Oh, Those Weapons of Mass Distraction!

Despite the fact that I don’t watch TV, my “anti-library” — books I own and desperately want to read but can’t just find the time do it — keeps growing.

A while back I realized that the most deadly weapon of mass distraction in my life is my smartphone. With apps like Twitter and Facebook on it, it’s just too tempting to go to them than to reach out for my Kindle where most of my books reside waiting for me…

And so I decided to take action.

I deleted Facebook and Twitter apps from my smartphone. I can still go to them through my browser but I have to log in every time. (can’t delete the browser damn!). And because that requires some effort, the time I spend on those apps has dropped by more than 70%

On my laptop (macbook pro) I use technology to fight technology. I have actively started using this app called Self Control. It’s an absolute boon because it

lets you block your own access to distracting websites, your mail servers, or anything else on the Internet. Just set a period of time to block for, add sites to your blacklist, and click “Start.” Until that timer expires, you will be unable to access those sites–even if you restart your computer or delete the application.

For several hours of the day, I block myself from all social media and google news (noise?).

Then, I switched off most notifications from my phone. No more sound or vibration when a message (including from dear wife) or a mail arrives and no notification on number of unread messages/mails etc. I also switched off most notifications on my laptop. And I use the do-not-disturb feature on my iPhone which blocks all calls or messages or those from unknown numbers as long as I want.

For my professional work, which requires focus on long term fundamental performance rather than real time stock price movements, I deleted the google finance bookmark from my laptop and deleted all apps on my phone which gave real-time stock prices. Sorry Bloomberg!

I love technology and what it can do for me. But I absolutely hate it’s ability to distract me from reading and from my work. The above measures have caused my productivity to increase significantly. Perhaps, they will be of some use to you. If you have any tips on how to win against weapons of mass distraction (no I don’t want to give up my smartphone or my laptop!), please share them.

Thank you.

Sanjay Bakshi

The Eventual Consequences of Risk Seeking or Risk Blind Behavior

On 23 January, I had the privilege of addressing a group of investors at Mumbai Stock Exchange. The event was organised by Moneylife. Here is an edited transcript of my talk.

The Eventual Consequences of Risk Seeking or Risk Blind Behavior

This is going to be a personal talk based on whatever little experience I have accumulated over 21 years of practicing value investing in India. I think many of you will disagree with what I am going to say. I don’t have a problem with that. Think of what I am going to tell you as merely strong hunches of mine which I have stumbled upon over the course of 21 years.  Following these hunches has worked well for me.

These hunches came to me slowly over a long period of painful, direct experiences as well as vicarious experiences acquired through much reading and reflection upon the causes behind the unfortunate losses faced by many investors.

On 27 October 2011, two stuntmen were shooting a scene for a movie called The Expendables 2 starring Sylvester Stallone, Arnold Schwarzenegger and Bruce Willis. One of the scenes involved throwing a live grenade in water to create an explosion.

This is what happened:

Kun Liu died in this horrible accident. He was 26 years old.

You will recall this man from TV — Steve Irwin, the crocodile hunter.

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On 4 September 2006, while filming a documentary in Batt Reef, Queensland, Australia, Steve approached an 8 ft wide stingray from behind.

StingRay

Much to his surprise and shock – this had never happened before — the fish reacted as if a shark was attacking, striking him several hundred times in his body with its tail spine in a few seconds. Steve initially believed he only had a punctured lung but the tail spine had pierced his heart. He bled out and died.

He was 44 years old.

Stuntmen and documentary makers aren’t the only ones who display risk seeking or risk blind behavior. Here are a few more examples.

And here some examples that many of you will relate to.

What are the eventual consequences of risk seeking behavior? That is, if you persist with behavior that’s risky, then what will happen to you?

In my view, the answer to that important question is provided by one of the principles of probability. And it’s a principle which  all of you studied in high school. That principle states that probability of one occurrence of a rare event, if you increase the number of trials tends to become 1. That is, if you keep jumping out of planes with parachutes which fail to open just 1% of the time, you will eventually get killed.

Two Questions

Now, let me pose two questions which I will then try to answer.

  1. Why do people indulge in such behavior?
  2. What are the “functional equivalents” of such behavior in the world of business and investing?

Well, anyone who has studied Charlie Munger knows that such lollapalooza outcomes are not caused by a single force. Rather, they occur when multiple forces working in the same direction, combine. So, let’s use this approach to answer the first question: Why do people indulge in such behavior? In fact, let’s focus on just one situation. Why do people jump red lights and die or kill someone else? This is a very interesting question.

Part of the answer is that people who jump red lights are over-confident. While they may know the risk of sudden death exists, they believe that risk doesn’t apply to them. After all, over-confidence is a natural human tendency. Ninety percent of drivers think that they are better than average drivers and better than average lovers. Can they all be right? Of course not. But let me assure you that I am an above average driver and lover and no you are not allowed to check this from my wife who is sitting in the audience.

But such a lollapalooza outcome cannot be explained by just over-confidence. There has to be more to it for sure. But what? Let’s think about that. What else can contribute to such an outcome? Well, clearly there is social proof — the biological tendency to copy similar others. There’s also loss aversion or what Charlie called deprival super reaction. The fellow who sees a light turn from green to yellow is experiencing the psychology of a near miss as in  I am going to miss this chance, no no no that’s not acceptable, if I accelerate, I will go through.”

We know that when people face losses — in this case lost opportunity to go through a green light — they become risk seeking. It’s a like a flip switch. It happens in a flash of a second. When the switch flips, the driver is no longer rational. He is incapable of thinking that he is approaching a dangerous situation and that he must slow down. His mind is already make up. And it’s a decision that could kill him or someone else.

Now, let’s answer the second question: What are the “functional equivalents” of such behavior in the world of business and investing?

Well one that comes to mind immediately is open-outcry auctions. What happens in such situations? Well, the normaloutcome is that people go crazy as this scene from Only Fools and Horses shows.

We know this happens. But if we stop and think about the causal factors we will find more than one because such lollapalooza outcomes don’t happen because of just one thing. And an open-outcry auction situation is a very interesting social setting where multiple models from psychology like authority (where the auctioneer is a symbol of authority who not only certifies the authenticity of the object being auctioned, he also announces an initial big price which serves as an “anchor”, social proof (caused by observing other bidders bid up the price), the incentives of the auctioneer (the higher the price at which the object sold, the more the money made by the auctioneer), reciprocation/retaliation (resulting in competitive bidding), envy , low contrast effect (every new bid is a small increment over a previous bid), commitment bias (every bid and escalation of the bid is a public commitment), overconfidence, and deprival super reaction (caused by the countdown to end of auction) combine to turn this social setting into something like a death trap.

And what are the consequences of such behaviour in the world of business? Let’s take a look at just one example (there are many others) — that of Tata Steel’s disastrous  acquisition of Corus in 2006 in an competitive open-outcry auction.

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Just before Tata Steel’s first bid on 20 October, 2006, the market cap of the company was about Rs 26,000 cr. Tata steel. On 31 January, 2007 Tata Steel won it’s bid for Corus after offering 608 pence per share for the target company, valuing it for about $11 billion. Eight years later, Tata Steel’s market cap stands at Rs 23,000 cr. What an amazing case of value destruction! And  Hindalco’s acquisition of Novelis was not different.

Knowing what happens to people who get into open-outcry, auction-like situations, psychologically astute people like Buffett and Munger have a no-fault rule when they get invited to auction situations.

The rule is: Don’t Go.

Now let me tell you something about no-fault rules. The idea behind having a no-fault rule to prevent horrendous losses from risk-seeking behavior like the one described above, even though following such a rule may result in a few lost opportunities. The cost of missing those opportunities is reckoned to be minuscule as compared to likely losses from indulging in risk-seeking behavior. This is an important philosophical point to keep in mind.

The Value of Vicarious Experience

If you spend enough time reading about human folly across multiple disciplines, you will get plenty of vicarious experience in the spirit of the man — Charlie Munger — who said that you don’t have to pee on an electric fence to learn not to do it.

Indeed, part of the idea behind vicarious learning is to watch people pee on electric fences from a distance and yet feel their pain and keep telling oneself — Oh boy, I never want to end up like them.

Unfortunately, despite all the reading that I’ve done, I didn’t get all the experience cheaply and vicariously. I peed on many electric fences and have plenty of scars on my body. But 21 years is a fairly long period of time to help me come up with those hunches I mentioned earlier. Those hunches helped me formulate some of my own no-fault rules and today I will share three of them with you.

No Fault Rule # 1: Stay Away from Leverage

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Borrowing Money to Finance Purchase and Holding of Shares

It took three ruined holidays for me to learn this. It’s kind of spooky. Every time my family and I went on a holiday to a place whose name ended with “LI,” leverage ruined it completely.

First time this happened was when we went to ManaLI in May 2004.

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The market dropped 27%.

In May 2006, my wife and I went to KasauLI and this happened.

02After peeing twice on those two electric fences, my family and I decided to go to BaLI. In Jan 2008.

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And each of those holidays were ruined because we would get margin calls and we would have to sell stocks and suffer huge losses in order to meet our obligations.

My wife loves traveling and she jokingly said let’s go to ChiLI to see if this “LI” thing really works.

I said let’s not take debt to finance the purchase of shares anymore. The stress — both financial and psychological — was just too much.

And that was that. After that there have been other periods of market declines but no margin calls and no stress! So this became a no-fault rule.

Derivatives

Another no-fault rule relating to leverage was to do with using derivatives.

Derivatives are a zero sum game. That’s well known. But I have a hunch that the overwhelming majority of those who deal in derivatives lose money. I would speculate that the proportion of participants who do well in derivatives is very small.

I have friends who trade in derivates and have done well but they are very few. The vast majority of investors I know have, on balance, lost money in derivatives. Some of them have blown up millions of dollars.

The other thing that bothers me about derivatives is that they do to your brain as this cartoon in Where are the Customers’ Yachts show.

Derivatives

If you trade derivatives, my hunch is that you’ll lose focus on what really works — long-term buying and holding of quality businesses at reasonable prices. Derivatives have the capacity to turn you from an investor into a gambler.

My own experience with derivatives was just horrible. When I shorted a stock it would go up more than 50% which would totally ruin my sleep apart from the financial pain. I would be forced to close my position. In two such situations, the stocks I shorted ultimately declined by more than 90% from their peak levels but I couldn’t benefit from that. I only proved Keynes right when he wisely said: Markets can stay irrational longer than you can stay solvent.

And the stress was just too much. The pain of putting up MTM margins every time the market moved against you caused many sleepless nights.

Warren Buffett has called derivatives financial weapons of mass destruction. In my view, they are also weapons of mental destruction.

In one special situation operation I was was bought a convertible security issued by Network 18 and simultaneously shorted the underlying common stock to lock in a return. I had a very close shave on that operation which required several roll overs of hedges. Soon after the hedge was unwound, NSE removed the security from F&O trading. Had this happened earlier, my so called hedged operation would have fallen flat on its face. My experience with derivatives proved Robert Rubin right when he said: Condoms aren’t completely safe. My friend was wearing one but was hit by a bus.

The story of LTCM blowup demonstrates what happens when you combine complexity, leverage and risk seeking behavior.

These two gentlemen (along with Fisher Black) received Nobel prize for creating the famous Black-Scholes option pricing.

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Their hedge fund called Long Term Capital Management (LTCM) did exceptionally well for a while and then, over just a course of a few days, it imploded.

LTCM

Warren Buffett has a fantastic lecture on this topic in which he analyses this lollapalooza outcome. I think everyone should watch that video a few times a year to see what happens to people who indulge in risk-seeking behavior and combine it with extreme leverage and complexity.

Buffett uses a wonderful metaphor of a gun with a million chambers in it with only one chamber which has a bullet in it. He then states that if someone offered to pay him any sum of money to put the gun on his temple and pull the trigger once, he will decline. No matter how high the offer, he would decline.

This is a very important principle of probability that was ignored by the founders of LTCM and also ignored by many others I described earlier. The principle is that if there is a remote loss scenario with a financial and/or reputational outcome that’s unacceptable, then no matter how low the probability of that outcome, actions that can produce that outcome must be rejected. Or, as Warren Buffett puts it

A small chance of distress or disgrace cannot, in our view, be offset by a large chance of extra returns.[1]

This is the same point I made earlier which is that many people don’t think deeply enough about the consequences of remote loss scenarios. Instead, they only focus on weighted average expected returns which look so good because the weights of the remote loss scenario are so small in the expected value table.

And so, most of the time they make money in trades that have horrible remote loss scenarios but excellent expected returns.

Ultimately, however, the odds will catch up and it’s only a matter  time before they blow up. It’s not a question of if they will blow up. Rather, it’s a question of when. If you keep jumping out of planes with parachutes which fail to open just 1% of the time, or while pointing at your temple, keep pulling the trigger of a million-chamber gun which has just one bullet in one of the chambers, you will eventually get killed.

So, in a sense, some situations, by their very nature are what I like to calls as “Accidents waiting to happen.” And that’s exactly what happened at LTCM ultimately. In my view, those guys at LTCM were not any different from these guys at the guys who blew themselves on the boat.

Highly Leveraged Companies

So, that was my first example on leverage. But there are more. Over time, I also started appreciating the wisdom of avoiding excessive leverage in capital structures of businesses I was analysing for investment.

To arrive that this conclusion, I was deeply influenced by the writings of Charlie Munger, Warren Buffett, and Marty Whitman.

Here’s what Mr. Munger once said:

Obviously, if you leverage enough, you can get higher returns on equity, but you often have are chance of disaster. I think we are more disaster-resistant than most other places. As a friend of mine once said, “I don’t want to go back to go. I’ve been to go.”[2]

Here’s what Mr. Buffett has written on the subject:

Huge debt, we are told, causes operating managers to focus their efforts as never before, much as a dagger mounted on the steering wheel of a car could be expected to make its driver proceed with intensified care. We’ll acknowledge that such an attention-getter would produce a very alert driver. But another certain consequence would be a deadly — and unnecessary — accident if the car hit even the tiniest pothole or sliver of ice. The roads of business are riddled with potholes; a plan that requires dodging them all is a plan for disaster.[3]

Whenever I see a leveraged structure, I think about “potholes” — time overruns, cost overruns and far too optimistic revenue projections — and the consequences of encountering them on the fixed charges coverage ratio[4].

And all too often, when I factor in “potholes,” projected fixed charges coverage ratio would become 1 or even less. And the consequences of that happening are almost always devastating for the value of the common stock.

As fixed charges cover moves from a higher number towards 1, the value of equity shrinks dramatically. If pre-tax owner earnings can barely cover rent on other people’s money and property, then there’s nothing left over for the poor common stockholder at the end of the queue.

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Take, for example, the colossal wealth destruction in five of these large, highly leveraged Indian businesses which I happen to observe from a safe distance

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The stockholders of these companies, in a sense, have gone back to go.

Many years ago I read this by Mary Whitman

For a common stock to be an attractive investment, the company ought to have a strong financial position that is measured not so much by the presence of assets as by the absence of significant encumbrances, whether a part of a balance sheet, disclosed in financial statement footnotes, or an element that is not disclosed at all in any part of financial statements.[5]

That, and other similar advice I got from superinvestors like Buffett and Munger helped as well my own experience of observing the horrible averaged out outcome for stockholders of highly-leveraged companies, made me realize just how little margin of safety exists in such businesses.

Finally, I feel that leverage also has a moral dimension. For two reasons. One, in every single episode of financial excess, you’ll find leverage. It’s always there in some form or other. In his wonderful analysis of many episodes of past financial excess, John Galbraith writes:

All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets. This was true in one of the earliest seeming marvels: when banks discovered that they could print bank notes and issue them to borrowers in a volume in excess of the hard-money deposits in the banks’ strong rooms. The depositors could be counted upon, it was believed or hoped, not to come all at once for their money. There was no seeming limit to the debt that could thus be leveraged on a given volume of hard cash. A wonderful thing. The limit became apparent, however, when some alarming news, perhaps of the extent of the leverage itself, caused too many of the original depositors to want their money at the same time. All subsequent financial innovation has involved similar debt creation leveraged against more limited assets with only modifications in the earlier design. All crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment.[6]

Every time I read that passage in Galbraith’s book, I think  about how right he was on that one.

The second reason why I feel leverage has a moral dimension is that it attracts crooked people.

If a casino opens in an otherwise nice neighbourhood, soon you’ll start seeing a lot of sleazy, crooked characters in that neighbourhood and pretty soon crime rates will soar. In a sense, the same logic applies to leverage. If you were a sleazy, crooked businessman, why would you have an all-equity capital structure? You would want stupid, gullible people to buy your bonds or stupid, gullible, or corrupted banks to lend you money.

Now, I don’t want to take names here but I think you are getting my point.

And the reverse is also true. By and large, you will find a lot more morality in debt-free companies. Now, of course this doesn’t mean that all leveraged companies are immoral. Far from it. What it does mean is that a disproportionate number of businesses whose equity market caps gets destroyed have leverage on the crime scene.

I don’t think it’s a coincidence that the market cap of all the PSU banks now is less than that of just one HDFC Bank. This has a lot to do with the morality of those places…

No Fault Rule # 2: Seek Protection from Nature

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Nature is pretty brutal place to be in. As Garrett Hardin writes, Capitalism involves

bringing potentially useful but diffusely distributed materials together, concentrated. For several thousand years human beings have been concentrating various metals from their ores (iron, copper, and so on), thus making possible the manufacture of tools and machines, which greatly increase our ability to wrest a living from nature. We never create atoms of copper or iron, but we certainly concentrate them and rearrange them into more useful configurations.[7]

One of my key learnings as a value investor is that the closer you get to nature, the more you’re playing with fire. By “nature” I mean anything you get out of the ground — metals, minerals, oil whatever. These economics of things is so damn hard to predict accurately and these things experience just too much price volatility. Take a look at this chart which depicts the long-term movement of the Bloomberg Commodity Index which tracks the prices of 20 commodities including Aluminium, Crude Oil, Copper, Corn, Cotton, Gold, Natural Gas, Nickel, Silver, Sugar and Zinc.

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That index is now back to where it was in 1991. Crude oil alone has gone from less than $10 a barrel to $140 a barrel and now at less than $30 a barrel. When it was at $140, people were talking “peak oil” and now when it’s at below $30, the world is awash in oil.

In terms of probability, the problem with such industries is to do with ranges of outcome. They become very wide. Indeed, they become so wide, that even trying to value businesses in such industries should count as speculative. But when people have elaborate excel models and minds which tend to overweight recent experiences, they end up extrapolating near term trends. If prices are going up, they assume they will stay up and when they are going down they assume that they will keep going down even more. Charlie Munger calls this type of blind extrapolation not just slightly stupid, but massively stupid.

Investors should recognise that some things, by their very nature, are just too hard to predict. The value of ONGC at at $30 per barrel oil price is going to be vastly different from its value at $140 a barrel oil price. But people who are hell bent on trying to value ONCG (or Cairn or any oil company for that matter) try to deal with the massive uncertainty by using scenario analysis. They assign subjective probabilities to pessimistic scenario like a $30 per barrel, optimistic ones at say $140 per barrel and many other scenarios in between and then compute weighted average value. That’s the functional equivalent that 6 ft. tall statistician who drowned in water which was, on average only 4 ft. deep. He forgot that range of depth was between 1 ft and 7 ft.

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In my course at MDI, I give two exercises to students to check their confidence levels. I ask them to privately write down their estimate of the weight of an empty 747 jumbo jet in tons and the diameter of the moon in kilometres. I ask them to specify ranges with 90% confidence. That is, I ask them to state that “I am at least 90% sure that weight of the jumbo jet is between x tons and y tons and the diameter of the moon is between x kilometres snd y kilometres” where they have to specify x and y.

About 90% of them get it wrong despite the fact that they were free to chose very wide ranges that would guarantee that the correct answer lied within their specified range. For example, if a student is unsure about the weight of the plane (correct answer is 177 tons), she might say “I am 90% sure that it’s somewhere between 5 tons and 10,000 tons). Well, most students end up giving very narrow ranges and the correct answer falls outside their ranges more than 90% of the time.

The purpose of these exercises is to demonstrate that when it comes to thinking about natural resources, most people’s worldview is just too narrow and the world will tend to surprise them. When oil is at $30, its hard to visualize that it could go to $140 or $200 or $500. But who the hell can knowwhere it will go? Similarly, when it was at $140, it was hard to visualise that it could drop to $30 or $10 or $5.

The consequences of being wrong with one’s predictions in situations where the ranges of outcome are likely to be very wide — and that’s certainly the case when one is dealing with natural resources — can be devastating.

The problem is further compounded by financial leverage. Many of the businesses in such industries take on enormous amounts of debt for expansion during good times. Unfortunately, such times never last. And when the tide turns, many participants are found to be swimming naked.

The big lesson for investors here is that when you combine high volatility inherently present in a business model with financial leverage, you get extreme volatility in equity valuations. During good times these businesses may have reasonably strong balance sheets, and excellent profit margins. In bad times, they end up with huge debt and evaporation of profits. This swing from riches to rags is also reflected in their equity market values as the chart below shows.

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Ben Graham was quite aware of the futility of trying to make predictions about the value of equity in such businesses. He wrote:

The analyst must recognize that the value of a particular kind of data varies greatly with the type of enterprise which is being studied. The five- year record of gross or net earnings of a railroad or a large chain-store enterprise may afford, if not a conclusive, at least a reasonably sound basis for measuring the safety of the senior issues and the attractiveness of the common shares. But the same statistics supplied by one of the smaller oil- producing companies may well prove more deceptive than useful, since they are chiefly the resultant of two factors, viz., price received and production, both of which are likely to be radically different in the future than in the past.[8]

After observing many investors experience permanent capital loss because of overconfident bets on businesses that were too close to nature, I became quite averse to investing in such businesses. I looked for protection.

Now, we don’t have time to discuss all kinds of protections from ravages of nature, we can talk about just one of them. It’s a very simple idea called “buy commodities, sell brands.”

Many businesses which consume commodities to make things which are sold as branded products, have adequate protection from nature. Because of the brand and the market dominance, they enjoy pricing power which acts as a solid protective device. When input prices rise, these businesses can raise their product prices without fear of loss of unit volume or market share. And when input prices fall, they can choose to retain some or even all of the cost reduction. This ability to protect themselves from the extreme volatility of product prices allow such businesses to display far less volatility in profit margins as compared to those of their suppliers who do not possess any such protection from nature. And this reduced volatility narrows the ranges of possibilities. This makes these businesses models far more amenable to investment analysis instead of speculative guessing.

As I was preparing for this talk, I saw this tweet from The Economist and rolled my eyes.

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Apparently, there’s is a global shortage of Lithium Carbonate at present and prices are soaring. No doubt the existing producers will be experiencing bumper profits. Eventually, however, those very profits have within them the seeds of future profit destruction because of strong incentives to increase production. There is little protection for Lithium Carbonate manufactures from the inherent volatility in their business model.

Why play with fire?

No Fault Rule # 3: Be Wary of Promotions

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Example 1: Prediction Newsletter Scam

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Imagine that one day you receive a newsletter in which you’re offered a free stock market prediction. Reliance Industries would rise by more than 10% during the course of the next month. One month later, you notice that Reliance was up by 12%. A coincidence, you think.

The next edition of the newsletter predicts that Reliance will fall by at least 10% over the next month. And lo and behold, when the month ends it turns out that Reliance was down by 11%! Still, two correct predictions don’t mean much and you wait for the next edition.

The next prediction turns out to be right. And the next one. And the next one. And the next one. This is too much, you think!

Now, let’s just step back a bit and look at what was really happening. The fellow who sent the newsletter had no clue about what will happen to Reliance. But he knew that at least one the scenarios will play out. Either the stock will rise by more than 10%, fall by more than 10% or stay range bound between -10% and +10%. And so he decides to publishes three different newsletters with three different predictions and send each of them to three different set of people. A total of 364,500 people are selected which are then divided into three equal groups of 121,500 people each. Each group gets one prediction.

Clearly, one third of the people who receive the newsletter will get the correct prediction and the publisher would know who those people are. For the next newsletter, he identifies those people and further divides them into three equal groups of 40,500 people each and sends three different predictions again. And you can see where this is headed and I summarise this in the table below.

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By the end of a month after the 6th newsletter is issued, there would be 500 people who would have received six correct predictions in a row and who, by now, would be hugely impressed by the “predictive abilities” of the publisher.

The fellow will now send  a letter to each of these people offering to send them his next prediction at a subscription price of Rs 300,000. Clearly, many people will fall for this scam and will not only part with Rs 300,000 for something useless, they will end up acting on next useless prediction and may lose even more money. Indeed, many of such gullible people will be so overconfident of making money that they might make leveraged bets that would pay off handsomely if the next prediction turned out to be true.

The funny thing about this example is that people who pay for these predictions never stop to ask themselves as to why is the fellow selling his predictions? I mean, if he is so good about his predictions, should he not use them to make money for himself? The truth of the matter is that people wan’t to be told by someone how the future will unfold, even if there is no value in the predictions. As Peter Lynch wrote:

There are 60,000 economists in the U.S., many of them employed full-time trying to forecast recessions and interest rates, and if they could do it successfully twice in a row, they’d all be millionaires by now…as far as I know, most of them are still gainfully employed, which ought to tell us something.[9]

When I talk about this prediction newsletter scam example in my talks, many people in the audience laugh at the gullibility of the people who will fall for this scam. But, if you look carefully, you’ll find the functional equivalents of this scam. Take, for example, mutual fund advertising. How often does one get to see the performance track record of allproducts of a mutual fund company in an ad? Not very often. Most of the time, you’ll only get to see ads highlighting the performance of the best performing product. That’s the one they will promote while keeping silent about the others. They will make and promote products which are sellable at a given time instead of selling what’s right. That’s exactly the allegation made by John Bogle when he writes

Wall Street has become a place where salesmanship trumps stewardship; where marketing trumps management; and where the mutual fund industry has changed from a business in which “we sell what we make” to one in which “we make what will sell.”[10]

A big part of the reason behind all the salesmanship is, of course, the incentives. As Charlie Munger once said

Any time you create large differences in commissions where the guy gets X% for selling A, which is some mundane thing and 10 times X for selling B, which is something toxic you know what’s going to happen.[11]

In financial markets, if you end up buying products that are being promoted to you, you are very likely end up buying something toxic.

Investors must realise is that there is all kinds of promotional behavior in financial markets and prediction newsletter story was just one example. I will provide a few more examples but it’s very important to be able to sense when something is being pushed towards you and then you must follow Newton’s third law and push back.

Example 2: Boiler Room Operation

Here is a wonderful example from the movie “Boiler Room” which illustrates not just the power of incentives but also a confluence of models from psychology to produce a lollapalooza outcome. Watch this video.

In a typical boiler room operation the operators get a huge commission (sometimes as high as 40%) from dubious companies to promote their toxic shares to the gullible public.

In this extraordinary scene in the movie, a junior broker initially cold calls the doc and offers him “one idea and one idea only” (scarcity principle), and when he finds that his victim is a doc, he stars talking about a dubious pharma company which is in the “third stage of FDA approval.” Those words are clearly designed to invoke greed in the victim because he knows that doctors know what potential blockbuster drugs can do to the profitability of drug companies.

Once the doc bites on the bait, the junior broker tells him that he will ask a “senior broker” (authority bias) to tell him more about the prospective “investment.” Vin Diesel, who plays the role of the senior broker then steps in and uses multiple weapons of influence on the doc. He starts by telling that the stock he wants him to buy is experiencing “very high volume” (social proof). He tells him that if doesn’t buy the stock through him, he will see his colleagues get rich (envy). He pretends to open the door of his office so the sound of brokers screaming can be heard by the doc (social proof). He tells him to decide quick because he has a million other calls to make to “other doctors who are already in the know” (social proof, scarcity, envy). When the doc agrees to buy he offers to sell him no more than “2,000 shares” (anchoring effect, foot in the door technique, commitment bias). And of course he does all this because of the super power of incentives as reflected in the high commission he will make on this and subsequent sales he makes to the doc. The commissions are so high that he will do anything, no matter how unethical, to entrap the poor doctor.

The scene from Boiler Room shows just how difficult it is for customers to resist buying something that’s been heavilypromoted to them.

Example 3: IPOs

Another big example of heavily promoted merchandise in financial markets is that of new issues or Initial Public Offerings (IPO’s).

Screen Shot 2016-02-23 at 21.53.21

I started my career in investing in IPO’s in mid 1990’s. Now, I never buy into them. So, this is another no-fault rule that I follow. There are three reasons why I follow this no-fault rule. One, as Graham wrote:

New issues have special salesmanship behind them, which calls therefore for a special degree of sales resistance.[12]

Two, the structure of the IPO market makes it hard to find bargains. As Buffett writes:

An intelligent investor in common stocks will do better in the secondary market than he will do buying new issues. The reason has to do with the way prices are set in each instance. The secondary market, which is periodically ruled by mass folly, is constantly setting a “clearing” price. No matter how foolish that price may be, it’s what counts for the holder of a stock or bond who needs or wishes to sell, of whom there are always going to be a few at any moment. In many instances, shares worth x in business value have sold in the market for 1/2x or less.

The new-issue market, on the other hand, is ruled by controlling stockholders and corporations, who can usually select the timing of offerings or, if the market looks unfavorable, can avoid an offering altogether. Understandably, these sellers are not going to offer any bargains, either by way of a public offering or in a negotiated transaction: It’s rare you’ll find x for 1/2x here. Indeed, in the case of common-stock offerings, selling shareholders are often motivated to unload only when they feel the market is overpaying.[13]

Three, even if I love the business and the valuations of the business which is about to go public, I have no way of evaluating the track record of how management treats minority shareholders and my investment process requires that I have comfort on that front before I make an investment. If the business is truly outstanding then there will be multiple opportunities to own it over the many years after it’s gone public. So, I never rush into buying into heavily promoted IPO’s no matter how desirable the prospects. As for the behavior of investment bankers promoting IPO’s, I think not much has changed about their behavior since this was written in an article about them in 1894.

Firms of old standing vied one with the other in foisting unremarkable rubbish on the guileless investor.

Example 4: Over Promotional Companies with Little Substance

There used to be a company called Temptation Foods which had little substance but was crazily promotional. In fact it overdid the promotional bit so much that it’s annual reports are collectibles. Here are a few pages from them.

Screen Shot 2016-02-23 at 21.54.19

Screen Shot 2016-02-23 at 21.54.33

Screen Shot 2016-02-23 at 21.54.41
Screen Shot 2016-02-23 at 21.54.47

Even the Auditors Report was not spared!

Screen Shot 2016-02-23 at 21.55.00

The funny thing about this company is that it was able to sell its shares at lofty valuations to institutional investors. The company is now defunct and the stock is no longer traded but I like to cite its example to show just how important it is for investors to shield themselves from over-promotional managements of businesses with little substance.

To be sure, it’s the job of promoters to promote their businesses. When they do that, we should recognize that they are simply playing their part. As investors, our part, on the other hand, is to not get influenced by representations made by over-promotional managements.

Conclusion

In conclusion, I would like to list the three “no fault” rules I talked about:

  1. No Fault Rule # 1: Stay Away from Leverage
  2. No Fault Rule # 2: Seek Protection from Nature
  3. No Fault Rule # 3: Be Wary of Promotions

Following these rules has helped me avoid horrendous and permanent capital losses. I hope that you’ll find them useful.

Thank you!


[1] Warren Buffett’s Letter to Shareholders of Berkshire Hathaway Inc. in its 1999 Annual Report.

[2] Charlie Munger speaking at 2001 AGM of Wesco Financial.

[3] Warren Buffett’s Letter to Shareholders of Berkshire Hathaway Inc. in its 1990 Annual Report.

[4] Estimated pre-tax owner earnings before fixed charges/fixed charges, where fixed charges comprise of interest on debt and rent on other people’s assets.

[5] Martin Whitman in The Aggressive Conservative Investor

[6] John Kenneth Galbraith in A Short History of Financial Euphoria.

[7] Garrett Hardin in Living Within Limits: Ecology, Economics, and Population Taboos

[8] Graham and Dodd’s Security Analysis.

[9] Peter Lynch in One Up on Wall Street

[10] John Bogle in Foreword in Stewardship: Lessons Learned from the Lost Culture of Wall Street by John Taft

[11] Charlie Munger speaking at 2001 AGM of Wesco Financial

[12] Benjamin Graham in The Intelligent Investor

[13] Warren Buffett’s Letter to Shareholders of Berkshire Hathaway Inc. in its 1992 Annual Report.

MITIMCO @ MDI

On 4 Feb, Seth Alexander, President of MIT Investment Management Company and his Global Investment team member, Joel Cohen delivered a wonderful lecture to my students and ex-students at MDI. It was a privilege to host them at MDI.

A few days before the lecture, I had asked my students to read:

  1. This excellent interview of Seth, Joel and their colleague Nate Chesley conducted by the Manual of Ideas in December 2014; and
  2. MITIMCO’s investment brochure.

If you haven’t read these documents, I urge you to read them carefully.

The presentation delivered be Seth and Joel at MDI can be downloaded from here which I have uploaded with permission.

While the entire presentation was quite instructive, I got the maximum out of slide 8 on top down risk framework. While Seth and Joel were talking about top-down risk framework in the context of managing an endowment, in my view, there’s an important lesson which is equally applicable for building much smaller portfolios using the principles of value investing.

Essentially, Seth stated that at MITIMCO, they buy “bottoms up” but worry “top down” while constructing portfolios.

Most value investors are bottom-up stock pickers anyway. But having a top-down risk management framework while constructing portfolios is a different skill which is worth acquiring.

What are the type of things one should worry about while constructing portfolios? Well, to my mind, there are many things and just one of them is to do with the type of value investing one is following. In risk arbitrage, for example, you need lots of diversification while investing in high quality businesses with long runways you need a lot less diversification. But you still need diversification. How much is sufficient diversification? There’s is no right answer to this question in my view, and many other questions related to top down risk framework. Any constraints imposed by the portfolio manager will be necessarily arbitrary. The key point Seth made on this was that having an arbitrary constraint is better than having no constraint.

What are the other things one must worry about while constructing portfolios? An excellent answer to that question lies buried deep inside Warren Buffett’s 2001 letter, in which he wrote a wonderful essay titled “Principles of Insurance Underwriting.”  Here’s that essay in which I have bolded the relevant part for our purposes.

Principles of Insurance Underwriting

When property/casualty companies are judged by their cost of float, very few stack up as satisfactory businesses. And interestingly unlike the situation prevailing in many other industries  neither size nor brand name determines an insurer’s profitability. Indeed, many of the biggest and best-known companies regularly deliver mediocre results. What counts in this business is underwriting discipline. The winners are those that unfailingly stick to three key principles:

  1. They accept only those risks that they are able to properly evaluate (staying within their circle of competence) and that, after they have evaluated all relevant factors including remote loss scenarios, carry the expectancy of profit. These insurers ignore market-share considerations and are sanguine about losing business to competitors that are offering foolish prices or policy conditions.
  2. They limit the business they accept in a manner that guarantees they will suffer no aggregation of losses from a single event or from related events that will threaten their solvency. They ceaselessly search for possible correlation among seemingly-unrelated risks.
  3. They avoid business involving moral risk: No matter what the rate, trying to write good contracts with bad people doesn’t work. While most policyholders and clients are honorable and ethical, doing business with the few exceptions is usually expensive, sometimes extraordinarily so.

* * * * * *

Good insurance underwriters as well as value investors must worry top down about risk aggregation and they must “ceaselessly search for possible correlation among seemingly-unrelated risks.”

Seth’s remarks on MITIMCO’s top down risk framework should be read with Buffett’s principles of insurance underwriting. There is a very important lesson for value investors in there and that important lesson is this: Buy bottoms up, worry top down.

Mohnish Pabrai and Srini Pulavarti Lecture at MDI

On 22 December, value investor and philanthropist Mohnish Pabrai and Srini Pulavarti, President and CIO of UCLA Investment Company delivered a wonderful lecture to my students at MDI. Here are the links

Lecture video

Mohnish Pabrai’s Presentation

Srini Pulavarti’s Presentation

 

 

No Hedonic Treadmill for Mr. Chandran

Precisely at 1:46pm on December 28, a fax arrived at the Bombay Stock Exchange.

Fax

This rare gesture by Mr. Chandran was largely ignored by the media but when I learnt about it, I was delighted.

I do recall that in 2008, Siddhartha Lal offered to his minority shareholders at Eicher Motors a deal that he was not obliged to offer. As part of a JV transaction with Volvo, he sold a 13% of his family’s stake in Eicher Motors at a price which was more than twice the prevailing stock price. In a buyback transaction subsequent to that deal, he offered the same terms to Eicher’s minority shareholders by initiating a stock buyback program in which Eicher gave them an option to sell 13% of their holdings at the same price at which Siddhartha Lal had sold his family’s shares to Volvo. He didn’t have to do this. There was no legal obligation to do it. But he did. And that gesture went largely ignored by the media.

I am a stockholder at Ambika and a fan of Mr. Chandran. When I learnt about his gesture towards his junior partners, I wrote a thank you note to him.

Here’s what he wrote back:

I intend to live a simple life and the expenditure for that is very limited. The dividend that I receive from my Company is excess for my expenditure. The Shareholders of my company have reposed faith in me while investing in my Company and I should live up to their expectations. While they receive only dividends, I felt it should be the same for me as well.

A few days ago, I sent a note to my students titled “The Hedonic Treadmill” in which I reproduced Ben Franklin’s writings on the virtues of frugality and simplicity — virtues that are clearly present in Mr. Chandran in abundance.

END

NOTE: THIS IS NOT A RECOMMENDATION TO BUY THE STOCK OF AMBIKA COTTON MILLS. IT IS A RECOMMENDATION TO LEARN FROM THE VALUE SYSTEM OF A HUMAN BEING.

Motley Fool Interview

Last October, Rana Pritanjali of Motley Fool reached out to me for an interview. Here is the transcript of the email interview which took place towards the end of November.

Part 1

Part 2

None of the stocks mentioned in the interview are being recommended for purchase or sale. Also, about the title of the interview, I wish Motley Fool had not called me some kind of a genius. I have done plenty of foolish things in my investment life and there’s no doubt that I’ll continue to do more foolish things. Keep that in mind, when you read the transcript.:-)

 

The Hedonic Treadmill

I sent a note to my students on The Hedonic Treadmill.

Amit Wadhwaney Returns

My friend Amit Wadhwaney, who spent a couple of decades managing money at Third Avenue Value came to my class at MDI in 2014 and addressed my students on global value investing.

This year, Amit returned to MDI as portfolio manager and co-founding partner of Moerus Capital — an investment firm based out of NYC. The website of Amit’s firm tells us the story behind term “Moerus.”

Moerus’ name is derived from the Classical Latin word describing a city’s defensive walls, which were designed to protect both a city and its inhabitants from risks, both predicted and unforseen. Though we are unabashed value investors, we cannot emphasize enough that cheapness alone is not enough to warrant an investment. We believe a keen awareness of the risks facing an investment is essential to generating solid returns over the long run.

The opportunities that we often find ourselves pursuing typically face near term challenges, risks, and uncertainties. We welcome such transitory turmoil, as it sometimes provides unusually compelling opportunities. However, because of this short term turmoil, we seek to populate our portfolios with companies that have a “Moerus” – the strength, staying power and wherewithal – to withstand a variety of risks.

My students and I totally enjoyed learning from Amit who spoke about his firm’s approach towards investing with a particular focus on risk. I particularly enjoyed the part when Amit spoke about the importance of “knowing the neighbourhood that you are going to.” There’s a fabulous lesson in there and many more in the talk. I am confident that you’ll enjoy watching Amit’s lecture video and slides.

 

What did HE mean when he said Never Lose Money?

A while back I clarified what Warren Buffett really meant when he said:

You should invest in a business that even a fool can run, because one day a fool will.

Now, it’s time to clarify another one of his famous, and often misunderstood quotes which goes like this:

There are only two rules in investing. Rule # 1: Never Lose Money. Rule # 2: Never Forget Rule # 1

Here’s what I think Mr. Buffett really means with those words.

  • It means don’t get into a situation no matter how high the NPV, if it carries even a minuscule probability of financial ruin.
  • It means don’t play Russian roulette — even when the gun has a million chambers in it with a bullet in just one chamber. Or jump out of planes with parachutes which have a probability of opening up 99% of the time.
  • It means don’t do trades that will make money most of the time but carry a small chance of blowing you up. Don’t do what LTCM did. Or many other funds which blew up suddenly after delivering excellent returns for a while.
  • However, it doesn’t mean being loss averse. It’s perfectly OK to lose all your money in a few investment operations so long as they won’t cause ruin at the portfolio level.
  • It means be that one should be risk averse (where risk is defined as probability of financial ruin) but not necessarily loss averse.

END

The thoughts behind this post were triggered because of a tweet by Mr. Samir Arora on twitter for which I thank him.

The Multiplication Rule

The Multiplication Rule

Remember, back in school, when you were learning elementary probability?

One of the topics covered was the “multiplication rule.” My favorite mathematician, John Paulos explains the rule.

If two events are independent in the sense that the outcome of one event has no influence on the outcome of the other, then the probability that they both occur is computed by multiplying the probabilities of the individual events.
For example, the probability of obtaining two heads in two flips of a coin is ½ x ½ = ¼ since of the four equally likely possibilities—tail,tail; tail,head; head,tail; head,head—one is a pair of heads.

Like you, I too encountered the multiplication rule in school. I learnt how to use it to solve questions of probability relating to flipping coins, drawing cards, rolling dice or picking marbles. And then I forgot all about it.

Many years later, when I became a student of business and value investing, I started appreciating the practical significance of the multiplication rule. I found that its utility lay beyond the textbook probability world of coins, cards, dice or marbles.

Multiplication Rule in Investing and Insurance

My first encounter with the multiplication rule outside the abstract world of coins, cards, dice and marbles occurred when I discovered Ben Graham.

Graham never really talked formally about the rule. But, he did recognize the need to “spread the risk” over somewhat uncorrelated (“independent”) risks.

For example, in these these passages in two of his books — Security Analysis and The Intelligent Investor — he wrote about diversification.

An investment might be justified in a group of issues, which would not be sufficiently safe if made in any one of them singly. In other words, diversification might be necessary to reduce the risk involved in the separate issues to the minimum consonant with the requirements of investment.
The instability of individual companies may conceivably be offset by means of thoroughgoing diversification.
There is a close logical connection between the concept of a safety margin and the principle of diversification. One is correlative with the other. Even with a margin in the investor’s favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss—not that loss is impossible. But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses. That is the simple basis of the insurance-underwriting business.
A margin of safety does not guarantee an investment against loss; it merely guarantees that the probabilities are against loss. The individual probabilities may be turned into a reasonable approximation of certainty by the well known practice of “spreading the risk.” This is the cornerstone of the insurance business, and it should be a cornerstone of sound investment.
Pure Grahamites believe in wide diversification because in their worldview, while bad things can happen to a handful of portfolio businesses at the same time, the probability of bad things happening to all portfolio businesses at the same time is remote, thanks to the multiplication rule.

Graham drew strong parallels between the worlds of value investing and insurance underwriting. Both the value investor and the insurance underwriter, according to Graham, should worry about aggregation of risks. Don’t put all your eggs (portfolio positions) in one basket (e.g. one industry). They may be different eggs, but they are one basket and if the basket falls, they will all break together.

Graham’s most famous student — Warren Buffett — has also written about the multiplication rule, although like Graham, he too didn’t mention it specifically. For example, in an essay in one of his letters, he described a principle followed by disciplined insurance underwriters.

They limit the business they accept in a manner that guarantees they will suffer no aggregation of losses from a single event or from related events that will threaten their solvency. They ceaselessly search for possible correlation among seemingly-unrelated risks.

The Deceptive Guise of Independence

Independence of events is a very important notion in probability but is also a deceptive one. This is especially true for some domains like financial markets which lie outside the world of coins, cards, dice or marbles.

Many global investors who practice wide diversification by spreading their money across “seemingly-unrelated risks” across geographies and asset classes found this in 2008 and 2009 when the global financial apocalypse of the time proved diversification to be a fair weather friend. He failed to come to their rescue just when they needed him the most just like an home insurance policy which expires moments before an earthquake strikes.

When shit hit the ceiling, their so-called diversified portfolios were slaughtered by the carnage that took place in asset prices across geographies and asset classes. The prices of  almost every financial asset other than US treasuries crashed. Having one’s eggs in many baskets didn’t really help because what was thought to be “independent” and “uncorrelated” turned out to be anything but.

That experience, made Warren Buffett make an acute observation:

When there is trouble, everything co-relates.

So much for the multiplication rule!

My own thinking about diversification changed quite a bit post the 2008-09 experience but that’s not the subject matter of this post. Let’s stay focused on the multiplication rule instead.

Multiplication Rule in Aircraft Design and Engineering

A few years ago, while researching the idea of “margin of safety” for my class, I came across another idea related to the multiplication rule from the world of engineering. That idea is called “redundancy.” Here’s an example from the world of aircraft design, as illustrated by Wikipedia:

Duplication of critical components of a system with the intention of increasing reliability of the system, usually in the case of a backup or fail-safe… In many safety-critical systems, such as fly-by-wire aircraft, some parts of the control system may be triplicated. An error in one component may then be out-voted by the other two. In a triply redundant system, the system has three sub components, all three of which must fail before the system fails. Since each one rarely fails, and the sub components are expected to fail independently, the probability of all three failing is calculated to be extremely small. [Emphasis mine]

Obviously, this is a very powerful idea. The practical applications of the multiplication rule in engineering — of which aircraft design is just an illustration — have proven to be hugely beneficial for civilization by providing it with, amongst many other things, safer and more reliable planes, cars and nuclear power plants.

What I found interesting was that while “seemingly unrelated risks” in the world of financial markets proved to be not so unrelated after all, in the world of engineering, this wasn’t so. And so, my respect for the multiplication rule returned.

:-)

Multiplication Rule in Investment Thinking

Over the years, my appreciation of the multiplication rule has only increased. And even though the rule failed to protect widely-diversified investment portfolios (including mine) from collapse during the global financial meltdown of 2008-09, I continue to apply it to my investment process in other ways.

One of them involves the application of a related principle:

A chain is no stronger than its weakest link.

Let me explain this with the help of an example. A few days ago, my colleagues and I were discussing the investment merits of a situation involving a company which had, a few quarters earlier, announced plans to manufacture a product related, but not identical to, it’s existing products. The new product required a new plant. Moreover the company would need to sell the new product to its existing customers. Also, before the company could start manufacturing the new product, it needed some environmental approvals which, as it happened, had already been delayed.

Furthermore, our analysis revealed that a very significant part of the total expected return from the proposed ownership of this business (acquired at prevailing market price) over the next few years was largely dependent on the success of this initiative. So, in a sense, the entire investment thesis rested on this project.

We saw three, independent risks on this project:

  1. a prolonged delay in receiving the environmental approvals. We figured the probability of this risk materialising was 50% which meant that there was a 50% chance of no further delays
  2. production related risks relating to product quality and cost, given that this was a new product which the company had never manufactured before. Considering the extensive experience of the company, however, we figured that there was only a 20% chance of this risk materialising, which meant that there was an 80% probability of no production hiccups
  3. the inability of the company to sell the new product to its customers. We figured the probability of this risk materialising to be only 10%, which meant that there was a 90% chance that it would be able to sell the product.

For the project to succeed, none of the risks should materialise and the probability of that was simply the product of the probabilities of each of these risks not materialising or

(1-0.5)*(1-0.2)*(1-0.1) = 0.36 or 36%

Therefore, there was only a 36% chance of success on all three parameters which, of course, meant that there was 64% chance of failure. As the consequences of failure were no return for us, we passed the opportunity.

To be sure, this type of thinking is deeply subjective but to paraphrase Keynes, we would rather be subjectively right than be objectively wrong.

Now, imagine that the company does indeed get the environmental clearances. So, risk # 1 is eliminated. What is the joint probability of success now? The multiplication rule tells us that the probability of success has now doubled to

(1-0.2)*(1-0.1) = 0.72 or 72%

Suppose, however the market ignores this development or under-reacts to it. Clearly then, there might be an excellent opportunity to make an investment in this situation, if it looks attractive in relation to other opportunities available at the time.

– – – – – –

A few years ago, Warren Buffett wrote on probability chains derived from the multiplication rule, which would serve as an even better example on how the rule should be used in one’s investment thinking.

Last year MidAmerican wrote off a major investment in a zinc recovery project that was initiated in 1998 and became operational in 2002. Large quantities of zinc are present in the brine produced by our California geothermal operations, and we believed we could profitably extract the metal. For many months, it appeared that commercially-viable recoveries were imminent. But in mining, just as in oil exploration, prospects have a way of “teasing” their developers, and every time one problem was solved, another popped up. In September, we threw in the towel.
Our failure here illustrates the importance of a guideline – stay with simple propositions – that we usually apply in investments as well as operations. If only one variable is key to a decision, and the variable has a 90% chance of going your way, the chance for a successful outcome is obviously 90%. But if ten independent variables need to break favorably for a successful result, and each has a 90% probability of success, the likelihood of having a winner is only 35%. In our zinc venture, we solved most of the problems. But one proved intractable, and that was one too many. Since a chain is no stronger than its weakest link, it makes sense to look for – if you’ll excuse an oxymoron – mono-linked chains. [Emphasis mine]

Clearly, Buffett learnt an important lesson there. The way I see it is that some business models, by their very nature are so complex (e.g. drug discovery) that one has to worry about lots of “moving parts” — independent risk factors. For the investment to be successful, all of those risks must be mitigated. And given the way the multiplication rule works, that’s a long shot. To be sure, long-shots can sometimes be offset by bonanza profits if success does occur, but that kind of investing is more in the nature of a venture capital operation than a value investing operation.

In contrast, other things remaining unchanged, simple, easy to understand businesses with fewer moving parts carry much lower risk of disappointment. As Buffett writes:

Our investments continue to be few in number and simple in concept:  The truly big investment idea can usually be explained in a short paragraph.  We like a business with enduring competitive advantages that is run by able and owner-oriented people.  When these attributes exist, and when we can make purchases at sensible prices, it is hard to go wrong (a challenge we periodically manage to overcome).
Investors should remember that their scorecard is not computed using Olympic-diving methods:  Degree-of-difficulty doesn’t count. If you are right about a business whose value is largely dependent on a single key factor that is both easy to understand and enduring, the payoff is the same as if you had correctly analyzed an investment alternative characterized by many constantly shifting and complex variables.

– – – – – –

My own, intuitive application of the multiplication rule can also be understood by another example.

Some time ago, I read a story in The Economist which promoted me to quote it in a tweet

Screen Shot 2015-11-28 at 15.26.36

I followed that tweet up with a blog post titled “Who will Bail Shale” in which I was asked to comment on the probability of oil prices remaining low for the next few years. While my original, tongue-in-cheek response was to estimate that probability to be “somewhere between zero and 1,” I subsequently wrote:

My head starts spinning when I think about the economics of shale, gas, regular good old crude oil, wind power, solar power and how they interact with geopolitical developments in Russia and USA and Syria and and Iran and Iraq and Saudi Arabia. I could go on and on but I hope you get the point. There are too many variables and too much variability. This one goes in my “too tough basket.”

Contrast the complexity involved in predicting the future price of oil or other commodities with the simplicity of investing in a business like Relaxo — India’s largest footwear manufacturer which despite volatility in input prices, does not experience volatility in its profit margins.

Why?

Because Relaxo follows the simple notion of buying commodities and selling brands. It has the ability to pass through cost inflation to customers without fear of loss of unit volume or market share. The business that manufactures EVA has lot more “moving parts” than the business that uses EVA to make and sell branded footwear.

– – – – – –

If you have used the multiplication rule in your investment process in a manner different from what I described above, I would love to know more about it.

Note: The use of Relaxo in the post was just an example to illustrate a point and must not be construed as a stock recommendation.

END

 

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