Risk can come from anywhere

In life, risk can come from anywhere. More so, in equity investing. This thought has been captured very well by the following quote :

“Condoms aren’t completely safe. A friend of mine was wearing one and got hit by a bus.” — Robert Rubin

Lakshmi Vilas Bank (LVB) has been in the news for poor functioning and an aborted attempt to merge with Indiabulls. That tells a lot about both. As Yogi Berra said "You can observe a lot by just watching".

On Nov 17th, RBI put LVB under moratorium and decided to merge the same with DBS India. Merging LVB with a strong entity like DBS would ensure safety of the depositors' money, I think. But what happens to the shareholders ? Read the following :

So, the entire equity capital of LVB stands written off and the shares are now worth zero. Didn't I tell you, that in life, risk can come from anywhere. And more so, in equity investing.

Knowledge is like sunshine

Once upon a time, there lived a group of 4 friends: Cleverwit 1, Cleverwit 2, Cleverwit 3 and Dumbwit. As the names suggest, three of them were quite clever and one of them was considered dumb according to conventional standards.

All of them lived in the ashram of their guru to attain education. After having spent many years in the ashram and having completed their education, they headed home. The journey home was long and encountered forests on the way. While passing through one of the forests, they came across some scattered bones.

Cleverwit 1:  Hey! Let’s utilize our guru’s education and test ourselves. By looking at these bones, I can tell you that these belong to a lion. I can arrange them.

Cleverwit 2:  And if you could do that, I should be able to put flesh and skin around it.

Cleverwit 3:  Well, if both of you are successful, by the grace of our guru – I should be able to infuse life into the lion.

Dumbwit who was until now silent and patiently listening to their conversation shivered at the idea and expressed the danger, all of them would get into should the lion come to life. All cleverwits, too consumed by their knowledge and an opportunity to show it off dismissed his apprehensions and called him a coward.

Having realised that it would be difficult to rationalise with his friends once they have made up their mind, he requested them to let him climb a tree before they brought the lion to life. Cleverwits agreed and Dumbwit quickly climbed the tree. The Cleverwits were successful, the lion came to life and filled its belly with the bodies of 3 cleverwits. Dumbwit witnessed this sad scene from a tree and wished his friends had listened to him.

Cleverwits were all clever but they made a fundamental error. Dumbwit may have been otherwise dumb but he got his basics right.

In investing too, we encounter situations where the business is all good and we may think we are clever to spot such a business but there is this element which if comes to life would devour the capitalist. The risk could come from a single supplier, single customer, single geography, single asset or dependency on a favourable regulation etc. The risk could also come from a questionable quality of management. Dubious related party transactions and schemes of arrangement are fertile grounds to perpetrate wrongdoings on minority shareholders. 

IF we encounter such a business or a management with a fundamental flaw, we should think like Dumbwit and climb to a safe vantage point. Investing in situations fraught with grave risks is stupidity not bravado. Sadly, in investing stupidity often appears camouflaged as bravado.

I read this story in Amar Chitra Katha (a popular comic magazine) and added to my mental framework. The message here is Buffett’s Rule No 1 in investing “Never lose money”. 

 

Another favourite story of mine is one from the book of Osho.

Once a dhobi (washerman) came for his morning rounds to pick up dirty laundry from his customers’ houses. He was accompanied by his donkey whom he used to transport laundry. In the village also lived a Seth (wealthy merchant).

Having arrived at the Seth’s house, the dhobi asked for laundry. The Seth saw a shining glass piece tied around the donkey’s neck.

Seth:    Hey! What have you tied around your donkey’s neck? And where did you get it?

Dhobi:  I don’t know what it is, Sir. I was passing through a road and found it lying there. I liked it, picked it up and tied it around my donkey’s neck.

Seth: Okay. It’s of no use to you and your donkey. Let me buy it from you. I will give you Rs 10 for it.

Dhobi thought for a few moments and agreed to sell but for Rs 20. Seth thought that the dhobi is going to come back in the evening and sell the same thing to him for 5 bucks. Seth spent the whole day thinking about the glass piece and waited anxiously for the dhobi to return in the evening.

The evening finally came and so did the dhobi with the washed laundry and his donkey. But the glass piece around his neck was missing.

Seth: Wherrrre is the glass piece?

Dhobi:  Oh! Somebody in the market offered me Rs 50 and I gave it to him. Good that I didn’t give it to you for Rs 20 in the morning.

Seth: You fool ! That was a piece of diamond and was worth atleast 10,000 bucks and you sold it for 50.

Dhobi:  Sir, I am ignorant and do not know anything about diamonds and their values. I asked you 20 bucks because my donkey eats grass worth that much in a day. And I thought either I would sell it for atleast that much or else I won’t. But you haggled for 10 bucks knowing very well that it was a diamond and was valued much more. Don’t you think you are a greater fool than me!

Most of the time in investing, we are like the dhobi. We are ignorant about the businesses and we don’t know their values. Market prices in isolation should not mean anything to us. But sometimes, we understand the business and we can also conservatively calculate its intrinsic value. IF we find ourselves in such a situation and the price offered by the market offers a good margin of safety, we should act decisively to buy and not act like the Seth and haggle for lower prices. 

This is a story which reminds me that historical prices are irrelevant. A business might have traded at much lower valuations in the past but we may have been the dhobi at that time knowing nothing about the business. The important thing is to know when you are the dhobi and when you are the Seth.

I would like to add a word of caution here. This story should not turn you into an unjustifiable optimist and buy any business that you like disregarding the valuations. 3 things are important: you should understand the business, the business should be conservatively valued and finally it should be available at a good margin of safety.

The above 2 stories remind me of the important elements of risk avoidance and acting decisively when things are within our circle of competence. These elements have been taught by investment masters over a long period of time. I have tried to understand these in the form of stories as stories have a powerful way of wiring our brains.

I read these stories in different books in contexts which were not related to investing. But knowledge is like sunshine and should be welcomed from all directions.

What say you?

Niti and Nyaya

Many a time, we come across a business which is of a good quality but the management has conducted itself in the past in ways which do not fully conform to ethical and legal standards.

Should we reject that idea? On what parameters should we decide? 

Niti and Nyaya

In Sanskrit, both these words denote justice. However, according to philosophical texts, there is a subtle difference between the two. “Niti” stands for moral conduct, correctness of behaviour and is abstract in nature. “Nyaya” stands for rules and procedures and is absolute in nature. 

A king had a wise minister who always spoke the truth. The king once decided to put-down his minister. He showed his closed fist to the minister and said “You are so wise and you always speak the truth. In my fist, there is an ant. Tell me if it’s dead or alive.” The minister thought for a moment and replied that the ant is dead. The king laughed and feeling victorious- opened his fist. The ant was alive and walking. The king told the minister that he had been proved wrong. The minister remained silent. 

Later on, one of the minister’s friend in the court asked if he knew that the ant was alive. The minister said, “Yes, I knew. But had I spoken the truth, the king would have closed his fist tighter and killed the ant. In order to save the life of the ant, I had to side with Niti (moral conduct) at the cost of Nyaya (legal conduct).”

Let’s look at some examples of management actions through the lenses of Niti and Nyaya.

1.     A pharma company has a monopoly on some drugs and raises prices exorbitantly. Assuming that the drugs were not under any price regulation, the company was well within its right to raise the prices. So, Nyaya (legal conduct) was intact. 

But raising the prices beyond a reasonable limit causes undue hardships to families who needed the medicines. Did the company’s management behave with the correct Niti?

2.     A company decides to pursue a buyback at a cheap price with negative consent from the minority shareholders and promoters do not participate in the buyback. Negative consent means that if the shareholders don’t opt out, it would be deemed that they agree to the buyback. Minority shareholders who didn’t understand the matter completely found their shares bought back (stolen) from their accounts at low prices. The company has followed all due legal procedures and hence has Nyaya on its side. But did it have Niti on its side? 

3.     Munger once bought a business and had a couple of widows on other side of the transaction. Unaware about financial matters, the widows quoted a lower price than what Munger had calculated. He decided not to take advantage of their ignorance and paid the higher price. He ignored the rule-based conduct in favour of an overarching moral conduct.

4.     A company under debt reconstruction gets settlement terms from all the creditors. There are hundreds of small depositors who had put their savings into the company’s deposits. Realising that even though under financial stress, it can still pay the small depositors, the company decides to pay in full to them. An example where the management is guided by the moral conduct and not by the legal conduct alone.

During our investing careers, we will come across many such permutations and combinations of intermeshed legal and moral conducts.

1.     When a management runs a business both with Niti and Nyaya on its side, one can quickly conclude that you have got the right set of partners.

2.     One can also immediately conclude when neither Niti nor Nyaya is present. Don’t venture close to such managements. You will lose both- character and money.

3.     If the management has been guided by a higher moral conduct at the expense of rules, look carefully. If you conclude that it is indeed the case, then it is a very good management to partner with.

4.     The tough situations are the ones where a management has followed all legal procedures but their actions do not pass the test of moral conduct. What to do in such cases?

I think about them in the following way:

• Is the issue-at-hand going to damage the core business of the company?
• What % of revenues or value pertains to this issue at hand? 

If the issue is small relative to the revenues/value of the business, I would tend to take it in my stride and not reject the idea outrightly.

• Does the issue make me question the basic DNA of the management?

Irrespective of the % contribution to revenues/ value, if the basic DNA of the management becomes questionable, I would stay away and not partner with them. Dubious schemes of arrangement and related party transactions are fertile grounds for such behaviour.

• Are there more than one distinct corporate governance issues?

Judging corporate governance practices in a business is quite a subjective call. Two well-meaning investors can have different perspectives on the same issue. It depends on one’s own tolerance level, risk appetite and overall attitude towards investing.

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