DON’T TAKE NEWS ANCHORS SERIOUSLY – Chauffeur Knowledge

There are two types of knowledge. First, we have real knowledge. We see it in people who have committed a large amount of time and effort to understand a topic.

The second type is chauffeur knowledge – knowledge from people who have learned to put on a show. These people just make show that they know everything but they just speak what they have heard from the source. They speak as per the predefined script ready for them.

Any fool can know. The point is to understand. – A. Einstein

Source – Vivify

Investment – It is difficult to judge who is an expert and who has just a bird view of knowledge.

In 1998 Wesco meeting, Charlie Munger Quoted –

I try to get rid of people who always confidently answer questions about which they don’t have any real knowledge. To me, they are like the bee dancing its incoherent dance. They are just screwing up the hive.

Mr Warren Buffett suggests us to decide what we know and stay with it, what he calls a circle of competence. Mr Munger suggests that the size of the circle is not important but important is, we stay within its limit well. If we do not know anything, we should simply say we don’t know rather act as an expert. I also faced such problems during the initial days of my career. I considered people with Chauffeur knowledge as an expert until I do not meet real experts.

In the stock market, we meet many people who act as an expert but the majority of them not. We have to carefully check their knowledge before trust on them. We have to understand their investment philosophy and process before making a judgement of them. True experts recognize the limits of what they know and what they do not know. If they find themselves outside their circle of competence, they keep quiet or simply say, ‘I don’t know.’ We also have to perform the same for becoming an expert in our field.

This entire series will be review with various examples from books which are “Thinking, Fast and Slow” and “The Art of Thinking Clearly“.

Overconfidence – 2

The Illusion of Validity

Subjective confidence in a judgment is not a reasoned evaluation of the probability that this judgment is correct. Confidence is a feeling, which reflects the coherence of the information and the cognitive ease of processing it. It is wise to take admissions of uncertainty seriously, but declarations of high confidence mainly tell you that an individual has constructed a coherent story in his mind, not necessarily that the story is true.

Business – When the business personal preparing blueprint for a particular project and the narrative of the project seems good then he starts believing that this project is very good. Thus, they have to execute that project. But this confidence can turn out as overconfidence.

Investment – When we study a particular company and its narrative looks so good then we start getting confidence in the future performance of the company. But this confidence has created a story in our mind and that does not necessarily to be proven as true so that we also should work on writing down what can kill this idea. This helps us to make wise and rational decision.

The Illusion of Stock-Picking Skill

What made one person buy and the other sell? What did the sellers think they knew that the buyers did not?

Buyers think the price will increase and sellers think that price will fall.

Individual investors try to react to each news but institutions are selected about the reaction on the news which also proves their label of Smart money.

The majority of people have an illusion of skills. The majority of people believes that picking stocks and getting a return on them is mostly responsible for their skills and does not appreciate the role of luck.

But it is not the ultimate truth. There is a role of luck that should be appreciated. Not believing the role of luck will lead to overconfidence in their skill. And that will tend to make any irrational decision. So that after buying or selling, we will think that stock price will move as per our expectation because we have completed with all necessary study and confident about movement.  

We should always think that the seller/buyer has much more insights than us which make him selling/buying a particular stock. This thought process helps us with widening our thoughts process.

This entire series will be review with various examples from books which are “Thinking, Fast and Slow” and “The Art of Thinking Clearly“.

WHY YOU SYSTEMATICALLY OVERESTIMATE YOUR KNOWLEDGE AND ABILITIES – Overconfidence Effect

We tend to overestimate our knowledge, ability to predict events/future, own behaviour, etc. The overconfidence effect does not deal with whether single estimates are correct or not. Rather, it measures the difference between what people know and what they think they know.

Expert suffers more from overconfidence rather than normal laypeople. We have statistically proven data but we ignore it and overestimate our abilities and knowledge. Overconfidence has been called the most “pervasive and potentially catastrophic” of all the cognitive biases to which human beings fall victim.

The Illusion of Understanding

In The Black Swan, Taleb introduced the notion of a narrative fallacy to describe how flawed stories of the past shape our views of the world and our expectations for the future. Narrative fallacies arise inevitably from our continuous attempt to make sense of the world.

When we read about anything, our mind starts creating an illusion of understanding regarding those concepts or event. When we make any critical decision and that succeed then we give huge credit to our skills and underestimate the role of luck.

The core of the illusion is that we believe we understand the past, which implies that the future also should be knowable, but in fact, we understand the past less than we believe we do.

We try to learn many things from the success of others but we have to understand that things can be more different than what we are understanding.

Business – Management of any business easily fall under such bias, if they have a strong track record in past. Few managers have overconfidence in their ability to run a business. So that they acquire any business or plan for a new capex at the top of the business cycle at sky-high valuation. They just follow their intuition rather than follow data and facts. We should avoid businesses having such a manager for investment purpose.

Successful businesses also can meet failure in some of their ventures. Google has achieved success in the search engine, e-mail services, mobile operating system, video streaming, maps etc. but Google also has faced failure in social media platform such as Orkut, Google Plus.    

The Illusions of Pundits

Investment – When we have research and made investment decisions then we overestimate our knowledge and think that we cannot go wrong. Though the result shows that we have got wrong in past then also we blame it on external forces.

Everything makes sense in hindsight, a fact that financial pundits exploit every evening as they offer convincing accounts of the day’s events. And we cannot suppress the powerful intuition that what makes sense in hindsight today was predictable yesterday. The illusion that we understand the past fosters overconfidence in our ability to predict the future.

Few experts are becoming overconfident as they acquire more knowledge. They fall more under the illusion of skills. So that does not try to predict the future based on the past.

“The mistake appears obvious, but it is just hindsight. You could not have known in advance.”

When we see the 2008 financial crises now, we can say that such mistakes are obvious and should avoid. But we can only do it after it happens rather than during that period.

In conclusion: be aware that you tend to overestimate your knowledge. Be sceptical of predictions, especially if they come from so-called experts. And with all plans, favour the pessimistic scenario. This way you have a chance of judging the situation somewhat realistically. Experts miscalculate; championships change hands; and winners become losers.

We can save ourselves by killing our ideas.

When we are investing, we should write down every decision in an investment journal so that we can track the quality of our own decision. Also, we should prepare a checklist which helps us to reduce our emotions and improves decision.

This entire series will be review with various examples from books which are “Thinking, Fast and Slow” and “The Art of Thinking Clearly“.

John Paulson You Only Need to Win Once

Luck is not always going to support us if we do not have the proper skill to make appropriate decisions. If we won by help of luck but make the wrong decisions thereafter then we end up with the losing a game. And for making an appropriate decision, we need to work on developing our skills. If we get success by using a stroke of luck then we cannot say that failure will not come to our way. Actually, success and failure is a cycle so that if we meet success then failure will come to meet us next. By developing a skill, we can reduce the intensity of the failure.

John Paulson has started a hedge fund company with $2 million of own fund in the year 1994. His firm is specialized into the merger arbitrage. But during the year 2005, one of his analyst Mr. Paolo Pellegrini suggested him that US housing market is into the bubble territory. And after reviewing facts presented by Mr. Paolo Pellegrini, Mr. Paulson convinced to go against the housing price. He started acquiring credit default swaps. As he got a confirmation for his idea, he has started acquiring more swaps. The largest mortgage guys of the country were positive on the sub-prime during the year 2005. But outside of his team called him a crazy. He has earned during a fall of subprime in the year 2007 worth of $15 billion for the fund and $4 billion for personal.

After the big success, he started searching for a similar big winning idea. When we get a huge success then we need to save ourselves from the trap of ego. This is a very crucial emotional bias which enters to us and we remain unknowable about it.

Mr. Paulson has an idea to buy more valuable asset compared to inflation during the year 2010. So that he bought gold and gold-related investment worth of $5 billion, he became the largest owner of gold in the world. He could not able to repeat his past success and lost 30%+ value in a year and after that, he lost value for consecutive three years. Mr. Paulson other funds also lost in value and also merger fund where he has an expertise that also falls.

We cannot able to hit winning shot every-time but when we hit a winning shot, we need to keep those value which we received. But generally, we try to repeat those winning shot again and again which create destruction of wealth for us. I learn from my Guru – Mr. Neeraj Marathe Sir, from Howard Marks and Mr. Ben Graham, that protection of wealth must be our priority. Neeraj Sir always mentioned that if we focus on avoiding mistakes then we won half of the battle. So that we should focus on not to hit a winning shot but rather focus on not to lose money. If we survive into the game then we may have a chance to hit winning shot again. But if we do not survive into the game then there will not be any probability to hit a winning shot again. If we keep our focus on hitting a winning shot then we compromise with the capital protection which is an essential part of the game. And we should not forget it ever.

Read for more detail: Big Mistakes: The Best Investors and Their Worst Investments by Michael Batnick

Benjamin Graham There Are No Iron-Clad Laws

During my course at Flame University “Art of Investing with Neeraj Marathe”, Mr.Durgesh Shah Sir has suggested me to read a book which is “Big Mistakes”. So that I am hereby starting to write my learning from the book.

We make many mistakes in life and learn from those mistakes. We keep focus on does not repeat the same mistakes again and again.

My Guru always quotes that “If we focus on avoiding mistakes then we won half of the battle.” We always cannot keep on making mistakes and learning from it but also we can learn from others mistakes which we can avoid during our journey.

Learning from others mistakes and experience is the easiest way to learn and grow.

I am hereby starting my learning from mistakes made by well know investors. Upcoming series will be going to include learning from the book “Big Mistakes”. I am grateful to Michael Batnick – author of the book.

The first article of the series, I start with Mr. Benjamin Graham who is a father of a value investing. He has given a new direction to the investing field.

Mr. Graham is a guru of Mr. Buffett and we cannot imagine investing field without Mr. Graham. Few biggest gift from Ben Graham to the investing field are Margin of safety, the difference between price & value, calculation of value to the business, etc.

Many a time, we think that stocks fall ~40-50% from the high price, we should start trying to catch “falling knives” (Such terminology is widely used by so-called professionals). But we should focus on the value of the particular business rather focus on the high price and current price. During recent fall to the stock market, many of the people started picking stocks just because they fall much from the high price.

Indian companies examples

One of the media & Entertainment Company which is falling by ~51% from its high price but the company is making losses, negative CFO, management is taking a higher salary and also giving a loan to the subsidiary companies.

One of the companies which are into the DTH services and that company fall by ~79% from its high price. The company is making very little profit, very little FCF, huge debt, negative ROE% and where value can be still very less.

Such a fall in price does not make it attractive to buy which has very little or no value.

The market always works in a pendulum and people generally forget the nature of the pendulum. The pendulum always moves towards both extreme directions.

Whenever pendulum moves towards the bullish extreme, many of us forget that such situations will not stay forever. Many of us forget about the risk which involves during the bull phase. And start taking higher risk for generating higher returns; which invites a further huge amount of risk. At bullish sentiment, people generally buy assets at the highest valuations multiple and that invites the risk to the particular asset class. This scenario has a very high chance of getting damage to our wealth compared to generating a higher return.

Reverse to such scenario, whenever the pendulum moves towards extreme bearish phase, then generally people start recognizing the risk and start avoiding to invest in the particular asset class; which take out the risk from that particular asset class. Such a scenario is the appropriate time for capturing the opportunities because in such scenario we have very less chance to lose.

When people warmly accept any securities then the price will go far from the value and when people avoid or hate any securities then the security will fall in its value.

Mr. Graham has a strategy to purchase undervalued securities and shorted overvalued securities which have made him successful. Mr. Graham has started with $450000 and which he turns to be $2500000 in just three years.

During the last month of the year 1929, Dow Jones has started going down and Mr. Graham has started to cover his short positions and shifted to preferred stocks by considering prices are low. But the calculation of Mr. Graham went wrong and he lost 20% while Dow Jones down by 17%. After this Mr. Graham has considered that market has made the bottom and he used to leverage money to boost profit but again his calculation went wrong and he lost 50%. During the year 1929 to the year 1932, Mr. Graham has lost 70% of his money.

My learning

We should not take leverage to boost up our profits from the market, we cannot measure the madness of the market. I have implemented this learning from the mid time of my investment career and I have parked my money where I am convinced to park. I have never taken a leverage position rather I have to keep liquidity with my portfolio (I was holding ~73% liquidity in my portfolio during January – 2018 and currently having ~65% liquidity position). I have always focused on capital protection over the missing out of opportunity.

 An example of one the biggest wealth creator company of the Indian stock market—

Read for more detail: Big Mistakes: The Best Investors and Their Worst Investments by Michael Batnick

WARREN BUFFETT’S LETTER – 1996

Warren Buffett’s Letter – 1996

Acquisitions

Kansas Bankers Surety (KBS)

The company is an operating into the business of insurance which has a presence in 22 states, decent underwriting record with Don Towle as a manager. They made a deal to acquire a company at $75 million.

FlightSafety International

The company is the world’s leader in the training of pilots. The company operates in 41 locations, outfitted with 175 simulators of planes ranging from the very small, such as Cessna 210s, to Boeing 747s. About half of the company’s revenues are derived from the training of corporate pilots, with most of the balance coming from airlines and the military. They made an acquisition at $1.5 billion.

We need to prepare a list of the errors which can be dangerous for the health of our investment and work to avoid those errors. If we work on the avoiding mistakes then we can win 50% of the battle.

List of mistakes which I have experienced during my investment journey –

• Never ignore the true value of the company—Every business has some value and that we should not have to ignore. If we commit such a mistake then the market will defiantly punish us. Be careful with the true worth of the company and only buy it when it falls below its true worth. And if business not available below its true worth then ready to missed that opportunity. Loss of opportunity is better than the loss of capital.
• Don’t buy HOT —-If we buy the hot business such as recent trend, new IPOs, business on which everyone is bullish etc., then we must have to exit it at the proper time. So if we aren’t able to exit at the proper time then it’s better to let it go such opportunities. If we buy HOT then that HOT will BURN our portfolio.
• Buying a high leverage business — We need to avoid a business which has a huge borrowings, such borrowings can kill the business and also kill our investment journey.
• Using the wrong valuation method — Every business will not get valued with a similar valuation matrix. We need to identify the nature of the business and then value a particular business. Such as we should not use the valuation matrix of growing non-cyclical business for cyclical business, should not use the valuation matrix of assets light business for assets heavy business and vice-versa. If we made such a mistake then whether we might miss a decent investment opportunity or we might lose our capital.
• A mistake of buying a story, not a fundamental — I have never ever made such a mistake because I am a hard-core lover of numbers. But I have seen many of the people who always focus on the story and also which is very trending to the market. I believe that without the support of numbers, no story can survive for long. In the year 2014-15, Logistics stocks due to GST gets a trending story but due to lack of good numbers, the story gets failed. People generally avoid numbers due to lack of understanding of it. I firmly believe that “Stories are for kids, not for investors.”
• Investing without a process and philosophy — I can overcome this mistake at the initial period of my investment journey and that is only because of my guru – Neeraj Marathe Sir (who always believe on having a process and philosophy for making an investment). I have seen many people who spent lots of time into the market but they do not have any process or philosophy. They change their philosophy as they meet various people. If we do not have our own process and philosophy for making an investment then we will not able to create a successful investment journey. I also learn from my guru that we must have our philosophy in a written format so that we can refer it over a period of time and stop ourselves from occurring a mistake.
• Not using a checklist — We should have a checklist for a business, industry, financial, management etc. so that we can focus on the points to study and also not forget any point to study. I am using a checklist for the last 3 years and I can say that having a checklist helps me a lot. My checklist keeps on improving as my experience grows.
• Making an investment decision with disturb mind — We should avoid making an investment decision while our mind is disturbed. Disturbance in mind will end up with the faulty investment decision and which can be harmful to our wealth.
• Cloning a well-known investors/fund managers — Again I can overcome this mistake at the initial period of my investment journey and again credit goes to my guru. If we have our process and philosophy then we will not try to clone others. I have seen many people who have spent 10-15-20 years to the stock market then also not having any process and philosophy & they clone others. Many of the people have cloning as their investment philosophy because they love to use shortcuts. I always remember the quote of my guru –

When Company does not have an opportunity to reinvest earnings at a higher rate than the company should distribute those earnings to the shareholders so that they can use it somewhere for getting a higher return. If the company does not have a good opportunity to reinvest earnings and then also company does not distribute earnings as a dividend then we need to be careful with a company (Question on the capital allocation decision of a management or earnings can be manipulated or business always needs a huge capital to sustain only).

Examples – No/Low growth high dividend payout

Examples – No/Low growth low dividend payout

We need to check the above-mentioned factors in the company where we have made an investment and where we want to make an investment. Most important is to gain a market share. The company cannot able to gain market share, though the company has a competitive advantage then that competitive advantage not useful for us. We should not focus on the leadership position of the company rather need to focus on the companies which focus on the manufacturing, distribution, packaging and product innovation. Market leadership can be changed if the company does not focus on the mentioned points.

According to Mr.Buffett, paying a higher price does not risk for the good companies compared to paying higher prices for the bad companies.

Let me take an example of one the biggest wealth creator company of the Indian stock market—

If someone has bought this company during the March-2000, at the high price of around Rs.431 then after the 16 years of the period, he gets returned at 7% CAGR. And if enter to the similar company at the low price of around Rs.275 during the March-2000 then after the 16 years of the period, he gets a returned of 10% CAGR (*Considering all-time high price for calculating returns). Though revenue has grown at 30% CAGR, Operating profit grown at 27% CAGR and Net profit also grown at 27% CAGR during the same period with supported by a good management team. During March-2000, the company was traded at 64x P/E at the low price of Rs.275 and this multiple is common nowadays.

When management of a good business diverts their focus into the business which is not performing well then such decision of the management affect the performance of the business.

Example – We have seen examples such as liquor manufacturer enter into the airlines business, airport contraction business has diversified into the power business.

Mr.Buffett has also mentioned the Circle of Competence concept –

Control on our temptation, control on our emotion towards our investment is essential to survive and create wealth from our investment.

Warren Buffett’s Letters 1957 – 2012

WARREN BUFFETT’S LETTER – 1992

WB Letter 1992

Mr. Buffett has written that they own a collection of business which is exceptional and also a run by an exceptional manager which has resulted in the higher returns.

Nowadays I have experience that everyone is becoming a market expert and providing their view on the short-term direction of the market. For such people, Mr. Buffett has given a good quote –

The Salomon Interlude

In 1991, Salomon Brothers caught for bond trading scandal and Mr. Buffett has performed as a chairman of Salomon for the ten months to resolve a problem at Saloman. At Salomon, they have been submitting false bids in an attempt to purchase more Treasury bonds than permitted by one buyer during the period between December 1990 and May 1991.

Five authorities – the SEC, the Federal Reserve Bank of New York, the U.S. Treasury, the U.S. Attorney for the Southern District of New York, and the Antitrust Division of the Department of Justice – had important concerns about Salomon.

Acquisitions

Many acquisition-hungry managers made an acquisition with the hope that they will transform business which will provide them with a good opportunity to earn. When a manager gets failed, they learn a lesson but shareholders pay fees for selecting them as an investment candidate. Mr. Buffett has accepted that during his earlier career, he also has made an acquisition but he able to achieve success due to cheapness into acquisitions and some of the acquisition got failed also. And due to such mistakes to get a failure, he revised his strategy to make an investment.

Berkshire has made an investment into the Central States Indemnity which is an insurance company provides an insurance to the credit-card holders who are unable themselves to pay because they have become disabled or unemployed.

H.H.Brown, a Subsidiary of a Berkshire has made an acquisition of Lowell Shoe Company which is into the manufacturing of the shoes for nurses, and other kinds of shoes as well.

Mr. Buffett has initial thought of purchase General Dynamics for the tendering stocks to the buyback and earns a small profit in short term. But Mr. Buffett began to study the company and he found that Bill Anders, CEO of the company has performed a decent job to run a business. Mr. Buffett has dropped the idea of buyback opportunity and decided to become a long-term investor of the company.

Investing strategy of Berkshire has been little change and also Mr. Buffett has made some compromise on the price to purchase a business’s due to market condition and their increased size.

Now, how to know an attractive price? Mr. Buffett has explained that we look attractive price with the framework of value or a growth investor – what we consider to ourselves. He explained that growth is always a component of the calculation of the value of any company. He mentioned that people using value investing term everywhere with the paying higher price then calculated the value in the hope that someone pays higher to purchase an asset from them. But such activities do not consider as an investment, it is a speculation.

People consider value investing where attribute such as low Price – to – Earnings ratio, low Price to Book Value ratio or high dividend yield or combination from mentioned and not consider value investing where reverse attributes are available. Many a time, business growth also tell us little about the value but it is also true that often growth has a positive impact on the value. We have to analyze that whether a business can able to generate a good return on the incremental invested capital or business generating a low return on incremental capital. Former one provides the benefit of growth to the investors and latter one hurts to the investment.

Ex – Value Trap

Taken from Thoughts on Thoughts blog

The company looks very cheap on the basis of the financial metrics, but if someone who does not have paid attention to the business of the company then—

An investor has lost his capital also. So, that in value investing also, we cannot escape from the future. (For detail article, Kindly visit – http://neerajmarathe.blogspot.in/2010/04/mtnl-value-trap.html)

Value Trap – One of the educational providing company which fall under the criteria of value investing –

The company is not able to generate good growth in sales and in the profitability but investment and cash have grown well. Also currently the company is available below cash + investment which fall under the criteria of the value investing. But what about the growth into the business or on the survival of the business. Will be cash & investment remain with the company in the future? Lower sales, higher expenses, lower profitability and for last 3 years the company has stopped paying a dividend. Should we consider such investment as value investing or value trap?

Ex – Growth at the low return on capital companies

The company which is generating a good sales growth but they is not able to generate a higher return on capital they employed then those companies require to take debt or dilute an equity (in-short they need external funding). Investors in such companies will face difficult to create wealth or sustain wealth.

We can see that companies having a higher sales growth but cannot able to generate a higher return on capital then they require to bring external finance to fund the growth. The growth of such companies will extend for the long period but investors face difficult to create wealth.

Ex – Growth at the higher return on capital companies

Reverse to above if company having a good growth with having a higher return on employed capital then company does not require to bring external financing (if they having a borrowing or a dilution of capital then the size of it is very small in proportion) to fund the growth of a company and also investors of such a company can create a good wealth.

Ex – Higher growth but no value

If we just focus on the growth of the company and not on the quality of the growth then we need to lose our capital also.

A company having good growth but does it have a quality of growth?

More dangerous balance-sheet quality after FY2010 –

Every time does not value investing or growth investing provides a better investment opportunity but a rational combination of the both can be good investment opportunities.

Mr. Buffett has explained valuation matrix given by Mr. John Burr Williams which is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset. He has given matrix which similarly uses for bond and stocks. But bond involves fixed future cash inflow in-terms of coupon received by us and in equities such coupon is not fixed, we cannot say with surety about future cash inflow and outflow for business. Cash inflow and outflow into equities are highly dependence on the nature of a business, quality of management. For overcoming such problem Mr. Buffett uses two rules at Berkshire –

According to Mr. Buffett, new issue market is controlling by the stockholders and institution; also new issues come during favorable market conditions and we need to pay a higher multiple. Here, we are not going to get any bargain whereas in the secondary market, many a time, we get x value business at the 1/2x.

Warren Buffett’s Letters 1957 – 2012