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.