Thought provoking for entrepreneur

Vinod Khosla's Co-founder of sun micro system thought on entrepreneur at MIT

http://www.youtube.com/watch?v=YxYVOMj6F2U&feature=youtube_gdata_player

Value Investing and Investment Psychology - By Mahesh Hamne: Thinking About Thinking

Value Investing and Investment Psychology - By Mahesh Hamne: Thinking About Thinking

Risk V/S Uncerainty

In our day-to-day language, and even in finance, people tend to use the terms risk and uncertainty interchangeably. But in the 1920s economist Frank Knight made a distinction that I find quite useful. He argued that risk describes a system where we don’t know the outcome, but we do know what the underlying probability distribution of outcomes looks like. So think of a roulette wheel—when the croupier spins the wheel, you don’t know where the ball will land, but you do know all the possibilities and their associated probabilities. Risk also incorporates the notion of harm—that is, you can lose.

In contrast, uncertainty reflects a situation where you don’t know the outcome, but you also don’t know what the distribution of the underlying systems looks like.  Uncertainty also doesn’t necessarily imply harm, although it often does. So it’s not hard to see that most systems we deal with in the real world are really uncertain, not risky. Uncertainty better describes issues like terrorism or the avian flu, or even markets. Here’s why I’m stressing this distinction: we can model risk using probability calculus. In fact, the statistics of risk are relatively straightforward. In contrast, we can’t model uncertainty easily. And real trouble arises when we model uncertain systems using the mathematical tools of risk. Yet this is precisely what many people do in financial markets and in other domains as well. We’ll come back to this issue of risk or uncertainty quantification in a moment.

Psychologists have demonstrated that  events that are not vivid in our minds get assigned very low probabilities—much lower than the facts warrantI suspect for us to mobilize, as a society, to address risks like global warming or energy constraints we will need one or more 9/11-type events—a tragic incident that reveals what’s really going on.

To summarise, we humans are still not very good at dealing with risk or uncertainty. We are still linear thinkers, we have a nearly-insatiable need to link cause and effect, and we assess probabilities poorly.  However, we do now better understand some of the mechanisms that underlie complex systems, and that  knowledge can be very helpful in preparation for future catastrophic events.

Being Value Investor means

• Under 5% of all assets are run under value investors, a real minority in the investment world.

• The stock market is created for the other 95% of people, that is where your opportunity and challenge is..
• Biggest challenge: understand whether you are the 5% or the 95%
• It is tempting to do what the other 95% of people do. Emotionally very difficult to be in the 5%, but value investors typically have better returns. The money is really for traders and they tend to amass more assets.
• 5% have a spectacular return, but 95% of money probably always resides to somewhere else.
• Understand who you are. You will be tested. You will have to ask yourself whether you are or aren’t a value investor.
• If you are a value investor, you are probably genetically mutated and comfortable being in the minority. This is unnatural to human beings. You have to be comfortable being by yourself. You have to adopt the idea that you are right because your reason and evidence, not because others agree with you.
• You will probably spend most of your time being an academic researcher rather than a professional. You are a researcher or journalist, with insatiable curiosity. You are trying to figure out how everything works.
The more you know, the better you are as an investor.
• Politics, science, technology, literature, poetry, everything can affect businesses and help you.
• Occasionally you can find insights that will give you tremendous insights that other people don’t have.
• Then you find if the business is cheap. Is the management good? What else? Why is the opportunity there?

To summarize value investing not natural habit, most often you will alone/in minority, so your rational thinking is only the only friend in the process.
To fight and succeed against the majority you need to have edge that comes from patience , patience and patience and independent rational thinking and  virocious reading.

Smart Investors traits

What sets the smartest investors apart from the rest? More often than not it comes down to consistently superior decision making in ‘uncertain’ conditions.

Any effort in coping with uncertainty must define, recognise and understand its different dimensions. McKinsey & Co. have developed a four-level format to identify the spectrum of possibilities.

At Stage 1, the future is relatively clear and dealing effectively with a single uncertain variable is adequate.

Stage 2 needs the ability to cope with several different views of the future but the alternatives are limited, discrete and fairly easily defined.

 Stage 3 is where the level of uncertainty is complicated by the fact that a large number of dynamic interrelated variables come into play.

 Finally, Stage 4 is about a truly ambiguous environment that requires constant learning and great agility, as investors can never adequately anticipate enough of the future in advance.

While dealing with a Stage 1 situation, it is vital to make an accurate assessment of just how much you really know. Once you get to terms with the limits of what’s known, the best way forward is to estimate a range for the unknown outcome and identify the level of confidence one has with the given range as opposed to the false comfort of a single-point forecast. The knowledge that there is a 75 percent chance of Sensex EPS in FY12 being in a range of 1,170-1,280, is far more useful than a number such as 1,240 which has a 10 percent chance of being right.

Stage 2 demands that one generates multiple views of the future by recognising the inherent uncertainty rather than seek a single ‘most certain’ outcome. The time tested technique of ‘pro versus con’ reasoning is effective since it typically leads to a balanced view. Equally interesting is ‘back to the future’ reasoning. In effect, you need to harness your ability to explain events in hindsight to enhance your skill in anticipating what lies ahead — or oxymorons being permitted, prospective hindsight. The impact of such intellectual time travel is usually greatest in coping with decisions involving large stakes!

Stage 3 events are difficult to tackle given the incredible complexity at work. Scenario planning — a disciplined method for envisioning a range of plausible future outcomes — is by far the most widely used analytical technique. It is a mistaken belief that more information will always lead to better decisions. In fact, additional information inputs are of value only to the extent that they help to ‘see’ the jigsaw with greater clarity. Beware of the genuine risk that increased information will lead to a misplaced rise in confidence with no corresponding impact on the accuracy of the decision.

So where does that leave us given the nuclear fallout possible in Japan, the turmoil in the Middle East, the debt mess in Europe,  a raw material related margin squeeze about to hit corporate profit margins, high domestic inflation .

Maybe Samuel Butler had a profound take on investing when saying: “Life is the art of drawing sufficient conclusions from insufficient premises”.

Value Investors and different types Risks

Risk management is the essence of a value investing approach. Creating a margin of safety at each stage is really nothing but a form of protection against errors of judgment and bad luck

My  belief in behavioural economics and the importance of “fundamentals”, risk seems to be probably the most misunderstood concept in modern finance. Clearly, risk is not defined numerically by measuring the standard deviation of historic returns. Rather, it is a concept that helps an investor to focus on the factors that might lead to “a permanent loss of capital”.

The Dean of value investing, Benjamin Graham, identified three primary sources of danger: Valuation risk, business risk and balance sheet/financial risk.

Valuation risk- Most of us know that the stock-market performance of a company is driven more by changes in expectations rather than actual corporate results. This is further compounded by the basic math that determines investment results: If you suffer a 50 percent decline, you must double the current value to just get back to where you started out from.

The second source of danger — business risk — is really to assess the lasting damage that can be caused to earning power as a result of negative changes in the environment. Quite often we assume that current margins can be extrapolated indefinitely into the future rather than contemplate the prospect of mean reversion caused by cyclicality and a deterioration in the business outlook. Indian IT services companies find themselves at an important turn in the road — greater long-term strength for the rupee, an inability to move up the value chain, increasing competition as well as a more hostile political environment in the US. The habit of comparing current earning power to long-term averages can help you keep out of trouble — at least one will receive early warning signs of a “value trap”.

The final element of this unholy trinity is balance sheet risk. In essence, this translates into a compulsive focus on cash flow. Rising debtors or inventories, relentless capital expenditure leading to greater financial leverage or constant equity dilution, declining operating efficiency, an inability to improve or maintain productivity, eccentric capital allocation, all lead to fragile cash flows and deteriorating financial health.

Interestingly, investors are pre-occupied with “reported earnings” and growth at the height of booms, oblivious to the seeds of destruction being sowed for the long haul!

Over-reaction and investment decisions

The  majority of investors tend to formulate investment strategy by naively extrapolating recent trends. Second, they tend to be overconfident in their ability to predict the immediate future accurately. Finally, their confidence intervals are skewed, which means their best guesses are not evenly spaced between their high and low estimates. Why does this happen? In effect, individuals are most influenced or tend to ‘anchor’ their predictions on just how salient they believe recent history is. Nobel Prize winner Daniel Kahneman suggested that we tend to judge the probability of an event by the ease with which we can call it to mind. The more vivid our memory of something similar in the past, the more probable it will seem to happen again. Remember 2008 — AIG, Lehman Brothers, Bear Stearns.

Paul Slovic, psychologist has an explanation that is based on our intuitive sense of risk being driven by two factors — dread and knowability. His conclusion: These two factors ‘infuse risk with feelings’. Dread is really a function of how dramatic, controllable or potentially catastrophic a risk appears to be. The knowability of a risk depends on how immediate, specific or certain the consequences appear to be.

Therefore, our perceptions are distorted such that we underestimate the probability and severity of common risks such as inflation. On the flip side, less comprehensible risks that we have never personally experienced seem potentially lethal. As Jason Zweig put it, “We see the world through warped binoculars that not only magnify whatever is remote, but shrink whatever is near.” So, blinking in the face of risk might well be natural, yet the over-reaction is incredibly dangerous in arriving at investment decisions.
 
The financial media seems to revel in highlighting the current woes of the stock market with laser-like precision — the interminably long list of new 52 week lows, faltering corporate earnings, the soaring price of gold and the incredibly muddled response of policymakers around the globe. So, does financial holocaust beckon just round the corner or are there signs that the deathly pall of gloom might lift within the next two or three quarters?

Your Money and Your Brain

•  our investing brains often drive us to do things that make no logical sense—but make perfect emotional sense. That does not make us irrational. It makes us human. Our brains were originally designed to get more of whatever would improve our odds of survival and to avoid whatever would worsen the odds. Emotional circuits deep in our brains make us instinctively crave whatever feels likely to be rewarding—and shun whatever seems liable to be risky.

•  To counteract these impulses from cells that originally developed tens of millions of years ago, your brain has only a thin veneer of relatively modern, analytical circuits that are often no match for the blunt emotional power of the most ancient parts of your mind. That's why knowing the right answer, and doing the right thing, are very different.

•      "Financial decision-making is not necessarily about money It's also about intangible motives like avoiding regret or achieving pride." Investing requires you to make decisions using data from the past and hunches in the present about risks and rewards you will harvest in the future—filling you with feelings like hope, greed, cockiness, surprise, fear, panic, regret, and happiness

•   There are three kinds of investors: those who think they are geniuses, those who think they are idiots, and those who aren't sure. As a general rule, the ones who aren't sure are the only ones who are right.

•   Monetary loss or gain is not just a financial or psychological outcome, but a biological change that has profound physical effects on the brain and body. Financial losses are processed in the same areas of the brain that respond to mortal danger.

•     expecting both good and bad events is often more intense than experiencing them.

•   our intuitions can often mislead us, he fails to emphasize that our intuitions about our intuitions can be misleading. Among the most painful of the stock market's many ironies is this: One of the clearest signals that you are wrong about an investment is having a hunch that you're right about it. Often, the more convinced you are that your hunch will pay off big, the more money you are likely to lose.

·                      The best financial decisions draw on the dual strengths of your investing brain: intuition  
             and analysis,   feeling and thinking

 Your investing brain the reflexive (or intuitive) system and the reflective (or analytical) system.

The reflexive system: 

• (which some researchers call System 1) gets "first crack at making most judgments and decisions,".   We  count on our intuition to make initial sense of the world around us—and we tap into our analytical   system only when intuition can't figure something out., "We run mostly on System 1 software."our brains can't possibly keep up with everything that's happening in our environment. Whenyou are at rest, your brain—which accounts for roughly 2% of the typical person's body weight—consumes 20% of the oxygen you take in and the calories you burn. Because your brain operates at such a high "fixed cost," you need to ignore most of what is happening around you. The vast majority of it isn't meaningful, and if you had to pay separate, equal, and continual attention to everything, information overload would fry your brain in short order. "Thinking wears you out,".  "So the reflective system tends not to want to do anything unless it has to."  
  
  Therefore, our intuition acts as the first filter of experience, an instantaneous screen that enables us to conserve our vital mental energy for the things that are most likely to matter. Because of its phenomenal skill in recognizing similarities, the reflexive system sounds an instant alarm when it detects a difference.

Reflexive system is so fixated on change that it makes it hard for you to focus on what remains constant.( your reflexive system will prompt you into paying more attention to a single stock rising like a rocket or sinking like a stone than the much more important (but less vivid) change in the overall value of your portfolio)

The reflexive system this way: "It's kind of like a guard dog. It makes rapid but sort of sloppy decisions. It will always attack the burglar,but sometimes it might attack the postman,
too."

The Reflective Brain 

The reflective system may rely on what they call "tree-search" processing.
   
In the financial markets, people who rely blindly on their reflective systems often end up losing the forest for the trees—and their shirts as well.  There's always something to measure on Wall Street, which spews out a torrent of statistics on everything under the sun 

If the reflective system can't readily find a solution, the reflexive brain will resume control, using sensory and emotional cues as shortcuts. 

you need only to understand that the most reliable way of determining whether something is true is to try proving that it is false.

6 lessons from Warren Buffet on investments

Invest in quality business and not stock symbols

Let me ask you how far do you analyze the business you invest in? Well most of the investors don't. They simply follow the symbols or brands of successful corporate houses. If you plan on investing in IPOs, you need to do a complete research about the concerned company, its past performance, how the IPO money will be utilized, details about the company management, and when the operations will commence so that company starts generating profits. Before buying stocks the stocks of a company find out what kind of products they sell, how consistent they are in the sales, how do they survive the competition from their investors.

Scan through the stocks

It is common to see investors investing in the stock that has a great demand. But what differentiates a smart investor from the rest is when you identify which stock are available at a low and reasonable price and which has a great potential to grow in the years to come. Carefully analyze the company and its business.

Maintain the right temperament

Stock values keep fluctuating. Don't dwell on the price of stocks. Instead, study the underlying business, its earnings capacity and its future. If other investors panic when the value of the stock drops you have to maintain the right temperament that will help you get out of that situation. Remember staying invested in a value company will pay you rich rewards over a long-term period. This will help you succeed in the market.

Know how the company uses the money

The success of any business depends on how well its management uses its capital. You can make this analysis on two factors Return on Equity (ROE) and Return on Capital Employed (ROCE). Interpret the company's financial statements and understand the quality of return on his investment. Invest in companies with good returns on capital invested.
Make your own investment decision

It is your money that you plan to invest and you know needs well. So when you to invest in stock don't listen to brokers or analyst. They could probably be selling it to you. Make your own decision. Become a value investor. Don't invest in stocks that are recommended by stock analysts/editors on popular television channels. You should perform your own research then make vital investment decisions. Be a conscious investor.

Sell loss-making stocks during a bull run

The best practice of warren is to sell loss-making stocks during a bull run and buy the winner stocks during a bear hug. The amount you get after selling the stocks could be used to buy stocks with future growth potential and there by achieving better returns.

The Seven Immutable Laws of Investing

James Montier of GMO, LLC recently penned a piece titled “The Seven Immutable Laws of Investing.”  These “laws” are certainly not new to adherents of value investing.  However, I believe we need to constantly reinforce these laws, especially since they are often inconsistent with our natural tendencies.

So, now, for the moment of truth, I present a set of principles that together form what I call The Seven Immutable Laws of Investing.

1.  Always insist on a margin of safety

2.  This time is never different

3.  Be patient and wait for the fat pitch

4.  Be contrarian

5.  Risk is the permanent loss of capital, never a number

6.  Be leery of leverage

7.  Never invest in something you don’t understand

MANAGEMENT FAIR OR FOUL

· Promoters who keep diluting equity. In Corporate finance studies the cost of equity capital is taken to be higher then that of debt. It therefore makes sense for companies to take on debt for further growth and be very conservative with equity dilution.

· Promoters who issue warrants to themselves at substantial discounts to market price.

· Check whether the company sticks to its guidance. Mastek and Polaris are two Indian software companies that have often deviated from what they promise. While Mastek and Infosys were incorporated at around the same time the latter trades at a market cap of more then 100 times the former.

· Whether the stock price moves just about a fortnight before the unexpected news (e.g. acquisition, hefty dividend etc). Investors will have to distinguish between what is known asmosaic theory. This theory assumes that the analyst committee can forecast some of the corporate actions. Stock specific news that hit the market after the stock has been ramped up is a bad sign indicating that the insiders knew of this development. E Serve and Digital Software were up quite a bit before the company came out with their open offers.

· Companies that buy back their own shares only to reissue them later at huge premiums areagain playing foul on small investors. Bharti Airtel did this but investors have benefitted since then. there is nothing easy in this business!

· Companies that buy back their own shares are always a great bet on the bourses

· Companies having good managements have a large dividend pay out ratio.

· Decline or rise in promoter holdings. After the 2000 tech debacle the promoter holdings in companies like DSQ Software and Himachal Futuristic saw a continous decline.

· A very high Tax Payout Ratio is a signal that earnings are for real and the management genuine.

· A very large Institutional Ownership means that the company is well researched and prima facie management concerns are not there. But companies that have large institutional ownership do not generate above market returns.

· The CEO position. Whether it is within the family or outside?

· Educational Qualifications of the top Brass. It has been my personal observation that companies that are headed by graduates from IIM and IIT perform very well. They also follow a very high level of Corporate Governance. Alternatively Companies headed by Accounting professionalsare unable to perform that well.