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Tuesday 16 January 2018

Portfolio Sizing - Prof Bakshi's pointers on having a good process

I was going through my notes of a discussion I had with Prof Bakshi (you can reach the goldmine of investment writing here) on portfolio sizing - a topic which I think has been very less explored in financial writing and books.

Here are some of the pointers he had said. Re-reading them again reinforces the right way to think about this topic.

1. Learn what NOT to do. For example, Kelly Formula, which is widely used in betting systems is not a reliable mechanism in investing. Because you cannot predict definitive probabilities in the market, and hence cannot know the computable odds of winning or losing.

2. It is reasonable to start with similar weights, but one can think of allocating higher to higher conviction bets. 

3. Portfolio sizing depends on investment style. If you follow Munger, Phil Fisher then a concentrated approach is possible. Read Phil Fisher's chapter on when to sell

4. Regret analysis - understand how much you will regret if the worst case scenario plays out in the stock with high allocation. Do you have the wherewithal to withstand a major catastrophe in the stock? Determine your sleeping level.

5. Think across disciplines (horizontally) on what can be the risks of stocks in your portfolio. There may be a portfolio level concentration of a single factor which if plays out can mean a lot of problems. e.g. if you have stocks in different sectors but with a common factor of market/ factory in Maharashtra and the state has a major earthquake. Diversify thoughtfully.

6. Read "Principles of Underwriting" by Warren Buffett which is for insurance underwriting but is equally useful to think about portfolio sizing.
The 3 points that Buffett has wrtitten as principles of underwriting in his 2001 investor letter
1) They accept only those risks that they are able to properly evaluate (staying within their circle of competence) and that, after they have evaluated all relevant factors including remote loss scenarios, carry the expectancy of profit. These insurers ignore market-share considerations and are sanguine about losing business to competitors that are offering foolish prices or policy conditions.

2) They limit the business they accept in a manner that guarantees they will suffer no aggregation of losses from a single event or from related events that will threaten their solvency. They ceaselessly search for possible correlation among seemingly-unrelated risks.

3) They avoid business involving moral risk: No matter what the rate, trying to write good contracts with bad people doesn't work. While most policyholders and clients are honorable and ethical, doing business with the few exceptions is usually expensive, sometimes extraordinarily so.
My take from an investment perspective on these 3 points are:
Point 1 - First consideration is risk management. It is alright to let go of phenomenal returns (in a roaring bull market) by keeping away from buying stocks just because others are doing so.

Point 2 - Prof Bakshi's point 5. Diversify so that one event does not have cascading and catastrophic impact on your portfolio.

Point 3 - Don't bet on companies with bad managements. It does not pay in the long run.

Thursday 28 December 2017

2017: Year in Review

2017 was an interesting year, both for the markets and for the world. India saw a major tax reform in the rollout of GST. Along with last year’s demonetization, it resulted in a definite slowdown in business performance, where companies took time to adjust themselves to the new way of doing business. Globally, tensions rode high with North Korea and US presidents taking potshots at one another.

Bitcoin became the rage this year. At the time of writing this, it has already risen more than 15 times. A lot of my friends have asked me about how to invest in them in the last one month, which gives me an impression (and I could be very wrong) that we are staring at a classical bubble. Most of the signs of a bubble are visible in the way the cryptocurrencies are trading today. The fall may not come immediately, but the story is unlikely to end well for those who are coming to the party late.
In India, Sensex has gone up about 25% over the year.

2017 was fairly challenging in identifying good companies which were available at reasonable valuations. Across global markets, valuations have been fairly high throughout the year.

As an investor, I focus on generating absolute returns with a usual time-frame of 2-3 years for an investment to work out. I try to identify businesses with good management and reasonable growth that can compound well over time. Along with that I also focus my energies on identifying turnaround sectors and companies – those where things are getting from worst to bad or from bad to good.

The focus for 2018 remains the same. I continue to look for good, well-managed, undervalued mid and small cap stocks which have a promise of above-average returns.

I am a firm believer in wealth creation through equities over the long term and I think we in India are in the midst of a multi-year bull market. Some of the reasons why I think we are in a major bull market are:

i) Global liquidity: Globally, some $9 trillion of global government debt still trades at negative rates. Investors are desperate to find avenues where they can get a positive return.

ii) Domestic participation: Participation in equity through mutual fund SIPs has gone up consistently. Just a look at the numbers shows that SIPs in the full year FY16-17 was Rs 43,921 crores and in 8-months of Apr-Nov Fy17-18 is already Rs 40,780 crores! Monthly SIPs are closing in on Rs 6,000 crores per month.

iii)TINA (There Is No Alternative): With low interest rates, real estate market in dumps after demonetization and gold prices also stagnant, common Indians are flocking to the equity markets through the SIP route.

iv) Growth: India is already more than a $2 trillion economy and GDP is growing at 6-8%. This means in the next 8-10 years India will double its economy size. Just think about the implications of it. We will be adding as much to the economy in the next 8-10 years, as we currently have! The per capita income will correspondingly double as well, bringing millions (if not billions) of people out of poverty into the consuming class.

It is not as if everything is rosy. Indian demography is both its advantage and its weak point. If as a country we are unable to provide jobs or livelihoods to the millions of young people, then we are most likely going to see increased social tensions. They may come up in different forms and may not be directly attributable to economic challenges, but the root cause will most likely point to that.

Short-term government policy, taxation rules can be risky and create uncertainties for businesses and the markets as we have seen with both the demonetization and GST exercises. Global macro factors can also result in changes in market dynamics in the short-to-medium term.

Overall, the future for Indian equities looks to be bright over the long term. Like every year, 2018 will bring with it its own set of challenges. There is no way to predict how the year will pan out. The only thing for sure is that it will be volatile.

May we live in interesting times.

Here is wishing all a very happy and prosperous New Year.

Friday 8 December 2017

Weekly Reading: Some interesting stuff

A Q&A with arguably India's best banker today - Uday Kotak

Why professionals will beat amateurs in the future

Lou Simpson, former chief investment officer for Geico discusses his portfolio strategy

A logical future is for blockchain based currency issued by central banks in lieu of paper currency

Focus in the answer to superior results. And a Not-To-Do-List!

A sneak peak into the famous and controversial Paul Singer and his hedge fund Elliot Management. The article also covers how they took on Samsung and how at times their practices can border on the boundaries of ethics.

Tuesday 21 November 2017

Wednesday 15 November 2017

A Few Lessons From Sherlock Holmes - Peter Bevelin

Since I read Peter Bevelin's Seeking Wisdom, I have wanted to read his other books. So, I managed to get through his "A Few Lessons From Sherlock Holmes" recently. To be honest, I was a bit disappointed. The book seemed, to me, to be a collection of quotes from Sherlock Holmes books collated thematically. Though Seeking Wisdom was also on similar lines, that is, someone who had read all of Munger's writings and speeches would actually find it very repetitive, it had a structure to it. Also, Seeking Wisdom can be read without knowing anything about Munger, which is not really the case in this instance.

I had highlighted some quotes from the book. I am putting them here. Hope this is beneficial for those who have not read the book to get an idea of what it is about.

What distinguishes Holmes from most mortals is that he knows where to look and what questions to ask. He pays attention to the important things and he knows where to find them.

To know what to do and not do, we first need some genuine understanding on how reality is - how things and people are and what works and not

Considering many ideas over a wide range of disciplines give us perspective and help us consider the big picture or many aspects of an issue

But only what is useful - it can be dangerous to know too much

He said that he would acquire no knowledge which did not bear upon his object. Therefore all the knowledge which he possessed was such as would be useful to him.

It is useful to know something about human nature and what motivates people

Ask: What is in their interest to do?

But knowledge doesn’t automatically make us wise - the most learned are not the wisest

What is the problem? What do we ultimately want to achieve or avoid? That is the problem which we have to solve.

“The greatest sign of an ill-regulated mind is to believe things because you wish them to be so.” (Louis Pasteur)

Never jump to conclusions and try to collect facts as open-minded as possible

“Men see a little, presume a good deal, and so jump to the conclusion.”

It is a capital mistake to theorize before one has data. Insensibly one begins to twist facts to suit theories, instead of theories to suit facts.

Don’t be too quick Let us know a little more before we act.

And don’t blindly collect endless amounts of facts

One forms provisional theories and waits for time or fuller knowledge to explore them.

Data! Data! Data!...I can’t make bricks without clay.

Make sure “facts” are facts - Is it really so? Is this really true? Did this really happen?

We must look for consistency. Where there is a want of it we must suspect deception.

Don’t miss the forest for the trees - It is not the amount of information that counts but the relevant one.

Separate the relevant and important facts from the unimportant or accidental

The first thing was to look at the facts and separate what was certain from what was conjecture.

It is of the highest importance in the art of detection to be able to recognize out of a number of facts which are incidental and which are vital. Otherwise your energy and attention must be dissipated instead of being concentrated.

There may be many theories that fit the facts

Sometimes it helps to shift perspective

Never trust to general impressions, my boy, but concentrate yourself upon details.

What have we overlooked?

Sometimes we overlook that which is most obvious

In searching for the obscure, do not overlook the obvious.

Use the simplest means first

Sometimes things are not as simple as they seem. But sometimes they are not as complex as they seem, either

But don’t try to over-simplify complex matters - especially when we deal with systems with complicated interactions

What normally happens in similar situations? Why should this be any different?

Analogies - What does this case resemble? What is the same between this situation and others?

Negative evidence and events that don’t happen, matter when something implies they should be present or happen

What doesn’t matter? What can’t happen? What can’t it be? What can’t be done?

Test Our Theory- if it disagrees with the facts it is wrong

Facts don’t lie but we may have interpreted or stated them wrong and therefore drawn the wrong conclusion

Patience - Take time to think things over

And avoid distractions and concentrate on the problem

Put yourself in the other person’s shoes

Get a different view - talk it over with someone else

Don’t make the world fit your tools and use the right tool for the job

Watch out for overconfidence

Update our beliefs in light of new information

Criticize ourselves - Have we tried to find evidence against what we believe? Why might we be wrong? What have we overlooked? What (new) information or evidence is needed to make us change our mind?

When we get better understanding or the facts or evidence don’t agree with the theory we must change the theory and change course

Learn from your mistakes - and learn the general lessons

To learn we must face the mistakes and try to find out why we made them. Then comes our gain.

Know our limitations

Don’t think about how to get things done, instead ask whether they’re worth doing in the first place

Avoid danger - we shouldn’t expect to survive when we enter tough seas

We shouldn’t disregard even a small probability

The future is hard to predict