A sound mental approach towards stock fluctuations (1)

Intelligent investment is more a matter of mental approach than it is of technique.

A sound mental approach towards stock fluctuations is the touchstone of all successful investment under present-day conditions.

Your portfolio should consist of:

(a)  Savings Bonds, which have no price fluctuations, and,

(b)  Common Stocks, which are likely to fluctuate widely in their market price.

Such changes in quoted prices may be significant to the investor in two possible directions:

(A)  As a measure of the success of your investment program.

(B)  As a guide to the selection of your securities and the timing of your transactions.

Judged by past history, you always had a chance to buy them back at substantially lower levels at some time later.

Another encouraging element for the preceptor is found in the strong warp of continuity that seems to underlie the pattern of financial change.

Important developments affecting broad groups of security values do not come suddenly or in one piece.

An excellent example is found in the long term course of the stock market; this has never moved to permanently higher levels without retreating at least once to former territory.

Hence, investors who sold out representative stocks at what seemed a high price as judged by past history have always had a chance to buy them back at substantially lower levels at some later time.

This proved true in spite of the inflationary effects of the First World War and again of the Second World War, and it also was notoriously true after the extreme market advance of 1928 - 29.


Benjamin Graham
The Intelligent Investor


Comments:

Here are the charts of KLSE and the annual returns of KLSE.

Observe for yourself whether the statement by Benjamin Graham above holds true.

It generally is so but how can you hope to profit from this strategy?

Annual Stock Market Returns in KLSE

2005      -0.84%   
2006      21.83%   
2007      31.82%   
2008     -39.33%   
2009      45.17%   
2010      19.34%   
2011        0.78%   
2012       10.34%   
2013       10.54%   
2014      -5.66%



MSCI Malaysia (price) index

2005      -1.52%
2006      33.11%
2007      41.54%
2008      -43.39%
2009      47.79%
2010      32.51%
2011      -2.92%
2012      10.76%
2013      4.17%
2014      -13.41%

Either you ignore market fluctuations or you buy and sell based on value.

It is people generally who make high and low markets, because they are optimistic (and greedy) in high markets and pessimistic (and disgusted) in low markets.  

How can you - a member representing the public at large - be expected to act otherwise than the public acts?

Does not this mean that you are doomed, by some law of logic, to buy when you should be selling and to sell when you should be buying?

This point is vital.  The investor cannot enter the arena of the stock market with any real hope of success unless he is armed with mental weapons that distinguish him in kind - not in a fancied superior degree - from the trading public.  

(1)  One possible weapon is indifference to market fluctuations; such an investor buys carefully when he has money to place and then lets prices take care of themselves.  

(2)  But, if the investor intends to buy and sell recurrently, his weapons must be a frame of mind and a principle of action which are basically different from those of the trader and speculator.  He must deal in values, not in price movements.  He must be relatively immune to optimism or pessimism and impervious to business or stock-market forecasts.  

In a word, he must be psychologically prepared to be a true investor and not a speculator masquerading as an investor.  If he can meet this test, he will be a member not of the public at large but of a specialized and self-disciplined group.

Returning to the matter of the market's cyclical swings,we must point out that the duration or frequency of these swings has changed considerably since 1921.  This is an added obstacle to the pleasing project of investing regularly in low markets and selling out in high ones.  Between 1899 and 1921 the industrial average made five well defined highs and five definite lows, an average cycle of about four years.  Since then there have been only two clean-cut swings and the intervals between low points have been eleven years and ten years, respectively.  

An investor nowadays is likely to grow uneasy and impatient while waiting for his cyclical buying opportunity to reappear.  In the meantime, also, his funds will bring him no interest in the bank and only a negligible rate if placed in short-term securities.  Thus he can lose more in dividends foregone than he can ever gain from buying at eventual low levels.  




Summary

Either buy carefully and then ignore the market fluctuations or if you intends to buy and sell recurrently, deal in values.  

Should you patiently wait for your cyclical buying opportunity to reappear?  The low-points of the market maybe 10 or 11 years apart.  While waiting for these hoping to buy at eventual low levels, you can lose more in dividends foregone; earning little income from your cash holdings.

The case of the market declines and unsuccessful stock investments.

There is a vital difference here between temporary and permanent influences.

A price decline is of no real importance to the bona fide investor unless it is either very substantial - say, more than a third from cost - or unless it reflects a known deterioration of consequence in the company's position.


In a well defined bear market many sound common stocks sell temporarily at extraordinarily low prices.

• It is possible that the investor may then have a paper loss of fully 50 per cent on some of his holdings, without any convincing indication that the underlying values have been permanently affected.

A significant price decline is of importance to the investor.

• He would have been well advised to scrutinize the picture with some care, to see whether he had made any miscalculations.
• But if the results of his study were reassuring - as they should have been - he was entitled then to disregard the market decline as a temporary vagary of finance, unless he had the funds and the courage to take advantage of it by buying more on the bargain basis offered.

Price Changes as Measuring Investment Results

When the general market declines or advances substantially ....
.... nearly all investors will have somewhat similar changes in their portfolio values.

Benjamin Graham, in his book Intelligent Investor, wrote that the investor should not pay serious attention to such price developments unless they fit into a previously established program of buying at low levels and selling at high levels.

The investor is neither a smart investor nor a richer one when he buys in an advancing market and the market continues to rise.

That is true even when the investor cashes in a goodly profit, unless either
(a) he is definitely through with buying stocks - an unlikely story - or
(b) he is determined to reinvest only at considerably lower levels.

In a continuous program no market profit is fully realized until the later reinvestment has actually taken place, and the true measure of the trading profit is the difference between the previous selling level and the new buying level.

The INVESTMENT SUCCESS of the investor may be judged by a long-term or secular rise in market price, without the necessity of sale.

The proof of that achievement lies in the price advances made between successive points of equality in the general market level.

In most cases this favourable price performance will be accompanied by a well-defined improvement in the average earnings, in the dividend, and the balance-sheet position.

Thus in the long run the market test and the ordinary business test of a successful equity commitment tend to be largely identical.



SUMMARY
Most of us are invested for the long run.
Even if you manage to sell your investment for a profit from your previous buying price, no market profit is fully realized until you have reinvested this amount back into the market.
Your trading profit is the difference between the previous selling level and the new buying level.

Market Fluctuations and Your Emotions

The stock market can fluctuate widely.  Prices of stocks are determined by various factors.  It is better for you to focus on the fundamentals of the stocks.  However, the prices of stocks can be driven very high and pushed very low by sentiments of the players which may not have anything to do with the underlying fundamentals.

As a rational investor, what should you do in such situations?  Let's assume you own good quality companies with durable competitive advantage which you plan to hold for the long term.  You rightly have chosen these companies to be in your portfolio due to their earnings power, mainly gauged from their historical performances. 

Firstly, you should be able to compute the intrinsic values for the companies, using conservative estimates in your valuation.  This ability is important as it is the strength you will have over the other players.  It is not uncommon for your stock prices to fluctuate 50% above or the equivalent 1/3rd below its average market price over a 52 weeks period.  Check these out to confirm this statement in your local press of the listings of the various companies' stock prices.

If you hope to buy and sell to profit from these market fluctuations in the prices of your stocks, believe me that to make money consistently and to grow your portfolio value at a meaningful rate, though possible for a few, is not easy.  Frequent trading incurs costs and expenses, and also your time, which can be better employed to pursue some better, more productive and healthier activities.  Rather than hoping to profit from trading these prices, focus on profiting from the long term returns you can expect with a high degree of probability from holding these stocks with great earning power. 

How then should you approach these market fluctuations of the prices of your stock?

When the price of the stock is higher than your calculated intrinsic value, don't buy to add to your portfolio.  Do you sell based on valuation?  Often, you need not have to.  There are times when you may consider selling some (perhaps 20%), but not all, should the stock be too overpriced  Selling your winners to lock in a gain, may not mean that you will be able to buy the same back at lower prices in the future.  Moreover, the gain that you locked in at the time of selling, you may realise that you have missed out on the even bigger gains that these stocks deliver over the long term.   (Just to emphasize, this is different from stocks which fundamentals have deteriorated permanently.  These should be sold urgently to prevent harm to your portfolio.) 

Great companies can often be bought at fair prices and still be very profitable over the long term in your portfolio.  You should be greedy when such companies are available to you at low prices, especially during a general market correction or a bear market, when even these good stocks are sold down by the less savvy investors, due to fear, during such periods.

Using Market Fluctuations as a guide to making Investment Decisions*

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.

The Intelligent Investor by Benjamin Graham

Why I am interested in stocks?

Stock prices fluctuated wildly while the underlying value of the business was far more stable.  

To be a successful investor you need to have the time to stop and contemplate what's going on.  

MARKET FLUCTUATIONS OF INVESTOR'S PORTFOLIO

Note carefully what Graham is saying here. 

It is not just possible, but probable, that most of the stocks you own will gain at least 50% from their lowest price and lose at least 33% ("equivalent one-third") from their highest price -regardless of which stocks you own or whether the market as a whole goes up or down.

If you can't live with that - or you think your portfolio is somehow magically exempt from it - then you are not yet entitled to call yourself an investor.

Any price - and therefore P/E - movements that is not related to the company's earnings is transient.

The stock market is governed by a diverse set of influences.  And just as the sea is, it is predictable over the long term but not over the short term.

Probably the most widely watched reason for the long-term fluctuations of the price and P/E is the rise and fall of the stock market itself.  This can be a function of the economy's volatility.  The economy is battered by the rise and fall of interest rates, by inflation, and by a variety of factors that drive consumer confidence or buying power up or down.  Actual changes in the economy itself will cause longer-term changes in the market and the prices of its individual stocks.  Speculation about such changes has a shorter-term effect.

In the shorter term, there are the ripples and wavelets.  Every little utterance of a government official or company offer, insider buying or selling (which may or may not mean anything), rumour, gossip, and just about anything else can influence the whims of those on the street.  Many people will use these stories to try to make or break a market in the stock.

Over the life of a company, its fair P/E - the "normal" relationship between a company's earnings and its stock's price - is relatively constant.  It does tend to decline slowly as the company's earnings growth declines, which happens with all successful companies.  For all practical purposes, however, that relationship is remarkably stable.  And for that reason, it's also remarkably predictable.

When a company's earnings continue to grow, so will its stock price.  Conversely, when earnings flatten or go down, the price will follow.

The little fluctuations in the P/E ration above and below that constant (fair) value are not so predictable because they are all caused by investor perception and opinion.  Think of them as the winds that blow across the surface of the sea.

The broader moves above and below the norm are the undulations that are typically caused by the continuous rising and falling of analysts' expectations.  When a company first emerges into its explosive growth period, the analysts expect earnings to continue to skyrocket.  Earnings growth estimates in the 50% range or more are not uncommon.

As the company continues to meet these expectations, investor confidence booms along with it, and more investors pay a higher and higher price for the stock.  The P/E rises as a meteor right along with the price.  The faster the growth, the higher the P/E.  This does nothing to alter the value of the "reasonable or fair" P/E multiple.  It just means that investor confidence has risen well above that norm and that there will eventually be an adjustment.

Sure enough, one fine day when the analysts' consensus called for growth of 45%, the company turns in a "disappointing" earnings growth of only 38%.  The analysts start wringing their hands because the company has not met their expectations, and some fund manger sells.  Next, all of the lemmings on Wall Street follow suit.  And not long thereafter you get a call from your broker telling you that you've had a nice ride, you've made a lot of money on the stock, and it's time to take your profit and get out.  In the meantime, the broker has made a commission on your purchase and is hoping to make it on your sale as well.

After a while, after the price and the P/E have plummeted and then sat there for a while, some analyst wakes up to the fact that a 34% earning growth rate is still pretty darn good and jumps back in.   Soon the cycle is reversed.  The market starts showing the company some respect again.  And you get a call from your broker.

Of course, as a smart intelligent investor you didn't sell it in the first place!  Because you were watching the fine earnings growth all along, you knew better than to sell.  And you chose the opportunity to buy some more.  In the meantime, your brokers'; clients who were not so savvy has taken their profits (and, had paid the taxes on them, by the way) and are now wishing that they had stayed in with you.  By the time their broker called them again, the price had already climbed past the point where it made good sense for them to jump in again.

It is best to assume that any price - and therefore P/E - movements that is not related to the company's earnings is transient.  If the stories - not the numbers - cause the price to move, the change won't last.  What goes up will come down, and what goes down will come up.,  You have to be concerned only when the sales, pretax profits, or earnings cause the change, and then only if you find that the performance decay is related to a major long-term problem that is beyond the management's ability to resolve.

Remember also that a sizable segment of Wall Street doesn't make its money investing as you do; it makes its money on the "ocean motion."  Buy or sell, it makes little difference to them what you do.  They make their money either way.  But it sure makes a big difference to you!

Benjamin Graham on Market Behavior

In Security Analysis, Benjamin Graham emphasizes the importance of not only focusing on a firm’s potential and accounting statements, but to also pay great attention to the business cycle. Individual investors should research and create their own one year outlook for the market.

Almost any security may be a sound purchase at some real or prospective price and an indicated sale at another price.
- Benjamin Graham, Security Analysis

Think Long-Term

However, Graham also stresses that day-to-day and month-to-month fluctuations of the market should be ignored. Instead, investors should focus on the major shifts in market sentiment and estimating what stage of the business cylce we are in. Clearly today we are in a brutal bear market that has brought down the S&P 500 over 40% year to date. But we have to ask ourselves, what inning of this bear market are we in? Where do we see the strongest values in the market?

Benjamin Graham on Investing in Bear Markets

In a typical case of bear-market hysteria or pessimism the investor would be better off if he were not able to sell out so readily; in fact, he is often better off if he does not even know what changes are taking place in the market price of his securities.
- Benjamin Graham, Security Analysis

Graham’s sentiment on holding onto securities in a bear market could have taken a huge chunk out of someone’s portfolio this year, I know holding onto crashing stocks has severly hurt my portfolio. However at this state of the bear market I believe the above quote is appropriate.

It is ill-advised at this moment in time to liquidate investments into weakness. Your portfolio may depreciate in the coming months, but sometimes you have to take a 3 month deep breath and try your best to not follow your stock prices on a daily basis and just enjoy your dividend yields! To do this you have to be sure that your portfolio is filled with strong, value stocks with years of consistent earnings growth. Ignoring equity prices does not mean you should ignore the latest news from stocks you own. Shares should be sold if there is a fundamental shift in the companies’ long-term outlook.

Even though Warren Buffet’s 2 month-old investment in Goldman Sachs (GS) at $115 a share has fallen almost in half to $65 a share, I’m willing to bet he is sleeping well at night knowing he is invested in a first-in class company (although the investment banking class may be gone forever) and enjoying a 10% dividend yield from his preferred stock.

Don’t Purchase a Stock at Any Price

Finding the strongest values is no easy task, and Benjamin Graham gives some bull market advice that is worth remembering once this cycle changes gears. “Don’t purchase stocks atany price.” He writes that great companies don’t necessarily indicate a great investment if their stock price is comparatively high. Be a patient investor and wait until the company drops to an attractive level. For instance during a bull market in 2006 you could have bought Microsoft (MSFT) at a high of $30.19 or a low of $21.92 (or today at $19.15!) - a 27% variation. If a stock price of a company you have been watching continues to soar far above the intristic value (you can use my post on the Dividend Growth Model to estimate intrinsic value) you give the company, don’t feel like you missed the boat, in the long-term the price very well will come down to levels you like or their earnings will improve to increase your valutation.

When to Invest In Small Cap Stocks

Graham also notes that small cap stocks are more sensitive to swings in the overall market. Your position in small caps should be minimized in your portfolio if you have a weak outlook for the coming year and your small cap positions should be increased in bull markets. This sentiment is supported decades after Graham’s writing, consider comparing SPDR DJ Wilshire Small Cap Growth (DSG) which retreated 49% YTD vs. SPDR DJ Wilshire Large Cap Growth (ELG) which declined only (only!?) 43% YTD.

Beware of Bull Markets

Beware of “bargains” when most stock prices are high. An undervalued, neglected stock may continue to be neglected through the end of the bull market and may potential be one of the hardest hit stocks in the following bear market.

Market Environment, Potential Value, and Intristic Value Produce Market Price

Post written by Max Asciutto

http://www.theintelligentinvestor.net/benjamin-graham-on-market-behavior

Good managements produce a good average market price, and bad managements produce bad market prices.

Market Price Fluctuations:  An Added Consideration

Something should be said about the significance of average market prices as a measure of managerial competence. 

• The shareholder judges whether his own investment has been successful in terms both of dividends received and of the long-range trend of the average market value. 
• The same criteria should logically be applied in testing the effectiveness of a company’s management and the soundness of its attitude toward the owners of the business.

This statement may sound like a truism, but it needs to be emphasized.

• For as yet there is no accepted technique or approach by which management is brought to the bar of market opinion. 

On the contrary, managements have always insisted that they have no responsibility of any kind for what happens to the market value of their shares.

• It is true, of course, that they are not accountable for those fluctuations in price which, as we have been insisting, bear no relationship to underlying conditions and values. 
• But it is only the lack of alertness and intelligence among the rank and file of shareholders that permits this immunity to extend to the entire realm of market quotations, including the permanent establishment of a depreciated and unsatisfactory price level. 

Good managements produce a good average market price, and bad managements produce bad market prices.

Market Behaviour: Crowd Behaviour IMPACTS Stock Prices

As a value investor, it is important to think for yourself and not follow the crowd.  But it is still important to understand market crowd behaviour and, by understanding that behaviour, know when the stock market is ripe for the picking.  (BFS, STS).

Be careful not to get caught up in the financial press hype if you do choose to listen to it.

Related topics:

Market Behaviour: The Least You Need to Know
Market Behaviour: Crowd Impacts on Stock Prices

Market Behaviour: Can You Beat the Market?
Market Behaviour: Bull Runs
Market Behaviour: Bear Stalls
Market Behaviour: Pendulum Swings (Volatility)
Market Behaviour: Irrational Exuberance
Market Behaviour: Unjustifiable Pessimism
Market Behaviour: Control Yourself (Patience)

Famous Mr. Market Parable

Stocks will fluctuate substantially in value. For a true investor, the only significant meaning of price fluctuations is that they offer ". . . an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal." 

Using his famous Mr. Market parable, Graham suggests the attitude one should adopt toward fluctuations in prices. Imagine owning a $1,000 interest in a business along with a partner, Mr. Market. 

Every day the accommodating Mr. Market offers either to buy your interest or to sell you a larger interest. Sometimes his price is ridiculously high, allowing you a good opportunity to sell. At other times his price is ridiculously low, allowing you a good opportunity to buy. Still at other times, his quotes are roughly justified by the business outlook, and you can ignore them. 

The point is that the market is there for your convenience and profit. And market valuations are often wrong. Price fluctuations, Graham believes ". . . bear no relationship to underlying conditions and values." It is a mistake, he argued, to let the market determine what stocks are worth. Generally an investor will be wiser to form independent stock valuations, and then to exploit divergences between those valuations and the market's prices.

Graham's Mr. Market parable is related to his view of technical analysis. According to Graham, nearly all of technical analysis is based on buying stock when prices have risen and selling when they have fallen. Based on over 50 years' experience, he had ". . . not known a single person who had consistently or lastingly made money by thus 'following the market.'" This approach, he declared, ". . . is as fallacious as it is popular." 

Business Valuations versus Stock-Market Valuations: Summary

1. The most realistic distinction between the investor and the speculator is found in their attitude toward stock-market movements.
2. The speculator's primary interest lies in anticipating and profiting from market fluctuations.
3. The investor's primary interest lies in acquiring and holding suitable securities at suitable prices.
4. Market movements are important to him in a practical sense, because they alternately create low price levels at which he would be wise to buy and high price levels at which he certainly should refrain from buying and probably would be wise to sell.
5. It is far from certain that the typical investor should regularly hold off buying until low market levels appear, because this may involve a long wait, very likely the loss of income, and the possible missing of investment opportunities.
6. On the whole it may be better for the investor to do his stock buying whenever he has money to put in stocks, except when the general market level is much higher than can be justified by well-established standards of value.
7. If he wants to be shrewd he can look for the ever-present bargain opportunities in individual securities.
8. Aside from forecasting the movements of the general market, much effort and ability are directed on Wall Street toward selecting stocks or industrial groups that in matter of price will "do better" than the rest over a fairly short period in the future.
9. Logical as this endeavor may seem, we do not believe it is suited to the needs or temperament of the true investor - particularly since he would be competing with a large number of stock-market traders and first-class financial analysts who are trying to do the same thing.
10. As in all other activities that emphasize price movements first and underlying values second, the work of many intelligent minds constantly engaged in this field tends to be self-neutralizing and self-defeating over the years.
11. 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.
12. He should always remember that market quotations are there for his convenience, either to be taken advantage of or to be ignored.
13. He should never buy a stock because it has gone up or sell one because it has gone down.
14. He would not be far wrong if this motto read more simply: "Never buy a stock immediately after a substantial rise or sell one immediately after a substantial drop."

An Added Consideration: Average market prices and managerial competence.

• Something should be said about the significance of average market prices as a measure of managerial competence.
• The shareholder judges whether his own investment has been successful in terms both of dividends received and of the long-range trend of the average market value.
• The same criteria should logically be applied in testing the effectiveness of a company's management and the soundness of its attitude toward the owners of the business.
• This statement may sound like a truism, but it needs to be emphasized. For as yet there is no accepted technique or approach by which management is brought to the bar of market opinion.
• On the contrary, managements have always insisted that they have no responsibility of any kind for what happens to the market value of their shares.
• It is true, of course, that they are not accountable for those fluctuations in price which, as we have been insisting, bear no relationship to underlying conditions and values.
• But it is only the lack of alertness and intelligence among the rank and file of shareholders that permits this immunity to extend to the entire realm of market quotations, including the permanent establishment of a depreciated and unsatisfactory price level.
• Good managements produce a good average market price, and bad managements produce bad market prices.

Ref: Intelligent Investor by Benjamin Graham

Business Valuations versus Stock-Market Valuations: The True Investor

1. The true investor is in a special position when he owns a listed common stock.
2. He can take advantage of the daily market price or leave it alone, as dictated by his own judgement and inclination.
3. He must take cognizance of important price movements, for otherwise his judgment will have nothing to work on.
4. Conceivably they may give him a warning signal which he will do well to heed - this in plain English means that he is to sell his shares because the prices has gone down, foreboding worse things to come.
5. In our view such signals are misleading at least as often as they are helpful.
6. Basically, price fluctuations have only one significant meaning for the true investor.
7. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal.
8. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.

Ref: Intelligent Investor by Benjamin Graham

Business Valuations versus Stock-Market Valuations: Critics of the value approach to stock investment

1. Critics of the value approach to stock investment argue that listed common stocks cannot properly be regarded or appraised in the same way as an interest in a similar private enterprise, because the presence of an organized security market "injects into equity ownership the new and extremely improtant attribute of liquidity."
2. But what this liquidity really means is, first, that the investor has the benefit of the stock market's daily and changing appraisal of his holdings, for whatever that appraisal may be worth, and second, that the investor is able to increase or decrease his investment at the market's daily figure - if he chooses.
3. Thus the existence of a quoted market gives the investor certain options that he does not have if his security is unquoted.
4. But it does not impose the current quotation on an investor who prefers to take his idea of value from some other source.

In these 113 words Graham sums up his lifetime of experience

1. Let us return to our comparison between the holder of marketable shares and the man with an interest in a private business.
2. We have said that the former has the option of considering himself merely as the part owner of the various businesses he has invested in, or as the holder of shares which are salable at any time he wishes at their quoted market price.
3. But note this important fact: The true investor scarcely ever is forced to sell his shares, and at all times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more.* Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons' mistakes of judgement.
4. (This may well be the single most important paragraph in Graham's entire book. In these 113 words Graham sums up his lifetime of experience. You cannot read these words too often; they are like Kryptonite for bear markets. If you keep them close at hand and let them guide you throughout your investing life, you will survive whatever the markets throw at you.)
5. Incidentally, a widespread situation of this kind actually existed during the dark depression days of 1931-1933. There was then a psychological advantage in owning business interests that had no quoted market.
6. For example, people who owned first mortgages on real estate that continued to pay interest were able to tell themselves that their invesmtents had kept their full value, there being no market quotations to indicate otherwise.
7. On the other hand, many listed corporation bonds of even better quality and greater underlying strength suffered severe shrinkages in their market quotations, thus making their owners believe they were growing distinctly poorer.
8. In reality, the owners were better off with the listed securities, despite the low prices of these.
9. For if they had wanted to, or were compelled to, they could at least have sold the issues - possibly to exchange them for even better bargains.
10. Or they could just as logically have ignored the market's action as temporary and basically meaningless.
11. But it is self-deception to tell yourself that you have suffered no shrinkage in value merely because your securities have no quoted market at all.

A&P was the largest retail enterprise in America, if not in the world, with a continuous and impressive record of large earnings for many years. Yet in 1938 this outstanding business was considered on Wall Street to be worth less than its current assets alone - which means less as a going concern than if it were liquidated.

1. Returning to our A&P shareholder in 1938, we assert that as long as he held on to his shares he suffered no loss in their price decline, beyond what his own judgment may have told him was occasioned by a shrinkage in their underlying or intrinsic value.
2. If no such shrinkage had occurred, he had a right to expect that in due course the market quotation would return to the 1937 level or better - as in fact it did the following year.
3. In this respect his position was at least as good as if he had owned an interest in a private business with no quoted market for its shares.
4. For in that case, too, he might or might not have been justified in mentally lopping off part of the cost of his holdings because of the impact of the 1938 recession - depending on what had happened to his company.

Ref: Intelligent Investor by Benjamin Graham

* "Only to the extent that it suits his books" means "only to the extent that the price is favourable enough to justify selling the stock."

Business Valuations versus Stock-Market Valuations: The A & P Example

The A. & P. Example.

This was one of Graham's original examples, which dates back many years but which has a certain fascination because it combines so many aspects of corporate and investment experience. Here is the story:

1. It involves the Great Atlantic and Pacific Tea Co.
2. A&P shares were introduced to trading on the "Curb" market, now American Stock Exchange, in 1929 and sold as high as 494.
3. By 1932 they had declined to 104, although the company's earnings were nearly as large in that generally catastrophic year as previously.
4. In 1936 the range was between 111 and 131.
5. Then in the business recession and bear market of 1938 the shares fell to a new low of 36.
6. That price was extraordinary. It meant that the preferred and common were together selling for $126 million, although the company had just reported that it held $85 million in cash alone and a working capital (or net current assets) of $134 million.
7. A&P was the largest retail enterprise in America, if not in the world, with a continuous and impressive record of large earnings for many years.
8. Yet in 1938 this outstanding business was considered on Wall Street to be worth less than its current assets alone - which means less as a going concern than if it were liquidated.
9. Why? First, because there were threats of special taxes on chain stores; second, because net profits had fallen off in the previous year; and third, because the general market was depressed.
10. The first of these reasons was an exaggerated and eventually groundless fear; the other two were typical of temporary influences.
11. Let us assume that the investor had bought A&P common in 1937 at, say, 12 times its five-year average earnings, or about 80.
12. We are far from asserting that the ensuing decline to 36 was of no importance to him.
13. He would have been well advised to scrutinize the picture with some care, to see whether he had made any miscalculations.
14. But if the results of his study were reassuring - as they should have been - he was entitled then to disregard the market decline as a temporary vagary of finance, unless he had the funds and the courage to take advantage of it by buying more on the bargain basis offered.

Sequel and Reflections

1. The following year, 1939, A&P shares advanced to 117 1/2, or three times the low price of 1938 and well above the average of 1937.
2. Such a turnabout in the behaviour of common stocks is by no means uncommon, but in the case of A&P it was more striking than most.
3. In the years after 1949 the grocery chain's shares rose with the general market until in 1961 the split-up stock (10 for 1) reached a high of 70 1/2 which was equivalent to 705 for the 1938 shares.
4. This price of 70 1/2 was remarkable for the fact it was 30 times the earnings of 1961.
5. Such a price/earnings ratio - which compares with 23 times for the DJIA in that year - must have implied expectations of a brilliant growth in earnings.
6. This optimism had no justification in the company's earnings record in the preceding years, and it proved completely wrong.
7. Instead of advancing rapidly, the course of earnings in the ensuing period was generally downward.
8. The year after the 70 1/2 high the price fell by more than half to 34. But this time the shares did not have the bargain quality that they showed at the low quotation in 1938.
9. After varying sorts of fluctuations the price fell to another low of 21 1/2 in 1970 and 18 in 1972 - having reported the first quarterly deficit in its history.

We see in this history how wide can be the vicissitudes of a major American enterprise in little more than a single generation, and also with what miscalculations and excesses of optimism and pessimism the public has valued its shares.

1. In 1938 the busines was really being given away, with no takers; in 1961 the public was clamoring fo the shares at a ridiculously high price.
2. After that came a quick loss of half the market value, and some years later a substantial further decline.
3. In the meantime the company was to turn from an outstanding to a mediocre earnings performer; its profit in the boom-year 1968 was to be less than in 1958; it had paid a series of confusing small stock dividdends not warranted by the current additions to surplus; and so forth.
4. A&P was a larger company in 1961 and 1972 than in 1938, but not as well-run, not as profitable, and not as attractive.

There are two chief morals to this story.

1. The first is that the stock market often goes far wrong, and sometimes an alert and courageous investor can take advantage of its patent errors.
   
2. The other is that most businesses change in character and quality over the years, sometimes for the better, perhaps more often for the worse. The investor need not watch his companies' performance like a hawk; but he should give it a good, hard look from time to time.

Ref: Intelligent Investor by Benjamin Graham

The more recent history of A&P is no different. At year-end 1999, its share price was $27.875; at year -end 2000, $700; a year later, $23.78; at year-end 2002, $8.06. Although some accounting irregulariteis later came to light at A&P, it defies all logic to believe that the value of a relatively stable business like groceries could fall by three-fourths in one year, triple the next year, then drop by two-thirds the year after that.

Business Valuations versus Stock-Market Valuations

1. The impact of market fluctuations upon the investor's true situation may be considered also from the standpoint of the shareholder as the part owner of various businesses.
2. The holder of marketable shares actually has a double status, and with it the privilege of taking advantage of either at his choice.
3. On the one hand his position is analogous to that of a minority shareholder or silent partner in a private business. Here his results are entirely dependent on the profits of the enterprise or on a change in the underlying value of its assets. He would usually determine the value of such a private-business interest by calculating his share of the net worth as shown in the most recent balance sheet.
4. On the other hand, the common-stock investor holds a piece of paper, an engraved stock certificate, which can be sold in a matter of minutes at a price which varies from moment to moment - when the market is open, that is - and often is far removed from the balance sheet value.
5. The development of the stock market in recent decades has made the typical investor more dependent on the course of price quotations and less free than formerly to consider himself merely a business owner.
6. The reason is that the successful enterprises in which he is likely to concentrate his holdings sell almost constantly at prices well above their net asset value (or book value, or "balance-sheet value").
7. In paying these market premiums the investor gives precious hostages to fortune, for he must depend on the stock market itself to validate his commitments.
8. This is a factor of prime importance in present-day investing and it has received less attention tha it deserves.
9. The whole structure of stock-market quotations contains a built-in contradiction. The better a company's record and prospects, the less relationship the price of its shares will have to their book value.
10. But the greater the premium above book value, the less certain the basis of determining its intrinsic value - i.e., the more this "value" will depend on the changing moods and measurements of the stock market.
11. Thus, we reach the final paradox, that the more successful the companyl, the greater are likely to be the fluctuations in the price of its shares.
12. This really means that, in a very real sense, the better the quality of a common stock, the more speculative it is likely to be - at least as compared with the unspectacular middle-grade issues.
13. (What we have said applies to a comparison of the leading growth companies with the bulk of well-established concerns; we exclude from our purview here those issues which are highly speculative because the businesses themselves are speculative.)
14. The argument made above should explain the often erratic price behaviour of our most successful and impressive enterprises.
15. Our favourite example is the monarch of them all - International Business Machines. The price of its shares fell from 607 to 300 in seven months in 1962-63; after two splits its price fell from 387 to 219 in 1970.
16. Similarly, Xerox - an even more impressive earnings gainer in recent decades - fell from 171 to 87 in 1962-63, and from 116 to 65 in 1970.
17. These striking losses did not indicate any doubt about the future long-term growth of IBM or Xerox; they reflected instead a lack of confidence in the premium valuation that the stock market itself had placed on these excellent prospects.
18. The previous discussion leads us to a conclusion of practical importance to the conservative investor in common stocks.
19. If he is to pay some special attention to the selection of his portfolio, it might be best for him to concentrate on issues selling at a reasonably close approximation to their tangible-asset value - say, at not more than one-third above that figure.
20. Purchases made at such levels, or lower, may with logic be regarded as related to the company's balance sheet, and as having a justification or support independent of the fluctuating market prices.
21. The premium over book value that may be involved can be considered as a kind of extra fee paid for the advantage of stock-exchange listing and the marketability that goes with it.
22. A caution is needed here. A stock does not become a sound investment merely because it can be bought at close to its asset value. The investor should demand, in addition, (1) a sastisfactory ratio of earnings to price, (2) a sufficiently strong financial position, and (3) the prospect that its earnings will at least be maintained over the years.
23. This may appear like demanding a lot from a modestly priced stock, but the prescription is not hard to fill under all but dangerously high market conditions.
24. Once the investor is willing to forgo brilliant prospects - i.e., better than average expected growth - he will have no difficulty in finding a wide selection of issues meeting these criteria.
25. More than half of the DJIA issues met our asset-value criterion at the end of 1970. The most widely held investment of all - American Tel. & Tel. - actually sells below its tangible-asset value as we write. Most of the light-and-power shares, in addition to their other advantages, are now (early 1972) available at prices reasonably close to their asset values.
26. The investor with a stock portfolio having such book values behind it can take a much more independent and detached view of stock-market fluctuations than those who have paid high mutlpliers of both earnings and tangible assets.
27. As long as the earning power of his holdings remains satisfactory, he can give as little attention as he pleases to the vagaries of the stock market.
28. More than that, at times he can use these vagaries to play the master game of buying low and selling high.

Ref: Intelligent Investor by Benjamin Graham

Net asset value, book value, balance-sheet value, and tangible-asset value are all synonyms for net worth, or the total value of a company's physical and financial assets minus all its liabilities. It can be calculated using the balance sheets in a company's annual and quarterly reports; from total shareholders' equity, subtract all "soft" assets such as goodwill, trademarks, and other intangibles. Divide by the fully diluted number of shares outstanding to arrive at book value per share.

Graham's use of the world "paradox" is probably an allusion to a classic article by David Durand, "Growth Stocks and the Petersburg Paradox," which compares investing in high-priced growth stocks to betting on a series of coin flips in which the payoff escalates with each flip of the coin. Durand points out that if a growth stock could continue to grow at a high rate for an indefinite period of time, an inestor should (in theory) be willing to pay an infinite price for its shares. Why, then, has no stock ever sold for a price of infinity dollars per share? Because the higher the assumed future growth rate, and the longer the time period over which it is expected, the wider the margin for error grows and the higher the cost of even a tiny miscalculation becomes.

Market Fluctuations of the Investor's Portfolio

1. Every investor who owns common stocks must expect to see them fluctuate in value over the years.
2. The behaviour of the DJIA since our last edition of Intelligent Investor was written in 1964 probably reflects pretty well what has happened to the stock portfolio of a conservative investor who limited his stock holdings to those of large, prominent, and conservatively financed corporations.
3. The overall value advanced from an average level of about 890 to a high of 995 in 1966 (and 985 again in 1968), fell to 631 in 1970, and made an almost full recovery to 940 in early 1971.
4. (Since the individual issues set their high and low marks at different times, the fluctuations in the Dow Jones group as a whole are less severe than those in the separate components.)
5. We have traced through the price fluctuations of other types of diversified and conservative common-stock portfolios and we find that the overall results are not likely to be markedly different from the above.
6. In general, the shares of second-line companies fluctuate more widely than the major ones, but this does not necessarily mean that a group of well-established but smaller companies will make a poorer showing over a fairly long period.
7. (Today's equivalent of what Graham calls "second-line companies" would be any of the thousands of stocks not included in the Standard & Poor's 500-stock index. A regularly revisited list of the 500 stocks in the S & P index is available at http://www.standardandpoors.com/. )
8. In any case, the investor may as well resign himself in advance to the probability rather than the mere possibility that most of his holdings will advance, say, 50% or more from their low point and decline the equivalent one-third or more from their high point at various periods in the next five years.
9. (Note carefully what Graham is saying here. It is not just possible, but probable, that most of the stocks you own will gain at least 50% from their lowest price and lose at least 33% from their highest price - regardless of which stocks you own or whether the market as a whole goes up or down. If you can't live with that - or you think your portfolio is somehow magically exempt from it - then you are not yet entitled to call yourself an investor.)
10. (Graham refers to a 33% decline as the "equivalent one-third" because a 50% gain takes a $10 stock to $15. From $15, a 33% loss [or $5 drop] takes it right back to $10, where it started.)
11. A serious investor is not likely to believe that the day-to-day or even month-to-month fluctuations of the stock market make him richer or poorer.
12. But what about the longer-term and wider changes? Here practical questions present themselves, and the psychological problems are likely to grow complicated.
13. A substantial rise in the marke is at once a legitimate reason for satisfaction and a cause for prudent concern, but it may also bring a strong temptation toward imprudent action.
14. Your shares have advanced, good! You are richer than you were, good! (1) But has the price risen too high, and should you think of selling? (2) Or should you kick yourself for not having bought more shares when the level was lower? (3) Or - worst thought of all - should you now give way to the bull-market atmosphere, become infected with the enthusiasm, the overconfidence and the greed of the great public (of which, after all, you are a part), and make larger and dangerous commitments?
15. Presented thus in print, the answer to the last question is a self-evident no, but even the intelligent investor is likely to need considerable will power to keep from following the crowd.
16. It is for these reasons of human nature, even more than by calculation of financial gain or loss, that we favour some kind of mechanical method for varying the proportion of bonds to stocks in the investor's portfolio.
17. The chief advantage, perhaps, is that such a formula will give him something to do.
18. As the market advances he will from time to time make sales out of his stockholdings, putting the proceeds into bonds; as it declines he will reverse the procedure. These activities will provide some outlet for his otherwise too-pent-up energies.
19. If he is the right kind of investor he will take added satisfaction from the thought that his operations are exactly opposite from those of the crowd.
20. (For today's investor, the ideal strategy for pursuing this "formula" is rebalancing.)

Ref: Intelligent Investor by Benjamin Graham