Value Investing, the Sanjay Bakshi Way – Part 2

First the bad news! The post below is still not the complete interview with Prof. Bakshi, as his answers, to my late realization, were more extensive than I think I’d heard (might be due to me having lost in the aura of meeting him). 🙂

So you will still have to wait for at least two more parts to get the complete transcript of the interview.

Now for the good news! The next 4,000 words are going to bring you great enlightenment in investing and human behaviour.

As I type, and type, and type the interview, I am getting newer ideas with each paragraph. And I hope the same for you as you read, and read, and read what’s written below.

So over to my second question of the interview with Prof. Sanjay Bakshi, and his answer to the same.

Safal Niveshak: You have talked and taught a lot about the importance of psychology in investing. What are the key mental models that investors must learn about and use while investing? Apart from Munger, are there any other great resources from where people can learn about these mental models?

• Read Part 1 of the interview here

Power of multi-disciplinary thinking
Munger’s idea of mental models is very powerful. He doesn’t limit himself to thinking in terms of models from only psychology. His models come from various disciplines. He talks about multi-disciplinary thinking.

Sure, he has given a lot of focus on the models he picked up from the field of psychology – even though he picked them up quite late in his career. I joke with my students that they are getting them well before Munger did, so they are luckier!

To become a good investor, understanding the role of psychology in financial markets is terribly important and, in my view, the single most important source to learn it from is by reading and re-reading the transcripts of various versions of Munger’s talk “The Psychology of Human Misjudgment“. Every student of value investing must read these transcripts.

He talks about 20 models, six of which came from Cialdini’s “Influence: Science & Practice” and the rest from Munger’s direct and vicarious experiences.

In my class, I focus on just 10 of these models. These are:

1. Availability bias
2. Contrast effects
3. Deprival super-reaction syndrome (scarcity model)
4. Bias from commitment and consistency
5. Bias from over-influence of authority
6. Bias from social proof
7. Dopamine (Chemical dependency, as per Munger)
8. Incentive and incentive-caused bias
9. Bias from over-optimism and overconfidence
10. Bias from Pavlovian mis-association

These are 10 different biases. If you really work hard towards removing or reducing these biases from your own personalities, I tell my students, you will become a better decision maker and a better investor.

While we don’t have time to talk about all ten, I will talk about one: bias arising out of availability heuristic.

Availability bias
As I mentioned earlier, people overweigh facts and data that are easily available to them. For example, they overweigh their own personal experiences, as those are the experiences they remember the most.

It’s harder for us to relate to a situation from somebody else’s experiences. It’s much easier to relate to our own experiences. And that results in mis-cognition in many ways.

“Prediction Newsletter Scam” story
Let me tell you this by way of a story. Let’s say one day you receive a newsletter sent to you by a person who claims to have some predictive skills about the stock market.

The newsletter states that Reliance Industries will go up by more than 10% over the course of next one month. You look at it and you toss it aside, but you don’t forget to notice that after one month, it has actually gone up by 10%.

You say, “Well, that can happen any time. It’s a random thing.”

The next newsletter comes in the beginning of next month, and this time it predicts that Reliance will fall by 10%. Again a month passes and you notice that the second prediction has also come true.

A third prediction comes at the beginning of the next month, and this time he makes another prediction about Reliance which also comes true. And the fourth, fifth, and the sixth prediction also turn out to be true.

You start thinking, “This can’t be a coincidence! This man has real predictive powers.”

But, what’s really going on? Well, it’s a scam. The newsletter publisher has no predictive powers. But he does know that if he makes three different predictions about Reliance – that it will go up, or down, or nowhere – then one of the predictions will come true, although he has no clue which one will come true.

So he sent his first newsletter to 364,500 people. 121,500 people get the first prediction, and an equal number get the second and the third prediction. Obviously, one third of the recipients – 121,500 of them – will get the correct prediction.

The publisher drops the others and focuses on these 121,500 for the next edition. This time he divides them again in three groups each having a size of 1/3rd or 40,500 recipients. Again, each group gets a different prediction, and one group, will obviously get the correct prediction.

He continues this process for four more rounds by which time, he would have 500 very-impressed recipients each of whom would have received six correct predictions in a row and you were one of them.

And you don’t know what’s really going on. All you get to see is six correct predictions in a row.

So, when the next six predictions are offered to you, for a price of Rs 50,000, you immediately start thinking how easy would it be for you to recover this cost from the trading profits made on the basis of the next prediction alone. Moreover, you would get over-confident and perhaps borrow money to finance the next operation.

You will also, eventually, go broke.

It’s a funny story, and the way it is told, it’s obvious to anybody that this is a scam. But to the gullible people, under the influence of “availability bias” – where they don’t see what they don’t see – and therefore assume that that’s all that there is to see – well, they go broke.

In the investment business this happens often – that people go broke over-reacting to what they know, and under-reacting to what they don’t.

I mean just think about it – Isn’t mutual fund advertising a variant of the “stock market newsletter scam”?

When you look at mutual fund advertisement, what do you see?

You see claims like: “During such and such period, our Technology/Infra/Real Estate fund was the best performing fund in the country.”

What you don’t see is that the fund house has a number of funds, which may not have done as well as the one being touted in the advert. So you are unlikely to be made available all of the facts about all of the ones. Rather, what that will impress the most will be the one that’s made available to you.

If you are in charge of designing adverts for mutual funds, you know that you must only talk about winners to take advantage of the gullible public which will chase recent excellent performance.

You’d know that your job is essentially to exploit the reader’s availability bias. And if the IT fund is not doing so well anymore because that bubble has burst, then perhaps it’s time to not talk about it anymore, and perhaps it’s time to replace it with data pertaining to the hot Real Estate fund.

Beware of the story-factor
What you don’t see can really kill you! And people don’t see the base rates.

Base rates are not as influential as stories are. Recall the story I told you about the man who smoked three packs of cigarettes a day and he lived to be 95 years old. His story is vivid.

The base rate of smokers living to as old as 95 may suck, but that doesn’t matter. What matters is this captivating story of the 95-year-old smoker.

People love stories. They captivate you. Base rates, on the other hand are boring.

Investment bankers are pretty good at telling stories. Facebook is the latest fairy tale story out, which is turning out to be more of a horror story for people who bought into its IPO. The stock is down almost 45% from its IPO price. And this isn’t a small company. This is a large company which was valued at US$ 70 billion less than 3 months ago and is now valued at US$ 40 billion.

But the story, when it was pitched, was captivating. Facebook was going to be the “next Google” or the “next Apple”.

What really happened? Why did the stock crash?

Simple: the earnings produced by the company turned out to be insufficient to support the IPO valuation.

So beware of “story stocks” with a lot of promotion behind them – promotion done by people incentivised to manipulate you.

Isn’t the Facebook lesson – a fool and his money are soon invited everywhere – so hard to get?

Well, if you learn psychology, it won’t be so hard to get such lessons. Better yet, you can get them vicariously.

Junk the news…avoid “recency bias”
Another variant of availability heuristic is the idea of recency.

You remember what you had for breakfast yesterday, but you probably won’t remember what you had for breakfast six weeks ago, do you?

Recent events tend to be much more remembered than not-so-recent ones. They are more “available” in your memory, so you will tend to over-weigh them.

So if something happened recently, which was terrible, but has little influence on overall value, might mis-influence you. There might be a poor election result, a bomb blast, a plague scare, an earthquake, or even a terrorist attack.

All these are instances of bad news, and typically markets crash when they occur. Fear spreads like contagion, thanks to the extensive media coverage and that fear translates into lower stock prices.

But in moments like these, isn’t it a good idea to have, what I call as the “DCF Frame of Mind?”

When in such a frame, you think along the following lines: “Ok, so there is a crash. But the value of any financial asset is the present value of its future cash flows. So there should be only two reasons why stock prices should come down because of this terrible event. Either, my estimates of future cash flows must come down, but that’s not true.

“Even though the cash flows may come down for a quarter or two, as far as long-term cash flows are concerned, this is really a non-event. Or, the interest rate used for bringing back the future cash flows to present value must come down. But that’s also not true. Interest rates aren’t going to change because of this terrible event. So, the decline in price must be irrational, unless of course the earlier price was higher than underlying value.”

So, if neither your estimates of cash flows, nor interest rates are going to change because of this terrible event, then the event is really a non-event, isn’t it?

But people find it hard to have a “DCF Frame of Mind” at such times. That’s because there is fear all around, which causes most people to become either paralysed, or to just to what everyone else is doing, which is to rush for the exits.

Very few people actually think of buying. But if you look at the base of long-term returns for investing on such “terrible” days, you’ll find that those returns are exceptional.

This reminds me of the wonderful Buffett quote: “Fear is foe of the faddist, but a friend of the fundamentalist.”

People focus too much on short-term quarterly results and too little on how the financial statements will look like 5 or 10 years from now, under reasonable assumptions. Well that’s recency bias.

Avoid “first conclusions bias”
Another variant of availability bias is the idea of “first conclusions bias”.

Our minds jump to conclusions. Humans tend to solve problems by using the first solution that comes to mind. Charlie Munger often says that “to a man with a hammer, everything looks like a nail.”

Let me give you an example of this from my own experience, as to why first conclusions are often wrong.

Let’s go back to the year 2003. This was the time when the steel industry was down in the dumps, and it was about to take off for a very big bull run. At that time, some of my value investor friends and I came to the conclusion that steel prices are going to go up. This was a time when most steel companies in the world were losing money. In fact, there were just a handful of companies that were making any money.

The steel cycle had been down for a very long time. We felt that here was a tipping point coming and things would get better, and steel prices will go up because steel capacity is getting tight and world economy, and in particular, Chinese economy, is growing.

Therefore, we thought there was going to be a shortage of steel, and it would take a long time for the shortage to go away because steel is a long gestation period industry.

We concluded that steel companies would benefit because of the huge rise in steel prices, which was a great insight. So far so good! But apart from concluding that rising steel prices must be good news for steel stocks, we also concluded that the same would be horrible news for auto stocks.

This kept us away from auto stocks based on pure automatic first conclusion that high steel prices were bad news for auto stocks. That first conclusion turned out to be wrong.

Think about why it went wrong. The value of an auto stock (or any stock) is based on present value of its future cash flows. And rising steel prices may or may not be bad news so far as those cash flows are concerned. A rising input price may be passed on to customer without suffering any volume decline. Or the rise in volumes caused the industry growth, may more than offset the shrinkage in margins because of a rise in input prices which the company is unable or unwilling to pass on to customers.

So the key factor to think about is not impact on margins but impact on cash flows. But the mind doesn’t always do this automatically. It jumps! It jumps to first conclusions, which are often wrong.

So you really have to train yourself out of first conclusion bias. You have to avoid seeking easily available answers to questions that begin with “why”.

Let me explain this with the help of an example.

Let’s look at this hypothetical stock. It has substantial cash on its balance sheet. It has no debt or other liabilities which have a prior claim on that cash. It also has an operating business. But the market value of the company is less than cash assets alone. This is a “cash bargain”.

Many of my students when they look at this thing, they say, “My God, this is not possible! How is it possible that in a market that is supposed to be efficient, you are seeing a stock selling below cash?” They want to buy it based on their first conclusions.

But under what circumstances would that first conclusion be wrong?

You see, the mind does not automatically think in those terms. The mind, instead, latches on to the first conclusion, which, in this case, is that the stock is ridiculously cheap, so it must be bought.

Now, I tell my students, “Let’s force ourselves to think of three reasons why buying such a stock would be a mistake.”

They have to come up with three reasons. Why three? Why not one? Why not four? Well, three is good enough! The idea is to force yourself to come up with multiple reasons that go contrary to your first conclusion and only when you force your mind to come up with three, will it generate three very good reasons.

So what are the three reasons for “not” buying that cash bargain based on your first conclusion that it’s cheap?

Reason 1: Cash burn: Maybe the operating business is losing money and cash will be dissipated away in just a few quarters.

This is what happened to dotcoms after that bubble burst. Many companies had raised cash in the IPO bubble and now that the bubble had burst they were selling below cash. There wasn’t any debt because no sane banker would lend such start-ups any money.

But the operating businesses were burning cash at a rapid pace and it was only a matter of time when the cash would disappear.

Buying such “cash bargains” when they became available in the stock market, would have been a mistake.

Reason 2: Corporate mis-governance: What if the promoters of the company are well-entrenched because they have a 70% stake, and they have no intention of sharing the wealth of the company with the minority investors?

They pay no dividends, and will never liquidate the company. What’s such a company worth?

This company is what Graham once called the “frozen corporation” which will never be liquidated and will never pay a dividend.

Then what the company owns is irrelevant for minority investors, isn’t it? So just because the stock is selling below cash assets alone doesn’t necessarily make it an attractive investment.

Reason 3: Bubble market: When the markets are frothy, people desperately looking for value gravitate towards “cash bargains” because they are evidently cheap.

Well they are almost certainly making a mistake because history shows that when the markets decline, these stocks will also decline, often by much more than the market.

So, now we have three very good reasons for not buying the stock and we can now have a much more balanced debate about whether or not we should buy it.

We have trained ourselves out of first conclusion bias. And you have to do this automatically, like breathing.

To question your first conclusions by thinking forcefully about why they could be wrong – by doing this over and over again – you will become a better thinker, decision maker, and investor.

Safal Niveshak: The same amount of cash in the hand of an ethical person would make sense, right?

Prof. Bakshi: Absolutely, but only when there were no other reasons strong enough to offset the reason to own the stock.

The metaphor I like here is that of a “tijori” (Hindi term for a safety locker for storing valuables).

Some of your money is in a tijori, and it is open, and you don’t have access to it but the fellow who has access to it is a crook.

What’s your money really worth? How much would you expect to fetch for your interest in that tijori when you sell it to another person in an arms-length transaction?

Well, the owner of a “cash bargain” in a company run by crooks is the functional equivalent of the part-owner of such a tijori.

Investors have to know that everything that’s cheap is not necessarily a sound investment. There are value traps to watch out for.

Watch out for “value traps”
It is useful to think about this in the following manner. There is a universe of stocks out there. A sample of such stocks is value stocks. A very large proportion of these value stocks are value traps. They are cheap for a very good reason. And they’re going to remain cheap.

People make this misconception of first conclusion bias that “because it’s cheap, I must own it. And if I own it, only good things will happen to me.” Well, maybe not!

That was my “little brief” on cognitive errors arising out of “availability bias.” But I just talked about a few variants of this bias – stock market prediction newsletter, vivid stories, recency, and first conclusions.

I could talk about 3-4 more variants of availability bias, but your readers will go to sleep, so I will refrain.

Psychology is so fascinating and if you get down to the details, you discover so many aspects of human nature which have a bearing on your investment thinking.

The reason why I don’t watch CNBC anymore is because I think I’m going to get over-influenced by what is happening “right now”. It’s not that important.

What’s important is what these numbers will look like 5 or 10 years from now, not what they are looking like right now. So the TV interview with the management on why this quarter’s result is off the street’s estimate is almost certainly noise. It doesn’t make any difference to the overall valuation of the company.

Safal Niveshak: Do you believe in meeting managements before buying stocks?

Prof. Bakshi: Not always. Sometime it’s very clear as the management is very communicative in the annual report about the underlying business and what is happening in that business.

You get to know a lot from the annual reports and the interviews that they might have given to other people – interviews which cover not quarterly results, but long-term economics of the business and the strategy being followed by the company.

But one thing that I must tell you is that in value investing, or for that matter any activity which is to do with social sciences, there is no way anybody can say that this is the right way to do it and that is the wrong way to do it. It depends on what will work.

So if you think that you prefer to meet the managements before investing, so be it. If you think that you will get mis-influenced by meeting managements, so be that.

There are people who will not invest without meeting managements, and they’ll do very well. And there are people who will meet the management and still not do very well. Walter Schloss did not believe in meeting managements.

So there is no law out there which says that meeting managements is a must. This is not physics. There is no way you can say that you must meet the management to get this result.

You have to try it out and see whether it works for you or not. Sometimes you will figure out, “Well, I don’t want to meet the management because they tell me all the good stuff and I may get influenced by them.”

Or you may come to the conclusion, “Well, I want to look at their body language and be able to tell whether they are telling the truth or not, and if there something wrong going on.”

So try it out. I don’t have a view on whether you must meet managers or not.

Safal Niveshak: Just one more question on psychology. You mentioned that we need to go into the depth on these aspects, both from our personal lives and also learn from the mistakes of others. So once you do all this kind study and form a habit of practicing good behaviour, can you completely eliminate all the behavioural errors from your investing?

Prof. Bakshi: You can’t eliminate errors. Life is about making errors and learning from those errors. So when you’ll fix one error, you’ll have another one creeping in. But you’ll make fewer errors and certainly fewer of the devastating errors that can destroy your returns or your life.

What you trying to accomplish here is not to make big mistakes. You’re really trying to improve a process.

Focus on process, not outcome
The thing I like to say here is the idea of process versus outcome. The world looks at outcomes but really should look at the underlying processes that produce those outcomes.

Safal Niveshak: That’s exactly like the athletes do. They focus on the process more than the outcome.

Prof. Bakshi: Yes, in any field of excellence, you have to work on a process.

A gambler may walk into a casino, which is a wrong process, but he may get lucky and win some money or even a lot of money. And that will make him attribute his success not to luck but to his special skill in drawing cards or throwing dice.

It will also make him over-confident and he will inevitably go back and gamble more. Eventually, he will lose it all.

So, when you see a good outcome, you need to understand that it could be the consequence of dumb luck. Whereas, if you have a good process, and if you stick to that good process, and if you improve it over a period of time, you must inevitably end up with a good outcome.

That’s what you are trying to do here is that over time, you’re trying to make fewer mistakes and one of the best ways to do that is to learn from social psychology.