Traders fail, regardless of age, race, gender or nationality due to inability to accept failure along the way as a constant companion in our everyday lives & learning from failure.

Lets discuss the work of the late, great Dr. W. Edward Deming, who is the father of Total Quality Management, commonly known as TQM. His story is quite interesting, and it actually has a lot to do with how to trade well.

Since American industry spurned many of Dr. Deming ideas, he went to Japan shortly after World War II to help with early planning for the 1951 Japanese Census. Deming’s expertise and his involvement in Japanese society, is largely responsible for why so many high quality consumer products come from Japan even to this day. In turn, Japanese society holds Dr. W. Edward Deming in the highest regard. Deming’s portrait hangs in the lobby at Toyota headquarters to this day, and it’s actually larger than the picture of Toyota’s founder.

So why do people fail? According to Deming, it’s not because people don’t try hard enough or don’t want to succeed.

People fail because they use inadequate systems. In other words, when traders fail, it’s primarily because they follow faulty trading systems—or they follow no system at all.

So what is the right system to follow as a trader? To answer this question, we offer you what the trader who broke the all-time real-money profit record in the 1984 United States Trading Championship offered. He revealed that a successful trader needs 5 essentials:

• A Method : You must have a definable method which should be thought out to the extent that if someone asks how you make decisions to trade, you can quickly & easily explain. Even more important, if the same question is asked again in 6 months, your answer will be the same. This is not to say that the method cannot be altered or improved; it must, however, be developed as a totality before it is implemented.
• The Discipline to Follow Your Method : ‘Discipline to follow the method’ is so widely understood that it almost sounds like a cliché. Nevertheless, it is such an important cliché that it cannot be ignored. Without discipline, you really have no method in the first place. And this is precisely why many consistently successful traders have military experience—the epitome of discipline.
• Experience : It takes experience to succeed. Many advocate “paper trading” as a learning tool. Paper trading is useful for testing methodologies, but it has no real value in learning about trading. In fact, it can be detrimental, because it imbibes the novice with a false sense of security. “Knowing” that he has successfully paper-traded during the past six months, the novice believes that the next six months trading with real money will be no different. In fact, nothing could be farther from the truth. Why? Because the markets are not merely an intellectual exercise, they are an emotional one as well. Think about it, just because you are mechanically inclined and like to drive fast doesn’t mean you have the necessary skills to drive F 1 car.
• The Mental Fortitude to Accept that Losses Are Part of the Game : The biggest obstacle is failing to recognize that losses are part of the game, and, further, that they must be accommodated. The perfect trading system that allows for only gains does not exist. Expecting, or even hoping for, perfection is a guarantee of failure. Trading is akin to batting in cricket. A player scoring 50 is good. A player hitting 100 is great. But even the great player fails to hit 50 half of the time. Remember, you don’t have to be perfect to win in the markets. Practically speaking, this is why you also need an objective money management system.
• The Mental Fortitude to Accept Huge Gains : To win the game, make sure that you understand why you’re in it. The big moves in markets come only a couple of time in a year. Those are the ones that will pay you for all the work, fear, sweat and aggravation of the previous 11 months or even 11 years. Don’t miss them for reasons other than those required by your objectively defined method. Don’t let yourself unconsciously define your normal range of profit and loss. If you do, when the big trade finally comes along, you will lack the self-esteem to take all it promises. By doing so, you abandon both method and discipline.

Lets approach how to handle a tumbling stock price. Should you cut your losses, buy more or sit on your hands nervously & do nothing? There are some techniques to help you with your thinking, emotions & help to arrive at a conclusion.

Unfortunately, there is no never-fail formulas. There are, however, some basic principles that we can look to for guidance.

First of all, you should be looking to sell (or not buy) shares that look expensive & aiming to buy shares that look cheap. The direction in which a share price has recently travelled is not in itself an indicator of this.

When to hold

You should always maintain a sensibly diversified portfolio so that your fortunes are not too closely tied to a few holdings.

If a share falls & you keep adding large chunks, then it might end up accounting for too much of your portfolio. That’s not a happy situation even if you think it’s the cheapest share on the market. Do not average a falling stock. It’s worth noting that all of this has just as much relevance if a stock in your portfolio has gone up in price, or even if it hasn’t moved at all. What matters is the relationship between the price & the underlying value, subject to diversification. Putting this all together, we can get an idea of what to do in certain situations.

If a share has fallen by, say, 20%, but you estimate that its underlying value has fallen by less, or grown, then it makes more sense to at least consider buying more (subject to keeping sensibly diversified).

Time to sell

If a share has fallen by a certain amount but you estimate that its underlying value has fallen by more, then you certainly shouldn’t be buying more. That would just compound the original mistake. Instead, you’d want to face up to the mistake & think about selling.

If a share has fallen & you estimate that its underlying value has fallen by a similar amount, then you’d sit on your hands & do nothing.

To avoid too much expensive trading, this should probably be your starting point. To either buy more or sell, your views should be very strongly held.

Different thinking

It can sometimes help to imagine that you don’t actually own your downtrodden shareholding, but instead have its value in cash. If that was the case, would you use the cash to buy those shares at the current price or invest in something else?

If you find you get a definite no, then it might be time to sell. If you get a definite yes, then you’d think of buying more.

If you get a maybe, then you’re probably in the area where the transaction & tax costs of taking any action would outweigh any potential benefits. In this case, it’s usually best to sit on your hands & hold on to your shares.

It’s never easy to deal with a falling share price & there are no clear-cut rules to follow. But this approach, used advisedly, can be a useful way of addressing the issue. We hope it helps.

Here we explain the classic investment mistakes that, you should avoid at all costs, to become a successful investor. Investing successfully poses many challenges. Here we explain some of the methods that can help you to rise to avoid these mistakes but first, a mention of a tool ‘invert, always invert’, from mathematician Carl Jacobi. This tool ask you to Instead of looking at how to make money, we’re going to look at great ways to burn it. That way you can aim to minimise your mistakes-a vital part of investing successfully.

So here are, classic investment mistakes guaranteed to ensure pathetic performance.

• Trade fast : Charlie Munger, Warren Buffett’s business partner, often refers to the huge mathematical advantages of ‘doing nothing’ to your portfolio. Someone who ‘turns over’ (buys & sells) all the stocks in their portfolio several times a year is at least a few percent behind , even with internet brokerage rates as low as 0.3%.

  There’s also an important, but less measurable, benefit to taking a longer-term approach. It makes you think long & hard about which stocks to include in your portfolio. When you are considering buying a stock for 5 years or more, you tend to pick quality businesses. & that can only be a good thing.

  So, if your intention is to lose money, trade fast.

• Follow the mainstream media : Most people aren’t resistant to popular views aired in the media. Charlie Munger refers to a condition known as ‘incentive-caused bias’ & it explains the functioning of media quite nicely. There’s a widely held belief, & it may be correct, although declining newspaper circulations suggest otherwise, that emotional, confrontational, dramatic coverage sells more papers than rational, factual reporting. Hence the tendency to induce panic in investors when calmness would better serve their interests.

  But incentive-caused bias doesn’t just affect the media. Just look at how honest managing directors can first convince themselves, then their board, then their shareholders, how an offshore acquisition or hostile takeover will be great for everyone, especially themselves. Generous options packages offer a fitting explanation for many examples of corporate foolishness.

  To lose money, avert your eyes from a factual assessment of a situation & bury yourself in the opinions & arguments of those with a vested interest in convincing you of the veracity of their own opinion.

• Follow ‘hot stocks or sector’ There is a human condition known as ‘social proof’. The evolution of the human, & sheep, was greatly assisted by a tendency to follow the crowd-safety in numbers & all that. In the mania of the dot com boom, millions of investor with the fear of standing apart from the crowd, played a huge role in fuelling the mania. Following the stock market crowd can be a costly mistake. As Buffett says, ‘you pay a very high price in the stock market for a cheery consensus.’ That’s why you should be excited when others are depressed & fearful when others are optimistic.

  If you’re intent on seeing your net worth dwindle, follow hot stocks & sectors.

• Beat yourself up over lost opportunities : In an imperfect activity like investing, mistakes are absolutely inevitable. But, odd as it may sound, sometimes even when you’re right, you’re wrong. To call tech stocks overvalued in late ninties was undoubtedly correct. But for the next few months, as speculators pushed prices higher still, it sure didn’t feel correct. It’s a fact of life that someone will always be getting rich a little quicker than you are. But then again, they may become poor just as quickly by adopting the same approach.

  If you take the conservative decision not to invest in a stock, & it goes up anyway, don’t crib. Just be patient-other opportunities are often just around the corner. But if you are interested in blowing your capital, now’s a good time to capitulate & buy at these higher prices.

• Buy cyclical stocks at the top There is a natural human tendency to extrapolate recent events. So when a cyclical stock like a steel company or property developer has a few tough years, investors tend to make the assumption that the bad times will last indefinitely. This can sometimes offer good opportunities for the canny investor, as it was seen in Tata Steel & TELCO.

  In the same way, when these stocks show a few years of good results, thanks, for example, to strong Chinese metal demand, a booming property market or some other factor, the market tends to extrapolate the good times. It’s the same mistake made at different ends of the cycle. Just at the peak of a cycle, investors can confuse a cyclical stock with a growth stock & bid the shares up, perhaps to a very high PE Ratio. But when earnings are at a peak, that’s exactly when cyclical stocks should be selling on a low PE Ratio. When earnings fall, as they inevitably do with a cyclical downturn, the shares come crashing down. Farmers-who are used to the feast/famine cycle of a life on the land-seem less susceptible to this folly than most.

• Follow overly acquisitive management More companies are ruined by bad management than by bad economies. We’d most definitely agree. Overly acquisitive managements-those hell-bent on growth, seemingly at any cost, are especially prone to getting into trouble. Acquisitions often involve large amounts of debt which thereby increase risk. As interest rates rise, for example, a growing portion of cash flow has to be diverted to service debt rather than deployed in the business or paid out as dividends. Secondly, acquisitive managements, often suffering from delusions of grandeur, can overstretch themselves. And finally, acquisitions tend to cloud the company’s financial accounts. This can fool bankers & shareholders for a while but by the time the gravity of a tough situation comes to light, it’s too late. Backing such management is almost bound to help lighten your purse.
• Invest in rapidly expanding financial institutions Depending on the riskiness of the borrower, a financial institution might make a ‘spread’ or ‘margin’ on loans of anything from 1-5% per annum. But when a loan goes bad, it can lose 100%. It’s a risk that must be managed very, very carefully. Warren Buffett once remarked that a bad bank manger can flush all your equity down the toilet in your lunch hour. Watching accounting ratios won’t always save you either. In banking, growth can actually be used to hide bad loans temporarily (as, perhaps, we are about to see). A bank that is experiencing a high rate of loan delinquencies can easily halve that rate temporarily by writing new loans & doubling the size of its loan book-after all, a new loan takes time before it can go bad. But hastily made new loans are likely to be of poorer quality than existing ones.

  If you want to burn money, put it on fast-growing financial institutions.

• Work to the ‘greater fool’ theory ( Financial Music Chair) > Some investors seem happy to buy expensive stocks, knowing full well they’re overvalued, because they feel confident that someone else will come along & pay an even higher price. That’s what happened in the dot com boom & it’s what seems to be happening in the current commodity boom. It’s financial musical chairs for suckers & is likely to end up costing many investors a bundle.
• Buy ‘Chest Beaters’ companies rather than ‘doer’ companies ‘Chest Beaters’ companies are those that are going to do this & that. Such unproven companies, & their attendant management teams, are a great way to lose capital. But even well-established companies can be ‘Chest Beaters’ companies. Management will explain away the poor performance of the last few years & concentrate on what it will do in the future. Chances are it will be putting on a similar show a few years down the track. While those sticking with proven companies & managements should do well, if you’re aiming to lose money, buy ‘Chest Beaters’ companies.

Aspiring traders typically go through three phases in this order:

• Methodology—The first phase is that all-too-familiar quest for unearthing – a trading system that never fails. After spending thousands of bucks on books, seminars and trading systems, the aspiring trader eventually realizes that no such system exists.
• Money Management—So, after getting frustrated with wasting time and money, the up-and-coming trader begins to understand the need for money management, risking only a small percentage of a portfolio on a given trade versus too large a bet.
• Psychology—The third phase is realizing how important psychology is—not only personal psychology but also the psychology of crowds.

But it would be better to go through these phases in the opposite direction. Aspiring traders should begin their journey at phase three and work backward.

The first step in becoming a consistently successful trader is to understand how psychology plays out in your own make-up and in the way the crowd reacts to changes in the markets. The reason for this is that a trader must realize that once he makes a trade, logic no longer applies as emotions of fear & greed take precedence—fear of losing money and greed for more money.

Once the aspiring trader understands this psychology, it’s easier to understand why it’s important to have a defined investment methodology and, more importantly, the discipline to follow it. New traders must realize that once they join a crowd, they lose their individuality. Worse yet, crowd psychology impairs their judgment, because crowds are wrong more often than not, typically selling at market bottoms and buying at market tops.

Moving onto Step two, after the aspiring trader understands a bit of psychology, he or she can focus on money management. Money management is an important subject and deserves much more than just a few sentences. Even so, there are two issues that are critical to grasp: (1) risk in terms of individual trades and (2) risk as a percentage of account size.

When sizing up a trading opportunity, the rule-of-thumb I go by is 3:1. That is, if risk on a given trading opportunity is Rs 5000, then the profit objective for that trade should equal Rs 15000, or more. With regard to risk as a percentage of account size, you can follow the same guidelines that many professional money managers use—1%-3% of the account per position. If your trading account is Rs 100,000, then you should risk no more than Rs 3,000 on a single position. Following this guideline not only helps to contain losses if one’s trade decision is incorrect, but it also insures longevity. It’s one thing to have a winning quarter; the real trick is to have a winning quarter next year and the year after.

When aspiring traders grasp the importance of psychology and money management, they should then move to step three—determining their methodology, a defined and unwavering way of examining price action. A very common method of determining price action is via technical analysis ( Wave Principle/ Candlestick charts/ Dow Theory, cycles). Whatever you choose to use, it should be simple. In fact, it should be simple enough to put on the back of a business card, because, like an appliance, the fewer parts it has, the less likely it is to break down.

The price-to-earnings ratio (PER), is an important concept to understand to value a company. Doing so will help you get more from your investments.

PER is exactly what its name suggests: a ratio of the price of a stock to the earnings it makes. A simple analogy is rental property. If you own a property worth Rs 2,00,000 and it earns Rs 10,000 a year in rent, the rental yield is 5% (Rs 10,000 divided by Rs 2,00,000). This calculation for yield divides rent (the E) by the value of the property (the P).

If we take the opposite, that is P divided by E, we get a multiple of 20 times (Rs 2,00,000 divided by Rs 10,000). Thus, the PER is the opposite of the rental yield. If the same property had a rental income of Rs 15,000, the rental yield would be 7.5% and the PER would be 13.

Market expectations

You can use the PER to compare different investments. For example, if property A yields 5% (PER of 20) & property B yields 7.5% (PER of 13) then property B is cheaper, everything else being equal. But if the rent on property A was likely to grow more quickly than the rent on property B, then everything else would not be equal. In this case, property A might be better value despite its higher PER. It all depends, of course, on how quickly the rent is going to grow

Turning to companies, we can compare the PERs of CDE (currently 22) and WXY (currently 24) to see which is cheaper on the face of it (CDE), and from which, therefore, the market is expecting more growth (WXY). . From the formula, it’s easy to identify the two components of the PER, the ‘price’ or ‘P’ & ‘earnings’ or ‘E’. This is where things start to get a little complicated, because there are as many different ways of calculating a PER as there are different ways of calculating earnings.

We can start by defining a basic PER—the one you’re most likely to see in a newspaper—as the current share price (P) divided by last year’s reported earnings per share (E). (Earnings per share being the net profit after tax divided by the number of shares on issue.) We call this a basic PER.

Making adjustments

A common variation to this ratio is the ‘adjusted’ or ‘normalized’ PER. It adjusts the E to take account of one-off profits & losses (such as ‘abnormal other income’ and ‘write downs’). This is done to try and produce a figure for E which is a more accurate estimate of a company’s sustainable level of profit.

A recent example is ABC Corporation’s reported net profit of Rs 1.58 Cr. This figure included a net profit of Rs 025 Cr from the sale of a company’s property (one time affair). An adjusted PER would subtract this to get an adjusted net profit of Rs 1.33 Cr, which can then be divided by the number of shares to get a figure for adjusted earnings per share of 20 paise. You can then divide the share price by this number to give the adjusted PER. As you can see from the table, at today’s share price of RS 3.60, these adjustments shift ABC’s PER up from 15.2 to 18.

The PER you read in the newspaper is often unadjusted, and it should always be treated with caution. In fact, anything you read in the newspaper should be considered a guide not a exact figure. If you see a PER that seems unusually low, don’t just assume that the company is cheap: it may be calculated on profits which are unlikely to recur in future periods. But you might have discovered a stock worthy of further investigation.

Forecasting the future

The other main variation is the ‘forward’ or ‘prospective’ PER. This is a PER based on a future estimate of earnings. For example, a ‘one-year forward PER’ would use the current share price as P and an estimate of earnings per share for the 2011 as E.

You can see this forward PER in action in various research reports. These reports may show three or four years of previous financials (marked A for actual) and an estimate for the current financial year (marked as E for estimate) as well as future 2-3 years. We invest in a company to participate in its future earnings, so the future PER is very relevant. But it’s worth remembering that forecasting company earnings is a bit like forecasting the weather—you can get it right as often as you like, but it’s the times you get it wrong that you really notice.

So the first rule is to be aware of what kind of PER you’re dealing with—historic basic PER, adjusted PER or forward PER. The three often tell very different stories. The other important thing to recognise is that the PER is just a guide to value, not a valuation in itself. Just as you wouldn’t expect to get the whole story by reading only one chapter of a book, don’t expect too much from the PER.

If you think a low PER means ‘cheap’ and a high one means ‘expensive’, be careful. It ain’t always so. From the beginning of our investing lives, we’re taught that a low PER means a stock is cheap, while a high PER means it’s expensive. Indeed this is a deeply held general belief.

But there are many areas where deceptively low PERs can spell trouble for unwary investors. We’ll look at several sectors that are particularly prone to these low PER ‘value traps’. Accounting standards should ensure a company’s profit reflects economic reality, right? Well, in some case nothing could be further from the truth. Some companies revalue its investments every year to fair value, taking the change to the income statement which can make for some extraordinary results.

This is like you, as a home owner, reporting the change in value of your house in your tax return each year, even though you haven’t actually received or paid out any money in respect of it. So, if your salary in 2004 was Rs 100,000, and you reckoned your house had risen in value by Rs 100,000, then you would have reported taxable income of Rs 200,000, even though the only cash you received was your salary. But in 2005, if your salary stayed the same but your house fell in value by Rs 150,000, then you’d have actually reported a loss.

So what should you use instead? As is so often the case, the trick is to focus on the cash flow. Using net operating cash flow, for example, generates far less impressive multiples.

By now, we hope you’re getting the idea: it’s important to understand just what drives a business’s reported revenue and profit. Cyclical businesses, whether they be heavy industrials like TATA Steel are type of company where the PER must be used with extreme care. These businesses tend to have high profits, and therefore low PERs, just when conditions are at their most buoyant. In these cases, the PER is often at its lowest point at the time a stock is most overvalued.

So, as you can see, there are plenty of cases where the PER is potentially very misleading. You need to think about the underlying business, and where the profits are coming from, to ensure you avoid these traps.

Investing great Seth Klarman* describes 20 lessons, from the (2008) financial crisis in excerpt from his annual letter, “were either never learned or else were immediately forgotten by most market participants.”

One might have expected that the near-death experience of most investors in 2008 would generate valuable lessons for the future. Memories of tough times of Great Depression affected investor’s behavior for more than a generation, leading to limited risk taking & a sustainable base for healthy growth. Yet one year after the 2008 collapse, investors have returned to shockingly speculative behavior.

Below, we highlight the lessons that we believe could & should have been learned from the turmoil of 2008. Some of them are unique to the 2008 melt- down; others, which could have been drawn from general market observation over the past several decades, were certainly reinforced in 2008. Shockingly, all of these lessons were immediately forgotten by most market participants.

20 INVESTMENT LESSONS OF 2008

• Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets & the economy. Whatever adverse scenario you can contemplate, reality can be far worse.
• When excesses such as lax lending standards become widespread & persist for some time, people are drawn into a false sense of security, creating a very dangerous situation. In some cases, excesses migrate beyond borders, raising the ante for investors & governments. These excesses will eventually end, triggering a crisis. Correlations between asset classes may be surprisingly high when leverage rapidly unwinds.
• Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat. Conservative positioning entering a crisis is crucial: it enables one to maintain long-term oriented, clear thinking, and to focus on new opportunities while others are distracted or even forced to sell. Portfolio hedges must be in place before a crisis hits. One cannot reliably or affordably increase or replace hedges that are rolling off during a financial crisis.
• Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty – such as in the fall of 2008 – drives securities prices to especially low levels, they often become less risky investments.
• Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing & reassessing the risk environment in real time. Despite the predilection the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.
• Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses & severe illiquidity at precisely the moment when cash is needed to cover expenses.
• The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance & should always be considered with skepticism.
• A broad & flexible investment approach is essential during a crisis. Opportunities can be vast, ephemeral, & dispersed through various sectors & markets. Rigid views can be an enormous disadvantage at such times.
• You must buy on the way down. There is far more volume on the way down than on the way back up, & far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.
• Financial innovation can be highly dangerous, though almost no one will tell you this. New financial products are typically created for sunny days & are almost never stress-tested for stormy weather.
• Ratings agencies are highly conflicted, unimaginative dupes. They are blissfully unaware of adverse selection & moral hazard. Investors should never trust them.
• Be sure that you are well compensated for illiquidity – especially illiquidity without control – because it can create particularly high opportunity costs.
• At equal returns, public investments are generally superior to private investments not only because they are more liquid but also because amidst distress, public markets are more likely than private ones to offer attractive opportunities to average down.
• Beware leverage in all its forms. Borrowers must always remember that capital markets can be extremely fickle, & that it is never safe to assume a maturing loan can be rolled over. Even if you are unleveraged, the leverage employed by others can drive dramatic price & valuation swings; sudden unavailability of leverage in the economy may trigger an economic downturn.
• Many leveraged buyout (LBOs) are man-made disasters. When the price paid is excessive, the equity portion of an LBO is really an out-of-the-money call option.
• Financial stocks are particularly risky. Banking, in particular, is a highly lever- aged, extremely competitive, & challenging business. A major European bank recently announced the goal of achieving a 20% return on equity (ROE). What the bank will do if it cannot get to 20%? Leverage up? Hold riskier assets? Ignore the risk? For a major financial institution to have a ROE goal is to court disaster.
• Having clients with a long-term orientation is crucial & important for an investment firm.
• When a government official says a problem has been “contained,” pay no attention.
• The government cannot with- stand much pain in the economy or the financial markets. Bailouts & rescues are likely to occur. The government will take enormous risks in such interventions, especially if the expenses can be conveniently deferred to the future.
• Almost no one will accept responsibility for his role in precipitating a crisis: not leveraged speculators, not willfully blind leaders of financial institutions, and certainly not regulators, government officials, ratings agencies or politicians. To effectively implement investment lessons requires a disciplined, often contrary, and long-term-oriented investment approach. It requires a resolute focus on risk aversion rather than maximizing immediate returns, as well as an understanding of history, a sense of financial market cycles, and, at times, extraordinary patience.

* Seth Klarman is a leading value investor & President of The Baupost Group, a Boston (USA)-based private investment partnership which manages over $7bn in assets on behalf of private families and institutions. Founded in 1983, the firm has achieved investment returns of 20% compounded annually. The firm invests in equities, debt, private equity and real estate. Mr. Klarman is notable for his willingness to hold significant amounts of cash in his investment portfolios, sometimes in excess of 50% of the total. In 1991, Mr, Klarman authored Margin of Safety, Risk Averse Investing Strategies for the Thoughtful Investor, which since has become a value investing classic (Now out of print). Before founding Baupost, Mr. Klarman previously worked for Max Heine and Michael Price of Mutual Shares. He is a graduate of Cornell University & Harvard Business School.

Since most investor are net buyers of stocks throughout their lives, which means that market falls should be welcomed rather than an opportunity to shed tear. You could be forgiven for thinking that there had been some major crisis in the stock market as there’s been talk of crashes, collapses & crunches by well-known analyst/ pundits.

The truth is that fear & panic get people’s attention & the media is well aware of it. But it’s at times like this that investors need to stand back from the crowd & make a cold assessment of what’s going on. No doubt some companies are affected by such prediction, but some have, &/or will generate enough earnings they need for their future investing plans & have little to fear from a crisis, which might in fact help them take market share from competitors. Yet these companies have been getting cheaper along with everything else & we’ve been licking our lips.

Canny investor welcome bigger falls as investing opportunities.

If all things being equal, you’ll do better from stocks if you buy them cheaply. But what people forget is that for most of their lives, they’re net buyers, or at least holders, of stocks. & the ideal situation is to reach retirement with enough in your DEMAT account that you never have to become a net seller. So for most people, for most of their lives, stock market falls are good things.

Price & value

The crucial point to understand is that the price of a stock & its value are two different things. The market sets the former & we try to estimate the latter. To make our life easier, avoid poorly managed, debt-laden or cyclical businesses where predictability is poor, & we look for a margin of safety to protect us against an error of judgment – the more uncertain we are about a company’s value, the greater the margin of safety we require.

Most of the time, price is pretty close to value. But sometimes it gets out of bound, & occasionally gives us a decent margin of safety. It’s these situations that present the greatest opportunities for canny investors & the greatest dangers for those who succumb to understandable but irrational mood swings. Preparedness makes all the difference.

Imagine you’re researching a company, XYZ, which operates in a predictable industry, has decent management & pays no dividends. It reinvests all its profits, meaning that returns are entirely in the form of capital growth. You’ve done the work, & are as comfortable as you can be that XYZ will grow earnings per share (EPS) at 10% per year, from the current level of Rs 1.00, with very little chance of variability.

Deeming XYZ have all the right stuff, you buy the stock for Rs 15 – a price-to-earnings ratio of 15. If your estimate of earnings growth is accurate, then EPS will grow from Rs1 to Rs 2.59 over the next decade. If the market is still happy to pay a PE of 15 at that point, then the stock will trade at around Rs 39 & you’ll have achieved an annual return of 10%, in line with the earnings growth.

The stock market & future is always uncertain

Of course, the stock might trade lower in a pessimistic market after 10 year, giving you a lower annual return (but an underpriced stock that’s likely to do well in future years). Alternatively, it might trade higher, giving you a larger annual return (but an overpriced stock that you might choose to sell).

What happens in the stock market over the next week, month or year doesn’t make a lick of difference as to how the market will view XYZ in ten years’ time.

So let’s say that shortly after purchasing ABC for Rs15, the market tanks & XYZ is down to Rs 8 – a ‘loss’ of almost 50%. The emotional investor gets the chance to do some real & permanent damage here. Avoid this at all cost.

Assuming that XYZ is still as likely as ever to grow its EPS at 10% per year & after 10 years clock EPS of Rs 2.59 & a stock price of Rs 38.85, your forecast of its future is unchanged, & your expected return from yesterday’s investment is unchanged at 10% per year. You won’t get that return if you sell out now. But if you do nothing but hold, your eventual wealth will be just as great as if the share price followed a straight line from Rs15 to RS 39 over the course of a decade.

But wait there’s more If you have some spare cash, though, you can actually improve your position, by going against the crowd & buying more shares in XYZ at Rs 8. At that price, your additional investment will compound at 17% per year until the shares trade at RTs 39 after 10 years, pulling up your average return. So the market tumble has actually provided an opportunity.

Of course, the real world isn’t so easy. Market crashes can hurt the economy, affecting company profits in the short & medium term. & the ten year value of XYZ will swing based on both the mood of the markets then, & the company’s growth in the intervening years. But that’s the case regardless of whether stocks are cheap or expensive today. Which brings us back to the fact that the less we pay for our stocks, the greater the bargains they’ll prove to be?

So remember that when the market takes a tumble, it’s just changing the price that it’s setting for stocks. The value of those stocks, all things being equal, will remain the same. You don’t have to sell your stocks, but you can choose to buy, if you have the spare cash & have done proper research & can find something undervalued. Viewed like this, market crashes won’t do any harm to long-term investors, but actually offer you the chance to compound your money at a greater rate.

There are great chances to risk losing money once we start spending too much time worrying about missed opportunities. A process of reflection is important, but more attention should be focused on mistaken purchases rather than regretted non-purchases. Mistakes are costly facts. Missed opportunities, however, are winners you’ve selected after the fact which have come from a pool of potential investments that also included many also-rans and disasters avoided.

There might be a useful analogy in a book called Unweaving the Rainbow, by Richard Dawkins. He talks about the strategies available to an animal with high metabolism, such as a small bird, which needs to find food ‘alarmingly often in order to stay alive’. He asks us to imagine that bird ‘cruising around a wood, looking for prey. It is surrounded by twigs, a very few of which might be edible (well camouflaged) caterpillars.’ The bird could successfully distinguish between twigs and caterpillars ‘if it approached the twig really close and subjected it to a minute, concentrated examination in good light.’

Survival of the most efficient: So what strategy would that bird employ to keep its tummy full? Dawkins says that the bird cannot scan each twig with the ‘equivalent of a magnifying glass’ or else it would starve before locating its first caterpillar.

‘Efficient searching demands a faster, more cursory and rapid scanning’ even though this process inevitably means missing many caterpillars. The bird has to find the right balance: ‘too cursory and it will never find anything. Too detailed and it will detect every caterpillar it looks at, but it will look at too few, and starve.’

Do you see the parallel for investors? If you substitute ‘investor’ for the small bird; ‘successful stock market purchase’ for a caterpillar; ‘poor investment’ for wasting time on a twig; and ‘maximizing returns’ in place of maximizing calories, then the analogy explains my suspicion quite effectively. To the extent that this analogy is accurate, optimal investment returns will come from a strategy that leaves plenty of tasty opportunities untouched. There’s just no point complaining over missed caterpillars, or stock market opportunities. Dawkins explains that the ‘parts of our brains responsible for doing intuitive statistics are still back in the stone age’. Apparently, in most situations humans display a tendency towards making more false positive errors (also called ‘type 1’ errors, like buying a stock that turns out to be a dud) than false negative errors (such ‘type 2′ errors such as missing a good opportunity). And when hindsight bias causes us to regret the latter form of error, it further encourages more of the former type that we’re already predisposed to. In other words, fear of missing out on the next TCS may lead an investor towards the next Austral Coke.

Dawkins’ theory theory explains why humans have evolved this way.

But for us, the key lesson is that successful investors have inevitably found a way to recalibrate this bias. They are, almost to a rule, more concerned with avoiding mistakes than they are with grasping every opportunity that comes their way. Some investors even actively embrace missed opportunities, finding it the most effective way to reduce false positive ones (poor purchases). For example, we don’t at all regret missing the run up in Tata Steel’s share price from under RS 150 to more than Rs 500 in just less than a year – not because we dislike making money but because we feel it could too easily have gone the other way (as the share price has more recently).

Results are driven by what you actually do, rather than what you don’t do. If you’re only interested in the biggest, juiciest, most certain caterpillars, then missing others isn’t a cause for concern. So don’t unduly stress over missed opportunities, just go out and try to spot more. But then take a much closer look before you bite.

Everyone loves the idea of buying stocks that double in price in 3-5 years timeframe. Here we discuss how to spot them.

Where do you look to find stocks with a reasonable chance of doubling over a reasonable period? Having pondered over this issue for a long time, some common themes have emerged. We think they offer some good pointers to individual stock picking and our general approach to investment.

• Out of favour. This is value investor’s most financially rewarding situation—a stock that’s out of favour &, with any luck, even hated. Many of most lucrative investments have risen from the depths of despair. Take Satyam for example, which dropped like a dead cat to less than Rs 30. Its woes included a change of Management, CEO and an inquiry into its financial bungling etc. All these events pushed the price down markedly, but it recovered as Tech Mahindra steps in. Please remember such events in the past in Global Trust Bank resulted in complete evaporation of investors money.

TIME LAG

• Hidden progress. Often a business’s progress will take some time before revealing itself in the financial statements. Yes Bank couldn’t do a thing right for a while initial phase but an astute understanding of the bank’s lucrative business model revealed it contained significant underlying growth.
• New technology. In certain industries companies can generate significant cost savings by introducing new technology thereby improving operating margins.
• Investment in R&D. The benefits of undertaking research and development and investing in specialist skills can take years to manifest themselves. Best companies to buy are those investing heavily in R&D today to provide the profits of the future like SPARC & Piramal Life Sciences.
• Industry tailwinds. The emergence of China and India as rapidly industrialising nations has added significantly to world demand for oil, placing those with production capacity in a sweet spot. It has benefited immensely metal & petroleum companies globally.
• Changes in industry structure. In a similar vein, changes to an industry’s structure or the number of competitors can provide opportunities for the remaining businesses. MICO never allowed any competitor manufacturing Diesel Valves in India to gain any ground. They bought majority of their competitors & consolidated their position.

OWNER MANAGER EFFECT

• Owner-managers. Most successful companies are run by business builders with their own money. And then there are the company-men with long and successful track records like Infosys, Larsen & Toubro, ITC. Time and again, the stocks which double do so because the company has exceptional management.
• Insider buying. While a strong leader with a vested interest in performance is a big positive, so is evidence that directors are buying the stock for their own portfolios. In fact, it’s such a strong signal that you should always look for.
• Financial strength. Flimsy balance sheets indicate weakness and invite disaster. Instead, the strong financial position of a company which operates in a very cyclical industry, for example, allows it to withstand the pressure of lean years and prosper in the fat ones.
• Unrecognised by the market. Finally, look for quality companies that are simply un-recognised. With more than 6000 listed stocks, there will always be opportunities for investors to discover rough diamonds thought to be coal by others.

INDEPENDENT THINKING

It’s that simple. But it isn’t really is it? Without genuinely independent thinking and a thorough understanding of the facts as you see them, even finding appropriate stocks is difficult, let alone having the courage to take advantage of opportunities when they present themselves.

But that’s what value investing is all about. Which is why the purpose of this article is to help you uncover opportunities and to inculcate the kind of thinking that will allow you to act with confidence when you find them. You have to be ruthless about your own research & spend your time, but success is all the sweeter when your homework uncovers one of these gems.

Favorite time of year, for many investor residing in Mumbai is Monsoon season which is annual general meeting (AGM) season. If you’re new to investing, or looking to become a little more proactive with your investments, here’s a quick rundown of what it’s all about attending an AGM.

You’ve read the annual report but queries remain. Why not attend AGM?

AGM are usually the only opportunity each year to listen to, and question, the senior management & directors of companies in which you own shares. They’re also very useful for getting a feel for management of those companies you are considering investing in. While the clichés often flow just as easily as in the annual report, you at least get a chance to read their body language and guess if they’re confabulating.

Having your say

AGM also gives shareholders a chance to vote on important issues, like directors’ appointments and salaries, executive options packages, issue of Rights/Bonus shares and Change in Auditors.

Not that you have to show up to have your say. You can vote via snail mail or by appointing any other person as your proxy allowing him to vote as he pleases, or instruct them on how you wish to vote on each issue. You can issue proxy in favor of the current management if you are satisfied with them.

Assuming you want to turn up yourself, you’ll need to take along your credentials, or simply identify yourself as a shareholder when registering outside the meeting. Non-shareholders are normally not allowed to attend.

The formal part of the meeting usually includes a speech by the chairman and managing director, giving a brief run-down of the last year’s performance and current operating conditions. It’s a great opportunity to see who’s reading what the PR department gave them, and who’s speaking with passion about a business they understand intimately.

At some of the better AGMs, opportunity is also given to divisional heads and second-tier management to talk about other aspects of the business. This indicates an open and trusting management style, as well as a desire to educate shareholders about the company.

Once the voting is over, often without so much as a modicum of resistance to management’s plans, the floor is usually then thrown open to shareholders, allowing those who normally couldn’t command management’s attention to have their say or ask a few questions. It can be quite tedious when the proceedings are hijacked by special interest groups or professional grumblers. And sometimes the repetition of questions can get downright annoying. But it’s usually worth sticking around for a pearl of wisdom or two, and it can also be revealing about the character of management, given that answering questions can’t be done from a prompt.

Annual meeting time is your one chance to hold directors to account, and score some free tea and Gift to boot. We suggest you make full use of the opportunity.

A speech was given by Seth Klarman at the Columbia Business School in 2006. Klarman’s hedge fund, the Baupost Group has done over 20% a year since he founded the firm in 1983, with only one down year. This is one of the best speeches. Klarman discusses his thoughts on the investment, why he doesn’t go short & why he uses derivatives.

HOW BAUPOST INVESTS

• Rule #1: Don’t lose money. Rule #2: Never forget Rule #1.
• Baupost always looks for catalysts in its investments. If you find a stock trading for 50% of what you think it’s worth, you want there to be something that will trigger it to reach fair value.
• Baupost will always sell an investment as soon as it nears their estimate of fair value. Baupost has analysts focused around the type of opportunity; Baupost has a spinoff analyst, index fund deletion analyst, post bankruptcy analyst, distressed debt analyst & an analyst looking at companies that are depressed because of a bad earnings announcement.
• Baupost looks at every merger, rights offering, privatization of government business, spinoff, major share repurchase Dutch auction tender, thrift conversion or anything else that could cause mispricing.
• Post-bankruptcy situations are a good place to look for bargains because people avoid them & don’t understand them. A lot of good things can happen in bankruptcy such as terminate overpriced contracts or leases, shed extraneous business units or, deal with union problems or settle contingent liabilities; all under the protection of bankruptcy court. Then all the debt holders have equity & they will want to sell.
• Baupost doesn’t go short because, unlike going long when you can take advantage of a drop in the value of an undervalued security by just buying more, if you’re short, even though you may be right that it’s worth less than the trading price you can still go broke. Its way more risky & you can lose to infinity. Think tech stocks – if you shorted them in ’97, ’98 or even ’99 you would have been killed. It works for a while, and then the market goes berserk & you get killed.
• Baupost uses hedges to reduce risk. For example, they use derivatives to hedge the interest rate risk in their real estate holdings.
• Baupost constantly reassess to find new information, if they’ve overlooked something or if something has changed.
• Klarman said he would rather hold treasury bills than invest in many of the hedge funds. If stocks do 10% & hedge fund charges 3% in fees, you’ve only got 7% left, plus it’s leveraged, holds illiquid securities, etc. He would prefer rather get 4.5% risk free.
• Value investing is risk aversion.

BAUPOST’S 3 INVESTMENT PRINCIPLES:

• Focus on risk before return. This is why Baupost has so much cash (around 45%). If they could find undervalued investments, they would put all their money to work tomorrow. If they had to they would have no problem holding 100% cash. People fail to have sell discipline because they can’t hold cash.
• Focus on absolute returns. Institutions focus on relative returns but Baupost doesn’t as Klarman can’t imagine writing a letter to clients saying “we performed well during the year, the market was down 25% & we were down only 20%”; also clients will pull money out at the wrong time & it has a strong psychological effect.
• Only focus on bottom-up investing. He has views on the macro but doesn’t think he has an edge in that type of investing. Klarman said that it’s really hard to turn a macro idea into an investment.