November 6, 2007

A deep value stock

Prof bakshi had posted a quiz to his students. You can find the answer to his question in the comments section. I have posted on the same company earlier.

In addition you may find my response in the comments section too. There are several other answers from others in the comments section such as VST, wyeth, divyashakti granite etc. Some of the ideas sound pretty interesting and I would be looking at them closely.

My suggestion – if you are interested in value investing, read prof bakshi’s posts ,
articles and interviews. There is a lot you can learn from him.

As an aside - i am reading a book : seeking wisdom - from darwin to munger. This book has been recommended by charlie munger himself. I dont remember the exact comment, but it seems he liked the book so much he bought a copy of this book for all his friends and relatives. He also said that if there are more books like this, he could bankrupt gifting them. I am not sure of the authenticity of the comment. But after reading 60 odd pages, i can tell you that this is a great book, especially if you are looking at developing a latticework of mental models. For those you who may not know charlie munger, he is the vice chairman of berkshire hathaway and a long term partner of warren buffett.


Anonymous said...

Hi rohit just wanted to know where you picked the book up from? Is it available here in India? Do let me know am looking forward to picking up a copy.

VISHNU said...


This is not the correct place to post..But interesting article.

Borrow now, while you're still young.

Sometimes the cleverest ideas are the ones that initially seem the most preposterous. Such was the case with a paper I recently heard presented by Yale Law Professor Ian Ayers, coauthored with Yale Business School professor Barry Nalebuff.

These authors contend that the typical young person should invest 200% of his net worth in stocks. That is, buy everything on 50% margin. This is because far too little is invested in stocks by individuals when those individuals are young, resulting in very poor diversification across time. What? You’ve never heard of inter-temporal diversification? Well the intuition behind it is obvious once you mull over it for a while. For me it was one of those “yeah-I-never-thought-about-like-that” moments. We all accept that exposure to only certain asset classes is risky, but what about the differential exposure to stocks that I have in 2007 (when I am young and less wealthy) and 2040 (when I am older and, of course, wealthier)?

Ever heard of the traditional wisdom by which you subtract your age from 110 and then invest that percentage of your wealth in stocks? Well as Warren Buffett might say, traditional wisdom is often long on tradition and short on wisdom. In this case, there is no theory behind the advice at all. It is just made up. Sure, it’s convenient for the investment adviser who needs to create the impression he is following some sort of strategy, and is a great marketing tool for the life cycle mutual funds that actually practice the principle. But why should we believe this is correct?

Ayers and Nalebuff argue that this rule is too conservative and actually provide theoretical support for their notion through a simulation of the strategy. Investors should leverage up significantly in their early years and then reduce their leverage over time. This gives them equivalent exposure to the stock market when they are young and when they are old and this diversification reduces the overall risk to their savings.

If you are like me, you can understand the intuition but nonetheless have some gut-level objection to the idea. The authors are prepared for this and address the issue directly.

There is definitely an aversion to borrowing to invest in our culture. Individuals have no problem borrowing to purchase a home, car or education. But borrowing to invest is taboo. Is this justified? Most folks will point to the ’29 market crash, when margin calls perpetuated an unstoppable slide. While this point is valid, the type of margin borrowing that occurred at that time was done for the purposes of speculating in the short-term. What these authors are suggesting is far different, with a time horizon for the borrowed funds several decades in length.

Margin calls are usually thought of as portfolio-destroying, but in this simulation the authors show that margin calls actually have no meaningful effect, since they assume that performance of the market after a margin call is as likely to be positive as it is negative. So sometimes a margin call will result in forgone profits, sometimes forgone losses.

And what about those high margin interest rates? Well in real terms they are still considerably lower than even conservative estimates of the equity premium, so the young investor still stands to benefit. But in fact margin rates should be much lower anyway. A loan secured by highly liquid assets with positive expected returns over which the custodian has power to liquidate at a moments notice is far from risky to the lender. Nonetheless margin rates are often double that of mortgage rates or student loan rates. That they persist at levels so high may, in fact, be further evidence of the cultural objection to margin investing. The perceived risk is far higher than the actual risk.

I hope I have accurately portrayed these scholars’ proposal. It is fascinating to me, both because I am a victim of the natural margin-aversion that many others are, but also because it suggests that aggressive investing, when done responsibly, can reduce risk.

Whether or not new ideas such as this prove to be wise, I think it’s always good practice to question the traditional wisdom. For instance, Warren Buffett’s assessment of diversification, and how lower diversification can actually reduce risk by increasing the deliberation made over any single investment, has always seemed a counterintuitive proposition. But there is certainly truth to it. Likewise, the idea of borrowing when young is counterintuitive and there may indeed be truth to it as well.

Ranjit kumar said...

Hi Vishnu,

I think the point you are describing makes some sense, risk it when you are young and can start all over again.

Ranjit kumar

Rohit Chauhan said...

hi vishnu / ranjit

i think there are some unstated assumptions in the article which are not explicit

- assumption 1 : you know what you are doing.

Being 200% invested with margin will work only if you invest well. if one is wrong, then margin call will wipe you out. i dont know about others, but investing is rarely a skill one is born with. it takes time and effort to learn and if you leverage in the begining , then the risk is even higher

assumption 2 : margin interest is not high if it exceeds equity risk premium.

i dont think one can be sure about this. equity risk premiums are not cast in stone. even if i earn 5% extra and use 3% extra margin cost, why take risk of a wipeout for 2% extra returns

I have read the reverse opinion in a lot of places like
- losing money in early years reduces the time your money can compound and hence the terminal value is reduce
- per warren buffet any returns*0 is equal to 0. So personally i would never favor an approach which has even a 1% chance of a wipeout

i have slighlty non convential approach to equity allocation. it may sound strange, but personally for me how much i invest in equity depends not on age or other factor but on the confidence (based on actual results) with which i can pick stocks. As i have improved, i have increased the allocation to stocks.

so much for my short answer !! :)


Anonymous said...

Hi rohit, could you tell me where you picked up the book you mentioned in your latest post. Is it available in India?


Ranjit kumar said...

Hi rohit/vishnu

There is some sense to both the views but Rohit's conventional approach is the best according to me.

Read the following famous article by Richard russell on Compounding and you will know that "Losing money early in your life, is not a good thing"

But when you find a very high probability event, you need to bet on big. You can take that chance.

Ranjit kumar

Rohit Chauhan said...

Hi mark/anonymous

i am not sure if the book is available in india. I got this from a friend in the US


Anonymous said...

"But when you find a very high probability event, you need to bet on big. You can take that chance"

Wrong statement.

This is what I sometimes find a bid odd. People who consider themselves Value Investors decry quantitative finance.

Kindly refer to Kelly's theorm (on communication) where he tells what to bet and how much to bet to maximize profit.

I know I have a holier than thou attitude, but I am a quant guy.

Rohit Chauhan said...

Hi anonymous
i find nothing wrong in this statement. it is completely in synch with kelly's theorem.
the above statement says if you find high probability event , bet big
kelly's theorem quantitifies the big.
the catch is how do you know that the odds you calculate are correct ?
i dont know about others, but i tend to bet lesser than what kelly's theorem suggests because i want to keep a margin of safety due to my own ignorance/ failings etc.
i personally dont understand quant finance and hence have no opinion on it.
actually i find it strange that investing has be like religion where if i belong to the 'value investing' religion, all the other approaches are wrong.
personally i dont subscribe to that kind of a mindset. if i can learn from other approaches , good for me. if i dont understand the other approach, i prefer not have an opinion till i can understand it well and analyse it for its merits or de-merits.

Sangram Pradhan said...
this is a good site to access similar information!
This is a great book!