The threshold to meet

If the new thing you are considering purchasing is not better than what you already know is available then it hasn’t met your threshold. This screens out ninety nine percent of what you see.

- Charles Munger

The above quote is not only applicable for new stock additions to your portfolio, but also to any goods you want to buy or find it as an attractive replacement to what you already know. If I go to a departmental store and see a new brand of biscuits; attractively priced than the one I regularly buy, I would look at two things first. 1) Whether the biscuit is from a reputed manufacturer, 2) What are the ingredients and is it comparable to my regular brand.

The first question answers whether I can trust the new product (to what extent determines my trust with each company and its various products I have tried so far) and spend the money even though it is bargain. The second question makes sure whether I can quickly decide how much value I am deriving by making an apple to apple comparison with the product I am familiar with.

When I bought the new biscuit, my mind would say it is a bargain. But in true fact, it will become a bargain only after I taste it (at least few times; I always find it difficult to form an opinion on the first instance, whether it is biscuit or a shampoo). If the taste of the new product is equivalent or better than my regular brand, then only I can truly say the product is bargain. Otherwise, my purchase is 100% waste as it can't replicate the satisfaction I derive from my regular brand.

But there are various other factors also on play when we make a decision to buy a product. But keeping aside those factors, thinking along the lines of the above two questions helps me to come to a quick conclusion.

People can form their own filters which work for them based on their personality. These filters should help everyone in a long way to avoid petty expenses, which tend to have a big impact when repeated over a long period of time.

Bargain

At the company where I work, I had an interesting observation among my colleagues over the last two weeks.

One of our East Asian Country affiliate had some excess stock to clear. The regional management decided to buy the distress inventory and then sell it among the regional staff as well as their family, friends and other vendors who are interested to buy the products at nearly 60% discount to market price. This in a way helps the affiliate to write off the inventory and recover some cash.

Over several days, the marketing department fixed prices for the products based on the production cost and almost all the regional staff members were able to grab bargains. The happy faces could not betray their glee in their mind.

Subsequently the floor was opened to family members and friends. The marketing team which was constantly assessing the stock movement offered bargains for the marginal stocks to clear the space. Those who bought the same products found out the reduced prices and started regretting that they could have waited longer to get these products at 50% lesser prices than what they bought earlier.

At the end of the exercise, several off them felt, they could have got a better price, had they waited for the offers which came in at surprising frequencies. While many of them were happy they could get products at a much lower price, those who could not buy it at the further discounted price were much more unhappy and regretful.

The behavior was exactly the same exhibited by the stock investors in a falling market. Buyers who bought the stocks at a price they see value, start regretting when the stock moves southwards. If they are correct in their valuation methodology, they should be happy to buy the same stock at a much lower price and instead, they start to regret their early entry. At times, they build courage and invest further at each drop. But sometimes the market surprises them buy going down again and again, the churn in their stomach overwhelms their mind. Investors, who are confident of their investment decisions and lack further buying power, hold on to their investments, regretting their lack of fire power at an opportune time. Another group would stop looking at the stock prices, unable to tolerate the loss day-in-and-out, but will hold on to their stocks. The third group which follows the "stop-loss" theory would start to sell the stock, thus doing exactly the opposite of buy-low and sell-high they wanted to do at the beginning.

There would be several other set of behaviors investors could exhibit. But let us see what we can learn from the three groups highlighted above.

1. The first group is confident of their valuation of the company as well as the future prospects of the company and gleeful to utilise the opportunity provided by Mr. Market to increase their stakes based on their capacity. This group would be happy to look back few years later how wonderful their decision is if their judgments are correct.

2. If you had exhibited the attitude of the second group, you are not far away to join the first group. Few cycles of market downturns would increase your confidence level. These investors would have much more confidence down the line when they see that their investments done five or ten years back are still positive even after a substantial market correction, would increase their holding in the said companies confident off their future.

3. The third group helps the other two groups to buy the stocks at bargain prices. So we need this group without which the other groups can't exist. Looking at the skill set of so many investors around you, there would be so many falling in this category. If you happen to be in this group, improve your knowledge about the markets and upgrade yourself. But if the task is difficult, sell your stock holdings and invest in index or ETF's on a regular basis and concentrate on your regular job.

Efficient Markets

Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day.

- Warren Buffett

Benjamin Graham has said that market is a voting machine over a short term period, and over a longer period it is weighing machine truly reflecting the strength of the company. Thus markets are efficient to truly judge the best from the worst.

But the efficient market theory has wrongly concluded a long term efficient market is also efficient in the short term.

This can be seen from the following example. During the height of the recent financial crisis, when the stock holders were assumed that all the financial sector companies were same as Lehman Brothers or Bear Stearns. This lead to the conclusion that none of the financial sectors are worth to hold and dumped the shares in droves. The result is a highly respected company like HDFC was quoting below 1300. Once the fear has subsided, the same market has re-priced HDFC at a price above 2500.

For a true "investor", market provides the opportunity to buy companies at great price and sleep well during every night.

You're never going to be right nine times out of ten.

In this business (investing) if you're good, you're right six times out of ten. You're never going to be right nine times out of ten.

- Peter Lynch

In investing, always mistakes are going to happen. This happens because there are always some variables as the investor is looking for the future which is always uncertain and there could be surprises and mistakes which the investor may have not factored in. As the objective is to minimise the mistakes and maximise the profits, doing the proper spade work before investing delivers the results.

How and when to invest

If you took our top fifteen decisions out, we'd have a pretty average record. It wasn't hyperactivity, but a hell of a lot of patience. You stuck to your principles and when opportunities came along, you pounced on them with vigor.

- Charlie Munger

Munger is referring to the python game, with the principles in mind. Patience is the virtue of the value investor. Once you have the game plan, wait for the opportunities to come by, which will happen when the Mr.Market is in a bad mood. In between relax and enjoy the dividends and read the newspapers to keep you up-to-date with the happenings around.

Think instead of calculating

People calculate too much and think too little.

- Charles Munger

Munger was 100% correct in his wordings. When looking for investing in a company, it is better to look at the business and how it functions and how the management is running the business. While the financial metrics do matter, these metrics are secondary as a result of the business functioning. To be a better investor, being a business analyst would be more important than a business valuer. The only way to become a business analyst is to think about the positives and negatives of the business and then keep up-to-date about the changes happening in the environment and its impact on the business. That would go a long way to be a successful investor.

The Fifteen Points to look for in a Common Stock

1. Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?
2. Does the management have a determination to continue to develop products or processes that will further increase total sales potentials when the growth potentials of the current attractive product lines have largely been exploited?
3. How effective are the companies research and development efforts in relation to it size?
4. Does the company have an above average sales organization?
5. Does the company have a worthwhile profit margin?
6. What is the company doing to maintain or improve profit margins?
7. Does the company have outstanding labor and personnel relations?
8. Does the company have outstanding executive relations?
9. Does the company have depth to its management?
10. How good are the company's cost analysis and accounting controls?
11. Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition?
12. Does the company have a short-range or long-range outlook in regard to profits?
13. In the foreseeable future will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders' benefit from this anticipated growth?
14. Does the management talk freely to investors about its affairs when things are going well but "clam up" when troubles and disappointments occur?
15. Does the company have a management of unquestionable integrity?

- Philip Fisher
from Common Stocks and Uncommon Profits

Mania

A mania is a mania, and the experts are caught in it just as the public is.

- Marc Faber

Is it possible for a layman investor to go against the crowd and avoid the trap? Yes it is possible, if you know the past history has given us enough to learn how many times the manias repeat. Once you know the valuations are stretched, make sure the business you own have solid strength to overcome any short term adversities and there is a good management in place to drive the business. If these two criterias are met, just stay on the sidelines and just watch the show. Dust off the "The Intelligent Investor" from your bookshelf and read it again and that should comfort your thoughts.

Don't rent stocks

Buy a business, don't rent stocks.

- Warren Buffett

Purchase decision of stock should not be taken as a casual decision with the intention to unload it when it reaches certain targets using the concept of "profit booking". Any stock should be purchased as business ownership in which you take part ownership of the business. The number of zeros in the percentage of your ownership in the company doesn't matter here. This way you can eliminate the tendency to buy any stock just because it is the fad of the season. For any stock you want to invest, spend some considerable effort to understand the positives and negatives of it. Finally value the stock to arrive at a reasonable purchase price. Once you are done with that, you start the python game until you catch the prey at the appropriate moment.

Diversification of the best, not the most

An investor should always realize that some mistakes are going to be made and the he should have sufficient diversification so that an occasional mistake will not prove crippling. However, beyond this point he should take extreme care to own not the most, but the best. In the field of common stocks, a little bit of great many can never be more than a poor substitute for a few of the outstanding.

- Philip Fisher

The purpose of diversification is to protect from the mistakes and not for the sake of it. By keeping the list minimum (probably less than 20), the investor keeps the list of seats available to fill to the bare minimum. Thus if a new stock looks much more attractive than your existing holdings, one of them has to give way to new stock instead of simply increasing the stock count by 1. This places an onerous responsibility on the investor to judge his decision before a new stock is added to the portfolio. I am not saying that the investor should steadfastly stick to certain limits.

This blog writer knows the fallacy of the diversification. At points in time when the list of stocks was more than 100, I found it difficult even to identify whether I own the stock or not!!!. Once I understood the foolishness of too much diversification, I took the step of moving out of the marginal stocks. Further investments were made only in the existing holdings, while I slowly eliminated the unwanted ones one by one. I deviated from the above decision only twice, when I took the conscious decision to add two wonderful stocks. While I don't have any fixed nos for my portfolio in my mind I would like to reduce it to less than 30.

Know the edge of your competency

You’ve often said that one of the keys to your success has simply been to avoid making the garden-variety mistakes that you see other people make.

Warren (Buffett) and I have skills that could easily be taught to other people. One skill is knowing the edge of your own competency. It’s not a competency if you don’t know the edge of it. And Warren and I are better at tuning out the standard stupidities. We’ve left a lot of more talented and diligent people in the dust, just by working hard at eliminating standard error.

- Charles Munger

For a small time investor like us what is the learning from Munger's answer. Looking back at the stupidities committed earlier gives us enough knowledge on that. I have listed some of them.

1. Invest in yourself to think like an investor. Reading books written by value investors help you understand how the market behaves at various points in time. Similarly reading books on individual sectors help you understand the positives and negatives of the sector which will help you to exploit it to your own advantage.

2. Invest in a company which you can understand. If you have already invested in any company which you find it difficult to comprehend, move away from it irrespective of whether it made a profit or loss. Once you have a better understanding about the company you can invest in it again.

3. Invest in a leader and not in a third rung or fourth rung company. Leader doesn't mean the said company has the highest market capitalization in the sector. Small companies growing into large company or finding another Infosys or Microsoft from the haystack is not your business. These are marketing gimmicks by fund management companies to increase their AUM. Investing in a large cap will serve most of the investors purpose.

4. Be like a python which lies motionless while hunting for its prey. To be an investor, you need not be a hyper active trader with regular buy and sell activity with up-to-minute stop loss calculations. Once you have done the homework be patient and wait for the right opportunity to invest in company. Mr.Market when feels pessimistic comes up with incredible offers. Those are the times you need to pounce on your preys. All other time, wait for the dividends to be credited to your account and give a thorough look at each of your investments.

5. Don't judge your investments based on how it quotes currently. If your calculations are correct, any dips in prices are opportunities to increase your holdings.

6. Never let your ego go to your head and brag about it to others. Overconfidence is the first step to the downfall. Be a eager learner, all the time.

7. And the most important of all, don't forget your mistakes. The mistakes commited by you today are the learning for the days ahead.

How to overcome inflation

... when a depression does occur it is apt to be shorter than some of the great depressions of the past. It is almost bound to be followed by enough further inflation to produce the type of general price rise that in the past has helped certain industries and hurt others. With this general economic background, the menace of the business cycle may well be great as it ever was for the stockholder in the growth company with sufficient financial strength or borrowing ability to withstand a year or two of hard times, a business decline under today’s economic conditions represents far more a temporary shrinking of the market value of his holdings than the basic threat to the very existence of the investment itself that had to be reckoned with prior to 1932.

- Philip A. Fisher

The words look prophetic as the famous author wrote in his first book "Common Stocks and Uncommon Profits" more than 50 years back.

Warren Buffett has double confirmed this through is own words as a follow up of Burlington Northern Santa Fe Railroad purchase. “I'd be more worried holding cash. I think that if you look at the side effects of the incredible dosage that we've had to give -- and I think that dosage has been 100 percent appropriate; I'm not knocking that. But when you apply the kind of medicine we've applied, you may have sort of unprecedented aftereffects, too. But the one thing about those unprecedented after effects is they're going to be very bad for cash. I would much rather own working assets than have cash in a period that well could become inflationary down the road.”

Now for the small time investors like us what are we supposed to learn from these experts whose quotes are nearly 50 years apart but still mean the same?

1. Cash is not the king during inflationary period. Keeping idle cash is the worst thing to do when the inflation is ruling the roost.
2. If not cash, how about fixed-income securities? While they look better than cash in absolute terms, they are in no way have the power to protect the investor’s capital from the daemon called inflation.
3. How about “real-assets”? A piece of land, which doesn’t earn a penny of rent to the investor or biscuits of gold locked deep inside the bank locker. While these are far better than the earlier two, they still don’t allow them to “earn” an income, particularly if his earnings are poor.
4. Commodities? These are buzz words which appear on the pink magazines over the last few years. As the experts say, commodities seem to have the real protection against the inflation. But caution is advised not to touch this asset class if you don’t know how the commodities behave. I really don’t have a clue on how to price a commodity to see whether they are cheap or expensive.
5. Working Assets? Any asset which has the capacity to earn as it is put to use has the capacity to overcome the effect of inflation. These assets could be classified under soft asset or as a hard asset. If you are consultant, the knowledge you possess is the soft asset which allows you to earn the “rent” for the service you provide. As the inflation rises, you can increase the “rent” nullifying the loss caused by the inflation. The ratio of increase depends on the uniqueness of the soft asset you possess. A real estate property which earns a rental income is a hard asset. The beauty of this asset is it provides the flexibility to increase the “rent” during the inflationary period and also the capital value rises as the years go by. Thus it retains the value adjusted to inflation. Another hard asset is a “good company” which has the financial strength and pricing power in the market. If you have learnt to deal with Mr. Market with respect and caution, and know how to select a good company with the above characteristics, you are pretty much ready to deal with the inflationary situation.
   

While high inflation has a devastating effect on the economy and the poor who are hurt more than others, nearly all the economists and governments and even ordinary people are comfortable with moderate inflation. If you don’t have inflation, the asset you bought ten years back would quote the same price even now. Nearly no one is ready to accept this principle.

How about deflation? Deflation leads to a down word spiral which is hard to control than inflation. In a deflationary situation every consumer knows that the price of a discretionary good will cost him less in next one month than the current price. He will postpone the purchase until he can carry on without buying that goods. This in turn leads to shrinking economic pie and job losses aggravating the pain the consumer is already going through. Japan is a classic example of the deflationary situation which has been aggravated by its political leaders for the past 10 years.

Read forever

I constantly see people rise in life who are not the smartest - sometimes not even the most diligent. But they are learning machines; they go to bed every night a little wiser than when they got up. And, boy, does that habit help, particularly when you have a long run ahead of you.

- Charles Munger

What is wrong

Once we realize that imperfect understanding is the human condition, there is no shame in being wrong, only in failing to correct our mistakes.

- George Soros