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.

Ludicrous Earnings of JPM

When JPM announced its first 1Q2012 results in April 2012, the investors were happy. It made good profits for the first quarter!  The CEO Jamie Dimon brushed off the questions about the potential CDS linked losses of its London office - he stated the trade is just a 'tempest in a teapot'!

However, during the conference call yesterday, JPM put the CDS trade losses at $5.8 billion, with the potential to grow another $1.6 billion (totaling $7.4 billion) in a worst-case scenario.

It definitely questions either the (i) integrity of top management at JPM or (ii) managerial capacity. In other words, when the CEO misled the investors in April 2012, either he knew it and had hidden the information from shareholders or he was kept in dark by his staff!

The beauty of the entire episode is that despite the loss, the second quarter results are better and profitable! Where have the losses gone? Well, the company simply restated its first-quarter results to reflect $1.4 billion in related CDS losses. What an accounting!! Let us see who signs the audited accounts of JPM!  

But for the state protection, both JPM and Goldman Sachs would have licked the dust in 2008 crisis. Well after all, there is not much difference in Communism and Capitalism at times. (Karl Marx had predicted in mid 1800s that the capitalist banks will have to be salvaged by the state after narrating incidents more or less in line with the 2008 crisis)

And the stock rallied because the 1Q2012 earnings were marked down to losses so that 2Q2012 can show some profits. If this continues, during the next conference call in Sept 2012, they may re-state 2Q2012 figures downwards to show profits in 3Q2012! and the stock may rally! Just wondering who is fooling who? Does it suggest a massive cover-up & isn’t it obvious that a critical examination required?

Across the Atlantic, another Anglo-Saxon banking model also shows loopholes. Barclays Chairman Marcus Agius and CEO Robert Diamond had resigned in the wake of that firm's LIBOR-rigging scandal. But is amazing that Dimon continues to be the CEO despite scandals after scandals – the power brokers are keeping him up there as he is an expert in mis-leading investors and public?  I like the British way of handling the situation - as they know how to treat erring CEOs or the CEOs that either lacks integrity or capability.

Driving the Indian entrepreneurs abroad!

Thank God, Finally Pranab Mukherjee left the Finance Ministry

When Pranab took the reins of financial affairs of India, the country was growing at about 8%, FIIs and FDIs always considered India as a desirable destination and Indian entrepreneurs were enthusiastic to start new ventures. After all, Chidambaram, who hailed from a reputed business family in South India, conducted the financial affairs in business-like fashion. Of course, India’s foreign currency rate hovered around healthy 1USD= Rs 45/- . Even when international oil prices peaked at US$148/- p/b in July 2008, petrol prices in India was around Rs 50-55/- per litre.

Now, as Pranab leaves the finance ministry, the country’s growth rate has fallen to 5% levels, FIIs and FDIs have dropped to a trickle, currency stability has become a joke, petrol prices increase to the north of Rs.70 p/l (although international crude oil price is around USD 90 p/b only). All of the above is nothing compared to the main achievement ‘driving the Indian entrepreneurs’ abroad!

Recently, I got a few Clients from India, who came to the UAE enquiring how to set up factory in this country. The reason is the changes in Indian income tax. They have informed that the export income which was hitherto tax free in India is now made taxable through MAT (Minimum Alternate Tax). So, the entrepreneurs are planning to shift the production base to business friendly UAE in such a manner that the production for exports will be done in the UAE. Whilst this is good for UAE Economy as the economic multiplier and accelerator works in its favour, Indian economy will suffer in terms of lost jobs, lost government revenue and negative multiplier effect.  Wealth creation in the country will be affected.

This is over and above other myopic policies pursued by the government in tax front that will scare away BPO outsourcing, FII and FDI. We have covered this in an earlier blog see http://www.financialviewsonline.com/2012/04/income-tax-department-is-taking-lessons.html

‘Penny wise and Pound foolish’ seem to the dictum of Indian tax bureaucracy now!

Indian Economy Under Attack & a sleepy leadership - Part II

India begs new leadership. Whilst Dr. Manmohan Singh has many strengths, managing a coalition and Sonia Gandhi does not seem to be one of them. His Finance Minister and RBI Governor are making a mess of things and PM cannot do much.

Ex-minister Raja took the corruption to new heights by looting billions of dollars of public money (of several tax payers) walks free and even visits the temple of democracy (Parliament) without any impunity. At least 2% drop in economic growth of India can be attributed to the corruption orchestrated by Raja. This dented confidence of several foreign and domestic investors and led to great disappointment to the multitude of Indian citizens, to see them walking free - this will induce the future ministers and bureaucrats to loot billions more.

 

With the general elections to elect a new Govt. a few months away, let us hope voters of India will give replace UPA. Let us give a chance to NDA, even if it means Narendra Modi in power. What we need is performance. Modi can perform as he has proven in Gujarat. Of course, his attitude towards minority is a worry; however the Indian constitution has been designed with enough checks and balances to rein in PMs and Presidents who keep dictator ambitions. Moreover, India is not Gujarat and if he follows anti-minority policies all over India, someone has stated that it may even sow the seeds of next partition of India.

Of course, Dr. Manmohan Singh is among the best of the best economists world has seen. His track record under Narasimgha Rao during 1990s opened up new possibilities in Indian Economy. It surprised the world, who has mostly written off India as a sluggish, slow growth country of snake charmers. Suddenly the world realised the immense potential since ancient times and flocked into the country in the form of FDIs and FIIs. Many Indians became multi-millionaires while many poverty stricken households catapulted to middle class buying up consumer durables such as TVs, DVDs, PCs, Laptops, Fridge, etc. and even small cars. BJP Govt continued the success story. India even survived 2008 global crisis.

Those days India also had dynamic RBI governors such as Bimal Jalan, Reddy, etc. Bimal Jalan was able to reduce  Indian interest rates to 6% during early 2000 when US reduced its rates to 1%.

However, now when the US has reduced its rates to 0.25% India's RBI had hiked the rates to 8.5%, making it almost impossible to do business in India. The cost of capital and cost of borrowing are so high that doing meaningful business is almost impossible. We had discussed this earlier (See http://www.financialviewsonline.com/2011/11/foolish-rate-hike-part-ii.html ) The current drop in India's growth rate to 5.3% could have been avoided had RBI been more smart.

Similarly, the current sharp fall in Indian Rupee and the consequent costly imports of oil is self-afflicted. (See http://www.financialviewsonline.com/2011/12/indian-economy-under-attack-sleepy.html). Whilst many try to blame the poor performance of the UPA government on Euro, the matter of the fact is that most of the blames lies with the Govt.

Let us hope, very soon Dr. Singh will cease to the Indian PM which will give him time to author a few books on Economics and Finance. Financial thoughts firmly believe those books will be treasures and will be cherished by the generations to come, not only in India, but all over the world.

LAMENTATIONS OF GREECE - Part II

Euro is proving to be Man Made Financial Disaster!

On 2nd Feb 2012, Financial Thoughts have suggested that exit of Euro by Greece is good for the country. It was plain logic. After the stringent austerity measures put forth at the recommendation of Germany (reminding the colonial rule of 19th century?), by 2020 Greece will still have 120% Debt/GDP ratio! (For details see http://www.financialviewsonline.com/2012/02/lamentations-of-greece.html)

This was level of Debt/GDP ratio when the Greece crisis began couple of years ago! If the policy of austerity still fails to reduce it after a decade, it is common sense that the austerity is not the right medicine.

However, the Greece departure is sure create a big mess. It could be as disastrous as Lehman or even worse - or there is a fair chance that since the event of Greece departure is not a 'black swan' most of the financial world would be prepared.

Financial Thoughts is worried about the consequences to its stock portfolio. We have been searching for the comments and thoughts by the veteran investor and Guru of Gurus, Warren Buffet. We haven't seen any other than that during the recently concluded annual shareholders meeting of Berkshire, he has predicted a good performance of his company. We hope he will come out with his views soon.

We believe there is time till end of June 2012 before Greece officially declares its exit.

Those who are courageous can play a George Soros of 1992 - akin to the manner he made tons of money betting against the weak GBP. The Euro, at least in the short term, is on the weak footing.

The question is how to protect the stock portfolios. As financial thoughts mentioned earlier http://www.financialviewsonline.com/2011/07/nasty-experiment-called-euro-part-ii.html as long as Euro is in existence, there will be troubles.

Euro is proving to be a man made financial disaster. Financial thoughts is now concerned with how to protect the portfolio - there are several options, take short positions, buy puts, create straddles, create synthetic positions, take DITM/DOTM option positions, etc. However, an idea about the extent of damage that can be caused is required