Transcript of Sanjay Bakshi's Interview Conducted

In Gurgaon by Capitalideasonline (CIO) on March 22, 2007

Thank you for giving us the time to talk to you.

It's a pleasure to meet you here in my office. We are meeting after more

than four years and I remember very fondly what happened on the previous occasion! Indeed I

still get fan mails from people about the talk I delivered at your invitation at the Oxford Bookstore

in 2002. I don't talk to the media. I talk to my students in the classroom at MDI (six months in a

year) and I frequently talk to some value-oriented friends. You are the only one whom I have met

from the media in the last four years!

Many thanks.

So it's a pleasure to have you here and I just want to open up the

presentation, which I had given to the invitees at Oxford Bookstore in 2002. This presentation

was titled, "Value Investing - a Conservative Way to Invest." I had started by describing what is

value investing and why the focus of conservative investor is first one not losing money than on

making it (downside risk more important than upside potential) and then I gone on to the better

part of the presentation, which essentially dealt with three value investing themes. These were:

(1) Cash bargains; (2) Debt-capacity bargains; (3) Debt pay-down.

I only focused on these three themes in that presentation and gave a number of examples. Some

were past examples whereas some others were current examples at the time of that talk. With the

benefit of hindsight, I can now tell you that things have worked out pretty well for me

professionally using those three themes.

But knowledge is incremental, especially in the profession of security analysis, and experience is

a good teacher so I have evolved over the years and there have been many changes in the way I

think about investing. In my early years I was very influenced by Mr. Buffett. But over the last few

years, I have become more influenced by Mr. Graham. Hopefully, today we will interpret

Graham's bible for this profession, the Security Analysis and of course the Intelligent Investor.

CIO:

CIO:

Prof. Sanjay Bakshi:

Prof. Sanjay Bakshi:

01

02

Ten Deep Value Themes

So today, I am going to continue with where I left off in 2002 and focus on ten deep value themes.

Some of these are old themes and I just want to revisit them. And then I want to talk about other

themes on which I have accumulated some wisdom over the years. Specifically, I am going to talk

about:

1. The changes in my thought process over the years

2. The classic Ben Graham themes

3. Capital structure related themes

4. FM strategies I won't reveal what “FM” stands for right now - a bit of mystery I want to

introduce to hopefully keep your readers awake!

5. Dividend policy related themes

6. Event-driven themes

7. Availability bias related themes after my last interaction with you I became hugely

interested in psychology and spent a lot of my time learning it. Indeed, I now teach a

paper on behavioral finance which focuses on the “foolish man models” from psychology

rather than “the rational man models” from economics which I had been mis(taught).

Over the years, I have developed some themes which arise purely out of biases most

people and certainly Mr. Market suffer from. And some of these are hugely important in

my view. One of them, of course, is the availability bias. And I have a whole set of

strategies coming out of that bias.

8. Mean reversion strategies

9. Value-plus-momentum strategies, and

10. Over-optimism related strategies. The last one is essentially to do with shorting

overvalued stocks as a hedge against a major decline the the prices of deep-value

shares.

The Classic Ben Graham themes:

Let's just go to classic Ben Graham strategy. Of which six of them are:

i. Cash bargains

ii. Debt capacity bargains

iii. Earning yield bargains

iv. Large, unpopular companies

v. Low-priced common stock, and

vi. Special situations

03

The subject is vast. Graham's book (Security Analysis) is very useful. And if one really applies in a

creative way the essence of what Graham taught in that book, to what is happening around us

now, one can, in my view, build an entire life's career around just a few of the things he taught.

Personally, for me it's been very interesting to see how the same logic works even seventy years

after the book was first published. And Graham put it down his ideas so eloquently and they are all

there and people just don't use those ideas in the way I think they should be used.

i. Cash bargains

I talked about cash bargains in 2002. We know that, if the market value of a company is less than

the net cash (cash and marketable securities net of current liabilities and debt) in its possession,

then you're getting the fixed assets and assets other than cash, essentially for free. But Graham

gave a warning “Be careful about cash being dissipated away if there is a loss-making business

out there.” So you may have a company whose stock sells at a price making it a “cash bargain”

and the business is losing money. In such cases, the market is right in valuing the stock at below

cash, because the investors will not see the cash. And that's what I too had said in 2002, but then I

had some additional thoughts on that subject, over the years.

Take holding companies, for example Nalwa Sons or Jindal South West Holdings or

Consolidated Finvest, all of which are so-called-cash bargains. My simple question here is where

is the catalyst? Is it a family dispute? Is it the presence of Mr. Soros, for example in the case of

Jindal Southwest Holdings? Your know Jindal South West at Rs 225 at present is really

interesting because the company holds shares in JSW Steel on which futures and options can

now be traded. So one could technically go long in the holding company and short the underlying

and have a very interesting trade out there. But you can only make money on the trade if you

narrow the spread. Alternatively, one could just buy the holding company as a very cheap way of

getting an interest in JSW Steel. Well whether Mr. Soros will be able to narrow the spread or

whether people who are in that particular situation will be able to do it and whether it make sense

for us to buy into that situation or not, that's debatable.

But in the absence of a catalyst, I don't feel very excited about holding companies as I used to at

one point of time. I now feel that it takes a huge amount of patience for such situations to work out

in the absence of a catalyst. Moreover, the basic structure of holding companies, as Graham had

mentioned in his book, is a very defective corporate structure. It may be a wonderful structure

from the controlling stockholders' point of view - from the market's point of view it's a very

defective structure. The more layers you put in between the eventual property and the ultimate

04

owners, the more reluctant would the market be to give full value to that property.

This is pretty much the case with close-ended mutual funds and conglomerates, which are the

other two forms of bad corporate structures. Holding companies are a bad corporate structure

from minority shareholders' viewpoint. Indeed, in my view, holding companies are even more

inferior to close-ended mutual funds because at least the latter have a limited life. As per the

Indian regulations, all closed-ended funds are to be liquidated by the date mentioned in the initial

offer document, which ensures that the discount to NAV will eventually vanish otherwise it would

violate the no-arbitrage principle in financial markets (None of the funds are ultimately liquidated

all of them are converted into open-ended funds thus demonstrating the classic agency conflict

involved here but that's another story). Unlike closed-ended mutual funds, however, holding

companies have an unlimited life because they are companies and not funds. This makes holding

company akin to perpetual close-ended funds run by managements who really have no interest in

unlocking value for their shareholders. Its no surprise that discounts in holding companies are

much more than in close-ended mutual funds like Morgan Stanley Growth Fund.

Operating companies with cash

Another thing I want to say about cash bargains is that operating companies with cash are far

better than “boxes of cash” i.e. holding companies with no operating business. So, in contrast to

pure holding companies, which are nothing but “boxes of cash”, if you have an operating

business which generates surplus cash, and in addition you have a substantial cash on the

balance sheet, and if the company is under-leveraged, and if the stock price is not presently

implying a cash bargain in the pure Grahamian sense, but is low enough, so that one can actually

estimate as to how soon will this company become a cash bargain well that's a very attractive

combination in my view. It's far better in terms of relative attractiveness than just a box of cash

because the box of cash is really something they can take away. They can replace it with some

loan and the loan terms could be very onerous. So, all sorts of things can happen which could

prevent a minority investor to be able to realize that value of surplus cash.

In contrast, when you get a cash-generating operating business, a zero-debt company, lots of

cash on the balance sheet, and a market price of the stock which is not very far from the net cash

on the balance sheet, you have an attractive, low risk, high reward situation. By high reward, I do

not mean a multi-bagger, but rather a return which is at least twice of the AAA bond yield, which

incidentally, is what a Grahamite tries to look for.

05

So, I have sorted of moved away from pure holding companies without catalysts to companies

which are debt-free, selling at low price/earnings multiples - so low that if you remove the net cash

from the market value, the operating business turns out to be selling for a very low multiple of the

underlying corporate earning power. Indeed, you can actually predict, under reasonable

assumptions, as to how many quarters or years will it take for this company to go below cash if the

stock price remained unchanged. And, in my view, that's a very useful way of thinking. I think

these companies will not sell below cash for a prolonged period. Unlike boxes of cash, many of

which deserve to sell below cash, cash-generative operating businesses don't deserve to sell

below cash.

So companies like Neyveli Lignite or GAIL or some other companies which can easily be found

would probably fit this criteria One could predict perhaps how many quarters, how many months,

how many years will it take, if the market value were to remain unchanged, for this company to sell

at below cash because you can estimate how much cash is being made and you can estimate

how much dividend is being paid out. Cash is coming in and there are no other uses of cash. So

it's all there in the cash flow statement and in the earnings statement and one can make a

reasonable judgment as to how many years will it take to so if something is just two or three years

down the road to end up being below cash, I want to be an owner of that particular stock. I think it's

a very conservative way of investing, particularly if you combine it with dividend yield which is

fairly satisfactory to begin with. So, that was my other observation about cash bargains.

Why do markets hate the most easily valued asset on the balance sheet?

Why do markets hate the most easily valued asset on the balance sheet? Cash is after all

easiest to value. It's there, but the markets just hate it. Why does that happen?

Well, I think one reason why that happens is that Mr. Market loves EPS.

And cash doesn't contributes much to that EPS. It produces low treasury income and it doesn't

show up much in the EPS.

Another reason is that Mr. Market fears that the cash can easily be transported away by the

insiders. Now, you can't transport the plant and machinery, but you can easily siphon off cash, so

to speak. So, it's not that tough to remove cash and markets are very skeptical and that

skepticism gets reflected in low price/earnings ratios of businesses which has surplus cash. And

that skepticism may often be overdone, by and large the market is not totally wrong on this. While

many Indian companies have been good allocators of capital, the dividend policy of many many

CIO:

Prof. Sanjay Bakshi:

06

others are pathetic. They should dramatically increase their payout policies. You see much better

values and the cash on the balance sheet would get much better value in the market. So one of

the things which we will come to later when I'm talking about dividend policies is that what

investors can do is to make a point with the management to increase the dividend payout when

the money inside the firm is not being valued properly by the markets. It is more valuable in the

pockets of the investors than in the pockets of the company.

ii. Debt capacity bargains

On debt capacity bargains, there's been no change in my views over the last few years. Graham

was right when he wrote that an equity share representing the entire business cannot be less safe

and less valuable than a bond having a claim to only a part thereof. And I have used that theme

over and over again to identify, and, indeed arithmetically prove the cheapness of some stocks.

Mr. Munger taught us that if we have a problem to solve, then if we reduce the problem to a

discipline, which is more fundamental to our own discipline, then we have a very good basis of

solving that problem. Graham's approach to debt capacity bargains reduced the equity valuation

problem to basic math, a fundamental discipline. So, when you come down to that level of

accuracy, it's impossible indeed to argue that the debt-capacity bargain stock you are looking at

isn't cheap.

The private equity boom in this context is important because debt-capacity bargains are natural

candidates for going-private transactions. In my view, the private equity boom is here to stay.

Some people think it's a bubble and assume that private equity players will stay for a while and

then will go away. However, my view is that as an alternate to the stock market, companies that

are not being valued properly are likely to be taken out of the market by smart private equity

players. And that's generally a good thing. Because if markets are not giving good and

appropriate value to listed stocks and somebody else is willing to pay a premium over the market

value to the controlling and minority stockholders, then he has the right to enjoy the difference

between his estimate of value and what he paid to take the company private, to the exclusion of

the others. And I think that part of the return in private equity is a very substantial part, plus there is

the incentive effect to correct misallocation of capital from such companies the system. And, of

course, the private owners have the valuable option to decide when to bring the company back to

the public markets, which not co-incidentally, will be when markets are salivating for more stocks

in that particular industry, so that much of extra return is also there. So I think that the private-

equity wave is going to become a much bigger wave. I don't think that's a fad. It's here to stay.

07

The debt capacity bargains idea, which made me lots of money, led me to think about capital

structure as such. You know how important capital structure is and of course there is plenty much

to learn in Graham's books on that subject.

Could you comment on some such companies?

Capital Structure Strategies:-

Yeah. If you look at Abbott India, if you look at the surplus cash in the

company's possession and if you net it out from the market value of the company, you end up with

a business value which is fairly low, given the quality of the business, given the returns that the

business earns on the capital. So it's a cheap stock out there. And if it is a cheap stock, then

insiders have strong incentives to take the company private. They are not doing it (apart from two

small buybacks). There are different reasons for that. But these companies really don't deserve to

be in the market. They should be taken out from the market. Persistently, they sell at below what

they are really worth. And I think a lot of that has to do with the amount of cash in the balance

sheet, and management's reluctance to give it back to the company's owners.

In many of such situations, insiders are not really worried about increasing their stake in the

company or increasing the stake of the minority investors by virtue of a buyback or a leveraged

recapitalization which. They are not doing any of those things, but I think they should. They

should really think about it. And I don't know whether it will happen or not but it should happen.

So would you look at Abbott India as a good investment at this level given that it is cheap but

that there may not be any catalyst?

It's a cheap stock. But if I were to look at it, I would look at it with the point of

view of being a catalyst in the process of getting the company taken private. So, if they are holding

a percentage, why not go and make an open offer for the rest of the company and become a

private owner with the management, which is generally a very good management. And of course

you know the other thing about what would happen if you were to make such an offer. If somebody

were to come out and say well this company is out there and it's undervalued and the

management is not doing anything about it and if I make a public offer to buy out and take this

company private, how will the other side respond what Mr Munger calls “effects of effects”)? I

think they'll probably respond by delisting the company - you have to spur them to do it. They

won't do it on their own but if you nudge them a bit they will in all likelihood do it. If you have the

CIO:

CIO:

Prof. Sanjay Bakshi:

Prof. Sanjay Bakshi:

08

capital and if you have the conviction then the odds of losing money are very low.

What happens to a company that has too much equity and what happens when the

company has too much debt?

Modern corporate finance proclaims that capital structures don't matter. And I think that's

nonsense. I think it's better to ignore what Modigliani and Miller has said and instead listen to what

Graham had said on he subject and and what KKR has done. What did Graham say? The

essence of what Graham said, although he never used the phrase “optimal capital structure” is

that there is such a thing as an optimal capital structure. And he used his own system of credit

analysis which is very unique. For example, he never believed in credit ratings because credit

raters rate instruments whereas he rated companies. He had a single rating for a company. In

Graham's framework, if a company was credit worthy and all of its debt instruments were also

credit worthy, otherwise he would not touch it. And he said that if a company is debt free, then the

optimal amount of debt it should have on its balance sheet is the amount, which would classify as

a high-grade investment from the bond-holders' viewpoint using Graham's framework of credit

analysis.

So in the sense that's what he meant when he said there is a thing as an optimal capital structure

and there are all sorts of businesses which are not amenable to debt financing, so they shouldn't

have any debt in them, for example, new startups, or companies having businesses with very

volatile cash flows, but if there is a large company with very low debt-levels having very stable

cash flows then it can have a cheaper source of capital than equity on its balance sheet. How

much debt to put? Well, he had a very simple formula and I think that works. You don't have to be

exactly right, you can be just roughly right.

And KKR took it to the extreme by putting a huge amount of debt on target companies to finance

their acquisition at large premiums to pre-acquistion market prices. KKR did it and the private

equity boom is showing that it can be done and companies are being taken private and they are

putting debt on the balance sheet. And the main thing that works here is the change in the

incentives. The interesting thing that demolishes the MM argument is that MM forgot or they didn't

think about the possibility of a jump in EBITDA itself.

KKR showed that by putting large amounts of debt on the balance sheet of an under-leveraed

company you can change the management's incentives in a manner so that it has much less

desire to spend money on those fancy carpets or the air planes, then certainly the margins went

09

up and the EBITDA went up and if EBITDA goes up, the enterprise value goes up. If there is no

change in EBITDA, you have more debt, equity will shrink, if you have more equity, debt will shrink

that's what MM thought would happen they forgot that people respond to incentivres. The total

value of the firm is independent of capital structure if you ignore, among other things, the

incentive effects of debt on a mismanaged, under-leveraged company. But, if EBITDA itself

changes, the value goes up and that value will go to the equity because the claimants to the debt

are fixed. Incidentally, there is a wonderful Harvard case on Sealed Air, which I think every

investor should read.

So, all of this, led me to think about what happens when a company has too much equity and what

happens when the company has too much debt. So that sort of morphed into different things

evolving from the idea of capital structure. So if the company has too much equity and the Abbott

kind of situation or the stock is a debt-capacity bargain, there is too much cash, they need to

distribute the cash. And there have been some minor transactions where we have made some

money like Hindustan Lever shareholders got bonus debentures and Thermax shareholders got

bonus preference shares. So those were transactions, which were effectively distribution of cash

by changing eh capital structure. They were delivering shareholders instruments, which were

debt instruments that they could sell in the market priced as debt instruments, but they were

changing the capital structure. They were moving towards what was optimal and it was done at a

time when the companies were undervalued so there was a major upside returns for investors

who understand how these things work. I think this model is replicable by other similar companies

in India there are lots of such companies.

On the flip side you have companies with restrictive capital structures. There is too much debt and

too little equity. There is money to be made there too because the fact that you are observing the

company now which has too much debt means that you were not participating in the original

calamity which caused all the debt to come up in the first place. So the market is putting a very low

value on the enterprise, because it's highly leveraged and it sells at a ridiculously low PE multiple.

But, if the present value of debt was reduced as opposed to the book value of debt,, either

voluntarily or otherwise under CDR (Corporate Debt Restructuring), which has been a major

trigger for such transactions to happen, you are on to something. So we look very closely at

corporate debt restructuring as the theme arising out of the debt reduction theme, arising out of

the capital structure theme.

Equity is just a balancing figure and if you can value the corporate entity without thinking of the

capital structure and net off what you think that debt is worth under changed circumstances, there

10

may be instanes where you have a hugely under- valued equity.. Of course, we have to project as

to how that value will rise as debt is reduced and how likely is it that debt will get reduced and

whether their source of debt reduction would be voluntary or involuntary. It could be probably

voluntary in CDR cases under a strict timetable. They have to adhere to the timetable. The

interest of the minority investors in such transactions get perfectly aligned with the interest of the

lenders to the firm because under the CDR package, the lenders will get the company's

management to stop all that stupid diversification and they have people to ensure that it happens

and they stop the dividend, and instead focus on debt service and debt reduction, which is exactly

what a value investor wants. Paradoxically, the skipping of the dividend produces a very low

market price. So you have a system now where you can effectively project as to when will this

company be substantially less leveraged which means an automatic expansion of the equity

valuation and when will the dividend come. Because there are conditions laid down and the CDR

package is there on the side and one can read the model agreements and what kind of

restrictions lenders put on the whole process and you can effectively predict roughly as to when

this company will come back on the dividend list and we know that the stock prices are extremely

sensitive to the announcement of dividends from companies which have skipped dividends for a

number of years.

So, I think that's a very interesting field in itself. And there have been so many cases of CDR and

you know I don't think any deal that passes through that desk should escape the notice of a value

investor.

iii. Earnings yield bargains

Earning yield bargains are a classic case of inverting the PE multiple which Graham did and he

showed that if you can find stocks that promise to earn at least twice of AAA bond yield on your

opurchase price, then you should have it in a diversified portfolio.. That simple, elegant idea still

works in my view. The idea of earnings yield being stated as at least twice of AAA bond is a very

elegant idea because it removes the need to think about cost to capital. And I want to relate this to

Herb Simon's model of satisfysing as opposed to Markowitz' theory on optimizing. You know all

the optimizing models and they talk about the capital pricing models and the betas and so on and

try to estimate exactly what the cost of capital is. If an investor were to think about allocating

capital in opportunities where you can get twice of AAA bond yield, then he is automatically in a

system where if the interest rates were to go up, the effective PE multiple he would be allowed to

pay for a stock would go down.

11

And that works, it's simple and it's a very elegant way of thinking- and not just about stocks but

about life too as in if you want to achieve happiness then sometimes the best approach is to lower

your expectations i.e. be a satisficer and not an optimizer have a predetermined, and adjustable

aspiration level (twice of AAA bond yield in investing), and stop searching for greener pastures

once you find one or many, which meet your aspiration level. So I won't say much here because

this is very simple stuff and it's been discussed again and again and is one of the chief criteria

pertaining to Ben Graham's stock selection for purchase.

iv. Large unpopular companies

Graham also talked about the large, unpopular company as a deep value investing theme, and

that of course works a lot because large companies become unpopular for all sorts of wrong

reasons. We have a theme called 'dogs of nifty', statistically we measure which of those nifty

stocks are the cheapest ones at any given point of time. So it makes sense to look at these

companies exactly for the reason that Graham envisioned. These companies will go back much

faster than the small and popular companies. So to that extent if you have two situations; a large

and unpopular company (unpopular for the wrong reasons) and a small and unpopular company

(again unpopular for the wrong reasons), then you should obviously choose the larger one even if

the margin of safety is bit smaller than in the case of the smaller company. Even though the rate of

return on investment could be smaller in the large one, the probability of the return coming to you

rather quickly is that much higher. So it makes sense to go for the large ones even when the

value-price gap is smaller.

But large unpopular companies -- if you buy them when they're cheap and they are unpopular for

the wrong reasons, which means they are likely to go back to their normal valuations, should be

seen as a subset of a broader universe of mean-reversion strategies which is an area where we

have done some work and we are continuing to develop more ideas over there. I will come to that

later. I think that's a very fundamental model. The reversion of the mean is a mental model from

statistics its a very powerful model and there are a number of strategies that come out of it.

So, its very natural for us to look at deeply out-of-favour sectors because our experience tells us

that they go out of favor often times for the wrong reasons. One sector which has been coming up

rather frequently on my screen is sugar. It's deeply out of favor and the outlook is very terrible,

which is exactly what we are looking for. The near term outlook has to look terrible otherwise how

else will it be out of favor in the first place.? So, I think there will be money made in sugar stocks

eventually and it may be early days but one would get paid for holding on if one picks the right

12

stocks. I'm still working on this. So I don't want to talk much more about sugar right now.

v. Low-Priced common stocks

Mr. Graham also talked about low-priced common stocks and I have here an extract from

Security Analysis when he talked about the arithmetical advantage of a low absolute price. A

stock may move from 10 to 15 much faster than it would move from 1,000 to 1,500 and that part of

the arithmetical advantage is there. But that doesn't mean that every stock, which is at a low

absolute price, is a cheap stock. And he talked about super low prices where there are billions and

billions of shares outstanding and the market cap is so high in relation to the revenues and the

earnings and the asset values that what you'd think is a low-price is actually a pseudo low price

and he has given some examples of that. So he talked about PSR (price-sales-ratio). PSR is a

very important ratio and I think that's fundamentally important in the context of low-priced

common stocks, that the market value of the shares of the firm should be very small in relation to

the annual revenues of the firm.

And here I think I can talk to you about a company, which we have been recently looking at

Nagarjuna Fertilizers - the stock has come down from Rs.21 to Rs.12 in the recent decline in the

market valuations.

The company is hugely cash generative. The depreciation expense on the books is much higher

than the capex required. Over the last several years they have decided to go into the refinery

business about which I don't think they have any clue about but there are many ways in which you

can look at that problem.

The way I look at it is that well, they are not going to put any more money. They are not allowed to

put any more money. They have already put all the money that is required to be put in that refinery

and how do you value that part of the business? And if you put a zero value to that business then

how does it look now? So we start with a zero value from the refinery and see whether it looks

attractive. It looks attractive precisely because 1) no more money is likely to be thrown in that

direction 2) the company is under CDR and they are required under the strict timetable to reduce

debt and I am informed by the company that they are adhering to that and they are indeed ahead

of the schedule specified in the CDR scheme.

And in a stock which is a highly leveraged situation- they have Rs 1,400 crores of debt on a

Rs.500 crores market cap roughly speaking and a Rs 12 stock price and 42 crores shares

13

outstanding, so even if they reduce debt by Rs.300 or 400 crores which they can easily do in a

single year, if they really wanted to, the upside for the equity is very significant. And you also have

a possibility of a restoration of dividend, which would be a very interesting catalyst. So that's the

kind of things we'll want to look at when a low price common stock comes about the screen

because we have a low PSR, we have a highly leveraged balance sheet, we have a low absolute

stock price and there are multiple triggers out there.

But if you were to value the company based on EPS and PE multiples, they look expensive

because the earnings are not there. The earnings are not there because the depreciation

expenses are so high but if you look at the cash flow statement, you will easily get different, and

right conclusions.

vi. Special situations

Mr. Graham talked about special situations and I don't want to talk much about them because it's

a huge subject. Initially, I started my career in risk arbitrage, or special situations as Mr. Graham

called them. Some people call them event-driven strategies. We do a lot of work in that area and

there has been an explosion in the volume of corporate events, which provide us with

opportunities in this area and that trend is going to remain. And we get access to these important

announcements from the exchanges and that's our starting point. We don't respond to

anticipated events as Mr. Buffett recommends. One can lose enough money on announced

events. So we tend to ignore events anticipated by media and the analysts. It's been a great

adventure to use special situations more as a way of thinking because it forces you to think

probabilistically just as Robert Rubin describes in his book, “In an Uncertain World” as well as, in

his various talks. It's the purest form of security analysis, in my view, and even Mr. Graham almost

said that.

A few things on special situations that I have learnt along the way

If you're working on transactions, which involve say, a de-merger, and they have announced it

and there are milestones and there is the perceived value-price gap in your view. This gap is not

going to be narrowed gradually. Special situations do not behave like zero coupon bonds

approaching maturity. As milestones are achieved, as various approvals come in, the

shareholders say yes, the creditors say yes, the courts say yes - they go through various levels - a

huge part of the return comes towards the end when a lot of the milestones have been crossed.

And that, of course, reminds me of Kelly. The Kelly criteria is fundamentally important here which

14

means that as the probability of return goes up, you should increase the amount of money behind

a particular transaction. So we have been doing that a lot. One of the few things I have learnt over

the last few years is how to use the essence of the Kelly's idea - the elementary concept of

increasing the weights, if the odds are moving in your favor. So, the market in that sense is

inefficient because it gives you the opportunity to make money in a transaction on multiple

occasions over its life. It does require a lot of intensive interaction, reading legal documents,

talking to the company secretary, getting all sorts of data, interpreting the data and evaluating

whether a setback is a permanent setback or is it just a blip, and in a deal when you are looking at

a transaction like a spin-off, or its a merger-arbitrage deal, there are always surprises and most

surprises are bad surprises. But in the end it tends to work out in most cases. If you know that in

the end it is going to work out, then you will get a lot of chances during the course of this deal to

buy in.

What really happens is when people announce events (in-fact I think a bit of information with

some people who know about the impending announcement buy the stock in advance) there is a

lot of hype and excitement created. But then it sort of cools off it tires many people to remain

invested in a deal which is taking much longer than they originally anticipated and in the

meantime all sorts of lovely things are happening outside the deal which people are missing so

there is temptation to sell out on the sign of first adversity, or negative surprise.

But I think that's the best time to get in when there is the first sign of some adversity, something

going wrong with the deal, some delay, some court order, some dispute and if you try out such

transactions, you will see there is plenty of volatility coming out of the event risk itself. So the

event risk is fundamental here to understand and the classic case my mind comes to over here,

we did pretty well over the GE Shipping de-merger recently and there was a huge amount of

volatility involved in that as you know and the deal almost didn't happen. In fact it was canceled

and it then it came back. So one of the things that you learn when you do such a situation is that it's

not done until it's done. That's very important to understand.

Things were not really immune from market risks

The other thing which surprised me, which I learned in the May 2006 crash, was that these things

were not really immune from market risks. You know they appear to be immune but they are not

immune because when the market goes out for a toss, there is a huge crash. Then everything

goes down including special situations because of reasons to do with liquidity and you know

investors need money and they are forced to sell and there are margin traders who are selling out

15

and the spread widens to even these special situations. So, if you are a special situation analyst

you should be careful that you are not leveraged to the point where you could get hit because you

will get hit, if there is a systemic risk out there in market and that is something which I learned and I

paid a price for it. So I am talking from a standpoint of student who has paid a very large tuition fee

on that lesson. So you're not really immune or substantially immune unless you have taken out

the risk totally by hedging, using futures or options and that is not always possible because the

NSE shuts down trading in futures in many such transactions prior to the consummation of the

deal.

FM strategies

FM strategies “FM” stands for Frequency magnitude. That's the new thing that I have worked on

over the last few years and I love that content specially coming out of Kelly and evolving it. I learnt

it from Nassim Taleb (although the term “frequency-magnitude” was first seen by me in a paper by

Michael Mauboussin), and obviously you would know what he was talking about in his book. Well

he said that there is a 70% chance the market will go up and there is a 30% chance the market will

go down, even so, he was short the market. Why was he doing that? Well, the problem is that

most people focus only on frequencies. They don't look at the magnitudes and the expected

values, which are arrived at by multiplying frequencies and magnitudes of various scenarios and

then adding them up.

And in this case- as you can see in the table on the screen- the expected value of is -2.3%. So, on

an expected-value basis, it makes sense to be short the market even though you expect that it will

go up 70% of the time and 30% of chance that it will go down.

The human brain, as Nassim Taleb says, is not wired to think in expected-value terms. It is a

counterintuitive way to think and its basic Fermat Pascal, which Mr. Munger talks of. And, of

course, Mr. Buffett too said that one has to “take the probability times the amount of possible loss

from the probability of gain times the amount of possible gain, that is what we are trying to do. It's

imperfect but that's what it's all about.” Thinking in terms frequency magnitude really works. It's

the basic way of thinking and that's exactly what Robert Rubin has been saying in when he asks

us, through his wonderful book and speeches to do probabilistic thinking.

Even Pabrai talks about low down side plus high uncertainties equaling high return

possibilities.

CIO:

16

Prof. Sanjay Bakshi: That's the same thing but said elegantly. So we have done some work in

these areas and we find there are plenty of opportunities to think in that particular way and you

have to train your mind to think like that.

For example, just to illustrate the idea, suppose that we get to know of a company, which has

announced its intention to pay a dividend for the first time, or after a long gap. We know that in

most value stocks, market prices are extremely sensitive to dividend policy, however in this case

the stock has not yet reacted. So it might make sense to buy that stock. You have to think about

the chances of paying the dividend, the likely quantum of it, the likely outcome in the market when

the dividend is announced, and just before the stock turns ex-dividend, and also the outcome

when dividend is not announced after all (yes it can and does happen). And oftentimes, you will

conclude that the stock should be bought because if you are wrong you will be getting out at a

very small loss or no loss and if you are right, there is a lot of money to be made.

Similarly, the excise duty on some product might be reduced. So there might be an upside for a

certain industry, but market has not yet sensed it. So we just buy it with the expectation that if it

does happen it will be good, if it doesn't happen we can get out without much of a loss. It's not fully

risk-free because the market risk is still there, but its better way of doing things than just buying on

the gut.

So thinking by using FM has vast practical applications in security analysis - it is mathematical, it

is analytical, and it is amenable to analysis in the same manner as when we analyze the

companies. So, we do try to keep track of market sensitive announcements, which have not yet

been factored in by the market and use FM to exploit some obvious inefficiency in the market.

Trade-offs

Keeping in mind the overall risk control and how much money should be allocated to a given

opportunity, oftentimes we come to the conclusion that the expected returns are good but there

are other things that are happening which are more interesting the opportunity cost mental

model. You know if you have a chance to deploy your money at 20% per annum for a long time

and if you had a chance to make 3% or 4% return over a month, I would take the first any day. So

there are two kinds of trade-offs I have to think about. I think it should also be thought of in just

general value perspective. Why do value stocks become amenable to frequency magnitude kind

of a framework? I think the answer lies in the way news comes, and in the way markets respond to

the news. Well there is asymmetry here, which is very important to understand.

17

In deep value stocks when some important news comes the market's response is asymmetric

depending on whether the news I good or bad. The stock is cheap because it's out of favor. So the

market doesn't expect much from the company anyways. Now if you assume the news that is

coming in about the company is random, it could be good or it could be bad, we don't know. It's just

toss of a coin. In fact if you think about mean reversion, it should not be random. It should be more

likely to be good because in mean reversion, good things are more likely to happen to companies

which are deeply out of favor for a fairly long time than bad things. But even if you ignore that and if

you assume its random, then negative news will not have much of an impact on the market price

but even minor positive news will have a significant upside potential for you. And that's why FM

way of thinking really helps.

It's a classic way of thinking. For example, when the quarterly results are going to come out, are

they going to surprise the market? More chances of a positive surprise than a negative surprise

means that you have a system where you can take an in a deep-value stock with the expectation

of a positive surprise with all the lovely magnitude of that outcome factored in your thinking along

with the magnitude of the outcome of the absence of a positive surprise.

So, as a subset of a value portfolio, FM makes immense sense. What really matters is not

whether the news is good or bad, but whether it will surprised the market and you have more likely

good surprises than bad surprises in deep value stocks, over time. So what you get is asymmetric

payoffs with favorable odds and that's what essentially you are looking for.

Dividend policy related strategies

Back to Modigliani & Miller - Was it the real world? I think dividend policy matters a great deal

despite what two Nobel laureates said. They said that, “It doesn't matter at all.”

Modigliani & Miller assumed that capital markets would always welcome companies with open

arms, if they were to overpay dividends and now needed new capital injection to fund their

investment plans. The whole elegance of the idea of the irrelevance of dividend was that, 'if they

pay more, so what? If the company over pays, it can always raise back more equity capital.' Now

there are some implied assumptions in that. One of the implied assumptions is that the markets

are efficient, the value of the firm is equal to the market price of the firm and therefore if the

company does over pay, it takes back new capital which is issued at firm value, so there is no

dilution risk for old owners. The reality is very different. They also assumed that managements

18

will have zero incentives to squander the cash than to pay it out to investors i.e. there are no

agency problems. They ignored the wisdom of what Peter Lynch's called as the “bladder theory of

corporate finance” “The more the money that builds up in the treasury, the greater is the pressure

to piss it away.”

PE multiple of a stock

So, basically what Modigliani & Miller said was that if the company has got too much cash, then

management has no incentive to squander it away in useless or value destructive projects. Well

the reality is very different. So markets, when they sense that the company is going to misallocate

surplus cash on its balance sheet, punish the company by putting a very low value to that cash.

I think dividend policy matters a great deal in the valuation of a firm. I am reminded of what Mr.

Graham said in the context of a PE multiple of a stock. What is PE multiple? The E is the earnings.

From that E, dividends are paid to the shareholders. You could think of the earnings that are paid

out as dividends as a stream of cash flow coming out which you can value independently as a

bond and that value will have a high multiplier. Why? Let see today AAA bond yield is about 8%

and a bond which pays Rs 8 as interest should sell at par i.e. Rs 100 so the multiplier is 12.5,

which is much higher than the multiplier at which most earnings-based deep-value shares sell in

relation to their earnings. The equivalent multiplier on dividends will be higher because dividends

are not taxed in the hands of the investors.

In firms which have a reputation of squandering away the cash in low-return projects, that part of

earnings which are paid out would be capitalized at a much higher PE multiple than that part of

earnings which are retained. And the weighted average multiplier will be equal to the PE of the

firm which the market is giving. Enter Mr. Munger's concept of backward thinking. You can take

the market price of the shares of an over-capitalized firm stock having a low dividend payout ratio.

You can value the dividend stream separately, as if it were a bond and reduce that value from the

current stock price. What remains then the market's assessment of the value of the earnings

retained typically these will produce a much lower multiplier than the multiplier on earnings paid

out. So there are really two PE multiples in such stocks. It's elementary math. And then you can

think about what will happen to this company's market value if the dividend-payout policy were to

change (on its own, or due to a little bit of nudging on your part!). I find that idea very useful indeed.

Lets look at VST Industries as an example to illustrate the idea of two PE multiples to a stock. This

company is valued i.e. its stock is selling at 330 rupees per share. It's valued in the market at 510

19

crores rupees. There is no debt and out of Rs 510 crores rupees, if you remove the amount of

cash on that balance sheet you find that they have got 160 crores in cash and there is some other

cash in the balance sheet which I'm not counting. I am looking at only surplus cash. So you

remove this Rs 160 crores from the market cap. But that Rs 160 crores cash was in March 2006

and that figure would have increased by now. So if we look at the quarterly results and just roughly

speaking, can take the last four quarters of that we find that another about Rs. 50 crores of cash

has come in.

So if the company is valued at about Rs. 300 crores net of cash and on Rs. 330 market price and

they give you a dividend of Rs 12.50 per share. Now this Rs 12.50 of dividends is safe given the

nature of this business (cash generative, low capital intensity, low growth) we can think of this as a

perpetuity and if you can value this as a perpetuity coming in and it's the tax-free perpetuity, it is

valued at probably about 5.2% p.a. tax free yield (AAA bond yield 8% p.a. and tax rate of 35%). So

we have a multiplier of 19.2 times on that part of the earnings, which are being paid out as

dividends. That comes to Rs 240 per share. Which means that you are paying Rs 330 less Rs 240

i.e. only Rs 90 per share for that part of earnings which are retained inside.

What would happen if you were to change the dividend payout ratio?

Now, what Graham showed was what could happen - or rather how I interpret what Graham said

what would happen if you were to change the dividend payout ratio? If VST were to increase the

dividend from Rs 12.50 per share at present, then an additional part of the earnings which are

now paid out will attract a higher multiplier and a lower part of earnings which are retained will

attract the lower PE multiple, so the PE multiple of the firm should logically rise. Its elementary

math… In effect, inside such stocks is a hidden bond component, which can be easily valued, by

us. The value of the hidden bond component will rise if its coupons were to increase.

Now obviously that sounds very simple and arithmetical and elegant to say that in some

situations like VST if dividend payout ratio is increased, the stock's PE multiple warrants an

increase as well. But an increase in the dividend payout ratio involves, from the perspective of the

management a reduction in corporate assets under their control and that's not something that

managements typically like to do. MM assumed otherwise but they were living in a make-believe

world of perfect rationality.

So what works in theory and whether it will work in practice depends a lot on how persuasive

investors can become in getting managements to increase the dividend payout ratio in such

20

cases and I think there is a huge need for activism in that direction. I think institutional investors in

particular can play a role here, if Government of India can ask public sector units to pay a specific

dividend payout ratio because it needs the money, then why can't it not be the case with

institutional investors asking (who control a large number of corporations equity) to do the same

thing? So for every one rupee of dividend jump, you will get substantially higher jump in market

valuation. So it's not just the additional dividend that comes in. You also get additional market

value when dividends are hiked. You can have your cake and eat it too!

There are other deep-value strategies arising out of dividend policy. Market prices are very

sensitive to dividend announcements and rightly so because insiders are giving out signals as to

what the future corporate earning power is likely to be. So it makes a great deal of sense to always

track first-time dividend payers or companies, which are restoring dividends after a long gap. The

concept of “sticky dividends” is important here. Stock prices are inherently more volatile than

underlying corporate earning power and earning power is more volatile than the dividends which

come from this earning power. Companies that announce dividends for the first time, or hike

dividends, are unlikely to cut them they like to be consistent like everyone else. Mr Munger's

model from commitment and consistency is applicable here.

It makes sense to look at companies, which are starting to pay dividends because if the market

price is very sensitive than halving a dividend from Rs 4 to Rs 2 will cause a disproportionate

decline in the market price. So it might become a bargain simply because the company cut the

dividend. So, from a value investor perspective, a company which is doing badly for a temporary

reason, might actually be good news because the cut in dividend might give that investor a

chance to buy the stock at a much lower price than he was looking at earlier and conversely if the

dividend is then restored there is a major upside there for him.

So you get opportunities in stocks of companies that are cutting dividend, skipping dividend,

hiking dividend substantially or even announcing special dividends. There are some

opportunities which I have seen in capturing dividends, using futures market - initially when

futures trading came to India. There were some opportunities there because markets were not

that efficient and companies were announcing dividends and as we know the futures prices are a

function of spot prices plus an interest cost less the expected dividend before expiry. So, if you

can anticipate when the dividend is likely to come and if the dividend is large in relation to the

market price and you know which contract period it's going to come in, then you can effectively

buy the spot and short the futures and capture the dividend. This works if you are a little ahead of

the futures market in adjusting futures prices in response to, or in anticipation of significant

21

dividend announcements. Sometimes this window of opportunity is open for only a few hours, so

it pays to be prepared and act when the time comes.

Letting someone else take the dividend

Often we let someone else take the dividend. This is interesting. If you buy a stock for the

dividend, then you should be careful because when you are buying in the anticipation of the

dividend hike and a dividend hike occurs and the record date is still far away, and lots yield

chasers have jumped in or are likely to, then its very possible that the rise in the stocks price will

be several times the rise in the dividend per share. And once that rise happens and you are in the

stock you have to decide whether to hold on and take the dividend or to let someone else take it by

selling the stock just before it turns ex-dividend. Well, in my experience, its often better to let

someone else take it because if you decide to take it yourself you are taking a big risk on the

capital gains that are almost in your bag. And how the hell does it matter what you call your return?

It could be dividends or capital gains or anything (as Shakespeare said “what's in a name?”). You

are investing for total returns and while you focus on that there will be people who want tax free

yields and divided strippers and the like, and its often fruitful to let them do the stripping while you

enjoy the taxable capital gains.

Availability bias strategies

Now lets come to availability bias, which I think is fundamentally important. Mr. Munger said

famously, “The brain can't use what it can't remember or what it is blocked from recognizing

because it is heavily influenced by one or more psychological tendencies bearing strongly on it.

And so the mind overweighs what is easily available.”

I like to organize my thought process by revolving around various kinds of biases and one of the

key ones is availability bias. I think if you read the paper and you see all these news coming out to

you and it's so available and it's so recent and it's so vivid and it looks so important, and people

have a tendency to react rather over-react- to it. You see all those news flashes on the screen

there. There is some “big event” taking place. It looks very big at that moment and one of my

questions that I had asked before is that, if you pick up the paper of some three years ago, and

you pick up the headlines of that period and you see what was looking so important then, and

what really happened subsequently, you will figure out what availability bias really is all about

because things that are really temporary, transient, they get exaggerated by the media and

everyone else. They get hyped in the media because it sells that's incentive superpower and

22

incentive-caused bias. The media people have their own interests involved. People overreact to

things and when they overreact to things, some people can money off those hyper over-reactive

people. So as a theme itself, it makes a great sense to me to look at news from an availability bias

of other people's perspective.

I read somewhere once that people assess the frequency, the probability or the likely cause of

that event by the degree to which instances or occurrences of that event are readily available in

memory. That is very correct.

Mr Munger talks about vividness and recency. People over-react to something that's very recent

and is extra-vivid. And crazy people make markets go crazy too. They go to extremes on events,

not just because of availability bias, but a big part of the reason for market extremes is due to

availability bias. There are many other reasons which we don't have time for to discuss but they

are all combine and they produce these kinds of crazy situations - Mr Munger calls them

Lollapalooza events I love that word buy the way - and if you look at these crashes that you had in

May, you know, May 2004, May 2006 or even before that. At that point of time it is hard to come to

the conclusion that this was the time to buy. But it was.

People don't care about value, they care about prices

To everybody at that time it looks liked it was the end of the world and well, at the end, it was the

beginning of the world, so to speak.

I think the annual budget drama is also a good example. Every year we have this huge drama that

goes on and we have this huge analytical effort going into what this budget will do and what it will

not do and how important it is. I think there are fundamental flaws in the way people interpret the

budget and changes in government budgets.

First, how important is the budget? I don't think it's terribly important because if the government

has laid out the basic policy and there are no fundamental changes in direction, it's not going to

change the value much. The value of a company is the present value of all its future cash flows.

But markets behave otherwise and they tend assume that any change is in a policy is a

permanent change, while the reality is that governments are also fickle minded as investors.

No change is permanent. The only thing that's permanent is change. So the government keeps

on changing its fiscal and economic policies and markets also believe and I think government

23

also believes that any change that they would make would automatically result in, say, increased

revenues because they assume that people will sit back and do nothing about it. They don't think

of the consequences of consequences as Mr. Munger tells us to do. So people organize their

businesses in a manner that often defeats the very purpose of the change in government policy.

Very quickly we will see what's happening to dividend policy right now. Companies are

distributing dividend in March because they will escape the additional tax that the government is

talking about. So people miscalculate, Government's miscalculate, companies miscalculate, and

investors miscalculate. It's a huge drama going on out there and we would like to watch it from a

distance and we sometimes get opportunities there. But most of the times, I think it's a useless

waste of time thinking too much about how important is the budget and what's going to do to

corporate values or corporate prices? People don't care about value. They care more about

prices.

So we have interesting long-short strategies arising out of availability bias because markets go to

extremes. We have opportunities in both directions. We have people who get over excited about

a certain concept or fad. It's just the latest thing going on out there whether it is ethanol or whether

it is wind power or what have you - you have all these kind of new things which keep on coming up

and people go crazy and there is are also elements of social proof, envy, deprival-super-reaction

in all of this craziness. But I think availability bias contributes vary substantially to the extremes

that you see in market in both directions and there is money to be made there.

My education in a share holding structure, which I used to totally ignore earlier, is fairly recent and

its been hammered into me by a friend who is a very smart investor. I referred to this gentleman in

my earlier talk also. He has taught me that you should look at the shareholding patterns from

various perspectives, changes in the shareholding patterns and what's going on inside the firm. It

is very important to monitor what the insiders are doing and what all is happening to the

shareholding structure. It's not independent of valuation. It is independent of corporate valuation,

but it is not independent of market valuation and we are trying to make money in the market. So, I

think if you have an overvalued - a grossly overvalued stock, combine that with a large FII interest

plus the availability of that stock in futures and options plus insider selling plus weak accounting

plus your anticipation of slowdown in growth which is not factored into market prices, you have a

very good combination which gives you a potential candidate for shorting. Of course the

shareholding structure is important in holding companies. My initial comments on holding

companies arise primarily because they are boxes of cash controlled by a people, who are very

well entrenched and that's a function of the shareholding structure. So that point need not be

24

repeated.

On the other hand if you have an ultra cheap company and you see insider buying and low FII

interest, you have a very good combination. So FII interest is important. Class of investors are

also important because the class of investors tend to behave in similar fashion and if they take a

macro bet then they want to leave the country because they get scared about some plague of

some other macro event which really has no relevance to corporate values, then these stocks will

get hammered. These stocks are what you call as “over-owned stocks”. Nothing like that

happens to “under-owned” stocks.

Obviously the idea of insider buying or the insider selling is asymmetric. They need not be

interpreted in the same manner because when an insider is buying, he usually buys because he

is bullish. But he may be selling for all sorts of non-value-related reasons. It's not necessary that

he is selling because he is bearish. So, to that extent more weightage should be given to insider

buying than to insider selling. Of course blind copying of insider buying can be very foolish

because the insiders could be buying for the wrong reasons also. They may be foolishly bullish.

So you have to combine it with your own thinking, your own analysis and if you come to the

conclusion that it is a cheap stock and then you see there is heavy insider buying, you have a

confirmation coming into your original thesis. Whereas if you see insider selling then it need not

necessarily mean that you are onto something wrong. Modern databases also allow us to track

what other smart investors are doing. So if we find what we think is a cheap stock and then when

we look the company's shareholding pattern and find some people we respect, and if some more

analysis shows that the investor we respect paid a higher price than the current stock price well

that's a very nice and comfortable kind of place to be in!

And sometimes we find people whom we have never heard off in the shareholding pattern of the

companies we think are cheap, then what can we do with that information? Well, we can search

for what else such people own and then analyze those ideas. All my life I have learnt the wisdom

in “one thing leads to another.” So, having a process that allows one thing to lead to another is

very useful way of searching for ideas. Incidentally science works the same way much was what

a scientist discovers happens accidentally while he was working on something else! And many a

great scientist had the conviction to drop what he was working on the moment he observed

something very strange and worthy of further investigation. So, if great scientists can allow for

one thing leading to another, why can't investors do the same thing? I think they can, and should.

Mean reversion strategies

25

I come back to mean reversion as I mentioned earlier. It's a fundamentally important model and

the coin flipping experiment is obvious there. If you flip a coin 10 times, you might end up with

eight heads; you flip it 20 times you might end up with 15 heads. You flp it 100,000 times; you are

likely to end up with about 50,000 heads, i.e. 50%. So, as you increase the number of flips, the

fraction which equals total number of heads/total flips sort of gets pulled towards a number of 0.5,

that's kind of a magnet which is attracting and that's the mean.

The tendency to revert to mean is very fundamental because cycles can be explained with the

mean reversion process. Of course there is a whole bit of psychology involved in these cycles.

People expand recklessly because they don't think what the other guy is doing. They are envious

and they think that if they don't expand, the other guy will expand and he is going to lose (deprival

super reaction), and they copy each other automatically (social proof), and they get over-

confident, and they all have big egos (excessive self-regard) so you get a mixture that produces

gluts and the over expansion obviously means a decline in the price of the commodity and that

result in things going the other way.

The incentives to make are turned into incentives to buy. So you should buy out your competitors

instead of making because the Tobin's Q (the market value of the asset/its replacement cost) has

become less than one. Tobin's Q is very fundamentally important model to have in mind for long-

term investors because in at least cyclical stocks in commodities where entry barriers are not

there, why would Tobin's Q remain three or four for a long time? It shouldn't. There will be more

capital coming in that industry. And when Tobin's Q becomes less than one, there will be

consolidation.

I think sugar will be sweet one day. It's very bitter right now for an investor who bought in some

time ago. People have lost great deal of money in sugar recently, but valuations have gone below

replacement cost and they are making a commodity that people are going to continue to use and

everybody doesn't use “sugar free.” I don't think Indians are going to switch to “sugar free” any

time soon. So the product is going to be around and people are going to eat it and these guys are

politically fairly powerful and it looks horrible right now but that's what it's supposed to look like if

they have a low price. It is not supposed to look sweet. So it looks bitter right now. But one day I

predict sugar will be very sweet. It's like Templeton's idea of maximum pessimism. How far are we

from the point of maximum pessimism? That's the issue and the issue is not whether it's a buy or

not. The issue is how far is the point of maximum pessimism and which companies have the

staying power and which ones don't. The ones that don't will go away because they can't survive

26

and that will result in consolidation of an industry, which needs consolidation. So all those things

are important here for the mean to get reverted. Things will get attracted back to normal.

Stock prices don't revert to mean, but stock returns do and this is the fundamental arithmetical

truth that Mr. Buffett mentioned when he said that bull markets and bear markets can obscure

mathematical laws but they cannot repeal them. If the underlying return on capital is 15%, you

cannot have returns on the stock market of 25% p.a. forever. You will have periods of 25% returns

and you will also have periods of 5% return, maybe -10% returns or -20% returns. But in the long

run the stock returns must mirror underlying corporate returns and that return incidentally in India

has been going up. If you notice in the last several years, return on equity has been going up and it

hasn't been going up because of pricing power, indeed we have less pricing power. It is going up

because of efficiency gains caused by competition. So unlike Peter Lynch who said that

“competition is hazardous to investors' wealth” Indian companies record post-liberalization

shows they have fared much better for investors because of more competition and not despite it.

Its excessive competition that is hazardous to investors' wealth and not competition per se, in my

view.

The human mind also has another tendency. It tends to put an arrow at the end of a trend line.

Basically the human mind is not wired such as to think in terms of mean reversion. It's a natural

tendency to believe that trends are destiny, but all trends are not destiny and it takes a bit of

deprogramming to internalize the mean reversion concept and to use that to come to the

conclusion that things will change. It looks bad now or this is too good to be true. This is not normal

and the normal is going to come. Of course, there are exceptions, sometimes the trend line is

destiny, and sometimes what you see as light at the end of the tunnel is actually an oncoming

train. There are industries out there, which are going to be extinct and they should go extinct

because somebody else came with a better mousetrap and you see a trend line and a long-term

trend of diminishing visibility. Look at what's happening in fixed line telephony for example. It is

very negative sector according to Dalal Street. But that doesn't mean you can't make money

there. If you look at MTNL and if you remove the cash that they have and look at the company's

market value right now you will realize that the markets are extremely negative. If you work

backwards and you net off the cash from the market value of the company, you will find that this is

value of the business and how much the business has earned in the past and even if you project

the declining thing, basically the company doesn't have to deliver much in the next two or three

years to make up all the money that you are investing if were you have to buy the whole company

and this totally ignores all the real estate that they say they have which I think they do. I have seen

a few of their buildings and they look very expensive, so the point being that even though you are

27

looking at the company and Graham said this, “There is no such thing as a bad business. There

are only bad investments.” So if the price is so low even a company that is destined for oblivion,

you can make money in such stocks. And you should not ignore such stocks. Mr. Buffett would

disagree with me I think on this point. We've been long-term bearish on MTNL's business but that

has not prevented us from making money in the stock.

Time is the friend of the good business. Not the bad one. Buffett basically spoke of making

20 investment decisions over your lifetime, because that would help you to focus on the good

businesses.

Raw material theme

One theme, which we have come to recently, is what we call the raw

material theme. Why is that so important? Again my friend taught me this thing. He said that if you

look at the P&L account of the company, you find that they have these elements of cost. They

have basically the manufacturing cost, salaries and administrative expenses and other

overheads, depreciation, interest expense, and others. Out of these, the raw material cost, which

is part of manufacturing expenses, stands out for its significance in many manufacturing expense

as well as for its volatility.

If the raw material expense as a proportion of sales is significant as compared to the operating

profit margin, and if the raw material is a commodity and if it is a volatile commodity then you're

going to find major volatility in the basic margin of the business arising primarily because of the

change in the price of the raw material and its significance in the cost structure. So it makes sense

to look at companies, which are hurting on the raw material front for a very long time. Margins are

going down, down and down because there is a raw material, the prices of which have gone up,

which you think is temporary and you have reasons to believe that it is temporary but the market

thinks otherwise because the market does not believe in mean reversion. Rather the market has

a tendency to believe that trends are destiny.

So, there are situations where the current earnings of the company are hurting because margins

are going down and if things revert back to normal, if raw material prices were to go down, then

things will revert back to normal, you will have restoration of margin. In the meantime the market

value of this company also goes down because of the tendency of markets to project trends to

destiny and the assumption that this margin reduction is permanent. I have a case here which

came to my notice sometime back. If you look at this company called Britannia Industries, this

CIO:

Prof. Sanjay Bakshi:

28

company in March 01, 02, 03, 04, 05 and 06, I have got six years here, the EBITDA on sales for

the last six years has been 11%, 21%, 14%, 15%, 15% and 12%. But look at what happened to

the margins in every quarter from from June 05 onwards. Margin went from 17% to 16% then to

12% then to 9% then again 9%, and then 6%

Now part of the reason why this happened is because of competition from ITC. There is no doubt

about that. But a big part of the reason why it happened was because of wheat prices. Now how

likely is it that this is permanent and what if they went back to normal levels? Then the next

question that comes whether the jump in margin will be retained or will be passed on because of

the competition factor here. While I was analyzing this, I found another interesting angle to the

whole thing. I discovered Vinita Bali and I am fairly impressed by what she is doing to the

company. So from a business perspective, given the background that she has and the kind of

decisions that she is implementing, the dramatic rise in the growth rate in the top line of the

company changed after she came. What happened to the company after she took over and what

was happening before that? It's a very major change I think. So she knows, she recognizes that

there is a problem on this front, but these are self-corrective problems. These are problems,

which have to do with regression to the mean and there is nothing much she can do on that front.

Yet she can do something on the competition front and on the management front. In my view,

she's doing some very sensible things on what really matters because the basic business is a

high return on capital business and in such businesses if you have all the capital that this

company has, you should try to grow this business. And you should put more capital behind and

that's exactly what she is doing. She is doing joint ventures, she is introducing new products,

doing all these little tiny experiments in the product markets and some of them will work and some

of them will fail. It doesn't cost much to introduce a new product, but if it fails, it goes out; if it

succeeds, you have a winner. So she is really slicing the market and I am not a marketing

professor, but I know what she's doing is right here and it seems to be working. The top line of the

company is growing, so you have a very interesting combination of a stock which has fallen by

40%-50% from the peak to Rs 1260 at present. If you have topline growth and you have

restoration of margins, you are going to see a phenomenal jump in profitability and when you see

that happening, markets again will put a trend and an arrow at the end of that line and you will see

a major upside there.

There are management disputes. These stories keep on coming that might be settled. But if you

look at the real issues involved, the disputes that they have are not preventing Ms Bali to

implement what really matters. So I am giving more weightage to what she is doing and on what is

actually happening. I am seeing the result rather than the disputes, which have a way of getting

29

settled. I am really optimistic that people will settle their dispute and even if they didn't, it won't

destroy the company.

Well, this company has staying power, it has debt free, has cash, good management and

professional management. It is doing all the right things.

Value +Momentum

One of the things we are working on now is to think about combining value and momentum.

How do you combine value with momentum? Do you bring in RSI or something?

No. The essential idea is that there is a trade-off involved in buying a cheap

value stock and just sitting on it. We are buying it at the bottom or near the bottom and there is a

huge upside out there but you may have to wait for a long time to get that upside. However, in that

list of really deep value stocks that we have, if you observe that there is some interest in that

particular stock which would be reflected by the fact that there are huge volumes, and there is a

jump in the stock price.

Of course the price of the stock has gone up, but it hasn't gone up to the point where it ceases to

be a bargain. It is still a very good bargain, but it's not as good a bargain as it used to be. That's

normally an indicator and that should be counted as an indicator to increase your exposure as

explained earlier in the context of frequency magnitude way of thinking that I mentioned earlier.

Now everybody knows that it is a cheap situation and suddenly you notice that there is an interest

coming in. So the odds of return have gone up. The total return may have gone down because

prices have already moved up a bit. So when you take additional exposure, you are going to earn

a lesser return, but the period over which you are going to earn that lesser return is likely to be

compressed because of the momentum element involved here. So that's a trade-off. And I have

seen that happen in some of our stocks. And one of the stock which comes to mind was a Pioneer

Embroideries which has gone from what we thought was value to total glamour in a very short

while. We went and met the company and we thought it was an interesting play and we went and

bought into the stock and it's just gone up into glamour land.

In this case, we saw the momentum and we ignored it. And when the momentum became quite

rapid, we actually exited and we left a lot of money on the table which is fine and not a big problem

because I am very happy to sell a stock which is out of my value range and go back into

CIO:

Prof. Sanjay Bakshi:

30

something which is is much better value, than to continue holding it in expectation that

momentum will take it up and up and up because that's very risky. So I have seen in a number of

occasions in the deep value stocks, the reason why they go up is because there is momentum

coming in and there is an institutional interest, there is money behind that stock which lifts the

price to a level which is higher than your original cost but still significantly below what you think the

company is worth. The way we are trained as value investors, we don't do any thing, we just hold.

Well I now think that we need to change that mindset so as to allow combinations of momentum

strategies with value strategies.

How do you gauge momentum?

What I'm saying is that we should take the essence of momentum and put it

in a value strategy. I think it's testable and it should be done and my hunch is it will work. In a total

holding period, when did the maximum returns come? It came over a very short period of time.

And what was happening in the short period of time? Well, the volumes were going up and the

price was going up like anything. So most of the return is compressed over a very short time

frame, which is essentially a momentum kind of time frame and yes, in most cases the price goes

way beyond our sell price. So we ignore that part of the momentum, which is in glamour land, but

we try to be in that part of the momentum, which is still in value land and then FM comes in. Put

more money behind it because the odds have gone up.

Over optimism

Last one is over-optimism. 80% of the drivers consider themselves to be about average,

including me. My wife doesn't agree.

We all know what over-optimism is. We are basically, being analysts, supremely optimistic. Why

do sell-side analysts give more buy calls than sell calls? Of course, incentives are the major

reason including incentive-caused bias. But I think there is more to it. They are very optimistic

people and managements tend to under-weigh competitive threats.

Recently we interviewed a company that makes a global commodity with a big, dumb competitor

out there. As you know, Mr. Buffett says that in some businesses, 'you can't be a lot smarter than

your dumbest competitor.' Well, this was one such business, and, in my view, that dumb

competitor is China because many of the Chinese companies are managed with the intention of

gaining market share, and not necessarily to create wealth for owners.

CIO:

Prof. Sanjay Bakshi:

31

So this company in China was on the verge of expanding capacity by a degree that would have

caused a global glut in the commodity and one of the things that we asked the management was,

what will happen if this new capacity comes to market? He said, well, that Chinese fellow doesn't

know how to make his plant work and you know it's very technical thing and it's going to take a

long time to stabilize the plant and his plant is in jeopardy and it's not going to happen. So don't

worry about it. And of course the plant came on stream. Yes it was delayed, but it started

producing in large quantities and the commodity prices had gone down and the company is

hurting. But the question to ask, if we meet management with supreme optimism, is why wouldn't

the competitor which has already sunk $500 million in a plant spend a little more money to revive

the situation that he wants to be in? He wants to restore the efficiency of the plant, he wants to

start production and there is problem and there are engineers out there who will be happy to come

in and fix the problems. It's not a non-solvable problem. So, it makes to ask the reverse question

(Mr. Munger's Backward Thinking idea) instead of simply swallowing what an over-optimistic

manager will feed you.

Security analysis

So, I think one of the main problems in security analysis is we tend to believe what the

management tells us and they normally tell us what they want us to believe. So it's a nice vicious

circle. So we have to be careful on the over-optimism front. Investors tend to become widely

optimistic about certain sectors and we use backward thinking in a lot in those situations. I think

Mr. Buffett in 2000 gave a wonderful example. He said, take this company (he was talking about

Yahoo or something - a company with $400 billion valuation) and if I want just a 10% return on it,

how much cash it should disgorge next year to rationalize today's valuation and if it could not

disgorge the required amount, then how much additional amount it would have to disgorge in the

year 2 or 3 or 4 or 5 0r 10 years to rationalize today's price?

So, he illustrated the powerful idea of backward thinking to figure out how much cash the

company needs to generate over the next few years, to justify today's value. And from that figure

of required cash generation, you can work backwards further to find out as to what kind of

volumes the business needs to produce to generate the necessary revenues and what kind of

margins will it have to earn, to generate the required EBITDA, to have those kind of free cash

flows to justify today's values.

You can reverse engineer the price and figure out the expectations, Michael Mauboussin CIO:

32

wrote about that in “Expectations Investing.”

Absolutely.

Backward thinking really works because it helps you to be more objective as Mr. Munger

described. It helps you to see the lunacy in the market prices occasionally because it allows you

the privilege of reducing the problem to a discipline which is more fundamental than your own

discipline. By working that way if you can hit against the law of physics and come to the

conclusion and that there is no way a company can have the kind of numbers in year 10 which wil

be required to rationalize today's valuation because there isn't enough capacity possible to be

able to produce the kind of revenues, to be able to produce the kind of EBITDA, and free cash

flows that will justify today's valuations.

So when you come to that kind of a conclusion, you are really on to something and it works both

directions. It doesn't just work on overvalued stocks. You may have even extreme pessimism

causing low prices and backward thinking in that sense really helps. So instead of doing the

elaborate exercise of projecting future free cash flow, which, I think, is just too tough to get right,

it's way better to take the market value as Mr. Mauboussin mentioned in his book as correct and

work backwards to figure out what those assumptions are to make it correct and then question

those assumptions. Most of the times you will agree with those assumptions which mean that

there is the range of value and within that range you can rationalize the value under normal

assumptions. Within this range, you can very easily rationalize the value. But when it goes out of

that range, then it becomes harder to rationalize and when it goes way beyond that range, it

becomes just impossible to rationalize it. So we have opportunities in that area.

Working capital bargains

Could you tell us something about ideas that you have discarded? You may have some

ideas which didn't work and which you discarded.

Working capital bargains. I have just discarded that.

Why?

I tried it over and over again but it didn't work out. I think Mr. Buffett also

mentions in his talks where he said that the working capital is not going to be there because in the

Prof. Sanjay Bakshi:

Prof. Sanjay Bakshi:

Prof. Sanjay Bakshi:

CIO:

CIO:

33

old days, in the US, if a stockholder found that the company is selling for less than working capital,

they could just take the working capital and go home. They could liquidate the company for the

working capital and take the money and go home. But you can't do that over here. You can't do

that in the US, you can't do that over here because there are rules and regulations which prevent

a company from being liquidatied. So whenever you are looking at a company from a liquidation

standpoint, you should think carefully as to what are the chances of that liquidation taking place.

Value is one thing but the probability of realizing that value is a totally different ballgame

altogether. So if you think of the probability of realizing that value is low, then the markets are

going to factor that in the valuations. So in a working capital situation, the company is working

capital heavy, but the working capital is not likely to be converted into cash and distributed to the

stockholders, then it may remain a bargain. So that's not worked for me at all.

Holding Company

The other one that I mentioned to you was the holding company. I have become pretty skeptical

on that. I talked about that earlier. In the absence of a catalyst, investing in asset-bargains is going

to cost you hugely in terms of patience and opportunity cost. I know some investors who have

faced that problem.

So when you look at asset heavy companies selling at less than liquidation value then you should

look at, like perhaps my favorite would be Great Eastern shipping. Look at the company they

recently completed a spin-off and they have all these wonderful vessels and the company is on its

way to become debt free with the amount of cash that the business is generating, it's break up

value is 400 bucks a share plus according to the management. And the current stock price is Rs

192.

Well, I think the NAV is somewhere in the region of Rs. 350 a share and it's easy to value these

pieces of assets because there is an active second hand market, you have to do is to get a

reasonably good hang of what the liquidation value is and that number is very large in relation to

the current market price of the stock and again the promoters are vulnerable because I think they

have only about 27 or 28%.

They are buying their own stock.

But they are buying it in very small quantities. It's very small. The point is

that on one hand they are expanding. And I think the fundamental question to ask is that are you in

CIO:

Prof. Sanjay Bakshi:

34

the shipping business or are you in the business of making money for your stockholders?

So if you are going to make money for your stockholders, then you have to deliver a return to them

on their investment and sometimes the best way to do that is to do a trade-off. You want to

expand, be a little more realistic in that and allocate a bit of the capital and your debt capacity and

your excess cash that is building up in your treasury to a very aggressive buyback program and

many of the best businesses that Mr. Buffett has owned have been ones which have grown in size

and profitability and at the same time have shrunken the number of shares outstanding. Its

analogous to owning a slice in a pizza which keeps on growing and the number of slices keep on

shrinking.

So I think that's the trade-off, which managements have to acknowledge and understand and I

don't think they do it. They don't just get it unless it's given to them in some forceful manner which

may happen or may not happen, who knows, but what matters is that there are companies out

there which have liquid assets, in the sense that they can be liquidated very easily in the

international markets and which are selling in the stock market at a fraction of those valuations.

And managements are not doing anything about it. So will this last? Well, I don't think it would. I

don't think it should also.

Diversification

As far as diversification is concerned, how diversified should you be?

I have been thinking and pondering over this question for a long time and I

think I have the answer. At-least the answer which is right for me is that, as you should be willing to

figure out what are the odds of success are. It again boils down to frequency magnitude. It's such

a fundamental concept. Graham bought cheap shares. He had no clue what the companies were

doing. He didn't know whether the stock would go up or not. He knew the chances of its going up

was high but it was not a certainty; even a 60% chance was good enough for him and he

diversified enormously. So the probability of the portfolio doing very well went up because they

built up large number of stocks. On the other hand, Mr. Buffett now in his current form wants

certainties, which means if he finds those certainties he'll put a huge amount of capital them and if

you find those certainties, then the amount of effort that goes in identifying them and

understanding them requires much more intensity. So it depends on what you find. If you found

something that is overwhelmingly likely to be giving you phenomenal returns over a period of

time, then you should back up the truck as Mr. Munger recommends. So the diversification comes

CIO:

Prof. Sanjay Bakshi:

35

from your ability to identify opportunities.

Now in my own experience in the past, if I look at my own track record, my personal track record

where I am not governed by the so-called diversification norms which my clients used to ask me

to adhere to, I have seen that the times when I have had those jumps in my net worth, you know

those spurts you have, they happen because of only a few transactions and that happens only

because I put a lot of money behind that particular idea. So, the Buffett model of low

diversification has clearly worked for me. But, by and large, I think Graham's model works

enormously because it allows you the privilege of not doing too much intensive analysis in a

specific situation. You are doing statistical analysis. You are doing a kind of analysis which

doesn't require you a great deal of insight into the products of the company or the kind of

competitive advantages they have, the kind of Porter analysis that is required to be done in Buffett

kind of a system. We don't have that in Graham. So it all depends on what's right for you. In my

case most of my best investments required me to put a bigger amount of money, bigger amount of

my net worth into a given idea, while at the same time there have been ideas where I put a smaller

amount of money. There has been a lot of diversification and that has also served me well. But as

Mr. Buffett, if he removes 10 of his best ideas, the returns will become very sub normal and that is

the case with me also.

Are you saying that you will put a large amount of your net worth into company which may be

cheap but are not 'inevitable.”

Those are inevitables because there is a catalyst and the catalyst happens

to be me or somebody known to me. So once you know that it is cheap, but there are elements in

place which will cause it to be not so cheap over a period of time, then the condition comes from

there because its you who are controlling the events. Because at the end of the day the market

value of a share will be only what somebody else will pay for it and you have no way of predicting

with any degree of certainty as to what that is or is likely to be. But on the other hand if you are

involved in a corporate event where you know that or if you are talking to a company and you

know advising them and telling them, look, the company is very cheap and if you implement these

three or four things, that might get your company to be much better recognized in the market than

is the case right now or you might do things which will force the market to recognize that they are

making a valuation error which would have happen for example if you, as I mentioned to you

convince companies to dramatically hike their dividend payout ratios. In certain cases it will have

an inevitable effect of a sudden jump. When you are behind that kind of a situation and you are

advising them and you are hoping that they will agree and you are coming to the conclusion they

CIO:

Prof. Sanjay Bakshi:

36

are likely to agree, then it makes sense to back it up with your capital.

Should one use leverage?

Leverage

I would indeed use leverage. Graham had this wonderful definition of what

is an investment and what is speculation and he said that an investment operation is one, which,

upon thorough analysis, promises safety of principal plus an adequate return on that principal. So

you put the safety first and the return later, that's obvious, but he never talks about long-term

versus short term. He never said that you should buy stocks on margin or you could buy them with

your own money. He never advised against about using borrowed money and in an example he

demonstrated that you couldn't have made money unless you had invested low-cost borrowed

money in that deal investment operation. The situation was such that it made sense for you to

borrow money and do it. It was extremely low market risk kind of a situation and the spread was so

narrow, but the cost of debt capital was cheaper. So it spiked up your equity return if you borrowed

money and did it. Now if you go through many such opportunities in life, occasionally you will find

a chance to double or triple your own capital in a situation if you put a lot of borrowed money

behind it. So that's what I have done. But you better be sure about what you're doing.

I believe Graham said, and I may be wrong, that an investor should have at least 25% cash.

He wrote that in the “Intelligent Investor” which was meant for the layman.

“Intelligent Investor” is not the book I would prescribe for people who are in this profession. The

book for them is “Security Analysis”. Even in the “Intelligent Investor” he has in chapter on the

enterprising investor who would take more risks because he could bring more analysis on the

table. So if you are going to be able to analyze situations more thoroughly and if you're able to

identify opportunities, which give you a very good return, then I think you should allocate more to

equities. You should use leverage if the market risk is not there. An event risk may be there. But

even so when you use leverage, use it to the point where even if things go wrong on the worst-

case scenario that you don't lose much. You don't have a solvency problem. You don't lose much,

which is exactly what Mr. Buffett does in his insurance underwriting. You see if you think about it,

the insurance underwriting business is essentially borrowing. He says he doesn't use much

leverage, but I think most of the money he gets from the float, is borrowed money. It's just low,

zero cost borrowed money, which he has to eventually pay back. So he is using leverage. He is

using other people's money and most fortunes of the world, if you really think about it, are made

CIO:

CIO:

Prof. Sanjay Bakshi:

Prof. Sanjay Bakshi:

37

not by your own money but the use of other people's money and people use have creative ways of

doing that and Mr. Buffett has a wonderful creative mind and he has done that. It appears that he

has not used any leverage. But I think he has used a phenomenal amount of low-cost, beautifully

structured, long-term leverage and that zero cost leverage is coming from his genius of having

people like Ajit Jain working with him and giving him a zero cost float to work with. Now if you are

really conservative, you could take a zero cost float and put it in a treasury bond and capture the

difference. But he puts it in stocks. He puts it in operating businesses. And he makes 30% against

the zero cost. So you know that shows up in his equity.

Risk & Uncertainty

What is the difference between risk and uncertainty?

Basically Mr. Buffett lays it down very elegantly in his 1993 letter. He wrote

down three or four things on the certainty in which you can estimate the future prospects of the

business, the operating skills as well as the capital allocation skills of the management, the

integrity of the management, and the inflation and the taxation that would reduce the gross return.

Those are the four or five things he listed and as he said, these are not things that you can

measure statistically or download from a database. There is no database that will throw a number

at you to measure its riskiness. He also showed that the same investment could have different

risks profiles for different investors. If I don't know enough, then it may be more risky for me than it

is for you.

So you can't use a number called beta or some other number that tells you that this is the risk of

this investment because the risk is different for different people.

The other thing that Mr. Buffett said in his talk at Columbia (Superinvestors of Graham-and-

Doddsville) that in value investing, the less the risk you take the more the return you can expect to

make. And that obvious common sense but counter-intuitive because most people think that you

can't increase returns without increasing risk. Well, that's not the way it works. As Mr. Buffett said,

to increase returns you must reduce risk risk as he defined and not as modern academic finance

defines it.

So you are trying to control risk. There is no doubt about that. Now, what is important in that is that

how sure are you that you are buying something cheap. Graham never tried to value a stock. He

CIO:

Prof. Sanjay Bakshi:

38

only tried to ensure that he had significant margin of safety, which is a far easier job to do than to

value a stock. So he just wanted assurance that the price that he was paying was much lower

than the value he was obtaining through his purchase. He insisted on a large margin of safety

without specifying how large it should be. And, after a point it stops mattering howlarge it should

be. So he was perfectly happy to sell stocks below fair value because he found something else

that was even cheaper. So he won't wait for the actual value to come because he doesn't really

didn't know what the value is. So from the risk perspective what matters most is that you are

buying cheap things which means that (1) you have odds in your favor; and (2) you are not putting

too much money behind a given idea so that if it turns out to be wrong, you don't suffer grievous

harm.

Global events or some systemic events or the business getting destroyed because somebody

invents a better mousetrap, something which you even cannot anticipate at that time of

investingthose risks you have to assume away through diversification. So you have this two-

pronged strategy- buy cheap and diversify and if you do these two things, then it's OK.

But you can also get into the mindset where you don't want to diversify, you want to focus, you

want to put a lot of money behind of a given idea then you have to do Mr. Buffett's way of analysis

where you have to really look at the management, you have to look at the product the prospects.

You have to look at the operating skills of the management and that is not enough because there

are a whole lot of companies out there with phenomenal operating skills but are zero in capital

allocation. They don't know what market cap means. They don't know what a buyback does. They

don't know that buyback can compete beautifully against a capital-intensive project and deliver

returns to stockholders far in excess of what a wonderful capital-intensive project would. So, it's

better not to do that but just to shrink the company and buy back the stock. So they don't know all

those things and they don't know dividend policies. They don't know how you can hike the

dividend payout ratio and have a much better return to the stockholders. So these capital

allocation skills are not very well known. So it's not that people have bad intentions. It's just that

they don't know that these tools are available and they don't know what really matters. It doesn't

matter that you don't really want to have the biggest company, or the biggest market share. You

want to produce the maximum amount of money, that's what you're there for. So I think there is

some hope there because if you are able to convince at least some management that look at

these things. I think we should try. As investors isn't it our duty to approach management as

capitalists and say look, it's my company and this is a way you should be doing things and be very

persistent about it?

39

We have role models like Carl Icahn and others. How do they do it? They are so persistent. So I

think you have to be persistent, you have to have capital and you have to just keep on going after

it. It's not just the operations, it's the allocation of capital decisions where corporate value

maximization potential lies its not that they don't want to maximize value but that they mis-

associate value maximization with sales maximization, with market share maximization or

customer satisfaction maximization which are the wrong objectives. The might be a means to an

end but not an end in itself. You shouldn't confuse the means and ends. The end should be to

create value. You know how, in the last speech in the wonderful movie, 'Other people's money',

“Larry the Liquidator” demolished the argument and explained what capitalism really is about.

Everyone should see that movie and that speech.

Edward Lampert, I am very impressed with that guy because he is very young. He's just 42. I

think he is already worth $1.8 billion. Now if you want to get rich in the stock market, you have to

be an activist.

Have you read Martin Fridson, 'How to be a billionaire?' There are many

chapters in it each one organized around a theme. He basically went to all the billionaires and he

found out what did they just do. I mean converted them into different chapters and put them in a

nice book. One of them was on activism.

Being an activist it doesn't mean that you take on the management. You could be proactive, you

can make suggestions, you can be persuasive, you can approach the management and sit them

down and let them understand as to where they are going wrong from the perspective of an

educated investor who can see things on a broader canvas than what they can see. They have to

realize that they are not in the textile business, they are not in the steel business, they are not in

the airline business. They are in the allocation of capital business and that's the job of a portfolio

manager and that if you approach the management in a humble manner and with an educated

idea of what that company is really about, I don't think it's impossible.

Opportunity cost

You know opportunity cost, you can't think of it the way academics wants you to think. Because

they think that you should know the expected returns of every security out there and that's how

you estimate opportunity cost. But that's not the way. So when you think of corporate

capitalization and opportunity cost, it's a fundamental economic concept, you have to bring in

certain level of confidence. You can't do without it. You have to bring in satisficing. So you know

CIO:

Prof. Sanjay Bakshi:

40

that these are the areas within which I have a competency. So within this area if I do something

then the cost of my doing something is also the next best thing. I could have done within that. So

there are lots of things, which are outside that universe which I don't know and I didn't buy into like

that Unitech IPO. Does that make me envious of that situation? I don't think so. It was outside my

understanding so I didn't do it. But it happens sometimes that you make mistakes of omission on

a scale that is grand in an area where you have a competence. You just missed it, you just it whiz

past you. Now that's opportunity cost the cost of a missed opportunity that was available to you.

There was a book, 'Contrarian Investment Strategies: The Next Generation' by David Dreman.

He has a chapter in it in which he says that you should buy the cheapest company in the hottest

sector which is a bit similar to the momentum thing which I mentioned in 'Value plus momentum

strategies'. He liked the idea. I have never done it but I'd love to experiment and see whether it

works over here or not. Because in hindsight it is easy to say that real estate will become hot.

However, if you are a deep value investor, you are usually trained to not look at things which have

gone up a lot already. Some people can train themselves out of it like Peter Lynch did. He talked

about the foolishness of ignoring a stock simply because its gone up.

A stock that has doubled or trebled does not appear cheap anymore. Well, that's anchoring bias

one is latching on to the wrong anchor of past price. The correct anchor should be potential value,

and not some past price from which it has risen. And reverse is also true. Simply because as stock

has fallen 80% from is past peak level does not necessarily make it cheap. It may have fallen

80%. It can fall another 100%. There are many dot-com speculators who averaged down their

portfolios all the way to zero.

You spoke about your interest in psychology and what are the important mental models you

have taken from there. Mr. Munger did mention a few in his book.

Six of them are from Robert Cialdini's book, “Influence: Scence and

Practise” - Reciprocation, Commitment and Consistency, Social Proof, Authority, Liking, Scarcity

and then Mr. Munger expanded that list vastly in his marvelous talk on psychology. Obviously the

combinatorial effect of several of them is enormously useful way to analyze a lot of things. So is

the idea of observing something extreme and then working backwards to identify the models

which combined to produce that extreme outcome. It gives you a huge insight and predictive

abilities about what could happen in the future. The mental model approach is not just limited to

psychology. I think it should be expanded to other disciplines as Munger recommends.

CIO:

Prof. Sanjay Bakshi:

41

Biology, Business innovation & Evolution

Which would be the other disciplines that you are using in your mental models?

Biology would surely be one. The essence of evolutionary biology is very

much applicable in understanding lots of things in the business world. At the end of the day the

businesses exist to survive and prosper and propagate just like species do and there are new

industries that will come up.

The model of fitness landscape from evolutionary biology is hugely important to understand

because the landscapes change. You know landscapes of various industries change all the time

and the organisms in the industry - species within that industry which could be those companies

that are most adaptive to the changes in the environment are the ones that are going to survive.

And the fitness landscape model is very essential to understand because it tells you that there is a

point beyond which you can't change any more because you've reached the top of your peak and

the next peak you have to come down. So in some industries you find that the way the business is

run is so different from the way your business is being run. There is no way you can compete with

the new business model and you are too well entrenched in your own way of doing things that you

are eventually going to become a niche player. You cannot remain competitive.

Also, I feel that you cannot understand innovation properly unless you understand Darwin's ideas

on adaptation. It's the same thing the same ideas that come from evolutionary biology that can

help us understand innovation in the business world. Evolution is about survival of the fittest and

how you fit into your environment when environment changes. So it's just that sometimes you

happen to be in the right place at the right time and you just got lucky and then things worked. So if

you're innovating, you do this little experiment which is what evolution does. You know little

changes, copying errors from one generation to the next one. Some of those copying errors

which are random in nature and there is an element of randomness from one to the next

generation. Some of all those copying errors would become improvements and then the

randomness stops because from then on, if it is an improvement it will propagate and if it

propagates then it will become prosperous and that species is going to become more and more

prosperous and that applies to industry on a grand scale. That's exactly how things work in the

business world too.

There is a very good book I don't think if you've have read it “The Origin of Wealth”. It is new

economics. The author has taken models from biology rather than physics to explain economics.

No I have not but now I will.

Many thanks.

CIO:

CIO:

CIO:

Prof. Sanjay Bakshi:

Prof. Sanjay Bakshi: