Monday, December 30, 2013

Putting all your eggs in one basket

This article was first published in the Hindu Businessline, Investment World, December 30, 2013; Co-Author: Lokesh Kumar, ISB.

One of the most famous proverbs in the financial world is, “Don’t put all your eggs in one basket”. The idea behind diversification is risk reduction by investing in a variety of assets.
Conventional theory also says that risk and return are proportional to each other. Diversification results in the reduction of risk, but returns also reduce.
John Maynard Keynes, the father of modern macroeconomics, held quite different views. Keynes believed that investing in a few stocks gives much better returns than diversification and his faith in portfolio concentration rewarded him far with superior returns than a widely diversified market portfolio. In his view, an investor who knows something about the market can get better returns by holding few stocks rather than a variety of assets.
Keynes also argued that a concentrated portfolio would be less risky than a diversified portfolio because the investor could undertake due diligence of stocks if his portfolio is limited and would typically invest within his circle of competence.
“As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence,” said Keynes.
In a way, Keynes was emulating the idea of specialisation propagated by Adam Smith — the father of economics — who believed that breaking down a large job into many small jobs makes each employee an expert in one isolated area of production and thus improves productivity, which leads to higher economic growth.
Expansion of a portfolio beyond a certain number of stocks dampens performance because one loses the ability to effectively monitor the holdings. Keynes once said, “To carry one’s eggs in a great number of baskets, without having time or opportunity to discover how many have holes in the bottom, is the surest way of increasing risk and loss.”
In a research paper by Professors Zoran Ivkovi´c, Clemens Sialm and Scott Weisbenner, Portfolio Concentration and the Performance of Individual Investors published in the Journal of Financial and Quantitative Analysis in 2008, the authors show that investments made by households with concentrated portfolios outperformed those with diversified portfolios. The results indicate that households with concentrated portfolios evolve the ability to identify stocks that give higher returns.
A few other advantages of a concentrated portfolio are lower transaction costs and potentially lower monitoring costs. In comparison to a diversified portfolio holder, the concentrated portfolio holder has the fear of loss and that fear influences him to rigorously scrutinise companies before picking a stock.
For people who do not have risk appetite, or do not understand the business of the company in which they are investing, it is best to diversify.
Most fund managers invest in diversified portfolios as their customers may not have the ability to take a large loss. But those who have the risk-taking ability and appetite, besides the expertise to identify good stocks, might want to try their hands at concentration!

Saturday, December 28, 2013

Massive open online courses may be a mere flash in the pan

This article was first published in on December 28, 2013; Co-author: Sanjay Fuloria (Cognizant Research Centre)
Are Massive Open Online Courses (MOOCs) here to stay? Well, no one really knows. They are the new buzz on the education circuit and top universities are rallying to get a share of the pie. Though there is definite merit in learning from a professor and fellow students in a physical classroom, the business of education would flourish by roping in more and more students, and in this respect the traditional channel has certain limitations which the online channel does not. With starkly different learning impacts and revenue models, one must be candid in saying that this alternative method cannot be considered a replacement for the traditional method. At best, it can play a complementary role. However, factors that impact its sustainability and longevity are yet to be understood or managed. 

Started by reputed institutions with the aim to democratize education, Coursera, edX and Udacity are the pioneers in the area of online education. While MOOCs have come into existence only since 2011, each of the three institutions offer staggering 500 courses on an average. The courses are 3 to 17 weeks in length and have 30000 to 40000 students in each course on an average. The highest number of registrations for a popular course has been as high as 240,000. Average completion rate for the courses remain low at 10%.

Most of these are run by the star, mostly tenured, professors of elite institutions. Currently these courses are mostly free as they are subsidized by universities and venture capitalists (VCs). For example, edX and Coursera received $60 million and $16 million respectively from the VCs in the last two years. Eventually, when a successful revenue model is developed, these professors would be well positioned to mint money.

A fact that cannot be refuted is that the learning that happens in a classroom environment within an institution cannot be equaled in an online scenario. Peer group interactions and time spent with professors outside the classroom contribute towards a well-rounded personality. Campus life also promises a great opportunity to start business ventures in collaboration with peers. This kind of collaboration and networking is almost impossible to develop while being co-participants or co-learners in an online course. Whatever be the number of chat rooms created during an online course, who does business with a social network friend, especially if they have never met? Moreover, university is the platform where students assimilate different cultures, languages and cuisines, all of which make them truly global citizens. Globally, between 2010 and 2012, 6.7 million online course enrollments concluded in mere 670,000 completions. Though we do not know the usefulness of the courses for those who completed them, we do know that experiments have found that only 50 percent of credit-seeking students passed an online course as compared to 75 percent of students who undertook the regular course in a classroom. So why waste VC money on comparatively ineffectual online courses? This money could well be used in creating new institutes of higher learning or in creating branches of existing reputed institutes. That would ensure accessibility to good education. Turning to greener pastures, MOOCs plan to tap into the lucrative executive education market. Though online courses reduce cost to company, employees scorn on them as these reduce their time off from the job, travel and networking opportunities- aspects on which the physical classroom scores. Even short training programs arranged by the employers are attractive as they provide an opportunity for face to face interaction.

One of the biggest pluses of MOOCs, however, is their reach and in that they can complement regular brick and mortar courses. A university can expand the reach of its unique classroom courses, taught by a handful of experts worldwide, by opting for the online channel. In the field of executive education, especially for new hires, MOOCs can act as a post training module. Thus, if used innovatively, MOOCs can co-exist with the regular classroom training, especially because they are more cost-effective than their traditional counterparts.

If learning impact is one concern with regard to MOOCs then untenable revenue models is another. There is an eerie resemblance between MOOCs and the dotcom companies of the 1990s. The dotcom companies based their valuations on the number of eyeballs and clicks, which fetched them huge investments from venture capitalists. Similarly, MOOCs seem to be after number of enrollments. Dotcoms did not have a solid revenue model in place, which is the case with the MOOCs of today. They are toying with a multitude of options for getting their revenue much earlier in their lifecycle than dotcoms, however they need to get their revenue model right. Several profitability ideas are being brainstormed in the online education circles. These range from charging a nominal fee for giving a course completion certificate to charging users for complements offered by the online education providers to charging recruiters who hire students of an online course. However, all these ideas need to be tested and until there are signs of profitability, the fate of MOOCs remains uncertain.

Wednesday, November 27, 2013

Investing? How to build an optimal portfolio

This article was first published in the business section of on November 27, 2013; Co-Author: Lokesh Kumar (ISB)
Lucky scratched his head. Looked around. Buried his head again in the newspaper. 

Looked up again. Scratched his beard. Got up and hesitantly walked up to the lady sitting on the far end right corner of the student lounge at the University.
She looked up at the smartest guy in her executive education class. Lucky was a successful software developer, who had made money through stock options that his company gave him for performance. Gesturing him to take the chair opposite her, she asked, "where are you lost?".

"Look at this Professor Nicky", said Lucky, holding out the newspaper to her and pointing at the article that he was reading.
"Modern Portfolio Theory: Bigger Profit with less risk", read the heading. Nicky quickly scanned the article and asked, "So?"

Lucky: I have some money as fixed deposit with my bank. It is giving me a return of 9.25 percent per annum. I know it is a very safe way to get returns. But I also know that I am not maximizing my returns.

I may get more returns by taking some measured risk. I am a bachelor. I don't need to send money home. I can afford to take some risk.
But I don't know how to go about doing it. I am comfortable with programming, but finance scares me. If you can help me understand this article and what is modern portfolio theory, I might get over my fear and get started.

Nicky: But you can go to an investment advisor!
Lucky:  Yes. But I don't want to. I have had a bad experience earlier when one of them sold me a Unit Linked Investment Plan and I lost half of my invested money. I later came to know that they get a hefty commission for selling some of the products. So now I want to manage my investments on my own.

Nicky: Well, once bitten twice shy. But not all investment advisors are bad. And now, even the regulators are tightening the norms and making it safer for the investors. Having said that, it is good that you want to manage your own portfolio.
Let me start from the beginning. Harry Markowitz, a Nobel laureate in economics, introduced modern portfolio theory, a theory of finance that shows how risk averse investors can construct portfolio to maximize expected return for a given level of risk or to minimize risk for a given level of expected return.

He developed a simple framework, known as Mean-variance analysis, to analyze the tradeoff between risk and return. To diversify the money in risky and risk free assets, the first step is to find the optimal portfolio of risky assets and the second step is to find the best combination of risk free asset and optimal risky portfolio.

Lucky: Now you are losing me. Risk free? Optimal risky portfolio?
Nupur: Risk free assets are typically government issued short term bills or bonds. Even though technically a fixed deposit is not risk free, you may consider it to be close to risk free and continue to invest part of your money in fixed deposits.

An optimal risky portfolio is the market portfolio that provides maximum reward to risk ratio; in other terms, the best combination of risky assets to be mixed with safe assets to form the complete optimal portfolio.  It can be constructed by using a simple tool, Solver, in excel.
Lucky: This article here says that there can be many minimum variance portfolios. If that is the case, then which one should I choose?

Nicky: On right track! To build an optimal risky portfolio, you need to maximize the ratio of portfolio excess return to portfolio risk (standard deviation). This ratio is known as the Sharpe Ratio. Once you find the portfolio which maximizes the sharpe ratio, you can take that portfolio and invest part of your money in it and the balance in a risk free asset.
Lucky: How will I know how much to invest in each?

Nicky: Ah that really depends upon how much risk you want to take. If you don't want to take any risk, then your investment in risky portfolio will be zero percent. But if you want to take some degree of risk, then you will invest say 30 or 40 percent of your money in the risky portfolio and balance in risk free assets. It really depends upon your risk appetite.
Lucky: Wow! And all this was told by Markowitz?

Nicky: Yes. And he said many more things. But I guess this is enough for today. If you want to know more about his and his theory, google his name and you will find his originally published paper in the Journal of Finance in 1952.

Tuesday, November 26, 2013

Rolling like a coin: the evolution of money down the ages

This book review was first published in The Hindu on November 26, 2013

Easy Money: Vivek Kaul
Sage Publications India Pvt. Ltd.
B 1/I-1, Mohan Cooperative Industrial Area,
Mathura Road, New Delhi-110044
Rs 395

I wish somebody had told me these things when I was a student of Finance and while I was pursuing a PhD in finance. I would have had a much better perspective of how and why things work (or don't) the way they do! That's the first thought that came to my mind when I read the first book of the trilogy tracing the evolution of money.
The second thought was that this indigenous writer has written a book which is truly global in every sense. I would take the liberty of placing him in the same league as a Niall Ferguson or a Peter Bernstein, even though this is Vivek Kaul's first book.

We have heard of many college dropouts who have gone on to become billionaires. Here is an example of a PhD dropout, who it seems, is on the path to becoming a best-seller and an authority on Money, its evolution, regulation and consequences.
'Easy Money' published by Sage Publications takes us through the era when anything and everything was treated as money in some or the other part of the world. From salt, to dried cod, cowry shells to cattles and even slaves! Going as long back as the 12th century BC, the book chalks the path for evolution of Gold as money by meticulously laying forth the problems with alternatives and with having too many different money types.

There are many interesting facts throughout the book. It is fascinating to know that it was the Chinese who first started using coins and that they "believed that money is meant to roll around the world, and so it should be round". That the Chinese thought of this in the 12th century BC is fascinating.
The depreciation of the currency, or debasement, as it was known in the early centuries of the Christian era, and practised by reducing the metal content in the coins, eerily echoes the concept of printing more and more paper money to meet expenses, whereby 'money' systematically loses value.

From barter to commodities as money to paper money and then the evolution of the banking system, the journey has lessons, as highlighted by the author in the conclusion, that all regulators would do well to imbibe. Wildcat banking, free banking, bailing out institutions existed centuries ago as well. But we have not learnt from history and hence history repeats itself.
Kaul weaves together stories from Egypt, China, India, Rome, USA and UK effortlessly, as also he does with Marco Polo, Leonardo Fibonacci, Kublai Khan and the kings of the United Kingdom. He explains the evolution of concepts like 'settlement' and 'bill of exchange' through simple examples which make the book highly readable by even those who do not have a basic degree in Finance, Accounting or Economics. The research is thorough, language simple, stories fascinating. Everyone should read it.

Tuesday, November 19, 2013

Don't trust stocks experts! Here's how to do your own research

This article was first published in the business section of on November 19, 2013; Co-author: Lokesh Kumar (ISB)
Lucky was fascinated by the world of stock markets. He had started investing the money made from his stock options in equities a few months back.

The stocks were mostly selected based on recommendations made by analysts on business news channels and the newspapers.
Having lost 60 per cent of his principal invested in a particular stock, he decided to take matters in his own hands and learn about stock selection rather than depend on other. With determination in his eyes, he knocked at Professor Nicky's door.

Nicky:  Good to see you Lucky. What brings you here?
Lucky: Professor, I invested in a stock based on a recommendation, where the analyst had used Price-To-Earnings (P/E) multiple.  Before you accuse me of blindly following the analysts, let me clarify that I did Google the term, did my own analysis and then took a call to buy.

Nicky: The dark side of valuation!
Lucky: What do you mean?

Nicky:  Let me elaborate. The same multiple can be defined in different ways by different people.  Multiples can be misleading if you don’t know what fundamentals drive each multiple and how the multiples are estimated.
Price to earning is not the only multiple, though it is the most common. There are numerous multiples that exist.

A multiple is simply a ratio of two financial variables where enterprise value (measure of market value of all the securities, viz. common stock, preference stock etc., of a company) and equity market capitalisation (measure of  market value of just common stock) are used in numerator and various proxies for cash flow are used in denominator such as Earnings Before Interest and Tax (EBIT), Earnings Before Interest Tax Depreciation and Amortisation (EBITDA), Book Value, Sales, Employees, etc.
Lucky: But how do we know which is the right multiple to use for a company? This analyst always uses P/E Multiple.

Nicky: Keep in mind that you can’t use these numerators interchangeably to define a multiple. When the denominator is an enterprise level quantity such as EBIT, EBITDA, Sales or employees, you should use the enterprise value in the numerator; and when the denominator represents the shareholder level measure such as earnings or book value of equity, you should use equity market value in the numerator.

Lucky: That makes sense. But you did not answer my question. I am wondering whether any specific multiple is used for a particular industry.

Nicky: Yes. Some multiples make more sense for a certain industry than the other multiples. For example, Price/Customer multiple can be used to value Cellular phone and Internet companies while Price/unit multiple is suitable for soft drinks and consumer product companies.

Price to Earnings-growth ratio is generally used for growth Industries such as technology, health and luxury goods.

Lucky: What about Banks?

Nicky: Price/Book value is the more appropriate multiple for valuing a Bank. However, you must realise that when valuing a company using multiples, average multiple of the rest of the companies in the industry or few select companies in the industry is used.

If the company which you are valuing, is very different from the other companies in terms of size, geographical area of operation, growth prospects or technology used, you may not get a meaningful value for the company using multiples.

Lucky: What about other valuation techniques?

Nicky: There are many. Discounted cash flow method, dividend discount model, moat based valuation, etc. The key is to figure out which model is best suited to the company, which you want to value.

Lucky: Now, I realise why you earlier said, “The Dark side of valuation”.

Nicky: Yes. While valuation can be tricky, it is still better to invest with 'informed ignorance' than total ignorance.

Wednesday, November 13, 2013

The untold coal story: Jharkhand’s cycle pullers work for a pittance

This article was first published in on November 12, 2013; Co-Author: Puran Singh

The Chutupalu valley, about 30 kilometers from Ranchi, capital of the state of Jharkhand, in India, reminds you of the beauty of some of the hill stations in northern India. But apart from the greenery, as far as the eye can see, an occasional rainbow and foggy mornings, what characterizes the valley is the sight of hundreds of men pulling their cycles uphill, with 10 to 20 sacks of coal loaded on each.

They buy the coal from various mines or from illegal miners near the Ramgarh district, load the sacks of coal on their cycles early in the morning and start the journey to Ranchi. The journey, one way, is about 80 kilometers. The elevation is about 1000 ft. The weights on each cycle could be anywhere between 150 to 200 kilograms.

They take one and a half days to reach Ranchi, where they sell the coal to local restaurants and households and make Rs 400-500. They return to Ramgarh on the evening of the third day, only to start the three-day cycle starts once again the following day. Their earnings are often less than the average minimum daily wage of Rs 155 per day (2012-13) under the Mahatma Gandhi National Rural Employment Guarantee Act (MNREGA), and in inhuman conditions.

Their bare, cracked feet, blackened and wet (from sweat) vests, and blackened trousers pulled up above the knees make you wonder about the motivation for undertaking such hardship. Ask them and the answer is simple: “Pet ke liye” for food.

That the benefits of MNREGA, the flagship programme of the United Progressive Alliance government, does not reach them is obvious. So may be the case with the Food Security Act as well whenever it is rolled out in Jharkhand. That the state and the central government don’t know about these ‘coal pullers’ is also not believable as they are as much a part of the valley as the rocks and the trees.

There are no official statistics on the number of people engaged in pulling coal in the region. While people have been engaged in coal picking and selling them locally since the last 40 to 50 years, the numbers were small till about 15 years back. But they have been steadily increasing. A rough estimate is that around 7,000 to 8,000 men are involved in this activity in the Ramgarh district. Around 1,000-2000 of them would be operating between Ramgarh-Ranchi, through the Chutupalu valley. There has been no effort to either organise them or help them in any way.

They are often accused of stealing coal. “This is not right,” one of them says. “We buy from some people. Where they get it from, we do not know”.

Theft is a factor often attributed to the shortage of coal in the country. Coal mines in India, mostly in the central and eastern part of the country, are located in isolated hilly terrain and tribal areas. These underdeveloped areas, low on socio-economic development, are perfect setting for anti-social activities such as coal theft.

According to a report by Infraline Energy Research, New Delhi, people in these areas, steal coal from all possible avenues. They come in groups, outnumber the security personnel and take coal from stockyards. They create huge bumps on the road to slow down open trucks loaded with coals and loot away tons of coal. In another adventurous fashion, they arrest railway sidings, stop trains and take away hundreds of sacks of coal in a jiffy. These groups include men, women and children – on foot, on bicycles and on bullock carts. These groups of looters, local unemployed people, are controlled and supported by mafia in these areas. They steal 50-100 bags at one go and later sell it to the mafia for small sum of money who later make big profits in black market. This is the way of life for thousands of families in the state.

However, these coal pullers vehemently deny such charges. They maintain that they have nothing to do with the coal thieves or the mafia. A coal puller says, “We don’t want to do this. We know that in three to four years we will permanently spoil our knees and develop other severe ailments. If we stole, life would have been easier. But we don’t steal.”

In a state which is known as the coal capital of India, such a plight is an irony. On the one hand, billions are being made by industrialists and politicians through just the allocation of the coal blocks, and on the other are the hardships suffered by these coal cycle pullers for a pittance. It is a shame.

Friday, November 1, 2013

India and gold (2): gold loans on the up

The second part of the gold analysis was published in the beyondbrics blog of the Financial Times on October 31, 2013. Once again my comments were used in the article. Do read it by clicking on the link below:

Registration to Financial Times is free. It allows you to read a limited number of articles in the month.

India: Part of the Fabric

In an extensive analysis of Gold in the Indian context, Avantika Chilkoti and James Crabtree of the Financial Times have used my comments in their article. The article can be read at:

Thursday, October 31, 2013

Mohnish Pabrai on Cloning as a Strategy

This interview was first published by the Global Association for Risk Professionals on October 29, 2013

As a hedge fund manager, Mohnish Pabrai does not have to be fully transparent with his results- except to the investors who receive his reports. But he makes no secret about his targets and successful results in terms of compound returns, nor about the fact that they are grounded in value investing principles, particularly those espoused by Warren Buffett.

Anyone can gain insight into Pabrai's way of thinking in books he has written: "The Dhandho Investor: The Low - Risk Value Method to High Returns" and "Mosaic: Perspectives on Investing".

Pabrai talks up a principle of his own, which he describes as cloning. Successful formulas are visible for all to see, but, as Pabrai observed in a recent interview, there is something in human nature that devalues cloned ideas and strategies. “Be a cloner… but clone the best”, advises the managing partner of Pabrai Investment Funds.

The Irvine, Calif. firm is billed as a family of hedge funds inspired by the Buffett Partnerships, with more than $500 million of assets.

A Mumbai native and former IT consultant- founder of TransTech in 1990, which was sold 10 years later to Kurt Salmon Associates- Pabrai won the 1999 Illinois High Tech Entrepreneur Award given by KPMG, the State of Illinois and the City of Chicago. In 2005 he and his wife, Harina Kapoor, started the Dakshana Foundation, with the goal of recycling most of their wealth. The foundation is focused on alleviating poverty in India through education and scholarship grants.

The interview with Pabrai was conducted by Dr. Nupur Pavan Bang (, senior researcher, and Dr. Vikram Kuriyan, director of the Centre for Investment, Indian School of Business, Hyderabad.

Tell us about your belief in the concept of compounding.

Einstein called compounding the 8th wonder of the world. Let me tell you a story.

One day an inventor of games brought a game to the king- the game of chess. Since it was about battle between two armies, the king was amused and spent a lot of time playing the game. So impressed was he that he offered the inventor to ask for any reward. The inventor asked that he be given an amount of rice that would be equal to what the board could hold if we were to start doubling one grain of rice from the first square of the board up to the 64th square.

The king thought that this was a petty and stupid request and ordered for the reward to be given. The minister who was in charge of arranging this did not return for a few days. Upon inquiring about the delay the minister said that the whole kingdom did not have the 18,446,744,073,709,551,615 grains of rice required, or close to $300 trillion worth. Much greater than the combined wealth of the earth.

Such is the power of compounding. This is a concept that many great investors have time and again used for wealth creation. The celebrated Warren Buffett is a great example.

Warren Buffett and Charlie Munger have had a lot of influence in your life. How did you first learn about them and what got you interested in them?

In 1994, I was 30 years old and heard of Buffett for the first time. I did not have any knowledge about investments or capital allocation. Around that time, a couple of his biographies were published. I read them and looked at his track record from 1950 to 1993. Over 44 years he had compounded money at 31% a year. If you compound money at 26% a year, it will double every three years; at 31% you will double in less than three years. I thought about the story of the chess board again and realized that if Warren continued doing what he was doing, he would become the wealthiest person on the planet. He did became the wealthiest person on the planet.

I have never been to a business school and thought of investment, but few things stood out to me. In the investing world, hardly anyone followed Warren Buffett and hardly anyone generated returns the way he did. However, I thought that his approach to compounding was right, and these things were related. Buffett’s approach looked replicable, but no one was doing that. I liked compounding and thought of giving it a try.

How did you start? Where did you get your initial capital from?

I had sold some assets in the business I was running at that time [1994] and ended up with $1 million in the bank. I had no immediate use for that money. When I read Buffett’s biography,  I decided to play his game for 30 years. If I compounded at 26% a year, and my money would double every 3 years, a million would become a billion in 30 years. I thought that even if I fail by 95%, or 97%, I would be okay.

Swami Vivekananda used to say, "Take one idea, make that one idea your life. Think of it, dream of it, live on that idea. Let the brain, muscles, nerves, every part of your body be full of that idea, and just leave every other idea alone. This is the way to success". That is exactly what I did.

Could you tell us a little bit more about your journey from then on?

In 1995 I started putting the million dollars to work. By 1999, $1 million had become $5.1 million, growing at 43.4% per annum, way above my target of 26%. So I said, I think this could be done.

When did you start Pabrai Funds?

I used to give investment tips to friends and family. They would ask me to manage their money. So, in July 1999, I set up Pabrai Funds with $1 million in assets from nine investors. From 1999 to 2007, we compounded at 37.2% per annum before fees, 29.4% after fees.

Did the financial crisis hit you?

Oh yes, it hit everyone! From the mid 2007, for the next 21 months, we compounded at a negative 47.1%. That came to an end in 2009. Eighteen and a half years after I first started [1995 to mid 2013], I have compounded at 25.8% per annum. Short by 0.2. The good news is that I still have 11.5 years left, and in investments, the more you play, the better you get at the game (unlike tennis). I am excited to see how next 11.5 years unfold.

So how do you compound at 26%- especially since you were not formally educated in finance or investments? [Editor's note: Pabrai left his master's degree program at Illinois Institute of Technology to start his consulting and systems integration company, TransTech.]

When I set up Pabrai funds, I looked at the Buffett Partnership. It was closed in 1969; I opened in 1999. In that 30-year period, I did not find a single fund that replicated the Buffett model. I got all the information that I could about the model from published sources, took it to my lawyer and told him to simply replicate it. I adopted cloning in a very serious manner. I then started investing in stocks in which Buffett and his Berkshire Hathaway invested.

Why is it that we don't see many others succeed like you have? If it's only about cloning, anyone can do it.

That's right. Anyone can do it. But nobody does. There is something strange in the human genome which makes people think that cloning is beneath them. Everyone wants to do something unique.

There are other examples of cloning that have succeeded. If you look at Microsoft, Excel was cloned from Lotus; Windows, Word, and a lot of its other products are cloned. It's not even a great cloner, as most of its products take a number of versions to remove bugs. Even though Microsoft is not a great cloner, it is one the most successful companies in the world.

McDonald's spends a lot of time to figure out locations for their franchisees. They do a lot of analysis. While Burger Kings that compete with McDonald's, just look at where McDonald's is opening up.

There is a lot of debate going on about letting retailers like Wal-Mart into India. What perplexes me is that there is nothing in Wal-Mart's business model that anyone cannot figure out by walking into their stores. There is nothing in their model that cannot be replicated. India does not need Wal-Marts. It just needs an entrepreneur to look at their model and replicate it.

Do you blindly follow Warren Buffett and invest in any company he is investing in?

There were some professors in the U.S. who looked at every stock Warren Buffett bought from 1975 to 2005, and they did an analysis. If you bought what Buffett bought after it became publicly known, on the last day of the month at a higher price and held it until Buffett started selling and sold it after it was known publicly that Buffett had sold, and got the price which was the lowest price on the last day of the month, and you did this for every stock he bought and sold for 30 years, you would beat the index by 11.5% a year.

Bottom line, cloning is a very powerful notion. No good books have been written on cloning yet. If you take what Buffett did, then you are already beating the S&P by 11.5% per year. Mostly what Pabrai Funds did was to copy the other investors. I just give a slight tweak to it. I don't buy what others are buying. I look at what they are buying. Then I buy what I can understand and limit myself to two-three decisions a year.

How has your strategy evolved over the years?

We don’t learn from success. When we stumble we learn a lot. I am grateful that every time I stumbled, it has lead to growth. The period 2007-'09 was wonderful from a growth and learning perspective. Over the entire 1999-'07 period there were no negative returns. Not only did we make 37.7% per annum on a compounded basis, but there were no negative returns. We thought nothing went wrong, and I never saw the housing bubble.

In 2008-'09, financial system was out of oxygen. I had companies which depended on access to capital markets and financing. They just went into a tailspin. In one case, our investment went to zero. We had permanent losses. We had things which were knocked down on price and we had no ability to be offensive. We had no cash. I learned the rule that cash is king. Most of last year I was sitting with 20% cash. That was a big change.

Another change in my approach was the development of a pre-investment checklist, which is very powerful. It looks at mistakes made by other investors. This checklist helps me in catching those mistakes. One of the Warren Buffett biographies reveals that as a kid he used to walk in a strange way. It was to absolutely take out the probability of falling. He picks stocks similarly. He looks at the downside- how can he lose money. So  I did the same...questioning and re-questioning many times about how can I lose money on an investment. The checklist helps me there.

Also, I started having conversations with another investment manager. I got this advice from Charlie Munger, who said he always has someone to talk to about his investments. Until 2008 I never talked to anyone about investments. We mostly never agree, but conversations are helpful.

What about your fee structure?

My investors love my fees structure- which is copied straight from Buffett. Zero management fees for assets under management.  First 6% of returns go to the investor. Above that 6%, I get one-fourth and they get three-fourths. So if the portfolio is up 10%,  I get one-fourth of 4 percent (that is, 1%). If it is up 5%, we get nothing.

Warren Buffett is a Value investor. Isn't it very restricting to just copy him? There may be many more opportunities out there that may not strictly fall under the Graham and Dodd definition of a value investment, and yet be a great opportunity.

Well, Buffett is a multi dimensional investor. Dozens of investments that he has made are not moat based or may not be value investments. For example he has done a lot of restructuring and arbitrage deals. It is not so much about moat or value investing. It is about what you pay for a business. If you pick four or five investors and decide to pick the best of their ideas with some of your own criteria put in, you will be fine. You can skip the businesses which you don't understand or which are in conflict with your own criteria, and you will still have enough options to invest. Keeping it simple and buying at a great price are important. It is also important that if you are cloning, you clone the best.

Tuesday, October 29, 2013

Superman or not, Raghuram Rajan has indeed made a difference

This article was first published in the business section of on October 28, 2013; Co-author: Puran Singh (ISB)

"I am not a superman", he says, but the reaction of markets to his initiatives has been super indeed. He took over the office of RBI Governor amongst much hustle and media gush on September 4, 2013. Having predicted the financial crisis and carrying an image of an internationally recognised economist, Raghuram Rajan was seen as the savior for the Indian economy that had multiple economic issues to grapple with.

He had his guns ready and fired right away on the day he took over. He endorsed transparency and financial stability in addition to issues related to inclusive growth and development. A range of measures were announced that included elimination of license requirements for new bank branches, appointment of committee to assess RBI’s approach to financial inclusion, allowing rebooking of cancelled forward exchange contracts by exporters and importers, issue of cash settled ten year interest rate future contracts, interest rate futures on overnight interest rates, special concessional window for swapping FCNR (B) dollars, increase in foreign borrowing limit of banks to 100 per cent of unimpaired Tier I capital, etc.

On Financial Infrastructure front, he expressed an intention to implement Electronic Bill Factoring Exchanges to facilitate prompt bill payment facility to Micro Small and Medium Enterprises (MSMEs). He acknowledged the need to have Debt Recovery Tribunals and Asset Reconstruction Companies for efficient loan recoveries.

For households, the governor announced that they will issue Inflation Indexed Savings Certificates, come out with national giro-based Bill Payment System to facilitate bill payments any time, start mini ATMs operated by non-bank entities for better financial access.

These measures were well received by markets as the key economic indicators improved swiftly. Depreciating rupee that had been a cause of concern for some time, gained considerably from a low of Rs 68 per dollar on August 29 to stabilise at Rs 62 per dollar by September 16.

Sensex rode on investor expectations of favourable policies by the RBI and rallied by a maximum of 700 points, eventually crossing the psychological mark of 20,000 points. Forex reserves also remained stable during the time. Gold imports remained low at 7 tons in September helping India's current account deficit. Only thing that remained unleashed was inflation that rose to 6.46 per cent for the month of September 2013 (see Figure 1).

Figure 1: Key Financial Indicators before and after Raghuram Rajan’s taking over

Source: Reserve Bank of India;;;

In order to arrest inflation, in his first monetary policy review on September 20, Rajan increased the interest rate to 7.5 per cent (by 25 basis points), against the common expectations. This might have irked Finance Minister P Chidambaram, but he remained quiet, while he had openly criticised Rajan's predecessor Subbarao for a similar move.

Rajan maintained that controlling inflation was important which eventually provided a growth environment pretty much in line with his predecessor’s line of thinking. He made up for the increase in interest rate to some extent by rolling back the rate on Marginal Standing Facility (MSF rate is the rate at which the RBI lends emergency funds to the banks) to 9.5 per cent from 10.25 per cent earlier (it helped reduce the cost of funds to banks and hence their lending rates).

In one of the measures, norms for Non-Resident Indian (NRI) deposits and overseas borrowings by banks were relaxed. This helped the foreign exchange reserves of the country. When Rajan took over, the reserves were at three year low of $274 billion. A month after, the reserves are up by $5.6 billion.

The month of September also saw gold imports go down that resulted in trade deficits to trim down to a 30 month low of $6.76 billion, resulting in a much lower second quarter (July-September 2013) deficit of $29.9 billion as against $50.3 billion in the first quarter (April-June 2013).

On October 3, Rajan met Chidambaram and decided to provide additional capital to banks for lending to auto and consumer durables sector. On October 7, RBI reduced the Marginal Standing Facility rate by another 50 basis points (now 9%) to bring down the cost of funds to the banks (RBI had increased the MSF rate from 8.25 per cent to 10.25 per cent in July 2013). Two reductions in MSF indicated that the rupee position of India was comfortable. According to Rajan, current account deficit of $70 billion was achievable at a stable rupee.

On October 10, RBI allowed banks to raise funds from international institutions until 30 November 2013 for general banking purposes (not for capital enhancement). On October 12, Rajan announced that major reforms in the form of allowing foreign banks to enter and takeover domestic banks were to be introduced in the coming months.

He promised near national treatment to the foreign banks subject to couple of operational conditions. In a meeting at IMF on the same day, he pointed that India must not be seen as a country in crisis as he did not see India running for IMF money in next five years and even beyond.

In a speech at Harvard University, Rajan stated that Indian economy was to pick up in fourth quarter of the financial year as government cleared stalled resource projects worth $115 billion. Also, good monsoon season was expected to boost agricultural production. He also pointed that economic troubles of India had to do with unwinding of stimulus during financial crisis and increased spending on things such as gold rather than any structural problems.

RBI launched new Real Time Gross Settlement (RTGS) system for large-value funds transfer for settlement of inter-bank transactions (first implemented by RBI in 2004) on October 19. Its advanced liquidity and queue management features were expected to make financial markets more efficient.

On October 21, Confederation of Indian Industries and Association of Chamber of Commerce and Industries urged Rajan to cut key policy rates for better liquidity conditions. However, the seven month high inflation figure of 6.46% for September does not go in their favor. Given Rajan's reputation, we may see another hike in interest rates on October 29 and given his ability to communicate to all stakeholders, the finance minister may not even be in a position to criticize his policies as it may not be received well by the markets.

In this short span of time, Raghuram Rajan has introduced/announced many initiatives, most of them yielding positive reactions from markets. Whether this is first aid or permanent solution, is too soon to tell.

Thursday, October 24, 2013

Raghuram Rajan goes home

In an exclusive feature on Raghuram Rajan, columnist Savita Iyer-Ahrestani writes about the challenges of running India's central bank. I have been quoted in the article published by the Global Association of Risk Professionals. Do read it by clicking on the link below:

Monday, September 30, 2013

Concentration: the case for putting all your eggs in one basket

This article was first published in the Financial Times, FTfm, on September 30, 2013; Co-Author: Khemchand H. Sakaldeepi

Is diversification the best way to invest in the market today? Not really. The portfolios of major investors worldwide make the case for another, often-ignored, strategy: concentration. Business schools need to refrain from pushing the merits of diversification without highlighting the efficacy of concentration.

“Do not put all your eggs in one basket. Diversify.” In 1952, investment aspirants received this clarion call fromHarry Markowitz, a US economist and Nobel laureate.Peter Lynch, the famous US businessman and stock investor, “never saw a stock he didn’t like” and was a great proponent of portfolio diversification. While managing the Magellan fund, at the peak of his career, Mr Lynch’s portfolio had more than 1,000 stocks. To date, portfolio diversification remains the most important lesson taught to students of investment and risk management. The concept is a common thread in the investment approach of most fund managers and investors.

However, if we look at the portfolios of the rich and famous, they are, surprisingly, mostly concentrated. Several great investors, spread across geographies, have very concentrated portfolios. Warren Buffett, George Soros, Rakesh Jhunjhunwala and many others are renowned proponents of portfolio concentration. To Mr. Buffett, over-diversification presented a “low-hazard, low-return” situation and thus he dismissed it. A concentrated portfolio pivots on the absolute conviction of the investor in his or her stocks and his or her risk appetite.

A diversified portfolio, on the other hand, works well if the investor is optimistic about the stock, but wary of the associated risk. Investors like the first billion-dollar Indian investor, Mr. Jhunjhunwala, walk a fine line between the two.

John Maynard Keynes, the influential British economist, was another staunch supporter of concentration. “As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes,” he once said.

Mr. Buffett, echoing Benjamin Graham, the father of “value” investing, says he does not just buy an insignificant thing that bounces by a small percentage every day on the stock market. He buys part of a real business and thinks like the owner of a business would.

Mr. Buffett says: “Wide diversification is only required when investors do not understand what they are doing.” Bruce Berkowitz, founder of Fairholme Capital and a leading “value” proponent, adds that just a handful of significant positions are enough to do unbelievably well in a lifetime.

In 2012, the results of a study from the Paul Woolley Centre for the Study of Capital Market Dysfunctionality, University of Technology Sydney, showed that if skilled fund managers invested in concentrated portfolios, they would improve their performance markedly as compared with the portfolios that they would build under the compulsion to diversify. Despite mitigating stock-specific risks, the method of diversification cannot fortify the portfolio against market risks.

Advocates of concentration also opine that building or creating wealth with a diversified portfolio is difficult, unless the entire market is experiencing a bull phase and all the stocks in the portfolio are performing well. Even then, you may not get the full advantage of a multi-bagger as your investment in that particular stock would be just a fraction of your entire portfolio. The anti-diversification camp proposes that to generate wealth some concentration is required, provided people know how to assess their risk appetites and simultaneously pick winning stocks.

Fund managers today are caught in a catch-22 situation. Is wealth generated first by diversification and then maintained through concentration or vice versa? Knowing that concentration has been the mantra for success for most investment gurus, is it savvy to jump on the “diversification bandwagon” by adhering to popular belief? Awareness of such dilemmas and seeking clarity on them is essential for future managers.

It is, thus, time for business schools to introduce concentration as an important strategy in wealth creation, management and enhancement. Special attention needs to be given to this in business pedagogy, as the training of financial advisers and finance students will remain incomplete if it is restricted to the hallowed realm of diversification as the only plausible investment strategy.

Thursday, September 12, 2013

Duvvuri Subbarao: Green Horn that Locked Horns

This article was first published in the business section of on September 11, 2013; Co-Author: Puran Singh

"May you live in interesting times. I can hardly complain on that count. I had come into the Reserve Bank five years ago as the 'Great Recession' was setting in, and I am finishing now as the 'Great Exit' is taking shape, with not a week of respite from the crisis over the five years."

- Duvvuri Subbarao on his term as the Governor of RBI
He began his tenure on September 5th, 2008 as the 22nd Governor of the Reserve Bank of India (RBI). Within days, the roller coaster ride began. Global financial crisis set in and the newly appointed RBI governor, Duvvuri Subbarao, geared up for toughest of the times RBI had seen.

India had limited exposure to international markets in the year 2008. As a result of which impact of global financial crisis was not as severe. However, a comfortable rupee position and foreign exchange liquidity had to be maintained along with economic growth.
Under his leadership, RBI kept the domestic markets, to a large extent, alienated from the international meltdown to avoid liquidity or solvency cascades. Apart from conventional steps for liquidity infusion such as reduction in rates, he took unconventional steps such as rupee-dollar swap facility for Indian banks, refinancing window for Non-Banking Financial Companies and facilitating refinancing of the credit to small industries. Through these measures, liquidity to the tune of $75 billion or approximately 7 percent of GDP of the country was induced in the economy post November 2008.

Everyone agreed that the country had fared relatively better during the global financial meltdown. Subbarao's original term of three years was extended for another two years by Government of India in September 2011. Most bankers and economists supported the move as any change in apex bank’s policies may not have been the best for the economy at that point of time.
The year 2012 brought more challenges for the Governor. Increased liquidity in the economy had led to a period of high inflation starting from 2009-10 that eventually became a hot potato. In February 2012, RBI decided to increase the bank rate from 6% to 9.5% for the first time in nine years (there had been no change in the bank rate since April 2003) calling it a technical adjustment.

The bank rate was decreased to 9% in April 2012 to support the growth push that the economy needed. But seeing the ineffective efforts of government to rein in the deficit and high inflation, Subbarao decided to hold the bank rate unchanged from then on despite pressure from the Center to lower it further. He had to make a tough choice between reining inflation and supporting growth through fiscal policies that the government had in mind. For lack of belief in the government’s plans, Subbarao took a stand in favor of the common man and refused to further cut the rates much to the disappointment of Mr. Chidambaram who publically expressed his anguish over it.
Listed among ‘India’s 50 Most Powerful People 2009’ by Bloomberg Businessweek, Subbarao stood against the wide calls to cut interest rates by the industry and the government. He stuck to his belief that inflation hurts the common man and hence curbing it was more important even if it meant sacrificing part of the growth.

Subbarao made efforts to make RBI a body that was ‘communicative, honest, open minded and accountable’ rather a black box which was a mystery for people. He had the opinion that people should know what RBI does. He aimed to demystify RBI and make it a role model for central banks globally.
In this direction, RBI designed financial literacy programs and pushed the states to introduce financial education curriculum at school and college levels to help enable the people to demand services from banking system.

In similar direction, he pressed on IT enabled banking, promoting financial awareness, and starting financial inclusion drives. In February 2013, in its new guidelines for banking licenses, RBI mandated that the aspirants, in their business plan, include ways to achieve financial inclusion.
He was criticized for not maintaining high forex reserves when rupee was appreciating during 2009-10. Also, his tenure was worded as the worst by a RBI governor by Arvind Panagariya, Professor of Economics at Columbia University. During the last few months of his tenure, he was blamed for falling rupee. Despite all criticisms he stuck to his guns and defended his decisions. While the government blamed RBI’s tight monetary policy and non-cooperative policy behavior for deteriorating economic situation, RBI governor convincingly reallocated the blame to loose fiscal policies of the government and policy paralysis.

A Green Horn five years back, he retired locking horns with the bosses. On September 4th, 2013, as he handed over charge to Raghuram Govind Rajan as the 23rd Governor of the RBI, he may not have been the favorite of the finance minister of India, Mr. Palaniappan Chidambaram, but had certainly raised RBI's stature as an autonomous body. He charted an independent path from the government, refused to succumb to the pressure from the Center.

Wednesday, September 11, 2013

Punishing India’s love of gold will not yield result

This article was first published in the Financial Times, Beyond Brics, on September 10, 2013; Co-Author: Puran Singh

"Getting married this year would be very costly for me. With gold prices at all-time high, jewellery shopping will literally wipe out all my savings. My parents will insist that I buy at least 50g of gold jewellery for my future wife. It does not make sense  right now at such high prices", says a friend who is planning to postpone his marriage to his fiancĂ©.

India's finance minister P Chidambaram has blamed the $86bn (4.5 per cent of GDP) current account deficit on India's "passion for gold", and has introduced various measures to curb demand. There are several reasons why such steps are unlikely to succeed. 

At the start of 2013 import duty on gold was increased from 4 to 6 per cent. At the same time, the duty on raw gold was doubled to 5 per cent. In February, gold deposit rules were relaxed by the Reserve Bank of India (RBI). In March, the RBI started monitoring gold coin sales by banks. In May, the RBI restricted consignment-based gold imports by banks. In June, import duty on gold was hiked to 8 per cent. In July, RBI tied gold import quantity to total imports. 

But, the demand for Gold did not budge downwards. Having failed to curb demand, a hike in import duty was announced in August for the third time. The import duty currently stands at 10 per cent.

The bad news for the RBI and Chidambaram is that 2013 is scheduled to have 31 extra wedding days in India, because according to the lunar calendar only 117 days will be lost to Chaturmas (considered inauspicious) compared to 148 days in 2012.

If it can, the Government of India should come out with an incentive for couples planning to get married to not do so this year. About half of gold jewellery shopping in India happens during weddings.

India produces a negligible 2.3 tonnes of gold a year and consumes almost 1,000 tonnes a year. No points for guessing where the balance comes from. Increase in gold demand in any year has to be met by importing more, and given the importance of gold in Indian marriages, any reduction or postponement in gold demand is not a reasonable assumption.

Apart from weddings, festivals are the second most important occasion for the Indians to buy gold jewellery. Just under a quarter of the demand for gold jewellery is bought during festivals in India, according to a survey by AlphaWise and Morgan Stanley Research in 2012, compared to 43 per cent for weddings.

Diwali, the most important festival for Hindus is in early November and people buy gold on Dhanteras to please Goddess Laxmi (the Goddess of wealth). Our presumption is, given the sentiment attached to buying gold and the returns it has offered post 2008, people will not mind buying gold even at soaring prices. 

In history, wars have been fought over the ownership of gold. Now the battles take place in the form of derivatives, exchange traded funds, and mutual funds. Gold is still much sought after, but more so for its financial than aesthetic value. The government of India and RBI are fighting another war against its own people. 

People are wondering why the RBI and the government would try to curb gold imports to solve a problem that is created due to government overspending and policy paralysis. Why would a government which is not able to protect its citizens from inflation prevent them from buying gold, which is considered a hedge against inflation?

Gold gives a common backdrop to an India which is otherwise diverse in religion, faith and culture. Embedded in the Indian psyche as symbol of prosperity and wealth, owning gold is akin to the American dream of owning a home. 

Hence, the curbs on gold may not yield the desired result. But it will succeed in building up further anger against the ruling government.