the bitcoin puzzle

Bitcoin is a cryptocurrency and worldwide payment system. It is the first decentralized digital currency as the system works without a central repository or a single administrator. Bitcoins are created as a reward for a process known as mining. I have not come up with this definition. 

Since it is accepted as a medium of exchange by a fair number of buyers and sellers of products and services, and is being considered as a store of value too, it is a type of currency. I am not too sure if it is a legal tender though. Who's backing bitcoins? Where's the promise to hold it as a valid medium of payment under the legal system for meeting financial obligations? Bitcoins are not issued by the government of any country. Sure, it is a type of digital currency, because it is not a physical currency. 

All major currencies are traded on the foreign currency exchanges. Bitcoins too are being traded on the digital currency exchanges. What's the big deal about it? That its price reached $10000 recently? Yeah, it is a big deal. 

From nowhere the price soars to $10000 within no time. It actually has become everyone's envy. If only one had bought it in April 2011 when it was priced $1, or in June 2013 when it was $100, or in November 2015 when it was $500, or when, heck, one could go on. Little does one realize that envy does not take us anywhere; it only puts us down. 

You can see the levels of greed and envy from bitcoin's price history. Yet, for those who are eternally greedy and envious, there's no need to be disheartened; the price of bitcoin is only going to go up, for $40000 price is very near as per this prediction. Volumes are going up, and prices are going up. Everyone is happy.

No, not everyone is happy; we just noted earlier that those who did not buy it are not happy. But they too can be happy if they bought at $10000 and are able to see $40000. Bitcoins are happiness quotients, aren't they?

I am not bothered by the surge in bitcoin prices. People trade in all sorts of things in life, from wood, shoes, and paintings to currencies, oil, gold, and other commodities. They trade in bonds and stocks too. These are the traders' paradise. Speculation is fine if people know that they are speculating. The tragedy though is that most do not know that they are speculating the prices of things they trade. They think that they are buying (or selling) something that has a fundamental value which is going to go up (or down). And this is a dangerous psyche; a recipe for disaster. 

Only assets that throwout cash can be valued. For instance, real properties, bonds, and stocks. Obviously then assets that do not bear cash flows cannot be valued. For instance, gold, silver, and currencies. They can be traded and priced. The price is then purely based upon demand and supply. And demand and supply are clearly based upon the traders' perceptions. They are not backed by the intrinsic characteristics of the underlying asset. For instance, prices of stocks are of course defined by the movements in demand and supply. But demand and supply are based upon the quality of the business behind the stock. That means, when the business does well, the prices go up, and vice versa. That is true on a scale of long periods of time. However, there is no such scale for assets that do not have any underlying (and cash flows). Their  prices move on whims of speculators. Nothing wrong, but nothing much for someone in the right mind, who wants to make money on a probabilistic note.

Now, bitcoins do not have any cash flows associated with them. There isn't any business or an asset behind it. In such cases, how do we know the intrinsic value of bitcoins? Well, we cannot. We are then dependent upon someone else's perception. One fool buys in the hope that there will be another fool to buy at a higher price. The second fool is in the hope to sell to another for profit. And it goes on...until there aren't any fools around to buy. This is when we say that the bubble has burst. The greater fool's theory is an interesting one, for it has been witnessed in the past many times, but lessons are never learned. There's also a reason for that. The early fools usually get away with substantial profits; and everyone wants to be the early fool during every bubble in the making. 

If one of the sharpest minds we have seen could not control greed and envy, how could lesser mortals make do with it?

I have been talked to in the past few months to buy into bitcoins. I resisted like I always do when it comes to speculation; I am no good at it. When you are likely to fret over things, you rather stay away. In fact, I am not even sure if bitcoin is able to sustain as a store of value for long; to that extent it might even fail the currency test.

If your neighbor is driving a fancier car, and you fret over it, there's something wrong with you. And if you chase the neighbor's car, there's seriously something wrong with you. The earlier you realize this, the happier you will be. 

What I know for sure is this: there is an easier route to riches, rather to being financially independent. That is to play the investing game, for long. You could do index investing, or you could do the business of investing. There's a choice. 

Let the bitcoins be. 

money managers, greedy or cheats

I don't like money managers, and I have made it clear more than once. They are the biggest shitheads for what they do. Consider this: asking for money from other people in the pretext of making them rich, is some kind of a sham. The motive is clearly to make themselves rich. And why would they do it? Perverted incentives, I reckon. This is true with all of them, who managed money for others by taking money from them. It is true with those, who continue to do that, and who intend to do it. I know that is harsh, but, I mean it. Their incentives are so misaligned that investors just do not understand it, or prefer to ignore it. 

Before we dwell into what these idiots engage in, let's find out why individual investors hand their cash to others. Investors are either too busy with their affairs that they don't get time to do it on their own, or they are ignorant about investing in general. That makes it easier for them to just pass it across to the so-called experts to do the job. That is understandable. Yet, there is a better way out for them; and this they do not understand. 

We invest because we want to retain, or rather increase our purchasing power in future. We need to be compensated for inflation. We need to be compensated for facing uncertainties of time. We need enough stash to take care of our future requirements. Among all available opportunities, equities have proven to be best suited to play this game. So we need to invest enough in equities in order to have enough in future. 

Here come money managers: mutual funds, hedge funds, alternative investment funds, and you-name-it funds. You have private portfolio managers. There are those, who manage money for only few groups of people. A number of small-time individual money managers have sprung up calling themselves (value, what else?) investors, who are capable of beating all others. Then there are some combinations of sort. What is common among them is that all of them seek money from others in the pretext of making them rich. Let's collectively call them money managers, although I prefer some other name.

There are two types of money managers: Those who generate excess returns consistently, and those who do not. Excess returns are possible when they beat the market returns over a long period of time. Not many are able to play this game well enough. By virtue of their doing, they are either greedy, or cheats. Yet, both types are frauds. Here's why:

The greedy

Let's take money managers, who are good at the game, and therefore, their operations are able to achieve consistent, superior returns over a long period. Their pitch is the precursor; that they promise to generate higher returns for investors. But if we invert, we get a different motive. These managers want to get rich quickly. These are the greedy breeds. Consider this: If someone is good at investing, the best one could do is to start one's own investment operations, which involves investing own money, and build wealth. Over a period of time, because of the superior investing skills, the investment returns would be superior, and consequently, wealth gets built. Getting rich is not going to be a problem for the person. I know so many of them, who mind their own affairs, and have gotten rich along the way. And I admire them more than others. But, our typical money manager will not do it because of greed. This manager knows that by promising superior returns to investors, there will be two advantages: One, asset management fees, irrespective of returns. Two, performance fees. This manager will get richer faster than he or she would have if other people's money was not sought. So the greed factor makes them tell others that they will make investors rich by earning superior returns; and thus seek money. Well, I give two hoots. 

The cheats

Then there are money managers, who are not capable of achieving consistent, superior returns over a long period. And they are the majority. Their pitch is the same: I will make you rich. However, they don't know how to play the game, and despite that, they get asset management fees, and some (non?) performance fees too. If investors don't call them cheats, what else do they want to name them? Investors should ask these men and women to get the heck out of their life. They are no better than mis-selling salespeople.

The ideal strategy

Now that we have dealt with both the types, what should investors do to stay in the equity game? They have two options:

The first is, if they know the game, like it, and have time to spend on it, they are better off playing the game themselves. Why give your money to others when you can invest yourself? Consistent, superior returns are more of a behavioral thing than of intellectual. Average intelligence, knowledge of accounting, time value of money, and basic statistics are all you need to do well if you have the right behavior.

The second option is for those, who cannot understand investments, or have no time and interest for it. These investors can easily invest their cash on a periodic basis in a diversified index fund. If they carry out such automatic investment operation for a long period of time, they will be assured of market returns, and also will be reasonably rich along the way. I mean rich enough to take care of their future financial requirements. Instead of worrying about purchasing power of money, they can continue to do what they are good at and enjoy life. Index investing will take care of the purchasing power, inflation, time value of money, and so forth.

Cavet emptor
In conclusion, if a money manager uses other people's money to invest, the manager is either greedy, or a cheat. Take your pick.

Also, it is always the caveat emptor that buyers need to be blamed first for choosing to buy without understanding consequences. There is always enough time to build wealth and resources to take care of our needs, but never enough to feed our greed. 

buffeted by buffett

Warren Buffett is a great buy. If he had not done what he has done, we would not have had the Warren Buffett we know. Sharp, witty, and an amazing storyteller. He is a cult. I have mentioned earlier as well that he has shaped my thought process in a major way, both in investing and in life in general. Needless to say again, I admire him a lot. 

Berkshire Hathaway has never paid out any dividends, nor has it bought back its stock so far. The reason: Buffett feels that he can allocate capital better than his fellow shareholders. And why not? History is with him. The strategy has worked superbly over many decades. Yet, now the time is different; he is working with truck loads of cash that he needs to allocate in a manner that returns higher than alternative opportunities. Admittedly by him, repetition of historical returns is getting way tougher. 

There is at least one investment that has not gone well with him in the past decade. Never mind that I don't like the product personally. Coke is all fizz and fuss; sugar and soda. And that's the reason I had a fourth question for him. In 2007, Berkshire had 200 m shares of Coke, representing 8.6% ownership, the market value of which was $12.274 b. In 2012, it had a 2:1 split, and Berkshire owned 400 m shares, representing 8.9% ownership, and worth $14.500 b. In 2016, the 9.3% ownership in Coke had a market value of $16.584 b. The increase in ownership was due to Coke's share buybacks, in which Berkshire never participated, Buffett being an all time fan of both Coke as a product and a business. 

Berkshire's investment in the stock had a high market value of $12.864 b and a low of $9.092 b in 2007. The values were $16.264 b and $13.316 b in 2012; and so far in 2017, the high value has been $18.972 b and the low has been $16.176 b. Berkshire neither bought, nor sold any Coke shares during the last decade. Therefore, the original 200 m shares have become 400 m post stock split. When we consider high values throughout, the return for the first five years from 2007 to 2012 was 4.80%. And for the next five years from 2012 to to date in 2017 has been less than 3.13%. The return over the last decade has been less than 4%. 

Now some math. If Buffett had sold the shares in 2007 at a high value of $12.864 b, and invested in Berkshire's (his own) alternative opportunities, the investment would have been much more than the current value of $18 b. If the opportunity cost of 10% is considered, the loss to Berkshire and its shareholders has been $15 b. When you madly fall in love with the stock, you have some serious consequences. 

What about the opportunity cost of his fellow shareholders? Surely, some or more of them would have dealt with the cash better than Buffett. Check out the S&P-500 just for comparison, and you will know. What next? Is he going to be in a denial mode all through? Hasn't Coke lost its mojo? It's a surprise, surprise that all-sugar-and-soda had its magic prevailing over the century; the stupidity of humans knows no bounds; remember, some of the smartest guys we know have extraordinary fondness for the can; and that's a debate for another day.

In May 2017, I did suggest to return cash back to the shareholders to mend themselves. Of course, Buffett is human, and is entitled to his share of mistakes. But would he listen now? Surely, you're joking, Mr...

hdfc bank, where can it go

HDFC bank's market value of equity was Rs.367 b in 2007; it was also available for Rs.198 b in the same year. Now, the whole bank is worth Rs.4750 b. That's a massive change in fortunes. And there is a reason for that. Earnings per share has increased from Rs.7.15 to Rs.59.52 during the period, even after accounting for dilution. Check this out: the number of common shares outstanding increased from 1.59 b to 2.56 b, adjusted for a 10:2 split in 2012. 

Market share has been steadily increasing. More importantly, the bank has been managed exceptionally well by Aditya Puri and his team. Book value per share increased more at the rate of 24.42% annually during the last decade. Mere increase in book value is meaningless if do not consider how good the book equity is. And that is measured by the quality of its advances, which were at Rs.5854 b, and  increased at 28.7% annually. Gross NPA was 1.05% in 2017, and net NPA was 0.33%. Including restructured loans, net NPA was 0.43%; that is phenomenal. Compare that to ICICI and Axis in the private sector, have a look at the entire public sector banks, and we will get the picture. Its equity capital is healthy too, with Tier 1 capital at 12.79% in 2017. 

The bank has excelled in other parameters as well. Its return on assets was 2.09% in 2017. Net interest margin was 4.30%. Average CASA ratio was 48%, which makes its cost of funds lower. Cost to income was 44.50%. Return on equity was 20.53%.

The story has been so good for the bank that its investors have really reaped rewards. The low base of a newly incorporated bank, and the advantages of a superior management have been clear. But where does it go from here? Is there anything left for the new investors to achieve superior returns?

The problem is that a good quality company always commands premium valuations. HDFC bank's price-to-book was 5.71 (high in 2007) and 3.08 (low). During 2008, 2009, and 2010, it was available at less than 3 (low). Even during 2014, 2015, and 2016, it was available at less than 3 (low). The high PB was never more than 5 during 2009-2016. I am measuring the ratio based upon latest annual historical numbers, rather than projected book numbers. Now the bank is selling at 5.18 times 2017 book equity. From March to September 2017, the book value has increased making it lower than 5 probably.

With the mess that has been around in the public sector banks regarding low quality book, their need for fresh equity is imminent. And, with the digital push from the government, it is reasonable to expect that the market share of public sector banks will gradually diminish, and private banks will gain. HDFC bank stands to gain from two counts: one, because of the sectoral changes shaping the economy, and two, top class reputation. 

HDFC bank will grow; but we do not know by how much. It will also command superior valuations compared to its peers; but again, we do not know how much. The bank's stock was trading at a high value of Rs.1454 during the year ended March 2017. In eight months time, it is quoting at Rs.1854 per share, a gain of more than 27%. 

Should we wait for the declines, or should we buy in bulk for the next decade? Or, should be accumulate on a periodic basis, averaging out the cost per share? My guess in terms of the strategy and results, is as good as anyone else's.

amazon q3 2017

Amazon announced its third quarter financial results. And here's the thing:

For the nine-month period, revenues of $117 b comprise, $12 b of AWS, and $105 b of the regular Amazon. That is 40% growth for AWS, and 27% for Amazon. The operations include Whole Foods business post its acquisition.

Operating income was $1,979 m, of which AWS was $2,977 m. What's going on? Yeah, Amazon suffered an operating loss of $988 m. Ok, North America showed profits of $1,144 m, but with a margin of 1.66%. International operations have continued to lose; for nine months, it was $2.1 b. 

While revenues have been growing, its core operations have not been great, yet. I have to say yet, because, the markets are forever willing to bet on Amazon. Its stocks are trading over $1000 per share, making Mr.Bezos, the world's richest along the way. Amazon never ceases to amaze me. 

Let's move to cash, for that is what is counted. At the beginning of the period, it had cash of $19 b excluding marketable securities, and over nine months, it ended with a little over $12 b. That means, it consumed a net cash of over $6 b. This story is not that meaningful. 

So we go first to the operating cash. How much cash did the operations generate during the period? It was positive cash earnings of $6 b. So far so good; collectively, Amazon and AWS generated some cash. This cash belongs to both lenders and common shareholders. Before attributing it to the capital providers though, Amazon needs cash to feed its growth projects, and there are many of those. It consumed $7 b for its capital expenditure. Boom...that is all of operating cash, and some more; now it is short by $1 b. During the period, it also acquired Whole Foods for more than $13 b. Effectively, Amazon's operating business, which from now onwards will include Whole Foods, used over $20 b cash compared to $6 b cash accruals. That is a net negative cash of over $14 b. If we are willing to bet that Amazon will not venture into more acquisitions in future, we can exclude that $13 b as a one off item. The chances are that it will not be the case. Even when we spread that number over say, 3 years, it becomes $4.5 b of annual acquisitions cost. So average annual capital spending would be over $13 b. Put another way, Amazon will have to generate operating cash of over $13 b just to breakeven. To be fair, Amazon did generate $15 b and $17 b for the twelve-month period ended September 2016 and 2017 respectively. Also its earnings are understated due to expensing of its technology and content costs. If we adjust that, its earnings will shoot up substantially. I will come to that later.

But where do its capital providers stand then? Amazon has debt of $25 b on its books. It raised $16 b to fund Whole Foods acquisition. It had to, remember it did not have enough cash. It is another matter that for a growing company like it is, which does not have stable, sustainable cash flows to service debt, increasing debt is not a good idea. But, that damn thing called equity dilution is pervasive...

It is fair to say that Amazon does not have any free cash flows for its shareholders, yet. Yet is the word, for the markets expect the business to do extremely well in future.

There is a goodwill allocation of $13 b, which I am going to ignore despite the accounting anomaly, we have no other choice. And for discussions on how it is an anomaly, I will keep for another day.

Its operating business looks like this: Assets $92 b; liabilities $66 b; that's net assets of $26 b. Then there is cash equivalents of $23 b. Total capital is: $25 b debt; and $24 b equity. Annualized return on capital was 10%, and return on equity was a little over 6%. These are improved figures compared to the prior periods; so the Amazon story is building up, isn't it? 

Now, for equity investors the equation is like this: What kind of returns is the business going to give on its book capital of $25 b? For an expected return of 10%, Amazon operations should generate $2.5 annually, and growing based on retained equity. For 15%, it is $3.75 b.

These numbers are prior to the adjustments due to technology and content costs though. When this is done, both capital employed and operating earnings will go up, and therefore, return on capital will change. For Amazon, it should increase.

For new shareholders, it is a different question. With a total market capitalization of $525 b, what are the expected returns? Even when we apply 52.5 times earnings multiple, the business has to generate $10 b in earnings.

As noted earlier, there is one key adjustment to be made in all this analysis. Amazon spends tons of money on its research and development activities for which the benefits are going to accrue in future periods, but the entire costs are expensed in accordance with the accounting rules. It spent $38 b during the previous three financial years. For 2016, the technology and content costs were $16 b. These costs are to be capitalized ideally and a portion should be amortized each year based upon the number of years the benefits are supposed to accrue. Take your pick; but is Amazon really worth $525 b?

I come back to my original hypothesis: Is Amazon a hype, or is there something we have missed, and the markets have not?

quality stocks, what to expect

Recently a friend of mine forwarded a report presented by an analyst, who is quite popular in the investing community. It was about buying quality stocks and getting excess returns. The key points of the report were: Investors tend to use higher discount rates to bring the estimated cash flows to the present value. All high quality stocks trade at large premiums. And because of that, their expected buy price never comes across. As a result, they miss high returns over the long period. And therefore investors should instead use a lower discount rate. Then they will have a higher present value for their stock; and lo and behold, they can buy the stock, and make make higher returns for a long time. It appeared cool to many, and why not?

I was surprised after I read the report; it was an interesting thought indeed, except there was a catch. The whole idea of discount rate and expected returns was pushed apart, and how. I have written about expected returns in the past. Expected returns are never precise. The aim should be to increase the purchasing power over time, rather than asking for more than what is warranted. CAPM is great, but has its limitations. Although it starts with the right footing, it falters when we come to measuring risk in cash flows, and unnecessarily looks for precision. And so does the concept of margin of safety, which is both overrated and getting more due than it deserves. Perhaps I will have to do a more detailed post on both CAPM and margin of safety.

Value of any business is the present value of its cash flows over its lifetime. We need two things: Cash flows for the entire period; and a discount rate to bring them to present. Simple, profound, but a complicated affair. How do we know what cash our favorite business will throw until its liquidation? The size of cash flows and their timing have a significant effect on present value. Therefore, our estimation task is futile to that extent. This is one reason why it is prudent to stick to businesses which are more likely to be stable over the period of our investment. Stable businesses tend to throw out stable cash flows; so our work is that much easier; but not as easy, because it still involves estimation.

If our cash flows estimation is getting difficult because the business is complex, or is subject to disruptions, or because of some shit, we cannot compensate it with either higher margin of safety (which all value investors do) or higher discount rate (which all other investors do). It doesn't really matter whether you try to eat shit with a spoon or hand, you are still eating shit. Most value investors don't get it.

Once we have our estimated cash flows, we need a discount rate. CAPM provides some framework on that, which is still the best tool available with us. It requires one adjustment though. Let's start with a risk free rate, and say that our investment returns will have to be higher than that. How much higher, is a great question. It is not volatility as measured by beta times equity risk premium. It should rather be based upon qualitative analysis and our own expectations. Short term volatility is investor's best friend for it helps in picking stocks at the right price, and then proves that often markets are inefficient. And yeah, beta is shit; period.

When our expected returns are 15%, we discount cash flows at that rate, and our expected returns will be 15%. In reality though it could be 10% or 25% because of at least two things: One, our estimated cash flows are wrong always. Two, markets can be more pessimistic or optimistic than our own estimates. The key point, however, is that when we expect to make 15%, we discount the cash flows at 15%, not 10%. This is the flaw in the aforesaid report of the analyst.

The guy is making a point that we should discount the cash flows at a lower rate so that we can make returns higher than that over the period. How profound...

What I would do for a quality stock is what I do for not a high quality stock too. A business that is not high quality may have cash flows that are visible for a short period of time. Why shouldn't we use those cash flows and discount them based upon our expected returns over that (short) period? Why should we use lower discount rate for a high quality business when we want much higher returns?

The analyst missed another key point. It is to be able to play the waiting game. What you do is analyze the business, and have a rate of return expected from the stock; and then wait for the markets to offer you a chance to get that. If that means waiting for more time, so be it. There is another way to play this as well. If you think that markets are not willing to give in, and your patience is running out, you can lower your expected returns, discount the cash flows at that rate, and see if the stock can be bought at that price. Again, these decisions are made based upon quality of business and interest rate environment. When risk free rates are 5%, your expected returns can be lower than when they are 10%. Long term interest rates change the course of our expectations.

A better game to play is to check the implied rate of return in the market price, and see if that is suitable for us. If not, we have to play the waiting game, and rely on the market's histrionics. I do know that there are times when markets are too kind to us; and a better investor waits for such times of cuddling.

For quality stocks, we can use lower discount rates for minimum acceptable rate of return, and then say that anything higher is icing. What we cannot do is, use lower discount rate, and then say we want returns higher than that.

The truth is that markets set higher premiums for stocks as long as they remain high quality. That means what we should be doing is look for those stocks that are high quality in terms of business and management, and then discount the cash flows, which are usually large and growing, with a rate, which is higher than risk free rates. And, how much higher is again a great question...

investment in property

I have noted how property prices are a delusion as prices were firming up in 2012. Later in 2013 prices appeared too high compared to cash flows associated with them. And in 2016 I noted that rentals were not aligned with prices in India. Recently, someone asked me why I do not invest in property. This is what I said: 

There are two caveats before I begin though. First is that I am biased towards equities. Naturally, I will banish everything else. But then so is everyone; aren't all biased too? Second, I don't have an edge in the game. My knowledge on property market is limited; and I neither fancy nor am I interested any further.

There are at least five reasons why I don't deal with the property market. 

1) I buy assets based upon an intrinsic valuation that I carry out. For a real property, say an apartment in a building, the cash flows are rentals net of maintenance costs. As noted in my earlier posts, rental yields have been too low in India. With a 2% yield for instance, the investor will have to say a prayer if the expected returns, including capital gains, are to be reasonable. I do not indulge in hoped-based-only instruments. Of course, we need hope all the time in life; we always hope that everything goes well. But while investing, I feel better when the probability of earning expected returns, based upon analysis, is higher, and then coupled with some hope that prices will come along with value at some point. There is always some meaningful work behind hope. 

Dividend yields on quality stocks in India aren't too high either; less than 2%. Yet, I prefer stocks. The reason is that mispricing in equity markets helps us pick stocks at prices we like. I don't find such privilege in property markets. Inefficient equity markets are investor's friend. 

2) Investing in real properties is highly concentrated with no regard for diversification. Usually for me it is not a problem when I have to buy stocks because of the comfort level I get based upon my analysis helped by the price I get to pay. Absent such comfort, property market becomes even more dangerous. For instance, with say, Rs.20 m, I would rather pick five stocks than throw the cash for one single apartment. The hope-based investment becomes prominent, and you will have to desperately seek a greater fool for your expected returns. 

3) The liquidity in equity markets is another reason why I prefer them. It takes time to first find a seller, and then to find a buyer in order to complete a property transaction. Heck, it is too much of a hassle. 

4) Tax regulations are too kind to equities in India, where as of now, there are no taxes on long term capital gains. And dividends are, generally, tax free. The difference could be enormous compared to the property especially when the transaction value is usually large. 

5) Then there is the fifth reason why I don't deal with the property market. I do not know it yet though.

Beware that you can defy equity markets; property markets have the capacity to defy you. The game is on.