Lofty Business

It's festival time. Festivities results in one very important annual ritual in every Indian household. The ritual of cleaning your house! It's time when every nook and corner of the house is turned upside down to make it spotless. There are many things associated with cleaning the house before Diwali. It is done to welcome Goddess Lakshmi or to welcome new year with the motto of "doing away with old and bringing in new".

This ritual happens in my home as well. It's a family affair. Things that require climbing and reaching out is done by male members. Recently, I was given the responsibility to clean the loft. Loft, an area of home that remain untouched for rest of the year. This is the time when old boxes and bags are removed and checked.

I realized there are 3 types of boxes or bags...

While some bags contain things that are kept with the hope of using them next year, there are also certain things that are no longer relevant and needs to be "donated" to maids and watchmen. Some items can be scrapped, providing that source of money to pay for bakshis to maids and watchmen.

Sometimes we also come across a third category are those boxes that brings the thought of "What the hell is that?" to mind. Boxes that are not touched for ages or we do not have any recollection of..

Some of these find their way to one of the above two categories and are either dumped back or scrapped.

On the other hand, there are some pleasant surprises in store too. Things that you've been looking for for a long time. Your favourite jacket or some memories. This year I stumbled upon the my childhood photographs, back from the days when photos were physical, rare and very valuable. Certainly cleaning the loft was worth the effort!

Something similar goes with investments as well. There are a set of investors, whom I call as "Closet Investors" (can probably be rechristened as "Lofty Investors"), who get active during bull markets and shy away from it after making losses when market crashes. They just resurface every bull market. They hold shares of 100s of companies in their closet, some dating back to pre-demat days as well, hard, physical share certificates, forgetting they ever existed or were left behind by parents.

Like Diwali, when bull market returns, these investors conduct the ritual of checking their lofty portfolio. Some companies that are making them some money are sold of for whatever profits they have made for them while other loss making ones are kept back on the loft, hoping they will pay back some day!

There are some positive surprises in store too... 

Have heard quite a few cases where old forgotten investments for some people turned out to be worth millions. Physical shares of Bajaj Auto found while moving houses worth Rs 80 lakhs, investment in yester year's bluechip textile company turned out to be worth Rs 60 lakhs on account of real estate boom, a mis-selling by a private bank sales person of Rs 25000-30000 in some closed ended real estate fund turned out to be worth Rs 4.5 lakhs (a structured product by a prominent AMC!).

One of the veteran from the industry had once told me that all this analysis and strategy is meaningless. Over the years, he has observed that it is wise to stick to 15-20 stocks based on informed decision making. One should be ready to lose money in some of them whereas let winners make up for that and over the years most of us will be much better off than investing very actively.

However, I have also seen many other portfolios that has probably done a mediocre job for investors. They hold nothing but collector's edition stocks and have done a mediocre job for the investors. 

Michael Mauboussin has defined success as : 

Success = Skill + Luck

Great Success = Skill + Great Luck

I think all these anecdotes and experiences largely are a function of the luck element involved with investing. They are more towards luck as compared to skill. In his book "The Success Equation", Michael has placed investing success more as a function of luck vs skill. This should not be taken in wrong context. Skill is very much required for investing success, but it plays out over a long period of time. In the interim, luck can play a major role in driving portfolio returns.


Picture source

Thus, some of those lofty investors have an interesting dinner table conversations on how they had great vision in identifying those great investing trends while some continue to hope for being right every bull market.

As for the lessons, I hope to make "checking my portfolio" a systematic affair rather than just during Diwali (bull markets). Just like we do not clean our loft everyday, it also does not make sense to check the portfolio everyday. But whenever we do, just need to ensure to properly identify useful things from the hopeful things. If things are not used for say 2 or 3 years, they ought to be scrapped away to pay for bakshis or other useful things. In the same way, if investment thesis has not played out over last 2 or 3 years, instead of hoping to be right, it might be beneficial to have a re-look at it altogether.

Happy Cleaning...

The Path

"I can only show you the door, you are the one that has to walk through it."

 - Morpheus to Neo in the movie 'The Matrix'

This was an iconic moment from the movie. But unlike movie where Neo had one Morpheus, in the world of investing we are surrounded by many Morpheus. There are whole host of investing schools for a novice investor to follow. Fundamental, quantitative models, technical analysis, value approach, growth approach, finding structural shifts and value migrations, momentum, short term, long term... and the list can be further complicated with mixture of many.

There is always a question of what works the best. The answer to that was aptly put by Howard Marks when he noted that he has seen all type of successful investors so far. Be it value investors, speculators, growth investors or any other type. He is correct. We can see all types of people making money, globally as well as in India. 

So which path to follow? Well, we need to choose a path, walking on which we find most suitable to our character and personality. The path on which you can walk longer as compared to any other path. The beauty is that you can take pavements from different paths and even create your own, and the creation can be an ever evolving process.

Why to do this?

Each human being has a different set of beliefs. The world that he has seen is different. The circumstances that the world has thrown at each person are different. I have known twins who have personalities that are poles apart despite being raised by same parents, attended same school, same college and despite both ended up being Chartered Accountants. One is introvert where as other one is extrovert.

These beliefs are difficult to change as the person grows old. They are hard wired in our brains. These beliefs play a large role in the way we act. This is our nature, our prakruti. And if we are acting against it, we are exposed to higher chances of committing a big mistake over longer term. This is because at some point of time, the animal within will start playing its part. And then the same old story of "anything multiplied by zero, is zero".

First half of this video beautifully explains how our brain is structured.

  

The most important thing in my opinion of creating a path, suitable to your temperament, is that it gives you a longevity in the market. The longer you are able to deploy your ideology in the market, better the rewards can be. Now again, everyone cannot be Warren Buffet or Rakesh Jhunjhunwala or Howard Marks or Damanis. They are outliers. But then we are maximizing our chances of utilizing our capabilities to the fullest and generate returns that are best possible given our temperament.

I am in no way suggesting of sticking to our comfort zone. Learning is a perennial process and it is in our interest to be comfortable with as many types of hunting grounds that can come in our path as possible. We may not be able to change the existing hard wires, but with persistent learning, we can surely create new ones.

Moats

Moat refers to a water body surrounding a castle. It is said that moats surrounding the castles even had predators like crocodiles for extra safety. This moat protects the castle from being attacked.

In investing, the term is made famous by Warren Buffet and refers to characteristics of a business to protect itself from competition. Warren Buffett likes to invest in companies with large moat so that they can survive and are relevant even after 10 years, 15 years or 20 years. The idea is to remove / minimise the business risk while taking investment decisions and not overpay for it so that the inherent compounding in the business can take care of the returns.

The term these days have been made sort of generic. Everyone likes to use this term in their analysis. And the general feeling that I get is that companies with moat are now being considered to have been given a right to survive. Long-term investing in moat companies has become a holy grail for accumulating wealth.

But is it that simple?

Well, yes the answer to this is NO.

All that an "impenetrable" moat provides to the company is time to protect its castle. Presence of it just allows the company to first know that is being attacked, identify the attackers and then formulate strategies to protect itself. By very nature, the moat companies are in advantageous position to defend itself. Wider the moat, more the time company gets to protect itself. To protect itself, companies need to be proactive and act upon it when under attack rather that just relying on moat to defend the castle. Else, sooner or later, crocodiles and sharks in the moat will be killed and the walls will be breached.

Thus in no way there is a writing on the wall that moat companies can survive any catastrophe. By nature, they have been given a chance to protect themselves. But the rules of :Adapt or Perish" still apply to them.

Microsoft, in my opinion has (had?) one of the strongest moat. It has network effect whereby large number of user base and software developers are tied to each other. It has high tangible and intangible costs. Moving to other operating system can be expensive in terms of money as well as time invested. Lots of data resides on its Office suite, making it difficult to migrate. Can spend a large amount on R&D or sales promotion and spread it over millions of units. And of course the intangible in the form of a brand. Kids grow up looking at the Windows logo while starting a PC. It has become generic like Xerox.

Most of us have grown up looking at generations of windows logo while starting our PCs

However, Microsoft' moat has been under attack for some years now. Google and Apple are moving the world towards mobile computing. They have changed the way we use "computers". I am writing this blog on a tablet at 4.30 in the morning and will give a finishing touch tomorrow morning at work. That's the power of internet that these companies are exploiting.

The game is disrupted and first movers have found themselves in an advantageous position. They are changing how the world computes. Microsoft is finding difficult to come out with products that can compete with Google. Future will go to the person that holds and controls maximum (online) data and it is Google's products where maximum amount of online data is generated (and stored).

But Microsoft has recognized this and is thus trying to defend itself. It is trying to get control on the search market by integrating its Bing platform in a lot of ways. It is pushing its Office cloud solutions aggressively. Currently, it is advantage Google (and other online platforms). But will Microsoft be able to get its lost glory? Only time can tell that. As for now, it is struggling to protect its moat (relevance) since mid-2000s.

Anyways, to conclude, having a moat is not something that gives the companies a right to survive over longer term. Risks still exists with these companies as well, though in lesser proportion as compared to others since in case of disruptions, you still may have some time to protect against permanent loss of capital. And of course, valuations is something that shouldn't be overlooked in this case as well since:

A great company need not be a great investment any all points in time.

The 10th Man

The movie 'World War Z' seemed to be just another Zombie movie to me. A very passable movie in fact. But one scene from the movie turned out to be a hidden gem.

The movie so far has gone like this....

World is infected by a virus that converts people into "undead" or zombies. These zombies bites the normal humans who then gets infected and turns into zombies. The virus has thus spread quickly across the world and remaining uninfected people are looking for a defense.

Our dude, the savior, here is Gerry (Brad Pitt), a former U.N. investigator. He has been called back by UN Secretary-General to find the source and cure of this trouble. The search takes him to South Korea where he learns that Israel knew about this potential crisis and had prepared themselves before hand by building walls around Jerusalem. Gerry wanted to know how did Israel knew about this crisis before others and were able to prepare themselves for that.

Gerry sets off for Jerusalem from Korea as his search for the solution widens. At Jerusalem he meets Jurgen Warmbrunn from Mossad. What follows next is a brilliant concept of "The 10th Man". Watch the below video...

As an equity market investor I have been learning about outliers and fat tails. The "10th" man to me signified the events that are outside the 90% confidence interval. These are the events that a normal human mind is not equipped with to think about. Events that his minds has not seen or assessed so far. These are black swan events as popularized by Naseem Nicolas Taleb, the fat tails.

"Most people don't believe something can happen until it already has. That's not stupidity or weakness, that's just human nature."

Are these events predictable? The answer can be yes and no. Yes, because based on conditions and evidences available one can assess higher probability of something happening and can prepare himself for that. No, because in my opinion it is very difficult to assess the timing as well as the magnitude of the impact that these events can cause. The turn of events are dependent on so many unknown factors. Who knows where the domino will be broken. Few people I know had assessed about the sub prime crisis, but even they were surprised at the magnitude of the financial meltdown it created.
(By the way, zombies did manage to breach the Jerusalem wall in the movie!)

Thus, one can just prepare themselves for this as much as possible. How to assess this? Well the 10th man concept. Critical thinking. If most indicators are telling you to buy something, wear the hat a 10th man. Assume that it is not a buy. Start your investigation with that notion. What can kill the company? Where can the current thesis go wrong? Of course, one will never be able to ascertain everything. But noting down these concerns can help in presetting your next decision making points about the company, avoiding interim behavioral swings.

Every people we save is one less zombie to fight. 

Of course, one needs to be mindful about creating a situation of "decision paralysis". If 9 men are saying something, there is only 10% probability that the 10th man will be right. Just note down what 10th man has to say and look for conditions where he can be right. Start building the wall (protecting your portfolio) when you see those conditions materialize. The more you think about possible fat tail scenarios, lower your probability of making a permanent loss of capital. 

Would just like to conclude with one of my favorite quote of all time...

When all men think alike, no one thinks very much - Walter Lippman