I had the privilege of attending Professor Bakshi’s second talk at the BSE, having also attended the first one last year, where he spoke about the deadly consequences of risk seeking behavior. The event itself was a full house, held in the iconic convention center, seating a full house of around 600 people. Apart from Debashis Basu and Sucheta Dalal from Moneylife, Dr Vijay Malik and Neeraj Marathe were also notably in attendance.
Below is the fleshed out version of the rough handwritten notes I took, organized and edited for clarity and interspersed with links to other material he referenced.
“What Happens after you buy a stock”
Professor Bakshi began by comparing investing in a stock to being in a relationship, and as with all relationships, the participants will go through phases of happiness, boredom, frustration and disenchantment
How does an investor process new information?
The application of Bayes theorem allows an investor (or anyone) to evaluate conditional probability (posterior odds) based on prior odds and a likelihood ratio. Professor Bakshi has already given an excellent talk on Bayes theorem, part of which he reiterated in this lecture, most notably the example of the wife who must determine whether her husband is cheating on her after discovery of a piece of underwear in her bedroom
Human beings are not naturally wired to think in a Bayesian manner, and we are too judgmental and jump to conclusions too easily. We tend to impose our own moral rules and judgments on others, which colors our view of the world with our own biases and prevents us from being objective.
Professor Bakshi suggests that a good framework for being objective is Benjamin Franklin’s Prudential Algebra, which is an example of System 2 thinking as it allows pros and cons to be weighed in an impartial, calm manner.
Filter out the Facts
One must be careful to ascertain that facts are in deed facts and that events are true. It is very difficult for a mind to disregard a fact, even after it has been discredited, thus one must be careful about what sources of information one is exposed to. As Sherlock Holmes puts it:
“I consider that a man’s brain originally is like a little empty attic, and you have to stock it with such furniture as you choose. A fool takes in all the lumber of every sort that he comes across, so that the knowledge which might be useful to him gets crowded out, or at best is jumbled up with a lot of other things, so that he has a difficulty in laying his hands upon it. Now the skillful workman is very careful indeed as to what he takes into his brain-attic. He will have nothing but the tools which may help him in doing his work, but of these he has a large assortment, and all in the most perfect order”
Signal to Noise Ratio
Today the media, especially social media, has made it very easy for information to be shared. Unfortunately, there is a lot of noise that gets mixed up in the signal, and it is the investor’s job to separate the signal from the noise. Professor Bakshi references Ian Cassel of Microcap club here, who asks a simple question to test the relevance of new information to an investor, in his article “What Matters Most”
“Does any of this new information make a material impact on the relationship or bond the business has with its customers?”
As an extension to this, the Professor wants us to think about whether the information affects:
- The ability of the business to earn a high return on capital
- The ability of the business to reinvest earnings in a profitable manner
- The ability of the business to fund its growth without dilution or affecting its financial strength.
Various Sources of Information will have varying degrees of Signal Strength
- Dis-confirming Evidence: While it is difficult to prove anything conclusively, a single piece of dis-confirming evidence can shatter a hypothesis (Taleb’s Black Swan idea: A single black swan disproves the hypothesis that all swans are white). A caveat to this is that some confirming evidence is required when you have paid up for a stock as you want to ensure that things are actually playing out in a manner that justifies the thesis.
- Direct Evidence: It is better to source information directly if we want to receive an un-distorted version of facts. For example, an annual report is better than a research report, because the latter will have elements of the analyst’s own biases creep into the facts.
- Credit Reports: These are a great source of information because they often highlight important information about a business that are not often required to be reported in the Annual Report
- News: The news makes us prone to availability bias, because it reports only vivid events and in a dramatized manner. For example, we often see murder reports on the TV and in the newspaper that may lead us to falsely conclude that crime is on the rise, even though crime rates may statistically be dropping. (Prof Bakshi references Rolf Dobelli’s “Avoid News” here)
- Personal Impressions: One should give a very low weight-age to personal impressions as they often give a distorted perspective and are not statistically relevant. For example, people can draw misleading conclusions from reading customer reviews because people usually speak out only when they have extreme opinions
- Elementary Fundamental Analysis and Boiling Frogs: Slow change often gets unnoticed as it is not in the interest of journalists and reporters to talk about things like this. Factors such as debt reduction, management learning from mistakes are examples of this and fundamental analysis (simply looking at the financial statements) can help unearth these changes
- Stock Prices: The very act of looking at stock prices simply because they are available to you is a mistake, because there is a temptation to act. If you must, set up a filter to only look at extreme movements where something significant might be occurring
- Books: Biographies and Autobiographies offer some of the best learning, and one should learn from both success and failure.
- Qualitative Factors: Certain qualitative factors such as delayed gratification behaviour by the management, customer obsession while still making money and reputational advantages are good signs and although they seem qualitative will show up in the P&L.
Guidance from Spiritual Philosophy
- The Seduction of Vishwamitra by Meneka: Markets and stock prices have the same distracting effect on the focus of the long term investor as the Apsara Meneka did on the meditation of the sage Vishwamitra
- The Human body as a Chariot (Bhagavad Gita): Only when the horses are reigned in can the chariot go to where it must.
Psychological Dangers of Ownership
- Bias from commitment and consistency: Investors need to be able to change their minds in response to new information and many experienced investors are often reluctant to talk about their holdings publicly for fear of developing this bias
- Confirmation bias: Only looking at evidence that confirms your hypothesis while rejecting anything that threatens it.
- Endowment effect: Investors tend to overweight the stocks they hold simply because they own it and often fall in love with their stocks.
- Psychological Denial: Refusing to accept that the thesis was wrong even in the face of overwhelming evidence (Own sidenote: See Bill Ackman and his stubborn defense of Valeant)
- Anchoring Bias: Investors tend to anchor to the cost they paid for an investment, which messes with their heads and prevents them from objectively reacting to new information, as well as averaging up when the company is executing even better than they had imagined.
The “Good” Endowment Effect
- Having some emotional attachment to a really good business is a good thing as it helps you resist the urge to take a profit and be more tolerant with minor mistakes
- Large amounts of money have been made by people who have sat on great businesses for long periods of time.
- Jumping in and out of stocks is risky as it can lead to foregone profits as the distribution of stock returns is such that it often follows the pareto pattern: 80% of the returns comes from 20% of the days in which the stock is held.
- Reduce churn rate and if you must replace one idea with the another, the second must be significantly better than the first in terms of expected returns. This is a lower stress form of investing. (See Professor Bakshi’s article on return per unit stress)
The Agony of high returns & Roller Coaster Investing
People often have the misconception that the best performing stocks for any particular period are the ones that are the most comfortable to own and that will bring a smile to the face of the owner every day. The truth is somewhat opposite, and many high performing stocks are a roller coaster ride
The Rules for Buying a Stock are not the same as those for holding
As Ben Franklin once said: “Keep your eyes wide open before marriage, half shut afterward”. An investor entering into a long term commitment with an excellent business should be vigilant during his period of due diligence period prior to buying but learn to be more tolerant and more patient afterward. You often learn more about a business in the period after you buy a business as for long term investors, the period of holding is often far longer than the period spent researching before buying
He posed the question on buy versus hold to Charlie Munger, whose response can be read here: The Paradox of Buy vs Hold decisions in long term investing
On mentioning Charlie’s response to Peter Bevelin, the latter’s response was that he agreed completely and Peter said
“The way to look a business is to simply ask whether it is going to be producing more and more money over time. If you can definitively say yes, then there is no need for further questions”
Bonus Round: Q&A session
I don’t remember the exact questions, but I’ve paraphrased the general idea behind them
Stock picking versus portfolio construction
- At the end of the day, what matters is the overall portfolio returns
- Stock picking and portfolio management involves differing skillsets
- While stock pickers are looking at downside risk factors of a single stock, portfolio managers think about the aggregate risk a group of stocks have to a portfolio. For example, a group of stocks may be individually very solid but all have exposure to a particular geography hence may be risky to hold in aggregate
- A mature investor knows to sacrifice some return upside by capping his exposure to manage risk
Import factors in sell decisions
- The rules to sell in the Graham approach differs from the Quality (Charlie Munger style) approach
- Graham type bargains are typically sold on valuation i.e bought with large margin of safety when they are cheap and sold when they are no longer cheap
- Graham had a system to limit the effect of value traps by selling an under-performing stock after 3 years no matter what.
- With Quality, you need to have a moat impairment test and also ask knowing what I know today, would I still buy it.
- People often make the mistake of undervaluing great companies, and there is a bias among value investors against paying higher multiples even for excellent businesses. (Own sidenote: See Pay up but don’t overpay)
Danger of rationalizing away new information
- Important to use an objective, rational checklist to combat.
- Generally when you buy without an exit plan, you tend to be more careful before buying (Buffett’s 20 punch rule)
Infusion of cash into Portfolio
- Typically investors who are full-time investors that live off their portfolios have a greater urge to churn to generate yield
- When you have fresh cash coming into the portfolio, this is reduced. The generation of float is a good way to do this
- Graham investors sell decisions are based on degree of margin of safety
- Munger approach thinks more about expected return, which is a function of entry multiple, earnings growth, dividends and exist multiple. This sidesteps the question of initial valuation and makes you think about expected return over a long period (say 10 years or more). [Own Sidenote: See John Bogle’s Expected Return Formula]
Importance of optionality
- The idea of optionality is an important one for investors
- Partner with people who are good deal makers (example of Ajay Piramal) who have access to lucrative deals and long runways for growth.
Position sizing & Allocation
- Makes sense to prune some large positions down for risk management reasons unless the company itself has a diverse earnings stream
- Berkshire Hathaway would be example of a company with diverse earnings as it is a huge conglomerate with over 70 operating subsidiaries
- Buying quality de-anchors you somewhat from the need to make cash calls
- Set a minimum benchmark return of say 2x AAA bond yield as the expected return and invest if expected return is above that.
- Cash thus becomes a function of whether you can find good ideas above your threshold rate of return
Are Life cycles getting shorter for businesses
- Apprehension about businesses that rely on network effects as they could potentially be affected by disruption
- Business models with low cost advantages (e.g Costco) that can offer customer bargains are likely to continue to do well
- Permanent capital is a huge structural advantage for an investor to have
- Having permanent capital allows you to ignore drops in market valuation and focus on earnings power of businesses
Initial Filter for Buying
- There are many ways to do this, but for Prof Bakshi it is astonishing fundamental performance that he wants to know more about.
Book recommendations for new investors
- One up on Wall Street by Peter Lynch
- Margin of Safety by Seth Klarman
- Little Book that Builds Wealth by Pat Dorsey
- Intelligent Investor by Benjamin Graham
Concentrated vs Diversified Portfolio
- Investing is not like physics where there is a right or wrong answer to questions like this or similar questions like whether or not you should meet management
- Typically newer investors should start out more diversified as you are more likely to make mistakes early on and a diversified portfolio would help reduce the impact of any one bad decision.
All in all, it was an excellent talk and I am grateful to the professor for taking time out of his schedule to share his wisdom with us.