Great Expectations

Children like stories and so do investors. The latest story, which has captured the imagination of investor community, is, ‘a stable government will unlock the growth potential of India.’

This story has, in part, restored investors’ faith, which was thrashed, when the ‘decoupled from developed nations’ story failed to stand up to their expectations.

What investor community doesn’t realize, however, is that just as children stories are fictitious; these stories can be fictitious, inspite of them sounding realistic. And, as a famous philosopher, once observed, ‘“we're never so vulnerable than when we trust someone,’ investors’ end up being a vulnerable lot.

The behavior of investors, at large, can be likened to a balloon. The more inflated it is with optimism, the more vulnerable it is to blow up in the face of slightest trouble.

The historic rally, which we have witnessed during this week, highlights the tendency of investors to take a good story too far. Of course, it is a relief, more than anything else that we have a stable government after numerous elections resulting in hung parliament halting economic reforms.

But, as Benjamin Franklin observed, ‘he who pays in advance gets a penny worth for a nickel paid,’ investors, in their optimism, always seem to end up paying in advance (think, forward earnings estimate to justify the high valuations of stocks) and end up disappointed (as earnings fail to catch up with expectations and PE multiples collapse).

The SENSEX closed at 13,887 on May 22nd, 2009. This discounts the earnings at19x. Given the cloud of uncertainty prevailing world over and dipping industrial production levels, such an earnings multiple seem to contain elements of irrational exuberance.

At PPFAS, we are not in the business of making market predictions and neither is this a prediction that markets are ripe for correction or over-valued. After all, there is a lot of wisdom in John Maynard Keynes’ advice, ‘markets can remain irrational for longer than you can remain solvent.’

The purpose of this article is to highlight the manic depressive behavior that market displays every now and then and how susceptible, in the process, it becomes to disappointment. And in markets, disappointments mean losing not only one’s hard-earned savings but also losing one’s sleep.

Let me end the article with an excellent quote from Benjamin Graham, which sums up the essence of the whole article succinctly and is, to some extent a reply to the ‘unlocking of growth potential of India’ story,

‘Obvious prospects for physical growth in a business do not translate into obvious profits for investors.’

Creative Destruction (or) Destruction of Creativity?

What is Creative Destruction? And what has creative destruction got to do with investing?

As the name suggests, Creative Destruction is a principle which is used to denote the process of something new bringing about a revolutionary change resulting in the destruction of something old. It can be observed that much of human progress has been the result of one long chain of creative destruction, where innovation has resulted in the death of old.

A great example of creative destruction is the invention of wireless telephone technology, which in spite of its countless advantages, has rendered uneconomical the huge investments made in laying out the landline telephone networks around the nation. From the perspective of landline network owners, this invention has been tragic but for the civilization as a whole this has been an event which marks human progress in its grandeur. It must be noted, however, that someday some new invention will bring about a destruction of this technology, which seems invincible at present, and it will be a change for the better.

Killing Old Ideas:

At the heart of creative destruction lies the ability to kill old ideas and establish innovative ways to accomplish better results. And if you notice, all the new transformational innovations are separated by generations. The reason behind it is that we, as individuals or peer group, are not good at killing ideas to which we get used to. It takes fresh dose of imagination and lack of historical conditioning to think out of the box and question the existing notions.

As an investor, the question that I am interested in is – are we good at killing our own investment ideas and replacing them with better ones as they present themselves from time to time?

Experience of an Investor – Destruction of Creativity:

Consider the following hypothetical situation:

If you expect Rs. 10,000 invested today in the stock of NEW Ltd to grow to Rs 20,000 by the end of one year as compared to the same amount growing to Rs 15,000 in the stock of OLD Ltd., then is it not foolish to still invest in the stock of OLD Ltd.? Who would do something like this?

The answer is - all of us are susceptible to do something like this, especially, when we are already holding the stock of OLD Ltd. and have to book a loss to replace it with the stock of NEW Ltd.

Rationally speaking, that is, we would rather wait a year to recover the quotational loss in OLD Ltd. than book the loss today even if it increases our chances of recuperating the losses and making more money on the capital risked.

Just the other day as I was looking at the constituents of my portfolio it struck me that something that looked cheap (and was cheap), when the Sensex was at an all time high, did not look attractive enough as compared to other opportunities that have surfaced as the stock markets corrected. And I noticed that I should have replaced this with another stock with better risk-reward ratio but simply did not do it as it meant booking a loss of 20% in the old investment.

The end result – we often stay invested in the stock of OLD Ltd. and at the end of one year end up having Rs 15,000 instead of Rs 20,000. As Warren Buffett rightly observed when he said that the worst mistakes are those which do not show up anywhere because we simply keep on repeating them.

Why? Loss Aversion:

The reason behind this irrational response lies in loss aversion, which says that we feel uncomfortable booking losses as it causes regret, even when booking losses might be a rational thing to do.

Error of judgement is not that big an impediment to human progress as is his inability to judge his errors reasonably.

I am sure you would relate to the following and see what I am trying to say. How often have we come across people who are still holding onto the share certificates of the stocks from their IPO allotments from the early 1990s or the favourite IT stock from the IT bubble at the turn of the century, simply because they are still selling well below their purchase price? It is like that they have given up on those investments. It is as if, thinking about those investments results in pain. So, we end up doing the next best thing, which is, do not acknowledge the mistake by holding onto them and waiting for losses to be recovered.

Rationalization Trap:

Benjamin Franklin once famously observed, ‘So convenient a thing it is to be a reasonable creature, since it enables one to find or make a reason for everything one has a mind to do.’

The inability to be good at judging our own errors stems from the need to justify ourselves to others and self. Accepting a mistake makes one feel vulnerable. So, we pay the price in the form of covering up our past mistakes.

The defining ability, however, of any super-achiever, in any area of work, is his ability to accept his failures with as much humility as he does his successes. Moreover, sometimes it is not even a case of mistake just that something that seemed (and might have been) right at one point in time ceases to be so as things evolve.

It is easier said than done. In fact, it was my inability to act in the way recommended above to start with that led to this revelation and not the other way around. But as Benjamin Franklin observed a few centuries ago, "Would you live with ease, do what you ought, and not what you please."

It just happened that I realized one of the things that, as an investor, I ought to learn to do is reshuffle the portfolio on a regular basis even if it means killing my own best loved ideas and booking losses...

Perception of Misperception

As an investor, each one of us is trying to buy low and sell high. In the process, we, more or less, have the same set of information to help us decide. But for every trade done on the stock exchange, there is always that other guy who disagrees with you and only one of us ends up as right. What one gains is somebody else's loss. This not only highlights one of the important aspects of investing, that is, that it's a zero sum game but also highlights the fact that the people reach diverse set of opinions based on the differential in the way they construct reality. Excluding the element of luck, over the long run, the one, who is better at constructing reality or making sense out of the surrounding, is the one who will end up one amongst the winner. Thus, I think, it will be a good exercise to understand what leads to the perceptual contrast amongst people.

Bounded Rationality:
Herbert Simon, the person who propounded this theory, says that as human beings, we are not blessed with unlimited circuitry to make sense out of the complexity of the world in its entirety. To cope up with this limitation, he argues that we rely on simplistic models of reality, which helps us get through most of the things happening around us decently well, but in a complex situation this limited circuitry might fail us, leading to sub-optimal decision making. In the context of investing, each one of us has our own philosophy, which helps us decide which opportunity is suitable to deserve our attention and our capital, eventually. The more potent our philosophy is at replicating the underlying reality the better would be our results.

No matter how hard one tries, our mind-set (philosophy, in the context of investing) has its limitations and understanding where and how it might fail us would be indispensable. The prime reason, which is inescapable, but mistake prone is Satisficing.

Satisficing:
Satisficing says that we start with a tentative hypothesis and start to look for evidence supporting the initial hypothesis. (Insiders are buying. Oh, the most probable reason has to be that the management feels that the business is undervalued by Mr. Market. Is it so, let me check it out?). In the process, the goal is to seek enough information, broadly speaking, to validate our hypothesis satisfactorily.

Even though, I don’t think we can do away with rationality, which is bounded anatomically, and satisficing, which helps us reach decisions amidst uncertainty, I do think that by understanding as to how they can fail us under certain ways, we can improve our ability at constructing reality.

Pre-conceptions can lead to Concussions:
None of us can claim to analyze a problem being 'completely blank' to start with. The software (mind), which we develop in certain ways, but which is also pre-conditioned and shaped by surroundings, is different in each one of us. Moreover, no matter how hard we try, it is a mystery even to its possessor (remember, how often we end up over-estimating or under-estimating our ability at various activities). Given this understanding, it might not be wrong to assert that pre-conceptions/mind-set, when incomplete and unsuitable, can lead us to construct reality under false impression. Let me quickly add that I do not intend to say that we should do away with our pre-conceptions, which is impossible, but just that better understanding of the limitations of pre-conceptions can help us gain an edge over others (remember, the guy at the opposite end of the trade. He might not be, manic depressive, Mr. Market but, say, the smartest investor out there!)

When can pre-conceptions fail us? Mr. Munger answers it best - ‘To a man with a hammer everything looks like a nail.’ The best way to overcome is to gather multiple models and use mental tools like checklist, zoom-out, zoom-in, reductionism, backward thinking, and forward thinking. As each one of those will also help overcome the following limitation by developing multiple hypotheses...

Selective Perception:
The cost one pays in starting with a single hypothesis and looking for evidence supporting his initial claim is that he overlooks the information, which is not related to the narrowed down scale of the problem at hand, but which might none the less be substantial when viewed from a different angle. And I think, the dissonance increases, in cases where the hypothesis cannot be supported. In such cases, we simply take a pass. But who knows, looked from a different angle, the investment opportunity might have been very attractive and a cinch. Let us look at a solution, which can help us overcome this limitation.

Decomposition:
It is nothing but breaking a complex problem into numerous simple problems. For example, this is what happens when we follow Mr. Buffett’s method of asking ourselves ‘whether keeping aside the element of price, would I like to own this business?’ or ‘would I approve if my daughter wants to marry the executive of the company’ or ‘Is this opportunity better than, say, most of the opportunities I can invest my capital in?’... This way, I think, it allows us to make better use of information available at hand and make a calculated guess, weighing the pros and cons more efficiently...

Conclusion:
As I sit down here reflecting on my answer to the problem of misperceiving reality, I wonder if I have done justice at perceiving the problem at hand. I shall continue to reflect if I have I become a victim of selective perception, man with a hammer tendency, confirmation bias, and all those sort of stuff.

Having said that, I would like to add what Prof. Sanjay Bakshi once said–A tiny edge is all you need... (as compounding will magnify the impact of the edge as time goes by...). And I wish that this reflection has helped me (and, hopefully, the reader as well) gain a tiny edge in a certain way...

Theory of (Appraisal) Relativity

Taking cue from the saying that 'when you're not near the girl you love, you fall in love with the girl who is near you,' I would like to outline the gist of the theory as 'In the absence of an ideally cheap stock to chose from, the context in which a stock is appraised can have a huge impact on the quality of classifications done.'

Accordingly, if the context in which something is appraised makes a difference in the quality of the appraisal, then it would make sense to spend some time thinking about the general context in which potential bargains are appraised and try to make sense out of it.

Cheap Stock (vs.) Cash:

For various reasons, the chances are quite high that any given point in time, one has a portion of his portfolio in cash/bonds, to be deployed in securities. This could be because of new cash coming in (or) closure of our existing positions. Thus, while appraising a potential equity canditate for a place in our portfolio, the competitor facing it is cash (or) High quality bonds.

Under such circumstances, I have many a times felt that the urge - to replace excess cash/bond position in the portfolio with some potential bargain having high reward ratio - is quite high. Given that urge, I think that that impulse makes a given opportunity look a far better opportunity than it truly is, to some extent, because of an unattractive canditate it replaces.

Let me clarify here that my concern is more severe in terms of getting a rough idea about the magnitude of a potential bargain's attractivenesss and not necessarily in terms of the inherent attractiveness itself. Thereby having an impact on your portfolio allocation decision, rather than investment decisions themselves, which are none the less equally important.

Antidote: What to Buy (vs.) Which one of these to Buy?

'Heart has its reason that reasons don't understand' - Blaise Pascal

It appears that every man, to varying degrees, seeks to derive reward from the investments made in terms of time and effort. This tendency can sometimes lead him to fix reality to fit his representation of the reality to justify his initial commitment. In the context of security analysis, I think this tendency plays a crucial role in making investment decisions.

For ex: having spent a week analyzing a potential canditate for investment, the urge to have it qualify as a replacement for cash is relatively high. The prospect of all the effort summing up to zero and sticking with the cash component might trigger a whole set of behavioral biases preventing us from moving towards an optimal decision.

The possible antidote, which I can think of, is to substitute the weak competitor in the form of cash/bond set with a canditate having similar attributes - potentially cheap stock on our radar - being analyzed side by side, in terms of their investment attributes. A slightly weaker but slight better, than cash/bond as the competitor, could be an incumbent investment from our portfolio.

The reason, I think, this should help one make better investment decisions, in terms of quality and allocation, are as follows:

1)Induces Falsification:

'So convenient a thing it is to be a reasonable creature, since it enables one to make or find a reason for anything one has a mind to do' - Benjamin Franklin

One of our most powerful tendency, for good or for bad, involves forming an opinion about something, based on our first impression, and go about looking for evidence comforming it. It is only when we fail to find confirming evidence we tend to revert our opinions.

In the context of the discussion on security analysis, it seems that when we have two or more competing ideas to chose amongst, the process of comparing and chosing one, should induce the use of falsification (why this one and not that one?) as a means rather than a confirmatory one, which is generally prevalent otherwise (Should I buy this?).

2) Doesn't make you a slave of initial commitment:

Also, in the process of comparing the pro's and con's of two distinct propositions, the chances are quite high that we would not shy away from discovering (or) looking for con's. Moreover, the difficulty of chosing one over another, shall induce an urge to look for negatives in both the situations, eventually leading to nullifying one or both of our initial presumptions because it would lead to an overall positive sum game as compared to a negative sum game otherwise, when seen in terms of investment made in time and effort.

3) Shall Optimise Allocation Process:

Moreover, this game of comparing amongst their pro's and con's should better bring to light the overall attractiveness of a security than seeing in their individuality leading to a better ability in forming a set of expectations, going along with the investment decision, towards the situation leading to better portfolio allocation decisions...

On Grahamian & Fisherian Framework

(Following is a transcript of a mail, which I had written sometime back, to a fellow value investor cum colleague of mine on the scope of Grahamian and Fisherian Investment framework)

Date: Mon, 18 Feb 2008 05:24:29 -0800 (PST)
From: Arpit Ranka
Subject: Discussing Graham & Fisher

Following our discussion a couple of weeks ago, I spent sometime reading Fisher's 'Contrarian Investor Sleeps Well.' And I have to say that it helped put things in perspective, in quite an unexpected and interesting way... :-)

Let me put forward for your consideration and comments, the key lessons that I have realized, pertaining to the whole discussion on the scope of Graham and Fisher Investment methods.

1) Understanding Stock Returns:

One thing I realized is that, irrespective of whether you subscribe to Graham or Fisher, the importance of PE expansion in helping you derive above average returns cannot be underestimated. For ex:

As a Grahamian investor, looking for low PE stocks representing decent businesses, majority of the gains are earned in the form of PE expansion and not in terms of EPS growth. The prospect of EPS growth ensures that while you wait, you are being paid to wait with the commensurate increase in intrinsic value, and also equally importantly, in some cases, it might also act as a catalyst. It would not be far off to say that it is akin to trading, where you are betting on a positive reversal of appraisal of a business by the market participants based on fundamentals.

As a Fisher proponent, if one is looking to buy great businesses, which are few in number at around, say, 15-20 x earnings for a business with a prospect of growing earnings at 15% and generating/maintaining high returns on capital employed - the chances of generating returns using PE expansion over the long run are minimal - unless one is betting on speculative increase, just like in Grahamian framework, in positive reversal of appraisal of such businesses - and one can only expect to earn the returns that reflect the performance of the corporation in the long run.

For ex: if I buy into something at 20 x earnings, and expect the earnings to grow at 15% over the next five years, and have reason to believe that the quality of business would be maintained, five years hence, to ensure that the earnings would be appraised at 20 x earnings then, I would get a 15% return.


2) Non-Linear relationship between Known and Unknown; Expected and Unexpected:

The only problem is that to execute Fisher's investment methodology and be successful at it requires a couple of things - 1) availability of businesses where future can be predicted, with considerable certainty, and those predictions can be comfortably backed by capital today, and 2) ability on the part of the investor to have the competence to judge those sort of businesses, which no matter how hard one tries would require superior understanding and experience, of the whole business landscape, to go along with the psychological requirements of being patient along the way.

This brings us to the discussion of non-linear relationship between known and unknown on the part of the investor; and what can be expected and not expected from the business performance going forward. The things that can be known and expected constitute not much of what that cannot be known and expected, yet in the Fisher approach we are required to back with more capital and time, in the form of holding periods, than in the Grahamian approach, on what can be known and expected. That is, the margin of safety - in terms of betting on your own understanding of a situation - is put to test more vigorously in Fisher's approach than in Graham's.

3) Re-investment Risk, Transaction Costs & Taxes:

I think a couple of factors that add considerably to the Fisher approach, when rightly implemented, and not to Graham's approach are 1) Re-investment risk and 2) Transaction Costs & taxes. The very fact that Graham's approach leads one close to trading like approach - selling on the expansion of PE ratios and looking to invest in other cheap stuff exposes one to re-investment risk (a big concern for people operating with huge amounts of capital and, resultant, smaller universe of stocks to choose from) and higher transaction cost and taxes over the long run. But barring the first constraint of large pool of capital to invest, I think transaction cost and taxes are sufficiently compensated by the lack of precision required in generating above average returns from Grahamian approach, unlike Fisher's approach, which without doubt is much difficult to successfully implement.

Considering the above and PE expansion criteria, I think that Fisher approach would be a better way to deploy capital, particularly when businesses of great quality can be bought at throw away prices, like Mr. Buffett did by buying into great businesses at 1973-74 and 1987 period. That way we would not be paying much for future growth and the growth, at high returns, which can be considered probable, would provide icing on the cake. Towards this end, I think Mr. Buffett has successfully managed to seam the best from both the schools and his results speak for his brilliance.... Hats of to Fisher and his successful disciples!

-----------------

Considering the overall scope and limitations, particularly relating to human competence and conditions requisite, for successful implementation of these strategies - I have come out with a lot more appreciation and reinforced vigor towards Graham's framework of sticking with buying good businesses at cheap prices...

Moreover, if any transition is to happen, I think it has to be a natural evolution based on increased understanding of great majority of businesses operating in the corporate landscape leading to a conviction about being capable of seeing the prospects of such businesses far, far into the future and more importantly, exceedingly depressed market/security specific levels to start thinking of taking a very long term view (10 years plus) on an opportunity.

It would be great to hear your thoughts on this, if and when time permits.

Thanks & rgds,
Arpit Ranka

What's in a Name? Not Much...

I am going to use this post to discuss a key lesson from a recent experience involving the whole process of trying to understand things around us.

'What's in a name?' - Shakespeare

Not much. When a company shows up on your screen, on various metrics (div yield, cash yield, high RoE) quite often, you are supposed to take a look at it. Right? I did not for a month. The reason - the name of the company sounded familiar. Familiar to an extent that I concluded that I must have seen this company a few months before and must have had a reason to take a pass, which I failed to recall.

When I actually started looking at the company - it was up 20% from those initial levels. And, even at that price, I found it attractive and could not spot any significant negative which would have justified those depressed valuations.

Let me point out the lesson I learnt using the following quote:

'You can know the name of a special bird in every possible language and yet know nothing about the bird' - Feynman's father to Feynman, as recalled by Feynman. (From memory)

I realized that unless I can claim to be familiar with the characteristics of the subject matter in discussion (be it a stock, mental model, principle...) it is imprudent to start believing that I know something about it. And this exercise of trying to be sceptical, about the so-called knowledge, might be an un-natural process.

In essence, Just knowing the name, when it does not induce inquiry (series of why), might be worse off than knowing nothing because it can trigger a false sense of understanding...

When (Not) to Trust Yourself

To be Skillful is to be able to accomplish a given task, directed towards seeking an intended result, with comfort and in the least possible time. However, an another important aspect of being skillful at something, and importantly to retain the skill with the changing times, is the ability to understand when not to trust your own skills and make necessary changes as we move along.

As an investor, discovering an investment psychology that suits our temperament and which is sound enough to beat the indices, when appropriately implemented, is akin to acquiring a professional skill. One of the major impediments in mastering that skill is learning to deal with the conflicting thoughts arising out of occasional disconnect between our investment philosophy and negative outcomes from individual investment operations. And how we deal with such discontents, over the long run, should determine if we manage to develop and retain the skill.

The underlying reason behind the disconnect could range from any limitation in our investment philosophy (or) simply an event where the process was right but outcome was negative due to some low probability external event. To be able to come up with a possible reason, it is important that we understand our typical response mechanism to such dissonant conditions. Eventually, a better understanding should lead us to either improve our investment approach (or), just as importantly, manage to not tread away from our investment philosophy when times are testing.

Cognitive Dissonance & Psychological Immune System:

Human beings normally tend to have a positive image of themselves. It could be argued that such a positive self concept evolved through centuries to enable us to have decent levels of self esteem and, in effect, lead us to maintain a healthy state of happiness. In short, it could be said that such a positive self concept is integral to leading a, psychologically, healthy life.

But when a human brain, which is wired to seek a stable state of self concept, is faced with disconfirming evidence, we are confronted with a realization that we might not be as good as we believe ourselves to be. Because disconfirming evidence indicates possible mistakes, which in turn could be taken as indicative as a sign of inability by the society. Thus when a positive self perception is faced with evidence suggesting possible mistakes a psychological conflict is triggered. This state can be considered as similar to unpleasant drive states like hunger, thirst and pain. Under such conditions, to reduce the dissonance and anxiety, a psychological immune system gets triggered and can potentially leave us vulnerable to psychological pitfalls.

Let me discuss three most common reactions triggered under such state and possible solutions suitable for investors to overcome such limitations triggered while investing.

Misperceiving the Past:

Memory plays an integral role in the way we deal with dissonance. It not only helps us remember the past without any considerable conscious effort but it also leads us to sometimes misperceive the past. When human brain is faced with evidence conflicting decisions from the past, our memory could lead us to tweak our ability to recall relevant facts in an effort to reduce the dissonance. In short, memory has the potential to not only help us remember - what made us happy in the past but also misremember an unpleasant experience for a pleasant one, if subjected to dissonance.

Antidote:
As an investor, this limitation of memory of occasionally misperceiving our past can be dealt by relying on journals and discussion records, where we try and answer every possible aspect of an investment operation while making the decision (Why I am buying into this opportunity? What do I expect going forward? What are key threats that could possibly work against us? Why did I invest only 3% and not 5-10%? etc...).

Seeking Selective Exposure:

A wise philosopher once said that one should keep both his eyes open before marriage and half shut afterwards. But reality seems to suggest that people do just the opposite - keep half shut before marriage and both open afterwards. How else could we explain the fact that quite a few people are blindly in love with each other only to file for divorce within a few years. The reason behind this phenomenon could be that they take selective exposure to the qualities of other person leading to disproportionate weighing of attributes.

Antidote:
For the lack of experience, I cannot comment on how we can go about overcoming this pitfall while choosing an appropriate partner. But as an investor, I think we could get into a habit of consistently looking for disconfirming evidence and seeking clarification in the form of counter evidence against it. (Darwin used to write up conflicting thoughts on a paper as soon as it struck him, as he believed that otherwise mind would get busy suppressing such contradictory thoughts).

It is easier said than done - but the beauty of the whole process is that the awareness itself can help one deal with it and also lead one to find better solutions suiting his temperament.

External Justification:

Everybody's life is a play, in which not only is all the world a stage for each one of us to act as we wish but is also full of prospective protagonist and antagonist. And one of the most common methods of dealing with dissonance, sometimes for better and sometimes not, is looking for the other people (or) external circumstances to play the role of antagonist in our play.

Antidote:
As an investor, bearing the cost for (perceived) mistake of somebody else is a deadly combination. Because then the whole mindset gets into deciding if we were lucky/unlucky and all those sort of things, which might be right sometimes but as a process might prevent us from learning through our mistakes and, simultaneously, progress. I think subscribing to Mr. Munger's 'Iron Prescription' can help us deal with this mindset to a great extent:

“Whenever you think that some situation or some person is ruining your life, it’s actually you who are ruining your life. It’s such a simple idea. Feeling like a victim is a perfectly disastrous way to make go through life. If you just take the attitude that however bad it is in anyway, it’s always your fault and you just fix it as best you can – the so-called “iron prescription” – I think that really works” - Charlie Munger

Conclusion:

Inspite of all the scientific progress that we have made during the last few thousand years, one of the greatest mystery still facing mankind is to his inability to completely understand the processes of human brain, which has its own set of advantages, making it far superior than other forms of life, but also fails us in understanding reality intending to maintain a positive self image.

The only way to learn to limit the effects of disadvantages is to develop a sense of inquiry into the conditions under which it might fail us. And that understanding, along with systematic solutions to limit the impact, would guide us as to when not trust our mental processes.

My Search for Meaning

“Wat are you really living for - is it money, fame, helping others, power .. or wat?”

A friend of mine had asked me this important question sometime back. Trying to figure out what was the very purpose of my life has had a huge impact on my approach towards life and might have on you if you try and answer the question. Hence, I have decided to share this correspondence with you…

Hi,

I would like to quote the following para from 'Man's Search for Meaning' which pretty much summarizes my take on life.

'...the meaning of life differs from man to man, from day to day and from hour to hour. What matters, therefore, is not the meaning of life in general but rather the specific meaning of a person's life at a given moment. To put the question in general terms would be comparable to the question posed to a chess champion: 'Tell me, master, what is the best move in the world?' There simply is no such thing as the best or even a good move apart from a particular situation in a game and the particular personality of one's opponent. The same holds for human existence. One should not search for an abstract meaning of life. Everyone has his own vocation or mission in life to carry out a concrete assignment which demands fulfillment. Therein he cannot be replaced, nor can his life be repeated. Thus, everyone's task is as unique as is his specific opportunity to implement it.'

'...In a word, each man is questioned by life; and he can only answer to life by answering for his own life; to life he can only respond by being responsible.'

As you can see, I think life is not about being unidirectional in our pursuit towards a specific purpose. Rather it is the multi dimensional approach towards fulfilling various aspects of life that makes it interesting. Moreover this reminds me of an excellent quote by Einstein,

'A life directed chiefly toward the fulfillment of personal desires will sooner or later always lead to bitter disappointment'

Currently the very purpose of my existence is to learn value investing and be successful at implementing it in the real world, there has been one instance where all I wanted to do was hang on to 'dear' life and nothing else mattered, there will be a time when I might be drawn towards the idea of building good libraries for the public...(the role of family/guru/friends constitute such a large portion of our existence that it becomes synonymous with our very own existence)

Moreover it is not the feasibility of a particular idea that drives me, it is the act of me being responsible towards that goal that drives me. And talking of goals they are like the series of next best thing you want to accomplish - not the ultimate thing you want to accomplish. The ultimate goal is to live life to the fullest, which in itself is all about being dedicated towards a never ending pursuit called life.

I will always be grateful to you for asking me a question that led me to search for the very meaning of my life...

Thanks & rgds,
Arpit

Protection (Vs) Prediction

“Life can only be understood backwards—but it must be lived forwards”—Soren Kierkegaard.

Just as a kid starts to lose interest when things become predictable we will lose interest if life ever becomes predictable. I think that if each one of us knew how is his life going to fare out he might not prefer living it over. But fortunately for us life is unpredictable.

When it comes investing if there is one thing that helps stock market to be liquid and create opportunities for investors, it is the unpredictability and the fact that people tend to approach it differently.

Protection (vs.) Prediction:

The best way to learn to handle uncertainty is to learn how successful investors did that and try to replicate it. And who better to listen to than Benjamin Graham himself,

“Every competent analyst looks forward to the future rather than backward to the past, and he realizes that his work will prove good or bad depending on what will happen and not on what has happened. Nevertheless, the future itself can be approached in two different ways, which may be called the way of prediction (or projection) and the way of prediction”

The Way of Prediction:

“The qualitative approach may supply as dependable a margin of safety as is found in the ordinary investment—provided the calculation of the future is conservatively made, and provided it shows a satisfactory margin in relation to the price paid”—Ben Graham.

One of the most important things to realize is that good investment and good business are two different things. A good investment might not translate into good investment because market has the tendency to price good businesses near their intrinsic values. And this is where the problem lies: by doing so they tend to value stocks based on the ‘best case scenario’ and not the ‘worst case scenario.’ I am reminded of the following quote by Walter Bagehot,

“People are most credulous when they are most happy”

On the other hand, value investors value a stock based on the ‘worst case scenario’ and there upon seek margin of safety. Buying securities at a discount to their earnings power value calculated conservatively is as far as I wish to go in predicting future when it comes to investing.

Earnings Power Value:

“(Earnings power is)…the amount that the firm can be expected to earn year after year if the business conditions prevailing during the period were to continue”—Ben Graham

Earnings Power Value = (Normalized Earnings/(r-g))

As Ben Graham puts it that one has to be very conservative about the future projections I prefer not to expect anything out of growth and would not pay for it either, so ‘g’ is out of the equation. And normalized earnings would be the average of the past 3 or 5 years’ free cash flow. The average earnings are used so as to remove the element of favorable and unfavorable business conditions of any given year which can lead us to overpay for the business. If the company does grow it can be considered as an icing on the cake. And to compensate for the extra effort put in (or extra risk taken as some might say), the discount rate(r) used is 2 times the current yield on AAA bond.

When a business is selling for less than two-thirds of the value thus calculated, it can be classified as a possible bargain. All such stocks cannot be classified as bargains without checking other important numbers such as current ratio, debt-equity ratio, interest coverage, ROE…In short the numbers should give a clear indication that the business will, at the least, survive if adverse business conditions are to develop.

The Way of Protection:

“In our own attitude and professional work we were always committed to the quantitative approach. From the first we wanted to make sure that we were getting ample value for our money in concrete, demonstrable terms. We were not willing to accept the prospects and promises of future as compensation for the lack of sufficient value in hand”—Ben Graham.

I would briefly discuss the valuation techniques that Benjamin Graham used to make sure that he was receiving much more in value than the price paid.

Cash Bargains:

This type of bargain arises when the market cap of a company falls below the amount of cash and equivalents in its possession, net of current liabilities and debt. The irrationality on the part of market to quote a business at such low levels is well illustrated in the following analogy used by Prof. Sanjay Bakshi,

“If you were to walk into this fine book store and make an offer to the owner that, "I want to buy your store for the amount of the cash in the till plus the money that you have in the bank or money market mutual funds", he will throw you out. But the stock market periodically allows you to make such kind of offers”

Debt Capacity Bargains:

"There are instances where an equity share may be considered sound because it enjoys a margin of safety as large as that of a good bond. This will occur, for example, when a company has outstanding only equity shares that under depression conditions are selling for less than the amount of the bonds that could safely be issued against its property and earning power. In such instances the investor can obtain the margin of safety associated with a bond with all the chances of large income and principal appreciation inherent in an equity share"—Ben Graham

This type of bargain arises when a debt free company is selling for less than the debt it can comfortably raise and service. I would use a hypothetical example to drive home the point.

5 year average EBIT	$ 40 m
Interest coverage	4
Interest it can serve	$ 10 m
Debt Capacity (@ 10% interest rate)	$ 100 m

Thus a company that has an EBIT of $ 40 m can easily raise $ 100 m of high quality bonds (Considering that we used 4 as the Interest cover). Benjamin Graham says that if such a company sells for less than $ 100 m then it can be classified as a bargain on the following basis,

"An equity share representing the entire business cannot be less safe and less valuable than a bond having a claim to only a part that of"—Ben Graham

Net-Net Working Capital Bargain:

“The idea here was to acquire as many issues as possible at a cost for each of less than their book value in terms of net-current assets—i.e., giving no value to the plant account and other assets. Our purchase were made typically at two-thirds or less of such stripped-down asset value”—Ben Graham.

This type of bargain can be spotted in industries that are experiencing bad times. They could also be going through what buggy whip industries underwent when automobiles came around (ie) extinction. So it would make sense to make sure that the problem is a temporary one.

Conclusion:

I would like to end the write up using a quote that drives home the very essence of the article.

“The task of man is not to see what lies dimly in the distance, but to do what lies clearly at hand”—Thomas Carlyle

The Case of mistaken identity

“We are not so sensible of the greatest health as of the least sickness”—Ben Franklin (Read profit for health and loss for sickness)

People want to make money not only for the need of it but also for the identity it creates for the person who makes it. After all in today’s world to be successful is to be rich. When so much is at stake it is only natural that the very prospect of ‘loss’ makes people anxious. And the best way to deal with it is not psychological denial but by taking appropriate measures to handle those emotions.

“Distrust and caution are the parents of security”—Ben Franklin

As an investor I think that the intensity of emotions become stronger after we commit ourselves to a particular stock. Because once we commit ourselves to a stock it becomes a case of mistaken identity (ie) we identify the stock as a reflection of our ability and its success for ours. In short, the quality of the result becomes more important than the quality of the process, which can be misleading when trying to work out in a complex system such as stock market. And the best way to deal with the anxieties arising out of mistaken identity is to realize it and incorporate certain antidotes in our investment philosophy.

Stocks Does Not Know That You Own It:

“If you know that the stock doesn’t know that you own it, you are ahead of the game. You are ahead because you can change your mind and your actions without regard to what you did or thought yesterday; you can start out with no preconceived notions. Every day is a new day providing a new set of continuously measurable options”—Adam Smith (of ‘The Money Game’)

A stock does not know us and it has nothing against us or for us. It is we who, by means of our action, try to make profit through that stock. And what guides our action is the ability which leads us through the whole process. And ability is the result of what we have learnt about the game and nobody can learn it in its entirety, just that we can keep on improving. To improve we need to realize our mistake when we have made one and that is not possible unless we are ready to question the validity of an investment. And to question an investment it is necessary that we zoom out and see it for it is rather than what we think it is. And to do that it is necessary that we emotionally detach ourselves from the stock by overcoming the anchoring bias.

Overcoming Anchoring Bias:

The reason I think that people find it hard to book losses is that they substitute the intrinsic value of the stock with their purchase price and thus end up comparing current market price with price paid thus leaving value out of the equation, which leads to all sort of irrationalities. But we can learn to avoid making that mistake by listening to Philip Carret,

"The investor should seek so far as possible to re-analyse each commitment from a detached standpoint. Psychologically this is a very difficult thing to do, to consider dispassionately a venture in which he risked his funds. Nevertheless, the investor should make a determined effort to do just this. If he has 100 shares of a given stock, for example, which is selling at 90, he should disregard entirely the price that he paid for it and ask himself this question: "If I had $9,000 cash today with which to purchase some security, would I choose that stock in preference to every one of the thousands of other securities available to me?” If the answer is strongly in the negative, he should sell the stock. It should make not the slightest difference in this connection whether the stock cost 50 or 130. That is a fact that is entirely besides the point, though the average individual will give it considerable weight”

Conclusion:

“Those who will not face improvements because they are changes, will face changes that are not improvements”—Munger.

And realizing a loss when faced with one is an improvement as compared to ignorance or inaction.

Can We Expect To Get Lucky?

Somebody once said, “The moment I leave something on luck. It runs away.”

One thing that has always fascinated me is the way some people overemphasize the luck factor in life. I have thus for long tried to understand how important is the element of chance in achieving success.

Social Proof & Luck:

As often happens in the free market economy if there is a demand to be met, somehow it will be met. Thus the desire of the people to increase their probability of getting lucky has become a great market in India, at the least. The market comprises of astrologers mainly who always have reason for everything that has happened to you. I don’t know if that all works or not but I know for sure that people tend to overemphasize the utility of these things. This reminds me of a famous quote by J.K.Galbraith,

"This is a world inhabited not by people who have to be persuaded to believe but by people who want an excuse to believe."

Probability & Luck:

“Probability is omnipotent and omnipresent. It influences every coin at any time in any place, instantly. It cannot be shielded or altered. And probability is not limited to coins and dice and slot machines. Probability is the guiding force of everything in the universe, living or nonliving, near or far, big or small, now or anytime”—Scott Adams

I think that the above para explains pretty well the concept of luck which according to me is nothing but permutation and combination. And only if we can zoom out and see ourselves as the part of the ecosystem it will be apparent that we cannot by any means control the things happening around us all we can try and do is make the best use of the things around us. But the problem is that when things don’t go the way we expect them to go. We would say that ‘I did everything that needs to be done and yet things did not work out. Why?’ I think that the following quote explains it rather well that some things are unexplainable,

“Every other question has an answer to why. Only probability is inexplicable”—Scott Adams.

Investing & Luck:

“When we try to pick anything by itself, we find it hitched to everything else in the universe”—John Muir

I think once we start thinking of stock markets as an ecosystem we realize that there are lots of variables that can influence it. To add to it, we are not competent enough to understand and extrapolate all the variables into stock market reactions. There will always be this systematic risk which can work against us and sometimes for us.

Thus I think one of the most important thing in investing is to be in a position where we are not required to close a position because of financial need. And if we play the game long enough and diversify as we go along we can expect to achieve what we deserve.

“We might see randomness in the outcome of an individual coin toss, but as the number of tosses increases, probability has firm control of the outcome”—Scott Adams

Conclusion:

Human nature being what it is we tend to overestimate the influence luck or chance has on the outcome when something goes wrong. This might reduce dissonance for a while but the trade off is the state of psychological denial which is a big drag on understanding things the way they are. And few things are more important than understanding things as they are. Thus I think that the following advice from Charlie Munger is worth its weight in gold,

“Whenever you think that some situation or some person is ruining your life, it’s actually you who are ruining your life. It’s such a simple idea. Feeling like a victim is a perfectly disastrous way to make go through life. If you just take the attitude that however bad it is in anyway, it’s always your fault and you just fix it as best you can – the so-called “iron prescription” – I think that really works”

Take A Simple Idea & Take It Seriously

“Our ideas are so simple that people keep asking us for mysteries when all we have are the most elementary ideas”—Munger

While watching Memento I realized that a man with limited ability or cognitive tools can still accomplish otherwise seemingly impossible task if he somehow manages to create a system that serves as an antidote to the limitations. One good example can be the sign language that mute people use to interpret their thoughts with other people.

Much engrossed by this thought I started thinking, as an investor, about the importance of creating a system which not only incorporates proper checks and balances to take care of our limitations but also serve as a foundation to stick to the knitting. This post is a way of giving structure to such a system. The following are the important ideas that constitute the system so far.

Mental Models:
I think one of the major difficulties that we face as an individual is matching our actions with our notions. The reason I think is the dominance of cognition, which is situation dependent, over perception. And it is also true that cognition per se can be misleading at times because of the biases. This is where I think connecting reality with pre held notions (mental models) can help us extrapolate past and present in a better way. And once you start using mental tricks the system becomes that much more efficient.

“If you skillfully follow the multidisciplinary path, you will never wish to come back. It would be like cutting off your hands”—Munger.

I don’t know if I have been following the multidisciplinary path skillfully but it has been six months since I was introduced to mental models by Prof. Sanjay Bakshi and ever since I have not spent a day without thinking about mental models. It just becomes a part of what you are and it is fun, after all. For ex:

“He’s the best physician that knows the worthlessness of most medicines”—Ben Franklin. (Backward thinking/reductionism)

Opportunity Cost:
“Opportunity cost is a huge filter in life. If you’ve got two suitors who are really eager to have you and one is way the hell better than the other, you do not have to spend much time with the other. And that’s the way we filter out buying opportunities”—Munger.

Life is all about making choices. Right from buying a shoe to buying a stock everything boils down to opportunity cost. It so happens that the next best alternate foregone becomes a sort of hurdle rate. For example consider the opportunity cost of getting married. The hurdle rate in this case is sacrificing half your bed (just that?). Now if the person who occupies the other half is worth more or less dependents on the choice one makes—choosing your spouse. Many a times I have seen people who some where down the heart feel that half a bed is worth more than the spouse! But taking steps accordingly can be cited as similar to selling a stock that has lost 90% of its value. So one ends up becoming a rationalizing animal. This reminds me of the following quote by Ben Franklin,

“Keep your eyes wide open before marriage, half shut afterwards”

Compound Interest:
“Understanding both the power of compound interest and the difficulty of getting it is the heart and soul of understanding a lot of things”—Munger.

By understanding this simple idea one can realize that it is not necessary to do extraordinary things to become successful, just doing good enough over the long run will lead to that end. Having said that we should also realize that there will always be people who will do better than us. Instead of getting envied we should only acknowledge their work and try and learn something from them. In short if one is trying to increase his productivity per hour one should not wonder at somebody else doing better than him but instead learn something from him. The time wasted wondering comes at a cost and it of course will reduce the productivity per hour. Mankiw said in ‘Principles of Economics’ that wealthy nations have better productivity per hour as compared to poorer natoins. The same is the case with wealthy individuals as compared to poorer ones, I think.

It’s not a one way road to Rome:
“What you learn in adversity—no university can teach you”—Imran Khan.

Here I would like to bring in one of the properties of cause and effect, “Cause and effect can be widely separated in time and space.” Thus if we can somehow keep on doing what we ought to do irrespective of all the hurdles that come along the way we will somehow reach our goal. This is my belief in the power of the simple law of cause and effect stated above, nothing higher than that.

Circle of Competence:
“I’m no genius, I’m smart in spots, and stay around those spots”—Thomas Watson Sr.

I think most of us have problem realizing our circle of competence because human nature being what it is, we tend to overestimate our capability and undermine the capability of others. But once we approach somebody who has something good by asking, ‘why is he better than the most of us?’ we stand the chance of not only learning great many things but also better realize our limitations. And working backwards from our limitations we can easily sort out the better qualities in us.

“The name of the game is continuing to learn. Even if you’re very well trained and have some natural aptitude, you still need to keep learning”—Munger.

A small leak can sink a great ship:
Somebody once said, “A chain is as strong as its weakest link.”

Just as a value investor looks for opportunities which have very low downside risk, we should not allow any characteristic in our system that can act against other powerful ideas. This variable can be our attitude or some kind of addiction.

Conclusion:
When we start thinking of our environment as a system we realize that we are nothing but a variable of that system. It is this collection of variables that make that system possible but malfunctioning of one particular variable will have no or little effect on the system. Similarly, our system is designed to operate in a much larger system. What makes our system efficient is the power our system can absorb from the much larger space. For example, an investor cannot hope to realize the fruits of compound interest without acknowledging the way stock markets work. Thus we should be ready to make changes as things change around us.

“Those who will not face improvements because they are changes will face changes that are not improvements”—some Victorian minister.

Practice Makes Permanent

It is fairly easy for Jonathan, a 5-year-old kid taking his tennis lessons every weekend to improve than it is for Roger Federer. I think the reason lies in the transition of thought process associated with the game from System 2 to System 1, a concept well explained by Daniel Kahneman and Amos Tversky.

Two System Thinking:
They use this term to distinguish intuition from reasoning, where

Intuition (System 1):
Intuitive operations are basically fast, automatic, effortless, associative, and difficult to control (or) modify. Think of Pete Sampras’ serve.

Reasoning (System 2):
These operations are basically slower, effortful, and deliberately controlled. The other two defining characteristics of this process are: they are rule governed and flexible. That is why a kid who is most flexible (or quick learner) and a great teacher (say a guy who knows what works) will make a great combination (think Warren Buffett and Benjamin Graham.)

System 1 (Intuition) & Status Quo Bias:
Status quo bias is a consequence of system 1 (Intuitive) mode of thinking. I also think that status quo bias is a big drag on unleashing human potential to its best possible level. But we don’t realize it because what’s forgone can only be measured in opportunity cost whereas the advantages associated with it are ‘psychological and real.’ I will try and discuss the psychological (dis) advantages in the next section.

Human Beings Hate Uncertainty:
“Willingness to change is a strength, even if it means plunging part of the company into total confusion for a while”—Jack Welch.

This can be cited as very uncommon behavior because associated with the confusion is the whole lot of uncertainties. It is under such conditions of uncertainty that we are most susceptible to all the biases, as explained by Dr. Cialdini,

“When we are unsure of ourselves, when the situation is unclear or ambiguous, when uncertainty reigns, we are most likely to accept the actions of others as correct”

Thus I think we tend to stick to what is consistent with the current setting when all we forgo for doing so is measured in opportunity cost, which nobody cares to address when they don’t have any incentives to do so.

Grandma’s Rule:
It says “You have to eat the carrot before you get the dessert.”

While thinking about how to overcome status quo bias, I realized that it is not the lack of insights that hold us form seeking change, but the lack of enterprise or incentives to carry out the change. For example, we often hear our inner voice claim that from now on we have got to change this and that, but many a times that tomorrow never comes. To make sure that we accomplish what we think we should, we can set incentives for ourselves. I remember reading somewhere that Warren Buffett decided that he would not invest unless he reads “Intelligent Investor” eleven times. I don’t bet on the authenticity of this but I surely think that this is a good example as to how to set incentives for ourselves. After all, Incentives are super-powers.

Conclusion:
“Practice makes permanent—not perfect”—Warren Buffett.

As an investor, it is only natural to work hard to try and make security analysis as effective as possible. It is also natural that as we practice harder, it will tend to become less effortful. But at the end of the day, security analysis is not an exact science but an art where it pays to stick to certain well-grounded principles and also be flexible.

To be flexible, we need to be receptive to the feedback we receive from the system (ie) success or failure of an idea, as the case may be, and try and incorporate the learning in our collective thought process.

“One mended fault is always better than two found faults”—Ben Franklin.

Thinking Like A Kid

I believe that the propensity to learn new things decreases as a man ages (ie) a 1 year old kid learns a lot more in a day as compared to a 10 year old, who instead learns a lot more as compared to 25 year old.

“A high school teacher drew a dot on the blackboard and asked the class what it was. ‘A chalk dot on the blackboard,’ was the only response. ‘I’m surprised at you,’ the teacher said. ‘I did this exercise with a group of kindergartners and they thought fifty different things it could be: a squashed bug, an owl’s eye, a cow’s head. They had their imagination in high gear. As Picasso put it, ‘Every child is an artist. The challenge is to remain an artist you grow up.”—Creative Whack Pack (card no: 16)

I think one way to maintain our artistic caliber as we grow up is to learn to think gray, and free. I will draw the lessons from my understanding of an excellent book “The Contrarians Guide to Leadership” by Steven Sample and this wonderful post by Prof. Sanjay Bakshi.

Thinking Gray:
“The essence of thinking gray is this: don’t form an opinion about an important matter until you’ve heard all the relevant facts and arguments, or until circumstances force you to form an opinion without recourse to all the facts (which happens occasionally, but much less frequently than one might imagine)”—Steven Sample.

Understanding why ‘thinking gray’ is difficult to follow can help us overcome the difficulty. One possible reason could be social conventions. For ex: we generally tend to relate a successful person with good instincts, quick judgments, being decisive… Those are indeed some of the pre-requisites to become a good decision maker, but we should not forget to bring in an important factor, situation. There are situations when one has to think black and white (ie) make instinctive decision, say playing tennis. On the other hand there are situations where the best decision is to not decide at all. (Please read this excellent post by Prof. Sanjay Bakshi in which he has discussed ‘preserving optionality’ at length)

“Never make a decision today that can be reasonably put off till tomorrow”—Steven Sample.

Thinking gray requires us to overcome the tendency of being decisive just for the sake of it. For example we have a tendency to record first impressions of people and try to check if our impression is right or wrong. This when supported by anchoring bias can lead to Munger’s ‘man with a hammer’ tendency. Thus it can be said that instead of reaching conclusions, we can just record the events or news as pieces of information and preserve our options to reach conclusions.

“The test of the first rate mind is the ability to hold two opposing thoughts at the same time while still retaining the ability of function”—Scott Fitzgerald

Thinking Free:
“Much of our thinking is associative: one idea makes you think of another—no matter how logical the connection. Use this ability to generate new ideas. Look at something, and make associations based on whatever you can think of: function, location, size, shape, sound, personal, opposite, weird, etc…” Creative Whack Pack (card no: 15)

The importance of the above paragraph lies in the fact that it advises us to overcome first conclusion bias, which when combined with inconsistency avoidance tendency results in human mind functioning like a human egg (ie) when one sperm gets into a human egg, there’s an automatic shut-off device that bars any other sperm from getting in. It is fine with human egg, but when something of that sort happens to human mind; it tends to hold onto its beliefs irrespective of their validity. Thinking about the consequences of such a condition reminds me of a wonderful quote by Ben Franklin.

“When you’re finished changing, you’re finished”

Understanding why ‘thinking free’ is so difficult to follow might help us in our endeavor. One possible reason could be people’s aversion to failure. I mean to say that just as people prefer avoiding losses over acquiring gains (as explained by ‘Prospect theory'), people tend to avoid experimenting with thought process if it carries with it the possibility of embarrassment. This could well be the reason behind people blindly falling prey to ‘herd mentality.’ That is, fear of getting caught as a group is very different from getting caught all alone, whatever be the pursuit.

It is easier said than done but with persistent practice we can learn to overcome such shortcomings and learn the art of thinking free. This reminds me of a quote by Warren Buffett,

“Practice does not make perfect; it makes permanent”

Conclusion:
All in all, I think that we should have these important cognitive tools in our repertoire of mental models. The more we practice with such tools, the better informed we can become of their limitations and eventually their advantages.

"Just as a man working with his tools should know its limitations, a man working with his cognitive apparatus must know its limitations"—Charlie Munger.

Is There Time for Timing?

(This is a response to a question asked by Shai to me and Bill of NoDoodahs. You can read Bill's reply from here)

Shai’s Question: What role should the exploration of stock price charts play in a value investor's intelligent analysis of equity?

“When I disagree with a rational man, I let reality be our final arbiter; if I am right, he will learn; if I am wrong, I will; one of us will win, but both will profit”—Ayn Rand

When Shai asked me to become a part of this debate, I reminded myself the above quote and agreed. (Moreover there is no winner or loser, we all can learn something) I have decided to use Charlie Munger’s two-track analysis to answer the above question,

“One approach is rationality—the way you'd work out a bridge problem: by evaluating the real interests, the real probabilities and so forth. And the other is to evaluate the psychological factors that cause subconscious conclusions, many of which are wrong”—Charlie Munger

Rational Consideration:
“Extrapolation may give you the ability to see what’s coming down the street but not what is coming around the corner”—Henry Kaufman

The maxim on which value investing is based is ‘Margin-of-safety.’ To put it simply one tries to buy a dollar bill for, say, 40 cents and waits for the stock market to appraise it to its intrinsic value.

Instead of trying to refute the validity of technical analysis, I think it will be much more rewarding if we think in terms of opportunity cost because at the end of the day we are trying to find if technical analysis can be of any help in ‘value investing.’ Let us assume that technical analysis works and work backwards to see what effects it can have on our perfomance.

Presume that a dollar bill is selling for 40 cents and technical analysis suggests that it will fall to 30 cents. If technical analysis holds then you will buy it and end up making 70 cents. (For the sake of simplicity consider that market will quote the dollar bill at $1 sooner or later) On the other hand what if, technical analysis does not hold and you end up waiting for it to fall to 30 cents and it never does? For an extra return of 10 cents, one can end up missing upon an opportunity to make 60 cents.

Now assume that technical analysis holds 7 out of 10 times. As a result, you would have made an extra return of 70 cents, but you would have missed out on an opportunity to make $1.80. This could be the reason that one is able to find well-to-do technical analyst, but not in the Forbes list!

Thus it is fairly clear that instead of trying to make value investing complicated by linking it to technical analysis we would, rather, do well to keep it as simple as it is. This reminds me of a wonderful quote by Albert Einstein,

“Everything should be made as simple as possible, but not simpler”

Psychological Consideration:
“What we wish, that we readily believe”—Demosthenes.

Apart from realizing that it might not be reasonable to try and predict market prices, I think it is equally important to understand the psychological tendencies that make people do that, so as to try and avoid falling prey to these biases.

Availability Bias:
“An idea or fact is not worth more just because it is readily available to you”—Charlie Munger.

We have a tendency to focus excessive attention on a particular fact or event, rather than the big picture, simply because it is more visible or fresher in our mind. I am not saying that one should not pay any attention to the stock price, all I am saying is that think of the stock price fluctuations as a function of demand and supply for the stock, which varies from time to time for all sorts of reason, which we cannot explain, let alone foresee. But when we have any reason to relate price movement to changes in the business or industry we should classify it as information and make necessary changes in our assumptions.

Social Proof:
“If you want to stand out of the pack, you have to stand outside the pack”—Ralph Wanger.

It is easier said than done. But if it had been that easy, everybody would have done that and in effect we would have found ourselves standing in the pack again, sooner or later [Tragedy of the commons]. So I think before jumping to conclusion that ‘majority is right,’ we should consider our actions as means to a desired end and not confuse with the fact that repeating other people’s moves will not result to that end.

Representativeness heuristic:
“It has struck me that all men’s misfortunes spring from the single cause that they are unable to stay quietly in one room”—Pascal.

We have a tendency to treat events as representative of some well-known class or pattern. This gives us a sense of familiarity with an event and thus confidence that we have accurately diagnosed it. This can lead us to ‘see’ patterns in data even where there are none.

I don’t have any facts to prove that stock prices are random, but I have not come across any convincing explanation that stock prices are not random, either. Hence I think we should stick to what is provable and lies in our circle of competence. This reminds me of a wonderful quote by Ben Franklin,

“There is none deceived but that he trusts”

Conclusion:
We should make sure that we realize which school of thought we belong. We either believe in technical analysis or we don’t. But please avoid taking an intermediate stand because the consequences of being uncertain about something can be worse than being certain about a fallacy. I think this is applicable not only to the current topic but generally speaking. This is very well explained by Benjamin Graham,

“Where an intermediate stand is taken, the result will usually be confusion, clouded thinking and self-deception.”

Understanding Cause & Effect

Perception is our understanding of reality & we understand reality by relating cause & effect. When what we perceive is in line with reality, the perception becomes an information. Mental blocks of such information collectively consititutes our knowledge. But sometimes what we perceive, because of cognitive illusions, can be in contradiction to reality.

"When perception does get through to man’s brain, it is often misweighted, because what is registered in perception is in shockingness of apparent contrast, not the standard scientific units that make possible science and good engineering"-Charlie Munger

I think understanding the limitations in relating cause and effect can help us reduce the perception-reality gap.

"Just as a man working with his tools should know its limitations, a man working with his cognitive apparatus must know its limitations"--Charlie Munger.

Cause & Effect:
"Today is yesterday's effect & tomorrow's cause"--Philip Gribble

The above quote highlights the importance of the fact that the present can be seen in context of past & future. Similarly we can use our thought process in two different, both equally important, modes, Forward thinking & backward thinking. None of the these is limited to relating present to past or future, as the name may suggest. Instead, backward thinking suggests relating causes to some known effect & vice versa.

Backward Thinking:
"'Invert, always invert,' Jacobi said. He knew that it is in the nature of things that many hard problems are best solved when they are addressed backward"--Charles Munger.

It is the process of working backwards from the effect & attributing causes, based on our understanding of the effect. We all do this almost on a daily basis. But we often forget a very important property of cause & effect,

"Causes & effects can be widely separated in time & space" by Joseph Connor in 'The Art of Systems Thinking'

The reason behind that is human mind has limited circuity & it can easily get influenced by psychological tendencies (like availability bias, first conclusion bias while attributing) The point is while attributing we tend to overweigh the elements which are readily available for our cognition to assimilate.

"Cognition is ordinarily situation-dependent so that different situations often cause different conclusions, even when the same person is thinking in the same general subject area"--Charlie Munger

This could be dangerous as we could end up without attributing any cause to the effect or even worse we can end up attributing wrong cause to the effect. Operating with such a disadvantage can be cited as similar to Mr. Munger's, 'disadvantage of one legged man in an ass kicking contest'

Forward Thinking:
"If corporate pregnancy is going to be the consequence of corporate mating, then the time to face that fact is before the moment of ectasy"-Warren Buffett

This is the bottom up approach where we work from a cause & think of various effects that the cause could induce. But we often forget an important property of cause & effect,

"Effect can be disproportionate to the cause" by Joseph Connor in 'The Art of Systems Thinking'

Think of a conglomerate which enters into a new business. Once the new business is created it gets a life of its own. The reason behind that is 'effects of effects' (ie) effect can become cause & induce further effects, which may become uncontrollable. The point is while thinking we should incorporate the effects of effects, where the smallest of causes can lead to a larger effect & vice-versa.

Conclusion:
The cornerstone for successful investing is "Take care of the downside & the upside will take care of itself." Similarly, I think the cornerstone for successful use of our cognitive apparatus is

"Take care of the limitations & the advantages will take care of themselves"

Responding to Noise

"There is lots of noise that comes with information and one needs to train himself to separate noise from information" -- Naseem Taleb (in substance)

Over the past few weeks, I have realised that two areas where discerning information from noise can be of great help are decision making & interpretaion of financial information.

I will use a famous experiment done by Tversky & Kahneman & quote Charlie Munger, Buffett, & Ralph Wanger to drive home the point.

Decision Making:
Success or failure is a consequence of decisions that we make over our lifetime. We can control our decision making process but not how they will fare out. This reminds me of wonderful quote by Ayn Rand,

"One can evade reality but he cannot evade the consequences of evading reality."

To understand how to make decisions I think it is important to realise how decisions are not to be made & work backwards from there.

Psychological tendencies (or) Noises:
We all get, to varying degrees, influenced by psychological tendencies while making decisions. Some of the most common are Availability Bias, Doubt avoidance tendency, Inconsistency avoidance tendency & Psychological denial. (List of other tendencies)

Tversky & Kahneman's Experiment:
Question: 'Are there more words in english language starting with letter 'K' (or) with 'K' as third letter?'

Tversky: "The responses to the question illustrate the general principle that people use to reason under the conditions of uncertainty. They try to think of examples of the word starting with 'k' & with 'K' in the third place. Just because it is much easier to recall words starting with 'K' they assume that there must be more letters starting with K whereas in reality there are twice as many words with K in the third place. We refer to this as Availability Heuristics."

Charlie Munger on Human misjudgment:
"The brain of man is programmed with a tendency to quickly remove doubt by reaching some decisions" (Doubt Avoidance Tendency)

"The brain of man conserves programming space by being reluctant to change, which is a form of inconsistency avoidance." (Inconsistency Avoidance Tendency)

"It is easy to see that a quickly reached conclusion, triggered by Doubt avoidance tendency, when combined with a tendency to resist any change in that conclusion, will naturally cause a lot of errors in cognition for modern man."

I think that we should train ourselves on how to deal with these biases while making decisions and one of the ways of doing that is to try what Charlie Munger has done all through his life,

"I have long looked for insight by inversion in the intense manner counseled by the great Jacobi: 'Invert, always invert.' I sought good judgment mostly by collecting instances of bad judgment, then pondering ways to avoid such outcomes."

Interpretation of Financial Information:
The movement of stocks or markets is a function of how a given news or event is interpreted by the group of investors & traders. If we interpret those news or events the way most of the investors do then we will end up doing the same things as most of the investor & with the same results too. This is where I think we need to train ourselves to think differently than the herd which we are trying to outrun. This is well explained by Ralph Wanger as,

"If you want to stand out of the pack, you have to think out of the pack"--Ralph Wanger.

Having said that I would like to add that being contrarian for the sake of being one can be cited as similar to markets overreaction to good news.

Buy & Sell Decision?
We all aspire to be successful. But confusing that aspiration with the means to attain that objective can be dangerous (ie) while deciding when to buy & when to sell, we should not let our subjective aspirations clash with what the current situation--based on the value of the underlying stock-- warrants us to do.

Taking a loss should not make us feel like a stupid, if our process is right & taking a profit as genius, if our process if wrong. One can hope to achieve what he aspires in the long run. But, in the short run, we have to learn to accept what we deserve & keep on improving.

Conclusion:
During the last decade or so, with the development of internet, ease with which the information gets transmitted from one place to other has increased substantially. Thus it becomes even more important that we respond to information that we think are information & not noises.

"You don’t need 99 percent of the information out there for investments”-Warren Buffett.

Lessons taught by a Coin

"Your idea has to be original only in its adaptation to the problem you are working on"-Edison.

In the last chapter of Security Analysis (1934), Ben Graham mentioned about an experiment done by Frederick Macaulay to prove the invalidity of technical analysis.

Experiment:
"...Frederick Macaulay plotted the results of tossing the coins several thousand times (heads = one point up; tail = one point down) & had thereby obtained a graph resembling in all respects the typical stock chart--with resistance points, trend lines, double tops, areas of accumulation, etc. Since the chart could not possibily hold any clue as to the future sequence of heads or tails, there was a rather strong inference that stock charts are valueless." (Pg no: 608)

I got fascinated & wanted to try it out myself. The plan was to plot a chart with 100 coin tosses & see how it looks like. But then I looked at the chart & wanted to check if regression to mean holds. In the process I ended up with 400 coin tosses & few important lessons.

Invalidity of Technical Analysis:
Everybody will agree that it would be fallacious to look at the above chart and conclude that there will be a more head or tails in the next 50 tosses.

One argument that, I think, people who believe in technical analysis can use against the logic here is 'Each coin toss is an independent event, whereas daily stock price moments may not be independent events. How do you rationalise it?'
I don't know the answer but it reminds me of wonderful quote by Ben Franklin,

"There's none deceived but that he trusts."

Gambler's Fallacy:
There were many instances where I had sequence of 5 heads or tails in a row. I could clearly hear in the back of my mind, while the coin went up in the air, that this time it should be head or tail based on the past vivid sequence.

All this even after being aware of the fact that each coin toss is an independent event & it has got nothing to do with the past events. This is also one of the reason that I continued till 400 (ie) I did it until I stopped predicting, subconsciously. This reminds me of what Tversky & Kahneman have said,

"Under some conditions, when the conditions are knowable, we should not trust our intuition because we are liable to predictable errors & biases. Also the fact that we can predict in advance, when intuition might falter, gives us some hope of implementing procedures to avoid the errors."