Stock Picking V/s Portfoilo - Talk by Sanjay Bakshi

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  Prof Sanjay Bakshi and Paresh Thakkar talks on Stock Picking vs Portfolio Construction

  The following is a summary of Prof Bakshi’s and Paresh’s speech/comments during the

  presentation.

  Captain Sully and the Hudson River landing

  Prof Bakshi started the talk by showing a clip from the movie Sully.

  On January 15, 2009, Chesley Sullenberger better known as Captain Sully, was pilot in

  command of a US Airways Flight 1549, an Airbus A320 taking off from LaGuardia Airport.

  Shortly after takeoff, the plane struck a large flock of birds and lost power in both engines.

  Quickly determining he would be unable to reach any airport Sullenberger piloted the plane

  to a water landing on the Hudson River. All aboard were rescued by nearby boats.

  After the incident, there was an investigation and public hearing. During that hearing, it was

  alleged that captain Sully made a mistake and endangered lives by landing the plane in

  Hudson. He should have tried to get to the nearest airport which was seven miles away.

  The investigators even tried to replicate the situation on a flight simulator and showed that

  he could have landed the plane. Sully made a point in his defence that those trying to say he

  made a mistake are not taking into account the ‘human element’. The pilot who had landed

  the plane in the simulation exercise had practiced it seventeen times before he could do it

  successfully. Later on, when they incorporated a 35 second delay (which is the least time

  any pilot would have taken to react in a real life situation) in the simulator exercise, the plane

  crashed.

  The National Transportation Safety Board ruled that Sullenberger made the correct decision

  in landing on the river instead of attempting return to LaGuardia because the normal

  procedures for engine loss are designed for cruising altitudes, not immediately after takeoff.

  What is the difference between what we do and Sully situation?

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  A flight lasts only a few hours but our investment operations last more than a decade.

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  We can afford to be more reflective (while sully had all of 208 seconds), though some

  sort of value investing operations do require a quick response (e.g. if there is massive

  moat impairment in a position) but most of the time, most of our decisions are slow

  decisions.

  -

  Longer decision time means feedback is delayed. This is unlike day trading or for that

  matter archery or shooting, where you get instant feedback on your performance.

  -

  Life is not long enough to allow for feedback to be a good teacher in long-term value

  investing. Therefore, we have to rely on vicarious learning or learning from past

  experience of others.
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  What is the similarity between what we do and Sully situation?

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  Good portfolios are like good airplanes. They do not usually crash as they have multiple

  engines. If one engine fails, there is a fallback option. In portfolio management parlance,

  a crash would be equivalent of decimation of earnings (and not decline in market value)

  of any position in the portfolio.

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  Multiple engines are there to create redundancy. The principal of redundancy is also

  applied in civil engineering e.g. in construction of a bridge where the bridge is

  constructed to bear 3x the maximum load it is expected to bear.

  “When you build a bridge, you insist it can carry 30,000 pounds, but you

  only drive 10,000-pound trucks across it. And that same principle works in

  investing.”

  -Warren Buffett

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  Similarly, to have robust portfolios, one should create redundancy which is actually

  nothing but a margin of safety. The weights of various investments in the portfolio

  should be restricted to a maximum number (say 1/6th of the total portfolio) so that any

  unexpected negative outcome doesn’t threaten its very existence.

  Casinos, Insurance companies and Margin of Safety

  “In order to take proper advantage of the margin-of-safety principle in

  investment operations, its almost always essential that the investor

  practices adequate diversification. A margin of safety does not guarantee

  an investment against loss; it merely guarantees that that probabilities are

  against loss - and in case of common stocks, that the probabilities favor an

  ultimate profit.”

  -Benjamin Graham

  -

  One can best understand the concept of margin of safety by understanding how a

  casino operates. A casino is usually a safe place for an investor/owner as casinos tilt

  the odds in their favour. The casinos make sure they have the winning edge. Players do

  not stand a chance. As a collective, they are playing a game that they can never win in

  long term as odds are not in their favour.

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  Consider the game of American roulette. It has 38 slots – numbers 1-36, 0 and 00. If a

  player bets on number and the winning number matches, the player wins 35x.

  Otherwise, he loses the bet amount. Eg: If a player bets Rs 1000 on a number his

  probability of winning Rs 35000 is 2.63% and probability of losing 1000 Rs is 97.37%.

  Expected value is negative Rs 53.20.

  -

  This is how Casinos make sure they have a winning edge:
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  

  Set the odds against the players. They have a small albeit a clear edge (in the

  long run, house wins)

  

  Since they have a small edge, they need to diversify a lot. So they make sure to

  get lots of players to play (Any one player’s outsized winnings cannot bankrupt

  them)

  

  Put limits on bet size (No player can keep increasing bet size to harm the casinos

  in case he/she gets lucky on an oversized bets)

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  Insurance business does something similar to casinos to manage risk.

  “What counts in [insurance] business is underwriting discipline. The winners

  are those that unfailingly stick to three key principles.

  1. They accept only those risks that they are able to properly evaluate

  (staying within their circle of competence) and that, after they have

  evaluated all relevant factors including remote loss scenarios, carry the

  expectancy of profit. These insurers ignore market-share considerations

  and are sanguine about losing business to competitors that are offering

  foolish prices or policy conditions.

  2. They limit the business they accept in a manner that guarantees they

  will suffer no aggregation of losses from a single event or from related

  events that will threaten their solvency. They ceaselessly search for

  possible correlation among seemingly-unrelated risks.

  3. They avoid business involving moral risk: No matter what the rate,

  trying to write good contracts with bad people doesn’t work. While most

  policyholders and clients are honorable and ethical, doing business with

  the few exceptions is usually expensive, sometimes extraordinarily so.”

  -Warren Buffett on Principles of Insurance Underwriting

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  In both the businesses (Casinos and Insurance), there is one common principle:

  The lower the edge (margin of safety) of the casino over the customer, the higher

  the need to diversify, and vice versa.

  -

  Just like casinos and insurance businesses, a prudent investor should reduce the

  probability of failure (and increase probability of success) by combining margin of safety

  with proper diversification.
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  “The individual probabilities may be turned into a reasonable approximation

  of certainty by the well known practice of “spreading the risk.” This is the

  cornerstone of the insurance business, and it should be the cornerstone of

  sound investment.”

  - Benjamin Graham

  What it means for Concentrated Investing?

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  If a narrow edge warrants a diversified portfolio, a concentrated portfolio would warrant

  a wider edge.

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  In concentrated portfolios, you don’t want even a single position to blow up, as that

  would be a major setback.

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  That means one has to be extra careful while selecting what to include in the portfolio.

  Rejection rates have to be very high. One needs to add layers of protection, apply strict

  filters so that the few ideas which can pass those filters are the most robust ones.

  Redundancy: Adding layers of protection

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  The Idea of “Margin of Safety” is based on the idea of Redundancy in Engineering.

  -

  Critical components of a system are duplicated with the intention of increasing reliability

  of the system. If one component fails, the other one acts as a backup making it a fail-

  safe system.

  -

  In such a system, all components must fail before the system fails. If each one rarely

  fails, and events of failure of each is independent to others, the probability of all three

  failing (system failure) will be extremely small.

  -

  Similarly, good portfolios also need several layers of protection. All this protection has a

  cost in the form of reduced return. This is because the investor will sacrifice some return

  to avoid blow ups. This protection will come from

  1. Avoiding what doesn’t work

  2. Seeking what does work

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  From past experience of self and others, one can look for patterns, and decide on a

  stringent exclusion criterion which very few ideas could pass. This will reduce the

  clutter.

  Avoiding what doesn’t work

  -

  Managing a concentrated portfolio is probably opposite of how most venture capitalists

  (VCs) work.

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  Complexity and Unpredictability – If we do not understand a business and can not

  visualise it a decade down the line, we would like to avoid it.

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  Models Prone to Disruption – If we don’t know whether the company is strong

  enough to survive or some other rival can disrupt it with new technology, we would

  avoid it.

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  Binary Outcome Situations – Cases where either the company is a big success or

  they perish completely (e.g. e-com companies)

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  Lack of Pricing Power – Businesses which do not have the ability to pass on the pain

  of inflation to customers (e.g. power companies in India)

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  Corporate Mis-governance – No amount of margin of safety can justify to be partners

  in a business which doesn’t respect minority shareholders.

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  Overvaluation – This is functional equivalent of a bet where odds are against you

  Seeking what does work

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  Moats – High RoC businesses which have a competitive edge. These businesses

  have inbuilt shock absorbers.

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  Entry Barriers – Businesses which are not easy to compete with by new entrants.

  Strong brands, Long gestation etc.

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  Owner Operators (Soul in the Game) – Business should be only/primary source of

  income. Reputation/identity of promoter associated with that business.

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  Hard to Replicate, Admirable Corporate Culture

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  Growth – Good sustainable growth. Long runways. Growing size of overall industry.

  Growing market share because of low cost or better management. Unlike Buffet, not

  interested in non-growing or declining businesses (e.g. newspapers) as we can not

  take out cash as he can. Would prefer to pay up for quality rapidly growing company.

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  Ability to self-finance growth – Happy with entrepreneurs conscious about leverage,

  asset allocation, using incremental capital wisely. More happy with those who never

  dilute capital to grow. If they have diluted, it should be for good reason.

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  Good Governance

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  Reasonable Valuation

  Role of Checklists

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  A checklist is needed to protect ourselves against our own mental flaws, biases and

  laziness. A checklist forces you to look for contradicting evidence.

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  Qualities of a Good Checklist

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  It should focus on things that really matter
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  It should be short (for example you don’t need six ratios to determine if a

  business has strong balance sheet or not)

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  There should be some deal breaker questions while other questions may require

  trade-off

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  Our Initiation Checklist

  

  Focuses on three things: Business, People, Price - in that order (no tradeoffs)

  

  We try to make it short

  

  We have deal breaking questions. For example if a business is pro-social or

  not

  System of Redundancy in Stock Picking

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  Layer 1 - Avoid things that don’t work

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  Layer 2 - Seek good businesses, run by good people, at good prices

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  But this is not enough because of risk tend to gets aggregated at portfolio level.

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  Some examples of Risk Aggregation in Portfolio

  

  Geographical

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  Customer/Supplier Concentration

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  Regulatory

  

  Judicial

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  B2B vs. B2C

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  Local vs. Exporters

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  Market Capitalisations

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  For example, let’s say we invest in five companies which are

  1. Dominant in their industries

  2. Run by great owner operators

  3. All exporters

  4. in different industries but have customers in US

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  They are all wonderful investments individually but have one common factor which

  leads to aggregation of risk. What if USD/INR goes to 45? The probability of that

  happening may be very low but if it happens, the Consequences for the portfolio

  could be and would be significant. If such a scenario is unacceptable to you, then you

  have to take care of it in portfolio formation. This will probably involve sacrificing

  returns as you may have to forgo some investments which may be suitable

  individually but may not fit well with the rest of the portfolio by creating a probable

  outcome which may not be acceptable.

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  This is just one way to demonstrate how risks get aggregated at portfolio level. There

  could be many other ways depending on what is there in the portfolio. You have to be

  creative and think about these scenarios as you don’t know where risk is going to

  come from. You have to carry the worry gene not just in initiating a position but also

  in building the portfolio.

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  So, in a good, robust system, the Risk Manager Should be allowed to overrule an

  excitable stock picker. But in reality the stock picker and the risk manager are the

  same guys. They are just wearing different hats. The stock picker wears the
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  “creative” hat and his “worry gene” prevents him from recommending ideas that have

  significant risk of permanent capital loss.

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  The risk manager’s worry gene making him think about how “shit happens” at the

  portfolio level (recall what happened to a respected fund because of an oversized

  position in Valeant) and how to put in limits to rein in the excitement of the stock

  picker.

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  A Well-constructed portfolio will almost always cost money in terms of sacrificed

  returns

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  We are not trying to maximize returns, because that may also mean that we may go

  to zero (or anywhere close to zero). We do not want that.

  -

  That is why Risk matters as much as returns.