Keep INVESTING Simple and Safe (KISS) ****Investment Philosophy, Strategy and various Valuation Methods**** The same forces that bring risk into investing in the stock market also make possible the large gains many investors enjoy. It’s true that the fluctuations in the market make for losses as well as gains but if you have a proven strategy and stick with it over the long term you will be a winner!****Warren Buffett: Rule No. 1 - Never lose money. Rule No. 2 - Never forget Rule No. 1.
Tuesday 22 May 2012
Monday 21 May 2012
Sunday 20 May 2012
Why is investing confusing?
Behavioural Finance Solutions
Dale Carnegie ..... How to stop worrying.
What is the worst that can happen if you take a decision.
Analyze the facts and the situation: it may not be as bad as you think.
Be prepared for the worst.
GO AHEAD AND TAKE THE DECISION.
Morningstar's Equity Valuation Methodology
Stock Strategist
Introducing Changes to Morningstar's Equity Valuation Methodology
We've enhanced our methodology, which could result in modest fair value changes.
Morningstar's Three-Stage Discounted Cash Flow Valuation
Our DCF model includes three stages of analysis. The first stage includes our forecasts for the next five to 10 years. In the first stage, analysts make explicit forecasts for all of a company's important financial statement items, such as revenue, operating costs, capital expenditures, and investments in working capital.
In the second stage, analysts are more limited. We take earnings from the last year of Stage I and assume that they grow at a constant rate. We determine the investment needed to achieve this growth by assuming a constant return on new investment. Analysts are responsible for choosing the growth rate, the rate of return on new investment, and the length of Stage II, but otherwise don't need to make explicit forecasts for individual financial statement lines.
Stage II assumptions are the primary vehicle for incorporating our analysis of economic moats in our fair value estimates. Companies with wide and narrow moats are expected to earn returns on new invested capital that exceed their cost of capital in Stage II. The wider the moat, the longer Stage II is likely to last. In general, we assume narrow-moat companies can earn excess returns on capital for at least 15 years, while wide-moat companies can earn excess returns on capital for at least 20 years.
Our model concludes with a third stage. In Stage III, all companies are assumed to be the same. Return on new invested capital is set equal to the weighted average cost of capital; every moat is eventually eroded--no company can earn excess returns forever. We also assume returns on existing invested capital remain constant in Stage III.
Our latest model includes several alternative Stage II-III methodologies, as well. These include terminal multiples (such as EV/Sales and EV/EBITDA) and the ability to enter the total value of cash flows beyond Stage I directly. These alternative approaches should only be used in special circumstances where the standard three-stage method would be inappropriate.
A change to our formulas for valuing Stage II and Stage III cash flows will have the largest downward effect on our fair value estimates, particularly for companies where a significant portion of value is concentrated in these later periods. This is because of more conservative assumptions for long-run reinvestment needs relative to previous versions of our model.
Estimating the Cost of Capital
We discount future cash flows using the weighted average cost of capital, which incorporates the cost of debt, equity, and preferred capital. The discount rate is a key assumption in any DCF model. While the cost of debt and preferred stock can be observed in the marketplace, the cost of equity presents a significant challenge. In the past, analysts have been allowed significant discretion in choosing a cost of equity (COE), but we have formalized our approach in the latest model.
The most common methodology for estimating the COE in practice is the Capital Asset Pricing Model (CAPM). However, we find that the CAPM raises more questions than it answers by replacing one unobservable input (the cost of equity) with three (the risk-free rate, the equity risk premium, and beta). Even among experts, there is significant disagreement about appropriate values for the equity risk premium and beta.
Since we believe our analytical advantage is in estimating cash flows rather than making precise estimates of inherently unknowable quantities, we have chosen a greatly simplified approach that still captures the essence of the CAPM. We will be assigning each of the companies in our coverage universe to one of four "systematic risk buckets." For companies based in the U.S. and several other developed markets, below-average systematic risk will correspond to an 8% COE, average to a 10% COE, above average to a 12% COE, and very high to a 14% COE. Some international markets will require that a premium be added to these values, currently ranging from -1% for Japan to +11% for Greece.
Holding all else equal, we expect our enhanced cost of capital methodology to result in modest increases to most fair value estimates. However, in some cases where companies are deemed to have above-average systematic risk, it is possible that the new methodology could result in slight downward pressure on some fair value estimates.
Accounting for the Time Value of Money
The final significant change to our methodology involves the time value of money. Discounted cash flow valuation produces an estimate of a company's worth as of a specific point in time. That value tends to increase over time as cash flows are earned and future cash flows are discounted less.
In the past, fair value estimates in our models have adjusted continuously, with the published fair value estimate representing the valuation as of the day of publication. Unfortunately, this means that our fair value estimates can become stale as time elapses between report updates. It can also make it difficult for analysts to parse the causes of a change in a fair value between altered assumptions and the time value of money.
We are enhancing our time value of money methodology so that in the future, our fair value estimates will refer to the end of the current fiscal year. Fair value estimates will be updated for time value of money only once per year, when we roll our models. This should make our fair value estimates more forward-looking as well as provide better clarity around the causes of fair value changes. In isolation, this change would tend to increase our fair value estimates modestly.
Introducing Changes to Morningstar's Equity Valuation Methodology
We've enhanced our methodology, which could result in modest fair value changes.
By Matthew Coffina, CFA | 05-17-12 |
At Morningstar, we assign fair value estimates to around 1,800 companies across the globe. Each of these fair value estimates is based on a rigorous discounted cash flow (DCF) model built by one of our analysts using a standard Morningstar template. Occasionally, we find ways to improve our methodology. Over the next several months, we will be rolling out the sixth generation of our internal DCF template. In this article, we describe some of the key features of our updated valuation methodology.
Changes to our methodology may require adjustments to some of our fair value estimates, which you may notice in the coming months as analysts transition their companies to the new model. Some of these changes will tend to increase our fair value estimates, while others will cause our fair value estimates to decline.
Our DCF model includes three stages of analysis. The first stage includes our forecasts for the next five to 10 years. In the first stage, analysts make explicit forecasts for all of a company's important financial statement items, such as revenue, operating costs, capital expenditures, and investments in working capital.
We discount future cash flows using the weighted average cost of capital, which incorporates the cost of debt, equity, and preferred capital. The discount rate is a key assumption in any DCF model. While the cost of debt and preferred stock can be observed in the marketplace, the cost of equity presents a significant challenge. In the past, analysts have been allowed significant discretion in choosing a cost of equity (COE), but we have formalized our approach in the latest model.
The final significant change to our methodology involves the time value of money. Discounted cash flow valuation produces an estimate of a company's worth as of a specific point in time. That value tends to increase over time as cash flows are earned and future cash flows are discounted less.
Is Management in Your Corner?
Morningstar's new Stewardship Ratings for stocks can help reveal if management teams are working in shareholders' best interests or just their own.
http://www.morningstar.com/Cover/videoCenter.aspx?id=548155
http://www.morningstar.com/Cover/videoCenter.aspx?id=548155
How to Learn From When Buffett Sells
Adopting Buffett's very-long term perspective can help individual investors focus on what is important, says Morningstar's Paul Larson.
http://www.morningstar.com/Cover/videoCenter.aspx?id=548155
Should Berkshire Pay a Dividend?
Buffett authors weigh in on the possibility and wisdom of Berkshire Hathaway returning capital to shareholders.
http://www.morningstar.com/cover/videocenter.aspx?id=547398
Friday 18 May 2012
Will You Buy Facebook, the Largest IPO of All Time?
Are you ready for the largest IPO of all time? Well, you'd better be. No matter what you choose to do with the decade's hottest IPO, you deserve as much information as possible.
But there's more than one way to value an IPO. Most of us are more interested in how much value that initial offering places on the entire company. By that measure, Facebook is head and shoulders above General Motors and every other "biggest" IPO that's come along in recent years:
We know Mark Zuckerberg started the site at Harvard in February 2004. Now, 99 months later, it's worth $100 billion. That's an incredible amount of value to create in a relatively short time, but I didn't truly appreciate how outsized that valuation was until I compared it to these former IPO champions and the length of time each took from founding to reach the IPOs that earned them so much.
How did Facebook's tech peers begin their public lives? In every case (even Google's), far more humbly:
With the benefit of hindsight, we can see that most of these companies were bargains at the time, and continued excellence has brought early shareholders some amazing gains:
http://www.fool.com/investing/general/2012/05/16/will-you-buy-the-largest-ipo-of-all-time.aspx
But there's more than one way to value an IPO. Most of us are more interested in how much value that initial offering places on the entire company. By that measure, Facebook is head and shoulders above General Motors and every other "biggest" IPO that's come along in recent years:
We know Mark Zuckerberg started the site at Harvard in February 2004. Now, 99 months later, it's worth $100 billion. That's an incredible amount of value to create in a relatively short time, but I didn't truly appreciate how outsized that valuation was until I compared it to these former IPO champions and the length of time each took from founding to reach the IPOs that earned them so much.
How did Facebook's tech peers begin their public lives? In every case (even Google's), far more humbly:
Apple and Microsoft were '80s kids, debuting in 1980 and 1986, respectively, but they represented high-water marks for high-tech interest in their days.
If you'd like to think that Apple was more reasonably valued than Facebook at their respective debuts, you're wrong. Facebook's IPO valuation is actually in line with many of its high-tech peers, including two that didn't wait for profitability before going public:
With the benefit of hindsight, we can see that most of these companies were bargains at the time, and continued excellence has brought early shareholders some amazing gains:
With the exception of AOL, which has fallen on some hard times of late, and Amazon.com, a longtime high-valuation stock, major tech companies that survive the ravages of age have all seen their valuations shrink and their gains explode. Google, with the least growth of the bunch, has still been a six-bagger for IPO investors. Apple has earned its earliest investors 290 times their initial investments, while Microsoft has a cumulative return of more than 33,000% since going public.
Is there anything left to "like"?
For those of you expecting huge returns from Facebook, here are a few sobering numbers to consider -- assuming, of course, a $100 billion debut that isn't pumped to the moon by rabid demand. For your investment to offer Google-like returns, Facebook would need to be worth more than $600 billion, a market cap no company has held for very long. To approach even Yahoo!'s post-IPO growth, you'd need Facebook to be worth more than $2 trillion. And to become the next Microsoft in terms of share-price appreciation, Facebook would have to someday be worth $3 quadrillion dollars. Good luck with that.
For those of you expecting huge returns from Facebook, here are a few sobering numbers to consider -- assuming, of course, a $100 billion debut that isn't pumped to the moon by rabid demand. For your investment to offer Google-like returns, Facebook would need to be worth more than $600 billion, a market cap no company has held for very long. To approach even Yahoo!'s post-IPO growth, you'd need Facebook to be worth more than $2 trillion. And to become the next Microsoft in terms of share-price appreciation, Facebook would have to someday be worth $3 quadrillion dollars. Good luck with that.
Perspective is important when considering the growth prospects of any hot IPO, and Facebook's public debut will demand it. Do you believe that Facebook can be the next Google, AOL, Apple, or Microsoft? I don't.
http://www.fool.com/investing/general/2012/05/16/will-you-buy-the-largest-ipo-of-all-time.aspx
Wednesday 16 May 2012
Monday 14 May 2012
Joris speaks to a trader about City short-termism, high pay, the excitement of recent years and why he now wants a way out
Derivatives trader: 'The trouble is, regulators are idiots'
Joris speaks to a trader about City short-termism, high pay, the excitement of recent years and why he now wants a way out
• This monologue is part of a series in which people across the financial sector speak about their working lives
• This monologue is part of a series in which people across the financial sector speak about their working lives
We are meeting in Lombard One, a restaurant in the heart of the City popular with financial types where a beer goes for £4.50. He is a confident man in his early 30s, the son of south-east Asian immigrants who now works as a derivatives trader, at director level. It's around 6.30pm and he orders a beer.
The Joris Luyendijk banking blog
- Anthropologist and journalist Joris Luyendijk ventures into the world of finance to find out how it works
- This is an experimentFind out more
- Are you an outsider?Meet the people who work in finance
- Are you an insider?Find out how you can help
- Follow updates hereThe Joris Luyendijk banking blog
- ... or on Twitter@JLbankingblog
"Why trading? I read maths in university, and I love the beauty of it. Success in trading is binary. In areas like history, geography or languages, grey is the most obvious shade. Trading, at its core, is black and white. I have generated value today, or I haven't.
"Why trading? There was the glamour of it. You know, the money, the girls, rock and roll without the guitars. Another thing is, in trading you get to define yourself from an early age. You come in at 22 and you can prove yourself right away. I know guys making £1m a year at 25. This doesn't happen a lot, but it does happen and that's such a contrast with other jobs. As you know, investment banking breaks down into financial markets, where I work, and advisory, such as mergers & acquisitions. I could never be in M&A. A friend of mine works there. He was told in the first year he couldn't leave the M25 [London ring road], ever. He had to stay within a radius where he could be in the office within an hour.
"In M&A you don't really get to do anything of value in the first years. Asthese guys in your interviews are saying you work horrible hours, fidgeting with pitch books and getting the spacing right. Worst of all: if you sell advice, like M&A bankers, you almost have to puff yourself up. Why would clients pay for your advice, unless you are the smartest person on earth? It's a salesman's job – you know, a dirty job?
"If you don't come from money, you realise early on that actually, money is quite important. Let's say experienced traders like me can make anywhere between £300k and £1m a year. Meanwhile somebody fighting for our country in Afghanistan is making £22,000. It's funny how that works. When you ask me if that's fair, I also think of the guy who is making £5m, while I know I am smarter than he is. Life isn't fair.
"I come into the office around 7, in time for the 7.15 morning meeting. There'll be salespeople there, and traders. The traders will get up and give their ideas; basically they're telling the salespeople, this is what you should be pushing with clients. Salespeople have spoken to their regular clients, and they might say, there's massive client interest for this or that. You don't get much out of these morning meetings.
"At 8 the market opens, and I'll be responding to both clients and the market. It can be so hectic you can't even go to the toilets. Or so dull you end up doing your internet shopping.
"At 4.30 the business closes, you calculate your P&L (profits and losses) and file a report on why you made or lost money. Around 5.30 people begin to drift away. The more complex stuff you trade, the longer you need. If you have positions in the US, you may need to stay in as markets there are open until 9pm London time.
"Trading is a seductive world. In a bull market, with prices going up, basically everybody makes money. You ask yourself, was it me or just the market going up? It's tempting to attribute everything to your brilliance. What do I say to people claiming that a monkey with darts regularly outperforms traders? Well, for me the money hits the bank every month.
"I wish I could take you on the trading floor. There's no privacy, people are meant to overhear each other on the phone. The toilets are always in a horrible condition. I don't know why, because people on a trading floor are animals? It's just how it is.
"I love to be one of those people there, the energy, the buzz … Weird thing is, sometimes you can feel the floor exhale before you see the price action on your screen that people are responding to. The price action might be a number coming out, say higher inflation or lower unemployment … It's almost like an opera.
"There's jealousy, of course. People whispering "he had a really easy book to trade", after you had a good year. I'd say the low point is when everybody around you is making money and for some reason you are not. Everyone has bad periods, like sportspeople. You need to be strong, tell yourself "it's fine, I'm good". It's everyone's fear: to have lost "it".
"What is "it"? Call it intuition, call it the equivalent of what Messi can do with a ball. In the morning you ask traders who have "it", what do you think the market is going to do? And they go: "up". And up it goes. It's quite something.
"There seems to be this blanket anger towards bankers. It's as if you'd say: all sportspeople are bad, after some doping scandal or obnoxious misconduct by a footballer. Outsiders seem to think we're all the same. But even among traders, there is equity (shares), commodities (oil, grain etc), fixed income … Within fixed income there are interest rates people and foreign exchange. Within equity there's say, the oil and gas sector, the financials sector etc – and these are completely different beasts from those trading CDOs (complex financial instruments).
"You've got prop traders who use the bank's money to make money for the bank. And flow traders, like me, who trade on behalf of clients. Again, a huge difference.
"For flow traders the holy grail is to become a prop trader, and be away from all the politics, salespeople, clients. "Prop" is the purest form of trading. It's dying out because regulators don't want banks to take risk with their own capital.
"How it works in flow trading. At the beginning of the day I have "a view" of how the market will go. On that basis I will take "positions". Then I wait for clients to call, or be called by our salespeople, who want to buy some of that position. We pocket a commission for doing so, and we may make money from the margin between what I bought the contracts for, and what I sold them on to clients for.
"I said earlier that the beauty of trading is the black and white, but actually there is grey. There's office politics involved when it gets decided what book you trade – for example, the oil and gas sector, or the financials sector. Clearly, there can be more client flow in one book than in another.
"Sometimes a client who is very important to the bank wants to do a trade you think isn't going to be profitable. Sometimes in the interest of holding on to that client you end up doing the trade. Then office politics kicks in because you want your manager to know you sacrificed your P&L. The industry is a microcosm of society, only more intense, sharper and more fast-paced.
"Traditionally banks and firms have cared only about so-called top-line revenue, the net number of how much money you made. But management should look below the line. Say you made a lot of money from one massive trade for a client. Is that really you? Also, firms should look at revenue in relation to risk. If nobody takes notice of the potential losses you exposed the bank to, then you get traders taking huge risks, obviously. Because the easiest way to make a lot of money is to take some massive position and hope it works out. 'Efficient use of capital' is the new buzzword. Capital used to be almost infinitely available. That's over.
"It's a valid question: do we, as a society, want 25-year-old traders making £1m a year? If not, you need regulation, on a global scale. The trouble is, regulators are idiots. I am sorry to put it so bluntly but you can't expect it any other way. If an investment bank hires a graduate, two years later they will be making over £100,000. Meanwhile at the regulators you are getting £30,000. Why would a smart, aggressive, competitive 22-year-old decide to work for the Financial Services Authority?
"You now have a generation who were told as graduates by their bank: we'll make your rich. They weren't taught to think in terms of risk. Basically at banks it's quite simple: if you are generating £100m a year in profits, you can be the biggest arsehole and get away with it.
"A thing that struck me going over the comments on your blog is that people seem to think all of us saw the crisis coming. But apart from Goldman and maybe Deutsche Bank, nobody expected this. I am also angry about the crisis. When I think of the CEO of some Wall Street bank that went bust, and he still has his $400m … I mean, I owned shares in some of these banks, and they've gone to zero.
"Another thing is some people don't seem to understand risk. Risk per se is not bad. Banking is about properly pricing the risk of everything. There are very different sorts of risk, for traders. We seem to be seen as gamblers, but I know of few people who live up to that cliche. It's really quite hard to take a huge gamble. There's risk and compliance, you have risk limits you can't exceed. If you suddenly take a massive position, somebody will see it.
"Sometimes I hear outsiders say about trading 'I could do it'. When we hire people we tell them, you have to be comfortable with running an amount of risk every day of your working life. You end up thinking about it in your sleep, while you eat. It starts when you wake up and never goes away. On an emotional level, it's not that easy.
"In the old days, before the democratisation of knowledge, only a limited number of people had access to information. Our sales guys would get calls from clients who read something in the FT. These days clients go on the internet themselves. Our added value is a lot less. Investment banks have this army of analysts putting out research, salespeople peddling it to clients, traders … Do we need all this?
"An element of panic is pervading the industry. What's our business model going to be? In the past 10 years I have never seen this pace of people dropping out. Pay will only go down. A lot of people are thinking, screw it, I'll survive as long as I can, take the money, and see what happens next.
"Generally the trading floor is meritocratic and I never felt any racism. A couple of pockets, like foreign exchange, are mostly populated by old school English white boys. No idea why that is.
"The trading floor is like a playground. I was in a minority in a white school and I have learnt to see how a comment about my background is meant. Jokes can be about your weight, hair, the university you went. It's an expression of camaraderie. There you are, sitting with two levels of screens in front of you, as in the trenches. You know that the guy to your right and the guy to your left both understand exactly what it is you're doing. We all have the same desire: to get on the floor, to make money.
"Derivatives flow traders have very little scope to rip off clients – a better word would be counter parties – actually, as these are professional investors. Multiple traders at multiple firms and banks can provide the kind of derivatives I am trading.
"In my experience salespeople have very weak technical knowledge of the products. If not, they would be trading themselves. With salespeople it's crucial they have this rapport with that really important client, so they can call him in bed at 10pm. We call this the ability to make the "first call in a non-standard environment". Say the shit hits the fan and we need to offload some inventory on a client. That's when you need the salesperson.
"Salespeople always want you to meet the clients, so they can say: here's my trader. Look at him. Just like a human being, he won't steal your children's inheritance.
"The repeal of the Glass-Stiegel Act allowed investment and retail banks to merge – that was a mistake in my view. There's no easy way to go back now. The Too Big To Fail banks have become even bigger. These banks will always find a way through. What so many people fail to grasp: banks are subject to the same discipline of quarterly earnings reports as the rest of the corporate world.
"Global heads of banks know: I have to make x billion in the next 18 months or I'm out. They can't say: it's going to be difficult for the next five years. The market demands results, from banks as much as from any other company.
"Bank CEOs are like salespeople. They are selling the dream to the outside world of how they are going to make the bank more profitable. The way it works, if you are a pension fund with shares in Morgan Stanley, and you see that Goldman Sachs made 50% more profit, you will not like that. These numbers make you look like a bad investor. So you put pressure on Morgan Stanley, saying, you have 18 months to prove you can turn this around or there'll be a sell-off.
"The short-termism is endemic. In my career I have almost never seen anyone trying to build something. There are just cycles of new guys coming in. They put forward a plan promising to make money in three or four years. So the pressure is huge, and the easiest way is take more risk. It doesn't always have to be obvious, visible risks, sometimes it can be "shadow" risks that are harder for outsiders to see.
"It's like an election cycle, really. You get new management coming in, and they will go for levers that can hit the revenue number within 18 months to three years. They go over the numbers and decide: this desk doesn't work. They fire the senior guy and bring in a new guy, for x million. New guy kicks out four more guys, and brings in his own. When after three years it hasn't worked out, the bank fires those five, and it starts all over.
"This is what a lot of people miss about Goldman Sachs. You look at most guys at the top there, they are Goldman guys. There's actually less short-termism there – for me their consistent management is one of their great strengths.
"Some managers are simply psychopaths. They come up to you on a day when you've lost money, and say: "you are losing money. Why are you losing money? Do you enjoy losing money?" I mean, that is not constructive, or is it? Management, on the whole, is terrible. You rarely get somebody who understands that managing me is not about competing with me, but about getting the best out of me.
"The City, or my niche in it, is like a club. Everybody knows everybody. We went to the same universities, at one time or another dated one another's girlfriends. It's relatively incestuous.
"The past few years were the most amazing, difficult, interesting times. Absolutely exhausting. In the morning you come in and RBS is down 40%. It's Sunday evening and you get a call: Lehman is about to go bust.
"That kind of excitement has washed by now. It's back to normal, the drudgery. I wonder, is this just what happens to people 10 years into a job? You get disillusioned? Everyone around me is thinking about exits. Then again, everyone in finance seems always to be playing with this idea of "getting out", of your "escape route".
"Banking is very honest, you can measure performance and keep score. On the other hand there are so many elements contributing to your performance that you do not control (market conditions, what product you trade, how interested clients are in what you offer them). So sometimes it feels like a very expensive prison term.
"Would I want my kids to work in finance? Most people would say no. Me too. I wouldn't feel they're adding anything. I find myself more and more interested in people who have built something. My life has revolved around a number on a screen for more than 10 years now. It can't be healthy to trade a number on a screen for your entire life?"
• Follow @JLbankingblog on Twitter
Sunday 13 May 2012
Intelligent Investor Summary
Benjamin Graham's The Intelligent Investor
http://jeffpearson.efoliomn.com/iis
Graham, Chapter 1:
Graham lays out his definition of investing right from the start of this chapter. His description is "an investment operation is one which, upon thorough analysis promises safety of principal and an adequate return" (p. 18). He labels anything not meeting these standards as speculation. Graham then describes two different approaches to investing: defensive and aggressive. Obviously, safety is a big concern for the defensive investor, and that shows in his example of putting half of your money in stocks and half in bonds. He lists other approaches of defensive investing, like investing only in well established companies, and dollar-cost averaging. Graham's take on aggressive investing isn't as kind. The three types of the aggressive approach (trading the market, short-term selectivity, and long-term selectivity) are all considered to have less profitability. This is explained by the possibility of the aggressive investor being wrong on his or her market timing.
Graham, Chapter 8:
In chapter eight of Graham's book, he brings up the subject of market fluctuation. I think he makes an important point to those people who are monitoring their retirement portfolios almost on a daily basis. He states that "the investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizable declines nor become excited by sizable advances" (p. 206). With this in mind, he suggests using these fluctuations in the market as a guide to making investment decisions. More precisely, he suggests using the dips in the market as points to acquire more of a quality stock along with finding new opportunities for suitable investments.
Graham, Chapter 9:
Mutual funds are the subject of the ninth chapter of The Intelligent Investor. Fund performance and the different types of funds available to the investor are covered. One of those types of funds is the performance fund, which seeks to outperform the Dow Jones Industrial Average in this case, so they are the more aggressive of the funds. Another type, the closed-end fund only offers a specific number of shares at one time, instead of continuously, and is the most illiquid of the bunch. The last mutual fund type Graham mentions in this chapter is the balanced fund. These types of funds contain a certain percentage of bond holdings. Even the conservatively investing Graham suggests you would be better off investing in bonds by themselves, rather than mixed in a fund with stocks.
Graham, Chapter 20:
Chapter 20 is entitled "Margin of Safety as the Central Concept of Investment" (p. 512). I think this chapter sums up Graham's investing philosophy. He not only covers the risk of buying a good quality stock at a high price, but buying a poor quality stock at a high price during an up-trending market. The latter is one of the riskier moves you can do with your money in the context of the margin-of-safety. On the other hand, purchasing stock in a good quality company, even if it's at a high price, will ultimately end up being the better choice. One other important point in this chapter is the mention of diversification as a tool of safety, not perfection. While he doesn't go into specific methods of diversification, Graham does point out that even if one stock tanks, diversifying your portfolio "guarantees only that (you) have a better chance for profit than for loss - not that loss is impossible" (p. 518)
Saturday 12 May 2012
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
Interesting interview by John Bogle.
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