Randomness and survivorship Bias

Situation
Think of a situation where you get an email on the First of Jan saying that the markets are going to up this month and they actually go up in the month. Again on the first of next month you receive a mail saying that this month the markets are going to go down and BINGO you notice they go down. This happens consecutively for 6 months, with a right prediction every time.

Your Analysis is that the person sending you the mail must be a top notch analyst who has figured the movements of the market well. On the next month again you receive a mail saying that the markets are going to go up substantially up this month and also with an accompanying brochure of advertisement to invest a small sum of US$ 100 in his fund so that you can benefit from his analysis. You are tempted to do so and you do so.

Result:
The person was a con and he loots you of the money.

How did it all happen? Why would an analyst of repute do that?

The story behind all this is that a mathematician sent out an email the first month of Jan to 64 people, in which for 32 he wrote that the markets are going to go up and for 32 to that the markets are going to go down. Depending on how the markets behaved that month and to the set of people he was right he divided the set into two and to one group he sent the email the markets are going up and to the other the markets are going down. At the end of the six months he had given right set of signals for 6 consecutive months to one person whom he sent out the promotional material.

So actually you were just a victim of survivorship as you were the person who survived the random attempts of the mathematician.

Observation:
We are very observant of success around us and gladly dissect the past of successful person and find a trend in terms of personal qualities, hard work and honesty. What we miss out is the thousands and millions of who had similar qualities and who set out in similar ventures of the likes of Narayan Murthy, Bill Gates, Warren Buffet, Dhirubhai Ambani etc. One probable reason is only successful people right biographies and the history remembers only those who lived or were successful.

“Heroes are Heroes because their actions are Heroic in Nature, not because they won or lost.

{Thoughts adapted from Fooled by Randomness by Taleb}

Career advice- Buffet

A question to Warren buffet and his reply …so apt


Q: What is your career advice?
A: If you want to make a lot of money go to Wall Street. More importantly though, do what you would do for free, having passion for what you do is the most important thing. I love what I do; I'm not even that busy. I got a total of five phone calls all day yesterday and one of them was a wrong number. Ms. B from NFM had passion, that's why she was successful. A few months ago I was talking to another MBA student, a very talented man, about 30 years old from a great school with a great resume. I asked him what he wanted to do for his career, and he replied that he wanted to go into a particular field, but thought he should work for McKinsey for a few years first to add to his resume.

To me that's like saving sex for your old age. It makes no sense.

Understanding Depreciation

Depreciation is a charge on the assets of the company to reflect the loss of assets through wear and tear or obsolescence.  While in accounting terms it would simply writing down the value of an asset annually by a fixed percentage generally in line with what the income tax authority’s numbers.
Meaning Depreciate as per Webster:  to lower the price or estimated value of

However, what is relevant depreciation is can be clearly defined by economic depreciation…meaning a charge that will provide for the replacement of assets (and the earning power) in place of the current assets. This is the point where accounting and economics start to show a wide gap. While accounting is in favor of charging the book value of an asset with a regular amount, the actual earnings power or cash flow is never taken into account.

Then, what are the implications for company’s accounts whose market value of assets is far higher than what is carried on books. Well the standard argument would be since the value of an asset is the present value of the cash flows that can be generated by the asset, in case the market value of an asset has increased, it would reflect in the cash flows (earnings) of the company.

Let’s assume to scenarios of High asset value:

Asset value is high
For example: A company with a gold mine.
With gold prices spiraling and touching new highs, the company market value of asset would be far higher than what would be reflected in the books. While the increase in value of the asset would be analyzed and reflect in the earning’s and due weightage is likely to be given by the Analysts over a period of time. The immediate appreciation of such a gain due to holding of high quality, high earning assets in Books is frequently ignored. This is mainly due to the trouble of analysts in revaluing the assets and related entries which at the times the market would not appreciate terming it as very aggressive.

This was seen when the carbon credit story played out in the news. While the Carbon credits gave an incrementally high value to the Fixed Assets of some of the companies, analysts took considerable time in appreciating the same. SRF was a case in point.
The lack of clarity of on Pricing of carbon credits, made certain analysts vary of the projections based on assumption and appreciating the true potential.  (I have no personal opinion on the carbon credits pricing or any view on how it would span out)

However, one learning that I got on observing this was relatively complex ideas remain under researched and analysts relatively take very conservative (to avoid being completely wrong) opinion and there is a possible of unearthing huge value based on thorough analysis.

A thought: “Equity Analysts estimates of calls on stock would be far more worth if there was no active stock price being quoted in the stock markets. Something that clouds over the mind before sitting on any fair value analysis.

Financial statement analysis will not easily help in finding the actual hidden value of assets. At best hidden value in assets may reflect in lower charge of depreciation in relation to income. Analysts and owners have to maintain their conservative approach and seldom right up assets.

What happens if no adjustment to the asset value and depreciation is made?
Reported Earnings for the year will be reported higher due to a low depreciation charge. Hence all earning ratios (P/E, ROE) would look good but Book value ratios would not look attractive.  

Godrej consumer products is a case in point.
The company currently trades 23 times its TTM earnings and 51 times its book Value.  The actual value of the asset is in the Brand (something very true with strong franchises). The company’s depreciation is just 8% of its operating profit.
While I generally look at book value business  ...in this case it was just not possible as the value of the brand is to be added on to the book value.

However, accounting for appreciation or depreciation of assets does not change the cash flows and any valuation done on the cash flow would hold good.