Thursday, May 27, 2010

The Milgram Experiments

In 1961, Stanley Milgram conducted a series of social psychology experiments to measure the willingness of ordinary people to obey an authority figure who has instructed them to perform acts that conflicted with their personal conscience.

The experiment

Three people took part in these experiments - the teacher (participant), the learner (victim) and the experimenter (authority figure). Only the teacher was the real participant in the experiment. The role of experimenter was that of stern, impassive doctor with a white beard & wearing a long white overcoat. The learner was an actor who didn't have a major role in the experiment.

The experimenter would tell the teacher that this experiment was being conducted to study memory and its impact on learning in different situations. Per the rules of the experiment, the teacher would ask a question to the learner and if the answer is incorrect, then a small electric shock would be administered on the learner. These shock increased at a 15-volt increment, starting from 30 volts and going all the way upto 450 volts. After these instructions the teacher and the learner are separated and moved to different rooms. They cant see, but can listen to one another. The experimenter is in the same room as the teacher.

As the experiment continues and the teacher administers these shocks to the learner - it becomes apparent that the learner is in considerable pain. He shouts back at the teacher to stop and even bangs the wall. At around 135-150 volts, most teachers start questioning the experimenter on the purpose of the experiment after listening to the learner experiencing pain. The experimenter would normally say "Please continue" or "The experiment requires you to continue" or "These shocks will not have any long-term damages on the learner". The teacher would then continue and keep addressing his concern to the experimenter who would blankly request the teacher to continue the experiment.

The results

Now ask yourself these questions :

At what point (volts) will you stop when you know that the person on the other room is in excruciating pain? Will you go on and deliver 450 volts of lethal electric shock?

When this question was asked of a fairly large sample of people, only 1.2% were prepared to inflict the lethal 450-volt shock. And although there is no record on the voltage point of stopping the activity, I assume this would be pretty low as most people know how lethal even a 220 volt shock can be. (220 volts is the standard voltage in UK and India)

However when Milgram conducted his experiments - 65% of the participants pressed the 450-volt button. Most of them ever very uncomfortable doing so and at some point, every participant paused and questioned the experimenter. But 24 out of the 40 participants continued and delivered the lethal 450 volts. Of the remaining 35% (who stopped participating mid-way), only 1 person stopped before reaching the 300-volt mark.

The learnings

The experiment shows that ordinary people will go against their conscience and morality to even inflict pain on others, when ordered by an authority figure. Very few people have the resources to resist authority and these are the frightening implications of human nature.

Professor Milgram elaborated two theories explaining his results -
1. The theory of conformism which says, a subject who has neither ability nor expertise to make decisions, especially in a crisis, will leave decision making to the group and its hierarchy.
2. The agentic state theory wherein under an environment of obedience, a person comes to view himself as the instrument for carrying out another person's wishes, and he therefore no longer sees himself as responsible for his actions.

BBC re-enacted the Milgram experiments under a series "How violent are you?". The videos can be viewed here (Part 1 - 6 mins) (Part 2 - 6 mins) (Part 3 - 4 mins). These are worth watching.

Questions for you :
1. How many times do you get swayed by and invest based on recommendations by brokers, day traders and friends?
2. How often do you follow the mob especially in crisis situations? (although they are excellent opportunities for sane investors)

Extra : The Asch experiments also give proof of social conformity. There is a lot of literature on the subject but can be best described in this video (here - 2 mins)

Wednesday, May 26, 2010

Asian Electronics and Ben Graham's principles of investing

Asian Electronics is not my ideal value stock. The company has earned net profits of 71 lacs, 52 lacs and 14 lacs in the last 3 quarters. To its credit, the company has over 220 crores of annual sales but seems to be in dire straits at a CMP of 25.30 rupees. This wasnt the case always; in early 2008, the share price of Asian Electronics was a respectable 515 rupees per share but has faced investor apathy since then.

Is there any value?

While the DCF model will not work any magic here, the NCAV is a different story. One of Ben Graham's potent evaluation tools - the NCAV, throws some interesting numbers when I see the company's Mar-09 numbers.
Net Current Assets = Rs. 355.2 crs
Total debt = Rs. 238.8 crs
Shares outstanding = 2.98 crs
Hence, NCAV (net of all debt) per share = Rs. 39.06

At CMP of 25.30, Asian Electronics is valued at 64% of it's NCA (net of debt) per share.

This corresponds to one of Ben Graham's strict criteria - CMP at 66% of it's NCAV per share. Graham's reasoning was very simple - assuming there is no drastic reduction in the quality of the firm's current assets, there are high chances of getting a sumptuous deal when the firm goes into liquidation. This is a classical situation where the company is better dead than alive.

The NCAV is conservative in approach (which is good). It assumes that the firm will potentially get nothing for it's plant and machinery and investments - not even the salvage value. Asian Electronics seems Grahamian in this respect.

Discount-to-NCAV stocks are normally the ones that have been out of favour with most retailer investors and traders. They are the ones bordering around the no-profit-no-loss mark, have been big previously but have not been able to change to the times. Finding such stocks is not easy but not difficult aswell. Over the last 5 years, I have invested in 9-10 such companies but have had mixed success. I would advice the use the NCAV strategy with caution. Remember, the greater-fool theory is not at work when you are value investing.

Tuesday, May 25, 2010

The perils of emotional overinvestment

Emotional overinvestment is a state where one leans towards doing irrational things under the weight of the time and effort invested in supporting that same irrational act.

EI is most commonly seen in negotiations, where one party relents due to mental weariness. It becomes too difficult for the person to comprehend a no-result after having invested so much of time and effort. In the process he takes decisions which are detrimental to the company. I recently saw one where the buyer quoted 50 rupees and the seller quoted 150 rupees for a shawl. After 5 minutes, the buyer relented to 80 rupees while the seller was stuck on 150 rupees. Then 110-150 and then 130-150 .. and finally the deal closed on 150 rupees. The buyer had overinvested over 30 minutes of his time to come out the deal drawing a blank.

The same behavior is seen in auctions where bidders, inspite of having a maximum price for themselves, keep up with the increments. They too feel the the sapping effects of EI.

Investing is no different. As a student of value investing, I too have been a victim of it. Researching every stock, however good or bad, takes time and effort. To make matters worse, it also has an element of opportunity cost attached to it. In a bid to find that one hidden gem, I run the danger of picking a weak stock just because of the 'emotional investment' I put into the research of it.

Today, as the market touches 16,000 points on the BSE, we might see some value buys. Every value investor must be vary of the perils of emotional overinvestment as they runs their numbers in annual reports, moneycontrol and tomes of articles on the Internet. Its easy to make a mistake, almost impossible to rectify it.

In conclusion, I am reminded of a line in the movie "Syriana" where one of the attorney says - "When they write the GAAP like abstract art ... you look at a liability long enough and it'll start looking like an asset".

Good luck.

Friday, May 16, 2008

How to spot deep value stocks

This article (here) was published in The Economic Times on 4th May 2008. (nah! I didnt write it).

"Manish Sonthalia of Motilal Oswal Securities believes that PSU banks like Oriental Bank of Commerce, which is trading at a PE of 5.6 with book value of Rs 240 for FY09, is a perfect example of a deep value stock." (unfortunately this was the only stock discussed in the entire article)

Recently, OBC declared it's Q4 results and showed a net loss of Rs. 99 crs as against a profit of Rs. 54 crs last year. Additionally, on a full year basis, OBC closed the year on a profit of Rs. 353 crs as against Rs. 580 crs last year. The primary reason for the lowering of profits was the writing-off of the entire unabsorbed losses of Global Trust Bank (GTB) amounting to Rs. 487 crore, including the Rs 242 crore earlier slated for 2008-09, in the financial statements for 2007-08 itself. This means OBC starts of FY08-09 on a clean slate. 

To put some quick numbers around this - OBC will save on about Rs. 242 crores this year (apportioned as GTB write-off) this year. So reconstructing FY2007-08 numbers (without the OBC w/off) comes to -
Operating income : Rs. 5,800 crores
Other income : Rs. 615 crores
Operating expenses : Rs. 5,155 crores
Hence, profit before taxes : Rs. 1,260
Less: Taxes @ 35% : Rs. 441 crores
Net profit : Rs. 819 crores

At the current price of Rs.207 and a market cap of Rs 5,186 crores .. the stock is priced at a price-earning of 6.33. I am not assuming any increase in income here (or being a pessimist - am not apportioning additional provisions in the P&L for dubious asset quality). At 6.33, the stock is a bit undervalued. How deep the value is ... anyones guess !