Patsy in the Game

“As they say in poker, “If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.”” — Warren Buffett

The dictionary defines a “patsy” as someone who is “easily taken advantage of, especially by being cheated or blamed for something.”

Here’s a problem which helps in identifying patsies: Assume that a coin is fair. That is, it has an equal probability of landing heads or tails when tossed. I toss it ninety-nine times and get heads each time. What are the odds of my landing tails on the next toss?

If this question is posed to a mathematics student in school, the answer, almost always will be this:

“The probability of getting a tails on the 100th toss will be 50%.”

When asked to provide the reasoning for that answer, the student will promptly puke out what he or she learnt in school. Which is this:

“These are independent events. The coin has no memory. It does not remember that it landed heads 99 times in a row. The probability of it landing tails on the 100th toss is exactly what it was before each of the previous tosses. And that’s unchanged at 50%.”

This student is a patsy. He or she is displaying what we call as naïvety which is defined as “a state of having a lack of experience, understanding or sophistication, often in a context where one neglects pragmatism in favor of moral idealism.”

What does this mean? It means that the student continues to believe that coin is fair, even if has landed heads 99 times in a row!

A person of “experience, understanding and sophistication” will never make that mistake. Such a person would reason along the following lines:

“The probability that the person who is tossing the coin is lying (or is mistaken) about its fairness is vastly more than the probability that a FAIR coin will land heads 100 times in a row. Therefore, I must bet that the coin is unfair. It’s a rigged game!”

It’s easy to work out the probability of getting 100 heads in 100 tosses in a FAIR coin. That’s simply 0.5^100. Or 1 in a 1,267,650,600,228,229,401,496,703,205,376 chance.

To be precise, that’s 1 in 1 nonillion 267 octillion 650 septillion 600 sextillion 228 quintillion 229 quadrillion 401 trillion 496 billion 703 million 205 thousand 376. That comes to a very very very low probability of  0.0000000000000000000000000000007888609052210118054117285652827862296732064351090230047702789306640625. Not zero, but it might as well be zero.

The person of “experience, understanding and sophistication” will reason that the probability of the coin being rigged is vasty more than 1 in a 1,267,650,600,228,229,401,496,703,205,376 chance. So he will bet that the coin is rigged and that both sides are heads. He will bet that coin will land on heads on the 100th toss. He will not bet on tails because there’s NO tails in the coin.

The moment you discard the belief that the coin is fair, you can no longer believe that those 99 tosses were “independent.” And if you drop the independence assumption, your conclusions change completely.

To those of you who are familiar with Nassim Taleb’s work, you will recognise this as the “Fat Tony problem” in The Black Swan where “Fat Tony” is the street-smart trader of “experience, understanding and sophistication.”

Fat Tony does not take anything on face value. He does not assume anything without evidence. He carefully looks at evidence and he thinks in terms of probabilities.

And if he has to choose between believing that either (1) someone is trying to fool him; or (2) a virtually impossible event will occur, he will pick (1)

And that’s why Fat Tony is not a patsy and he not naïve.

Are there generalized lessons in financial markets from this story? I think there are many. I will list and describe just a few of them. But first let’s go back to that definition of naïvety.

What was the definition? Here it is again. Focus on the CAPITALISED WORDS:

Naïvety: “a state of having a lack of experience, understanding or sophistication, often in a context where one NEGLECTS PRAGMATISM IN FAVOR OF MORAL IDEALISM.”

What do the CAPITALISED words mean? They means that a naïve person believes that the world is a fair and moral place and he is not being fooled, even when the odds of that happening are monumentally higher than those of the other alternative. This person is not “pragmatic,” a term that’s defined as a person who “evaluates theories or beliefs in terms of the success of their practical application.” That is, a naïve person is not a practical person who would see the world as it truly is. Such a naïve person is “morally idealistic” who does not assume ulterior motives in others when he deals with others.

By the way, generally speaking, naïve people are very likeable people precisely because they are not born skeptics, they believe in humanity, they have this cute, child-like innocence (gullibility) about them that makes you, if you are a pragmatic but not a manipulative person, want to be-friend and protect from the “evil world” out there.

But the world of capitalism has this evil aspect to it, this zero-sumness to it which turns naïve people into natural prey for the predator-types. Being naïve in life in general may not cause you much harm if you’re lucky, but being naïve in financial markets could easily ruin you.

Ok, now let me return to some of the “functional equivalents” of the Fat Tony example in the financial markets. Remember, we are dealing with situations where you are being over-trusting of someone else even though there is strong evidence to suggest that you shouldn’t. We are talking about the “functional equivalents” of situations where you think that the coin is fair when in fact it’s overwhelmingly likely that it’s not, and the game is rigged and you are the patsy in the game.

What are these games in the world of financial markets?

Example 1: IPOs

If you buy into IPOs, you are a patsy in the game. The people on the other side of the game (the companies that come to market and their helpers) have certain advantages over you which they will use against you.

One, information asymmetry. They know more than you. They are insiders and you are not.

Two, timing. They decide when to come to market and they will come only when circumstances are more favorable for them. And “more favorable” for them means “less favorable” for you.

Three, scarcity. They can create artificial scarcity by limiting the quantity of shares they will sell in the IPO market and the hype that’s created prior to the IPO will suck in the patsies.

This happens over and over again in IPOs.

Example 2: Heavy Promotions

Generalising from IPOs, anything that’s being heavily promoted where the person doing the promotion is has a financial incentive to pitch you, even if the product or service being promoted is unsuited to you, or even worse, is toxic.

I mean this should be fairly obvious, right? If someone tells you to buy x (say, bonds of a company) and the person who created x, and not you, pays a lot of money to the person who promotes x and if you think that the person pitching you is acting in your interests, then you are a patsy in the game.

This applies not just to investment advice. It also applies to over-promotional managements talking up their stock and sometimes indulging in aggressive accounting to portray a more beautiful picture than reality to basically trap investors.

And it also applies to credit rating opinions and audit opinions.

Let me state one thing here. I am not suggesting that you must never trust credit ratings or audit reports. I am saying that the default position you should take is to not trust them blindly. If you do, then you are the patsy in the game.

Example 3: Spotting Frauds

People who are pragmatic and do not take anything at face value, and are not prone to give into what Robert Cialdini calls “authority bias” and bias from “social proof,” are well positioned to spot frauds well before other “believers” who will turn out to be patsies in the game.

My favorite example here is that of Harry Markopolos and Bernie Madoff. Markopolos is the analyst who spotted Madoff’s USD 50 billion dollar ponzi scheme in the garb of a hedge fund through which he promised and delivered low risk “returns” to willing believers (“patsies”) for decades.

Markopolos is a trained mathematician and a “certified fraud examiner,” a qualification which, you will agree, requires him not to be sort of the person who will “neglect pragmatism in favor of moral idealism.” Among many things in a 61-page testimony (and several other submissions to the SEC) , here’s what Markopolos told the Committee:

“The biggest, most glaring  tip-off that this had to be a fraud was that BM only reported 3 down months out of 87 months whereas the S&P 500 was down 28 months during that time period. No money manager is only down 3.4% of the time. That would be equivalent to a major league baseball player batting .966 and no one suspecting that this player was cheating, and therefore fictional.”

Here, Markopolos is Fat Tony. He doesn’t believe other investors. He doesn’t believe the auditors. He doesn’t believe the claimed performance. Indeed, he thinks the performance is just too good to be true. And he believes that if something’s too good to be true (like landing 99 heads in a row in a “fair” coin), then it probably is.

This “too-good-to-be-true” aspect about Fat Tony, Markopolos, and similar skeptics, may not make them very sociable, likeable creatures. It does, however, prevent them from getting hurt in many “predatory” settings like the financial markets.

Example 4: You Fooling Yourself

While I was writing the above, I was thinking about myself and I thought that well I don’t do IPOs and I am wary about “over promotional” activity in financial markets (although I admit I am not immune and have been burnt more than once), and I don’t blindly trust auditors and credit rating companies. But, all of these are situations where I try to protect myself from being fooled by someone else who has a financial incentive to part me from my money.

And then I thought what about protection from myself? After all does “patsy in the game” have to be a multi-player game? And the answer to that question, in my mind, is an unqualified no.

Patsy in the Game: That game can be a single player game.

Richard Feynman was right when he said that “the first principle is that you must not fool yourself and you are the easiest person to fool.”

Take for example of what happens when you are invested in something and new evidence comes that ruins your  hypothesis. Maybe the business is no longer as good as you thought. Maybe the management is really not as good as you thought or maybe the valuation model was wrong. There could be so many reasons which can ruin any investment hypothesis. The correct thing to do, in such situations, is to recognize the mistake, scramble out of it, and then try not to make that type of mistake again.

Well, the normal outcome, as many of us know, is the opposite. And this happens for reasons we may label as “commitment bias,” “endowment effect,” “psychological denial,” “blind overconfidence” etc etc. We may give this type of tendency all sorts of names, but the reality is that we are really good at fooling ourselves into believing the unbelievable despite contrary evidence.

When we choose to ignore overwhelming evidence showing that we were wrong and continue to stay invested in situations which just don’t make sense anymore, how different are we from that naïve school kid who continued to believe that the coin was fair even after it had landed heads 99 times in a row?

We are not that different at all. And by not being different from that naïve kid, we become a patsy in the game.

END

A New Barber in Town

I read this story on Aircel’s lenders agreeing to take a 99% haircut on dues worth Rs 20,000 crore.

And decided to take a (pathetic) shot at poetry on a Saturday morning…

🙂

A New Barber in Town

I went to Khan Market for a coffee

But I bumped into my barber instead

And in a moment of my utter weakness
I ended up disregarding Buffett



I asked him if I needed a haircut

He took a good look at me and said:

Yes of course you need a haircut!

I mean, what else could he have said?



And while I was getting my haircut

I picked up the newspaper and read

a story about another haircut

and lenders whose money was dead



And as I flipped the pages of the paper 
I found more stories on haircuts

and bankers whose money was now vapour

finding all doors to recovery were shut



I showed the stories to my Barber

He looked at them in anguish and said:

Why aren't bankers coming to me for haircuts?

while his face was angry and red

I thought for a moment, then told him
about the big, new barber in town
Yes, the one who will now do all the trimming
and is called NCLT HAIRCUTS DOWNTOWN

Leveraged Promoters, Haemorrhaged Stockholders

Thread…

  1. Let’s say that a highly-profitable, listed business is un-leveraged but its promoters are highly leveraged in their personal balance sheets. Let’s also say that loans taken by the promoters are secured by the collateral of the promoters’ shares in the listed company.
  2. Let’s further assume that the mistakes were made by the promoters with the money they had borrowed and it’s gone. Or it’s substantially gone. What happens next?
  3. What will happen next is that the lenders who hold the collateral will dump it in the market and the stock price will crash. Some lenders may not do this for a while because of other compulsions such as the need to maintain the relationship with the promoters, or the need to avoid creating a massive selling pressure on the stock etc etc. And so they may enter into “standstill agreements.”
  4. One problem with such agreements is that the incentive to cheat is high. The lender who abandons the agreement and dumps the stock has the best chance of recovering his money. So, he has an incentive to quietly dump the stock. This kind of thinking amongst lenders make standstill agreements (like cartels) inherently unstable.
  5. The other problem is that these agreements are not secret. The market knows. The market knows that the agreement has a limited life and the lenders have thrown a lifeline to the promoters. A lifeline to somehow find the money from somewhere, anywhere to prevent their shares being dumped in the market.
  6. And if the market believes that no money will come or not enough will come (and the market may be right or wrong about this belief), then the stock price will crash because of what we call as “supply overhang.”
  7. Notice, for the stock price to crash, it is not necessary for the actual dumping of shares to occur, although that’s often the case. But it’s not a precondition. Markets set prices based on expectations and not reality. It’s the EXPECTATION of the stock price crash that creates the stock price crash.
  8. And so, for no fault of theirs or the company, the minority stockholders will see the market value of their holdings in the stock plunge by a huge amount leading to a situation I earlier labeled as “Leveraged Promoters, Haemorrhaged Stockholders.”
  9. Many value investors, at this time, think along the following lines: “The stock price has crashed by 50% or even more. The multiple is low. The balance sheet is strong. The problem is not in the company. The problem is in the promotors’ balance sheet which is totally irrelevant for the purpose of valuation. And as the price has fallen but the value remains unchanged, the margin is safety has gone up. This is a wonderful opportunity to buy the stock.”
  10. And it seems logical to think like that. After all, why should the value of a firm depend on what’s going on in the personal lives of its owners? But can this type of thinking go wrong? If so, then under what circumstances?
  11. If we really think a bit more deeply about this, we can visualise situations where the value of the firm is NOT independent of the whatever is happening in the life of the promoters.
  12. One example: If the promoters are in deep shit, but the company they own is not, then there’s always the temptation to raid the coffers of the company to escape from the “clutches of creditors.”
  13. There are multiple ways this can be accomplished. Just make the company borrow money and then get it to lend that money to a company controlled or “influenced” by the promoters, who then pays off their lenders. If something like that happened, clearly the value of the firm is reduced to the detriment of minority shareholders.
  14. Another way: Make the company buy something belonging to the promoters at inflated value and get a friendly and compliant Chartered Accountant to bless the valuation.
  15. I could go on to tell you about many more ways to do this, but I think you get the point. The value of a firm is NOT independent of what’s going on in the personal life of its promoters. And that, of course, is a big reason which explains why markets are wary of companies in which a large part of the promoter stake is pledged. They are wary for the right reasons.
  16. Another Example: If the lenders do dump the stock then whoever buys a lot of it gets to control the company. What if the new owner is a crooked person who will merge the company into his other company by using a highly favorable swap ratio, blessed, of course, by a friendly and compliant Chartered Accountant?
  17. If the ownership of the company is going to change, then to value the business properly, minority investors needs to know how they will be treated by the new owners. And any uncertainty about that must be factored into the valuation equation TODAY.
  18. The reason I am citing these examples is to show that while a stock price crash in such situations is likely to create an attractive investment opportunity, it’s not a sure thing. It’s not a slam dunk. Things can still go very very wrong.
  19. Of course this does not mean that one should avoid investing in such situations post the stock price crash. What it does mean that the investor’s thought process must factor in these hidden risks and the consequences of those risks.
  20. Risk has a way of materialising in ways that people often find hard to imagine. Just as Robert Rubin’s once explained when he described the true nature of risk and who, ironically, saw it manifest itself in his own life a few years later and in the very manner he described it:
  21. “Condoms aren’t completely safe,” Rubin said. “My friend was wearing one and he was hit by a bus.”

END

What can Long-term Value Investors Learn from Traders?

Thread..

 

  1. A few years ago, I was invited to speak at a conference where both the organisers and the audience were hugely dominated by traders.
  2. And the topic that I chose for my talk revolved around one question: What can long-term value investors learn from Traders?
  3. The talk was a long one and it continued till the wee hours of the morning. I spoke about many things but there was one key idea about this talk. That investors can learn to be more detached from traders.
  4. While I believe that the success rate in trading is less than that in long-term value investing (and this belief is debatable), I also feel that good traders are far more detached than value investors.
  5. What do I mean by “detached?” By the term detached I mean the willingness to be objective about the situation. This means first acknowledging that all trading is probabilistic and there are no sure things and what should work often doesn’t. The same, by the way, is true about investing.
  6. Recognition of this reality makes it easier for a trader to quickly change his mind when evidence tells him that he is wrong.
  7. For successful traders, this means that the willingness to readily acknowledge about their being wrong and acting accordingly will preserve their capital.
  8. When they think they are wrong and they act in accordance with that belief and they turn out to be wrong, they will their protect capital from impairment.
  9. Sometimes they will be wrong about their belief that they were wrong too but the consequences of that type of error would typically be opportunity losses. And real losses matter more than opportunity losses.
  10. For a trader, the mindset of capital preservation first, makes him far far more detached than a typical value investor who tends to fall in love with his ideas and cling to those ideas even when evidence warrants a change of mind.
  11. We may give many names to this tendency – confirmation bias, commitment bias, endowment effect etc etc, but it turns out that successful traders do not have these tendencies.
  12. Nor, you will say, do value investors. But traders makes far more decisions than value investors. And for them the need to change their mind in light of disconfirming evidence is far more than for long-term value investors.
  13. It is for this reason why people who want to make living from value investing have much to learn from successful traders. Those successful traders, have had far more practice in changing their minds! And over time they become really good at it. And moreover they don’t sulk about going wrong either.
  14. Successful traders are true Baysians – they routinely think in terms of probabilities and their “systems” allow them to change mind slowly as well as quickly as the situation warrants.
  15. The value of your network is a function of its diversity. This means that if you are a budding value investor, you should have in your network, a few successful traders. Observe them. See how they think. How and why they change their mind. How they truly practice “detachment” – a trait that’s necessary for success whether you are trading or investing.
  16. This type of fertilisation of, not trading ideas, but methods of thinking, has great utility, in my view.

END

A Thread on Diversification

My friend Shyam, wrote an excellent column on diversification. I agree with everything he has written and have some additional thoughts.

Thread…

A Thread on Diversification

  • Diversified conglomerates get a bad rap for very good reasons. One big one, as Shyam points out, is capital misallocation.Companies in diverse industries have, for the most part, destroyed value by allocating precious capital into businesses in which they had little experience.
  • We know this for sure. If a standalone business misallocates capital, then over time, it will wither and die and its value will become zero. This does not happen with businesses residing inside large conglomerates. The capital misallocation continues and the value actually becomes negative.
  • This is an important aspect regarding valuation in conglomerates. The value of a lousy, stand-alone business can never be negative. The least it can go to is zero. But that’s not true for lousy businesses residing INSIDE a conglomerate.
  • Management continues to throw good money after bad and markets punish such companies by valuing them at a discount to their break-up values. We call this “conglomerate discount.” By applying this discount, markets, in effect, assign a negative value to the lousy businesses which should have been shut long ago but which continue to operate thanks to funding from the good businesses in the conglomerate.
  • In markets like India, where many listed conglomerates are controlled by families which have significant equity stakes in them, this “conglomerate discount” persists because activist investors cannot take them over, eliminate the cross subsidies, and break them up.
  • For investors, these situations are what we call as an illustration of “value traps.”
  • The STATED intention of the management for diversification is always the same: that it’s a shareholder-friendly act. But, it’s almost always not a shareholder-friendly act. The UNSTATED intention is that through diversification, controlling stockholders can build bigger empires which is what, deep down, they really want and that’s why they almost never compare the economics of retaining earnings for diversification with that of giving the money to stockholders so they could compound it themselves.
  • Indeed, for value investors who don’t believe in Capital Asset Pricing Model (CAPM) and Modern Portfolio Theory (MPT) with all their greek letters (me included), there is one big and important lesson from these theories. And that lesson is this: Investors can get the benefit of diversification in their own portfolios more efficiently than companies can do on their behalf.
  • But there is one aspect of the stated rationale for diversification which requires our attention. Managements state that diversification will make cash flows more stable. If a steel company gets into the retail business and if two earnings streams have low co-relation, then the combined cash flows will be less volatile that the volatility of each earning stream.
  • Why do we need to pay attention to this rationale? Because it’s the key for understanding the benefits of diversification if we broaden our understanding of the term.
  • Think of a hotel or a theme park company which has one property. Or a B2B manufacturing business with only 5 customers in the same industry. Or a manufacturing company which requires a critical raw material for its operations but has only two vendors for it. Or an FMCG company with just one product.
  • We know that often, this type of concentration – geographical, customer, vendor, or product can have devastating outcomes.
  • In a brilliant interview, value investor Anthony Deden talks about the risk from this “dependence.”  He says: “Dependence makes a system fragile. The more independent an organism is from external weaknesses, the more likely it will endure.”
  • When we think of risk, we should think of worst case scenarios and the CONSEQUENCES of those scenarios materialising. A lot of the people don’t like to think about remote loss scenarios. They like to think along these lines: “Oh that’s scenario is never gonna happen, so there’s not point thinking about its consequences.”
  • Wrong. That’s a totally wrong way to think. People massively underestimate the importance of remote loss scenarios by focusing on the low PROBABILITY of their occurrence instead of focusing on the CONSEQUENCES of their occurrence.
  • What’s the risk of having just one hotel, or just one theme park, or only 5 customers, or only 2 vendors, or just one product? The risk, of course, is that if something adverse happened to any of those “things”, the financial consequences could be deadly.
  • To be sure, there will always be examples of such situations where there was acute concentration and yet it lead to huge success. Coca Cola, for example. In fact it can be argued that intense focus is good. And that people with intense concentration do better than those who are distracted by diversification. And there’s an element of truth in that.
  • But even if it’s true that extreme focus is good, it’s even more true that averaged-out outcomes of over-dependence on a key variable makes the over-dependent entity fragile, it makes it accident prone and accidents happen.
  • The NORMAL outcomes in these situations are not good. If you take a hundred fragile businesses which have just one product, once in a while, you will find a Coca Cola, but a huge majority of those business would have died because of over-dependence on just one product.
  • So, let’s focus on the AVERAGE outcomes or the MOST LIKELY outcomes instead of the exceptional ones which stand out. How should businesses deal with this fragility?
  • Through diversification of course. Any business leader who is acutely aware of a source of fragility in his or her business model, will work towards finding ways to mitigate it.
  • For that business leader, this almost always involves taking very tough decisions. Saying no to a very large customer who wants to give you additional business is never going to be easy. Sacrificing near term profitability for longevity is never going to be an easy trade-off. But it is exactly here that you separate the men from the boys.
  • Which brings me to an important valuation principle which is this: Given two, otherwise identical investment situations, you should pay more for the one which is less fragile.
  • Example: Take two companies A and B. Both are in the same industry. Both have identical fundamental ratios – margins, capital turns, return ratios, revenues, market share, capital structure, etc. The only difference is that A has 5 customers and B has 15.
  • Which one should you should pay more for? Company B, of course. The reason is that the downside risk is lower for Company B.
  • Ok, now here is one of my key points. What’s the difference between diversification of the type that Shyam has written about and the diversification that reduces fragility from geographical concentration, customer concentration, vendor concentration or product concentration?
  • Conceptually, don’t the two appear to be the same? After all, both reduce dependence. In the type of diversification Shyam wrote about, the stated logic is that through diversification into other industries, the company becomes less dependent on a single source of earnings.
  • Similarly, when a company moves from one income producing asset to multiples one, from just five customers to 15, from just two vendors for a critical input to 5, and from making and selling one product to 7 products, isn’t it reducing dependence on a key business variable?
  • If these two situations are the same, then a question arises and they question is this: Why, on one hand, should investors pay more for a company which reduces fragility from dependence on a single variable, while on the other hand, pay a discounted price for a diversified conglomerate?
  • This is a seemingly paradoxical question which I will not answer here because I want to leave some mystery for you to work on. 🙂 One hint though: The answer is there in Shyam’s column.
  • Will end this thread by two examples. One is that of a company called Western India Palm Refined Oils. A few decades ago, if that company had not diversified from edible oils into IT Services, we would not have heard much about that same Indian company now called WIPRO having a current market cap of USD 25 billion.
  • Finally, if a guy called Jeff had not diversified away from books, we would not have seen an American company reach a market cap of almost one trillion dollars.

End

Ashoka University Lecture on The Practical Utility of Seven Math Ideas

This is a re-recording of an expanded version of a talk delivered by Sanjay Bakshi to undergraduate students of Ashoka University on 23 March 2019.

Link

Moneylife Lecture

I delivered my 4th Annual Moneylife Lecture recently.

You can watch it from here (paywall, no payments to me).