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

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

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

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

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

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

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

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

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

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

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

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

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

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

Killing Old Ideas:

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

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

Experience of an Investor – Destruction of Creativity:

Consider the following hypothetical situation:

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

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

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

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

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

Why? Loss Aversion:

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

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

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

Rationalization Trap:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Cheap Stock (vs.) Cash:

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

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

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

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

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

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

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

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

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

1)Induces Falsification:

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

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

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

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

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

3) Shall Optimise Allocation Process:

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

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

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

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

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

1) Understanding Stock Returns:

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

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

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

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


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

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

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

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

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

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

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

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

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

Thanks & rgds,
Arpit Ranka