Thursday, October 23, 2014

Book Review #16: The Intelligent Investor: Author: Benjamin Graham

Note: This is the 16th book in a series of 50 Books on Finance and Investment that I am planning to review. You can read the other reviews HERE

Quick Review
The 'Intelligent Investor' is an iconic book written by the Late  Mr.Benjamin Graham to guide the investors to invest prudently in financial markets by avoiding losses and generating adequate return on investment. The two words 'Intelligent' and 'Investor' have specific meanings in this book. ‘Investor’ is defined in this book by what she does, vis. engaging in Investment Operations. An ‘Investment Operation’ is one which, upon thorough analysis, promises safety of principal and adequate return. Investor should be ‘Intelligent’ to undertake investment operation. The term covers both IQ and EQ. An investor should have the IQ to learn, understand and apply the knowledge of finance, accounting, business and of course investing. An intelligent investor also require the EQ to be patient, disciplined and willing to learn. She should also be able to ignore the daily fluctuations in the market prices and to overcome the emotions of greed and fear that is so rampant in the general investment public. 

Intelligent investors understand that a stock certificate confers on them a stake in the business. Before investing they do a thorough analysis of the company - its financials, operations, management, book value and future prospects. Based on the above analysis they decide to invest in the company. Once they invest, their only action is to do regular review of the financials to ensure that the basic assumptions that led them to invest in the stocks have not (or will not) undergone any significant changes.

The introduction to the book delineates the purpose of the book as ‘to supply, in a form suitable for laymen, guidance in the adoption and execution of an investment policy.’ The text is for investors and not for speculators and traders who has a short term view of the market. The focus is on buying issues (both stocks and bonds) that are trading at a significant discount to the intrinsic value. Mr.Graham discourages the idea of buying stocks at any price.

The overarching theme of this book is Value Investing. That is not surprising, since Mr.Graham, along with his famous student Warren Buffet, are considered to be pioneers of Value Investing. You will read the following words very regularly in this book – Intrinsic Value, Bargain, Aversion of Loss and Margin of Safety- all of which are corner stones of Value Investing.

As mentioned above, the target audience of this book is the investor and not the speculator. The difference between an Investor and Speculator has been discussed elsewhere and is beyond the scope of this review. Mr.Graham has strategies for both the defensive (passive) investor as well as for the more enterprising (active) investor. For both class of investors, DI and EI, Mr.Graham recommends a mix of bonds and stocks with varying allocation between them. For DI, Graham recommends an allocation of 50:50, while for an EI, the recommendation is between 25:75, depending on the market conditions.

Since discovery of Intrinsic Value is the most important aspect of Value Investing, much of this book is directed at helping the investor calculate the same. The objective is to help the investor establish proper mathematical, mental and emotional approaches towards their investment decision. The emphasis is on measurement and qualification. The aim is to help the investor answer the question 'How much' a stock is worth.

Mr.Graham recommends that investors should buy stocks that are trading near their book value. The focus is on balance sheet and not on the income statement (earnings). As per Mr.Graham, a lay investor can make a creditable return on investment with minimum effort and capability. However to improve this attainable standard requires a lot of application. A little extra knowledge and cleverness without detailed application of mind can lead to losses.

The book tries to simplify portfolio investing, with a mix of leading common stocks and high grade bonds. As mentioned previously, getting beyond this require knowledge and temperament. While investing in market, an investor should know the difference between investing and speculating. She should also know the difference between the price of the stock and its intrinsic value. It is very important that she consider a share certificate not as a piece of paper, but as a part ownership of business. She should be aware that Share price can fluctuate significantly around the intrinsic value and intelligently use the concept of 'margin of safety' while buying shares. The importance of loss avoidance comes out in almost all the pages of the book.

Many of the points mentioned in this book has direct relevance to the Indian Markets. When Mr.Graham talks of a great company going through temporary crisis, one remembers the crisis that Infosys went through in the last one year with senior managers quitting en masse and stock market thrashing the stock. Now it has come back to become the darling of investors. Some other points in the book can be illustrated by other companies in the Indian markets. I have cited minimal examples from the Indian market. However, it is always subject to update.

Given that Indian market (US Markets as well) is in the cusp of a major bull run, this review could not have been more timely. While many of the stocks have run up a bit, there are still pockets of value in some sectors. And therein lies the advantages for the readers of the book. They should be able to avoid the mistakes that others make in the market by avoiding the stocks and sectors that have fully run up in their prices thereby offering investors little value. This book will also help them seek value that still exist in the Indian Markets.

This book is a difficult read. With important concepts hidden within deluge of prose and written in convoluted language, it takes the reader lot of effort to ‘take in’ this book. I have tried to help the reader by summarizing the key ideas of each chapter below. Having said that, no serious investor worth his bonds can afford not to read this book. After all which investor will want to accept that he is not ‘Intelligent’?

Chapter Summary

Chapter 1: Investment versus Speculation: Results to be expected by the Intelligent Investor
The entire focus of the book is on Investor. How do you define Investor? The book attempts to define Investor as one who undertakes 'Investment Operations'. An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. The above definition suffers from a paradox. If you invest when the market is down and stock prices are low, you are considered to be speculating as per market parlance. However as per Mr.Graham's definition, when you do that you are investing. On the other hand, if you buy shares during market highs the market considers it as investing while Mr.Graham considers it as speculating.
As per Mr.Graham, 'Intelligent Speculation' is as important as 'Intelligent Investing'. Examples of unintelligent Speculation include, one, speculating when you think you are investing, two, speculating seriously without proper knowledge and three, risking more money in speculation than you can afford to lose. Mr.Graham advises the investor to keep a separate speculation fund.
A defensive investor should have a good mix or quality stocks purchased at reasonable prices and high grade bonds.  If you are a defensive investor without much knowledge (it is another paradox, if you are reading this book, you are already an informed investor and you have knowledge of stock investing. This book is not for novices) Mr.Graham suggests three options. Mutual Funds, Investing in stocks directly through experts and dollar cost averaging. All these are explained in later chapters.
Since the enterprising investor spends more time and energy into here investing, she expects a better return (+5%) than that of a defensive investor. Mr.Graham advises that an enterprising investor focus first on loss avoidance. She should have a clear idea of the options that could lead to success. In her quest for better returns, the enterprising investor should neither trade in the market nor pay too much for growth, either short-term or long-term

Chapter 2: The investor and inflation
The conventional wisdom considers stocks as a hedge against inflation. In this chapter Mr.Graham debunks this theory. According to him socks are inflation hedges only if purchased at the right value. He points that over the long-term corporate earnings have not beaten inflation. However corporations are trying to increase the return on equity by taking on more debt which is a risky strategy in times of inflation. This is because, as the interest rates go up, the Interest payments go up exponentially while the value of the principal goes down. Author is not in favour of the other conventional inflation hedges including Gold since they have not been effective historically  as an inflation hedge.
In his commentary to the chapter, Mr.Jason Zweig, takes the discussion further. He talks about what is known as 'Money Illusion', the common idea that a two percent gain with four percent inflation is considered to be better than negative two percent return when the inflation is zero, even though both have the same impact on the purchasing power of the individual.
History shows that the market has performed badly both when the inflation was falling (as is happening now) and when the inflation goes above a particular limit. This leads us to the conclusion that there is an inflation sweet spot where the markets will go up.
In Mr.Graham's time, there were no vehicles to handle inflation. Since then, the availability of instruments like TIPS (Treasury Inflation Protected Securities) and REITs (Real Estate Investment Trusts) has provided investors with tools to fight inflation.

Chapter 3: A century of stock market history
This chapter discusses the lessons learned from more than a century of stock market history. Some of the lessons learned are, one, markets have fluctuated wildly in the past and will fluctuate in future. An investor should not get scared when the markets are falling and should not become hysteric when the markets are rising. Two,a strong rise in market invariably portends to an impending fall. Three, serious money is made in the market when the stocks are purchased when they trade at low valuations and not when they trade at highs. Four, over the long-term, the ratio of bond yields to stock yields have moved in favour of bonds. What does this mean for the investor? Given the same macro-economic situation, bond prices have risen more than the stock prices over the long-term. This means that the portfolio of an intelligent investor should contain some proportion of bonds (Mr.Graham recommends 50:50 allocation between stocks and bonds). Five, Mr.Graham strongly discourages the investor from investing based on hot tips. By the time an investment opportunity becomes a hot tip, the price would have run up significantly.

Chapter 4: General portfolio theory: The defensive investor
Based on the efforts spend to learn investing, the investors can be divided into two groups. A defensive investor neither has the inclination nor the time to learn about investing. An enterprising investor on the other hand spends a lot of time learning about investing concepts and has a knowledge about various investment tools available and the strengths and weaknesses of each. This chapter focuses on the defensive investor. Mr.Graham advises the defensive investor to invest in equal proportion of stocks (of big companies with earning stability and dividend history) purchased at low valuations and investment grade bonds. The suggestion is to start off with a 50:50 allocation in both the above. Later on, at regular intervals, adjust the allocations so as to bring the allocation to original 50:50. While it is a mechanical approach, it is very difficult to practice since it expects the investor to sell the winners and invest in the laggards. The chapter ends with a discussion on various debt instruments available for the investors.
It should be noted that during the time Mr.Graham wrote this book, the options available for defensive investors to invest in stocks was limited. The advent of Index Funds have provided the Investor with low-cost, low effort opportunity to take part in the stock market. In addition, we also have Index ETFs which further facilitate investment in stock market. In addition, nowadays investor can also participate in bond market by investing in high quality bond funds brought out by the mutual funds.

Chapter 5: The defensive investor and common stocks
There are two criteria that a defensive investor should use while selecting stocks. One is protection against inflation and second is to improve the returns of their portfolio. The key to getting better returns is not paying more than the intrinsic value for the stocks. While selecting stocks to buy, the defensive investor should use the following four rules propounded by Mr.Graham. One, she should have a well diversified portfolio of stocks. Stock concentration is antithetical to a defensive investor. Two, buy shares of large companies. Avoid small companies altogether. Three, the companies should have a record of continuous dividend payment. Four, have an upper limit of 15 times earnings for the the stocks that is bought. This means that the investor should stubbornly avoid growth stocks.
One simple method a defensive investor can use to get the better than average returns in the stock market is 'Dollar Cost Averaging' where she invests a fixed amount regularly in buying the stock. This will ensure that the investor gets more number of stocks when the prices are low.
One interesting idea being made in this chapter is about the definition of the word risk. The standard definition defines risk in terms of fluctuations in stock price. However as per Mr.Graham, since price fluctuations are a normal course in the stock market, the only risk is the actual loss in value over the long-term.

Chapter 6: Portfolio policy for the enterprising investor: Negative approach
The focus of this chapter is on the types of instruments that an enterprising investor should avoid. Like a defensive investor, an enterprising investor also should have allocations in both stocks and bonds. An enterprising investor should avoid the following. Preferred stocks, Junk Bonds (Unless trading at a significant discount), Foreign government bonds, all kinds of new issues including convertibles, preferreds, common stocks without long-term earning growth and IPOs.
The last instrument (IPOs) is interesting. An IPO is always marketed highly and is issued under favorable conditions. This is designed to make money for the initial investors in the market. A retail investor always end up losing in IPOs. If the quality of issue is good, the investors will not get allocation in the IPO. If the quality of issue is bad, the retail investor will end up getting the full allocation. In the former case, the investor's money is blocked and in the latter case the investor is left with a dud. (I have personal experience of getting full allocation of duds that I purchased through IPO and not getting allocation of good stocks that come up in IPO).

Chapter 7: Portfolio policy for the enterprising investor: The positive side
For an enterprising investor (EI) Mr.Graham suggests an allocation anywhere between 25:75 for stocks and bonds depending on the market conditions. Mr.Graham suggests the following special opportunities that exist in bonds. One, various tax-free and taxable bonds guaranteed by US Government, two, bonds issued by municipal corporations backed by lease payments from large corporations and three, lower quality bonds trading at bargain prices.
For stocks, an EI can consider the following strategies.
  1. Buy low, sell high
  2. Select growth stocks
  3. Bargain issues of all types
  4. Special situations
Lets look each of them in detail.
1. Buy low, sell high: This strategy is difficult to practice on a regular basis. However, in specific cases, the EI could increase his allocation to stocks to very close to 75% especially if the overall market is trading at very low levels.
2. Growth stocks are those where a significant part of the price of the stock is based on the markets expectation of future growth potential. This makes these stocks inherently volatile. Due to this volatility, the prices of growth stocks tend to fluctuate wildly. While Mr.Graham avoids 'Growth' stocks, he recommends that an EI can invest in these when the price comes down significantly. (Havells is a good example. In the last one week, its price has fallen from 330 to 260)
3. Bargain Issues: Mr.Graham defines bargain issues as those trading at less than 50% of their intrinsic value. There are two situations where market can create bargain issues. First is large companies going through a temporary crisis. Since large companies with stable earnings growth tend to be inherently volatile (there will be more demand on these stocks, hence the price could move away from intrinsic value making these stocks volatile), a temporary crisis could bring down the price of these stocks to bargain level.
Second is bargain stocks. A stock can become a bargain due to three reasons. One, Currently disappointing results despite long term earnings stability (Infosys about a year ago, this is also an example of a large company going through a temporary crisis), two, protracted neglect by the market (NTPC and many of the PSU Banks currently) and three, inability of the market to evaluate its true earnings picture. An easily identified bargain stock is one that is trading below its net working capital after accounting for all prior obligations including long-term debt. This means that you are getting the company and its assets for free.
A special case of Bargain issue is secondary stocks (also called Small Cap and Mid Cap Stocks). Since markets tend to undervalue secondary stocks, bargain can be available in this sector. There are six reasons why investing in secondary stocks can be good for the portfolio. First, their dividend yields tend to be high due to low purchase price. Second, reinvested earnings are high in comparison to the price paid and will ultimately affect the price. Third, a bull market tend to raise the price of these issues offering good return. Fourth, even in normal markets a continuous price adjustment happens which will increase the price of these stocks. Fifth reason is that the factors that caused undervaluation may get corrected over a period of time and Sixth is that these companies are good targets of acquisition which leads to value discovery.
4. Special Situations. These include arbitrages, buying into troubled assets, buying into small companies that are getting acquired etc. These are for really savvy investors.
Mr.Graham leaves the last section of the chapter to deliver some blunt message. There are only two categories of investors. Defensive or Enterprising. Since an Enterprising Investor need to devote time and efforts into their investment efforts (for most of them it is full time work, READ HERE), most of the readers of this book will fall into the category of defensive investors. These investors may have different levels of knowledge about finance and investments. However, if they cannot devote time to their investment effort, they are still classified as defensive investors and should limit their portfolio to 50:50 allocation between stocks and bonds.
(It is sad. I spent a lot of time reviewing this chapter only to see that I am a defensive investor in the end and most of the points discussed here are not relevant for me. On the plus side, this chapter helps me know what to avoid. In life as in stock market, knowing what to avoid is as important as knowing what to select)

Chapter 8: Investor and Market Fluctuations
Over a longer market cycle, an investor's portfolio value is bound to fluctuate, with bond prices fluctuating with lower volatility and frequency than stocks.
Investor can profit from these fluctuations in two ways, Timing and Pricing. In timing, you anticipate the direction of market movement and buy and sell as appropriate. In pricing, you buy a stock or bonds when they are trading sufficiently below their fair value and sell the same when they trade above their fair value. A simple way of pricing is to ensure that you do not pay too much for the stock, by buying them at a low P/E and a lot P/B.
Timing is for Speculators and Pricing is for Investors. Investors should opt for timing the market only if it also coincides with Pricing, ie. if he can buy the stock at a sufficiently lower price to offset the loss of his dividend income.
Mr.Graham decries the 'Buy Low Sell High' approach (One can't predict if either the lows or the highs have been reached, it ultimately ends up as a Timing approach) and the Formula Plans, where one takes investment action based on a specific formula. It has to be noted that Mr.Graham had recommended 50-50 allocation based formula approach for a defensive investor.
How do investor handle long term market fluctuations? How does he know if the bull or bear market has ended? The best approach is to buy stocks that are trading very near their book values and which has good earnings potential, a strong Balance Sheet and a good P/E ratio. Mr.Graham points to the fundamental contradiction in Stock Market. The more successful a company, the more divergent is its market value to the book value, the less certain the basis of calculating the book value and  and hence more volatile will be its share price (Infosys is an example)
In this Chapter, Mr.Graham introduces his famous character, Mr.Market.
Should investor listen to Mr.Market? Yes he should, however his investment decisions should not be influenced by Mr.Market.
Market fluctuations have only one meaning for a wise investor. They enable him to buy when the prices are low and sell when the prices are high.

Chapter 9: Investing in Investment Funds
Mr.Graham recommends Investment Funds (aka 'Mutual Funds') as an option for a defensive investor. Different types of Funds: Open Ended-,Close Ended, Income-Growth, Load-No Load, Equity-Debt-Balanced etc. In this chapter he addresses three questions. One, How can investor ensure better than average returns by choosing the right funds? Two, If One is not possible, how can he avoid funds that will give him worse than average returns? Three, Can he make an intelligent choice between different types of funds?
Why should an average investor invest in Mutual Funds? For an average investor, Mutual Fund returns are traditionally better than returns from direct stock purchases. Also, if an average investor is not temperamentally suited for direct stock investing. If he starts investing in Stocks, he could end up as a speculator.
To identify the best funds, the investor often relies on past performance as a proxy for future performance. Mr.Graham says that evidence for this approach is not clear. Ideally, an investor can compare the performance of various funds provided market has not run up a lot. Author also points out that since most of the investment funds perform same as the market, if not worse, it is very difficult for an average investor to find funds that perform better than average. Here Mr.Graham seems to be making case for index investing.
This chapter also points to the difficulty faced by a reviewer. Having informed early in the chapter that he will address three question, the reviewer is justified in expecting direct answers to the questions in the rest of the chapter. The answers, if at all, are presented in a very roundabout way. For example,
For example, Mr.Graham mentions that by investing in a set of Close Ended funds trading at 10-15% discount to the NAV, an investor can outperform most of the Open Ended Funds. The question is if the average investor has the capability to do that level of analysis.
The Chapter rounds off with a short note on Balanced Funds. As per the author, a better approach to buying a balanced fund is to buy an all Stock Fund and buy treasury bonds directly from market to complete the bond part of the portfolio.

Chapter 10: Investor and his advisers
There are three main groups of advisers. Investment Councils, Financial Services and Brokerages. Investment Councils include mutual funds who give advice to and invests on behalf of the investors. This is useful for Defensive Investors who do not have time or inclination to invest on their own. Financial Services give advise and information on Stocks and Broader Market and expects the investor to invest. Investors use Brokerages to invest in stocks by paying  a commission. Brokerages also provide information on specific stocks. It is important for the investor to know his risk profile before approaching any of the advisers.
In his commentary to the chapter, Jason Zweig, provides the reader with a set of signals to show if you really need an adviser. These include, big losses of >40%, a chaotic portfolio, and major changes in your life situation. The commentary also provides guidelines in how to identify good advisers and also the personality traits and temperaments of a good investor.

Chapter 11: Security Analysis for the lay investor
Security analysis is the process of analysing the past, the present and the future prospects of a security issue. The ultimate outcome is to identify the 'Investment Worthiness' of the issue, Safety of the issue of bonds and preferreds and intrinsic value of an equity
Paradox of analysis: When the value is highly dependent (high P/E stocks) on Growth Projection rather than past performance, the mathematical analysis become imprecise.
When interacting with a security analyst, a lay investor should be able to evaluate the soundness of the analysis.
Key ratio to consider while analysing Corporate Bonds is Interest Cover (EBIT / Interest Expense) and for Preferred Stocks is 'Preferred Dividend plus Bond Interest' cover (EBIT / Preferred Dividends plus Interest Expense). Other factors to consider are Size of the Enterprise (bigger the better, Debt / Equity Ratio and Debt / Assets ratio (both lower the better)
For valuing the stocks, Mr.Graham suggests forecasting the future earnings and discounting the same by a factor. The factor should consider General Long-term Prospects, Management Quality (useful if there has been a recent change in management, Financial Strength and Capital Structure (availability of Surplus Cash is a big plus), Dividend record and Current Dividend Rate. Since historical information will not be available for growth stocks, Mr.Graham suggests a formula to value the same. The formula is Current (Normal) Earnings X (8.5+(2 X Expected Annual Growth Rate)). For example, if the current Earnings per share is 4 and the expected annual growth rate is 15 % Per Year, the Value is 4 X 38.5 = 154.
Mr.Graham rounds off the chapter by discussing the 'Two part appraisal process'. First step is to identify the 'Past Performance Value'. Having determined it, the next step is to adjust it to future growth potential. The second step can be done using a formula that considers Profitability, Stability, Growth and Financial Position.
In his Chapter Summary, Jason Zweig gives the readers a few more criteria to identify companies where one should or should not invest in. For example, one should avoid companies that are deeply in debt, or is a 'Serial Acquirer' or if relies on one or a few customers for its business. On the other hand, one should look for companies with a 'wide moat' (a competitive advantage), or if it spends money on R&D to build business. While it is difficult to evaluate the quality of management, one can do so by reviewing the past financial reports and see if the management has done what it had committed to do and it its accounting policies are transparent. When it comes to Financial Strength and Capital Structure, one should look for Stock Options Accounting, Interest Cover and Dividend History. Look at the buyback history of the company to see if it has used market lows to buy back the shares rather than buying them back when the share prices are at their peak.

Chapter 12: Things to consider about per share earnings.
There is a tendency for the lay investor to give a lot of importance to Earnings Per Share (EPS) data. The financial media tend to focus on EPS Growth and the investor could get carried away by all this brouhaha. EPS numbers are very easy to manipulate. Some of the obvious signals of EPS miscommunication are the difference between Normal EPS and Fully Diluted EPS (latter is more significant), presence of special charges which are not reflected in EPS numbers, sudden change in depreciation method, change in inventory valuation method from FIFO to LIFO or vice versa, reduction in Income Tax Liability on account of past losses (this will tend to inflate EPS) etc, Additional signals from recent examples include declaration of Proforma EPS, Mismatch between Revenue Recognition and Cost Recognition (Former is done early and latter is done later), regularity of Inventory write offs etc.
How can the lay investor handle this manipulation? One is by being aware of the same. Another way is to consider the Average of EPS for the past 3 years or 7 years, Another approach is to compare the current EPS growth rate to that of the same period 10 years ago. These comparisons will give an indication to the investor about the veracity of the EPS number.

Chapter 13: A comparison of four listed companies
In this chapter Mr.Graham illustrates the application of the concepts that were discussed in the previous chapters by analysing the financials of four companies listed in NYSE. The companies are ELTRA, Emerson Electric, Emery Air Freight and Emhart. He analyses the following performance elements: Profitability, Measured by the ratio Earnings to Book Value, Stability, measured by looking at the maximum decline in EPS in any one of the previous 10 years as against the average of preceding three years, Growth in EPS, both 10 year and year on year, Financial Position, measured by Current Ratio, Debt to Equity ratio and 'Dilution', Dividends, measured as history of uninterrupted dividend payout and finally Price History, measured by 30 year high-low data.
Author rounds off the chapter by enumerating seven statistical requirements that a stock must meet to be included in the portfolio of a defensive investor. They are:
1. Adequate size
2. Sufficiently strong financial condition
3. Continued dividend for at least the last 20 years
4. No earnings deficit in the past 10 years
5. 10 year growth of at least 30% in per share earnings
6. Price of stock no more than One and Half times net asset value
7. Price no more than 15 times the average earnings of past three years.
All these point will be elaborated in a latter chapter.

Chapter 14: Stock selection for the defensive investor
In this chapter, Mr.Graham elaborates the 7 points mentioned in the previous chapter. In short,
1. Adequate size: Sales should be more than $100 Million (Approximately 600 Crores) for an industrial company and assets more than $50 Million (300 Crores) for a public utility
2. Strong financial condition: Current Ratio of at least 2 and Debt  to Net Current Assets Ratio less than 1.
3. Earning stability is self explanatory. Some earning for common stock in each of the previous 10 years
4. Dividend Record: Uninterrupted for the last 20 years
5. Earning Growth of at least 30% in the last 10 years
6. Price to Net Asset Value not greater than 1.5
7. P/E ratio of less  than 15. (PE * PB Should not be greater than 22.5)
There are two approaches to stock picking: In Predictive (Projection or Qualitative or Growth) approach the focus is on evaluating the future potential of growth in EPS. In Protective (Quantitative or Value) approach, the focus is on safety of the principal. Predictive approach looks for future growth in economy, Industry growth, expected new product launches, expected changes in technology and customer behaviour, quality of management etc. Protective approach restricts itself to analysing the past performance of the company through analysis of financial data and forms a reasonable opinion on the future prospects of the company.

Chapter 15: Stock selection for the enterprising investor
The chapter starts off with Mr.Graham saying that it is difficult for an expert to beat the market. He suggests two reasons for the same. One, if the current stock price contains all the information related to the stock any fluctuation in prices will be random and speculative in nature and cannot be predicted through analysis. Two, it is possible that analysts seek out industries and companies with good prospects and their prices would already have run up and hence it is difficult to get above average returns on those stocks.
Having said that, an enterprising investor can identify situations where he can beat the market by investing in beaten down sectors and stocks and wait for the market to discover their value. In addition, there are other 'mechanical' opportunities in the market like arbitrages, liquidations, related hedges, Bargain Issues trading below their net current asset (working capital) value etc. If you are asked to identify a single criteria for identifying issues that could give better than average returns, Mr.Graham has identified two such. One is to buy Index Companies at trading at low PE multiples and Two, buy a diversified group of stocks selling under their net current asset value.
One key suggestion for the investor is to stick to quality stocks (Mr.Graham has already identified seven criteria for identifying them). Do not buy low quality stocks unless they are bargains.
The chapter ends with a brief description on 'Special Situations' which the enterprising investor can take advantage of.
In the commentary to the chapter Jason Zweig provides a formula to calculate ROIC (Return on invested capital) which is a better measure than EPS
ROIC = Owner Earnings  /  Invested Capital
Owner earnings equal,
Operating profit
plus depreciation
plus amortization of goodwill
minus Federal income tax (paid at the company's average rate)
minus cost of stock options
minus "maintenance" (essential) capital expenditure
minus any income generated by unsustainable rates of return on pension funds
and where Invested Capital is equal to:
Total Assets
minus cash, short term investments and non-interest bearing current liabilities
plus past accounting charges that reduced invested capital

Chapter 16: Convertible issues and warrants
Ideally both the investor and the company should benefit through Convertible issues. Investor will get a steady return with a potential to participate in the future growth of the company. Company will get funds at a lower rate. However, this is not the case usually. In his quest for conversion privilege, investor gives up on quality, yield or both. The shareholders of the company lose out due to dilution effect. Since shareholders end up losing, convertible issues usually show poor investment quality and companies use this as the last resort.

Chapter 17: For extremely instructive case histories
The chapter discusses case studies of four companies that went through bankruptcies and try to see how detailed analysis based on the lessons discussed in this book would have sensitized the investors of the impending loss. First company analysed is Penn Central. A careful analysis of the financials would show that the company's interest cover was around 2 (Mr.Graham's recommendations is 5 for public utilities), the company had not shown any income tax expenses in their books for years since they were using the carried forward tax loss, there was undeclared 'special charges' which were not considered for EPS calculation.
The second company discussed is Ling-Temco-Vought Inc. When analysing this company, the analysts missed the fact that the company had dumped all the expenses and charges into one bad year so as to make the future years look good. In addition, the company had taken a lot of debt from banks who, did not do a clear due diligence. Also, in 1998 the value per share of the company was shown to be 77 dollars but if you remove the preferreds at full value and exclude the good will items and the bond discount 'asset', the value would have come down to 3 dollars.
The learnings from the remaining two case studies, NVF takeover of Sharon Steel and AAA Enterprises are the same. Use of dubious accounting practices, incompetent analysts who botched up the analysis, speculative investors who hysterically purchased the stocks at the bare news of profit (even though they were cooked up)
Towards the end of the chapter, Mr.Graham decries the habit of the speculative public to buy anything at any price so long as there is some 'action' in the stock. The tendency is to buy the 'Flavor of the day' kind of issues irrespective (despite) the negative financials, very high valuation and the overall trend in the market.

Chapter 18: Comparison of eight pairs of companies
The chapter compares the performance of eight pairs of companies over a three year period from 1968-71. Mr.Graham convincingly argues that in stock markets the same mistakes are repeated. Investing based on perceived 'actions', investing based on momentum, investing in over valued stocks, accounting gimmicks - like special charges, hiding period expenses, loading all the negative news to one bad year etc, excessive debt, growth through acquisition...the list is endless. The lesson learned is that the age old principles of prudent investing are still valid. An investor who buys based on value will still make money. A buy and hold strategy will make money over long term than a frequent trading strategy. Paying more for past performance and less for future performance is still the best investment strategy. The sad fact, as pointed out in the commentary to the chapter, is that the as time passes, we find more and more ways to lose money by following risky investment strategies.

Chapter 19: Shareholders and Managements: Dividend Policy
Mr.Graham is a strong proponent of Shareholder Activism. However he also realizes that an individual shareholder or a small group of shareholders cannot do much to change the behaviour of the management. By Shareholder activism Mr.Graham means both strengthening good management and removing weak management.
Mr.Graham also sees that the new trend of poorly performing companies being subject to 'Take Over' could force them to improve the quality of their management. There are arguments in favour of a regular dividend payout. Key argument is that many shareholders plan their annual budgets expecting a steady dividend. Over the years Mr.Graham sees a trend of companies reducing and even withdrawing dividend payout and shareholder acquiescing to this. Companies should be allowed to do this only if they can convincingly demonstrate that they can reinvest the retained earning to produce returns above their cost of capital. This is a test that most companies fail. Mr.Graham also talks about two examples, one where the company's share price went up with increasing dividends and the other where the reverse happened. Companies also pay the shareholders by issuing Stock Dividends (called Bonus Shares in India). While issue of such shares do not impact the overall wealth of the shareholder, Bonus Shares is a tax efficient way of distributing excess wealth.

Chapter 20: "Margin of Safety" as the central concept of investment
Margin of Safety is the cornerstone of  all investments. When investing in a corporate bond, adequate interest cover coupled with low Debt to Equity acts as a margin of safety. When investing in stock, the excess of expected returns from them over the returns from high grade bonds will act as a Margin of Safety. Dollar cost averaging mentioned earlier is a method of ensuring adequate safety for the investment. Since Margin of Safety is effected at the time of purchase of shares, it is important for the investor not to pay too much for a specific stock in comparison to its earning and book value. Mr.Graham also points out that significant risk to the investor, especially in a bull market, arises from purchasing stocks of low quality.
Can we measure the Margin of Safety of a growth stock. Mr.Graham's answer is yes. If the assessment about expected future price is arrived at after a detailed review, that acts as a margin of safety. What about other investments like junk bonds, secondary issues etc. According to Mr.Graham if the price of the issue is low enough to create a margin of safety, that issue becomes an investment opportunity. The caveat is that these investments should be restricted to enterprising investors.

The key point in Postscript is how Mr.Graham went against all his beliefs discussed in this book when he invested in Geico. When the rubber hit the road, when he had to practice what he preached in this book, Mr.Graham behaved just like a normal speculator.I am not saying this. Here I am quoting from the book, "in fact it did so well that the price of its shares advanced to 200 times or more the price paid for the half interest. The advance far outstripped the actual growth in profits and almost from the start the quotation appeared much too high in terms of the partner's own investment standards. But since they regarded the company as a sort of 'Family Business' they continued to maintain a substantial interest of shares..." (Italics mine). 

Thursday, October 9, 2014

Book Review #15: The Warren Buffet Way: Author: Robert G Hagstrom

Concepts: Circle of Competence, Moat, Owner's earnings

Quick Review

If you are a savvy and knowledgeable investor who want to augment your investing skills by learning from the expert practitioners, then this book is for you. If you are not, and still want to invest, then I will suggest index investing.

The operative part of the book 'The Warren Buffet Way' consists of three themes. The first theme deals with the various tenets followed by Mr.Buffet for identifying potential investment opportunities. Mr.Buffet follows 12 tenets grouped into four parts vis. Business Tenets, Management Tenets, Financial Tenets and Value Tenets. These tenets act as guiding non-negotiable principles that he uses to evaluate companies and businesses. He focuses on business that are simple and easy to understand, with high level of operational consistency and managed by exceptional talents with high level of integrity. Unlike other analysts who focus on Earnings Per Share as a measure of business valuation, Buffet focus on 'Owner's Earnings'. The key difference between these is that while the former focuses entirely on the Profit and Loss Statement, the latter also looks at the impact of Capital Expenditures (Balance Sheet Item) on the Overall Earnings. And finally, the objective is to buy businesses that are trading at a discount to the intrinsic value giving him a margin of safety.

The second theme looks at how an investor should build one's portfolio. Traditionally one of the two approaches is followed. First one is the Value Approach. A follower of this approach will will identify companies that are trading at deep discount to their intrinsic value expecting that the market will ultimately find the true value of the company. Growth Investing, on the other hand will try to identify companies that are in Growth Sectors and invest in companies in those sectors hoping to run with the growth. 

Both these approaches have their advantages. However the problem with both the approaches is that they place excessive focus on the current market price of the company and less focus on the future business potential. Even when you are investing in a potential growth opportunity, you have to pay attention to the market price. There is no point in paying excessively high price for a growth opportunity. In the same way, there is no point in buying a company simply because it is trading at very low valuations. 

Buffet follows a new approach called Focus Investing. The first step in focus investing is to create a concentrated portfolio of about 5-10 Stocks that are trading at substantial discount to intrinsic value. Once you identify such a stock, next step is to invest significant amount in that stock. Once you have completed the above steps, wait for market to discover the fair value. The holding period is long-term, 10 years to forever, and the daily price fluctuations are ignored. Since the initial research was thorough the portfolio risk is minimal.

The final theme in this book relates to behavioral aspects of investing. The chapter describes a few habits, also known as Heuristics, that can impact the portfolio returns of an investor. These have been extensively covered in the book by Mr.Parag Parekh.

That this book is a bestseller is a testament to its value and the interest that Mr.Buffet elicits among informed readers. The clarity and lucidity in this book is an added bonus. 

Chapter Summary

Chapter 1 discusses the initial years of Warren Buffets career as an investor. In the years from 1955 to 1969, Mr.Buffet converted a $100 of initial capital into 25 Million Dollars. On the way he purchased Berkshire Hathaway, a textile company, and converted that as his holding company for his market investments. From 1970 till today, he has outperformed the Dow Jones index for most of the years. Mr.Buffet invests within his 'Circle of Competence', list of business that he can understand. He is on the lookout for stocks that are trading at significant discount to intrinsic value and when he finds such company, he invests significant amount.

In his investment journey  Buffet has been influenced by experts like  Benjamin Graham, Charlie Munger,Philip Fisher and John Burr Williams. Chapter 2 covers the lessons that Buffet learned from the masters. From Graham he learned the concept of Value Investing. This involves buying companies that are trading at deep discount to the intrinsic value and wait for the market to realize the value. Graham also taught him to manage his emotions while investing in Stock Market. From John Burr Williams, he learnt the conceptual approach to identifying the intrinsic value. The approach called 'Discounted Cash Flow Model' consist of discounting the future cash flows at a risk adjusted discounted factor (Buffet used 10% as the discount factor). Charlie Munger taught Buffet how to identify businesses with significant growth potential and not to lay excessive focus on current valuation. Philip Fisher taught him the importance of keeping a tight portfolio and deeply understanding each stock in the portfolio.

Chapter 3 details the evolution of Berkshire Hathaway. This was a textile company that Buffet purchased in 1965. Over the years this has become a holding company for Buffet's investments. He closed down the textile business in 1985. Starting in 1967 with the purchase of GEICO Buffet has added many other insurance companies to his business portfolio. The attraction for insurance companies is the steady cash flow that they produce, a cash flow that Buffet uses to finance his investment activities. Cumulatively these companies produced about 44 Billion in cash in 2003. Buffet buys both businesses as well as invests in stocks of companies.

Over the course of his career, Buffet has purchased numerous business. He has also purchased the stocks of many companies that he has held for long-term. Chapter 4 deals with the approach that Buffet takes to his investment decisions. Buffet's approach to buying a business or investing in stocks of a company is the same. Look from the perspective of the owner of the business. He does the same due diligence to stock purchases as he would do for buying a business. He looks for businesses with consistent operating performance history, with sound management and which are trading at discount to fair value. Due diligence also involves considering the operational functions of the company - its products and services, raw material expenses, plant and equipment, capital expenditure requirements, inventories, receivables and need for working capital.

Chapter 5 details the first of the four tenets, vis. Business Tenets which looks at the basic characteristics of the business itself.. Buffet only invests in companies within his area of financial and intellectual understanding. He calls it his  'circle of competence'. The business should be simple and easy to understand. Since Technology stocks are outside his circle of competence, he avoided the sector altogether. He looks for businesses with consistent operating history. Not for him are those companies that do well in one quarter and badly in others. Same is the reason for avoiding turnarounds. He would rather wait for business to turnaround and produce consistent performance before investing in them. Finally he looks for companies with favorable long-term prospects. Buffet looks for companies with has a product or service that is widely needed, whose products do not have close substitutes, in an industry which is not regulated and an industry that has a strong barrier to entry. Buffet calls it the 'Moat'. The larger the Moat, the better the long-term prospects are of the company.

Buffet realizes that an exceptional company is led by an exceptional management. Chapter 6 considers the tenets that he considers while evaluating the management of the company. He looks for rationality in the way management makes capital allocation decisions. Faced with excess cash, a rational management makes either of the two decisions. One, invests in opportunities that can produce returns in excess of cost of capital. This will increase the shareholder value.Two, if such opportunities are not available, return the cash to shareholders in the form of dividends or share buyback (which is the preferred option). Buffet places a high premium on managements that are candid with the shareholders in terms of the financial performance of the company as well as in sharing the failures as well as successes and in admitting the mistakes committed.  When it comes to business decisions, many managers tend to 'follow the herd' or as Buffet calls it 'Institutional Imperative'. For example, the company makes risky investments because competitors are doing that and are getting away with it. Management's ability to resist the institutional imperative is the third tenet that Buffet follows along with test for rationality and evaluation of the candor. The chapter ends with a discussion on how one can identify a great management. One of the suggestions is to go back to the financial report of the past and look for effective implementation of strategies laid out in the past. Another check is to look for strategic consistency. Current strategies should seamlessly dovetail with the past strategies.

Chapter 7 looks at the Financial Tenets. Unlike other analysts Buffet do not give a lot of importance to Earnings Per Share calculations.His focus is on consistent growth in Return on Equity. To do this calculation, Buffet removes all the abnormal and one off items from the returns and considers the impact of asset base and inflation while calculating the equity base. Unlike traditional approaches that follow Cash Flow as a proxy to company's earnings, Buffet uses 'Owner's Earnings' which is calculated by reducing Capital Expenditures and Working Capital Requirements from the Cash Flow calculations. Consistent or increasing profit margins is another important parameter to be considered. Buffet looks for companies where cost reduction is a habit rather than a project. It is very clear that companies cannot increase profit margin on a regular basis without focusing on cost cutting. Finally, Buffet looks for companies that create at least one dollar of market value for one dollar of earnings retained. A company can achieve this only by generating returns at least equal to the cost of capital on every additional dollar of retained earnings.

Quote: "A manager forced to make the numbers will at some point make 'up' the numbers"

Chapter 8 covers the last of the four tenets, the Value Tenet. To calculate the value, Buffet uses the Discounted Cash Flow Approach. In this approach the value of a business is calculated by discounting all the future cash flows ('Owner's Earnings') by an appropriate discount factor. Buffet normally uses the interest rate on 30 Year Government bonds as the discount rate. Since he looks for companies with consistent operating history and high visibility of cash flows, he do not use risk premium in the discount rate. The second aspect to the value tenet is the price that you pay to buy the stock. Buffet looks for companies trading at significant discount to the intrinsic value so that a margin of safety is established. More about Buffet's Valuation Methodology is discussed in THIS BOOK

Chapter 9 focuses on Warren Buffet's investments in Fixed Income Securities. Three types of securities are covered. They are Bonds, Arbitrage and Convertible Preferred Stocks. By 2003, about 30 percent of Berkshire's portfolio comprised of Fixed Income Securities. Buffets devotes the same attention and follows the same principles to buying Fixed Income Securities as he does to stocks. While buying Fixed Income Securities, Buffet looks for Margin of Safety, discount to intrinsic value and uninterrupted cash flow. Buffet buys Fixed Income Securities at a discount to market value and then waits for market to discover the value.

Chapter 10 discusses Portfolio Management. The two traditional styles are Active Investing and Index Investing. Active Investing try to buy stocks that will perform better than the index. The objective is to get what are known as 'Alpha' returns. Active investors will need to be financially savvy. If you are not a savvy investor, and still want to invest in stock market, you can invest in the respective indexes. This involves identifying an index ( like Sensex or Nifty) and invest in the stocks in the index in the same proportion of their value in the index. Index investing, also called 'Passive Investing' is found to perform better than 90 percent of the Actively managed mutual funds. Buffet follows neither of the methods. He follows what is known as Focus Investing. There are four elements to Focus Investing. One, identify Outstanding companies run by efficient management. Two, Limit your portfolio to about 15 companies you can truly understand. Three, invest significant amounts in the companies that you identified in element one above. And four, ignore market volatility. If you have done your analysis thoroughly, you are not going to be significantly impacted by day to day price changes.

Chapter 11 covers the behavioral aspects of money. Making money is a mental activity. There are some behavioral trait that an investor need to cultivate if she wants to be successful. A true investor is calm, patient and rational. Some of the behavioral traits that can hamper successful investing include Overconfidence, Overreaction (especially to bad news), Loss aversion -  people feel twice as bad about loss as they do about gain and this makes them overly conservative investors, mental accounting - where people put money into different 'mental buckets' and treat these buckets differently and risk tolerance - Women are more risk averse than men and older people are more risk averse than younger people. Since he has done thorough due diligence before investing, Warren Buffet is immune from the psychological aspects of investing. He look for buying opportunities when market is down and people are selling and he is very cautious when the markets start going up uncontrollably.

Chapter 12, the final chapter, rounds off by summarizing simple investment style that an investor should follow. First step is to do the due diligence before investing in a stock and then turn off the stock market. The prices in the market keeps fluctuating, however if the fundamental analysis is correct then one should not react to the stock price movements. Like Buffet does, do an annual analysis to see if your assumptions are getting validated. Second step is to stop worrying about the economy. Buffet invests in companies that will do well in any economic scenario. Third aspect is to buy a business and not a stock. Invest in stocks as if you are buying a part of the business. Look at key operational functions, look at the business prospects, looks at the cash flow pattern...In short follow the tenets described in this book and invest for long term. Don't look at your portfolio as comprising stocks, look at it as comprising businesses. When you follow this approach, you are less likely to sell your business when it is making profit, you are likely to do thorough due diligence before investing in a new company and you are likely to maintain a tight portfolio. After all it is not the number of stocks in your portfolio that matters, it is the quality of the stocks that matter.

This book is for the informed investor, not a beginner. For an informed investor, this book is one heck of a value add.

Highly recommended. Will give 4/5.