Sunday, 15 October 2017

Bargains in Bonds and Preferred Stocks: How to profit from these bargains?


Bargains in Bonds and Preferred Stocks

The field of bargain issues extends to bonds and preferred stocks which sell at large discounts from the amount of their claim.

It is far from true that every low-priced senior issue is a bargain (there are default risks on non payment of interest and/or  principals).

The inexpert investor is well advised to eschew or stay away these completely, for they can easily burn his fingers.

There is an underlying tendency for market declines in this field to be overdone; consequently the group as a whole offers an especially rewarding invitation to careful and courageous analysis.

In the decade ending in 1948, the billion-dollar group of defaulted railroad bonds presented numerous and spectacular opportunities in this area.

Bargain-Issue Pattern in Secondary Companies (2): How to profit from these bargains?

Bargains in stocks of Secondary Companies

If secondary issues tend NORMALLY to be undervalued, what reason has the investor to hope that he can profit by such a situation?

For if this undervaluation persists indefinitely, will he not always be in the same position market wise as when he bought the issue?

The answer here is somewhat complicated.

Substantial profits from the purchase of secondary companies at bargain prices arise in a variety of ways.

  1. First, the dividend return is high.
  2. Second, the reinvested earnings are substantial in relation to the price paid and will ultimately affect the price.  In a five- to seven-year period these advantages can bulk quite large in a well-selected list.
  3. Third, when a bull market appears, it is most generous to low-priced issues; thus it tends to raise the typical bargain issue to at least a reasonable level.
  4. Fourth, even during relatively featureless market periods a continuous process of price adjustment goes on, under which secondary issues that were undervalued may rise at least to the normal level for their type of security.


An illustration of performance of undervalued securities (bargains companies)

Performance of two groups of undervalued securities selected at the beginning of 1940.
(Reference:  pp 689 and 690 of Security Analysis, by Graham and Dodd, 1940 Edition)


                                               (Excluding Dividends Received)
                                         Market Price                            Market Price
                                         Dec 31, 1939                           Dec 31, 1947
Group A 
10 Stocks
Total                                 120 5/8                                    449

Group B
10 Stocks     
Total                                  115                                         367 7/8

Total of Both Groups        236                                         817 
                                                                                         INCREASE 246%



Observations and Inferences/Conclusions

This performance is superior not only to that of the Dow-Jones list but to that of the growth-stock list as well.

Allowance should be made for the fact, that nearly all the smaller companies benefited more from the war than did the bigger ones.  

The figures, thus, prove without a doubt that under favourable conditions, bargain issues can yield a handsome profit.

His experience over many years led Benjamin Graham to assert that the average results from this area of activity are satisfactory.



Bargain-Issue Pattern in Secondary Companies (1): What led to creating these bargains?


Definition of Secondary Companies

A secondary company is one which is not a leader in a fairly important industry.

It is usually one of the smaller concerns in the field.

It may also equally be the chief unit in an unimportant line.

Any company that has established itself as a growth stock is not ordinarily considered as "secondary" company.



Stock Market's Attitude toward Secondary Companies

(a)  1920

In 1920, relatively little distinction was drawn between industry leaders and other listed issues, provided the latter were of respectable size.

The public felt that a middle-sized company

  • was strong enough to weather storms and 
  • that it had a better chance for really spectacular expansion than one which was already of major dimension.


(b)  Post 1931 -1933 depression

The 1931 - 1933 depression had a particularly devastating impact on companies below the first rank either in size or inherent stability.

As a result of that experience, investors have since developed a pronounced preference for industry leaders and a corresponding lack of interest in the ordinary company of secondary importance.

This has meant that the latter group has usually sold at much lower prices in relation to earnings and assets than have the former.

It has meant further that in many instances the price has fallen so low as to establish the issue in the bargain class.



No sound rational reasons for rejecting stocks of secondary companies

When investors rejected the stocks of secondary companies, even though these sold at a relatively low prices, they were expressing a belief or fear that such companies faced a dismal future.

In fact, at least subconsciously, they calculated that ANY price was too high for them because they were heading for extinction - just as in 1999 the companion theory for the "blue chips" was that no price was too high for them because their future possibilities were limitless.

Both of these views were exaggerations and were productive of serious investment errors.  

Actually, a typical middle-sized listed company is a large one when compared with the average privately-owned business.

There is no sound reason why such companies should not continue indefinitely in operation, undergoing the vicissitudes characteristic of our economy but earning n the whole a fair return on their invested capital.



The stock market's attitude toward secondary companies create instances of major undervaluation.

The stock market's attitude toward secondary companies tends to be unrealistic and consequently to create in normal times innumerable instances of major undervaluation.


As it happens, the war period and the post-war boom were more beneficial to the smaller concerns than to the larger ones, because then the normal competition for sales was suspended and the former could expand sales and profit margins more spectacularly.

  • Thus by 1946 the market's pattern had completely reversed itself.  
  • Whereas the leading stocks in the Dow-Jones Industrial Average had advanced only 40 percent from the end of 1938 to the 1946 high, Standard & Poor's Index of low-priced stocks had shot up no less than 280 per cent in the same period.  
  • Speculators and many self-styled investors - with the proverbial short memories of people in the stock market - were eager to buy both old and new issues of unimportant companies at inflated levels.   


Thus, the pendulum had swung clear to the opposite extreme.

  • The very class of secondary issues which had formerly supplied by far the largest proportion of bargain opportunities was now presenting the greatest number of examples of over-enthusiasm and overvaluation.
  • If past experience can be relied upon, the post-war bull market will itself prove to have created an enlarged crop of bargain opportunities.
  • For in all probability a large proportion of the new common stock offerings of that period will fall into disfavour, and they will join many secondary companies of older vintage in entering the limbo of chronic undervaluation.



The Intelligent Investor
Benjamin Graham

Value of a Business to a Private Owner

Value of a Business to a Private Owner Test

The private-owner test would ordinarily start with the net worth as shown in the balance sheet.


How to search for a bargain opportunity?

1.  Using the net worth as the starting point

The question to ask is:  Is the indicated earnings power sufficient to validate the net worth as a measure of what a private buyer would be justified in paying for the business as a whole?

If the answer is definitely yes, an ordinary investor should find the common stock attractive at a price one-third or more below such a figure.  


2.  Using the working capital as the starting point

If instead of using all the net worth as a starting point, the investor considered only the working capital and applied his test to that, he would have a more convincing demonstration of the existence of a bargain opportunity.

For it is something of an axiom or is self evident, that a business is worth to any private owner AT LEAST the amount of its working capital, since it could ordinarily be sold or liquidated for more than this figure.

If a common stock can be bought at no more than two-thirds of the working capital value alone - disregarding all the other assets - and if the earnings record and prospects are reasonably satisfactory, there is strong reason to believe that the investor is getting substantially more than his money's worth.



An example of how to find a bargain common stock:

[Peculiarly, in 1947, many such opportunities present themselves in ordinary markets.  Benjamin Graham]

National Department Stores as of January 31, 1948, the close of its fiscal year.
The price of the stock was 16 1/2.
The working capital was no less than $26.60 per share.
The total asset value was $33.30.
Deducting contingency reserves - mainly to mark down the inventory to a "LIFO" (last in first out) basis, these figures would be reduced by $2.20 per share.

The company had earned $4.12 per share in the year just closed.  The seven-year average was $3.43; the twelve-year average was $2.29.  (Growing earnings)
The year's dividend had been $1.50.  (Paying dividends)
Compared with a decade before,
-  the working-capital value had risen from $7.40 per share to $26.60,
-  the sales had doubled and (Increasing sales)
-  the net after taxes had risen from $654,000 to $3,224,000.  (Increasing profits)


Thus, we had a business
-  selling for $13 million,
-  with $25 million of assets, mostly current.  (Price < Net Assets)
-  Its sales were $88 million.  A fair estimate of average future earnings might be $2 million. (earnings record and prospects are reasonably satisfactory  or Not gruesome)

The average earnings prior to 1941 had been unimpressive, and the company was regarded as a "marginal" one in its field - that is, it could earn a reasonably good return only under favourable business conditions.  (Qualitative assessment)

In the past eight years, however, it has improved both in financial strength and in the quality of its management.  (Qualitative assessment - earnings record and prospects are reasonably satisfactory or improving quality of business and management)

Let us grant that Wall Street would still consider the company as belonging in the second rank of department-store enterprises.  (Investor sentiment/Market sentiment/Neglected by market)

Even after proper allowance is made for such an unfavourable factor, we may still conclude that on the basis of the figures the stock is intrinsically worth well above its market price.  (Worse case scenario, still Value > Price)


Conclusion:  At 16 1/2, the conclusion in the case of National Department Stores remains, whether we apply the appraisal test or the test of value to a private owner.  (Undervalued / A bargain)



Purchases of Bargain Issues

A bargain issue is defined as one which, on the basis of facts established by careful analysis, appears to be worth considerably more than it is selling for.

This includes:

  • bonds and preferred stocks selling well under par, as well as
  • bargain common stocks.

To be as concrete as possible, a suggested guide is an issue is not a true "bargain" unless the indicated value is at least 50% more than the price.



How to detect a bargain common stocks?  What kind of facts would warrant the conclusion that so great a discrepancy or bargain exists?

There are two tests by which a bargain common stock is detected.

1.   By method of appraisal.  
  • This relies largely on estimating future earnings and then multiplying these by a factor appropriate tot he particular issue.
  • If the resultant value is sufficiently above the market price - and if the investor has confidence in the technique employed - he can label the stock as a bargain.

2.  By the value of the business to a private owner.
  • This value also is often determined chiefly by expected future earnings - in which case the result may be identical with the first method (the method of appraisal).
  • In the second test more attention is likely to be paid to the realizable value of the assets with particular emphasis on the net current assets or working capital (current asset - current liabilities).

How do these bargains come into existence?  How does the investor profit from them?


1.  LOW POINTS IN THE GENERAL MARKET

At low points in the GENERAL MARKET, a large proportion of common stocks are bargain issues, as measured by the above standards.

[A typical example would be General Motors when it sold at less than 30 in 1941.  It had been earning in excess of $4 and paying $3.50, or more, in dividends.]

It is true that current earnings and the immediate prospects may both be poor, but a level-headed appraisal of average future conditions would indicate values far above ruling prices.

The wisdom of having courage in depressed markets is vindicated not only by the voice of experience but also by application of plausible techniques of value analysis.

2.  EXISTENCE OF MANY INDIVIDUAL COMMON STOCK BARGAINS AT ALMOST ALL MARKET LEVELS

The same vagaries of the marketplace which recurrently establish a bargain condition in the general market list account for the existence of many INDIVIDUAL BARGAINS at ALMOST ALL market levels.

The market is always making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks.  

A mere lack of interest or enthusiasm may impel a price decline to absurdly low levels.

There are two major sources of undervaluation:
(a) currently disappointing results and
(b) protracted neglect or unpopularity.

[Example of the first type (a):  In 1946, Lee Rubber & Tire Company, aided by the bull market and by steadily rising earnings, the stock sold at 72.   In the second half of 1947 the reported profits fell off moderately from the previous year's figures.  This minor development apparently generated enough pessimism to drive the shares down to 35 in early 1948.  That price was much less than the working capital alone (about $50 per share) and no greater than the amount actually earned in the previous five years.]

[Example of the second type (b):  During the 1946-47 period the price of Northern Pacific Railway declined from 36 to 13.5.   The true earnings of Northern Pacific in 1947 were close to $10 per share.  The price of the stock was held down, in great part, by its $1 dividend.  It was neglected, also, because much of its earning power was concealed by conventional accounting methods.]



The Intelligent Investor
Benjamin Graham



Saturday, 14 October 2017

GROWTH STOCK APPROACH

Every investor would like to select a list of securities that will do better than the average over period of years.

A growth stock may be defined as one which has done this in the past and is expected to do so in the future.

[A company with an ordinary record cannot be called a growth company or a "growth stock" merely because its proponent expects it to do better than the average in the future.  It is just a "promising company."]

It seems only logical that the intelligent investor should concentrate upon the selection of growth stocks.

It is mere statistical chore to identify companies that have "outperformed the averages" in the past.

However, investing successfully in them is more complicated.



Two Catches of Growth Stock Investing

Two catches to watch out for in growth investing.

1.  The common stocks with good records and apparently good prospects sell at correspondingly high prices. 

  • The investor may be right in his judgement of their prospects and still not fare particularly well, merely because he has paid in full (and perhaps overpaid) for the expected prosperity.

2.  His judgement as to the future may prove wrong. 

  • Unusually rapid growth cannot keep up forever; when a company has already registered a brilliant expansion, its very increase in size makes a repetition of its achievement very difficult.  
  • At some point the growth curve flattens out, and in many cases it turns downward.



Naturally, the purchase at a time when popular growth stocks were most favoured and active in the market would have had disastrous consequences.

  • They were too obvious a choice.  
  • Their future was already being paid for in the price.  
  • Popular growth stocks may have failed to continue their progress and have even reported downright disappointing results.



How can your investment into growth stocks be protected?

Presumably, it is the function of intelligent investment to overcome these hazards by the exercise of sound judgement and skillful selection.

This is the natural and appropriate endeavour for the enterprising investor.

Benjamin Graham regrets that he has little concrete guidance to offer the enterprising investor in this field.

The exercise of specialized foresight, the weighing of future probabilities and possibilities are not to be learned out of books - nor can they be aided much by suggested rules and techniques.

Elaborate study of the life cycle of industries and discussing a number of "symptoms of decay"; by noticing of which the alert investor may escape out of a once expanding industry before it is too late.

These suggested techniques require more ability and application than most investors can bring to bear on the problem.

[It is debatable whether once an industry has turned downward, it will never recover and that all securities within it must be permanently avoided.]



More guidance on Growth Stock Investing

The stock of a growing company, if purchasable at a suitable price, is obviously preferable to others.

No matter how enthusiastic the investor may feel about the prospects of a particular company, however, he should set a limit upon the price that he is willing to pay for such prospects.
  • Such a rule would result at times in the missing of an unusually good opportunity. 
  • More often, it would mean the investor's saving himself from "going overboard" on an issue that looked especially good to him and everyone else and consequently was selling much too high.




An illustration of investing in growth stocks

Two highly successful enterprises and both were considered to have excellent prospects of long-term growth.  Both were priced at 22 times that year's earnings.  The average price of Company A in 1939 was 62 and the price of company B in 1939 was 42.  The ordinary investor was as likely to buy one issue as the other.

Company A 's earnings had risen from $2.9 per share in 1939 to $10.90 per share in 1947.  Its price was equivalent to 150 or much more than double its 1939 average.  In the same years, the profits of Company B had moved up from $1.89 to $2.13, in spite of the record prosperity of 1947 and its price had fallen from 42 to 29.


                       Company A        Company B               Company C
                       1939    1947       1939   1947               1939    1947

Price               62         150         42       29                        6      26
Earnings        2.9         10.9      1.89    2.13                  0.13     3.14
P/E                 22                        22


The choice between the attractive issue that turns out well and the one that does poorly is by no means easy to make in the growth-stock field.


At the same time, it might be interesting to add a third pharmaceutical Company C which was by no means well regarded in 1939 - for its average price was only 6 (as against 28 in 1929) and it paid no dividend.  On its past record it could not qualify at all as a growth issue.  Yet in 1947 its earnings were $3.14 per share as against only 13 cents in 1939, and its April price in 1948 had risen to 26 - a much better percentage gain than CompanyA's.

The best opportunity in the field of drug stocks turned out to be where it was least expected - an all too frequent happening.


Inferences from the above illustration for investing in Growth Stocks

  • Superior results may be obtained in this field if the choices are competently made.
  • Even with careful selection, some of the individual issues may fare relatively poorly.  Some may actually decline and others may have only slight advances
  • Thus for good results in the growth stock field there is need not only for skillful analysis but for ample diversification as well.




Summary on investing in Growth Stocks


  1. The enterprising investor may properly buy growth stocks.
  2. He should beware of paying excessively for them.  He might well limit the price by some practical rule.
  3. A growth stock program will not be automatically successful; its outcome will depend on the foresight and judgement of the investor or his advisors rather than on any  clear-cut methods of analysis.




Avoid buying these securities when available at full prices

In selecting investments, in terms of psychology as well as arithmetic, we are guided by three requirements of:

  1. underlying safety,
  2. simplicity of choice, and
  3. promise of  satisfactory results.
Using these criteria has led to the exclusion from the field of recommended investment a number of security classes which are normally regarded as suitable for various kinds of investors.


INVESTMENTS TO AVOID AT FULL PRICES

Advised against the purchase at FULL PRICES of three important categories of securities:
(a) foreign bonds;
(b) ordinary corporate bonds and preferred stocks, under present conditions of relative yield when the best grade issues yield little more than his US Savings Bonds;
(c) secondary common stocks, including, original offerings of such issues.

By full prices, we mean 
  • prices close to par for bonds or preferred stocks, and 
  • prices that represent about the fair business value of the enterprise in the case of common stocks.



ADVICE FOR DEFENSIVE INVESTORS

The greater number of defensive investors are to avoid these categories REGARDLESS OF PRICE.



ADVICE FOR ENTERPRISING INVESTORS

Enterprising investors are to buy them only when obtainable at BARGAIN PRICES - which is defined as prices not more than two-thirds of the appraisal value of the securities.



REASONINGS


FOREIGN GOVERNMENT BONDS
Why people buy and why they should avoid purchasing foreign Government bonds?  
  • They wanted "just a little more income."  The country seemed like a good risk - and that was enough.  The purchasers of the foreign Government bonds must have told themselves that the bonds are practically riskless, presumably on the ground that the country was a far different kind of debtor than other know riskier countries.  
  • At times, the buyer was obtaining just a slight percentage more on his money than the yield on AAA corporate bonds - and this hardly enough to warrant the assumption of a recognized risk.  
  • By what process of calculation could the buyers of the foreign Government bonds assure themselves that at no time before their maturity date, would that country suffer severe economic, or internal political, or international problems?  Also, the high interest rates themselves helped to make default inevitable, especially in distressed countries offering by high interest on their foreign Government bonds.

CORPORATE BONDS OR PREFERRED STOCKS
How to entice people to buy corporate bonds or preferred stocks?  
          For corporate bonds and preferred stocks to be bought, these would either 
  • have to increase their yields so as to offer a reasonable alternative to US Savings Bonds for individual investors or 
  • else would be bought solely by financial institutions - insurance companies, savings banks, commercial banks, and the like,  Such institutions have their own justification for buying corporate securities at current yields.

SECONDARY COMMON STOCKS
How and when to buy secondary common stocks?  
  • Secondary issues, for the most part, do fluctuate about a central level which is well below their fair value.  They reach and even surpass that value at times; but this occurs in the upper reaches of bull markets, when the lessons of practical experience would argue against the soundness of paying the prevailing prices for common stocks.  The aggressive investor should accept the central market levels which are normal for that class as their guide in fixing own levels for purchase.  Financial history says clearly that the investor may expect satisfactory results, on the average, from secondary common stocks only if he buys them for less than their value to a private owner, that is, on a bargain basis. 
  • [There is a paradox here, nevertheless.  The average well-selected secondary company may be fully as promising as the average industrial leader.  What the smaller concern lacks in inherent stability it may readily make up in superior possibilities of growth.  Consequently, it may appear illogical to many readers to term "unintelligent" the purchase of such secondary issues at their full "enterprise value."  ]



Intelligent Investor
Benjamin Graham

Portfolio Policy for the Enterprising Investor

Negative Approach

  1. Avoid ordinary corporate bonds as long as the best grade issues yield little more than his US Savings Bonds ("risk free" bonds).
  2. Leave high-grade preferred stocks to corporate buyers (they enjoy a tax benefit).
  3. Avoid inferior types of bonds and preferred stocks unless they can be bought at a bargain levels (at least 30% under par).
  4. Let someone else buy foreign government bond issues, even though the yield may be attractive.
  5. Be wary of all kinds of new issues (new bonds, new preferred stocks and new stocks), including convertible bonds and preferreds that seem quite tempting.
  6. Be wary of common stocks with excellent earnings confined to the recent past.


The Positive Approach (4 Approaches)


  1. Buying in low markets and selling in high markets.
  2. Buying carefully chosen "growth stocks".
  3. Buying bargain issues of various types.
  4. Buying into "special situations".


The Intelligent Investor
Benjamin Graham

Friday, 13 October 2017

Here's Why Malaysians Can't Afford a House


By Pooi Koon Chong
October 11, 2017,

Regulator sets up housing website to defend finance complaints

Central Bank Tells Malaysians Homes not Affordable

Malaysia’s central bank has a response to those saying it needs to do more to spur home loans: houses simply aren’t affordable.

Bank Negara Malaysia has created a website packed with data aimed at debunking the “myth” that access to financing was deterring home ownership, showing that loan approvals for key cities are near 70 percent or higher. The central bank has resisted calls to loosen mortgage lending, instead saying the property industry should boost efforts to cut costs and accelerate supply.

Rising home prices have added to the grievances of Malaysians grappling with the cost of living since a goods and services tax started two years ago, and as the government removes subsidies on daily items including petrol and sugar. That’s made affordable housing a key voter issue for Prime Minister Najib Razak ahead of a general election that must be held by mid-2018.

“It’s a tricky situation,” said Wan Saiful Wan Jan, chief executive officer of the Institute for Democracy and Economic Affairs in Kuala Lumpur. “I don’t think it’s right to say that there’s no problem with financing. But lending rules have to be both strict and balanced at the same time, otherwise we’ll have more non-performing loans and that is not good for anyone in the country.”


The median house price in Malaysia was 4.4 times the median annual household income in latest available data, making the housing market “seriously unaffordable” compared to global standards, according to a 2015 report by state-run Khazanah Research Institute. The report classed an affordable market as one with a median multiple of 3 times.

That still makes Malaysia cheaper than many other markets, with affordable housing in key cities something of a rarity in the 21st century. In the latest Demographia study, Kuala Lumpur had the eighth best housing affordability out of 18 metropolitan regions around the globe, with Hong Kong homes costing 19 times income and Beijing 14.5 times.

Take a closer look at the forces shaping Malaysia's economy, politics and markets

Malaysia’s central bank is seeking to strike a balance: its housing website aims to show transparency in the market while the lender also stands firm on stricter financing rules introduced since 2010 to curb speculation, as well as measures to promote responsible lending amid elevated consumer debt.


Household debt as a proportion of gross domestic product fell to 88.4 percent last year from 89.1 percent. It’s still one of the region’s highest and the nation needs to be careful of such levels, central bank Governor Muhammad Ibrahim said in July. The central bank has left borrowing costs unchanged at 3 percent since July last year.

Just 20 percent of new Malaysian housing launches in the first quarter were priced below 250,000 ringgit ($59,000), down from 33 percent between 2010 and 2014, according to the central bank’s “Housing Watch” website. The bulk of new homes cost between 250,000 ringgit and 500,000 ringgit. The median annual household income is estimated at around 63,000 ringgit.

“It is an issue of not having enough income and houses being too expensive,” Muhammad told a conference in August, reiterating that “the problem is not about access to credit” and the lender “must have the courage to say it loudly and clearly to the public.”

Only about half of people living in Kuala Lumpur own a home, while nationwide the number was 72.5 percent at the last census in 2010. Demand is set to rise: the median age of Malaysia’s 31.7 million people is 28 years and the nation’s urban population is growing at an average 4 percent a year, among the fastest pace in East Asia, according to the World Bank.

Najib has pledged to focus on boosting living standards when he tables next year’s spending plan in parliament this month. He may announce an increase in the number of affordable homes built by state-linked companies, tax relief for private developers and subsidies for affordable home buyers, RHB Research Institute Sdn. said last month.

Filling the Gap

Banks are being “prudent and responsible” in providing finance to buyers, an association of Malaysia commercial lenders said in a statement this week. It was seeking to refute claims by developers that house buyers are finding it harder to obtain a housing loan and that approval times are increasing.

Developers should instead be looking at their own industry, said Paul Selvaraj, secretary general of the Federation of Malaysian Consumers Associations.

“The focus should be on building houses which people can afford, not building expensive houses and then trying to push them, and then complaining that the banks are not giving loans,” he said. “The reason people are having problems getting loans is because the houses are not affordable. It’s beyond their repayment” ability, he said.

Some developers are slowly starting to fill the demand. Mah Sing Group Bhd., the nation’s third largest, is selling apartments within 5 kilometers from Kuala Lumpur’s center with prices starting from 328,000 ringgit for a 650 square foot unit. That’s within the maximum price a family on the city’s median income could afford.

The problem is set to become a bigger one over time. There is currently a shortage of 960,000 units of affordable housing in Malaysia, with the number projected to reach 1 million units by 2020, according to the central bank’s estimates.

“It’s a very important issue for Najib to address,” said Wan Saiful. “I’m just really wondering what more can Najib do other than provide heavy subsidies, at a level that maybe even the government cannot afford to do.”


https://www.bloomberg.com/news/articles/2017-10-10/here-s-why-you-can-t-afford-a-house-central-bank-tells-malaysia

DEFENSIVE AND ENTERPRISING INVESTORS

The basic characteristics of an investment portfolio will be determined largely by the position of the individual owner.


  • Savings banks, life insurance companies and "legal" trust funds:  High grade bonds and high grade preferred stocks.
  • The well to do and experienced businessman, as long as he considers these to be attractive purchases:  Any kind of bond or stock. 


Those who cannot afford to take risks should be content with a low return on their invested funds.





DEFENSIVE AND ENTERPRISING INVESTORS

The general notion is the rate of return which the investor should aim for is more or less proportionate to the degree of risk he is ready to run.

The better view is the rate of return sought should be dependent, rather, on the amount of INTELLIGENT EFFORT the investor is wiling and able to bring to bear on his task.

An intelligent investor is one who is endowed with the capacity for knowledge and understanding.

The minimum return goes to the passive or defensive investor, who wants both safety and freedom from concern.

The maximum return would be realized by the alert and enterprising investor who exercises maximum intelligence and skill.

In many cases, there may be less real risk associated with buying a "bargain issue" offering the chance of a large profit than with a conventional bond purchase yielding under 3 per cent.

The kinds of investments that are suitable for  defensive and enterprising investors

A.  The defensive investor will buy:
1.  US Savings Bonds (and/or tax-exempt securities)
2.  A diversified list of leading common stocks, at prices that seem reasonable in the light of past market experience - or
2a.  Shares of leading investment funds

B.  The enterprising investor will buy:
1, 2, 2a.   As above
3.  Growth stocks, but with caution.
4.  Also, or alternatively, representative common stocks when the general market is historically low
5.  Secondary common stocks, corporate bonds and preferred stocks at bargain levels.
6.  Some exceptional convertible issues, even at full prices.


There are important categories of securities which the intelligent individual investor will not buy.  These are as follows:

1.  Investment-grade corporate bonds and preferred stocks when their current yields are lower or only slightly higher than US Savings bonds or foreign government issues at full prices.
2.  Leading common stocks when the market is at high levels as judged by past experience.
3.  Secondary common stocks, except at tempting low prices.
4.  As a corollary of 3, he will not buy new issues of common stocks, with infrequent exceptions.  (This does not refer to the exercise of subscription rights on leading issues.)


The intelligent investors should not support new security financing except on terms which offer them proportionately as attractive a combination of income and safety as is obtainable by the purchase of US Savings Bonds plus common stocks of leading corporations at normal market prices.


The Intelligent Investor
Benjamin Graham

CONCEPT OF "RISK"

The opposite of risk is safety.

Are good bonds less risky than good preferred stocks?

Are good bonds and good preferred stocks less risky than good common stocks?

Are common stocks, thus, not "safe"?



RISKS IN VARIOUS ASSETS


  1. BOND:  A bond is clearly unsafe when it defaults its interest or principal payments.
  2. STOCK:  Similarly, if you have bought a preferred stock or a common stock with the expectation that a given rate of dividend will be continued, then a reduction or passing of the dividend means that it is unsafe.  Another risk is, if there is a fair possibility, that the holder may have to sell at a time when the price is well below cost.
  3. PROPERTY:  The man who holds a mortgage on a building might have to take a loss if he were forced to sell it at an unfavourable time.  In the judging the safety or risk of ordinary real-estate mortgages, the only criterion being the certainty of punctual payments.
  4. BUSINESS:  The risk attached to an ordinary commercial business is measured by the chance of its losing money, not by what would happen if the owner, were forced to sell.




MARKET PRICE DECLINES AND THE STOCK INVESTOR'S WELL SELECTED PORTFOLIO

A bona fide investor does not lose money merely because the market price of his holdings declines; the fact that a decline may occur does not mean that he is running a true risk of loss.

If a group of well-selected common-stock investments shows a satisfactory over-all return, as measure through a fair number of years, then this group investment has proved to be "safe."

During that period its market value is bound to fluctuate, and as likely as not it will sell for a while under the buyer's cost.

If that fact makes the investment "risky" it would then have to be called both risky and safe at the same time.



CONCEPT OF RISK IS SOLELY A LOSS OF VALUE

This confusion may be avoided if we apply the concept of risk solely to a loss of value which either
(a) is realized through actual sale or
(b) is ascertained to be caused by a significant deterioration in the company's position.

Many common stocks do involve risks of such deterioration.

But it is our thesis that a properly executed group investment in common stocks does not carry any substantial risk of this sort and that therefore it should not be termed "risky" merely because of the element of price fluctuation.



MARKET PRICE DECLINE


  • The prices of all stocks may decline 
  • In fact, other than Savings Bonds, all financial assets' prices can decline.  
  • Stocks then to decline to a greater extent than bonds and preferred shares.
  • This decline may be of a cyclical and temporary nature and the holder is also unlikely to be forced to sell at such times. 
  • Market price decline is not a true risk (in the useful sense of the term).


The concept of risk. Risk = Loss of VALUE

We should apply the concept of risk solely to a loss of value which either

(a) is realized through actual sale or

(b) is ascertained to be caused by a significant deterioration in the company's position or fundamentals.  (Many common stocks do involve risks of such deterioration.)






YOUR PORTFOLIO OF STOCKS AND MARKET PRICE FLUCTUATIONS

A carefully selected and constructed portfolio in common stocks does not carry any substantial risk of this sort, that is, the risk of loss of value.

Therefore, it should not be termed "risky":

  • merely because of the element of price fluctuation, which maybe of a cyclical and temporary nature, and,
  • moreover, the holder is unlikely to be forced to sell at such times.

Market price fluctuation is not risk; it is the friend of the value investors.

Tuesday, 10 October 2017

Warren Buffett’s $1 test and how to tell if a company is allocating its capital wisely

Buffett is essentially talking about return on invested capital.
  • If a company invests $100 in something at the cost of capital of 10%, which in turn earns $7 in earnings forever, it would have a market value of only $70 ($7/10%), failing the $1 test. 
  • Earnings of $11 or more would pass the test. 
  • When companies make the decision to invest in M&A, CapEx or buybacks, they must make a conscious effort in evaluating if the potential returns would be meaningful and not capital destructive.



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By The Fifth Investor on October 9, 2017

Companies small or big must make capital allocation decisions on a frequent basis to maximize returns for shareholders. But only a few companies in the world have excellent capital allocators at their helms, most companies are run by excellent operators who alone are enough to generate meaningful profits, which shareholders would find forgiving enough.

Before a corporation invests in machinery, equipment, property or securities, like us they must make comparisons of returns that they’ll get when they allocate capital. These decisions are far more complex than personal decisions as they often involve a giant leap of faith into the unknown.

  • How did Google calculate that Android would be a massive hit when they decided to allocate millions of R&D to it? 
  • How did Google’s other failures not stop it from deciding to simply invest their monies in stocks or bonds or themselves (share buybacks)?


These decisions are of the highest risk, have a high potential for failure but if successful often give shareholders a multifold return. Although this may seem daunting to a budding retail investor, there are simpler ways to see if a company is allocating capital wisely: think top-down, think big.

1.  Capital expenditures

  • Is the company spending its cash meaningfully in CapEx? 
  • What is the return on invested capital for the company? 
  • Has the company managed to earn healthy returns on the incremental invested capital over the years? 
  • What is their strategy? 
  • In CapEx intensive industries, sometimes CapEx is spent not to expand and grow the business, but to just survive. That is often not an ideal situation as there’s no buffer should the market turn. 
  • On the other hand, a CapEx-lite industry would see companies compete by spending in other areas that may not appear in the CapEx category.


2.  Share buybacks

  • Is the company spending its precious money buying back shares at all-time highs? 
  • There’s a difference between mandated share buybacks and opportunistic buybacks. One is buying back shares no matter the price of the shares, and the latter is buying back shares only if the value of the company is worth more than its traded price (E.g. Berkshire will only execute buybacks when its P/B ratio is below 1.2).


3.  Mergers & acquisitions

  • Is the company acquiring businesses to bolt on to their existing operations? 
  • How competent is the current management in the new industry where they’ve acquired a company? 
  • How much of a premium have they paid to buy a company? 
  • Does it even make sense? 
  • A wasteful merger or acquisition can be deadly to your financial health.


4.  Cash

  • Is this company cash rich? 
  • Does the management not know what to do with it? 
  • What’s holding the company back? 
  • Companies that are cash rich often trade at a discount, making them appear cheap, the most famous example would be Apple (although there may be tax reasons why Apple has stashed such a huge pile). 
  • There’s a reason why companies like these appear cheap – the market deems the management to be incompetent in redeploying capital to earn a meaningful return for shareholders, and applies a discount to its shares.




Another way to look at it is the simple $1 test that Warren Buffett came up with in the 1980s:

“We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained.

Unrestricted earnings should be retained only where there is a reasonable prospect – backed preferably by historical evidence or, when appropriate by a thoughtful analysis of the future – that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.”

Buffett is essentially talking about return on invested capital. If a company invests $100 in something at the cost of capital of 10%, which in turn earns $7 in earnings forever, it would have a market value of only $70 ($7/10%), failing the $1 test. Earnings of $11 or more would pass the test. When companies make the decision to invest in M&A, CapEx or buybacks, they must make a conscious effort in evaluating if the potential returns would be meaningful and not capital destructive.

Companies that have heavy R&D spending as opposed to being CapEx-intensive like technology or pharmaceutical firms would require a more sophisticated understanding of their business models. That being said, the fundamentals of capital allocation are like the laws of physics – you can only spend so much cash on multiple failed ventures before the market realizes that you are incompetent.


The fifth perspective

Looking from the lens of an individual, companies are no different from investors at the very root – they’re in the business of making money. There will always be foolish investors and companies alike that waste their money in failed ventures or stupid decisions, and there will always be some rare, exceptional cases that earn outsized returns. Sticking to the basics in asking the most fundamental and simple questions can sometimes save your wealth and/or your company.



http://fifthperson.com/warren-buffetts-1-test-tell-company-allocating-capital-wisely/