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. Blog Search Engine blog catalog EatonWeb Blog Directory Bloggapedia, Blog Directory - Find It! Blog Directory Directory of Investing Blogs Blog Listings Superblog Directory