Archive for category Lessons from Masters
If you already have a million dollars or more, this blogpost is not for you.
For all others, I’ll cut the bullshit and get to the chase. I am just mighty pissed off.
When you have less than a million dollars –
Please don’t listen to any or all the Gurus who are propagating 16% CAGR, 18% CAGR, 20% CAGR. You know the usual spiel. Say, you have 5 Lakh rupees. Gurus recommend that you should be happy be 18% CAGR or 20% CAGR and over a long period of time (40 years), you would be so rich, that even the rich would be ashamed.
For all those studies, where you read that if you had invested in quality at any price, and just held on to them for a long period of time (40 years), you would have made enough money to be proud of yourself.
You really want to know what they DON’T tell you.
By the time you are rich, you will be OLD. You will be very old. Your kids and grand kids, of course, would really appreciate all your journey, effort and all the good things that you have done for them. You will just die as a rich man without all the good things before it. That’s just a tragedy.
Since the readers of this blog are reasonably well versed with numbers, let me illustrate it with numbers.
Let me get the first and the easiest thing out of the way without the numbers. People keep doing these fancy calculations in excel about how much their salary is growing to grow, how health expenses will increase, plug in a sexy inflation number and try to arrive at a figure which they think will be enough for retirement.
Let me solve that for you. You need a million dollars (ex-Mumbai). Unless you want to live the luxurious life of Vijay Mallya ,(well, if you were Mallya, you wouldn’t do all these calculations), a million dollars would let you live and eventually die peacefully.
Ok, now for the numbers bit.
Let’s say you start investing at the age of 27 (well, how better it would be if you could start investing at the age of 15, but try convincing your teenage son or a fresh graduate not to spend on the latest smartphone and you’ll know what I mean). You start with Rs. 5 lakh (You can plug in any arbitary number).
Let’s say you manage to do 18% CAGR over a long period, say 40 years. Do you know how much money you would have by the time you are 67? 37 cr 51 lakh.
Whoa. That’s a lot of amount you say. Definitely it is.
But what would you do with so much amount at 67? You would be old, frail and not really ready to say travel widely or eat whatever you want or whatever shaukh (sic) you have.
Ok. So, how much money would you have by the time you are 57? 7 cr 16 lakh. Did you observe the difference?
Ok. So, how much money would you have by the time you are still fit, healthy and want to do what you want – say at the age of 47? 1 cr 37 lakh.
Did you see the difference? Did you really observe the beauty of compounding? You would not dream to live a reasonably luxurious life, traveling where you want, doing what you want to do with 1 cr 37 lakh.
And that’s my problem with folks preaching ‘my target is 18% cagr because the Gurus said it’, ‘I am ok with 16-20% cagr, but I don’t yet have a million dollars’.
Nobody, or rather, from whatever I have read spells out clearly on this intricate relationship between CAGR and Age. You can be rich, but you are already old.
I would rather die with 10 cr, in the process doing what I want than die with 37 cr to make my children and grand children happy.
And that brings me to my real point.
You should really not be aiming anything less than 35-40% CAGR if you are not already a millionaire. It just sucks not to aim for it.
Why did I say 35-40% at a minimum? That’s because, you can make 100x your money in 15 years with a 36% CAGR. Your 5 lakh will become 5 cr in 15 years (if you start at 27, by the time you are 42 – you are reasonably rich and an almost millionaire). This is not something that I picked up from the now famous 100-to-1 book. That never spoke of age. In fact, he talks very long time frames.
Is this the bull market in me speaking? Definitely. But why not? Look, unless you are outrageously lucky with a stock or timing the depth of a bear market, your BIG returns are going to come only in a bull market. Again, numbers. If a Rs. 20 has to become Rs. 100, you need a 400% return. That same Rs. 100 to come back to Rs. 20 requires just a 80% drop. So, you absolutely need to make killer returns in the bull market to survive the bear market.
People will try to dissaude you by quoting process will get corrupted, people will indulge in speculative stocks etc. My question is – what’s a corrupt process? Just because there is a wave of high quality, high management integrity bull market this time, everybody is on this bandwagon of the right process etc. It’s almost as if investing was just born in 2009.
And speculation. I don’t think speculation is going to net you 35-40% CAGR for 15 years. I have not met anybody yet doing this.
Is this easy? It’s obviously not meant to be easy. Just because you have some internet forums and whatsapp groups these days doesn’t mean investing is easy. There is a lot of hard work, there is a lot of luck and there is a lot of position sizing science involved before you make that million dollars. As Munger says, ‘It’s not meant to be easy. If you think it is easy, you are stupid’.
And speaking of Munger (which, in these days of the current bull market, seem to encapsulate all other Gurus), here’s what he had to say in Snowball – remember, when he was young –
So, for all those people who keep saying 18-20% CAGR, you are either already a millionaire or you are just bullshitting. Aim higher. Work harder. Enjoy the process of investing. And actually enjoy life at the right age. There is no fun in dying rich. And there is a tragedy in dying really rich without having enjoyed or doing what you really wanted to do.
Go for 35-40% CAGR (atleast). Become a millionaire. Live comfortably.
P.S – Cynical folks may obviously point out that 5 lakh is only a starting capital and people will add as and when they grow in life. You know, if people were so disciplined in investing, we’d have a lot more people active in 10 year and 15 year SIPs.
P.P.S – Other folks might point out CAGR is not important but how much, as a % of your networth, is more important to overall gains. Absolutely agree. Convince your friend in a bear market to put 90% of his networth in equities. % of networth is very important, but even with smaller sums of money (and I do think Rs. 5 lakh is a smaller amount of money these days, with freshers from IIMs earning Rs.20 lakh), CAGR at the right levels covers a lot of ground.
Earlier this week, I had the privilege to be a part of an intense, immersive and absolutely enlightening investor conference in Goa. It was an invite-only and unfortunately, I am not at liberty to disclose either the names of participants in the conference, nor the name/theme. Participants were amazing. It was such an intensely collaborative conference that the time spent on the beach in 2.5 days of the conference was about 2.5 hours 🙂 But Goa, being the place it is, relaxes you completely in those 2.5 hours.
Anyway, enough about the background. I think I do have the liberty to compile a list of learning that I had from this conference. This is more like a list that I wrote down on paper, so there might have been a zillion other things that I missed. Papers get lost but Internet is forever (or something like that) and hence this attempt:
1) Owner’s View: Look at every business from the owner’s standpoint. What motivates the owner? What are 1 or 2 key factors that the owner understands that bring value to the business? How will the owner react in adverse conditions? That’s absolutely critical to value the business. (Book recommendation for this point: “Creating Shareholder Value”)
2) Crossing the Chasm. An excellent mental model to think about businesses, especially emerging businesses. There are two critical strategies for listed markets based on this mental model. a) Initially, follow a basket strategy in an emerging theme (bowling alley phase) and b) More critically (and this was the key learning), the leader usually gets a disproportionate share of the market and hence move capital from basket strategy to the leader once data/analysis points to who would be a leader.
3) Invest in Leaders: Try investing in large, proven and addressable markets (companies trying to create a market usually face a lot of headwinds and probably will not be successful). A further refinement would be to always invest in leaders in pull-based (demand) businesses.
4) What’s the DNA?: Understand the company’s DNA. Look for greatness DNA. The strengths and weaknesses of promoter/owner/leadership gets amplified in the company (and thereby earnings).
5) Write it down: Try and write down core investment thesis before investing in any stock (or selling a stock, for that matter). This would serve as a record to check against reality.
6) Sell a bit: Sell a bit of your most favorite/loved stock and check if the love holds (selling will trigger rationality in a much loved stock in your portfolio). Especially, sell a bit if numbers get disappointing to get rational.
7) Growth, growth, growth: The weightage for growth (usually, sales and then profits) in the Indian stock markets is 50%.
8) What’s your insight?: Decent opportunity size, difficult to dislodge and high predictability are critical factors for any business and in all markets (bull and bear). What requires more effort, insight and is more important to returns is the evaluation of a visible gap between performance and perception (especially, in bullish times like these).
9) Successful patterns: Some of the successful patterns in the Indian stock market have been Growth + Deep undervaluation, Operating leverage + reducing debt, maiden dividend, industries with a reform tailwind, demand businesses + oligopoly and small equity + illiquidity
10) Leverage Darwin: Buy shares (in tracking quantity) of all businesses that you like. Else, it’s usually ‘out of sight, out of mind’. And Darwin theory will force you to forget those stocks even though you seem to be hearing good news (since you don’t even own a share)
11) Read, Read, Read: I found that most good investors in that forum read, at a minimum, 500 annual reports a year (may not be 500 different companies; may be 5-7 annual reports of every company that one likes). And as Munger says, it adds up over a lifetime.
12) Psychological Denial: One of the bigger mistakes that bright investors usually make is psychological denial. It’s not that they fail to recognize that the business is deteriorating. It is that they don’t act upon it. There would be plenty of time to recognize deterioration of a business and act upon it (sell). But psychological denial comes into play and these bright investors are left holding the bag.
13) Are you screwed yet?: If you are not screwed by the markets in 2 years (consecutively), then watch out. Screwing is just round the corner (not just a bull to bear, but due to transition from confidence to overconfidence, mistakes are bound to happen)
14) Don’t take the lollipop: Many a bright investor with wonderful track records for 5, 7, 10 years get lulled by the market and their analysis. Market, at some point in time, gives a wonderful, sweet (but dangerously poisonous) lollipop which these investors partook and then got rogered. Sometimes, they don’t recover financially and worse, are broken in confidence too. The key always is to be watchful.
15) My observation/contribution in the conference: Be absolutely obsessive about working capital (and detailed components). Working capital is a leading indicator of competitive advantage. If working capital (days) is increasing for all businesses in your portfolio, either you have a shitty portfolio or the economy is going in a tailspin.
P.S: As I mentioned earlier, these are the ones that I wrote down (the essence as such. Detailed discussions on these points obviously were a killer). Such was the intensity of the conference and discussions that there were a zillion other things which I couldn’t/didn’t note down. My biggest takeaway from this conference was the humility and down-to-earth behavior of these brilliant investors who have seen the ups and downs of the market for more than 10-15 years and also have made a lot of money still looking to learn, still looking to share and in general, being absolutely stellar. Lot to learn. And as Frost lingers on, ‘miles to go before I sleep, miles to go before I sleep’.
After what seems to be a fabulous year for the stock markets in the hope of ‘acche din’, we seem to be headed for a confusing year in 2015. More on that later.
Massive year for the stock markets. I am yet to come across any person in my circle of investors who have not made atleast a 100%+ gain on their portfolio. The extreme I have heard is a 600%+ gain. Multiple nuances to these claims obviously. Suffice it to say that all the hard work on investing in 2011, 2012 and 2013 paid off in 2014 in my personal portfolio too with 300%+ gain (and obviously, the CAGR will automatically get bumped up). Let’s see how it goes from here.
More than the monetary gains, which are no doubt important, I have made some highly knowledgeable, highly networked and yet very humble friends in the bargain and I immensely thank God for this blessing. Markets and studying about Markets have taught me way more than I could ever imagine – useful stuff not just for Markets but in personal and corporate life. The role of luck is hugely understated in every success is one of my most important learning. Stellar stuff in finance, behavior, management, logic, probability, luck, black swans – I mean, the range of thought processes that I was exposed to, thanks to friends, well-wishers and various social networks, has made life that much more richer (and more unsure of?). They say that Ignorance has the highest courage and the more you know about something, the more you realize you know less about that something. I guess that’s true across all aspects of life, including markets. And also perhaps the reason why older folks are more circumspect than the young folks about any decision they make/take.
Since multiple blogs have been talking about successes, I want to go a bit contrarian. What I want to do in this post is not to talk about successes, which obviously involve luck too, but talk about failures. Failures in thought processes than any price action per se (as it was very difficult to lose money in the 2014 bull market even with a faulty thought process).
As the Prof says, there are two types of mistakes – mistakes of omission and mistakes of commission. I committed both types of mistakes in this year. My selfish effort in documenting these mistakes on the blog is to publicly put pressure on myself to minimize these mistakes to re-occur again (and a bear market is very unforgiving).
Mistake of Omission: This is a easier form of mistake, as opportunity cost doesn’t get reflected in numbers or CAGRs. But opportunity cost is a cost and it needs to be accounted for. So, in this year, I missed two stocks – Symphony and Eicher Motors.
Of course, it’s easier to say that in Bull markets all stocks go up, so what if you missed a couple of them? The point is, there was a flaw in the thought process which led me to not invest in any of the two.
Symphony – It’s a little strange as to how much time I spent studying this stock, business, management, listening to their concalls, doing localized scuttlebutt etc. The price was around Rs.325. My logic of not buying this stock hinged on two reasons –
a) Historically, the management of Symphony was known to give very aggressive targets that they were not able to fulfill. Classic case of overpromising and under-delivering.
b) The Sales growth year on year (unless you took the low of 2009 and calculated CAGR) was not encouraging at all. In all stocks I invest, I try to check the historical sales growth and see if the management had the capability to ramp up sales and if there was a temporary industry/global issue. Symphony sales growth was left wanting. \
And then, the Prof also wrote a great blogpost on Symphony and its business. Q2FY14 results came in very well. I bought a token position of 1% at around Rs.370 post Q2 results. However, I was not convinced that Symphony was a stock I wanted to invest (I am usually a concentrated investor, with no more than 7-9 bets). Inspite of all these good indicators, I sold out the stock at Rs.450 and moved on to something else.
You may call it price anchoring. You may call it wrong judgment of business. Or maybe – and this might be my learning – I underestimated the market’s power of re-rating a stock with an asset-light model, good dividends and a demonstrated quarter-on-quarter sales growth for two consecutive quarters. I really should have bought a chunk post Q2FY14 results. But I didn’t.
Of course, I never expected the stock to go from a 20 PE to a 60 PE to the current price of Rs.2000. But, at a bare minimum, I missed a 3-4 bagger from Rs.370 levels in a easy to understand asset-light business with high dividend payouts coming up the curve on sales growth.
Similar mistake of omission occurred on Eicher Motors. Saw it at Rs.1000. Never expected the RE division to contribute so heavily. Was always thinking that CV division is the one that will turn around Eicher. Totally under-estimated Siddharth Lal’s vision, inspite of seeing a rapid increase in Royal Enfield’s on the roads. The learning – Reading all those Peter Lynch’s books over and over again came to nought. Absolute zero understanding and implementation of Lynch’s statements and thereby losing out on a massive gain (my view has always been, if you can’t implement even such simple things, why read at all?). Of course, never expected this to go to 85 PE. Even at 40PE, I missed a 4-8 bagger from Rs.1000-2000 levels. At current levels, the margin of safety seems quite less, although every analyst and his friends think this is a Rs. 1 lakh stock price business as the CV business is also turning around. If it does go to Rs.1L, I’ll probably write another mistake of a mistake, a meta-mistake blogpost 🙂
Mistake of Commission: A more grave mistake, and probably a bear market would have destroyed my CAGR. I got out unscathed, with some decent returns, but the thought process was pretty sub-standard.
So, I bought this auto-component stock owned by a private equity player as I thought it was highly undervalued at Rs.110 bucks and kept buying till Rs. 120. Nothing wrong with that. But greed overtook me. What I did, since I didn’t have any surplus cash, I sold out most of a artificial leather company, a cpvc company and a three-wheeler company for buying this stock. The thought process was – I will sell these three -> invest in the auto-component story as I saw private equity triggers coming through -> once it becomes fairly valued, I will sell that –> get back into these stories yet again.
The reason why I called such a thought process pedestrian is because I was betting on a series of probabilities rather than a decision or two. I was selling three very good compounding stories, which had given me stellar returns to buy a stock which was only undervalued but not really as great as those three stories with a hope of getting back into those three stories. I was basically trying to time the market, as I thought those three stories were fairly/over valued and this one was undervalued. I got out once I realized the gravity of this mistake (and thanks to the bull market, sold out at Rs.160 in about 2-3 months I think).
The learning, really was, and I keep repeating this to myself over and over – is to never sell a longer term story for a shorter term story. Sell a longer term story for another longer term story. Once in a while, like in 2014, you escape unscathed (with decent returns for a bad process). But in a bear market, such mistakes are going to cost me a lot.
Anyway, those were my mistakes. I may have committed more, but I have probably not yet realized them 🙂
Back to the initial statement about confusing state of affairs in 2015. The markets seem fairly to over valued depending on who you ask. Nobody in the market is saying that markets are undervalued at this point in time. There are a lot of discussions (maybe more than necessary), across all channels of communication, about raising cash to prepare for a crash.
This blogpost should hopefully clarify matters – http://calculatedwagers.blogspot.com/2015/01/when-to-sell-and-when-not-to.html
But my personal view on cash is this – Given that Nifty is not over-valued by traditional means (TTM PE < 24-25 PE) and given most stocks in my portfolio are fairly to slightly over-valued, there is no hurry to get into cash. Cash gets built over time. Of course, there might be minor crashes (10-15%), but that’s the nature of equity markets and you probably shouldn’t be in the markets if you are not ready for such corrections. My view is either be in 0% cash (and expect these minor corrections, and if the businesses you have bought are good, there is only going to be a temporary loss) or be in 30-40-50% cash (which is really like preparing for a crash). Having a 10% cash for example, is only satisfiying the psychological urge to assume you are in control than help you in any sort of corrections. Past corrections in this bull market have led me to believe that quality is not going to correct much – so a 10% cash may not really help in minor corrections. In major corrections, everything’s going to fall and a 10% is no respite.
Disclosure: I am not a financial analyst nor a research analyst. All posts on this blog are only for my documentation and educational purposes. Please contact your financial adviser before taking any decisions.
These guys were also known as Brescon Corporate Advisors till a few months ago (just in case you’d like to check on brokerage reports of the past – if there are any).
I will evaluate this special situation combining the principles/questions outlined by the Prof in this post (which, needless to say, is a must read for anyone who wants to do risk arb and the complexity is getting complexier and complexier 🙂 ) along with the analysis I had done for Tata Sponge Iron/Tinplate company in my previous post.
This open offer was brought to my notice by my friend Ashish Kila today morning. Also, at today’s closing CMP, there is no trade that can be done in this open offer on a profitable basis. This post is only for analysis (which reminds me, I need to come up with a mindmap kind of thing for open offers after the Prof’s complete post on the risk arb problem).
Anyway, Nusarwar Merchants Pvt. Ltd. (NMPL) has come up with an open offer to buy 26% of Brescon at a price of Rs. 123/-. Today’s current CMP is Rs. 113/-. The genesis of this offer was a 33.75% buyout from certain sellers (looks like a part of the promoter group, also called ‘persons acting in concert’ in the latest AR) in Brescon on 29/Sep/2012 and hence this open offer is a triggered offer. Here’s the link to the open offer.
Let’s go through the Prof’s questions to analyze this then (and given that all regulatory approvals are through and the chances of any regulatory surprises are close to nil, the relevant template would be template #2).
a) What’s the expected return of this operation?
Ans. The current CMP is Rs. 113/-. The offer price is Rs. 123/-. Payment would be done by Dec 25th, 2012 according to the schedule (2 months from current date). Since 33.75% has been acquired, theoretically, 66.25% can tender. Theoretical acceptance ratio would be 26/66.25 = 39.24% (approx to 39%). Let’s say I buy 100 shares and I expect the price after the open offer closes to be Rs. 100/-.
Investment = Rs. 113 * 100 = Rs,11,300/-
39 shares would be accepted at Rs.123/-. 39*123 = Rs. 4797 (Rs. 390/- would be the gain, on which 30% marginal tax would be applied since STT wouldn’t be applicable while tendering, but I’ll ignore this for now)
Remaining 61 shares would be sold at Rs.100/-. 61*100 = Rs. 6100/-.(a loss of Rs.793/- can be used to offset short term capital gains, if any)
Total return = 6100+4797 = Rs. 10897/-
That is, Investment > Total return, resulting in a loss, assuming a theoretical acceptance ratio.
b) Should you look at fundamentals of the target company? Why or why not?
We should certainly look at the fundamentals of the company since there is a chance that we can acquire shares of a good company at a very low cost. However, in case of Brescon, after looking at the fundamentals over the last 2-3 years and this slump sale arrangement (where they sold Brescon Corporate advisory business to their own subsidiary company on a slump sale basis citing some convoluted logic, read Item No. 3 on Page 6 of that arrangement for starters), I am not too comfortable in acquiring shares of this company for the long term.
c) What is the likely acceptance ratio i.e. how many of your shares are likely to get accepted under the offer (theoretical vs. practical) and what key factors will govern that ratio?
The theoretical acceptance ratio is 39% as stated in a). The practical acceptance ratio might be different. Given that only one part of the promoter group has sold out, the remaining promoter group has approx. 24% of the shareholding. Since this looks like a voluntary sellout by one part of the promoter group, the rest of the promoter group may not participate in the open offer. However, the chances of the promoter participating is non-zero. The retail shareholding is close to 20%. On a historical basis, not all retail investors have tendered for various reasons. Let’s assume 5% brain dead investors then. Let’s look at the two different scenarios then (am assuming the rest will tender) –
|1||Promoter group doesn’t tender; 5% brain dead investors||71%||Highly likely||70%|
|2||Promoter group tenders; 5% brain dead investors||43%||Probably not||30%|
A few calculations summarized in the table below –
|No of shares||100|
|Price post open offer||100|
|Acceptance ratio 71%||333|
|Acceptance ratio 43%||-311|
|Expected value per share based on probabilities above||1.40|
|Gain% on expected value on an annualized basis||7.50%|
Therefore, we’ll have a gain of 7.5% on an annualized basis without considering the effect of taxes, service tax, cess etc. This is poorer than the return if we invest the same money in a liquid plus mutual fund for 2 months. Hence, this opportunity is a pass.
d) How can you use the “inversion” (invert, always invert) trick to estimate market’s assessment of the acceptance ratio?
Ans. Let’s assume that the market cost of capital is 12%. That is, 2% for 2 months of money.
CMP is Rs. 113/-. At the end of 2 months, at the market cost of capital, the money should have been Rs.115.26. We can find the market’s expected acceptance ratio by
Rs. 115.26 = Offer price * Accepted shares + Remaining shares * Resultant share price after open offer.
Plugging in the values,
Rs. 115.26 = 123*x+(1-x)*100 and solving for x, we get an acceptance ratio of 66.34%. That is, the market is pricing to almost close to the best case scenario (refer table above) where the rest of the promoter group doesn’t tender and there are 5% brain dead investors. This is clearly very optimistic and hence the chances of a substantial upside is close to nil.
e) Should you borrow money to do this operation? Should you have done it in Template 1? Why or why not?
Ans. With the expected value of 7.5% p.a, and being a retail investor, I cannot borrow at less than 12%, if not more. This clearly is a losing operation for me. Hence, I wouldn’t borrow for executing this operation.
a) There is certainly a price at which this operation can deliver a lot of value. Between now and 11 December 2012, if the market price of Brescon falls below say Rs. 100/-, this operation will have a quite a bit of value. It is not profitable just right now.
b) I have not considered the scalper syndrome scenario where you buy at Rs. 113/- and say if the market shoots up and if the price goes to Rs.118/- by end of next week, you can make some returns in quick time. However, then I would be speculating than evaluating.
Disclosure: No position in this open offer. This post is only for analysis and not for investment purposes.
Special Situation: Open Offer Analysis – Tata Steel’s Open Offer for Tinplate Company of India and Tata Sponge Iron
Last Friday (15th June, 2012), there was a corporate announcement by Tata Steel. It had announced an Open Offer for two of its group companies – Tinplate Company of India and Tata Sponge Iron.
Seemingly, there was some insider information trading already (hello, Rajat Gupta speaking!) going by the increase in stock prices of both stocks as seen below (courtesy: Moneycontrol)
Tinplate Company of India
Tata Sponge Iron
Of course, nothing can be proved in India and hence we can all rest easy and get back to Insider trading (kidding!).
Anyhow, I was all excited about this Open Offer since the closing price was Rs. 45/- for Tinplate Company of India and Rs. 306/- for Tata Sponge Iron. In my excitement, I wrote up an investment note about this Open Offer. I however didn’t realize that the announcement had come about after market hours and I didn’t consider the impact costs.
Please download the investment note (clicking on the link will automatically start a word document download) Open Offer_Tata Steel_Evaluation that I wrote up for the Open Offer. Even if using this document doesn’t generate any returns currently, it atleast has the framework to work on future open offers.
Looking forward to your comments/insights/learnings from past open offers.
P.S: I had shared this investment note with a few senior investors on Saturday. Thanks to Neeraj and Ankur, I realised that I have to include the following points in that analysis:
a) Consider impact costs. Ankur was a little gentle, saying that I didn’t consider impact costs in the calculations while Neeraj was a little more blunt saying ‘this is theoretically perfect, but practically, the market will not give you a chance since you didn’t consider impact costs’ 🙂 .
b) Tax implications: If and when you tender in an Open Offer, since you don’t pay STT, the gains are subject to taxes (long term and short term). The market will usually raise it up to a level where there is no arbitrage due to the tax angle. This is another angle that I need to add to my Open Offer framework note.
Every Tom, Dick and Harry seems to be posting about Berkshire’s Annual Letter 2011. Most of the blogposts I’ve read seem to be interpreting what Buffett said. However, my endeavor in this blogpost is to cull out the bits that I liked (and thought were important) in the Annual Letter and present them here. No interpretations, no extension of logic etc. Just pure excerpts from the annual letter found here. I am sure each one of us on different points on the investing learning curve will interpret his statements differently and there is no one single interpretation that would do justice.
On Berkshire’s intrinsic value,
Our share of their earnings, however, are far from fully reflected in our earnings; only the dividends we receive from these businesses show up in our financial reports. Over time, though, the undistributed earnings of these companies that are attributable to our ownership are of huge importance to us. That’s because they will be used in a variety of ways to increase future earnings and dividends of the investee. They may also be devoted to stock repurchases, which will increase our share of the company’s future earnings.
On Buffett’s Natural Gas bet,
A few years back, I spent about $2 billion buying several bond issues of Energy Future Holdings, an electric utility operation serving portions of Texas. That was a mistake – a big mistake. In large measure, the company’s prospects were tied to the price of natural gas, which tanked shortly after our purchase and remains depressed. Though we have annually received interest payments of about $102 million since our purchase, the company’s ability to pay will soon be exhausted unless gas prices rise substantially. We wrote down our investment by $1 billion in 2010 and by an additional $390 million last year.
On Berkshire’s performance in bull and bear markets,
We’ve regularly emphasized that our book-value performance is almost certain to outpace the S&P 500 in a bad year for the stock market and just as certainly will fall short in a strong up-year. The test is how we do over time. Last year’s annual report included a table laying out results for the 42 five-year periods since we took over at Berkshire in 1965 (i.e., 1965-69, 1966-70, etc.). All showed our book value beating the S&P, and our string held for 2007-11. It will almost certainly snap, though, if the S&P 500 should put together a five-year winning streak (which it may well be on its way to doing as I write this)
On Stock buyback/repurchases,
Charlie and I favor repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated.
The first law of capital allocation – whether the money is slated for acquisitions or share repurchases – is that what is smart at one price is dumb at another. (One CEO who always stresses the price/value factor in repurchase decisions is Jamie Dimon at J.P. Morgan; I recommend that you read his annual letter.)
When Berkshire buys stock in a company that is repurchasing shares, we hope for two events: First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and second, we also hope that the stock underperforms in the market for a long time as well.
Let’s do the math. If IBM’s stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%.
The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply.
On Insurance businesses,
At bottom, a sound insurance operation needs to adhere to four disciplines. It must (1) understand all exposures that might cause a policy to incur losses; (2) conservatively evaluate the likelihood of any exposure actually causing a loss and the probable cost if it does; (3) set a premium that will deliver a profit, on average, after both prospective loss costs and operating expenses are covered; and (4) be willing to walk away if the appropriate premium can’t be obtained. Many insurers pass the first three tests and flunk the fourth.
On his two new personnel,
Todd Combs built a $1.75 billion portfolio (at cost) last year, and Ted Weschler will soon create one of similar size. Each of them receives 80% of his performance compensation from his own results and 20% from his partner’s. When our quarterly filings report relatively small holdings, these are not likely to be buys I made (though the media often overlook that point) but rather holdings denoting purchases by Todd or Ted.
On Berkshire’s derivative positions,
Though our existing contracts have very minor collateral requirements, the rules have changed for new positions. Consequently, we will not be initiating any major derivatives positions. We shun contracts of any type that could require the instant posting of collateral. The possibility of some sudden and huge posting requirement – arising from an out-of-the-blue event such as a worldwide financial panic or massive terrorist attack – is inconsistent with our primary objectives of redundant liquidity and unquestioned financial strength.
On basic choices for investors (which I highly recommend to be read in full rather than this brief summary),
Investing is often described as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.
From our definition there flows an important corollary: The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability – the reasoned probability – of that investment causing its owner a loss of purchasing-power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, a non-fluctuating asset can be laden with risk.
Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge.
The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century. This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future. The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful).
Our first two categories enjoy maximum popularity at peaks of fear: Terror over economic collapse drives individuals to currency-based assets, most particularly U.S. obligations, and fear of currency collapse fosters movement to sterile assets such as gold. We heard “cash is king” in late 2008, just when cash should have been deployed rather than held. Similarly, we heard “cash is trash” in the early 1980s just when fixed-dollar investments were at their most attractive level in memory. On those occasions, investors who required a supportive crowd paid dearly for that comfort.
My own preference – and you knew this was coming – is our third category: investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment.
One book recommendation,
I think you’ll also like a short book that Peter Bevelin has put together explaining Berkshire’s investment and operating principles. It sums up what Charlie and I have been saying over the years in annual reports and at annual meetings.
(all emphasis mine)
a) Once in a while it is good to go back and read up what the Gurus have said. Especially Graham. Did I say ‘once in a while’? Scratch that. I think it should be all the time for value investors. Ben Graham in his last days proposed 10 criteria which he said ”seemed to be practically a foolproof way of getting results out of common stock investments with a minimum of work.”
Here are the 10 criteria that make up the new Ben Graham Formula.
1) An earnings-to-price yield at least twice the AAA bond yield.
2) A price-earnings ratio less than 40 percent of the highest price-earnings ratio the stock had over the past five years.
3) A dividend yield of at least two-thirds the AAA bond yield.
4) Stock price below two-thirds of tangible book value per share.
5) Stock price two-thirds net current asset value.
6) Total debt less than book value.
7) Current ratio greater than two.
8) Total debt less than twice “net current asset value.”
9) Earnings growth of prior ten years at least 7 percent on an annual basis.
10) Stability of growth of earnings in that no more than two declines of 5 percent or more in the prior 10 years.
Now, now – 10 criteria. ‘Too tough. I am already switching off and moving along my internet surfing exercise’, eh?. Hold on. Read on for a while. According to the Gurufocus article “The Investment Methods of Benjamin Graham”, the first five criteria in the new Graham formula were related to reward and the second five to mitigating risk of loss of capital. One needs to select a stock with at least one from the reward and one from the risk mitigation section. Very few if any stocks will pass all 10 critieria.
Interesting. This is getting slightly easier. Just (atleast) one from the top 5 and another one from the bottom 5. Very nice. If only some researcher/investor did some analysis to tell me which criteria should I pick in each category so that my investment becomes multi-fold?
Good news! Someone has already done it. (Ok, I will stop it. I am sounding like someone on the TV shopping network commercial). In a “Test of Ben Graham’s Stock selection Criteria,” Henry Oppenheimer studied whether or not a set of Ben Graham’s investing criteria actually worked. Oppenheimer discovered that two of the Ben Graham criteria, number 1 and number 6, produced exceptional returns. Oppenheimer found that the mean return during the time studied (1974-1981) was 38% vs. the S & P 500’s 14%. A remarkable out-performance. He also found that using criteria 3 and 6 would have achieved mean annual return of 26%.
Nice. So, I’ll pick criteria 1, criteria 6, I will add my own criteria on return ratios and earnings growth etc., and ta-da, I have my list of stocks, no? Good thought process. Now think about – ‘what will happen if this list consists of only one stock?’, ‘what will happen if this list consists of 94 stocks?’. Would you invest in just one? Would you invest in 94? How would you segregate? Let me know your thought process.
Of course, Graham criteria was tested only on the US market and the results are dependent on the time period chosen. I am not aware of any such study done on the Indian markets though. If only some researcher/investor….. 🙂
b) Terrific list of 115 learnings, investing ideas and investment wisdom from the brilliant Greg Speicher (as always). A must read (and his blog is a must follow). Link here
c) I wanted to compile a list of good investment books I have read and a list I want to read this year in this post (I should probably make a tab to keep track). Please feel free to add to the list in the comments.
i) The Intelligent Investor and Security Analysis – Ben Graham
ii) You can be a Stock Market Genius – Joel Greenblatt
iii) Common Stocks and Uncommon Profits – Phil Fisher
iv) One up on Wall Street – Peter Lynch
v) Stocks for the Long Run – Jeremy Siegel
vi) Margin of Safety – Seth Klarman
vii) Reminiscences of a stock operator – Edwin Lefevre
viii) Black Swan and Fooled by Randomness – Taleb
ix) Thinking, Fast and Sl0w – Daniel Kahnemann
x) Predictably Irrational – Dan Ariely
xi) Extraordinary popular delusions and madness of crowds
Want to read (in no particular order)
1) Essays of Warren Buffett – Lesssons for corporate america
2) The five rules for successful stock investing – Pat Dorsey
3) Influence by Robert Cialdini
4) In an uncertain world – Robert Rubin
5) Against the Gods – The remarkable story of risk
6) Seeking Wisdom by Peter Bevelin (Munger’s ideas explained)
7) Financial Shenanigans – Howard Schilit
8) Behavioral Finance and Wealth Management
9) It’s when you sell that counts – Don Cassidy
10) The Richest man in Babylon
11) Contrarian Investment Strategies – David Dreman
12) The Little book of value investing – Christopher Browne
13) Where are the customers’ yachts – Fred Schwed
14) A short history of Financial Euphoria – JK Galbriath
A good friend of mine, and a reader of this blog complained recently that I write about where not to invest but hardly about where to invest (of course, he did not say it nicely – he interspersed it with shudh hindi gaalis). This is an attempt to rectify that, although must warn you that the returns hardly come up to any substantial number. I personally felt analyzing this situation very intellectually stimulating. The opportunity is still available (so that my good friend can invest 🙂 ) although the returns are nothing to be excited about. So, here goes.
NCD (Non-convertible debentures) are a very recent and interesting development in the bond markets in India. NCDs at a very basic level, allow companies/corporates to issue debt to the public and the market is growing for the past 2-3 years (Muthoot, Mannapuram, Shriram group, Tata group etc. have issued them). NCDs can be secured (as in, backed by assets) as well as unsecured.
Tata Capital was one of the first corporates to come out with a NCD issue way back in 2009 (it was a secured issue). Here’s the link to their prospectus (and here’s the link to Deepak’s post in 2009 where he scared the bee-jesus out of everyone, and rightly so!). They had 4 issues – N1 (paid interest monthly 11% p.a), N2 (paid interest quarterly 11.25% p.a), N3 (paid interest yearly 12% p.a) and N4 (paid cumulative interest 12% p.a). And a recent announcement triggered a special situation opportunity almost immediately in my mind. Here’s a more detailed prospectus of that recent announcement.
If you are not very link-savvy (like me), here’s the summary. Tata Capital had something called a Put/Call option when they issued NCDs. Put/Call essentially meant that investors could surrender their NCDs/company can call in the NCDs at par value (in this case Rs.1000/-) after 3 years from the date of issue. They issued these NCDs in 2009 and they had an option to exercise the put/call in 2012 (which is now). Why would any corporate give such an option? Well, it’s a play on interest rates. Back in 2009, they gave us 12% because you could hardly raise any money at that point in time. However, in 2012 (3 years from date of issue), when the put/call option became active, Tata Capital realized that the interest rates were heading down, they wanted to call the costly bonds back/continue them at a lower interest rate. So, they said, boss, either you give us our bonds back (and we will pay you back the par value of the bond) or you can continue them at the rates as stated below –
At this point, you are probably saying – Ok dude, great information. Can you get on with the special opportunity please?
I’d say yes and probably go on to tell you that you have a special opportunity both in the N3 (Annual interest) and N4 (cumulative interest) series. I will enumerate the analysis for N3 (N4 follows a similar track).
When I started this analysis (03rd Feb weekend), Tata Capital N3 series was quoting at Rs. 1093/- (it is currently at Rs. 1100/-). N3 series pays out interest (12%) on 01-Mar every year and so it is with the current year too. The interest record date is 14-Feb (i.e., you need to own the bond as on 13-Feb-2012 for getting the interest). A 12% interest rate works out to Rs. 120/-.
Bond markets in the case of interest payment, work exactly like stocks which give out dividends. The markets reduce the price of the bond by the interest paid out. As time goes on after interest payment, the interest for the subsequent year starts accumulating and the price of the bond rises.
In this case, the price of N3 series might correct by Rs. 120/-. If I buy at 1093, the price should have fallen to 1093-120 = Rs. 973/- after the interest record date (14-Feb-2012). However, since Tata Capital has already decided to exercise its put/call, the minimum value that would be paid out is Rs. 1000/-. If we read through the recent announcement in detail, it clearly states that an investor can tender his NCDs between March 23rd and April 5th and Tata Capital while redeeming the NCD would also be paying the interest for the period from March 5th till redemption (which should be within a period of 3 months from March 5th). That is, redemption amount would be Rs. 1000 (par value) + any accumulated interest (from 5th March to redemption).
This special opportunity arises only because Tata Capital wants to redeem the bonds (just playing for interest is pure speculation) (for those who want to hold on to these bonds at a lower interest rate – good for you, I have some analysis for you as well at the bottom of this post!). I will detail out the arbitrage using figures –
Fantastic. A risk-free return on 17.90% p.a (if you do analysis for N4 series, it is more or less the same). At this point, I thought awesome.
And then it hit me. Tax. We haven’t considered the tax impact in this calculation at all. I am very ‘delighted’ after all this analysis to announce that interest will be taxed at the marginal tax rate and short term capital gains will also be taxed at the marginal tax rate. I will ‘eagerly’ take a 30% marginal tax rate and incorporate it into these calculations –
Ta-da! ‘Absolutely phenomenal’ returns of 1.74% p.a after incorporating the tax impact. I might be better off investing in a savings bank account which gives me a mammoth 2.8% p.a. post tax.
And I don’t think the Income Tax act allows you to claim a short term loss (I invested 1096, I got back only 1016 and hence loss of Rs. 80/- type of argument). The price of the bond fell after payment of interest and hence will not qualify for a tax loss.
N4 is no better.
Lesson learnt: Finding arbitrage situations in bonds (and NCDs) is difficult. Even if you find it, the taxman will not allow you to exploit it for decent returns. 30% tax rate is absolutely killing. For people in the 20% tax bracket, the returns in this arbitrage would work out to 7.04% (post tax, which is decent). NHAI bonds would give you a post-tax rate of 7.97% though, at today’s rates.
For people who want to stay invested in Tata Capital NCD at reduced interest rates (@10.5%), the yield works out to –
Of course, pre-tax is 11.38% p.a. Post-tax returns, it works out to 6.52% (tee-hee ).
Disclosure: People actually had to tie me in chains to not invest in this 🙂 . I mean, I was beaming with pride to find this special situation and read up a ton of material and then, the tax situation hit me. Not invested. And I say that with a heavy heart. Rationality doesn’t allow me to. I remember Munger ‘The stock/bond doesn’t know you own it – so, keep a check on your ego’.
And general point/advice. If you are not using XIRR while valuing bonds, you are doing it wrong. And please include tax considerations while calculating your actual rate of return.
Azim Premji University gave investors residing in Bangalore a reason to rejoice today, the 9th of January 2012. They had invited George Soros to deliver a talk, as part of their public lectures series. I had obviously subscribed to the event immediately and reached the venue 30 minutes early to grab the best seat. If there are three investors in the world that I wanted to see and interact with in my life, they are Warren Buffett, George Soros and Seth Klarman. George Soros check.
The lecture began in the form of a conversation with the Chancellor of Azim Premji University, Mr. Anurag Behar. Soros in his unimitable fashion took over the conversation with gusto (and without anybody noticing – credit to Mr. Behar not to interrupt like some news anchors would have done). I scribbled down notes as fast as I could and am presenting with what I wrote down. I definitely would have missed some points – so anybody reading this who also attended the lecture – please fill in the gaps. Caution though – investors who follow George Soros religiously will of course find nothing new in here. Notes follow (all italics are statements made by George Soros, emphasis mine) –
Soros talking about his initial days –
A lot had to do with my father. Year 1944. World War II. I was a Jew. Persecution loomed. My father saved me from persecution by taking a lot of risks. If he hadn’t taken those risks, I probably wouldn’t be in this position. That gave me my first insight ‘Sometimes, its more risky not to take a risk and act all precautionary’
Soros talking about his Guru, Karl Popper –
Karl Popper shaped my philosophy. He was a strong proponent of ‘critical thinking’ and idea of a ‘open society’. I was very young when I read him. He influenced me a lot, and I have read all his books.
The big topic. 2008 Financial Crisis –
The theory of financial markets states that markets do not tend towards equilibrium. Boom-bust cycles happen regularly. The problem of this super bubble that led to the crisis of 2008 started in 1980 with the Reagan Administration.
If financial capital is free to move around, that capital will tend to find a place where there is least regulation and taxes. Therefore, globalization and de-regulation always go hand-in-hand. Govt. authorities always come to rescue – whether it was the S&L crisis, the Asian crisis, IT bust in 2001, leading to moral hazard. Growth of credit and leverage led to the super bubble. I thought that the bubble would pop in 1997 during the Asian crisis, but the authorities intervened. Then IT bubble-bust happened, and authorities reacted by reducing interest rates and kept low interest rates for too long, which led to the housing bubble. In the crash of 2008, the authorities let Lehmann Brothers collapse and the financial markets essentially stopped functioning. Subsequently, financial rescue came through and the market was put on artificial support. What the authorities essentially did was to substitute financial credit with state credit. But they did not try to address the underlying imbalances.
On the Euro situation and crisis –
The Euro crisis is a direct consequence of that replacement of credit. Due to that, sovereign credit is in question now. The 2008 crisis revealed the inherent weakness in Euro and the region as a whole. This Euro crisis is larger than the financial crisis.
In case of Euro, there is a Central bank (ECB), but there is no Treasury. Central Banks deal with liquidity. Treasury deals with solvency. There is no Treasury in Europe currently and they are currently in the process of creating it.
When the Euro was brought into existence, the authors (or its creators) knew that there were chinks, but rationalized that with a common currency, political integration would come through and these chinks would be ironed out. But that didn’t happen. Now we realize that only in the time of crisis, politically impossible becomes possible.
Slowly, Treasury will have to be created. We are in a more dangerous situation than 2008. Euro banks failing would be catastrophic because of the current state of financial integration across the world. The chances of failing poses a great risk to the economy of the world.
The point is – if the crisis is brought under control, period of austerity has to begin and creditors will call the shots. Essentially, Germany will call the shots. And Germans might come up with a draconian austerity program. There is a real possibility of a deflationary cycle, hence impacting the real economy. Deleveraging is already happening and I am afraid, there is more to come.
On the Developed vs Developing world debate –
This crisis is hitting the developed world. 2008 crisis was primarily hitting the US. But the repercussions of this crisis will also be felt by the US. Developing world will be affected by the crisis too, but less affected than the developed world. There is an underlying shift from the developed to the developing world happening right now. The rate of growth in the future in the developing world will be positive while in the developed world, it might be negative.
India is a fascinating country, and I am long term optimistic on India.
On Market fundamentalism, Economic theory and Reflexivity –
Market fundamentalism is a political interpretation of the prevailing economic dogma – the economic dogma being ‘Markets left to their own devices will find the optimum outlets…’. I don’t subscribe to it. Financial capital will move to wherever there is less regulation and taxes. It is difficult to globally regulate economy and still ensure that the financial capital moves freely. The regulation of Banking system is not going well.
As they say, Economists predicted 8 out of the last 3 recessions. Economic theory doesn’t resemble the real world. It is just being mistaken to be relevant to the real world. Economic theory tries to imitate Newtonian physics and hence tries to arrive at a equilibrium by modeling the real world using universal laws. This equilibrium is a mirage. Social affairs have thinking participants and hence lead to in-determinant situations.
Reality and people’s view of reality are never equal and are more often divergent. There is always a two way connection between thinking and actual course of events. There are two aspects that everyone is trying to grapple with. One, understanding reality. Two, impacting that reality. These often stretch in opposite directions and creates a feedback loop (termed as ‘reflexivity’). This impacts the state of affairs depending on the type of feedback. Positive feedback reinforces prevailing trend, introduces bias and creates distortion. Negative feedback corrects the reinforcement. Due to the nature of feedback, there will always be booms and busts. Reflexivity disturbs the equilibrium while Economics explains only theory.
On Regulation –
Markets are prone to create bubbles and busts and therefore, you need regulation. Ever since financial markets existed, financial crisis have happened. Every time crisis happened, regulation was created. Regulation is a part of the financial markets. There is always an interplay between Regulation and Financial markets. Both are imperfect and both exhibit reflexive interplay.
This reflexive concept has not been invented by me. It was explained long ago by Frank Knight, in the Knightian Uncertainty. Risk management techniques ignore unquantifiable uncertainty, thereby creating financial crisis (impact of fat tails). We should rebuild economics on imperfect understanding of the markets. I have had an edge and made money by understanding the concept of reflexivity better than others, till I explained it in my book ‘Alchemy of Finance’ (laughter!)
In today’s world, the business of spending some money to create a loophole in the regulation so that it benefits one party is growing tremendously.
On Democracy and his Charity Foundation –
I am less optimistic about democracy in the US than in India due to a combination of financial and political crisis.
There is a theory that poor share more than the rich, and probably the reason why they have remained poor.
I have found, through my foundation that the theory of fallibility and reflexivity work not only in the financial sphere but also in the political sphere. For example, I did not foresee the collapse of USSR, but became more alert as it was collapsing. I immediately set up a foundation for democracy. Similar in Burma, where I was in recently.
Time was running short and Soros seemingly had multiple engagements today that he had to rush to.
I personally wanted to ask a question ‘What are the 2 subjects/industries that you would encourage students of investing to learn today, to be successful investors 25 years into the future’, but never got the chance. Always next time.
Hearing it from the horse’s mouth, as they say, is an experience in itself. Soros walked after a thunderous applause from the audience (the auditorium was jam packed by the way!). Calm, collected, humble and seer-ish. You never could make out he was one of the smartest guys in the world (apart from being one of the richest). Absolutely phenomenal stuff.