Transcript of my first lecture at BFBV course at MDI.
Dear Prof. Bakshi,
Thank you so much for sharing this!
Many of us didn’t have the good fortune to attend your classes, but consider you their teacher. We would be immensely grateful, if the entire BFBV lectures this year could similarly be transcribed.
Belated Happy Teacher’s Day Sir.
Thank you! If possible try to post your upcoming lectures as well in this format so that students like me can also benefit from your knowledge.
Thanks a lot for posting this and for me timing works out to be perfect and finally decided to go through all the books you have recommended for BFBV course. I have gone through presentation couple of times but realized unless and untill I read the books, am not going to understand in detail and will not retain….. Thanks again and eagerly awaiting for more such transcripts….
Excellent post Professor. I see it playing out so much in the technology sector. The currently successful companies focus too much on error reduction/perfection, too much on the current set of products that they miss out on newer opportunities, newer insights. Even large well managed companies with big ecosystems like Microsoft have fallen for this where their response to innovation has generally been copying. I think Apple too seems to be falling into the same trap. It becomes even more difficult specially when you have large cash cows.
Sir 2 points:
Gary Klein’s quote on page 2 “reporting bias after bias” is a major criticism of behavior finance.
I quote Hersh Shefrin – Kahneman’s contemporary – who admits in a paper titled ‘Behavioralizing Finance’: “Among its (behavioral finance) main weaknesses is the reliance by its proponents on an ad hoc collection of models that lack mutual consistency and a unifying structure…Its weaknesses emanate from an overall approach that has been piecemeal. There is no generally accepted coherent behavioral counterparts to the workhorses of neoclassical finance, mean-variance portfolios, asset pricing theory, and the value maximizing agency theory approach to corporate finance. In contrast, much of the literature in behavioral finance is scattered, ad hoc, unsystematic, and lacking in discipline.”
Is it necessary to organise the 20 odd major irrationalities that you mention, in a highly organised manner like Physics does or neoclassical finance (mistakenly) does? Or does an ad hoc list of bias-after-bias work just fine?
2. Can the inverted valuation examples of both Buffett and Penman be traced to Ben Graham’s debt-capacity bargains, that you had first discussed at the Oxford Bookstore speech?
Satyajeet, literature in behavioral finance may be scattered, unsystematic etc but its roughly right. In contrast, the traditional academic finance theories like CAPM, APT, MPT, and EMT may be very precise and unscattered and mathematically sound but they are precisely wrong and I am confident that you’ll agree with Keynes that it’s better to be roughly right than to be precisely wrong.🙂
You don’t need a list of 100+ biases as have been listed in the the new book “The Art of Thinking Clearly“. That’s a very useful book to learn about various biases but I would much rather re-organize them in 20-odd biases as was done by Mr. Munger.
One’s objective shouldn’t be to eliminate each and every bias. Rather one’s objective should be to become a lot more rational than the other folks out there.
As for your second point, any good thinker will use inversion as a standard technique in his/her thinking and Graham was a very good thinker. Apart from his ideas on debt capacity, Security Analysis, there are several other extremely instructive examples.For example, on page 642 of the 3rd edition, he writes about “Overvaluations within a Company.” He provides and example of American & Foreign Power securities on page 648 to 649.
What’s fascinating is that Graham often used the path of contradictions to come up with very unique insights. This is exactly the point made by Klien in his book. I urge you to read it.
Dear Sir, This is a great service to humanity. Please do post your other lecture transcripts as well. Those not fortunate to sit in your class will benefit.
Dear sir, you can also consider putting your video lectures on iTunes U. It’s easy and continent also. Prof Damodaran also uses the same to put all his lectures on valuation.
[…] https://fundooprofessor.wordpress.com/2013/09/08/klein-vs-kahneman/ […]
Dear Sanjay Sir,
My question is irrelevant to your post. I am from non-finace background and am trying to read your recommended book “Accounting for Value”. This is great recom from u, becauze naive people like me think stocks available at PE=5, PB=0.5, growth=5% are cheap/value stocks AND stocks available at PE=30, PB=5, growth=25% are expensive/growth stocks. This book certainly clears everything matrhematically and shows how growth stock could actually be cheaper than value stock.
I am stuck at one point(in their principle formula itself). Please help me in that?
Value of equity 0 = Bo + (ROCE1-r)*Bo/(1+r) + (ROCE2 – r)*B1/(1+r)2 + (ROCE3-r)*B2/(1+r)3(r − g)
My question is about “denominator of speculative componet” i.e. (r-g). “g” represents growth in residual earnings. Now what if g > r(which is often the case like Page Industries 30% and r=10%). In that case, speculative component becomes negative. Please help in understanding this. Where I am going wrong??
Example: Page Industries: V-2013 = 200 + [(0.5-0.1) * 200 / 1.1 ] + [(0.5 – 0.1) * 280 / (1.1*1.1) ] + [ (0.5 – 0.1) * 392 / 1.1*1.1*1.1 * (0.1 – 0.3)] = 200 + 70 + 92 – 589 = -227.
How come this beautiful stock have negative fair value? I am certainly missing something here🙂
Sameer, you’re referring to a well-known problem in valuation called the St. Petersburg Paradox. Even Mr. Buffett referred to it a few years ago. He said:
“When the [long-term] growth rate is higher than the discount rate, then [mathematically] the value is infinity. This is the St. Petersburg Paradox, written about by Durant 30 years ago. Some managements think this [that the value of their company is infinite]. It gets very dangerous to assume high growth rates to infinity – that’s where people get into a lot of trouble. The idea of projecting extremely high growth rates for a long period of time has cost investors an awful lot of money. Go look at top companies 50 years ago: how many have grown at 10% for a long time? And [those that have grown] 15% is very rarified. Charlie and I are rarely willing to project high growth rates. Maybe we’re wrong sometimes and that costs us, but we like to be conservative.”
You can get the doc Mr. Buffett referred to from here.
One of the key risks in valuing growth stocks is that people tend to get too carried away when they think about long-term growth rates. One very good way to deal with that problem is to invert it. Instead of plugging in a long-term growth rate yourself, why not reverse engineer yourself from the current market value to figure out market’s assessment of that rate and then try to get some insights from there?
One more point. Even if you use forward thinking and project out a perpetual growth rate, that rate can never be more than the growth rate of the world economy because if it was, then implicitly you would be assuming that one day that company will become bigger than the world economy and that’s absurd. Btw, that was another proof by contradiction…
Thanks Sanjay Sir for clearing doubt
The St. Petersburg Paradox (didn’t know it was called that) and the ceiling imposed by the growth rate of the economy are frequently asked questions in entry-level (sell-side) analyst interviews.
Of course, what employers are looking for is familiarity with valuation text-books like Prof. Damodaran’s. The job applicant is well advised to say:
“We should go for n-stage DCF for high growth rate companies. That’s because, high growth rates are allowed for ‘explicit forecast period/s’ but not for ‘terminal value’. Only low (stable) low growth can work with terminal value since the St. Petersburg Paradox and the ceiling apply.”
What a valuation text-book doesn’t point out is that even with low growth rates, the compounding-till-infinity ensures terminal value ends up contributing to around 60% to 70% of the total valuation (explicit + terminal). That’s a bummer, because the explicit forecast is where the analyst is supposed to split hairs and earn her salary; while terminal value is essentially a black-box.
How can an analyst armed with an MBA and dazzling excel skills consign valuation to a black-box?
That’s when we realize the limitations of DCF and the need to add a variety of tools to our kit box. And thus we turn to value investing and behavioral finance. Which leads us straight to Prof. Sanjay Bakshi.
How do you account for goodwill in calculating excess return over cost of capital, especially when it relates to brands acquired? For example Mondelez’s acquisition of Cadbury has resulted in a big goodwill component.
Market Value = Book Value + (e.p.s – (required rate * Book Value)
31.22 = 17.66 + ( 1.60 – (0.1*17.66) ) / .1-g , I am directly calculating terminal value of cash flows instead of projecting 2 or 3 years
If we use book value as is, MDLZ doesn’t seem to be a successful investment as management expected EPS of 1.6USD for the year does not cross hurdle rate , This is where making qualitiative judgements on Cadbury’s purchase comes into picture.
Requesting you to share your thoughts on accounting for goodwill in calculating adequate return
The best guide on dealing with Goodwill is Mr. Buffett’s essay titled “Goodwill and its Amortization: The Rules and Realities”
Some of my additional thoughts:
1. Accounting goodwill and economic goodwill are two very different concepts.
2. A lot of accounting goodwill relates to failed acquisitions (in the sense that they will fail to create value more than AAA yield on the money spent to acquire the asset).
3. Economic goodwill exists but is rarely recognised on the balance sheets of companies enjoying them. It arises out of ability to earn sustainable and high returns on tangible capital over AAA bond yields. This happens in the presence of a long-term competitive advantage arising out patents, trademarks, brands, a low-cost edge, network effects, or high switching costs (see Pat Dorsey’s work on this subject). Or intuitively, think of it this way: companies like Nestle and Unilver earn super high returns on tangible capital. Why? Because they have valuable brands. The value of those brands is economic goodwill. If you put them on the balance sheet and then calculate return on capital (tangible and intangible), you’ll get a much more reasonable ROIC ratio than what you get when you calculate that ratio based on tangible capital alone.
4. If you’re dealing with a serial acquirer with a poor track record in M&A, having a lot of Goodwill on its balance sheet, don’t even bother to study the company in detail because you’re dealing with bad quality management here. In contract, if you see businesses which create important sources of delivering them sustainable competitive advantage but do not record such advantages on their balance sheets as assets, you should look at such companies closely not just because of what they are doing in the business but also because of their conservative accounting.
[…] Prof. Sanjay Bakshi explains in his BFBV lecture notes, using an answer provided by Warren Buffett to one of the shareholders. The actual returns NIIT […]
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