Saturday, May 20, 2006

Butterfly Effect

"What happened? 13.2% down in 7 days. It's brutal. It didn't even give you time of adjust your expectations. And all for no obvious reasons. You tune into CNBC and the analysts talk about the correction that was long over due. Correction! all right..but why the **** you didn't tell me that it was incorrect."

I've seen it happening so many times that I've almost lost interest. But I want to answer the question that many people have asked me in past few days.Why did the markets fall?

Do you know about Butterfly Effect?


Ok…Do you know butterfly's wings might create tiny changes in the atmosphere that ultimately cause a tornado to appear (or, for that matter, prevent a tornado from appearing).

No jokes. It a concept from Chaos Theory. The butterfly effect is a phrase that encapsulates the more technical notion of sensitive dependence on initial conditions in chaos theory. Small variations of the initial condition of a dynamical system may produce large variations in the long term behavior of the system.

The concept becomes relevant in investing world because the valuation methods used to estimate value of a stock are ultra sensitive to the initial variable. On top of that we routinely indulge in oversimplification of valuation concepts so that they can be expressed in simple ratios.

Lets talk about P/E. Most of you would know that the ratio is calculated by diving price by earnings. But which year's earning are talking about. You would often see reports stating that the stock is quoting just 8 times its FY08 EPS! Cheap..isn't it?

Even if you calculate by taking the average earnings of last 3 years, as Graham suggested, how would you know if P/E 15 is expensive or not? What's the benchmark?

The benchmark is provided by the risk free interest rate and the estimate of risk premium.

The valuation process is known as Discounted cash flow method.

But the problem with the model is that it takes estimates of highly volatile variables as inputs. There is no way of predicting the growth rate of next 10 years. Nor can you ascertain the trends in risk free interest rates or the right level of risk premium. At best we go by our guesstimates which are susceptible to changes in general mood. When everything looks positive people find 1% risk premium enough to invest in blue chip stocks. At the same time they overestimate the expected growth rate. To see the effect lets take an example.

Suppose you were given a task for estimating these variables for 10 year period and here are the actual results


Interest rate

Risk premium









The interest rate rise a bit. Growth is a little lower and investors little more cautious. By all means you have performed very well. But the result.

You valuation model will show that the value of stock must be 75% of your initial estimate. Its shocking. and it's analogous to Butterfly Effect in chaos theory.

This minor change in initial estimates can cause the estimates of correct valuations to change. The impact is almost always coordinated. That means the changes in these variables impact the valuations in the same direction. For instance when the interest rates rise the estimates of growth are revised downward and risk premium shoots up. The combined effect can be disastrous.

To answer the question..Why did the markets fall? A butterfly flapped its wings, which, through complex chain of intermediate events, caused instability in the world financial system and well......Rest is history


Note: text in italics sourced from wikipedia

Thursday, May 04, 2006

Sensex and Sensibility

In 2004 end I has posted a report Exclusive report on Sensex underperformance on the poor performance of Sensex and reason behind that. The summary of the report was that BSE has done rather too many changes in the index and has gone more ‘with the momentum‘ which has made it a speculative portfolio which can never beat a long term portfolio.

Though it is too early to say, but the Sensex has become more stable as a portfolio. The number of changes per year have come down and have become sensible. In last 2 years they made only 3 changes with Maruti, NTPC and TCS taking place of MTNL, HPCL and Zee tele.

The following stats would give you the idea about this.

1996 - 15 changes

1998 - 4 changes

2000 - 4 changes

2001 - 1 change

2002 - 4 changes

2003 - 5 changes

2004 - 1 changes

2005 - 2 changes

The results are showing up. I can bet that they wouldn’t have done any better by making more changes to the indices in last 2 years. In fact the number of changes in popular global indices is very low. Dow had 7 changes between 1999-2006. S&P 500 typically has 15-20 changes per year. If an index has to become worthy of tracking by the index funds then it should be like a long term portfolio.

Its very difficult to beat a well diversified index with minimal changes. Princeton University Professor Burton Malkiel found that the S&P 500 beat 70% of all equity managers retained by pension plans over the 1975–1994 20-year period. Another study by Robert Kirby, former Chairman of Capital Guardian, indicated that out of 115 U.S. equity mutual funds that were in business for 30 years or more, only 41 (36%) beat the S&P 500 by some margin, and only 23 of the funds (20%) beat the index by 1% per year or more. Report

But why should it be so difficult. For example if you want to beat S&P then all you have to do is to find JUST 1 stock which you think would perform worse than performance of S&P next year. Then you should divide the money in rest 499 stocks as per the index weightage. If you turn out to be correct then you will beat S&P 500 and you would be doing better than 70% well paid finance managers.

It looks good as a theory but in reality the only god damned stock which you removed turns out to be the stock which outperforms the index. (remember m&m’s expulsion from Sensex in 2002)

That’s why its such a fun to race against indices. I envy the pleasure Buffett gets while beating S&P 500 year after year. I hated Sensex because it could be beaten hands down with value investing approach. If it continues on the path of stability (buy and hold) and it would be fun to compete against it.

Monday, May 01, 2006

Comparing your performance

Comparing performace of 2 investment portfolios is not a matter of comparing 2 numbers. In this message I would describe what factors you should consider before comparing performance of your portfolio with anybody else's.

1. Performance of a portfolio on paper(on one web) is not comparable to the performance of your invested money. Many members have said that they were following the portfolio on paper. Paper portfolios are waste of time and create illusion of learning. This is because the two important psychological factors, fear and greed are absent when you operate without money.

2. Performance can be compared on equal timeframes. If you have beaten Sensex this year, it not a reason to be happy. Similarly if you failed to beat it(like me) you don't need to worried.

3. Performances on short time frames(less than 3 years) are not worth comparing.
[By my estimates, next 3 years be a disappointing for all those who are investing today by selecting top performing mutual funds. ]

4. Performances on dissimilar investing styles are not comparable. You can not compare value investing based portfolios with growth oriented portfolios. Similarly comparisons in mid cap vs. large caps, focused vs. diversified portfolios are equally meaningless. Each of these have different risk associated with them which doesn't show up in `Top 10' lists.

5. Performance which don't take into account the short term capital gain tax and brokerages are a delusion. Similarly for mutual fund investors what matters is the returns after subtracting loads/expenses. This factor alone makes indices difficult benchmark to beat because the indices are long term portfolios and have no fee(or minimal fee charged by ETF)

While ending this experiment I'm not proud because it gave 53% p.a returns. I'm proud because I got those returns by following my investment philosophy. This gives me confidence that I can reasonably hope to continue getting above average returns in future.

In investing the determining factor your maturity aren't your returns. Its your investment philosophy. Returns are byproducts of how you think. For new investors I think its OK to loose money on the way towards figuring out your investment philosophy. For mature investors its OK to under perform the markets in short/medium terms as long as you are following your investment philosophy(see Buffett's relatively poor performance in 1997-2000 period).

Hence I should extend my congratulations to all the members who didn't get good returns while following their well thought investment philosophy. We are all running a life time marathon. If you are right then the time will prove you right. If you are throwing darts then the laws of probability will catch up with you, sooner or later.

Posted: Apr 23, 2006

Holding companies: A real life example of complexities involved

I would like to share a 'live' case from my personal portfolio on the subject of investment in holding companies.

On August 6th, 2004 I sold Sterlite and bought MALCO to take advantage to disparity in the prices.

When Sterlite came out with rights issue, I was concerned that MALCO would increase its debt to unsustainable levels(it later renoucned its right and pruned its debt). A month after the swap I reversed this transaction. Though we made 14% gain in this, the swap was a mistake because the LWB Special portfolio was not supposed to take risky bets for small arbitrage gains.

However in my personal portfolio I continued back and forth swap between Sterlite and MALCO depending upon which looked expensive relative to other. Over next year I completely swapped Sterlite with MALCO. MALCO became my single biggest investment and it was the only stock where my personal portfolio differed from LWB Special. Sterlite continued its rise and MALCO couldn't keep pace. Consequently I was underperforming compared to market.

Considering the fact that MALCO's market capitalization was less than the value of stake it owned in Sterlite, I had every reason to remain patient but as I've explained elsewhere holding companies test the limits of your patience.

The following table shows the movement of the stocks from starting value of 100. Its clear that although in long term the value of holdings is taken into account, it can take years. One might get frustrated and sell(or may be die in the meantime!). When the revaluation takes place its sudden and abrupt. MALCO gained 76% in 5 months in 2004. After this it became dormant while Sterlite continued to rise. On April 7th, 2006 Sterlite had risen by 353% whereas MALCO was up by only 127%. At this point MALCO's market capitalization was 625 crs. whereas the value of 4.61% stake it held in Sterlite was 1057 crs.
















View chart of relative price movements

I was obviously frustrated with this situation and broke my prudent limits on maximum exposure to single stock. To my pleasant surprise the price of MALCO rose 64% in last 10 days. Even today it was locked at upper circuit breaker at Rs.458. (consequently last 10 days turned out to be most profitable 10 days of my investing career)

Coming back to original question. Was I right about swapping Sterlite with MALCO? May be not. Sterlite rose from 416% since July 04 whereas MALCO rose only 272%.

I know what you are thinking! If I had swapped from Sterlite to MALCO on July,2004, back to Sterlite on Dec, 04, back to MALCO again on 7th April 06 then I would have made 920% gain. Such perfect timing works only in theory.

The reasons which compelled me to buy MALCO remained valid throughout the period from July 04 to date. So in such case if I did a swap it was logically correct decision. In spite of a correct decision I haven't made anything more than what I would have made by just sticking to Sterlite, the way we did in LWB Special.

To summarize, exploiting the inefficient valuation of holding companies remains a perennial attraction for many value investors. Many of us underestimate the complexities and timeline involved in correction of these inefficiencies. The purpose of holding company is to hold the stock..forever. Isn't it irrational to expect that `unlocking of value' in such cases?

On the other hand it is easy to get impatient in such cases and miss those 10 days when the inefficiencies are corrected. As a rule most value investors would be better of staying away from complicated situations like this.

This rule may not apply if you are willing to hold INDEFINITELY. In those cases its always advisable to swap as soon as you see a sizeable advantage. If you try to time your entries and exits you may end up getting returns lower than either of the stocks involved.


Do we learn from mistakes?

Not necessarily.

Our assumption that we learn from mistakes is one of many such fallacies that arise from confusing logical deduction with logical induction. Other such fallacies include "taking high risk for high returns".

Allow me to delve little deep here. Its happens to be my favorite subject. Logical deduction implies a guarantee that if the premise if true, the conclusion would be true.

Lets take a classic example. "If it rains the ground would be wet". If you know that it has rained today then you can deduce that the ground would be wet.

However when you see a wet ground in the morning and say that "it must have rained tonight", you are using inductive logic. In logical induction, a premise provides some degree of support for the conclusion but not a guarantee.

Nothing new..Right?? Just look around and you would find that this is THE MOST COMMON mistake we make regularly and we never learn from it.

A learning process requires assimilation of knowledge and putting it to practical use. When we venture out in open, with `less than perfect' knowledge, we make mistakes. It's a part of learning process. But its not the mistake, per se, which teaches you. It requires a rigorous amount of discipline and analysis to be able to figure out what went wrong. An Iranian saying goes like this "man is a donkey which falls twice in the same ditch" . Leaving aside the question "are women any better", I tend to agree with this saying. More often than not, you would find a pattern of mistakes getting repeated in your life. That's what you call your weaknesses.

Coming back to original question.

We commit mistakes in the learning process but committing mistakes doesn't teach us anything. It's the analysis and corrective measure that enables us to learn. Unless this feedback loop is established you can continue making the same mistakes forever.

My personal experience suggests that the costliest mistakes of my investing life didn't teach me anything worthwhile. Its like having a crush on someone as a teenager. You don't really learn anything. You aren't mature enough to be able to analyze otherwise you wouldn't have been in that situation in the first place. In the initial few years, I lost lot of money in trading but I didn't learn anything from that. You can argue that I learnt the lesson that you can't make money in trading. I use the same argument to justify that foolishness but the fact of the matter is, I was sowing seeds in an arid land. It was waste of time and money.

There is no correlation in the number of your own mistakes and learning. I've leant a lot by reading and analyzing mistakes made by other people. At this stage I don't need to commit a mistake to be able to learn.

So my advise to new investors is that unless you are sure that you have, what it takes to learn from mistakes, don't commit them. Stay away from direct equity investments. You don't have to be jack of all trades. You got to be good at what you doing for living.

This doesn't mean that you can't be master of all trades. You can(my mind is saying I am!). Its difficult, time consuming, complex and confusing task but not impossible.

Posted: Mar 21, 2006

Asset Allocation

In this message I would like to give my views on the question of "What assetclass should one look into and does the fund size matter?

You should invest in the areas which you know of. There are thousands
of areas where you can invest but if you don't know anything about
that field, stay away! For instance I don't invest in real estate even
though I know that it has given decent returns in past. I simply don't
know enough about it to take decisions. I know that many people would
say that they can invest with help of some financial advisors but it
takes a certain minimum knowledge to be able to decide whether the
financial advisor can be trusted to take investment decision on your

Having limited your asset classes in this manner you can evaluate the
risk/return profile of that asset class with your own risk appetite
and return expectations.

The asset allocation would be different if you had different amount of
investment money. An investment transaction has two aspects, the
investor and the investment. When you invest 10% of your total
networth(including cash, fixed income instruments, equity, real
estate, precious metals & other assets) then you can afford to take
higher risk because even a 100% equity portfolio mean that your
exposure to equities is just 10% of your networth.
Another aspect that comes into play is the effect of volatility of
the investment. If you have networth of 20 lacs and you invest 50% of
it in equities, then be ready to face few days in year when your
networth may be down by 2% or Rs 20,000. If you panic in such case and
loose you sleep then I would say that the asset allocation itself was
Finally the amount of investment matters in asset allocation because
of the time characteristics of assets. Liquid investments can be
encashed at your will but in other cases you can end up losing if you
liquidate your investment before maturity date. This is true not only
in debt but also in equity. If you plan for a long term equity
investment then you should know that in short term the prices may go
down. If you are forced to sell due to your needs then you have paid a
penalty. So you got to create a rough demand/supply schedule of your
funds. How much money you might need in less then a year, in 1-3 years
and how much of money you can safely park for future. In economic
terms this is called a demand schedule for funds. Similarly if you are
earning more than your immediate needs then you will be accumulating
funds which create your supply schedule for funds. Your aim should be
to avoid mismatch in requirement for your funds and availability of
liquid assets.

Having done all this homework yourself or with help of your financial
advisors, you are ready to ask specific questions about specific asset
class. There is no direct asnwsers for asset allocation problem.

Posted:Mar 7, 2006

My Investment philosphy

I don't have any academic background in finance and I don't miss it.
I've followed a unique way to train myself in this subject. The basic
tenets of my approach are.

1. Hear it straight from the Horse's Mouth: I don't like text books. I
would rather read Kenyes and Adam Smith, than reading a text book on
economics. Similarly in investing I've learnt more from the investors
like Graham, Ficher and Buffett. Here too I preferred reading all the
60 odd letters to shareholders rather than a cook book on Buffett.

2. Practice it: No matter how much you read theory you never learn
without applying the theory into practice. If you lack conviction to
put your money where your mouth is, then you haven't really learnt. At
various times 70 to 140% of my net worth has been in stocks and it has
given me a lot of impetus to learn, to avoid mistake. I can not afford
to speculate. I reserve my gambling instincts to card games.

3. When someone points to the moon, don't catch the finger: You got to
imbibe the essence of teachings and develop your own strategy. Time
and again people ask me that you buy commodity stocks and still say
that you follow Buffett's philosophy. I'm operating in a different
environment, with different fund size and with different level of
skill. I have much better chances of getting high returns following
myself than following Buffett. Just the same way as Buffett developed
his own strategy after learning from Graham, I have to develop my own
optimized for my operating environment.

I said that "Circle of competence is a fuzzy thing" because everyone
misjudges his competence level. You would remember the famous
experiment where people in the group were asked to judge their driving
skills on a scale of 1 to 10 relative to the group.
The average of their scores was 7.5 !

I'm no different. In 1994, when I was 18, I used to think that I know
a lot about stocks. Five years later I had lost a fortune, trading in
stocks and I still believed that I knew about investing. All that
changed after I read Buffett. Things have become much simpler and
pleasant fro that point on.

The differences between my approach 4 years ago and today have to do
with maturing of my strategies, more realistic assessment of risks
involved and increased confidence. Now I know that I can afford to sit
back for a while and still generate above average returns. I don't
have to outperform Sensex in each of its every mad rush.

Over the years I have become more circumspect in giving advise. The
quality of investment is just of facet of investment transaction. The
investor is the second facets. Suppose I give a long term `buy' advise
and you think that it will give you 100% in 2 month. It falls by 30%
that month and you sell it, then my advise is meaningless. I've come
to know that even sound advise can harm people. That's why you would
never see messages from me, with glossy titles like "million dollar
advise" even if I believe it is.

In spite of being in IT I find IT businesses very difficult to
predict. I like commodities because the equations are very simple
there. The next thing I like are branded businesses where revenues are

To summerize, investing is not about making great and accurate bets.
Its about being 100% sure in avoiding big mistakes. The amount of
effort it takes to be 100% sure automatically ensures that you end up
buying stakes into great businesses and returns usually follow.

Posted: Feb 5, 2006

Dividend yield

Low dividend yield can have different meanings for different people.
To me dividend is a very useful return provided by the company for
today's income needs while retaining sufficient cash to keep growth
engine humming. The future earning is like promise of a party later
in lieu of a starvation diet today. The investor who lives on
investment income needs dividend and has every right to consider 1.5%
dividend yield as low(compared to returns from fixed income). The
investor who is skeptical about the promise of party at a later
date(like me) would not like the starvation diet.

In the matter of dividends I belong to old schools(of Graham). I don't
like companies which pay very low dividend. I can't imagine such a
bright future which requires the management to keep every penny of the
cash the business is generating. The capacity to pay dividends lends
credibility to the assumption that the management expects the current
earning to grow from here.

My past experience in this field shows that dividend yield can be an
important parameter in judging the sustainability of earnings.
1. Most good companies have maintained their dividend at the same
levels even in the time of crisis(M&M 2000-01). This may be an
indicator that the management thinks that the lower earnings of that
years are temporary downturns.
2. Most good companies have increased the dividends as their profits
have grown, thereby maintaining the dividend payout ratio.
3. Many dishonest companies can be nailed down during analysis because
they show continuous rise in earnings but no change in dividend. Such
earnings are either fake or ephemeral.
4. The good companies which pay very little dividends(Software
Infy/TCS) haven't really achieved anything much by retaining the cash.
I would have been happier if these companies paid more liberal dividends.

I'm not convinced by the argument that you can get the same return due
to rise in the price of stock. In such cases I've to (1) make an
assumtion that such price rise is permanent (2) I've to liquidate a
part of my holding to satisfy my income needs.

I've reservations on both counts. Capital gain is not comparable to
dividend till the gain is booked. If I've to reduce my stake in a
company just to get enough cash for my current needs, then it doesn't
solve my purpose.

Posted: Nov 28, 2005

Deferred Revenue Expenditure

In last few years many Indian companies had adjusted their accumulated
deferred revenue expenditure against the security premium
account(SPA). Such write offs have helped the companies to escape the
reduction in profits due to amortization. In my analysis I try to
account for such things but I felt a need to have a broader discussion
on this subject. So here is the complete story. Do post your views and

Around 2001-03 the companies started the restructuring binge. The auto
companies were leading the pack. Here are some new items.
Tata Engineering set off Rs 1,180 crore against the share premium
account in 2001-02, Ashok Leyland is in the process of writing off Rs
160 crore the same way while Tata Steel had planned to set off a huge
Rs 1,550 crore now.

M&M wrote off around 500 Crs. from SPA.

While I understand that there is nothing wrong in deferring the
genuine product development expenditure which is going to pay off in
later years, I have 2 serious objections.

1. I'm skeptical about the type of expenditure being charged into
Deferred Revenue account. I read a document on guidelines for
accounting for such costs.
Monograph on Accounting for Research and Development Cost

Page 13 of this document sets out what can be termed as a Research and
Development cost. It further adds "The amount of the research and
development costs described above should be charged as an expense of
the period in which they are incurred except to the extent that
development costs are deferred in accordance with the following
paragraph" In page 14 it describes what can be deferred.

The essence of this document is that you can defer the costs only when
you can reasonably expect the costs to be recovered from future
revenues. However the trend I noticed in Indian companies is to treat
it as "when you can dream the costs to be recovered from future
revenues". All the new product developments are straight away being
deferred regardless of their commercial viability. You can see this by
looking at low R&D expenses of Indian Companies because they never
account for it in the year such costs are incurred but defer it for
later periods.

2. The second and most significant objection to this related to
avoiding amortization of such costs. You say that I've spent 100 crs.
this year on R&D and I'll recover that in future revenues and hence
you don't treat 100 crs. as expenditure but defer it. Next year you
write of 100 crs from balance sheet. Let's assume our R&D pays off and
you make 30 Crs. per year for next 10 years. As you have already
written off the costs you would report 30 Cr p.a. profit. Had you not
done, and amortized the costs over 10 years, your profits would have
been 20 crs. p.a.
And what if the product fails. If you write off your mistakes will
never be visible in the income statements and quarterly results. After
all in a world blinded by Q on Q growth who has the patience to read
balance sheets!!

The guidelines clearly say "If development costs of a project are
deferred, they should be allocated on a systematic basis to future
accounting period by reference either to the sale of use of the
product or process or to the time period over which the product or
process is expected to be sold or used"

It is clear that any such write offs will give incorrect picture of
the future earnings. Now coming back to Indian companies, I'm
surprised that the managements have lauded their decisions to resort
to such "deceptive" tricks.

An excerpt from Tata Motors report
`Telco has recently written off assets and expenses to the tune of Rs
1,180 crore from its balance sheet against its securities premium
account (SPA), thereby eroding its reserves by 40 per cent and net
worth by 36 per cent. The company has written off deferred revenue
expenses on account of product development and employee separation of
Rs 933 crore, accounting for the bulk of the write-off. The write-off
due to the fall in the value of investments and fixed assets is Rs 32
crore and Rs 215 crore respectively.
According to Mr Kadle: "The rightsizing of the balancesheet will give
a true reflection of the company in the future years. This is not the
end of the restructuring process. We are looking at further cost
reduction and the requirements of working capital." `
Other companies are no different in their description of "financial

As an analyst I don't care what the managements say but any deviation
from standard accounting practices makes my life difficult. I'm unable
to delegate my analysis process to my analytical models and I'm forced
to do a case by case analysis. The legalese used in notes to accounts
makes it even more difficult to understand what's happening.

let's take an example. Tata Motors had spent around 1400 Crs. on
development of Indica. Out of that they deferred 1000 Crs. and then
wrote it off by charging it to SPA. Now I should amortize it over a
period same as expected life time of the product. I'll to make a
guess here and take a random 10 year period. You would notice that the
write off has significant impact of jacking up profits. More than this
it gives very incorrect picture of the Return on Net Worth(RONW). The
numerator(Profit) is jacked up as there is no ammortization. The
denominator is braught down because the net worth is brought down by
write off. The results are obvious. In case of Tata Motors the RONW is
24.2% for FY03-04 and 30.16% for FY04-05. No auto company in the world
generates such returns on networth(GM -15.56%, Toyota 12.94%, Ford
13.49%, Daimler Chrysler 6.59%). If you adjust the book value and
account for amortization the RONW comes to more reasonable figures 15%
and 20% for last 2 years. Looking at the results of Tata Motors for
last 15 years you would realize that the CAGR of its book value(even
after adding back the 1180 crs) is ONLY 6.83%. Taking dividends into
account the returns come to 12.38% p.a. This shows to what extent the
write offs skew the real picture. (For detailed calculations refer to
the following file)

Some people go even farther to skew the reality using prism of their
wishful thinking and their ignorance of valuation concepts. If a
company has average RONW of r and has dividend retention ratio b then
the expected growth rate would be r*b. With the jacked up RONW of 30%
in case of Tata Motors and taking average retention ratio of 55% you
can get a Expected long term growth rate of 16.5%. The they calculate
FY07 EPS and multiply it with P/E based on 16.5% long term growth
rate. If you do this you can stretch the valuations like rubber band.
I see renowned analysts applying such faulty logic every day.

To summarize, analysts should make the adjustments for such write offs
because if you don't, you would end up with grossly incorrect picture
of company's profitability.

Posted: Nov 20, 2005

Corporate (Mis)Governance Index

I would like to share some of the methods I use to quantify "Lack of
Corporate Governance". These simple and unorthodox methods may not
sound convincing but they work.

In 2003 I realized that most of my mistakes in past 2 years were
occurring due to inability to filter out dishonest managements. After
looking various texts I was unable to come out with anything concrete.
That year I started work on a Corporate (Mis)Governance Index.

I would admit that
1.The initial target was to create a Corporate Governance Index. After
failing on this I tried the reverse and created Corporate
(Mis)Governance Index.
2. Initially I was skeptical of any success in this project. But the
experience of last 3 years has shown that these homegrown tricks are
better than having no clue.

here is the methodology I use(Don't laugh at it till you try!!)
1. Check board composition.
variables :
a. Number of people of the same surname in the board i.e. no of
Ambani's in RIL board. With some knowledge you can also add related
surnames:). Check both absolute and percentage of total board strength
Interpretation: >3 or 16.66% means bad, >4 or >25% is too bad

b. Number of executive directors from the pervious set (point a)
Interpretation: Little fuzzy here. If the ratio is too high that means
they are paying all their uncles and nephews fat salaries. If its too
low it means they have added even 'Mataa jii' to the board.

c. Find number of non-working directors. (Mother's, sons, daughters of
main promotor who never attend a board meeting)
Criteria: people who skipped more than 1/3 of the board meetings. Give
AGM, EGMs extra weightage.
Interpretation: This is to find the how many of the family members are
there on board just for the heck of it. Sometimes it also points out
independent directors who are just pawns of promoters.

d. Total salaries + commissions + bonuses as a percentage of Net
profits (take average of last 3 year's profit because 100% jump in
profit shouldn't mean 100% hike in salaries)

e. Check the history of equity dilution. You can find this in any
financial website like IciciDirect.
Search for word preferential allotment. Can't find it use google!
Interpretation: Preferential allotment at low prices is the most
misused tool in the times of bearish markets.

f. Check history of mergers and acquisitions. If you find that there
are acquisitions of companies where promoters held 100% stake, you can
be sure that the parent company would have paid hefty price.

g. Similarly check for the divestment/ de-mergers /sellouts. Check the
price the company got out of them and who bought the assets.

h. You can also check the ratio of independant directors. In my tests
it hasn't helped in a single case(not sure why)

The data about points a -d is available on the annual reports. Don't
ignore the corporate communications that the companies send as
worthless crap. Atleast read the salary increases part!.

As for f, g, h experience helps. One reason why I never start with
high investment ina company is that it takes time to come to know
about a company. Once you hold some stake your eyes are on lookout for
news about the company and you would learn to see the instances of

Some interesting cases of high Corporate MisGovernance Index
1. Penta Media (scored on virtually every point)
2. Reliance group (scored very high on a-d)
3. Sah petroleum (small company which came out with IPO. The faily
members take 8.5% of profits home!!)

Some of the companies from LWb Special whose scrored were relatively
higher are Jindal Steel and Power & Sterlite.

The companies which scroed zero on Corporate MisGovernance Index
include HDFC, ITC, HLL, INFY. It just shows that this index is not
exhaustive enough to measure MisGovernance by professionals.

Surprisingly all PSU's scored low on Corporate MisGovernance Index.
may be that's becasue the index doesn't measure lack of
disclosures/lack of foresight etc.

Mutual Fund selection

"The dumbest reason in the world to buy a stock is because it's going
up" – Warren Buffett

I would say the next dumbest thing would be to buy a mutual fund
scheme just because it's NAV is going up. But that's exactly what the
investors do when they buy mutual funds on the basis of short term
performance. I read an artcile about the (in)consistency of mutual
fund performance.

EXCERPT: "The S&P's Mutual Fund Performance Persistence Scorecard
(link opens a PDF file) measured the consistency of top-performing
mutual funds over three and five consecutive years. As of May 31, only
10.7% of large-cap funds, 9.2% of mid-cap funds, and 11.5% of
small-cap funds maintained a top-quartile ranking for three
consecutive years. Which is to say that only one in every 10
top-performing funds in a given year stays in the top 25% for the next

This is a word of caution for the investors who think that they are
making intelligent decision than the people jumping directly into
markets. After all, if you fall from 10th floor it hardy matters if
fell from the window or you were inside a lift which fell 10 floors.

The article further goes on to suggest that you should carefully note
the expense ratio of the fund. As per the author, one of the golden
rule is "If you are investing in mutual funds, look for funds with an
expense ratio of less than 1%".
In India most of the equity funds have expenses ratio higher than 2%
which means that Indian investors have more reasons to worry.

Read the complete article at.
Beware of Dogs

If you want to know more about expense ration read the following post
Expense ratio : The indicator of Mutual fund costs

Posted:Oct 10, 2005

Investment vs Speculation

In every bull run the media reports are full of the references to the
return of the Small Investors to the equity markets. Lured by the
headlines of Sensex crossing 8000 and stories of neighbor making huge
money, otherwise intelligent people, decide to try their luck in the

I find the word Small Investor little misleading. The term is used for
the people who are really Small Speculator but think that they are
investing. It is very important to make the distinction between the
two. Any advise which is valuable to the investors, can be dangerous
for the speculators. Before I go on to explain this I want to put
forward the definition of investment as given by Benjamin Graham

"An investment operation is one which, upon thorough analysis promises
safety of principal and an adequate return. Operations not meeting
these requirements are speculative."
Graham and Dodd's Security Analysis (original 1934 edition)

Graham goes further to suggest that speculation is not wrong but
entirely different ball game and should not be confused with investment.

"Outright speculation is neither illegal, immoral, nor (for most
people) fattening to the pocketbook . . . There is intelligent
speculation as there is intelligent investing. But there are many ways
in which speculation may be unintelligent. Of these the foremost are:
(1) speculating when you think you are investing; (2) speculating
seriously instead of as a pastime, when you lack proper knowledge and
skill for it; and (3) risking more money in speculation than you can
afford to lose. . . everyone who buys a so-called "hot" common-stock
issue, or makes a purchase in any way similar thereto, is either
speculating or gambling. Speculation is always fascinating, and it can
be a lot of fun while you are ahead of the game. If you want to try
your luck, put aside a portion--the smaller the better--of your
capital in a separate fund for this purpose. Never add more money to
this account just because the market has gone up and profits are
rolling in. (That's the time to think of taking money out of your
speculative funds.) Never mingle your speculative and investment
operations in the same account, nor in any part of your thinking"

Benjamin Graham in The Intelligent Investor

When you speculate on a stock while thinking that you are investing,
the time tested principles of investing can do you more harm than
good. For instance take "Buy and Hold" approach. The investors who
have done property analysis can afford to hold the stock even if the
price goes down. If they are really sure about their reasoning they
can (and they should) increase their investment as the price goes
down. The same is not true for the speculator who is investing in a
penny stock. He can lose his entire amount just by waiting for the
time stock goes up.
The same goes with diversification. If you buy all slots of a
roulette, you have a 100% chance of losing money equal to the %
charged by the Casino. Similarly if you try to be a contrarian when
you know less than what market knows you would lose more that you
would by following the trend.

That brings me to the question I want you to answer for yourself. Are
you sure that you are not a speculator?
If you don't know the answer then you can get the answer the
following question.
(a) Do you know about the main products/business of the company you
have invested in?
(b) Can you tell , with (+-)50% accuracy, the revenues or profits of
the company.
(c)Have you ever checked the financials or results of the company?
(d) Do you have some reasonable expectation about the returns from the
money you have put in the stock and have you compared those
expectations with the returns available from other non-equity
(e) Do you have some estimate on risk that you are undertaking, e.g in
worst-case scenario how much you can lose.
(f) Have you done more than a day of homework per stock before forming
your expectations and risk estimates?

If you answer more than 4 of the above question as NO than you are
definitely an speculator irrespective of your opinion. If you have
answered at least one NO then you would be better of undertaking
investment under guidance from experts. Finally, if you have answered
all of this as yes it is difficult to guess whether you are an
investor but you are definitely on the way.

None of the points mentioned above are for discouraging or disparaging
speculation. Very few people in the group would know that I'm an
expert gambler but I never speculate in the markets….And I know, it
pays to be really sure when you are speculating.

Oct 19, 2005

Holding company structure

Holding companies are a tool used by promoters to retain management
control over companies with minimum amount of investment.

Assuming you want to retain management control of a company A which
has 100 Crs of paid up capital. You need to shell out 33 crs. to get
33% share which can give you control if no other shareholder hold that
much stake. Assuming you have a holding company B where you have
management control with 51% stake. If B holds 33% stake in A then B
gets management control over A.
Now think how much you will have to pay to get 51% of B ? Assuming B
the only asset of B is its holdings in A and its paid up capital is 33
crs. You will have to pay only 17.5 crores to get management control
over B and by virtue of its 33% stake in A you get management control
over A.

This is one of the many benefits promoters get using holding company
structure. You can create a pyramid of holding companies and get
management control over large companies with personal holdings as
small as 5 -10%.

Other benefits include fooling the creditors to supply loans of
disproportionate sizes. As a promoter your interest would lie in
retaining control with as minimum investment possible. If you get the
creditors to pay 100 cr loans on equity of 50 crs, you can get 33%
stake in a company with 150 crore assets , by paying just 17 crs.
Obviously no sane banker should pay loan as high as this but here the
holding company comes to rescue. For instance, Reliance paid loans
worth 12000 crs. to Reliance Infocomm when Reliance Infocomm's equity
was around 450 crs, that to at 8% interest rates.

That's another reason why its is unreasonable to expect the promoters
to unlock the value by resolving such structures even though the
holding companies remain undervalued for long periods of time. They
can keep increasing their stake in the holding company by creeping

In nutshell, the investors of the holding companies fund your
investment in the subsidiaries and help to getting top management
positions with fat pay checks as large as 1-2% of net profits of the

that's why the investors have to bee very cautious and very patient
when dealing with investments in holding companies. Its a complicated
business and should never be attempted unless you know enough abut
these tricks

Valuations in India compared to other emerging markets

In last weeks I had explained the fact that the
market capitalization of Indian equity markets seems on a higher side
in comparison to India's GDP. I've been able to get hold of some data
to support this claim. Here are the figures of market Cap to GDP
ratios of different countries(based on data from World bank on GDP for
FY 2004).

USA 132.2%
UK 132.1%
taiwan 87.0%
japan 80.3%
S. Koria 77.2%
India 64.9%
Russia 57.7%
Brasil 55.6%
China 22.7%

Please note that this ratio is not a single yardstick to measure the
relative valuations because the ratio depends following factors.

1. Ratio of listed companies compared to the unlisted companies (which explains why china's M.Cap/GDOP ratio is low)
2. ratio of contribution of unorganized sector to the organized sector.
3. Prospects of growth(higher the growth prospects the higher would be the ratio)
4. Interest rates (Low long term interest rates would result in higher valuations)
5. Risk premium (if the systematic risk are high the valuations would be low)

Even after accunting for expected growth I find it difficult to
justify assumtions that equities can yield 20%+ gains in coming years.
hence I believe that the markets are going to give returns of 11-13%
in next 5 years. While these returns are pretty good it implies a risk
premium of 3.5% to 5.5% over risk free rate. This may not be enough to
justify investment in stocks in general. This means that you should
concentrate your holdings into only those stocks where the prospects
of high returns justify the risk you are taking.

Posted: Aug 22, 2005

Why Diversify?

You may have heard of the oft repeated advise about not putting all
the eggs in a single basket. It is repeated so often that people want
to rebel against it. But I think diversification is a theory which has
sound mathematical basis.

Assume that you and me decide to gamble on 1 lack rupees on a toss of
a coin. Also assume that you have a special coin which churns out
head 70% of time and tail 30% of time and you have the liberty to pick
up your choice(head or tail). You can also choose how much you would
bet on 1 toss.. i.e that you can toss the coin 1 lack times by betting
1 rupee on each toss or you can put entire 1 lack rupees at stake in 1

What would be your strategy? How many times would you throw up the
coin? If you had read the chapter on probabilities well, you should
bet 1 lack times on getting head and you have assured chances of
winning approximately 40000 Rs. If you decide to bet 1 lack in a
single toss of coin you may lose up to 1 lack or win 1 lack.

Clearly the choice is yours. In equity investment, there are no risk
free bets just as there are no coins without a flip side.

In such cases diversification increases your probability adjusted returns.

Having said that diversification is necessary but not sufficient
condition to safer returns. This is because if there is any
correlation between returns of the stocks in which you have
diversified you may lose in all of them if things turn worse.

Also there are risk involved in over diversification because of the
transaction costs. Another reason is that it is difficult to find more
than a few stocks where you can get 70% chance of returns. This means
that the more you diversify, the closer you get to average performers.

My personal view is that an equity portfolio having less than 7 stocks
or more than 25 stocks is badly designed.

Posted: July 21, 2005

Housing prices: Are we building castles in air

Last week I read an insightful article in The Economist on the Global
housing boom and the high probability of impending crash. I was quite
interested to get some information about real estate market which is
not my home turf. Though the analysis of housing market in India is
difficult task due to lack of information, lack of transparent legal
structure to support property rights and an inefficient market, I
would still like to initiate a discussion about housing prices in India.

To my mind investment in the Real Estate is like any other investment
with risk and rewards associated with it. But the majority of people
do not think about the risks in investing in real estate because they
think the prices will always go up. They usually base their arguments
on the fact that the supply of land is limited and the demand keeps
growing. However history doesn't back this argument. ( In the links to
the articles you would find some instances of sever crashes in real
estate prices and the reasons why it happened)

As an investment real estate investment has some interesting
characteristics. At least till your first house, the home acts both as
an investment and a consumable commodity. In that sense if you live in
a house you own you would not be in particular hurry to sell it just
because prices are falling.

But to reverse the argument would you buy a house just because you
have enough money to buy or enough cheap loan available to buy it.
Without giving any recommendations I would give you an interesting
scenario of my own rented flat. The rent is 14,000 p.a. with 5%
increase per year. If I want to purchase the house I'll have to pay
approx. 40 lacks.

If I use discounted cash flow model to determine how much time it
would take for me to break even with the rent saved at this price and
using risk free rate of 7.5%, it would be take me 36 years.

For obvious reasons I'm not interested to buy this house(or any house
for that matter, even though I afford one and I need one). So this
equation is simply not adding up. To make LHS= RHS one of the
following has to occur.
1. The rents will go up by more that 5%
2. The long term interest rates will come down
3. The price of the house comes down

The option 1 is rules out unless the prices in entire city move up. At
the rent I'm paying is on the higher side and I don't think that it
can go up further.

The long term interest rate are on the lower side now and will not
move down further unless there are structural changes in Indian Economy.

The last option seems more likely (I know you would disagree!). Two
years ago the prices were close to 28 lacs. In the last 2 years the
rents have moved up by 10-15% and the prices by 60%.

My case may be one off case. I want you to do the same analysis(or
send me data) and figure out for yourself if the house is worth buying.

Now the story is same globally. People are paying more price to buy
house than the returns they can get from them in their lifetime. the
argument is the same that the prices will go up and up.

I would leave you here with the following articles. Hope that you
would send your opinions even if you don't agree with me or The Economist.

The global housing boom: In come the waves

House prices : After the fall

Beware housing bubble: HDFC Chairman

Bonus shares - why bother?

The declaration of the bonus can be thought of as recognition of
additional equity capital provided by the investors by virtue of
agreeing to reinvest part of the profits. To understand this, let's
assume that a company X has a equity capital of Rs. 100 crs and no
accumulated profits. The company X earns 20 Crs and pays 5 Cr. as
dividends. Also assume that there is another company Y, which is
similar in all aspect to company X but gives entire 20 Crs as
dividend. Assuming that the profits and all other variables remain
same the company X would have a networth of Rs. 175 Crs. and Y would
have a networth of 100 Crs.

In the year 5 if both X and Y pay 20 Crs dividend which company has
higher payout ratio? same..they both have 100 Cr. equity and they both
pay 20 Crs. However we are ignoring the aspect that the shareholders
of company X have put additional 75 Crs. of capital in the company by
investing part of profits.

If the company X gives a bonus it is recognizing the fact that the
shareholders have provided additional capital by allowing the company
to deploy profits back to the business. This expanded capital base
need to be serviced through dividend and if a company recognizes the
contribution then it is highly likely to raise dividend payout.

All this may sound highly theoretical because the capital structure
doesn't change a bit through bonus. However, empirical evidence
suggests that bonus issues imply higher dividends in longer term. To
that extent the favorable opinion about bonus issues is logical up to
a certain limit.

The reaction of the market is many times exaggerated. Many analysts
seems to overvalue the advantages of more liquidity provided by the
bonus but I think it is of very limited long lasting value. The stock
splits serve the same purpose as bonus as far as liquidity is
concerned but they have no long term consequences.

In economics and finance, the expectation of change of variables is
more powerful factor than the change in variable. The variable in this
case happens to be the dividend. The bonus also raises expectation
that the profits are less likely to fall from current levels because a
conservative management would never like to reduce the dividend payout
even in bad times.

This subject has been nicely explained in the Intelligent Investor by Graham and
you can refer the book for more details.

Posted: Jul 1, 2005

Investing in holding companies

Holding companies make a good target for the value investors. I have
used this quite effectively in the past in case of M&M/Sterlite etc.
The principles I follow in these cases are as follows;

1.Analyze the companies independently to judge the prospects of
subsidiaries by themselves.

2.Find out the triggers of unlocking the value in the subsidiaries.
That may not necessarily mean that subsidiaries need to be made public
or sold. it simply means whether they would achieve the critical mass
to make the market realize their worth. In fact if a holding company
has stake in a strong subsidiary then by the value investing
principles it may not make sense to divest the stake.

3.Find out the pitfalls.
a.Figure out why such holding structure is created. Many times the
companies do this to hide debts in the books of subsidiaries. The
extreme example of this is pyramiding capital structure, a la Enron.
b.Check if the parent company is using transfer pricing to sell the
products at higher price then it can get in the markets and booking
profits whereas the subsidiary is suffering from losses.
c.Avoid complicated structures with substantial cross holding

4.Check if there are any synergies in the business of parent company
and the subsidiaries. History shows that diversified companies making
everything from steel to software are unable to remain focused in
disparate businesses.

5.Check if the managements of the subsidiaries have enough expertise
and freedom to shape the future of the subsidiary.

6.Having done all of the above mentioned analysis, evaluate the value
of the interest of the parent company in the subsidiary. You can get
this by looking into the consolidated accounts. Here a catch is that
the accounting norms do not force the company to consolidate the
accounts for the subsidiaries where the parent company holds less than
505 stake. Reliance Infocomm is the case to the point.

7.If you can determine with reasonable degree of confidence that that
the total value of the consolidated enterprise is more then what
market estimates buy it. But you got be very patient in such cases
because it may take years before market realizes that.

Posted: June 20, 2005