Blog on Value Investing | Safal Niveshak

Thank You Matadin Babu!

I received several email and text messages over the past few days with people asking about my whereabouts.

“Where have you been? No posts for the past two days?” emailed a reader.

“I hope you are fine,” wrote another.

“Alive?” asked a friend who is also a reader.

Well, if you have been wondering where I’d been over the past few days, just want to let you know that I am still here…alive and kicking.

Over the past few days, I was in a small, nondescript town of Bankura in West Bengal – the place I was born. [Read more…] about Thank You Matadin Babu!

How to Invest and Not Get Killed

A company’s financial statements can be an investor’s best friend, or biggest foe.

If read carefully, an investor can gain valuable insights into the company – like finding durable sustainable moats a la Buffett.

However if these statements are read without care, and one acts upon his hunch, thinking – “Let me buy the stock since it’s rising! I’ll read the annual report later.” – he or she can lose his/her entire investment.

Like it happened in the case of Deccan Chronicle recently, or for that matter, Suzlon. Of course there are hundreds of other companies that come to mind, but then that’s not the point here.

The point is that some financial statements shout out to be read – and carefully – by investors who are buying into these stocks without looking into the deep mess the balance sheet and cash flows are hinting at.

If you have been a buyer of such messy businesses in the past, and have now vowed to find out the red flags that lie within a company’s financial statements, there is one book you must read right away.

Notes from Value Investing Conference

If you are a budding cricketer, and suddenly find yourself in the company of Sachin Tendulkar, Rahul Dravid, and Kapil Dev, what would you feel like? Great, isn’t it?

Also, what if they spend the entire day with you, sharing the simple batting and bowling tactics that made them immortals – tactics that are so simple that you can learn them yourself to make your own mark as a cricketer? Amazingly lucky, isn’t it?

Well, I felt something like this yesterday, while attending a value investing conference organized by a leading Indian financial advisory company.

I found myself extremely lucky to be in the company of the doyens of value investing in India – Chandrakant Sampat, Chetan Parikh, Prof. Sanjay Bakshi, Prashant Jain, and Parag Parikh – and several other practitioners of this beautiful art.

Sensex at 2003 Levels! Is the Next Big Bull Run Really Coming?

Like I suggest that you must not watch CNBC (or any business channel) for their expert views on where the stock market is heading, and instead watch them just for entertainment purpose…

…I also suggest you read my today’s post for entertainment purpose. This is because today I talk about my view on Indian stocks market, and where I see it going forward.

Please note that I am not trying to make a prediction here – I’ve failed many times at that and have got over that addiction few years back.

All I’m trying to do is put forward my thoughts on Indian stock market’s current situation and how it is placed for the future. There’s a 100% chance of my view falling flat on its face, so watch out!

Warning: A Big Investing Mistake You May Commit in these Rising Markets

A simple definition of investing is that it is the process of laying out money now in the expectation of receiving more money in the future.

In simpler words, investing is the transfer to others of purchasing power now with the well-calculated expectation of receiving more purchasing power in the future.

Even simpler, investing is forgoing consumption now in order to have the ability to consume more at a later date.

I would’ve made this even simpler, but then as Albert Einstein said, “Everything should be made as simple as possible, but not simpler.” 🙂

But isn’t “simplicity” what you as an investor looking for in your investment life?

Ask any expert his view on the latest sharp rise in stock prices and where does he sees the market going forward, and you may hear words like – monetary policy, fiscal policy, current account deficit, QE, shifts in Philips curve, inflationary expectations, interest rates, etc.

As an individual investor, I have little interest in such esoteric terms. I hope you are sailing in the same boat as I am.

Wit, Wisdom, Warren (Issue #4): Value Unlocking

Last week, I reviewed lessons from Warren Buffett’s 1959 letter to partners of Buffett Partnership.

Today, I review the letter for 1960.

This is going to be a long-long review given the amazing number of ideas I could cull out from the letter, so make yourself comfortable before you start reading it.

Lessons in beating the street
The US stock market as represented by the Dow Jones Industrial Average (DJIA) declined in 1960, after strong gains in the previous two years. Including dividends, the DJIA fell by almost 6% during the year.

Buffett’s seven partnerships (up from six in 1959) gained around 23%, thereby again outperforming the broader market by a decent margin.

In the 1960 letter, Buffett reiterated his objective…

My continual objective in managing partnership funds is to achieve a long-term performance record superior to that of the Industrial Average. I believe this Average, over a period of years, will more or less parallel the results of leading investment companies. Unless we do achieve this superior performance there is no reason for existence of the partnerships.

However, I have pointed out that any superior record which we might accomplish should not be expected to be evidenced by a relatively constant advantage in performance compared to the Average. Rather it is likely that if such an advantage is achieved, it will be through better-than-average performance in stable or declining markets and average, or perhaps even poorer-than-average performance in rising markets.

I would consider a year in which we declined 15% and the Average 30% to be much superior to a year when both we and the Average advanced 20%. Over a period of time there are going to be good and bad years; there is nothing to be gained by getting enthused or depressed about the sequence in which they occur. The important thing is to be beating par; a four on a par three hole is not as good as a five on a par five hole and it is unrealistic to assume we are not going to have our share of both par three’s and par five’s.

A few lessons can be gained from these notes:

1. Set performance standards in advance and then follow them: As we read in the review of Buffett’s 1957 letter, he had set a standard of outperforming the market by 10% per annum over the long term.

Setting your own long-term return target will also make your task simpler as against accepting whatever return you earn and then using that as a benchmark. This way, you will see a strong year (when your portfolio advances by say 25%) as just an aberration like you will see a weak year (when you are down -20%).

The important thing to do is to start with a reasonable standard (like I want to beat the Sensex by 8-10% annually over the long run) and then try to meet it over a period of time. This will keep you focused. Of course, the standard has to be reasonable and you can’t expect to be beating the market year after year, especially during periods of mania.

2. Direct investing versus mutual fund investing: A lot of investors enter directly into stocks expecting to “do well” in the long run. Doing well isn’t enough when you are working hard to identify great businesses and then taking the risk of putting your money where your faith is.

Of course, your foremost target must not be to earn supersized returns from your overall investments. You must only target a return that can help you meet your financial objectives (like Graham’s “adequate return” as per his definition of investment).

But when it comes to stock picking, you either target outperforming the market or else give your savings to a smart fund manager who can beat the market on your behalf (and consistently over the long run).

As Buffett writes in the letter, the important thing is to be beating par (index), and especially in down markets.

There is a simple criterion I suggest people just starting out in stock picking – check your direct equity returns over five years. If you can outperform the benchmark and most good mutual funds, continue to pick stocks. Otherwise just give your money to a fund manager (of course, a majority of fund managers are a joke, but then you can always find a smart guy with some hard work).

There’s no point running on a treadmill – investments that don’t go anywhere – where you will be worse off the longer you stay.

Buffett advises something similar to his partners…

Unless we do achieve this superior performance there is no reason for existence of the partnerships.

I’m not sure how many investors and mutual fund managers are so honest with themselves and their clients respectively.

3. Good years and bad years: Stock market does not move in a straight line. There are good years, there are bad years, and they follow each other. Of course for people who started investing in 2008, there are only bad years, but even they need to understand that law of averages work very well in the stock market.

Here’s a quote from Horace that Benjamin Graham used for the foreword of the first edition of Security Analysis, and which summarises what Buffett mentioned about good and bad years above – “Many shall be restored that now are fallen and many shall fall that now are in honor.”

Thus the target for you, the value investor, must not be to earn great returns year after year. Rather, your target must be to do better than the average market in a bad year (like 2008) and do at par with the market in a good year (like 2009).

To reiterate what Buffett wrote in the 1960 letter…

I would consider a year in which we declined 15% and the Average 30% to be much superior to a year when both we and the Average advanced 20%. Over a period of time there are going to be good and bad years; there is nothing to be gained by getting enthused or depressed about the sequence in which they occur.

For the long term, however, you must set a standard return target (which should be better than what the market could earn), and then work towards meeting it.

Like Buffett was working towards beating the US market, especially in the bad years (like 1957 and 1960)…

Data Source: Buffett’s 1960 Letter
This is where the real importance of value investing lies for you – buying sustainable businesses at margin of safety so that you reduce your chances of permanent loss of capital, even in bad markets.

4. Conventional investing vs. conservative investing: Buffett wrote…

Although four years is entirely too short a period from which to make deductions, what evidence there is points toward confirming the proposition that our results should be relatively better in moderately declining or static markets.

To the extent that this is true, it indicates that our portfolio may be more conservatively, although decidedly less conventionally, invested than if we owned “blue-chip” securities. During a strongly rising market for the latter, we might have real difficulty in matching their performance.

Buffett described “conventional investing” as buying blue-chip stocks – ones that are generally traded at rich valuations as compared to non-blue-chip, and despite this fact, are considered as safe havens.

Data Source: Ace Equity
For Buffett, safety of an investment always negatively correlates with the valuation an investor pays for stocks. So a higher valuation as compared to intrinsic value means lower safety (what if things go wrong?) and a lower valuation equates with greater safety.

Thus, Buffett was happy investing in a “conservative” manner, i.e., focusing his sights on non-blue-chip stocks that traded at reasonable to cheap valuations – ones that had large margin of safety attached to them (we’ll study a case below).

This was classic Benjamin Graham, as Buffett was then 100% Graham (only later did he call himself 85% Graham and 15% Philip Fisher).

The art of “value unlocking”: Sanborn Map
In the 1960 letter, Buffett talked extensively about his investment in Sanborn Map, a map-publishing company. Sanborn Map formed a huge 35% of Buffett’s assets, and he presented it as a case study in value unlocking.

Sanborn was a Graham-style investment for Buffett. On the nature of this business, this is what he recognized…

For seventy-five years the business operated in a more or less monopolistic manner, with profits realized in every year accompanied by almost complete immunity to recession and lack of need for any sales effort.

Buffett also gave an historical perspective on Sanborn, wherein he mentioned that the company’s once-lucrative core business of map publishing declined starting 1950s (driven by a new and competitive method that made inroads into the company’s territory).

The impact on Sanborn was so much that it, as Buffett wrote, “…amounted to an almost complete elimination of what had been sizable, stable earning power”. Its net profit of US$ 500,000 in the late 1930s declined to less than US$ 100,000 by late 1950s.

Source
Then, Buffett added…

However, during the early 1930’s Sanborn had begun to accumulate an investment portfolio. There were no capital requirements to the business so that any retained earnings could be devoted to this project. Over a period of time, about $2.5 million was invested, roughly half in bonds and half in stocks. Thus, in the last decade particularly, the investment portfolio blossomed while the operating map business wilted.

In other words, while Sanborn’s core business was declining, the company was gradually adding to its investment portfolio, which at the end of 1959 was about a size of US$ 2.5 million (at cost).

On a market value basis, the investment portfolio was valued at US$ 65 per share (up from US$ 20 per share in 1938) as compared to Sanborn’s stock price of US$ 45 per share (down from US$ 110 per share in 1938).

Effectively, in 1938, Sanborn’s core mapping business was selling at US$ 90 per share (US$ 110 of stock price minus US$ 20 per share of investment portfolio). Against this, by 1958, the core business was valued at US$ -20 (US$ 45 of stock price minus US$ 65 per share of investment portfolio)!

Source: Buffett’s 1960 Letter
This raised Buffett’s interest in the company, as he saw a great margin of safety in it.

His basic assumption was that, despite the decline in business profits (Sanborn was still profitable then, and the business still exists in 2012 to provide mapping services to the US insurance industry)…

…Sanborn in 1958 still possessed a wealth of information of substantial value to the insurance industry. To reproduce the detailed information they had gathered over the years would have cost tens of millions of dollars.”

In effect, for a business that was selling at around US$ 4.7 million of market cap (US$ 45 x 105,000 shares), Buffett’s replacement value was around “tens of millions of dollars”!

Seeing this anomaly, he bought Sanborn’s stock throughout 1958 and 1959. As Roger Lowerstein mentions in his biography of Buffett – Buffett: The Making of an American Capitalist – the master investor was trusting in Graham’s testimony – sooner or later a stock would rise to value.

But it didn’t!

As Buffett wrote…

The very fact that the investment portfolio had done so well served to minimize in the eyes of most directors the need for rejuvenation of the map business.

This was a clear case of idiots running a good (cash generating) business.

Buffett was appalled at seeing that the company’s 14 directors combined held just 46 shares of stock out of 105,000 shares outstanding. In effect, these top men had no interest in seeing the value of Sanborn’s stock rise and thus were not interested in improving the company’s core earning power.

What is more, while the company was cutting back on its dividends due to declining profits, the salaries and other payments made to the directors were not cut.

Anyways, in a true Graham style, Buffett accumulated Sanborn’s shares by buying the stake of a deceased director, who was holding 15,000 shares in the company. Then, aided by his open market purchases, Buffett came to own a large stake in the company, became a director, and then lobbied the management to unlock the value in the investment portfolio.

His idea was to…

…separate the two businesses, realize the fair value of the investment portfolio and work to re-establish the earning power of the map business. There appeared to be a real opportunity to multiply map profits through utilization of Sanborn’s wealth of raw material in conjunction with electronic means of converting this data to the most usable form for the customer.

A control position added massively to Buffett’s margin of safety, which was already there in terms of the company’s stock valuation being low as compared to its investment portfolio.

After the initial opposition to Buffett’s plan of unlocking value of the investment portfolio, Sanborn’s management capitulated in 1960.

Buffett unlocked Sanborn’s value by separating the investment portfolio into a separate unit, sold the investments at fair value, and then distributed the investments among the company’s shareholders (including himself).

Effectively, he bought a wallet with US$ 100 in it for US$ 70, and not only got to keep the money, but also sell the wallet!

Buffett did all this quickly after coming on board because a large portion of Sanborn’s money was tied up in blue-chip stocks, which Buffett didn’t care for at then prices (as we discussed above).

In all, as per Lowenstein’s book, Buffett made a quick 50% profit on his investment in Sanborn.

This sharp profit in a short time and on a large proportion of his portfolio was the reason Buffett earned a market-beating return for his partnerships in 1960.

But he was quick to point out that Sanborn’s case showed…

…the futility of measuring our results over a short span of time such as a year. Such control situations may occur very infrequently. Our bread-and-butter business is buying undervalued securities and selling when the undervaluation is corrected along with investment in special situations where the profit is dependent on corporate rather than market action.

To the extent that partnership funds continue to grow, it is possible that more opportunities will be available in “control situations.”

In other words, while Buffett was always willing to take advantage of special situations (like Sanborn’s value unlocking) when they arose, he was at heart an investor who preferred to buy undervalued securities and sell when the undervaluation was corrected.

By the way, an interesting insight that initially missed my eye was Buffett’s understanding of “technology”, which he has otherwise claimed that he does not understand. 🙂

This is what Buffett wrote of the future prospects of Sanborn’s mapping business…

There appeared to be a real opportunity to multiply map profits through utilization of Sanborn’s wealth of raw material in conjunction with electronic means of converting this data to the most usable form for the customer.

If that’s not a sharp understanding of the future of technology, than what is it?

Investing heavily in your best ideas
While this may be a scary choice to make – concentrating your investments in a few stocks – that is what the young Buffett was doing in 1960s.

Sanborn, for instance, formed about 35% of Buffett’s portfolio in 1960. Plus it was a small company with an illiquid stock (just 105,000 shares outstanding).

Despite these attributes that can scare any investor, Buffett saw a great opportunity and invested heavily in Sanborn. He later did the same thing with See’s Candy in the 1970s.

Let’s me be clear here. I am not suggesting that you put 30-40% of your money in any one stock or investment. However, if you really believe in an idea, you may be willing to take it to around 10-15% of your portfolio.

Too many people over-diversify – allocating the same amount of money to their best ideas as to their worst ones. But then, as they say, “Concentrate to grow your wealth and diversify to preserve it.”

In fact, one of Buffett’s most ardent followers, Mohnish Pabrai discusses the importance of making big bets infrequently in his book The Dhandho Investor.

So while you may buy a number of stocks for your portfolio, it pays in the long run to put most of your money in your best ideas.

“But I am no Buffett!”
You might wonder – “Buffett was able to unlock value in Sanborn simply because he earned a seat on the board and then spun off the investment portfolio. I can’t buy enough shares to get on the board of a company that I think holds a value unlocking potential! So how could I profit like Buffett did?”

Well, what if I say that you are more empowered than Buffett of 1960?

Yes it’s true! The Information Age empowers you, dear investor.

If you can find a value unlocking potential like Sanborn (though it’s difficult to find such a bargain in a period when information spreads so fast…but just in case), all you need to do is own the stock and then spread the word around.

Sure, nobody may notice your analysis or even care about it at first, but then have faith in what Graham said, “Sooner or later a stock would rise to value.”

As long as your intention is not to find a greater fool to unload your junk upon (which means you are not trying to create a fake market in a junk stock), go out and tell the world about your analysis (like you may share it on the Safal Niveshak Forum :-)).

Your (genuine) story will spread, sooner than later. That will lead to value unlocking.

There have been several cases of value unlocking in India that have earned investors a good amount of money – Bajaj Auto, Cadila Healthcare, Eicher Motors, Zee Telefilms, and Piramal Healthcare are some prominent names that come to mind.

So there’s a potential to earn good returns in this space of value unlocking through special situations. I am no expert in this space, but am really looking forward to learn more (to add to my limited circle of competence).

Next Friday, I will review Buffett’s 1961 letter to partners, which you can read here.

Archives of Wit, Wisdom, Warren

Wit, Wisdom, Charlie: Elementary Worldly Wisdom from Charlie Munger (Issue #1)

Charlie Munger This post is authored by Puneet Khurana, a Safal Niveshak tribesman.

Are you planning to buy a specific car? Go out and you will start noticing that so many people have the same car. You never noticed it was so damn popular!

Astrology column told you that your lucky number is 999, and miraculously you started seeing that number frequently (house numbers, phone numbers, license plates and even the shares quoting at that price). In fact, you see the number so frequently that you feel the universe is trying to tell you something.

Going through a tough breakup? Sadly, every song on the radio is about heartache. As if somebody told the RJ that you were listening.

Or on a more positive note, you are in love and somehow every song is romantic!

Ever witnessed any of those? If yes, it’s called ‘divine intervention’. Or atleast that’s what we are told most frequently.

On a serious note though, psychologists have a different term for it. It’s called ‘Frequency Illusion’ – the fact that something becomes more frequent in your observation once your mind is introduced to it.

There’s more to it. The phenomenon explained above doesn’t stay in its natural occurrence. Human beings have a natural propensity to take this illusion from its passive existence to an active pursuit and the result is that rather than waiting for things to appear more frequent you start looking for them.

Psychologists call this as Confirmation Bias.

Do you suffer from Confirmation Bias?
Let me explain it a bit more. Even though we like to believe that we are objective human beings with rational thought process, nothing can be far from truth.

Human beings as a species are extremely curious, constantly seeking answers to the puzzles existing in the Universe. But unfortunately, our brain has a very limited circuitry and it’s a natural propensity for us to look for easy answers to complicated questions.

Due to this propensity, the mind has the tendency to jump to conclusions. The first plausible answer that the mind finds to a question becomes the ‘near-truth’ and there is a natural resistance to seek more answers and accept it as a conclusion.

This is popularly known as the ‘first conclusion bias’.

Once this idea/thought/conclusion is accepted by the brain, human beings tend to push aside any other observation which disregards the initial conclusion.

So, if we think about it, our whole thought process since childhood is an outcome of subconsciously seeking out books, writings, evidences in support of the ideas we believed to be true (and disregarding the evidences which oppose it).

Just like a vicious circle, the very act of this selective seeking of supporting evidences makes the initial ideas even more prominent till a point we are absolutely convinced that nothing else is truth.

This is what I introduced above as ‘Confirmation bias’.

Francis Bacon puts it succinctly:

The human understanding when it has once adopted an opinion (either as being the received opinion or as being agreeable to itself) draws all things else to support and agree with it.

Since now you are aware of the two biases, let me come to the big gun.

This one was explicitly mentioned by Munger in his speech – ‘The Psychology of Human Misjudgment’ as ‘Availability-Misweighing’ tendency.

It builds on the two biases explained above and states that the mind, due to its limited capacity, works with what is easily available to it. The things are easily available to mind for variety of reasons.

3 reasons we fall for Availability Bias
Reason #1 – Recent activity: Something which is more recent occupies more recalling power in the brain compared to something that happened long ago and hence we tend to weigh that activity as more important than others.

For example, your tendency to go in a train after a train blast (unless you absolutely have to) is extremely low immediately after a bomb blast.

Similarly our tendencies to avoid areas which had terrorist attacks in recent times despite the fact that the place is safer immediately next day after the blast than let’s say 10 years after it.

Gamblers fallacy is a classic phenomenon explaining this bias because of recent events.

Investopedia defines it this way:

When an individual erroneously believes that the onset of a certain random event is less likely to happen following an event or a series of events. This line of thinking is incorrect because past events do not change the probability that certain events will occur in the future.

For example, consider a series of 20 coin flips that have all landed with the “heads” side up. Under the gambler’s fallacy, a person might predict that the next coin flip is more likely to land with the “tails” side up.

Reason #2 – Personal Experience: Something which has happened to us is easy to recall compared to something which has not. Since your all senses are involved in personal experiences, the impression in the memory is significant and hence it’s easily recallable.

Reason #3 – Vividness: The more vivid the thing, the easier it is to recall for the brain. The technique (vividity) which works as a brilliant memory tool, ironically, also acts as an impediment in logical reasoning due to our tendency to overweigh the importance of a vivid event compared to a ‘not-so-vivid’ event.

Add to all the above our tendency to further look for confirming evidences and we have things so strong that they are most often recalled by our brains during the decision making process.

Some of you might be wondering, “Yes, wonderful, very elegant all this is, but can we please switch to investing and stocks? If you haven’t noticed, this site is called Safal ‘Niveshak’!” 🙂

Well, here it is.

Availability bias and investing
First, let’s understand how an investors ‘suffers’ because of this ‘When-I-am-not-near-the-girl-I-love, I-love-the-girl-I-am-near’ fallacy and then see what can be done to avoid it.

The most common behaviour is observed in the panic/euphoric markets. A recent event causing a sudden reaction in the markets, like a terrorist attack causing a crash are the example of this bias.

At times like these, it is imperative for investors to take themselves mentally away from the scene and think objectively as to why the value should be affected.

We all know that value is affected only by two variables – (1) Cash flows and (2) Interest rates.

If there is no reason for these two to change, there is no reason for prices to change. These markets create opportunities for rational investors. Another way this bias affect us is during the evaluation of business prospect. We have a natural tendency to give too much importance to the current or past few quarters.

The reason is simple, the experience of those quarters is very recent and it’s easy for us to recall that straight away. Combine this with the vividness provided by business channels and experts telling you day in and day out what’s great or bad about the company and that makes you overoptimistic or over-pessimistic about the prospects.

Even the contrarian in you sometimes may feel overwhelmed and succumb to “they must know something I don’t” syndrome.

This can be avoided by taking a longer operating history of the business while evaluating it. Almost every prominent investor has emphasized this fact. Look for a long operating history preferably 10 years or more. In a lot many Indian companies, 10 years history may not be available, but take as much as you can and then evaluate the business.

Important: I am not asking you to ignore the recent quarters. The aberration in recent quarter results may or may not be just aberrations.

Structural changes are also very subtle. But the idea is to look the picture from both far off (10 years) and close (recent quarters) without over-emphasizing any view.

Another way in which availability bias impacts investors is the tendency to give too much importance to an idea (let’s take a stock idea for e.g.), the moment it strikes to us.

The sources of the idea may differ. You may have heard about a company from an intelligent friend or a known stock picker or worse, a TV stock expert and you work on it and you agree with the prospect.

Now don’t get me wrong here! It’s good to be excited about something you just ‘discovered’. I am just pointing out to the fact that the tendency is to give too much importance to the one idea. After all, the stock doesn’t know we own it.

Always remember…

An idea or a fact is not worth more merely because it’s available to you.

The examples are many, like:

Overoptimistic about upcoming IPO because your previous IPO investment made money, completely disregarding the fact that in general IPOs have been losing propositions for investors.
Selling a security just because it has risen up substantially in the recent times without giving the regard to the value-price gap.
Buying something just because it has fallen 80% from the peak. (this is also called anchoring bias but I will discuss it later)
Giving too much importance to price movement of recent past.
Giving too much importance to stocks that are covered by the media and ignoring the ones those are not.

And so on…..

But what can rational investors do to deal with this bias?

The solutions have to be customized according to the investor. But here is a general broad guideline which have helped number of investors and which I have found very helpful personally.

Since most of the biases are psychological, unless you are trained to think about them yourself, a written reminder is of utmost use. Infact, we can almost remove all inefficiencies from our thinking process if we follow written procedures (general guidelines).

This idea has been very well explained by Atul Gawande in his book The Checklist Manifesto and the strong idea of checklists have been used and promoted by very savvy investors including Buffett, Munger, Mohnish Pabrai, and Guy Spier.

As a defense against our cognitive disability of remembering everything, checklists help us avoid first conclusion bias. But always remember, the effectiveness of the checklist will be determined not only by its existence but by its exhaustiveness and its ability to accumulate your learning, be it direct or vicarious.

The checklists differ for different kind of investors and the more you read, the more you will be able to develop one. For me personally, checklists serve two important purposes:

Since mistakes made in recent investment operations are recallable easily but mistakes done few years back are not, a checklist serves as a reminder to avoid the same.
Incorporates not only learning from your own investment operations but also from the other investors’ and hence adds the vicarious learning benefit to your process.

Mistakes are very costly in the markets. There are some mistakes we can’t avoid but some we can. As Buffett have told us a number of times…

An investor needs to do very few things right as long as he or she avoids big mistake.

To do: Don’t do all the mistakes yourself. Learn from others, add to your checklist and follow it religiously. (If possible, I will write a separate post just on checklists considering its importance in the investment process)

Another way of avoiding this bias is not a concrete idea like a checklist but a conscious change in the cognitive thought process.

This is what I learned from Darwin, something he wrote in his autobiography…

I had, also, during many years followed a golden rule, namely, that whenever a published fact, a new observation or thought came across me, which was opposed to my general results, to make a memorandum of it without fail and at once; for I had found by experience that such facts and thoughts were far more apt to escape from the memory than favorable ones.

The idea is extremely powerful and the notion behind it is simple: One can never conclusively prove anything but one can conclusively disprove something.

This is the same idea we use in statistics where our objective is to ‘reject the hypothesis’ or else we ‘fail to reject the hypothesis’. We never accept the hypothesis.

Sighting of 100,000 white swans doesn’t conclusively prove that all swans are white but sighting of one black swan disproves the notion. And hence the idea is to consciously seek disconfirming evidences. As I explained above, it’s our natural tendency to seek out what is consistent with our view. So it becomes absolutely imperative to seek out things which disprove us.

It’s a very powerful idea and so many great investors have made it such a habit that now they do it subconsciously. It becomes the way of operating. And this is not only true for investors, but prominent thinkers, politicians, humanists, businessman and countless successful people.

Some examples where I have used this technique in past:

Whenever I have a view on a stock, I don’t read the research reports with the similar conclusions. In fact, if I have a bullish view, I make a point to read all the analyst reports which have a sell on the stock and discuss with them, their viewpoint. Remember, there is no right or wrong, just point of views. Right and wrong are always in hindsight.
When I am studying one school of thought, it’s important to understand other school of thoughts to get the complete picture. I am a proponent of Austrian school of economics but it’s imperative not just to read Hayek or other prominent Austrian economists but also to read Keynes, Krugman etc. to get varied point of views and then decide.
Don’t assume some strategy work because some investor told you so. More so, why not challenge yourself and read Soros and not just Buffett every time. Or on an unrelated topic, when reading Dawkins work on atheism, you don’t only read Dawkin’s ‘The God Delusion’ but also David Bernilski’s ‘The Devil’s Delusion’.

To do: Have lots of ideas. Have opposite point of views and constantly seek out disconfirming evidence. It’s a very essential trait in a profession where our major enemy against our success is our psychology.

Finally, always remember the wise words of Emile Auguste Chartier…

Nothing is more dangerous than an idea, when it’s the only one you have.

About the Author: Puneet Khurana works with an India focused hedge fund. A student of Prof. Sanjay Bakshi at MDI and a CFA (charter awaited), Puneet is an avid reader of books on investing, finance, psychology, philosophy, physics and various other disciplines.

His investing journey has gone from speculating as a college student to investing based on ‘margin of safety’ principle over a period of 9 years. Currently besides his work, Puneet spends considerable time taking guest lectures in subjects like Investment Management and Business Strategy for MBA students and also training CFA aspirants. He blogs at Pragmatic Investing.

Disclaimer: The views expressed in this post are those of the author only and do not constitute in any way an official position, policy, or pronouncement of his employer.

Wit, Wisdom, Warren (Issue #3): The Valuation Junkyard

Image Source: Rediff

Last week, I reviewed lessons from Warren Buffett’s 1958 letter to partners of Buffett Partnerships.

Lest you forget, here is a summary of the key lessons we discussed in that review:

In rising markets, there’s a rise in the ratio of mercurially tempered people – those with rapid and unpredictable changeableness of mood. The overall mood is of exuberance. People invest in stocks for any and every reason. These combine together to further stimulate rising stock prices. Whenever you find such a deadly combination next time, simply run for cover…because such exuberance will always leads to eventual trouble – stock market crashes.
Be very careful while buying illiquid stocks – The impact cost of a large sell order can be huge in case the stock surges and a large investor wants to cash out.
Illiquidity of a great stock can work to your advantage as a small investor. You can buy it over a period of time without impacting the price materially. Then, when big investors come to know the story and take a bite of it, you would’ve already made your money.
Avoid extrapolating short term performance into long term performance. A 30-40% return from your stocks in one year doesn’t mean you will retire a rich investor in 10 years. It never happens!
Use intrinsic value as a reference point to sell stocks – Sell when a stock reaches close to intrinsic value, and also when intrinsic value reaches close to stock price.
Sell a stock (but only when you don’t have any investible cash left) if you can find a better opportunity – one with a greater margin of safety.
Beware of permanent loss of capital…and then when you identify businesses that won’t impair your capital permanently, buy them and be willing to wait for even 10-15 years to create tremendous wealth from them.

Today, I review the letter for 1959.

Wit, Wisdom, Charlie: Elementary Worldly Wisdom from Charlie Munger

Charlie Munger There are only two ways of clearing an exam. The first involves rigorous reading of the books and understanding the fundamental concepts which a subject is trying to teach, and develop a framework.

Once you have a framework, you then assimilate additional information (either via theory or via practical in labs) on that framework to see whether it makes sense or not.

If you are able to do it, the new information is understood and is stored in your knowledge repertoire to be recalled at ease and also to help you understand other things in future.

If you are not able to do it, you improve upon the framework.

The second way, which if not everyone, at least 90% of engineers will agree upon is as follows.

Dear Me

Dear Me As adults, we all nurture the secret wish to go back in time and change a few things here and there, so that our life gets better than it is now, in the present.

“Ah, I wish I had studied harder during my masters!” some might resent.

“Only if I had chosen Commerce over Engineering!” is another common wish.

Some would say, “I would have been richer only if I had behaved better as an investor when I was just starting out.”

And then, “I wish I had started saving and investing 15 years back!”

Well, imagine you are given a chance to flip a switch to go back in time when you were young. What would you do?

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