Saturday 21 January 2012

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

The Intelligent Investor by Benjamin Graham






Preface to the Fourth Edition,
by Warren E. Buffett

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

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

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

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




BENJAMIN GRAHAM
1894–1976

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

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

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

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

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

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

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



How to Diagnose What’s Wrong With Your Business

January 18, 2012, 9:25 AM



Over the years, I have met a lot of entrepreneurs who have been frustrated by low profits, lack of growth, or the stress of the never-ending demands. Many struggle with all three. While every business is different, there are common denominators. In fact, I believe there are 10. The tricky part is that failing to have a handle on just one of these areas can result in mediocre performance, a stressful existence, or ultimate and intimate failure. That is one reason the failure rate for small businesses is so high (here are some others).
This is the checklist I review when I’m not satisfied with my company’s performance.
Marketing
1. Targeting. Do you have a strategy to reach your best potential customers with your sales and marketing efforts? A shotgun approach is too expensive and inefficient for any company, especially a small one. What percentage of the people you approach actually buy a product or service like yours?

2. Advertising and Public Relations. There are many choices for where to place an ad and how to execute a public relations campaign. The problem with many small businesses is that their marketing activities are driven primarily by which salespeople happen to call on them. Ineffective advertising or public relations can be not only a tremendous waste of money but a tremendous waste of opportunity. If you are doing things the same way you did them 10 years ago, you are probably getting less response.
3. The Message. Lots of companies still use this line: “We will exceed your expectations.” I even saw it on the back of an ambulance. (I don’t know about you, but I have pretty high expectations when I call an ambulance! Are the technicians going to give me a haircut after they bring me back to life?) It was a good line when someone first thought of it. Now, it is old. It is tired. It needs to retire. You need to exceed people’s expectations by coming up with your own line. Maybe it is not a line at all. Maybe it is a message. Whatever it is, it should say something about your company that means something to potential customers.
Management
4. Hiring. I can’t think of anything more important than hiring the right people. Great hiring is a skill, one that frequently is not the strong suit of the typical entrepreneur. Do you have a hiring process? Hiring by trial and error is a very expensive and painful way to build a staff. I have found that hiring the right people is 75 percent of management. What percentage of the people you hire work out great? It should be 80 percent or 90 percent, and perhaps less in a low-wage environment.
5. Firing. This is never a popular subject, and it’s especially uncomfortable these days. But it is a harsh reality of business that some people are just not suited for some jobs. Many bosses avoid firing at all costs, including going broke, because they want to see themselves as being “nice.” In reality, customers and other employees just see them as irresponsible. Here is a simple test: Are there people who work for you who you would be relieved to have come in tomorrow and quit? If the answer is yes, that is not a good sign. Especially if the employee is a relative.
6. Operations. Training, standards, support, recognition, systems, key performance indicators, follow-up, etc. Is your company getting the job done? Are customers happy? Do you know? How is employee turnover? Are employees happy? Would they tell you if they weren’t? Do you have people who tell you the truth? Do you yell? (I know. You’re passionate.) Have good people left your company for more money? That is frequently an indication of other problems.
Accounting and Finance
7. Basic Accounting. Many seemingly successful companies have gotten into big trouble by neglecting accounting until it is too late. Accounting is not just about paying taxes. It is about information, insight, and control. Great accounting will not make a business successful, but bad accounting can destroy a business. Is someone staying on top of receivables, being careful about opening new accounts and making sure the existing ones are current? Could you walk someone through your financial statements and explain each part?
8. Pricing. This is probably the sleeper on this list. I can’t tell you how many times I have seen entrepreneurs either put themselves out of business, or never make the money they should have, because of bad pricing models. They charge prices that bear no relation to the costs or to the value proposition. This is just one of the reasons a company needs accurate accounting — so it can determine the true cost of a product or service. Do your salespeople have control of the pricing for jobs that they quote? If so, are they selling at a price that allows you to make a profit?
9. Financing. Most businesses need some kind of financing. Whether it comes from investors, banks, credit unions, factoring or even credit cards, there is a lot to know and understand. This is another place where a good accountant can be of great help. Or not. If you have one of the many accountants who just do tax returns and are not really experienced at helping businesses grow, you can find lots of information in books and online. Or you can hire a better accountant. Here is a test: Do you know your debt-to-equity ratio?
Leadership
10. Any one of these topics could fill a book, and leadership is no exception. Let me count the ways: vision, direction, inspiration, support. It is similar to management, but they are not the same thing. As my company has gotten larger, I have found that leadership gets easier because I now have managers managing. When a company is smaller, the boss has to manage and lead. One minute you are writing someone up for violating the late policy, and the next you are trying to inspire the troops. Perhaps management is pushing, and leadership is pulling. It’s not easy doing both at the same time.
Whether you score well or poorly on this list, keep in mind that it is an ongoing struggle. Personally, I’ve been doing this for 30 years, and I can assure you that I am constantly wrestling with almost every item on the list.
So how did you do?
Jay Goltz owns five small businesses in Chicago.

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


To Sum Up

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

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

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

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

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

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

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


Ref:  The Intelligent Investor by Benjamin Graham

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



Also read:

Margin of Safety Concept in Conventional and Unconventional Investments


 Extension of the Concept of Investment

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

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


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


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


The fact that the purchase of these bonds actually resulted in what is generally called “a large speculative profit” did not prevent them from having true investment qualities at their low prices. 
  • The “speculative” profit was the purchaser’s reward for having made an unusually shrewd investment. 
  • They could properly be called investment opportunities, since a careful analysis would have shown that the excess of value over price provided a large margin of safety. 
  • Thus the very class of “fair-weather investments” which we stated above is a chief source of serious loss to naive security buyers is likely to afford many sound profit opportunities to the sophisticated operator who may buy them later at pretty much his own price.†


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

To carry this discussion to a logical extreme, we might suggest that a defensible investment operation could be set up by buying such intangible values as are represented by a group of  “commonstock option warrants” selling at historically low prices. (This example is intended as somewhat of a shocker.)* 
  • The entire value of these warrants rests on the possibility that the related stocks may some day advance above the option price. 
  • At the moment they have no exercisable value. 
  • Yet, since all investment rests on reasonable future expectations, it is proper to view these warrants in terms of the mathematical chances that some future bull market will create a large increase in their indicated value and in their price. 
  • Such a study might well yield the conclusion that there is much more to be gained in such an operation than to be lost and that the chances of an ultimate profit are much better than those of an ultimate loss. 
  • If that is so, there is a safety margin present even in this unprepossessing security form. 
  • A sufficiently enterprising investor could then include an option-warrant operation in his miscellany of unconventional investments.1




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

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

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


Ref:  The Intelligent Investor by Benjamin Graham

Margin of Safety Concept in Speculation and Investment

A Criterion of Investment versus Speculation

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

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


Probably most speculators believe they have the odds in their favor when they take their chances, and therefore they may lay claim to a safety margin in their proceedings.
  • Each one has the feeling that the time is propitious for his purchase, or that his skill is superior to the crowd’s, or that his adviser or system is trustworthy. 
  • But such claims are unconvincing. 
  • They rest on subjective judgment, unsupported by any body of favorable evidence or any conclusive line of reasoning. 
  • We greatly doubt whether the man who stakes money on his view that the market is heading up or down can ever be said to be protected by a margin of safety in any useful sense of the phrase.


By contrast, the investor’s concept of the margin of safety—as developed earlier in this chapter—rests upon simple and definite arithmetical reasoning from statistical data.
  • We believe, also, that it is well supported by practical investment experience. 
  • There is no guarantee that this fundamental quantitative approach will continue to show favorable results under the unknown conditions of the future. 
  • But, equally, there is no valid reason for pessimism on this score.



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


Ref:  The Intelligent Investor by Benjamin Graham

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



Also read:

Margin of Safety Concept in Diversification

Theory of Diversification

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


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

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

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


* In “American” roulette, most wheels include 0 and 00 along with numbers1 through 36, for a total of 38 slots. The casino offers a maximum payout of 35 to 1. What if you bet $1 on every number? Since only one slot can be the one into which the ball drops, you would win $35 on that slot, but lose $1 on each of your other 37 slots, for a net loss of $2. That $2 difference (or a 5.26% spread on your total $38 bet) is the casino’s “house advantage,” ensuring that, on average, roulette players will always lose more than they win. 
  • Just as it is in the roulette player’s interest to bet as seldom as possible, it is in the casino’s interest to keep the roulette wheel spinning.  
  • Likewise, the intelligent investor should seek to maximize the number of holdings that offer “a better chance for profit than for loss.” 
  • For most investors, diversification is the simplest and cheapest way to widen your margin of safety.




Ref:  The Intelligent Investor

Friday 20 January 2012

Margin of Safety Concept in Undervalued or Bargain Securities


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


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

But the field of undervalued issues is drawn from the many concerns—perhaps a majority of the total—for which the future appears neither distinctly promising nor distinctly unpromising. 
  • If these are bought on a bargain basis, even a moderate decline in the earning power need not prevent the investment from showing satisfactory results. 
  • The margin of safety will then have served its proper purpose.



Ref:  The Intelligent Investors by Benjamin Graham

Margin of Safety Concept in Growth Stocks


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

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



The margin of safety is always dependent on the price paid.
  • It will be large at one price, small at some higher price, nonexistent at some still higher price.
  • If, as we suggest, the average market level of most growth stocks is too high to provide an adequate margin of safety for the buyer, then a simple technique of diversified buying in this field may not work out satisfactorily.  
  • 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.



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

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

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