Lessons from Charlie Munger-VIII

Dec 15, 2011

In the previous article, we had discussed how you can make consistent stock returns by understanding and avoiding the trap of inconsistency-avoidance tendency. Today, we shall discuss a very basic tendency that often drives our thoughts and actions and is very relevant to our behaviour in stock markets. And in doing so, our aim is to help you identify dysfunctional behaviour patterns and thinking errors that may be hampering your stock market investments. 


Envy / jealousy tendency 

What do the words envy and jealousy bring to mind? Whatever they bring to mind, we often try our best to dissociate ourselves from them. Such is the taboo attached to these emotions that we do not want to link our behaviour and actions with them. Yet these very emotions are so innate to human nature that it is almost impossible to get rid of them. More importantly, given the crucial role that these emotions play in the human world, you could risk ignoring them at your own peril. 
So let's ponder a bit about the roots of envy and jealousy. Charlie Munger gives a very interesting evolutionary perspective on this, "A member of a species designed through evolutionary process to want often-scarce food is going to be driven strongly toward getting food when it first sees food. And this is going to occur often and tend to create some conflict when the food is seen in the possession of another member of the same species. This is probably the evolutionary origin of the envy/jealousy tendency that lies so deep in human nature." If these lines sound very geeky and clinical, let us elaborate in simple words. Food is very basic to the survival of any life-form. Without nutrition, no life can exist. So the chief life-long struggle of any creature is about securing the supply of food. Throughout history, the availability of food has dictated the survival or extinction of species. Given the utmost importance of this vital resource, a creature will be instinctively driven to possess the food the moment it notices it. The conflict arises when it sees food in the possession of another creature. This explanation, though difficult to verify accurately, does broadly explain the origin of envy and jealousy. And it extends to all other things other than food as well.


Envy and jealousy tendency in stock markets

It is often said that stock markets are driven by greed and fear. Sounds pretty neat, isn't it? But legendary investor and Charlie Munger's 'Siamese twin,' Warren Buffett, has an important interruption to make here. He very wisely points out, "It is not greed that drives the world, but envy."A patient contemplation of this sentence will reveal to you its utmost significance. While 'greed' refers to an excessive desire to possess something, 'envy' is a desire to possess what the other person is possessing. And more often than not, greed is fuelled by envy. A lot of times, we desire something simply because we see someone else enjoying it. Such human tendency of envy and jealousy is very well orchestrated in the stock markets, albeit in overwhelming proportions. Everyone is here not just to make money, but to make more money than what the next person is making. Comparison and competition is intense, creating a perfect recipe for jealousy tendency. Let us give you a couple of examples to elaborate our point:

a) Mr Gupta made 25% annual gain on his stock portfolio in 2007. He is quite satisfied. But then he learns that his colleague Mr Agarwal made a whopping gain of 300% that same here. Now Mr Gupta is distressed and feeling left out. His 25% gain now looks paltry in comparison to Mr Agarwal's triple-digit gains. He gets desperate to replicate his friend's success. In his frenzy, he ends up playing some stupid bets and loses quite a lot of money. 

b) Mr Rao has made a lot of money on certain stocks in recent times. Mr Desai, whose portfolio hasn't fared too well, is secretly disturbed, or in other words, jealous of his friend's prosperity. He decides to do exactly as his friend does, so that he would be as successful as him. Around this time, Mr Trivedi is extremely bullish on silver and places big bets on silver futures. Mr Sharma is tempted to copy. Despite not being in a very sound financial position, he jumps on the bandwagon and ends up burning his fingers. 

It is clear that it was jealousy that motivated wrong behaviour in both these cases. The list of such cases is long. The important point to take home is to not let such negative emotions affect your investment decisions. But isn't it a little too difficult to not feel bad if your friends and colleagues make a lot more money than you do? It is indeed difficult. So the best antidote in such a case is to avoid discussions that would trigger feelings of jealousy. In fact, some of the best investors in the world keep extremely low profile and keep their discussions limited to stock ideas and business fundamentals. In the absence of such external disturbances, they are able to make more rational investment decisions. 
We will continue to discuss some more thinking errors and psychological tendencies that can affect your investment decisions in the subsequent articles of this series. 

https://www.equitymaster.com/detail.asp?date=12/15/2011&story=1&title=Lessons-from-Charlie-Munger-VIII

Lessons from Charlie Munger-VII

Dec 8, 2011

In the previous article, we had discussed the roots and the consequences of the 'doubt-avoidance' tendency. Today, we shall discuss another extremely important human tendency that every serious investor should be well aware of.

Inconsistency-avoidance tendency 

Imagine what it would be like if you woke up every day and had to learn all the physical and mental tasks from scratch. It's impossible to even imagine such a situation. Thanks to the human brain, we don't have to bother about most tasks every single day. Through countless sets of programs, the human brain ensures our smooth and consistent functioning. Habits, which are patterns of behaviour which routinely repeat themselves subconsciously, are also a result of this process. While habits can be good, and good habits doubly so, there are several disadvantages as well. Habits often come in the way of any kind of change or transformation. As Charlie Munger puts it very aptly, "People tend to accumulate large mental holdings of fixed conclusions and attitudes that are not often reexamined or changed, even though there is plenty of good evidence that they are wrong." 

This brings us to the inconsistency-avoidance tendency which is very rampant amongst human beings. In simple words, we filter away any piece of information which may be inconsistent to our ideas and beliefs. You may have read as students how many great scientists and discoverers were often discredited and ridiculed for their so-called lunacies. Many were acknowledged for their great work only after their death. Do you see how the inconsistency-avoidance tendency works? Not just history, even our day-to-day life is filled with such stories.


Inconsistency-avoidance tendency in stock markets

Our aim is not to profess psychology for its own sake but to attempt to relate it to human behaviour in the stock markets. Stock markets are largely driven by sentiment. So you must do your best to be as objective as you can and guard yourself from the lures of greed and fear. 

Getting back to inconsistency-avoidance tendency, can you remember instances when you have used this tendency to your own peril? We'll point out a few for your benefit:

Have you lost money on your favourite stock that had once been an outperformer? The company's prospects may have changed, it may no longer be worth putting your money into, but you still couldn't let go of it. Why? Because letting go of it would be inconsistent with your original beliefs about it. So you did everything to console and convince yourself that nothing was wrong. But your portfolio losses have a different story to say, don't they? 

Each investor will have innumerable such instances to share. Now the more important question, how exactly do you get rid of this tendency? There are several ways to do that, but more than anything else, you need to be very disciplined with your approach. 

• One great way is to play the devil's advocate. If you find a prospective company very compelling, first start with rejecting the hypothesis. In other words, try to gather facts and arguments that will prove that the stock is a bad investment. After all your analysis, if you arrive at the conclusion that the stock is still good, then it has passed the bar. 
• You can also take a good lesson from the court of law. Law courts have processes and procedures in place that tend to minimise hasty and biased decision-making, which can cost someone's life. As investors, you must learn not to be hasty. Adjourn your stock purchases till you're not clear in your mind. 

Always remember, stock markets will always keep swinging higher and lower. Investing opportunities will be there. We can assure you that if you can tackle with your inconsistency-avoidance tendency, money will consistently keep pouring into your bank accounts. 

We will continue to discuss some more thinking errors and psychological tendencies that can affect your investment decisions in the subsequent articles of this series.

https://www.equitymaster.com/detail.asp?date=12/08/2011&story=5&title=Lessons-from-Charlie-Munger-VII

Lessons from Charlie Munger-VI

Sep 29, 2011

In the previous article, we had discussed how the 'disliking and hating' tendency can be a threat to your investments. Today, we shall discuss a very important human tendency that every investor should undoubtedly not avoid.


Doubt-avoidance tendency 

The name itself is quite self-explanatory. Doesn't our mind often display a tendency to steer clear of doubts to quickly reach a decision or conclusion? It surely does, and at times to our own disadvantage. Charlie Munger presents an evolutionary perspective about how this tendency must have developed in humans from their non-human ancestors. He asserts that it would be suicidal for a prey animal threatened by a predator to take a long time to decide what to do. The development of this tendency has come as a survival tactic in times of stress and confusion. Much of religious propaganda has in fact taken advantage of this tendency. How otherwise would you explain the immense faith displayed by people in religious decrees that will otherwise find difficulty to get past the check-post of logic? 
So the evolutionary justification of this tendency is reasonable. But the problem with any kind of psychological tendency or mental programming is that it doesn't work well in all situations. Say, a person who is neither under pressure nor threatened should ideally not be prompted to remove doubt through rushing to some decision. Yet, more often than not we find ourselves doing exactly the opposite.


Doubt-avoidance tendency in stock markets

Have you observed the doubt-avoidance tendency manifesting itself in the stock markets? The answer is a loud 'yes' in our view. How often do you trade on impulse without asking the right questions? How open are you to hear negative things about stocks that you are very optimistic about? When a person comes to the stock markets with a bag full of money to invest, he is usually inclined to fall in love with any stock that seems promising. The boredom and pain that is usually part of a thorough scrutiny and analysis of a stock is often avoided. Quick conclusions and quick decisions are often preferred instead of the burden of doubts and ambiguity. 

Without any exaggeration, we strongly believe that if you learn how to reign over the doubt-avoidance tendency while you conduct your business in the stock markets, there is little that can stop you from becoming a successful investor. 

We will continue to discuss some more thinking errors and psychological tendencies that can affect your investment decisions in the subsequent articles of this series.

https://www.equitymaster.com/detail.asp?date=09/29/2011&story=2&title=Lessons-from-Charlie-Munger-VI

Lessons from Charlie Munger-V

Apr 7, 2011

In the previous article, we had discussed how loving your stocks too much can distort your perception and in turn be a threat to stock investing. Today, we shall discuss the other extreme of the emotional spectrum: how feelings of dislike and hatred too can derail your investments. 


Disliking and hating tendency

Take the recent Cricket World Cup. Rewind back to the semi-final match between India and Pakistan. Was it a cricket match? Or was it war? War it was! The high-voltage match that ended with India beating Pakistan saw our feelings of patriotism and national pride touch the sky. But it's not pride for India alone that makes us so jingoistic. There's also an intense hatred towards Pakistan that equally nourishes that feeling. So we get back to where we started- emotions and biases. 

From the time we are born, we learn to dislike and hate the same way as we develop tendencies to like and love. The history of human evolution boasts of almost continuous wars. Neither religion, nor advancements in civil life have done much to change the basic savage instinct. And wars are not the only way in which hatreds find expression. In more sophisticated societies, hatreds and dislikes find expression in more non-lethal things such as elections, sports and even stock markets. 

Charlie Munger has very aptly explained how the "disliking & hating tendency" acts as a conditioning device:

• We ignore virtues in the object of dislike
• We dislike people, products, and actions merely associated with the object of dislike
• We even tend to distort other facts so as to justify our hatred.

Do you recall a promising stock that you had fallen for faltering miserably? There may have been some unfortunate event or probably a cyclical downturn. Maybe your timing wasn't right. Or maybe, the markets were just too pessimistic and overreacting at that moment. But your instinctive reaction could have been that of disappointment and anger. In your fury, you may have even decided never to put money in such a money-sucking monster.

This kind of biased approach to investing could be very detrimental to your stock portfolio. While negative events should be viewed diligently, you will be better off if you fairly consider the pros and cons of every situation. You never know, your blind dislike for a certain stock or sector could destroy a potential multibagger

https://www.equitymaster.com/detail.asp?date=4/7/2011&story=2&title=Lessons-from-Charlie-Munger-V

Lessons from Charlie Munger- IV

Mar 3, 2011

In the previous article, we had discussed how a wrong set of incentives across the entire economic system was responsible for the US financial crisis. Today, please do not panic, for we are going to talk about love.


Liking and loving tendency

Love is one of the most basic of emotions. The very first manifestation of it is between a mother and the new-born child. For a child, this earliest experience has far reaching effects. The child learns to love and to be loved in return. It becomes a kind of a programming device. And it extends not only towards people, but also towards things, ideas and concepts. Of course, the child learns to dislike and hate as well. But we'll limit this piece to our tendency to love and to like.

This tendency to love has its own set of side effects. It acts as a conditioning device and often distorts our perceptions. To make it simple, think of someone you love- your spouse, your kid, your favourite actor or cricketer. You could also think of any idea or belief that is very dear to you. Now ask yourself these questions:

• Do you tend to ignore their faults? Do you readily comply with their wishes?
  
• Do you favour people, products, and actions merely associated with them?
  
• Do you distort any unpleasant facts about them?

Now why are we talking about all this? Has it got anything to do with investments and stocks? Most certainly yes! We are firmly of the belief that being a successful investor requires discipline and a sound emotional make-up.

Have a look at your stock portfolio. There is one very common error that most investors do with stocks that they own. Once they have bought a stock, they automatically start developing a feeling of affection towards it. Don't we often hear people raving about certain blue chips with an admiration that borders around reverence? Any negative comment about them will either be ignored, dismissed or defended. It almost seems like a marriage brimming with loyalty and affection. Take the so-called "hot" sector stocks. Don't they often cause many a feeble hearts to melt? And what happens to all thoughts about business and valuation? Well, well, well... You know best. We dislike challenging and reasoning with things and ideas that we love.

Our bottom line is this. Do fall in love, but not with your stocks. Love your capital and do the best you can to protect it and to help it grow. And what better of doing that than being a disciplined value investor!

https://www.equitymaster.com/detail.asp?date=3/3/2011&story=6&title=Lessons-from-Charlie-Munger--IV

Lessons from Charlie Munger- III

Jan 13, 2011

In the previous article, we had discussed the influence of incentives at the level of individual firms and some antidotes for investors. In this article, we'll discuss the power of incentives in the context of economic systems. 

We all are part of various systems or groups- from a micro-system like a family to a macro-system like an economy. If you rip apart any system and look at its core design, you will find mainly two things: incentives and disincentives. They may be in the form of rules, regulations, norms, customs, traditions, mores or ethics. And you see them everywhere, don't you? Be it religion, politics or economics, every system is made up of these elements. 
We'd like to point out to you how the success or failure of any economic system depends on how incentives and disincentives are designed. Let us explain.


What made the free-market economy work?

The success of the free-market system as an economic system comes from its inherent reward-punishment mechanism. Owners have a strong incentive to prevent all waste in operations. Their businesses will perish in the face of brutal competition if they are not efficient. Replace such owners by salaried government employees and you will normally get a substantial reduction in overall efficiency. 

Communism has failed due to the absence of exactly those incentives that have motivated private enterprises to flourish in democracies. The fall of the Soviet communists is a glaring example of wrong system design. But one may also point the knife at the US- the epitome of free-market economy, for bringing in one of the worst financial crises ever. What really went wrong? Well, there is not just one simple answer to this. But we'll restrict our discussion to the main theme of the article.


The US financial crisis: an outcome of wrong incentives and absence of disincentives 
It is fashionable to bash up the US Fed and the big investment banks for all the menace they created. But blaming them alone would do us more harm than good; because the crisis was a failure of the entire system and not the outcome of a few crooks alone. In one part, the financial crisis was a result of a series of incentives that induced unscrupulous behaviour across the entire system. The other major mishap was a complete dearth of penalties for wrong behaviour. Looking back, the evidence comes out pouring, often overwhelming.

Though it is not widely discussed, the original subprime lenders of the 1990s had already gone bust by turn of the century. A child could point and say, "Don't make loans to people who can't repay them." Simple. But amusingly and frighteningly, the lesson learnt was a bit complicated: "Keep making such loans; just don't keep them on your books." The lenders made the loans, and then sold them off to the fixed income departments of big Wall Street investment banks. These investment banks in turn packaged them into bonds and sold them off to investors. So the originator of loans had little incentive to bother at all about creditworthiness. On the other hand, there was hardly any penalty to curb his recklessness. As Mr. Raghuram Rajan, a leading economist who saw the crisis unfolding as early as 2005 noted, "Incentives were horribly skewed in the financial sector, with the workers reaping rich rewards for making money but being only lightly penalized for losses." 

Also, the problem was not that no one warned about the dangers. It was that those who benefited from an over-heated economy- which included a lot of people- had little incentive to listen. So everyone enjoyed this "passing the parcel (read atom bomb)" game as long as the music played. And we all know what happened after the music stopped.

India 2010: A carnival of scams

We just emphasised the omnipotence of incentives and how a flawed reward-punishment mechanism can bring about the collapse of a giant system. It is quite clear that man responds more often and more easily to incentives than to reason and conscience. Didn't we see this axiom crystallizing before our own eyes with the cracking of a series of scams last year? Again, we will not arrive at an effective solution if the issue is not addressed at the most fundamental level. Firstly, we have to accept that man is fallible and corruptible, if the situation so allows. So the solution does not lie in moralising individuals alone, but more importantly, in creating robust systems that reward fair and ethical behaviour and deter deceitful practices. 

https://www.equitymaster.com/detail.asp?date=1/13/2011&story=5&title=Lessons-from-Charlie-Munger--III

Lessons from Charlie Munger- II

Jan 5, 2011

In the previous introductory article, we briefly discussed Charlie Munger's multidisciplinary approach to investing. Starting with this article, we'll discuss his list of "24 Standard Causes of Human Misjudgment" and understand how they have powerful implication for investors.

Reward and Punishment Super-response Tendency

Why do we do what we do? Why are we tempted to do certain things while refraining from others? Well, all creatures seek their own self-interest. Our innate drive is to maximise pleasure, while at the same time avoiding or reducing pain. In any given circumstance, we assess the risks and the associated rewards and respond in a way that seems to best serve us. With this premise, it is imperative to understand the role of incentives and disincentives in changing cognition and behaviour. 

The power of incentives

There is this interesting case of the logistics services major FedEx Corporation. The integrity of the FedEx system required that all packages be shifted rapidly among airplanes in one central airport each night. And the system had no integrity for the customers if the night work shift couldn't accomplish its assignment fast. And FedEx had a tough time getting the night shift to do the right thing. They tried moral persuasion. They tried everything in the world without luck. Finally, somebody thought it was foolish to pay the night shift by the hour. What the employer wanted was not maximized billable hours of employee service but fault-free, rapid performance of a particular task. So maybe if they paid the employees per shift and let all night shift employees go home when all the planes were loaded, the system would work better. And that solution worked just perfectly. This is a classical case of the power of incentives and how they can be used to produce desirable behavioural changes. 

The abuse of incentives

One of the most important consequences of incentives is what Charlie Munger calls "incentive-caused bias." The following example will explain the same. Early in the history of Xerox, Joseph Wilson, who was then in the government, had to go back to Xerox because he couldn't understand why its new machine was selling so poorly in relation to its older and inferior machine. When he got back to Xerox, he found out that the commission arrangement with the salesmen gave a large and perverse incentive to push the inferior machine on customers. An incentive-caused bias can tempt people into immoral behavior, like the salesmen at Xerox who harmed customers in order to maximize their sales commissions.

The story of mutual funds in India is quite similar to that of the Xerox case. Mutual funds that offer the maximum commission to distributors are the best sold funds. Also, consider your own stockbrokers. There will be seldom one who will not lure you to trade too often. And seldom will a management consultant's report not end with an advice like this one: "This problem needs more management consulting services." Such behavioural biases exist in most places and situations. And human nature, bedeviled by incentive-caused bias, causes a lot of ghastly abuse. 


Some antidotes for investors

For you investors, we believe it is important to understand the motives and incentives of people and organisations you're dealing and investing with. Everyone ranging from the company you're investing in to your stockbroker, your mutual fund agent and your equity advisor (yes, even we) must pass your scrutiny.

Widespread incentive-caused bias requires that one should often distrust, or take with a grain of salt, the advice of one's professional advisor. The general antidotes here are:

1. Especially fear professional advice when it is especially good for the advisor.
2. Learn and use the basic elements of your advisor's trade as you deal with your advisor.
3. Double check, disbelieve, or replace much of what you're told, to the degree that seems appropriate after objective thought.

https://www.equitymaster.com/detail.asp?date=01/05/2011&story=5&title=Lessons-from-Charlie-Munger--II

Lessons from Charlie Munger- I

The Multi-disciplinarian

Both men have as many striking differences as similarities. One may typecast Buffett as purely an investor and philanthropist. And quite rightly so, for the man devotes his time almost exclusively to his business. Munger, on the other hand, is a generalist for whom investment is only one of a broad range of interests. In many ways, his personality has traces of his own hero-Benjamin Franklin, who along with being a great scientist and inventor, was also a leading author, statesman and philanthropist, and played four instruments. On similar lines, Munger hops around science, architecture, psychology and philanthropy with as much passion and curiosity as he does with business and investments.

Thinking errors and misjudgements

Munger very aptly follows this multidisciplinary approach in all kind of situations. He draws influences from fields as diverse as physics and psychology to his investment process. For long, he had been interested in standard thinking errors. Without diving much into academic psychology textbooks, he developed his own system of psychology more or less in the self-help style of Ben Franklin. In a series of articles that will follow, we will pick up insights from a speech that Munger gave on "24 Standard Causes of Human Misjudgment". But before we start discussing these thinking errors, let us tell you why these lessons have very powerful implications for investors. 

Do we behave like ants?

We may take great pride in our evolutionary superiority over other creatures. But we also often behave like ants. Strange? Not really. Munger has pointed out some very intriguing observations about the behaviour of these social insects. Each ant, like each human, is composed of a living physical structure plus behavioural algorithms in its nerve cells. Mostly, the ant merely responds to stimuli with a few simple responses programmed into its nervous system by its genes. For instance, one type of ant, when it smells a pheromone given off by a dead ant's body in the hive, immediately responds by co-operating with other ants in carrying the dead body out of the hive. Harvard's great E.O. Wilson performed one of the best psychology experiments ever. He painted dead-ant pheromone on a live ant. Quite naturally, the other ants dragged this useful live ant out of the hive. This despite the poor creature kicked and protested throughout the entire process. Such is the brain of the ant.

Of course, our brain is far more complex and advanced. Ants don't design and fly airplanes. But under complex circumstances, don't we also find ourselves behaving counterproductively just like ants? And aren't stock markets a perfect playground for this kind of behaviour? We'll discuss this and a lot more in the forthcoming articles. 

https://www.equitymaster.com/detail.asp?date=12/29/2010&story=6&title=Lessons-from-Charlie-Munger--I&utm_source=archive-page&utm_medium=website&utm_campaign=sector-info&utm_content=story

Charlie Munger - Conservative investing with steady savings without expecting miracles is the way to go.

Charlie Munger

Charles Thomas Munger (born January 1, 1924, in Omaha, Nebraska) is an American business magnate, lawyer, investor, and philanthropist. 

He is Vice-Chairman of Berkshire Hathaway Corporation, the diversified investment corporation chaired by Warren Buffett; in that capacity, Buffett describes Munger as "my partner." 

Munger served as chairman of Wesco Financial Corporation from 1984 through 2011 (Wesco was approximately 80%-owned by Berkshire-Hathaway during that time). He is also the chairman of the Daily Journal Corporation, based in Los Angeles, California, and a director of Costco Wholesale Corporation. 

Like Buffett, Munger is a native of Omaha, Nebraska. After studies in mathematics at the University of Michigan, and service in the U.S. Army Air Corps as a meteorologist, trained at Caltech, he entered Harvard Law School, where he was a member of the Harvard Legal Aid Bureau, without an undergraduate degree. - Wikipedia 

"It's in the nature of stock markets to go way down from time to time. There's no system to avoid bad markets. You can't do it unless you try to time the market, which is a seriously dumb thing to do. Conservative investing with steady savings without expecting miracles is the way to go." - Charlie Munger

https://www.equitymaster.com/outlook/charlie-munger/charlie-munger-value-investing.asp

Stay Rational in the Downturn

By Emil Lee 
January 22, 2008 

There's been a bloodbath in the markets lately. Investors, banks, and investment banks are all trying to stay afloat in a sea of red ink.

Forgetting about the happier, more bullish times is easy to do when circumstances turn against us, but we must do our best to stay calm. To keep your cool as a rational investor, here are a few wise words to remember when dealing with the stock market's ups and downs.

It happens, even to the best investorsYou can easily feel isolated when you're handed huge losses, but even the best investors falter.

Charlie Munger, now vice chairman of Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) , ran an investment partnership called Wheeler, Munger & Co. back in the '60s and '70s. Munger's partnership performed admirably and trounced the indexes. However, in the brutal bear markets of 1973 and 1974, it recorded back-to-back annual losses of 31.9% and 31.5%, compared with losses of 13.1% and 23.1% for the Dow.

Wheeler, Munger & Co. persevered. It returned 73.2% in 1975, and Munger went on to become a billionaire with Berkshire Hathaway. I'm skipping the interim details, but the moral of the story is: Just because you're sitting on a big loss doesn't make you a horrible investor.

Some losses are temporaryAn article in the latest issue of Barron's noted that private-equity firm Warburg Pincus remains committed to its capital infusion of $500 million into besieged bond insurer MBIA (NYSE: MBI  ) , even though its cost basis will be about $31 per share, compared with the current trading price of around $11.43 per share.

In the article, a Warburg spokesperson pointed out that the firm's early '90s investment in Mellon Bank -- now part of the Bank of New York Mellon (NYSE: BK  ) -- also rang up a sharp loss before it turned into a huge gain.

Time will tell whether Warburg's patience will be rewarded. It's worth noting that successful firms and investors draw a sharp distinction between temporary and permanent losses of capital.

Bill Ackman, a prominent bear on the other side of MBIA trade, feels the same way about differentiating between temporary and permanent losses. His large stake in Target (NYSE:TGT  ) plummeted as investors dumped recession-prone stocks.

However, Ackman pegs Target's worth, given its valuable underlying real estate, credit card receivables, and strong cash flows, at $120 per share, and on Bloomberg.com he said that Target "is a case actually where I think a mark-to-market loss is not a real loss." In other words, as long as an investment thesis remains intact, Ackman doesn't consider a stock that's down because of short-term market movements is a permanent loss.

Look for buying opportunitiesIf the stock market will make us suffer huge losses, the least we can do is take advantage of the great prices. If you've ever wondered how Warren Buffett does what he does, one crucial factor is when he does it.

During the banking crisis of the early '90s, when everyone else was running for the exits, investors such as Buffett and Prince Alwaleed made fortunes buying huge stakes in ailing banks, including Wells Fargo (NYSE: WFC  ) and Citigroup (NYSE: C  ) . When everyone else was dumping stock, the smart guys were looking to buy.

Foolish thoughtsKeeping your composure isn't easy when the stock market plummets. However, Fools need to stay rational and composed to make the most of a temporarily bad situation.

http://www.fool.com/investing/value/2008/01/22/stay-rational-in-the-downturn.aspx

Comment:  Warren Buffett "timed" his buying of the market during the Global Financial Crisis.  He asked the public to buy in October 2008 when the Lehman collapsed.

How to analyze real estate developers

How to analyze real estate developers

Real estate stocks make up a significant number of companies in Asian stock exchanges and many of them are among the the most volatile stocks. Whether the real estate developer is listed or not, they are influenced by a host of cyclical factors ranging from government policies, interest rates, unemployment rates, affordability, etc. Hence, it is important to understand how real estate companies can be analyzed.


Profit Model

Real estate industry can be separated into the following sub-industries or types of real estate developers:

1. Residential real estate developers
2. Commercial and mixed use real estate developers
3. Industrial real estate developers

Profit model of residential real estate developers

Residential real estate developers are more dependent on economies of scale than ever because of increasing land prices and declining rate of increase in residential property prices. In many developing countries, developers used to be able to acquire land at cheap prices and hope for rapid increase in home prices to make huge profits. In developed countries, land prices are higher, and price increases are more muted. Hence, brands and good management are playing an increasingly important role.


Profit model of commercial real estate developers

As prime real estate for commercial developments become more scare, commercial real estate developers tend to prefer to have rental incomes rather than selling units so that they can have consistent income and manage the properties. These developers are also more likely to sell their commercial properties to real estate investment trusts to free up capital and many are REITs that also develop properties.


Profit model of industrial real estate developers

Industrial real estate developers operate more like commercial real estate developers as they seek to have stable rental incomes and also sometimes selling their properties. Some industrial estate developers might even have a fund to invest in promising industrial companies so as to achieve higher profits.



Factors that Affect Value

1.  Land bank - the value of a real estate developer is directly influenced by its land bank. As the larger the land bank, usually means the developer can make more profits from developing the land banks later. Hence, the land bank that a real estate company has is always disclosed in detail in the listed companies' reports.

2.  Inventories - Real estate inventories can be separated into a few categories. Usually increasing values of construction-in-progress and land held for development will translate to higher future earnings for the company:

• Completed developments - properties whose construction has been completed
• Construction-in-progress - means the value of properties under construction.
• Land held for development - value of land help for future developments.
• Investment properties - properties held for rent or sale

3.  Customers deposits - for residential projects, it is often that developers will collect customers deposits or even prepayments of entire houses prior to completion of the units. As these properties are pre-sold and their profit and loss have yet to be recognized in the income statement, growing customer deposits could signal increasing revenue and most likely profits in the coming years ahead.

4.  Housing prices - the profits from real estate developers that primarily sell their developments come from selling the units at above costs. Hence, the moving of housing prices have direct impact on the profitability of residential real estate developers. Usually the stock price of real estate developers have high correlation with the anticipated housing price direction.

5.  Rental rates - Rental rates are especially important for commercial and industrial real estate developers as most of them do not sell all the units that they developed but they keep these units for rental returns. Rental rates have direct bearing on stock prices of such developers and REITs.

6.  Industry consolidation - as economic difficulties mount and economies of scale becomes more important, mergers and acquisition activities will also drive prices of real estate companies as the merged entities might be more efficient given a larger land bank.

7.  Macro economic factors - government policies play a huge role in controlling property prices as the following factors will determine the direction of property prices. We have listed

Factor                 Movement      Likely Effects
Interest rates         Up                Negative
Land supply          Down            Positive on short term price but will affect future
                                                  profitability if land bank dries up
Loan Quantum      Up                 Positive
Reserve ratio         Up                Negative
GDP                     Up                Positive
Unemployment      Up                       Negative




Valuing Real Estate Developers

A common method to value real estate developers is using the Revalued Net Asset Value ("RNAV") approach which basically determines the net asset value of a real estate developer by adding up

• the change in value of the investment properties held by the company, 
• the surplus value of properties held for development using Discounted Cash Flow method and 
• the net asset value of the company with any other adjustments that are deemed necessary.

Usually a discount or premium percentage is multiplied with the RNAV base on the developers other qualities such as management capabiltiies, branding, track record, etc. A smaller developer with poor record of continuously generating consistent income is usually given a significant discount to its RNAV.

Using the RNAV approach only takes into account of what the developer can earn with the assets that it has in its books at the time of the valuation. If properly applied, it is usually more conservative than the market approach such as P/E multiples.

However, to use this method, it requires a lot of work in revaluing the properties held by the developer, making it difficult to implement by most people as information needed to determine RNAV needs some skill in obtaining.

The price earnings ratio method could also be useful to cross check the RNAV method.

Source: http://roccapitalholdings.com/content/how-analyze-real-estate-developers

How I Analyze a Bank Stock

How I Analyze a Bank Stock
A four-part framework to clarify banking.

Anand Chokkavelu (TMFBomb) Apr 29, 2014

Here's the beauty of the banking industry: Banks are similar enough that once you learn how to analyze one, you're pretty much set to analyze 500 of them.

That's about how many banks trade on major U.S. exchanges.

Now, the details get messy when you factor in complicated financial instruments, heavy regulations, byzantine operating structures, arcane accounting rules, the macro factors driving the local economies these banks operate in, and intentionally vague jargon.

But at their core, each bank borrows money at one interest rate and then lends it out at a higher interest rate, pocketing the spread between the two.

And as investors we can get far by focusing on four things:

1. What the bank actually does
2. Its price
3. Its earnings power
4. The amount of risk it's taking to achieve that earnings power

To give a concrete example, let's walk through one of the banks I've bought in the banking-centric real-money portfolio I manage for the Motley Fool: Fifth Third Bancorp (NASDAQ:FITB).

As quick background, Fifth Third is a regional bank based out of Cincinnati whose 1,300+ branches fan out across 12 states. It's large enough to be in the "too big to fail" group that gets stress tested by the Fed each year but still less than a tenth the size of a Bank of America or a Citigroup -- and much simpler.

Alright, let's start with...


1.  What the bank actually does

When you read through a bank's earnings releases, it's easy to get sidetracked by management's platitudes and high-minded promises -- guess what, EVERY bank says it's customer-focused and a conservative lender!

Words are nice, but in banking, you are your assets -- the loans you make, the securities you hold, etc. They're the things that will drive future profitability when they're chosen carefully, and they're the things that will force you to fail (or get bailed out) when you get in trouble.

Here's the asset portion of Fifth Third's balance sheet. Take a look, let your eyes glaze over, and then I'll let you know the numbers I focus on (until we get to the "Its price" section, I'm using the financials from Fifth Third's last 10-K because they're more detailed for illustrative purposes).

Loans are the heart of a traditional bank.

In my mind, the greater a bank's loans as a percentage of assets, the closer it is to a prototypical bank.

In this case, two-thirds of Fifth Third's assets are loans (87,032/130,443). This number can range far and wide, but Fifth Third's ratio is pretty typical. For context, note that Fifth Third's loan percentage is double the much more complex balance sheet of JPMorgan Chase.

If a bank isn't holding loans, it's most likely holding securities. You'll notice Fifth Third's various buckets of securities in the balance sheet lines between its cash and its loans. There are many reasons a bank could hold a high percentage of securities.

• For example, its business model may not be loan-driven, 
• it may be losing loan business to other banks, or 
• it may just be being conservative when it can't find favorable loan terms. 

In any case, looking at loans as a percentage of assets gives you questions to explore deeper.

The next step of digging into the loans is looking at what types of loans a bank makes. You can see in the balance sheet that Fifth Third neatly categorizes its $88.6 billion in loans. Clearly, Fifth Third is a business lender first and foremost: When you add up "Commercial and industrial loans," "Commercial mortgage loans," "Commercial construction loans," and "Commercial leases," almost 60% of Fifth Third's loans are business-related. Also, given the almost $40 billion in "Commercial and industrial loans" (as opposed to mortgage loans), a lot of Fifth Third's loans aren't backed up by real estate (though other forms of collateral may be in play).

For simplicity, I'll stop here. The one-line summary: On the assets side, look at the loans.

Let's move on to the rest of the balance sheet:

Just as the loans tell the story on the assets side, the deposits tell the story on the liabilities side. The prototypical bank takes in deposits and makes loans, so two ratios help get a feel for how prototypical your bank is:

• 1) Deposits/Liabilities 
• 2) Loans/Deposits.

Deposits are great for banks for the same reason you complain about getting low interest rates on your checking and savings accounts. Via these deposit accounts, you're essentially lending the bank money cheaply. If a bank can't attract a lot of deposits, it has to take on debt (or issue stock on the equity side), which is generally much more expensive. That can lead to risky lending behavior -- i.e. chasing yields to justify the costs.

Fifth Third's deposit/liabilities ratio is 86%, which is quite reasonable and leads to an equally reasonable 89% loan/deposit ratio. All of this confirms what we suspected after looking at the loans on the asset side. Fifth Third is a bank that, at its core, takes in deposits and gives out loans with those deposits. If that wasn't the case, we'd want to get comfortable with exactly what it's doing instead.

We're now ready to take a quick peek at the income statement:

The big thing to focus on here is the two different types of bank income: 

1. net interest income and 
2. (you guessed it) noninterest income.

Still lost in that mess above? See the lines

1. "Net Interest Income After Provision for Loan and Lease Losses" (3,332, or $3.332 billion) and 
2. "Total noninterest income" (3,227, or $3.227 billion).

I told you earlier that at its core, a bank makes money by borrowing at one rate (via deposits and debt) and lending at another higher rate (via loans and securities). Well, net interest income measures that profit.

Meanwhile, noninterest income is the money the bank makes from everything else, such as

• fees on mortgages, 
• fees and penalties on credit cards, 
• charges on checking and savings accounts, and 
• fees on services like investment advice for individuals and corporate banking for businesses.

For Fifth Third, it gets almost as much income via noninterest means ($3.2 billion) as it does from interest ($3.3 billion).

Like most of what we've covered so far, that's not necessarily good or bad. It furthers our understanding of Fifth Third's business model. For instance, the noninterest income can smooth interest rate volatility but it can also be a risk if regulators change the rules (e.g. banks can no longer automatically opt you in to overdraft protection...meaning they get less of those annoying but lucrative overdraft fees).

There are many, many line items I'm glossing over on both the balance sheet and the income statement, but these are the main things I focus on when I'm looking over the financial statements. As you'll see, many of the things I've ignored are covered a bit by the ratios we'll look at in the other sections.

Next up is...



2.  Its price

The oversimplified saying in banking is "buy at half of book value, sell at two times book value."

Just as if I told you to "buy a stock if its P/E ratio is below 10, sell if it's over 25" there are many nuanced pitfalls here, but it at least points you in the right direction.

If you're unfamiliar with book value, it's just another way of saying equity. If a bank is selling at book value, that means you're buying it at a price equal to its equity (i.e. its assets minus its liabilities).

To get a little more conservative and advanced than price/book ratio, we can look at the price/tangible book ratio. As its name implies, this ratio goes a step further and strips out a bank's intangible assets, such as goodwill. Think about it. A bank that wildly overpays to buy another bank would add a bunch of goodwill to its assets -- and boost its equity. By refusing to give credit to that goodwill, we're being more conservative in what we consider a real asset (you can't sell goodwill in a fire sale). Hence, the price-to-tangible book value will always be at least as high as the price-to-book ratio.

In Fifth Third's case, it currently has a price-to-book value of 1.3 and a price-to-tangible book value of 1.5. In today's market that's a slight premium to the median bank.

Like any company, the reason you'd be willing to pay more for one bank than another is if you think its earning power is greater, more growth-y, and less risky.

Our first clue on Fifth Third's earnings power is also our last valuation metric: P/E ratio. Fifth Third's clocks in at just 10.7 times earnings. That's lower than its peers. In other words, although we're paying an above average amount for its book value, we're seeing that it's able to turn its equity into quite a bit of earnings.

Let's look further into that...


3.  Its earnings power

I talked a bit about how Fifth Third has a lower than average P/E ratio (high Earnings Yield) despite having a higher-than-average P/B ratio. The metric that bridges that gap is called return on equity (ROE). Put another way, return on equity shows you how well a bank turns its equity into earnings. Equity's ultimately not very useful if it can't be used to make earnings.

Over the long term, an ROE of 10% is solid. Currently, Fifth Third is at 12.3%, which is quite good on both a relative and absolute basis.

Breaking earnings power down further, you can look at

1. net interest margin and 
2. efficiency.

Net interest margin measures how profitably a bank is making investments. It takes the interest a bank makes on its loans and securities, subtracts out the interest it pays on deposits and debt, and divides it all over the value of those loans and securities. In general, it's notable if a bank's net interest margin is

• below 3% (not good) or 
• above 4% (quite good). 

Fifth Third is at 3.3%, which is currently higher than some good banks, lower than others.

While net interest margin gives you a feel for how well a bank is doing on the interest-generating side, a bank's efficiency ratio, as its name suggests, gives you a feel for how efficiently it's running its operations.

The efficiency ratio takes the non-interest expenses (salaries, building costs, technology, etc.) and divides them into revenue. So, the lower the better.

• A reading below 50% is the gold standard. 
• A reading above 70% could be cause for concern. 

Fifth Third is at a good 58%.

There are nuances in all this, of course. For instance, a bank may have an unfavorable efficiency ratio because it is investing to create a better customer service atmosphere as part of its strategy to boost revenues and expand net interest margins over the long term.

Meanwhile, ROE and net interest margins can be juiced by taking more risk.

So that brings us to...


4.  The amount of risk it's taking to achieve that earnings power

There are a lot (and I mean a LOT) of ratios that try to measure how risky a bank's balance sheet is. For example, when the Fed does its annual stress test of the largest banks, it looks at these five:

1. Tier 1 common ratio
2. Common equity tier 1 ratio
3. Tier 1 risk-based capital ratio
4. Total risk-based capital ratio
5. Tier 1 leverage ratio.

If you think that's confusing, you should see their definitions -- they're chockfull of terms like "qualifying non-cumulative perpetual preferred stock instruments."

Personally, I rely on a much simpler ratio: assets/equity.

When you buy a house using a 20% down payment (that's your equity), your assets/equity ratio is at five (your house's value divided by your down payment).

For a bank, I get comfort from a ratio that's at 10 or lower. My worry increases the farther above 10 we go. Fifth Third's is at a reasonable 8.7 after its most recent quarter (8.9 if you're doing the math on the year-end balance sheet above).

We can get more complicated by using tangible equity, but this is a good basic leverage ratio to check out. If you're looking at a bigger bank like Fifth Third, it's also a good idea to check out the results of those Fed stress tests I talked about.

That leverage ratio gives us a good high-level footing. Getting deeper into assessing assets, we need to look at the strength of the loans. Let's focus on two metrics for this:

1. Bad loan percentage (Non-performing Loans/Total Loans)
2. Coverage of bad loans (Allowance for non-performing loans/Non-performing loans)

Non-performing loans are loans that are behind on payment for a certain period of time (90 days is usually the threshold). That's a bad thing for obvious reasons.

Like most of these metrics, it really depends on the economic environment for what a reasonable bad loan percentage is. 

• During the housing crash, bad loan percentages above five percent weren't uncommon. 
• In general, though, I take notice when a bank's bad loans exceed two percent of loans. 
• I get excited when the bad loan percentage gets below one percent (so Fifth Third's 0.8% is looking good).

Banks know that not every loan will get paid back, so they take an earnings hit early and establish an allowance for bad loans. As you've probably guessed, banks can play a lot of games with this allowance.

• Specifically, they can boost their current earnings by not provisioning enough for loans that will eventually default. 
• That's why I like to see the coverage of bad loans to be at least 100%. Fifth Third's is at a conservative-looking 202%.

Finally, I use dividends as an additional comfort point. In an industry that has periods that incent loose lending, I like management consistently taking some capital out of its own hands. I like to see banks paying at least a two percent dividend. A bigger dividend isn't a foolproof way to gauge riskiness, but I get warm fuzzies from a bank that can commit to a decent-sized dividend. As for Fifth Third, it pays out about a quarter of its earnings for a dividend yield of 2.3%.


Putting it all together

I've tried to simplify analyzing a bank as much as I can. I've left out many metrics and concepts, but you've still been bombarded with a lot of potentially boring information.

What's important to remember is that a bank (through its management) is telling you a story about itself. It's our job to figure out whether we believe the tale enough to buy it at current prices.

Because most banks share similar business models, the numbers will go a long way to help you determine if those stories hold water.

If a bank says it's a conservative lender, but half of its loans are construction loans, it has a 10% bad debt ratio, and it's leveraged 20:1, I'm trusting the numbers not the words.

Look at the numbers over the last decade or two and you'll see many clues. When a bank has been able to deliver large returns across a few economic cycles while keeping the same general business model, that's a very good thing. Even better if the same management team has been there the whole time or if the bank clearly has a conservative culture in place that stays in place between management teams.

It's easy to get lost in the minutiae of analyzing a bank, but going in with a framework helps you keep your eyes on the big picture. What I've shared today are the four tenets of my basic framework...I hope it helps clarify yours.




Anand Chokkavelu, CFA owns shares of Bank of America, Citigroup, and Fifth Third Bancorp as well as warrants in Citigroup. He swears his other articles are more interesting. The Motley Fool recommends Bank of America. The Motley Fool owns shares of Bank of America, Citigroup, and Fifth Third Bancorp. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

http://www.fool.com/investing/general/2014/04/29/how-i-analyze-a-bank-stock.aspx