Book Review #14: Liar's Poker: Author: Michael Lewis

1980s was a decade of financial innovation in the US. The bond markets had exploded. Bonds, that were once considered to be boring and sedate products fit only for Pension Funds and retirees, suddenly became volatile and highly risky. It all started in 1979 when then US Treasury secretary, Paul Volker, announced that the monetary policy will be defined by fixed money supply with the interest rates being the only monetary policy tool that the US Fed will use to stabilize US Economy. This policy change lead to wildly fluctuating interest rates. Bond prices which behave inversely to interest rates suddenly became highly volatile as a result.

Where there is volatility, there is money to be made. The volatility in bond markets led to investment banks setting up their bond trading desk. The biggest of them all was Solomon Brothers, the wall street firm which specialized in Bonds. With bonds no longer remaining a sedate product and transitioning into a vast money making opportunity, the demands for bonds exploded. Business started booming and huge amount of money was to be made.

Innovation was the name of the game. The greatest innovation was the realization that there was a huge market for innovatively packaged mortgages. Prior to this, mortgage loans were never a flavour of the market due to two reasons. First, the size of the individual mortgage (ticket size) was very small and did not interest a serious investor. Second was that while mortgages had a well defined cash flow pattern, the borrowers were allowed to prepay their mortgage in full without any penalty for prepayment. This second factor meant that an investor in mortgage loan market faced unpredictable cash flows. After all, it is not happy situation if you buy a mortgage backed bond expecting a steady cash flow and suddenly find that the mortgage has been prepaid and the cash flow will stop from the next month.

These two factors, small ticket size of mortgages and prepayment risk ensured that the demand of mortgage based bonds remained low. Solomon saw a huge potential for anyone who can resolve these challenges. They were the leaders in bond trade and here was an untapped opportunity. Solomon set up a mortgage bond desk and over a period of two years, this team came up with a series of path-breaking innovations (which were the scourge of any MBA student studying Finance in the next 20 years !) that redefined the mortgage based markets. The first innovation was what is known as 'Asset Securitization', where Solomon bought over the mortgage loans from the banks. They got a very good rate since Banks were keen on offloading these loans from their books and receive the cash flow that they converted to more mortgages.

What did Solomon do with these bonds that they purchased? They mixed and matched these loans to various bond offerings that could meet the expectations of different class of investors. For example, they stripped the interest component of these loans and packaged them as 'Interest Only' securities that produced regular cash flow. They sold these to investors whose primary objective was steady cash flow. They packed the principal component to 'Principal Only' bonds  and sold them to Pension Funds which did not care for regular cash flows and were interested in Capital Appreciation. Wall Street was raining innovative products and the innovation was limited only by the imagination of the Bond Trader. Young bond traders became multi-millionaires overnight.  It helped that the regulatory authority was behind this rapid innovation and could not provide the required oversight.

Suddenly bond trading organizations found that they did not have enough hands to trade and sell bonds. Non-availability of man power became the limiting factor to increasing business. Firms started going to campuses to pick the best of the lot. Solomon Brothers recruited a set of trainees for its batch of 1985. The author of the book 'Liar's Poker' was a member of that batch of '85.

He remained with Solomon for three years till he left the company in 1988. In this book, he provides a ringside view of the Bond Market, Wall Street, European Markets, Bond Innovations dotting the book with descriptions of interesting personalities and path-breaking events that defined the glorious decade for the bond traders, the years from 1980 till the collapse in 1988.

Arrival of Mortgage backed securities was one such path breaker. Another was the arrival of Junk Bonds. This was initiated by Mike Milken, the master of them all. He understood that the bonds issued by financially weak companies with good managements can provide high yield to the investors. This is because the market prices these bonds cheap considering the poor financials of the company. This increases the yield of the bonds. By packing a set of similar bonds Milken was able to spread the interest rate risk significantly. This led to bonds with high yield and relatively low interest rate risk. There was a vast demand for such bonds and Milken and the company he represented Drexel Burnham Lambert.

This was also the decade of 'Leveraged Buy Outs (LBO)' and 'Managed Buy Out (MBO)'. In both these Debt, in the form of Junk Bonds was used to buy out the company. In LBO, outsiders used Leverage to overthrow the management and buy out the companies. Critics of these allege that the ultimate objective of both these innovations is to take the company private and then strip the assets. Many giants became a victim of LBOs. In MBO, the management used the Debt financing route to buy out the companies from the market and make it private.

Solomon Brothers was one of the victims of an attempted LBO. In this case Milken, in association with another Wall Street investor, attempted to buy out the stake of the company. The company brought in Warren Buffet as a 'White Knight' to foil the takeover bid. Buffet used an innovative approach called 'Convertible Preferred' at 9% interest with an Option to buy the shares of Solomon at 38 Dollars a share any time within the next 10 years. As mentioned in THIS BOOK, Buffet later converted the same to Solomon Shares and made a tidy profit.

Towards the end of the 80's bond market started losing its sheen. It will not come back to its original glory (with new derivative products) till the next Mortgage Boom in the early 2000. Many of the key players in the Bond Boom of the eighties either lost their jobs or were investigated for misdeeds and punished. In addition, the regulators learned their lessons well and the arc of the law started catching up. Fortunes were lost in this period.

Michael Lewis, the author of the book, had 'Been there and Done that'. His Wall Street experience comes out very clearly in each page of this book. This book provides a spell bounding ride through the great bond boom of the 80's. There are thrills, there are characters and there is fun. And money.

Lots of it.

"Is dividend the same as preference shares?": Challenges to Equity Investing....

On a recent weekend, I was flying down to Bangalore from Mumbai.

There was this dignified gentleman sitting next to me. The flight was delayed a bit and we got chatting, starting off with cribbing about how the flights have started getting delayed of late. He was telling me about the 'Flight Delay Paradox', in that the flights that you genuinely want delayed (early morning flights, for example) are never delayed and the flights that you don't want delayed, the ones which are taking you home, are the first ones to be impacted by the delay.

This gentleman is working as Vice President Marketing of a multi national corporation. He was in Mumbai for a customer visit. He is an Engineering graduate with an MBA from a leading management institute in India.

Airline bashing stands next to weather and 'So what do you do?' as great conversation starters. It breaks the ice pretty quickly.

We got talking about investing. I told him that I am interested in equity investing and have been doing that from about 2004, with mixed results. In my opinion, currently, the Indian markets are poised for a very good appreciation. It is time to invest in Equities, I told him.

"What kind of returns can I expect?", he asked me.

I went into a conceptual discussion of two forms of returns from equity. One is in the form of dividend and the other is in the form of capital appreciation.

"What is dividend?", he asked me, "Is it the same as preference share?"

I was dumbstruck. The fact that a senior professional with an MBA from a leading institute in India did not know the difference between dividend and preference share was inconceivable to me.

That set me thinking. If a highly educated and highly qualified professional did not have the basic idea of investing and finance, then what chances  do other less qualified people will have? Only about 3% of the investible surplus in India is invested in Equity.  Government is trying its level best to encourage people to move their savings to equity. Long term capital gains tax on returns from equity is zero if the investment is held for more than 365 days. Mutual funds spend tons of money in putting up advertisements encouraging people to invest in equities through SIP route. Indian markets are in a bull run that is expected to continue for another 4-5 years.

To what purpose?

You ask a common man whether he invests in equities and the stock answer is 'I don't like gambling'. The perception is deep rooted that equity investing is like gambling. The same guy will have no qualms about paying 2000 per square feet for a parcel of land with the intention of selling it after one year at 3000 per square feet. Isn't that gambling?

The problem is that equity investing is complex and calls for a basic knowledge of Finance. One has to understand the concepts like PE, PB, PEG, Dividend Yield, Earnings Yield and Shares. Just like any other investment, for an investor to make serious money, s/he will have to learn some concepts that drives markets. Also, one has to invest when the prices are low. If you do the basic work like learning the basic concepts and buy low, one is virtually guaranteed to make money in stock market. However, many investors wait till market has run up to invest. And they have an intention to sell very quickly. The combination of above two, vis. buying when prices are high with an expectation to sell in a very short time, will convert equity investing to Gambling. 

What my experience shows is that we have a lot of work to do to change the investors savings habits from Bank FD to Equity Investing. It can be done. After all, if we can move people from investing in money lenders to investing in Bank FDs, we can move them to invest in equity. Equity investing is risky, definitely. So is bank FD. Who can forget the failure of Global Trust Bank and the concomitant loss to the depositors. Equity investing has its advantages, low taxes, capability to beat inflation, significant appreciation potential over the long-term etc are some. 

Education is the key. We need to put a lot of effort in educating the common man about the benefits of investing. 

Teaching the difference between Dividends and Preference Shares is a good start.

Why real estate my friend, why not stocks?

(Warning: 
The article below is intended to educate the investors on the option of Equity Investing. This do not make any investment recommendations. There are many options for investing your funds. Equity investment is only one of the options. Equity investment is risky. Pl. discuss with your investment adviser before investing in equity market)

Notes:
1. It is recommended that if you are venturing into equity markets, you do it through Mutual Funds
2. Unless specified otherwise, all the references to the markets relates to Indian Equity Markets.

Now to the article....

I overheard my friend Raj talking to a friend about potential investments

Raj: I have some money to invest in. Where should I invest?

Friend: Why don't you invest in Real Estate?

Raj: That's what I have also been thinking.

This kind of discussion is all too common among middle class in India who has an investible surplus.

This always puzzles me, this fascination for real estate. Being a hardcore follower of equity market, and knowing that any day equity will outperform real estate, it is very hard to curtail the impulse to butt in when I listen to similar conversations.

On one level I can understand this fixation with real estate. I can think of the following reasons why people find it comfortable when investing in real estate.

They are in control of the transaction: When it comes to real estate, most of us are dealing with a tangible item. There is a parcel of land, or a block of apartment, you can touch, you can feel, you can meet up with others who have purchased similar property, you can meet up with and negotiate with the seller regarding price....

You are investing a large amount of money and you feel that you are in control, that you are taking charge of your investments. You have an emotional connect with the purchase process.

Buying a stock is just an unemotional transaction. You are dealing with an invisible entity, the stock exchange. In these years of Demat, you are buying something which you don't see and feel (earlier, you used to get a physical share certificate for your investments), price is given to you, you are a price taker. There is no scope for negotiations. None of your traditional purchase habits work when buying stocks.

Tangible vs. Intangible: As mentioned before, real estate is a tangible asset which you can see and feel. Stocks on the other hand is intangible. You can feel its presence only by the upward or downward movement in its price.

Parents have set example: Most of the people who buy property have seen their parents or some significant elders in their life go through the process of buying real estate. That is not the case when it comes to investing in Stocks. Despite phenomenal, mind-boggling returns from equity, many people of the previous generation were afraid of investing in stocks.  Culture of equity investing is a recent phenomenon in India. This has started only in the 90s with the advent of the new middle class. The first stock exchange was set up in India only in the late 70's. So for many people, buying stocks is a new experience and they have no one to look up to.

Friends have made money: Everyone out there has a friend who bought a house at 1500 per square feet, which is trading at 3000 (or 6000, whatever number) per square feet. It creates a visibility and removes the aura surrounding real estate investing. It is also possible that all their friends also invest in real estate and are not aware of equity investing (remember that birds of the same 'Investment Habits' flock together). Coupled with the fact that significant elders in their life had never invested in stock market, this leaves them with no examples of people having made money in any investment other than real estate.

Appreciation in real estate prices are highly visible: People can see and feel the appreciation in the price of real estate. Almost every real estate property advertisement presents the price information. This helps people to compare prices. Raj can say things like "Six months ago price was 1000, now it is 1250. It is a 25 percent appreciation in 6 months'. However, the price information on equity market is relegated to the pink papers and even here it is relegated to some esoteric language like '450, 475, 444, 453, 22'. One can't make a head or tail out of this information. (Information seen in Tickers in Financial Channels are only related to a few stocks and their prices are normally beyond the range of a retail investor)

Emotional value: This is a no-brainer. World over there is an emotional value attached with real estate. Having a home of one's own is considered a symbol of safety. Society (which mostly consist of people with similar aspirations) look up to people holding real estate. (It is a different matter that while doing the spring cleaning, you come across a share certificate of 100 Shares of Wipro bought in 1980 (purchased by your dad) at 10000 and see that the market value of that investment is currently 440 Crores (44000000000) and you have unclaimed dividends of about 118 Crores!!!!)

However there are some obvious disadvantages to buying real estate.

Your returns are not what they are: There are lots of taxes and duties associated with the purchase of real estate. Assume that you buy a 1500 square feet of house at Rs.1000 per square feet  and sell it at Rs.2000 per square feet. At the time of purchase you have to pay an overall tax of about 5% which inflates your purchase cost to 1050. At the time of selling, again you have to pay a tax of (let's say, 2.5%) which decreases your sales price to 1950. So your net return will be 900 per square feet, 100 (10%) lower than what is visible. Remember that I have not considered the time element here. If you had kept your house for 10 years before selling, that is a measly return of about 6% per year, lower than the inflation rate, which means that you have lost money in the transaction. (You could argue that you would have got rental returns, see my point below about rental returns)

Additional charges that lower your returns: Real Estate calls for two additional annual charges, vis. Maintenance charges and Property taxes. Those will further lower your returns. No such charges exist in case of Equity Investing.

The profit on your first house is always notional: One may pride himself saying that the house that you had purchased 10 years ago has quadrupled in value. But my question is, are you going to sell the house? Most of the time, your answer is no. This means that the returns are only notional.

Rental incomes are meagre: As I had mentioned in this post about Kambles the rental returns are measly. For instance, if you purchase a house for about 60 lakhs, which gives you a rent of 25000 per month (3 lakhs per year), the annualized return is only 5% which do not beat the inflation. Which means, as I mentioned in this post about Two Thieves, is a net annual loss for you. A bank deposit at 10% interest rate would have given you 6 Lakhs on the above.

You are not the real owner: Till you pay off the final installment of your EMIs (Mortgages), you are not the real owner of your property. The lender, usually the bank, is the real owner of your property. This was amply demonstrated by the recent housing bubble in US where the banks had to resort to distress sale of many properties where the owners could not pay back the mortgage.

Now let us talk about Equity Investing. It is a known fact that only about 3% of the annual savings in India are invested in equity markets. While there are many aspect as to why this rate is very low, including regulatory aspects, there is no question that attitude and perceptions of the people with respect to equity investments has got a lot to do with such minimal savings rates in equity in India.

The basic perception is that the Stock investing is esoteric and that it needs some expertise which many of us do not have. There is talk of PE, PB, Cash Flow, Balance Sheet...Not all people have the requisite knowledge to handle stock investing and hence are discouraged to invest in equity markets. However, expertise is required for any kind of investment, not just for investments in equities. If you don't have the requisite knowledge, you could either make sub-optimal investment decisions or worse, you could lose a lot of money. I remember once standing in a 'Tanishq' shop. One lady brought her gold jewelry to check it Caratage (Gold Content). When told that it was 18, she was inconsolable. The vendor who sold it to her had told that it contained 22 Carats and was charged her accordingly. How many of us know of people who purchased real estate and found that it was not what was promised? It is important to do due diligence no matter whatever the investment.

Despite above drawback, even when someone invests in equity markets, the make the following mistakes. 

They enter the market late in the cycle: This is the first mistake that most people make. Before a stock comes into the public domain, it would have already run up quite a lot. This means that an average investor is purchasing an expensive stock and as anyone know, an expensive item can only come down in value. This leads to investors losing money which reinforces their perception that equity investing is only for experts. (Read my post on 'Chaiwalla (Tea Vendor) Threshold')

Sell winners and keep losers: This is a peculiar habit of retail investors. They invariably sell the winners at the earliest opportunity and keep the losers all the way down to significant loss. Since the profit is limited and loss is unlimited, the investor ultimately lose money. Some time they compound the loss by buying more of the losing stock in the name of 'Cost Averaging'.

(I can go on. I have made more equity investment mistakes than I care to remember). 

If you put the effort to learn the basics, equity investing is much more lucrative (and intellectually satisfying) than any other form of investing. Following are some of the benefits of Investing in Stocks over Real Estate:

Easier Purchase and Disposal: Equity investment is very easy to enter and exit. You can get into the market for amount as low as 1000 rupees. Also it is very easy to exit from your investment. This provides easy liquidity. So if you have a requirement for liquidity, it is better to have some investments in equity markets 

Zero tax on long-term capital gains: This is the most important benefit of investing in equity markets. Long-term capital gains taxes are zero. This means that if you keep your stocks for more than 365 days and then sell, the profits are totally tax free. Compare this with investing in real estate where short-term capital gains tax is applicable if it is sold within 36 months and long-term capital gains tax applicable thereafter, unless you buy another property within a year of disposing off your previous property.

Much faster appreciation: Invested properly, Equity Markets can provide significant returns if an investor identifies and invests in the correct stock at the correct time. Just an example, a stock like 'Avanti Feeds' has quadrupled over the last one year.

Cycle turnarounds are much faster: This is another major advantage of investing in equity markets. Even when they fall, they recoup their losses very quickly, much more quickly than real estate. For example, in 2008, the market fell from 21000 to 8000 and in the last 6 years, it has recouped all those losses and then some. 

With all these benefits of investing in equity markets, my question to friend Raj is, 

Why real estate my friend, why not stocks?

'Chaiwalla (Tea Vendor)' Threshold in Equity Investing....

'Chaiwalla' is the hindi translation for the 'Roadside Tea Vendor'

I heard an expert say this on TV.

"When my 'Chaiwalla' starts recommending a stock, I know it is time to get out of Stock Market"

One of the greatest challenges when it comes to Equity Investing is the decision on when to sell you investments and book profits. Wrong timing and you could end up in losses, since a market can come down dramatically in a short time.

Given that I found the observation of the expert very interesting...

Normally this is what happens to the price of a typical stock. Let us call it Ratan Shaw Industries Limited (RSIL)

The price of RSIL is less than 10 rupees per share, the balance sheet is very week, the company is debt laden, sales seem to be declining quarter on quarter and there is doom all around. Then something happens and the stock price starts appreciating stealthily. Company is turning around, but only insiders know. Insiders start increasing their shareholding through creeping acquisition route. Externally the things are still worse. No one is ready to touch the stock even if you give them a bargepole free of cost. However the people in the know have started accumulating the stock. 

The new quarter results are announced. The debts have started coming down and sales is increasing and a few outsiders and bravehearts buy the shares. In the meantime the share price of RSIL has almost doubled in a month. 

Chaiwalla Threshold Diagram

Still you and I are unaware of the existence of this stock. We are still following the Infys and the TCSs of the world. Meanwhile the stock of RSIL has moved to 30, a 200 percent gain in about 4 months. 

The next quarter numbers are announced. The EPS has grown about 30 percent QOQ (Quarter on Quarter) and the share price of RSIL has touched 50 slowly moving to 100 and then 150 in about a year. EPS is growing at 50% per annum compounded. 

This is when CNBC experts notices. When the stock price has touched 200, the expert talks about the strong Balance Sheet and impressive Earnings Growth. Mutual funds start accumulating. The share is now noticed by the Stock exchanges. The experts start accumulating the stock of RSIL in good scale. 

The Stock start appearing in CNBC ticker. The retail investor starts noticing the stock and tentatively starts purchasing. Our retail investor Rajesh purchases 100 shares of RSIL at a price of 200. 

Meanwhile the stock price goes on its relentless upmove. It touches 300, 400, 500.....

It has touched 800. One day Rajesh is sipping tea at the local Chaiwalla with his friend Sujesh.

"I purchased RSIL at 200 and my investment has touched 800 in 6 months. Awesome returns, almost 800% annualized", Rajesh informs Sujesh. Chaiwalla is listening. 

Another week passes. The stock price has touched 1000, PE is 90, overpriced and for the first time in two years, the Sales growth has plateaued. Mutual funds are worried. The price has come down to 950. 

One day two friends, Ajay and Ashish, are sipping Chai in the same Chaiwalla. Ajay has got a recent bonus and is discussing with Ashish on opportunities to invest.

Chaiwalla is helpful. "The other day I heard that RSIL is a good investment opportunity. I have heard many of my customers (!) say that they have made good profit out of RSIL stock."

Friends, this is what I call 'Chaiwalla Threshold'. When your Chaiwalla starts recommending a stock, it is time to sell it and exit. Market may be about enter the bear phase.

Your 'Exit' problem is solved.

Book Review #13: Value Investing and Behavioral Finance: Author: Parag Parekh

Key Concepts: Law of the farm, Growth Trap, Contrarian Investing, Prospect Theory, Value in use, Value in exchange, False consensus effect, Group think, Ambiguity effect, Buyer's remorse, Confirmation Trap, Recency Effect, Base Information, Singular Information, Extrapolation Bias

Introduction

As readers of my blog, especially of the Book Review Series on 50 Books on Finance, will no doubt know, I love reading and reviewing books that contain pearls of wisdom, great insights and which are conceptually compelling. This book, 'Value Investing and Behavioural Finance' offers all the three. To top it all, the book focuses on the Indian Market.

I had always wanted to review a book written by Indians and which focus on the Indian market. Such books are few and far between. Given my stated interest in reviewing books on Indian markets, it is surprising that I had allowed this book to remain unread in my library shelf for over a year.

Better late than never, as they say.

Burst a few knowledge bubbles, did this book. All through my education on Investments (Including Chapter 7 here), I have been led to believe in the superiority of Index Investing over investing through mutual funds or direct purchase of stocks. The argument was that over the long-term (there we go again !) the returns from Index Investing (also known as 'Passive Investing') offered superior returns than almost 90% of actively managed mutual funds. During the course of my investing education I bought into index investing for a brief period of time and gave up because the returns were not in sync with that of the respective indices. Two questions always bothered me about index investing. One was that if all the mutual funds were investing in the same index, why do the performance of index funds vary across the funds and with reference to the index being tracked? Value Research has given 5 Star rating to some index funds and 2 Star rating to others. This didn't make sense to me.

My other beef about index investing was that there were a number of actively managed diversified equity funds that had consistently outperformed the index and the index funds over a significant period of time. This was illogical.

I got answers to both these questions when I was reading the chapter on 'Index Investing' in this book. 

Another myth that got burst was related to IPOs (Initial Public Offerings). There is a craze in India (I suspect world wide, see the frenzy on IPO of Alibaba in NYSE) for investing in IPOs. In the chapter on IPOs, I read about how the companies and that investment managers have a motivation to inflate the price of IPO offering. 

The focus of this book is on value investing. As the author says, the objective of every equity investor should be to identify great companies with sound management that are trading at reasonable valuations, buy and hold them ("What is the best time to sell a stock? I will say never"). This approach is close to my heart. 

The division of actual returns into real returns and speculative returns is something that I learned from this book. The book also talks about the failed IPOs of Reliance Power and DLF (that cost investors crores of money) and offers key insight into the behavioral aspects of both the promoters and the investors that led to the colossal failure of these IPOs. I was one of the unfortunate victims of the Reliance Power IPO scam. Reading these insights made my blood boil. 

Behavioral aspects of Finance is an area that has gained tremendous traction over the last 20 years. This book looks at the various concepts of behavioral finance and their applicability to Indian stock market. This book was written in 2008, when the last major bull run from 2003 to 2008 was winding down. At the time of writing this book the Indian market had corrected from a high of 21000 to about 15000. As we all know, the market ended going all the way down to less than 8000 (61% Fibonacci Retracement). I am sure that we would have gained much more insights had the author waited for the entire correction to pan out (he need not have waited for long !) before publishing this book. 

It is worthwhile to note that from those lows of 8000, we are currently trading at 26000, a 300% gain in about 6 years !. And still we are talking about 'India being at the beginning of the next bull market'. Mind boggles when one thinks of the potential !.

The key objective of the book is to sensitize the readers to many decision making patterns (called 'Heuristics') that an individual investor uses when investing in equity market. Equity investing calls for the painstaking work of analyzing the current and future prospects of a company.  This involves macro economic analysis, industry analysis, company analysis, talking to the company...the works. To avoid the tedious work, investors resort to decision making shortcuts known as Heuristics. For example, I resort to heuristics like low PE /low PB /low Debt-Equity/52 Week high etc. While these are explicit heuristics, investors also resort to implicit heuristics like Availability Heuristics - 'Everyone is talking about this stock, this should be good', Herding - 'Everyone is buying this stock, I also should', Representative Heuristics - 'Logistics industry will do well, so all logistics companies will do well' and others.

An investor who is aware of the decision making heuristics that he is using is a better investor. He will understand that during bull market there will be availability of a lot of positive news (availability heuristics) not all of which may be correct. He will be alert to the representative heuristics and will not invest in all the stocks in a sector just because the sector is going up.

This book creates that much needed awareness.

Author points out that when it comes to equity investing, investors forget history and repeats the same mistakes which were previously made by others. This is because of, one, demographic shift (new younger investors come and make the same mistakes as made by their seniors!) and two, the preponderance of recent events and news that overtakes the relevant information from the past (Availability Heuristic and Recency effect). As an example, author points out that despite the failure of Morgan Stanley Close Ended Fund which underwent 'Brute' manipulation by Gray Market Operators, Anil Ambani allowed his Reliance Power IPO to be manipulated by Gray Market, which in the end, led to significant losses for investors and loss of face for ADAG group.

This book is well structured through its 12 chapters taking the reader through the behavioral impact on various aspects Indian equity markets. Chapter 1 discusses the behavioral traits that lead to personal success and failure with emphasis on delayed gratification. Chapter two talks of human behaviors applicable to stock market and how these behaviors make the market risky for investors. This chapter also provide a peek into 'Prospect Theory' which won Nobel Prize. Chapter 3 starts off the operative part of this book with a discussion on the behavioral obstacles to value investing. This is followed by a chapter each on Contrarian Investing, Growth Trap, Commodity Investing, Investing in PSUs (Public Sector Units aka Government Controlled Companies), Sector Investing, Initial Public Offerings (IPOs) and Index Investing. Chapter 11 discusses the investor behavior that lead to bubbles int he equity market. The book winds down with a look in Chapter 12 about a new concept called 'Investor Behavior Based Finance' which discusses how a company can use the understanding of its investors while taking Corporate Finance Decisions.

Chapter Summary

If the purpose of the first chapter of a book is to arouse curiosity in the reader about the rest of the book, Chapter 1 titled 'Success and Failure' fails to do that. Were it not for my current project of reviewing 50 Books on Finance I doubt if I would have continued reading the book beyond the first chapter. The chapter is filled with generalizations, cliches and platitudes. It says that many of us are lazy, greedy, ambitions, selfish and ignorant. We strive for security, comfort, leisure, love, respect and fulfillment. I regressed to my MBA Class where professor was talking about Maslow's need hierarchy. The chapter makes two key points. Once is that the in life always the 'Law of the Farm'  works. You have to sow before you can reap. The other point is that the basic cause of failure is our penchant for 'Instant Gratification'. Key recipe for success is the ability to plan our goals and the self discipline to ignore temptations and strive relentlessly towards achieving those goals.

Chapter 2 titled 'Understanding Behavioral Trends' starts off by looking at the two components of equity returns vis. fundamental returns and speculative returns. Fundamentals deal with the returns from growth in earnings and dividends. Speculative component is due to PE expansion or contraction. The speculative components depend on investor sentiments and could fluctuate wildly.
Formula for calculating the Fundamental return is,
[ (Ending EPS - Beginning EPS) X Beginning PE + Dividends for the period ] / Price Paid
and the formula for speculative returns is,
[ (Ending PE - Beginning PE) X Ending EPS ] / Price Paid
The author advises retail investors never to get carried away by 'Noise' in the market and stick to buying fundamentally good companies at a low to reasonable price.

So what are the behavioral obstacles to value investing? This is addressed in Chapter 3 titled 'Behavioral Obstacles to Value Investing'. This chapter looks at both Value and Growth investing styles and analyses as to why people favour one style over another. There are two types of value, Value in use and Value in Exchange. Water has a lot of value in use whereas gold has a lot of value in exchange. Value Investors should know the difference between the above concepts of value and only buy those companies that has good value in exchange which appreciates over time. Behavioral obstacles to value investing include Recency effect - giving more importance to recent information at the cost of older but relevant information, Prospect theory - People give more value to loss aversion over profits and tend to sell off profitable investments soon and tend to keep ( and add to) the loss making investments in their portfolio and Instant Gratification - Not having the patience to stay invested over a significant period of time. Since the process of identifying value is complex, people resort to heuristics like PE, PB and Price / Sales Heuristics to identify value.

Author makes two observations about Growth Investing. One, growth is not the same as returns. If you buy a growth stock at a high price, you will not reap returns. Two, there is a difference between good companies and good stocks. It is not necessary that good companies are good stocks at all time. Some time there will be a divergence between the performance of the company and its potential to provide good investment returns. Another important point is that investors are reluctant to change courses and sometimes are content with sub-optimal returns.

Contrarian Investing is the focus of Chapter 4.  Contrarian investor is one who goes against the conventional wisdom when picking investment opportunities. The book discusses personal and organizational heuristics that could become an impediment to contrarian investing. Personal heuristics include Group Thinking - where you sacrifice your views to become a part of a group, False Consensus Effect - tendency to overestimate the percentage of people we think would agree with us, Buyer's remorse - tendency to regret our decisions if they go against us in the short-term, Ambiguity Effect - Depending on external inputs to reduce uncertainty of stock purchase and reduce ambiguity (looking for validation in message boards, for example), Herding, Recency effect - giving undue importance to recent negative stock and Confirmation Trap - Tendency to seek confirmation of your decision through actions of others (You may not want to buy when all others around you are selling) etc. The author talks of a study done by his firm that showed that over a 10 year time-frame, contrarian investing (at the beginning of the year buying the 10 lowest PE stocks in the index and holding them for one year) outperformed conventional investing (at the beginning of the year buying the 10 highest PE stocks in the index and holding them for one year) by a wide margin.

Chapter 5 discusses Growth Trap. This occurs when the investor pays high price for growth. Despite the stock being a growth stock, the investor do not gain any return since he paid a high price for the stock. The behavior heuristics followed by investors chasing growth stock are Availability Heuristics: Every one is talking about this stock and one invests based on readily available information, Herding (already discussed), Over confidence bias: Due to confidence in their assessment, one under-reacts to negative information relating to the stock, Bystander effect: Even when one believes counter to the market, one is hesitant to act on their belief, Information Cascade: copying the actions of the experts without doing the required analysis and Halo Effect: taking decisions based on only one prominent information. Author illustrates growth trap through multiple examples from Indian Markets. For instance, in 1979, Century Textiles was a growth company and ACC was a neglected stock. If you had invested 100000 each in both these stocks in '79, ACC would have given about 6 Percent more return (which translates to about 4 Crores in 25 years) than Century Textiles. This is because, the investor overpaid for Century Textiles which was a growth stock.

Commodity investing is the focus of Chapter 6. The book examines the difference in investor behaviour when it comes to investing in commodities. It has been observed that when the commodity cycle turns around, it is the historically underperforming companies with carried forward losses and high level of debt that provides the maximum returns. The reason is that the losses are due to high interest rates and when the cycle picks, the revenues increase but the interest costs remain the same or they decrease. In addition the carried forward losses act as an asset that can be set off against period taxes. Both the above inflates the EPS and hence the share price.

Chapter 7 of the book looks at PSUs (Public Sector Units, Government owned companies) and discusses the reasons for the perception of under-performance in those stocks. Author discusses the absence of Availability Heuristics (not much information is available about those companies unlike private sector company which is tracked by every analyst and his mother in law) and Herding - All PSUs are grouped together, as some of the reasons for this. The key point being made is that some PSU units like SBI and Oil companies are trading at very low valuations and offer significant returns over the long-term.

Each phase of a bull market is led by different sectors. Chapter 8 discusses Sector Investing. When a sector becomes fancy, investors start hearing a lot about the prospects of the sector (availability heuristic), all the stocks in the sector appreciate irrespective of fundamentals (Representative Heuristic), everyone starts investing in the sector (Herding), everyone becomes optimistic (Overconfidence), Taking wrong decisions (Winner's curse, as when TISCO purchased CORUS) etc. Sector bubble happens when many new companies spring up in the sector and the stock prices of the companies appreciates without any fundamentals. Investors should be very careful when investing in sectors. It is very important to get out at the right time. When tide turns, sector bubble can crash very fast.

Those investors who lost money in IPOs (yours truly, for instance) will no doubt identify with the points made in Chapter 9 on IPOs. Investors use 'Singular Information', which are available recently and not the 'Base Information', which are the historical information relevant to the current investment decision. Since IPOs appear in bull market, singular information is normally very positive and hyped up. Investors extrapolate the singular information (extrapolation bias) and make decisions which they regret later. Another point discussed is 'winner's curse', where uninformed investors tend to get full allocation of bad IPOs, (I remember receiving full allocation of Orient Green IPO and lost money heavily. It listed lower than IPO price and has avoided the IPO Price since then) since informed investors avoid these IPOs. The Chapter points out that ever since 1990, investors have lost money in more IPOs than they have made. Despite this well known fact, author finds it puzzling that those investors who did not get the allotment in IPO tend to buy it on listing, normally at a higher price, as if the stock is some hot target or something. (Current craze of Snowman IPO is an example). The chapter analyses the behavior of various stakeholders in IPO market and come to the conclusion that the idea that IPOs are normally under-priced is incorrect. The motivation for the company coming to IPOs is to get as much money from the market as possible, so they have a motive to steeply price the IPO. The bankers to the issue get their bonuses depending on how much money the IPO can accumulate from the market. Hence they have a motive to over price the IPO.  

Chapter 10 covers Index Investing. To understand this one must know the difference between the philosophies driving a corporation and index. Corporations focus on continuity. If they do not inject fresh blood at regular intervals, they could decay. Indexes on the other hand focus on discontinuity. They are always scanning the markets and injecting new potential stock and removing the weaker ones. This way Index is never resting on the past laurels and is always focused on future potential. This is the fundamental principle behind Index Investing.

The problem comes in execution. Market Capitalization is considered to be the benchmark for a stock to be in the index. Sometimes weak companies enter the index by playing the market capitalization game. This is the reason why different index funds perform differently. Due this manipulation of the index, especially in emerging markets (I presume), an efficiently monitored active investing strategy can pay rich dividends (and stock appreciation !).

Author sites a study done by his team. Starting from the 90's, each time a stock is replaced in the index by a new one, he invested equal amounts of money in both of them on the day the transition occurred. In this way, he built up two portfolios, one of rejects and others of entrants. To their surprise, the team found that the portfolio or rejects consistently outperformed the portfolio of new entrants by a statistically significant margin !

When markets go through bubbles, investors tend to lose heavily. Investors want answers to four questions. How are bubbles formed, What are the types of bubbles, How can one identify if bubbles are forming / formed and How should an investor handle bubbles. Chapter 11 on Bubble Trap answers these questions. Bubbles start to form based on real information. For example, the cue for the bubble of 2008 was the real GDP Growth from 6 to 9 percent. As initial investors start making money, the news spreads and others waiting in the wings enter and the prices go up. There is overconfidence and optimism all around and this leads to bubbles. Bubbles can be either market bubbles, sector bubbles or stock bubbles. There are two characteristics of Bubbles. One, rapid PE expansion to abnormal levels and two, entry of new and small companies into market through IPO. Investors should keep the valuations always in mind when investing in market. As soon as they see PE expanding beyond reasonable limits, they should sell and exit. Do not wait for the stock to touch the last 5% to exit. As Livermore mentions in the book Reminiscences of a stock operator, 'If all the people who lost money waiting for the first 5 percent or last 5 percent and laid end to end, they will cover the entire coast of England'.

The final chapter of the book, Chapter 12 discusses Investor Behavior Based Finance. Just as an investor will benefit by researching on the company before investing, the company's can also benefit by understanding their investor profile before taking any major corporate finance decisions. Some investors may be long-term, some medium-term and some short-term. Some investors may be focused on the Organization, for some others focus may be on the management, for some it will be strategic direction of the company and some others may be only focused on the financials. Through this knowledge, company can predict impact of their decisions (lets say Restructuring) on the share prices of the company and decide if that kind of movement is acceptable.

This completes the review of this book.

As I mentioned in the beginning, the field of equity investing is heavily influenced by the emotions and behavior of the investors. Investors are driven by two primary emotions, greed and fear. An understanding of these emotions is primary to become a successful investor. While taking investing decisions an investor relies on many heuristics. Some of them may be explicit and some implicit. Some may be beneficial, some may be detrimental. He/She becomes a better investor if they know the heuristics that they use. And that is where this book comes useful.

The glossary of this book provides an exhaustive list of heuristics that people (not necessarily investors) use in decision making. That is one heck of a list worth reading !!!