Latticework of Mental Models:

1. Contrast-Mis reaction Tendency (CMT) – Main point

One of the problems in society is that the most important issues are often
these incremental type things…But, if you keep doing it over time, the
incremental problems are hard to attack because that one extra piece of
pie doesn’t really seem to make a difference…but the cumulative effects of
them will make a huge difference over time, just like overeating will make a
huge difference over time. The time to attack those problems is early.
2. Kantian Fairness Tendency – Main point
It is not always recognized that, to function best, morality should
sometimes appear unfair, like most worldly outcomes. The craving for
perfect fairness causes a lot of terrible problems in system function. Some
systems should be made deliberately unfair to individuals because they’ll
be fairer on average for all of us. I frequently cite the example of having
your career over, in the Navy, if your ship goes aground, even if it wasn’t
your fault. I say the lack of justice for the one guy that wasn’t at fault is
way more than made up by a greater justice for everybody when every
captain of a ship always sweats blood to make sure the ship doesn’t go
aground. Tolerating a little unfairness to some to get a greater fairness for
all is a model I recommend to all of you. But again, I wouldn’t put it in your
assigned college work if you want to be graded well, particularly in a
modern law school wherein there is usually an over-love of fairness-seeking
process.
3. Social proof – main point

“Here is a wisdom here that goes far beyond the narrow world of investing. What
I’m about to tell you may be the single most important secret I have discovered in
all my decades of studying and stumbling…What I stumbled upon was this.
Desperate to figure out how to lead a life that was more like his [Warren Buffett], I
began constantly to ask myself one simple question: “What would Warren Buffett
do if he were in my shoes? The minute I started mirroring Buffett, my life changed.
It was as if I had tuned in to a different frequency.”

Whenever you find yourself on the side of the majority, it is time to pause and
reflect
You’re neither right nor wrong because the crowd disagrees with you. You are
right because your data and reasoning are right.

4. Anchoring – Catching the right Anchor to Avoid Sinking

Anchoring is the psychologist’s term for one shortcut the brain uses. The brain
approaches complex problems by selecting an initial reference point (the anchor)
and making small changes as additional information is received and processed.
Look for the stock price in totality and not on isolation bases just on price.

5. Alternative Histories –
The silent events i.e., the events which could have happened but didn’t.
Another unintended outcome of alternative history blindness is that we grow
confident about our understanding of the game. We rationalize the causal link
between the event and the associated outcome (also known as Narrative
Fallacy or Hindsight Bias). Our thinking becomes outcome-centric
Process are more important than outcome and good process will mostly produce
great results.
 6. Inversion –
Always invert - invert Always to find the problem of Tough
problem
Reversing how you look at a situation can open up new possibilities and
dislodge assumptions. Example: When everyone else is gazing at a glorious
sunset, why not turn around to see the blues and violets behind you? What do
you notice when you look at a coffee cup? Its design or color? Reverse your
focus and look at the space inside – that’s what gives it its functional value.
Reading a text backwards reveals glaring errors which aren’t normally caught
while you’re reading forward – inverse
Inverting the problem not just helps you in solving the problem, but it will also
help you in avoiding trouble. In every business deal or transaction, identify the
worst thing that can possibly go wrong, and then make sure it doesn’t happen.
Instead of doing the post- mortem do the pre- mortem and comes with all the
options for the project to fail and then think about all possible option.
Inversion on using Investing - The idea is that instead of asking what’s the
present value of future cash flows, ask what growth rate market is assuming to
justify the present value of future cash flows.

1. How to earn great returns, and more on how to avoid permanent capital loss;
2. How to pick the great stocks, and more on how to avoid the dangerous ones;
3. Things to do for investing success, and more on things to avoid for investing
failure.

Backward Thinking make us more objective and in business and life inversion
will help solve problem that you cannot handle otherwise.

7. Association (Wit and Wisdom) of love and Hate Main points

Liking tendency acts as a conditioning device that makes the liker or lover tend:

1. To ignore the faults of, and comply with the wishes of, the object of his
affection;
2. To favor people, products, and actions merely associated with the object of
his affection (Influence from Mere Association Tendency); and
3. To distort other facts to facilitate love.

Disliking/hating tendency also acts as a conditioning device that makes the

dislike/hater tend to:

1. Ignore virtues in the objects of dislike,

 2. Dislike people, products and actions merely associated with the objects of his
dislike, and
3. Distort other facts to facilitate hatred

8. Slow Contrast Effects – Main points

When things change gradually, you don’t notice the changes.

Example – frog kept in room Temperature and slowly boil will not be able to
understand and it will die.

9. Authority – As people follow top down so the ethical management

usually leads to simpler culture for the entire organization and same is true
for the unethical management.

When confronted with a situation where you find yourself agreeing with the
expert pause and question it.

Ask yourself two important questions…

1. Is this authority truly an expert? This question helps to enquire the credibility
of the expert.
2. How truthful can we expect this expert to be? This question should help us
understand his incentives, interests before we give any credence to his words

And once you are convinced then only you take the word of the person.

10. Availability -

Frequency illusion – something become more frequent in your

observation once your mind notes it.
The human understanding when it has once adopted an opinion (either as
being the received opinion or as being agreeable to itself) draws all things
else to support and agree with it

3 Reasons we fall for Availability basis.

1. Recent Activity - Something which is more recent occupies more

recalling power in the brain compared to something that happened
long ago and hence we tend to weigh that activity as more important
than others.
 2. Personal Experience - Something which has happened to us is easy
to recall compared to something which has not. Since your all senses
are involved in personal experiences, the impression in the memory
is significant and hence it’s easily recallable.
3. Vividness - The more vivid the thing, the easier it is to recall for
the brain

Look for recent quarters and earning but need to study 10 Years of the
business history as structural changes are very Subtle. But the idea is to
look the picture from both far off (10 years) and close (recent quarters) without
over-emphasizing any view.

An idea or a fact is not worth more merely because it’s available to you.

Learning from Darwin - I had, also, during many years followed a golden rule,
namely, that whenever a published fact, a new observation or thought came
across me, which was opposed to my general results, to make a memorandum of
it without fail and at once; for I had found by experience that such facts and
thoughts were far more apt to escape from the memory than favourable ones.

Seek out things which disprove us.

Nothing is more dangerous than an idea, when it’s the only one you have.

FIVE SIMPLE IDEAS FOR VALUE INVESTMENT:

1. Size of opportunity is mother idea- It is more about the size of a pond rather
than the size of a fish. Pond must be large so that there is headroom for a capable fish
to grow.
2. Management Quality is far more tangible than is believed -Capital
allocation and capital distribution skills are the hallmarks of a good management.
Integrity, vision and execution are the defining attributes of a quality management. It
is only when a large size of opportunity meets with quality management, that the
outcome is gratifying.
3. Earning growth - What's more important for the growth is to be long-term,
relatively predictable and consistent. Such growth creates compounding machines.
4. Quality growth -Quality comes from the ability of the underlying business to create
rising economic value. That can happen only when business generates not only
superior but also durable, predictable and consistent ROCE. Quality of business is at
a heart of good stock picking for outstanding long-term value creation.
5. Economic value - An investor can generate investment returns, even superior to the
underlying economic returns if he can buy such a business at a Margin of Safety (or,
Price-Value Gap) to its intrinsic worth.
“The Joy of life consists in the exercise of one’s energies, continual growth,
Constant change, the enjoyment of every new Experience. To Stop means
Simply to die. The eternal mistake of mankind is to set up an attainable ideal.

Financial peace isn’t the acquisition of stuff. it’s learning to live on less than
you make, so you can give money back and have money to invest. You can’t
win until you do this.

Investing calls for wisdom apart from knowledge it calls for discipline and
merely high IQ is no guarantee for great investment result.

Good investment is a heady mix of both a lovely beauteous art and a very
precise looking Science. The art part is about understanding the quality and
character of the business, of the people behind the business, appreciating
what makes the business work and what make it fail, what makes it robust
and what makes it brittle. The art part also covers the wisdom, discipline,
patience and independent mind aspects of investing.

The three simple things to learn – Simplicity, patience and Compassion. These
three are your greatest treasure. In good investing read it as Simplicity (of
business), patience (of investor) and passion (for Quality).

The idea of certainty of growth vis-à-vis quantum of growth, quantum of

growth vis-à-vis quality of growth and quality of growth vis-à-vis valuation
are the ideas which define the quality of return or the idea of risk.

To create greater wealth out of wealth is really the crux of investing. “it is
not how much money you make, but how much money you keep, how hard it
works for you, and how many generations you keep it for”.

“The mind once expanded to the dimension of large ideas never returns to its
original Size”.

Size of opportunity is a very fundamental points, it is about the notion of

whether a business can grow at a meaningfully high rate for a meaningfully
long duration.it is one of the most important factors for predicting the
Sustained long-term wealth creation and outstanding compounding.

How large a particular firm may become within a sector with strong
potential will of Couse be a function of capabilities and character of the
management of the firm.
 The Size of opportunity can be understood with the frame work of size of fish
and size of a pond.one can visualize for 4 possible combination.

 Large fish in a large pond.

 Small fish wallowing in a small pond
 Large fish Struggling in a shallow pond
 Small fish growing in a large pond.

The first choice is clearly the most desirable investment opportunity, not only
fish is already fat and has acquired Strength and Stature, but it also swims in
large pond which means it has potential to get even bigger over time.

Option no 2 and 3 are worst long-term investment decision.

Last option – small fish in a large pond would imply that headroom for growth is
favourable if the pond condition are right.

There are no great limit to growth because there are no limits of human
intelligence, imagination and wonder.

A man begins cutting his wisdom teeth the first time he bites off more than he
can chew.

Acquisitive growth vis-à-vis organic growth- market does not reward acquisition
growth in the same way as organic growth.it is also seen that Conglomerates
don’t enjoy Superiority in the eyes of the market but actually suffer a discount.

Bank and Finance Business represent a unique opportunity in Several Respect.

1. They are inherently a compounding machine, especially in a continued

phase of high growth of the economy they represent a proxy on the
growth of the economy.
2. These businesses tend to be a lead indicator of the growth rather than a
lag, these precede the GDP growth.
3. It tends to be force multiplier compare to the GDP growth i.e. the growth
of the Sector tends to be a multiple on the growth of the GDP.
 Three Type of Business Manager

PERFECT IMPERFECT JUNK

Passionate in running the
business, honest, great
capital allocators, treat all
Stakeholder well and love
their business more than
money.
Rare so own them when you
find them
Passionate in running the
business honest most of the
time and play a fair game,
but seldom (not often) play
near the baseline, may be
prone to capital allocation
mistake.
Empathize with them, and
own them but keep margin
of error
Love money more than
business, often dishonest,
aggressive capital allocator
and love leverage, focused
on growth even at the cost
of Safety.
Avoid at all cost Esp. when
they look darlings during
good times.

Quality of business in simple terms is its ability to generate superior, consistent,

predictable and durable ROCE. Source of moats can be protected intellectual
advantage, legally sanctioned monopoly, a valuable brand, an exclusive
technology, favourable customer goodwill, lasting cost advantage and the like.

Two vital tests for quality are capital intensity and capital Efficiency –

Capital intensity -whether the business fundamentally required high amount of capital.

Capital Efficiency – whatever be the amount of capital required in the business, whether it
generate a superior return or not.

Certain business by their very nature have a frontloaded and capital-intensive base like
Airlines, hotels, theatre Screens, retailing, metal, oil exploration etc.

A business which requires both high fixed capital as well as high circulation capital is
business with a rather unfavourable capital intensity profile, it is better to have capital
intensity due to working capital rather than due to fixed assets.

Persistent and Superior Capital Efficiency is the Single most important Evidence of Quality.

Profits are merely costs of staying in a business.

Value creation can occur only if there are economic profits. Earning growth is necessary but
not a sufficient condition for value creation.

Economic value Added (EVA) is the measurement of difference between ROCE and cost of
capital. Running a tight ship for both fixed assets and working capital in many ways
emanates from internal capability and strength of a management, profits have a relatively
greater externality while the balance sheet has a greater internality.
 If we are looking at sign for sustainability of ROCE, then the greater evidence has to
unearthed from the balance sheet and relative less reliance has to be placed on the profit
and loss account.

Key possibilities are

High ROCE with high High ROCE poor High ROCE with Inferior ROCE but ROCE is persistently
earning growth earnings growth Plunging earning high earning growth lower than the cost
of Capital
ROCE>20 % and ROCE>20, Growth < 5 ROCE 10-20%,
Earning growth>15% -15% Growth>15%
These are business High ROCE with sub- Can lead to value Such business may Then any growth will
with both strength par growth is at best destructions despite not destroy value but be destructive rather
and character leading a recipe for high ROCE may not lead to high than productive.
to high & sustained maintenance and value creation
value creation preservation of
capital

Gentry Aspirer Winner

High>20%

R Struggler treadmill
Moderate
(10-20) %

O
C
E

Value obliterator / Sweatshop

<10%
Low

Low < 5% Moderate (5 -15) % High >15%

Growth

Winners -Firms enjoying high ROCE and high growth should logically create highest value.
These companies generally enjoy superior compounding multiplier over time. The reason for
such high performance over a longer period of time includes-

1. A very favourable entry point

2. Large and growing size of opportunity
3. Greater clarity of earning growth
4. Higher predictability of earnings
5. Superior management quality
 6. Outstanding capital efficiency
7. No capital dilution for a prolonged period.

Aspires: companies which have a high ROCE and moderate earnings growth should logically
provide safety

Roots to preservation of wealth solely resides in Quality i.e. Quality of Business and Quality
of Management.

Preservation of value is one of the most important objectives of any serious investment or
inventors –

1. Preservation of capital (or avoiding permanent loss of capital), over a period of time
comes from and is aided by quality of the business, quality of the management and
the margin of safety.
2. To grow the capital overtime.

The superiority of a business is inferred from the superiority of the ROCE and the
superiority of a management from the Superiority of the ROE.

Wisdom, compassion and Courage are three universally recognized moral qualities of men.

Capital Allocation is the fundamental test for judging the calibre, temperament and character of the
management. The ability to allocate capital intelligently and wisely is a fundamental test of
discipline, character, temperament and stamina of a management.

A business which typically generate free cash can use it for 4 purpose.

1. Some amount of cash generated may be used for funding the growth (capex + working
capital) of the business.
2. To fund any possible acquisition
3. Some amount of cash may need to be put back into the balance sheet to build a cushion and
resilience against any shock or contingency.
4. Balance amount left is the amount which must be given away because it is a real surplus.

Excess cash on balance sheet indicates –

1. Misadventure into greener new pasture (diversification).

2. Loose operational management & slackened efficiency
3. Control freak operation of the management, in such case market tends to put lower value on
cash surplus that its really worth.

Conglomerate complexity leads to less value creation even with good business and good management- when a
firm has more than one business as a part of it, overall firm valuation tends to gravitate towards the lowest
business in term of the valuation. The market abhors the complexity and prefer simplicity. e.g. ITC, Wipro, L&T,
M&M and Aditya Birla nova.

When Excess cash is hoarded on balance sheet it has following bad Consequences –

1. Dilution of ROCE and ROE

 2. Slackening the tightness of the operation
3. Possible flirtation into inferior or new activities in which management may not have competence.

Capital Allocation has a deep impact on the investment returns. When misallocated, it could be a spoilsport
even for the best of the management and Business.

The capital misallocation may occur in many ways –

1. When ROCE get diluted in a material/permanent manner over a period of time, this can occur when a
business acquires, in a similar line but a business “too big to chew”.
2. Capital mis allocation can also occur when a Sizeable expansion of existing business fails to carefully
evaluate demand- supply dynamics.
3. It could also occur by venturing into an unrelated area in which the firm has little or no control.

Good Business typically seems to Attract Good management and vice versa, Good (or bad) Business and Good
(or bad) Management come as combo Deal But one and Get one Free.

Human Integrity is largely a personal Trait, when you expect it from others, it is a Self-delusional idea, Integrity
in essence is largely an individual or a personal trait, applied strictly to one’s own self.

Value of business ( Stock) is nothing but the present worth future value, the careful assessment of that
future, from the perspectives like size of opportunity, growth( of earning), quality of growth (ROCE & ROE)
and predictability/sustainability/longevity of growth, would provide useful conjectures of future cash flow
(both inflow and outflow) over the believed useful life of the business.

Greater is the quantum of earning growth, its quality, predictability, certainty and longevity, clearly greater is
the present worth or value.

When banks fail, people lose their savings. When they lose their savings, they stop spending.
When they stop spending, businesses fail. When businesses fail, banks fail. When banks fail people
lose their savings. And so, on endlessly.

“Being right is the enemy of staying right because it leads you to

forget the way the world works.”
The majority of your lifetime investment returns will be determined by decisions that take place
during a small minority of the time. Stability is destabilizing and a lack of recession plants the seeds
of the next recession. Money chases returns. Bubbles form when the momentum of short-term
returns attracts enough money that the makeup of investors shifts from mostly long term to mostly
short term. Bubbles do damage when long-term investors mistakenly take their cues from short-
term traders.