Things changed. Is detailed analysis of individual stocks necessary?

Just before he died, Graham was asked whether detailed analysis of individual stocks - a tactic he became famous for - remained a strategy he favoured.  He answered:

"In general, no.  I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities.  This was a rewarding activity, say, 40 years ago, when our textbook was first published.  But the situation has changed a great deal since then."

What changed was:   Competition grew as opportunities became well known; technology made information more accessible; and industries changed as the economy shifted from industrial to technology sectors, which have different business cycles and capital uses.

Things changed.

Recognise the phenomenal long-term wealth-creating power of a company that possesses a durable competitive advantage over its competitors.

History of investment analysis

Benjamin Graham

Benjamin Graham had adopted early bond analysis techniques to common stocks analysis.

He focused primarily on determining a company's solvency and earning power for the purposes of bond analysis.  

Graham never made the distinction between a company that held a long-term competitive advantage over its competitors and one that didn't.

He was only interested in whether or not the company had sufficient earning power to get it out of the economic trouble that sent its stock price spiraling downward.  

He wasn't interested in owning a position in a company for ten or twenty years.  If it didn't move after two years, he was out of it.

Warren Buffett

Warren Buffett discovered, after starting his career with Graham,  the tremendous wealth-creating economics of a company that possessed a long-term competitive advantage over its competitors.

He realized that the longer you held one of these fantastic businesses, the richer it made you.

While Graham would have argued that these super businesses were overpriced, Warren realized that he didn't have to wait for the stock market to serve up a bargain price, that even if he paid a fair price, he could still get superrich off of those businesses.

Warren developed a unique set of analytical tools to help identify these special kinds of businesses.  

His new ways of looking at things enabled him to determine whether the company could survive its current problems (recall Washington Post at the time when he first bought into this company).

Warren's way also told him whether or not the company in question possessed a long-term competitive advantage that would make him superrich over the long run.  

Warren's two simple and stunning revelations:  

(1) How to identify an exceptional company with a durable competitive advantage?

(2) How to value a company with a durable competitive advantage?

Behavioural Finance: We are hardwired to be lousy investors.

1.  We are hardwired from birth to be lousy investors.

Our survival instincts make us fear loss much more than we enjoy gain.  We run from danger first and ask questions later.  We panic out of our investments when things look bleakest - we are just trying to survive!  We have a herd mentality that makes us feel more comfortable staying with the pack.  So buying high when everyone else is buying and selling low when everyone else is selling comes quite naturally - it just makes us feel better!

We use our primitive instincts to make quick decisions based on limited data and we weight most heavily what has just happened.  We run from managers who performed poorly most recently and into the arms of last year's winners - that just seems like the right thing to do!  We all think we are above average!  We consistently overestimate our ability to pick good stocks or to find above-average managers.  It is also this outsized ego that likely gives us the confidence to keep trading too much.  We keep making the same investing mistakes over and over - we just figure this time we will get it right!

We are busy surviving, herding, fixating on what just happened and being overconfident!  Maybe it helps explain why Mr. Market acts crazy at times.

2.  So, how do we deal with all these primitive emotions and lousy investing instincts?  

The answer is really quite simple:  we don't!

Let's admit that we will probably keep making the same investing mistakes no matter how many books on behavioural investing we read.

3.  How to invest in the stock market?

Traditionally, stocks have provided high returns and have been a mainstay of most investors’ portfolios. Since a share of stock merely represents an ownership interest in an actual business, owning a portfolio of stocks just means we’re entitled to a share in the future income of all those businesses. If we can buy good businesses that grow over time and we can buy them at bargain prices, this should continue to be a good way to invest a portion of our savings over the long term. Following a similar strategy with international stocks (companies based outside of the United States) for some of our savings would also seem to make sense (in this way, we could own businesses whose profits might not be as dependent on the U.S. economy or the U.S. currency)

4.  These words of wisdom from Benjamin Graham

In an interview shortly before he passed away, Graham provided us with these words of wisdom:

The main point is to have the right general principles and the character to stick to them.… The thing that I have been emphasizing in my own work for the last few years has been the group approach.  To try to buy groups of stocks that meet some simple criterion for being undervalued—regardless of the industry and with very little attention to the individual company.… Imagine—there seems to be practically a foolproof way of getting good results out of common stock investment with a minimum of work. It seems too good to be true. But all I can tell you after 60 years of experience, it seems to stand up under any of the tests that I would make up.

That interview took place thirty-five years ago. Yet we still have an opportunity to benefit from Graham’s sage advice today.

I wish you all—the patience to succeed and the time to enjoy it. Good luck.

Book:  Joel Greenblatt:  The Big Secret for the Small Investor (2001)

General Portfolio Policy (Benjamin Graham)

General Portfolio Policy: The Defensive Investor

Graham opens the chapter defining two different kinds of investors: the “active” investor, which is the kind of investor that actively seeks new investments and invests serious time into studying investments, and the “passive” or “defensive” investor, the kind of investor that wants to invest once (or on a highly regular basis) and just let his or her portfolio run on autopilot.

Regardless of the activity that you apply to your investments, Graham sticks hard with his recommendation from the earlier chapter: 50% stocks, 50% bonds (or a close approximation thereof, with an absolute maximum of 75% in either side). It’s important to remember with a recommendation like that that Graham is very conservative in his investing, dreading the idea of an actual loss in capital. Only in the most dire of down markets (like 2008, for example) would such a portfolio actually deliver a loss to the investor.

Things that enterprising investors should focus on. (Benjamin Graham) 2

Portfolio Policy for the Enterprising Investor: The Positive Side

Graham says that there are four clear areas of activity that an enterprising investor (read: not an ultra-conservative investor) should focus on:

1. Buying in low markets and selling in high markets.
Graham says, in essence, that this is a good strategy in theory, but that it’s essentially impossible to accurately predict (on a mathematical basis) when the market is truly “low” and when it’s truly “high.” Why? Graham says that there’s inadequate data available to be able to accurately predict such situations – he basically believes fifty years of data is needed to make such claims, and as of the book’s writing, he did not believe adequate data was available in the post-1949 modern era. 

2. Buying carefully chosen “growth stocks.”
What about growth stocks – ones that are clearly showing rampant growth? Graham isn’t opposed to buying these, but says that one should look for growth stocks that have a reasonable P/E ratio. He wouldn’t buy a “growth stock” if it had a price-to-earnings ratio higher than 20 over the last year and would avoid stocks that have a price-to-earnings ratio over 25 on average over the last several years. In short, this is a way to filter out “bubble” stocks (one where irrational exuberance is going on) when looking at growth stocks.

3. Buying bargain issues of various types.
Here, Graham finally gets around to the idea of buying so-called “value stocks.” For the most part, Graham focuses on market conditions as they existed in 1959, pointing towards what would constitute value stocks then. A brief bit on page 169, Graham discusses “filtering” the stocks listed by Standard and Poor’s (essentially a 1950s precursor to the S&P 500) and identifying 85 stocks that meet basic value criteria, then buying them and finding that, over the next two years, most of them beat the overall market.

That’s an index fund. Graham had basically conceived of the idea in the 1950s – it worked then, and it works now.

4. Buying into “special situations.”
Graham largely suggests avoiding “topical” news as a reason to buy or sell, mostly because it’s hard for investors to gauge how exactly such news will truly affect the stock’s price. Instead, one should simply file away interesting long-term news for later use if you’re going to evaluate the stock. For example, recalling that a company is still paying off an incurred debt from ten years ago and that debt is about to be paid off might be an indication of an upcoming jump in profit for the company – and a possible sign of a good value.

Things that enterprising investors should focus on. (Benjamin Graham) 1

Ben Graham has a lot of ideas about what you should avoid.  Defensive investors should avoid everything but large, prominent companies with a long history of paying dividends. Even enterprising investors should avoid junk bonds, foreign bonds, preferred stocks, and IPOs.

To put it simply, Graham doesn’t like risk. It comes through time and time again in every chapter of the book – do the footwork, minimize risk, and don’t swing for the fences.

So what kind of real-world investing does that lead to? Graham finally gets down to actual tactics here, finally pointing toward some specific investment choices that he actually supports! At last!

Things that even enterprising investors should avoid. (Benjamin Graham) 2

Portfolio Policy for the Enterprising Investor: Negative Approach

So, what should you avoid?

First, avoid junk bonds. If they have anything less than a stellar bond rating, don’t bother, even if they appear to return very well. Junk bonds put your principal at risk, and the point of buying bonds is to have a safe portion of your portfolio.

Second, avoid foreign bonds. Here, there are stability issues, and it’s often hard to adequately judge the risk of buying bonds from government and private entities operating under rules unfamiliar to you. 

Third, avoid preferred stocks. Preferred stocks are ones that have a higher priority in the event of a liquidation of the business, but often come at a premium price. Almost always, Graham doesn’t feel these are worth any sort of premium. Of course, in the United States, preferred stock is generally not sold directly to individual investors, only to large institutions, so it’s largely a moot point.

Finally, avoid IPOs. To put it simply, new issues do not have any track record upon which to adequately judge the company. The “hype” of an IPO is all you really have to judge the issue on. Instead, let others jump into that feeding frenzy and wait until time has shown which companies swim and which ones sink.

Those are some good rules for anyone to follow, particularly if you’re concerned about not losing the money you invest. Most of these investments have a pretty significant amount of risk and in Graham’s world, one shouldn’t put the principal at undue risk.

Things that even enterprising investors should avoid. (Benjamin Graham) 1

Graham’s view of a conservative investor is very conservative. Focus primarily on big, blue chip stocks that pay a dividend and counterbalance that with roughly an equal amount of bonds. Very conservative, indeed.

But what about those of us who are less conservative and want to seek out other investments? After all, isn’t The Intelligent Investor supposed to be a guide to value investing, not just “buy blue chips and wait”?

Graham starts to head down this path here as he turns his sights from the very conservative investor to the … less conservative investor, the type of person who would actually follow value investing principles and seek out investments that show every sign of being undervalued – and then invest in them.

But first, a chapter of cautionary advice. Graham is nothing if not cautious, after all. The focus here is on things that even enterprising investors should avoid.

The Defensive Investor and Common Stocks (Benjamin Graham)

The Defensive Investor and Common Stocks

Graham’s advice, tends to focus on people who are willing to put in that extra time – and if you’re willing to do that, he has a lot of wisdom to share.

First of all, diversify. You should own at least ten different stocks, but more than thirty might be a mistake, as it becomes difficult to follow all of them carefully and also seek out new potential stock investments.

Second, invest in only large, prominent, and conservatively financed companies. Look for ones with little debt on the books and ones with a large market capitalization.

Third, invest only in companies with a long history of paying dividends. If a company rarely pays dividends, your only way to earn money from that company is if the market deems the stock to be valuable, and you shouldn’t trust that the market will do so.

Graham seems to point strongly towards the thirty stocks that make up the Dow Jones Industrial Average as a good place to start looking, as they usually match all of these criteria. I’d personally stretch that to include stocks that make up the S&P 500, but the Dow is a great place to find very large blue chip companies that are very stable and have paid dividends for a long time.

Other than that, Graham pooh-poohs many other common strategies. Buying growth stocks? Nope. Dollar-cost averaging? Good in theory, not great in practice. Portfolio adjustments? Be very, very careful – and only do annual evaluations. In short, be very, very wary and play it very, very cool.

Remember, this is Graham’s advice for the defensive, very conservative investor.

Strong, thorough research is the most important part about owning stocks. (Benjamin Graham)

The Intelligent Investor by Benjamin Graham

There’s one big underlying theme to this book. Yet, it keeps coming to the forefront again and again. It’s the one point that I believe Graham wants people to take home from this book.

Strong, thorough research is the most important part about owning stocks.

If you can’t – or aren’t willing to – put in a lot of time studying individual stocks, identifying ones that genuinely have potential to return good value to you over time, and keep careful tabs on those individual stocks, then you shouldn’t be investing in stocks.

Over and over again, Graham makes this point, in both obvious and subtle ways. He’s a strong, strong believer in knowing the company. If you don’t have clear, concrete reasons for buying a stock, then you shouldn’t be buying that stock, period.

What if you don’t have that time? This book was written before the advent of index funds, but I tend to think that broad-based index funds can be a reasonable replacement for the stock portion of your portfolio.

The Future of Common Stocks

https://www8.gsb.columbia.edu/sites/valueinvesting/files/files/DOC004.pdf

http://www.firstavenue.co.za/sites/default/files/downloads/the_evolution_of_valuation_22112011.pdf

https://en.wikipedia.org/wiki/Edgar_Lawrence_Smith

http://www.firstavenue.co.za/sites/default/files/downloads/the_evolution_of_valuation_22112011.pdf

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

Bargains in Bonds and Preferred Stocks

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

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

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

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

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

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

Definition of Secondary Companies

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

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

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

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



Stock Market's Attitude toward Secondary Companies

(a)  1920

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

The public felt that a middle-sized company

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

(b)  Post 1931 -1933 depression

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

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

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

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



No sound rational reasons for rejecting stocks of secondary companies

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

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

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

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

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



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

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


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

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

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

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

The Intelligent Investor
Benjamin Graham

Value of a Business to a Private Owner

Value of a Business to a Private Owner Test

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


How to search for a bargain opportunity?

1.  Using the net worth as the starting point

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

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


2.  Using the working capital as the starting point

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

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

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



An example of how to find a bargain common stock:

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

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

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


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

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

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

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

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


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

Purchases of Bargain Issues

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

This includes:

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

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

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

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

1.   By method of appraisal.  

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

2.  By the value of the business to a private owner.

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

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

1.  LOW POINTS IN THE GENERAL MARKET

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

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

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

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

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

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

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

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

There are two major sources of undervaluation:

(a) currently disappointing results and

(b) protracted neglect or unpopularity.

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

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

The Intelligent Investor
Benjamin Graham

GROWTH STOCK APPROACH

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

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

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

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

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

However, investing successfully in them is more complicated.



Two Catches of Growth Stock Investing

Two catches to watch out for in growth investing.

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

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

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

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

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

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

How can your investment into growth stocks be protected?

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

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

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

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

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

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

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



More guidance on Growth Stock Investing

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

No matter how enthusiastic the investor may feel about the prospects of a particular company, however, he should set a limit upon the price that he is willing to pay for such prospects.

• Such a rule would result at times in the missing of an unusually good opportunity. 
• More often, it would mean the investor's saving himself from "going overboard" on an issue that looked especially good to him and everyone else and consequently was selling much too high.

An illustration of investing in growth stocks

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

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


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

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


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


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

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


Inferences from the above illustration for investing in Growth Stocks

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

Summary on investing in Growth Stocks

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

Avoid buying these securities when available at full prices

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

1. underlying safety,
2. simplicity of choice, and
3. promise of  satisfactory results.

Using these criteria has led to the exclusion from the field of recommended investment a number of security classes which are normally regarded as suitable for various kinds of investors.

INVESTMENTS TO AVOID AT FULL PRICES

Advised against the purchase at FULL PRICES of three important categories of securities:

(a) foreign bonds;

(b) ordinary corporate bonds and preferred stocks, under present conditions of relative yield when the best grade issues yield little more than his US Savings Bonds;

(c) secondary common stocks, including, original offerings of such issues.

By full prices, we mean 

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

ADVICE FOR DEFENSIVE INVESTORS

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

ADVICE FOR ENTERPRISING INVESTORS

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

REASONINGS

FOREIGN GOVERNMENT BONDS

Why people buy and why they should avoid purchasing foreign Government bonds?  

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

CORPORATE BONDS OR PREFERRED STOCKS

How to entice people to buy corporate bonds or preferred stocks?  

          For corporate bonds and preferred stocks to be bought, these would either 

• have to increase their yields so as to offer a reasonable alternative to US Savings Bonds for individual investors or 
• else would be bought solely by financial institutions - insurance companies, savings banks, commercial banks, and the like,  Such institutions have their own justification for buying corporate securities at current yields.

SECONDARY COMMON STOCKS

How and when to buy secondary common stocks?  

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

Intelligent Investor

Benjamin Graham

Portfolio Policy for the Enterprising Investor

Negative Approach

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

The Positive Approach (4 Approaches)

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

The Intelligent Investor

Benjamin Graham

Charlie Munger's opinion of Benjamin Graham's deep Value Investing

Why Charlie Munger Hates Value Investing

When Charlie Munger ( Trades , Portfolio ) came to Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) in the late '60s, Warren Buffett (Trades, Portfolio) was still running the business and investing how his teacher, Benjamin Graham, had taught him to - by buying a selection of cigar butt type companies and holding for many years.

Unlike Buffett, who had essentially grown up under Graham's wing, Munger had no such attachment to the godfather of value investing. Instead, Munger seems actually to dislike deep value investing:

"I don't love Ben Graham and his ideas the way Warren does. You have to understand, to Warren - who discovered him at such a young age and then went to work for him - Ben Graham's insights changed his whole life, and he spent much of his early years worshiping the master at close range. But I have to say, Ben Graham had a lot to learn as an investor. 

"I think Ben Graham wasn't nearly as good an investor as Warren Buffett is or even as good as I am. Buying those cheap, cigar-butt stocks was a snare and a delusion, and it would never work with the kinds of sums of money we have. You can't do it with billions of dollars or even many millions of dollars. But he was a very good writer and a very good teacher and a brilliant man, one of the only intellectuals - probably the only intellectual - in the investing business at the time." - Charlie Munger, The Wall Street Journal September 2014

When he arrived at Berkshire, Munger actively tried to push Buffett away from deep value toward quality at a reasonable price, which he did with much success.

All you need to do is to look at Buffett's acquisition of See's Candies in the late 1960s to realize that without Munger's quality over value influence on Buffett, Berkshire wouldn't have become the American corporate giant it is today.



A love of high quality

Munger always had a fascination with buying high-quality businesses, and in the early days, his style differed greatly from that of Buffett. He always placed a premium on the intangible assets of a company, those assets that had no financial value to other companies but were worth billions in the right hands.

"Munger bought cigar butts, did arbitrage, even acquired small businesses. He said to Ed Anderson, 'I just like the great businesses.' He told Anderson to write up companies like Allergan ( AGN ), the contact-lens-solution maker. Anderson misunderstood and wrote a Grahamian report emphasizing the company's balance sheet. Munger dressed him down for it; he wanted to hear about the intangible qualities of Allergan: the strength of its management, the durability of its brand, what it would take for someone else to compete with it. 

" Munger had invested in a Caterpillar ( CAT ) tractor dealership and saw how it gobbled up money, which sat in the yard in the form of slow-selling tractors. Munger wanted to own a business that did not require continual investment and spat out more cash than it consumed. Munger was always asking people, 'What's the best business you've ever heard of?'" - "The Snowball: Warren Buffett and the Business of Life" by Alice Schroeder

Munger understood that it's these businesses where big money is made as the high returns on capital, and a nonexistent need for capital investment ensures shareholders are well rewarded over the long term.

For example, in his 1995 speech, "A Lesson on Elementary, Worldly Wisdom As It Relates to Investment Management & Business," Munger said:

"We've really made the money out of high-quality businesses. In some cases, we bought the whole business. And in some cases, we just bought a big block of stock. But when you analyze what happened, the big money's been made in the high quality businesses. And most of the other people who've made a lot of money have done so in high quality businesses. 

" Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return -even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive-looking price, you'll end up with a fine result. 

" So the trick is getting into better businesses. And that involves all of these advantages of scale that you could consider momentum effects."

Buffett added some meat to this statement at the 2003 Berkshire Hathaway meeting:

"The ideal business is one that generates very high returns on capital and can invest that capital back into the business at equally high rates. Imagine a $100 million business that earns 20% in one year, reinvests the $20 million profit and in the next year earns 20% of $120 million and so forth. But there are very very few businesses like this. Coke ( KO ) has high returns on capital, but incremental capital doesn't earn anything like its current returns. We love businesses that can earn high rates on even more capital than it earns. Most of our businesses generate lots of money but can't generate high returns on incremental capital - for example, See's and Buffalo News. We look for them [areas to wisely reinvest capital], but they don't exist."

These quotes do a great job of summing up Munger and Buffett's investment strategy. Even though there are thousands of pages of investment commentary from both of these billionaires, their investment style can be summed up with the simple description of quality at a reasonable price, and the above quotes show exactly why they've both decided this style is best.

By: GuruFocus

http://www.nasdaq.com/aspx/stockmarketnewsstoryprint.aspx?storyid=why-charlie-munger-hates-value-investing-cm774232

Are you an intelligent investor? What does intelligent means in investing?

Benjamin Graham

Intelligent investor:  this is an investor "endowed with the capacity for knowledge and understanding."

Intelligent here is not to be taken to mean "smart" or "shrewd" or gifted with unusual foresight or insight.  

The intelligence here presupposed is a trait more of the character than of the brain.



Defensive investor

For example, a widow who must live on the money left her.

Her chief emphasis will be on the avoidance of any serious mistakes or losses, in the sense of conserving capital.

Her second aim will be freedom from effort, annoyance and the need for frequent decisions.

A woman in this position, with substantial funds, will not be satisfied to leave her financial affairs entirely in the hands of others.

She will want to understand - at least in general terms - what is being done with her money and why.

She will probably want to participate to the extent of approving the broad policy of investment, of keeping track of its results and of judging independently whether or not she is being competently advised.

This will be equally true of men who wish to throw the major burden of their investment operations on the shoulders of others.

For all these defensive investors, intelligent action will mean largely the exercise of firmness in the application of relatively simple principles of sound procedure.



Enterprising investor

These are not distinguished from the others by their willingness to take risks - for in that case they should be called speculators.

Their determining trait is rather their willingness to devote time and care to the selection of sound and attractive investments.  

It is not suggested that the enterprising investor must be a fully-trained expert in the field.

He may derive his information and ideas from others, particularly from security analysts.

But the decisions will be his own and in the last reckoning he must rely upon his own understanding and judgment.

The first rule of intelligent action by the enterprising investor must be that he will never embark on a security purchase which he does not fully comprehend and which he cannot justify by reference to the results of his personal study or experience.