Predictably Irrational

The IHT featured a brilliant article on keeping too many options open.

The writer argues that having too many options open actually allows for irrationality to seep into decisions. A copy of the entire article can be found here.

1. People find it let go of options like you don't even know how a camera's burst-mode flash works, but you persuade yourself to pay for the extra feature just in case.

2. People act irrationally when they have more options. In investing, I've prefered to put as low as Rs. 20,000 in 4 separate stocks equally, although I knew that stock A was better than stock B, C or D. While I call it diversifying my risks, value investors call me 'dumb'. A better thing would have been discard the 3 inferior options.

3. Closing a door on an option is experienced as a loss, and people are willing to pay a price to avoid the emotion of loss.

Thanks to Anand Dugar for posting this article on Lollapalooza

iRules

I came across a splendid article on Rule Maker Criteria, which put forward certain rules to stock investing. These rules are enclosed. I have further tried to explain each of these below.

1. Sustainable competitive advantage
2. The company must be dominant in its given industry
3. Dominant for more than a decade
4. Cash King Margin in excess of 10%
5. Foolish Flow Ratio below 1.25
6. Sales above $4 billion per year and growing revenues at 10% plus rates
7. Great management
8. Return On Invested Capital above 11%
9. Cash no less than 1.5 times debt
10. A reasonable purchase (or holding) price

If you find any company in India, that fits the profile .. pls use the comments column to this further. Or feel free to email me.

1. Sustainable competitive advantage
This includes companies which are sheltered from competition, powerful brands, patents, monopolies and unduplicable distribution systems. This is where you look at possible threats to a company, something which often companies themselves fail to list in their management discussion and analysis pages. E.g. BillPay's 3000 outlet distribution network is in risk of mobile bill payments, newspaper's advertising revenue replaced by online advertising etc.

2. A dominant company
The higher the market-share (and mind-share) of the company, the better positioned it is. E.g. Naukri or Monster for job searches, CRISIL for ratings, IIM for management education.

3. Dominant for over a decade
This is quite self-explanatory. Maruti Suzuki is a good example that comes to mind. (discounting the Nano effect for now)

4. Cash margin in excess of 10%
Pls notice that it reads cash margin, and not net margin. If a company's free cash flow is over 10% of it's revenue, then it warrants more investigation. FCF is quite a weapon: money that it can either reinvest or return to shareholders. Some businesses, such as many types of retailing, will not allow such margins but most others do. FCF is calculated by taking the cash from operating activities and subtracting it by capital expenditure for the year.

5. The Flow Ratio
Let me explain the background behind the ratio first. A 'flow ratio' represents how well a company is managing it's cash. This is applicable to individuals aswell, like you and me. It's like saying, we are more comfortable when our debtors paid their dues, and we still have a few days left before we pay our creditors. For us, as investors, a company that does that has a lot of breathing space and gives us more comfort.

As a formula :
Flow Ratio = (Current Assets - Cash - Cash equivalent - Marketable securities) divided by (Current Liabilities - short term debt - current portion of long-term debt)

So, if this ratio is below 1.25 - the company is comfortably placed around managing it's cash.

There is one part of this principle that I dont quite understand. Let me take an example here. Sales = 100; Cash = 5; CA = 30; ST debt = 5; CL = 35. Here, the flow ratio comes to 0.83. But, I am not still not comfortable with the fact, that 30% of my sales for that year has been accrued but I have not yet received the cash. This is similar to the inventory turnover ratios, which also warrants a look while understanding a business.

6. Sales above USD 4 billion per year and growing at 10%
This is absolutely upto you. Since I prefer to invest in mid-cap companies, my minimum annual sales benchmark is Rs. 300 crores (USD 75 million). However, the annual growth of my companies is a much stricter 25% of organic growth. (organic doesnt include revenue increase from any acquisitions or mergers)

7. Great management
Fisher's insights into management revolved around - unquestionable integrity, commitment to new product development, outstanding labor and personnel relations, outstanding executive relations, managerial depth, long-range outlook on profits and open communication with investors.

8. Return on capital invested over 11%
This is a way of saying, does it make sense for me to put this capital in this business or just stash it in a fixed deposit that can give me 9.5% pre-tax. 11% (post tax) is definitely one-up on a risk-free investment or fixed deposit. Some pundits settle for nothing less than 15%.

9. Cash to debt should be 1.5 or higher
Businesses like this carry a huge moat with them. These are cash rich companies which can produce earnings using internal accruals rather than borrowing from the market. Such companies are difficult to find. The IT sector would have a few of them though.

10. A reasonable price
As a thumb rule, dont pay a price more than 60% of the intrinsic value of the business. I would agree to this rule. 40% is a good margin-of-safety ... and a brilliant price to pay for a good business.

Value investing requires discipline. I would suggest all to make a rule list for yourself and examine businesses in the light of these.

The Kelly Criterion

While reading an article over the internet, a certain line caught my attention - "while most of the investment world talks about what stock to buy, no one tells us how much of it should be bought."

I investigated further to find a paper written way back in 1956 by J. L. Kelly Jr. which evaluates "how much" a gambler needs to bet on a table such that he can maximize the growth of capital at a rate which is equal to his information rate over the channel. In other words, how can one achieve the maximum growth in capital for the amount of risk one is taking.

There has been a lot of work around this and is today called the Kelly Criterion. The question that the criterion seeks to answer is : how much of my capital should I allocate towards a trade?

Assume your research has indicated that there is 70% chance that the price of Ranbaxy is going to drop in the next 2 days. Further, you feel that the drop will be a good 12% from it's current price. Just to be on the safer side, you assume that even if the price of Ranbaxy rises, it wont go over 8%.

In other words, your probability of winning is 70%; your probability of losing is 30% and the win/loss ratio is 1.5 (12% divided by 8%).

Kelly % = Prob (winning) - [Prob (losing) / win-loss ratio]

In this case, Kelly % comes to 50% ... i.e. 70% - [30%/1.5]. Thus Kelly's % says that you must not invest more than 50% of your capital towards this trade i.e. shorting Ranbaxy.

Over time, the Kelly % has come under criticism for being too heavy (as in this case, 50%) to allow for easy diversification of portfolio. Most people who use Kellys' have settled for a half-Kelly i.e. 25% as in this case. However, I found the Kelly % quite simple and useful in ensuring that an investor is not putting too much capital into a single trade. So, the next time you run a buy or sell decision, try to measure it's effects using the Kelly criterion.