The 400 year old lesson in math that can help you be a better investor

May 11, 2015

In this issue:
» Gap in retirement savings
» Time to get rid of bank wage pact?
» An update on the markets
»  ...and more!

Buffett was not joking when he said "If calculus or algebra were required to be a great investor, I'd have to go back to delivering newspapers." Compounding wealth is not easy and investing is not an exact science. Indeed, if it were the case, mathematicians would be the richest people on earth.

Buffett's genius lies in identifying companies with the strongest moats . And with that one would assume that the job of successful investing is almost done. Unfortunately, that is not always the case.

If you are assuming that despite being the genius that he is, Buffett shied away from using Maths to his advantage, you would be dead wrong. For he and his partner took inspiration from a 400 year old principle in mathematics to hone their investing skills.

None other than Buffett's partner Charlie Munger attributed the secret of Buffett's success to his mathematical thinking abilities. He once wrote, "One of the advantages of a fellow like Buffett, whom I've worked with all these years, is that he automatically thinks in terms of decision trees and the elementary math of permutations and combinations."

Munger then went on to refer to two 17th century mathematicians - Pierre de Fermat and Blaise Pascal - and shared this story about them. In the summer of 1654, one of Pascal's friends, a gambler who was smart, but consistently lost money, came to Pascal asking for help. He wanted to know why he consistently lost money. This problem was interesting for Pascal, and a series of letters ensued that summer between Pascal and another mathematician, Fermat. By the end of the summer, these casual letters ended up proving to be a linchpin in the fundamentals of modern day - 'Probability'.

But how does probability impact investing in companies with wide moats? Well, this comes into play when one considers investing in such companies at the wrong time. For example buying Coke in 1998 or Microsoft or Infosys in 2000. The stock of Infosys crashed by almost 80% in 2000 and an investor prior to the crash would have had to wait for 6 years (until 2006) to just recover his money. Irrespective of the strong fundamentals of these companies, the stocks performed poorly due to the miniscule probability of them retaining their premium valuations. More often than not, these kinds of mistakes result in mediocre returns and not necessarily significant loss of capital. The big losses definitely come from being wrong about the business' moat. However, investors blinded by the moat, tend to overlook the probability of stagnancy in valuations.

Here again we can defer to Munger's wisdom on what he calls the 'easy decisions'. The low risk, high success probability investing bets come from the best companies that are in distress. Or from companies with limited moats but having huge probability of upside in valuations with almost negligible risk of permanent capital impairment.

In fact when we recommended Tata Motors in December 2008, Rahul Shah, who was tracking the stock then, said exactly this. "This company has survived several near bankruptcy situations in the past. And at current valuations this is one company that will repeat history and turn multibagger" .

Thus evaluating the probability of upside and permanent loss of capital are absolutely necessary even while considering investments in companies with the widest moats. And this 400 year old mathematical principles can be very handy when buying Safe stocks for your long term portfolio.

Do you consider the probability of loss or mediocre returns when investing in companies with wide moats? Let us know your comments or share your views in the Equitymaster Club.

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 Chart of the day
Talking about probability of another kind, what are the chances of most Indians have insufficient savings at the time of retirement? Well, as per a study, at the time of retirement, Indians (on an average) have about Rs 8,200 as their retirement funds. That's a scary figure isn't it! A per the survey report, India only has about 15% of its GDP in the form of retirement assets. This is a very low figure when compared to developed nations such as Australia, UK, US, Japan. Retirement assets to GDP ratio for these nations are in range of 65% to 147%. If it's of any consolation, India fares better than China which has a figure of 5.5% in this regard.

Today's chart of the day also indicates the average per capita retirement assets. The figures for India and China are so small, that they cannot be seen in the chart below. For India it stands at about US$ 128, while for China it stands at US$ 141. In comparison, for Australia, UK and the US, the figure stands at about US$ 43,160, 34,930 and 27,070 respectively.

Do Indians save enough for retirement?

As it turns out, the survey has identified that Indians are generally less bothered about saving for retirement - despite the knowing its importance. While there many stats and data points which indicate how much money one would need to invest to maintain one's present lifestyle, and essentially how much one would need to save till the time they retire, the fact of the matter is that other costs and expenses tend to take preference in one's life. In other words, the goal of savings for retirement loses its priority.

But do think about this - Rs 100 today would be worth a little over Rs 432, three decades from now (assuming an annual inflation rate of 5%). If we up the rate by a percent i.e. with inflation of 6%, the value would be worth about Rs 574. Add another percent and the amount would be worth Rs 761. As such, for one to maintain their lifestyle, it would be important for their money to beat these figures. As per us, equities should be a significant part of one's retirement savings portfolio as this asset class has then tendency to comfortably beat inflation rates over longer periods.

It is a fact well known that public sector banks are less efficiently managed than their private counterparts. The fact that the government has a lot of say with respect to how these banks function does not help much. Having said that, not all public sector banks (PSBs) can be painted with the same brush. And there are some which are certainly much better managed than the rest. This then should be reflected in the pay scale. Indeed, the metrics for measuring employee productivity is business per employee and profit per employee. And this varies across PSBs. But if the industry wide wage pact is anything to go by, that does not appear to be the case. In fact, all employees across banks are more or less treated equally. Moreover, the benchmark for such a pact is the paying capacity of the weakest of the banks and this is unfair to the employees of strong and profitable banks. Clearly this needs to change. If performance is not likely to get rewarded, then PSBs will find recruiting skilled personnel with the necessary expertise quite a challenging task indeed.

Buying interest in auto, banking and commodity stocks helped the Indian markets to consolidate gains as the day progressed. At the time of writing, the BSE-Sensex was trading higher by 396 points or 1.2%. Stocks from FMCG and IT sectors failed to elicit investor interest. Asian markets ended the day on a mixed note. European markets too were trading mixed at the time of writing.

 Today's investing mantra
"Cash combined with courage in a time of crisis is priceless." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Tanushree Banerjee.

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2 Responses to "The 400 year old lesson in math that can help you be a better investor"

Shankar S

May 12, 2015

The story of Tata motors is one eg of the things falling in the right place at the right time for everything around the world..

this company had spent much less in research for years together. Selling trucks which was a 1960 models to Indians, During this period the trucks and MCV of companies around the world like Volvo had evolved into much better engineering marvels compared to TAMO vehicles.

It was pure luck that the world economy collapsed and TAMO could take over Jaguar Land rover, which has been the savior for this company.

What if this had not happened. What would have been the Tata motor today.

With this i remember the letter from Howard Marks of Oaktree capital titled "Getting Lucky" where he writes "Buffett is insightful enough to realize and secure enough to admit that he isn’t solely responsible for
his success. What if he’d been born in Bangladesh instead of the U.S.? Or a woman rather than a man in
1930, having much fewer opportunities? Or in 1830 (when there would be no hedge fund industry for a century) or 2014 (when there are smart people crawling all over
it)? Or to different parents? Or if he ’d missed out on studying under Ben Graham at Columbia? Or if he hadn’t partnered with Charlie Munger? "

So luck and time plays a very important role


Ujagar Singh

May 11, 2015

I could not agree with the negatively worded article to show low pension/retirement funds and savings in India and that Indians don't take retirement savings as seriously as in USA, EU, OZ etc. The fact of the matter is that our inflation rates are much higher than these countries, effectively negating the gains of maturity amounts of retirement savings. 6 - 7% inflation adopted in the article, itself is a mis-match between the CPI and the assured maximum returns at maturity, thus discouraging the savings sentiment. After 10 or 20 years, one gets pittance if reckoned with respect to the CPI levels even if the Govt figures are accepted. Actual price increases of essential commodities like food, cooking mediums, transport, health and medicines, sanitation items, soaps, shampoos and toiletries, etc gallop and get much ahead of the maximum appreciation percentages on the savings. Add to that the I.T. burden which one has to bear on the maturity amounts. Further, the pensioners have to pay I.T. on the pension drawn by them, even though it is really meant for their sustenance and maintenance during the later years when they can not work. Here the Govt has a faulty thinking in the sense that it assumes that children of the aged person would take care of them. It is not so. In a large no. of cases, the children don't take care. Or even if the son wants to, the daughter-in-law won't allow. So the concept of Senior Citizen homes came in, aping the West. But there again one has to pay in order to get into these homes, and it makes things very complex. Govt funding support is badly lacking. In most cases, NGOs are expected to step in. Who are these NGOs? Most of these are set up by local politians in pseudo names to divert funds and garner money. It is high time the Govt fixes adequate pension, even if it be for those who have no support of their children or have no children to support. Further, there should be no further erosion by compelling the pensioners to pay I.T. on it.

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