What we don't know

During the recently concluded Emerging Markets Finance Conference, organised by Finance Research Group,  Michael Barr presented on the topic 'Finacial Regulation: The Long View'. As a precursor to his talk on the Dodd-Frank Act, Michael presented how financial crises are caused because of things 'we don't know'. It's not as simplistic as it sounds and luckily for us, Michael broke it down.

As an amateur investor who's grappling with so many unknowns, I thought Michael's first slide was very relevant to the investing process. After all, most financial misadventures, at the level of the entire economy or in individual investing, are caused due to human misbehaviour. We can save ourselves a lot of trouble by being intellectually honest and putting unknowns under different types before making any investment decision. Here's the list:

1. What we once knew but have now forgotten - Well, shame on you! As George Santayana famously said, "Those who cannot remember the past are condemned to repeat it." Enough said.
   
   
2. What is knowable but is kept hidden - There's some leeway to get around this. Attend conference calls and ask tough questions. Reach out to investor relations and seek meetings with management (some investors think that they might get biased after such meetings and that concern is warranted). Also one could do some scuttlebutt on their own and speak with customers, suppliers, dealers, etc. in the value chain to know things. Beyond this, if you're still unsure, you should give the idea. When in doubt, tune in later.
   
3. What we know, but don’t know what it means - These fall out of your circle of competence and are best avoided. For example, I know there's an NPA problem in Indian banking presently. So what? Can I take a contrarian call on some banks that are financially healthy? No, because I don't know how to evaluate NPAs, let alone the health of financial firms.
   
   There's scope for improvement here. Try to get to the bottom of things. Increase your circle of competence. If something seems difficult to understand, inverting might be helpful.
   
4. What we don’t know that we don’t know - The Black Swan. Even with the biggest firms (with supposedly high levels of transparency), agency problems will remain and in certain cases, shareholders will be poorer for it. For example, the Satyam scandal. If auditors were duped, there's little chance you'd have been diligent enough to see through the accounting gimmickry. Or the recent Welspun issue. Consider these as black swan events and move on. But learn from these events, so as not to repeat mistakes from type 1. This way you will be cognisant that none of your positions should be large enough (no matter how great your conviction is) to cause you permanent damage.
   
5. What we should do about things we know - Undoubtedly the most hilarious. On one hand, not acting on what we know leads to errors of omission. But on the other, acting inappropriately might lead to errors of commission.
   
   I am firmly in the camp that believes it's best to pass opportunities where one cannot ascertain potential upside/downside AND where the risk reward ratio is not favourable. With this framework, it's probably better to have errors of omission than errors of commission. Errors of commission can be avoided to some extent by putting every investment thesis through a checklist to see which ideas survive and how much you should bet on them. If type 4 types unknowables don't spoil the party, at least some of your investment thesis will stand the test of time. Only a few of these are required to make the biggest positive impact on your portfolio in the long run.

So what can you do?

• Type 1: Eliminate them. History is a great teacher and it's highly likely that the situation at hand resembles something that's happened in the past. Not to you maybe, but maybe to some other great soul. Buffett says - "It's good to learn from your own mistakes. It's better to learn from others' mistakes."
  
  Read financial history, about investing legends and their investment process. You're likely to come across many companies from mature economies such as US and these learnings may be directly applicable to India currently or in the future.
  
• Type 2 & 3: These can be minimised through constant learning and an increasing circle of competence.
• If you are unable to increase your competence because of lack of will/time, pass such opportunities for a future date when you're more inclined to think about them in greater detail.
• If you can't eliminate the 'hidden' aspect of the unknown, be cognisant that it might come to bite you in the ass as a type 4 unknowable. Even if the risk/reward ratio is highly favourable, you're better off not assigning high weight to such a position in your portfolio.

• Type 4: What you cannot avoid, you must live with. Take these in your stride. Don't give very high weights to any position no matter how high your conviction.
  
• Type 5: Stick to the checklist and create feedback loops to your investing process. Be the devil's advocate and ask - what you think you know is really all that is required to know? If the answer is not a resounding yes, there's scope for improvement.

It is my attempt to think about the moving parts of any business and put different components under these different silos. Hopefully, this will make me cognisant of strengths and weaknesses of my knowledge and lead to more sound decisions.

Investment Checklist I.I - Filtering your ideas

Once you have a hunting ground for ideas, the next task is to filter them and put them in different buckets. Charlie Munger does this quite simply. He has only three buckets - in, out, too tough. But how to filter?

Circle of Competence

Working inside your circle of competence is crucial. It's not so much that you can never make money outside your circle of competence, but mistakes made here will take a toll on your portfolio and consequently your mental well-being. Also with investments failures outside your circle of competence, you are unlikely to learn anything from a post-mortem. 

Try to widen your circle of competence. Don't be despondent if you're unable to do so. You will find opportunities if you're patient enough. For example, till recently Buffett did not invest in technology stocks. He was ridiculed prior the tech bubble, but in hindsight his obstinacy saved him. 

Once you have identified that an idea is within your circle of competence, you may proceed to detailed questions based on past performance.

Criteria is a filter

Shaern points to a number of questions which can be used to filter investment ideas. More than anything else, I like to boil it down to some very basic things. Motivated from an interview with the Big Bull, I like to look for five things during my initial search - 

• Opportunity - This is a measure of how long the runway is for the industry and consequently the business. 
• Scalability - Is the business scalable? Can additional plants/manufacturing units be put up with increased return on incremental capital?
• Management integrity -  Probably the most important facet to avoid sour grapes in the Indian context. Does the management have a clear vision? Does it communicate this is a transparent way to stakeholders? Are minority shareholders given an equal opportunity to reap benefits from the underlying business?
• Competitive ability - This covers aspects related to Porter's five forces and moats.
• Valuation - "Price is what you pay; value is what you get" - always remember this. Without a reasonable estimate of value, you're only gambling.

Valuation is a criteria

There are numerous ways to arrive at valuations - DCF, relative or residual. Each has its own pros and cons. What one may use is highly dependent on the situation at hand. [post forthcoming]

For instance, Shearn quotes the example of Brad Leonard who uses enterprise value (EV) to EBITDA as a qualifying valuation criteria. In his words - 

"When you are paying one or two times EV to EBITDA, not much needs to go right. If the business survives, you win. As long as the business does not end, you don’t need to make a lot of great assumptions in your analysis. If instead I were paying a 5 percent earnings yield (earnings divided by market capitalization) on depressed earnings, it would not really be that cheap."

Valuation lies in the eye of the beholder. Subject to inherent assumptions, two people can come up with varied notions of intrinsic value. They may be both right (or wrong) at the start, but in the long run, the one to gain profitably from investing is likely the one who's honest and conservative in his assumptions and bets with good margin of safety.

Using a tracking sheet

A tracking sheet is a wonderful way to monitor businesses. More often than not, you'll encounter businesses which look strong fundamentally but do not offer any margin of safety. A tracking list gives you a number of advantages in making rational decisions:

• The sheet keeps our favourite businesses on the radar. An alert system can be incorporated to notify us about stocks that offer good price-value propositions in the future.
• Putting a business on the tracking sheet helps wear off the novelty of a new idea. We are conditioned to act impulsively and the sheet instills the discipline to think holistically before a buy decision.
• Ignoring other businesses in the sheet is the opportunity cost of making a new stock purchase. One is likely to make the best choices amongst a list of relatively good stocks. Over time, this is likely to deliver handsomely to the overall portfolio.

I've touched base with the most rudimentary ideas here - in further posts, I'll delve deeper into each of the matters listed here.

Investment Checklist I: Hunting for ideas

This is the first in a series of posts inspired by Michael Shearn's work The Investment Checklist. I'll be following a chapter-wise format as provided in the book. I will also follow up points made in the book with my own commentary of my understanding so far. For any examples provided in the book, I will use Indian examples for my own benefit (and hopefully for yours too).

This post deals with generation of investment ideas. Quite frankly, I am boggled with the multitude of options illustrated in investing literature on how to make money. The answer perhaps lies in developing your own strengths, learning about your biases and making informed and rational decisions with a long term perspective. Investment ideas can be qualitative or quantitative or both. Let's start with hunting grounds for investment ideas.

At the outset, Shearn warns his readers quite prophetically -

"You need to mentally prepare yourself in advance with the idea that you will not have many outstanding investments in your lifetime."

Are we indulging in intellectual masturbation here? What is the point of this all, if you're not going to get rich. No, no. I didn't say it. If you're a Munger fan and practice second-level thinking, you've probably already figured it out - most of your money will be made in just a handful of investments. So pull no punches when opportunity presents itself. But how many punches - if you're listening to Buffett, no more than 20!

Some places to seek new ideas:

1. Times of crisis undoubtedly present exceptional opportunities. Take for example the Asian crisis of 1997-98, the tech bubble of 2000 or the mortgage crisis of 2008. Most of the these opportunities arise out of forced selling. This happens when institutions must make good on large-scale client redemptions. Even though fund managers may have some inclining that the stocks they're dumping are intrinsically undervalued, they have no choice but to meet their mandates.
   
2. Other examples of forced selling include selling after a stock is dropped out of an index. This usually happens because stocks are ousted as index constituents based on some mathematical computation (such as market cap). Spin-offs may also present If such stocks are fundamentally sound, they may present good opportunities.
   
   Comment: In the Indian context, I am unaware of any academic study which checks the stock performance of stocks which dropped out of indices. But the exercise may be worthwhile. With regard to spin-offs too, I am not very well informed. In recent times, Syngene IPO and the run up in both its stock and that of its parent Biocon may be a worthwhile consideration [post forthcoming].
   
   

   

   Syngene and Biocon (after listing of Syngene)

3. Broad market sell-offs: look for sectors which are in greatest distress. In other words why is capital scarce in such sectors and why are investors fleeing? Invert and ask yourself, when the
   cycle reverses - which companies will stand to gain the most.
   
   Inversely, which sectors seem to have an abundance of capital? Which sectors have highly leveraged balance sheets and appear to be heading into bubble territory? These may the ones to avoid.
   
   Comment: As an illustration I compared the BSE Metal Index with the Sensex. Metals unde-performed the broader market for three years from 2012 to 2015, but staged an impressive comeback in 2016 during which time Sensex has been almost flat [post forthcoming].
   
   

   

   Sensex v/s Metals (2013-15)



Sensex v/s Metals (2016)

4. Stock-specific sell-off: When bad news hits a particular business, investors dump the stock quickly. This can be good hunting ground if you can make the distinction between permanent and temporary distress. Take for example, Buffett's investment into American Express after the Salad Oil Scandal.
   
   Comment: In the Indian context, think of the Maggi fiasco. Or more recently, the Welspun cotton-issue or promoters at VRL saying they will get into airlines. Are these investment bets for the future? I don't know. But if you do your homework and find the distress temporary and inconsequential to long term profitability for the companies, these may present good buying opportunities. [posts forthcoming]
   
5. Stock screens: Tools like screener.in are indispensable to retail investors. They help us quickly sort through a multitude of companies using financial indicators which are most important to us. But perhaps, screens are too simplistic. When the devil lies in the detail, some caution is warranted. A principal concern can be in the nature of accounting itself. One needs to look at real earnings [post forthcoming]. Also, if you're looking at earning multiples, a temporary loss can throw a company out of the screen. Most importantly, without the necessary tools build into a screen, it's difficult to investigate the qualitative aspects on an investment thesis such as management integrity.
   
   Comment: For example, Lycos Internet is always thrown up on my screen whenever I use return metrics for screening. But it's trading at PE of 0.88 currently! Surely something must be wrong here? Could this be a case of creative accounting? [post forthcoming].
   
6. Low lifes: It maybe worthwhile to investigate companies which are hitting 52 week lows. Some companies may be deservedly in the list, but some may be going through temporary distress. If you can connect the dots with point 4 related to stock specific sell-off, you may find good bargains.
   
   Comment: For example, look at Speciality Restaurants. The company has been hitting lows since its IPO. But they have no debt on their books and whenever I've been to Mainland China, I've always been pleasantly surprised with the quality of their service. A turnaround could augur well for shareholders. [post forthcoming]
   
7. Coat-tailing: Following investments of renowned investors and betting with them is called coat-tailing. It can be incredibly useful to hunt for investment bets. A word of caution is warranted here. Without an investment thesis, betting your money is akin to gambling. So while coat-tailing may be a good idea to discover companies, without independent research you cannot build conviction.
   
   Comment: Investments above a certain percentage of shareholding of the company or monetary value must be disclosed as Bulk/Block deals to the exchanges. These can be the mostly timely indicators of interest by seasoned investors. Annual reports also carry names of top ten shareholders besides promoters and management.
   
   
8.  Buying shares to track a business: Sometimes you need motivation to get things going. This involves buying small quantities of some companies which look interesting but where you've not completely formed your investment thesis. These holdings generally don't affect your overall portfolio (consequently, you can't expect to gain enormously if these do well too). Paul Sonkin of Hummingbird Value Fund calls this the grab bag. This idea maybe seem to be at odds with Warren Buffett's 20-punch rule, but examples like American Express come very infrequently. In most cases, conviction builds over time. The idea is to keep these holdings in your mind space and research in greater detail (even if valuations aren't very rosy). In the long run, when the iron is hot, you'll know where to strike.
   
   Comment: I've been guilty of indulging in some investments with this point of view. Consumer discretionary businesses like Wonderla Holidays and Mahindra Holidays present some examples.
   
9. Looking inside: Sometimes you already own the best ideas and don't need to go looking around. When valuations are favourable and your original investment thesis is still at play, you can buy more stocks of business you already own. Think in terms of opportunity costs.
   
10. Researching IPOs: Shaern points to something important - while researching IPOs, you don't have any prices to disrupt your valuation process. Without availability bias, you're likely to form an independent opinion of the company. Soon after listing, you can validate your valuation against the market quoted price. IPOs are inherently cyclical in nature (just look at the money raised in 2016 compared to previous years). In a bull market, valuations can be exaggerated. Having an independent opinion can save you from losses. Moreover, many IPOs are likely to be those of new-economy firms. Tracking changing industry trends in the market can serve in the long haul.

This list is obviously not exhaustive. To an amateur whose just starting off though, this list can be handy. To cut it short, ideas can be discovered anywhere. If you're a Peter Lynch follower you'd keep an eye for brands in the supermarket too.

Please note: I'm not a SEBI registered investment advisor and my discussion of stocks is not a recommendation to buy/sell/hold or transact in any way on the stock exchange. Please do your due diligence and make informed decisions. 

What this blog is about?

Recently I've gotten interested in value investing. As a construct to compound long term gains in the stock market, I think value investing trumps other methods. While others may understand technical analysis better and use it more frequently than fundamental analysis to invest (or speculate) in the market, I believe the fruits of investing come from proper understanding of how businesses are run in their economic environment. Given the vagaries of the stock market in the short term, I believe trading in a speculative fashion requires nerves of steel. Exciting as that might be, my temperament is more suited to making long term bets based on exhaustive research on individual equities.

Over the course of this blog, I plan to publish articles and book reviews on value investing and make notes on companies being analysed. By penning down ideas, I hope to compile a ready compendium of knowledge which I can revisit from time to time. as need be. Posts may thus be subject to numerous edits spaced irregularly through time.

While you eat your banana

If a smart person goes into a room with an orangutan and explains whatever his or her idea is, the orangutan just sits there eating his banana, and at the end of the conversation, the person explaining comes out smarter.

- Charlie Munger's Orangutan theory

I've felt this myself while explaining my ideas on investing to friends and family. In similar fashion, you, dear reader, are my orangutan. You're most welcome to debate and question my reasoning of course. Actually I'd even encourage it if I believe you make valid points which invalidate my arguments. 

A note about the blog name

For lack of imagination, the blog derives its name from moolya - the Hindi world for value. Value investing disciples go gaga over margin of safety (MOS).  MOS is considered to be the cornerstone of value investing. It's a pretty misrepresented term though. This is because it is derived as the difference of intrinsic value (IV) and market price. While market price is available all the time, IV is actually a make believe concept. Different people can come up with completely different values of IV, and based on their assumptions and line of thinking about future outcomes, they may all be right. In time though, Mr. Market will reward only some of these forecasters. Technically speaking, there's nothing intrinsic about IV at all then!

Since I'm an amateur myself, I will not claim to outdo more learned and experienced practitioners in this field. Instead, I will focus more on mooley - a very distant, but well thought through, cousin of intrinsic moolya. My successes and failures will then be my own (with some attribution to whimsical luck). In the long run, my sincere hope is that this blog will bring much moolya to you and me.