The Wisdom of Finance- Mihir Desai in Conversation with Paul Smith, CFA

Speaker: Mihir Desai, Mizuho Financial Group Professor of Finance, Harvard Business School; Professor of Law, Harvard Law School

Paul Smith, CFA, President and CEO, CFA Institute

Written by: Vivek Rathi, CFA

Prof. Desai tried to explain how finance is related to Humanity. His book “The Wisdom of Finance: Discovering Humanity in the World of Risk and Return” tries to connect two worlds which one thinks are not connected. He started by a quote from Wallace Stern “Money is kind of Poetry”  and followed it with a number of Pictures from history, each trying to communicate something important in contemporary world.

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Few key takeaways from his session:

  • Stories should be used to understand Finance
  • The world is random and not structured, there is randomness everywhere. Good part is, this randomness can be managed
  • Investors/managers generally face Principal-Agent problem
  • It is really hard to become principle
  • We do not punish people who fail
  • The gap between Finance and Humans is a real loss
  • Optimistic about India but expectations have to be rational
  • Indian companies should focus on Corporate Governance
  • Indian companies spend too much time on analyzing Policy makers/actions, instead corporates should focus on Innovation
  • VR

 

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Decision Making Under Uncertainty- Less Is More

Speaker: Gerd Gigerenzer, Director, Harding Center for Risk Literacy, Max Planck Institute for Human Development

Moderator: Madhu Veeraraghavan, Director and T.A. Pai Chair Professor of Finance, T.A. Pai Management Institute (TAPMI)

Written by: Chetan Shah, CFA, Director and Secretary, CFA Society India (IAIP), and Partner, 3 Jewels Investing

Most of the activities or events in the real world do not need complex formulae or algorithms to deal with them successfully. Take the example of Fly ball or cricket ball. In order to catch the ball, one can build in complex equations taking into consideration the angle of trajectory from the ground, force it has been hit with the bat, acceleration and later deceleration, and finally the spot where it will land. If the player were to do all those calculations in fraction of seconds will he be successful? Nope. Instead he is trained to run behind the ball keeping the angle of gaze constant, until the ball lands up in his hands.

Take another example of using simple heuristics. Chesley Burnet Sullenberger III (Sully) is a well known airline captain who landed US Airways Flight 1549 on the Hudson River off Manhattan after both the engines shut off as the plane was being hit by a flock of Canadian Geese shortly after take-off. All the 155 passengers on board survived. After the trials, the National Transportation Safety Board ruled that Sully made a correct decision in landing the plane on the river instead of attempting to return back to LaGuardia airport. Simulations performed at the Airbus Training Center Europe in Toulouse showed that the flight could have made it back to the airport had that maneuver begun immediately after the bird strike. However, such scenarios both neglected the time necessary for the pilots to understand and assess the situation, and risked the possibility of a crash within a densely populated area.

 

In both the above examples the intuitions of experts and the simple rules they followed helped them take faster and better decision. Such simple rules or heuristics are often been overlooked by the people. There are three widespread misconceptions about them viz. heuristics are always second-best to optimization based decision models, heuristics are unconscious and error prone, and complex problems require complex solutions. That happens because of failure to distinguish between “risk” and “uncertainty” and responses to deal with them. Professor Gerd Gigerenzer provided valuable insights in this area in a simple and humorous way.

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The four key messages from Gerd were (1) “risk” is not “uncertainty”. This distinction is still not very well understood & appreciated by many academicians. When we talk about risks, perfect knowledge of the future states of the world, their consequences and probabilities are available. Whereas under uncertainty all the future states, consequences and probabilities cannot be foreseen. Hence the best decision under “risk” may not be the best decision under “uncertainty”. (2) For taking rational decision making under uncertainty, simple heuristics are helpful as they reduce error compared to complex models which over-fit the past data. To illustrate the same consider the last year’s data on London’s daily temperatures or levels of any financial market index. Professor showed curves fitting the past data drawn with polynomial equations having degrees ranging from 1 to 12 degrees. Which one of these fits this data better? Naturally, the one with more degrees. However, when it came to predicting future temperatures or levels that was not true. The one with 3 (and up to 7) degrees predicted better than the higher degree polynomials. Likewise the one with only one degree showed higher variance. Hence the phrase from Einstein “make it simple but not too simple”. One degree has high bias + moderate variance. Third degree polynomial too has high bias but low variance. Higher degree polynomials like 12 degrees lead to low bias but very high variance in predictions. So in the field of predictions under uncertainty, you need to scale things down. (3) Are Finance Theories useful? We need new financial models, which are simple and have better predictability. Optimization models used to manage risk only create illusions of safety. (4) Lastly, less is more. Simple heuristics decision model can be more effective than complex optimization models. For example, the Fast & Frugal Tree for assessing bank vulnerability and comprising of only few key variables like (a) leverage ratio (<4.1%?), (b) market-based capital ratio (<16.8%),  (c) Loan to deposit ratio (> 1.4%) is more likely to succeed. This is because (i) they are simple to explain to key stakeholders like management and investors and easier to monitor, (ii) the correct combination of indicators can be less prone to gaming by the industry and (iii) banks can be spared with all complex stress tests. Hence simple effective rules are better.

  • CGS

 

 

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India’s Economic Ambitions: Can the Financial Sector Deliver?

Speaker: Ratna Sahay– Deputy Director, Monetary and Capital Markets Department, International Monetary Fund

Moderator: Ajit Ranade, Group Executive President and Chief Economist, Aditya Birla Group

Written by: Ishwar Chidambaram, CFA, FRM, CAIA

Ratna Sahay- Deputy Director, Monetary and Capital Markets Department, International Monetary Fund- gave an engaging presentation on the role of the Financial Sector in realizing India’s economic ambitions. She began by informing that every 5 years the IMF reviews the financial sectors of all the major nations globally. India is consistently at the top, as compared to the likes of Brazil, Russia, China, etc. with respect to GDP growth rate. This growth has been inclusive and there has been an overall decline in poverty. Comparing 2010-13 with 2014-17, India’s deficit has actually fallen. Moreover India has adopted a flexible inflation targeting approach, which has looked at different measures of inflation. On the flip side, India is one of the few nations where the State dominates the banking sector. This is bad, as it is desirable to have competition in this sector. India also suffers from having a lower number of transactions in banking sector, as compared to the US. Further, the spread between the lending and deposit rates in India is very high, which indicates lower efficiency in the financial sector.

The speaker then provided a number of measures of financial debt for India. She said that in most of these, India is comparable with the US, except for the Pension markets- where India is very small by comparison. Also domestic credit to private sector (as percentage of GDP) is less in India compared with Developed Markets (DMs). This could be because the Public Sector Banks (PSBs) are in deleveraging phase. She then proceeded to ask the important question of whether there is a limit to finance that is best for a country. She informed that the IMF has answered this by constructing a financial development index comprising 128 nations. They used regression analysis to see whether there is an inflection point. The results show that beyond a certain point, growth in financial sector can be detrimental. Many DMs have too much finance, while Emerging Markets (EMs) have scope for growth. She added that there exists a trade off between financial sector development and financial stability. One third of the IMF’s regulatory principles are very essential for financial stability. There is no trade off for regulation and supervision.

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Growth must be inclusive to sustain. If the gap between rich and poor widens then good policies start getting reversed. In India’s case, the implementation and growth of Aadhaar has brought a greater share of the population into the financial system. Subsidies can now be brought into beneficiaries’ accounts directly without any middlemen. There is also a gender gap in access to financial services, with men having more access to finance than women. In India this gender gap has narrowed considerably from 2011 till today. There is generally no trade off between financial inclusion and financial stability, as it is always better to bring maximum people into the financial sector for transactions, subsidies, etc. However, the exception to this rule is that if credit is extended beyond a certain limit, then it will hurt financial stability. If there exists high quality of regulation and supervision, then credit can be extended without any threat of financial crisis. In case of poor regulation and supervision, there can be a deterioration in banks’ credit quality with rising levels of credit. In India, PSBs are doing poorly, hence they are unable to extend credit to the economy. PSBs poor performance is reflected in their dismal ROAs, CARs and NPLs. The Non-Banking Finance (NBF) sector is actually doing better than PSBs, at least from the CAR perspective. The problem facing NBFCs is that of maturity mismatches. There have been a number of excellent reforms like IBC, PCA, Recapitalization of PSBs, etc.

For next steps, the IMF feels that RBI should get full regulatory and supervisory powers over the PSBs. IBC should provide for out of court, flexible ways to do restructuring. PSBs need to be restructured or privatized. Weak banks need to be shut down. Authorities should improve their crisis preparedness.

  • IC

 

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Incorporating Geopolitical Analysis into your Investment Process

Speaker: Matt Gertken, Vice President, Geopolitical Strategy, BCA Research Inc.

Moderator: Ananth Narayan, Associate Professor, Finance, S.P. Jain Institute of Management and Research

Written by: Vivek Rathi, CFA

Matt Gertken spoke in details about geopolitical situation globally. He delved in to history, explaining how move to the right in 1990’s created inequality and the resultant backlash in UK & USA. Then, he went to explain the poll arithmetic and how pundits generally get it wrong but the polls aren’t that bad.

He also explained, why politicians react the way they do, as they are driven by constraints and not by preferences.  According to him, a recession makes it significantly challenging for an incumbent president to win back the mandate. In fact, structural reform may lead to set back for ruling dispensation but will be beneficial for the economy in long run.

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On the future outlook, the key take away were: Fed is expected to hike interest rates, there will be patches of corrections stock Market, don’t expect trade wars to be resolved any time soon, Oil prices will rise and China may try to stimulate economy without success, developing markets will continue to perform better & due to rising trade dispute, consumer oriented economy like India are expected to outperform. Also, India is slowly de-leveraging which is a positive sign. The cleaning up of banks, formalization of taxation and markets is credit positive for India.

On the US China trade war, though, the recent correction in US markets would have prompted Trump to soften position on trade dispute but the US is more insular economy, thus less depended on trade. In contrast, China is slowly becoming insular but is still vulnerable.

  • VR

 

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Session by Mr. Thomas Russo- 2nd Value Investing Pioneers Summit ,Delhi 2018

Contributed By : Ashwini Damani, CFA

Lessons from Global Value Equity Investing

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At the second Value Investing Pioneers Summit, Mr Thomas (Tom) Russo gave a talk on ‘Lessons from Global Value Equity Investing’. Given below is a summary of the talk.

  • Tom Russo believes one can earn added alpha by deferring taxation, as any taxes not paid and deferred compound and add to overall returns. For deferring taxation, we need to invest in Long Term Ideas where we can minimize churn and hold for substantial period of time.
  • Tom Russo is a big advocate of Investing in Multi National Corporation (MNCs) as because of their global nature, these companies have more opportunities to reinvest their free cash flows . He himself holds a lot of MNC’s in his portfolio. This reduces the need to churn the portfolio and look for new opportunities as he can keep holding on to the same businesses as they grow by investing their cash flows in markets which offer growth opportunities.
  • The following factors as per him, make Global MNC’s very good investment candidates :
  1. Capacity to reinvest free cash flows in various opportunities and countries. Very rare companies exist that can reinvest right amount of cash flows.
  2. Global Population Growth allows them natural growth
  3. Consumer Disposable Income growth also provides better ability to capture wallet share
  4. Globally Adept Management, which are multilingual and multicultural: He mentioned that just like an Indian does not know names of any good Baseball Player, similarly Americans don’t know names of any Cricket Player. Very few people in the world speak more than 3 languages and yet there are some remarkable MNC’s that transcend borders and cultures and are able to operate in many countries.
  5. There are rare companies that reinvest the ‘right’ amount. Most managements usually underinvest as they are worried about the impact on their earnings in short term and the resultant effect on stock prices and the value of their stock options.
  • Capacity to SufferHe further emphasized that he prefers to invest in Family Controlled companies. Family Controlled companies can say no to what wall street demands of them. They can thrash short term in pursuit of long term, give a long rope and lend support to management for the long term, thereby aligning interests and minimizing agency costs. Family controlled businesses normally have better vision.
  1. For eg Berkshire Hathaway can afford to suffer by not succumbing to near term returns. Warren Buffett holds large cash reserves for long times and prefers to wait for big opportunities. This allow him to use these reserves to buy businesses at throwaway prices, because he is the only person available with cash
  2. Nestle has a 35 year Planning Horizon
  3. Sab Miller and Heineken prefer to wait for right time to invest. They don’t fear public backlash and don’t fear PL hit for short time
  • Tom Russo looks for investment in business which have a lot of “White Space” – businesses which have a large underserved market which gives them repeated opportunities to reinvest large amounts of capital, such as :
  • Global Payment Space 
  1. Global Commerce continues to grow
  2. 85% Global Commerce is still in Cash
  3. He prefers MasterCard as a very good vehicle to play this space
  • Luxury Branded Jewellery
  • Global Jewellery Category has been growing consistently
  • Within that, the luxury branded jewellery is gaining even more market share
  • A very good alternate is to play this theme through Swatch and BRK
  • Premium Spirits
  1. 1.5 Billion Cases of Spirits consumed per year in China
  2. The entire Western Premium Spirits market is just 4 million
  3. So there is a huge runway and market opportunity available
  4. He holds 10% of his portfolio in Pernod Ricard, Diageo and Brown Forman
  • Sub Saharan African Beer
  1. 400 million barrels of Beer is consumed per year in Sub Saharan Region
  2. Whereas rest of the market sells only 100 million barrels of bottled, branded and refrigerated beer.
  3. Best way to play this theme is to invest through Heineken, Anheuser-Busch Inbev
  4. These businesses have a huge growth opportunity as there is a large unserved market.
  5. They also have pricing power and demand in-elasticity as consumers of a beer brand like Heineken are usually loyal to it and do not like to change
  • Global Whiskey Market
  1. Global Spirits demand is showing healthy growth worldwide
  2. The premium category continues to outgrow main spirits market
  3. This offers price growth and price inelastic growth.

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  • Tom also gave examples of companies who lacked the “capacity to suffer” or took short term decisions to please wall street and destroyed shareholder value.
  • At the end, Tom talked about how as a portfolio manager or investor who is looking to outperform over long term, should also have the capacity to suffer in the short term for long term benefit of the portfolio and investors. As an example, he explained how the portfolio of his partnership – Semper Vic Partners – depreciated by 2% in year 1999, when the DJIA was up by 27% due to the rally in tech stocks.  Due to the capacity to suffer that one bad year, the portfolio outperformed substantially for next five years.
  • The learnings from Tom Russo’s session can be summarised in this quote from noted poet Khalil Gibran –
    “Out of suffering have emerged the strongest souls; the most massive characters are seared with scars”
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Session by Mr. Samir Arora- 2nd Value Investing Pioneers Summit ,Delhi 2018

Contributed By : Jatin Khemani, CFA

What they don’t teach you anywhere?

At 2nd Value Investing Pioneers Summit, Mr. Samir Arora, Founder of Helios Capital Management Pte Ltd. gave a talk on “What they don’t teach you anywhere?”

The underlying theme or message of his talk was that – there are no rules and everything must be doubted and challenged.

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Samir went on to dispel some of the common beliefs/assertions that most value investors have. He said that as there are no rules, these should also be challenged.

  • We (should) buy stocks where we have high conviction.
    • Conviction on rejected stocks is more as we know with more clarity what is bad than what is good.
    • What we buy, we track/watch closely. if the conviction was high, one would tend not to do that.
    • Research focus should be on eliminating bad, not in choosing what is good.
  • Our favorite holding period (should be) is forever
    • Most investors take this statement of Warren Buffett as gospel truth without fully understanding what he actually said.
    • “When we own a portfolio of outstanding business with outstanding managements, our favorite holding period is forever.” – is what Buffett said in Berkshire letter to shareholders 1988. The conditions of ‘outstanding business’ and ‘outstanding managements’ have to be met for stocks to qualify as ‘forever’ bets.
    • While Buffett’s favorite holding period is forever, it is not the only option but favorite amongst many.
  • We (should) own stocks for the long term.
    • Our biggest advantage as an investor is we can walk away anytime unlike a promoter, so why should we hold stocks for long term? As an investor, we need to revisit our thesis on a regular basis and hold only if company continues to deliver. Example: We are holding HDFC bank for more than 20 years but yet don’t call it long term stock because the day anything goes wrong we can move out.
  • An investor should act as though he had a lifetime decision card with just twenty punches on it.

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  • Warren Buffet: 1980-2006
      • 2,140 quarter-stock observations from publicly available information
      • 30% of stocks sold within six months
      • Median Holding period: One year
      • Approximately 20% of stocks held for more than two years.
  • Buy companies with good management
    • When will you know the management is good?
    • How will you separate the Halo effect?

      “Show me a company that delivers high performance and I can always find something positive to say about the person in charge.”
    • You will know good management only if stock price increases. Perception of management changes based on the stock performance. Before stock price increase ; nobody knows is it a good management or not.

Example: Samir gave a great example of Cisco. In May 2000, Fortune magazine ran a story on Cisco in which John Chambers was portrayed as the world’s best CEO (after the stock’s superlative performance of more than 50x over the last 6 years). Exactly a year later, after the stock had crashed by more than 80%, the same Fortune magazine ran a story titled “Cisco fractures its Own Fairy Tale”

  • Diversification is a protection against ignorance, it makes little sense for those who know what they are doing.
    • We don’t know we are ignorant till something unexpected happens
    • If concentrated funds do better, what if you buy 3 such funds? Do you still do better? Overall we own 40-50 stocks of three concentrated funds but our portfolio is diversified.
    • Your stocks in a diversified portfolio are always part of some guy’s concentrated portfolio
  • Before investing in an idea based on some facts and analysis, ask “who doesn’t know that”?
    • While investors know a lot of information, not everybody acts in the same way.
    • It is possible to have an insight basis well known facts and act on it even though the same information may be available to everyone else
    • Example: In case of HDFC Bank everyone knows everything about the company. As an investor we need to focus on big picture & size of opportunity as tiny incremental information may not add any value.
  • To make money in a company, you must know it better than anyone else
    • If that is the case then only a single person can make money in any stock.
    • It is not necessary to know more than everyone else. What is important is how we act and behave basis whatever information we have.
  • Good people should not buy sin business
  • If good people would not buy, then bad people will buy and make money to become stronger (pun intended).

So what should they teach you?

  • Keep it simple
  • Believe in equity investing (50% job is done)
    • Book Suggestions:
      • Triumph of the Optimists – by Elroy Dimson/Paul Marsh/Mike Staunton
      • Wealth, War and Wisdom – by Barton Biggs
    • These books show that over long period equity beat all the asset classes.
  • Have a diversified portfolio. Reject Concentration.
  • Try to get more knowledge, not more information.
  • Money Saved is better than money earned. How one performs during negative months matter a lot to the performance. Example: Nestle, HUL etc.
  • Bottom-up strategy works best in sectors/themes with strong tailwinds.
  • Look first for reasons to reject, not for the reasons to buy. Rejection has far more conviction than buying.
  • Investing isn’t complicated – buy businesses quoting less than they are worth. How do you know the worth? Well, that’s really complicated..!

Link to complete presentation by Samir Arora

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Market Cycles & Investment Lessons from History

SD

Contributor: Sumit Duseja,CFA (Co-Founder of Truemind Capital Services)

What we have learned from history is that people don’t learn from history. And that is the reason why a majority of investors do not earn good returns from their investments over the long term. Those who make superb returns on their investments are good students of market history and have learned the lessons quite well and stick to it.

There is no denying that equity markets go through a cycle. Broadly we can call it a cycle of Greed & Fear. These cycles have happened many times in the past and will continue to happen in the future.

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Stock markets are a reflection of collective human emotions. Like we experience phases of joy and sorrow in our lives, similarly, equity markets also experience emotional upheavals due to collective actions based on perceptions of human beings.

Do note that the euphoric scenario in the cycle of Greed & Fear comes with the point of maximum financial risk. On the contrary, despondency in the cycle presents the point of maximum financial opportunity. To depict the same in terms of returns, let’s see the tables below:

In a course towards market peaks in the last 20 years, following are the Sensex returns whenever it has crossed 25x PE multiple.

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Sensex crossed 25x PE three times in the last 20 years and the average CAGR over the next 5 years period is paltry 2.54%.

 On the contrary whenever Sensex PE fell below 14x multiple, the point to point returns in subsequent years have been terrific.

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Equity markets generally go through intermittent (small) corrections and big secular corrections. The intermittent corrections are up to 20% which occurs while the markets go through a longer trajectory from trough to peak. From the peak a major secular correction of 50-60% occurs once in a decade. These corrections happened multiple times in the past and will continue to happen in future. The timing and the extent of such corrections is difficult to ascertain but there are telltale signs during the extremes of the market.

We usually observe the following behavior during market peaks:

  1. Retail participation is huge. People with very less knowledge about stocks and most risk-averse FD investors start putting money in equity markets.
  2. Newspaper headlines scream with euphoria about new peaks achieved by markets
  3. There is utter rejection/ridicule of thought or statement that markets can decline by more than 20%
  4. Majority of the stocks start trading at the valuations much above their historical averages

 However, those consumed by greed always have reasons to ignore on the premise that “this time it’s different”. Unfortunately, these words prove to be the most dangerous words in investments every time.

During market bottoms most common behavior to witness:

  1. Retail participation dips significantly. Rather, they start taking out money fearing a further fall.
  2. Newspaper headlines sounds of gloom and doom scenario
  3. There is a loss of hope and complete rejection of the idea that situation can improve from here and markets can bounce back with handsome returns in the medium to long-term
  4. Majority of the stocks start trading at the valuations much below their historical averages

Again, the investors consumed by fear believe that the world is going to end and this time it’s different than the previous bottoms.

In hindsight, everyone saw the financial crisis coming in 2007. In reality, it was only a fringe view. The next correction will be the same (they all work like that). However, the reasons are different every time.

“Stock markets cycles don’t repeat but they rhyme”

Our memories of financial history seem to extend about a decade back. It also erases many important lessons. Here are some lessons that we learn from market history which helps us prevent major losses and maintain sanity at market extremes to use it to our advantage:

  • Do not get mislead by the term – this time it’s different. Never forget that “mean reversion” happens over medium to long term.
  • Do not buy something which is priced much higher than it’s worth. Finding true worth of any business/asset class is not an easy exercise. You can invest in the best business and still lose your money.. Price you pay versus the value you get makes a lot of difference in investment returns.
  • Markets can continue to remain irrational (expensive or cheap) for a very long time. Be patient. Expensive doesn’t mean that market will fall tomorrow and cheap doesn’t mean that market will start moving up tomorrow.
  • Never predict or try to time the market on day to day basis. But this doesn’t mean that you buy at any price. The price, compared to the intrinsic value, at which one buys, determines the potential risk and returns.
  • Caution yourself against the herd mentality. Investing in popular themes/assets etc. won’t generate good long-term returns. Do not get mislead by past returns.
  • Selling is important too. Market peaks provide a good opportunity to reduce allocation to ridiculously expensive assets. If you avoid loses during a market downfall, you can make significant returns in a market upswing, provided you have courage to buy when everyone else has given up hope.

Based on the lessons learned, one should develop an investment philosophy which guides you during different market scenarios. If you do not have an investment philosophy in place, you end up buying at the top and selling at the bottom like all other people.

The most significant tenet of investment philosophy followed by many successful investors is “margin of safety”. Many wised-up investors understand that they cannot predict the future. So, the best one can do is to invest at prices lower than what something is conservatively worth, thus providing a margin of safety. Lower the price from the worth of an asset, higher is the margin of safety (lower downside) and greater are the potential future returns.

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