Value Investing, the Chetan Parikh Way – Part 1

I recently had the privilege of meeting one of the highly regarded value investors in India, Mr. Chetan Parikh in his office in Mumbai.

Mr. Parikh is a director of Jeetay Investments Pvt. Ltd., a portfolio management firm. He is also associated with Capitalideasonline.com, a website dedicated to investor education.

He had obtained his MBA from the Wharton School. He had written for ‘Investment Week’ which was a popular weekly financial publication in India and developed a statistical model for them. His writings have been published in Business Standard, Business World, Economic Times and Business India. He has been rated as amongst one of India’s best investors by Business India. He is a visiting faculty member of Jamnalal Bajaj Institute of Management Studies, Mumbai.

Like my meeting with Prof. Sanjay Bakshi, this meeting was also like a dream come true for me, having met a guru who has been a great teacher in my investing pursuits over the past few years.

What follows below is Mr. Parikh’s answer to just a couple of my questions. I will publish the entire interview in parts.

Here we start with the first one.

Safal Niveshak: What are the key factors that shaped your life as a value investor? What inspired you because I believe there would not be many equity investors in India at that point, no Internet, no people to guide, not much research etc.?

Mr. Parikh: Investing my money was a default option after I sold my family business at a young age. Whilst I looked at starting another industry, I found that I was not temperamentally suited to take that risk. My educational background also drew me to the markets.

I learnt a lot about value investing from Prof Russi Jal Taraporevala and Mr. Chandrakant Sampat, both of who are superb investors. I believe that an investor has to be wise, not only intelligent. Part of wisdom is knowing what not to do. A wealth of information that we have today does not translate into superior insights or knowledge. In fact it leads to the illusion of knowledge.

Safal Niveshak: How would you describe your investment philosophy? Has it changed over the years? What has gone out and what has come in?

Mr. Parikh: A lot about my investment philosophy is in my interview on Seeking Alpha and the website of the investment management firm I’m associated with, Jeetay…so I do not wish to repeat the same here.

However there are some additional thoughts that I’ve had.

An investment philosophy needs some mental models from philosophy. Logicians would find the statement pretty obvious.

1. Reasoning does not necessarily makes actions rational – one needs to distinguish good reasoning from bad and psychological biases often prevent an investor from doing so.

The ability to reason and think independently of the opinion of others is a necessary though not sufficient component of rationality.

David Hume went a step further when he wrote: “We speak not strictly and philosophically when we talk of the combat of passion and of reason. Reason is, and ought only to be the slave of the passions, and can never pretend to any other office other than to serve and obey them.”

So-called bad reasoning, maybe not amenable to the dictates of strict logic, maybe intuitive, is not irrational if the judgment is good.

In fact Western philosophy has also had the debate between reason and experience as the foundational principle of knowledge. Rationalism and empiricism have been extremely influential and contentious schools on how we acquire knowledge.

But to my mind, good judgment needs both reasoning and experience, vicarious or otherwise.

Edward de Bono has noted: “90 percent of our errors in thinking are not errors of logic at all but errors of perception. Logic does not control perception and cannot control perception (Godel’s theorem). Logic within a system cannot determine the starting–points of the system. This hyper-emphasis on logic has had two disastrous effects. The first is that we have paid insufficient attention to ‘perception’ and the second is that we have the highly dangerous ‘feeling’ of being right – when we have selected the perceptions.”

Moreover, good reasoning is not easy.

So the focus should be on good judgment as a yardstick of rationality.

2. Much of investing discipline has to do with our future selves. David Hume (again) had the wonderful metaphor of “The Theater of the Mind” – “The mind is a kind of theatre, where several perceptions successively make their appearance; pass, repass, glide away and mingle in an infinite variety of postures and situations.”

There is a TED talk of behavioral economist Daniel Goldstein titled. “The battle between your present and future self.” The Homerian tale of Odysseus tying himself to the mast to resist the sirens was what psychologists would call a “commitment device”.

A decision made with a cool head should be binding in the future to prevent future regrettable actions with a hot head. Philosophers call this the metaphor of the two selves. An investor needs to create a “behavioral time machine” to remain connected to his future self. And that must be an important part of his investment process.

3. The great 17th century German philosopher and mathematician Gottfried Leibniz brought out the concept of “possible worlds” for dealing with logic and metaphysics. This idea amounts to a framework for talking about possibility.

Things might go differently than they actually went but people, especially historians, forget that. So possible worlds are ways in which things may have been i.e. in understanding counterfactuals. This is also a useful way to counter “hindsight bias.”

An investment philosophy needs to combine the use of Bayesian probabilities and counterfactual thinking, the first to deal with the future and the latter to better analyse the past.

4. “Is it bad to be unlucky or is it unlucky to be bad?” Philosophers have debated about “moral luck”. Thomas Nagel argued as follows: “if one negligently leaves the bath running with the baby in it, one will realize as one bounds up the stairs towards the bathroom, that if the baby has drowned one has done something awful, whereas if it has not one has merely been careless”.

A good search and evaluation investment process takes some of the sting out of “moral (bad) luck”.

I cannot deny the large role of luck in markets in the short-term, but adherence to a good process is not only vital for long-term returns, it is also necessary for sleeping well at night with a quiet conscience.

And as has been remarked before, luck is the residue of design.

5. Clearly presented arguments in philosophy and science are open to criticism and progress depends upon revision and rejection.

A famous example was the “Russell Paradox” where German mathematician Gottlob Freges’ attempt to define the whole of arithmetic in logical terms by means of set theory was contradicted by Bertrand Russell. Herr Frege stated: “A scientist can hardly meet with anything more undesirable than to have the foundation give way just as the work is finished. In this position I was put by a letter from Mr. Bertrand Russell as the work was nearly through the press.”

A Devil’s Advocate is as important as an investment philosophy.

6. There must be great care not to use untested valuation methodology to make sense of so-called “paradigm shifts” in investing. These shifts may cause science to evolve, but applying them to investing can only be regressive.

Investment professionals today may well agree with the statement Lord Kelvin made in 1900 – “There is nothing new to be discovered in physics now” – as applied to investing. If the equivalent of an Einsteinian theory of relativity comes to investing, like the capital asset pricing model, throw it away.

7. The process must allow for a certain degree of vagueness and imprecision.

“Fuzzy logic” may be the right term to use here and it was originally developed by the computer scientist Lotfi Zadeh who stated in 1965 that “As complexity rises, precise statements lose meaning and meaningful statements lose precision.”

Benjamin Graham brought this necessity of imprecision in value investing well with his statement:

“To use a homely smile, it is quite possible to decide by inspection that a women is old enough to vote without knowing her age, or that a man is heavier than he should be without knowing his weight.”

In calculus, insights come when variables are taken to limits. And so too in investing. But there is inherent vagueness in many parts of the continuum from “cheap” to “expensive” and in some context or circumstance may be one or the other.

8. “Occam’s razor” which comes from the 14th century philosopher and necessitates the idea of shaving off unnecessary assumptions from a theory. In engineering it’s the “KISS principle” (keep it simple, stupid) – avoiding complexity and overspecification.

In investing, it means being able to support an investment thesis, including calculations, on the back-of-an-envelope. This would require a simple focus on a few economic variables that are important. Accuracy, not precision, is what an investor should strive for.

9. Whilst Zeno of Citium, a Greek philosopher, founded the Stoic school of philosophy, it was the Roman Stoics – Seneca, Epictetus and Marcus Aurelius – that emphasized its unique psychological component, the methods to attain tranquility.

Some of their techniques are vital for investors too and we attempt to practice them at Jeetay.

a. Negative visualization: Translated into simpler language, it means always asking the question – “What’s the worst that can happen?”

The Stoics believed that all we have is “on loan” from Fortune, which can be taken without our permission or advance notice.

Profitability, margins and growth depend much more on a company’s ecosystem and the forces shaping it than on management. Ecosystems are fragile. Much as managements with a “halo” may dispute this, a company’s good fortune is also “on loan”.

The Stoics argued that “flux and change” are part of the world.

Many company valuations depend on “speculative” developments, and I use this term in a Grahamian sense.

Rather than wanting the things that the company already has (earnings, assets and proven and sustainable growth) as the Stoics would, Mr. Market often asks a price for things that a company desires and promises – but currently does not have – and many investors pay this price. In financial markets, as in life, this is bound to lead to unhappiness in the long term.

Negative visualization can be aided by what Frank Partnoy in his wonderful book “Wait – The Art and Science of Delay” calls “pre-mortems”.

Many investors do post-mortems, or learnings from decision made, but a “pre-mortem” assumes that a decision has failed and asks why.

Let me hasten to add that we do not spend all our time thinking negatively or worrying about it obsessively because we always build a sufficient “margin of safety” in the price we are willing to pay, but we do think of gloom and doom periodically.

A honest confession – when we are sitting on large amount of cash with just a few ideas, we (perversely) wish that it comes to pass.

In the words of Marcus Aurelius, a real philosopher-king (a Stoic philosopher and a Roman emperor), we take care to be “the user, but not the slave, of the gifts of Fortune.”

b. The dichotomy of control: Epictetus’s “dichotomy of control” comes from his statement that “some things are up to us and some things are not up to us”, some things over which we have complete control and some things over which we do not have complete control.

As Ben Graham pointed out that an investor has complete control only over the price he chooses to pay. If he is not a “control investor”, he has no say in managerial decisions reflecting corporate strategy and capital allocation. He has also no control over his exit price.

This one decision and the only thing over which the investor has complete control – the price to be paid – should be thought of with rationality, rigor and facts, but it often surrendered to fads, fashions and rumors.

c. Fatalism: Again in simpler language, it means letting go of the past. This means not being hostage to “if only” thoughts.

These are elements of the Stoic way of thinking that have helped us at Jeetay.

10. Socrates claimed that the only thing he was sure of was his own ignorance. He stated. “The only thing that I know is that I know nothing.”

Remembering this statement is a sure formula for humility and curiosity, both of which are the hallmarks of successful investors.

It is through the influence of Socrates that philosophy developed into the modern discipline of continuous critical reflection. From Socrates, investors can learn that the greatest danger is the suspension of critical thought.

11. Much more than any other philosopher before him, Aristotle made much of observation and detailed classification of data in his studies. Thus he was considered as the father of empirical science and the scientific method.

Unlike his predecessor Plato, Aristotle conducted his investigations by considering the opinions of both experts and lay people, before detailing his own arguments, assuming that some truth was to be found in commonly held ideas.

Investors should remember this when investigating companies and engaging in what Phil Fisher calls “Scuttlebutt.”

12. The great Roman sceptic Sextus Empericus who wrote the monumental eleven volume work “Arguments against the Dogmatists and Mathematicians” and the “Outlines of Scepticism” offered a number of sceptical arguments to fortify his claim that for any proposition its contradictory can be asserted with equal justification.

According to him, because of the logical gap between reality and appearance, there was no way of proving that things are really one way rather than the other.

For any investment case, bearish and bullish arguments can be mustered with equal ease and the investor must be naturally sceptical of any investment case made to him.

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This concludes the first part of the interview. I hope you benefited immensely from it, like I did.