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.
