UU Investing Creating wealth from the unknown and unknowable By Raamdeo Agrawal December 15, 2010
Theme 2011 UU Investing Creating wealth from the unknown & unknowable www.motilaloswal.com 15 th Annual Wealth Creation Study 2
What is UU Investing? “ • UU Investing is investing in the unknown & unknowable (UU i.e. the “world of ignorance”) The real world of investing often ratchets the level of non- knowledge into still another dimension, where even the • What is UU? = Situation where future states of the identity and nature of possible future states are not known. world are unknown This is the world of ignorance. • UU investing = the art of “selecting assets that will fare well when future states ” of the world become known.” www.motilaloswal.com 15 th Annual Wealth Creation Study 3
Understanding UU • 3 states of the world – Known (K), Unknown (U), “ Unknown & Unknowable (UU) The real world of investing often ratchets the level of non- Understanding K, U and UU knowledge into still another Knowledge of Investment Stock market relevance dimension, where even the outcomes environment identity and nature of possible future states are not known. Known Outcomes known; Distribution of returns known Not very relevant; very This is the world of ignorance. (Risk) Probabilities known few outcomes have (K) known probabilities ” Unknown Outcomes known; Distribution of returns Faced by all stock (Uncertainty) Probabilities conjectured market investors (U) unknown Distribution of returns Unknown & Outcomes unknown; Profitably exploited Unknowable Probabilities conjectured ONLY by intelligent Complementary (i.e. special) (Ignorance) unknown investors (UU) skills rewarded www.motilaloswal.com 15 th Annual Wealth Creation Study 4
UU Investing in stock markets • When the future is broadly a Evolution of stocks – from UU to UK to KK continuity of the past, it becomes knowable through Evolution of investor – from KK to UK to UU research and analysis. • When the future is Future - discontinuous from the past, discontinuous it enters the realm of the unknowable, and calls for Unknowable Key investing skill: null set unusual judgement, courage Unusual judgement and patience. Returns: Omega of stocks Facts Future - Evolution continuous to date Key investing skill: Key investing skill: Knowable Information access Research and analysis Returns: Returns: Market performance at best Alpha Evolution of investor Known Unknown www.motilaloswal.com 15 th Annual Wealth Creation Study 5
Past examples of UU investing KK UK UU www.motilaloswal.com 15 th Annual Wealth Creation Study 6
Past examples of UU investing www.motilaloswal.com 15 th Annual Wealth Creation Study 7
Past examples of UU investing www.motilaloswal.com 15 th Annual Wealth Creation Study 8
Past examples of UU investing www.motilaloswal.com 15 th Annual Wealth Creation Study 9
Past examples of UU investing www.motilaloswal.com 15 th Annual Wealth Creation Study 10
Past examples of UU investing www.motilaloswal.com 15 th Annual Wealth Creation Study 11
UU investing for Omega returns • In the traditional investing model, portfolio return in “ excess of benchmark is called "Alpha". • We call the very high excess return possible from UU There are systematic ways to situations “Omega”. think about unknowable situations. If these ways are followed, they can provide a path to extraordinary expected investment UU investing returns returns. (omega) Omega ” Returns Alpha Traditional investing returns (alpha) Market-linked returns (beta) Time www.motilaloswal.com 15 th Annual Wealth Creation Study 12
How to go about UU investing “ Step 1: Know UU Success Principles (SPs) Clear thinking about UU situations, which includes prior Step 2: Look out for UU situations diagnosis of their elements, and relevant practice with simulated situations, may vastly improve investment decisions Step 3: Be aware of the pitfalls where UU events are involved. ” www.motilaloswal.com 15 th Annual Wealth Creation Study 13
Step 1: Know Success Principles “ SP #1: High asymmetric payoff • Higher the challenge, higher the payoff Payoff 500% • Higher the skill, higher the upside payoff, lower the downside The opportunity to get a 10 or payoff 100 multiple on your UU • Unlimited upside, downside capped at 100% 400% investment as often as you lose virtually all of it is tremendously attractive. 300% Positive payoff Uncertainty 200% ” Risk 100% Special skills Risk -50% Uncertainty Negative payoff UU -100% www.motilaloswal.com 15 th Annual Wealth Creation Study 14
Step 1: Know Success Principles “ SP #2: High level of complementary skills Alas, few of us possess the skills • Domain knowledge of specific businesses to be a real estate developer, venture capitalist or high tech • Past experience elsewhere (in other companies, pioneer. But how about becoming a star of ordinary in other industries, or in other geographies) stock investment? For such efforts an ideal complementary • Management assessment skill is unusual judgment. • Imagination and unusual judgement • Conviction and courage to commit the ” investment www.motilaloswal.com 15 th Annual Wealth Creation Study 15
Step 1: Know Success Principles “ SP #2: High level of complementary skills (continued) Alas, few of us possess the skills With complementary skills, the investor moves from to be a real estate developer, Quadrant C to Quadrant D, earning healthy returns venture capitalist or high tech pioneer. But how about becoming a star of ordinary stock investment? For such Easy for Others to Hard for Others to efforts an ideal complementary Estimate Estimate skill is unusual judgment. D. Benefit from the Easy for you A. Tough markets; UU situation using to estimate no excess returns special skills ” B. Avoid action; Hard for you C. Potential UU possibility of to estimate situation significant loss www.motilaloswal.com 15 th Annual Wealth Creation Study 16
Step 1: Know Success Principles SP #3: Portfolio approach to diversify risks Initial Portfolio 5 1 1 1 1 1 Stock A Stock B Stock C Stock D Stock E Portfolio Year 0 Healthy final portfolio 12.5 despite low stock Portfolio up 2.5x success ratio 10 5 1 0.75 0.50 0.25 Portfolio Stock A Stock B Stock C Stock D Stock E Portfolio Year 0 Year n www.motilaloswal.com 15 th Annual Wealth Creation Study 17
Step 1: Know Success Principles “ SP #4: Non-aversion to hindsight criticism • Non-aversion to hindsight criticism is the core behavioral principle. If none of your investments looks foolish after the fact, you • UU portfolio may offer healthy returns, but several are staying too far away from individual ideas would perform very poorly. the unknowable. • This creates room for hindsight criticism of these investment decisions. ” SP #5: Long-term outlook and patience • To allow for the UU situation to play out into KK and for the positive upside to pay off With time and patience, the mulberry becomes silk. — Chinese proverb www.motilaloswal.com 15 th Annual Wealth Creation Study 18
Step 2: Look for UU situations • “ Where the future is discontinuous from the past • In 3 areas: (1) Business (2) Management (3) Valuation Unknowable situations are 1. Business UU situations widespread and inevitable Low history of industry and/or company Huge size of opportunity with scalability Technology intensity of business ” Change (or scope for change) in regulation Value migration Demand J-curve inflexion point Change in competitive landscape Turnaround Discontinuous corporate action Discontinuous change in operating metrics www.motilaloswal.com 15 th Annual Wealth Creation Study 19
Step 2: Look for UU situations “ 2. Management UU situations Management with no track record Change in management Integrity issues with management If the events are unpleasant, it is not clear when to celebrate their end. 3. Valuation UU situations Extreme pessimism and optimism in the markets ” creates UU situations e.g. Infosys valuation at the height of dotcom boom Indian stock valuations at the height of global crisis in early 2009. www.motilaloswal.com 15 th Annual Wealth Creation Study 20
Step 3: Be aware of pitfalls 1. Overconfidence “If you lack Buffett capabilities, you will get chewed up as a bold stock picker.” 2. Hindsight criticism “One might be blamed for a poor outcome if one invests in ignorance when, in fact, it was a good decision that got a bad outcome.” www.motilaloswal.com 15 th Annual Wealth Creation Study 21
UU Investing case study NTD to TTS Indian Banking Sector: Stocks for 2020 • UU situation: Which bank(s) will deliver superior stock returns through 2020 • Complementary skills: Clear NTD framework www.motilaloswal.com 15 th Annual Wealth Creation Study 22
NTD to TTS • Size of opportunity: TTS by 2020 - Ten Trillion Saving (in dollars, decadal cumulative), 5x last decade Huge opportunity for financial intermediation www.motilaloswal.com 15 th Annual Wealth Creation Study 23
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