Incorporating Socratic Questioning in Investing. But Why ???

Today I am going to tell you 3 stories. Out of which 2, I heard from my IIIT professor and 1, I read in a biography book.
So here they goes:

Story 1:

A Bengali bride got married and the couple started a new journey, in a new house, in a new city. She is very good at cooking Fish (and most importantly she enjoyed it).
Fish is more or less on the menu on every alternate day. The process she normally followed is “She used to chop 2 inches each on both ends of the fish”, and put it in the micro oven. Everything was going good, until the day has come when the husband observed this peculiar behaviour and asked “WHY?”

Not knowing the answer, her reply was “My mother used to do so”.

Curious hubby, called up his mother-in-law to ask the reason. But all he got was the same answer “My mother used to do so” !

Not being satisfied with the answers, he tried to contact the old lady (mother-in-law’s mother), and asked “Why did you teach your kids to chop 2 inches on both the ends of the fist while cooking in micro oven ?”

The old lady was astonished with this question and replied, “What, Are they still following it ?”

Her explanation:

There used to be no micro oven nor gas stoves in those days, and hence I had to fry the fish on pans placed on wooden fire (Primitive Cooking). The length of the pan was small and hence I had to cut 2 inches each and fry it, so that it will be evenly cooked. “But I never knew that they are still following that practise even after having micro ovens, gas stoves, and large pans”.
Story 2:

There used to be an Indian Saint who lived in the banks of Ganges river along with his disciples. The ashram was so calm & pleasant. Everything was going good, until one day a cat from some where entered the ashram and started making noise, disturbing the saint and his meditation. It also used to poop all round the ashram making it even more disgusting for the disciples to make it clean.

Frustrated with these actions, the saint ordered the disciples to “Tie the cat and put it in a basket during his meditation hours”, so that it will not disturb him during his most productive time.

Everyday just before his meditation starts, he used to asks his disciples one single question, “Had the cat tied in the basket ?”. If the answer was Yes, he used to continue with his meditation, or else it was not so good day for disciples from the saint. This continued for years together and it became a daily routine & habit of the disciples to make sure the cat is tied before saint’s meditation begins.

But one fine day, the Cat died. This made the disciples furious. Being afraid of his saint, “who needs the Cat to be tied and kept in the basket”, everyday just before his meditation, all the disciples went in search of a NEW cat, bought it, tied it & kept in the basket before his saint ask for it.

(True) Story 3:

Warren in his 19, was asked by one of the then greatest traders of Wall street “Why he wants to buy GIECO ?”.

(This is image of the article which Warren wrote on GIECO during his initial days)

Warren knowing in & out of the entire company, his future potential, the scope, low cost provider which is a moat etc, kept everything in his mind and answered just one line,

“Because Graham likes it”. Of course Warren never forgot the expression given by the trader at that time.

This takes us the topic of the post “Socratic Questioning”.

Definition: Socratic questioning is disciplined questioning that can be used to pursue thought in many directions and for many purposes, including to explore complex ideas,
to get to the truth of things, to open up issues and problems, to uncover assumptions, to analyze concepts, to distinguish what we know from what we don’t know, to follow out
logical implications of thought or to control the discussion.

The key to distinguishing Socratic questioning from questioning per se is that Socratic questioning is systematic, disciplined, deep and usually focuses on fundamental concepts, principles, theories, issues or problems.

Watch this 2 min video:

Socrates was a deep thinker. He always believed that great ideas needs time & effort. If you get a great idea without critical thinking (which he states in 6 different points which we are going to discuss below),
more often than not, its not a great idea or not going to be one for long time.

So what did he say ?

1) Revealing the issue: ‘What evidence supports this idea? And what evidence is against its being true?’

Socrates asks us to search for dis-confirming evidences.

Wait a minute ? Are you thinking, what I am thinking right now ?
Yeah, you read or heard that many times. Where ? Well, our 2 Charles had spent there entire life practising this particular thought.

Charles Darwin & Charles T Munger.

They always ask us to look for dis-confirming evidence. If a particular company is destined to give good returns, spend some time negating the thought, push the thoughts to get the evidence (if any) to prove that “It will NOT give good returns this year” (Inversion).
2) Conceiving reasonable alternatives: ‘What might be another explanation or viewpoint of the situation? Why else did it happen?’

Sanjay Bakshi sir in his recent podcast with Shane Parrish of Farnam street says, he always articulate a problem by saying “The Part of the reason is…”,
meaning there are many reasons for a particular thing to happen. If we try to fix ourself with the first or second reason we think of, it is like pondering ourself to first confirmation bias and shutting off our brain to think further. In many cases is not recommeneded by these people.
3) Examining various potential consequences: ‘What are worst, best, bearable and most realistic outcomes?’

Richard Branson’s autobiography “Loosing My Virginity”, was an amazing, inspiring & roller coaster ride. In the book he says, his idea to start Virgin Airlines had became strong
only after he calculated the downside (roughly). He says, if Airlines fails all it takes is 2 quarter earnings of most successful “Virgin Records” and one year of effort.
He always insist to keep an eye on downside. Even while opening his 301th business also, he made sure that if it fails, it should not have more impact on other 300 businesses.

Isn’t this how we should learn about Portfolio Construction and practise it ?

4) Evaluate those consequences: ‘What’s the effect of thinking or believing this? What could be the effect of thinking differently and no longer holding onto this belief?’

The best thing to do is to disprove thyself. Once you found few points which contradict your initial thought process, feel happy to accept them & continue this process.

5) Distancing: ‘Imagine a specific friend/family member in the same situation or if they viewed the situation this way, what would I tell them?’

Guy pier says, he practise a strong thought process where he places himself in the shoes of Warren & Charlie in every part of his daily life. He just imagines how they both will do that thing which I am going to do now. There is no need to restrict this thought process to Investing. Infact Warren & Charlie are great investors because there were rational human beings & NOT vice versa.

Finally,

Asking these 5 Why’s, will bring us to the root cause of any problem.

Let’s try to make “Socratic Questoning” a part of our daily life & Investing practise.

Happy Learning & Investing 🙂

-END-

How to Calculate Value At Risk for your favorite stock ?

This is a little detailed post. Please get your coffee before moving forward 🙂

What is the most I can lose on this investment? This is a question that almost every investor who has invested or is considering investing in a risky asset asks at some point in time. Value at Risk tries to provide an answer, at least within a reasonable bound. In fact, it is misleading to consider Value at Risk (or VaR as it is widely known), to be an alternative to risk adjusted value and probabilistic approaches.

How much Loss can I take ?

So, lets try to understand the basics of it and see how we can calculate VaR for any of our favorite stock with an Example using Excel sheet.

What is VaR or Value at risk?
VaR is a technique to probabilistically calculate the market risk of an investment or a basket (portfolio) of investments.  It uses historical values of security’s trend and volatility do determine the potential loss that a security or portfolio can witness for a particular time frame (daily, weekly or monthly) at a certain confidence level. Remember VaR is used to calculate market risk and is only valid for securities which face market risk per se. It is important to note that it is a statistical tool and only helps estimate the potential risk of an investment. The actual loss may exceed under drastic circumstances which may not be considered in the historical data used.

For stock investments, this can include situations like damage to important assets of the company, a lawsuit filed or lost etc. However, such situations can be assumed to be improbable and can be neglected.

What is confidence level?
In a general concept, it is a statistically used number used for forecasting.
Generally confidence level is used at 95% or 99% which means that these percentage of times (of the period), the loss will not exceed the VaR. For example, if monthly VaR in percentage terms for a security A is -20% at 99% confidence level,  it means that the security A can be expected to return at least -20% return (or higher) in a month 99% of the times for the entire holding period.
There is only 1% probability that it will fall more than 20%.

Who uses VaR analysis?

Every major player in the Financial world !!!

 and Many more…

VaR is used by banks, hedge funds, mutual funds, derivatives traders, pension funds and other trading organizations. It can be used by small retail investors or retail wealth managers as well; who are planning for future wealth requirements (financial goals).  It is suggested that any investment made for a period of more than 6 months should be considered for VaR analysis.

How is VaR calculated?
There are various methods to calculate VaR. However there are three widely used methods:
1. Historical returns method
2. Variance-Covariance method
3. Monte Carlo simulation
For retail investors and traders like us, we can use historical returns method which is fairly simple to use and calculate.
Variance-Covariance method can also be used and it is a quicker way to calculate VaR.

As usual, I know neither me nor you are interested in only theory part of it. Lets dive into the numbers & practical use of it using Historical returns method.

This is a crude way to calculate VaR (mainly for retial investors like us). If you want to learn more about How banks and Large financial institutions  calculate VaR. You can start from here http://tinyurl.com/mf5v3hh

Here is a step by step process to calculate VaR using Historical returns method:

Step 1: Open http://www.bseindia.com and navigate through Markets -> Historical Data
OR click directly on http://www.bseindia.com/markets/equity/EQReports/StockPrcHistori.aspx?expandable=7&flag=0

Step 2: Select the stock for which you want to know the VaR. Also select daily, monthly or yearly interval data.  So if you want to calculate daily value at risk, you can download daily period data.
If you want to know monthly VaR then download monthly. For daily, a period of historical data for one year or more should suffice.  For monthly VaR, download at least past 3 years’ data.
Remember, longer the historical data period more accurate will be the statistical calculations.
This calculation assumes that the historical data has a normal distribution. A larger data set would make this assumption valid. Hence, the more historical data you use, the better result it gives.

Step 3: Click on the Download option given below in CSV/XLS file format.
We only need the Day/Month column & Closing price column. Hence Hide all the other unnecessary columns like Open Price, No.of Shares, Deliverables etc.

Step 4: Filter the Date/Month column from Ascending to Decending order.
And Starting from second day/month row, we calculate the return since the last period (day or month).
(current close price – previous close price)/previous close.

Before moving forward understand this following statistical function:

NORMINV (p, µ, sigma):

The Excel NORMINV function calculates the “Inverse of the Cumulative Normal Distribution Function” for a supplied value of x, and a supplied distribution mean & standard deviation.

The format of the function is :

NORMINV( probability, mean, standard_dev )

probability – The value at which you want to evaluate the inverse function
mean – The arithmetic mean of the distribution
standard_dev – The standard deviation of the distribution

Step 5: 

Step 6:

Kindly do understand that this is a theoretical approach and markets are NOT bound to follow then. In practice there are many days where Eicher motors stock was down by more points than what we have derived at. Here we have to consider the Time frame (which is one of our parameter in calculating VaR). So over a period of time T, we are 95% sure that the stock price will not go beyond -468 points (again, this conclusion in completely theoretical and acting on this is sure shot way for disaster)

Also remember VaR calculation is not to understand the risk of downside of a script. Imagine if you have take a Short position on a stock. What if the stock price goes towards North.
Hence in general Risk means not the only downside moment of the stock price. But it should be considered from the perceptive of your current portfolio position.

-END-

The day I met the Prof !!!

Firstly, sorry for long gap from my previous post. It was unintentional and happened because of my hectic project work with my new company.

Now, this post is about my experience of meeting my Guru (Prof. Sanjay Bakshi), To all the readers of this post, their is no need to introduce this legend.

This is how it all happened…

During February 2015, one of my holding Eicher Motors had released a notification saying that its AGM was going to happen on 20th March 2015. The first thought that came to my mind is if I go to Delhi, I may also get an opportunity to meet Bakshi sir. Without second thought I requested Bakshi sir on his FB page. He is very kind enough to accept my request immediately.

Later, all I have done is to just wait for the day.

I bought two books (which are his favourites) Influence and Fooled by Randomness, to get it signed from him.

Finally the day has arrived, I reached Delhi on 19th March morning. I had a pre-booked room. After fresh-up, without any delay I got the Metro from New Delhi Railway station to reach Saket.

Below is his office building (pic taken from Google). I reached the office on time and contacted the security guys, who in turn contacted Value Quest Capital.

Bakshi sir was in a meeting at that time, and I had waited for around 15 minutes in his waiting room.

In the room I just wanted to get as much information as I can get from the room. I have seen 2 news papers Business Standard and Economic Times. The Economist magazine. TV which is currently off and a nice painting on the back side. The ambiance was amazing.

Finally the moment has come. There he was, Bakshi sir. As an instant reaction, I touched his feet out of respect.

He made me comfortable and asked me about my qualification, current Job etc.

And this was my first question to him.

Me) Sir, what are the 3 qualities that made you where you are now ? In other words, what 3 qualities you suggest to a budding investor like me ?

Bakshi sir)

1) Krishna, you have to be extremely passionate, curious to learn. Money will follow later. Always ask WHY, WHY & WHY ? You may not get answer for everything, but that is how
we learn. Learn from people who established great businesses over a period of time. Read MD&A reports of them. For example, read MD&A reports of Sun Pharma. Dilip Sanghvi is a visionary, learn how he envisioned it and achieved it, slowly and steadily, year or year, he created an Empire. Understand how those people made it BIG.

2) You should have Role models. Not just the Good ones, but also the bad ones. You must know how to be and more importantly How NOT to be ?
For example, Nassim Taleb (pointing out to my book, Fooled by Randomness on the table), is a very arrogant guy. You can get the sense from his tweets. But, I like the way he thinks. He is an extreme thinker, I like it and take that from him. Have role models and work, dream to be as them one day. Have multi-disciplinary thinking like Charlie Munger.

3) Be a voracious reader. And switch off that Idiot box (pointing out to the TV in the room). Just watch a cricket match or something once in a while. That’s it. It is of zero use. It takes a life time to write a book and we have to respect it and dedicate enough time for it daily. There are enormous learning in books.
As Mark Twain says, “The man who does not read has no advantage over the man who cannot read.” You must know what to read and what not to. There is not point in reading news paper end to end. Most of it is of irrelevant (at this instance I remembered Nassim Taleb’s Noise vs Signal discussion in my subconscious mind). Clearly differentiate Good reads and bad reads. Buffett reads 500 pages every day. That’s how knowledge builds like a snow ball over a period of time.

Me) Thanks a lot sir, what are the books you suggest for any investor to reach next level in Investment world. I know you always suggest to start from BH annual letters, but apart from that can you suggest some books ?

Bakshi sir) Read all Pat Dorsey, Stephen Penman, Michael E. Porter books. All these are great collections in their respective fields and helps to make you understand deeper in the world of Investing.

Me) Thanks a lot for your encouraging words sir. This will be the most memorable day for me.

Bakshi sir) Its OK. Just one second, I will be back.

(After 2 min…)

I was stunned with his Gift. He bought a signed copy of Berkshire Hathaway Annual letters book (1965-2012), which will cost around Rs 4500/- in India (http://goo.gl/Xn1yVy).

Me) Sir, this is very costly sir.

Bakshi sir) No problem Krishna. I give it usually to my students. All the very best for your future.

Me) Sir, I am not sure how you felt when you received a signed copy of Poor Charlie Almanack from Charlie himself. But this moment is much more than that for me sir.
I am speechless currently by your kindness and encouragement.

With a heart full of Joy, enthusiasm, memories and a strong motivation, I came out of his office.

This small meeting of around 10 minutes had given me immense confidence and enormous encouragement. Thanks again to Bakshi sir for giving me most memorable moments.

Here are the pics, I took with him…

-The END-

Unfolding the Multi-folds. How multibaggers happen ?

Please NOTE: This post is not to discuss”How to create Multibaggers ?”, but to understand how does it happen and how does it unfolds during that time.

Most of the investors who come to stock market have one thing in common. They dream to have a few multibaggers in his/her portfolio. Nothing wrong in that, but the problem comes if he doesn’t know how it works.

The curiosity to understand how few things teaches a lot. And that undying quality of the investor is his strength.

Now lets try to unfold how multi-folds happen.

Their are mainly two types of multibaggers that happen:

1) Steady compounding machines: These companies usually are sector leaders and are compounding machines (read my previous article here). They compound for decades together (due to their inbuilt Longevity nature) and create HUGE wealth for share holders.

Few Examples:

HDFC Bank: It had its IPO in March 1995 and till date it has multiplied 1000 times. If you have few hundred shares of HDFC Bank during its IPO, you will be sitting next to Sanjoy Bhattacharya and Raamdev Agrawal during the investors meets.

Asian Paints: This company came public in 1982 and have give around 2400 times till date (adjusted for splits & bonuses).

ITC: In 1988, the total market cap of the entire company is just 110 crores (meaning, with just 1.1 crore you can buy 1% of this debt free company). Now, the total market cap of the company is 2 Lacs 92 thousand crores (Just imagine about those 1% if you have own, now turned to 2920 crores excluding dividends).

The list never ends.

2) The Newbies, fast runners and turnarounds:

This is the interesting part of the story. Multibaggers that happen in this category create HUGE wealth within short period of time. And most investors look for this category only.

Example:

Hawkins Cookers: A CAGR of 84% in the last 5 years. If someone invested 1Lac in 2009, now he will be sitting a cashpile of about 21 Lacs.

TTK Prestige: Returned a CAGR of close to 90% from 2009. Here 1Lac might have turned into 35 Lacs.

Eicher Motors: CAGR of around 87% in the last 5 years and still running fast.

The list also includes few other gems like Page Industries, Astral Polytec, Titan Industries, Crisil, Mayur Uniquoters, Cera sanitaryware, Kajaria ceramics, La Opala etc.

So, what made these stocks to give those spectacular returns in such a short span of time ?

What is the difference between Category 1 and Category 2 ?

Before answering that, lets understand this:

Their are 2 factors by which the stock prices move upward/downwards, PE and EPS.

EPS gives the earnings of the company per share. In most of the cases these earnings are real (this may not apply for Infra companies, Real estate company, Companies whose management is a crook and some times even for 20th or 25th company is a sector which is in bubble. Example: Penta media soft, DSQ software during 2000)

Now PE is nothing but the sentiment of the investors community (this includes everyone, Trader, Speculator, Bull Operator, Bear Operator, Algorithmic trader, and a dull and boring investor like me).
Technically, PE means “How many rupees you are willing to pay for a single rupee of earnings”. This gives the PE.

For example, Asian paints PE is 54 (or put it in another words, Asian paints is trading at 54 times earnings). This means the investors community is willing to pay 54 rupees for every single rupee that he is going to get from Asian paints on yearly basis.

Below graph shows that how PE moved with respect to its Price for ITC and Shriram transport.

Images source: http://fundooprofessor.wordpress.com/

The unexpected interest of a company among the investors makes the PE to expand in short period of time. First of its kind company in a new sector enjoy this benefit.

1) Bharti Airtel: It was an emerging company in an emerging sector in 2003. Initially people didn’t understand the true potential of the company. Veterans like Raamdev Agrawal, Basant Maheswari had a vision to see the next 5 years of the company and made a killing out of it. During those days, Bharti Airtel used to trade at a single digit PE. In the next 5 years, PE expanded to around 80 times and made it a potential multibagger in just 5 years.

2) Page Industries traded at a PE of 22 in 2008 and it expanded upto 55 times in the span of 6 years and currently trading at around 55 times.

3) TTK Prestige PE expanded from 12 to 40 in 5 years.

Now what do we understand ?

Multibaggers of category 1 happen:

When their is longevity of Earnings. In other words, these companies continue to deliver for years together and their “Earnings” increase with very little movement in “PE” of those stocks. These companies usually take decade or two to multiply 50, 100 times with very less risk to the portfolio.

Asian Paints, HDFC bank, ITC, Nestle etc always traded at premium PE’s because of the trust on its Earnings. (Some exceptions are incidents like 2008 crisis where these companies are available at throw away PE’s)

Multibaggers of category 2 happens mainly because of PE Expansion:

It can happen some where or the other sector in every bull run:

IT in 1997-2000,
Infra in 2003-2007,
Consumer durables 2007-2013,
Semi-Urban and Rural housing (as expecting by many): Currently.

It can even happen on company basis (first time companies in that sector) on both bull and bear periods:

Airtel 2002-2007,
Pantaloons 2002-2008,
Eicher Motors 2009-Till date.

Krisha enough of Gyaan. Show me the NUMBERS !!!

Yes, even I too love numbers. Lets jump into it.

PE Expansion:

Initially, the stock remains unrecognized. Therefore the PE multiple is less then the growth rate. Usually here, even though the company is
growing, market does not believe the growth that the company is experiencing.

Let us assume that a company with a growth of 30% is given a multiple of 10 for an EPS of Rs 10. The market price is Rs 100.

After one year, earnings rise to 13 (10 + 30%). Investors started believing in the company and its earnings. As the stock gains recognition and more coverage it starts getting a higher multiple of say 30 times.
This makes the market price of the company to go to 13*30 = Rs 390/-

See, even though there is no absolute increase in the company’s earnings. Just because the investors have recognized the true potential of its earnings, its price moved up 4 times in just one year.

This is just half of the story !!!

PE Expansion will make you RICH and at the same time PE Contraction will cut off the neck unknowingly.

PE Contraction: 

The heights of Infosys stock price in 2000’s weren’t reached till 2006-2007. The peak of Bharti Airtel (574 in 2007) haven’t met till date and is currently trading at 392 (as of Nov 17th 2014).

Why & How ?

Lets take the same example:

Once the stock has been recognized and the market convinced about the growth rates the PE multiples move ahead of the growth rates.  For instance during the 2000 technology boom Infosys was valued at more than 100 times its earnings since the company was delivering a growth of 100% year after year.

Let us assume that in the example given above the company’s growth rates tapers off to a more realistic 15%.
These changes in growth rates do not happen year on year but still the market responds to this change earlier
then they are out in the public domain because of this the PE multiple of the company will contract

See what made the price to move from 100 to 390 in one year and the same price to move back to 160 in next year.

Many times, the company in category 2 moves to category 1. If it doesn’t then it will be part of a next coming bubble, be prepared.

If you understand this, then next time you can classify why a company price is increasing and on what basis ?

So, tomorrow morning you go to office and check you portfolio as part of your daily routine and see the price movements. If it is NOT an earnings season, make sure you keep a close eye on PE expansion and PE contraction of your stock.

Finally, “PE expansion is like a pinch hitter in the cricket XI it makes a quick fire 40 in 25 balls but expecting it to make another 40 in the next 25 balls is difficult.”

END

Sources:

Theequitydesk.com

Motilal Oswal wealth creation reports

My Best friend named “Emergency Fund” !!!

My own experience:

1) 20 days back, I got a call from home. Summary of that call is to arrange 1 Lac in 2 days.
– Done. Thanks to Emergency fund.

2) 5 days later, an unexpected and unstoppable expense of 60k.
– Done. Again thanks to Emergency fund.

3) Exactly 4 days later, Mother hospitalized (She is Fine now!) because of existing disease which is not covered by my Oriental Family floater.
– Handled it as well. Again thanks to Emergency fund.

Remembering my Investing Gurus !!!

On this occasion of Guru Purnima, I take this opportunity to thank all my Investment Gurus who taught me (and their is lot more yet to learn) and stood like a Light house in my Investment Journey.

In the investment world, some people think it is “cool” to say “I am a Value Investor”. But it is not so cool to follow it. Not at all. Infact it is a mindset that should be incorporated in the life style itself and not only in Investment related decisions.

One person who is the dean of Value Investing is “Ben Graham”.

What should be my first stock ?

Last Sunday, I met a friend and the conversation went some thing like this.

Friend: Krishna, last year when I asked you to suggest one good fund as my First equity mutual fund, you suggested me to go with balance fund and chosen HDFC Prudence. It is performing amazingly well. I am sitting on a return of nearly 29%. Thanks for it.

Me: Welcome. But actually, the major chunk of your credit must go to Modi mania, another major portion to Prasanth Jain’s conviction and only a decimal fraction of it should come to me.

Friend: Now I want to come to direct equities. Can you suggest me one good stock to buy right now ?

Me: NO. Believe me, this is the best suggestion I can give you (at least for now).