Wednesday, January 21, 2015

Book Review #21: How to think like Benjamin Graham and invest like Warren Buffet: Author: Lawrence A Cunningham

If you start reading the book 'How to think like Benjamin Graham and invest like Warren Buffet', written by Lawrennce A Cunningham, with the objective of getting a deeper insight into Graham's thoughts and Buffet's investment style, you may be in for a disappointment.

Note: If you are keen on knowing how Graham thinks, you can also check out BOOK REVIEW #16
If you are keen on knowing how Buffet invests, also check out BOOK REVIEW #12 and BOOK REVIEW #15 in this BOOK REVIEW SERIES

I read this book twice, still I am not clear what the theme of this book is. Other than occasional mention of Graham and Buffet, there is no attempt to provide details of their thoughts or investment styles. The book spends a few chapters on the various theoretical constructs relating to stock market investing. But, is explaining these the theme of the book? No. One chapter is dedicated to detailing the factors to be considered while analysing the company, but neither that is the theme. The book spends one chapter on various valuation methods, but that is just one chapter.

So what is the theme? What is the message?

At a high level the message seems to be that Value Investing is the way to go if you are an investor. The approach has made money for many investors. Despite the plethora of theories disproving it, Value Investing has stood the test of time. The focus of the book is to provide cogent arguments to the investors to move from 'Q Culture' (Q for 'Quotes', focusing solely on the market quotes (prices) in making investment decisions) to 'V Culture' (V for 'Value', focusing on capitalizing on the mismatch between intrinsic value of the company and the price being offered).

Some new ideas seem to appear in this book. For example, traditionally, a company was found to have value if it has been in existence for a number of years with uninterrupted dividends for at least 20 years and whose PE is about 15 to 18. In this book, the author has included the so called 'Growth' companies, new companies without a track record and trading at high PEs also as Value Stocks. For these companies, the 'Value' lies not in past performance but in future potential

The book is divided into three creatively named parts. Part 1, titled 'A tale of two markets', sheds light on the various theoretical concepts, relating to equity markets, that have evolved over time. The author starts off by illustrating the bipolar behaviour of stock markets. Over a period of 30 years, there have been cases where market fell by more than 3% (Bust) and went up by more than 3% (Burst). It is the normal behaviour of the equity markets to oscillate between 'Burst' and 'Bust' and an investor that follows the approaches of the Gurus of Value Investing, will not have any reason to be perturbed by the cyclical nature of the market. 

The book then spends the next three chapters detailing various theoretical constructs relating to equity investments. Modern Portfolio Theory, Random Walk Theory, Efficient Market Theory and Capital Asset Pricing Model are all discussed and discarded. Different aspects related to Chaos Theory are considered next, but author concludes that these theories also do not support Value Investing. Finally different types of Volatility are discussed. 

The outcome of this discussion is that Stock Markets have a memory of about 4 years, which means that boom and burst could happen in four year intervals.

Part 2, 'Show me the money', covering chapters 6 through 10, is the operative part of this book. Different valuation methods are explained innovatively through the story of the farmer wanting to sell his apple tree. Through a lucid example, the story illustrates the difference between Salvage Value, Valuation based on Current Revenue, Book Value Method, Replacement Cost Method and Discounted Cash Flow Method of valuing a company. This is also the section where the author comes close to doing justice to the title of the article. A chapter is dedicated to identifying your 'Circle of Competence'. As per the book, we should identify the initial circle of competence as an industry that we are familiar with. Starting from there, one can expand our circle of competence to other industries. Since Industries tend to change over time, one should also regularly nurture their circle of competences. The author gives a clear set of guidelines on how to evaluate an industry and a company within that industry.

The thrust of the book is that the value of a business comes from its future cash flows. An investor who can best analyse the future cash flows will have an edge over others. Keeping up with this idea, the rest of the section focus on analysing the financial numbers of the company. A number of key ratios and their significance is explained in a lucid style, without any mathematics whatsoever (which was what interested me about this book, this can be an easy read). 

Whatever be the valuation method adopted, current earnings and its growth potential are key parameters to be considered. The executives of the company know this and they use 'creative accounting' to dress up the financial numbers and make earnings look more respectable than they really are. This means that a smart investor should always be on the lookout for accounting shenanigans and financial legerdemain (how I wanted to use that word once in my blog posts !!!) that could impact the valuation of the company. The last chapter in the Part 2 focuses on various tricks that the finance managers use to dress up the numbers and how a retail investor can identify the same thereby making better investment decisions.

Both Buffet and Graham gives a lot of importance on the quality of management in making investment decisions. One quality that Buffet looks for is Integrity, the manager should do what he promised to do. The quality of management is the theme of part 3 of the book 'In managers we trust'. The section starts off with a comparison on the corporate governance laws in both UK and US. There is a discussion on the role of the Board of Directors ('Board') and on managerial compensation. The section rounds off with briefly profiling some of the great CEOs of American Corporations including Jack Welch of GE, Roberto C Goizueta of Coca Cola, Mike Eisner of Walt Disney.

The book ends with a very brief summary of 'V Culture'. The trifecta of value investing is Finance, Accounting and Corporate Governance. Learning Finance will help the investor to identify the intrinsic value of the company, accounting will help you evaluate the accounting policies of the company and will give a window into the accounting shenanigans followed by unscrupulous managers. A good investor should give importance to Corporate Governance. In my opinion, it is difficult for an average investor to get access to the management discussions. Having said that if an investor can identify a method to evaluate the corporate governance of the company, she would have become a better investor.

In my opinion, this is an average book. The target audience is a tyro investor.

My rating? 3 Stars.

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