Are you an expert ?

Found this new article from ‘Michael J. Mauboussin‘ from Legg Mason capital management ( Links to his other articles can be found on the sidebar and his website).

A highly relevant article for an investor, especially if one is looking at improving his expertise (not necessarily trying to become an expert)
Found the following excerpts very interesting (emphasis mine, comments in italics)

• What it takes to become an expert appears remarkably consistent across domains. In field after field, researchers find expertise requires many years of deliberate practice. Most people don’t become experts because they don’t put in the time.


• Experts train their experiential system. Repeated practice allows experts to internalize many facets of their domain, freeing cognitive capacity.


• Intuition is only reliable in stable environments. In domains that are nonlinear or nonstationary, intuition is much less useful.


• Expert investors exist. Unfortunately, it is not clear that their skill sets are transferable. Expert investors are likely a product of both mental hard wiring and hard work.

And

Experts are not casual about their domain. They build their lives around deliberate practice and practice every day, including weekends. But experts also report sleep and rest as critical elements of their results, and they avoid overtraining or overexertion. Evidence shows that performance diminution in cognitive tasks coincides more with reductions in deliberate practice than with aging.

As it turns out, expertise requires about ten years, or ten to twenty thousand hours of deliberate practice. Little evidence exists for expert performance before ten years of practice. 3 Even prodigies like Bobby Fischer (chess), Amadeus Mozart (music) and Wayne Gretzky (sports) required a decade of practice to generate world class results - So I have a long way to go. But I enjoy the process of learning, so it is both fun and profitable

Are you an expert ?

Found this new article from ‘Michael J. Mauboussin‘ from Legg Mason capital management ( Links to his other articles can be found on the sidebar and his website).

A highly relevant article for an investor, especially if one is looking at improving his expertise (not necessarily trying to become an expert)
Found the following excerpts very interesting (emphasis mine, comments in italics)

• What it takes to become an expert appears remarkably consistent across domains. In field after field, researchers find expertise requires many years of deliberate practice. Most people don’t become experts because they don’t put in the time.


• Experts train their experiential system. Repeated practice allows experts to internalize many facets of their domain, freeing cognitive capacity.


• Intuition is only reliable in stable environments. In domains that are nonlinear or nonstationary, intuition is much less useful.


• Expert investors exist. Unfortunately, it is not clear that their skill sets are transferable. Expert investors are likely a product of both mental hard wiring and hard work.

And

Experts are not casual about their domain. They build their lives around deliberate practice and practice every day, including weekends. But experts also report sleep and rest as critical elements of their results, and they avoid overtraining or overexertion. Evidence shows that performance diminution in cognitive tasks coincides more with reductions in deliberate practice than with aging.

As it turns out, expertise requires about ten years, or ten to twenty thousand hours of deliberate practice. Little evidence exists for expert performance before ten years of practice. 3 Even prodigies like Bobby Fischer (chess), Amadeus Mozart (music) and Wayne Gretzky (sports) required a decade of practice to generate world class results - So I have a long way to go. But I enjoy the process of learning, so it is both fun and profitable

Expected value and value to be expected

I saw this concept in the book ‘A mathematician plays the stock market’ which I am reading currently and liked the explaination and its relevance to me as an investor.

Expected value is essentially the sum of product of gain/losses from an investment and the associated probabilities. The expected value is the most likely result from an investment.

Let me explain

Let us consider a stock S. I have reasons to believe that the stock would decrease in value by 10%, with a 80% probability. At the same time, there is a long shot product if successful could result in bumper profits and could increase the stock price by 100%. However the chances are just 20% for this event.

So in the above scenario the expected value from the stock is = (-10%)*.8+(+100%)*.2 = 12%
However value most likely result to be expected from such as stock (atleast 80% of the time) is a return of –10%.

A large group of positive ‘expected value’ investment with negative ‘value to be expected’ should be profitable over a period of time. This is same as the principle of arbitrage or value investing from ben graham. The above concept is also critical if one is dealing with options. For example, sellers of put options have a negative expected value (sometimes very high), but a small positive ‘value to be expected’.

So next time if some analyst talks of a positive ‘value to be expected’, you may want to check the assumptions and figure out the ‘expected value’ of the recommendation

Expected value and value to be expected

I saw this concept in the book ‘A mathematician plays the stock market’ which I am reading currently and liked the explaination and its relevance to me as an investor.

Expected value is essentially the sum of product of gain/losses from an investment and the associated probabilities. The expected value is the most likely result from an investment.

Let me explain

Let us consider a stock S. I have reasons to believe that the stock would decrease in value by 10%, with a 80% probability. At the same time, there is a long shot product if successful could result in bumper profits and could increase the stock price by 100%. However the chances are just 20% for this event.

So in the above scenario the expected value from the stock is = (-10%)*.8+(+100%)*.2 = 12%
However value most likely result to be expected from such as stock (atleast 80% of the time) is a return of –10%.

A large group of positive ‘expected value’ investment with negative ‘value to be expected’ should be profitable over a period of time. This is same as the principle of arbitrage or value investing from ben graham. The above concept is also critical if one is dealing with options. For example, sellers of put options have a negative expected value (sometimes very high), but a small positive ‘value to be expected’.

So next time if some analyst talks of a positive ‘value to be expected’, you may want to check the assumptions and figure out the ‘expected value’ of the recommendation

The wisdom of Martin Whitman

Found the following article on capitalideasonline (bold emphasis and italic comments are mine)

In an investment classic “Greatest Investing Stories”, there is a brilliant piece on Martin Whitman.

“We don’t carry a lot of excess baggage,” he says in the flatted vowels of his native Bronx. “A lot of what Wall Street does has nothing to do with the underlying value of a business. We deal in probabilities, not predictions.”

“The record entitles him to argue that “There are only two kinds of passive investing, value investing and speculative excess.” For the last two years, like 1928-1929 and 1972-1972,” continues Whitman, “we’ve had nothing but speculative excess.”

“These days, argues Whitman, management has to be appraised not only as operators of a going business, “but also as investors engaged in employing and redeploying assets.”

“As a long-term investor looking to a number of possible exit strategies, Whitman glories in the freedom to ignore near-term earnings predictions and results. Acidly, he argues that Wall Street spends far too much time “making predictions about unpredictable things.”

“His search is for companies backed by strong financials that will keep them going through hard times (“safe”), selling at a substantial discount below private business or takeover value (“cheap”). Buying quality assets cheap almost invariably means that the company’s near-term results are rocky enough to have turned off Wall Street. “Markets are too efficient for me to hope that I’d be able to get high-quality resources without the trade-off the near-term outlook not being great,” says Whitman. He chuckles and runs a hand through a fringe of white hair. “When the outlook stinks, you may not have to pay to play.”

“It’s a lot better than being called an indexer or an asset allocator,” he says, taking another poke at standard Wall Street dogma.”

“Whitman’s job is to sniff out what is wrong, and figure out the trade-offs against what is right, particularly in terms of some form of potential asset conversion.”

“Among the most common wrongs Whitman tries to avoid:

a) Attractive-seeming highly liquid cash positions that on inspection prove to be in the custody of managements too timid to put surplus assets to good use;
b) Seductively high rates of return on equity that often signal a relatively small asset base;
c) A combination of low returns on equity and high net asset value that may simply mean that asset values are overstated;
d) High net asset values that may point to a potentially sizable increase in earnings, but which just as often point to swollen over-head.

I have seen point b come up in several of my stock screens. Based purely on the screen, the company looks attractive. Digging deeper show some asset write offs which has artifically raised the return on equity.kind of highlights the risk of relying blindly on stock screen (I never do that though, generally using them to generate a finite list of companies to look at deeper)

“Whitman’s willingness to take on companies like the stereotypical “sick, lame, and lazy” he treated as a pharmacist’s mate – the old salt, in Navy slang, still thinks of himself as having been a “pecker checker” – is not unalloyed. Buying seeming trouble at a discount, Whitman ignores market risk (current price swings). Whitman worries all the time, though, about investment risk (the possibility he may have mis-judged a temporary illness that will prove terminal).”

“As smallish niche producers, often protected by proprietary tech­niques, the equipment manufacturers seemed less vulnerable to shake out, and had better "quality" assets. Unlike the far more capital-intensive chip makers, with their heavy investments in bricks and mortar, the equipment producers operate out of comparatively low-cost clean rooms, and buy, rather than make, most of their components. Research and development costs are high, but Whitman cannily focused on com­panies that expensed rather than capitalized them. Those running charges understated earnings, making them seem particularly weak in the down cycle. So much the worse for Wall Street.”

“Whitman continued to buy a cross section of equipment producers at quotes he regarded as "better than even first stage venture capitalists have to pay, and for companies already public and very, very cash rich."

“Whitman was averaging down, a key part of his strategy, but anathema to Wall Street's momentum players.”

Should be done only if one is sure of what he is doing and has strong reasons to believe that the market is wrong ( ‘I feel the stock will do better’ does not quality)

"Most," he thought, "ought to do okay and a few ought to be huge winners, but there would be a few strikeouts." The exit strategy for the strikeouts, in a consolidating industry, would almost certainly be acquisition.”

“Beyond diversification, Whitman protected himself by loading up on management that fit his two acid tests: good at day-to-day operations and equally good as asset managers.”

“Once again scoffing at market risk, Whitman underlines the com­forts of being cushioned by strong financials. "When you're in well­-capitalized companies, if they do start to dissipate, you get a chance to get out." "On the other hand," he continues, "when you're in poorly cap­italized companies, you better watch the quarterly reports very closely."

“That's because he thinks in terms of multiple markets. What may seem to be a very rich price to an individual investor can be a perfectly reasonable one for control buyers looking to an acquisition. They can afford to stump up a premium because of the advantages control brings. Among them is the ability to finance a deal on easy terms with what Whitman calls "OPM" (Other People's Money) and "SOTT" (Something Off The Top) in the form of handsome salaries, options, and other good­ies that come with general access to the corporate treasury.”

Read the book ‘Value Investing : A Balanced Approach’ for a better understanding of multiple market referred to by martin whitman.

“Shop depressed industries for strong financials going cheap and hang on. By strong financials Whitman means companies with little or no debt and plenty of cash. What's cheap? No hard and fast rules. "Low prices in terms of the resources you get," he generalizes.”

“Some of his other pricing rules of thumb:

a) For small cap, high-tech companies, a premium of no more than 60 percent over book - about what venture capitalists would pay on a first stage investment.
b) For banks, Whitman's limit is no more than 80 percent of book value.
c) For money managers, Whitman looks to assets under management (pay no more than two percent to three percent).
d) For real estate companies, he zeros in on discounted appraised values rather than book.”

Good reference point to look at when doing your own valuations for any of these type of companies

“Whitman, thumbing his nose at convention, has clearly established himself as an outside force on Wall Street. Despite the philosophical linkage, he even backs off from identification with what he calls Graham & Dodd Fundamentalists. The basic similarities are striking: long-term horizons, a rigorous analytic approach to the meaning behind reported numbers, and an unshakeable belief that probabilities favor those who buy quality at the lowest possible price. Like Ben Graham, Whitman scoffs at the academicians who hold that stock prices are set by a truly knowledgeable and efficient market. Acknowledging his debt to Graham, Whitman argues that his calculated exploitation of exit strategies has added a new dimension to value investing.”

“Whitman says, "I couldn't be a trader. I'm very slow with numbers. I have to understand what they mean."

"It's the art of the possible," he says. "The aim is not to maximize profits, but to be consistent at low risk. I never mind leaving something on the table."

“Whitman, look to a credit against the probability of a default. He looks beyond the credit to see what can be got when it does default-yet another variant on "safe and cheap."

“Whitman backs this contention with a notably unsentimental view of how Wall Street really works. He argues that heavy reliance on short-­term earnings predictions as the key to market values makes trend play­ers of money managers. Such linkages are the stuff of stock market columns. The Genesco shoe chain allows that fourth quarter earnings will "meet or exceed" analysts' estimates, and the stock pops with a gain of almost 25 percent. Sykes Enterprises, a call-center specialist, signals that earnings will be down, and the stock falls by a third.”

"Making forecasts about future general market levels," writes Whitman in Value Investing, "is much more in the realm of abnormal psychology than finance."

“Analysts who focus on earnings trends to the exclusion of asset val­ues, continues Whitman, tend to think laterally. "The past is prologue; therefore, past growth will continue into the future, or even accelerate." Unfortunately, the "corporate world is rarely linear," and becomes a particularly dangerous place for trend players who leave no 'margin of safety in concentrating on high multiple growth stocks.”

“A bargain that stays a bargain isn't a bargain."

I think he is refering to a value trap. A company which stays cheap forever either due to poor management or because the intrinsic value is shrinking

The wisdom of Martin Whitman

Found the following article on capitalideasonline (bold emphasis and italic comments are mine)

In an investment classic “Greatest Investing Stories”, there is a brilliant piece on Martin Whitman.

“We don’t carry a lot of excess baggage,” he says in the flatted vowels of his native Bronx. “A lot of what Wall Street does has nothing to do with the underlying value of a business. We deal in probabilities, not predictions.”

“The record entitles him to argue that “There are only two kinds of passive investing, value investing and speculative excess.” For the last two years, like 1928-1929 and 1972-1972,” continues Whitman, “we’ve had nothing but speculative excess.”

“These days, argues Whitman, management has to be appraised not only as operators of a going business, “but also as investors engaged in employing and redeploying assets.”

“As a long-term investor looking to a number of possible exit strategies, Whitman glories in the freedom to ignore near-term earnings predictions and results. Acidly, he argues that Wall Street spends far too much time “making predictions about unpredictable things.”

“His search is for companies backed by strong financials that will keep them going through hard times (“safe”), selling at a substantial discount below private business or takeover value (“cheap”). Buying quality assets cheap almost invariably means that the company’s near-term results are rocky enough to have turned off Wall Street. “Markets are too efficient for me to hope that I’d be able to get high-quality resources without the trade-off the near-term outlook not being great,” says Whitman. He chuckles and runs a hand through a fringe of white hair. “When the outlook stinks, you may not have to pay to play.”

“It’s a lot better than being called an indexer or an asset allocator,” he says, taking another poke at standard Wall Street dogma.”

“Whitman’s job is to sniff out what is wrong, and figure out the trade-offs against what is right, particularly in terms of some form of potential asset conversion.”

“Among the most common wrongs Whitman tries to avoid:

a) Attractive-seeming highly liquid cash positions that on inspection prove to be in the custody of managements too timid to put surplus assets to good use;
b) Seductively high rates of return on equity that often signal a relatively small asset base;
c) A combination of low returns on equity and high net asset value that may simply mean that asset values are overstated;
d) High net asset values that may point to a potentially sizable increase in earnings, but which just as often point to swollen over-head.

I have seen point b come up in several of my stock screens. Based purely on the screen, the company looks attractive. Digging deeper show some asset write offs which has artifically raised the return on equity.kind of highlights the risk of relying blindly on stock screen (I never do that though, generally using them to generate a finite list of companies to look at deeper)

“Whitman’s willingness to take on companies like the stereotypical “sick, lame, and lazy” he treated as a pharmacist’s mate – the old salt, in Navy slang, still thinks of himself as having been a “pecker checker” – is not unalloyed. Buying seeming trouble at a discount, Whitman ignores market risk (current price swings). Whitman worries all the time, though, about investment risk (the possibility he may have mis-judged a temporary illness that will prove terminal).”

“As smallish niche producers, often protected by proprietary tech­niques, the equipment manufacturers seemed less vulnerable to shake out, and had better "quality" assets. Unlike the far more capital-intensive chip makers, with their heavy investments in bricks and mortar, the equipment producers operate out of comparatively low-cost clean rooms, and buy, rather than make, most of their components. Research and development costs are high, but Whitman cannily focused on com­panies that expensed rather than capitalized them. Those running charges understated earnings, making them seem particularly weak in the down cycle. So much the worse for Wall Street.”

“Whitman continued to buy a cross section of equipment producers at quotes he regarded as "better than even first stage venture capitalists have to pay, and for companies already public and very, very cash rich."

“Whitman was averaging down, a key part of his strategy, but anathema to Wall Street's momentum players.”

Should be done only if one is sure of what he is doing and has strong reasons to believe that the market is wrong ( ‘I feel the stock will do better’ does not quality)

"Most," he thought, "ought to do okay and a few ought to be huge winners, but there would be a few strikeouts." The exit strategy for the strikeouts, in a consolidating industry, would almost certainly be acquisition.”

“Beyond diversification, Whitman protected himself by loading up on management that fit his two acid tests: good at day-to-day operations and equally good as asset managers.”

“Once again scoffing at market risk, Whitman underlines the com­forts of being cushioned by strong financials. "When you're in well­-capitalized companies, if they do start to dissipate, you get a chance to get out." "On the other hand," he continues, "when you're in poorly cap­italized companies, you better watch the quarterly reports very closely."

“That's because he thinks in terms of multiple markets. What may seem to be a very rich price to an individual investor can be a perfectly reasonable one for control buyers looking to an acquisition. They can afford to stump up a premium because of the advantages control brings. Among them is the ability to finance a deal on easy terms with what Whitman calls "OPM" (Other People's Money) and "SOTT" (Something Off The Top) in the form of handsome salaries, options, and other good­ies that come with general access to the corporate treasury.”

Read the book ‘Value Investing : A Balanced Approach’ for a better understanding of multiple market referred to by martin whitman.

“Shop depressed industries for strong financials going cheap and hang on. By strong financials Whitman means companies with little or no debt and plenty of cash. What's cheap? No hard and fast rules. "Low prices in terms of the resources you get," he generalizes.”

“Some of his other pricing rules of thumb:

a) For small cap, high-tech companies, a premium of no more than 60 percent over book - about what venture capitalists would pay on a first stage investment.
b) For banks, Whitman's limit is no more than 80 percent of book value.
c) For money managers, Whitman looks to assets under management (pay no more than two percent to three percent).
d) For real estate companies, he zeros in on discounted appraised values rather than book.”

Good reference point to look at when doing your own valuations for any of these type of companies

“Whitman, thumbing his nose at convention, has clearly established himself as an outside force on Wall Street. Despite the philosophical linkage, he even backs off from identification with what he calls Graham & Dodd Fundamentalists. The basic similarities are striking: long-term horizons, a rigorous analytic approach to the meaning behind reported numbers, and an unshakeable belief that probabilities favor those who buy quality at the lowest possible price. Like Ben Graham, Whitman scoffs at the academicians who hold that stock prices are set by a truly knowledgeable and efficient market. Acknowledging his debt to Graham, Whitman argues that his calculated exploitation of exit strategies has added a new dimension to value investing.”

“Whitman says, "I couldn't be a trader. I'm very slow with numbers. I have to understand what they mean."

"It's the art of the possible," he says. "The aim is not to maximize profits, but to be consistent at low risk. I never mind leaving something on the table."

“Whitman, look to a credit against the probability of a default. He looks beyond the credit to see what can be got when it does default-yet another variant on "safe and cheap."

“Whitman backs this contention with a notably unsentimental view of how Wall Street really works. He argues that heavy reliance on short-­term earnings predictions as the key to market values makes trend play­ers of money managers. Such linkages are the stuff of stock market columns. The Genesco shoe chain allows that fourth quarter earnings will "meet or exceed" analysts' estimates, and the stock pops with a gain of almost 25 percent. Sykes Enterprises, a call-center specialist, signals that earnings will be down, and the stock falls by a third.”

"Making forecasts about future general market levels," writes Whitman in Value Investing, "is much more in the realm of abnormal psychology than finance."

“Analysts who focus on earnings trends to the exclusion of asset val­ues, continues Whitman, tend to think laterally. "The past is prologue; therefore, past growth will continue into the future, or even accelerate." Unfortunately, the "corporate world is rarely linear," and becomes a particularly dangerous place for trend players who leave no 'margin of safety in concentrating on high multiple growth stocks.”

“A bargain that stays a bargain isn't a bargain."

I think he is refering to a value trap. A company which stays cheap forever either due to poor management or because the intrinsic value is shrinking

Arithmetic return is what you see, geometric return is what you get

I am reading a fairly enjoyable book ‘A Mathematician plays the stock market’ (see section ‘currently reading’ under sidebar). Found the discussion on geometric mean v/s arithmetic mean (for returns) fairly relevant for an investor.

Let me explain

Arithmetic mean (or returns) is the simple average of returns over the time period being considered.

For ex: consider a stock X that has the following returns for the year
Week 1 : + 80 %
Week 2 : -60 %

The average return for a two week period is +10%. The ‘average’ return for the year would be 1.1^52 = 142 times the original investment. If average return is what an investor gets, then anyone can be fabulously rich in no time.

Geometric mean of the same stock will be derieved by the following formulae
Total return = (1+0.8)*(1-0.6)*(1+0.8)…….( for 52 weeks) = 0.000195

The scenario in the above formulae is that the investor makes a positive return the first week, followed by negative the next and then positive and so on. So the real return he/she actually gets is less than 1 % of capital invested

Another example
An investor is on the lookout for a hot mutual fund. He looks at the mutual fund rankings and sees a fund, which has returned 100 % last year. He invests his money in the fund. The hot fund promptly proceeds to lose 50% next year ( reversion to mean or maybe bad luck ).

The return the fund publicizes is 25 % (average for 2 years ). An investor who was invested for 2 years is lucky to get his money back. The performance chasing investor looses half his money. The fund manager and his company get their asset management fee and are able to show great performance at the same time.

Reminds me of a famous title of a book – ‘where are customer’s yatch?’

There is another interesting discussion happening on the BRK board on MSN (registration required ) on the same topic.

Arithmetic return is what you see, geometric return is what you get

I am reading a fairly enjoyable book ‘A Mathematician plays the stock market’ (see section ‘currently reading’ under sidebar). Found the discussion on geometric mean v/s arithmetic mean (for returns) fairly relevant for an investor.

Let me explain

Arithmetic mean (or returns) is the simple average of returns over the time period being considered.

For ex: consider a stock X that has the following returns for the year
Week 1 : + 80 %
Week 2 : -60 %

The average return for a two week period is +10%. The ‘average’ return for the year would be 1.1^52 = 142 times the original investment. If average return is what an investor gets, then anyone can be fabulously rich in no time.

Geometric mean of the same stock will be derieved by the following formulae
Total return = (1+0.8)*(1-0.6)*(1+0.8)…….( for 52 weeks) = 0.000195

The scenario in the above formulae is that the investor makes a positive return the first week, followed by negative the next and then positive and so on. So the real return he/she actually gets is less than 1 % of capital invested

Another example
An investor is on the lookout for a hot mutual fund. He looks at the mutual fund rankings and sees a fund, which has returned 100 % last year. He invests his money in the fund. The hot fund promptly proceeds to lose 50% next year ( reversion to mean or maybe bad luck ).

The return the fund publicizes is 25 % (average for 2 years ). An investor who was invested for 2 years is lucky to get his money back. The performance chasing investor looses half his money. The fund manager and his company get their asset management fee and are able to show great performance at the same time.

Reminds me of a famous title of a book – ‘where are customer’s yatch?’

There is another interesting discussion happening on the BRK board on MSN (registration required ) on the same topic.

Concept of variant perception

I have been reading a book ‘No bull’ by Micheal steinhardt. He was hedge fund manager and was able to deliver around 30% returns for almost 30+ years.

I found his concept of variant perception useful. According to micheal, every investment idea should be explainable in 2 minutes and four points

• The idea


• The consensus view around the idea


• The variant perception of the analyst


• The trigger event which would unlock the value

For example, if there is a solid growth company which is expected by the market to grow at 20%, and as an investor my expectations are close to the same number, then I am not going to make more than the cost of equity if the actual numbers meet the expectations (for more detailed understanding of how to evaluate market expectation read the book Expectations investing)

I have used this concept of variant perception in some form although not exactly in the same manner as explained by micheal. Let me give an example

Marico in the year 2003-2004 was selling at around 10-12 time trailing earnings. A simple DCF would easily show that the market was discounting 2-3 years of competitive advantage period -CAP (for detailed understanding of CAP, please read this article) with growth in low teens. Now if one looks at the brands, the history of their New products and their distribution network and management,it is easy to see that this company could grow in low teens for considerably more than the market implied CAP of 2-3 years.

So basically my variant perception was not centred around the growth (which is the the usual variant perception generally given by most of the analysts) but around the CAP of the company.

Marico now sells for a much higher PE and the growth was also much higher than implied by the market (around 15% +).

To a certain extent, one can see the same kind variant perception being exploited by warren buffett, except that he is a genius at recognising such businesses with CAP much higher than implied by the market price (ex: coke, GIECO etc)

Concept of variant perception

I have been reading a book ‘No bull’ by Micheal steinhardt. He was hedge fund manager and was able to deliver around 30% returns for almost 30+ years.

I found his concept of variant perception useful. According to micheal, every investment idea should be explainable in 2 minutes and four points

• The idea


• The consensus view around the idea


• The variant perception of the analyst


• The trigger event which would unlock the value

For example, if there is a solid growth company which is expected by the market to grow at 20%, and as an investor my expectations are close to the same number, then I am not going to make more than the cost of equity if the actual numbers meet the expectations (for more detailed understanding of how to evaluate market expectation read the book Expectations investing)

I have used this concept of variant perception in some form although not exactly in the same manner as explained by micheal. Let me give an example

Marico in the year 2003-2004 was selling at around 10-12 time trailing earnings. A simple DCF would easily show that the market was discounting 2-3 years of competitive advantage period -CAP (for detailed understanding of CAP, please read this article) with growth in low teens. Now if one looks at the brands, the history of their New products and their distribution network and management,it is easy to see that this company could grow in low teens for considerably more than the market implied CAP of 2-3 years.

So basically my variant perception was not centred around the growth (which is the the usual variant perception generally given by most of the analysts) but around the CAP of the company.

Marico now sells for a much higher PE and the growth was also much higher than implied by the market (around 15% +).

To a certain extent, one can see the same kind variant perception being exploited by warren buffett, except that he is a genius at recognising such businesses with CAP much higher than implied by the market price (ex: coke, GIECO etc)

My problem with stock screens

Most of us know the problem with simple stock screens such as one’s based on low P/E ratio, low P/B ratio etc. A lot of stocks which get filtered through the screens are typically companies with poor economics. I have tried to overcome this problem by building a screen which has the following additional screening criteria

• An ROCE/ROE of atleast 13% or more


• No loss during the past 5 years


• Above average growth over 5 years in NP


• D/E < 2

Adding the above stock screens has filtered out companies in the following industries (partial list below)

• auto components


• bank


• cement


• Chemical


• Shipping


• Fertiliser


• Shipping


• Paper


• Textile

I have started analysing one company at a time under each of the classification. Unfortunately the reason these companies have filtered out is either due to a cyclical uptick in the industry (cement, shipping, paper etc) or it is tier II company in the industry with high operating leverage and has seen a reduction in interest cost. Due these reasons , the recent PE, ROE etc of these companies is good, debt is down and these stocks look good.
My concern is how these companies would fare once the cycle turns downwards. Let me explain using the example of shipping industry which I am analysing currently.
The main companies in the shipping industry which have filtered out through the screen are

• mercator lines : High asset addition recently through debt which has resulted in high earnings and high ROE. The risk to the business is high if the business cycle reverses as the company may be unable to service its debt


• Varun shipping / Shreyas shipping: high operating leverage, high debt and high growth in earnings in recent times due to high shipping rates. Earnings risk is high due to operating leverage


• Essar shipping : High earnings due high shipping rates. Also ROE is high to asset revaluations. This stock looks interesting and worth investigating further.

I guess the stock screen is throwing up a lot of companies which may be statistically cheap but not really a value stock. So essentially I am not be able to come up with a list of companies which are great value. I guess it is to a certain extent an indication of the kind valuation levels existing in the current market (The same filter in 2003 gave much better companies). So I guess I will have go through the entire list and maybe at the end (the list has 100+ companies) come up with a few good stocks. It defintely not a waste of time because it helps me to understand more companies/ industries which could be helpful in the future

any suggestions on improving the above screens ?

My problem with stock screens

Most of us know the problem with simple stock screens such as one’s based on low P/E ratio, low P/B ratio etc. A lot of stocks which get filtered through the screens are typically companies with poor economics. I have tried to overcome this problem by building a screen which has the following additional screening criteria

• An ROCE/ROE of atleast 13% or more


• No loss during the past 5 years


• Above average growth over 5 years in NP


• D/E < 2

Adding the above stock screens has filtered out companies in the following industries (partial list below)

• auto components


• bank


• cement


• Chemical


• Shipping


• Fertiliser


• Shipping


• Paper


• Textile

I have started analysing one company at a time under each of the classification. Unfortunately the reason these companies have filtered out is either due to a cyclical uptick in the industry (cement, shipping, paper etc) or it is tier II company in the industry with high operating leverage and has seen a reduction in interest cost. Due these reasons , the recent PE, ROE etc of these companies is good, debt is down and these stocks look good.
My concern is how these companies would fare once the cycle turns downwards. Let me explain using the example of shipping industry which I am analysing currently.
The main companies in the shipping industry which have filtered out through the screen are

• mercator lines : High asset addition recently through debt which has resulted in high earnings and high ROE. The risk to the business is high if the business cycle reverses as the company may be unable to service its debt


• Varun shipping / Shreyas shipping: high operating leverage, high debt and high growth in earnings in recent times due to high shipping rates. Earnings risk is high due to operating leverage


• Essar shipping : High earnings due high shipping rates. Also ROE is high to asset revaluations. This stock looks interesting and worth investigating further.

I guess the stock screen is throwing up a lot of companies which may be statistically cheap but not really a value stock. So essentially I am not be able to come up with a list of companies which are great value. I guess it is to a certain extent an indication of the kind valuation levels existing in the current market (The same filter in 2003 gave much better companies). So I guess I will have go through the entire list and maybe at the end (the list has 100+ companies) come up with a few good stocks. It defintely not a waste of time because it helps me to understand more companies/ industries which could be helpful in the future

any suggestions on improving the above screens ?

Comparing performance when invested capital is low

Good article (free registration required) on mckinsey quarterly on how to evaluate performance, when the invested capital is low in a business (like IT services, FMCG, consulting services etc)

http://mckinseyquarterly.com/article_abstract.aspx?ar=1678&L2=5&L3=5

Some excerpts

A more useful way to measure performance is to divide annual economic profit by revenue.2 Grounded in the same logic as conventional ROIC and growth measures,3 this metric gives executives a clearer picture of absolute and relative value creation among companies, irrespective of a particular company's or business unit's absolute level of invested capital, which can distort more traditional metrics if it is very low or negative. As a result, executives are better able to evaluate the relative financial performance of businesses with different capital-investment strategies and to make sound judgments about where and how to spend investment dollars.

In application, this approach will vary from business to business, depending on what is defined as volume and margin. In a people business, such as accounting, the margin would likely best be broken down into the number of accountants multiplied by the economic profit per accountant. In a software business, however, it would be better calculated as the number of copies of software sold times the economic profit per copy of software; in this case, deriving the margin from the number of employees wouldn't make sense. But in all cases, this approach can provide a more nuanced understanding of performance across businesses or companies with divergent levels of capital intensity.

Equally important, economic profit divided by revenue avoids the pitfalls of ROICs that are extremely high or meaningless as a result of very low or negative invested capital. Economic profit, in contrast, is positive for companies with negative invested capital and positive posttax operating margins, so it creates a meaningful measure. It is also less sensitive to changes in invested capital. If the services business mentioned previously doubled its capital to $20 million, its ROIC would be halved. But its economic profit would change only slightly and economic profit divided by revenue hardly at all (to 6.8 percent, from 6.9 percent), thus more accurately reflecting how small an effect this shift in capital would have on the value of the business.4

my thoughts : The above metric is not sufficient to evaluate. I would still consider a low capital intensive business superior compared to a capital intensive one , even if the above ratio is low , as a low capital intensive business could have higher free cash flow (provided both have similar competitive advantages ) and hence could be worth more.
The above metric is good to look at, but i would not base my decision on it (or any other single metric)

Comparing performance when invested capital is low

Good article (free registration required) on mckinsey quarterly on how to evaluate performance, when the invested capital is low in a business (like IT services, FMCG, consulting services etc)

http://mckinseyquarterly.com/article_abstract.aspx?ar=1678&L2=5&L3=5

Some excerpts

A more useful way to measure performance is to divide annual economic profit by revenue.2 Grounded in the same logic as conventional ROIC and growth measures,3 this metric gives executives a clearer picture of absolute and relative value creation among companies, irrespective of a particular company's or business unit's absolute level of invested capital, which can distort more traditional metrics if it is very low or negative. As a result, executives are better able to evaluate the relative financial performance of businesses with different capital-investment strategies and to make sound judgments about where and how to spend investment dollars.

In application, this approach will vary from business to business, depending on what is defined as volume and margin. In a people business, such as accounting, the margin would likely best be broken down into the number of accountants multiplied by the economic profit per accountant. In a software business, however, it would be better calculated as the number of copies of software sold times the economic profit per copy of software; in this case, deriving the margin from the number of employees wouldn't make sense. But in all cases, this approach can provide a more nuanced understanding of performance across businesses or companies with divergent levels of capital intensity.

Equally important, economic profit divided by revenue avoids the pitfalls of ROICs that are extremely high or meaningless as a result of very low or negative invested capital. Economic profit, in contrast, is positive for companies with negative invested capital and positive posttax operating margins, so it creates a meaningful measure. It is also less sensitive to changes in invested capital. If the services business mentioned previously doubled its capital to $20 million, its ROIC would be halved. But its economic profit would change only slightly and economic profit divided by revenue hardly at all (to 6.8 percent, from 6.9 percent), thus more accurately reflecting how small an effect this shift in capital would have on the value of the business.4

my thoughts : The above metric is not sufficient to evaluate. I would still consider a low capital intensive business superior compared to a capital intensive one , even if the above ratio is low , as a low capital intensive business could have higher free cash flow (provided both have similar competitive advantages ) and hence could be worth more.
The above metric is good to look at, but i would not base my decision on it (or any other single metric)

Warren Buffett, Unplugged

http://online.wsj.com/article_print/SB113175788303495486.html

Good article on warren buffett !!

Warren Buffett, Unplugged

http://online.wsj.com/article_print/SB113175788303495486.html

Good article on warren buffett !!

The practise of giving price targets in research reports

I have always wondered why analysts give price targets, when it is extremely difficult to predict the price level of a security, which is dependent on a host of factors with a few of these factors related to the psychology of the market at a future date.

The typical research report ( at least the free ones which I typically read) usually starts off with a very brief background of the industry. It would then discuss the latest results with a brief analysis of the last 2-3 years. The next 2-3 years income statement and balance sheet is projected. The report would typically end with a price target with simplistic analysis which is typically based on the projected EPS and a PE no.

The more rigorous analyst would give his logic for the PE assumed(often  based on the past PE of the company ). Most don’t bother to do even that.

PE as a measure is fairly flawed measure as it does not consider the ROE of the firm, its competitive advantage, impact of industry dynamics etc. At the same time the number used in backward looking (based on past PE, earning etc).I would assume a more rigorous mode of valuation would be based on DCF, with various scenarios being considered and valuation range being arrived at (with degree of confidence for this range).

But then the analyst is giving the consumer (the investor) what he wants – A precise price target (which would be hopefully achieved in the future) , a certainty,  where none exists.

It’s not that all analyst reports are of a poor quality. Some do discuss the industry in depth and attempt to do a more thorough valuation exercise. But most are superficial and not worth reading. I have found the original source of the information – The annual reports, far more useful than the analyst reports and have never made a serious commitment of capital based on an analyst report.

Do we have any good source of analyst reports in India? If you are aware please email me.,

The practise of giving price targets in research reports

I have always wondered why analysts give price targets, when it is extremely difficult to predict the price level of a security, which is dependent on a host of factors with a few of these factors related to the psychology of the market at a future date.

The typical research report ( at least the free ones which I typically read) usually starts off with a very brief background of the industry. It would then discuss the latest results with a brief analysis of the last 2-3 years. The next 2-3 years income statement and balance sheet is projected. The report would typically end with a price target with simplistic analysis which is typically based on the projected EPS and a PE no.

The more rigorous analyst would give his logic for the PE assumed(often  based on the past PE of the company ). Most don’t bother to do even that.

PE as a measure is fairly flawed measure as it does not consider the ROE of the firm, its competitive advantage, impact of industry dynamics etc. At the same time the number used in backward looking (based on past PE, earning etc).I would assume a more rigorous mode of valuation would be based on DCF, with various scenarios being considered and valuation range being arrived at (with degree of confidence for this range).

But then the analyst is giving the consumer (the investor) what he wants – A precise price target (which would be hopefully achieved in the future) , a certainty,  where none exists.

It’s not that all analyst reports are of a poor quality. Some do discuss the industry in depth and attempt to do a more thorough valuation exercise. But most are superficial and not worth reading. I have found the original source of the information – The annual reports, far more useful than the analyst reports and have never made a serious commitment of capital based on an analyst report.

Do we have any good source of analyst reports in India? If you are aware please email me.,

Good post on ‘Understanding Risk & Fear of Consequence’

Saw a good post by arpit ranka who has a good blog on Value investing & Behaviorial finance.

This post reminded me of a comment by warren buffett on risk and tendency of investors to gamble everything on a single decision/ event ( The LTCM episode – where the hedge fund was full of these super brilliant guys, but still blew up)

from memory – ‘I have never understood why one would bet everything he has for something he does not need’

Good post on ‘Understanding Risk & Fear of Consequence’

Saw a good post by arpit ranka who has a good blog on Value investing & Behaviorial finance.

This post reminded me of a comment by warren buffett on risk and tendency of investors to gamble everything on a single decision/ event ( The LTCM episode – where the hedge fund was full of these super brilliant guys, but still blew up)

from memory – ‘I have never understood why one would bet everything he has for something he does not need’

Looking at exide industries

I came across a few research reports on exide industries and liked what I saw . In a nutshell

• Exide industries is in the business of  Automotive batteries with brands such as Exide and Standard furukawa.


• Exide supplies to OEM customers in cars ( Maruti, Hyundai, Ford etc), 2 wheelers ( Bajaj, Honda etc ) and has now made an considerable in roads in the tractor segment too. It has a very high market share of around 80%+ in the OEM segment


• Exide has a dominant position in the replacement market ( 60%+) market share and a strong brand and extensive distribution network ( Read  competitive advantage )


• Exide has a strong balance sheet with ROE in high teens and consistent topline and bottomline growth inspite of increases in lead prices ( lead account for around 65 % of Raw material costs )


• Exide seems to have a reasonable pricing power due to its strong brand and is a preferred vendor for a number of OEM customers


• The company is now expanding into the export market ( which accounts for only 5 % of the topline currently )


• The next few years look good for the company as the Automotive sector ( cars, CV and 2 wheelers) has seen good growth and as the replacement cycle is around 18-24 months, strong demand from the both the OEM segment and replacement segment  should kick in.

A few negatives

• Lead pricing would have an important bearing on the margins going forward. However over the next 2-3 years the impact of higher lead prices could be reduced if Exide is able to pass through the cost increases.


• Valuation – The company is priced at around 15 times FY06 earnings. For me it is on the higher end of the price range. If I am able to get more comfortable and confident of the  business (need to read about other companies in this industry), then 15 times FY06 earnings may have a margin of safety. But for the time being, I am still evaluating and trying to get my arms around it.

Looking at exide industries

I came across a few research reports on exide industries and liked what I saw . In a nutshell

• Exide industries is in the business of  Automotive batteries with brands such as Exide and Standard furukawa.


• Exide supplies to OEM customers in cars ( Maruti, Hyundai, Ford etc), 2 wheelers ( Bajaj, Honda etc ) and has now made an considerable in roads in the tractor segment too. It has a very high market share of around 80%+ in the OEM segment


• Exide has a dominant position in the replacement market ( 60%+) market share and a strong brand and extensive distribution network ( Read  competitive advantage )


• Exide has a strong balance sheet with ROE in high teens and consistent topline and bottomline growth inspite of increases in lead prices ( lead account for around 65 % of Raw material costs )


• Exide seems to have a reasonable pricing power due to its strong brand and is a preferred vendor for a number of OEM customers


• The company is now expanding into the export market ( which accounts for only 5 % of the topline currently )


• The next few years look good for the company as the Automotive sector ( cars, CV and 2 wheelers) has seen good growth and as the replacement cycle is around 18-24 months, strong demand from the both the OEM segment and replacement segment  should kick in.

A few negatives

• Lead pricing would have an important bearing on the margins going forward. However over the next 2-3 years the impact of higher lead prices could be reduced if Exide is able to pass through the cost increases.


• Valuation – The company is priced at around 15 times FY06 earnings. For me it is on the higher end of the price range. If I am able to get more comfortable and confident of the  business (need to read about other companies in this industry), then 15 times FY06 earnings may have a margin of safety. But for the time being, I am still evaluating and trying to get my arms around it.