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“Sound investment principles
produce generally sound results”1
A guide to prudent capital allocation
Benjamin Graham; The Intelligent Investor (the original 1949 edition, Introduction - Page # xxvii)
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As an investor, you are, for lack of a more civil word, screwed.
You are competent in your profession or business; you’ve worked hard, and you’ve saved
diligently. But when it comes to deploying this hard earned money in the equity market,
most investors will be alarmingly irresponsible, and will repeatedly exhibit very poor
This is partly the fault of the investor herself and partly the fault of the financial
ecosystem; but it is also entirely the fault of how easily the human brain can be
manipulated into making bad decisions - we discard sound reason and logic by giving in
to fear and greed.
My intention is to draw on the mistakes of investors past and present, including my own,
and contrast it with the investing habits of prudent minds readily available to us - Charlie
Munger, Phil Fisher, Warren Buffet, Peter Lynch, Benjamin Graham, and the like. By doing
this, I hope to convince you of the following:
1. Why otherwise intelligent people, as investors, make decisions with their money
that is contrary to their own best interests
2. How hyperactive equity markets operate in a way that first and foremost, benefit
the financial intermediary, and not the investor
3. How the investor can utilize the frenzy of the markets using simple business
principles, and create sustainable long term wealth
4. And finally, my advice for long term investors on deploying capital with
rationality, patience, and discipline
Whether or not you are swayed by my reasoning, I sincerely hope that you find the
contents of this white paper useful in making you a better investor.
Thanks & Best Regards,
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Your money manager will fail you - and mathematics & human
behaviour will come together to ensure it
What does the Mean, mean?
Everybody wants to beat the market, and everybody hopes to better the crowd. But how can you
expect to ‘beat the market’ if you yourself are the market? If you do what everyone else is doing,
you will get what everyone else gets. All the money managers in the world, put together, will
necessarily produce the mean - the average. It is therefore imperative for the investor to understand
that they, collectively, will never produce an above average result.
Your investments must be deployed with the aim of the underlying assets producing superior
business performance - not aping what the market is currently chasing. “Think about what counts”,
as Warren Buffet advises his managers, “not how it’s counted”2
A culture of mediocrity
Trying to chase fads and hype (the flavour of the month/quarter etc) is the surest method of
following the crowd - and the crowd always loses. Think of every “boom”, and remember how in
each instance, the ‘experts’ were able to justify how ‘this time, it’s different’. Whether it’s
companies “with landbanks that will unlock value”, or .com’s with no actual assets or business, the
game of buying something simply because it is currently in demand, is a guaranteed path to an asset
bubble. And bubbles burst.
If this is your preferred way of making money, then you must also understand that you are playing a
game of passing the parcel - where there are multiple parcels (and lots of them empty), and your
only method of winning is hoping that you aren’t holding any parcels when the music stops - and
where you have no control over the music. This is hopeful gambling, and not investing.
The degradation of investment philosophy from intelligent business-like commitments to wanting to
ride euphoric waves on horrendous and pretentious conclusions (of often irrelevant data) is to play a
judge in John Maynard Keynes’ hypothetical Beauty Contest3
- with judges instead of trying to
ascertain who is the most beautiful, is attempting instead to guess what their fellow judges will think
the average opinion of beauty to be; a spiralling form of the lowest common denominator resulting
in very poor decisions for market participants as a whole.
The Essays of Warren Buffet; Lawrence A. Cunningham (First Revised Edition, Page # 43)
John Maynard Keynes, The General Theory of Employment, Interest and Money (Chapter 12)
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Beauty is only skin-deep - look underneath the surface..
The largest beneficiary of a frenzied and hyperactive equity market is always the financial
intermediary. I cannot emphasize that enough. Equity markets are enlivened by a supporting
infrastructure of brokers, mutual funds, banks and other distribution agents, investment bankers,
advertising outlets, 24 hour business news channels and wires, and a plethora of analysts and
research & advisory firms.
Nominally their collective function is to bridge capital and its deployment, provide the public with
relevant information (and reduce information asymmetry), reduce transaction costs, and in sum to
make the markets more efficient. In practice, however, they interact with one another in ways that
result in the investor making counterproductive decisions, exasperated in a system riddled with
Hidden Costs and Bad Incentives.
As a rational investor, do you think that the value or selling price of Reliance or Britannia or Titan
should be based on its business performance, or be determined daily by what an ‘’expert’’ or
technical chart pattern would “predict” it to be? Assuming that my reader readily recognizes it to be
the core business performance (which does not fundamentally change every minute, hour, or day),
shouldn’t she be surprised then, that money managers trade in and out of companies as though
their fortunes depended on it (and perversely that might actually be the case for intermediaries as a
whole). There are mutual funds with turnover ratios (the number of times the holdings of the
portfolio have been “churned”, or bought and sold) not just reaching, but far, far exceeding 50%,
100%, and even 200% per year!
And if trading excessively by fund managers isn’t bad enough (as an investor, how often do you
calculate brokerage charges as lost capital?), imagine how badly that can be incentivized in a
marketplace where fund companies and brokerage houses often are owned by the same parent
company or are in business together. Add in commissions that Banks and other agents earn from
mutual fund distribution/sales, and advertising blitzes for you to buy into the latest fund offer, and it
should become clearer to even a lay investor that hyperactive equity markets represent loaded dice
in favour of the salesman, and against the investor.
Money Managers, like you and I, also don’t like to be embarrassed. If company XYZ is the latest
“buzz” and rival fund managers have rushed out and bought it, you risk becoming the only fool who
hasn’t yet bought it. Similarly, if company ABC has been in the news for the wrong reason, whether
or not the news is relevant or not, and its business impact temporary or permanent, you risk being
judged as incompetent for not having seen it coming. So come reporting time, you just might be
incentivized into a bit of position jugglery to ensure that XYZ does appear in your holdings, or that
ABC does not.
And of course, your local broker will always have the latest recommendation waiting for you. And
not enough investors ask how that could be the case. The most successful investors of this century
and the last have considered themselves lucky to have had a good investing idea or opportunity
once every 2 or 3 years. But to your local broker, whose bread and butter is secured and enriched by
an active market, your zealous participation in that market is necessary for his own prosperity. All in
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all, the Psychology of Human Misjudgement4
will produce a system where whether or not the
investor wins or loses, the salesman or middleman will always win.
And now back to averages - so money managers and their client’s money that they have deployed,
must collectively, by mathematical law, produce an average return to all market participants
combined. And so the investor is truly not even receiving an average return, for after expenses and
fees, it must surely be even less than average.
So in the final analysis, in a marketplace dominated by the volatility of furious trading supported by
large financial intermediaries, whom does the salesman truly serve?
So, are you far better off with simple Indexation?
The world had made very little economic progress for ten centuries or so, leading up to the 1500’s. It
is only in the last few centuries, in what is now the Developed World that an incentive-based
market system evolved out of the slow convergence of private property rights, the decentralization
of religion, and personal freedoms. And it is only in the last few decades that countries like ours
have seen this convergence, and begun to grow at a faster pace than the rich world. And that is a
great investment story. And it can be partially, but successfully replicated via an index fund.
So up to a point, yes, the average investor is better off investing in Index Funds which merely
mimic a particular index, and typically have very low management fees and turnover ratios (the
Index Fund can go only so far, because the math again would ensure that such investments would
fail if everybody did it. For the near and medium term, however, it is a sound path for those wishing
the market return).
But for the patient accumulator of wealth, hyperactivity produces irrational outcomes in asset
pricing from time to time - including great assets - and that is where the true investor gets
separated from the herd, and produces sustained and superior investments results.
Global data going back more than eighty years tells us that almost 80% of active fund managers will
underperform their respective benchmarks. What this summarises is perhaps what might be best
described as the collective failure of the financial ecosystem to serve the capital allocation needs of
From Charles Munger’s speech on “24 Standard Causes of Human Misjudgment”. I highly recommend it!
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The Collective Failure of the Financial Ecosystem as your Best
The markets may be frequently efficient, but they are a far cry from being perfectly efficient
This is a critical point that cannot be overstated. Modern Portfolio Theory dictates that markets are
perfectly efficient. I am yet to see a market that is so. And you should know that a perfectly efficient
market is the base assumption used by the financial industry at large. And while markets are
efficient quite frequently, they fail reason and proportionality often enough. In understanding this
distinction the investor can readily extrapolate opportunity from the fear psychosis of crowds.
Let fear be your friend, and volatility your servant
Once you recognize the panic of the market as an expression of desperation and an inability to cope
calmly and rationally with uncertainty, you can capitalize on the volatility in asset prices it
produces, and gain a significant edge over your short-term-minded market participants.
Time in the market, or market timing? Choose wisely5
How do you think you would have financially fared, if instead of trying to guess the best time to buy
into or sell out of a stock, you had just held on to your HDFC, ITC, or M&M - for the last 5, 10, or 20
years? Great businesses, like fine wine, get more and more exquisite with time. Patience can
sometimes be disguised as lethargy - and can be very rewarding to the rational investor.
Some Long Term Value
Creators from the current
Adjusted price in Rupees Current value of
Rs 1,000 invested
Name Jan-91 Jun-12 in Jan 1991*
Wipro 0.38 408.5 10,75,000
Hero Motocorp 4.1 1,945.75 4,74,573
Cipla 0.76 308.95 4,06,513
HDFC 2.37 649.35 2,73,987
ITC 1.04 234.15 2,25,144
Mahindra & Mahindra 9.95 675.7 67,910
State Bank of India 33.02 2,159.45 65,398
Hindustan Unilever 9.34 420.15 44,984
Reliance Industries 18.75 714.1 38,085
*List filtered of current BSE500; Compiled by BS Research Bureau, Source: Bloomberg
I remembered this as an advertisement of Fidelity Investments. I started my career in 2004 as an equity &
derivative trader for Fidelity, and distinctly remember this ad as a paraphrase of Peter Lynch, the fund
manager for Fidelity Magellan, a fund that consistently beat the market for decades. So obviously there will be
exceptions; and it would be wise to remember that only the top 1% performers will get the top 1%
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Allow rationality to guide you to prudency
You may invest like a businessman, or speculate like a compulsive gambler. I don’t think I would like
for there to be room enough for any middle ground here. Should you be uninterested in the latter,
and concern yourself with only the former, then your business-like investments will produce
business-like results. In being an investor, be the Prudent Businessman.
What the Prudent Businessman knows
The generation of wealth
Sustainable wealth is generated over time by concentrating capital towards productive assets that
generate good cash flows on the capital put to work. To turn this on its head, a key takeaway is also
the recognition that short cuts like trading in and out of companies; treating them as ‘positions’
instead of business commitments, are a lot more unreliable, and not worth your time.
Inflation & Real Purchasing Power
Governments around the world have continually been spending more than their take in tax
revenues, borrowing & printing money to fund revenue and capital expenditures. Inflation therefore
presents itself as a serious problem, as the real purchasing power of money steadily comes down
Equity markets will therefore on balance rise over time, to keep in step with the true prices of
industrial/asset ownership. The prudent businessman recognizes this reality and keeps a majority of
his/her capital in productive assets like their businesses, commercial property, or equity.
The power of time
1 lac invested for 20 years, earning 10% per annum, will yield you about 6.72 lacs; but earning just
another 5% more over the same period will yield you almost 2.5x that - about 16.36 lacs.
This is simple math, and while most people shrug it off as a well-known fact, few actually act in a
manner rationally consistent with established truth. How else is one to explain the ease with which
people trade in and out of stocks, treating them as fungible slot machines instead of a legally secure
method of owning proportional fractional interest in a business concern over decades?
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Great companies take time to dominate the marketplace, and make investments to secure and
improve their station that pay off in years, and not quarters. Time creates outstanding companies
producing huge profits like a compounding machine - and the true investor duly befriends her.
Tuning out the Noise
Allow facts and its logically consistent interpretation to guide your capital allocation decisions. The
noise generated by talking heads, market pundits and technical chartists can be very easily be
drowned out by those whose eye is not lazily fixated on “breakout” patterns or short term
macroeconomic data, but instead on the market dominance, capital investments, and long term
trajectory of growth of the businesses they own, whether in whole or part. The Prudent
Businessman recognizes what data (or person!) is relevant, and what data is a distraction.
Market Corrections and Crashes are your allies and wealth enablers
Would you sell your house, company or business practice, simply because your neighbour or
competitor had a panic attack - or had borrowed too much money and now is forced to sell his
family heirlooms to pay for the servicing of his luxury car? Of course you wouldn’t. But that’s exactly
what people do all the time in a more general sense in the equity markets.
Greed will nearly guarantee sums of money cyclically chasing sporadic fads, effectively driving up
the prices of various assets to astoundingly insane levels at various times. And by the time sanity
gets a vote, the rush to pass on the hat of The Greater Fool (buying something not for its value, but
simply because you think that someone else will pay a higher price for it in the future) will create
corrections and crashes at least equal to the manic rise - but often much worse.
And there lies your opportunity. For something of actual intrinsic value would likely also fall with the
“hot” stocks. And if it falls from 100 to 50 it would represent a 50% loss - but that same asset going
from 50 back up to 100 is a 100% gain. It’s a lesson again of simple arithmetic that fails us when we
succumb to fear psychosis, running away exactly when we should be running towards.
It is lamentable that the public at large tends to buy the most at market peaks and sell at the
troughs. Simply being a buyer when the crowds are selling in times of crises will in itself vastly
improve your financial fortunes.
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My Advice for the Long Term Investor
Allocate your capital as though you were guided by rationality, discipline, and patience
Simple and Sound Principles
1. Invest only in productive assets.
No gold. No currency positions. No macroeconomic calls.
2. No Speculation. No Leverage.
No Exceptions - and never buy equity if you have a time horizon shorter than
3-5 years; the approximate duration of average economic downturns
3. Buy fractional ownership of quality businesses on reasonable terms
Companies with long term business viability and competitive visibility
Should either have existing or potential for scale
Management has a clear understanding on how to preserve and grow the
company’s brand equity
Companies which at most have only a reasonable level of debt in its capital
4. A Concentrated Portfolio
Most investment returns come from a handful of investments. You aren’t
going to find quality investments going for a song all the time. Whenever
you do, however, it would be very foolish, in my view, to not “load up”, as
Charlie Munger has correctly recommended, on a well-researched
investment idea whose time has come.
Construct a portfolio with as few companies as stringent screening will yield
to. Just as one need not be an expert on every subject matter, you need not
own 100 or 50 or even 20 companies. But research and know your
companies exceptionally well.
5. Sitting Tight - both on cash, and on your investments
Where you’re able to find a great company at a reasonable price, hold on to
it for as long as your business analysis of its future value stays true.
In a rarer circumstance that an alternative investment is so lucrative, and
spare cash so insufficient, grudgingly be willing to sell an investment to
make that swap
Where you’re able to find a great company, but its valuation is obviously and
unduly high, wait it out or give it a pass
If there isn’t any investment worth making, and this can happen from time
to time (during euphoric bubbles); sit on cash and cash-like (FD/Money
Markets etc) instruments - even if for extended periods of time.
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Choosing the right Investment Adviser
1. Avoiding bad incentives is half the battle
You need an unbiased partner - not a broker, or sub-broker, or the
distribution agent of a financial intermediary
Have a compensation structure that does not incentivize your adviser to
jump in and out of stock positions, and one that measures performance not
in terms of the next month or quarter. This will enable your adviser to
become your partner - and look instead at the end game - to build a
portfolio of quality businesses over a period of many years through the
gyrations of markets and interest rate cycles.
2. The Bigger Picture, the Long Term View
That your fortunes should be tied to the business performance of your
underlying assets - not on the ad-hoc ability of someone to give you the
right ‘tips’ or have you chase the flavour of the month, month after month
And that if you concentrate your portfolio with quality businesses and
stick with your winners over multiple years, that you can gain a serious
advantage over the masses that make up the averages
To conclude and restate what I started with - I hope this white paper will play a role, however small,
in making you a more prudent investor.