Category Archives: Benjamin Graham

Some Reflections on Chapter 8 of The Intelligent Investor (Part 2)

Graham observes that, generally speaking, the better the prospects for a business, the higher its price to book ratio. Graham viewed these type of stocks as risky because of the large speculative component of their multiple. He advised not paying more than a 33% premium over tangible book value, ideally paying no more than book.

As is well documented, this is where Buffett would ultimately part ways with his teacher and focus on great businesses with high return on equity. I’m sure he would have liked to pay 1x tangible book for these stocks, but they rarely if ever trade at such a cheap price. That is why he say he wants great companies at a good price. The big qualifier for Buffet is that he will not buy such a stock if it does not have a clear competitive advantage. Buffett has stated this is the key to investing: finding stocks with a durable competitive advantage.

The A&P example which Graham gives provides a convincing example of the market’s inefficiencies. The key to taking advantage of these types of mispricings is PATIENCE. If it is not obvious, you’re forcing it. To quote a tried and true cliché, “Let the game come to you.”

1929 – $429/share

1932 – $104/share

1936 – $111-$131/share

1937 – $80/share (12x five-year average earnings; sensible entry point, per Graham)

1938 – $36/share (price < current assets) Point of maximum fear.

1939 – $117.50/share

1961 – $705/share (without splits) (30x earnings)

This example shows how greatly fear and greed can impact a stock’s share price. In 1938, shares were being given away. The price in 1961 implied that A&P’s earnings would “grow to the sky”.

Graham teaches us that we should not let the quoted price of our holdings dictate our behavior or assessment of our net worth, unless the fundamentals of the underlying business have changed. The only exception would be if you are forced to sell at market bottoms. That is the great drawback of using leverage: it can turn on you at the worst possible time (Black Swan).

This is why Buffett speaks of a kind of advantage present in more illiquid investments like real estate and private businesses in that their price is not quoted on a daily basis. This tends to focus attention on what really matters: the performance or quality of the asset. The irony is that the liquidity of stocks need only be a problem if you allow the quoted price to dictate your determination of value. Otherwise, the price quote is simply there to serve you, which it almost certainly will with the proper dose of patience and analysis.

Some Reflections on Chapter 8 of The Intelligent Investor (Part 1)

Buffett has said that chapters 8 and 20 of The Intelligent Investor are the most important things ever written about investing. That’s pretty high praise and, given who its coming from, we should probably commit them to memory.

Today I offer a summary and a few thoughts on chapter 8.

Common stocks are subject to recurrent large swings in price. An investor should try to profit from these occurrences.

There are several approaches to try to profit from these prices swings.

The first approach is to time the market by attempting to purchase shares of a stock by anticipating when it will go up (or down). This approach is widely followed today by analysts who pick price targets and by cable television shows such as Fast Money and Mad Money. Graham is suspicious that this can be done on a consistent basis and thinks it will lead to speculation. The flaw with market timing – buying strictly on an anticipated price movement – is twofold: first, you must be right, and second, you are dependent on someone purchasing the stock from you at a higher price. You must rely on a greater fool to make money.

Graham believes that people are attracted to trying to time the market because they want quick profits. They abhor the idea of buying a stock and having to wait a year or more for the market to realize that the stock is undervalued and adjust the price upward.

Graham is equally suspicious of mechanical trading systems, which, in general, fail to work as well in the future as they did in the past. There are two reasons for this. First, mechanical systems have been backfitted to the data, even if unwittingly, and when the future changes, as it inevitably does, the system will no longer work as well as the backtest shows. Second, as the mechanical system becomes more popular, it will influence the behavior of those who use it and cause its performance to decline.

The Problem with Buying Low and Selling High

It would be nice to buy a basket of stocks during a bear market and sell them for a large profit at the peak of the ensuing bull market. Graham does not believe this can be done on a consistent basis because it is too difficult to recognize bear markets and bull markets with that level of precision. Simply put, there are too many variations from cycle to cycle to make this work.

For that reason, he believes it makes more sense to vary the allocation between stocks and bonds, never having less than 25% of your funds in stocks and never more than 75%. The allocation is adjusted based on the level of under or overvaluation of stocks. [Several modern value-oriented hedge funds such as Blue Ridge and Greenlight use shorts and options to adjust their long exposure.]

Graham is skeptical of formula invested programs, for example, systematically selling a portion of your stocks as the market rises. One problem with this approach is that a bull market can go on far longer than you might think, and you could end up selling all your stocks only to watch the market continue higher without any clear re-entry point.

Graham favors buying stocks as you would a business. Try to buy shares when they are undervalued in relation to their intrinsic value and then sell them when the price rises above fair value.

Investors should prepare psychologically for the probability that their stocks will advance 50% or more from their lows and decline 33% or more from their highs over the next five years.

Graham counsels investors to resist putting any importance on the day-to-day swings in market prices. When markets rise and investors feel good about themselves and their growing net worth, he cautions them against giving in to the urge to chase the market and invest additional fund when the market is overvalued.

Ben Graham on the Role of Intrinsic Value in Analyzing Stocks (Part 2)

Yesterday, I looked at Graham’s caclulation of the intrinsic value of Wright Aeronautical Corporation. Today, I want to look at his example of J.I. Case.

J.I. Case

Earnings per share
1932 – ($17.40) loss
1931 – ($2.90) loss
1930 – $11.00
1929 – $20.40
1928 – $26.90
1927 – $26.00
1926 – $23.30
1925 – $15.30
1924 – ($5.90) loss
1923 – ($2.10)

Average: $9.50

Here is a profile of the company in early 1933:

Share price: $30.00
Earnings: ($17.40) for 1932
Asset value: $176
Dividends: none
Graham’s range of intrinsic value: $30 to $130

Observations

  1. Graham thought that J.I. Case was an example of a situation where an analyst cannot reach a reliable estimate of intrinsic value.
  2. He goes on to say that if the price were low enough, an analyst MIGHT be able to conclude that it was undervalued, for example at $10.00 per share.

Takeaways:

  1. An analyst cannot assume that a regression to the mean will occur or that an average of past earnings will persist. There must be “plausible grounds” to support the analyst’s projection, particularly if it involves growth.
  2. Some value investors will simply not pay for future growth, on the assumption that no such projection is reliable. Others, such as Buffett, are highly selective and will only invest in a growth company if, in addition to having good growth prospects grounded in facts, it also has a clearly entrenched competitive advantage.
  3. Some companies should be put in the “too hard” pile. There are plenty of fish in the sea and time is valuable; don’t waste it on trying to figure out the unsolvable.
  4. Be highly suspect of asset values, particularly of distressed companies. Sellers of newspapers in today’s market are receiving a cruel object lesson in the value of assets that can no longer produce profits. In his 1985 letter to shareholders, Buffett described what happened when he liquidated Berkshire Hathaway’s looms.

“Some investors weight book value heavily in their stock-buying decisions (as I, in my early years, did myself). And some economists and academicians believe replacement values are of considerable importance in calculating an appropriate price level for the stock market as a whole. Those of both persuasions would have received an education at the auction we held in early 1986 to dispose of our textile machinery.

The equipment sold (including some disposed of in the few months prior to the auction) took up about 750,000 square feet of factory space in New Bedford and was eminently usable. It originally cost us about $13 million, including $2 million spent in 1980-84, and had a current book value of $866,000 (after accelerated depreciation). Though no sane management would have made the investment, the equipment could have been replaced new for perhaps $30-$50 million.

Gross proceeds from our sale of this equipment came to $163,122. Allowing for necessary pre- and post-sale costs, our net was less than zero. Relatively modern looms that we bought for $5,000 apiece in 1981 found no takers at $50. We finally sold them for scrap at $26 each, a sum less than removal costs.

Ponder this: the economic goodwill attributable to two paper routes in Buffalo – or a single See’s candy store – considerably exceeds the proceeds we received from this massive collection of tangible assets that not too many years ago, under different competitive conditions, was able to employ over 1,000 people.”

In conclusion, Graham’s notion of intrinsic value is a highly useful concept, if you use it correctly and understand its limitations. As Aristotle said, “It is the mark of an educated man to aim at accuracy in each class of things only so far as the nature of the subject allows.” Be patient and hold your fire until it’s obvious. There have been plenty of these opportunities in the past and there will be plenty in the future.

Ben Graham on the Role of Intrinsic Value in Analyzing Stocks (Part 1)

A lot of what passes for security analysis looks a lot like the Greater Fool Theory. Investopedia defines the Greater Fool Theory as, “A theory that states it is possible to make money by buying securities, whether overvalued or not, and later selling them at a profit because there will always be someone (a bigger or greater fool) who is willing to pay the higher price.” This approach is as old as Wall Street, and, although a (very) few traders may consistently make money using this approach (without the benefit of an advantage such as high-frequency trading), the average person cannot.

Against this backdrop, Benjamin Graham came along and introduced a powerful new idea into the field of security analysis. The foundational idea was that when you buy a stock certificate you are buying a small piece of a real business. And if that is the case, a person ought to be able to come up with some idea of what the business is worth by studying the facts: the assets, earnings, dividends, future prospects, management, litigation, etc. This is what Graham called intrinsic value. Graham further recognized that because of the enormous volatility in the stock market, it would be possible from time to time to purchase shares of a given stock at a clear discount to what the underlying business was worth. This discount not only provided a rational basis for the expectancy of a decent return (or indecent, depending on the level of undervaluation), but also afforded the investor a cushion of safety against errors in judgement and analysis, and unforeseen future events.

Graham points out that it is not possible to determine the intrinsic value of a business with exact precision. It is usually a range of values. If you can establish this range, you can then determine if the stock is undervalued, overvalued, or fairly valued. This lack of precision need not be a problem, if you can buy the stock cheap enough. By analogy, Graham says it is quite possible to determine that a man is obese even if we do not know his precise weight, or that a woman is old enough to vote even if we do not know her precise age.

In Security Analysis (Sixth Edition) (pages 63-67), Graham gives two example of equities where he determines their intrinsic value.

Wright Aeronautical Corporation

Here is a profile of the company in 1922:
Share price: $8.00
Earnings: over $2.00
Dividends: $1.00
Cash per share: $8.00
Graham’s range of intrinsic value: $20 to $40

Observations:

  1. Graham concluded the stock would be a bargain at $8.00 per share.
  2. The low end of the intrinsic value range is at most 10x earnings and as low as 6x earnings if we assume that the company had no debt. (At $20 per share you would only be paying $12 per share net of cash.)
  3. In no case would Graham estimate the value to be greater than 20x earnings ($40/$2).

Here is a profile of the company in 1928:
Share price: $280.00
Earnings: over $8.00 ($3.77 in 1927)
Dividends: $2.00
Net-asset value: $50.00
Graham’s range of intrinsic value in 1929: $50 to $80

Observations:

  1. Graham thought that Wright Aeronautical might be worth as little as just over 6x its 1928 earnings. Graham may have looked at the earnings in 1927 and been unconvinced that the company could maintain earnings at the $8.00 level.
  2. In no case would Graham pay more than 10x (what appear to be peak) earnings of $8.00 per share.
  3. At $280.00 per share (35x 1928 earnings), Graham thought it was clear that Wright Aeronautical was overvalued.

Tomorrow I’ll take a look at J.J. Case Common and draw some conclusions for our use as contemporary value investors.