Review – The Intelligent Investor

The Intelligent Investor: A Book of Practical Counsel

by Benjamin Graham, published 2006

What follows are the notes from my third (lifetime) re-reading of Graham’s classic investment treatise. I had planned to re-read this book after a market sell-off, but I realized this was a futile act of meta-market timing self-delusion and decided since I was interested in it I should just re-read it now. I am glad I did!

Introduction

Developing knowledge about past market experience with stock and bond investments is key to intelligent investment; surveying the past with its ups and downs not only makes the future more predictable but helps to create a rational baseline for our own expectations about what is possible with our investment portfolios. Experience shows that enthusiasm almost always leads to disaster. Market conditions can reward, on a relative basis, a passive versus an active approach– sometimes the effort to reward ratio of active management is not worth the trouble.

The investor’s chief problem is likely to be himself. Mastering oneself is a necessary part of mastering one’s investment program.

The future is uncertain. Nonetheless, we must act on the assumption that sound principles will see us through a variety of conditions over time, just as they have in the past.

Chapter 1

In most periods of market experience there is a “speculative factor” in common stock prices due to the enthusiasm of the marketplace. We must keep it within limits and be prepared for short and long-term adverse results in terms of both financial and psychological experience whenever this speculative factor is present. Acknowledging this reality, it’s extremely important to keep speculative and investment positions in separate accounts and never to let them mingle financially or in our thoughts.

Better than average results require promising prospects (in terms of risk versus reward) and a lack of popular following of certain portfolio holdings when purchased.

Chapter 2

There is no close, time-causal relation between inflationary or deflationary conditions and stock earnings and prices (likely because of Cantillon effects). Earnings rates have shown no general tendency to advance with wholesale price increases. The best result to expect from one’s investment program over long periods of time is approximately an 8% per annum return from a combination of dividends and price increases.

It is the uncertainty of the future that makes the lack of diversification (between common equity and cash/fixed income in a portfolio) folly. At one extreme, one might allocate 25% to stocks and 75% to cash or fixed income, and at the other extreme the inverse. The “happy medium” is 50%/50% between the two. Never should one have 100% of one’s capital in stocks or cash/fixed income– the former suggests an irrational optimism about the future and a total disregard for the risk of adverse conditions, and the former suggests an overly pessimistic view that has given in to the unknowable temptation to time the markets.

Chapter 3

Rather than try to time the market, it is more important to follow a consistent and controlled common stock policy and to discourage the impulse to “beat the market” and to “pick the winners”. The work of a financial analyst falls somewhere in the middle of a mathematician and an orator, in that he must be exact where he can, and qualify where he can’t.

Chapter 4

The rate of return sought from one’s investment portfolio should be dependent upon the amount of intelligent effort one is willing (and able) to bring to bear on the task. Passive indexing requires the least intelligent effort and should bring the lowest return expectation; active value strategies entail the most intelligent effort and should have commensurately higher return expectations.

Long experience shows that the average investor should stay away from high yield (junk) bonds. Experience also teaches that the time to buy preferred shares is when prices are depressed by temporary adversity.

With every new wave of optimism or pessimism, we are ready to abandon history and time-tested principles, but we cling tenaciously and unquestioningly to our prejudices. This is a bias of human psychology which must be overcome if one is to have a successful long-term investment record.

Chapter 5

Common stocks have an added degree of security when the average dividend yield exceeds the yield over that which can be obtained from good bonds.

Rules for common stock portfolios for the defensive investor:

  1. Minimum of ten different issues
  2. Large, prominent and conservatively financed companies
  3. Long record of continuous dividend payments
  4. 25x past 7yr average earnings (4% earnings yield) and 20x LTM earnings, at a maximum

Experience shows that large, relatively unpopular companies offer a good hunting ground for the defensive investor to search in.

Chapter 6

Avoid inferior bonds and preferred stocks at prices greater than a 30% discount to pay value; never buy yield without safety. Owners of foreign debt issues have limited legal recourse, which increases their risk. IPOs can be good purchases… years after the fact, at small fractions of their true worth; let others make the quick profits and experience the harrowing losses of recently issued stocks.

Chapter 7

Danger lies in market/public price enthusiasm outstripping earnings growth. Confidence in your investments is a function of proximity and control.

There are 3 primary sources of selection for the enterprising investor’s portfolio:

  1. Large, out of favor companies due to temporary developments; large companies are safer than small companies because they’re more likely to weather the storm; always judge average past earnings, not LTM
  2. 50% discount to BV or greater, due to currently disappointing results or protracted neglect/lack of popularity
    1. require reasonable stability of earnings over past decade
    2. no earnings deficit in the company’s history
    3. sufficient size and strength to meet possible future setbacks
    4. NCAV bargains are safe and profitable method for finding bargains
  3. “Special situations”

The reasons why bargain issues lead to good performance:

  • dividend returns are relatively high
  • reinvested earnings, which are substantial relative to price paid (BV grows rapidly)
  • bull markets are more generous to low-priced issues
  • specific factors contributing to poor earnings may be resolved in the interim

One must choose to engage in either active (enterprising) or passive (defensive) investing, there is no room to do both without becoming speculative in one’s thoughts and actions, ie, can’t be “half a businessman”.

Bargain pricing territory begins at 66% of appraised value, as a return to 100% or fair value indicates a 50% potential upside at purchase price.

If you can control a company, you can safely pay closer to fair value for it.

The investor’s choice as between the defensive or the aggressive status is of major consequence to him and he should not allow himself to be confused or compromised in this basic decision.

Chapter 8

Investment formulas are ephemeral and their popularity is their undoing. Rather than market timing, commit to proportional exposure to stocks and cash/fixed income. Every investor who owns common stocks must expect to see them fluctuate in value over the years. Most holdings will advance as much as 50% above the lows, and fall 33% from highs, so set your expectations accordingly.

The virtue of the proportionality formula is that it gives the investor something to do; often it is the inability to sit still and the propensity to tinker that leads to risky novelty. Ironically, higher quality common stocks have more of a speculative element in their price which contributes to their volatility; it is their very popularity and perceived safety which invites unscrupulous risk-takers to dabble in the trading at the margin where the price is set.

Stocks bought closer to book value allow for greater detachment from price fluctuations. Try to be in a position to buy more, including what you already own, when prices fall, assuming value remains in tact. The stock market is often wrong, far wrong, creating opportunity for courageous and alert investors.

All business quality changes with time, sometimes for better and sometimes for worse. Everything is a trade given circumstances and time. Allowing unjustified price action in one’s holdings to influence one’s actions is to turn the basic advantage of liquidity into a disadvantage. True investors see price fluctuations one way: as opportunity to buy what is cheap and sell what is dear. Therefore, the litmus test for investment versus speculation is this, Do you try to anticipate and profit from market fluctuations, or do you look for suitable securities to acquire and hold at suitable prices?

Good managements produce good average market prices and bad managements produce bad market prices.

Chapter 10

Businessmen seek professional advice on various elements of their business, but they do not expect to be told how to make a profit; investors must be similarly responsible.

Chapter 11

The behavior of a security analyst includes:

  • examine past, present and future of a security
  • describe the business
  • summarize its operating results and financial position
  • explain the strengths and weaknesses of the business, its possibilities and risks
  • estimate future earnings power under various assumptions
  • compare companies, or the same company at different times in its history
  • provide an opinion as to the safety of the security

The more dependent valuation is on an assumption about the future, the more vulnerable that valuation is to miscalculation and error.

When evaluating corporate bond safety, judge it by the total interest charges as a multiple of past average earnings (7yrs) or against the “poorest year” of earnings.

No one really knows anything about the future. A company with a high valuation for good performance is already getting a premium for good management, don’t double count management value separately.

One test of quality is an uninterrupted record of dividends going back a number of years. Dividends can’t be forged.

The multiple on earnings is an implied growth rate, pay attention to this fact. There is no way to value a high growth company in which the analyst makes realistic assumptions of both the proper multiple for current earnings and the expected multiple for future earnings.

An analyst can be imaginative and play for big profits as a reward for his vision (entrepreneurship) or he can be conservative and refuse to pay more than a minor premium for possibilities as yet unproved; but do one or the other.

As an exercise, do a valuation based on past performance and another on expected future performance and compare the two. This can be beneficial because it:

  1. provides useful experience
  2. creates a record of the experience (allowing for self-evalution)
  3. may lead to improved methods of analysis in examining the record

Chapter 12

Don’t take a single year’s earnings seriously, it’s too easy to fudge the numbers with special charges and one-off items. Sometimes large losses in the past create tax advantages which boost earnings unfairly in the present, so remember to adjust earnings for the average tax impact. Using average earnings smooths out special charges and other one-time items which is another reason to use an average as it reduces the work of trying to “normalize” earnings over time.

Chapter 13

High valuations entail high risks.

Chapter 14

You should reject from your consideration companies which:

  • are too small
  • have a relatively weak financial condition
  • have a stigma of earnings deficit in their 10 year record
  • do not possess a long history of continuous dividends

There is an absence of safety when too large a portion of the price is dependent on ever-increasing future earnings. Stock portfolio earnings overall should be at least as high as the rate on high grade bonds.

Even defensive portfolios should be turned over occasionally, if a holding has seen excessive advance and this is a more reasonably priced issue available. It’s better to sell and pay the tax than not to sell and repent the foregone profits.

Do not be willing to accept prospects and promises of the future as compensation for the lack of sufficient value in hand. Leave the “best” stock alone, instead emphasize diversification more than individual selection. If one could select the best unerringly, one would only lose by diversification.

Chapter 15

There are extremely few companies which have been able to show a high rate of uninterrupted growth for long periods of time; conversely, remarkably few of the larger companies suffer ultimate extinction. Competitive advantage in investing lays in focusing one’s efforts on the part of the market systematically overlooked by everyone else.

When Graham owned net-nets, he owned about 100 at a time– “extreme” diversification.

The Graham-Newman playbook included:

  • self-liquidations and related hedges (performed well in bear markets)
  • working-capital bargains (NCAVs)
  • a few control operations

The right time to buy a cyclical enterprise is when:

  1. the current situation is unfavorable (macro)
  2. near-term prospects are poor
  3. the low price fully reflects the pessimism of the market

When browsing the stock guides for opportunity, look for the following characteristics:

  1. P/E of 9x or less
  2. financial condition
    1. current assets >= 1.5x current liabilities
    2. debt <= 1.1x net current assets
  3. earnings, no deficit in the last 5 yrs
  4. some history of dividends
  5. earnings growth, last years earnings > 5 yrs ago
  6. price < 1.2x BV

You can use ValueLine, stock screeners or Google Finance-linked GSheets to filter.

If you were to use a single criteria to pick stocks, two items have worked successfully in the past:

  1. important companies (S&P 500) trading at a low multiplier
  2. a diversified list of net-nets have performed “quite satisfactorily”

When the going is good and new issues are readily saleable, stock offerings of no quality at all make their appearance.

Special situations are the realm of the pro and require focus and dedication to yield results. Do not do them as one-offs.

Chapter 16

The addition of a conversion privilege on a security betrays the absence of investment quality.

Chapter 17

If a company pays no taxes for a long time, it throws into question the validity of reported earnings. Watch out also for “channel stuffing” of special charges into a single year on the income statement.

Chapter 19

When to raise questions with management:

  • unsatisfactory results
  • results which are poor compared to competitors
  • long discrepancy between price and value

As a rule, poor managers are changed not by activism, but by a change of control.

Dividends can be valuable to the owner of a poorly-run company because they allow some value to escape from the clutches of bad management.

There is no reason to believe expansion moves by a bad management will deliver anything other than more poor results.

Chapter 20

The function of the Margin of Safety is to render unnecessary an accurate estimate of the future. In stocks, the Margin of Safety lies in the expected earning power being considerably above the going bond rate. Chief losses come from low quality businesses bought in favorable times. Margin of Safety is totally dependent on the price paid; it is largest at one price, smaller at another and non-existent at a third.

The insurance underwriting process can be thought of as Margin of Safety applied to diversification of bets.

There is no Margin of Safety available in staking money on a market call.

There is no valid reason for optimism or pessimism of the continued function of quantitative methods of analysis.

The Margin of Safety is demonstrated by figures, persuasive reasoning and reference to actual experience.

Do not try to make “business profits” out of securities unless you know as much about their value as you’d need to know about the value of merchandise you proposed to manufacture and deal in. Do not enter into an operation unless a reliable calculation shows it has a fair chance of a reasonable profit. Stay away from situations where you have little to gain and much to lose. Have courage in your knowledge and experience; act on your judgment even when it differs from others. Courage is the supreme virtue when adequate knowledge and tested judgment are at hand.

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

Postscript

One lucky break, or shrewd decision, may count more than a lifetime of journeyman efforts; but those efforts — preparation and disciplined capacity — are what expose you to the good fortune in the first place.

The Superinvestors of Graham-and-Doddsville

  • Think always of price and value.
  • With a significant Margin of Safety in place, something good might happen to me.
  • Size is the anchor of performance.
  • Always buy the business, not the stock, mentally speaking.
  • The greater the potential for reward, the less risk there is.
  • Don’t make easy things difficult.
  • Potential for profit will exist as long as price and value diverge in the market.
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What I Learned Selling My Nintendo Stock

I’ve been giving some thought to what I have learned from my experience with investing in and subsequently selling Nintendo stock over the last 5 years.

The story begins in 2012, when I noticed that this beloved company, one whose products I was intimately familiar with growing up, was trading at a price that valued the company little beyond the enormous pile of cash on its balance sheet. This cash stockpile was the result of an enormous run of success with the company’s smash global hit game console, the Wii, and its conservative corporate practices. The Wii-era resulted in the coining of a new term amongst the company’s followers and managers, “Nintendo-like profits”, which translated into layman’s terms simply means “insane profitability.”

Investors came to expect “Nintendo-like profits” from Nintendo as a right, when the reality of looking at the company’s business in the past would’ve shown that it was a cylical business with unpredictable fads and discouraging failures. The Nintendo Entertainment System (or Famicom, as it was known outside the US) put the company on the map as a home gaming company, the Game Boy handheld gaming system proved to be revolutionary and a success and the follow-up 16-bit era console, the Super NES, was also commercially successful.

But the follow-on systems in the Game Boy line, while commercial successes, were not global phenomena like the original. And the home console business took it on the chin two generations in a row. While fondly remembered by fans, neither the Nintendo 64 nor the Gamecube saw wide install bases in the era of the Sony Playstation and Microsoft Xbox, an era that also saw the downfall of SEGA and other one-off competitors. Like clockwork, this led to critics and investors questioning the Nintendo model, which had emphasized creativity and pushing the cutting edge of technology whereas Sony and Microsoft competed on the basis of raw hardware power emulating a home PC and captured the coming-of-age “hardcore gamer” market demographic. Nintendo seemed like kid stuff, for people who weren’t serious about gaming.

Of course, that is precisely where Nintendo scored its home run with the Wii, a console aimed at casual players. I rehash all this history only to demonstrate that the company never was and likely never will be a “blue chip”, steady eddy company with a predictable earnings stream built on a permanent plateau. The nature of creative offerings (like a movie studio) and the insistence on being fresh, original and looking for new ways to play (“blue ocean strategy”) is inherently cyclical and prone to incredible volatility in earnings and expense.

Luckily, Nintendo has a super strong culture that knows and understands their own business strengths and weaknesses and engages in corporate planning accordingly. They don’t carry debt and, as mentioned before, they held on to their massive cash stockpile earned in the boom years, knowing it would be valuable to them in getting through the inevitable lean years. Most companies would go on an acquisition spree after this kind of “windfall”, not knowing what to do with it. And their mercenary management team would be looking for another big score to increase their glory before driving the company off a cliff– and rolling out the door of the vehicle and on to their next disaster before it plummets to its fiery death.

But Nintendo is served by extremely-long tenured managers and creative designers, many of whom have been with the company before it was a dedicated gaming company and was a purveyor of cheap toys and other mishmash business lines.

Additionally, Nintendo has built a powerful library of IP over the years with their character and game world properties, which they have done little to monetize in ways outside of traditional gaming through other creative licensing. And it wasn’t even until recent generations of their game systems, such as the Wii, where they even had the technology or willingness to monetize their own game library for nostalgic customers.

So, let’s review some items discussed so far:

  • Nintendo is a cyclical company prone to booms and busts in its fortunes
  • Nintendo has a strong culture, driven by its long history and dedicated creative and marketing strategy
  • Nintendo has long-tenured leadership with experience and comfort with the cyclical nature of its business
  • Nintendo has a pristine balance sheet driven by its conservative corporate culture
  • Nintendo has an extremely valuable IP library it has barely worked to exploit

Because the company has a cyclical model, it was available at an unreasonable price when I came upon it, trading for little more than the value of the cash on the balance sheet. While it is true that the cash is “phantom” because the company will need it to fund its continued R&D and marketing during off years, that didn’t make it a value trap but rather valuable– outsize success is as predictable as disappointing failure for this company, and over time value is accruing to stockholders on average.

This is a strong franchise business, one that will be worth more and more over long periods of time because of its IP-based business model. And when you’re able to buy it so cheaply, the Margin of Safety is enormous, because the company has so much positive optionality because of its strong culture, strong IP library which remains unexploited and its conservative corporate practices. There are so many things that can go right for it which are surprising and hard to predict, while there are relatively simple and certain threats or things that can go wrong which are already accounted for and factored into the price– a poorly-received system, a change in the industry that makes dedicated home consoles a less valuable offering, etc.

What I did wrong is I got scared and I got greedy. From the lows at which I purchased stock in Nintendo, the company rocketed upward over the next 4 years, in spite of the massive depreciation of the Yen (which actually caused major forex headaches, because a lot of the company’s cash has been repatriated and held as Yen), in spite of the sudden death of its beloved and talented president, Satoru Iwata, and in spite of the abysmal fortunes of the Wii U. The company followed its strategy very faithfully and began exploiting its IP in new ways, as predicted– movie studio partnerships, licensing to theme parks, strategic partnership with a mobile gaming company (DeNA) to release official Nintendo smartphone games, the opening up of the company’s game library IP to more “virtual console” sales, greater emphasis on digital product distribution at higher margins, renewed success with the 3DS handheld gaming platform, the rollout of the wildly popular Pokemon GO and most recently, the release of the greatly anticipated Nintendo Switch, which has met both critical and commercial acclaim during its first two, non-holiday sales period months on the market.

I decided to “take profits” during the Pokemon GO craze, thinking this bubbly atmosphere was not sustainable and people would soon come to their senses. I was worried about the Nintendo Switch (still code-named “NX”) being a flop. I was worried about a global recession taking the wind out of consumers’ sails and reducing discretionary income for gaming. I was worried about the lack of news about Nintendo’s “Quality of Life” division. I was noticing a big gap between Nintendo’s new valuation and its actual reported earnings, creating a multiple I wasn’t comfortable with.

I am not trying to engage in hindsight based off of recent price movements. While the company’s stock is off its most recent highs during the Pokemon GO craze, it is still “lofty” compared to where I bought it (as of this posting, the stock trades for about Y29,000 per 100 block unit, and I bought around Y9,800 per 100 block unit). What I am trying to do is evaluate a decision to sell a company that is just now hitting a predictable stride when I bought it at a price closer to it seeming like it was going out of business.

What I have learned from this experience is that when you buy something valuable cheaply, you can afford to wait. You can afford to be patient. You can afford to watch it run up, and potentially run back down again. It doesn’t matter. You make your money in buying it below what it’s worth, not selling it when it’s “too far gone.” That low cost basis becomes an absurd comp for future dividend streams, embedding a high cap rate in the initial purchase, and then you get whatever further corporate value the company generates in the meantime as a bonus.

I really regret selling Nintendo, not because the stock didn’t crash like I thought it would (it was silly for me to think I could “time” it, but that’s a separate issue), but because I had owned it so cheaply, it has done everything I expected it to and I could’ve afforded to be patient.

Review – Common Stocks And Uncommon Profits

Common Stocks and Uncommon Profits: And other writings by Philip A. Fisher

by Philip A. Fisher, published 1996, 2003

Stock market investors who have studied Warren Buffett in detail know that he has cited two “philosophers” of investment theory more than anyone else in being influential in the formation of his own investment approach: Benjamin Graham and Phil Fisher. Graham represents the cautious, conservative, balance sheet-driven Buffett, while Fisher represents the future-oriented, growth-focused, income statement-driven Buffett. If you ask Buffett, while Graham got him started and taught him key lessons in risk management (Margin of Safety and the Mr. Market metaphor), Fisher was the thinker who proved to have the biggest impact in both time and total dollars accumulated. Buffett today, whether by choice or by default due to his massive scale, is primarily a Phil Fisher-style investor.

And yet, in my own investment study and practice, I have dwelled deeply on Graham and did little if anything with Fisher. I tried to read Fisher’s book years ago when I was first starting out and threw my hands up in disgust. It seemed too qualitative, too abstract and frankly for a person of my disposition, too hopeful about the future and the endless parade of growth we’ve witnessed in the markets for several decades since the early 1980s. Surely there would be a time where the Fisher folks would hang their heads in shame and the Grahamites would rise again in the fires of oblivion! After all, “Many shall be restored that are now fallen and many shall fall that are now in honor.”

As my professional career wore on, however, I found there was less and less I could do with Graham and more and more of what Fisher had said that made sense. And if you’re in business, you can’t help but be growth oriented– buying cheap balance sheets isn’t really the way the world works for the private investor. So, I decided it was time to take another look at Fisher’s book and see what I could derive from it as an “older and wiser” fellow. What follows is a review of Part I of the book; I plan to read and review Part II, which is a collection of essays entitled “The Conservative Investor Sleeps Well At Night”, separately.

Keep Your Eye On The Future

One thing I noticed right away is the consistent theme of future-orientation throughout Fisher’s book. Whereas balance sheets and the Graham approach look at what has happened and what is, Fisher is always emphasizing a technique that involves conceptualizing the state of the future. For example, in the Preface he states that one of the most significant influences on his own investment results and those of other successful investors he was aware of was,

the need for patience if big profits are to be made from investment.

“Patience” is a reference to time preference, and time preference implies an ability to envision future states and how they differ from the present and therein see the arbitrage available between the two states. The other key he mentions is being a contrarian in the market place, which sounds a lot to me like the lesson of Mr. Market.

Fisher also says that market timing is not a necessary ingredient for long-term investment success,

These opportunities did not require purchasing on a particular day at the bottom of a great panic. The shares of these companies were available year after year at prices that were to make this kind of profit possible.

While he cites the structural inflationary dynamic of the modern US economy and seems to suggest the federal government’s commitment to responding to business cycle depressions with fiscal stimulus puts some kind of ultimate floor under US public company earnings (unlike in Ben Graham’s time where large companies actually faced the threat of extinction if they were caught overextended in the wrong part of the cycle, Fisher suggests the federal government stands ready to create conditions through which they can extend their debt liabilities and soldier on), he says that the name of the game over the long-term is to find companies with remarkable upside potential which are, regardless of size, managed by a determined group of people who have a unique ability to envision this potential and create and execute a plan for realizing it. In other words, the problem of investing is recognizing strong, determined management teams for what they are, that is, choosing superior business organizations in industries with long runways.

Getting the Goods: The Scuttlebutt Approach

People who know about Fisher typically identify him with the “scuttlebutt approach”. Fisher says scuttlebutt can be generated from:

  • competitors
  • vendors
  • customers
  • research scientists in universities, governments and competitive companies
  • trade association executives
  • former employees (with caveats)

Before one can do the scuttlebutt, however, one has to know where to look. Fisher says that “doing these things [scuttlebutt] takes a great deal of time, as well as skill and alertness […] I strongly doubt that [some easy, quick way] exists.” So, you don’t want to waste your time by going to all the trouble for the wrong idea. He says that 4/5 of his best ideas and 5/6 of the total gains generated over time that he could identify originated as ideas he gleaned from other talented investors first, which he subsequently investigated himself and found they fit the bill. Now, this is not the same thing as saying 4/5 ideas he got from others were worth investing in– the proportion of “good” ideas of the “total” he heard about is probably quite low, but the point again is not quantitative, but qualitative. He’s talking about where to fish for ideas, not how successful this source was.

When I thought about this section, I realized the modern day equivalent was investment bloggers. There are many out there, and while some are utter shit (why does this guy keep kidding himself?) some are quite amazing as thinkers, business analysts and generators of potential ideas. I have too many personal examples of my own here to make mention of them all. But I really liked this idea, cultivating a list of outstanding investment bloggers and using that as your primary jumping off point for finding great companies. The only problem for me in this regard is most of my blogroll are “value guys” that are digging in the trash bins (as my old boss sarcastically put it), whereas to find a Fisher-style company I would need to find a different kind of blogger interested in different kind of companies. But that’s a great to-do item for me to work on in this regard and should prove to be highly educational to boot!

So, assuming you’ve got a top notch idea, what’s next? Fisher is pretty clear here: do not conduct an exhaustive study of the company in question just yet. (In other words, don’t do this just yet, though I loved SoH’s follow-up where he explained what kind of things would get him to do that.) What he does do is worth quoting at length:

glance over the balance sheet to determine the general nature of the capitalization and financial position […] I will read with care those parts covering breakdown of total sales by product lines, competition, degree of officer or other major ownership of common stock […] all earning statement figures throwing light on depreciation, profit margins, extent of research activity, and abnormal or non-recurring costs in prior years’ operations

Then, if you like what you see, conduct your scuttlebutt, because,

only by having what “scuttlebutt” can give you before you approach management, can you know what you should attempt to learn when you visit a company […] never visit the management of a company [you are] considering for investment until [you have] first gathered together at least 50 per cent of all knowledge [you] would need to make the investment

This is the part that really gives a lot of investors pause about Phil Fisher’s approach, including me. Can you really do scuttlebutt, as he envisions it, in the modern era? Can the average investor get the ear of management? Does any of this stuff still apply?

First, some skepticism. Buffett’s biographer Alice Schroeder has said in interviews that much of what made Buffett successful early on in his career is now illegal and would amount to insider trading. The famous conversation with the GEICO chief is one of many that come to mind. This was classic scuttlebutt, and it worked amazingly well for Buffett. And even if it wasn’t illegal, most individual investors are so insignificant to a company’s capital base that they can’t expect nor will they ever receive the ear of management (unless they specialize in microcap companies, but even then management may be disinterested in them, even with significant stakes in their company!) And, assuming they DO somehow get management’s ear, they aren’t liable to learn much of value or interest specifically because most managements today are not only intellectually and politically sophisticated, but legally sophisticated and they are well aware that if they say anything more general than “We feel positive about our company” they’re liable to exposure under Reg FD. This seems like a dead end.

But let me try to tease the idea out a little more optimistically. Managements do provide guidance and color commentary on quarterly earnings calls, and if you are already dealing with a trustworthy, capable management (according to the 15 points outlined below), then there is opportunity to read between the lines here, even while acknowledging that there are many other people doing the same with this info. And people who do get managements’ ear are professional analysts employed by major banks. Again, lots of people read these reports, but there is some info here and it adds color and sometimes offers some “between the lines” information some might miss. And while the information you can get from any one company may be limited, by performing this analysis on several related companies you might be able to fill in some gaps here and there to the point that you can get a pretty fair picture of how the target company stacks up in various ways.

I hesitate a little, but I think the approach can be simulated to a fair degree even today. It’s still hard work. It can’t be done completely, or perhaps as Fisher imagined it. But I think it can be done. And it still comes down to the fact that, even with all this info that is out there, few will actually get this up close and personal with it. So, call it an elbow-grease edge.

After all,

Is it either logical or reasonable that anyone could do this with an effort no harder than reading a few simply worded brokers’ free circulars in the comfort of an armchair one evening a week? […] great effort combined with ability and enriched by both judgment and vision [are the keys to unlocking these great investing opportunities] they cannot be found without hard work and they cannot be found every day.

The Fisher 15

Fisher also is known for his famous 15 item investment checklist, a checklist which at heart searches for the competitive advantage of the business in question as rooted in the capability of its management team to recognize markets, develop products and plans for exploiting them, execute a sales assault and finally keep everything bundled together along the way while being honest business partners to the minority investors in the company. Here was Fisher’s 15 point checklist for identifying companies that were highly likely to experience massive growth over decades:

  1. Does the company have sufficient market scale to grow sales for years?
  2. Is management determined to expand the market by developing new products and services to continue increasing sales?
  3. How effective is the firm’s R&D spending relative to its size?
  4. Is the sales organization above-average?
  5. Does the company have a strong profit margin?
  6. What is being done to maintain or improve margins? (special emphasis on probable future margins)
  7. What is the company’s relationship with employees?
  8. What is the company’s relationship with its executives?
  9. Is the management team experienced and talented?
  10. How strong is the company’s cost and accounting controls? (assume they’re okay unless you find evidence they are not)
  11. Are there industry specific indications that point to a competitive advantage?
  12. Is the company focused on short or long-term profits?
  13. Can the company grow with its own capital or will it have to continually increase leverage or dilute shareholders to do it?
  14. Does the management share info even when business is going poorly?
  15. Is the integrity of the management beyond reproach? (never seriously consider an investment where this is in question)

What I found interesting about these questions is they’re not just good as an investment checklist, but as an operational checklist for a corporate manager. If you can run down this list and find things to work on, you probably have defined your best business opportunities right there.

In the chapter “What to Buy: Applying This to Your Own Needs”, Fisher attempts to philosophically explore the value of the growth company approach. First, he tries to dispel the myth that this approach is only going to serve

an introverted, bookish individual with an accounting-type mind. This scholastic-like investment expert would sit all day in undisturbed isolation poring over vast quantities of balance sheets, corporate earning statements and trade statistics.

Now, this is ironic because this is actually exactly how Buffett is described, and describes himself. But Fisher insists it is not true because the person who is good at spotting growth stocks is not quantitatively-minded but qualitatively-minded; the quantitative person often walks into value traps which look good statistically but have a glaring flaw in the model, whereas it is the qualitative person who has enough creative thinking power to see the brilliant future for the company in question that will exist but does not quite yet, a future which they are able to see by assembling the known qualitative facts into a decisive narrative of unimpeded growth.

Once a person can spot growth opportunities, they quantitatively have to believe in the strategy because

the reason why growth stocks do so much better is that they seem to show gains in value in the hundreds of percent each decade. In contrast, it is an unusual bargain that is as much as 50 per cent undervalued. The cumulative effect of this simple arithmetic should be obvious.

And indeed, it is. While great growth stocks might be a rarer find, they return a lot more and over a longer period of time. To show equivalent returns, one would have to turnover many multiples of incredibly cheap bargain stocks. So this is the philosophical dilemma– fewer quality companies, fewer decisions, and less room for error in your decisions with greater return potential over time, or many bargains, many decisions, many opportunities to make mistakes but also less chance that any one is critical, with the concomitant result that your upside is limited so you must keep churning your portfolio to generate great long-term results.

Rather than being bookish and mathematically inclined (today we have spreadsheets for that stuff anyway), Fisher says that

the successful investor is usually an individual who is inherently interested in business problems. This results in his discussing such matters in a way that will arouse the interest of those from whom he is seeking data.

And this still jives with Buffett– it’s hard to imagine him boring his conversation partner.

Timing Is Everything?

So you’ve got a scoop on a hot stock, you run it through your checklist and you conduct thorough scuttlebutt-driven due diligence on it. When do you buy it, and why?

to produce close to the maximum profit […] some consideration must be given to timing

Oh no! “Timing”. So Fisher turns out to be a macro-driven market timer then, huh? “Blood in the streets”-panic kind of thing, right?

Wrong.

the economics which deal with forecasting business trends may be considered to be about as far along as was the science of chemistry during the days of alchemy in the Middle Ages.

So what kind of timing are we talking about then? To Fisher, the kind of timing that counts is individualistic, idiosyncratic and tied to what is being qualitatively derived from one’s scuttlebutt. Timing one’s purchases is not about market crashes in general, but in corporate missteps in particular. Fisher says:

the company into which the investor should be buying is the company which is doing things under the guidance of exceptionally able management. A few of these things are bound to fail. Others will from time to time produce unexpected troubles before they succeed. The investor should be thoroughly sure in his own mind that these troubles are temporary rather than permanent. Then if these troubles have produced a significant decline in the price of the affected stock and give promise of being solved in a matter of months rather than years, he will probably be on pretty safe ground in considering that this is a time when the stock may be bought.

He continues,

[the common denominator in several outstanding purchasing opportunities was that ] a worthwhile improvement in earnings is coming in the right sort of company, but that this particular increase in earnings has not yet produced an upward move in the price of that company’s shares

I think this example with Bank of America (which I could never replicate because I can’t see myself buying black boxes like this financial monstrosity) at Base Hit Investing is a really good practical example of the kind of individual company pessimism Phil Fisher would say you should try to bank on. (Duh duh chhhhh.)

He talks about macro-driven risk and says it should largely be ignored, with the caveat of the investor already having a substantial part of his total investment invested in years prior to some kind of obvious mania. He emphasizes,

He is making his bet upon something which he knows to be the case [a coming increase in earnings power for a specific company] rather than upon something about which he is largely guessing [the trend of the general economy]

and adds that if he makes a bad bet in terms of macro-dynamics, if he is right about the earnings picture it should give support to the stock price even in that environment.

He concludes,

the business cycle is but one of at least five powerful forces [along with] the trend of interest rates, the over-all government attitude toward investment and private enterprise [quoting this in January, 2017, one must wonder about the impact of Trump in terms of domestic regulation and taxation, and external trade affairs], the long-range trend to more and more inflation and — possibly most powerful of all — new inventions and techniques as they affect old industries.

Set all the crystal ball stuff aside– take meaningful action when you have meaningful information about specific companies.

Managing Risk

Fisher also gives some ideas about how to structure a portfolio of growth stocks to permit adequate diversification in light of the risk of making a mistake in one’s choices (“making at least an occasional investment mistake is inevitable even for the most skilled investor”). His example recommendation is:

  • 5 A-type, established, large, conservative growth companies (20% each) -or-
  • 10 B-type, medium, younger and more aggressive growth companies (10% each) -or-
  • 20 C-type, small, young and extremely aggressive/unproven growth companies (5% each)

But it is not enough to simply have a certain number of different kinds of stocks, which would be a purely quantitative approach along the lines of Ben Graham’s famous dictums about diversification. Instead, Fisher’s approach is again highly qualitative, that is, context dependent– choices you make about balancing your portfolio with one type of stock require complimentary additions of other kinds of stocks that he deems to offset the inherent risks of each. We can see how Buffett was inspired in the construction of his early Buffett Partnership portfolio weightings here.

For example, he suggests that one A-type at 20% might be balanced off with 2 B-type at 10% each, or 6 C-type at 5% each balanced off against 1 A-type and 1 B-type. He extends the qualitative diversification to industry types and product line overlaps– you haven’t achieved diversification with 5 A-types that are all in the chemical industry, nor would you achieve diversification by having some A, B and C-types who happen to have competing product lines in some market or industry. For the purposes of constructing a portfolio, part of your exposure should be considered unitary in that regard. Other important factors include things like the breadth and depth of a company’s management, exposure to cyclical industries, etc. One might also find that one significant A-type holding has such broadly diversified product lines on its own that it represents substantially greater diversification than the 20% portfolio weighting it might represent on paper. (With regards to indexation as a strategy, this is why many critics say buying the S&P 500 is enough without buying “international stock indexes” as well, because a large portion of S&P 500 earnings is derived from international operations.)

While he promotes a modicum of diversification, “concentration” is clearly the watchword Fisher leans toward:

the disadvantage of having eggs in so many baskets [is] that a lot of the eggs do not end up in really attractive baskets, and it is impossible to keep watching all the baskets after the eggs get put into them […] own not the most, but the best […] a little bit of a great many can never be more than a poor substitute for a few of the outstanding.

Tortured egg basket metaphors aside (why on earth do people care what their egg baskets look like?!), Fisher is saying that the first mistake one can make is to spread your bets so thin that they don’t matter and you can’t efficiently manage them even if they did.

Aside from portfolio construction, another source of risk is the commission of errors of judgment.

when a mistake has been made in the original purchase and it becomes increasingly clear that the factual background of the particular company is, by a significant margin, less favorable than originally believed

one should sell their holdings, lick their wounds and move on. This needs to be done as soon as the error is recognized, no matter what the price may be:

More money has probably been lost by investors holding a stock they really did not want until they could “at least come out even” than from any other single reason. If to these actual losses are added the profits that might have been made through the proper reinvestment of these funds if such reinvestment had been made when the mistake was first realized, the cost of self-indulgence becomes truly tremendous.

Further,

Sales should always be made of the stock of a company which, because of changes resulting from the passage of time, no longer qualifies in regard to the fifteen points… to about the same degree it qualified at the time of purchase […] keep at all times in close contact with the affairs of companies whose shares are held.

One vogue amongst certain investors is to be continually churning the portfolio from old positions to the latest and greatest idea, with the assumption being that time has largely run its course on the earlier idea and the upside-basis of the new idea is so much larger that liquidity should be generated to get into the new one. Fisher advises only using new capital to pursue new ideas rather than giving in to this vanity because,

once a stock has been properly selected and has borne the test of time, it is only occasionally that there is any reason for selling it at all

The concept of “investment” implies committing one’s resources for long periods of time. You can’t emulate this kind of trading activity in the private market, which is a very strong indication that you should try to avoid this behavior in public markets. A particularly costly form of this error is introducing macro-market timing into one’s portfolio management, ie, this stock has had a big run up along with the rest of the market, things are getting heady, I will sell and get back in at a lower cost. I’ve done this myself, most recently with Nintendo ($NTDOY) and even earlier with Dreamworks ($DWA). Fisher says it’s a mistake:

postponing an attractive purchase because of fear of what the general market might do will, over the years, prove very costly […] if the growth rate is so good that in another ten years the company might well have quadrupled, is it really of such great concern whether at the moment the stock might or might not be 35 per cent overpriced? That which really matters is not to disturb a position that is going to be worth a great deal more later.

It plays to a logical fallacy that a company that has run up has “expended” its price momentum, while a company that has not had a run-up has something “due” to it. On the contrary, Fisher points out that many times the material facts about a company’s future earnings prospects change significantly over time from the original purchase, often to the good, such that even with a big run-up, even more is in the offing because the future is even brighter than before– remember, always keep an eye on the future, not the present or the past!

And similarly, if one has an extremely cheap cost basis in a company, one has an enormous margin of safety that should give further heed to trying to jump in and out of the stock when it is deemed to be overvalued.

He adds that, like wines, well-selected portfolio holdings get better with age because,

an alert investor who has held a good stock for some time usually gets to know its less desirable as well as more desirable characteristics

and through this process comes to develop even more confidence in his holdings.

If you’ve read some of my thinking about the philosophy of building multi-generational wealth through a family business, you’ll see once again the direct parallel to private market investing in Fisher’s conclusion:

If the job has been correctly done when a common stock is purchased, the time to sell it is– almost never.

Conclusion

Distilling Part I down to its essence, I concluded that the most important skill for generating long-term gains from one’s investing is still about having a disciplined and consistent investment program followed without interruption and in the face of constantly nagging self-doubt (“In the stock market a good nervous system is even more important than a good head.”) The particular program that Fisher recommends be followed is to:

  1. Create a network of intelligent investors (bloggers) from which to source ideas
  2. Develop a strong scuttlebutt skill/network to develop superior investment background
  3. Check with management to confirm remaining questions generated from the 15 step list
  4. With the conviction to buy, persevere in holding over a long period of time

If you can’t do this, you probably shouldn’t bother with the Fisher approach. Whether it can be done at all is an entirely separate matter.

Review – The Intelligent Investor

The Intelligent Investor: A Book Of Practical Counsel; The Definitive Book On Value Investing

by Benjamin Graham, published 1973, 2003, 2006

All you need to know about intelligent investing

Graham’s layman’s manual for thoughtful investing in common stocks and bonds is a long book, chock full of useful theory and wisdom-gained-by-experience as well as numerous “case studies” which serve to illustrate Graham’s points. While it’s all worth considering, the truth is that certain parts of the book shine more brightly than others and, following the 80/20 principle, are clearly more valuable overall.

Starting out

The Intelligent Investor is of course a practical guide to sound investment, but it is also a work of philosophy. Buried throughout the book are invaluable caveats that are easy to overlook yet deserve to get full billing because they can spare an amateur a lot of headaches down the road. In the book’s introduction, there are two such provisos quite nearby one another, the first being,

be prepared to experience significant and perhaps protracted falls as well as rises in the value of [your] holdings

and the second being,

while enthusiasm may be necessary for great accomplishments elsewhere, on Wall Street it almost invariably leads to disaster

Subtle, but profound, these two warnings are Graham’s opening salvo on the subject of investor psychology, or more accurately, the investor’s own psychology. It will be a common thread running throughout TII— your biggest risk in investing is yourself and your psychological reaction to events impacting your portfolio.

Translating the first message, Graham is trying to gird the investor for the inevitabilities of the market, where volatility is constant in both directions. The key, as you will see, is to master volatility by recognizing that the upward variety is not necessarily proof of a good decision and the downward variety is not punishment but an opportunity to buy at bargain prices.

The second message is even more important– successful investing requires an even-keeled temperament and reasonable expectations about long-term success. The game is about expecting little and learning to be pleasantly surprised, rather than expecting a lot and constantly being disappointed. Most of your fellow market participants are excitable folks and their optimistic expectations will work with yours to crowd out any chance at realizing value, while you’ll always have plenty of room to maneuver on your own if you seek out the waters everyone of which everyone else has become bored.

The last warning is to be consistent and disciplined, to never abandon your principles in dire times because that is in fact when they become most valuable:

Through all their vicissitudes and casualties, as earth-shaking as they were unforeseen, it remained true that sound investment principles produced generally sound results

This is again a psychological appeal. When everyone else is losing their shirts, and their minds, forgetting what they’re doing and why, it will pay the long-term investor great dividends to be mindful of who he is and by what principles he invests as his conservatism is always in due time rewarded.

Security analysis 101

While the best treatment of Graham’s principles of security analysis are given in great detail in his treatise of the same name, [amazon text=Security Analysis&asin=0070140650], The Intelligent Investor does come with several basic recommendations on how to perform basic security analysis for issues under consideration for inclusion in one’s portfolio.

Bond analysis

The key to bond investing is interest coverage, as without it a bond is in default and its principal value is imperiled. Therefore, the primary analytical factor is the number of times total interest charges have been covered by available earnings in years past. Typically two values are consulted:

  1. average coverage for a period of years (7)
  2. minimum coverage in the poorest year

Graham recommends 4x for public utilities, 5x for transportation companies, 7x for industrials and 5x for retail concerns, before income taxes on an average of 7 years basis, and 3x, 4x, 5x and 4x, respectively, measured by the poorest year.

On an after-tax basis, Graham recommends 2.65x for public utilities, 3.2x for transportation companies, 4.3x for industrials, and 3.2x for retail companies on an average of 7 years basis, and 2.1x, 2.65x, 3.2x and 2.65x, respectively, measured by the poorest year.

Additional factors for consideration are:

  1. size of the enterprise – something large and robust, so that depletions in revenue do not imperil the business as a whole
  2. equity ratio – the market price of equity versus the total debt, which shows the amount of “cushion” for losses standing in front of the debt
  3. property value – this is the asset value on the balance sheet, though “experience has shown that in most cases safety resides in the earning power”

Stock analysis

Some basic principles of stock selection and analysis are considered in more detail below, based upon whether one is determined to be a defensive or an enterprising investor. For now, it is sufficient to quote Graham on the subject in the following manner:

The investor can not have it both ways. He can be imaginative and play for the big profits that are the reward for the vision proved sound by the event; but then he must run a substantial risk of major or minor miscalculation. Or he can be conservative, and refuse to pay more than a minor premium for possibilities as yet unproved; but in that case he must be prepared for the later contemplation of golden opportunities for gone

In essence, Graham is outlining the philosophy of “growth” versus “value” investing and stock analysis– attempting to forecast the future, or being content one is not paying too much for what he’s got based on an assessment of the past.

Keeping the shirt you have: the defensive investor

In Graham’s mind, there are two kinds of investors– the defensive investor, who is passive and seeks primarily to protect his capital, and the enterprising investor, who treats his investing like a professional business and expects similarly profitable results for his efforts. First, let’s talk about the defensive investor.

The defensive investor must confine himself to the shares of important companies with a long record of profitable operations and in strong financial condition

Specifically, Graham lists 4 criteria for selecting common stocks for the defensive investor’s portfolio:

  1. diversification – minimum of 10, maximum of 30 separate issues
  2. standing – companies which are large, prominent and conservatively financed (over $10B mkt cap and in the top third or quarter of their industry by market share or some other competitive metric)
  3. dividends – a long record of continuous payments
  4. price – no more than 25x avg earnings of past 7 yrs, nor 20x LTM earnings

Additionally, Graham warns against excessive trading or portfolio turnover:

if his list has been competently selected in the first instance, there should be no need for frequent or numerous changes

Graham also defines risk early on, saying,

the risk attached to an ordinary commercial business is measured by the chance of its losing money

and that further, a defensive investor should never compromise their standards of safety and quality in order to “make some extra income.” Safety first, income/returns second, or you’re likely to wind up with neither in the long run.

In terms of selecting individual stocks for the defensive investor’s portfolio, Graham suggests 7 criteria:

  1. adequate size of enterprise – generally speaking, small companies are excluded and medium size companies are included if their market/industry position is robust
  2. sufficiently strong financial condition – 2:1 current ratio, and LT debt < net current assets (working capital)
  3. earnings stability – some earnings for the common stock in each year over the past decade
  4. dividend record – uninterrupted payments for the past 20 years
  5. earnings growth – minimum of 1/3 increase in per-share earnings in the past ten years using three year average at the beginning and end
  6. moderate P/E – no more than 15x avg earnings of past 3 years
  7. moderate P/A – price should be < 150% of TBV, though may be higher if earnings multiplier is below 15, never to be greater as a combined ratio than 22.5 ( P/E * P/B <= 22.5)

The purpose is to eliminate companies which are: too small, with a weak financial position, with earnings deficits or with inconsistent dividend histories. In general, these factors should combine to create a stock portfolio which, in the aggregate, has an earnings yield (earnings/price) at least as high as the current high-grade bond rate.

At all times, remember that the defensive investor is

not willing to accept the prospects and promises of the future as compensation for a lack of sufficient value in hand

and that, generally speaking, rather than emphasizing the “best” stocks,

let him emphasize diversification more than individual selection

Making more and better shirts: the enterprising investor

Like the defensive investor, Graham counsels the enterprising investor to think firstly of not losing what they’ve got. But in this sense, the enterprising investor has a new tool in his kit that expands his realm of possible investment options while still maintaining safety of principal– the search for “bargain” priced opportunities, the idea here being that the price being offered for a security is a steep discount (generally 30% or greater) than the indicated “intrinsic” or underlying value of the security itself based upon its asset or earnings power fundamentals (with any luck, both).

About bonds and preferred stocks, Graham suggests that preferreds never be bought without at least a 30% discount, and a similar discount on a high-yield bond. More importantly,

experience clearly shows that it is unwise to buy a bond or preferred which lacks adequate security merely because the yield is attractive […] it is bad business to accept an acknowledged possibility of a loss of principal in exchange for a mere 1 or 2% of additional yearly income

About IPOs, Graham says to never touch them, however, busted IPOs can present interesting opportunities later on down the line:

Some of these issues may prove excellent buys– a few years later, when nobody wants them and they can be had at a small fraction of their true worth

With regards to selecting equity securities, Graham lays out three “recommended fields” for enterprising investors:

  1. large cap contrarianism
  2. “bargain” issues
  3. special situations

Digging in further, let’s take a closer look at large cap contrarianism. The idea here is to focus on companies that are well-known but are currently experiencing an earnings hiccup or some other negative news or general investor boredom that leaves them unpopular and trading at a lower than average multiple. The value in these companies are that,

they have the resources in capital and brain power to carry them through adversity and back to a satisfactory earnings base [and] the market is likely to respond with reasonable speed to any improvement shown

A good example of this principle in practice would be a situation such as buying well-known, large cap companies whose shares had strongly sold off during the financial panic of late 2008, early 2009.

According to Graham, a bargain issue is one in which the indicated value is 50% higher than the current price. Bargains can be detected one of two ways, either by estimating future earnings potential and applying an appropriate multiple and comparing this to current trading price for shares, or else by studying the value of the business for a private owner, which involves particular emphasis on the value of the assets (or the tangible book value of the shares).

For an earnings-based bargain, Graham adds some further criteria, such as:

he should require an indication of at least reasonable stability in earnings over the past decade or more — ie, no year of earnings deficit — plus sufficient size and financial strength to meet possible setbacks in the future

with the ideal being a large, prominent company selling below its past average price and P/E multiple.

Special situations encapsulate a range of investment activities, from liquidations (workouts), to hedging and merger arbitrage activities. While Graham sees this area as one offering special rewards to dedicated and knowledgeable investors, he advises that the trend is one towards increasing professionalization and thus even the enterprising investor is best to leave this area alone unless he has special confidence and competence in the area.

Of special emphasis is the idea of focus and dedication, that is to say, one is either an enterprising investor or a defensive one, but not some of both:

The aggressive investor must have a considerable knowledge of security values– enough, in fact, to warrant viewing his security operations as equivalent to a business enterprise. There is no room in this philosophy for a middle ground, or a series of gradations, between passive and aggressive status. Many, perhaps most, investors seek to place themselves in such an intermediate category; in our opinion that is a compromise that is more likely to produce disappointment than achievement

When considering individual stock selections for the enterprising investors portfolio, Graham reminds the reader that

Extremely few companies have been able to show a high rate of uninterrupted growth for long periods of time. Remarkably few, also, of the larger companies suffer ultimate extinction

To the last point, it is fascinating to see in the footnote commentary by Jason Zweig how many of Graham’s various example companies used throughout the book disappeared not due to bankruptcy, but because they were at some point acquired and absorbed wholesale into the operations of another business.

Several categories of equity selection stand out as particularly valuable for the enterprising investor in Graham’s eyes:

  1. arbitrages – purchase of one security and simultaneous sale of one or more other securities into which it is to be exchanged under a plan of reorganization, merger or the like
  2. liquidations – purchase of shares which are to receive one or more cash payments in liquidation of the companies assets; should present a minimum of 20% annual return w/ 80% probability of working out or higher
  3. related hedges – purchase of convertible bonds or convertible preferred shares and simultaneous sale of the common stock into which they are exchangeable
  4. NCAV – 2/3 or less of net current asset value (current assets – TOTAL liabilities); portfolios should have wide diversification, often of 100 securities or more, and require patience
  5. contrarian cyclical investing – buying important cyclical enterprises when the current situation is unfavorable, near-term prospects are poor and the low price fully reflects the current pessimism

Graham also recommended a special set of 5 criteria for selecting “bargain” issues of small or less well-known enterprises, which can be generated from lists from a stock guide or a stock screen beginning with companies trading for a P/E multiple of 9 or less:

  1. financial condition – current ratio of 1.5:1 and debt <= 110% of working capital
  2. earnings stability – no deficit in the last five years
  3. dividend record – some current dividend
  4. earnings growth – last year’s earnings greater than 5 years ago
  5. price – less than 120% of TBV

Graham notes that diversity is key to safety in these operations and such companies should be bought on a “group basis”.

A balancing act: the portfolio

As a broad strategic principle, Graham recommended that defensive and enterprising investors alike seek to allocate a minimum of 25% and a maximum of 75% of their portfolio into stocks and the remaining amount into bonds. In most cases, an even 50-50 split is recommended. The rule of thumb used to guide allocations above or below 50% is that, as the investor determines the “general price level” of the market to be higher than is prudent, he should allocate toward 75% bonds and 25% stocks, whereas when he determines this price level to be much lower than is reasonable (say, in the midst of a bear market), he should allocate toward 75% stocks and 25% bonds.

As Graham says on page 197,

the chief advantage, perhaps, is that such a formula will give him something to do

Remember, you are your biggest risk. Graham was concerned that without “something to do”, an investor might “to do” his portfolio to death with over activity, over-thought or over-worry.

This is a useful insight, but is Graham’s portfolio balancing technique still valid in today’s era of higher inflation risks?

Without stepping on the maestro’s toes too much in saying this, my thinking is that it is increasingly less valid. As Graham himself warns throughout the book, bonds provide no protection against inflation and, while inflation is not “good” for stocks in real terms, the ability to participate in increased earnings is at least better than having a fixed coupon payment in an inflationary environment.

In this sense, an allocation toward 100% stocks makes more sense, assuming we are entering a period of protracted inflationary pressures such as we are.

That being said, Graham’s warning about having something to do is still worth considering. Having kicked the legs out from under the “rebalancing act(ivity)”, perhaps a good substitute would be a continual turning over of rocks in the search for new investment ideas for the enterprising investor. For the defensive investor, the best course of action may be to enjoy the benefits of doing something through dollar-cost averaging, that is, making a little bit of his total intended investment each month or quarter rather than all at once. Another idea might be to allocate 10 or 15% of his portfolio into a MMF or equivalent when he feels the market is rising beyond prudent levels. But the thing that has never sat right with me about Graham’s reallocation technique is that, while in principle it makes sense, in practice it comes down to base attempts at market-timing that always end up generating unsatisfactory results.

Better to focus on Graham’s other major portfolio strategy tenet, which is diversification. Graham is a supporter of diversification for defensive and enterprising investors alike, mostly because it can serve to shield them from their own ignorance or over-enthusiasm. More specifically, many of Graham’s favored techniques (such as special situations, net-nets and bargain securities), while bearing overall pleasing risk/reward balances, nevertheless never bring certainty of either one and for this reason he believes developing a diversified portfolio of such opportunities is the best way for an investor to protect themselves from permanently losing a large part of their capital on one idea.

Saving the best for last: Mr. Market and the Margin of Safety concept

Mr. Market-mania

Markets are made up of people, and people are emotionally volatile. As a result, financial markets are volatile as well. While the vast majority of the time prices tend to move slightly above and slightly below an established trend line, at other times they can swing wildly off course in either direction:

the investor may as well resign himself in advance to the probability rather than the mere possibility that most of his holdings will advance, say, 50% or more from their low point and decline the equivalent one third [ X * 1.5 * .66 = ~X] or more from their high point at various periods in the next five years

Graham also warns against what might be termed the Paradox Of Market Goodwill:

The better a company’s record and prospects, the less relationship the price of its shares will have to their book value. But the greater the premium above book value, the less certain the basis of determining its intrinsic value–ie, the more this “value” will depend on the changing moods and measurements of the stock market

In Graham’s mind, the solution is to

concentrate on issues selling at a reasonably close approximation to their tangible-asset value– say, at not more than one-third above that figure [130% of TBV]

as a general principle of careful investing for the defensive investor. But there is more. Graham represents additional criteria based on the consideration of the firm’s earnings power, outlining what value-blogger Nate Tobik of Oddball Stocks likes to call the “two pillar” method:

A stock does not become a sound investment merely because it can be bought at close to its asset value. The investor should demand, in addition, a satisfactory ratio of earnings to price, a sufficiently strong financial position, and the prospect that its earnings will at least be maintained over the years

In terms of mastering an investor’s own psychology when facing the market, asset values reign supreme, however, because

the investor with a stock portfolio having such book values behind it can take a much more independent and detached view of stock-market fluctuations than those who have paid high multipliers of both earnings and tangible assets. As long as the earnings power of his holdings remains satisfactory, he can give as little attention as he pleases to the vagaries of the stock market. More than that, at times he can use these vagaries to play the master game of buying low and selling high

By Graham’s reasoning, buying a stock close to book value puts him in the same position as an individual offered an opportunity to buy into a private business’s book. Because he has paid a fair, businessman’s price, he doesn’t have to worry about what someone else thinks of his ownership stake, only the operating performance and financial strength of his chosen enterprise.

From a psychological standpoint, it is the high ground and much sought after.

But what is this “master game” of which Graham speaks? It is nothing more than the most masterly metaphor of the entire investing world, Mr. Market.

The idea of Mr. Market is that of a manic depressive business partner who on any given day may offer to buy your stake in the joint business for far more than you think it’s worth, or to sell you his stake for far less than you think it’s worth. The key to taking advantage of Mr. Market is to avoid trying to guess and anticipate why his mood ever suits him, instead relying on your own judgment and thinking about the value of the underlying enterprise regardless of Mr. Market’s various mood swings.

It’s worth quoting Graham at length on this subject:

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 judgement

Further:

the existence of a quoted market gives the investor certain options that he does not have if his security is unquoted. But it does not impose the current quotation on an investor who prefers to take his idea of value from some other source [such as his own study of the fundamentals]

[…]

price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies

In other words, once you have made your investment, the only value of further quotations is to be appraised of another opportunity to buy (if prices decline sharply from that point) or of an opportunity to sell at a profit (if prices rise sharply from that point).

The rest of the time, you can judge the soundness of your decision by studying whether the operating performance of the business plays out according to your expectations. If the underlying business performs as you anticipated over a long period of time, you only need wait for the market to recognize your good judgment. However, if the business steadily deteriorates in a surprising fashion, you may have a basis upon which to second-guess your original judgment. But a falling stock market price would not be the primary indicator in such a situation, nor would a rising one signal you have done well.

Margin of Safety, the central concept of investment

The intellectual principle of the margin of safety involves “inverting” a stock and thinking about it like a bond.

The margin of safety for bonds may be calculated, alternatively, by comparing the total value of the enterprise with the amount of debt

For example, if a business owes $X, but is valued at $3X, the business could shrink by 2/3rds before imperiling the position of the debt holders.

Similarly,

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

the common stock can be considered to enjoy a margin of safety as large as that of a good bond.

Broadly, margin of safety can be thought of as the consistent earnings power of the equity, wherein

the margin of safety lies in an expected earning power considerably above the going rate for bonds

A proxy measure here would be to look at the earnings rate, or earnings yield (earnings/price) and compare this to the going rate on a similar bond.

Another, more general way to think about Margin of Safety is that it is the difference between how much you pay for something versus the calculated intrinsic value you determine that thing to have. In this sense, the Margin of Safety is always price dependent and will be higher at lower prices and lower at higher prices, relatively speaking.

And the Margin of Safety works in tandem with the principle of diversification:

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 a profit than for a 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

The emphasis is always on finding an adequate margin of safety in order to protect your principal because if you do that, the returns will tend to take care of themselves:

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

Special note on market-timing

There isn’t much more to it than this:

if he places his emphasis on timing, in the sense of forecasting, [the investor] will end up as a speculator and with a speculator’s financial results

In case you’re wondering, that’s a bad thing in Graham’s mind because he is convinced that all but the most talented and luckiest speculators lose out in the end because they do not pay attention to safety of principal.

Review – The Richest Man In Babylon

The Richest Man In Babylon

by George S. Clason, published 1926, 1988

The Richest Man in Babylon

Do you want to know the secret to wealth? Do you want to know how the richest man in Babylon came to a prosperous life?

He never forgot, A part of all you earn is yours to keep.

Seven Cures for a Lean Purse

  1. Start thy purse to fattening; save at least 10% of everything you earn
  2. Control thy expenditures; budget your expenses so you never spend more than 90% of what you earn on necessities and luxuries alike
  3. Make thy gold multiply; put your savings to work and let your wealth multiply
  4. Guard they treasures from loss; always ensure first that you don’t lose what you have and that you can get your money back out of any investment you make
  5. Make thy dwelling a profitable investment; own your own home
  6. Insure a future income; your financial planning should take into consideration the fact that you will have decreased earnings power as you age, and that one day you may pass on and leave dependents behind who need financial sustenance
  7. Increase thy ability to earn; cultivate your own powers, study and grow wiser, learn new skills and enhance your ability and number of ways you can earn income

Meet the Goddess of Good Luck

Men of action are favored by the goddess of good luck

The Five Laws of Gold

  1. Gold comes easily to anyone who would put aside 10% of his earnings to provide for an estate for his future and his family
  2. Gold will work for the wise person who finds safe investments in which it can multiply on its own
  3. Gold clings to the owner who looks after its safety in his dealings
  4. Gold slips away from those who invest it carelessly or in ways he is not familiar with
  5. Gold flees the man who has unrealistic earnings expectations, listens to tricksters and schemers or who follows his passions and desires rather than consideration and experience

The Gold Lender of Babylon

Better a little caution than a great regret

The Walls of Babylon

We cannot afford to be without protection

The Camel Trader of Babylon

Where determination is, the way can be found

Notes – The Intelligent Investor Commentary By Jason Zweig

The Intelligent Investor: A Book of Practical Counsel

by Benjamin Graham, Jason Zweig, published 1949, 2003

The Modern Day Intelligent Investor

The following note outline was rescued from my personal document archive. The outline consists of a summary of the end-chapter commentary written by Jason Zweig. Zweig did such a good job of reviewing Graham’s lessons in each chapter and practically applying them that I find you can get most of the major principles of The Intelligent Investor by reading the combined commentary chapters as if they were a standalone investment book.

Of course, Graham’s original work is a classic in the value investing tradition and it should be read and savored on its own, as well.

Chapter 1, JZ commentary

  1. What is investing?
    1. You must thoroughly analyze a company, and the soundness of its underlying businesses, before you buy its stock
    2. You must deliberately protect yourself against serious losses
    3. You must aspire to “adequate”, not extraordinary, performance
  2. How to invest
    1. An investor calculates what a stock is worth, based on the value of the underlying business
    2. A speculator gambles that a stock will go up in price because somebody will pay even more for it
    3. You should be comfortable owning the underlying business even if you couldn’t get timely, regular quotes of its market price
    4. Price is what the business is selling for, not what it’s worth. Value is what the business is worth. Money is sometimes made in the arbitraging of the two, but price does not dictate value; in the long-term, value dictates price
  3. Limit your risk
    1. Never mingle speculative accounts and investment accounts
    2. Never allow your speculative thinking to spill over into your investing activities
    3. Never put more than 10% of your assets into your “mad money” account

Chapter 2, JZ commentary

  1. Stocks have not had a perfect record of keeping up with inflation, as measured by the CPI
  2. 20% of the 5year periods from 50s today in which inflation dominated saw falling stocks
  3. Two strategies for branching out beyond stocks during inflation:
    1. REITs (Real Estate Investment Trusts)
    2. TIPS (Treasury Inflation Protected Securities)
      1. IRS considers an increase in TIPS value to be taxable income

Chapter 3, JZ commentary

  1. “By the rule of opposites, the more enthusiastic investors become about the stock market in the long run, the more certain they are to be proved wrong in the short run.”
  2. The stock market’s performance depends on three factors:
    1. real growth in earnings and dividends
    2. inflation(-expectations) within the general economy
    3. speculative appetite for stocks/risk (increase/decrease)
  3. In the long run, you can reasonably expect stocks to average a 6% nominal return, 4% real return (with inflation calculated at 2% historical rate)
  4. Be humble about your ability to forecast future stock returns– don’t risk too much on a forecast that could turn out to be wrong.

Chapter 4, JZ commentary

  1. Two kinds of intelligent investors:
    1. active/enterprising – continual research, selection and monitoring of a dynamic mix of stocks, bonds or mutual funds (intellectually/physically demanding)
    2. passive/defensive – create a permanent portfolio that runs on autopilot and requires no further effort but generates very little excitement (emotionally demanding)
  2. How to allocate amongst stocks and bonds for defensive investors?
    1. “Age” is arbitrary and pointless
    2. Instead, consider the fundamental circumstances of your life and the financial needs you’ll have for the foreseeable future
    3. For the aggressive investor, 25% in bonds and cash, 75% in stocks
    4. For the defensive investor, 25% in stocks and 75% in bonds and cash
    5. Rebalancing should be done on a predictable, disciplined basis– not when the market dictates, but when the “calendar” or schedule does
  3. Income investing (bond choices)
    1. Taxable or tax free? Choose tax free (municipal) unless you are in the lowest income bracket
    2. Short-term or long-term? Intermediate term bonds of 5-10yrs allow you to avoid the guessing game and see-saw risks of short and long-term bonds
    3. Bonds or bond funds? Unless you have a lot of capital to make minimum purchases, probably more cost effective to buy a bond fund
    4. Watch out for preferred stock, the worst of both worlds
      1. Secondary claim on assets in bankruptcies (junior to bonds)
      2. Offer less potential profit than common equity because they are often forcibly called by businesses when interest rates drop or credit ratings improve
      3. Companies can not deduct the interest payments like they can with bond issuance, ask yourself, “Why would a company that is healthy issue preferred rather than bonds?” Answer is, probably because they aren’t healthy
    5. Sometimes, stocks can offer competitive yields with Treasuries, which can increase income yield while raising potential return (as well as increasing potential risk of loss)

Chapter 5, JZ commentary

  1. Markets are least risky after a crash, most risky at the top
  2. Should you buy what you know? Psychological studies say that we tend to discount risk inappropriately when we feel we are experts on something due to familiarity
  3. Dollar-cost averaging can be a disciplined way to force oneself to invest through bear and bull markets

Chapter 6, JZ commentary

  1. Junk bonds
    1. Graham warned against them because they were difficult to diversify away the risks of default; today, many junk bond funds exist which allow an investor to diversify
    2. While junk bonds have outperformed 10yr UST even with historical default rates factored in, many junk bond funds charge high fees which reduces their appeal
  2. Emerging market bonds
    1. Typically not correlated with US equity markets
    2. Restrict holdings in bond portfolio to 10% (published 2003)
  3. Day trading
    1. The increased transaction costs of day trading is a surefire way to bomb a portfolio
    2. Day trading raises transaction costs to the point where returns must be beyond what one could reasonably expect to make with a conservative estimation of returns, just to break even
  4. IPOs
    1. Most people who have bought-and-held IPOs have been decimated over time
    2. Hard to find value in the mania buying of an IPO
    3. The public excitement of an IPO often leads investors to forget about valuing the underlying business; many investors have paid ridiculous sums for businesses that were not profitable and never had a chance of being profitable
    4. “It’s Probably Overpriced”

Chapter 7, JZ commentary

  1. Market timing is essentially a fools errand: Life can only be understood looking backwards, but it is lived forwards.
  2. Growth stocks– the faster the companies grow, the higher goes their stock multiples
    1. A $1B company can double its business fairly easily, but how will a $50B company double itself?
    2. A great company is not a great investment if you pay too much for it
    3. When growth companies expand beyond 25-30 times earnings, they’re expensive and should not be bought
    4. One way growth companies could become temporarily attractive is when they suffer a setback or disclosure of upsetting information, creating “the relatively unpopular large company.”
  3. Most great fortunes in the world are made through concentration into one industry or business idea; similarly, most great fortunes are lost this way as well
    1. Because markets are sometimes cyclical, people who got rich in one industry as it boomed will likely lose their fortunes in that same industry when it busts
  4. Bargain hunting for stocks can be a winning strategy; consider stocks that are selling at or for less than their net working capital (Current Assets – Total Liabilities, including preferred stock and long-term debt)
    1. One way to quickly find these stocks can be to search for companies that have recently hit new lows for the past 52 weeks
  5. Diversifying outside the US (or home market) is adviseable because national economies suffer booms and busts as well as specific industries do
    1. If you had been Japanese in 1989, you would probably think it foolish to invest in America; however, you would lose 2/3 of your equity value over the ensuing decade as a result
    2. The country that you live and work in is already a multilayered bet on the economic prospects of that country’s economy; buying foreign stocks (including emerging markets) provides insurance against the possibility that your home market might be a laggard

Chapter 8, JZ commentary

  1. Do not let the movement of Mr. Market, up or down, affect your decision on whether to buy or sell a particular company or stock at a particular time
    1. Don’t buy just because the market is going up
    2. Don’t sell just because the market is going down
  2. Graham: “The primary cause of failure is that they pay too much attention to what the stock market is doing currently.”
  3. Investing intelligently is about controlling the uncontrollable
    1. your brokerage costs
    2. your ownership costs (mutual fund fees)
    3. your expectations (keep them reasonable)
    4. your risk (how much of your total assets do you put into each investment)
    5. your tax bills (short vs. long term cap gains)
    6. your own behavior
  4. “To be an intelligent investor, you must also refuse to judge your financial success by how a bunch of total strangers are doing”
    1. You haven’t lost if everyone else has won
    2. You haven’t won if everyone else has lost
    3. Focus on your own absolute performance
  5. Remember: market quotations are what other people think the value of a stock is– not what the true value of the stock is in relation to underlying intrinsic value
  6. Selling into a bear market can occasionally make sense in relation to taking a realized loss for tax purposes; consult a tax professional before doing so

Chapter 9, JZ commentary

  1. The pitfalls of mutual funds:
    1. avg fund does not pick stocks well enough to overcome the costs of researching and trading them
    2. the higher a fund’s expenses, the lower its returns
    3. the more frequently a fund trades, the less it tends to earn
    4. highly volatile funds tends to stay volatile
    5. funds with high past returns are unlikely to remain winners for long
  2. Why don’t more winning funds stay winners?
    1. migrating managers; top mgrs get picked off by higher paying companies or go on to start their own funds
    2. asset elephantitis; when a fund is too large, it reduces the types and size of investments it can possibly make, reducing its nimbleness
    3. no more fancy footwork; many fund “incubate” before going public and whatever advantages they had during incubation are generally lost afterward, yet they use the incubation period performance to promote the fund
    4. rising expenses; it often costs more to trade in size than to trade smaller because markets become illiquid when trading in size
    5. sheepishness/herding; fund mgrs who have been successful and attract higher fees grow accustomed to these fees and their reputation and don’t want to take any risks that might jeopardize either one, so they trade like other fund mgrs
  3. The solution for the individual investor is boring, low cost index funds– they won’t beat the market, but they won’t get beaten by it either
  4. How to pick good mutual funds?
    1. managers should be the biggest shareholders
    2. they should be cheap/low fee; high returns are temporary, high fees are permanent
    3. they should be run creatively and “dare to be different”
    4. they shut the door before they get too big
    5. they don’t advertise much if at all
  5. Expense fee guidelines:
    1. taxable and muni bonds, .75%
    2. US equities, 1%
    3. high-yield bonds, 1%
    4. US equities (small stocks), 1.25%
    5. foreign equities, 1.5%
  6. When to sell a mutual fund?
    1. a sharp and unexpected change in strategy
    2. an increase in expenses
    3. large and frequent tax bills (caused by excessive trading)
    4. suddenly erratic returns (big gains or big losses)

Chapter 11, JZ commentary

  1. Five decisive elements for determining price multiples
    1. the company’s “general long-term prospects”
      1. Warning flags
        1. the company is a serial acquirer, gaining revenues and profit growth through the acquisition of other businesses
        2. the company is addicted to OPM and is continually floating debt or issuing new stock
          1. cash from operating activities negative, while cash from financing activities positive, on a general or recurring basis, means the company is not profitable in its own line of industry
        3. the company relies on one or only a handful of important customers to generate a significant share of its revenues and profits
      2. Positives in company analysis
        1. the company has a wide “moat” to competition
          1. brand identity
          2. monopoly or near-monopoly
          3. economies of scale
          4. unique intangible asset
          5. resistance to substitution
        2. the company is a marathoner, not sprinter
          1. revenues and income should grow steadily, not in spurts
          2. less likely to attract and then offend “hot stock” money
        3. the company sows and reaps
          1. the company should be spending on R&D to develop new lines of growth in the future
          2. 3-6% of revenues by industry is a typical measure
    2. the quality of its management
      1. is it looking out for #1?
        1. executives should not be paid too much
        2. company should not be reissuing or repricing stock options constantly
        3. use fully-diluted share totals when calculating EPS
        4. insiders should not be selling the company
      2. are they managers or promoters?
        1. mgrs should spend most of their time managing, not being in the media promoting the company’s stock
        2. watch out for accounting opaqueness, recurring non-recurring charges, ordinary extraordinary items and the focus on EBITDA rather than net income, etc.
    3. the financial strength and capital structure
      1. it should generate more cash than it consumes
      2. cash from operations should grow steadily over time
        1. use “owner earnings” (Net Income + Amortization + Depreciation – Cost of Stock Options – Unusual/Nonrecurring Charges – Company Pension Fund “Income”)
      3. capital structure considerations
        1. total debt ( + preferred stock) should be under 50% of total capital
        2. is debt fixed-rate or variable, exposing the company to interest rate risk (check footnotes)?
        3. check annual reports for “ratio of earnings to fixed costs” which can demonstrate if the company is able to make interest payments
    4. its dividend record
      1. the burden of proof is on the company to prove they shouldn’t issue you a dividend because they can grow the company better with the retained earnings
      2. the stock should not be split constantly
      3. stock buybacks should occur when the company’s shares are cheap, not at record highs
    5. its current dividend rate

Chapter 12, JZ commentary

  1. Accounting gimmickery
    1. make sure capitalized expenses really ought to be capitalized
    2. watch out for firms realizing revenues on their accounting statements that they have not actually earned
    3. inventory write-downs should not be occurring regularly if the company is using proper inventory accounting methods
    4. “net pension benefit” should not be more than 5% of the company’s net income
  2. How to avoid accounting fraud
    1. read backwards; the dirty secrets are buried at the end
    2. read the notes; never buy a stock without reading the footnotes in the annual report
      1. look for terms like “capitalized”, “deferred” and “restructuring”
    3. read more; check out Financial Statement Analysis (Fridson and Alvarez), The Financial Number’s Game (Comiskey), Financial Shenanigans (Schilit)

Chapter 14, JZ commentary

  1. Investing for the defensive investor
    1. Substantially all of ones stock picks should be limited to a total stock market index fund; or, 90% total stock market index fund and 10% individual stock picks
  2. Graham’s criteria for stock selection:
    1. adequate size; market cap > $2B, unless owned through a “small cap mutual fund” that allows for diversification
    2. strong financial condition; 2:1 current assets:current liabilities ratio
    3. earnings stability; some earnings for the common stock in each of the past ten years
    4. dividend record; the company should pay a dividend, even better if it increases over time
    5. earnings growth; 33% cumulative EPS growth over ten years, or essentially, 3% annual EPS growth
    6. moderate p/e ratio; current price should be no more than 15x avg earnings over past 3 yrs
    7. moderate price-to-book ratio; price-to-assets/price-to-book-value ratio of no more than 1.5
    8. alternatively, multiply p/e ratio by price-to-book and the number should be below 22.5
  3. Do the due diligence
    1. do your homework; read at least 5 yrs worth of annual and qtrly reports and proxy statements disclosing managers’ compensation, ownership, and potential conflicts of interest
    2. check out the neighborhood; check for institutional ownership ratios, over 60% probably means the company is overowned and overpriced
      1. if one sells, they’ll all sell; could be a time to find bargains in that stock
      2. check who the biggest holders are, if they’re money mgrs that invest like you, you could be in good hands

Chapter 15, JZ commentary

  1. You can practice stock-picking for a year, without investing any real money, and see how you do
    1. if you beat the S&P500, maybe you are good enough to pick stocks
    2. if you don’t, stick to index funds
  2. How to pick stocks for the enterprising investor
    1. Start with stocks that have recently hit 52 week lows
    2. use the ROIC method of analysis; ROIC = Owner Earnings / Invested Capital, where Owner Earnings is:
      1. Operating Profit + Depreciation + Amortization of Goodwill – Federal Income Tax – Cost of Stock Options – Maintenance (Essential CapEx) – Income Generated By Pension Funds
      2. Invested Capital = Total Assets – Cash and ST Investments + Past Accounting Charges That Reduced Invested Capital
      3. ROIC can demonstrate, after legitimate expenses, what the company earns from its operating businesses and how efficiently it has used shareholders’ money to generate that return
      4. ROIC of 10% is attractive, 6-7% in special occasions with strong brand name, focused management or the company being temporarily unpopular
    3. you can also look for comparable companies that have been acquired recently for valuations for the company you are looking at
      1. check the “Business Segments” (or “Management Discussion and Analysis”) section of the company’s annual report for industrial sector, revenues and earnings of each subsidiary
      2. then, check Factiva, ProQuest or LexisNexis for examples of other firms in the same industry that have been acquired
      3. then, look at past ARs for these companies for information about purchase price to earnings for those companies before acquisition
      4. this might reveal a “60-cent dollar”, a company whose assets and earnings are selling for 60% or less than the businesses might be worth to an acquirer

Chapter 20, JZ commentary

  1. The first objective of investing: “Don’t lose.”; this is Graham’s “margin of safety” concept in a nutshell
  2. Consider a market that is returning 5% a year, while you have found a stock that you think can grow at 10%; if you overpay for it and suffer a capital loss of 50% in the first year, it will take you 16 years to overtake the market, and nearly 10 years just to break even again
  3. The biggest financial risk we face is ourselves; ask yourself the following questions:
    1. How much experience do I have? What is my track record with similar decisions in the past?
    2. What is the typical track record of other people who have tried this in the past?
    3. If I am buying, someone is selling. How likely is it that I know something they don’t know?
    4. If I am selling, someone else is buying. How likely is it that I know something they don’t know?
    5. Have I calculated how much this investment needs to go up to cover my taxes and trading expenses?
  4. Then, make sure you have considered the consequences of being wrong by asking yourself:
    1. How much could I lose if I am wrong?
    2. Do I have other investments that will tide me over if this decision turns out to be wrong? Am I putting too much capital at risk?
    3. Have I demonstrated a high tolerance for risk by continuing to invest after large losses in the past?
    4. Am I relying on willpower alone to prevent me from panicking or have I made preparations in advance by diversifying and dollar-cost averaging?
  5. “In making decisions under conditions of uncertainty, the consequences must dominate the probabilities. We never know the future.”
  6. Never make the mistake of following investment crazes or putting all your eggs in one basket; if you make one error, you will have wiped yourself out
  7. Instead, diversify, and always protect yourself from the consequences of being wrong just as much as you hope and plan to enjoy the benefits of being right

[amazon asin=0060555661&template=iframe image2]

Notes – Buffett Partnership Letters, 1957-1970

Recently I sank into my overstuffed armchair (in this situation, “sank” is used derisively to connote frustration and discomfort with regards to ideal reading conditions) with a copy of Buffett’s partnership letters from the 1957-1970 period in my hands. I found them on CSInvesting.org and had never taken the time to read them before, but figured it was about time as I was curious to consult a primary source on this period of Buffett’s investment career, having already read a 3rd-party recounting in The Snowball.

My interest was to read critically. Buffett’s letters have been read and analyzed and mulled over by thousands of investors and business people and have been discussed ad nauseum. But everyone seems to come away with the same lessons and the same pithy quotes that they throw up on their blogs when appropriate. I wanted to see if I could find anything original. From my own set of knowledge and understanding of Buffett and “how he did it”, I achieved my goal, but I can not guarantee creativity to anyone else who may be reading this. Somehow, somewhere in some overlooked nook of this vast interweb, I may have missed the discussion where someone went over these exact points.

Market timing, or the “value climate”

Amongst value investors, the sin of attempting to time the market is considered to be one of the greatest (for example, see the special note at the end of my recent review of The Intelligent Investor). Luminaries like Graham warn us that attempting to jump in and out of the markets according to their perceived price level being high or low is a speculative activity that will be rewarded as such, which is to say, it’ll eventually end in disaster.

However, while value gurus like Graham warned against market timing as a primary tool of analysis in an investment program, it’s also true that both Graham and Buffett were nonetheless intimately aware of market valuations and sentiment and both of them discussed the way their perception of market valuation influenced their portfolio orientation at any given time. For Graham and his intelligent investors, the response was to weight the portfolio toward bonds and away from stocks when the market was high and the opposite when the market was low. Similarly, Buffett advised in his 1957 letter:

If the general market were to return to an undervalued status our capital might be employed exclusively in general issues… if the market should go considerably higher our policy will be to reduce our general issues as profits present themselves and increase the work-out portfolio

This quote alone, along with many others just like it throughout the partnership letters, makes it clear the Buffett did not ignore broad market valuations. And not only did he not ignore them, he actively manipulated his portfolio in response to them. However, there are a few key things to note in terms of the heavily nuanced differences between what Buffett did and what the average market timer does:

  • Market timers are forecasters, they act on a perceived market level because of their anticipation about future market levels; Buffett refused to speculate about what the future of the market level might be and instead accepted it for what it was, changing what he owned and in what proportions, not whether he was invested or uninvested
  • Market timers are binary, choosing between “risk on” or “risk off”; Buffett responded to higher market levels by seeking to gain greater exposure to market neutral opportunities (special situations revolving around corporate action) while still continuing to make investments in individual undervalued businesses as he found them
  • Market timers always maintain the illusion of “full control” knowing they can always sell out or buy in any time they like in response to market valuations; Buffett acknowledged that many times he might desire to have greater market neutral exposure but that such opportunities might dry up in the late stages of a bull market, dashing his plans

The importance of relative performance

Another concept of Buffett’s money management style that stood out was his obsession with relative performance. I found this interesting again because the orthodox value investment wisdom is that it is not relative, but absolute, performance which matters– if you permanently lose a portion of your capital in a period, but your loss is smaller than your benchmark, you’ve still lost your capital and this is a bad thing.

Again, from the 1957 letter, Buffett turned this idea on its head:

I will be quite satisfied with a performance that is 10% per year better than the [Dow Jones Industrial] Averages

Because Buffett calculated that over the long-term the DJIA would return 5-7% to shareholders including dividends, Buffett was aiming for a 15-17% per annum performance target, or about 3x the performance of the Dow. But, as always, there was an important twist to this quest for relative out performance. In his 1962 letter, Buffett stated in no uncertain terms:

I feel the most objective test as to just how conservative our manner of investing is arises through evaluation of performance in down markets. Preferably these should involve a substantial decline in the Dow. Our performance in the rather mild declines of 1957 and 1960 would confirm my hypothesis that we invest in an extremely conservative manner

He went on to say:

Our job is to pile up yearly advantages over the performance of the Dow without worrying too much about whether the absolute results in a given year are a plus or a minus. I would consider a year in which we were down 15% and the Dow declined 25% to be much superior to a year when both the partnership and the Dow advanced 20%

And he concluded by noting:

Our best years relative to the Dow are likely to be in declining or static markets. Therefore, the advantage we seek will probably come in sharply varying amounts. There are bound to be years when we are surpassed by the Dow, but if over a long period we can average ten percentage points per year better than it, I will feel the results have been satisfactory.

Specifically, if the market should be down 35% or 40% in a year (and I feel this has a high probability of occurring in one year in the next ten– no one knows which one), we should be down only 15% or 20%. If it is more or less unchanged during the year, we would hope to be up about ten percentage points. If it is up 20% or more, we would struggle to be up as much

In his 1962 letter, he added further detailing, sharing:

Our target is an approximately 1/2% decline for each 1% decline in the Dow and if achieved, means we have a considerably more conservative vehicle for investment in stocks than practically any alternative

Why did Buffett focus so much on relative out performance in down years? Because, as a value investor, he was obsessed with permanent loss of capital. In a broad sense, making money in the market is somewhat easy as over long periods of time as the market has historically tended to rise higher and higher. Every now and then, however, it corrects sharply to the downside and it is in these moments when the average investor panics and sells out at a loss, thereby permanently impairing his capital.

Buffett believed that by buying at a discount and taking a more conservative approach to the investment problem from the outset, he would limit any losses he might sustain in the inevitable downturns in the market. This by itself would put him ahead of other market participants because he’d have more of his capital intact. The real power behind this strategy is what comes afterward, as then the just-as-inevitable recovery would continue the compounding process again– with more of his original capital than the other guy, Buffett would enjoy greater pure gain over time as he would have a relatively shallower hole to climb out of each time.

True Margin of Safety: two pillars of value

Fellow value investor Nate Tobik over at OddballStocks.com has talked repeatedly about one of Ben Graham’s concepts which he refers to as the “two pillars of value”, namely, that a company which represents a bargain both on the basis of a discount to net assets and a discount earnings is the most solid Margin of Safety one can possess because you’re not only protected two ways but you also have two ways to “win.”

Reading the Buffett partnership letters, it’s clear that the reason Buffett was knocking it out of the park in his early years was because he relied upon the same methodology. Buffett later was critical of his own early practices and many others have derided the investment style as akin to picking up soggy cigar butts and taking the last puff before discarding them, but there is no denying in studying several of the investments Buffett disclosed that Buffett was buying things which were “smack you over the head” cheap.

For example, in the 1958 letter, Buffett disclosed the partnerships’ investment in Commonwealth Trust Company of New Jersey, a small bank. Buffett claimed the company had a computed per share intrinsic value of $125, which was earning $10/share and trading for $50. This meant that Buffett bought the company for 40% of book value, or at a 60% margin of safety to indicated value. And, in two pillar tradition, he was also buying at a 5x multiple of net earnings– by any standards, an incredibly cheap value. If one were to look at the company as a bond and study it’s earnings yield, this company was offering a 20% coupon!

Making good buys, not good sales

In the example of Commonwealth Trust Co. discussed earlier, though Buffett calculated an intrinsic value of $125/share, he ultimately sold for only $80/share. He did not sell out near intrinsic value but rather far below it. Still, because he had originally bought at $50/share, he nonetheless earned a 60% return despite the company trading at a still-substantial discount to intrinsic value.

As Buffett chirped in his 1964 letter:

Our business is making excellent purchases– not making extraordinary sales

Why does Buffett harp on this idea so frequently? There are a few reasons.

One, an excellent purchase price implies a substantial discount to intrinsic value and earnings power, therefore there is a built-in margin of safety and the downside is covered, a principle of central importance to sound investing.

Two, an individual has 100% control over when they buy a security but relatively little control over when and in what conditions they sell, particularly if they use margin. You may not always get the price you want when you are ready to sell but you will always get the price you want when you buy because that decision is made entirely by you and doesn’t require the cooperation of anyone else. Buying at a discount ensures you “lock in” a profit up front.

Three, buying at a discount gives one optionality. If a better deal comes along, it is more likely you can get back out of your original investment at cost or better when you buy it cheap. When your original purchase price represents a substantial discount you have a better chance of finding a buyer for your shares because even at higher prices such a sale would probably still represent a bargain to another buyer meaning both parties can feel good about the exchange.

This last point was critical in Buffett’s Commonwealth situation. He was happy to sell at only $80/share despite a $125/share intrinsic value because he had found another opportunity that was even more compelling and because his original purchase price was so low, he still generated a 60% return. Meanwhile, the other party who took this large block off his hands was happy to provide the liquidity because they still had a 56% upside to look forward to at that $80/share price.

Early activism, the value of control

Another lesson from Buffett’s partnership letters is the importance and value of activism and control. From an activism standpoint, the examples of Sanborn Maps and Dempster Mills are well-known and don’t require further elaboration in this post (follow the links for extensive case study analysis at CSInvesting.org, or even read Buffett’s partnership letters yourself to see his explanation of how these operations worked).

But activism is something that is best accomplished with control, and often is its by-product. On the topic of control, Buffett said in his 1958 letter with regards to Commonwealth:

we became the second largest stockholder with sufficient voting power to warrant consultation on any merger proposal

By gaining a large ownership share in an undervalued company, an investor can play a more active role in ensuring that potential catalysts which might emerge serve to adequately reward shareholders. Similarly, time is money and when one has control,

this has substantial advantages many times in determining the length of time required to correct the undervaluation

An investment situation offering, say, a 30% return, offers a 30% annualized return if captured within a year, a 15% annualized return if gained after two years and only a 10% annualized return if it takes 3 years to realize value. Having control can often be the difference between a 30% and a 10% annualized return by allowing an investor to accelerate the pace at which they turn over their capital.

It is a myth, therefore, that Buffett only became a wholesale/control buyer as he employed greater amounts of capital in his later years. While many of his investments were passive, minority positions in the partnership years, Buffett never shied away from control and activism, even saying in his 1961 letter:

Sometimes, of course, we buy into a general with the thought that it might develop into a control situation. If the price remains low enough for a long period, this might very well happen

In this sense, “value is its own catalyst” and something which is cheap and remains cheap for an extended period of time can actually be a unique opportunity to accumulate enough shares to acquire control, at which point the value can be unlocked through asset conversion, a sale or merger of the company or through a commandeering of the company’s earnings power.

Portfolio buckets: generals, work-outs and control

In his 1961 letter, as well as later letters, Buffett outlined the three primary types of investments that could be found in the partners’ portfolios, the approximate proportion of the portfolio to be involved with each and the basis upon which such investments should be chosen.

The “bread and butter” according to Buffett was his “generals”, businesses trading at substantial discounts to their intrinsic value which were purchased with the intent of eventually being resold at a price closer to the intrinsic value:

our largest category of investment… more money has been made here than in either of the other categories… We usually have fairly large positions (5% to 10% of our total assets) in each of five or six generals, with smaller positions in another ten or fifteen… Sometimes these work out very fast; many times they take years. It is difficult at the time of purchase to know any specific reason why they should appreciate in price… individual margin of safety coupled with a diversity of commitments creates a most attractive package of safety and appreciation potential… [we] are usually quite content selling out at some intermediate level between our purchase price and what we regard as fair value to a private owner

While admitting that the particular and eventual catalyst was often not known with the average investment in a general security, Buffett also admitted in his 1963 “Ground Rules” letter section:

Many times generals represent a form of “coattail riding” where we feel the dominating stockholder group has plans for the conversion of unprofitable or under-utilized assets to a better use

The next category was workouts:

our second largest category… ten or fifteen of these [at various stages of development]… I believe in using borrowed money to offset a portion of our work-out portfolio since there is a high degree of safety in this category in terms of both eventual results and intermediate market behavior

The beauty of work-outs is that they relied on corporate action, not market action, to realize value. In this sense, they could provide a meaningful buffer to share price declines in generals during bear markets as their performance was largely “market neutral.” For example, in his 1963 (1962 being a bear market) letter Buffett said:

This performance is mainly the result of having a large portion of our money in controlled assets and workout situations rather than general market situations at a time when the Dow declined substantially

The final category was control, which started out as something of an after-thought or an accidental consequence of investing in certain generals which remained cheap, but later turned into an active category Buffett would search for opportunities in.

Buffett also mentioned the idea of the “two-way stretch” in control situations– if bought at a significant discount, there were generally two ways to profit from a control investment. Either the stock price remained low for a long period of time and control was acquired, in which case “the value of our investment is determined by the value of the enterprise,” or else the stock would move up in the process of consolidating a position in which case it could be sold at a higher level in the way one would normally “complete a successful general operation.”

Time horizons for performance

This particular point is more well-known but it bears repeating here. Buffett was obsessed with long-term performance and constantly advised his partners about appropriate timelines for judging investment performance, especially based-upon the particular type of investment being considered. For example, in his 1960 letter he said:

My own thinking is more geared to five year performance, preferably with tests of relative results in both strong and weak markets

In the 1961 letter, Buffett discussed “establishing yardsticks prior to the act” and again emphasized:

It is my feeling that three years is a very minimal test of performance, and the best test consists of a period at least that long where the terminal level of the Dow is reasonably close to the initial level

In other words, what did your performance look like after a three year period where the broad market index made no progress, or even reversed?

With control situations specifically, Buffett advised:

Such operations should definitely be measured on the basis of several years. In a given year, they may produce nothing as it is usually to our advantage to have the stock be stagnant market-wise for a long period while we are acquiring it

Diversification

It’s clear that Buffett had 15-21 “generals” or about 50-60% of his portfolio, with another 10-15 positions in workouts or another 15-30%, with the remainder in control situations. However, control situations could scale up to as much as 40% of the portfolio in an individual investment if the situation called for it in Buffett’s mind.

And while Buffett mentioned in an earlier letter of having approximately 40 positions in the portfolio in total, he later (around the time he started being influenced by Charlie Munger and other “quality over quantity” investment practitioners) became more critical of the idea of diversification. In the 1966 letter, Buffett lamented:

if anything, I should have concentrated slightly more than I have in the past

He also castigated “extreme diversification”:

The addition of the one hundredth stock simply can’t reduce the potential variance in portfolio performance sufficiently to compensate for the negative effect its inclusion has in the overall portfolio expectation

Buffett was learning the merits of “concentration” in areas outside the portfolio, as well. In discussing slight additions to the office space at Kiewit Plaza and the hiring of additional support personnel, Buffett added:

I think our present setup unquestionably lets me devote a higher percentage of my time to thinking about the investment process than virtually anyone else in the money management business

Of course, the results of this focus were obvious to all in time.

Sizing things up

Buffett dwelled on “the question of size” at length in his letters to partners. He made it clear that portfolio size and investment opportunity looked something like a continuum with small size on the left of the spectrum and large size on the right, with “generals” hanging near the left pole (size is a disadvantage), workouts inhabiting some kind of middle ground where they were neither benefitted nor impaired by size and control situations distinctly on the right where size was an enormous advantage.

Generals and control situations are, in this sense, almost opposites because Buffett warned that some generals were too small to buy meaningful stakes in for a large portfolio, whereas a small portfolio might never be able to acquire enough shares to gain control of certain investments.

Inflation-adjusting Buffett’s portfolio positions and capital at various points in time also gives important clues to the role size played in his operations. For example, Sanborn Maps was apparently around a $4.5M market cap when he mentioned the company in his letters. This would be about $35M or so in today’s dollars (this is not an endorsement of BLS/CPI measurement techniques, just a convenient rule-of-thumb), so clearly Buffett was hunting in a small/micro-cap space at least at this time.

In a similar vein, Buffett started with $105,000 in capital in 1956, which is about $893,000 in 2012. In his 1966 letter, he complained that the amount of capital being managed at the time, $43,645,000, was beginning to be burdensome in terms of size versus opportunities. This would be about $312,000,000 in 2012, to put it into perspective.

Apparently, the value investment framework Buffett created could work quite well even at a scale that we might consider to be decently large.

Serendipity: the reason for Buffett’s rise, and retirement

Few ever think to mention the incredible role serendipity played in Buffett’s early fortunes, but Buffett himself was well-aware. Not only did he begin his career at the outset of an astounding decade-long-plus bull market, but in 1952,

and for some years subsequently, there were substantial numbers of securities selling at well below the “value to a private owner” criterion we utilized for selection of general market investments

As the bull market started to grow gray hairs in the late 1960s and Buffett began contemplating an exit from the business, he similarly remarked in his 1967 letter:

Such statistical bargains have tended to disappear over the years. This may be due to the constant combing and recombing of investments that has occurred during the past twenty years, without an economic convulsion such as that of the ’30s to create a negative bias toward equities and spawn hundreds of new bargain securities

The comment on the aftermath of the 1930s bears repeating. The primary reason for the prevalence of bargain issues in the market around the time Buffett started investing was due to a massive psychological paradigm shift in attitudes about the stock market following the crash of 1929 and subsequent depression of the 1930s. By the late 1960s, a new inflationary thrust had managed to erase this psychology and great gains were actually made in sending it in the reverse direction. Buffett was convinced of

the virtual disappearance of the bargain issues determined quantitatively

the kind whose figures “should hit you over the head with a baseball bat”, which were being replaced by

speculation on an increasing scale

So how did Buffett respond to these new market conditions where his toolkit didn’t seem to work as well? Did he compromise his standards, or try to shape-shift his style into the “New Era” of investors and keep going? Well, anyone who has studied Buffett already knows the answer. Buffett knew his circle of competence and he knew what worked. When what he knew worked stopped working (because the opportunities weren’t available), he quit.

Despite writing in his 1968 letter that the answer to a potential phase out of the partnerships was “Definitely, no.” Buffett nonetheless in his 1969 letter suggested that “the quality and quantity of ideas is presently at an all time low” and that “opportunities for investment that are open to the analyst who stresses quantitative factors have virtually disappeared” and for this reason, he decided to close up shop.

There’s a lesson for all of us here. As Joel Greenblatt has argued, value investing doesn’t work all the time, which is why it works. We should respect this, just as Buffett did– when the deals dry up, we should go fishing (or at the very least, look for bargains in other markets that are in a different stage of psychology/sentiment/valuation). Trying to make great long-term returns when valuations won’t support it is a fools game and more likely to end in failure.

A few miscellaneous notes

In the 1968 letter, Buffett referred to 10-12% as “worthwhile overall returns on capital employed”.

With regards to dividends, although Buffett always described the return of the Dow for each annual period inclusive of dividends earned, and although when describing his investment in Commonwealth he specifically mentioned that the company was not paying dividends, and although we know from an anecdote in The Snowball that Buffett was receiving substantial dividend checks from his partnership portfolios because his wife Susie accidentally through a few away one time, I noticed that Buffett makes no specific mention in any of the letters of the importance of dividends nor that dividends impacted his investment decisions or philosophy.