Tuesday, November 22, 2005

One sided Love Affair & Investing

"The price you pay determines (your potential) rate of return"
"The price you get determines (your actual) rate of return"

A hypothetical situation:
Consider 2 equally intelligent investors buying stock of 'Pendulum, Inc' for $50, which they both know is worth $100. As all of you might agree that there is very little chance that they both will sell out at the same time (ie) end up with the same rate of return. Why? The possible answer could be the varying levels of emotional discipline. This is brilliantly explained by Warren Buffett as,

"Only when you combine sound intellect with emotional discipline, you get rational behavior"

Emotional Discipline:
When to sell is as important as when to buy. Because once we buy a security it becomes, "I own Pendulum, Inc ","I think it will do this & this"... The psychology that comes into play here is similar to how a mother feels of her child to be the best in the world. That psychology helps life flourish on earth but that tendency can wipe us in the markets.

The puspose of this write up is to share with you all my basic understanding of 'What causes fear & greed?' & 'How can we deal with them?'

Understanding Fear:
As a human being we might not expect the unexpected. But as an investor we cannot afford to not expect the unexpected. I think Ben Graham's emphasis on diversification is based on this notion (ie) expect the unexpected & be prepared for it.

"Emphasizing once again the element of diversification as a safeguard in all such operations, we express the view that a number of purchases of this type will in all probability turn out quite satisfactorily in the aggregate. That some losses will occur goes without saying, but the proportion of such losses should undoubtedly be much lower than the favorable outcomes in a normal period"--Ben Graham.

Also as Buffett has said, "If you cannot stand 50% paper loss on your stock, stay away from the markets."

We all think we can stand such a situation, simply put, it is not just that simple. Moreover the logic is simple, 'It's not a one way road to Rome'. One might have done everything right about picking up a stock but who knows tomorrow UFO might come up and carry away the management team of the firm & keep doing it every time shareholders replace them... We never know. What I am trying to say is, there are things over which we have no control and when somehow they happen we have to live with it. This is why diversification makes sense as far as I am concerned.

Understanding Greed:
"Content makes poor men rich; discontent makes rich men poor"--Ben Franklin.

I think of greed as 'Somebody expecting to have what he desires rather than what he deserves, provided that the desire is more than what he deserves. If it were other way around it will make him a satisficer.'

As human we all at various times end up being greedy to varying degree. But when it comes to investing we should train ourselves to be desirious of what the stock price deserve to be. It reminds me of beautiful quote by Ben Franklin,

"There's none deceived but that he trusts"

The bottomline is buying a stock is much like one sided affair. "The stock does not know that you own it. Even if it does, say somehow, it does not care." Stock does not understand the word 'emotion'.

We should rather train ourselves to be respectful of the feelings of stock, if she does not like being loved, we better be good people and reciprocate that by not loving her. Moreover she(stock) might say thank you for being nice to her. We all know in what denomination does stock say 'Thank you'...

"All is well that ends well"

Sunday, November 13, 2005

Conflict of Interest

"The officers of large corporations constitute a group of men above the average in probity as well as in ability. But this does not mean that they should be given carte blanche in all matter affecting their own interets. A private employer hires only men he can trust, but he does not let these men fix their own salaries or decide how much capital he should place or leave in the business"--Ben Graham.

Recently Prof. Sanjay Bakshi screened the movie, "Other People's Money" in his class to demonstrate why, usually, managements don't realise that their company may be going down the tube and keep on evading the reality by taking irrational decisions, thereby causing huge losses to owners(ie) shareholders. I will quote Ben Graham extensively, among others, from his Security Analysis(1934) throughout this post while discussing the issues where there is conflict of interests between management & shareholders.

Worth more dead than alive:
"We're dead all right. We are just not broke. And do you know what is the surest way to go broke? To get an increasing share of a shrinking market. Down the tube. Slow but sure"--Larry the liquidator (Danny Devito in the movie) on the consequences of management not facing up with the reality.

Management don't realise it, even if they realise they just don't act. Why?

"Complete liquidation means loss of the job itself. It is scarcely to be expected, therefore, that the paid officers will consider the question of continuing or winding up the business from the standpoint solely of what is in the best interest of the owners"--Ben Graham

Though a retail shareholder is rightfully the owner of a business, he cannot in anyway alter the way management work. So it will be much more prudent to try and avoid management that don't adapt to changing times

Capital Allocation:
This is one of the most important decision that a management makes. Generally capital can be allocated to 2 activities:
  • Expansion (organic or inorganic)
  • Buybacks
"Management are naturally loath to return any part of the capital to its owners, even though this capital may be far more useful-and therefore valuable-outside of the business than in it. Returning a portion of the capital means curtailing the resources of the enterpirse, perhaps creating financial problems later on, and certainly reducing prestige of the officer."--Ben Graham.

The problem is not expansion but unwise expansion as Warren Buffett explains:

“We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained. To date, this test has been met. We will continue to apply it on a five-year rolling basis. As our net worth grows, it is more difficult to use retained earnings wisely. We continue to pass the test, but the challenges of doing so have grown more difficult. If we reach the point that we can't create extra value by retaining earnings, we will pay them out and let our shareholders deploy the funds.”

Yet managers having committed themselves to a losing project keep on pushing it. This is quite similar to an investor holding onto his losers. Peter Bernstein explains this in Against the Gods: The remarkable story of risk as follows,

"Investors(Managers) hate to take losses because a loss taken is acknowledgment of error. Loss-aversion combined with ego(reputation) leads investors to gamble by clinging to their mistakes in the fond hope that some day the market will vindicate their judgment & make them whole"


One usage of retained earnings we often greet with special enthusiasm when practiced by companies in which we have an investment interest is repurchase of their own shares. The reasoning is simple: if a fine business is selling in the market place for far less than intrinsic value, what more certain or more profitable utilization of capital can there be than significant enlargement of the interests of all owners at that bargain price?” – Warren Buffett.

But the desire to acquire the stock at lowest possible level, sometimes, pushes the management to manipulate the price to bottom out before announcing the buybacks. This is generally done by reducing or passing out the dividends even when the free cash flow may be sufficient even to carry on with the dividends,

"The desire to buyback shares cheaply may lead to a determination to reduce or pass the dividend, especially in times of general uncertainty. Such conduct would be injurious to nearly all the shareholders, whether they sell or not"--Ben Graham

He further adds,

"If the reason for passing the dividend as a desire to preserve cash then it is not easy to see why, since there was money available to buy in stock, there was no money available to continue a dividend."

In general, not only what the management does is important but also how and when it is done.

"Human nature what it is, such(managerial compensation) developments are not in the least surprising. They do not really reflect upon the character of of corporate managements, but rather on the patent un wisdom of leaving such matters within the virtually uncontrolled discretion of those who are to benefit by their own decisions." - Ben Graham

Also Warren Buffett has been since long advocating against the stock options & bonuses as compensations to employees.

Role of Directors:
"The role of individual directors are frequently joined by many close ties to cheap executives. It may be said in fact that the officers choose the directors more often than the directors choose the officers. Hence the necessity remains for the stockholders to exercise critical and independent judgments on all matters where the personal advantage of the officers may conceivable be opposed to their own"-Ben Graham.

Keeping with the style of the post I would like to end the post with quotes, whatelse,

"By failing to prepare, you are preparing to fail"--Benjamin Franklin.

"We can evade reality, but we cannot evade the consequences of evading reality"--Ayn Rand.

Wednesday, November 09, 2005

Trading on the Equity

“In a speculatively capitalized enterprise, the common stock holders benefit—or have the possibility of benefiting—at the expense of the senior security holders. The common stockholder is operating with little of his own money & with a great deal of the senior security-holder’s money; as between him & them it is a case of “heads I win, tails you lose.” This strategic position of the common stockholder with relatively small commitment is an extreme form of what is called “Trading on the Equity.” Using another expression, he may be said to have a “cheap call” on the future profits of the enterprise.”—Benjamin Graham.

A “Cheap call” on the future earnings. How?
I will use a hypothetical example to illustrate Graham’s assertion. Consider a steel company “Cyclical Business Inc” with the following financial statement numbers (I have for the sake of simplicity used only the numbers which are important in this case)


$75 m at 8%


$25 m



No of shares

1 m

Scenario A
: Bad year of a typical cyclical business.
Scenario B: Good year of a typical cyclical business.

$ m



% Increase
















$ 6





Market price




What is relevant in above table is the sensitivity of the EPS as compared to sales growth and the prospective markets returns. Having said that I would like to clarify that the sensitivity holds even on the downside (ie) if earnings drop we can expect that the drop in market price will be more as compared to drop in the sales. So it is all about where you catch the pendulum when it is swinging.

Leveraged Buyouts (LBO):
Apart from the advantages of speculative capitalization structure and sensitivity of EPS, LBO comes with an added advantage. Will use pie charts to illustrate,

(Table below represent the capital structure of a LBO company at the start of the buyout and after a few years)

While buying

After reducing debt


$ 10m

$ 10m


$ 90m

$ 40m


$ 20m

$ 20m

EBITDA * 5 (Value)



Market Value of equity



The advantage:
Generally it is the free cash flow from operations or sale of non productive assets that is used in paying off the debt. Thus we can probably expect that the EBITDA is atleast same even when the debt is down to $40m. Suppose we can sell out the company at the same multiple of EBITDA at which we got into it then our profit is atleast 100% (non-annualized)

LBO & Leveraged Arbitration:
We can apply the concept discussed above in increasing our return substantially from arbitration opportunities. Again will use a simplified example:

Expected return from arbitration

20 %

You have (equity)

$ 100

You can borrow (900% of your equity)

$ 900 @ 10% (say)

Total Profit after interest on leverage

$ 110

Return on your Equity

110 %

I am not saying that whenever an arbitration opportunity comes up we should borrow money and play the game, rather, only when the odds make it sensible enough to do so.

A conservative capital structure is a must for a good business, I used to think, but when it comes to making a good investment “Price changes everything”. In other words,

“Safety does not reside in titles, or forms, or legal rights, but in the values behind the security issue”—Benjamin Graham.

Thursday, November 03, 2005

Understanding Risk & Fear of Consequence

As human we are programmed to tackle physical risk instinctively but as an investor we have to learn to manage risk in every investment decisioin we take.

Understanding Risk:
"Price & probability are not enough in determining what something is worth. Although the facts are same for everyone, the utility is dependent on the particular circumstances of the person making the estimate. There is no reaon to assume that the risk anticipated by each individual must be deemed equal in value"--Daniel Bernouli in Peter Bernstein's "Against The Gods: The remarkable story of Risk"

Reflecting upon the above paragraph I found a relationship between understanding risk and portfolio management. I would serve the learnings in the form of a game to make it more reader friendly & easy to understand. (I myself learnt the lesson by putting myself in the scenario that follow)

Simple game of Coin toss. You have to bet on either head or tail. You win if you are right.

Scenario 1:
You bet Rs. 10 & if you win you will get Rs. 100. Will you play? Mathematically the expected value is Rs. 50, so one can easily conclude that you should play. I will.

Scenario 2:
The rules remain the same, only change that comes about is all you have is Rs. 10. If you win you become 10 times as much richer as you are now, on the other hand if you lose you go broke. Will You play? I won't.

Scenario 1 looks like a very favorable bet but scenario 2 looks like a very risky proposition. Mathemetically nothing has changed to make scenario 2 more risky than scenario 1. What is that has made Scenario 2 more risky (or atleast make it look more risky)? The answer is fear of consequence. Hence we can conclude that, risk is sum of probability of an event happening & price you pay for it & fear of consequence.

Risk = Probability of the Event & Price paid & Fear of consequence

What makes this so important is that the facts are same for everybody it is the fear of consequence that differs for everybody & that in effect changes risk factor from person to person. (Think of a person who has Rs. 1,000 and what do you think he will do in scenario 2)

Scenario 3:
In the same game, you can bet Rs.1 from your total of Rs. 10. If you win you get Rs. 10 for your Rs. 1. That is you can play the game 10 times with the money you have. Will you play? I will.

Reflecting on Scenario 3 & relating it to Investing:
Mathematically speaking, the expected value is same for Scenario 1, 2 & 3, Rs. 50. But I think we will be attracted towards scenario 3. Why & what does that mean?

The reason is bounded rationality. We have no expertise as to predict the outcome. All we know is that probability is 50% and the more times we play the game the more the chances that the result will be near the mean(regression to mean). But still we can go broke, 10 tails or 10 heads in a row is not an improbability, just that it is highly improbable. (I remember reading somewhere that the probability of that is around 0.1%). It reminds me of beautiful quote by Ben Franklin,

"In this world nothing is certain but death & taxes"

In scenario 1 & 2, if you win you make 900% return on your portfolio(from Rs. 10 to Rs. 100) & negative 100% if you lose. And the probability of that happening is good 50% on either side. But in the scenario 3 you cannot think of making 900% return, but you will hopefuly come out a winner, because you need to win once from the ten chances to take your principle back. But the probability of winning 10 times is around 0.1% (getting 10 heads or 10 tails simultaneously). So you have to be a satisficer in giving up some probable extra return for much needed safety.

All said & done, this quote by Warren Buffett is even more important to understand and could find nothing better (a satisficer, that I am)

"Risk comes from not knowing what you're doing"