THE SECRET FORMULA

Edward Thorp is a successful investor, a contemporary of Warren Buffet. He is of almost the same age of Warren Buffet and has been beating the Dow and S&P over several decades since 1960s through his own hedge fund. The brilliance of Warren Buffet is evident as he scaled up his activities from a hedge fund into a listed company and relied on insurance premiums instead of hedge fund limited partners.

 

Edward Thorp is a mathematician by profession and hence relied on mathematical approach to risk and ran a well sought after hedge fund. When Warren Buffet liquidated his hedge fund in 1968/69, he had recommended Thorp to the limited partners who didn’t opt for the shares of Berkshire.  

Edward Thorp’s contribution to the investment area is great and we can learn a lot from his track record and insights.

 
He is an avid follower of Kelly formula for taking positions in the market. By the way, Charles Munger  (Warren Buffet investment partner) also expressed support to this formula.

What is Kelly formula?
 
Let us go back little bit in history.

John Kelly, who came out with the formula in 1956, was Bell Labs scientist. The formula is a corollary to a Bell Lab  application for information theory’s ideas which were developed to facilitate higher information rate for a given channel capacity (of Bell Lab projects). The genius of Kelly understood that the insight of the application is good to solve uncertainty element of gambling or risk taking.

If you have an edge in a probabilistic outcome, Kelly formula would show the exact amount to invest/ risk in order to maximize your capital over the long term.

When applied to stock market, it means the maximum rate of return comes when you know something the market doesn’t or ignores or you can structure a trade or investment where your gains will be more.

The formula is as follows:

Capital to be committed = Pw- (Pl / edge)

Where Pw     = probability of winning

           Pl          = probability of losing

           Edge  = the win ratio i.e. winning amount/ losing amount

For example, if the investment outcome shows a gain of 2000 vs. a loss of 1000, you have an edge in the ratio of 2:1. You assign a 60: 40 probability. The capital you have to invest is 100,000/- . How much you may invest in this deal? Is it full capital? Let us try Kelly’s formula.

= 0.60 – (0.40/2)

= 0.40 or 40% of the capital can be invested

Suppose, after observing some latest developments on the market, you are less confident and revise the probability to 35:65. How much you should invest?

= 0.35 – (0.65/2)

= 0.0250 or 2.5% of the capital can be invested.

Before trying in real life situation, you have to master the formula and understand its limitations as well. If interested, the original 1956 article, “A New Interpretation of Information Rate” by John Kelly is available. Although there are critics to the above formula-  Edward Thorp is a strong supporter. He has penned an article in support “The Kelly Criterion in Blackjack, Sports Betting, and the Stock market’. Edward Thorp is also the author of two successful books related to investment and risk taking.

If interested to know more on the topic/ articles mentioned above, you may please email me at ciby@financialviewsonline.com

CAG REPORT ON COAL ALLOCATION MAY BE IGNORED

Everyone tries to bring in sensationalism! Indian movies, TV serials, Politicians, Media entertain the public with sensationalism and breaking news!

CAG Reports (of India) seem to be no different. As they investigate each accounts, they bring out with more sensationalised scams. Telecom was the biggest scam so far.

Now the purported Coal scam is even higher! Rs. 1.86 lac crore (or USD 35 billion) That is lot of money!
Are you wondering where all this money has gone? Well this is a notional loss!
Are these numbers true and fair?
Are there willing buyers/ bidders at the price levels CAG Report is assuming?

Assumptions are dangerous stuff - as many financial analysts in banks and FIs can confirm. In my previous life, I was a financial analyst and had headed a team of financial analysts in a MNC bank.

During the boom time of 2008, the assumptions made presumed the continuation of the boom times of 2008 into the future. Then the great crash (global financial crisis) came which made many a fantastic projections, IRR, DSCR, PLCR, etc look like a mirage.

CAG assumes that had the coal blocks allocated between 2004 and 2009 were done at a particular price, then there would have been loss to Govt. 

What if there were no bidders at these levels? Even if there are bidders, what is the probability that they have the capability to execute?

As is well known in tender process, the contract is not awarded to the lowest/highest bidder, but to the one who has the capability to deliver on time.

India's future growth will be driven by private sector, which is incentivized by profit motive. Private sector (and even the public sector) is not motivated by charity.  Efficiency & productivity of resources (incl. capital) in private sector is much better than in public sector. Ignore the concerns of private sector of India at the peril of the economic growth, new job opportunities and prosperity.

Hope these kind of allegations don't pull down India's growth.

Standard Chartered Woes

Standard Chartered was basking in glory these days when most of their counterparts were fighting a battle against economic slowdown and other issues in Europe and USA. It had good reserves, low exposure to euro zone and wasn’t guilty of LIBOR manipulations.

But - out of the blue-moon came the thunder that upset and injured Standard Chartered‘s stock price and its top management. Financial Thoughts believe that the style of New York State’s Department of Financial Services accusations of Standard Chartered is a surprise for everyone.

Standard Chartered has the right to defend and they are doing that by even spreading the news that they may ‘Fight the Fed’. Let us wait and see.

It is interesting to note that on 30 July 2012, UK's Financial Times (FT) carried an article (http://www.ft.com/cms/s/0/2ae72322-da45-11e1-b03b-00144feab49a.html#ixzz237nCKZSB) that mentioned about a company that attracted sanctions from US for Iran deals.

FT states that the US secretary of state had said that this company had …..

”….. provided more than $70m in refined petroleum to Iran in multiple shipments in late 2010. The company has tended to work with local banks, and with international banks including Standard Chartered.” 

Read the last sentence again! Other international banks are also involved with Iranian shipments mentioned above. So why singling out Standard Chartered alone? 

A few of my business clients are quick to point out that even US based companies (incl. oil field services co.) have business interests in Iran.

The media carries a lot of news / rumours on Standard Chartered’s possible defence against the allegations it broke US sanctions on Iran that could complicate things further – more counter lawsuits, fines and the loss of business, besides reputational damage . Some of the rating institutions are itching to downgrade Stan C's 'AA-' credit rating - this could impact its cost of refinancing.

For some investors, this may be a good news! After the dust settles, if Standard Chartered bank’s stock price goes down further, it may worth to have a look at it as an investment alternative.