Bullbear Buffett Stock Investing Notes

Market Analysis and Market Traders

2012-01-29T15:02:00.000+08:00

Investors are continually bombarded with market analyses, all of which fall into one of two categories:

1. The first approach is backward looking. It constitutes "chart reading" of past behaviour.
2. The second is forward looking. It anticipates interest rate changes, industry cycles, business and political conditions that might impact corporate earnings or investor attitude.

Trading on market movements seems easier and maybe more PROFITABLE IN THE SHORT RUN, but it is MORE DIFFICULT FOR MARKET TRADERS to ACCUMULATE LONG-RUN PROFITS AND HOLD ON TO GAINS.

In market analysis there are NO margin of safety; you are either right or wrong, and if you are wrong, you lose money.

Benjamin Graham took a conservative approach to investments. He viewed the stock market as a RISKY PLACE where investors can make money as long as they keep their heads about them.

Thriving in Every Market

2012-01-29T14:46:00.000+08:00

Understand the market's reason for being. "It is important that an issue be readily saleable, it is still more important that it command a satisfactory price."

"Value in relation to price, not price alone, must determine your investment decisions." Just because a stock seems cheap or dear doesn't,t mean that it should be bought or sold.

Though investors cannot predict market conditions, they can take advantage of conditions once they are recognised.

It's not a stock market, it's a market of stocks. Any company can be out of step with the market, ready to be bought and sold in it's own good time.

My occasional rumination

2012-01-22T17:36:00.002+08:00

Comprehending the Thinking Driving the Behaviour in Investing

One of the most fascinating figure in investing is the wide range of intrinsic value one can obtain from various types of valuations and by various analysts.

It is this inability to determine the intrinsic value or the lack of consensus of what constitutes the right intrinsic value that allows the price of the stock to zig-zag but always tracking the intrinsic value. Over the short term, the price may be up or down by a wide margin. However, over the long term, it always reflect the fundamental value of the business.

Are you a bargain hunter? Are you a trend follower? There are more than one way to make a profit from the stock market. There are also more than one way to make a loss from the stock market. The rules are generally fair, though one need to watch out for manipulations in certain price movements of certain stocks.

There are those who discard the fundamentals and only study and follow the sentiment driving the supply and demand of the stock. Buy low and sell high. Buy high and sell higher. It sounds so easy for an "expert" to pronounce that those who did not do this on the first trading day of this month by following the chart would have been stupid or foolish, given the chart patterns. To these believers, fundamentals do not matter in their trades.

On the other hand, there are those who discard the charts. They painstakingly study the fundamentals. They patiently analyse their thinking and behaviour guiding their investing. They are generally followers of value investing as practised by Benjamin Graham and his students. They track a few high quality stocks and bargain hunt when the price is right. They have strict rules too guiding their selling. Their achievements are not measured by the days, weeks or months, but over a long period of years. After an initial period of investing, their returns are often positive by a huge percentage over their initial cost. Short term fluctuating prices in the stocks of their portfolio rarely cause a capital loss in their portfolio value. The low markets significantly reduced the compound annual growth rate returns for the whole investment when these were measured at those times. On the other hand, the compound annual growth rate rebounded when the returns were calculated at the time when the market shot up to stratosphere.

Those who trade protects their downside with stop loss strategy. They often take profit when a certain percentage gain is achieved. They may also allow the winners to climb higher at the same time moving their stop loss value higher.

Those who employ value investing, protect the downside through buying with a margin of safety and careful stock picking. They often allow these stocks to eventually reflect the fundamental intrinsic value. Often the carefully chosen stock can be held for long term, without the necessity to take short term profit. Compounding over years provide the substantial returns. The reinvested dividend returns contitute a substantial part of the return too, this return is not enjoyed by the chartists whose investing period are often short term..

While the traders may plough in a certain amount onto a certain stock, to make big gains over a short trading period, this amount has to be meaningful and substantial. Short term volatilities are unpredicatable and this constitutes the main risk in trading.

On the other hand, those who value invest can usually afford to keep a large amount in their portfolio permanently. This is safe except druing those times when the market is truly bubbly. The volatilities in the market over the short term do not affect their investment behaviour which is strategized for the long term. The short term volatility is often treated as a "friend" when the price can be taken advantaged of. Over the long term, these short term volatilities - often a tinyl blip on the long term price chart - is in fact very small for carefully chosen good quality stocks.

http://myinvestingnotes.blogspot.com/2010/01/my-occasional-rumination.html

Benjamin Graham and The Power of Growth Stocks

2012-01-22T17:09:00.001+08:00

Benjamin Graham and the Power of Growth Stocks: Lost Growth Stock Strategies from the Father of Value Investing

by Frederick K. Martin CFA & Nick Hansen

Use a master's lost secret to pick growth companies bound for success

In 1948, legendary Columbia University professor Benjamin Graham bought a major stake in the Government Employees Insurance Corporation. In a time when no one trusted the stock market, he championed value investing and helped introduce the world to intrinsic value. He had a powerful valuation formula.

Now, in this groundbreaking book, long-term investing expert Fred Martin shows you how to use value-investing principles to analyze and pick winning growth-stock companies—just like Graham did when he acquired GEICO.

Benjamin Graham and the Power of Growth Stocks is an advanced, hands-on guide for investors and executives who want to find the best growth stocks, develop a solid portfolio strategy, and execute trades for maximum profitability and limited risk. Through conversational explanations, real-world case studies, and pragmatic formulas, it shows you step-by-step how this enlightened trading philosophy is successful. The secret lies in Graham's valuation formula, which has been out of print since 1962—until now. By calculating the proper data, you can gain clarity of focus on an investment by putting on blinders to variables that are alluring but irrelevant.

This one-stop guide to growing wealth shows you how to:

Liberate your money from the needs of mutual funds and brokers
Build a reasonable seven-year forecast for every company considered for your portfolio
Estimate a company's future value in four easy steps
Ensure long-term profits with an unblinking buy-and-hold strategy

This complete guide shows you why Graham's game-changing formula works and how to use it to build a profitable portfolio. Additionally, you learn tips and proven techniques for unlocking the formula's full potential with disciplined research and emotional control to stick by your decisions through long periods of inactive trading. But even if your trading approach includes profiting from short-term volatility, you can still benefit from the valuation formula and process inside by using them to gain an advantageous perspective on stock prices.

Find the companies that will grow you a fortune with Benjamin Graham and the Power of Growth Stocks.

http://www.lybrary.com/benjamin-graham-and-the-power-of-growth-stocks-lost-growth-stock-strategies-from-the-father-of-value-investing-p-125191.html

Ownership Principle: Investment is most intelligent when it is most businesslike.

2012-01-22T17:07:00.000+08:00

1. Investment is most intelligent when it is most businesslike.

2. Every corporate security may best be viewed as an ownership interest in, or a claim against a specific business enterprise ... and the investor seeking to make profits from his security purchases and sales, is embarking on a business venture which must be run in accordance with accepted business principles.

3. Principles of business

know your business -- for the securities investor, this means do not try to make "business profits" out of securities--that is returns in excess of normal interest and dividend income.
do not let anyone else run your business unless you can adequately supervise, and you have unusually strong reason to have confidence in the integrity and ability of the person.
do not enter upon an operation unless a reliable calculation shows that it has a fair chance to profit-- not based on optimism, but on arithmetic.
have the courage of your knowledge and experience.

Graham separates Intelligent Investors into two camps: Defensive and Enterprising

2012-01-22T08:55:00.001+08:00

Graham also goes on to separate intelligent investors into two camps:

Defensive Investor: One who wants safety and less involvement
Enterprising Investor: One who wants higher returns that he/she is willing to work for

In contrast to the conventional view, an enterprising investor is not one who is more risky or aggressive; instead, it is one who has an interest in investing and is willing to work hard for it. I think it is important for investors to figure out which category they fall into.

Most people fall into the “defensive investor” category. Graham provides examples such as::

a widow who cannot afford unnecessary risks,
a physician who cannot devote the time for proper analysis, and
a young man whose small investment will not return enough gain to justify the extra effort.

The beginning investor should not try to beat the market.

The investor only realizes a loss in value through the sale of the asset or the significant deterioration of the firm’s underlying value. Careful selection and diversification helps to avoid these risks.

A more common and difficult problem is overpaying for securities; that is, paying more for a security than its intrinsic value warrants.

Dollar Cost Averaging

2012-01-22T08:49:00.000+08:00

Dollar Cost Averaging (“DCA”) often is popular during rising markets.

If DCA is adhered to over many years, then this formula should work.

The difficulty is that few people are so situated that they can invest the same amount each year.

Economic downturns often constrain one’s ability to invest just when stocks are trading at their lowest valuations.

Furthermore, when prosperity for the average investor returns, so too do high valuations.

Benjamin Graham - The Intelligent Investor - Summary Notes

2012-01-22T08:41:00.000+08:00

http://www.conscious-investor.com/books/intelligentinvestor.pdf

Benjamin Graham's The Intelligent Investor Summary

2012-01-22T07:59:00.000+08:00

Intelligent Investor Summary

Benjamin Graham's The Intelligent Investor

Graham, Chapter 1:

Graham lays out his definition of investing right from the start of this chapter. His description is "an investment operation is one which, upon thorough analysis promises safety of principal and an adequate return" (p. 18). He labels anything not meeting these standards as speculation. Graham then describes two different approaches to investing: defensive and aggressive. Obviously, safety is a big concern for the defensive investor, and that shows in his example of putting half of your money in stocks and half in bonds. He lists other approaches of defensive investing, like investing only in well established companies, and dollar-cost averaging. Graham's take on aggressive investing isn't as kind. The three types of the aggressive approach (trading the market, short-term selectivity, and long-term selectivity) are all considered to have less profitability. This is explained by the possibility of the aggressive investor being wrong on his or her market timing.

Graham, Chapter 8:

In chapter eight of Graham's book, he brings up the subject of market fluctuation. I think he makes an important point to those people who are monitoring their retirement portfolios almost on a daily basis. He states that "the investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizable declines nor become excited by sizable advances" (p. 206). With this in mind, he suggests using these fluctuations in the market as a guide to making investment decisions. More precisely, he suggests using the dips in the market as points to acquire more of a quality stock along with finding new opportunities for suitable investments.

Graham, Chapter 9:

Mutual funds are the subject of the ninth chapter of The Intelligent Investor. Fund performance and the different types of funds available to the investor are covered. One of those types of funds is the performance fund, which seeks to outperform the Dow Jones Industrial Average in this case, so they are the more aggressive of the funds. Another type, the closed-end fund only offers a specific number of shares at one time, instead of continuously, and is the most illiquid of the bunch. The last mutual fund type Graham mentions in this chapter is the balanced fund. These types of funds contain a certain percentage of bond holdings. Even the conservatively investing Graham suggests you would be better off investing in bonds by themselves, rather than mixed in a fund with stocks.

Graham, Chapter 20:

Chapter 20 is entitled "Margin of Safety as the Central Concept of Investment" (p. 512). I think this chapter sums up Graham's investing philosophy. He not only covers the risk of buying a good quality stock at a high price, but buying a poor quality stock at a high price during an up-trending market. The latter is one of the riskier moves you can do with your money in the context of the margin-of-safety. On the other hand, purchasing stock in a good quality company, even if it's at a high price, will ultimately end up being the better choice. One other important point in this chapter is the mention of diversification as a tool of safety, not perfection. While he doesn't go into specific methods of diversification, Graham does point out that even if one stock tanks, diversifying your portfolio "guarantees only that (you) have a better chance for profit than for loss - not that loss is impossible" (p. 518).

http://jeffpearson.efoliomn.com/IIS

Book Summary: The Intelligent Investor by Benjamin Graham

2012-01-22T07:56:00.000+08:00

As shocking as this may sound to some of you, I just finished reading The Intelligent Investor by Benjamin Graham. The shocking part for many of you may be why I only read it now. Well, the answer is a dumb one but it's the truth. I remember looking at some excerpt of the book 5 or 10 years ago and saw something about railroads (or something like that). Back then, being the young, dumb, person I was, I was like "What the hell is a railroad? Aren't those some ancient relics of the past? I know there is a train that goes by my house but so what? Does anyone even make money on them?" Obviously my youthful arrogance, not to mention lack of time, made the worst of me. Little did I realize that, although the examples are somewhat dated, the concepts behind the book were quite insightful. I do have to admit that I have read most of Graham's principles in articles, websites, reports, and so forth, so I basically knew most of Graham's philsophies (I just didn't get around the reading his actual book).

I think it's quite fitting to pick the best value investing book of all time as my first book review on this "young" site. Since this book has been beaten to death by many (i.e. talked about, quoted, reviewed, etc), I probably won't provide much insight. I think my future book commentaries may be more interesting given that my interests are diverse and I may pick something less commonly talked about.

For most of the books I'll be looking at, I won't necessarily write a review but instead talk about insightful elements from the book, while adding some thoughts regarding my investments. If you find anything I say interesting, purchase the book or sign it out at the library or something (written knowledge is one of the cheapest things in life).

(All errors in quotations are mine. Please do point them out to me. All italics and bolds are mine.)

(image courtesy amazon.com)

The Intelligent Investor: A Book of Practical Counsel
By Benjamin Graham
2003 Revised Edition (based on the 1973 4th edition)

You know you are reading something great when the book you signed out from the library is worn out even though it is only a 2003 book. In fact, I had to sign out multiple times (didn't finish in time) and each book was worn out. Warren Buffett even considers The Intelligent Investor the best investing book ever written.

The edition I read was the 2003 revised edition with commentary by Jason Zweig (of Fortune)--this edition happens to be based on the 1973 edition. Although I haven't read the other editions, and some think the earlier editions are better, I think this one is best for newbies such as myself. The problem with investment books is that the market environment changes so rapidly that some of the concepts may not be relevant--and in fact wrong. Jason Zweig does a fine job giving modern examples (from the 2000s), as well as elaborating on Graham's points at the end of each chapter. However, Jason Zweig mainly addresses Graham's defensive investors (definition below) so I found most of what he said to be not too insightful.

If there is a weakness in the book, it is the fact that the prose isn't necessarily easy to understand, and that some things aren't as significant nowadays. For instance, it would be difficult to find many securities in a stock market in a developed country satisfying Graham's requirements. Criteria such as high dividend yield and price below book value are rare nowadays. A bear market will result in more securities fitting Graham's requirements but, even then, the selection will likely be small. Some of the things that Graham talks about, such as warrant dilution, is also less of an issue now, as Jason Zweig points out (although warrant dilution has been replaced with option dilution so human behaviour is still the same).

The Intelligent Investor is written for lay investors and is relatively easy to read. Being the so-called father of value investing, Graham defines the core terms that are important to value investors. In the paragraphs below, I will talk about items that I personally find useful (this means that I will skip over many other things that you may find benefitial).

Some Categorization

The first thing an investor needs to understand is the difference between an investor and a speculator. Graham cites the following:

An investment operation is one which, upon thorough analysis promises safety of principal and an adquate return. Operations not meeting these requirements are speculative.

Note that I emphasized the notion of safety of principal. Graham's definition has nothing to do with volatility or inherent risk in an asset. In contrast, the Wall Street view keeps changing with time. At one time, all stocks were considered speculative; while at other times, almost all stocks were investments.

Graham also goes on to seperate intelligent investors into two camps:

Defensive Investor: One who wants safety and less involvement
Enterprising Investor: One who wants higher returns that he/she is willing to work for

In contrast to the conventional view, an enterprising investor is not one who is more risky or aggressive; instead, it is one who has an interest in investing and is willing to work hard for it. I think it is important for investors to figure out which category they fall into. I, as well as nearly all readers of this blog, will be considered enterprising investors. Therefore, I will only talk about concepts inThe Intelligent Investor that apply to enterprising investors. Make sure you understand that most of what I reference below is not suitable for defensive investors.

What to Avoid

There are many roads that lead to the Kingdom of Financial Success. You can become wealthy by pursuing a multitude of methods, but if you choose to follow Graham's techniques, you should avoid the following:

Trading
Short-term selection (buying based on near-term expected earnings results)
Long-term selection (buying based on expected future growth (typically in computers, drugs, etc))

Graham suggests that any successful strategy be "sound and promising" and "not popular on Wall Street". In the book, he develops some strategies that fit those desired conditions. For enterprising investors, Graham tells them to avoid:

High quality preferred stocks: These are mainly advantageous for cross-corporation purchases because corporations supposedly don't pay taxes on them
Bonds and lower quality preferreds: Never buy lower quality bonds at par.Only purchase if they are trading 30% below par for the high coupon ones, and a bit lower for the lower coupon ones
Foreign government bonds: These generally do poorly, and right now many emerging market bonds are priced as if they will never default--something I find unlikely
New issues (IPOs) and new stock offerings (by existing companies): A lot of statistical evidence from other sources against this idea
Common stocks with short history of good earnings

Since I'm looking at the Pulte Homes exchange-traded bonds (PHA), I'm going to delve into Graham's comments about bonds for a bit. I'm not sure if PHA would be considered second grade or not. Moody's has Pulte's bonds on watch for a potential downgrade, which will put them into junk territory so you are looking at a very low quality bond. But Pulte is one of the largest homebuilders in USA so it is a leading company (secondary companies are not leaders). Graham essentially says never to buy second grade bonds at par value! Graham points out that practically all bonds trade below par when economic conditions are poor, so should be patient and wait. In fact, in an ideal situation, first grade bonds of high quality corporations can trade at a big discount at times (Graham points to railroad bonds early on and utility bonds later on).

If one if interested in bonds, best place to look is in out of favour sectors. Recall that Warren Buffett and Mohnish Pabri bought Level 3 Communications convertibles back in 2002 (I believe), when technology stocks were totally out of favour. Right now homebuilders are totally out of favour and that's why I'm looking at them. Right now PHA is trading 20% below par (with a yield of around 8.4%), and I'm waiting until price drops even further to, say, 40% below par (and yield of around 10%). If Moody's downgrades the bonds (a possibility if Pulte posts weak earnings this quarter), I think they will drop to my target range.

If you ever thought stocks were volatile, wait until you check out foreign bonds (on a side note, I think a lot of emerging market bond buyers are going to suffer greatly when the commodities boom ends within a few years). Anyone up for a rollercoaster ride:

How many readers have any idea of the repeated vicissitudes of the 8% bonds of Czechoslovakia, since they were first offered in this country in 1922 at 96.5? They advanced to 112 in 1928, declined to 67.75 in 1932, recovered to 106 in 1936, collapsed to 6 in 1939, recovered (unbelievably) to 117 in 1946, fell promptly to 35 in 1948, and sold as low as 8 in 1970!

Strategies to Use

For the enterprising investor, Graham recommends the following strategies:

Relatively unpopular large company: This would entail buying unpopular S&P500-type companies in a group
Bargain Issues: Graham says to buy securities 50% below their true value. You determine the actual worth by (i) appraisal, where you discount future earnings, or (ii) business value to a private buyer, where you look at future earnings but also seriously consider net current asset
Special situation or "workout": This involves things like merger arbitrage, takeovers, bankruptcy investing, and so forth. Graham says only a small percentage of enterprising investors are likely to use this method so this book does not go into this strategy.

Graham strongly suggests that one needs to be dedicated if they are to follow the enterprising investor role:

The aggressive investor must have a considerable knowledge of security values--enough in fact, to warrant viewing his security operations as equivalent to a business enterprise. There is no room in this philosophy for a middle ground, or a series of gradations, between the passive and aggressive status. Many, perhaps most, investors seek to place themselves in such an intermediate category; in our opinion that is a compromise that is more likely to produce dissapointment than achievment.

The Intelligent Investor elaborates on some tools to be used in analyzing securities. It is quite brief but it gives enough of a starting point for the lay investor to pursue. One of the insightful items I found was the following simplified formula for valuing growth stocks:

value = current_(normal)_earnings x [8.5 + 2 x expected_annual_growth_rate]

So at 0% growth, P/E is 8.5, and growth in 10 years is 0.
At 2.5% growth rate, P/E is 13.5, and growth in 10 years is 28%.
At 5% growth rate, P/E is 18.5, and growth in 10 years is 63%.

I was always uncertain when it came to pricing future growth and this rough formula provides some help to me. It isn't accurate but one should keep in mind that projecting the future can be misleading so a rough guide is all that I want.

It seems obvious nowadays but it's worth mentioning the point from Graham about earnings manipulation. Graham says to read the fine point (footnotes) and think about charges and other one-time items. He recommends that one should use average earnings over a period of time, rather that the present one year earnings. (Instead of earnings, it is prudent to look at ROIC and book value per share growth--this is not Graham's suggestion).

Based on his experience at his firm, Graham-Newman, Graham suggests the following for enterprising investors:

Arbitrages: True arbitrage is risk-free but most so-called "arbitrage" strategies carried out by most people are single-sided bets. For instance, when Warren Buffett recently took a stake in Dow Jones, before it was acquired by News Corporation, there was no way to hedge the transaction*.
Liquidations: This involves buying shares where you will receive cash payments from liquidations. This sounds interesting but I am not sure how to search for these stocks (if anyone has some ideas, leave comments or e-mail me please).
Related hedges: Graham talks about buying covertibles and selling the underlying stock
Net current asset (bargain) issues: Buying below 2/3 net current asset value. Graham suggests wide diversification (his firm had 100 securities at once).

(* On a side note, I thought that deal was risky (before hearing about Buffett's move) but Buffett clearly thought otherwise. The risk I saw was that the family that controlled Dow Jones may not accept the deal but Buffett correctly predicted the deal consummation.)

One strategy is to look at beaten down cyclicals:

If he [enterprising investor] followed our philosophy in this field he would more likely be the buyer of important cyclical enterprises--such as steel shares perhaps--when the current situation is unfavourable, the near-term prospects are poor, and the low price fully reflects the current pessimissm.

The above is what being a contrarian is all about!

Graham suggests the following screen to narrow down stocks:

(a) current assets greater than 1.5 x liabilities; (b) debt less than 110% of net current assets (for industrial companies)
no earnings deficit in last 5 years
some current dividend
earnings greater today than 5(?) years ago
stock price less than 120% of net tangible assets

There are very few stocks that will pass that screen right now (the screen for a defensive investor is even more stricter than what is given above). To satisfy Graham's filter, one either needs to wait for a market correction or look at ignored places like foreign stocks, smallcap stocks, pink sheet stocks, and so forth.

The Most Important Lessons

Even if one doesn't follow everything else that was covered in the book, there are two important insights for any investor.

The first is the God-like entity that we all love and hate, Mr. Market. The ever-emotional Mr. Market has a habit of offering prices higher than the true worth of a firm, and at other times, a price lower than what a company is worth. The lesson to learn is that one should take advantage of the market and sell when the offering price is higher than a company's true value, and buy when the price is clearly below the worth of a company. The choice to act is yours and, in general, one should just ignore the quoted prices. Investing is as simple as that!

The second important point can be summed up in a few words--perhaps the most important in all of investing--by Graham: margin of safety. Those three words are just as immortal as the old saying that applies to all situations: "this too shall pass". If there is something that seperates value investors from other investing styles, it is this concept of margin of safety.

Graham suggests that an investor only buy securities with a big margin, where the price paid is far below the value of the business. He also recommends diversification in addition to a margin of safety (although I should note that Graham at one time had 25% of his portfolio in one stock, GEICO--he made more money on this than all his other investments combined).

Ultimately, Graham says that investors should think like a businessperson. He gives some principles to act like a businessperson:

Know what you are doing--know your business: Just like a businessperson knows the details of the product or service he/she is selling, so should you.
Do note let anyone else run your business unless (1) you can supervise his performance with adequate care and comprehension or (2) you have unusually strong reasons for placing implicit confidence in his integrity and ability.: Only let others manage your money if they fit these suggestions.
Do not enter upon an operation--that is, manufacturing or trading in an item--unless a reliable calculation shows that it has a fair chance to yield a reasonable profit. In particular, keep away from ventures in which you have little to gain and much to lose.: Graham says the an investment decision should be based on arithmetic rather than optimism.
Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it--even though others may hesitate or differ. (You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.): Graham is basically saying that one needs to act on their convictions after a solid case can be made.

The above suggestions are the hardest for me. I need to start thinking like as if I'm running a real business.

Final Opinion

Overall, I think this is a remarkable book--Benjamin Graham isn't called the father of value investing for nothing. Since a lot of the concepts have been repeated in other books or covered in magazines, I did not find this book as mindblowing as some others may have. I highly recommend this book to any investor that has some knowledge of investing (if you are total newbie and doesn't know what a bond or preferred share is then you should read an introductory book before this one). Even if you are not a value investor, you should check out this book to see what value investing is all about. Contrarians will find a lot of insight from an experienced master who lived and breathed Wall Street for almost half a century.

http://can-turtles-fly.blogspot.com/2007/10/book-summary-intelligent-investor-by.html

A Summary of the Principles of Benjamin Graham

2012-01-22T07:50:00.000+08:00

The Intelligent Investor

Part 1 - A Summary of the Principles of Benjamin Graham

1. Speculation vs. Realistic Results

Investment vs. Speculation

Investing, as defined by Benjamin Graham, promises Safety of Principal and an adequate return by thoroughly analyzing investment opportunities. Investing may be contrasted to Speculating. Speculation includes any activity that unduly risks principal. Speculation is acceptable only if the speculator acknowledges that such behavior will result in losses over the long run. If the speculator confuses his activity for investing, undertakes it seriously, or risks more than he can afford to lose, then the speculator is acting foolishly.

The Defensive Investor

The Defensive Investor seeks Safety of Principal and freedom from bother. Without exertion, the defensive investor cannot expect to achieve better than average results. Yet achieving results that are better than average is itself uncommon. In fact, most mutual funds fail to achieve better than average results.

The Defensive Investor’s portfolio is comprised of 1^st quality common stocks and bonds, of which neither comprises less than 25% of the portfolio at any one time. Thus, the defensive investor may hold as much as 75% stock at the end of a recession and as little as 25% stock at the end of a bull market. Notwithstanding, market timing itself is speculation. Stocks provide a hedge against inflation. 1^st quality bonds are less subject to severe price fluctuations in turbulent markets.

The Defensive Compromise

Investment quality bonds are always safer than stock except during periods of inflation. Inflation causes interest rates to rise, and this devalues fixed income securities. A business that can raise prices has protection against inflation. Appreciation of common stocks is based largely on reinvestment of earnings, which usually increases during periods of inflation (albeit maybe not during periods of stagflation). Thus, a conservative investor should keep at least 25% of his portfolio in stock as a hedge against inflation. As stated, the defensive investor can expect no more than average results. The defensive investor can not do better by purchasing new offerings or “hot” issues to make a quick profit. In fact, the contrary is almost certain.

Three alternatives for the Defensive Investor

1. Buy shares of established investment funds.

2. Utilize a trust company, bank, or certified investment counselor.

3. Use Dollar-Cost-Averaging, which means placing equal monetary amounts into a fund regardless of the current economy. However, this assumes that the investor will have the same resources available to him in all economies, regardless of his employment status, and that the investor has the courage to continue investing during turbulent times.

The Enterprising Investor

Although the enterprising investor should expect to do better than the defensive investor, he is likely to do worse. Three speculative areas that the investor should avoid are:

1. Trading in the market – short selling and betting against trends. This neither offers safety of principal nor a satisfactory return.

2. Short-term selectivity – buying stock of firms that are expected to report increased earnings. Not only may the investor be wrong in his selection, but also the issue may be fully valued due to a relatively efficient market.

3. Long term selectivity – Choosing companies that show great promise. The same arguments apply for short and long term selectivity based upon expected favorable results.

To achieve success, an investor must follow policies that are sound and not popular on Wall Street. There are large discrepancies between market price and actual value. Often, speculative stock movements are at unreasonably high or low levels. Nonetheless, buying neglected and undervalued issues can prove both protracted and frustrating.

The ingrained, long-standing and seemingly insane maxim of Wall Street is to buy stocks when they have gone up and to sell them when they have gone down. This is as opposed to the cliché of buying low and selling high. One may take advantage of this contradiction by concentrating on bargain issues, that is, those possessing a market price less than their net current asset value (i.e. working capital less long term liabilities).

The search for these types of issues, and the diligence required to investigate them, is not worth an investor’s time unless the investor can add at least 5% before taxes to the average annual return. Thus, the aggressive investor seeks a 5% return over the market average.

2. Inflation

Fixed income investments fare worse during inflationary periods than do common stocks. During inflationary periods, firms can increase prices, profits, and dividends causing their share price to increase and offsetting declines in purchasing power. In 1970, the most probable average future rate of inflation was 3%.

The investor can not count on more than a 10% return above the net tangible assets of the DJIA. This is consistent with the suggestion that the average investor may earn a dividend return of 3.6% on their market value and 4% on reinvested profits.

There is no underlying connection between inflation and the movement of common stock earnings and prices. Appreciation does not result from inflation, but rather from the re-investment of profits. The only way for inflation to increase common stock values is to raise the rate of earnings on capital investment, which it has not done historically.

Economic prosperity usually is accompanied by slight inflation, which does not affect returns. Offsetting factors include rising wage rates that exceed productivity gains and additional capital needs that cause interest rates to increase. The investor has no reason to believe that he can achieve average annual returns better than 8% on DJIA type investments.

Graham describes alternatives to common stocks as a hedge against inflation. These alternatives range from gold and diamonds to rare paintings, stamps, and coins. Gold has performed poorly, far worse than returns from savings in a bank account. The latter categories, such as paying thousands of dollars for a rare coin, can not qualify as an “investment operation.” Real Estate is still another alternative; however, its value fluctuates widely, and serious errors may be made when purchasing individual locations. Again, the defensive investor is best served by purchasing a portfolio of carefully chosen common stocks and bonds.

3. Stock Market History

During the last 100 years, stocks have made an underlying advance through numerous market cycles. These cycles can be divided into 10 year periods.

The period from 1900 to 1968 can be subdivided into three segments. From 1900 to 1929, market cycles lasted 3 to 5 years. From 1929 to 1949, the DJIA barely moved, rising a mere 1.5% per year, evidencing the public disdain for common stocks. Then, from 1949 to 1968, there was mostly one single bull market punctuated by only several short recessions. During this 20 year period the DJIA advanced 6 times, averaging an annual 11% compounded rate of return not including average dividend returns of 3.5%, for a total return of 14% per annum. Just when the market seemed its rosiest, the DJIA fell 36% between 1968 and 1970, then returned to an all time high in 1972. 1970 marked a definite deterioration in the health of American firms. The average ROIC fell to its lowest level since WWII, and a number of important bankruptcies occurred. Measuring market performance in 10 year increments smoothes annual fluctuations.

Only 2 of the last 8 decades had a decrease in common stock earnings and prices. However, shorter term fluctuations have been more severe. For example, during the period from 1959 to 1961, many “hot” issues went public at astoundingly high valuations. These valuations were further elevated by speculation. By 1962, many of these same issues had lost as much as 90% of their value.

In the 1964 writing of the “Intelligent Investor”, Graham believed that the market was overvalued. He stated that the old standards of valuation were inapplicable and major investing uncertainties existed. He stated that if the current market level was not too high, then no price was too high. When markets are overvalued, Graham recommends the following actions:

1) Do not borrow to buy or hold securities.

2) Do not increase the proportion of stocks held in funds.

3) Reduce common stock holdings to no more than 50% of the overall portfolio.

4) Suspend contributions to any “dollar-cost averaging” stock contribution plan.

4. The Defensive Investor’s Portfolio Policy

Those who can not afford to take risks should be content with a relatively low return. The rate of return is dependent upon the amount of effort put forth by an investor. As previously stated, the defensive investor’s portfolio should consist of no less than 25% high grade bonds and no less than 25% large stocks. Yet these maxims are difficult to follow, because like the herd of Wall Street, when the market has been advancing, the temptation is strong to bet heavily on stocks. This is the same facet of human nature that produces bear markets. The time to invest in the stock market is after it has suffered a large loss.

A 50% ratio of stocks and bonds was a prudent choice except during periods of excessive increases or decreases in stock value. This simple formula guards against the mistakes caused by human nature even if it does not provide for the best returns. Again, Safety of Principal is Graham’s chief concern.

Bonds

The decision between purchasing taxable and tax-free bonds depends mainly on the difference in income to the investor after taxes. Those in a higher bracket have a greater incentive to closely examine this issue. For example, in 1972, an investor may have lost 30% of his income from investing in municipal issues (“munis”) as opposed to taxable issues.

Bonds come in many types, a description of which follows:

US Savings Bonds are a great choice. In 1972, they came in two series: E and H. The Series H Bond paid semi-annual interest. Series E Bonds did not pay interest, but rather sold at a discount to their coupon rate. In 1972, Series E bonds provided the right to defer income tax payments until the bond was redeemed, which in some cases increased the value by as much as one-third. Both E and H Series Bonds are redeemable at any time providing bondholders protection from shrinkage of principal during periods of rising interest rates (or rather, the ability to benefit from rising rates). Both series paid in or around 5% in 1972. Federal, but not state, income tax was payable on both series. Graham recommends US Bonds due to their assurance of transferability, coupon rate, and security.

Other US Bonds come in many varieties. Federal taxes, but not state taxes, are charged on other US Bonds. Some of these issues are discounted heavily. Others bonds are guaranteed, but not issued, by the US government. As of 1972, the US government had fully honored its commitments under all guarantee obligations. Federal guarantees, in essence, permit additional spending by various federal agencies outside of their formal budgets.

State and Municipal Bonds are exempt from federal and state tax in the State of their issue. However, not all of these bonds possess sufficient protection to be considered worthy of investment. To be worthy of investment, a bond should possess a minimum rating of “A”.

Corporate Bonds are taxable and offer higher yields than all types of government issues bonds.

Junk Bonds are those that are less than investment grade. Their title is aptly given. The investor should steer clear of these issues. The additional yield that junk bonds provide is rarely worth their risk.

Savings and Money Market Accounts are a viable substitute for US Bonds. They usually pay interest rates close to rates paid on short-term US bonds.

Preferred Stocks should be avoided. Not only does the preferred holder lack the legal claim of a bondholder (as a creditor), but also he lacks the profit possibilities of the common stock holder (as a partner). The only time to purchase preferred stock, if ever, is when its price is unduly depressed during times of temporary adversity.

Early redemption of bonds by issuers was commonplace before 1970, and resulted in an unfair advantage for the issuer by not allowing the investor to participate in significant upside values if interest rates fell. However, this practice largely stopped. The investor should sacrifice a small amount of yield to ensure that his bonds are not callable.

5. The Defensive Investor and Common Stock

Common Stocks offer protection against inflation and provide a better than average return to investors. This higher return results from a combination of the dividend yield and the reinvestment of earnings (undistributed profits), which increases value. However, these benefits are lost when the investor pays too high a price. One should recall that prices did not recover again to their 1929 highs for another 25 years. However, the defensive investor can not do without a common stock component.

4 Rules for the Defensive Investor Accumulating Common Stock:

1. There should be adequate, although not excessive, diversification; that is, between 10 and thirty stocks.

2. Each stock should be large, prominent, and conservatively financed. Conservatively financed means a debt to capital ratio no greater than 30%. Large and prominent means that the firm, in 1972 dollars, has at least $50 million in assets and annual sales, and it should at least in the top third of its industry group. Each of the 30 DJIA firms met this criteria in 1972.

3. Each firm should have a long record of continuous dividend payments.

4. Each stock should cost no more than 25 times the average of the last 7 years of earnings, and no more than 20 times the last 12 months earnings.

This last rule virtually bans all growth and other “in-favor” stocks. Due to the fact that these issues sell at high price, they necessarily possess a speculative element. A “growth stock” should at least double its earnings per share every 10 years for a minimum compounded rate of return of 7.1%.

The best of the growth stocks, IBM, lost 50% of its value during the declines of 1961 and 1962. Texas Instruments went from $5 to $256 (a 50x increase) in six years without a dividend payment as its earnings rose from $0.40 to $3.94 (a 10x increase); 2 years later TI’s earnings fell 50% while its stock price fell 80% to $50.

The temptations here are great, as growth stocks chosen at the correct prices provide enormous results. However boring, large firms that are unpopular will invariably perform better for the defensive investor.

Dollar Cost Averaging (“DCA”) often is popular during rising markets. If DCA is adhered to over many years, then this formula should work. The difficulty is that few people are so situated that they can invest the same amount each year. Economic downturns often constrain one’s ability to invest just when stocks are trading at their lowest valuations. Furthermore, when prosperity for the average investor returns, so too do high valuations.

Most people fall into the “defensive investor” category. Graham provides examples such as a widow who cannot afford unnecessary risks, a physician who cannot devote the time for proper analysis, and a young man whose small investment will not return enough gain to justify the extra effort. The beginning investor should not try to beat the market.

The investor only realizes a loss in value through the sale of the asset or the significant deterioration of the firm’s underlying value. Careful selection and diversification helps to avoid these risks. A more common and difficult problem is overpaying for securities; that is, paying more for a security than its intrinsic value warrants.

6. Portfolio Policy for the Enterprising Investor – the Negative Side

What to Avoid

The aggressive investor should start with the same base as the defensive investor, dividing the portfolio more or less equally between stocks and bonds. To avoid losses or returns lower than that of the defensive investor, the aggressive investor should steer clear of the following pitfalls:

1. Avoid all preferred stocks. Preferred stock rarely possesses upside component that is the basis for owning common stock. Yet compared to debt, preferred stock affords little protection. Since dividends can be suspended at anytime, unlike debt, why not just own debt instead?

2. Avoid inferior (“high yield” or “junk”) bonds unless such bonds are purchased at least 30% below their par value for high coupon issues, or 50% below par value for other issues. The risk of these issues is rarely worth the interest premium that they offer.

3. Avoid all new issues.

4. Avoid firms with “excellent” earnings limited to the recent past.

Quality bonds should have “Times Interest Earned” ratio, that is EBIT/net interest, of at least 5x.

Preferred stocks, convertible bonds, and other high yield or “junk” bonds often trade significantly below par during their issue, so purchasing them at par is unwise. During economic downturns, lower quality bonds and preferred stocks often experience “severe sinking spells” where they trade below 70% of their par value. For the minor advantage in annual income of 1%-2%, the buyer risks losing a substantial amount of capital, which is bad business. Yet purchasing these issues at par value provides no ability to achieve capital gains. Therefore, unless second grade bonds can be purchased at a substantial discount, they are bad deals!

Foreign Government Bonds are worse than domestic high yield junk, for the owner of foreign obligations has no legal or other means of enforcing their claims. This has been true since 1914. Foreign bonds should be avoided at all costs.

Investors should be wary of all new issues. New issues are best left for speculators. In addition to the usual risks, new issues have salesmanship behind them, which artificially raises the price and requires an additional level of resistance. Aversion becomes paramount as the quality of these issues decrease.

During favorable periods, many firms trade in their debt for new bonds with lower coupons. This inevitably results in too high a price paid for these new issues, which then experience significant declines in principal value.

Common stock issues take two forms - - those that are already traded publicly (secondary issues) and those that are not already traded publicly (IPOs). Stock that is already publicly traded does not ordinarily call for active selling by investment houses, whereas the issue of new stock requires an active selling effort. Most new issues are sold for account of the controlling interests, which allows them to cash-in their equity during the next several years and to diversify their own finances. Not only does danger arise from the poor character of businesses brought public, but also from the favorable market conditions that permit initial public offerings.

New issues during a bull market usually follow the same cycle. As a bull market is established, new issues are brought public at reasonable prices, from which adequate profits may be made. As the market rise continues, the quality of new issues wanes. In fact, one important signal of a market downturn is that new common stocks of small, nondescript firms are offered at prices higher than the current level for those of medium sizes with long market histories.

In many cases, new issues of common stock lose 75% or more of their initial value. Thus, the investor should avoid new issues and their salespeople. These issues may be excellent values several years after their initial offering, but that will be when nobody else wants them.

7. Portfolio Policy for the Enterprising Investor - the positive side

Selection of Bonds

In addition to the US Bonds described in previous chapters, US guaranteed bonds like “New Housing Authority Bonds” and “New Community Bonds” (both of which were widely available in 1972), as well as tax free municipal bonds serviced by lease payments of A rated corporations, are good investments. Lower quality bonds may be attainable at true bargains in “special situations”, however these have characteristics that are more similar to common stocks.

Selection of Stocks

The enterprising investor usually conducts 4 activities:

1. Buying in low markets and selling in high markets.

2. Buying carefully chosen growth stocks.

3. Buying bargain issues.

4. Buying into “special situations”.

1. Market timing - This is a difficult proposition at best. Market timing is more of a speculative activity.

2. Growth Stocks – This also is difficult. These issues are already fully priced. In fact, their growth may cease at any time. As a firm grows, its very size inhibits further growth at the same rate. Therefore, the investor risks not only overpaying for growth stocks, but also choosing the wrong ones. In fact, the average growth fund does not fair much better than the indexes. Also, growth stocks fluctuate widely in price over time, which introduces a speculative element. The more enthusiastic the public becomes, the more speculative the stock becomes as its price rises in comparison to the firm’s earnings.

3. Special Situations – This is a specialty field that includes workouts in bankruptcy and risk arbitrage arising from mergers and acquisitions. However, since the 1970s, this field has become increasingly risky with available returns less than were previously realizable. In addition, this field requires a special mentality as well as special equipment. Thus, to the common investor, this area is highly speculative.

4. Bargain Issues – This is the area in which the common investor has the enterprising investor has the greatest chance for long term success.

The market often undervalues large companies undergoing short-term adversity. The market also will undervalue small firms in similar circumstances. Large firms generally possess the capital and intellectual resources necessary to carry the firm through adversity; plus, the market recognizes the recovery of large firms faster than it does for small firms. Small firms are more likely to lose profitability that is never to be regained, and when earnings do improve, they may go unnoticed by the market.

One way to profit from this strategy is to purchase those issues of the DJIA that have either the highest dividend yields or the lowest earnings multiples. The investment returns using this method should result in a return approximately 50% better than purchasing equal amounts of all 30 DJIA issues. This is a sound starting point for the enterprising investor.

Caution must be paid not to purchase companies that are inherently speculative due to economic swings, such as the Big 3 automakers. These firms have high prices and low multipliers in their good years, and low prices and high multipliers in their bad years. When earnings are significantly low, the P/E is high to adjust for the underlying value of the firm during all economic periods. To avoid this mistake, the stock selected should have a low price in reference to past average earnings.

Bargain issues are defined as those that worth considerably more than their market price based upon a thorough analysis of the facts. To be a true bargain, an issue’s price must be at least 50% below its real value. This includes bonds and preferred stocks when they sell far under par.

There are two ways to determine the true value of a stock. Both methods rely upon estimating future earnings. In the first method, the cumulative future earnings are discounted at an appropriate discount rate, or in the alternative, the earnings are multiplied by an appropriate p/e multiple. In the second method, more attention is paid to the realizable value of the assets with particular emphasis on the net current assets or working capital.

During bear markets, many issues are bargains by this definition. Courage to purchase these issues in depressed markets often is later vindicated. In any case, bargains can be found in almost all market conditions (except for the highest) due to the market’s vagaries. The market often makes mountains out of molehills. In addition to currently disappointing results, a lack of interest also can cause an issue to plummet.

Many stocks, however, never recover. Determining which stocks have temporary problems from those that have chronic woes is not easy. Earnings should be proximately stable for a minimum of 10 years with no earnings deficit in any year. In addition, the firm should have sufficient financial strength to meet future possible setbacks. Ideally, the large and prominent company should be selling below both its average price and its past average price/earnings multiple. This rule usually disqualifies from investment companies like Chrysler, whose low price years are accompanied by high price earnings ratios. The Chrysler type of roller coaster is not a suitable investment activity.

The easiest value to recognize is one where the firm sells for the price of its net working capital after all long-term obligations. This means that the buyer pays nothing for fixed assets like buildings and machinery. In 1957, 150 common stocks were considered bargain issues. Of these, 85 issues appeared in the S & P Monthly Guide. The gain for these issues in two years was 75%, compared to 50% for the S & P industrials. This constitutes a good investment operation. During market advances bargain issues are difficult to find.

Secondary issues, those that are not the largest firms in the most important industries, but that otherwise possess large market positions, may be purchased profitably under the conditions that follow. Secondary issues should have a high dividend yield, their reinvested earnings should be substantial compared to their price, and the issues should purchased well below their market highs. Regardless of the circumstance, purchasing a firm’s issue prior to its acquisition usually results in a realized gain for the investor.

General Rules for Investment

The aggressive investor must have a considerable knowledge of security values and must devote enough time to the pursuit as to consider it a business enterprise. Those who place themselves in an intermediate category between defensive and aggressive are likely to produce only disappointment. There is no middle ground. Thus, a majority of security owners should position themselves as defensive investors who seek safety, simplicity, and satisfactory results.

As stated earlier, all investors should avoid purchase at full price of all foreign bonds, ordinary preferred stocks, and secondary issues. “Full price” is defined to be the fair value of a common stock or the par value of a bond.

Most secondary issues fluctuate below fair value and only surpass their value in the upper reaches of a bull market. Thus, the only logic for owning common secondary issues is that they are purchased far below their worth to a private owner, that is, on a bargain basis. In secondary companies, the average common share is worth much less to an outside investor than the share is worth to a controlling owner. In any case, the distinction between a primary and secondary issue often is difficult to determine.

8. Market Fluctuations

Fluctuations of Common Stock Prices

Since common stocks are subject to wide price swings, the investor should seek to profit from these opportunities. However, attempting to time the market usually ends in unsatisfactory results. Graham believes that market timing is pure speculation and is not an investing activity. The best an investor can do is the change the bond and stock proportions in his portfolio after major market swings.

Formulas do not work, although they have been in vogue since the 1950s. When the market reached new highs in the mid-1950s, many formula investors sold their equities according to formula only to witness the market grow increasingly higher. Any approach to the market that is easily described is sure to fail (except for Graham’s method).

The investor also can focus on the price of a security. Graham recommends this practice. Short-term fluctuations should not matter. Over a period of 5 years, the investor should not be surprised if the average value of his portfolio increases more than 50% from its low point or decreases 1/3 from its high point.

Market advances and declines tempt investors to make foolish decisions. Varying the proportion of stocks and bonds between the 25%-75% ratio occupies an investor’s time during turbulent markets and prevents him from making gross errors in judgement. The true investor takes comfort that his actions are opposite from the actions of the crowd.

The better a firm’s record and its prospects, the less relationship that its price will have to its book value. The more successful the company, the more likely its share price is to fluctuate. More often than not, a fast growing firm’s market price will exceed its intrinsic value. So, the better the quality of the stock, the more speculative it will be. This explains the erratic price behavior of some of the most successful and impressive enterprises, such as IBM and Xerox.

The investor should purchase issues close to their tangible asset values and at no more than 33% above that figure. These purchases logically are related to a company’s balance sheet and not to its earnings. Any premium over book value may be thought of as a fee for liquidity that accompanies any publicly traded stock.

Just because a stock sells at or below its net asset value does not warrant that it is a sound purchase. In addition to below market values, the investor also must demand a strong financial position, a satisfactory p/e ratio, and an assurance that the firm’s earnings will be sustained over the years. This is not an entirely difficult bill to fill except under dangerously high market conditions. At the end of 1970 more than half of the DJIA met these investment criteria. However, the investor will forgo the most brilliant, high growth prospects.

With a portfolio purchased at close to book value, the investor can take a more detached view of market fluctuations. In fact, so long as the earning power of the portfolio remains satisfactory, the investor can use these market vagaries to buy low and sell high.

As seen with the stock fluctuations of A & P over many years, the market often goes wrong. Although the stock market may fall, a true investor is rarely forced to sell his shares. Rather, the investor is free to disregard the market quotes. Thus, the investor who allows himself to be unduly worried about the market transforms his basic advantage into a disadvantage. In fact, the investor who owns common stock owns a piece of these companies as a private owner would, and a private owner would not sell his business when it is undervalued by the market. A quoted stock provides an option for the investor to sell at a given price and nothing more. The investor with a diversified portfolio of good stocks should neither worry about sizeable declines nor become excited about sizeable advances. An investor never should sell a stock just because it has gone down or purchase it because it has gone up.

Graham provides the parable of “Mr. Market”, who like the stock market, quotes you a price for your shares each and every day. Mr. Market will either buy your shares or sell you his. The price will depend upon Mr. Market’s mood. You can ignore his efforts, or you can take advantage of him when he quotes you a price that you believe is priced advantageously. Finally, one should not forget the effect of management on a firm’s results. Good management produces acceptable results and bad management does not.

Fluctuation of Bond Prices

Short-term bonds, defined as those with a duration of less than 7 years, are not significantly affected by changes in the market. This applies to US Savings Bonds, which can be redeemed at anytime. Long term bonds, however, may experience wide price swings as a result of fluctuations in the interest rate. Thus, long term bonds may seem attractive when discounted, but this practice often leads to speculation and losses.

Low yields correspond with high bond prices and vice versa; prices and yields are inversely related. The period from 1960 to 1975 is marked by reversing swings in the price of bonds so much so that it reminded Graham of Newton’s law: “every action has an opposite and equal reaction.” Of course, nothing on Wall Street actually occurs the same way twice.

Graham acknowledges the impossibility of attempting to predict bond prices, even if common stock prices were predictable. Therefore, the investor must choose between long- term and short-term bonds chiefly on the basis of personal preference. If the investor wishes to ensure that his market values will not decrease, then the investor is best served by US Savings Bonds. With higher yield long term bonds, the investor must be prepared to see their market values fluctuate.

Convertible issues should be avoided. Their prices fluctuate widely and unpredictably based upon the price of the underlying common stock, the credit standing of the firm, and the market interest rate. Because convertible issues experience huge swings in market value, they are largely speculative investments.

Investing MBA.com

"By far, the best book on investing ever written." - Warren Buffett

2012-01-21T12:36:00.000+08:00

The Intelligent Investor by Benjamin Graham

Preface to the Fourth Edition,
by Warren E. Buffett

I read the first edition of this book early in 1950, when I was nineteen. I thought then that it was by far the best book about investing ever written. I still think it is.

To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework. This book precisely and clearly prescribes the proper framework. You must supply the emotional discipline.

If you follow the behavioral and business principles that Graham advocates—and if you pay special attention to the invaluable advice in Chapters 8 and 20—you will not get a poor result from your investments. (That represents more of an accomplishment than you might think.) Whether you achieve outstanding results will depend on the effort and intellect you apply to your investments, as well as on the amplitudes of stock-market folly that prevail during your investing career. The sillier the market’s behavior, the greater the opportunity for the business-like investor. Follow Graham and you will profit from folly rather than participate in it.

To me, Ben Graham was far more than an author or a teacher. More than any other man except my father, he influenced my life. Shortly after Ben’s death in 1976, I wrote the following short remembrance about him in the Financial Analysts Journal. As you read the book, I believe you’ll perceive some of the qualities I mentioned in this tribute.

BENJAMIN GRAHAM

1894–1976

Several years ago Ben Graham, then almost eighty, expressed to a friend the thought that he hoped every day to do “something foolish, something creative and something generous.”

The inclusion of that first whimsical goal reflected his knack for packaging ideas in a form that avoided any overtones of sermonizing or self-importance. Although his ideas were powerful, their delivery was unfailingly gentle.

Readers of this magazine need no elaboration of his achievements as measured by the standard of creativity. It is rare that the founder of a discipline does not find his work eclipsed in rather short order by successors. But over forty years after publication of the book that brought structure and logic to a disorderly and confused activity, it is difficult to think of possible candidates for even the runner-up position in the field of security analysis. In an area where much looks foolish within weeks or months after publication, Ben’s principles have remained sound—their value often enhanced and better understood in the wake of financial storms that demolished flimsier intellectual structures. His counsel of soundness brought unfailing rewards to his followers—even to those with natural abilities inferior to more gifted practitioners who stumbled while following counsels of brilliance or fashion.

A remarkable aspect of Ben’s dominance of his professional field was that he achieved it without that narrowness of mental activity that concentrates all effort on a single end. It was, rather, the incidental by-product of an intellect whose breadth almost exceeded definition. Certainly I have never met anyone with a mind of similar scope. Virtually total recall, unending fascination with new knowledge, and an ability to recast it in a form applicable to seemingly unrelated problems made exposure to his thinking in any field a delight.

But his third imperative—generosity—was where he succeeded beyond all others. I knew Ben as my teacher, my employer, and my friend. In each relationship—just as with all his students, employees, and friends—there was an absolutely open-ended, no-scores-kept generosity of ideas, time, and spirit. If clarity of thinking was required, there was no better place to go. And if encouragement or counsel was needed, Ben was there.

Walter Lippmann spoke of men who plant trees that other men will sit under. Ben Graham was such a man.

Reprinted from the Financial Analysts Journal, November/December 1976.

How to Diagnose What’s Wrong With Your Business

2012-01-21T08:10:00.000+08:00

January 18, 2012, 9:25 AM

By JAY GOLTZ

Over the years, I have met a lot of entrepreneurs who have been frustrated by low profits, lack of growth, or the stress of the never-ending demands. Many struggle with all three. While every business is different, there are common denominators. In fact, I believe there are 10. The tricky part is that failing to have a handle on just one of these areas can result in mediocre performance, a stressful existence, or ultimate and intimate failure. That is one reason the failure rate for small businesses is so high (here are some others).

This is the checklist I review when I’m not satisfied with my company’s performance.

Marketing

1. Targeting. Do you have a strategy to reach your best potential customers with your sales and marketing efforts? A shotgun approach is too expensive and inefficient for any company, especially a small one. What percentage of the people you approach actually buy a product or service like yours?

2. Advertising and Public Relations. There are many choices for where to place an ad and how to execute a public relations campaign. The problem with many small businesses is that their marketing activities are driven primarily by which salespeople happen to call on them. Ineffective advertising or public relations can be not only a tremendous waste of money but a tremendous waste of opportunity. If you are doing things the same way you did them 10 years ago, you are probably getting less response.

3. The Message. Lots of companies still use this line: “We will exceed your expectations.” I even saw it on the back of an ambulance. (I don’t know about you, but I have pretty high expectations when I call an ambulance! Are the technicians going to give me a haircut after they bring me back to life?) It was a good line when someone first thought of it. Now, it is old. It is tired. It needs to retire. You need to exceed people’s expectations by coming up with your own line. Maybe it is not a line at all. Maybe it is a message. Whatever it is, it should say something about your company that means something to potential customers.

Management

4. Hiring. I can’t think of anything more important than hiring the right people. Great hiring is a skill, one that frequently is not the strong suit of the typical entrepreneur. Do you have a hiring process? Hiring by trial and error is a very expensive and painful way to build a staff. I have found that hiring the right people is 75 percent of management. What percentage of the people you hire work out great? It should be 80 percent or 90 percent, and perhaps less in a low-wage environment.

5. Firing. This is never a popular subject, and it’s especially uncomfortable these days. But it is a harsh reality of business that some people are just not suited for some jobs. Many bosses avoid firing at all costs, including going broke, because they want to see themselves as being “nice.” In reality, customers and other employees just see them as irresponsible. Here is a simple test: Are there people who work for you who you would be relieved to have come in tomorrow and quit? If the answer is yes, that is not a good sign. Especially if the employee is a relative.

6. Operations. Training, standards, support, recognition, systems, key performance indicators, follow-up, etc. Is your company getting the job done? Are customers happy? Do you know? How is employee turnover? Are employees happy? Would they tell you if they weren’t? Do you have people who tell you the truth? Do you yell? (I know. You’re passionate.) Have good people left your company for more money? That is frequently an indication of other problems.

Accounting and Finance

7. Basic Accounting. Many seemingly successful companies have gotten into big trouble by neglecting accounting until it is too late. Accounting is not just about paying taxes. It is about information, insight, and control. Great accounting will not make a business successful, but bad accounting can destroy a business. Is someone staying on top of receivables, being careful about opening new accounts and making sure the existing ones are current? Could you walk someone through your financial statements and explain each part?

8. Pricing. This is probably the sleeper on this list. I can’t tell you how many times I have seen entrepreneurs either put themselves out of business, or never make the money they should have, because of bad pricing models. They charge prices that bear no relation to the costs or to the value proposition. This is just one of the reasons a company needs accurate accounting — so it can determine the true cost of a product or service. Do your salespeople have control of the pricing for jobs that they quote? If so, are they selling at a price that allows you to make a profit?

9. Financing. Most businesses need some kind of financing. Whether it comes from investors, banks, credit unions, factoring or even credit cards, there is a lot to know and understand. This is another place where a good accountant can be of great help. Or not. If you have one of the many accountants who just do tax returns and are not really experienced at helping businesses grow, you can find lots of information in books and online. Or you can hire a better accountant. Here is a test: Do you know your debt-to-equity ratio?

Leadership

10. Any one of these topics could fill a book, and leadership is no exception. Let me count the ways: vision, direction, inspiration, support. It is similar to management, but they are not the same thing. As my company has gotten larger, I have found that leadership gets easier because I now have managers managing. When a company is smaller, the boss has to manage and lead. One minute you are writing someone up for violating the late policy, and the next you are trying to inspire the troops. Perhaps management is pushing, and leadership is pulling. It’s not easy doing both at the same time.

Whether you score well or poorly on this list, keep in mind that it is an ongoing struggle. Personally, I’ve been doing this for 30 years, and I can assure you that I am constantly wrestling with almost every item on the list.

So how did you do?

Jay Goltz owns five small businesses in Chicago.

Margin of Safety Concept in The Business Venture of Making Profits from Security Purchases and Sales

2012-01-21T07:14:00.003+08:00

To Sum Up

Investment is most intelligent when it is most businesslike. It is amazing to see how many capable businessmen try to operate in Wall Street with complete disregard of all the sound principles through which they have gained success in their own undertakings.

Yet every corporate security may best be viewed, in the first instance, as an ownership interest in, or a claim against, a specific business enterprise. And if a person sets out to make profits from security purchases and sales, he is embarking on a business venture of his own, which must be run in accordance with accepted business principles if it is to have a chance of success.

The first and most obvious of these principles is, “Know what you are doing—know your business.” For the investor this means: Do not try to make “business profits” out of securities—that is, returns in excess of normal interest and dividend income—unless you know as much about security values as you would need to know about the value of merchandise that you proposed to manufacture or deal in.

A second business principle: “Do not let anyone else run your business, unless (1) you can supervise his performance with adequate care and comprehension or (2) you have unusually strong reasons for placing implicit confidence in his integrity and ability.” For the investor this rule should determine the conditions under which he will permit someone else to decide what is done with his money.

A third business principle: “Do not enter upon an operation— that is, manufacturing or trading in an item—unless a reliable calculation shows that it has a fair chance to yield a reasonable profit. In particular, keep away from ventures in which you have little to gain and much to lose.” For the enterprising investor this means that his operations for profit should be based not on optimism but on arithmetic. For every investor it means that when he limits his return to a small figure—as formerly, at least, in a conventional bond or preferred stock—he must demand convincing evidence that he is not risking a substantial part of his principal.

A fourth business rule is more positive: “Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it—even though others may hesitate or differ.” (You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.) Similarly, in the world of securities, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand.

Fortunately for the typical investor, it is by no means necessary for his success that he bring these qualities to bear upon his program—provided he limits his ambition to his capacity and confines his activities within the safe and narrow path of standard, defensive investment. To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.

Ref: The Intelligent Investor by Benjamin Graham

CHAPTER 20 “Margin of Safety” as the Central Concept of Investment

Also read:

Margin of Safety Concept in Conventional and Unconventional Investments

2012-01-21T06:50:00.004+08:00

Extension of the Concept of Investment

To complete our discussion of the margin-of-safety principle we must now make a further distinction between conventional and unconventional investments.

Conventional investments are appropriate for the typical portfolio.

Under this heading have always come United States government issues and high-grade, dividend paying common stocks.
We have added state and municipal bonds for those who will benefit sufficiently by their tax-exempt features.
Also included are first-quality corporate bonds when, as now, they can be bought to yield sufficiently more than United States savings bonds.

Unconventional investments are those that are suitable only for the enterprising investor. They cover a wide range.

The broadest category is that of undervalued common stocks of secondary companies, which we recommend for purchase when they can be bought at two-thirds or less of their indicated value.
Besides these, there is often a wide choice of medium-grade corporate bonds and preferred stocks when they are selling at such depressed prices as to be obtainable also at a considerable discount from their apparent value.
In these cases the average investor would be inclined to call the securities speculative, because in his mind their lack of a first quality rating is synonymous with a lack of investment merit.

It is our argument that a sufficiently low price can turn a security of mediocre quality into a sound investment opportunity—provided that the buyer is informed and experienced and that he practices adequate diversification.

For, if the price is low enough to create a substantial margin of safety, the security thereby meets our criterion of investment.
Our favorite supporting illustration is taken from the field of real-estate bonds.
In the 1920s, billions of dollars’ worth of these issues were sold at par and widely recommended as sound investments. A large proportion had so little margin of value over debt as to be in fact highly speculative in character.
In the depression of the 1930s an enormous quantity of these bonds defaulted their interest, and their price collapsed—in some cases below 10 cents on the dollar.
At that stage the same advisers who had recommended them at par as safe investments were rejecting them as paper of the most speculative and unattractive type.
But as a matter of fact the price depreciation of about 90% made many of these securities exceedingly attractive and reasonably safe—for the true values behind them were four or five times the market quotation.*

The fact that the purchase of these bonds actually resulted in what is generally called “a large speculative profit” did not prevent them from having true investment qualities at their low prices.

The “speculative” profit was the purchaser’s reward for having made an unusually shrewd investment.
They could properly be called investment opportunities, since a careful analysis would have shown that the excess of value over price provided a large margin of safety.
Thus the very class of “fair-weather investments” which we stated above is a chief source of serious loss to naive security buyers is likely to afford many sound profit opportunities to the sophisticated operator who may buy them later at pretty much his own price.†

The whole field of “special situations” would come under our definition of investment operations, because the purchase is always predicated on a thoroughgoing analysis that promises a larger realization than the price paid. Again there are risk factors in each individual case, but these are allowed for in the calculations and absorbed in the overall results of a diversified operation.

To carry this discussion to a logical extreme, we might suggest that a defensible investment operation could be set up by buying such intangible values as are represented by a group of “commonstock option warrants” selling at historically low prices. (This example is intended as somewhat of a shocker.)*

The entire value of these warrants rests on the possibility that the related stocks may some day advance above the option price.
At the moment they have no exercisable value.
Yet, since all investment rests on reasonable future expectations, it is proper to view these warrants in terms of the mathematical chances that some future bull market will create a large increase in their indicated value and in their price.
Such a study might well yield the conclusion that there is much more to be gained in such an operation than to be lost and that the chances of an ultimate profit are much better than those of an ultimate loss.
If that is so, there is a safety margin present even in this unprepossessing security form.
A sufficiently enterprising investor could then include an option-warrant operation in his miscellany of unconventional investments.1

* Graham is saying that there is no such thing as a good or bad stock; there are only cheap stocks and expensive stocks. Even the best company becomes a “sell” when its stock price goes too high, while the worst company is worth buying if its stock goes low enough.

† The very people who considered technology and telecommunications stocks a “sure thing” in late 1999 and early 2000, when they were hellishly overpriced, shunned them as “too risky” in 2002—even though, in Graham’s exact words from an earlier period, “the price depreciation of about 90% made many of these securities exceedingly attractive and reasonably safe.” Similarly, Wall Street’s analysts have always tended to call a stock a “strong buy” when its price is high, and to label it a “sell” after its price has fallen—the exact opposite of what Graham (and simple common sense) would dictate. As he does throughout the book, Graham is distinguishing speculation—or buying on the hope that a stock’s price will keep going up—from investing, or buying on the basis of what the underlying business is worth.

* Graham uses “common-stock option warrant” as a synonym for “warrant,” a security issued directly by a corporation giving the holder a right to purchase the company’s stock at a predetermined price. Warrants have been almost entirely superseded by stock options. Graham quips that he intends the example as a “shocker” because, even in his day, warrants were regarded as one of the market’s seediest backwaters. (See the commentary on Chapter 16.)

Ref: The Intelligent Investor by Benjamin Graham

CHAPTER 20 “Margin of Safety” as the Central Concept of Investment

Also read:

Margin of Safety Concept in Speculation and Investment

2012-01-21T00:55:00.003+08:00

A Criterion of Investment versus Speculation

Since there is no single definition of investment in general acceptance, authorities have the right to define it pretty much as they please.

Many of them deny that there is any useful or dependable difference between the concepts of investment and of speculation.
We think this skepticism is unnecessary and harmful.
It is injurious because it lends encouragement to the innate leaning of many people toward the excitement and hazards of stock-market speculation.
We suggest that the margin-of-safety concept may be used to advantage as the touchstone to distinguish an investment operation from a speculative one.

Probably most speculators believe they have the odds in their favor when they take their chances, and therefore they may lay claim to a safety margin in their proceedings.

Each one has the feeling that the time is propitious for his purchase, or that his skill is superior to the crowd’s, or that his adviser or system is trustworthy.
But such claims are unconvincing.
They rest on subjective judgment, unsupported by any body of favorable evidence or any conclusive line of reasoning.
We greatly doubt whether the man who stakes money on his view that the market is heading up or down can ever be said to be protected by a margin of safety in any useful sense of the phrase.

By contrast, the investor’s concept of the margin of safety—as developed earlier in this chapter—rests upon simple and definite arithmetical reasoning from statistical data.

We believe, also, that it is well supported by practical investment experience.
There is no guarantee that this fundamental quantitative approach will continue to show favorable results under the unknown conditions of the future.
But, equally, there is no valid reason for pessimism on this score.

Thus, in sum, we say that to have a true investment there must be present a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience.

Ref: The Intelligent Investor by Benjamin Graham

CHAPTER 20 “Margin of Safety” as the Central Concept of Investment

Also read:

Margin of Safety Concept in Diversification

2012-01-21T00:22:00.003+08:00

Theory of Diversification

There is a close logical connection between the concept of a safety margin and the principle of diversification. One is correlative with the other.

Even with a margin in the investor’s favor, an individual security may work out badly.
For the margin guarantees only that he has a better chance for profit than for loss—not that loss is impossible.
But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses.
That is the simple basis of the insurance-underwriting business.

Diversification is an established tenet of conservative investment. By accepting it so universally, investors are really demonstrating their acceptance of the margin-of-safety principle, to which diversification is the companion.

This point may be made more colorful by a reference to the arithmetic of roulette.

If a man bets $1 on a single number, he is paid $35 profit when he wins—but the chances are 37 to 1 that he will lose.

He has a “negative margin of safety.”
In his case diversification is foolish. The more numbers he bets on, the smaller his chance of ending with a profit. If he regularly bets $1 on every number (including 0 and 00), he is certain to lose $2 on each turn of the wheel.

But suppose the winner received $39 profit instead of $35.

Then he would have a small but important margin of safety.
Therefore, the more numbers he wagers on, the better his chance of gain. And he could be certain of winning $2 on every spin by simply betting $1 each on all the numbers.
(Incidentally, the two examples given actually describe the respective positions of the player and proprietor of a wheel with 0 and 00.)*

* In “American” roulette, most wheels include 0 and 00 along with numbers1 through 36, for a total of 38 slots. The casino offers a maximum payout of 35 to 1. What if you bet $1 on every number? Since only one slot can be the one into which the ball drops, you would win $35 on that slot, but lose $1 on each of your other 37 slots, for a net loss of $2. That $2 difference (or a 5.26% spread on your total $38 bet) is the casino’s “house advantage,” ensuring that, on average, roulette players will always lose more than they win.

Just as it is in the roulette player’s interest to bet as seldom as possible, it is in the casino’s interest to keep the roulette wheel spinning.
Likewise, the intelligent investor should seek to maximize the number of holdings that offer “a better chance for profit than for loss.”
For most investors, diversification is the simplest and cheapest way to widen your margin of safety.

Ref: The Intelligent Investor

CHAPTER 20 “Margin of Safety” as the Central Concept of Investment

Also read:

Margin of Safety Concept in Undervalued or Bargain Securities

2012-01-20T22:44:00.001+08:00

The margin-of-safety idea becomes much more evident when we apply it to the field of undervalued or bargain securities.

We have here, by definition, a favorable difference between price on the one hand and indicated or appraised value on the other.
That difference is the safety margin. It is available for absorbing the effect of miscalculations or worse than average luck.
The buyer of bargain issues places particular emphasis on the ability of the investment to withstand adverse developments.
For in most such cases he has no real enthusiasm about the company’s prospects.

True, if the prospects are definitely bad the investor will prefer to avoid the security no matter how low the price.

But the field of undervalued issues is drawn from the many concerns—perhaps a majority of the total—for which the future appears neither distinctly promising nor distinctly unpromising.

If these are bought on a bargain basis, even a moderate decline in the earning power need not prevent the investment from showing satisfactory results.
The margin of safety will then have served its proper purpose.

Ref: The Intelligent Investors by Benjamin Graham

CHAPTER 20 “Margin of Safety” as the Central Concept of Investment

Also read:

Margin of Safety Concept in Growth Stocks

2012-01-20T22:32:00.002+08:00

The philosophy of investment in growth stocks parallels in part and in part contravenes the margin-of-safety principle.

The growth-stock buyer relies on an expected earning power that is greater than the average shown in the past.
Thus he may be said to substitute these expected earnings for the past record in calculating his margin of safety.
In investment theory there is no reason why carefully estimated future earnings should be a less reliable guide than the bare record of the past; in fact, security analysis is coming more and more to prefer a competently executed evaluation of the future.
Thus the growth-stock approach may supply as dependable a margin of safety as is found in the ordinary investment— provided the calculation of the future is conservatively made, and provided it shows a satisfactory margin in relation to the price paid.

The danger in a growth-stock program lies precisely here.

For such favored issues the market has a tendency to set prices that will not be adequately protected by a conservative projection of future earnings.
(It is a basic rule of prudent investment that all estimates, when they differ from past performance, must err at least slightly on the side of understatement.)

The margin of safety is always dependent on the price paid.

It will be large at one price, small at some higher price, nonexistent at some still higher price.
If, as we suggest, the average market level of most growth stocks is too high to provide an adequate margin of safety for the buyer, then a simple technique of diversified buying in this field may not work out satisfactorily.
A special degree of foresight and judgment will be needed, in order that wise individual selections may overcome the hazards inherent in the customary market level of such issues as a whole.

Ref: The Intelligent Investor by Benjamin Graham
CHAPTER 20 “Margin of Safety” as the Central Concept of Investment

Also read:

Margin of Safety in Good-Quality and Low-Quality Stocks

2012-01-20T22:31:00.003+08:00

However, the risk of paying too high a price for good-quality stocks—while a real one—is not the chief hazard confronting the average buyer of securities.

Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.

The purchasers view the current good earnings as equivalent to “earning power*” and assume that prosperity is synonymous with safety.
It is in those years that bonds and preferred stocks of inferior grade can be sold to the public at a price around par, because they carry a little higher income return or a deceptively attractive conversion privilege.
It is then, also, that common stocks of obscure companies can be floated at prices far above the tangible investment, on the strength of two or three years of excellent growth.
These securities do not offer an adequate margin of safety in any admissible sense of the term.
Coverage of interest charges and preferred dividends must be tested over a number of years, including preferably a period of subnormal business such as in 1970–71.
The same is ordinarily true of common-stock earnings if they are to qualify as indicators of earning power.
Thus it follows that most of the fair-weather investments, acquired at fair-weather prices, are destined to suffer disturbing price declines when the horizon clouds over—and often sooner than that.
Nor can the investor count with confidence on an eventual recovery—although this does come about in some proportion of the cases—for he has never had a real safety margin to tide him through adversity.

Ref: The Intelligent Investor by Benjamin Graham
CHAPTER 20 “Margin of Safety” as the Central Concept of Investment

Also read:

Margin of Safety Concept in Common Stocks

2012-01-20T22:19:00.001+08:00

So much for the margin-of-safety concept as applied to “fixed value investments.” Can it be carried over into the field of common stocks? Yes, but with some necessary modifications.

There are instances where a common stock may be considered sound because it enjoys a margin of safety as large as that of a good bond.

This will occur, for example, when a company has outstanding only common stock that under depression conditions is selling for less than the amount of bonds that could safely be issued against its property and earning power.#

That was the position of a host of strongly financed industrial companies at the low price levels of 1932–33. In such instances the investor can obtain the margin of safety associated with a bond, plus all the chances of larger income and principal appreciation inherent in a common stock.
(The only thing he lacks is the legal power to insist on dividend payments “or else”—but this is a small drawback as compared with his advantages.)
Common stocks bought under such circumstances will supply an ideal, though infrequent, combination of safety and profit opportunity.
As a quite recent example of this condition, let us mention once more National Presto Industries stock, which sold for a total enterprise value of $43 million in 1972. With its $16 millions of recent earnings before taxes the company could easily have supported this amount of bonds.

In the ordinary common stock, bought for investment under normal conditions, the margin of safety lies in an expected earning power considerably above the going rate for bonds. In former editions we elucidated this point with the following figures:

Assume in a typical case that the earning power is 9% on the price and that the bond rate is 4%; then the stock buyer will have an average annual margin of 5% accruing in his favor.
Some of the excess is paid to him in the dividend rate; even though spent by him, it enters into his overall investment result. The undistributed balance is reinvested in the business for his account.
In many cases such reinvested earnings fail to add commensurately to the earning power and value of his stock. (That is why the market has a stubborn habit of valuing earnings disbursed in dividends more generously than the portion retained in the business.)*
But, if the picture is viewed as a whole, there is a reasonably close connection between the growth of corporate surpluses through reinvested earnings and the growth of corporate values.
Over a ten-year period the typical excess of stock earning power over bond interest may aggregate 50% of the price paid.
This figure is sufficient to provide a very real margin of safety— which, under favorable conditions, will prevent or minimize a loss.
If such a margin is present in each of a diversified list of twenty or more stocks, the probability of a favorable result under “fairly normal conditions” becomes very large.
That is why the policy of investing in representative common stocks does not require high qualities of insight and foresight to work out successfully.

If the purchases are made at the average level of the market over a span of years, the prices paid should carry with them assurance of an adequate margin of safety.

The danger to investors lies in concentrating their purchases in the upper levels of the market, or in buying nonrepresentative common stocks that carry more than average risk of diminished earning power.

As we see it, the whole problem of common-stock investment under 1972 conditions lies in the fact that “in a typical case” the earning power is now much less than 9% on the price paid.**
Let us assume that by concentrating somewhat on the low-multiplier issues among the large companies a defensive investor may now acquire equities at 12 times recent earnings—i.e., with an earnings return of 8.33% on cost.
He may obtain a dividend yield of about 4%, and he will have 4.33% of his cost reinvested in the business for his account.
On this basis, the excess of stock earning power over bond interest over a ten-year basis would still be too small to constitute an adequate margin of safety.
For that reason we feel that there are real risks now even in a diversified list of sound common stocks.
The risks may be fully offset by the profit possibilities of the list; and indeed the investor may have no choice but to incur them—for otherwise he may run an even greater risk of holding only fixed claims payable in steadily depreciating dollars.
Nonetheless the investor would do well to recognize, and to accept as philosophically as he can, that the old package of good profit possibilities combined with small ultimate risk is no longer available to him.***

# “Earning power” is Graham’s term for a company’s potential profits or, as he puts it, the amount that a firm “might be expected to earn year after year if the business conditions prevailing during the period were to continue unchanged” (Security Analysis, 1934 ed., p. 354). Some of his lectures make it clear that Graham intended the term to cover periods of five years or more. You can crudely but conveniently approximate a company’s earning power per share by taking the inverse of its price/earnings ratio; a stock with a P/E ratio of 11 can be said to have earning power of 9% (or 1 divided by 11). Today “earning power” is often called “earnings yield.”

* This problem is discussed extensively in the commentary on Chapter 19.

** Graham elegantly summarized the discussion that follows in a lecture he gave in 1972: “The margin of safety is the difference between the percentage rate of the earnings on the stock at the price you pay for it and the rate of interest on bonds, and that margin of safety is the difference which would absorb unsatisfactory developments. At the time the 1965 edition of The

Intelligent Investor was written the typical stock was selling at 11 times earnings, giving about 9% return as against 4% on bonds. In that case you had a margin of safety of over 100 per cent. Now [in 1972] there is no difference between the earnings rate on stocks and the interest rate on stocks, and I say there is no margin of safety . . . you have a negative margin of

safety on stocks . . .” See “Benjamin Graham: Thoughts on Security Analysis” [transcript of lecture at the Northeast Missouri State University business school, March, 1972], Financial History, no. 42, March, 1991, p. 9.

*** This paragraph—which Graham wrote in early 1972—is an uncannily precise description of market conditions in early 2003. (For more detail, see the commentary on Chapter 3.)

Ref: The Intelligent Investor by Benjamin Graham

CHAPTER 20 “Margin of Safety” as the Central Concept of Investment

Also read:

Margin of Safety Concept in Bonds and Preferred Stocks (Fixed Value Investments)

2012-01-20T21:17:00.003+08:00

In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, “This too will pass.” Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY. This is the thread that runs through all the preceding discussion of investment policy—often explicitly, sometimes in a less direct fashion. Let us try now, briefly, to trace that idea in a connected argument.

All experienced investors recognize that the margin-of-safety concept is essential to the choice of sound bonds and preferred stocks.

For example, a railroad should have earned its total fixed charges better than five times (before income tax), taking a period of years, for its bonds to qualify as investment-grade issues.

This past ability to earn in excess of interest requirements constitutes the margin of safety that is counted on to protect the investor against loss or discomfiture in the event of some future decline in net income.
(The margin above charges may be stated in other ways — for example, in the percentage by which revenues or profits may decline before the balance after interest disappears—but the underlying idea remains the same.)
The bond investor does not expect future average earnings to work out the same as in the past; if he were sure of that, the margin demanded might be small.
Nor does he rely to any controlling extent on his judgment as to whether future earnings will be materially better or poorer than in the past, if he did that, he would have to measure his margin in terms of a carefully projected income account, instead of emphasizing the margin shown in the past record.
Here the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future.
If the margin is a large one, then it is enough to assume that future earnings will not fall far below those of the past in order for an investor to feel sufficiently protected against the vicissitudes of time.

The margin of safety for bonds may be calculated, alternatively, by comparing the total value of the enterprise with the amount of debt. (A similar calculation may be made for a preferred-stock issue.)

If the business owes $10 million and is fairly worth $30 million, there is room for a shrinkage of two-thirds in value—at least theoretically—before the bondholders will suffer loss.
The amount of this extra value, or “cushion,” above the debt may be approximated by using the average market price of the junior stock issues over a period of years.
Since average stock prices are generally related to average earning power, the margin of “enterprise value” over debt and the margin of earnings over charges will in most cases yield similar results.

So much for the margin-of-safety concept as applied to “fixed value investments.” Can it be carried over into the field of common stocks? Yes, but with some necessary modifications.

Ref: The Intelligent Investor by Benjamin Graham

CHAPTER 20 “Margin of Safety” as the Central Concept of Investment

Also read:

Warren Buffett on investing in a climate of fear

2012-01-19T15:15:00.001+08:00

Warren Buffett on investing in a climate of fear

– a Q1 letter to send clients

April 12, 2010

"I have no idea what the stock market will do next month or six months from now. I do know that, over a period of time, the American economy will do very well and investors who own a piece of it will do well."

Warren Buffet in an interview on CNBC on Friday, October 10, 2008

After the market roller coaster of 2008 and 2009, the first quarter of 2010 has been blessedly uneventful by comparison. The US markets gained about 5% in the first quarter, the best start to the year since 1998 - the US market ended up about 60% from its lows of a year ago. Canada did well also, up almost 3% in the first quarter.

That said, there is still a cloud of uncertainty that is making many investors nervous.

Causes for concern ... and for optimism

Even with the stabilization of the global economy, there's no shortage of short term causes of concern:

... continued questions on the direction and timing of the economic recovery in the United States and Europe and the timing of higher interest rates

... US housing prices that are staying stubbornly low and unemployment levels in North America and Europe that are stubbornly high.

... and in late March the deputy director of the International Monetary Fund made headlines as he talked about the need for advanced economies to cut spending in order to reduce deficits.

Here's a New York Times article about the IMF's views: http://www.nytimes.com/2010/03/22/business/global/22imf.html?scp=1&sq=lipsky%20imf&st=cse

The good news is that there are offsetting positives, even if the media headlines that feature them aren't quite as prominent:

... on Monday March 22, the Wall Street Journal ran a story about dividend hikes as a result of rising profits by US companies. The article also mentioned that cash on hand on US corporate balance sheets was at the highest level since 2007.

... on the same day the Financial Times ran a similar story about dividend increases in Europe

... and there's growing attention to the impact that Germany's emphasis on manufacturing productivity had in sheltering it from the worst of the economic downturn - and questions about whether this might be a model for other countries. In March the Economist ran a 14 page feature on how Germany positioned itself for success.

Forecasting the future

Whether you choose to focus on the positives or the negatives, there's broad agreement that the steps taken by governments stabilized the financial crisis that we were facing a year ago - and there is almost no talk today of a global depression.

So the issue is not whether the economy will recover, but when and at what rate -and whether there might be another stumble along the way.

If you look for investing advice in the newspaper or on television, the discussion tends to revolve around what stocks will do well in the immediate period ahead ... this week, this month, this quarter.

We refuse to participate in that speculation - when it comes to short-term predictions, whether about the economy or the stock market, there's one thing we can say with virtual certainty: Most of them will be wrong. Quite simply, no one has a consistent track record of successfully forecasting short term movements in the economy and markets.

Which is why in uncertain times such as today, one of the people I look to for guidance is Warren Buffett.

Advice from Warren Buffett

In an investment industry poll a couple of years ago, Warren Buffett was voted the greatest investor of all time; among the runners up were Peter Lynch, John Templeton and George Soros.

Buffett's returns are a testimony to the power of compounding. From 1965 to the end of 2009, the growth in book value of his investments averaged 20% annually. As a result, $10,000 invested in 1965 would currently be worth a remarkable $40 million. By contrast, that same $10,000 invested in the US stock market as a whole, returning just over 9% during this period, would be worth $540,000.

In one of his annual letters to shareholders, Warren Buffett wrote that it only takes two things to invest successfully - having a sound plan and sticking to it. He went on to say that of these two, it's the "sticking to it" part that investors struggle with the most. The quote at the top of the letter, made at the height of the financial crisis, speaks to Buffett's discipline on this issue.

I try to apply that approach as well - putting a plan in place for each client that will meet their long term needs and modifying it as circumstances warrant, without walking away from the plan itself.

Boom times such as we saw in the late 90's and scary conditions such as we've seen in the past two years can make that difficult - but those conditions can also represent opportunity. Indeed, in his most recent letter to shareholders Buffett wrote that "a climate of fear is an investor's best friend."

Five core principles that shape our approach

On balance, I share Warren Buffett's mid term positive outlook, not least because many of the positives that drove market optimism two years ago are still in place, among these the continued emergence of a global middle class in developing countries like Brazil, China, India and Turkey. This educated middle class will fuel global growth that will make us all better off.

In the meantime, here are five fundamental principles that we look for in money managers and that drive the portfolios that we believe will serve clients well in the period ahead.

1. Concentrate on quality

The record bounce in stock prices over the past year was led by companies with the weakest credit ratings. Some have referred to last year as a "junk rally", with the lowest quality companies doing the best. That's unlikely to continue- that's why I'm focusing my portfolios on only the highest quality companies, those best able to withstand the inevitable ups and downs in the economy.

2. Look to dividends

Historically, dividends made up 40% of the total returns of investing in stocks and have also helped provide stability through market turbulence. Two years ago, quality companies paying good dividends were hard to find - one piece of good news is that today it's possible to build a portfolio of good quality companies paying dividends of 3% and above.

3. Focus on valuations

Having a strong price discipline on buying and selling stocks is paramount to success - history shows that the key to a successful investment is ensuring that the purchase price is a fair one. Investors who bought market leaders Cisco Systems, Intel and Microsoft ten years ago are still down down 40% to 70%, not because these aren't great companies but because the price paid was too high.

4. Build in a buffer

Given that we have to expect continued volatility, we identify cash flow needs for the next three years for every client and ensure these are set aside in safe investments. That buffer protects clients from short term volatility and reduces stress along the way.

5. Stick to your plan

In the face of economic and market uncertainty, another key to success is having a diversified plan appropriate to your risk tolerance - and then sticking to it. It can be hard to ignore the short-term distractions, but ultimately that's the only way to achieve your long term goals with a manageable amount of stress along the way.

In closing, let me express my thanks for the continued opportunity to work together. Should you ever have any questions or if there's anything you'd like to talk about, my team and I are always pleased to take your call.

Name of advisor

P.S. If you're interested, here's a link to Warren Buffett's 2010 letter to investors: http://www.berkshirehathaway.com/letters/2009ltr.pdf

http://clientinsights.ca/article/warren-buffett-on-investing-in-a-climate-of-fear-a-q1-letter-to-send-clients

A Q1 letter to send clients - Warren Buffett on investing in a climate of fear

An important note:

Over the past 18 months, the quarterly templates for a client letter have ranked among the most popular features on this site.

Research with investors has identified the five elements of an effective client letter. It has to be:

1. balanced in outlook

2. candid

3. short enough for clients to get through comfortably but long enough to be substantial

4. supported by facts

5. indicative of the advisors voice and personality

On this last point, if you like the basic structure of the letter, you MUST take the time to customize it to your own philosophy and outlook - I can't emphasize this strongly enough.