BIBLIOPHILE: THE MOST IMPORTANT THING BY HOWARD MARKS “UNDERSTANDING RISK”

Posted on May 22, 2017 by Jimit Zaveri under BIBLIOPHILE: THE MOST IMPORTANT THING BY HOWARD MARKS

For making any investment decisions, we have to be dealt with the future, which is uncertain in nature. So, that when there is an uncertainty, then there is an involvement of risk and we cannot escape from the risk. We must have to focus on asserting risk while making any investment decisions.

When we focus on the return of the particular instrument, then we have concentrated our focus on half of the movie and rest half will get completed with asserting risk in that particular investment.

Risk 01

Traditionally, we all have learned, that in making a higher return, we need to take an incremental risk.

But we think logically about the same that if we get a higher return for the taking of incremental risk than there should not be a risk. We get rewarded by the returns for taking a higher risk.

Risk 02

Traditional risk/return graph has communicated the positive relationship between risk and return but ignored uncertainty involved for making such returns. Additionally, traditional risk/return graph has shown a risk as similar to volatility, but not focused on the danger which is involved in the investment.

Many a times volatility cannot be an as riskier as compared to other dangerous events for our investment.

Risk 03

So, that risk is not a volatility in the price of stocks, but the real risk is the permanent loss of our capital. And we must have to be worried about the permanent loss of capital rather than volatility. We must have to focus on the understanding of the risk which could have the probability of erosion of our capital.

Many a times risk is not only limited to, permanent loss of capital or to volatility, some kind of risk are objective and personal in nature; such as-

1) Falling short of one’s goal

Many investors have a different need, goals and not meeting those by investment results can be the risk for the particular person.

If someone just requires meeting the routine expenses, then getting a fixed return from fixed return instrument might not be at risk for the person, but if someone who wanted to build capital for investment then such a lower return can be a risk for that particular person.

2) Underperformance

Such kind of risk is related to the investment manager. If the investment manager cannot able to generate higher returns compare to index than the investment manager might lose his clients.

Risk 04

3) Career risk

This is an extreme form of underperformance risk. Continuous underperformance can have resulted in the risk to the career.

4) Unconventionality

This risk is connected with a being different while making an investment idea. If unconventional idea got wrong, then there might be a risk to the career.

We buy metals, sugar stocks, etc. (at the worst time of the cycle). Instead of buying pharma, IT, Banking which is a darling of the industry. And if our stock picks up doesn’t work, then we have to face trouble and extreme risk of loss of career.

5) Illiquidity

This risk arises when investors need a money for some urgency and unable to break his investment.

Let me take an example of the cricket match for understanding a risk.

The main risk in the cricket match is to losing the match, series, etc. as similar to losing our capital in investment. If all the players play a poor game, then definitely team will lose the match and similar to an investment; if all our investment resulted in poor returns or more risk oriented than we might lose our capital or lose real value of capital.

As we have seen in Indian cricket history that Mr. Sachin Tendulkar, Mr. Rahul Dravid has played very well and created the record, they don’t always come to the ground for making a century or creating a huge score but always played well for protecting their wickets. Their focus on protecting their wicket helps them to play well for the longer period of time. And on against to them, many other players came to Indian cricket history and gone also; cannot able to stay for a longer period of time. They just have focused on making a score and sometimes due to the luck they can able to make good score but not always.

If players do not able to play well on a continues basis, then they will have lost the opportunity of staying with the cricket team (Career Risk). Also, we have seen that Mr. Mahendra Singh Dhoni has taken a many unconventional decision for the team during the match. Many of his decisions got success and many not. When he filled with his unconventional decisions, he has to face the anger of the people. This is as similar to our unconventional investment decisions and has to face anger from our clients if we filed into the unconventional decisions.

It is not necessary that we only can be incurred a loss by buying weak fundamental stocks. If we bought the comparatively lower fundamental company at a very lower price than that investment turns out to be a successful investment.

Sugar IT

We can see that if we have bought the comparatively lower fundamentally good stock at a cheap price than this stock has generated a higher return compared to the good fundamental stocks in last 5 years.

Also, not good macro environmental promises of safety. Because too positive news brings up prices at too high and any small adverse development can be enough for damages to our wealth.

People generally tend to associate with the things that are doing well. And that investment might be able to fulfill expectations for a while and thereafter small negative event can damage much higher. Such scenario having an involvement of higher risk.

So, that value investors believe in achieving higher returns from lower risk. We have to be ready with underperformance risk while we are buying bargains and market is in a heated bull phase. We need to accept it rather than incurring losses.

Investment is dealing with the future and the future is highly uncertain. And it’s impossible to know anything about the future.

Risk means more things can happen compared to what happened in the past. Understanding of risk requires a second level thinking and it’s not an easy task. The risk of losing money is observed by one that’s similar is not observed by another one.

Read for more detail: The Most Important Thing Illuminated by Howard Marks

BIBLIOPHILE: THE MOST IMPORTANT THING BY HOWARD MARKS “THE RELATIONSHIP BETWEEN PRICE AND VALUE”

Posted on April 23, 2017 by Jimit Zaveri under BIBLIOPHILE: THE MOST IMPORTANT THING BY HOWARD MARKS

As we have discussed regarding value in the previous article of a Bibliophile. Now, I am going to talk about the 4th Chapter of The Most Important Thing – The relationship between price and value.

01 P&V

There is not an availability of any asset class which having a birthright for providing a higher return. If we bought a particular asset class at an appropriate price, then that provides us a higher return to safety.

02 P&V

An example of one the biggest wealth creator company of the Indian stock market—

INFY Chart

If someone has bought this company during the March-2000, At the high price of around Rs.431 then after the 16 years of the period, he gets returned at 7% CAGR. And if enter to the similar company at the low price of around Rs.275 during the March-2000 then after the 16 years of the period, he gets a returned of 10% CAGR (*Considering all time high price for calculating returns). Though revenue grew at 30% CAGR, Operating profit grown at 27% CAGR and Net profit also grown at 27% CAGR during the same period with supported by the good management team.

If we buy such a good thing at a too high price, then we have to wait for the very long time for getting fair returns rather getting superior returns. But if we have bought junk asset class or good asset class at an appropriate value, then we can able to create a superior return.

We should focus on correctly buying an asset at a cheaper price so that we need not keep focusing on the selling decisions. Because our buying decision provides us a huge safety. Whenever we buy any stock at a cheaper price and all our calculations of intrinsic value are correct, then over a period of time, the stock price should reach its intrinsic value.

So, that One of a good idea of making an investment is to buy whenever the pessimistic situations around us which provide us a good return with proper safety. But such scenario not always comes. This means we construct our portfolio at the time of crisis, but every time, we cannot stay only dependent on the crisis for making our buying decisions.

03 P&V

Thus, most important are to understand the relationship of price & value. By knowing the relationship between price and value, we can able to take an advantage of mispriced valued stock and consistently create a wealth for the longer period of time. We also need to understand the Psychology of investors along with the understanding the price – value relationship because the psychology of investors can drive stock prices in the short run. But at a longer period, the price should reach its intrinsic value. So, that it is an essential for us to buy an asset at a discount from its intrinsic value.

IT Bubble

04 P&V

Investors Psychology is also one of the important factors along with the Fundamental value of the security which can drive stock prices to an extreme side and that provide us an opportunity for our entry/exit. We should avoid falling into the trap with short term price fluctuation due to the psychology of investors but should take an advantage from it.

05 P&V

06 P&V

RKD BUY

People never focus on the price at clever people make an investment. But they start herding towards the news of such deals. So, that more and more people start buying the same stock and due to the flow of buying, the stock starts rising and again more investor start buying into it and stock start rising again. Thus, psychology drives a price much more rather than its fundamental in the shorter period of time. Everyone starts creating stories after the clever people make an investment, those stories drive the price of the asset class at extreme direction.

As per the Howard Marks, there are few ways by which we can earn a profit on the investment:

Benefiting from rising in the asset’s intrinsic value.

In this method, an investor has to predict accurately to the improvement in the intrinsic value of the assets in the future. But this task is not as easy as it seems. We even don’t know our future and we are going to predict the future of the intrinsic value which is very uncertain in nature.

Applying leverage

Leverage means investing using borrowed money. Leverage always works as a double edged sword. It can either make you or will break you. It magnifies both gains as well as losses. So, leverage might provide us a higher return, but it can also create a threat to our own capital. Selling for more than your asset’s worth

Selling for more than your asset’s worth

Here, we need to hope for the buyer who is ready to buy an asset at a higher price. If we are holding an asset which is overpriced or fairly priced than we need a greater fool to buy an asset from us at a higher price.

Buying something for less than its value

In this option, we are buying an asset at the discount, from its intrinsic value. It’s just required for the proper functioning of the market and that brings an asset to its intrinsic value. This can be one of the most useful ways to make a consistent return with a safety of our capital.

Sultan Mirza

Click for Video — Sultan Mirza

As we have seen in the video that Ajay Devgan has bought Guava at a very high price compared to the real value of the Guava. We have many a time experienced such kind of the irrationality among the investors who focus on story prevailing at market space rather than focus on the real value of the particular stock. We will not always able to meet Sultan Mirza (Ajay Devgan) / Irrational investor who buy an asset from us at a very irrational price. So, that we always need to focus on the buying an asset at a discount from the real value for getting a consistent return to safety.

Read for more detail: The Most Important Thing Illuminated by Howard Marks

BIBLIOPHILE: THE MOST IMPORTANT THING BY HOWARD MARKS “VALUE”

Posted on March 18, 2017 by Jimit Zaveri under BIBLIOPHILE: THE MOST IMPORTANT THING BY HOWARD MARKS

In the 3rd chapter of the book “The Most Important Thing”, Mr. Howard Marks has discussed regarding different ways to identify the value of any business.

Hope

We always make an investment at a lower price with the intention to sell it at a higher price. Means that we buy something at less price than we can able to sell.

But what is high, price and what is a low price? How to identify it? That is the main confusion for all of us.

For taking it at a simplify manner, we can say that we buy at below the intrinsic value of any assets for selling that asset at a higher price.

“Intrinsic value is the value (i.e. what the company is really worth). Different investors use different techniques to calculate intrinsic value.” – InvestorWords

Now the question is how to identify an intrinsic value? As we all know that there is a major 2 discipline to identify an intrinsic value of the company’s securities.

1) Fundamental Analysis and,

2) Technical Analysis

Technical Analysis basically studies past behavior of price and from that past behavior, person predicts future price behavior.

I am not going to discuss this study in details because it’s not suitable to me and I am not able to make decisions based on past price behavior.

Move forward to the Fundamental Analysis, which is suitable for me and am comfortable with it. But again, a Fundamental Analysis also having two approaches to making a decision for an intrinsic value.

1) Value Investing and

2) Growth Investing

We need to Valuing a company by depending on a finance resource, management, business, plants & machines, factories, intellectual properties, human resources, brand name, etc.; which all having a potential to grow earnings of the particular company. And that is what we study into the fundamental analysis.

Then what is the main difference between value investing and growth investing?

Now, let me talk about the concept of valuing the company through value investing approach.

Value Investing generally focuses on tangible assets, current earnings, cash flow for valuing a company. This concept gives less weight to the intangible assets such as human resources with talents, future growth prospects, etc.

Value Investing focus on buying a company at a cheaper value based on its financial metrics such as current earnings, cash flow, dividends, tangible assets and enterprise value. Value Investors qualify the current value of the company and buy it when the current value is much higher than trading price.

Value Investing is also known as “net-net investing” approach, where investors try to identify the company which is available at below its current asset value.

Whereas growth investing focuses on to identifying companies which having a very bright future growth prospects. Here, no focus on the current value of the company and also given more weight to the intangible assets.

Difference GI VI

The Happy

Still having a confusion for selecting an approach for determining a value of the company.

If we have bought a security of a company which is available at cheaper than the current price, but at the operational level, the company is not able to do well enough, then that value cannot able to remain sustainable for the longer period of time. The value will get decompound rather than be getting compounded in the future. And that increases our probability of incurring the loss.

I read one wonderful article about the value trap company.

MTNL

The company looks very cheap on the basis of the financial metrics, but if someone who do not have paid attention to the business of the company then—

MTNL Chart

An investor has lost his capital also. So, that in value investing also, we cannot escape from the future. (For detail article, Kindly visit – http://neerajmarathe.blogspot.in/2010/04/mtnl-value-trap.html)

For the growth investing

But is it such easier to perform?

Let me take an example of one the biggest wealth creator company of the Indian stock market—

INFY Chart

If someone has bought this company during the March-2000, At the high price of around Rs.431 then after the 16 years of the period, he gets returned at 7% CAGR. And if enter to the similar company at the low price of around Rs.275 during the March-2000 then after the 16 years of the period, he gets a returned of 10% CAGR (*Considering all time high price for calculating returns). Though revenue grown at 30% CAGR, Operating profit grown at 27% CAGR and Net profit also grown at 27% CAGR during the same period with supported by good management team. During March-2000, the company was traded at 64x P/E at low price of Rs.275 and this multiple are common now-a-days.

There is a very thin line difference between Growth investing and value investing.

Value investing is more consistent in nature, but it’s not easy to find it out. It is not an easy task to valuing a company through value investing approach. I also learn this valuable learning after made the such mistake. If we don’t able to make our estimate appropriately than we might overpay or underpay to that particular security. If we overpay for some security, then we have to take support of good luck for getting some greater fool who buys securities from us at a higher price.

Also, the most important thing is not to just valuing security appropriately, but also, we need to hold it. Stock will not start moving up after we make our purchase. Stock does not know that we are holding it.

After our purchasing, many a time price will start to fall further. But we should hold to it firmly. If something good at price X then it will be more good at price X-1.

Fig3-1

This law of demand is not really put by investors into practice in the stock market. We tend to buy more stock when the price starts moving up. But if we have done all our work properly, then decline in the price of security should not make us uncomfortable and we should also need to add more at a lower level.

Last

Read for more detail: The Most Important Thing Illuminated by Howard Marks

Disclaimer

Above article is just my perception, and perception can be wrong. For me, my perception can be right but for others, it might be wrong.

BIBLIOPHILE: THE MOST IMPORTANT THING BY HOWARD MARKS “UNDERSTANDING MARKET EFFICIENCY”

Posted on March 7, 2017 by Jimit Zaveri under BIBLIOPHILE: THE MOST IMPORTANT THING BY HOWARD MARKS

In the last article, we have seen that what is 2nd level thinking and how we can able to take benefits from 2nd level thinking. In this article, I am going to discuss my learning from the 2nd chapter of the book “The Most Important Thing”. This chapter talks about efficient market theory and how we can use it for our own benefits to earn an above average return.

So first, we need to know what is an efficient market hypothesis?

UET01

Source: The Most Important Thing by Howards Mark

According to the efficient market theory, it is not possible to earn a consistently above average return due to the availability of information with each and every market participants at the same time. And also, there are many investors who tracking real-time information and make a decision based on this information. Due to this hard work by an investor, the price of securities reaches at fair value easily.

INFY_Daily_07-03-2017

We can see in the above chart that as the quarterly result get announced, many of the investors have made an effort to analyze available information and stock price reaches to the fair value.

So, that We cannot ignore that theory is not relevant to the practice.

UET03

Source: The Most Important Thing by Howards Mark

As per the above criteria, Bank Fixed Deposit is one of the suitable examples of the efficient asset class among all other asset classes. Bank FD can pass through all above criteria and due to its efficient nature, we cannot able to get an above average return from Bank FD, even cannot able to earn higher than the inflation.

We must have to agree with the parameters that investors work hard for analyzing each and every available information for reaching towards some conclusions. And additionally, everyone having the same access towards all information. So, that we cannot able to make an above average return consistently over a longer period of time.

So, those companies which are tracked by more and more analysts, FIIs, and retail investors then chances of getting an above average return will reduce. Thus, we have to focus on the companies which is different and where we can able to get the edge for creating an above average return.

If we take an example of the huge wealth creator company with every 5 years’ interval, then

UET04

So, this stock has given a huge return when not much known to the investors (i.e. inefficient) and as the stock becomes known to all (i.e. efficient), speed & rate of return start falling.

As we agreed with the parameter that every investor works hard, but what about the emotional interference for making a decision? Is it really easy to control our emotions while making any decisions?

Also, the psychology of all investors influences the decisions taken by them, which creates misprice opportunity for us. All investors react differently to the same information due to their emotional influences.

If any news regarding company comes then everyone can get it at a similar time (I am considering everyone accessing information at the same time) but the interpretation of that news is different with different participants.

tamo

Everyone gets the news of the fire at the plant of the company at the same time. But some people analyzed that this will incur an additional loss to the company & starts feeling far from this news and started selling out their positions. And some will use second level thinking to buy that same stock at an available discount due to temporary reasons.

So, that’s how to use information & capturing mispricing opportunities is dependent on skills and emotional ability of individual investors and that helps them to make an above average return.

Also, we should not ignore theory because theory helps us to limit our focus on mispriced opportunities rather focusing on all the available opportunities. We have to open for analyzing all the unknown opportunities with using of 2nd level thinking. Then and only then we can able to catch up opportunities to getting above average returns.

Many a time, we get an opportunity which is avoided by others or others are not willing to grab those opportunities. We have to identify mispriced opportunities and have to take benefits from such inefficiency.

Every most efficient opportunity is mispriced opportunities at once upon a time. So, that we have to limit our focus on identifying misprice opportunity. As I quoted in the above example of fire at the plant of the company. As that company is widely tracking by many investors, FIIs, DIIs etc., but capturing opportunity when it becomes a mispriced opportunity that is the importance of skill (Obviously with important of LUCK).

Also, we should try to capture the opportunity which is not well known and not tracked by many of the investors. By this, we can able to limit our focus and can able to generate an above average return.