Growing with growth stocks

Growing with growth stocks

Tags: Ang Kok Heng

Written by Ang Kok Heng
Monday, 27 July 2009 00:26

AXIATA Group Bhd, formerly TM International Bhd (6888), will cap capital expenditure (capex) at RM4.4 billion this year, in a move to cut costs amid a slowdown in the region's economies. "There are a few things we are doing given the economic situation — we are reducing capex from RM5.4 billion to RM4.4 billion, re-looking all operating costs and benchmarking ourselves to know where we stand," Axiata president and managing director Datuk Seri Jamaludin Ibrahim said.

Malaysia's third-placed mobile operator DiGi Telecommunications is planning to spend more than RM1.1 billion (US$318.9 million) in 2009, Reuters reports.

PPB GROUP BHD [] is planning to spend RM293 million on capex this year, its chairman Datuk Oh Siew Nam said. He said the group's flour-making subsidiary FFM Bhd, has been allocated RM173 million to build new flour mills in Kota Kinabalu, Sabah, and Jakarta, Indonesia.

Food-based QL RESOURCES BHD [] has earmarked RM280 million as capex for its current fiscal year and the next, deemed pivotal to spur its regional merger and acquisition (M&A) plans, and to improve its manufacturing facilities. Some RM130 million and RM150 million are allocated for the financial years (FY) ending March 2010 and 2011, respectively.

TA ANN HOLDINGS BHD [] plans to spend up to RM189 million in 2009, with most of the money going into oil palm PLANTATION []s, group managing director and chief executive officer Datuk Wong Kuo Hea said

TOMEI CONSOLIDATED BHD [] has budgeted about RM10 million for capex this year in a bid to expand amid the economic slowdown, the jeweller's group managing director Ng Yih Pyng said. "The amount allocated will be used mainly for our outlet expansion and also to improve our information TECHNOLOGY [] (IT) system," he told StarBiz in an interview.

Top Glove Corp Bhd chairman Tan Sri Dr Lim Wee-Chai said the group had allocated some RM80 million for capex, which would include organic expansion and potential acquisitions. TENAGA NASIONAL BHD []'s capex this year amounted to RM3.75 billion to RM4 billion, lower than RM4.5 billion previously. UMW HOLDINGS BHD [] plans some RM600 million in capex this year to beef up its oil and gas (O&G) business, according to managing director and chief executive officer Datuk Dr Abdul Halim Harun.

The capex planned by companies is mainly for future expansion. It is this capex that generates business and hence earnings growth for a company. Earnings growth is the main attraction in equity investment.

Stock grows
One of the main duties of the management is to grow the company. When a company is operating at full capacity, additional capex is needed to grow the earnings. The funds for capex could be internally generated or from borrowed capital. This type of reinvestment is the yearly expansion budget of a company. Every incremental investment will provide additional return which will add to the existing profit of a company.

Some companies may be faced with diminishing return which occurs when profitability falls over time either because of more competition or less lucrative investment return. So long as the return on investment (ROI) is higher than the bank's interest rates, there is value added from the expansion plan.

But the ROI of most investments is expected to be much higher than the bank's interest rates since every investment comes with a certain amount of risk. When ROI is substantially higher than borrowing rates, it will make sense to borrow to enhance business returns. Every capex may be viewed individually from the ROI point of view such that the return must be worth the effort and risk taken. In many cases, the return may not be immediate and some may even suffer losses for the initial few years before profit starts to flow in.


Growth stocks pay less dividends
Because of the need to grow, growth stocks normally pay less on dividends so that a larger portion of the profit is retained for future expansion. The amount of dividend paid to shareholders as a percentage of the profit is known as dividend payout ratio. The dividend payout of a growth stock could be less than 50% while some may be as low as 20%.

Generally, a stock with low dividend payout and low dividend yield is expected to have higher earnings growth. On the other hand, a stock with high dividend payout and thus high dividend yield has lower earnings growth. In this way, growth stocks tend to have higher price appreciation than high-dividend yield stocks.

It is not uncommon to come across management's explanation to its shareholders on the reasons for keeping some of the profit for future expansion. As every company has its own expansion plans, the company usually conserves some cash for future use and pay the balance to shareholders. In this way, there is no need to raise money from shareholders via rights issues for expansion purposes.

In certain cases, although the company may post profit, it may not have sufficient free cashflow to pay dividend, as the profit is just an "accounting profit". In this case, the "profit" is tied up in inventories or receivables and hence it cannot be paid to shareholders. A good company is one which can pay relatively high dividends and yet able to continue to provide reasonable growth.

More capex, higher growth
There are also many listed companies which did not pay high dividends and yet their earnings growth was mediocre. If the capex is not well spent, the earnings growth may not be forth coming. Although failed projects may not be entirely the fault of the management, a good manager should also avoid or minimise such losses.

More importantly bad investment should not be repeated. Unfortunately, it is not uncommon to see several companies listed on Bursa Malaysia which did not seem to get any of their investment strategies right year after year. The poor ROE (return on equity or shareholders' fund) in the past and non-improvement in ROE over the years prove the failures of the management to deliver basic economic profit to shareholders.

At the beginning of this article, several companies disclosed their capex requirements for the year. For a growth stock, the capex is likely to be higher relatively to its size. For the selected companies, we have listed them in Table 1. We have divided the capex by market capitalisation (a measure of value of a company) and also by fixed assets. Although these ratios may not be conclusive to determine which stock is a better growth stock, they provide some ideas on the expansion plans.



It should be noted that the low capex of a company in a particular year may not necessarily denote lower earnings growth going forward. It could be due to the adequate capacity for the time being or less need to expand due to the prevailing market conditions. Some companies may not be capital intensive and hence less need to spend as much.

Expansion path
Listed companies have many options to grow. They can grow organically through natural expansion or by way of acquisition. The growth can be financed by internally generated funds, borrowing or a combination of both. They may also issue new shares to acquire the target company or call for rights issues to finance the expansion (see Chart 1).



It is not uncommon for a company to move downstream by adding value to what it produces, for example, to process its products further. It can also go upstream to procure its own raw materials so as to be in a better position to control its supplies. A company facing limited growth in its existing business may also venture into new businesses to remain relevant. This type of diversification can also be useful to stabilise the cyclical business nature of a company.

Capital gain can be volatile
From an investor's perspective, the ROI is the dividend income received regularly and the capital gain from price appreciation.

For a high-dividend stock, the dividend yield is similar to assured return received, say 4% per annum. The capital gain, normally smaller for a high- dividend stock, is like a bonus on top of the dividend.

For growth stock, the dividend yield is smaller (see Chart 2) and capital gain is what an investor mainly aims for. Unfortunately, capital gain can be very volatile, since the share price could be influenced by market sentiment. Furthermore, as the business risk of a high-growth company is normally higher, the expected price appreciation will depend on the results of the expansion plan. Most investments provide both income and capital gain. Examples are unit trusts, bonds, PROPERTIES [] and foreign currencies.



There are also several investments which do not provide income. These are merely trading instruments. They include commodity trading, gold and similar types of commodity which bet purely on the price appreciation. Investors who "invest" in gold thinking that this is a good investment, must bear in mind that gold does not provide income, it only provides capital gain (or speculative gain). A kilogramme of gold remains a kilo after several years. A growth stock (provided it is a true growth stock and not speculative stock), on the other hand, will grow over time and will not be the same after several years.

Fixed-income instruments don't grow
Most investment grade stocks provide some growth. Even a low-growth high-dividend yield stock may have small growth. If the growth is only 2% per year, the dividend received is also likely to grow by 2% per annum. In this example, assuming the dividend yield is 4% per annum, a 2% growth in dividend will mean that after five years, the dividend yield will increase to 4.4%. As such, growth does make a difference in the return.

In the case of fixed-income instruments such as fixed deposits (FD) with the bank, the FD rate is fixed during the period of placement. If a one-year FD yields 3%, it is 3%. If the interest rate remains the same, the same FD will continue to give 3% return the following year.

While interest rate may go up one year later after the FD matures, it may possibly go down as well. There is no growth factor in FD placement. Some may argue that the growth in savings from interest rate is compounding. The compounding effect by reinvesting the interest earned is similar to the compounding effect achieved by reinvesting the dividend earned in the case of investing in a high-yield stock which may still provide some growth.

Some stocks don't grow
While investing in FD is a constant yield investment, there are also many stocks which don't grow over time. Unfortunately, the earnings of many stocks listed on Bursa Malaysia are very sluggish and they don't seem to increase even after ten years. It is a disappointing fact. These companies remain more or less the same after one or two rounds of the economic cycle. They seem to struggle with the same business year in year out.

Investing in non-growth stocks is like investing in FD with the same yield. The only difference is that non-growth stocks usually do not provide high dividend as they are not well-managed and hence their operating cashflow may not be stable. The lack of confidence to generate sufficient and consistent cashflow prevents these companies from paying higher dividend.

Some stocks degrade like their retiring owners
One of the reasons why some companies degrade and show stagnant earnings is the lost of drive (the oomph!) when the key promoters retire or on the verge of retiring. The lack of successors either among the owners' scion or from other professionals could not propel the companies forward. In some cases, the children who took over the businesses were not as capable as the founders were. As a result, these successors acted merely like a caretaker. Not only were they not able to grow the business, some of them were not even able to defend the companies' market shares.

Investing in non-growth stocks is already bad, investing in negative-growth stocks is even worst.

Investment provides yields and capital gains
In short, investment provides yields and capital gains. Some investments like FD provide pure yields but no growth at all. Some investments like gold and commodities only provide capital gains but not income. Pure capital gain investment is more speculative in nature and is not suitable for the buy-and-hold strategy. Trading strategy is more appropriate for this type of investment and market timing is crucial. Many other investments provide both yield and capital gain.

Yields are like a bird in hand and capital gains are like birds in the bushes. Some capital gains are easier to anticipate, while some capital gains are less predictive.

Ang has 20 years' experience in research and investment. He is currently the chief investment officer of Phillip Capital Management Sdn Bhd.


http://www.theedgemalaysia.com/business-news/129607-growing-with-growth-stocks.html

Margin of Safety as the Central Concept of Investment – Summary

Investment is most intelligent when it is most businesslike.

• It is amazing to see how many capable businessmen try to operate in Wall Street with complete disregard of all the sound principles through which they have gained success in their own undertakings.
• Yet every corporate security may best be viewed, in the first instance, as an ownership interest in, or a claim against, a specific business enterprise.
• And if a person sets out to make profits from security purchases and sales, he is embarking on a business venture of his own, which must be run in accordance with accepted business principles if it is to have a chance of success.
  
  

The first and most obvious of these principles is, “Know what you are doing – know your business.”

• For the investor this means: Do not try to make “business profits" out of securities – that is, returns in excess of normal interest and dividend income – unless you know as much about security values as you would need to know about the value of merchandise that you proposed to manufacture or deal in.
  

A second business principle: “Do not let anyone else run your business, unless (1) you can supervise his performance with adequate care and comprehensive or (2) you have unusually strong reasons for placing implicit confidence in his integrity and ability.”

• For the investor this rule should determine the conditions under which he will permit someone else to decide what is done with his money.
  

A third business principle: “Do not enter upon an operation – that is, manufacturing or trading in an item – unless a reliable calculation shows that it has a fair chance to yield a reasonable profit.

• In particular, keep away from ventures in which you have little to gain and much to lose.”
• For the enterprising investor this means that his operations from profit should be based not on optimism but on arithmetic.
• For every investor it means that when he limits his return to a small figure – as formerly, at least, in a conventional bond or preferred stock – he must demand convincing evidence that he is not risking a substantial part of his capital.
  

A fourth business rule is more positive: “Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgement is sound, act on it – even though others may hesitate or differ.”

• (You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.)
• Similarly, in the world of securities, courage becomes the supreme virtue after adequate knowledge and a tested judgement are at hand.
  

Fortunately for the typical investor, it is by no means necessary for his success that he bring these qualities to bear upon his program – provided he limits his ambition to his capacity and confines his activities within the safe and narrow path of standard, defensive investment.

• To achieve satisfactory investment results is easier than most people realize; to achieve superior results I harder than it looks.

Ref: Intelligent Investor by Benjamin Graham

Margin of Safety and Unconventional Investments

Margin of Safety and Unconventional Investments - Extension of the Concept of Investment

Investment can be further distinguished between conventional and unconventional investments.
Conventional investments are appropriate for the typical portfolio.

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

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

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

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1. It is our argument that a sufficiently low price can turn a security of mediocre quality into a sound investment opportunity – provided that the buyer is informed and experienced and that he practices adequate diversification.
2. For, if the price is low enough to create a substantial margin of safety, the security thereby meets our criterion of investment.
3. Our favourite supporting illustration is taken from the field of real-estate bonds.

• In the 1920s, billions of dollars’ worth of these issues were sold at par and widely recommended as sound investments.
• A large proportion had so little margin of value over debt as to be in fact highly speculative in character. In the depression of the 1930s, an enormous quantity of these bonds defaulted their interest, and their price collapsed – in some cases below 1 cents on the dollar.
• At that stage the same advisers who had recommended them at par as safe investments were rejecting them as paper of the most speculative and unattractive type.
• But as a matter of fact, the price depreciation of about 90% made many of these securities exceedingly attractive and reasonably safe – for the true values behind them were four or five times the market quotation.
• (Graham is saying that there is no such thing as a good or bad stock; there are only cheap stocks and expensive stocks. Even the best company becomes a “sell” when its stock price goes too high, while the worst company is worth buying if its stock goes low enough.)
• The fact that the purchase of these bonds actually resulted in what is generally called “a large speculative profit” did not prevent them from having true investment qualities at their low prices.
• The “speculative” profit was the purchaser’s reward for having made an unusually shrewd investment.
• They could properly be called investment opportunities, since a careful analysis would have shown that the excess of value over price provided a large margin of safety.
• Thus, the very class of “fair-weather investments” which we stated above is a chief source of serious loss to naïve security buyers is likely to afford many sound profit opportunities to the sophisticated operator who may buy them at pretty much his own price.
• [Wall Street’s analysts have always tended to call a stock a “strong buy” when its price is high, and to label it a “sell” after its price has fallen – the exact opposite of what Graham (and simple common sense) would dictate.]
• [As he does throughout the book, Graham is distinguishing speculation – or buying on the hope that a stock’s price will keep going up – from investing, or buying on the basis of what the underlying business is worth.]

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The whole field of “special situations” would come under our definition of investment operations, because the purchase is always predicated on a thoroughgoing analysis that promises a larger realization than the price paid.

Again there are risk factors in each individual case, but these are allowed for in the calculations and absorbed in the overall results of a diversified operation.

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

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

Ref: Intelligent Investor by Benjamin Graham

Margin of Safety as a Criterion of Investment versus Speculation

Margin of Safety concept can be used to distinguish an investment from a speculation

1. Since there is no single definition of investment in general acceptance, authorities have the right to define it pretty much as they please. Many of them deny that there is any useful or dependable difference between the concepts of investment and of speculation.
2. We think this skepticism is unnecessary and harmful. It is injurious because it lends encouragement to the innate leaning of many people toward the excitement and hazards of stock-market speculation. We suggest that the margin-of-safety concept may be used to advantage as the touchstone to distinguish an investment operation from a speculative one.
3. Probably most speculators believe they have the odds in their favour when they take their chances, and therefore they may lay claim to a safety margin in their proceedings.
4. Each one has the feeling that the time is propitious for his purchase, or that his skill is superior to the crowd’s, or that his adviser or system is trustworthy.
5. But such claims are unconvincing. They rest on subjective judgement, unsupported by any body of favourable evidence or any conclusive line of reasoning.
6. We greatly doubt whether the man who stakes money on his view that the market is heading up or down can ever be said to be protected by a margin of safety in any useful sense of the phrase.
7. By contrast, the investor’s concept of the margin of safety – as developed earlier in this chapter – rests upon simple and definite arithmetical reasoning from statistical data. We believe, also, that it is well supported by practical investment experience.
8. There is no guarantee that this fundamental quantitative approach will continue to show favourable results under the unknown conditions of the future. But, equally, there is no valid reason for pessimism on this score.
9. Thus, in sum, we say that to have a true investment there must be present a true margin of safety.
10. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience.

Ref: Intelligent Investor by Benjamin Graham

Margin of safety and the principle of diversification.

1. There is a close logical connection between the concept of a safety margin and the principle of diversification. One is correlative with the other.
2. Even with a margin in the investor’s favour, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss – not that loss is impossible.
3. But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses. That is the simple basis of the insurance-underwriting business.
4. Diversification is an established tenent of conservative investment.
5. By accepting it so universally, investors are really demonstrating their acceptance of the margin-of-safety principle, to which diversification is the companion.
6. This point may be made more colourful by a reference to the arithmetic of roulette.

• If a man bets $1 on a single number, he is paid $35 profit when he wins – but the chances are 37 to 1 that he will lose. (In “American” roulette, most wheels include 0 and 00 along with numbers 1 through 36, for a total of 38 slots.)
• He has a “negative margin of safety.” In his case, diversification is foolish.
• The more numbers he bets on, the smaller his chance of ending with a profit. If he regularly bets $1 on every number (including 0 and 00), he is certain to lose $2 on each turn of the wheel.
• But suppose the winner received $39 profit instead of $35.
• Then he would have a small but important margin of safety. Therefore, the more numbers he wagers on, the better his chances of gain.
• And he could be certain of winning $2 on every spin by simply betting $1 each on all the numbers.
• (Incidentally, the two examples given actually describe the respective positions of the player and proprietor of a wheel with 0 and 00.)

Ref: Intelligent Investor by Benjamin Graham

Margin of Safety concept as applied to undervalued or bargain stocks.

1. The margin-of-safety idea becomes much more evident when we apply it to the field of undervalued or bargain securities.
2. We have here, by definition, a favourable difference between price on the one hand and indicated or apprised value on the other. That difference is the safety margin.
3. It is available for absorbing the effect of miscalculations or worse than average luck.
4. The buyer of bargain issues places particular emphasis on the ability of the investment to withstand adverse developments.
5. For in most such cases he has no real enthusiasm about the company’s prospects.
6. True, if the prospects are definitely bad the investor will prefer to avoid the security no matter how low the price.
7. But the field of undervalued issues is drawn from the many concerns – perhaps a majority of the total – for which the future appears neither distinctly promising nor distinctly unpromising.
8. If these are bought on a bargain basis, even a moderate decline in the earning power need not prevent the investment from showing satisfactory results. The margin of safety will then have served its proper purpose.


Ref: Intelligent Investor by Benjamin Graham

Margin of Safety concept as applied to growth stocks.

1. The philosophy of investment in growth stocks parallels in part and in part contravenes the margin-of-safety principle.
2. The growth-stock buyer relies on a expected earning power that is greater than the average shown in the past. Thus he may be said to substitute these expected earnings for the past record in calculating his margin of safety.
3. In investment theory there is no reason why carefully estimated future earnings should be a less reliable guide than the bare record of the past; in fact, security analysis is coming more and more to prefer a competently executed evaluation of the future.
4. Thus the growth-stock approach may supply as dependable a margin of safety as is found in the ordinary investment – provided the calculation of the future is conservatively made, and provided it shows a satisfactory margin in relation to the price paid.
5. The danger in a growth-stock program lies precisely here. For such favoured issues the market has a tendency to set prices that will not be adequately protected by a conservative projection of future earnings. (It is a basic rule of prudent investment that all estimates, when they differ from past performance, must err at least slightly on the side of understatement.)
6. The margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price, nonexistent at some still higher price.
7. If, as we suggest, the average market level of most growth stocks is too high to provide an adequate margin of safety for the buyer, then a simple technique of diversified buying in this field may not work out satisfactorily.
8. A special degree of foresight and judgment will be needed, in order that wise individual selections may overcome the hazards inherent in the customary market level of such issues as a whole.

Ref: Intelligent Investor by Benjamin Graham

Margin of Safety concept as applied to common stocks.

The margin of safety concept as applied to “fixed-value investments” can also be carried over into the field of common stocks, but with some necessary modifications.


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

Ref: Intelligent Investor by Benjamin Graham

Margin of Safety concept as applied to common stocks, when market is pricy.

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


Ref: Intelligent Investor by Benjamin Graham

Margin of Safety concept as applied to common stocks, under normal market conditions.

1. In common stock bought for investment under normal conditions, the margin of safety lies in an expected earning power considerably above the going rate for bonds.
2. Assume, earning power (earning yield) is 9% on the price, and that the bond rate is 4%; then the stock buyer will have an average annual margin of 5% accruing in his favour. Over a ten-year period the typical excess of stock earning power over bond interest may aggregate 50% of the price paid. This figure is sufficient to provide a very real margin of safety – which, under favourable conditions, will prevent or minimize a loss.
3. In many cases, such reinvested earnings fail to add commensurately to the earning power and value of his stock.
4. If such a margin is present in each of a diversified list of 20 or more stocks, the probability of a favourable result under “fairly normal conditions” becomes very large. That is why the policy of investing in representative common stocks does not require high qualities of insight and foresight to work out successfully.
5. If the purchases are made at the average level of the market over a span of years, the prices paid should carry with them assurance of an adequate margin of safety.
6. The danger to investors lies in concentrating their purchases in the upper levels of the market, or in buying nonrepresentative common stocks that carry more than average risk of diminished earning power.

Ref: Intelligent Investor by Benjamin Graham

Margin of Safety concept as applied to common stocks, under depression conditions

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

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

Ref: Intelligent Investor by Benjamin Graham

Margin of Safety concept as applied to “fixed-value investment.”

1. This is essential to the choice of sound bonds and preferred stocks.
2. A railroad should have earned its total fixed charges better than 5 times (before income tax), taking a period of years, for its bonds to qualify as investment-grade issues.
3. This past ability to earn in excess of interest requirements constitutes the margin of safety that is counted on to protect the investor against loss or discomfiture in the event of some future decline in net income.
4. (The margin above charges may be stated in other ways – for example, in the percentage by which revenues or profits may decline before the balance after interest disappears – but the underlying idea remains the same.)
5. The bond investor does not expect future average earnings to work out the same as in the past; if he were sure of that, the margin demanded might be small.
6. Nor does he rely to any controlling extent on his judgment as to whether future earnings will be materially better or poorer than in the past, if he did that, he would have to measure his margin in terms of a carefully projected income account, instead of emphasizing the margin shown in the past record.
7. Here the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future.
8. If the margin is a large one, then it is enough to assume that future earnings will not fall far below those of the past in order for an investor to feel sufficiently protected against the vicissitudes of time.
9. The margin of safety for bonds may be calculated, alternatively, by comparing the total value of the enterprise with the amount of debt. (A similar calculation may be made for a preferred-stock issue.)
10. If the business owes $10 million and is fairly worth $30 million, there is room for a shrinkage of two-thirds in value – at least theoretically – before the bondholders will suffer loss. The amount of this extra value, or “cushion,” above the debt may be approximated by using the average market price of the junior stock issues over a period of years.
11. Since average stock prices are generally related to average earning powers, the margin of “enterprise value” over debt and the margin of earnings over charges will in most cases yield similar results.


Ref: Intelligent Investor by Benjamin Graham

Performance of iCap Closed Ended Fund (23.7.09)

http://spreadsheets.google.com/pub?key=tLGli-bysuYRLMUAtpdhnGg&output=html

Investing in Investment Funds

Chapter 9 - Investing in Investment Funds
Graham basically says that there are three questions you need to answer before investing in any fund.

1. Is there any way by which the investor can assure himself better than average results by choosing the right funds? [...]

2. If not, how can he avoid choosing funds that will give him worse than average results?

3. Can he make intelligent choices between different types of funds - e.g., balanced versus all-stock, open-end versus closed-end, load versus no-load?

Graham states that in general, individuals who invest in balanced funds tend to do better than individuals who invest in individual common stocks. The reason is simple: a person who is not an expert at picking individual stocks and balancing a portfolio is usually better off in the hands of a professional money manager even after the costs.

However (and this is big), Graham largely seems to suggest that the fees in a typical mutual fund are far too high and the time invested in finding a bargain fund (one with good results with limited costs) is well worth the time. He also believes that you should not expect to ever radically beat the market with a fund, and that funds who have astounding short term gains are usually not playing a healthy long-term gain - something that’s been shown over and over again over the history of investing.

Unsurprisingly, Graham isn’t particularly a big cheerleader of traditional mutual funds. One of Graham’s big requirements for investing is that you know exactly what you’re invested in, and by buying into a fund, you cede that control to someone else.

Of course, even if you’re using an index fund strategy, you still need to pay attention to diversification and should not have all of your eggs in one basket. Just because you’re invested with index funds doesn’t mean you shouldn’t balance your portfolio between stocks, bonds, and cash.

Price volatility is usually a bad sign.

Price volatility is usually a bad sign. If a company is experiencing far greater price fluctuations than the market as a whole is seeing, particularly when it alternates between going up rapidly and going down rapidly, avoid the stock. Such events happen only in companies that are either unstable or are involved in something else going on in the market, both of which are good to avoid.

Everything Buffett Needs to Know, He Learned Right Here

Everything Buffett Needs to Know, He Learned Right Here
By Morgan Housel
July 17, 2009


Millions of investors chase Warren Buffett. Tens of thousands attend Berkshire Hathaway's (NYSE: BRK-A) (NYSE: BRK-B) annual shareholder meetings. Wealthy fans bid millions of dollars to have lunch with him. His appearances on CNBC bring trading floors to a halt. People want to know what he's thinking. Why he's different. What secret has made him so much more successful than anyone else.

What's interesting -- and a little ironic -- is that Buffett has never held back what his secret is. As he recently told PBS:

I read a book, what is it, almost 60 years ago roughly, called The Intelligent Investor and I really learned all I needed to know about investing from that book, and particular chapters 8 and 20 … I haven't changed anything since.

One book. Two chapters. Legendary success.
You'd think such precisely guided advice would draw more attention. Not only has Buffett filtered his success down to one book, he's even listed the two specific chapters on which he built his wisdom. He's making this almost embarrassingly easy for us.

What bits of sage advice do these two chapters -- published in 1949 by Buffett's early mentor Ben Graham -- hold? Here are key points from each one.

Chapter 8: The Investor and Market Fluctuations
Markets go up. Markets go down. Most of us accept this fact until we experience the latter, at which time we throw up our hands and consider the whole thing a sham.

That kind of behavior is what Chapter 8 is all about: dealing with market movements, and how fundamental they are to investing success.

We have a tendency to become confident and invest the most money after stocks have logged big gains, and vice versa -- selling in panic after big drops. Two seconds of logical thought will tell you this isn't rational. Yet we do it over and over again.

Buffett built his success on exploiting the market's movements, rather than following them with lemming-like obedience. He bought companies like Coca-Cola (NYSE: KO) and Wells Fargo (NYSE: WFC) when the market wanted nothing to do with them. He then sat on his hands and laughed when companies like Microsoft (Nasdaq: MSFT) and Amazon.com (Nasdaq: AMZN) soared during the dot-com boom, ignoring heckles about his technophobic incompetence. It's truly as simple as "being greedy when others are fearful, and fearful when others are greedy."

Here's how Graham puts it in Chapter 8:

The true investor scarcely ever is forced to sell his shares, and at all other 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 judgment.

Chapter 20: Margin of Safety as the Central Concept of Investment
Graham opens Chapter 20 with a potent message:

In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, 'This too will pass.' Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.

We have an overwhelming urge to expect certainty, but live in a world that is anything but. Forward-looking projections of a stock's value are based on assumptions, prone to wild miscalculations and unforeseen events. And by prone, I mean 100% assured.

There's only one surefire solution to this: Pay far less for stocks than your estimate of value, leaving room for error. That's a margin of safety. It's giving yourself room to be wrong, knowing that you probably will be. Think a company is worth $50 a share? Great. Don't pay more than $25 for it. Think a company could earn $2 per share next year? Great. Set yourself up so you'll profit if it only makes a buck. There has to be a wide range of acceptance between the projected and the potential.

One stock that might epitomize the opposite of a margin of safety is Visa (NYSE: V). Visa is a great company, to be sure, exploiting a global consumer shifting from paper to plastic transactions. But it currently trades at more than 22 times 2009 earnings. My calculations of growth show this is probably what the company is worth if everything goes according to plan.

But what if everything doesn't? What if growth hits a speed bump? What if management drops the ball? What if consumer spending takes a sustained nosedive? What if, what if, what if -- that's the basis of a margin of safety. There has to be sizable room for error.

Moving on
These lessons might seem basic and dull. They are. Yet too many investors fail to implement them. Buffett obviously isn't the only one who's read The Intelligent Investor -- he's simply put its lessons and theories to work in a habitual manner.

Our Motley Fool Inside Value team strives to put these basic values to work with all of its recommendations, which are currently outperforming the market by an average of four percentage points each. To see what we're recommending right now, you can try the service free for 30 days. Click here to get started. There's no obligation to subscribe.

Fool contributor Morgan Housel owns shares of Berkshire Hathaway. Amazon.com and Berkshire Hathaway are Motley Fool Stock Advisor picks. Berkshire Hathaway, Coca-Cola, and Microsoft are Motley Fool Inside Value selections. Coca-Cola is a Motley Fool Income Investor recommendation. The Fool owns shares of Berkshire Hathaway, and has a disclosure policy.

http://www.fool.com/investing/value/2009/07/17/everything-buffett-needs-to-know-he-learned-right-.aspx

Companies with different EPS GR bought at different prices

Conclusion:

1. Best buy:
High EPS GR companies
Bought at a discount
Held for long haul

2. Good buy:
High EPS GR companies
Bought at a fair price
Held for long haul

3. Good buy:
Low EPS GR companies
Bought at a discount
Held for short haul

5. Do not buy
High EPS GR companies
Bought at high price
Avoid meantime
Be patient

6. Do not buy
Low EPS GR companies
Bought at high price
Avoid



The high CAGR in the early years of the investing period, due to buying at a discount, tended to decline and approach that of the intrinsic EPS GR of the companies over a longer investment time-frame.


http://spreadsheets.google.com/pub?key=thtZJOZYT-iKNP3VPKg9jig&output=html


Chapter 20 - “Margin of Safety” as the Central Concept of Investment
A single quote by Graham on page 516 struck me:

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

Basically, Graham is saying that most stock investors lose money because they invest in companies that seem good at a particular point in time, but are lacking the fundamentals of a long-lasting stable company.

This seems obvious on the surface, but it’s actually a great argument for thinking more carefully about your individual stock investments. If most of your losses come from buying companies that seem healthy but really aren’t, isn’t that a profound argument for carefully studying any company you might invest in?

To map out a course of action and follow it to an end requires courage.

Whatever strategy or strategies you use, the most critical thing in investing is to take a good map with you on your journey and stick to it no matter what. There will be all sorts of distractions along the road to your investment goals. You'll come upon supposed shortcuts that promise to get you where you're going twice as fast. You'll see and hear from all sorts of people who are telling you that they've found a better way to go than the road you're on. Sometimes, you'll even think that your map must be wrong, and that it has you headed in the opposite direction of where you want to go.



But remember, the people who gave you directions - the gurus upon whom some of the strategies are based - are expert mapmakers. They know how to get where you want to go because they've been there before - unlike most of the people who will be telling you to take those shortcuts or alternate routes.



With the map, you have what you need to avoid the obstacles and bad advice along the way, and to do what it takes to beat the market. Remember, while being a good investor is hard, it doesn't have to be complicated. The greatest difficult isn't in the details of stock-picking or portfolio management; you don't have to be a rocket scientist to produce nice returns. No, the hard part will be clearing those psychological and emotional barriers we reviewed, so that you stick to your road map no matter what happens.

If you stick to your roadmap, you should be quite happy with where you end up.

Investing Principle 6: Stick to the Strategy - Not the Stocks

If a stock no longer meets the fundamental criteria that led you to buy it, don't feel obligated to hold on to it.

You're a long-term investor if you stick to a strategy for the long haul - not because you blindly hold on to individual stocks for long periods.

Investing Principle 5: Don't Limit Yourself

Studies show that "style-box" investing can limit your gains by about 300 basis points per year.

Using "strategy-based investing" allows you to pick the best values in the market at any given time, regardless of market cap or growth-value designations.