Sunday, August 31, 2014

Good Investment Habits as per Mr.Warren Buffet

In his book 'How to pick stocks like Warren Buffet' the author Timothy Vick discusses good investment habits to be followed by a retail investor investing in Stock Market. These habits are culled from a series of comments made by Warren Buffet over a number of years.

These habits are required because human beings as investors make a series of mistakes. A rigorous following of these habits will help overcome these mistakes.

The mistakes regularly committed by human beings in their role as investors are:
  1. Desire to be a part of the crowd
  2. Overconfidence in our abilities
  3. Unable to assess probabilities rationally.
  4. Easily lured by story telling
  5. Want to rely on rules of the thumb even in absence of rigorous proof.
  6. Ignore statistical truisms regarding chance and probability
  7. Believe that intuitive skill possessed by some humans (successful stock pickers) are readily transferable

The following habits suggested by Buffet will help guard against these mistakes.

  • Follow your own counsel, not the advice of others. Have the courage of your knowledge and experience
  • Never be a price taker or assume the market is always right. Efficient market theory do not work at the level of individual stock.
  • Common sense and a knowledge of business is more important to the investment process than academic formulas. Let value scream at you.
  • Ignore da-to-day fluctuation in the market. They are often meaningless to the big picture. 
  • Most of the forecasts tend to be wrong. Don't blindly rely on them. We tend to 'Price' rather than 'Time' stock purchases. If you know that a share offers long term value, don't wait for the price to come down before you buy the same. 
  • Investing is about buying a piece of the company. It is not about shuffling share certificates
  • Arrogance will always get the best of you in finance
  • Let time be the natural friend of your portfolio. Run the winners and let compounding make money for you.
  • Don't overanalyse
  • Stay within your strengths when evaluating businesses
  • Judge a business by what it is worth to its owners and what it costs to maintain it.
  • Don't depend on others purchase prices to value the worth of the business. Do your independent analysis
  • Seek companies with Franchise Value (Like Kaya Skin Clinic)
  • Do your homework before purchasing a stock
  • Never feel compelled to buy or sell just because it seems fashionable
  • A low price doesn't guarantee bargain. The company must offer a combination of good value and improving fundamentals.
  • Volatility is you friend if you keep a business owner's perspective.
The last point worth a bit of explanation. Most of the investors feel happy when the share prices go up and feel sad when they fall. In this they are exhibiting the exactly opposite reaction to that they display to fluctuations in food prices. This was the point that I had made in my earlier post on Preethi Malhotra.

Why we welcome falling prices when it comes to food items and dislike the same when it comes to Stock Prices?. That is because, we know that we are going to buy food items perpetually and hence we can keep inventory of food items. However, when it comes to stocks, we consider each purchase as a one off purchase and hence feel Buyers Remorse when stock prices fall after our purchase.


Thursday, August 28, 2014

Book Review #12: How to pick stocks like Warren Buffet: Author: Timothy Vick

Key Concepts: Power of Compounding, Buy and Hold Strategy, ERR, Risk Premium, Book Value, Discounted Earnings Method, Takeover Arbitrage

One of the pleasures of my current project of reviewing the finance books is the opportunity to read some great books. Reminiscences of a stock operator written by LeFavre was one such book. This book 'How to pick stocks like Warren Buffet' written by Timothy Vick is another. Both the books are lucid and significantly simplifies the complexities of finance an investing. In addition, both the books are filled with pearls of wisdom that makes the reader a better person.

This book is divided into five parts. Part 1 covers the firs two chapters and discusses the timelines of Buffet's transition to a multi-billionaire. Part 2, covering the next 6 chapters discusses Buffet's use of mathematical concepts to add value to his investments. Part 3, covering chapters 9 through 15, discusses the core theme of the book, which is how one can analyze stocks like Buffet. The focus of part 4, covering the next three chapters 16 to 18 discusses the importance of avoiding losses when it comes to managing the investments. The last part, part 5, covers Buffet's idea of forming good investing habits. 

Warren Buffet is special. He is the only multi-billionaire in the world who has made his entire fortune solely through investing in stock market. Having completed his Post Graduation in Economics from Colombia University (where he studied under Benjamin Graham) in 1951, he worked as a stock salesman for his father till 1954. From '54 to '56 he worked under Graham. After leaving Graham in 1956, Buffet started Buffet Partnership whose goal was to invest other people's money in the stock market. Having started with Assets under management of about 100000 in 1957, the partnership ended with AUM of 104,429,431 out of which Buffet's share was 25% or 25 Million Dollars!

Second phase of Buffet's investing career started around 1970. Following Graham's concepts, Buffet started purchasing companies which were trading significantly lower than their intrinsic value and which generated good cash flows. One such Company that Buffet picked up was Berkshire Hathaway (BH), which was a Textile Company. Buffet converted it into his holding company and used it to invest in other companies either through buyout or through investing in shares of the companies. This way Buffet was able to focus single-mindedly on increasing the book value of BH which has increased at a compounded rate of 20% per annum.

It is worth noting that while Buffet started off as a Value Investor, towards the latter periods he started following the concepts of Philip Fisher.

The hallmark of any book on finance and investment would be the dollops of practical wisdom oozing out of its pages. While chapter 3 of this book purportedly deals with compounding, it is littered in every page with pearls of wisdom that made me say 'wow, that's me'. First the math. Buffet is a great fan of the power of compounding. The chapter dramatically illustrates the power of compounding by asking the question if Spain would have been better off today had they not spend 30000 dollars financing Columbus trip to find India. If that 30000 were compounded at 4% annually, that would have become 8 Trillion dollars by 1999, which was the total GDP of USA !.

Coming to the wisdom part of the chapter, it discusses the common mistakes made by retail investors in their strategy and execution. The strategic mistakes include low return expectations, excessive diversification, investing without doing the required analysis and finally failure to monitor the portfolio at regular intervals. Execution mistakes include selling a winner early and keeping a loser for a long time.

Successful investing is simple. Identify a good company with long-term growth prospects. Find out if the price that you are paying is in line with the expected growth and that you are not overpaying. And monitor regularly. Company's share price and growth compound in tandem. When price exceeds growth, it is time to sell and when growth exceeds price, it is time to buy. This shows the significance of PEG ratio for an investor.

How do you know if the market is overheated? When total market cap exceeds GDP of a country, we know that it is time to sell. Two factors that have an impact on stock performance are interest rates and corporate after-tax profit growth. These are related. Normally when interest rates are high, the profit growth rate is low.

It is said that profit in stock market is made when you buy and not when you sell. The three rules to follow when buying stock are, one, buy at low cost, two, maintain a concentrated portfolio rather than spreading oneself too thin and three, be mindful of the brokerage commission. One should also be aware of the opportunity cost of every penny that they spend. For example, 1000 rupees spend in a restaurant today is worth 2594 in 10 years at 10% interest, is worth 4045 at 15% interest and is worth 6192 at 20% interest. So if one has the opportunity to compound your money at 20% interest one is better off skipping the expensive dinner and investing the same amount.

Other than the opportunity cost of spending, there is an opportunity cost of investing. For example, if your investment returns 8% while Nifty returns 20%, you are paying a high opportunity cost of investing.

In the book Reminiscences of a Stock Market Operator, the protagonist, Larry Livermore, exhorts the investors to 'Sit Tight', meaning that when one invests into a trend one should curb the instinct to trade frequently. Buffet also follows the same strategy. Buffet 'Sits Tight' both before buying a stock and after buying the stock. Before buying a stock, Buffet is comfortable sitting on cash and waiting for the selected stock to reach the target price. Once he buys a stock, he holds it for the long term waiting for the benefits of compounding to accrue. One advantage of waiting for the right price is that it will give investor an opportunity to spend time studying the company, the industry and the business model. This in turn will make her a better investor.

Chapter 9 through 16 discusses the various mathematical models that Buffet uses to evaluate business. Chapter 9 starts off by listing various approaches to business valuation including Replacement Cost Method, Historical Cost Method, X times Revenue Method, Book Value method, and the traditional Discounted Earnings Approach.

The last approach (Discounted earnings) consist of four steps.
  1. Extrapolate the current earnings over a predefined number of years (normally 10 years) based on the historical (preferably) / projected growth rate
  2. Discount each year's earnings by your expected rate of return
  3. Add the terminal value of the company discounted to the current period
  4. Reduce the debt / share. The resulting value is the Discounted Value of the company.
One thought on the Expected Rate of Return (ERR). This will consist of a Risk Free Rate (10 year treasury bond rate) plus a risk premium which increases with the earnings fluctuation (higher the fluctuation higher the risk premium) and the size of the company (smaller the company, higher the risk premium)

Since Buffet only focus on big companies with steady earnings growth, his risk premium is close to zero.

For cyclical companies, where earnings growth fluctuates, Buffet users Historical Average Growth in earnings to extrapolate the earnings growth. Benjamin Graham recommends use of 16 PE to evaluate a cyclical business.

Buffet follows a different approach called 'Bond Parity Approach' to value the companies. This approach consists of two steps.

1. Current EPS (TTM) / Treasury Bond Rate will give you the Bond Parity Price.
2. Add growth premium to factor in the earnings growth.

Consider Waterbase for example. Current EPS is 4.5. Assuming the Treasury bond rate as 8.5%, the bond parity price is 4.5 / 0.085= 53. Currently this stock is trading at 55. This company is also paying 10% dividend (Rs.1 per share), which means that we are getting a Dividend yield of 1.8% and an average earnings growth of about 10% absolutely free. (Pl. do your research before investing in this Company)

Chapter 10 discusses Book Value. Buffet gives a lot of importance to Book Value as a valuation method. Companies can increase Book Value by expanding their profits, generating high returns on assets and acquiring companies that add economic values. Other ways in which companies can add book value are:
  1. Issuing more shares
  2. Acquiring other companies that are not related to their core business (unrelated diversification)
  3. Keeping their money in savings bank account
Investors should be vary of companies resorting to these approaches to increase Book Value

We have so far discussed Earnings Growth as a valuation method. Why are we now talking of Book Value? 

Earnings can be manipulated by
  1. Using restructuring charges
  2. Asset sales
  3. Write offs
  4. Employee lay offs
  5. Asset 'Impairment' Charges
All the above methods will increase the Future Earnings without corresponding increase in Book Value. The lesson that we learn from the above is that if earnings rise without corresponding increase in Book Value, it could mean that company has resorted to accounting charges (also called Provisions) to cover their operational problems. 

Chapter 11 covers Return on Equity (ROE). Companies that can generate high ROE need to be coveted because they are relatively rare. They should be purchased when they trade at attractive valuations relative to earnings growth and ROE. For a company to maintain a constant ROE, its earnings have to grow in excess of ROE.

Following points have to be considered when analyzing ROE
  1. ROE without debt is better than ROE with debt
  2. ROE differ across industries
  3. Share buyback can increase ROE
  4. ROE follow business cycle
  5. ROE can be inflated by one time charges
Finally, given the linkage between ROE and Earnings growth, one can use ROE to predict the earnings growth.

Buffet follows '15 percent rule' (Chapter 12) for buying companies. He believes that buying good companies at reasonable prices is the only way to create long-term wealth. The operative phrase is 'Reasonable Price'. Buffet's expected return from a stock is 15% compounded annually over his holding period. 

We can do that Math for Waterbase.

Current Price = 55
Price at the end of 10 years compounded at 15% rate = 55 *1.15^10 = 223
Current EPS = 4.5
EPS at the end of 10 years growing at 10% per annum = 4.5*1.1^10=11.67
Price at the end of 10 Years using current PE of about 12 = 11.67*12 = 140
Dividends received at 10% = 10
Total value at the end of 10 years = 150.

As you can see, with the given assumptions, the price is going to be only 150 while expected price is 223. Based on this, Waterbase is not a buy. If you want to buy Waterbase, you can either review if your assumptions are too conservative (10% earnings growth or 12 PE at the 10th year) or you have to wait for the price to fall to 37.

Inflation is an insidious tax that can significantly lower the return on investment. There is a clear correlation between inflation, stock prices and bond yields. When inflation rises:
  1. Interest rates tend to rise
  2. This lowers bond prices and increases bond yields
  3. Increasing interest rates also lowers the stock prices and increases the earnings yield 
The key point is that stocks are bonds with less predictable coupons. Earnings yield is defined as
 Earnings / Purchase Price. It is better to buy stocks with good potential for earnings growth at a very low price. As the earnings grow, the earnings yield will grow in tandem.

Six rules for comparing stocks to bonds.

  1. Main goal is to find companies whose returns can beat inflation
  2. Next goal is to beat the risk-free return on government bonds
  3. Compare the coupons of the stocks and bonds
  4. Try to buy stocks whose current earnings yield is near or above long-term bond
  5. If the current earnings yield is less than bond yield, the earnings should grow quickly soon so that the earnings yield overtakes bond yield
  6. Buying growth stock at the cheapest price is the best way to beat bond yields by a wide margin.
As Guy Thomas points out in his book 'Invest and Grow Rich', investing is a negatively scored activity. In these type of activities high premium has to be placed on avoiding mistakes and reducing loss. Part 4 of this book, covering chapters 16,17 and 18 discusses ways in which Buffet avoids losses. 

Losses occur due to three reasons.
  1. Taking bigger risks and exposure to a higher probability of losses
  2. Investing in an instrument that failed keep pace with inflation and interest rates
  3. Not holding the instrument long enough to let the intrinsic value to be realized
Suppose you start with three portfolios A, B and C each holding $10000. Each portfolio gives an annual return of 10 percent regularly for 30 years. Portfolio B gives Zero returns in the 10, 20 and 30th years. Portfolio C gives negative 10 (-10) percent returns in 10, 20 and 30th years. At the end of 30 years, Portfolio A will have about $171000, Portfolio B will have about $131000 and portfolio C will have about $96000. Even minor inconsistency in returns in Portfolio B and Negative returns in just three of the 30 years in Portfolio C had significant impact on the Compounded portfolio returns at the end of 30 years. 

Warren Buffet looks for stocks with consistency in earnings rather that fluctuating earnings. Consistency significantly improves long-term compounded earnings. 

Key aspect of avoiding losses is in handling the market risk. This means that you should be able to anticipate the market downturn and exit promptly. The fag end of a bull market is characterized by abnormal PE expansion without the corresponding earnings growth.

Given below are some of the factors that Buffet considers while deciding to enter or exit the market.
  1. Relationship between stock yields and bond yields. When bond yields are rising (Interest rates are rising and bond prices are falling) and overtakes stock yields, market is generally overvalued. Stocks are most attractive when stock yields are higher than bond yields.
  2. Rate of climb in market. If stock prices are climbing at a higher rate than the GDP, it is not sustainable.
  3. Abnormal PE expansion
  4. State of the Economy: When the economy is performing at full capacity the potential for further earnings growth will be limited. You can use 15% rule to gauge if stocks are worthy of holding. 
One of the strategies which Buffet reduces his losses is by buying convertibles, instruments with a fixed coupon and an inbuilt option to buy stocks at a predetermined price. During market downturn Buffet may buy convertibles to receive coupon payment that could beat bond yields.

Another strategy is to hedge his future stock purchases by selling put options on the stock. Assume that you plan to buy shares of TCS currently trading at 2500 per share. Your target price is 2200. You sell put option on TCS at 2300 and receive a premium of Rs.100. If the share price of TCS falls below 2300, the buyer of the call will exercise the put forcing you to buy TCS at 2300. (If it doesn't, you pocket the premium). If the Put is exercised, your net price is 2200, ( 2300 - 100 premium you received), which is your target price.

Yet another strategy is 'Takeover arbitrage'. This involves buying a share in a company when a takeover is announced and selling the same when the takeover is executed. The lower the time difference between the takeover announcement and the execution, the higher the return.

How can an investor profit from arbitrage? Follow these rules:
  1. Invest in cash deals and not stock deals
  2. Invest only in deals that have been announced
  3. Determine expected rate of return upfront
  4. Don't rely exclusively on arbitrage as an investment strategy. Arbitrage can only be a secondary strategy.
  5. Buy on margins if you think that the deal is a sure thing.
Final part of the book discusses some very good investment habits propounded by Buffet. The list of these habits can be found here.

That is it. This complete the review of this book.

The main value add from my perspective is that I intuitively understood the linkage between Stock Yields and Bond Yields. Till now whenever I heard anyone talking of this linkage, I was confused and not clear of the complete impact of this information.

Another important value add is the Bond Parity Rule. After reading this book, my quality of my analysis and my purchase decisions will definitely undergo improvement.

Arbitrage as a strategy is another approach that I should follow. I remember Fame Studios takeover by Reliance Mediaworks. Fame was trading at around 45 and Reliance announced takeover at 85 rupees. After the takeover announcement the share price of hit regular Upper Circuit Filter till the price reached more than the takeover price. It means that arbitrage as a strategy could be difficult for retail investors.

Another key value add for me is the realization that despite my being an MBA in Finance and have been an investor in Stock Market from about 2004, how little I know of its workings (Check out this post). I can talk a lot about Equity Investing and its role in one's retirement portfolio. I can expound on why equity investing is better than real estate investing. But this book burst a few bubbles here (I am pointing to my head). I had earlier mentioned that after reading this book, I intuitively learned about the linkage between Stock Yields and Bond Yields. Another lesson that I learned is about the 'Buyers Remorse' that occur after one buys stocks and prices go down. In other words, one is happy when price of tomato goes down and buys more, but one is sad when price of stock goes down and buys less (if at all). Till reading this book, I was not clear why this was happening. Now I know. When it comes to Tomatoes, one is planning to buy it perpetually and can do a 'Cost Averaging'. However, when it comes to stocks, for many people, it is a one time transaction, like buying a TV, or marriage. Cost averaging do not happen. This also means that methods that encourage cost averaging, like SIPs (Systematic Investment Plans) and SEPs (Systematic Equity Plans) can help remove the Buyers Remorse, since with those tools, you will be buying stocks perpetually and thus averaging your costs.

It was Winston Churchill who said, "Till I was 16, I used to think how illiterate my parents were. When I reached 21, I was surprised to see how much they had learned in the last 5 years" !.

That is what is happening to me as I read, review and summarize these invaluable books...

Over all a great read. Strongly recommended.

Saturday, August 23, 2014

Book Review #10: Cash Flow Quadrant: Author: Robert Kiyosaki

Key Concepts: Cash Flow Quadrant, Seven Levels of Investors, Be-Do-Have

From the perspective of a blogger who is reviewing a book to identify useful concepts to write in his blog review, books written by Kiyosaki makes a difficult read. 'Cash Flow Quadrant' is Part 2 of the 'Rich Dad' Series. The first one was 'Rich Dad, Poor Dad' reviewed here. It took me a long time to read this book (Cash Flow Quadrant). Finding a fresh concept in 'Cash Flow Quadrant' (which is not present in his earlier book Rich Dad, Poor Dad) is a difficult endeavor.

This is the second time that I am reading this book. First time I read it was when I bought 'Rich Dad, Poor Dad' and was very impressed with that book. Flush with enthusiasm, I purchased 'Cash Flow Quadrant' and was impressed by the simplicity of the points made in the book.

I am not as impressed with Cash Flow Quadrant the second time reading. I guess that now I am more experienced in investing and book review, having reviewed 10 books on Finance till now, with this being the eleventh, despite what the title of the post says. 

Based on their primary source of cash flow, people can be classified under one of the four Quadrants E, S, B or I. Quadrants E and S are on the left side and quadrants B and I are on the right side of the cash flow quadrant. The quadrant E stands for 'Employed' and covers people who get their primary cash flow from Salaries. Quadrant S stands for Self Employed, whose primary source of cash flow comes from personal services they provide to the customers. Quadrant B Stands for Business and Quadrant I stands for Investors, whose primary cash flow comes from their cash generating assets. 

Kiyosaki's noble life mission is to move people from E and S Quadrants to B Quadrant and finally to I Quadrant through the tool of Financial Literacy. The book mentions the differences between the people in various quadrants in terms of their thinking and language used. People in E Quadrant are Risk averse and their language is more about Salary and benefits that they can receive from their employer. People in Quadrant S are perfectionists and like to do the work themselves and do not trust others to do the work with the same quality as they deliver. They use words like 'hourly rate' and terms related to their area of expertise. B Quadrant are business people who discuss ROI and employing workers in their business and persons in I Quadrant talk of P/E (Price to Earnings) and P/B (Price to Book) and so on.

As you can see, if you want to move from one quadrant to another, you have to unlearn many a behaviour and learn new behaviours and language. The implicit assumption in this book is that people on the left quadrants are dissatisfied with their current state and will want to move to the right quadrants. What holds them back from transitioning to the right quadrant is the lack of Financial literacy which is one of the key skills required to be successful in the the right quadrants of B and I.

As mentioned above, to move to the right quadrants, one has to change one's behaviour. This can be achieved by changing one's thoughts. As per Kiyosaki, most people, when they want to achieve a goal, works in  the Have - Do - Be framework. For example, to achieve the goal of weight reduction, People go on a crash diet and once the goal is achieved, they go back to their original bad habits that increased the weight in the first place. The optimal framework for long lasting change is Be - Do - Have. First you have to BE. You have to change your behaviour and the cultivate positive thoughts in your mind. Next is to take action (DO) to achieve the goal (HAVE). 

For instance, to move to the right quadrants, you have to change your behaviour by becoming frugal and being aware of your spending. Taking steps to attain financial literacy and taking the first step are the crucial actions that are necessary to change quadrants.

One crucial point that the author makes is that one can work out of more than one quadrant at the same time. However it is important that one of those quadrants should be on the right side. The recommendation is to move to B Quadrant before moving to the I Quadrant which is presumably the holy grail of the Cash Flow Quadrants.

Author classifies Investors into seven levels. Level 0 includes those who do not have any money to invest since they spend all that they earn. They may be professionals who earn a lot but still they are Level 0 since they spend all. Borrowers form Level 1.  They borrow money to solve their financial problems. These people are neck deep in debt. Level 2 consists of Savers. These people have money to invest, but they are highly risk averse and invest their savings in low yielding fixed income securities. Primary objective for Savers is future consumption (buying TV, taking that Vacation) etc. 

Level 3 consists of the so called 'Smart' Investors. They are aware of the need to invest. However, they lack sophistication. Level 4 are the long term investors. They know that they need to invest, they have a long term plan and are actively involved in their investment decisions. They have wealth accumulating habits. Becoming a level 4 investor is the first step to attaining financial freedom. 

Level 5 consist of Sophisticated Investors. These people have good money habits and are investment savvy. They are focused investors with a track record of winning on a consistent basis. They are financially literate and aware of various investment options available. Most importantly, these people know that bad economic situations provide them with the best investment opportunities. The final Level, Level 6 is that of Capitalists. These people are more often a B and an I. They create deals that Level 5 and Level 6 investors buy. They make other people rich and provide employment to many. 

The last section in this book details Seven Steps to your Financial Fast Track. Each step is followed by a set of specific actions that one can follow to put the step in practice. The first step is 'Minding your own business'. This is a very important concept. If you are a salaried employee, you are actually minding your employer's business. Every line of expense in your personal income statement is making someone else rich and hence whenever you spend, you are minding their business. When you pay taxes, you are minding government's business. When you pay mortgage, you are minding your banker's business. You are minding your own business only when you are accumulating assets. Accumulating assets. That is your only business.

I liked the simple way in which the author is explains a very complex concept.

There are two actions that you have to take in this step. Action one is to prepare your personal financial statement. Author has provided a template that you can use to prepare your statement. Next action is to set your financial goals in terms of debt reduction, creating new cash flow streams etc.

Step 2 is to take care of your cash flow. You have to identify your current source of Cash Flow and the sources you want to have 5 years from today. The two parts of your cash flow management plan are one, 'Pay yourself first' and two, reduce your personal debts. 

Many people confuse the difference between 'Risk' and 'Risky'. One aspect of Cash Flow Management is to understand the meaning of risk and take steps to mitigate the same. Most people consider investing as 'Risky' due to lack of knowledge. Author recommends to improve the financial literacy so as to tackle that misconception. 

There are three types of investors. Type A investors seek problems to solve. Type B Investors seek answers and Type C investors are not interested in knowing much about investing. At the outset it is important for one to be clear as to what type of investor they want to be. Author recommends the reader to become Type A investor who solves problems. The action items include getting educated in business and investing. 

The next three steps (of the seven step process) are to have mentors, learn to handle disappointments and to have faith in yourself and god. One of the powerful techniques mentioned in this book is to note down the names of 6 people with whom you spend maximum time in a day. Once you identify those names, then classify them in terms of the quadrant that they operate. That tells you more about the quadrant in which you operate currently. If you want to change quadrants, you will need to change the people with whom you are spending most of your time. 

With big fonts, a large number of diagrams (each of which almost fills a page) and huge amount of personal opinions, separating the chaff of text from the 'Wheat' of concepts in this book is an arduous task. Too many sub headings separating the texts impact the flow of understanding. Most of the topics and ideas in this book are already covered in his previous book 'Rich Dad, Poor Dad'. 

First three steps in the final section are the only decidedly useful topics that I found in this book. As can be seen from the list of Key concepts list at the start of the review, there are hardly any and whatever are there are also not 'Concepts' in the technical sense.

Ever since Mr.Kiyosaki prided himself as a 'Best Selling Author' in his book Rich Dad, Poor Dad, I have got some aversion towards his books. I prefer reading a book the focus of which is to educate the reader and provide conceptual rigour  to reading a book the main talking point of which is that it is a 'Best Selling' tome. Mind you, I respect that it is a 'Best Selling' book and respect the views of the readers that made this book 'Best Seller'.

To be fair to the author, I am  a knowledgeable investor and I may not be the target audience for this book. Even if this book is targeted to the not so knowledgeable investors, the job of a book on Finance is to increase the knowledge level of the readers and inspire them by providing conceptual pegs which they can use. This is what Mr.Lynch has done with his book 'One up on wall street'.

This book fails that test in my opinion. 

If you want to read Kiyosaki, I recommend his first book, 'Rich Dad, Poor Dad'

Friday, August 15, 2014

Book Review #11: Invest & Grow Rich: Author: Guy Thomas

Key concepts: Change of State, Defensive Pessimism, Double Seven Shares, DVD Investing, Spider Chart, Strategic Lethargy, Tail Gating, Two types of luck, Positively Scored and Negatively Scored Activities, Core Thesis-Secondary Factors-Hygiene Factors, Kitchen-Sinking, Mispricing of insolvency risk, Illiquidity Discount

'Invest and Grow Rich' tells the story of 12 Investors who became Sterling Pound Millionaires by investing in stock market mostly in UK. Based on their approach to investing, these investors are grouped into four groups, Geographers, Surveyors, Activists and Eclectics. 

Geographers follow a top down approach. They first scan the macro economic environment to identify the potential growth industries. Once they identify the industries with potential growth, they try to find companies in the industry with potential to provide significant returns. Surveyors, on the other hand, follow a bottom up approach. They focus on companies and identify companies with significant growth potential. Activists try to build significant stakes in companies and then use their business skills to influence or force companies to unlock value to the investors. Eclectics are those investors who follow styles that cannot be classified as any of the above.

When it comes to investments, the question often asked about the role of luck. The author talks about two types of luck. One type of luck is the luck of a lottery winner. This is not the type of luck that favors an investor to become rich. That (the luck that favors investors) is reflected in the statement 'Fortune favors the brave'. The second type of luck is attracted to those who are prepared for it.

To review this book, you have to start with the Conclusion. This chapter compares the path to Financial Success of these Investors by identifying similarities and highlighting differences under the following three groups:
  • Life Choices and Chances
  • Attitudes
  • Working Methods.
When it comes to Life Choices, the focus of all the investors is on Future. They look back to the past only to reflect on the lessons that they learned. All the investors took to this perspective from young age. Almost all them took to investing before their marriage and before they had any dependents. The key characteristic of all of them is perseverance. Despite early failures with occasional minor successes, they learned lessons from their failures and persisted. For all of them investing was a full time occupation. 

All of them had enough wealth to assure them of lifetime freedom. Freedom without worrying about paying the bills was the motivator for most of them to get into investing. Once they achieved it, they continued investing since all of them enjoyed the investing process. It is pertinent to know that none of them used leverage and all of them liked working alone.  

When it comes to the working methods that they adopt, all of them adopt multiple strategies while investing. There is no single strategy that is applicable to any one of them. There are major strategies, for example Top Down Approach of the Geographers. All of them have concentrated portfolio of about ten stocks, all of them focus on small companies with good growth potential etc. While some of them are highly educated, there is very little of math they use while analyzing the companies and they all rely on their knowledge and do not depend on external advisers for their investment decisions.

The first investor in the series is Luke who started his career as a Transport Planner. At the
age of 28 he went on to do higher studies and post that transitioned as a Banker. He specialized in Oil Exploration and Production and is a top down investor. At the age of 47, he left his job to focus full time as an investor. While he spends a lot of time reading about the market, he invests very sparsely focusing on Quality rather than Quantity when it comes to investing. He talks of the concept of 'Strategic Lethergy', the habit of enjoying doing nothing. He feels that one needs just two great stocks to change one's life.

Next investor profiled in this book is Nigel, a Psychology Major who worked in the Banking Industry till the age of 47. He invests on the basis of two factors, Cyclicality and Market Psychology. He is a top down investor who believes that some investment markets moves in
cycles, with multiple shorter cycles nested within a large cycle. The cycles are irregular in that some cycles may last longer than others. Nigel tries to invest into the cycles as they start moving up and exits before the downswing begins. Another concepts he believes is in psychology of the markets. As per him, 'when many people believes that market can only go up, it means that market has hit its peak, and when many people believe that market can only go down, it means that market has hit bottom and is poised to rise'. He is also a big fan of 'Secondary Offerings' where company issues additional shares to existing investors at a discount (it is called 'Rights Issue' in India). His main approach is to sell half when a share has doubled.

The third investor profiled in this book is Bill, who is an Electronic Engineer who quit his job at the age of 41 to become a full time investor. Over a period of 9 years he had a compounded return of
30% per year on his portfolio. Based on his investing methodology, he is a surveyor, who follow bottom up stock picking strategy. He is a value investor who do not believe in paying excessively for growth. In analysing companies, he doesn't believe in the so called 'Soft' approach (Networking, Attending Company AGMs etc) and only listens to what the financial numbers tell him. He uses the concept of 'Value Spider', a spider chart showing different aspects of a company plotted on a single page. Bill believes in tracking a few simple matrices like P/E, EV/EBIDTA etc. He finds value in investing based on the ideas of a few people whom he trusts. He calls this 'Tail Coating' on the ideas of experts. He also follows 'Defensive Pessimism' as his investment philosophy. As per this, you should try to find all the reasons for not buying the shares of a company and buy it only when you can live with those reasons.

John Lee, the next investor in the series, follows the basic principle of investing that he calls 'DVD Investing'. DVD stands for 'Defensive Value and Dividends'. Defensive Value means that you
should not pay significantly higher than the value of assets. When it comes to Dividends, it is the trend in dividend rather than the actual percentage that matters. John looks for companies that increase dividends. Another aspect of DVD Investing is investing in 'Double Seven' shares, where the P/E is less than or equal to Seven and Dividend Yield is greater than or equal to Seven. Like Bill above, John also looks for simple matrices. Finally, John looks to buy companies where owners and directors have significant ownership.

Next investor profiled in this book is Sushil, a highly qualified Economist with a PhD in Econometrics. Sushil moved full time into investing at the age of 35 and has built an enviable
portfolio over the years. Sushil's investment philosophy is to 'Invest into a Change of State'. What this means is that whenever a company goes through a change of state (Increase in dividends, Restructuring, Mergers etc) the company offers potential for significant returns. Sushil's portfolio of about 60 stocks contain mostly UK Small Cap stocks. As per Sushil, the big difference between retail investors and professionals is as follows. Due to their large holdings, every time a professional takes an action, he wants the market move to be counter-intuitive to the same decision were to be taken by an average investor. For example, when he buys a stock, a professional wants the prices to go down (unlike a normal investor) since he plans to buy more and vice-versa when he plans to sell. Another key aspect of his approach is that Sushil always screens his ideas through the filter of 'Post Tax Returns'. In other words, he considers tax as an important component in investment decision making.

Among all the investors profiled in this book, Taylor, our next investor, is the only one without any structured financial education. He is a self taught investor having taught himself by reading a number of investment books. He maintains a very concentrated portfolio of about 6 to 10 stocks
often having 'Plunged' (taken significant position) in one or two stocks. Over a period from 2000 to 2010 his portfolio grew by 25% per year. Even though he keeps significant long positions in various stocks, he does not have any compunctions in selling the stocks at the earliest sign of trouble ('Change of State' as discussed by Sushil above).

The next investor, Vernon, adds so much value that I have to dedicate more than a paragraph for him. He holds a PhD in Science and stopped working at the age of 38. His style is 'Contrarian' who, as he calls it, 'Buys the Glitch'. In a period of 18 months between 1998 and 2000 his portfolio value increased by 15 times. Vernon is only one of the two (Other is Sushil) who made and kept money in the Technology Boom of the late 90's.


His investment approach is to consider the company in terms of three sets of factors, that he calls as Core Thesis, Secondary Factors and Hygiene Factors. Core thesis puts forth the main reason from buying the stock. Secondary factors are positive factors that support the decision. Hygiene Factors are negative factors that are potential deal breakers. Core thesis is similar to 'Two Minutes Drill' mentioned by Lynch in his book One Up on Wall Street.

The various glitches that prompt Vernon to research the stock include Profit Warning, Index Demotion, Mistaken Sector read across and bid failure. Once a glitch appears, Vernon waits patiently for the management to do what is known as 'Kitchen Sinking', where all the bad news associated with a company are released in one go. This will drag down the prices further at which point Vernon initiates purchase.

Vernon is acutely aware that time is a limited resource with strongly diminishing returns. The first hour you spend in researching a company is much more important than the tenth hour. Given his focus on effective utilization of time, he focuses only on a few sectors. The advantage is that this could lead to 'Economies of Scale in Knowledge Production'. Once you research one company in a sector, researching other companies becomes easy. The drawback is the 'Risk of getting stuck at Local Optima' which loosely translated means 'Missing wood for the trees'.

Vernon avoids new stock issues, also known as IPOs (Initial Public Offerings) here in India.

Vernon considers the decision of selling the stock as a decision to switch to alternative investment. Since timing of sales is difficult, he uses Heuristics like 'When it doubles, sell some' and 'When it is tipped, sell some'

Vernon considers investment as a game being played in the mind of the investor. Mental skills in Investing include the following:
  • Investor should cultivate the ability to be happy alone since investment is a solitary activity.
  • Investor's thinking should be in search of the truth rather than reinforcing prior affiliations. 
  • An investor should be able to keep conflicting ideas in mind in parallel, accepting uncertainty for long periods, and choosing between them (conflicting ideas) at the last possible moment. This is called working with 'Multiple Mental Models'.
  • In investing, 'Avoiding a mistake' is more important than 'Winning'. Investing is a 'Negatively Scored' activity. Activities can be divided into 'Positively Scored' and 'Negatively Scored'. In 'Positively Scored' activities like Selling, Leadership etc, attributes like 'Bravery', 'Having a go' and risk-taking gives a better chance of success and downside of making errors is low. In 'Negatively Scored' activities like driving a car, Giving Anaesthesia and Piloting a plane, the successful person is the meticulous one who avoids making big mistakes. Relevance of above to Investing? Ease of online investing makes people behave as if investing is a positively scored activity, but arithmetic of compounding dictates that it is negatively scored.
Next investor, Eric, falls into the category of Activist. If I have to pick one person who, in my opinion did not belong to this book, it must be Eric. It is true that he last worked in a job at the age of 28 and sold off his business at a handsome profit at the age of 39 and he has made more than a million by investing in UK stock market. However, to me as an investor, he does not add any conceptual value. He uses his concept of 'Strategic Naivety' by acting naive while hiding his shrewd business sense. To some people it could come off as trifle unethical.

There are two types of activists. Passive activists try to influence management action through their queries and power of persuasion. Eric, discussed above, falls into this category. Active activists like Owen and Peter (by the way, Peter and John Lee are the only two investors whose real names are used in this book) try to influence the management action by taking direct and significant stakes in the companies they invest in. A review of their methods is beyond the scope of this review.

The final section in the book discusses the Eclectics. First of the two eclectics profiled is Khalid
who is different from all the other investors discussed in this book. For one, Khalid is a day trader unlike all the others who are fundamental analysts. Khalid's typical holding period is minutes to hours (never more than a day) unlike others who buy and hold for the long term. Another difference is that Khalid uses leverage while others avoid it. That he has made more than 40% compounded over a period from 2004 to 2010, trading 30 shares on an average per day alone merits his being mentioned in this book.

Final investor profiled in this book is Vince. He is an eclectic because he does not restrict himself to a specific approach. He invests in equities and real estate. That he buys in to beaten down UK Small caps demonstrate his 'bottom up' approach. That he felt that German real estate will perform better that other European real estate displays his 'Top Down' approach. His typical holding period can be from a few hours to years. Once he finds a good idea, Vince buys significant holdings in that company. He holds 3% to 29% stake in many UK listed companies. According to Vince, small companies offer two benefits vis. mispricing of insolvency risk (institutions will sell at any price if the company appears to be in any sort of Solvency Trouble, and this provides opportunity to buy) and excessive discounts of illiquidity (an institution with a good holding will sell at any price if it wants to divest its holdings in the stock).

This completes the summary of the book. The 12 investors profiled are similar in many aspects including risk aversion, preference for small cap stocks, dislike for diversification etc. They are also different in aspects like the approach followed, reliance on Financial theory, knowledge and expertise in Finance etc.

There is no drama in this book, says the author in the introduction. This book provides a detailed look at the investment habits of 12 highly successful investors in UK and Europe. Reading this book can be a tedious exercise (much like reading this blog post, do I hear someone mutter?). Both the book and this blog post are content rich. Being content rich, they have to avoid all the drama and emotion and focus on raw data, which in this case is the successful investment habits and lessons.

The concept of 'Value Spider' propounded by Bill is a very useful tool for any amateur investor venturing into the market. In one diagram, it gives all the information necessary to make decisions. The beauty of this chart is that it is a 'progressive' chart. Every time you compare the chart of a company with a previous chart of the same company, you will get a clear view of the movement of all the parameters that are relevant to your investment decision. The guy who developed 'Spider Chart' should get a Nobel Prize or something, in my opinion.

Another concept that I found potentially useful is the Core/Secondary/Hygiene factors concept of Vernon. This is a very good approach for an investor to use since it provides a quick snapshot of why one should buy or avoid a stock. And it is evolving. By reviewing the factors regularly, one can easily validate ones assumptions and ensure that one is on the right track.

Third concept that I learned (again from Vernon. The  guy is concept rich. It is not for nothing that I devoted enough blog space for him) is the difference between 'Positively Scored Activities' and 'Negatively Scored Activities' and that investing is a 'Negatively Scored Activity' where avoiding mistakes is more important than winning substantially.

Every investor faces the choice of timing the sell. The investors in this book follow heuristics like 'Sell when the shares become popular', 'When it doubles sell half', 'When it is tipped, sell some' etc. It was eye opener to know that only two investors in the book (Sushil and Vernon) both made and kept money that they made in the Technology boom of early millennium.

Life lessons abound. Lesson one is about how investing is more about achieving freedom and less about making profits. Another lesson is about the importance of perseverance. All the investors profiled in this book has spent more than 7 years investing with minimal profits before they learned to make significant money through investing. Lesson three is about the the value the investors place on time in comparison to the value placed on money.

All in all a valuable book. The lessons learned in this book will stand you in good stead on your arduous journey to become a successful investor.

Sunday, August 10, 2014

What to teach your children about money?

It has been found that children as young as seven years old can understand the concepts of money and finance. So the question is, what will you teach them? Especially if you are not financially literate? 

Considering that money  is related to behaviour, the easiest things to teach the kids is 'wealth accumulating' related behaviour. These are behaviors and habits, if developed and maintained over a period of time, can help children grow as wealth accumulating adults. 

Here are a few such behaviors that you should teach kids and encourage their practice.

First one is related to Delayed Gratification. This is the habit of putting off instant gratification for a better outcome tomorrow. A simple example of this would be telling your kid that 'he can have one ice cream now or he can clean her room now and can have a weekly supply of ice cream'. A child who is aware of the benefits of delayed gratification will choose the latter option. It has been found that the children who practice this behaviour go on to achieve significant success in life. A college kid who refuse to go for a movie today and studies instead for the exam next week is exhibiting delayed gratification. A child who practices delayed gratification will ignore the plaintive pleas of a toy salesman knowing fully will that he will outgrow the toy in a week. 

Second behaviour that you can teach the child is the power of options. This involves trying to find out similar products in the market as the product that they liked in a shop and comparing the prices. It is very easy in the age of Internet. 

The power of options also means that the child will have to analyse the real reason for wanting something and look for the best product can meet the requirement.  An example of this could be buying a reasonably priced piece of clothing instead of an exorbitantly priced 'Designer Label'.

Another good habit to teach the children is the habit of analysing the intrinsic value of a product. The manifestation of this habit is asking the question: is this product worth the price? What factors determine the price? For example a branded pair of Jeans may cost anywhere upward of Rs.2000. But the same pair of Jeans, made by the company that exports its Jeans to the retailer, will sell it unbranded, made in Surat and will cost you probably Rs.400. Which means that for something whose value is about 200, you are ending up paying about 2000. This is no way to accumulate wealth.

Children should also be taught to identify and act on opportunity whenever it presents itself. The moment they identify something of value that is useful to them, it is better to close the deal quickly. This is the opposite of Delayed Gratification. If the opportunity is one that will be beneficial and it has good value (reasonably priced) the deal should quickly closed. 

One of the key reasons for making wrong financial decision is the fear of loss of opportunity. Children should be taught to handle the fear of loss of immediate opportunity. They should be asked to evaluate whether this is a permanent loss or a temporary one. For example, you see something on the shelf that you think is a bargain. The marketeer would have put a big notice 'Discount for next three days only'. There is a desperation to buy for the fear of losing the bargain. You don't do any of the analysis mentioned in steps above. You don't see the intrinsic value, you don't ask the question, why is this on a bargain, why was it not sold at the original price? You don't evaluate your real requirements. Only thing that guides your spending decision is that if I don't act now, I will lose this bargain. Action without proper due diligence is the best way to lose money.

In today's world, spending money has become very easy. You just have to check out an Online Market for any product and next time you so much as start the computer, the products you queried will be dancing in front of you all over the computer screen. In this environment, it is very easy to purchase online since the entire process so easy. However easy spending doth not rich you make. Frugality is an important habit that children (and even adults) should learn quite early in life. As Dr.Stanley and Mr.Denko point out in their path breaking work, 'The Millionaire Next Door', Frugality is one of the key attribute of every millionaire they analysed. Remember, One Dollar saved today could give you 10 dollars compounded 10 Years from now !.

It may sound counter intuitive but one of the important habits that children should learn is the Habit of Giving. Children should be taught to give at least 10 percent of their income to Charity. More importantly, they should be taught to donate their time, which is a more valuable resource for children. Right from the young age, children should be taught to express gratitude for their advantages that many disabled children can never hope to gain in their life time. 

Greed is the number one enemy of wealth creation. Doesn't make sense, does it? The problem is that greed makes you fall in love with your possessions and prevents you from exiting from them at the right time. Greed can be emotional, one may fall in love with your negative thoughts and refuse to give them up despite the fact that they are hurting. Greed may be financial, one may fall in love with their bad investment and refuse to sell despite evidence that they are floundering. Right from the childhood, children should be taught to handle greed.

Despite what Gekko says, greed is not good.

While I won't call it 'Bargaining', children should be taught the 'Art of Negotiation'. When it comes to wealth building, the art of negotiation deals with identifying the worth of a product by mutual discussion and price iteration. This ties in with the point I made earlier about identifying the intrinsic value of anything that you purchase.  You can be a good negotiator if you are good at assessing the intrinsic value of something. 

Another good habit to learn is the 'Art of Walking Away'. When it comes to making and keeping wealth, the kids should learn to Walk Away and not be emotionally involved in the process of procuring something. The best way to do this is by teaching them to handle the situation with a sense of detachment and not to be emotionally involved and not to fall in love with a product. Remember, we are not talking about the quality of the product here. You are negotiating because you think the product is good. You are negotiating the terms for procuring the product. In that negotiation, your ability and willingness to 'Walk Away' can give you a whole lot of leverage.

So there they are. My list of financial habit that one should inculcate in their children.

What do you think?