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.
8 comments:
Good story and lesson worth remembering. Wanted to share a anecdote: in the crash of 2009, Hawkins was at 150-160 Rs range. I let it go as I wanted the price to reduce by Rs. 10 as it was going down. But as market would have it, it never saw that price and rose Upto Rs. 4000+ in next 5-7 years. I always remember the anecdote.
This was great to read Ankur. Stories are a wonderful way to remember lessons.
On your first story, I would like to hear your thoughts on the below:
Should one not consider risk in relation to reward, and then size the position accordingly?
Take Cera Sanitaryware for example. For a long time, it had a plant in one single location which (still) provides the lion's share of revenues and profits.
Should one reject Cera? I would argue that at certain price, one accepts the risk and controls it at portfolio level provided the reward is more than commensurate...
On your second story, I agree with you.. If one gets a diamond for 20 rs one should not wait for 10 rs....
But I could not help recalling this excerpt from 'Damn Right':
Charlie glances around the kitchen, as if calculating the odds of carrying on a reasonably private conversation with his pal and business partner, the second richest man in the world, the Sage of Securities, Warren Buffett. Nancy Munger comes to her husband's rescue. "It's a walk-around phone Charlie. Just take it wherever you want and dial the number." As if unconvinced that the phone has enough range to work outside or from an upstairs bedroom, Charlie goes just around the corner into the living room and punches in the telephone number that he knows by heart. Pandemonium continues in the rest of the house as Charlie plops down in a lumpy upholstered chair to chat with Warren.
"Mumble, mumble, mumble."
Silence.
"Mumble, mumble."
Silence.
"So it's the price that bothers you?" asks Charlie.
Silence.
"If you wait, I think you'll get your price."
Silence. "Okay." Click
_____________
I am sure Mr. Buffett would not have called Mr. Munger for his opinion on a diamond available for 20rs.
But I do think, as you pointed out in a previous post, that the sages do think about prices beyond what is commonly thought.
What do you think?
Nice reading! These small stories are helpful.
Amazing and very well told ...I am also going to remember and remind myself when I invest ...
Excellent Post
Ram
Hi Ankur
HaHa - Super simple way to communicate the genesis of investing. And something difficult to forget now.
Ritesh
Thank you, Sumit Talwar for sharing your experience.
Hi @Rohith2988
Absolutely, there are 2 no ways about it. One should consider risk, reward and then size the position.
On Cera, yes, it’s true that it has a single plant and that carries a risk. But does Cera’s competitive advantage depend on that plant alone?
In my view, Cera’s competitive advantages come from – brand equity, manufacturing know-how, operational efficiency, economies of scale (single plant), large distribution network, availability of cheaper gas, debt free and cash rich balance sheet etc. Having a single plant is just one of the factors in this lollapalooza. If something untoward were to happen to the plant, earnings may get dampened for a couple of years till it gets back to its feet again. All other competitive advantages mentioned above would remain intact even if the plant gets damaged for some reason. Hence, I don’t consider “single plant” as a grave risk in the case of Cera.
Consider a paper company which has a single plant which is close to a large water source. Since paper manufacturing requires a lot of water, the key risk to that business is continuous availability of water. Let’s say the population in the nearby areas faces shortage of drinking water. In that case, the Government may bar the company from drawing water. No water and no paper would lead to no business. Dependency on a single plant would then destroy the business completely. So, with respect to the first story, I would emphasize on `knockout’ risks which if they materialise would not allow the business to rise on its feet again.
The second part of the question:
Thanks to share this excerpt from Damn Right. It’s refreshing to read it again. I agree that Buffett and Munger do think very carefully about the price paid for a business and so should we. Price paid for a business is one of the 3 legs of a tripod along with quality of business and management. I have made mistakes in the past of paying a higher price for businesses that I liked and hope to learn.
In my blog post, I have not suggested to ignore the price paid. What I have mentioned is that- if you come across a business that you understand AND is run by ethical and competent management AND is available at a good margin of safety, then you should be decisive in your action to buy. At that point of time, one should not let other phycological biases of anchoring (lower price in the past) or any other bias play on his mind.
Buffett also considers in his mistakes of omission- the act of not buying Walmart when he had made up his mind on the business and had started buying but the price went up a little and he stopped buying. He got anchored to the lower prices that he had paid during his initial purchases.
So, I think there should be a framework in our thesis to calculate the intrinsic value and the minimum margin of safety that we look for. As long as that minimum required margin of safety is present, we should buy upto the desired position size even if the price increases.
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