Value investor india

March 17, 2009

4 Min read

I recently visited icici and HDFC bank for some personal work and some of the sales folks at these branches went into a sales pitch, pushing their respective unit linked plans. These unit linked plans are a combination of an Insurance policy and mutual funds. The key highlights of these plans are

Highlights
– An annual ‘premium’ payment towards the plan for around 15 years.
– An option to pick from a range of 100% equity to 100% debt plans
– If the primary holder passes away, the nominee get the insurance amount in addition to the accumulated value of the mutual fund component (varies by plan)
– A max total insurance cover of around 12.5 lacs even if the annual premium exceeds 2.5 lacs
– 40% premium charge in year 1, 30% charge in year 2 and 2% thereafter.
– A plethora of other charges some of which are not very clear unless you dig further such as mortality charge, admin charge etc
– A 1.25% fund management charge

Now these sales folks are well intentioned and all that. But frankly my initial feeling was that anything this complicated and convoluted cannot be very good. Lets look at some math

For ex : I invest 2.5 lacs per annum for 15 years in a 100% equity option. So around 1.75lacs are deducted in year 1 and 2 combined and around 5000 rs per annum thereafter. The rest would be invested in a mutual fund of choice.

The insurance component

Lets look at the insurance component first. A pure risk policy (which is what the above is) is currently priced at around 4000-6000 p.a premium for a duration of 15 years. So clearly the insurance component is overpriced.

There is a bumper component which is paid at the end of the policy term which equates 70-80% of the premium. If you look at it in another way, this equals the 70% you pay upfront at the start of the policy.

So in a nutshell, the company is taking 70-80% of the annual premium from you and holding it interest free for 15 years. At an interest rate of around 9% per annum that is 3.6 times your annual premium !!

The 2% annual deduction would get you a similar pure risk policy with all the attendant benefits including tax deductions.

Mutual fund component

Lets look at the mutual funds component – Nothing special here. The company is taking 60% of your premium in yr 1, 70% in year 2 and 90% in yr 3 and onwards and investing it on your behalf for 15 years. At the end of 15 years, you redeem based on the NAV then.

What are the negatives here ?
– For starters my money could be locked for 15 years – a big negative if the performance turns out to be poor.
– The brochures, which I have seen show very average performance for all the concerned funds (most of them, barely beating the index before charges and actually underperforming the index after the fund management fees).
– A plethora of charges I noted earlier, get deducted from the mutual fund component. There is not much clarity in the brochures on the quantum of total charges, but I don’t expect it be less than 1% of the total (maybe more).

Conclusion
A pretty bad investment option. The insurance component is way overpriced !!. The mutual fund component has nothing special in it and has a load of charges attached to it, which will reduce your returns substantially in the long run. I will not be surprised if the banks are getting a hefty commission or good fee from these kind of plans.

My initial feel was that anything this convuluted and complex is a nice way for the bank or AMC to make good money off the fees and leave the investor with poor returns

Recommendations
Buy a low cost pure risk policy for the insurance cover. These policies do not pay anything if you survive ( A happy outcome !! as I have survived) and have a very low premium. For the mutual fund component invest in a low cost index fund or ETF or a decent mutual fund (if you can find one).
Finally, buy something nice for yourself or your spouse/friend with the money you save and send me a gift for saving you this money (just kidding !)

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Letter to shareholders from Warren buffett – Some thoughts

By Rohit Chauhan

In Uncategorized, Warren buffett

March 11, 2009

6 Min read

9 comments

Warren buffett as most of you must be aware is considered as one of the foremost investors. He is the chairman of Berkshire Hathaway and publishes an annual letter to shareholders which is a must read for any aspiring or seasoned value investor. You can access his letters here. The 2008 letters was published more than a week ago and I downloaded it the moment it was posted and read through it immediately (yes I am a complete fan !).

Some thoughts –

The options bet

One of most discussed topic about buffett is the options bet he has taken. The argument goes like this – Buffett has claimed that derivatives are a weapon of financial mass destruction and yet he has gone ahead and invested in the same instruments. He is being irresponsible and has doomed his company by this bet

Those who write the above are highlighting two points of their own ignorance

– Derivatives are dangerous for those who don’t know what they are doing. This is similar to giving a knife in the hands of a child. I don’t think any journalist, no matter how anti – buffett would consider him to be a novice investor. He has clearly spelled out what kind of bet he has taken in the letter and what are the risks associated with these instruments.

Following is the comment by buffett on the same above point in a recent CNBC interview

JOE: Those are derivatives. You don’t like derivatives, but you used them in that case, right?

BUFFETT: I–well, we’ve used derivatives for many, many years. I don’t think derivatives are evil, per se, I think they are dangerous. I’ve always said they’re dangerous. I said they were financial weapons of mass destruction. But uranium is dangerous, and I just went through a nuclear electric plant about two weeks ago. Cars are dangerous.

JOE: Yeah

BUFFETT: But I mean, every American wants to have one. You know, the–a lot of things can be dangerous, but generally we regulate how they’re used. I mean, there was a–there was some guard up there with a machine gun on me, you know, when I was at the nuclear plant the other day. So we use lots of things daily that are dangerous, but we generally pay some attention to how they’re used.

– They are getting confused between the possible and the probable. Let me explain – It is possible I will become a billonaire in the next 10 years and will have a personal jet . The probability of that happening is 0.0000001%. Buffett’s option bet stands to lose 37 billion dollars if the 4 indices on which he has written the puts go to zero. Let me tell you this – If these four main markets go to 0 in the next 10-15 years, money would be least of our worries. I for one be forced to work on a farm or forage for food as the markets as we know would not exist.

When I first read of these puts, my thought process was that these were akin to an insurance contract based on a long term event with the premium paid upfront (similar for CAT insurance written by Berkshire hathaway). Buffett has explained it in a similar manner in detail in the annual report. I would recommend you to read the explaination in detail.

In addition, the option bet is equivalent to taking a long term loan where the interest rate of the loan can vary depending on the final payout.

Drop in profits
Most of headlines are screaming a major drop in profits. Buffett in clear, uncertain language has written that the profits of his company are very lumpy and will vary depending on the sale of investments. In certain years, buffett sells off overvalued investments and those gains are realised in the net profit. In the subsequent years, in absence of any such gain the year on year comparison looks bad (look at page 28 of the annual report and the explainatory note at the bottom)

The company’s operating business had a approximate cash flow of 9 bn. However various write offs and other change has result in a drop in the quarter’s net profit. The bad economy has definitely affected the company, but the results are not as bad as they appear on the face of it.

Mea culpa
Buffett has admitted to two mistakes – his timing on purchasing Conco phillips and two irish banks. I have been reading and following buffett over a decade and have seen his mistakes to be sometime more profitable than most of the successes of other people. In any case, these could be genuine mistakes and could cost Berkshire 1-2 % of their networth in the worst case scenario.

Looking closely
If you look closely at the results and compare across the years, you will see that the insurance subs and utilities are doing well. Float continue to increase at a steady rate with cost of the float being below zero (which is more important than premium growth) . Both these subs which form a major portion of Berkshire’s business have actually done well compared to the overall economic environment.

The other business are doing quite fine considering the horrible economic environment (see pg 61 of the 2008 annual report)

But the price has dropped ?
Yes the price has dropped and the CDS spreads have widened. Do you always believe the market to be right and the price to be aribiter of value ? Well then we are speaking different language. The markets are often but not always right.

Berkshire CDS spreads are at record levels signalling liquidity or credit issues. To validate that, look at the balance sheet of the company and you will find that the company has 25 billion of cash and equivalents (after all the investment which buffett has done last year). Do you really think a company with 11Bn+ operating cash flow and huge cash reserves will go bankrupt ?

Buffett fan ?
You can rightly accuse me of being a Buffett fan. However to that name, please add the names of Seth klarman, Phil fischer, Charlie munger, Marty whitman, Bill miller, eddie lampart, Rakesh jhunjhunwala and Chandrakant sampat.

I am follower of all great value investors and try to use every opportunity to learn from them. I have never blindly followed their picks or tried to imitate any of these investors, but I always try to learn from each one of them, even if they have been wrong a few times.

Let me ask you this – If you wanted to learn how to play cricket or golf or tennis, would you learn it from sachin tendulkar or Tiger woods or Roger federer (if they were ready to teach someone) ? Sure these players make mistakes and lose matches, but does that take away the fact that these players are the one of the greatest sportsmen in their fields?

It is easy for armchair players or armchair investors to critize from the comfort of their seats, especially after the event with a 20/20 hindsight. Majority of the criticism I have read about buffett and the other investors lacks rigrious detail and analysis and is usually along the lines – The stock price has dropped and hence he is doing something wrong !!.

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How we decide

By Rohit Chauhan

In Book review, Uncategorized

March 3, 2009

6 Min read

6 comments

I recently came across a book – How we decide ? This is a book about decision making and how humans make decisions under various circumstances. Although this book is not on some best seller list or by a very well known author, I found the book good and learned quite a bit from it.

Let me list some of my key learning’s from the book

– The rational brain – prefrontal cortex is involved in rational decision making and can evaluate only a limited number of variables and data elements at a time. However our emotional brain, the amygdala and other parts are the hidden supercomputers of the brain. They are able to process more pieces of information and can do so much faster. The reason is evolution. When facing an immediate danger, such as a tiger, the emotional brain had to process the information quickly and cause a fight or flight response. There was no time to sit and think in such a situation.
– The standard model of decision-making has been the rationality based model. Emotions are considered bad for decision making and corrupt our thinking process. That however is not true. Emotions can and do lead us astray, but they are crucial to decision making. The emotional brain and the rational brain are constantly communicating with each other and help us in arriving at our decisions.
– The decision process is a not a smooth process involving the rational brain alone. It is actually an argument where the emotional brain and rational brain go back and forth and based on the situation a final decision is reached.
– The learning process of the brain has a big emotional component. The dopamine system is involved in this process. Whenever we commit a mistake, the dopamine levels drop in the brain and we ‘feel’ bad about it. The emotional centers of the brain encode this memory and use it for later decision making.
– Emotions mislead us several situations. For example, the normal response to price drops in the market is fear and panic. The typical response of most of the investors is to exit the market to avoid the pain and fear. However this is often an incorrect response. A rational and calm response would be to look at the individual stocks and evaluate the expected value at the given price. A decision should then been taken based on this number, than based on emotions.

Some key learning’s for investors (my conclusions)

– Stock market investing is all about decision making under uncertainty. As investors, we can never have complete and full information. Perfect information is a myth. No one can ever know all there is to know about a company, much less an industry or the market.
– A perfectly rational investor is an incorrect model. The above book and several other books I have been reading, point out that the best investors are able to combine rational thinking with their emotions.
– Emotions are formed based on repeated experiences in a particular field. These emotions are referred to by several terms – intuition, gut feel etc. As one develops experience, the learning’s are encoded in the brain as emotions or intuitions. However one should not rely on emotions when starting out as an investor. At that time, one does not have enough experience and the emotions have not developed fully. However as one gains experience, one should learn to trust one’s instincts or at least be mindful of them.

I have personally faced this several times. When analyzing a company, all the numbers will look fine and the company looks undervalued. However some stray facts or a few points will keep troubling me. In most of the instance, where I have ignored such feelings, I have regretted later.

– Smart investing is a mix of rational thinking combined with emotional learning. As one matures as an investor, one should learn to tune in to emotions and gut feel and try to at least understand what they are telling us. You will rarely see investors talk about gut feel or emotions. They are considered too soft or not macho enough!. That is however foolish. The human brain does not work that way. Decision making is a mix of rational thought and emotions. Ignoring emotions means using only a limited power of your brain.
– Novel problems require thinking and should not be based on emotions. When analyzing a new company or business model, do not rely on emotions alone. One should think rationally and assemble all facts before making a decision.
– Embrace uncertainty – It is amazing the level of confidence most people have on their investment. Analysts writing about a company, will provide you projections for the next 3-5 years. Sometimes these projections are not even round numbers (like sales would 1244 crs in FY2010). What crap !. Nothing is absolutely certain in the stock market. There are only varying levels of certainty. To simplify it, I look at low (20-30% probability), medium (around 50%) or high level of probability (around 70-80%) for any specific scenario. In addition, I always believe in developing multiple scenarios when trying to come up with an intrinsic value number. As a result you would have noticed that my estimates are generally in a range and not a fixed number
– Entertain competing hypothesis – One should always be open to counter arguments to one’s investment idea. That allows one to accept contradictory information and weigh it properly. I try to constantly look for points, which go against my investment idea though i am not sure how successful I am at it.
– Finally think about thinking. One should constantly analyze one’s decision making and thinking process. You should be able to look at your thought process objectively and look at ways of improving it ( read this process v/s outcome article by Michael J. Mauboussin ). This blog is my approach of doing it, though in a public fashion. In addition, I always write down my investment thesis when I am looking at an idea and also how I feel about it (though I don’t publish it as they are my private thoughts).

I would strongly recommend you to read this book. It is a very good book and has several crucial points on how the human mind works and how one can improve his or her decision making.

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Bear market to end soon !!!

By Rohit Chauhan

In Uncategorized

February 25, 2009

4 Min read

16 comments

Did I catch you on that ? are you expecting someone would be able to predict that for everyone ?

For the last one year, there has been an army of people trying to predict the end of the bear market. Most of the so called pundits were expecting the global recession to end by Q1’09. Now the predicitions have shifted to Q3’09 or towards the end of the year. The same pundits were predicting oil to touch 200 dollars a barrel. As the saying goes – If I had a penny everytime a bozo made a prediction, I would be rich !

I would suggest you to read N N taleb’s books – Fooled by randomness and The black swan which talks of this bias. All of us have this strong desire to predict and see patterns. It is a strong, innate human tendency which causes most of us to seek predicitions of the future and see patterns where none exist. The problem with markets is that there are often no such patterns and the future can rarely be predicted accurately for a long period of time. Yes, some so called gurus can get one predicition correct, but that does not mean that this person has some special ability to see the future.

If you predict often, you will be correct a few times too. There is considerable research into the accuracy and success rate of such predictions and most of the studies point to less than a 50% success rate. That is worse than a coin toss !!

How to invest without predicting the market ?
So how does one invest, if one cannot predict where the market will be in the future ? I think there is a big mis-understanding that one has to know where the market is going, to be a successful investor.

If you plan to invest in an option which will expire at a fixed time, then you will need to predict how the market will perform during the duration of the option. However if you are able to identify a good company with a sustainable competitive advantage, which is likely to do well over the next few years, then you are likely to get a good return on investment.

As the company does well, the underlying intrinsic value is bound to increase. When this happens, the gap between the price and the value will increase (assuming the price is stagnant ) and the stock will be get progressively more undervalued. In most of the cases (not necessarily all), this undervaluation will create an upward pressure on the stock price. In most of these cases, the gap closes suddenly and the returns are made quickly over a very short interval of time. It is however diffcult to predict when this will happen.

So what happens if the price takes longer to recover ? Well, if the intrsinc value is increasing, then you have an opportunity to increase your holding as the gap keeps getting larger and the returns should be better when the gap finally closes.

So why does’nt everyone do it ?
For one, it is painful to watch your stock stagnate over long periods of time. If you look at price to validate your decision, then a stagnant price only increases your self doubt and anxiety. Most investors are not wired to ignore the price and focus on the intrinsic value. That also explains why it is diffcult to practise value investing.

Where do we go from here ?
For starters, stop trying to figure when the bear market will turn. If your imvestments are based on the market turning soon, you could be in for a lot of dissapointment if that does not happen.

I personally watch CNBC, read the news and listen to all possible predicitions from all and sundry, but only for entertainment. Whenever some tries to give me an elaborate reason on when the market will turn or the recession will end, I have a single thought in mind – ‘How the hell do you know ?

What am I doing ?
I am reviewing my current holdings. The Q3 results have been announced for most of my holdings and I am in the process of analysing the same.

In addition I am focussing on learning about behavioral finance and biases. I would be updating my templates based on my learnings and would be re-analysing my holdings again. It is quite possible I may discover that I should exit some holding and some bias is holding me back. I will be posting such analysis when I come to such a conclusion.

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Why unit linked plans are a bad idea ?

Letter to shareholders from Warren buffett – Some thoughts

How we decide

Bear market to end soon !!!

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