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The Alchemy of Finance at Reliable Engineers

Anyone interested in investing/business should check out our other blog MIN. We post most ‘finance stuff’ at that site but this post was just too good not to post here as well. The story of Reliable Engineers explains quite clearly how a combination of subtle psychological misjudgments (mental models) can lead to extraordinary outcomes.

…Raju Banker invited Raghav MBA to participate in an auction of a controlling block of a large, leveraged, and struggling retail company. The block was being auctioned by Raju Banker’s firm to raise money to partially pay the retail company’s lenders. Intrigued by the idea of attending an auction, Raghav MBA ignored the very brief and very wise warning about auctions given Mr. Warren Buffett many years ago. The advice was: “Don’t Go.”

Social psychology experiments show that bidders in auctions often get carried away and end up bidding far more than underlying value of the objects being auctioned. Such outcomes are almost always caused by a combination of multiple forces working in the same direction. In auctions, these include greed, bias from commitment (every bid is a public endorsement of the bidder’s belief that value exceeds his bid), social proof (when there are lots of bidders, bidding is more frenzied), envy, low contrast (every successive  bid is only a tiny increment over the previous one), and deprival super reaction (the tendency to over-react to losses and near misses).

Not realizing that he was walking into a trap, Raghav MBA soon found himself participating in a bidding frenzy giving in to all the psychological tendencies mentioned above. Moreover,  his girlfriend was sitting right beside him in the auction room holding one of his hand while he was bidding with the other one. And so he had to impress her didn’t he? He just had to come out of the auction as a “winner” didn’t he? And so he bid so high that, when the auctioneer’s hammer fell, he Raghav MBA found himself in possession of a business he knew nothing about, at a price, which he will soon learn a lot about.

But that was not a moment to regret. Raghav MBA was a winner today and his girlfriend was thrilled with him. Suddenly Raghav MBA felt even better about his acquisition than ever before. This, my dear readers, is what psychologists call as the “endowment effect,” under the influence of which a man’s decisions are regarded by him as better than was the case just before he made them.

Regardless of the real reasons explaining why Raghav MBA bought the retail company, there was the little matter of explaining it to the company’s stockholders. Social psychology, as opposed to academic finance theory shows that man is not a rational animal but a rationalizing one. He is capable of inventing reasons and justifications for what he has already done or decided to do. Sir Francis Bacon was right when he wrote:”What a man believes, he prefers to be true.”

Raghav MBA came up with a clever rationale for his having bought a retail company in an auction with the money he made Reliance Engineers borrow plus the entire treasury of the company built by his father over more than two decades. This is what, roughly speaking, he told the company’s stockholders: “The cash flows of Reliable Engineers have been volatile in the past because they are dependent on the fortunes of one industry. Henceforth the volatility in these cash flows will decrease because the co-relation between the cash flows of the cement industry and those of the retail business is low. This reduction in volatility in cash flows is good news for you because the earnings multiple will rise.”

That this rationale was deeply flawed was lost on Raghav MBA, and interestingly on the stockholders. It was flawed because Raghav MBA paid a control premium over the prevailing market price of the retail company to buy it. He justified this payment in the interest of diversification. However, the benefits of diversification could have been achieved by Reliable Engineers’ stockholders themselves within their own portfolios, without paying any control premium. This singular and fundamentally useful lesson from Modern Portfolio Theory that investors can achieve the benefits of diversification within their own portfolios instead of achieving it at the corporate level, however, was lost on almost everyone. Everyone, after all, loves a winner and today Raghav MBA was a winner. The stock price of Reliable Engineers soared even higher and Raghav MBA had now found Financial Alchemy # 6….

Read the rest. You can also find the presentation here.