cash return is a valuation method. It evaluates the company’s ability to produce cash, as a going concern. cash return = annual free cash flow / enterprise value. Enterprise value = market value – cash + debt.
This is a brief review of The Intelligent Investor, Rev. EdProfessor Graham was a highly intelligent, educated and erudite gentleman who writes lucidly with a gentle humour. Warren Buffet thinks this is “the best book about investing ever written”.
It is mandatory reading for amateurinvestors because it explores three key insights. One is that market prices for potential investments are not predictable, at times tending to sink below the worth of the investment as a going concern (or even the company assets in liquidation), at other times greatly overstating the value of the company. Second, to achieve an adequate return on investment, one must buy at a price that is relatively low, in the sense that it is not a product of the market’s over optimistic view of the company’s prospects. And while particularly true for poor quality companies, this is even true for good quality, promising companies. Third, the investor must beware of his own emotions as a source of erroneous transactions; both in purchasing out of misplaced eagerness, or selling out of misplaced regret or fear.
Finding the listing for the hardcopy, 4th revised edition of this book on Amazon, I was surprised to encounter the notice that “You bought this book on May 1st, 2002”. I remembered that time of my first foray into the world of investing as one marked by trepidation. It was a difficult time for my family in NYC in the economic contraction following 911.
As a very late starter in investing, my first participation in the excitement offered by the market was guided by the breathless optimism of the internet/biotech/large cap growth bubbles that formed the landscape of the euphoric peak of the bull market at the climax of the 1990s.
Until the spring of 2000, there was still a magical energy which propelled seemingly all stocks worth talking about upward. In March this vaporized amongst earnings disappointments and surprise indebtedness on the part of the market darlings. The media conversation began turning to more prosaic matters such as, the requirement for actual earnings. But matters did not rest there, by any means. The market plunged at unpredictable intervals, repeatedly bludgeoning the remaining hope in the power of the market to heal all financial ills. Subsequent years were marked by the record breaking, wholescale corporate fraud and subsequent bankruptcies of Enron, then Worldcom among others, capped by the attacks of 911 and accompanying recession.
The online media pundits which had been so glibly confident were plainly wrong. But I had no alternative basis for a sound policy to guide investment, that is, until I found this book.
Warren Buffet, who did not invest in tech stocks, had been derided as an out of date bumpkin by the investing media during the halcyon days of the tech market bubble. The stock price of Berkshire Hathaway bottomed as the NASDAQ peaked, and surged as the tech stocks plunged, dashing media expectations. Now these same pundits held him up as a clairvoyant. I researched the name of the investor who was now held up as an oracle, began with reading his letters to shareholders, made my way to his mentor, Benjamin Graham.
A subsequent edition, contains commentary on each chapter by Jason Zweig Reading the original text gives an authentic sense of Mr. Graham’s pearls of wisdom. The commentary, while useful at times, also injects some scarcely relevant, unnecessary additional points which can detract from the uniqueness of Mr. Graham’s message. Once you have read the original, it might be useful to reread, this time adding the commentary. I mean no disrespect to Mr. Zweig. I own both editions and periodically reread parts of them. But Martin Zweig is not Benjamin Graham.
The content in the 1986 edition (which also forms the basis for the later 2005 edition with Zweig commentary) dates from 1971. A superficial reading results in the impression that the book is dull, because out of date. Rest assured, dear amateurinvestor, in this book you will find among many other nuggets: that there is nothing truly new under the sun in the recent history of wall street speculation and investor foibles; and that the fruitful search for worthwhile investments will take you in a quite different direction from wall street/media stock market forecasters, analysts and other pundits. These revelations are made even more clearly in Mr. Graham’s other masterpiece, Security Analysis: Sixth Edition, Foreword by Warren Buffett (Security Analysis Prior Editions) which I read following Intelligent Investor.
Some of the important points Mr. Graham makes:
The definition of investment: “an investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” This is a definition which I have adopted for my own “investment operations”.
Reviewing the implications to the investor of Market Fluctuations, he reiterates that “the future of security prices is never predictable”. That is, one can never predict precisely when or in what direction they will fluctuate. He illustrates this with innumerable examples of fluctuations in both bond and stock markets which were unexpected to the professional financial traders. “The investor can scarcely take seriously the innumerable predictions which appear almost daily and are his for the asking”.
He elaborates on the distinction of market price of a stock and its value, describing innumerable examples of “discrepancies between price and value” that he found for a specific companies. He addresses the effect of prices on the hopes and fears of the individual investor. He also notes that the attitudes of the population of investors drive market prices separately from the value of the underlying companies. Investors (including financial professionals) make decisions or rather follow each other as a crowd. The market therefore consistently exaggerates both over and undervaluation. Which brings me to one my favorite Benjamin Graham quotations:
“To enjoy a reasonable chance for continued better than average results, the investor must follow policies which are inherently sound and promising, and not popular on wall street”.
Mr. Graham emphasizes the work needed to achieve outstanding results. Reasonably reliable results can be obtained by choosing investments conservatively and making sure to purchase at a relatively low price relative to historical prices for comparable investments (defensive investor). To attempt to beat the market consistently by choosing companies liable to grow at a more rapid rate or investigating the finances of companies to make purchases at more notable discounts from asset value (enterprising investor), requires considerable learning and effort.
“…The art of investment has one characteristic that is not generally appreciated. A creditable, if unspectacular, result can be achieved by the lay investor with a minimum of effort and capability; but to improve this easily attainable standard requires much application and more than a trace of wisdom. If you merely try to bring just a little extra knowledge and cleverness to bear upon your investment program, instead of realizing a little better than normal results, you may well find that you have done worse.”
The rate of return to be expected does not dependent on the degree of risk the investor is willing to take on. Rather, it depends on the amount of intelligent effort he is able to bring to bear on his task. Moreover the enterprising investor’s efforts must be based on facts and reason.
“You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right”.
I note that he hinted at the role of an emotional commitment, for this assertion was preceded by the following:
“Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it, even though others may hesitate or differ”
The most efficient and simple formula investing method for the lay investor is cost averaging into a broad market index, carrying on regardless of market fluctuations. This approach is mathematically guaranteed to beat the market over time. In fact, this would also beat the vast majority of career investors in the financial industry. “Even the majority of the investment funds, with all their experienced personnel, have not performed so well over the years as has the general market” Why is this? Mr. Graham addresses the root cause. He recognizes the influence of emotions on buy/sell decisions. The greatest danger to the investor lies in taking emotional cues from the marketplace, confidently buying when the price is climbing, and anxiously selling as the price falls.
For the cost averaging investor, the only barrier remaining between the investor and his/her modestly market beating returns is the challenge of carrying on while ignoring market fluctuations. Mr. Graham recommends not starting a cost averaging program if the market is high relative to recent history, because if/when it falls, the investor is liable to fearfully stop the program. This shows that Mr. Graham did not consider that the average (defensive) investor attained the emotional discipline to ignore market fluctuations.
Margin of safety
As investors’ mood changes, the market will offer a price which does allow some margin of safety, or at least is more reasonable in relation to the past p/e ratio for the specific company.
Growth stocks are those representing companies whom are recognized as promising better than average income growth, and the stock price spends much time in an overvalued relative to the company assets. Its price is predicated on the expectation of a rate continued earnings growth. This growth is predicted by the same analysts who, as mentioned above, are unable to make long or short term market predictions accurately.
To avoid prolonged or permanent loss of capital, one must buy with a margin of safety, at a price which is relatively low. With growth stocks, this means one should wait until their price has experienced one of the dips which invariably occur and recur, although seemingly not when expected. Which brings me to the second of my favorite Graham quotations, and one the wisdom of which I have repeatedly had to relearn:
“while enthusiasm may be necessary for great accomplishments elsewhere, on Wall Street it almost invariably leads to disaster.”
And yet perhaps disaster is too vivid a characterization of the suboptimal price obtained for an investment, when patience would have allowed the appearance of a much better one. The limitations of Professor Grahams’ approach, lie in the fundamentally fearful or defensive approach to market fluctuations. His approach to avoiding losses hinges on making purchases at relatively low prices, so as to avoid having to endure the fear created by market downturns.
In my view, he did not go beyond this defensive posture, to attempt to identify companies which would provide above average investment returns over time, in spite of market fluctuations. This apprehensiveness extended to the cost average, whom he advised not to begin a cost averaging program when the market seems high, although mathematically speaking, continuing the program through “thick and thin” is the source of success in this formula investing.
He noted that some investments that he had sold, or that others held, continued to produce superior returns, and did appear overvalued by the market, nevertheless continuing to grow in value. He attributed the ability to hold investments through vigorous market fluctuations to emotional investment by the holder, but did not make a concerted attempt to understand how investments with these long term superior results are produced.
The amateurinvestor blog results from an attempt to address both of these issues. By learning to ignore market fluctuations, we can buy in the face of market fear and derision, or hold fast in the same. By insisting on only companies with a clearly sustainable competitive advantage, we can outperform the market. As Prof. Graham intimated, an emotional component of ownership is important. In my view, familiarity, resulting from fact based research on the company, gives the investor the fortitude to buy in the face of market fear, and continue to hold in the face market fluctuations based on an understanding of the company’s destiny as a going concern.
It is important to note the Prof. Graham’s cautious approach is likely attributable to his personal history. His family emigrated from England to the United States in 1895 and settled in New York City when he was one year old. His father Isaac was a workaholic who owned and operated a thriving business importing, distributing and selling European gifts and artifacts to the United States. While young Benjamin’s family lived in luxury initially, his father died of pancreatic cancer when he was 9 years old, and the family quickly and unexpectedly descended into poverty. Driven by need, Benjamin became as assiduous worker. He was extremely gifted in intelligence, and was offered full professorship in separate disciplines upon graduating from Columbia University at age 20, but instead went to work on Wall Street and became a partner through merit of his skills in an investment firm. The Crash of 1929 almost wiped out the firm, and this lesson is another source of Prof. Graham’s defensive approach to investing. The biography of Benjamin Graham is readable in the enjoyable book: The Einstein of Money: The Life and Timeless Financial Wisdom of Benjamin Graham
In my view, this story shows again, that personal emotions cannot be separated from investment. Investment means placing part of yourself into a vehicle from which you hope to gain. The fate of the investment will be shaped by economic and financial realities. But it will also be shaped by the human nature of the investor, with his or her hopes or fears determining the price of the final sale, as well as the unpredictably changing attitudes of the market of investors at large.
Professor Graham’s defensive approach may have been shaped by the fears of his childhood and early professional career. It was very successful, and he found greater fulfilment in intellectual pursuits including such as classical literature, writing, and social and romantic interests. Perhaps he did not have the emotional need or hunger to identify investments which would create riches vaster than any other’s. In this he contrasts with Warren Buffet, who has seemingly dedicated his life, from early childhood, to creating the strongest “financial fortress” on the planet, and who has recognized the power of the sustainable competitive advantage. Mr. Buffet’s efforts are have an important emotional component too, whether admitted or not.