Investing – An Operator's Blog

How Much To Bet On A Deal?

Say you are managing a corpus of $100 and intend to invest it across a portfolio of ‘N’ bets, how should you determine the size of each bet?

The Kelly Formula, as outlined by the famous math professor, investor, and gambler Ed Thorp, shows us a path.

One question that I have been studying for a while now is how to most optimally bet on a given deal? Public market investors call this ‘position sizing’ – say you are managing a corpus of $100 and intend to invest it across a portfolio of ‘N’ bets, how should you determine the size of each bet?

A. Nuances for every strategy

Based on studying how some of the best public market and venture investors approach position sizing, it’s clear to me that, like most things in life, it’s part art and part science.

Every investor will have their own nuanced perspective on this topic based on their individual ‘strategy’. This includes the following aspects:

1/ Asset class

Publicly listed stocks are liquid and play in a mostly-efficient, no information-asymmetry market. On the other hand, venture capital is perhaps the most inefficient market, governed by intense power laws and extreme loss ratios.

In a totally different game, real assets generate cash flows and are, therefore, conducive to debt financing that improves levered-equity returns.

2/ Beliefs and personality

Warren and Charlie believe in buying extraordinary businesses at fair prices. Joel Greenblatt believes in special situations. YC and 500Startups believe in the ‘Moneyball’ style of venture investing. Benchmark and Kleiner Perkins believe in the classical, craftsperson style of venture capital. Brookfield believes in buying high-quality real assets on a value basis.

3/ Circle of competence

Often called an ‘edge’ or ‘competitive advantage’. Peter Thiel and Vinod Khosla understand revolutionary technologies better than others. Li Lu gets China more than Western fund managers. Berkshire is unique in its understanding of insurance businesses.

4/ Selection criteria

Don Valentine, Founder of Sequoia, famously said that “great markets make great companies”. Keith Rabois of Founders Fund has a founder-driven investing style where he looks to figure out whether this founding team can build an iconic company that changes the world.

Public market OG Chuck Akre’s investment criteria are captured in the ‘three-legged stool’ – (1) extraordinary business, (2) talented management, and (3) great reinvestment opportunities and histories.

5/ Portfolio construction

On the public market side, Charlie Munger’s Daily Journal Corp has a super-concentrated portfolio of 4 stocks (~40% Wells Fargo, ~40% Bank of America, ~15% Alibaba Group, and the rest is U.S. Bancorp). Bill Ackman of Pershing Square has a classical, concentrated ’10×10′ portfolio that presently includes 8 stocks, with each position being 10-20% of the portfolio. Seth Klarman of Baupost Group is comfortable with a bit more diversification, owning 28 stocks at present with the largest holding at ~15% portfolio, and a bunch of positions in the single digit % range.

In venture capital, given its high-risk profile, the importance of diversification is generally well-understood. Yet, firms exhibit significant variance in their approaches to portfolio construction. While the likes of Brad Feld and Mark Suster believe in taking 30-40 shots even from reasonably large $300Mn+ funds, Mike Maples Jr. of Floodgate believes that a typical venture portfolio becomes statistically diversified at 12 companies, and beyond 25, there is no incremental value from excess diversification. Miriam Rivera of Ulu Ventures has studied data from LPs and concluded that even the best VCs have ~4.5% picking skills and therefore, a portfolio of 70-100 shots at goal is needed. Finally, an accelerator like YC funded 229 startups in just one Summer 2023 batch.

So, as we can see, position sizing approaches can vary dramatically based on the investing context and strategy being followed. But are there any broad rules and heuristics that can be useful for any investor out there?

B. The Kelly Formula

John L. Kelly was a researcher at Bell Labs in the 1950s. He developed a mathematical theory on how to bet most-optimally from a finite bankroll, in favorable gambling games.

Without going into the mathematical details of it*, here’s the basic idea behind the theory as explained by Rob Vinal of RV Capital in his H1 2023 Investor Letter:

The basic idea is that the greater the upside relative to the downside, the more an investor should bet. However, if there is a probability of a total loss, the bet size should be zero as the product of any series of numbers with a zero in it is zero.
Rob Vinal

*For those who are mathematically inclined, check out a couple of old must-reads by the famous math professor, investor, and gambler Ed Thorp – The Mathematics of Gambling and The Kelly Criterion and the Stock Market.

Based on studying the Kelly system, including commentary on it from the likes of Ed Thorp and Rob Vinal, here are some key rules that any investor should be aware of while position sizing for any strategy:

1/ Play only when you have an advantage

Here’s how Ed Thorp describes it:

The Kelly system calls for no bet unless you have the advantage. Therefore, it would tell you to avoid games such as craps and slot machines. However, if you have the knowledge and skill to gain an edge in blackjack, you can use the Kelly system to optimize your rate of gain.
Ed Thorp

Warren Buffet’s ‘Circle of Competence’ rule is also a play on this idea. To have the best odds of winning, choose a game you have an edge in and choose to play at the table with weaker players.

TLDR: focus on identifying your edge before thinking through bet sizing.

2/ Avoid the risk of ruin

In repeated games (say a coin toss) where there are some odds of a total loss (eg. heads you win, tails you lose), if you bet everything in each turn knowing that you have an edge in each turn (say you have odds of 0.52 for getting heads in each turn), as the number of turns ‘N’ increases, the probability that you will be ruined tends to 1 or certainty.

In the Kelly system, you never bet everything in a single turn so the chance of ruin is zero.

3/ Bet more when asymmetricity is high

The Kelly formula tells us to bet large where there is a big asymmetry between upside and downside. Conversely, it shows that if the risk of loss is too high on a single bet (eg. in Roulette), it’s too dangerous to bet a large fraction of your bankroll.

The former scenario is the method that top-value investors follow – betting a big proportion of the fund (10-20%+) on each high-conviction, high-quality business with a large margin of safety. Case in point: Berkshire has ~50% of its publicly traded portfolio in Apple.

We don’t put the most money into things that are going to give us 7-10x returns. We put the most in positions where we will never lose money.
Joel Greenblatt

Conversely, the latter ‘Roulette’ insight is the method venture capital investors follow while investing in extremely high-risk startups. They play on the right side of the power law curve – assembling an optimally diversified portfolio of high-risk, high-reward bets; and deploying enough capital in each bet so as to ensure enough ownership per company such that if and when it wins, it wins big enough to compensate for all the other losses in the portfolio.

4/ Value of holding cash

By using concepts like bankroll, betting small portions of it at a time, and not going broke, the Kelly formula also subliminally suggests the value of always holding cash in the portfolio.

Berkshire is famous for holding significant amounts of cash ($100Bn+ in recent years) on its balance sheet at all times.

We believe in always having cash. There have been few times in history where if you don’t have it, you don’t get to play the next day.

Cash is like oxygen. It’s there all the time but if it disappears for a few minutes, it’s all over.
Warren Buffet

Holding cash also helps in going on offense when unforeseen crises like the dotcom crash or GFC occur. As asset prices crash, these become once-in-a-lifetime opportunities to deploy capital.

C. Incorporating special considerations

While following the above heuristics from the Kelly criterion, it’s also important to keep some room to account for special considerations in your personal context. Eg. Rob Vinal keeps some buffer in case LPs want to withdraw money on short notice:

D. Closing Thoughts

Position sizing is both an art and a science. Having a well-defined view on it that is congruent with your overall investment strategy is crucial for any investor.

As you think through its nuances, it’s useful to keep in mind the guardrails that the Kelly formula tells us. The Kelly heuristics guide us towards the most optimal, risk-adjusted path for generating returns in probabilistic games like investing while avoiding the risk of total ruin.

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When To Sell?

Be it venture capital, public markets or real estate, “when to sell?” is an important question that both individual and institutional investors face.

Is it better to keep taking chips off the table? Or is hold-forever the right mindset? The journeys of Sequoia, USV, Berkshire and Brookfield give us some clues.

Yesterday at Primary’s NYC Summit, Fred Wilson (Managing Partner at Union Square Ventures) said something really interesting (and controversial) about venture firms that held on to their winners post-IPO in the recent cycle:

Their limited partners should fire them. They should never give them another dime. It is irresponsible what they did in my opinion.
Fred Wilson

Reading this argument brought me back to a question I think about often as an operator-angel – when is the right time to sell? In fact, I am faced with this dilemma right now wherein I might have an opportunity to exit a 2014 vintage investment. So, I guess it’s timely for me to attempt a deep-dive into this question, and analyze what the best investors across asset classes have to say on this topic.

A. Venture Capital

Clearly, Fred Wilson believes that venture firms should keep taking chips off the table as and when opportunities arise during late-stage financing rounds, and then cash out completely post IPO. Here’s an interesting excerpt from one of his posts on this topic:

Taking money off the table is smart portfolio management. It is very different from selling your entire position, which could be brilliant but is equally likely to be a mistake. Selling a portion of your position, returning a multiple or two (or eight) of the fund, and holding on to the balance works out for you no matter which way the position goes in the future. If the position blows up, you got a lot out and booked a huge gain. If the position goes up significantly, you make even more money on the part of the investment you retained. If it goes sideway, you got a little bit out early. It is a win/win/win pretty much every way you look at it.
Taking Money “Off The Table” by Fred Wilson

However, another OG VC – Doug Leone of Sequoia, has a different view. This is what he said on this pod with Jason Calacanis (paraphrasing):

It’s way tougher to go from 0 to $5Bn market cap than it is to go from $5Bn to $20Bn market cap.

There was significant upside created post IPO in companies like Yahoo, Google, ServiceNow and Facebook.

By holding for the long term, it’s a win-win-win for founders, LPs and Sequoia.
Doug Leone (Sequoia)

In fact, Sequoia started an evergreen fund in 2021 where the goal is to partner with entrepreneurs for 25 years, from idea to IPO and beyond. Here’s the firm’s stated thinking around evergreen hold periods for generational companies:

Source: The Sequoia Capital Fund: Patient Capital for Building Enduring Companies

So while one OG believes in taking chips off the table at every opportunity, another believes in staying all-in for decades.

Let’s see if we can break this deadlock by studying public market investors.

B. Public Markets

The first thing that comes to my mind when I think about the topic of when to sell public equities is the following legendary quote from Peter Lynch, later re-phrased and popularized by Warren Buffet:

Selling your winners and holding your losers is like cutting the flowers and watering the weeds.
Peter Lynch/ Warren Buffet

The gold standard in public markets investing is inarguably Berkshire Hathaway. Let’s look at the hold periods of some of its top holdings as per the 2022 Annual Letter:

1/ Coca-Cola – first started buying in 1988, and completed its purchase in 1994. Since then, annual cash dividends from Coke have increased from $75Mn in 1994 to $704Mn in 2022. The value of Berkshire’s investment has grown from $1.3Bn in 1994 to $25Bn in 2022, accounting for ~5% of Berkshire’s net worth.

2/ American Express – completed its purchase of Amex shares in 1995. Since then, annual cash dividends from Amex have increased from $41Mn in 1994 to $302Mn in 2022. The value of Berkshire’s investment has grown from $1.3Bn in 1995 to $22Bn in 2022, also accounting for ~5% of Berkshire’s net worth.

3/ GEICO – As a Columbia University business student, Warren Buffett made his first purchase of GEICO stock in 1951. Then in 1996, he purchased all outstanding GEICO stock, making it a subsidiary of Berkshire Hathaway, Inc. Warren paid ~$2.35Bn in total over these years to completely buy out GEICO. By 2022, the business was doing ~$39Bn in annual revenue itself.

Berkshire holds winners for extraordinarily long time periods, and benefits from their compounding, like no other investor on the planet. The 2022 Letter has an interesting para on this philosophy:

Source: Berkshire Hathaway 2022 Annual Letter

So till now, Sequoia, Peter Lynch, and Warren Buffet all seem to be in the hold-forever camp. Intrigued enough? Wait till you see what the world’s best investor in real assets (real estate and infrastructure) has to say on this.

C. Real Assets

IMHO, one of the best investing talks of all time is ‘Durable Principles of Real Asset Investing’ delivered at Google by Bruce Flatt, CEO of Brookfield. In fact, if you look at the video, it’s a travesty that only about 20 people actually attended this talk. Over 5 years since then, it has had a mere 175k views on YouTube, compared to the Millions that random TikTokers get.

Anyway, one of the core principles that Bruce talks about is investing with a mindset to hold assets forever. He cites an example of investing $432Mn in a marquee downtown NYC office building in 1996. Brookfield held it for 21 years, over 4 business cycles including 9/11 and the ’08 financial crisis, ultimately selling it for ~$2.2Bn in 2017. Note that this doesn’t account for additional returns created via using leverage for this asset and rental income.

Brookfield held this marquee office building on Park Avenue for 21 years, even through multiple global crises (Source: Durable Principles for Real Asset Investing)

Bruce says that when you invest with a hold-forever mindset, you automatically start looking at the asset’s long-term fundamentals, rather than what will happen to it next year or who will pay up for it later.

Cool – so we now have multiple OGs across asset classes in the hold-forever camp. From Sequoia in venture capital, Warren Buffet and Peter Lynch in public markets to Bruce Flatt of Brookfield in real assets.

D. Where I Stand On This

Based on personal experience as well as observations, I firmly lean towards hold-forever as a default mindset. Here are the reasons:

1/ Motivates fundamental analysis – as Bruce rightly said, a cross-decade hold mindset ensures that in the beginning itself, an investor will be prompted to think deeply and rigorously about the long-term future of the asset. Otherwise, there is a risk of investing with a ‘passing-the-buck’ mindset (expecting someone will be willing to pay a higher price for it in a few years) without building a strong investment thesis.

2/ Be on the right side of Power Laws – business outcomes across most contexts are driven by Power Laws, wherein only a few assets end up becoming winners in any portfolio. Therefore, adequately compensating for all the losers, such that the overall portfolio drives superior returns, requires milking the few winners as much as possible.

Those who regularly read this blog know that I worship at the altar of Power laws (refer to my posts on Conviction vs Randomness in Venture Investing and Only Need to Get a Few Right!).

In this regard, the following extract from Berkshire’s 2022 Annual Letter really caught my eye:

3/ Room for compounding – it’s important to hold assets long enough for this 8th wonder of the world to do the work for you. Studying the journeys of the best investors in history across asset classes, it becomes clear that compounding is really the true force that drives superior returns. As Bill Miller says – “the key to returns in the market is Time and not Timing”.

Am seeing the power of compounding in my own angel portfolio where the 2014-16 vintage companies have now hit strong product-market-fit and I expect a bulk of returns in these companies to be rear-ended. Check out what Susa Ventures has to say about its learnings from winners across vintages:

Source: Chad Byers, Co-founder/ GP at Susa Ventures

E. A Framework for “When To Sell?” Decisions

While I am philosophically in the hold-forever camp, I do believe a framework is needed to ensure rigorous thinking on a deal-by-deal basis, especially to catch edge cases where applying the default philosophy might, in fact, be sub-optimal. These could include either (1) luck-driven/ speculative upside cases (eg. a previously unknown crypto token hits unjustified all-time highs) or (2) scenarios with potential Risk of Ruin (eg. having an inordinate concentration in a single stock).

Inspired by Nick Sleep’s** decision-making framework on when to sell (via Mohnish Pabrai), here’s a set of proposed questions an investor can look to answer while making a sell decision:

1/ What is the ultimate destination? – Is there enough growth runway still left in front of the business? What does the business look like in another 10/20/30 years?

2/ Is the business getting better? – How are the operating and financial metrics trending? In particular, is its competitive advantage getting stronger?

3/ Have any of the fundamental assumptions underlying the original investment thesis changed in any way? – Is the market shaping up differently than expected? Have new competitors entered the space? Is a new technology disruption around the corner?

4/ Is a sale going to serve any other strategic purpose besides the quest for returns? – Are there any time-critical professional or personal requirements that need this capital? Is there an opportunity cost case to be made?

5/ Is the valuation egregious? – Is the asset at the peak of a hype cycle? Is the price at crazy levels that are unlikely to be seen again for several years?

Rather than giving a binary yes/no answer (real-life deal situations are rarely binary anyway), this framework should help in figuring out which side to lean on and in what proportion. Ultimately, one has to use judgment to arrive at the final decision.

A disclaimer…

My stance as outlined above applies more to the context of personal investments. In the case of managing other people’s money, various considerations related to fiduciary responsibilities kick in. My sense is Fred Wilson’s argument as outlined earlier is more focused on the latter.

F. Summarizing

Fred Wilson’s stance of de-risking via routinely taking chips off the table is a safe and conservative strategy that makes a lot of sense for most investors out there. But as many OG investors across asset classes have shown, generating outlier returns with generational impact requires going all-in and holding the winners for decades. Essentially, one has to become a smart gardener that only cuts the weeds and lets the flowers grow.

**If you enjoy reading investor letters, the Nomad Partnership Letters by Nick Sleep and Qais Zakaria are a must-read. FYI Nomad was one of the best-performing investment partnerships for 15 years starting in the early 2000s.

Making Money by Understanding the Crowd

During a recent train ride in London, I observed an interesting pattern in the crowd that “rang a bell” in my head.

Here’s why understanding patterns in crowd behavior is important for successful investing.

For those of you who regularly follow my writings, am sure you have observed by know my fascination with behavioral economics/ finance & the psychology of crowds. One of my major insights from studying the work of OG investors like Charlie Munger, Howard Marks and Bruce Flatt is that the key to superior (i.e., above market average) returns is to be non-consensus & right. Getting a read on how the crowd is behaving at any point in time is one of the important analytical tools necessary to achieve non-consensus behavior.

To simplify, a crowd is a set of largely independent & uncoordinated entities, though you can define it in many other ways as per your context. There are many mental models to visualize the properties & behavior of a crowd. These include the Madness of Crowds, Herd Behavior, Social Proof, Incentives etc. However, during a recent trip to London, the city’s “Tube” train system brought back the most fundamental of these models right in front of my eyes – the normal distribution, popularly called the bell curve.

So, here’s the story. Last week, I landed at Gatwick on a busy morning, and boarded the train to Heathrow. The first thing I observed is how significantly better the London transit system is compared to anything I have experienced in the US. Even the NYC subway is nowhere close in terms of quality, multi-modality & cleanliness.

This particular train (I think it was called the Southeastern) had a very cool feature wherein it displayed how crowded each carriage was in the train, so people could shuffle around. Check out the below pic I took of the display in my train – do you notice an interesting pattern within it?

The distribution of the crowd across carriages is very close to a bell curve. Out of 12 carriages, the middle 5 are “standing room only” (yellow), 3 on the right and 2 on the left are “few seats available” (dark green) and the 2 carriages on extreme left & right are “plenty of seats available” (light green).

Seeing this pattern in a random, real-life event involving hundreds of independent & uncoordinated strangers blew my mind. I couldn’t resist taking its picture even while hanging on to 2 large bags while getting jostled in a..wait for it..middle carriage (see the bottom part of the above pic, it says “you are in coach 7”). I was myself in the middle bulge of the bell curve!

Now, besides this being a nerdy but cool anecdote, is there anything to learn from it? The applicability or importance of a normal distribution is not the main point here. The real insight is that attempting to decode & model how the crowd is behaving in a certain environment, as well as its potential implications, can by itself give investors a massive head start.

As Howard Marks says in his latest memo “Taking the Temperature“:

So, to be successful at contrarianism, you have to understand (a) what the herd is doing, (b) why it’s doing it, (c) what’s wrong with it, and (d) what should be done instead & why.
Howard Marks (Taking the Temperature)

The importance of rigorously decoding crowd behavior (or what we often call “the Market”) can’t be emphasized enough due to the simple reason that the crowd is right most of the time. When the investor-crowd is signaling that a company is un-fundable, most of the time it has correctly identified a weak business. If the market is predicting an interest rate cut by the Fed in the next few quarters, its combined wisdom is likely to be more accurate than most experts. If investors at large are investing in the AI wave or piling into an EV stock, they are indeed spotting a market opportunity that is likely to be exponential. If investor interest is low in a particular real estate location or type, most of the times it’s due to the right reasons.

While going blindly against the market consensus is flawed, first-order thinking, asking the right questions around “what” the market is doing & “why” is the first step of rigorous, second-order thinking.

The difference between “the market has spotted/ rejected an opportunity correctly” vs “the market is overly optimistic/ pessimistic on the said opportunity” is a fine nuance that can create a big delta on long term returns.

In particular, second-level thinkers understand that the convictions of the masses shape the market, but if those convictions are based on emotion instead of sober analysis, they should often be bet against, not backed.
Howard Marks (Taking the Temperature)

Abstracting this idea of understanding patterns in crowd behavior a bit more, I believe there is tremendous value in seeing various aspects of life as a distribution of outcomes. Personally, I find probability distributions more helpful in understanding how the real world works in a continuum, as opposed to statistical distributions, which are like static snapshots of reality & more academic in their usefulness.

Probability reflects how life operates in the “grey”. I have found viewing the world probabilistically to be immensely helpful in managing risk & uncertainty in every aspect of life. Too bad they don’t teach these applications while covering the subject in school!

Btw, coming back to the earlier train story, I practically used the bell curve pattern in how Londoners board trains by myself lining up either in the extreme beginning or extreme end of the platform during subsequent trips. Oh, the joy of boarding an empty carriage from the busy London Bridge station. Just goes to show that being a bit nerdy can sometimes be useful in practice!

Investing Landmines

Successful investing, be it in stocks or venture capital, requires avoiding behavioral landmines at every step of the way.

Here are the major ones that every investor should have top-of-mind.

Successful investing outcomes, be it in public or private markets, are typically the result of the following sequence of events:

#1 Real world research and/ or experience germinates a non-consensus view.

#2 A conviction-building process for this view helps in getting to a probabilistic distribution of future outcomes.

#3 Courage helps in putting real money behind the view.

#4 If all goes well, the non-consensus view starts turning out to be right (non-consensus ➡ non-consensus-and-right).

#5 After a certain hold-out period, the market provides a liquidity opportunity that is attractive-enough for the investor to cash out.

Investors have to fight specific pitfalls at each step of this sequence:

For #1, it’s the herd mindset that evolution has deeply wired into our psychology. We seek comfort in others validating our views, which is the exact opposite of what contrarian thinking entails.

A by-product of herd mindset is FOMO, which has quickly become the dominant driving emotion of modern urban life.

For #2, it’s hasty bias-to-action. Individuals have a tendency to overcommit & get positively biased very quickly, often even before adequate investigation. Every investing action releases dopamine, which makes individuals feel powerful & good about themselves. Therefore, even sophisticated individuals are quite trigger-happy & demonstrate a tendency to “just do it”.

Running a solid investing process calls for a scientific approach that starts with default skepticism, generating a hypothesis & then putting in the work to approve/ disapprove it with intellectual honesty. PS: check out more about bias from consistency & commitment tendency in this amazing write-up by Charlie Munger on Farnam Street.

For #3, it’s fear. Fear of losing money, of losing face, of future distress. Am sure we all have seen many examples around us of folks who did a decent job at #1 and #2, but never pushed chips on the table. That friend who spotted Google at the earliest stages. Or who had heard of Bitcoin from credible sources before everyone else. Or who was seeing East Bay become the new South Bay or Gurgaon become the new Delhi.

Am also confident that as children, each of us saw our parents hold a non-consensus view for those times & not act on it, which in hindsight, would have led to asymmetric gains.

For #4, it’s lack of patience. Markets typically take time to appreciate & subsequently reward non-consensus views. This period can range from a couple of years to sometimes more than a decade. Holding out with a view that doesn’t match the crowd for long periods of time is extremely hard psychologically for even the most experienced investors.

Humans by nature seek thrill & quick rewards. While a lucky few are born with the delayed gratification gene (like this Nevada’s Pension Fund Manager), for others like us, we have to train ourselves to get better at it.

For #5, it’s greed. Once the market slowly starts appreciating your non-consensus view, given its pendulum nature, it then starts gradually moving towards the other extreme. At a certain point in time, it will soon provide windows where very attractive, & sometimes egregious, returns can be booked. Case in point: after the Nvidia stock stayed flat for several years, the recent AI-fueled stock run-up is finally providing an opportunity for insiders to cash-out.

But then, greed starts kicking in. Maybe hold-out longer for even better returns? This is where the discipline of taking chips off the table & booking profits becomes really important. However, this is really hard to do when investors have faced a long lean period & are now starting to see things finally go up. As legendary fund manager Mohnish Pabrai often says – the art of when to sell is the most difficult.

To summarize, the key to successful investing is recognizing and working towards actively avoiding the above landmines at every step of the way, most of which are behavioral.

From Stocks to Gaming: How Indians are Loving to Bet

New-age Indians are learning to bet & loving it. Everything from stocks to fantasy sports is fair game.

Unpacking this behavior change, its upsides & potential risks, as well as how it’s likely to shape India going forward.

During my recent India trip, one clear trend I observed was how prevalent retail day trading had become across generations. I met a 21-year-old fresh grad who does regular options trading. I met a bootstrapped founder who, to paraphrase his words, “goes into the market whenever his savings dip below a certain point”.

One of my mother-in-law’s friends was boasting how “her son made 50 Lakhs profit in shares”. FYI this person is the 2nd generation heir of a massive family business. My father too, though not exactly a day trader, actively invests in hot Indian tech IPOs via these new-gen brokerage platforms (without ever consulting me, of course!).

To validate these observations, I went back to check on the growth numbers of Zerodha, the #1 brokerage platform in India by market share. And it’s a classic hockey stick! I am sure this isn’t news for many of you but for me, this was an eye-opening stat given I have a bit of a blind spot around India’s digital evolution during Covid years when I wasn’t able to spend much in-person time there.

Another similar trend I have been intrigued by, and again this might not be news for many of you, is the rise of online real-money gaming (RMG). Dream11, India’s top fantasy gaming company, has shown hockey-stick growth numbers similar to Zerodha. During my conversations with even the next tier RMG companies, their active usage numbers & profitability (hence, cash flow) are off the charts.

One clear takeaway from the above charts is that both these digital verticals took-off simultaneously in 2017-18, just after the launches of Jio & UPI in 2016. Jio’s cheap 4G services, combined with easier micro-transactions enabled by a UPI-powered digital payments ecosystem, have proven to be major unlocks. While Zerodha was founded in 2010 and Dream11 in 2012, their real inflection points came much later once growth enablers at the ecosystem-level were in place.

The widespread adoption of new-gen brokerage & RMG platforms is indicative of how markets in India will behave very differently in the coming decade. Accessibility, ease of use & small ticket sizes is unlocking retail “betting” behavior like never before.

Fresh college grads doing options trading at scale was unheard of in my generation (and I am a cusp millennial, so not that outdated!). In my time, both education & access were gaps. We didn’t have financial influencers sharing everything about markets on YouTube & Instagram. I still remember the good old days where one had to jump through multiple hoops of paperwork just to open a demat account, not to mention the terrible online UX that was impossible to navigate. And playing games with real money on the Internet? Forget it!

On the positive side, this broad-based participation in public markets is going to provide support to many different types of IPOs. Case in point is the recent SME IPO of Infollion Research. Its public offer was subscribed a massive 279 times at close. The retail investors’ portion was subscribed 264 times. The stock was listed at INR 209 as against an issue price of INR 82, a huge 155% premium.

Btw this isn’t a hot growth story riding a trendy tailwind like AI. It’s a business research services company with INR 35 Cr topline & INR 5 Cr PAT. A few years back, no one would have counted on such a company to garner this kind of investor interest. I believe this is a sign of a new type of retail investor coming into the market, which is fantastic for smaller companies that want to go public in India.

While it’s great that more people have an opportunity to own shares of public companies, this accessibility & ease unlock is also fanning dopamine-inducing emotions of greed & thrill. I have seen that happen with Robinhood in the US. In fact, one of my frequent advice to anyone looking to create long-term wealth with stock investing is to first close their Robinhood account. There is a real risk of young investors falling prey to the cocktail of ease of use, greed, fun & small “casino-style” bets.

Another side-effect of this trend is going to be more herd behavior. So, for any new investing pattern or idea that is starting to emerge, expect it to unfold at a significantly accelerated rate compared to a decade back. Similar to the meme stock frenzy that we saw in the US in 2021, will India have its own GameStop or AMC moment in a few years? Highly likely!

Finally, expect regulators to have a keen eye on these markets. We are already seeing the SEC crackdown on Coinbase, a company that is formally listed in the US & has passed all scrutiny to get here. With Indian retail investors participating in various markets in a big way, local regulators will need to be ahead of the 9-ball & safeguard both the interests of these individuals as well as the long-term stability of these markets.

The intertwined trends of retail trading & online gaming are going to have some fascinating implications for India. While I am all for more digital consumption & market participation, given a few grey hair I now have, I would also advise young Indians to navigate these markets responsibly.

Munger’s Tao

I recently came across this awesome Tweet & Podcast from David Senra of Founders Podcast, wherein he captures learnings from his dinner with Charlie Munger, as well as his reading of The Tao of Charlier Munger.

Here are some insightful ideas & quotes from Munger that stayed with me from David’s experience:

1/ Buy wonderful businesses at fair prices

Before Munger joined Berkshire, Buffet used to invest in Ben Graham’s “cigar-butt” style – buying super-cheap stocks, often trading below book value.

Munger gave him a new blueprint: “Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices”. This is what led to Berkshire becoming the compounding machine it is today.

2/ Cash is king

Through a company called Blue Chip Stamp, Munger & Buffet learned about the value of “float”- excess cash that a business throws up due to the timing difference between receiving payments & settling payouts. This excess cash could then be re-invested in profitable companies.

Through his early investing experiences, Munger started seeing the advantages of investing in better businesses that didn’t have big capital requirements and did have lots of free cash that could be reinvested in expanding operations or buying new businesses.

Munger advises keeping enough cash at all times, in order to take advantage of stock market crashes.

We made so much money because when the great deals came during an economic crisis, we had cash and could move fast.
Charlie Munger

3/ Acting on the few big ideas that matter

Munger says that very few times, you will be presented with an opportunity to buy a great business run by a great manager. Not buying enough when presented with this opportunity is a big mistake.

You have to be willing to act when the right opportunity comes along. ‘Cos great opportunities don’t last very long in this world.

Good ideas are rare. When you find one, bet big.
Charlier Munger

4/ Portfolio concentration creates outlier outcomes

Real wealth is created via concentration. Or to put it in another way, over time, one should expect 1-2 outlier winners to constitute a majority of the portfolio.

When Munger wrapped up his pre-Berkshire fund, Blue Chip Stamp accounted for ~61% of his portfolio.

Worshipping at the altar of diversification is crazy. One truly great business will make your unborn grand children wealthy.
Charlie Munger

5/ Chase unfair advantage

Competition is for losers! Why would you want to compete with people?

Some quotes from Munger on this:

“My idea of shooting fish in the barrel is to first drain the barrel”.
“Only play games where you have an edge”.
“Differentiation is survival”.
“Aim for durability”.

Munger talks about how size and market domination has its own kind of competitive advantage. When a company is deeply entrenched with customers, it acts as a deterrent for other players to enter the space.

Sectors that are generally considered to be “bad businesses” (eg. retail, textile, airlines etc.) are intensely competitive. Players beat each other over price and drive down profit margins for everyone, killing cash flows and bringing down chances for long term survival.

That’s why Berskhire looks for great businesses that have a durable competitive advantage.

Mimicking the herd invites regression to the mean.
Charlier Munger

6/ The power of Compounding

Find an exceptional business where underlying economics are going to keep increasing its value, and then hold on to it over time.

Quoting Munger – “Time is the greatest friend of an exceptional business. It’s the greatest enemy of a mediocre business”.

Compounding also works in knowledge. Munger gives an example of how over 50 years of consistently reading Barrons, he found just 1 idea worth investing in but that made him $80Mn, which he then gave to Chinese fund manager Li Lu, who turned it into $400-500Mn!

7/ The value of Rationality

To quote Munger:

“We don’t let other people’s opinions interfere with our rationality”.
“Life is like poker. You have to be willing to fold a much loved hand when new info or facts come to light“.
“It’s remarkable how much long term advantage people like us have got by trying to be consistently not-stupid, instead of being highly intelligent”.

8/ Focus is a super-power

Munger says:

“I succeed because I have long attention spans. People who multi-task give up their advantage”.
“You will always lose in a race to that one guy who sacrifices everything he has in service of one idea”.
“Extreme specialization is the key to success”.
“Intense interest in a subject matter is super powerful”.

He cites examples of how great companies tend to focus on optimizing one specific lever in their business:

Costco – optimizes costs
Geico – optimizes distribution via direct-to-consumer
Nebraska Furniture Mart – optimizes price for the end customer

What’s the one thing that both Warren Buffet & Bill Gates said was the key to success? Focus!

9/ Frugality drives value

Munger cites one common quality amongst all Berkshire businesses – they will go to great lengths to keep operating costs low. Even Berkshire itself demonstrates the same behavior:

It has no PR department.
It has no investor relations office.
For many years, its annual report was published on the cheapest possible paper & had no expensive color photos.

10/ Brands are magic

Munger says – “A great brand is a piece of magic”.

Brands like Coca Cola & See’s Candies have a piece of a consumer’s mind & therefore, have no competition. Charlie calls them “consumer monopolies”.

A lot changed the day Berkshire realized the power of brands.

11/ Business plans are useless

Munger says Berkshire has no master plan – “We always wants to be accounting for new information. We are individual-opportunity driven. Our acquisition style is driven by simplicity”.

He shares an interesting anecdote. When Mrs. B (Rose Blumkin), Founder of Nebraska Furniture Mart, was asked about having a business plan, she said – “yes, sell cheap & tell the truth”.

12/ Patience is rare

Human nature is all about being impatient. People just can’t sit around, waiting patiently. They want to feel useful. So they end up taking action and doing something stupid.

13/ Learning from mistakes is crucial

Learning from history is a big form of leverage. The biggest financial disasters get forgotten in a few years.

Munger says:

“Wise people step on troubles early”.
“Every missed chance is an opportunity to learn”.
“Be willing to take life’s blows”.

I love rubbing my nose in my mistakes. It’s an extremely smart thing to do.
Charlier Munger

14/ It takes many, many attempts to find your life’s work

For context, Munger started working on Berkshire in its current form only in his 40s.

15/ Finally, lots of life advice…

“Build relationships with A players”.

“Problems are a part of life. So why are you letting them bother you?”.

“The best way of reducing problems is to go for quality – Go for Great!”.

“It’s the strong swimmers who drown”.

“Envy has no utility. The key to living a well-lived life is killing envy”.

“The best armor for old age is a well spent life preceding it”.

PS: If you love Charlie Munger’s wisdom, you might enjoy my post capturing his musings from the 2o23 Daily Journal Shareholder’s Meeting.

The real risk is the unknowable, not the unknown

I was discussing the SVB blowup situation yesterday with one of my friends who manages the public markets portfolio for a large family office. He and I both have deep financial services backgrounds, having worked across diverse services & asset classes (VC, PE, public markets, Investment Banking, debt etc.). Both of us came to the same conclusion regarding what has unfolded:

Given the complexity of financial markets, with many direct & indirect stakeholders, influencers, interconnections, interdependencies, manual & robo decision engines at play, it’s almost impossible for even the smartest operating teams & regulators to stay on top of systemic risks building up across thousands of organizations in our financial system.

Of course, this risk management challenge gets further exacerbated in pure capitalist markets such as the US, that consciously allow free market cycles, driven by excessive greed followed by excessive fear, to play out without much intervention.

Going beyond the macro discourse around SVB, of which there is enough now in the media & on Twitter, I want to highlight one learning that all of us need to pay attention to from this episode – the real risk in most things in life is in the “unknowable”, not the “unknown”.

What does this mean? In most planning exercises we do around risk management both professionally (eg. what’s the sensitivity around my company’s 2023 revenue?) & personally (if I plan to do a startup, how much personal runway do I need to be able to operate without a salary?), we focus mainly on outlining the “unknowns” – variations in outcomes of visible & obvious elements. Things like revenue from existing customers, attrition of top performers, house rent, holiday budgets etc.

Planning for unknowns is largely driven by first-order thinking. This includes the classic sensitivity analysis playbook of (1) listing out all obvious elements of the game, (2) thinking of a range of values for them (best case/ likely case/ worse case) & (3) using these values as inputs to model out various output scenarios that consequently drive the overall decision-making process.

But if most organizations & individuals follow this kind of solid decision-making framework, why is the real-world full of surprising blow-ups – bank runs, hedge fund unravels, fast-growing companies unexpectedly going bankrupt etc.?

It’s because the real world is a complex adaptive system with emotion-driven humans as actors. Michael Mauboussin, legendary analyst, academic & public markets investor, beautifully outlined the qualities of this type of system in his recent conversation with Tim Ferris:

So, “complex” means lots of agents. Those could be neurons in your brain, ants in an ant colony, people in a city, whatever it is. “Adaptive” means that those agents operate with decision rules. They think about how the world works, and so they go out in there and try to do their thing. And as the environment changes, they change their decision rules. So that’s the adaptive part, their decision rules that are attempting to be appropriate for the environment. And then, “system” is the whole is greater than the sum of the parts. It’s very difficult to understand how a system works, an emergent system works, by looking at the underlying components.
Michael Mauboussin

In such a system, while some risks fall under “unknowns”, a majority of them are “unknowable” given the system is self-evolving & therefore, impossible to predict at a granular level. Many words are used to describe these unknowables – edge cases, tail events, black swans etc.

Even if we do get some additional visibility into a few of these probabilistic unknowables & can foresee their 1st-order impact to an extent, their 2nd & 3rd order effects are really hard to model out.

Given this context, classic risk management approaches work well most of the time, until they don’t. And when they don’t, participants are caught unaware, unprepared, & often facing the Risk of Ruin.

So, how can organizations & individuals prepare better to deal with the unknowables? The following steps can help:

Start by recognizing the presence of “unknowables” – a major first step is to acknowledge one’s ignorance, & consciously keep overconfidence bias at bay by reminding oneself that even after all this data & analysis, there is a lot that is just not possible to predict. Approaching risk management with humility & in defense mode creates a conducive mindset for this.

2. Add a significant “Margin of Safety” on top of your analysis – while a rigorous Sensitivity Analysis will cover the unknowns well, adding a Margin of Safety goes a long way in providing a buffer for the unknowables. How much of it you want to add depends on context but given we live in a highly risky world, it should be significant enough. As an example, legendary value investors like Buffet & Munger insist on a 50% Margin of Safety while buying public securities (buying at half of the intrinsic value of a company).

Btw, this isn’t anything new. Engineers who design everything from trains & storage tanks to nuclear reactors & space shuttles, recognize error rates in their assumptions & therefore, always include an “allowance” in their computations. Millions of lives depend on this method!

3. Routinely stress-test & update your assumptions – with software continuing to eat the world at an exponential pace, cycles are becoming shorter & feedback loops quicker. The Fed raised rates from under 0.5% in Mar’22 to ~5% in less than a year! With information transmitted in real-time, especially via networks like Twitter, & decisions manifested at the push of a button, we saw how SVB unraveled in literally a day. Given this speed of change, it’s important to frequently stress-test your state-of-state, accounting for changes in external & internal environments & updating your assumptions (esp. Margin of Safety) accordingly.

While the Treasury, the Fed & FDIC have joined forces to save everyone impacted by this specific SVB case, most of us can’t count on such White Knights bailing out our families or our startups each time. A pragmatic & defensive risk management approach that accounts for unknowables, incorporates a healthy Margin of Safety, & includes periodic stress testing, can help us cope with outlier events & keep us in the game.

Munger Musings – Notes from DJCO Shareholders Meeting 2023

As a long-time student of Charlie Munger, I eagerly wait for his musings at the Daily Journal Shareholders Meeting every year. This time was no different! Here are some of my notes capturing Charlie’s wisdom at the DJCO 2023 meeting:

Importance of under-served markets in software

Both Munger & Buffet are big believers in moats. Having witnessed the natural creative destruction of even the best companies like Kodak & Xerox, they understand the power of competition & what it can do to long term returns of investors.

Munger spoke about how the software business of DJCO, which offers a solution to automate legal courts, is operating in a large yet unaddressed market that incumbent software companies hate. It’s an unsexy business that has long sales cycles & as Munger himself said – “it will be a long grind”.

However, these same reasons also limit competition in the space. Munger believes that this combination of a large, underserved TAM + low competition is likely to drive superior long-term returns, as long as DJCO shareholders are prepared to ride through the grind & hold over the long term.

In my view, this idea also has some interesting insights for venture investors in the enterprise software/ SaaS space. Too often, investors start chasing the hot market of the year without realizing that a space that is obviously popular will end up attracting disproportionate competition & investor $$. And as history shows us, too much competition in a market drives down returns for everyone.

Therefore, there is some merit in looking at startups going after unsexy or under-served verticals. These non-obvious nooks & crannies often hold the most potential for contrarian-and-right bets.

2. Holding is tax-efficient

Munger spoke about how he hates to sell his holdings as California would straight-up take 40% away in taxes. As he went on a brief rant about how California is driving businesses away with its tax policies, the underlying insight stayed with me – how holding securities over the long term is a brilliant strategy for tax efficiency. A simple rule that anyone from Berkshire & DJCO to common folks like you and me can follow in our lives.

As the likes of Robinhood have leveraged the excess liquidity environment over the last several years to create a generation of young day traders, many of them don’t realize how tax-inefficient frequent trading is.

3. #1 bias is denial

When asked what the #1 behavioral bias is, Munger said “denial”. And it’s so true. Often times, when the present reality is too brutal to bear, our brain tricks us into living in a delusion. While this stems from an evolutionary survival mechanism our brains have developed, taking major decisions under this denial state can cause havoc in our lives.

Proactively trying to see & live in one’s reality at any point in time is the best way to behave rationally. If one thinks of all of grandma’s wisdom handed down to us in popular sayings (eg. “live within your means”), they all urge us to recognize & live within our own realities.

4. Betting big when the right opportunity knocks

I loved this sentence from Munger – “What % of your networth should you put in a stock if it’s an absolute cinch? The answer is 100%”.

While I am positive that Charlie wouldn’t like this to be construed as a stance against diversification, which is important for almost all portfolios in varying degrees, the spirit of this sentence is this – a few times in your life, you will come across a no-brainer opportunity with massive asymmetric upside. It will happen very infrequently, but when it knocks on your door & you are convinced about it, go all in & bet really big. Over a lifetime, these bets will drive the majority of your returns, financial or otherwise.

If there is one thing that separates the likes of Buffet & Munger from other investors, it’s the mindset of betting really big when the odds are extraordinarily in your favor. During the meeting, Munger mentioned how Ben Graham made 50% of his money from just 1 stock – GEICO. Also, he illustrated the importance of power laws by sharing how Berkshire’s initial $270Mn investment in BYD (made in 2008) is now worth $8Bn!

PS: I have previously riffed on this idea in my post ‘Only need to get a few right‘.

5. On using leverage

Munger admitted to having used leverage to buy Alibaba stock in the DJCO portfolio. When asked why he violated his own rule (his famous quote being “there are only 3 ways a smart person can go broke – liquor, ladies & leverage”), Munger responded with another fascinating quote:

The young man knows the rules. The old man knows the exceptions.
Charlie Munger

The insight behind this is something I say a lot – context is everything! Rules & checklists are great for driving overall discipline & avoiding foolish behavior but as Munger demonstrates, it’s not wise to become a prisoner of your own rules. With experience, one should learn to spot exceptions & when the context is favorable, be bold enough to break the rules.

6. On long-term economic trends

While both Munger & Buffet generally hate to predict macro trends, Charlie mentioned a few interesting observations:

-Inflation is here to stay over the long run, given most democratic govts. globally have shown an ever-increasing inclination to print money.

-Most govts. across the world are going to be increasingly anti-business, with tax rates steadily going up.

-If one looks at economic history, the best way to grow GDP per capita is to have property in private hands & make exchange easy so economic transactions happen (the essence of capitalism).

If these trends are even directionally true, it makes sense to hold assets that can fight inflation (eg. stocks), as well as invest in a tax-efficient way, over the long term. Developing an investor mindset that can operate in a high-inflation environment will be important.

7. The playbook for success in life – Rationality + Patience + Deferred Gratification

When asked the thing that’s helped him the most in life, Munger said – rationality! Loved this line from him:

If you are constantly not crazy, you have a huge advantage over 90% of people.
Charlie Munger

To significantly improve the odds in your favor, Munger prescribes combining 3 things:

-Rationality (which is often, just doing the obvious)

-Patience (take advantage of compounding)

-Deferred gratification (live within means, save & invest)

Like most things Munger says, the above ideas are simple & profound, yet hard to consistently follow for most people as their biases come in the way.

Category: Investing

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