Thursday, December 30, 2010

Ahead of the Curve, Book by Hilary Kramer

I did not like the book. I found it full of self trumpeting, 'mayic illusions' and 'look at me now' fallacies that women are more prone to than men, and tiny bets on 100s of stocks. Failures are not mentioned, only success is broadcast. She could grow money to only 10 million $ calling it wildly successful career, while she earned a couple million $ from salary alone. She lacks conviction and follows other successful investors. Wharton MBA by the way.

We can still pick up a few noteworthy points from her book.

Her style is spotting trend, surfing wave. Important in spotting trend like biotech, nanotech, alternative energy etc is that most of the time is spent in spotting trend, being one with nature, being news junkie and not in surfing wave.

A reference to a game "Six Degrees of Making Bacon", every one in world is six connections away from most remote person. Similary a stock trend in one industry impact other industries. Corn industry impacted by Ethanol trend can be played not only through corn but by fertilzer, agri equipment and other crops that corn is outcrowding.

Keep looking back for reflecting and learning, not for regretting.

Dont forget Phychology 101

We all want to live long. In future there will be new industries, products, implants, surgeries that would claim to increase your life span or look young. That would be perpetual trend. Think clothes, creams, organic foods. Males have bigger ego, cars that cater to those ego like BMW are riding those trends. An example is provided of Honda Civic vs Jaguar having equally comfortable seats, but Jaguar caresses male pride.

Distinguish FAD from Trend

Atkins diet craze to get trim did not survive.

Trends are based on consumer needs and lifestyle changes. Trends are mainstream as well.

Fads appear in one industry and do not cross over or all states in all countries. Bellbottom pants is another example.

Demand and Supply never go out of fashion

That sounds credible both in trend based and cyclical industries. Failure of TiVO and Vonage affirms the fact that technology companies can be perilous where supply can quickly surpass demand. I had considered this in 2009 but rejected, recently D-Link is recommended by well a known 'expert' in India, think over, can it grow 20% per annum for next 5 years or even 3 years ?

Demand for organic foods led to success of Whole Foods from nowhere to a 9 billion $ company. Trend for low carb diet does not impact scrumptious cakes and bread despite being starchy eg. Panera bread.

Wednesday, December 29, 2010

The TAO of Warren Buffett : By Mary Buffett & David Clark (2008 first edition) - Part 2

Progressing with other notable quotes in this post.

"Its hard to teach a young dog old tricks"

Warren finds that the business ingenuity that comes with age is next to impossible to teach young managers. In Warren's world, age and experience can be far greater virtues than youth and enthusiasm when it comes to making money the old-fashioned way.


"In looking for someone to hire, you look for three qualities: integrity, intelligence, and energy. Most important of the three is integrity, because if they don't have that, the other two will kill you" 

Warren's management style is to afford his managers tremendous operational autonomy. He couldn't give his managers this much freedom if they lacked integrity. If you have to hire people who are not honest make sure they're not hard working and dumb as bricks.

"Never ask a barber if you need a haircut"

Ask an advisor if there is a problem and he will find it - even if there isn't one. 

"A public opinion poll is not substitute for thought" 

There is a great deal of comfort when you invest with the crowd. Just like in high school, no one stays popular forever. In majority of cases there isn't much upside potential left in a stocks after it becomes really popular.


"The business schools reward difficult, complex behaviour more than simple behaviour, but simple behaviour is more effective" 

William of Ockham, medieval english philosopher and monk put forth the idea that the simplest explanation is usually the best explanation. Priests of any profession need complexity to keep laity from performing their priestly magic. If you understood the investment process, there would be no need for investment analysts and advisers, nor would we need mutual funds or priests of profession.

Another example from my personal life is, I used to select harder of two questions in mathematics or physics even in final exams, including board exams in 10th and 12th in multiple choice questions with same weightage. I don't why I had that obstinate behaviour. There was some sort of contentment in conquesting paper to smithereens.

"There seems to be some perverse human characteristic that likes to make easy things difficult"

Only when something is made difficult to understand is there a need for experts, who can charge high fees for having figured it all out. The greater the complexity, the greater the need for an expert to help guide you through the complexity.

More than two people in the past couple of days have come back to me about Cravatex etc being selected as stocks by paid tip providers.

I would say that if you can't select a couple of stocks yourself from this list then you have no business to be in stock market doing personal investments in equity. Its better to give everything to fund managers. Better still is to spend your money on a few dozen books than paid tips, so you can keep fishing all your life.

http://www.etintelligence.com/etig/researchchannels/investorsspecial/fastest100Companies.jsp

"Recommending something to be held for thirty years is a level of self-sacrifice you'll rarely see in a monastery, let alone a brokerage house"

Its true that investing in PSU Banks, ITC, HDFC couple, Axis Bank in past delivered you 20-30% compounding but you will not see that advice from a broker, adviser. They would starve to death before adopting buy and hold for decade strategy. It isn't that they don't know or believe that this style creates wealth, but it does not create wealth for them. If your broker gets more than one great idea a year, the odds are that he is delusional. If he wants to continuously get you out of recent positions, odds are that he is more than delusional - he might just be dishonest.

"If you let yourself be undisciplined on the small things, you will probably be undisciplined on the large things as well"

A disciplined approach to turn down a  50 Rs cricket bet does really matter to Buffett. Sometimes what you don't do is just as important what you do.

"I never swung at a ball while it's still in the pitcher's glove" 

Ted Williams wrote in The Science of Hitting, that to become a great hitter you have to keep yourself from swinging at bad pitches. To become a great investor you have to wait for the right opportunity. Sometimes you have to stay away from investing in equities for years. Unlike Ted, we are luckier to have more than three strikes and we can let 100s of balls go by.

"In the search for companies to acquire, we adopt the same attitude one might find appropriate in looking for a spouse; It pays to be active, interested and open minded, but it does not pay to be in a hurry"

Look for companies in recession, out of favour situations, and at amazingly cheap prices.

"When proper temperament joins up with proper intellectual framework, then you get rational behaviour" 

Twice in Warren's investment career he completely stopped buying stocks because they had gotten way too high in price. In late 60s and late 90s, these helped him from becoming a victim to crashes that soon followed. 

"A good managerial record is far more a function of what business boat you get into than it is of how effectively you row. Should you find yourself in a chronically leaking boat, energy devoted to changing the vessels is likely to be more productive than energy devoted to patching leaks"

The best jockey in the world is never going to win races riding a lame horse.

"A pin lies in wait for every bubble, and when the two eventually meet, a new wave of investors learn some very old lessons"

Bubbles happened with radio, airplane, auto, computers, real estate, biotech etc. Stock prices reflect passion in the casino. When earnings fail to appear, the hope that holds up the stock, vanishes, prices hurl earthward when gravity takes over -- often with stunning velocity.

"Stock market is a no-called-strike game. The problem when you're a money manager is that your fans keep yelling, 'Swing you bum ! ' "

Money managers are slave to quarterly and yearly results, even though best course of action may be to redeem money to investors and go on vacation from equities.

"As far as I am concerned, the stock market doesn't exist. It is only there as a reference to see if anybody is offering to do anything foolish"

I would rate it as my second favourite Buffett quote after the one, "It makes sense to invest only when a stock screams in undervaluation at you. It jumps out from the screen and slaps to wake you up from stupor" 

Tuesday, December 28, 2010

The TAO of Warren Buffett : By Mary Buffett & David Clark (2008 first edition) - Part 1

There are generous quotes by Buffett in various books and on the web. This book selects 125 wise quotations with a one page commentary on experiences that led him to form his thoughts into these quotations

I personally find many of Buffett's quotes exposing his intuitive business acumen, words summed up elegantly. They help us all who follow, in seperating good businesses from mediocre ones or carry a deep message learnt over many years of experience. He is special.

I have selected a few from this book not in any order.

"The great personal fortunes in this country weren't build on a portfolio of fifty companies. They were built by someone who identified one wonderful business"

 Buffett mentions Walton family in retailing (Walmart), Hearst family in publishing, Mars family in candy, Coors and Busch in brewing.

"It is impossible to unsign a contract, so do all your thinking before you sign" 

Warren forgot to put a noncompete clause in his contract with eighty-nine-year-old Rose Blumkin when he bought her Omaha-based Nebraska Furniture Mart. A few years later Mrs. B. got angry at the way things were being done at the store, so she quit and started up a new store across the street -- stealing tons of business from NFM. After a few years of suffering the stiff competition, Warren caved in and agreed to buy her new store for a cool $5 million. The second time he had her sign a noncompete agreement, lucky for him as she lived until 103.

"It is easier to stay out of trouble that it is to get out of trouble" 

When Warren lost nearly all of his 700 Million $ in Wall St firm Salomon Brothers.

"It is not necessary to do extraordinary thing to get extraordinary results" 

We need not try to get rich overnight or in a year. Warren does not shoot for 200% returns per annum but 20% per annum

"My idea of group decision is to look in the mirror",  a similar one I recall is "With enough insider information and a million dollars, you can go broke in a year"

Warren is not seeking affirmation of his ideas from others. One has to think independently and be comfortable standing alone.

"You should invest in a business that even a fool can run, because someday a fool will" 

Coca cola, Budweiser, Wrigley's, Hershey, Walmart are dumbproof business.

"With each investment you make, you should have the courage and the conviction to place atleast 10% of youe entire net worth in that stock."

Can't agree more with him. Conviction is based on what you know will happen, belief is based on what you hope will happen. You need to know what you are doing.

"Money, to some extent , sometimes lets you be in more interesting environments. But it can't change how many people love you or how healthy you are"

Great deal of money will bring misery in your life. Your children are likely to not work, they will not develop self-esteem that work creates. They will wish your early demise, you may end up being surrounded by sycophants who will fill your life with lies to stoke your illusions of grandeur till you look like a fool to the rest of the world. Most of children that inherit lots of material wealth tend to do nothing with their lives. Warren believes a country prospers better if society is a meritocracy.

 "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact"

Mediocre businesses are struggling for cash and are loaded with debt. They usually have to rob Peter to pay Paul. Think paper, steel, textile businesses in India.

"The reaction of weak management to weak operation is often weak accounting" 

Self explanatory.

"In a difficult business, no sooner is one problem solved than another surfaces - never is there just one cockroach in the kitchen"

A business with poor economics is a slow boat to nowhere and makes a lousy long term investment. Auto companies can be lousy as they need to spend billions on retooling. Tata Motors has caught fancy. I wonder sometimes at experts like Shankar Sharma, RD etc going gaga over these scripts. Perhaps trading calls.

"You pay very high price in market for a very cheery consensus" 

If everyone agrees with you that a particular stock has a great future, you are going to have to pay a steep price. Trick is to buy stocks nobody believes in very cheap. Sometimes exceptional Walmart type stocks do create long term wealth despite being expensive.

Saturday, December 25, 2010

Be the change

Wishing you all a prosperous and Happy New Year.

At the same time I would like to apologise my fellow investors to whom I have not returned a phone call, since I do not like to discuss stocks. This is not to say I don't have an open mind but I like to build conviction in isolation.

Change


My expectation from the likes of other mature investors who spend more than couple of hours a day is to promote a culture of partnerships in India. I expect the likes of @kudva, @rahul and others even more Senior in investing field than myself, and those who have been applying their mind and energy for years to open your own partnerships over coming months, years.

Other alternative discussed in Lynch's book also is investment clubs where everyone pools money and there isn't any controlling partner. I for one am not a good candidate for the latter.

Why ?

All PMS and Mutual Funds in India are charging 1 - 2 % fixed Management Fees. You would be doing a great service to retail investors, consequently society by wiping out intermediate charges. At the moment Management Fees (same as wholesalers charges from farm produce to retail shops) is charged irrespective of fact, whether their funds grew or shrunk.

No wonder Bufett has this bet http://www.longbets.org/362

2% extra compounding can make a huge difference in long term returns. Its an idea whose time has come.

Next logical institution / business idea

I am not aware of similar body in the West but once we do have a few number of partnerships working on model of no fixed Management Fees, either someone who is reading this or we could ourselves over the coming years form an institution of Association of Independent Partners thus giving you a corporate form, probably buy a joint insurance and have wider reach. My motto is to save retail investors from 2% cut of fixed management fees in PMS and Mutual Funds.

While I have no plans to relocate to India for the next couple of years to actively pursue this change, I hope to see atleast many more partnerships from you. I believe it has a bright future, Walmart's success and Retail sector's potential in India is for similar reasons and we are yet to see a revolution in financial sector by cutting off middlemen.

Saturday, December 18, 2010

Valuation of Oil and Gas Exploration companies - SELAN

Someone asked me yesterday about Selan exploration.  I have not been a fan of oil industry and consequently could not convince myself to apply mind in it, due to its commodity nature, lack of pricing power for end product, too many variables outside its control.

However, I am open to learning and getting educated. As obvious, one cannot value downstream companies based on conventional metrics such as P/E, Revenue Growth, Debt/Equity, Sales/EV etc just as for mining company I wrote earlier about here.

VALUATION

Oil companies are valued on Proved Developed, Proved Developed Non Producing or Proved Undeveloped (PU). One can introduce a googly of Proved Probable (PP) too.

Please go through this five page valuation article before investing any money on oil exploration companies.
http://www.slideshare.net/hfbe/oil-and-gas-company-valuations-business-valuation-review



RISKS

Following is the extract from Annual Report of Selan available at next link.

http://www.selanoil.com/annualreport.html

"
Oil sector is a high risk and high return sector. Data acquired for seismic evaluation of oilfields & reservoir modeling involves interpretation by advanced software technology and equipment which
is capital intensive in nature and therefore prone to obsolescence coupled with uncertainty in results.

However, the inherent risks of dealing with nature cannot be completely mitigated and that is why drilling activity poses a great challenge and risk. The fluctuation in international oil prices as well as in the dollar
value of the rupee is another factor which adds to the uncertainty of profits in the oil industry.
"
DEALS

The private market for buying out of whole companies does not get as out of whack as stock market.  Private buyers of businesses act more rationally than investors at large exhibiting their emotional index on tickers.

A couple of recent deals that are done by intelligent buyers should be taken into account before putting a price tag on the company in sight.

Dana Buys

http://www.dana-petroleum.com/Press/pr_140610.htm

Dana Sells itself

http://www.bbc.co.uk/news/10486598

CAVEAT

If you do want to value the company, you have to anticipate a few extraneous factors.
  • Can the oil prices stay high
  • What are the reserves of company and what would be cost of extraction of those reserves
  • If the reserves will be extracted in possibly next 35 years, then value 200 Crores of Oil extracted in 2045 needs to be discounted adequately to todays price
  • You have to ask company for reserves report and trust in the independent valuer that estimated value of reserves
  • Stick to Proved Undeveloped resources otherwise you will go down the slipperly slope of EBIDTA rather than PAT 

FINAL THOUGHTS
There can be severe shocks on downside and likewise probability of upside. There may be 60% undervaluation on DCF or EV/PU model of Selan but I'd prefer buying companies growing at a consistent and healthy rate. I personally have faith in much stronger secular stories in Indian market. You can call me one trick pony.  That said, I will not shell out 40 PE for a 20% grower be it Nestle India Ltd (continues to be my mental block).

Again it can become a doubler, tripler like OMDC but I am happy to give it a pass. If all people were like me Soap/ Shampoo companies would stop advertising as they would see no impact of their Ad budgets, Sugar and Steel stocks would stop being so volatile as I would smoothen them out for next 20 years of cycles. Given that people act irrationally and stocks play out in emotional cycles, I would buy a luxury watch maker when rich people are cutting on expenses, a cruise ship company when people are not splurging on holidays, oil companies when something negative happens for oil industry. Those who do not have the problem of super abundant capital can avoid playing cyclicals unless ofcourse you know what you are doing. Question to ask is, will you buy more of Selan at 150 Rs or book loss at 20% drop ?

Thursday, December 16, 2010

A quick update regarding investing vehicle

I have consulted CAs and there are several options available. I want to obviously avoid SEBI's Portfolio Management Services as it involves 11 Lacs initial fee and 5 lacs every couple of years. These models are suitable for those fund managers who want to reach 100s of people, and minimum investment required by each portfolio client is 5 Lacs plus as per SEBI regulation.

I have also explored the option of registering as an FII, that also involves several thousand dollars fee every few years.

I have been advised by my CAs that the best vehicle would be a Private Limited entity, although there is more legal work, annual expenses relative to a Partnership Firm but it offers most flexibility. No matter what the legal or corporate identity, I'd run it as partnership.

If anyone of you would like to speak with me, have any queries, I am will to hear from one and all via a feedback from. I would be glad to make partner with anyone as long as our expectations match so I can aim to meet them.

http://www.aapartnership.com/contact.htm

Tuesday, December 14, 2010

Derivatives - An epidemic for society; and a Personal update

I will describe how derivates are a grave danger to society with an example from keen edged Munger.

WB : Warren Buffett
CM : Charlie Munger

Let alone the foregone fact that survival of those institutions is at stake which use leverage and derivatives, it also encourages a dishonest behaviour in society.

A simple Example :

Assume Cravatex Ltd outsources shoes from a manufacturer, assume Relaxo Ltd. There would be times when Cravatex is not going to pay cash instantly to the supplier i.e. Relaxo. In books of account of Cravatex if there is 5 Crores pending as in liabilities section dues to Relaxo Ltd, then in latters books there is 5 Crores in assets/ recoverables. If two auditors were to compare books of accounts it would Zero out. Therefore in toto, it balances out in society.

A non simple (Derivative) example:

When long lasting derivatives bets are undertaken that will come to fruition after 10 or 50 years, each party optimistically assumes that the likely possibility of its bet turning in favour is higher. Therefore if Party A and Party B have a bet against each other, they are likely to even out in 2030 when bet settles. But as of 2010 i.e. today if Party A is showing 1 million $ profits on derivatives contract, Party B is not showing 1 Million $ loss in book, thus overrating profits in short run. The total is not matching up. Auditors are not responsible as of today to cross check other organisations' accounts. This results in inflated profits motivated in increased commissions for those who inititated contract.

What the two young men have to say ?

Your opinion on derivatives?

WB : Charlie and I think that there is a low but not insignificant probability that at some time -- I don't know when; it could be three years, it could be 20 years -- derivatives could lead to a major problem. The problem grows as derivatives get more complex. We hoped to give a mild wakeup call to the financial world that there's a problem. In the energy sector, derivatives destroyed or almost destroyed institutions that shouldn't have been destroyed. [He mentioned Enron.]
Charlie and I would not know how to regulate it. We have some experience seeing specific dangers in that field and some insight into systemic problems that can arise. People don't want to think about it until it happens, but it is best thought about before it happens.
It's a low probability, but we think a lot about low probability events. We have some experience with Salomon and Gen Re. Charlie saw some things on Salomon's audit committee [that were very risky/questionable].

[CM: In engineering, people have a big margin of safety. But in the financial world, people don't give a damn about safety. They let it balloon and balloon and balloon. It's aided by false accounting. I'm more pessimistic than Warren. I'll be amazed if we don't have some kind of significant blowup in next 5-10 years.

Derivatives are advertised as shedding risk for the system, but they have long crossed the point of decreasing risk and now increase risk.

The truth is that Coca Cola could handle risk (currency exposure)[I think he was talking about currency exposure], but now with every company transferring risk to very few players, they are all hugely interdependent. Central banks are exposed to weaknesses. If Salomon had failed, the problems for the rest of the system could have been quite significant. When you start concentrating risk in institutions that are highly leveraged, [watch out]. They have big trading departments with people who make a lot of money.
It's not a prediction, it's a warning.
  • Source: BRK Annual Meeting 2003 Tilson Notes
  • Time: 2003
It’s fascinating to look at a company like Freddie Mac: an institution that dozens of financial analysts were looking at; that had an oversight office; that was created by Congress with committees to oversee it; that had two smart, exceptional board members, Marty Leibowitz and Henry Kaufman; and that had auditors present – yet Freddie misstated earnings by $6 billion in a short time. That’s big money. And a large part of it was facilitated by derivatives. You can go back and read the footnotes, listen to the conference calls, etc. and you wouldn’t have known. In the end, it was $6 billion, but it could have been $12 billion if they’d wanted.
Derivatives can lead to a lot of mischief. When you have a complicated derivative transaction, and a trader with investment house A on one side and investment house B on the other side, and on the day the deal is done, both record a profit, this can lead to mischief – and the scale is getting bigger every day.
I know the managements of many large financial institutions and they don’t have their minds around this. We tried at Gen Re [where we had a small derivative book] and couldn’t.
Whatever problems there were at Salomon [during its crisis years ago], they’re far, far worse now [systemwide].

In 1991, if the government hadn’t reversed himself [in its plans to take actions that would have put Salomon out of business], we were preparing documents [to file for bankruptcy. Had this happened,] We had $1.2 trillion [notional value] of derivative contracts that others were counting on, that would have gone bad. All sorts of securities transactions wouldn’t have settled, accounts in Japan and the UK would have been affected, etc. For instance, Salomon had a relationship with a bank in Germany which took large deposits in Germany and lent the money to Salomon. All kinds of things would have come out. You don’t need to put these strains on a system that’s already highly leveraged.

When you get huge amounts of transactions, which not many people understand, you create a huge problem that may be triggered by an exogenous event.

We use derivatives – we get them collateralized – and we’ve made money on them. But I predict that sometime in the next 10 years, we will have a big problem caused by or exaggerated by derivatives.

[CM: People don’t think about the consequences of the consequences. People start by trying to hedge against interest rate changes, which is very difficult and complicated. Then, the hedges made the results [reported profits] lumpy. So then they use new derivatives to smooth this. Well, now you’ve morphed into lying. This turns into a Mad Hatter’s Party. This happens to vast, sophisticated corporations.
Somebody has to step in and say, “We’re not going to do it -- it’s just too hard.”

If you want to have a little fun, go to the annual meeting of a big financial company and ask about the details of a complex transaction. They won’t know – but you can be sure the trader who did it will be well paid for it.

Any time you have situation where smart people can make money by taking risk, you’ll get it.

Q - How dangerous are derivatives to the financial system and what can be done to mitigate potential damage from them?

We’ve tried to mitigate it [raise warning flags about the dangers of derivatives] a little by talking about it, but realize there is nothing inherently evil about derivatives. We have at least 60 of them and will be discussing them at our upcoming Berkshire board meeting.

Derivatives are expanding rapidly, in more and more imaginative ways. They introduce invisible leverage into the system. In the 1930s, after the crash, the government concluded that leverage contributed to the crash and that it was dangerous. So the U.S. government empowered regulators to deal with this. For decades, they policed it and it was taken seriously when the Fed increased or decreased margin requirements.
But the introduction of derivatives has made any regulation of margin requirements a joke. The regulation still exists, but it’s an anachronism.

I believe that we may not know when it becomes a super danger or when it will end precisely, but I believe it will go on and increase until very unpleasant things happen because of it.
You saw one example of what can happen under forced sales in October 1987. It was driven by portfolio insurance, which was a joke. It was a bunch of stop/loss orders, but done automatically, and it was merchandized. People paid a lot of money for people to teach them how to put in a stop/loss order. When a lot of institutions do this, the effect is pouring gas on a fire. They created a doomsday machine that kept selling and selling.

You can have the same thing today because you have fund operators with billions of dollars – in aggregate, trillions of dollars – who will all respond to the same stimulus. It’s a crowded trade, but they don’t know it and it’s not formal. They will sell for the same reasons. Someday, you will get a very chaotic situation.
As for what could trigger this and when, who knows? Who had any idea that shooting an archduke would start Word War I?

CM: The accounting being enormously deficient contributes to the risk. If you get paid enormous bonuses based on profits that don’t exist, you’ll keep going. What makes it difficult [to stop] is that most of the accounting profession doesn’t realize how stupidly it’s behaving. One person told me the accounting is better because positions are marked to market and said, “Don’t you want real-time information?” I replied that if you can mark to market to report any level of profits you want, you’ll get terrible human behavior. The person replied, “You just don’t understand accounting.”

WB: When we went to close out Gen Re’s derivatives book, we took a $400 million loss on a portfolio that was “marked to market” by the prior management and auditors – and I’m not criticizing our auditor. Any auditor would have said the same. I wish I could have sold to the auditors instead!
Take a dry cleaning business that owes $15. Their books show a $15 accounts payable and the other company shows an offsetting $15 accounts receivable. But there are only four big auditing firms, so in many cases, if they’re auditing my side, the same firm may be valuing or attesting to the value of what’s on the books of the person on the other side. I will guarantee you that if you add up the marks on both sides, they don’t add up to zero. We have 60 or more derivative contracts, and I’ll bet the other side isn’t valuing them like we are. I have no reason to mark the value up – we don’t get paid for that. If I value it at $1 million on our side, the other side should be marking it at minus $1 million, but I guarantee the numbers are widely different. Auditors should check both sides of derivative trades and the “marks” should sum to about zero. They don’t.

CM: As sure as God made little green apples, this will cause a lot of trouble. This will go on and on, but eventually will cause a big denouement.
  • Source: BRK Annual Meeting 2007 Tilson Notes
  • Time: 2007

Q: What useful function do derivatives serve? Why aren’t derivatives illegal?

WB: Charlie may have more to comment.

CM: The usefulness of derivatives is overstated. We’d still have oats and wheat if we didn’t have derivative markets. The test is not ‘is there any benefit’, but is the NET benefit or disadvantage useful or better without. My own view is that if we had only [exchange traded] [Ed: another notetaker heard: agriculture and metals] and banned the rest – the world would be better place.

WB: BNSF has diesel contracts. If I was running the place, I wouldn’t hedge - unless you are smarter than the market in diesel fuel. If you are you shouldn’t be running a railroad, you should be run a diesel trading business. If you have someone in charge of running that hedge, they will hedge it. If he thinks that will make him a better manager of railroads, then fine, let him do it, but I will hold CEO responsible for running it over time. I wouldn’t condemn anyone for hedging diesel fuel. But I do think if you put up (slide4) – from Chapter 12 of Keynes General Theory – it is by far the best description of the way capital markets function. It is descriptive and prescriptive. Usually only the first two sentences are quoted, but it is better as a whole paragraph:

Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. The measure of success attained by Wall Street, regarded as an institution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield, cannot be claimed as one of the outstanding triumphs of laissez-faire capitalism – which is not surprising, if I am right in thinking that the best brains of Wall Street have been in fact directed towards a different object.

Wall Street is mix of casino and a very important social operation – and once academia got behind derivatives and schools taught more about how to price a derivative instead of valuing a business, the trouble began. In 1982 Wall Street allowed speculation in SP500 futures. I wrote letter to Congressman Dingle which was published in Fortune Magazine. What I forecasted occurred then it got squared, with new ways to gamble.

CM: Warren wrote the only letter saying the idea is insane. Only difference is then not very many people listened to him.

WB: It doesn’t make any sense that the tax treatment on gambling on S&P 500 contracts is better (partial long term capital gains treatment) than buying and holding individual stocks for less than a year (SP500 contract is taxed 60% long-term gain and 40% short term, even if you hold it for 60 seconds). This distortion came about as a result of the power of a small group of lobbyists. Charlie do you know why this is?

CM: It is neither fair nor sensible. The idea that the tax treatment on something that is held for 3 seconds is different than something that is held for less than a year (some long term gains treatment for the former and none for the latter) is insane. If someone with money and interest cares a lot and others are indifferent, that someone wins in front of the legislative bodies. As Bismarck said, don’t watch sausage making or law making.
  • Source: BRK Annual Meeting 2010 Boodell & Claremon Notes
  • Time: 2010

What are your views on derivatives and how do you think they have affected the global market?

In my 2002 letter to shareholders I referred to them as “weapons of mass destruction.” Derivatives are really just a way to create a product with a very long fuse, for example, 100 years, as opposed to stocks which settle in 3 days. That kind of system allows claims to be built up. AIG called me in September and told me they were about to get downgraded which would have required higher posting requirements. Now this is an enterprise that has been built up over decades and was effectively destroyed in 48 hours by these products. With derivatives, you’re exposed to counterparties and thus reliant on others. These claims built up over time to the tune of billions of dollars and when one falls, the whole system falls. Derivatives are not evil by themselves but rather everyone needs to be able to handle them. System wide, they’re rat poison. Berkshire holds many derivatives but we always hold the money at Berkshire. 
  • Source: Q&A with 6 Business Schools
  • Time: Feb 2009
Personal Update

I have been putting in over 40 hours a week on equity research besides the day job for the last few years now and its become my pet mania. Actually I believe I have been putting in more hours than that. It does not feel like work since I have enjoyed the process and learning, consequences of the process often pleasant and sometime painful were welcome too.

I realize than 95%+ of you who read blogs actively must enjoy the process of investing and I hope to continue to inspire those who enjoy the freedom that material wealth brings. However, there are those of us who do not like investing process or like to delegate that work to others have alternative of funds or investing partnerships.

Personally, I am tired of logging into Kotak, Indiainfoline, other Brokerages accounts of my relatives, in laws, close friends who are passive investors and have left everything for me to manage. I manage my personal money separate from theirs, infact they all have separate brokerage, bank, trading accounts and it has reached a stage where I cannot manage all accounts effectively.

I am consulting a CA to open partnership to consolidate all holdings for any new money. Once I am happy in next few weeks/months and have sorted out details and modus operandi, I would like to extend this to a handful of other people, since this is what I intend to do for next few years. Currently I have way too many ideas relative to funds, fortunately I am not in Buffetts position whose idea pool is starved relative to fund size.

I do realize that people feel more comfortable to invest their hard earned money with established fund houses or squander a few thousand bucks at tipsters for offering stock advice rather than parting their money to potential fly by night operators or Ponzi mafias. This is why I want to continue with a select coterie of friends who trust me and I do not want to belong to either mentioned category earlier. I'd be happy with accepting only a couple prospective friends per year or none at all, it suits me since I do not want the model to be scalable. 

Another reason is that I do not want to bite more than I can chew. Third reason is that excess capital can weigh down returns. I only want to attract a select few who do not want to touch the money for 3-5 years and redeem money once a year. I would accept interest in partnership only once a year. Needless to say, there is no entry or exit load unlike mutual funds. I would charge fee based on performance and high watermark only on returns in excess of certain threshold per annum, it would be same for my uncles, friends or parents in law.

This also implies that historically any stock that I have so far mentioned to everyone including relatives has been done so at same day and time would no longer be done so. Since my personal funds would be invested in partnership I'd like to buy before declaring publicly. Thus, I would have a vested interest in every stock I mention. I would choose to not disclose parts of holding publicly or to partners as well. I would be open for annual Audits and surprise Audits including those by any one at all including Big Four should my partners choose to. 

As always anyone who likes investing is encouraged to do personal research before making purchase decision and also ignore my opinion, everyone has one !  I would typically invest depending on opportunities, 15% in Microcaps like the ones I have mentioned on this blog for the past one year, 25% in Mid Caps and 50% or in Large Caps and some cash.  The ratio can change in extremely wild swings and mass available opportunities. Hence, please do your due diligence before making purchase decision. My fortunes should swing with yours and I would like to avoid any conflict of interest by putting my 100% of my holding in partnership unlike Fund Managers do, they all have personal account which is often front run before fund account. There would be no personal account after a year once I get out of taxation on existing positions.



Anything I say should be cross checked, neither my partnership nor I take any personal guarantee on authenticity of what is said. I or my partnership will have no liability for what is written and published on this blog. More details later. 

Saturday, December 4, 2010

FD vs Shares, Poor vs Rich, Middle Class thinking vs Entrepreneurship



















Figure: Middle class suckers, click on image to magnify their folly

I wanted to show you visually what I learnt from Peter Lynch. You don't want to be guy on the left, poor person having some spare change for Bank. Bank has expenses, employees, overheads etc also dividends for shareholders ! They forward your money to businesses or other individuals in need.

Your job as an investor is to find the business on right hand side that will not only avoid going bankrupt, but infact is strong ! That strong business is earning more than 20-30% per annum on invested capital. If you cannot find that business or are afraid that stock market volatility reduces the share price of business to 50% or 40% then continue to be the guy on left.

Wednesday, December 1, 2010

How your family can own 70% of India, thats right 70% of all listed and unlisted companies

I recently read about an entry on Kudva's blog here and reminded me of Jeremy Siegel's book here which has the most publicised record on stocks over past two centuries. In a nutshell, "If one had invested 1 million US $ in 1830s or so in Dow Jones Index/ equivalent index and held on until 2002" that money would be 8 trillion $ or about 70% of US market cap at the time or thereabouts.

Plenty of business people had that kind of money. It would be roughtly equivalent of 50 Crores in today's value which many individuals possess.

I have an entry on the case for how much one needs to retire from job one would like to leave here (5 Crores only for those who have 10 lacs INR annual expenses, increasing expenses by inflation will be taken care of by underlying businesses). I hope no wise person would waste all their life and energies on wealth aggrandisation for the lack of any other ambition.

As per following calculation, whether you want it or not, if we become a half decent, average stock picker, even index replicating like SENSEX, then there is a very high probability that we will end up with over 200 Crore INR over next 40 years. (10,000 Rs savings per month at 20% compounding per annum ). Sensex has done better than that over past 30 years. I won't go into how much your children may end up with if they continue with your investments.


If you can convince your four to five generations to keep money in Nifty fifty/ BSE sensex  and eventually in top 500 companies, you will control major holding in it in couple of hundred years. One could argue the merit in it or fact that if five families tried to do it in parallel then they all will end up with only 15% of India's material wealth.


Summary on this topic from Jeremy Siegel's book:
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The returns are computed by investing in the whole market, i.e. all listed stocks,
in weightage of their market caps, whether they survive or not. If one had invested in all listed stocks in proportion of their market cap, certainly not the best way, returns by equities would eclipse every other asset class.

Years of return computed : 1802 through 2001 for US markets

Real post inflation yield on stocks 6.7% to 7% over this 200 year period

Its dramatic if you factor in changes that happened, agri to industrial, to service to technology based economy. Change from gold to paper money standard, world wars..

Rate of real rise between 1946-1965 - 10%
Rate of real rise between 1966-1981 - -0.4%
Rate of real rise between 1982-1999 - 13.6%
Rate of real rise between 1982-2001 - 10.5%

Stocks have taken on average 10 years to double your purchasing power compared to 100 years for T Bills.

LT Govt. bonds have 3.5% real returns from 1802 - 2001.

In 1958 yields for the first time in 60 years were lower in stocks than LT Govt. bonds and stayed that way for next 50 years, person who wanted to be conservative would have just waited.

Above is true for German, US, Japan and UK market in terms of returns in Govt Bonds vs. Stocks from 1920s

In 1871 two actively traded stocks were Bank of New York and Bank of United States, Alexander Hamilton and his secretary at Treasury manipulated the price, thus was born antecedent to NYSE circa 1892.


By 1802, 300 companies had listed stock but less than 10 had frequent trading. Initial listings being transportation, canals, wharves, bridges, then financial companies.

Stocks always beat bonds if holding period is more than 20 years even if you buy at peak.

Best % / Worst % returns if Holding Period is 1 Year
Stocks 66 / -38
Bonds 35 / -21
T Bills 23 / -15

Best % / Worst % returns if Holding Period is 2 Year
Stocks 41 / -31
Bonds 24 / -15
T Bills 21 / -15

Best % / Worst % returns if Holding Period is 5 Year
Stocks 26 / -11
Bonds 17 / -10
T Bills 15 / -8

Best % / Worst % returns if Holding Period is 10 Year
Stocks 17 / -4.1
Bonds 12 / -5.4
T Bills 11.6 / -5

Best % / Worst % returns if Holding Period is 20 Year
Stocks 12.6 / +1
Bonds 8.8 / -3.1
T Bills 8.3 / -3.0


Best % / Worst % returns if Holding Period is 30 Year
Stocks 10.6 / + 2.6
Bonds 7.4 / -2.0
T Bills 7.6 / -1.8

Coming to original answer:
---------------------------

Investing in whole market from 1802 to 2001

Stocks 1 $ ==> 8.8 Million $
Bonds 1 $ ==> 13,975 $
Bills 1 $ ==> 4,455 $
Gold 1 $ ==> 14.6 $

Thus, 1 million $ is equal to 8.8 trillion $ i.e. 70% of entire market cap of US.

1 million $ in 1802 is equivalent to 15 Million $ in 2001 US money buying power.

Dow Jones does not include dividends.  Wilshire 5000 is broadest index available with 6200 firm (NYSE has 10,000 stocks if you exclude 20,000 penny stocks)

S & P 500 has 84% of market cap of WILSHIRE 5000

S & P 500 in 1957 had roughly 90% value of all NYSE shares

S & P 500 in 2001 had roughly 80% value of all NYSE shares


Conclusion: Stocks are more conservative than bonds, person investing in bond is speculating with purchasing power of money. Stocks have power to turn 1$ into millions by forbearance of generations.

Gold is a sure fire formula for buy and hold investor to get poor unless one is using dangerous leverage. This is what Buffett has to say about Gold



"You could take all the gold that's ever been mined, and it would fill a cube 67 feet in each direction. For what that's worth at current gold prices, you could buy all -- not some -- all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?"

http://finance.yahoo.com/news/Warren-Buffett-Forget-gold-hftn-727222639.html?x=0&.v=1&.pf=banking-budgeting&mod=pf-banking-budgeting

You can make an impact on the world with your will through this avenue, you can make India, USA, World take the direction of your desire in a few hundred years from now, hoping that your family will continue to uphold your wish. Certainly it would be idiotic to accumulate so much suffocating wealth. Let us also not forget that all this material wealth is on that small particle of dust on cosmic scale.

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