Interview with Professor and Fund Manager Sanjay Bakshi

ANSWER: Oh, I wrote about this in 2005. I went back and looked it up and I find that it’s still valid.There are times, when one should “preserve optionality” and times when one should “burn bridges.” In all the big decisions in my life, the burning bridges model has helped me in intensifying my commitment to a decision because there is really no turning back anymore.

Too much choice is in any case not good because it creates decision paralysis. Remember those twenty-page menus in restaurants and 25 types of ketchups in grocery sores? What you should really be looking for are a few very good choices and then make a decision. No chess grandmaster can figure out all the choices he has on the chess board. Rather, he tries to recognize a few patterns and then makes a choice causing the burning of bridges.

The decision to never work for anyone again came about early in my life when I discovered that I was unemployable. I did work for American Express that helped me reach that conclusion. It took just about six months. I was a total misfit there but I am glad I recognized that early in my life.

You asked about focus. That’s a very powerful mental model. I love Warren Buffett’s quote in which he says that the difference between successful people and very successful people is that the very successful people say no to almost everything. That’s the correct way to get focus.

Many years ago I look up photography as a hobby. I joined a couple of photography workshops and picked up the basic tricks. One of them, of course, is learning how to focus your camera’s lens. You use a lens with a wide open aperture, say f/1.4, and focus on an object. If you do that, the object would appear to be in very sharp focus while everything else around it would be blurry. Anyone who sees the picture knows exactly where to look.

Any expert in any field will attribute his or her expertise to focus.

ANSWER: Seems like we have had very similar journeys!I actually started my career as a value investor in 1994 after returning from London. At the time, I had no track record and no money. So, the only people I could approach were my friends and family. I raised about Rs 2 million from them and promptly started applying my ideas derived from whatever I had read up in the Buffett letters until then, and of course the two famous books of Ben Graham.

By about 1996, I was down about 40% and some of the money belonged to my mother in law. You can imagine my situation. It was horrible.

But, in retrospect, it was the best thing that happened to me as an investor. That experience helped me become more risk averse. So, I completely agree with you that losing money is a great educator. Moreover, framing losses as “tuition fee” for lessons learnt has really helped me.

Sometimes, I am faced with a situation when I am clearly wrong about some investment decision I have made. Confronted with the facts which ruin my original thesis, I now face two choices: (1) take the shelter of psychological denial; or (2) pay the tuition fee and move on.

Picking (2) is obviously the correct choice. It’s been a great idea for me to pay the tuition fee and let the resulting pain re-wire my brain so I am unlikely to make the same type of mistake again.

When my students ask for my blessings I bless them by wishing that they lose money early in their career, because they are young and full of energy and have the ability to bounce back and they really need that lesson to rewire their brains to become risk averse and the earlier this happens the better.

Whenever I lost money, it happened because of my own shortcomings. There were occasions when I was focusing too much on the business and too little on the people who were running it. On other occasions, I focused too much on the cheapness of the stock and not enough on the quality of the business or the management.

When thinking in terms of decision making one has to recognize that you are going to make mistakes. Indeed, if you’re not making any mistakes, then you are not innovating enough. Making mistakes is ok, so long as they don’t destroy you and also that you don’t repeat those types of mistakes again. People often behave like the guy who jumps out of a plane with a parachute that opens up 99% of the time. If you develop the mindset of never doing that, you’ll do fine.

I have my own mental “hall of shame” where I display my mistakes I have made, and the tuition fee I have paid. It’s something I look at often. I share it with my colleagues and students.

My hall of shame contains not just mistakes of commission, which I referred to above, but also mistakes of omission. I think it’s terribly important to understand the role of mistakes of omission in one’s career as an investor. Many investors I know don’t do this. Their logic is based on their belief that real losses matter while opportunity losses don’t. In my view, that kind of thinking is deeply flawed. It arises from a P&L account prepared by using accounting conventions which only allow the recording the results of what you did, and not what you could have done, but didn’t. The metaphor of an “Opportunity P&L Account” is a powerful one because it records the true tuition fee paid in return for the education acquired. That’s because it reflects both errors of commission and omission.

ANSWER:
Actually, I started teaching in 1996.I became financially independent in 2001 when, to borrow Robert Kiyosaki’s words, I could say to myself that that I don’t work for money anymore, rather money works for me. It changed me profoundly because now I understood the importance of Upton Sinclair’s words:

“It is difficult to get a man to understand something, when his salary depends upon his not understanding it!”

That quote refers to what Charlie Munger calls as “incentive-caused bias” which is one of the key biases in human cognition. And anyone who is working for a salary is prone to fall under its influence. But becoming financially independent produces conditions that should enable people to escape from the clutches of this bias. That’s one of best things I learnt from Mr. Munger which is that when you are not dependent on someone else to pay for your bread and butter, then you can have to privilege of looking at the world as it really is.

Now, it’s very hard for a graduate student to understand what incentive-caused bias does to people who work in the tobacco industry or the banking industry or the credit rating industry or even the money management industry. But if you are financially independent, you are free to look at the world from a different point of view.

Here is an interesting question: Ben Graham says that when you buy shares in a business you should think of yourself as a partner in that business and not as a owner of a piece of paper to be traded. If you agree with Ben on this, then should you invest in a business if it sells a product or service that on a net basis is bad for civilization?

Most investors I know don’t want to think about such questions. Why?

I recall something I read a while back:

“At its base is a piece of information, which simply tells us some basic fact about the world. Above that is knowledge — the understanding of how different bits of information fit together to reveal some truth about the world. Knowledge hinges on an act of correlation and interpretation. At the top is wisdom, which has a moral component — it is the application of information worth remembering and knowledge that matters to understanding not only how the world works, but also how it should work. And that requires a moral framework of what should and shouldn’t matter, as well as an ideal of the world at its highest potentiality.”

You can’t always add a moral component to complex issues when you need money to feed your family. Most such people are better off dealing with cognitive dissonance by rationalizing their behavior. Man is not a rational animal. Rather, man is a rationalizing animal.

If you work for a tobacco firm whose products cause death and misery or a firm that makes money through predatory lending practices, but you need or want the money, you’re not likely to question the morality of what you’re doing. You’re likely to rationalizing your being part of that system by inventing excuses like “it’s perfectly legal,” or “everyone is doing it,” or “what will happen to the tobacco farmers or the poor credit collection agents if these businesses were to shut down?”

But when you are financially independent you don’t have to compromise. So, Upton Sinclair was absolutely right when said those words. Being financially independent broadens your worldview. You can look at it the way it is.

ANSWER:
Yes, life as a value investor over the last 21 years, has seen many twists and turns. For the most part, I practiced classic Graham-and-Dodd style of value investing. This involved investing in statistically cheap businesses without much regard to their inherent quality. The key focus was on low price. Low price in relation to liquidation value of assets. Low price in relation to average past earning power and cash flows. And low price in relation to dividends and dividend paying capacity of the corporation. Other factors like reasonable quality balance sheets, the presence of insider buying, the strong possibility of cyclical upturn or the eventual arrival of a bull market also played a role in selecting stocks. Portfolio construction required wide diversification.Such investment operations involved building screens and Graham’s two books on investing provide a lot of clues to do that. One screen that I came across is what I call “debt-capacity bargains” did incredibly well. It involved buying stocks of debt-free businesses at aggregate market valuations which were less than their conservatively-estimated debt capacity. I found the mental construct of “debt capacity” in a debt free business as a very powerful idea and talked about it on several occasions.I also got very interested in Special Situations investing which is now called Risk Arbitrage. It started with an obscure essay titled “Special Situations” tucked away in an appendix to the 3rd edition of Ben Graham’s Security Analysis. In that essay, Graham provides a framework to analyse opportunities arising out of corporate events like spinoffs, recapitalisations, special distributions, and mergers. I got very interested in this field because: (1) it was very analytical requiring little or no predictions about future fundamental performance of businesses; (2) there was little competition in this field in mid 1990’s in India; and (3) the returns were largely uncorrelated to overall market movements.I did dozens of special situation operations and it was a lot of fun, although sometimes one had to go through a lot of pain because of a failed transaction. I wrote about some of the good experiences here many years ago.But, over the years the competition caught up and now we have funds in India which only do risk arb. As returns became far less compelling, I moved out of the space. Over the years I also started seeing the futility of investing in situations where you could earn 4% a month for 5 months and deliver a sensational IRR but when the money came back, you had reinvestment risk. And while you were monitoring five or six special situation operations at any given time, you had no time whatsoever to find exceptional businesses at very reasonable valuations which would earn you 20% a year for a long time. And so there was this huge opportunity cost.

So I left risk arb. But I retained the lessons I learnt from doing it. One of them is what I call as “shit happens.” If you do risk arb for a few years you will ultimately encounter a deal that blows up in your face. Under those circumstances only two things will protect you: (1) diversification; and (2) adherence to Keynes’ acute observation that “when facts change, I change my mind.”

Every budding value investor must do risk arb. It’s a great way to learn about the uncertainties of investing and how to deal with them.

Sometime in late 2012, I shifted gears completely and decided to become a moat investor. Up until then I had delivered an audited track record of compounding capital from 2001 till 2012 at 24% a year in USD terms. But the shift to buying moated businesses was instrumental in subsequent returns increasing to 45% a year.

As I reflect upon my journey towards quality I want to highlight two errors which don’t show up in the track record but which have cost me a great deal of money in terms of opportunity loss.

Error # 1 was to prefer to own mediocre businesses often run by poor managements but acquired at bargain prices. While I was doing all that, I ignored great businesses run by great managements but where entry prices were low double-digit earnings multiples which prevented me from buying. I guess one could call this mistake as reluctance to pay up for quality — without obviously overpaying for it.

Error # 2 was that once in a while I did end up buying a great business run by an intelligent fanatic. But I sold too early. In one instance the stock appreciated by more than 30x my sale price. That really hurt.

Buying quality, making concentrated bets, and holding on to winners (something I know you love to do as well) has made a huge difference…

ANSWER:
Everything I learnt about investing, I learnt by observing the experts in my field who were financially independent.When I started teaching in 1996, I was doing it for the money. I needed it. I had no income, a very small portfolio, and a family to take care of. At one time I used to teach at three different business schools in a day. There were times when I used take classes at all three locations in the month of June when the day temperature often soared to 45 degrees Centigrade. That’s 113 degrees Fahrenheit. The round trip would add up to more than a 100 kilometres (62 miles) and my car had no air conditioning. Getting roasted in the Delhi sun was no fun. And I wasn’t even teaching something I did believed in. I taught stuff like Efficient Market Theory, the Capital Asset Pricing Model and Markowitz’s Portfolio Optimisation. A classic case of whose bread I eat, his song I sing.When I became financially independent, I gave up that kind of teaching. And then in 2001, I was offered to teach at MDI where I was allowed and encouraged to design my own course. By then I had also completed an activist transaction which was widely reported in the media and so my future students knew about me. Designing my own course and of course financial independence helped me to become intellectually honest. I could now tell my students how I thought and invested without ever talking about beta or any of the other greek symbols approvingly. I could tell them about my accomplishments and my mistakes. Teaching, over time, became a spiritual experience. I won’t give it up for anything.

ANSWER:
eaching has helped me become a better investor in three ways. First, every year it forces me to reflect upon what has really worked for me, what I have learnt from my mistakes and the mistakes of others, what patterns have I observed that have really worked or not worked. And so I change the cases I do in my class every year. That’s obviously very helpful to the students but it’s also very helpful to me.Second, every time I teach investing, the best ideas that have really worked get pounded in my brain because I read the value investing super texts all over again and then relate them to examples. By the time I go to class every year, I have read a few dozen new books as well and some of the best ideas from those books end up on my slides.Repeating the best lessons in the class ensures that correct associations in my brain get reinforced and important new ones are created. So, as I am re-wiring my students’ brains through my teaching, the experience also rewires my own brain.There is a wonderful quote by William Glasser:

We Learn
10% of what we read
20% of what we hear
30% of what we see
50% of what we see and hear
70% of what we discuss
80% of what we experience
95% of what we teach others.

My own experience tells me that Glasser was absolutely right.

Third, over the years I have had the privilege of creating a talent pool of dozens of value investors most of whom, when they leave business school, qualify as what Allen Greenberg calls “PSD’s” — poor, smart, and a deep desire to become rich. I have had the privilege of working closely with some of these wonderful investors and human beings many of whom are no longer poor, but boy are they smart. And this amazing network keeps growing every year.

ANSWER:
One, massively underspend your income. Don’t take credit card debt or any debt. Don’t buy that new car or that new house. Don’t carry credit cards when you go shopping. Don’t become what MasterCard wants you to become.Cook at home. Buy clothes only when you need them and in a sale. Learn to cherish frugality instead of being ashamed of it. Look for and emulate rich but frugal people. Read The Way to Wealth by Ben Franklin and follow his advice even though most Americans didn’t.You are only entitled to spend on yourself what is left after you have made an investment. Build a nest egg.When I was poor, I came across an essay by P.T. Barnum in a book which influenced me deeply. Here is an extract:

“Avoid extravagance; and always live considerably within your income, if you can do so without absolute starvation!

It needs no prophet to tell us that those who live fully up to their means, without any thought of a reverse in life, can never attain to a pecuniary independence.

Men and woman accustomed to gratify every whim and caprice, will find it hard at first to cut down their various unnecessary expenses, and feel it a great self-denial to live in a smaller house than they have been accustomed to, with less expensive furniture, less company, less costly clothing, a less number of balls, parties, theatre-goings, carriage ridings, pleasure excursions, cigar smokings, liquor-drinkings, etc., etc., etc.; but, after all, if they will try the plan of laying by a “nest egg,” or in other words, a small sum of money, after paying all expenses, they will be surprised at the pleasure to be derived from constantly adding to their little “pile,” as well as from all the economical habits which follow in pursuit of their peculiar pleasure.

The old suit of clothes, and the old bonnet and dress, will answer for another season; the Croton or spring water will taste better than champagne; a brisk walk will prove more exhilarating than a ride in the finest coach; a social family chat, an evening’s reading in the family circle, or an hour’s play of “hunt the slipper” and “blind man’s buff,” will be far more pleasant than a fifty or a five hundred dollar party, when the reflection on the difference in cost is indulged in by those who begin to know the pleasures of saving.

Thousands of men are kept poor, and tens of thousands are made so after they have acquired quite sufficient to support them well through life, in consequence of laying their plans of living too expensive a platform. . .

Prosperity is a more severe ordeal than adversity, especially sudden prosperity. “Easy come easy go,” is an old and true proverb. Pride, when permitted full sway, is the great undying cankerworm which gnaws the very vitals of a man’s worldly possessions, let them be small or great, hundreds or millions. Many persons, as they begin to prosper, immediately commence expending for luxuries, until in a short time their expenses swallow up their income, and they become ruined in their ridiculous attempts to keep up appearances, and make a “sensation.””

Reading The Way to Wealth by Ben Franklin was also a wonderful guide. Here are a few quotes I loved in that book:

“What maintains one vice, would bring up two children. You may think perhaps that a little tea, or a little punch now and then, diet a little more costly, clothes a little finer, and a little entertainment now and then, can be no great Matter; but remember what Poor Richard says, many a little makes a mickle, and farther, beware of little expenses; a small leak will sink a great ship, and again, who dainties love, shall beggars prove, and moreover, fools make Feasts, and wise men eat them.”

“It is foolish to lay our money in a purchase of repentance; and yet this folly is practised every day.”

“Silks and satins, scarlet and velvets, as Poor Richard says, put out the kitchen fire.”

“These are not the necessaries of life; they can scarcely be called the conveniences, and yet only because they look pretty, how many want to have them. The artificial wants of mankind thus become more numerous than the natural; and, as Poor Dick says, for one poor person, there are an hundred indigent. By these, and other extravagancies, the genteel are reduced to poverty, and forced to borrow of those whom they formerly despised, but who through industry and frugality have maintained their standing; in which case it appears plainly, that a ploughman on his legs is higher than a gentleman on his knees, as Poor Richard says.”

“When you have bought one fine thing you must buy ten more, that your appearance maybe all of a piece; but Poor Dick says, ’tis easier to suppress the first desire than to satisfy all that follow it. And ’tis as truly folly for the poor to ape the rich, as for the frog to swell, in order to equal the ox.”

“These are not the necessaries of life; they can scarcely be called the conveniences, and yet only because they look pretty, how many want to have them. The artificial wants of mankind thus become more numerous than the natural; and, as Poor Dick says, for one poor person, there are an hundred indigent. By these, and other extravagancies, the genteel are reduced to poverty, and forced to borrow of those whom they formerly despised, but who through industry and frugality have maintained their standing; in which case it appears plainly, that a ploughman on his legs is higher than a gentleman on his knees, as Poor Richard says.”

“But what madness must it be to run in debt for these superfluities! We are offered, by the terms of this when due, six months’ credit; and that perhaps has induced some of us to attend it, because we cannot spare the ready money, and hope now to be fine without it. But, ah, think what you do when you run in debt; you give to another power over your liberty. If you cannot pay at the time, you will be ashamed to see your creditor; you will be in fear when you speak to him, you will make poor pitiful sneaking excuses, and by degrees come to lose you veracity, and sink into base downright lying; for, as Poor Richard says, the second vice is lying, the first is running in debt. And again to the same purpose, lying rides upon debt’s back.”

Two, invest wisely. Don’t get into trading in derivatives. Look for good role models and learn how they invest for the long term.

Three, find a new source of income. If you have an old car (you are not allowed to have a new one) and some free time, become an Uber driver. Be creative. The world is offering you a chance to rent your free time like never before.

Four, when you have some confidence about investing, get float. That is, get your friends and family to invest through you for a performance fee.

Five, when you become financially independent (it will happen if you follow the above advice and have reasonable luck) you must still love the idea of frugality. You can live it up a bit, but never forget that you still have to massively underspend your income no matter how rich you become.

ANSWER:
Thanks to a wonderful family, I get a lot of “me time.” A few hours every day. Charlie Munger likes to say that you should give yourself at least an hour a day for learning. Over time, these hours add up.Slowly building a network of really smart people — you are one of them — has been very helpful to me. And writing a blog has been very helpful too. Recently I did a couple of brainstorming sessions on Twitter and was blown away with the results.

ANSWER:
Oh, I am overwhelmingly in sync with you on micro-caps and would love to meet and exchange my learnings with you. I think you are doing a wonderful service to the investment community by telling them in a very articulate manner why it make sense to invest with great, yet to be discovered, businesses and entrepreneurs. I love your ideas on illiquidity and inactivity too.I think any investor who has long-term money which cannot be withdrawn at a short notice but has a relatively small sum of money should invest in microcaps. There is so much inefficiency there simply because its too small for the big boys.

ANSWER:
It’s always a good idea to have like-minded people to talk to. (But it’s an even better idea to interact with people who don’t agree with you). Over the years, I built friendships with many value investors who look up to me as their friend, philosopher, and guide. It didn’t happen by design, but by accident, like so many things in life and Lollapalooza too was an accident. While that particular group is not too active now, I do have Paresh — my partner, and our own team members to talk to. And then I have dozens of my ex-students who share the same intellectual philosophy.The biggest lesson for me is that that investing is a lot like treasure hunting. And to be a successful treasure hunter, you need a lot of curiosity. Anyone who is not very curious and does not see patterns which look odd and worthy of investigation is unlikely to become a successful treasure hunter. What I found was that sometimes young people, with fresh minds full of curiosity and energy and who are willing to do ethical, yet unconventional things need help and guidance from someone who is more experienced in the field. They need direction. They need good guides. They need someone to tell them if they are on the right track or the wrong one. So, somehow, I got that role by accident. And I feel so proud to have been chosen to be a guide, or an influence for some of the very good value investors here in India.

ANSWER:
The idea of Serendipity or accidental discovery is a very powerful mental model and is, in a sense, a counter to the model of deep focus. You need both models to become a successful thinker in my view. As I have already mentioned focus earlier, I will talk about serendipity now.Any good scientist knows the importance of finding something she is not looking for. “Oh, that’s funny!” is a common observation which leads to great discoveries.Nassim Taleb has written about this in his book, The Black Swan. One of the reviewers of that book, Arlene Goldbard, had this to say:

“I love what Taleb has to say about inventions, how almost all of the discoveries that have had tremendous impact on our culture were accidents in the sense that they were discovered while searching for something else. Because of hindsight bias, he says, histories of economic life and scientific discoveries are written with straightforward story lines: someone set out to do something and succeeded, it’s all about intention and design. But in truth, “most of what people were looking for, they did not find. Most of what they found they were not looking for…

Penicillin was just some mold inhibiting the growth of another lab culture; lasers at first had no application but were thought to be useful as a form of radar; the Internet was conceived as a military network; and despite massive National Cancer Institute-funded cancer research, the most potent treatment—chemotherapy—was discovered as a side-effect of mustard gas in warfare (people who were exposed to it had very low white blood cell counts). Look at today’s biggest medical moneymakers: Viagra was devised to treat heart disease and high blood pressure.”

But to become a great thinker, you have to sometimes abandon focus on what you’re working on, especially when you encounter something extraordinary. When Louis Pasteur sad that “chance favors the prepared mind” he was on to something.

Having a prepared mind to allow the power of serendipity is terribly important. Charlie Munger has stated that “opportunity comes, but it doesn’t come often so seize it when it does come.”

Great entrepreneurs understand this completely. Jeff Bezos, for example has said that “there’ll always be serendipity involved in discovery” and that “if you double the number of experiments you do per year you’re going to double your inventiveness.”

Some people are inherently constructed to welcome serendipity. They recognize unusual patterns and ask why is this occurring. Something they notice something is amiss and ask what could that mean? Sherlock Holmes was like that when he wondered about the dog who didn’t bark. Peter Bevelin a written a wonderful book which shows that one can train oneself to think like Holmes. He writes:

When an event differs from what Holmes expect, it draws his attention — What is out of the ordinary or atypical? The absence of something we expect to see or happen is information and a clue in itself.

“Is there any point to which you would wish to draw my attention?”

“To the curious incident of the dog in the night-time.”

“The dog did nothing in the night-time.”

“That was the curious incident,” remarked Sherlock Holmes.

There have been many happy accidents in my own investing career when I have spotted something I was not looking for. An unusual combination of facts for instance. The key thing to ask when one finds such unusual combinations is: Why? If you keep doing it, you will start recognising certain patterns. For instance, in moat investing, I found seven patterns of inefficiency which led to hidden treasures. I also have a wonderful team of colleagues who love treasure hunting this way.

There one trick I use which is incredibly important. It’s about capturing that aha moment before it escapes my memory. Sometimes the best ideas come in the shower. When they do you need to remember them. And if you continue to shower you will almost certainly forget them. You need to get out of that shower jot down your insight as quickly as possible. I am using this just as an example. You have to stop what you are doing when you get those amazing flashes of inspirations. You have chase those flashes. If you keep doing that, they come to you…

The other trick I love is to do things differently. Try it out. Take a different route to office every other day, don’t listen to same type of music, don’t read papers from front page, order desserts before the main course, expose yourself to different cultures — you don’t know what you idea might stumble upon… and when you get that flash of inspiration — your big idea — jot it down on something, anything. And don’t lose that thing.

Some of the best business plans were made on napkins.

ANSWER:
I don’t like marketing but you have to do that in a startup. But it also takes away the time I need to read my books. And my anti library (books I own but have yet to read) keeps growing.

I love inspiring my students on how to think, using investing as an excuse. I want to do that forever. There is nothing more than what a teacher would want than to see his students become great thinkers and achievers.

Charlie Munger has said that being an effective teacher is a high calling. He is right. Everything else is just icing on the cake.

ANSWER:
Read, read and read. Those are three of my favorite things now.I also love play pranks on my kids, wife, friends, and their kids. One should never grow up. It’s a trap.

ANSWER:
My wife has been instrumental in everything I have achieved since I turned 18 (that’s when I met her). I couldn’t have done it without her. Our kids grew up and got into the best universities and I hardly got to know. The bills get paid on time. She takes care of everything including helping me identify my own bags at airports in the US while she is in India. She handles relationships with bankers, brokers, custodians. I can’t even sign my own checks because my signatures keep changing and then the checks bounce. So, even for my personal accounts, she signs under a power of attorney for me.I am a very quirky, moody fellow. I once dropped out of a family holiday to the US because I had discovered Charlie Munger’s talks on mental models. I sent her alone with the kids. She understood (I think). And while she was away, my course at MDI, was born.Getting along with me is not easy. So, hats off to her. I will make sure she reads this because I am not very demonstrative. Last I showed her my appreciation, I did it by sending her this tweet.