds are stacked in your favor and if you play for sufficiently large number of times, you will win. And I'll give offer to roll the dice at least 30 times. I want to prevent you from putting 1 Rs bet after you have tripled your money. Hence I add another restriction, "You need to bet all the money in your wallet, including profits, on each bet".

Are you game for this?

While you think about this, let me recount a story. One day, I was sipping coffee with a friend at my office on the third floor. The room had glass walls. My friend asked,
"If I come running and slam against the glass, will it break?"
"I can bet it won't. Name the odds you want". I said
"Hmm, it isn't that strong. It CAN break," he said.
I replied, "Doesn't matter, If it doesn't break you'll pay, if it breaks, you are dead."

This is what I call a lose-lose bet. The bet I gave you before this story is also a lose-lose bet. How? Suppose you start with 1,000 Rs. You are likely to win one out of three games. In that typical three game set where results are win – lose – lose, your 1,000 Rs will go to 3,000 – 1,500 – 750.In 30 times, you win 10 times and lose 20 times. At the end of 30 games you will have 5,000* 310) / 230) = Rs 281.

You are expected to lose 62% in just 30 games but you won't be alone. People do this day in, day out in stock markets.

It is important to note that few additional constrains can make a statistically profitable bet a sure-shot losing bet. In investing, we work under these constraints. We have limited money to invest and a limited number of years left before we die. This changes the equation completely.
You cannot invest in marginally profitable bets. You need to ensure a big margin of safety. You cannot bet on highly rewarding bets which have low probability of success. If you do, your time on planet earth may run out before you strike gold.

Coming back to the questions I had asked.The answer to Q1 is b, 90%. The implication is that when you are exposed to multiple improbable yet fatal risks in a stock, your loss may become inevitable.

The answer to Q2 is a, 36.7%. If you bet on an event which has low chance, it may not occur in your lifetime. If you pay for each of these bets, you can get broke before you get lucky. If an event usually occurs once in N times, it has 36.7% probability of not occurring in N times (for large N).
[For mathematically inclined: The value of (1 – 1/n)n tends to 1/e where e is Euler's number, 2.71828 1828. You may want to read Jakob Bernoulli's seminal work on probabilities. He figured out the probability of an event happing exactly k times in n independent trials is (nCk)pk(1-p)n-k where p is the probability of the event happing in one trial]

The biggest mistake people make on probabilities is that if something has 50% chance, it doesn't mean it's going to happen half the time you try. Probability doesn't work on small sample sizes. The lesser you chance of success, the more number of tries you need to break even.
The net results from a set of investments depend not only on the number of successes and failures but also returns from each success and failure. That forces you to take into account the expected value, the probability weighted total of the money. This is another unintuitive number because a positive expected value does not guarantee success in small number of trials.

A related mistake is to bet something really important to get something that is unimportant. You are saving for years for a house you want to buy. Then you realize that you are still falling short by 10 lakhs. You decide to gamble in the market to get the extra money. You should never risk something important for a few extra bucks.

Warren Buffett in a talk to MBA students explained this in a very interesting way. Talking about failed hedge fund, Long Term Capital Management which was managed by really experienced and knowledgeable people (including 2 Nobel laureates), he said:

"To make money that they didn't have and didn't need, they risked what they did have and did need. And that's foolish. That's plain foolish. If you risk something that's important to you, to get something that is unimportant to you, it just does not make any sense. I don't care what the odds are 100:1 to succeed or 1000:1 to succeed. If you hand me a gun with a thousand chambers or a million chambers, and there is a bullet in only one chamber, and you say ‘Put it on your temple , how much do you want to be paid to pull it once?', I'm not gonna pull it. You can name any sum you want, it doesn't do anything for me. On the upside it does not make a difference and the downside is fairly clear.

Finally, you will always be better off believing in Murphy's laws than believing in a God that takes care of your interests. When things go wrong, they sometimes surprise you by their interrelations, creating what Munger calls the lollapalooza effect. In the recent times, you would see an almost synchronized movement of the various asset classes. When the economy is down, stocks, real estate, commodities, everything falls in tandem. To make matters worse, the employment levels fall and people lose jobs. Sometimes hyper inflation and high interest rates add to the misery. When such all round attack happens on your financial fortress, it may seem like a cosmic conspiracy against you but deep down you would see that a single factor may be at the root of all troubles.

Prudence demands handling such situations upfront. As a matter of policy, I don't invest in the stocks of my employer because if the company gets into trouble, I'll lose my investment along with my job. This is not a far fetched scenario. At Satyam, many employees had almost their entire networth invested in the company because their only investment was through the stock options that they got. When the company went through crisis, they were under serious risk of losing everything including their sleep.

You may wonder if I'm equating investing to betting when using terms like probability. After all, in investing you never know the probabilities. The answer is that estimating rough probabilities and having an intuitive understanding of the risks and of returns is essential in the field of investing. You don't know the intrinsic value of the company either. You invest a stock when it is available below your calculated guess on the value of the company, leaving a margin of safety. Similarly you have to estimate the risk of individual stock and that of your diversified portfolio.

You have to be wary of lose-lose situations and you have to be intelligent enough to spot a win-win deal. The biggest profits I've earned are in situations where I was taking absolutely zero risk – something that runs counter to the belief that you need to take more risk to get more returns. Almost all the mistakes I've made in the beginning of my investing career, were preventable if I had done my homework before jumping to buy.

There is a tendency among losers to attribute all of their profits to their brilliant mind and all their losses to bad luck. If you bet on a 50-50 event and lose you are not unlucky. Even if you bet on something having 99% chance of success and lose, I'll have to investigate further to call you unlucky. It is possible to lose despite such high odds if success gives you measly returns and loss takes everything away. If you keep betting your entire money on such a bet, you will definitely lose.

So the correct answer to the question "why do some people always lose money?" is not bad luck but the quote from Douglas William Jerrold:

Some people are so fond of bad luck that they run halfway to meet it.

Warren Buffett MBA Talk Video

On Bernauli’s Trials
Probability An Introduction

Defense is the best attack

If you haven't read War and Peace you must. If you have, read Sun Tzu's Art of War and analyze Russian general Kutuzov's strategies. When you do that, you would come to realize that ‘defense is the best attack' isn't just a catchy title.

In the summer of 1812, when 7 lakh strong Grande Armée of Napoleon attacked Russia, Mikhail Kutuzov replaced Barclay as Russian commander-in-chief because Barclay had refused to take the battle head on and had made strategic retreat. The regular Russian forces were one fifth the size of invading army and engaging enemy forces on open flanks would have been suicidal for Russians. Kutuzov, despite his rhetoric to the contrary, continued his predecessor's strategy of retreating when odds were not in his favor and fighting minor battles opportunistically. By September, the Russians had retreated beyond Moscow and the empty city fell into enemy hands. The city was burned to ashes in a major fire. Having accomplished his mission Napolean started on his way back to France in October. Amid this seemingly stunning defeat, Russian commander Kutuzov managed not only to preserve a majority of his forces but to increase the strength by drafting a large number of reinforcements. He forced the retreating French army to take the same route from which they had come. The French Army(and retreating Russians before that) had already stripped the entire region of food supplies on their way to Moscow. On the way back, they ran short of supplies. As the unforgiving Russian winter arrived, the French army was literally eating their horses. With no cavalry and wagons left, the attacking power and logistics of the army were severely impaired. At this point, Kutuzov launched guerilla attacks and literally wiped out the enemy forces from Russian territory. When the Grande Armée reached France, it was a small force, a tenth of its original size; weakened by starvation, disease and casualties. This disastrous invasion marked the beginning of an end to Napolean's dream of dominating Europe. Three years later Napolean met his waterloo.

This extensive detour was meant to underline a strategy hugely successful in investing and many times in war. I call this strategy "defense is the best attack". Every time a stock jumps by 15% or more in a day, somewhere a heart sinks. "Why didn't I buy it?" Unitech Ltd, troubled real estate and infrastructure company, fell 90% in 6 months from its peak in May 2008. You were thinking of buying it but you didn't. The stock went up by 41.86% on Oct 27th, then again by 15% on Oct 28th. You cursed yourself for not buying it. You were neck deep in losses. You told yourself "attack is the best defense" and bought it at 49.1Rs. After all it was still 84% blow its peak. In coming months it sank back to 25 and so did your heart. Then came the rally and finally you got the chance to exit at no profit no loss. Sigh of relief.

Just forget it. You are not in casino. You worked hard in you college days to equip yourself with skills for a job. Then you toiled day and night to earn money and denied yourself many things to save the money you are investing now. Why lose it?

I'm never in the race to buy the stocks that can potentially give me 100% returns in few weeks. I'm after the opportunities that given me close to 100% probability of making above average returns in long run. Let me explain with an example.

On November 24th, Dredging corporation , a PSU monopoly in dredging business, was selling at 200Rs. It's a debt free company and it had Rs 663.60 Crs, as Net current assets at the end of last financial year which translate into Rs 237 per share. Last year it earned Rs 55.29 per share and in the current year, it has earned Rs 20.5 per share in nine month. So the stock was selling at 23% discount to the cash when I bought it. Can I lose money in this bet in long term. Highly improbable! Markets recognized this fact later and the stock is up by 85% in 6 months.

Can someone else lose money on this stock? Yes. If you don't have an idea of its worth, you CAN. Say you buy at Rs 235, still a good price and it falls down to 175(which it did). You may not have guts to stick to this stock at this price and may have sold at loss.

The trouble with small investors is that there are far too many people having guts to buy not-yet-in-business Reliance power in its IPO at 430, distressed Unitech at Rs 50 and tainted Satyam at 100 but there are no takers for buy a Dredging Corporation at Rs 200, way below its worth. I'm usually like a lone buyer at deserted counters where live elephants are selling for peanuts because everyone is busy bidding sky high prices for dead cats for the supposed aphrodisiacal properties of their bones.

These misplaced bets speak volumes about the misplaced confidence in the capability of the market to price assets correctly. When you look at 52 week highs, you giving looking upto a fool who thought the stock had got wings and it can defy gravity. In some corner of your heart, you are hoping that the same fool will be back, willing to buy at the same exorbitant price. Most people are once bitten twice shy. They don't lose money on the same things that cost them a fortune last time around. They discover new ways of losing money. Don't be fooled by such flights of fancy. Even ants get wings that last only for a brief nuptial flight!

Aggressive strategies which run a risk of significant losses can cripple you so badly that you may not be in a position to make good returns when markets revive. There is an interesting mathematical certainty of losing associated with flawed strategies which will be dealt in next article in Unfair Value.

The last part of my argument is that defensive approach not only protects your principal, it produces extra ordinary returns for you. These extraordinary returns come because you make reasonable gains when markets go up but you lose very little, if any, when they go down. If I were to quote the performance results of legendary value investors like Buffett, you may attribute their extra ordinary results to their brilliant minds but much of that brilliance is the brilliance of strategy adopted by them. That's why I would rather talk from my personal experience. During the boom from 2003 to 2008, I managed to earn returns slightly below the returns of Sensex even though my portfolio was much less volatile due to significant exposure to defensive stocks and some debt. However, the Sensex couldn't hold on to its gains whereas I did, by selectively pruning exposure into stocks which had become overpriced and increasing exposure to businesses that are bound to live through the this downturn. I did not sell my favorite stocks and bought more of the same on declines. The result is that in past 12 months, I haven't lost money even as Sensex has lost a third of its value and mid cap indices have lost close to half their value. I've been comfortably cruising above my targeted long term return rate of 2.5 times the risk free rate(currently 8%) and I've no reason to change my strategy or prescribe any other strategy to others.

To quote Sun Tzu, from Art of War. "The general who advances without coveting fame and retreats without fearing disgrace, whose only thought is to protect his country, is the jewel of the kingdom". Protect your portfolio. Don't get adventurous just because you want to show your friends how quickly you doubled your portfolio. Buy companies with wide moats sustainable competitive advantage around them, buy them at prices that leave a huge margin of safety, and you will never lose money.

Morons and oxymorons

It's fun to switch on a business news channel to hear morons talking in oxymoron. The world economy is going to witness negative growth this year. All major US banks are saddled with toxic securities that causing insecurity among investors. There aren't any truly bankable bank in US. The US govt plans to help banks dispose their toxic assets will give a boost to bank stocks.

What the hell is going on in here? Just few decades have passed when comedian Bob Hope said that a 'bank is a place that will lend you money if you can prove that you don't need it'. The banks of 21st century became a place that will lend you money if you can prove that you don't deserve it. I'm not joking. That's precisely what Ninja loans are. (Ninja stands for No Income, No Job, no Assets).

I'm glad that I'm watching this drama from sidelines. I'm glad I've no toxic assets to dispose off. When did I first think of toxic assets? I think it was 2005. Britney Spears displayed her assets so well on a song called titled 'Toxic' that she got a Grammy for best dance recording. It wasn't what music lovers would call 'music', yet it sounded like music to financial firms in wall street. Caution was thrown out of windows and in came craziness. The craze for 'toxic' securities saw the financial world going into a direction where people just forgot something very fundamental. A four letter world called risk.

The song 'toxic' says it all
'There's no escape
I can't wait
I need a hit
Baby, give me it
You're dangerous
I'm loving it'

And the hit came.. a bit late and a whole lot more powerful than asked for. It knocked out many financial giants and the rest were found leaning on government support. But the tremors were felt far and wide and we are still reeling under aftershocks.

Many would ask a question, could it have been predicted? The answer is a definite yes. Most of the times, common sense, open eyes and open ears are enough to keep you out of harms way but this precondition is stricter than it seems. We get biased by what we see and hear and start ignoring the writings on the wall. Before this crash came crash, we had precedents too. We had not completed even a decade from the last boom in 1999 where people were telling that profits doesn't matter…Eyeballs do. Many lost their balls in crash that came with the new millennium.

Seven years later( June 13th 2007), in US the interest-rate spread between the main junk-bond index and the ten-year Treasury bond shrank to 2.4 percentage points. People were willing to investing in junk bonds giving 7.7% when the safest for of fixed income instruments, US govt bonds were giving 5.3% yield. Such a small risk premium for such a big risk was unheard of.

In stocks the situation was even worse. Jeremy Grantham in his April 2007 letter reported the 'first ever negative sloping' risk return line which indicated that 'investors are paying for the privilege of taking risk'

And then there was real estate…mother of all manias. In Nov 2006, Peter Schiff gave a talk to the Mortgage Bankers Association where predicted the doom in real estate as well as the general economy. I have nothing to say about the speech (you better watch it if you haven't) except the climax that came during question answer session. A guy asked 'Peter, as a lender myself and as a property owner and wider [question] about real estate, on what's going on….Should I just slit my wrist?'

The pendulum is going slowly towards the other extreme. People are being extra cautious and hurting themselves even more in the process. Last month, Warren Buffett said in an interview to CNBC 'the interesting thing is that the toxic assets, if they're priced at market, are probably the best assets the banks has, because those toxic assets presently are being priced based on unleveraged buyers buying a fairly speculative asset. So the returns from this market value are probably better than almost anything else, assuming they've got a market-to-market value, you know, they have the best prospects for return going forward of anything the banks own.'

In US the banks are now unwilling to give loans even when the cost of capital has fallen to unprecedented lows due to government support. These banks are able to get money at 1% whereas the lending rates continue to be high. In India, although the banking sector is on strong footing, there is a definite unwillingness to part with the cash. Such a strong comeback of risk aversion is giving rise to irrational things happening all around.

Consider FCCBs. There are companies who are able to buyback their FCCBs at huge discounts, which implies that the bond holders fear that these companies aren't going to make it, yet the market capitalization of same companies is rising. This means that the stock holders, whose claim on returns and principal is secondary to the bondholders, are more confidant about the capability of their companies to come out of downturn alive.

Ok. Coming back to (oxy)morons. The entire economy, we are told, is a phase of deleveraging (Have you ever used a lever? Yes, try deleveraging!). The rally, you see, was just a bear market rally. The markets went down due to profit booking(if people are doing profit booking when market is half its peak, when the hell do they book losses?). The biggest question is the shape of recovery…whether it will be U shaped, V shaped or W shaped. Who said you need to know ABC of finance to talk about it. You can start with UVW.

Jeremy Grantham's letter

Peter Schiff Mortgage Bankers Speech

Is it riskier to invest today than a year ago?

A bright summer afternoon in a hill station, I was taking a stroll along the lake shore with few friends. A paddle boat operator approached us and asked: "Boating … want go out for boating? Half rate."

His offer was surprising because he knew us. It was our hometown. The natives rarely indulge themselves with activities that are a favorite among tourists. In a second, we realized why he was asking us. There was an accident in the lake a few days ago where a paddle boat sank along with three tourists. Even after frantic efforts of the divers, the bodies couldn't be recovered. It was big news in the sleepy little town. The tourists were scared and didn't want to go out to the lake on their own. There was widespread fear that the paddle boats were inherently unsafe.
The business of paddle boat operators came to standstill. They added a few safety measures like rubber tubes (life jackets weren't popular in those days) but it didn't help. So the offer from the paddle boat operator was essentially a confidence building measure. He thought if we take the boats, perhaps the tourists will follow suit.

We showed no interest. He sweetened the deal. "Ok take it out for free…all yours." We were smiling but uninterested. Then he started pleading, "Tourists are scared like sheep…take the boat…please." Half of my friends were already tilting towards a 'yes' when the boat man made the offer irresistible: "Ok...free ride and free beer… enjoy."

So we went. Six people in six boats. And a crate of beer. It was a win-win deal. We had a gala time in the lake. It was completely free of traffic. We paddled, in formation, passing the beer and potato chips from boat to boat. We even did a boat race. As we returned to shore after a few hours of wild party, we could see tourist boats tricking back to the lake. In a few days, it was business as usual.

The story ends here. The question is, were we taking risks?

The answer is no. A risk is a risk before it is discovered and neutralized. Everyone who went on a paddle boat before the accident was taking that risk and three people paid for it with their lives. We were entering the scene after the accident when the boat operators had taken counter measures by providing safety rubber tubes. [drunken boating was definitely a risk but let's set it aside for now ]

I'm reminded of this incident in every market crash and subsequent fear wave that sweeps through the investing world. Two years ago, if you asked a 100 people: "Do you think investing in real estate is risky?", 99 would have said no. Ask the same question today and more than two third will answer in the affirmative.

In equities today, there are equivalents of the boat operator's free offer, i.e. buy at cash, and get fixed assets free. But the perception of risk is so high that people are ignoring the fact that there is a bigger margin of safety available today than there was in the last five years. Most people think that in investing, the risk-reward equation is such that the quest for higher returns always demands taking higher risk. It's a myth. The times when risks are highest are the times when the returns are lowest. Contrary to popular belief, for investors, the risks aren't highest at the time of recession, but they are highest at the peak of a boom.

The simplest logical explanation for this inversion of the risk-reward equation is this. When the risk appetite becomes bigger, the investors are willing to ignore the risks and that brings down the risk premium. The decrease in risk premium fuels the rise in prices. The value of each asset is driven by its fundamentals and there are limits to profitability of the companies. The higher the price, the lower is your return. If the best case scenario plays out in future, you gain a little because the expected profits are already built into the prices you paid. If the future disappoints, you my lose 80-90% of your investment. So the expected value of returns (probability-weighted sum of possible returns) hits a low exactly when you are taking highest risks.

This unintuitive result is a direct outcome of confusing the business risk with investment risk. If you invest in a business which is almost certain to grow, you are competing against millions of other investors who want a slice of the same cake. The desire to outbid the fellow investors results in a price which exposes you to a risk of having overpaid for the stock. Hence, a low risk business doesn't always translate into a low risk investment. You, as an investor, are subject to the business risks and valuation risks. If you don't take these in conjunction, you are bound to get negative surprises.

Similarly, high business risk doesn't always mean high risk for the investor. If the future profitability of a business is uncertain, yet you are fairly certain of it breaking even, you are taking very little risk when you buy such business below its net current assets after adjusting for debt. You are paying absolutely nothing for the profit potential of the assets. If by a stroke of luck, the company does well, you can get huge amount of returns.

People call this the 'contrarian approach' but I prefer calling it intelligent investing. The notion of going against public opinion doesn't excite me. If you ask a demented person to pick a correct answer among two choices, he will answer the question correctly roughly 50% of the time. You can't do better by merely picking the answer which he didn't pick. If you instead apply your own mind, you can get most of the questions right. So don't jump into buying the stocks just because everyone is selling them. Choose your investments carefully because choice is a luxury that has become affordable nowadays.

The world economy is in a bad shape. The markets have dropped to their lowest point in the millennium. A boat has sunk and no one is daring to venture out. Just take a stroll by the lake side and if you find a boatman giving you a free boat ride, take it.

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