Friday, July 18, 2014

Essential Lessons From Ben Graham

I recently read Joe Carlen's book called "The Einstein of Money", a book on Ben Graham. The book was half bibliographical while the other half tried to explain his investing philosophy. It was a great read and I would recommend the book. 

I found myself looking back at the notes I made when I read The Intelligent Investor after I read Carlen's book. I would like to share some of the notes I made in this post. 

Buffett was absolutely correct in claiming that the book was "by far the best book on investing ever written." The principles advocated by Graham remains relevant today even though the first edition of the book was written in 1949. Buffett's quote in the preface proves this point: "To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights or inside information. What is needed is a sound intelligent framework for making decisions and the ability to keep emotions from corroding that framework." (preface 4th edition revised, Graham 2003) Hence successful investing is about following a disciplined approach and controlling one's own emotion from getting too euphoric when the markets are rising and from getting to pessimistic when markets are falling. Investor may not realize this fact: an investor's worst enemy is himself/herself. Investors should note that no matter how intelligent or diligent they are, they will fall prey to their own emotions, which is often much harder to control and difficult to correct. Graham was correct when he stated, "the investor's chief problem - and even his worst enemy - is likely to be himself. (The fault dear investors is not in our stars - and not in our stocks - but in ourselves." (p.8) 

Buffett said that chapter 8 and 20 were his favorites. I would add chapter 1 to the list. Therefore I hope reader will enjoy my notes for these chapters. 

Chapter 1: Investment versus Speculation 
An investment operation is one which, upon thorough analysis, promises the safety of principal and an adequate return. Operations not meeting these requirements are speculative (p.18)
The quote above is one of Graham's best quote on investing. Many investment operations are essentially speculations because they do not require a thorough analysis of the underlying securities to ensure the safety of principal and an adequate return. Many investors believe the key to make money is to forecast what the stock market, or any other financial market, will do tomorrow. These forecasting approaches, while popular, are not the right method to make money in the long run. Without an examination of the underlying security, any fancy method, such as using complex formulas, that claims to have the ability to generate high returns should be taken with a grain of salt.  

What is "thorough analysis", "safety of principal" and "an adequate return"? Graham defined "thorough analysis" as "the study of facts in the light of established standards of safety and value." This simply implies the detailed study of the underlying security (stock or bond) with a close attention to the risks and facts relating to the intrinsic value of the security. His definition of "safety of principal" is "protection against loss under all normal or reasonably likely conditions or variations." Therefore, investors should ensure that all risks of the investment are analyzed and the price paid for the security is attractive versus potential risks that may result in a permanent loss of capital. Finally, his definition of "an adequate return is "any rate or amount of return, however low, which the investor is willing to accept provided he acts with reasonable intelligence." Thus, investors must make sure their investments can satisfied the minimum required returns in the long run.  

For defensive investors, Graham warned that going after "hot" issues is speculative. Since defensive investors want to achieve a satisfactory result without much effort, they need to keep their investment operation simple. Graham suggestion that they should (1) purchase shares of well-established companies (e.g. S&P500 companies) or well-established funds. He also suggested the use of "dollar cost averaging" in order to limit the number of shares/fund units when prices are high and increase the amount of shares/fund units bought when prices are low. 

For enterprising investors, there are three pitfalls Graham warned against:

  1. Trading in the market: He referred to this activity as "buying stocks when the market has been advancing or selling them after it has turned downwards." In today's terminology, this activity would be called "momentum chasing" or "trend following". Graham concluded that investors' overall of success in trading in the market is very low.
  2. Short-term selectivity: He defined this method as "buying stocks of companies which are reporting or expected to report increased earnings or for which some other favorable development is anticipated." Graham warned this approach is dangerous because (1) the prediction of near-term events could be wrong or (2) the current price may already fully reflect or "discount" good events like upcoming earnings. 
  3. Long-term selectivity: This approach is about picking companies with unusual high growth in the future or picking stocks that are expected to establish a high earnings power later. The biggest problem in this approach is the selection of the right stocks that will do well even if an investor has found the growth industry. 
Graham instead gave the following suggestion for enterprising investors: 
To enjoy a reasonable chance for continued better than average results, the investor must follow policies which are (1) inherently sound and promising and (2) not popular on Wall Street (p.31) 

My translation: (1) boring, but sound, investment approaches (like value investing) that are ignored because it is boring as watching paint dry (2) must go against the grain

Chapter 8: The Investor's and Market Fluctuations

This is an important chapter to understand and it took me years to understand the content because the principle espoused in this chapter is truly "unconventional" compared other finance theories.

Graham discussed the difference between the pricing and timing techniques. I explained these concepts in my prior post. The former is about trying to figure out the intrinsic value of the underlying business (pricing) and buy/sell dependent on the variance between price and value. The latter point is about timing the market or stock prices in order to profit from those forecasts. As stated above, Graham did not believe in market forecasting or timing because it is very competitive and no one seems to make right forecasts consistently over time. It is almost impossible to do that.

Graham advocated the pricing technique but many investors may not feel comfortable with the approach because of the wrong attitude towards price fluctuations. All investors should read the following paragraph carefully:
Imagine that in some private business you own a small share that cost you $1000. One of your partner, named Mr. Market is a very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly. If you are a prudent investor or a sensible businessman, will you let Mr. Market's daily communication determine your view of the value of a $1,000 interest in the enterprise. Only in case you agree with him, or in case you want to trade with him... the rest of the time you will be wiser to form your own ideas of the value of your holdings on full reports from the company about its operations and financial position (p.204-205)
As I stated in my prior post on intelligent investing, investors should transact with Mr. Market only if it is favorable to do so. Most of the time, investors should ignore Mr. Market. He'll just come back with another quote tomorrow and never feel bad when you ignore him. When discussing Graham's Mr.Market analogy, Buffett said: "the market is there to serve you, not to instruct you." Far too often however, investors cannot resist looking at daily quotations and trying to make a few quick bucks by looking at price trends because they believe Mr. Market can give them good instructions. Instead of trying to profit from price fluctuations, investors should keep the following Graham quote in mind:
Basically, 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 operation results of his companies. (P.205) 

Chapter 20: Margin of Safety as the Central Concept of Investment 
Confronted with a like challenge to distill the secret of sound investing in three words we venture the motto, MARGIN OF SAFETY (p.512) 
I completely agree with Graham that the margin of safety principle is paramount for successful investing. Buying stocks near intrinsic or underlying value does not allow wiggle room if the appraiser has made a mistake. Therefore, an investor must purchase the stock at much lower prices than the calculated intrinsic value

On the margin of safety principle, Graham explains:
The margin of safety idea becomes much more evident when we apply it to the field of undervalued securities. We have here, by definition, a favorable difference between price on the one hand and indicated or appraised value on the other. That difference is the safety margin. The buyer of bargain issues places particular emphasis on the ability of the investment to withstand adverse developments.... If these [value stocks] are bought on bargain basis, even a moderate decline in the earning power need not prevent the investment from showing satisfactory results (p.517-518)  

Hence a margin of safety is needed to prevent negative outcomes of the future and  provide a safety cushion if the estimated intrinsic value is correct. The key here is buying dollar bills for 50 cents. 

Graham stated the importance of considering the price paid when assessing the margin of safety for any investment: 
The margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price and nonexistent at some still higher price. (p.517) 

The margin of safety principle is also applicable to bonds. A bond must meet the minimum coverage ratios, even in recession years, in order to qualify as an investment. Graham utilize both pre-tax and after-tax earnings coverage ratios, unlike most professionals who prefer using EBITDA coverage ratios. If Graham was still alive today, I don't think he would change his methodology since EBITDA coverage ratios overstate the cash generation capability of the business by not considering capital expenditures.

Conclusion:
Investment is most intelligent when it is most businesslike (p.523) 
While most investors believe the most profitable method of investing is predicting future prices, it is not true. Trying to outsmart countless other geniuses who are trying to do the same will not yield handsome results. Instead, readers should realize that stocks are fractional ownership of businesses and investors should realize that the best results will be realized when they think like business owners. Hence I completely agree with Graham that "investment is most intelligent when it is most businesslike." Buffett also agree with Graham's conclusion and have referenced the same quote in many of his annual letters, including the most recent 2013 letter.

I hope this post was useful to readers. If you haven't read The Intelligent Investor yet, I hope this post has convinced you to at least try reading it.


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Appendix (More Quotes from The Intelligent Investor): 


We draw two morals for our readers: (1) obvious prospect for physical growth in a business do not translate into obvious profits for investors (2) the experts do not have dependable ways of selecting and concentrating on the most promising companies in the most promising industries.  (p.7) 
Comment: Be wary of investing in the next "hot" industry. Even if you can guess the industry, picking the winners is extremely hard. Although investors may hear success stories of Facebook, Twitter, Linkedin etc., there must have been over thousands of social media company that failed for each one that succeeded.

We hope to implement in the reader a tendency to measure or quantify. For 99 issues out of 100 we could say that at some price they are cheap enough to buy and at some other price they would be so dear that they should be sold. The habit of relating what is paid to what is offered is an invaluable trait in investment (p.8) 
 Comment: The attractiveness of a stock is always dependent on the current price. At some price, it is cheap enough to buy and at some other price, it is so expensive it should be sold.

Buying a neglected and therefore undervalued issue for profit generally proves a protracted and patience-trying experience.And selling short a too popular and therefore overvalued issue is apt to be a test not only of one's courage and stamina but also the depth of one's pocketbook. (p.32)
Comment:  Buying undervalued securities requires a boatload of patience. Shorting overvalued stocks not only requires patience but also it requires a large amount of capital. Investors often forget the latter point and lose money shorting stocks that eventually collapsed.

Nearly all bull market had a number of well-defined characteristics in common, such as (1) a historical high price level (2) high price/earnings ratios (3) low dividend yields against bond yields (4) much speculations on margin (5) many offering of new common-stock issues of poor quality (p.193)
Comment:  Goods indicators Graham wrote on identifying overvalued markets. Intelligent investors do not try to time the market top or bottom. Nonetheless, if the market is overvalued, they should reduce current positions and raise cash levels.

A stock does not become a sound investment merely because it can be bought close to its asset value. The investor should demand, in addition, a satisfactory ratio of earnings to price, a sufficient financial position and the prospect that its earnings will at least be maintained over the years (p.200) 
Comment:  I believe many readers of the book overlooked the quote above and confused Graham's purchase of net-nets with his idea of buying a good business. In addition to selling near tangible asset value (tangible book), the companies under consideration should be selling at a low price in relation to its future earnings power, have a healthy balance sheet (low debt) and the earnings should remain stable.

The development of the stock market in recent decades has made the typical investor more dependent on the course of price quotations and less free than formerly to consider as a business owner (p.198)  
 Comment:  I believe this quote is more applicable to investors now than in 1972 when Graham wrote the 4th edition of the book. With the increased use of smartphones, investors have the convenience of checking prices no matter where they are. While technology has enriched our lives, I believe technology has also transformed many investors into speculators.

 The speculator's primary interest lies in anticipating and profiting from market fluctuations. The investor's primary interest lies in acquiring and holding securities at suitable prices (p.205)
Comment:  Graham identifies the correct and incorrect method of thinking about market fluctuations.

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