Monthly Archives: September 2009

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.

The Yield on the S&P 500 vs. High-Quality Corporate Bonds

Another tool I use to gauge the valuation of the stock market is to compare the earnings yield of the S&P 500 (based on trailing earnings for the past five years) to the earnings yield on the 10-year AA corporate bond.

The spread has narrowed considerably with the S&P 500 yield currently at 5.85% and the 10-year AA corporate yield at 5.07%. Here is the data.
Based on this, the market does not appear to be undervalued. Investors should become increasingly cautious (fearful) as the market rises.

Thinking about a P/E Ratio of 25

When people go to Las Vegas they often think about their money in a way that is very different from the way they think about it in everyday circumstances. This is summed up nicely in the following joke I found at the Certified Financial Planner website (cfp.net). This joke is told by economists regarding a phenomenon in behavioral finance known as mental accounting. Mental accounting is the tendency to think about money differently depending on the circumstances.

“A husband and wife spend a night in Las Vegas, and the man decides to try his luck at the casino. He loves roulette, but vows not to wager more than $5. So he puts his $5 down — on his lucky number, 17 — and wins. He keeps betting on number 17 and he keeps winning, so much so that towards the end of the night he is up more than $10 million. He decides to wager it all one last time on number 17. But this time he loses, and his $10 million gain is gone in an instant. When he returns to his hotel room, his wife asks him, “How did you do?” “Not bad,” he replies. “I only lost $5.”

The man could afford to be so relaxed about his multi-million dollar loss because of a phenomenon known as mental accounting, the tendency to value money differently based on where it comes from, where you keep it, how you spend it, and whether you expected more or less of it. As far as the gambler was concerned, the only money that was really ‘his’ was the initial $5. He didn’t have the $10 million before he started gambling and he didn’t have it when he finished, so for him the only real loss he suffered was the $5.”

I believe a form of mental accounting can occur when a person buys a stock with a high P/E ratio, for example 25 or higher. Granted, as Buffett pointed out in his 1991 letter to shareholders, an outstanding business can be worth 25 times earnings. Here’s the passage:

“A few years ago the conventional wisdom held that a newspaper, television or magazine property would forever increase its earnings at 6% or so annually and would do so without the employment of additional capital, for the reason that depreciation charges would roughly match capital expenditures and working capital requirements would be minor. Therefore, reported earnings (before amortization of intangibles) were also freely-distributable earnings, which meant that ownership of a media property could be construed as akin to owning a perpetual annuity set to grow at 6% a year. Say, next, that a discount rate of 10% was used to determine the present value of that earnings stream. One could then calculate that it was propriate to pay a whopping $25 million for a property with current after-tax earnings of $1 million. (This after-tax multiplier of 25 translates to a multiplier on pre-tax earnings of about 16.)”

Buffet has also said that when you buy a stock you should think about the same types of things you would think about if you were going to purchase a private businesses in your hometown. How is the business’s competitive position? Is the business growing or in decline? What will it look like in five and ten years? What factors could cause you to lose your investment? Here’s the point: if you found a business that was earning $1,000,000 a year in after-tax profits, it would have to be quite an extraordinary business for you to pay $25,000,000 to buy it. You would immediately think of how many things would have to go right for many years into the future just to get your money back and that’s without even including the effects of inflation. You would also think about how hard it would be to predict if the business would be going strong a decade into the future given the amount of factors at play.

Yet “investors” routinely purchase stocks at this multiple of earnings without much of a second thought. Perhaps many are really speculating. If you look at a discounted cash flow of the business in Buffett’s example, fully 67% of the cash comes after the 10th year. That is putting a lot of faith in your ability to predict the future with no margin of safety.

Mason Hawkins at The Ben Graham Centre for Value Investing (Part 2)

1. The second part of the investment process is being able to value a business.

2. Hawkins values a business three ways.

3. The first way is to go down the balance sheet, add up all the assets, subtract all the liabilities, and divide what’s left by the number of shares. Adjustments need to be made: for example, sometimes there are intangibles which overstate the value of a company and sometimes just the opposite is true. Hawkins mentions General Foods which had Jello on the books for very little when it is the dominant brand in its category. You need to be fair and ask what you would pay for the assets.

4. On the liability side, you need to read the footnotes and get into the details.

5. If you can buy a business for 50% of its assets, you have a riskless investment.

6. The second approach is to calculate the discounted cash flow of the business. They look at gross cash flow from operations and then subtract maintenance capex – what is needed to run the business. This is what you could put in your pocket if you owned the business. They are very conservative with the terminal value and they use a conservative 9% discount rate. They limit this valuation process to businesses they can understand.

7. The third approach is to look at private-market arms-length values. They keep an extensive database of all transactions in the industries they follow and compare prospective purchases to the sales price of comparable businesses. They adjust these sales prices to the prevailing interest rates. They have a thirty-year database.

8. Discipline and patience are key. They don’t swing unless there is a significant discount to appraised value. They wait until opportunities occur.

9. They require all their employees to have their equity in the Longleaf Funds which they manage. This focuses people’s attention and prevents conflicts of interest.

10. The vigorously debate all purchases because their own money is on the line.

11. When you look at a company you must look at the entire capital structure. Sometimes the debt is more profitable than the equity. He cites their investment in the debt of Level 3.

12. They evaluate litigation risk with common sense and experience. It is important to remember that you never need to invest. If there’s doubt they will forgo the opportunity.

Mason Hawkins at The Ben Graham Centre for Value Investing (Part 1)

On March 22, 2005, Mason Hawkins spoke at the Ben Graham Centre for Value Investing at the University of Western Ontario. Here is a link to the video. Having a great search strategy is critical to being a successful value investor. Hawkins gives some valuable nuggets on how he does it.

1. Good character is important. Whatever you do, behave as if your mother was going to read about it in the paper the next day.

2. The two main texts at The Ben Graham Centre for Value Investing are “The Intelligent Investor” and “Value Investing: From Graham to Buffett and Beyond” by Greenwald.

3. At Southeast, Hawkins’ investment company, they focus on the main points from the Intelligent Investor: the Mr. Market parable, that buying a stock is buying part of a business, and margin of safety.

4. Investing is insuring the return of your capital plus an adequate return. Anything else is speculating.

5. Many “investors” don’t pay attention or even understand intrinsic value.

6. Over time, a good business will retain earnings and its intrinsic value will increase.

7. If the intrinsic value is growing at 12% per year and you can buy the business at 50% of its intrinsic value, you can get a 29% annual return if it takes five years for the price to rise to the level of intrinsic value.

8. The key to great returns is purchasing a business at $.50 on the dollar.

9. In the Internet bubble, Diageo became very cheap because people were selling it to buy internet stocks. Diageo was a great business with hidden assets, a great competitive position and great management.

10. For Hawkins to invest the business has to pass both quantitative and qualitative hurdles. Management must be able to run the business to generate free cash flow and reinvest the cash. Finding both is tough.

11. Hawkins mentions that he had just spoken to Bruce Greenwald’s class at Columbia. Greenwald outlines three things to be successful as an investor: 1) a great search strategy, 2) the ability to value a business, 3) discipline to buy only cheap stocks. You also need patience.

12. Hawkins started in the early 70’s which was a great time to start because stocks got cheap. At that time Hawkins ran computer screens against the Compustat database to find cheap stocks: 1) ROC > 12% and less than 8x earnings, 2) < 10x free cash flow, 3) below net asset value, 4) below net asset value plus 20% of PP&E, 5) below book value after taking out intangibles.

13. He does not run the screens today because over the past 35 years they have already valued most of the businesses they understand and it takes little time to update the values.

14. They look at every company on the new low list each day.

15. They scan every Value Line issue thinking both quantitatively and qualitatively about the companies.

16. They used to look at every S&P tear sheet.

17. They look at 13F’s of the best investors. Mentions Peter Cundill. They particularly like to find stocks in the 13F’s that have since gone down. That gets their attention.

18. They read everything in the business press: Forbes, Fortune, WSJ, Barron’s, etc.

19. They read trades in every industry they can understand.

20. They revalue the top 200 businesses in the world every week to see if they are less than 60% of value.

21. They visit with many management teams and they always ask who their best competitor is to find new ideas for investments.

Mason Hawkins on How to Get a 29% Return

In this excerpt from Longleaf Partners’ March 31, 2000 Quarterly Report, Mason Hawkins writes about the three ingredients that can lead to extraordinary results:

  1. Buy at a deep discount to intrinsic value.
  2. Buy a business where the intrinsic value is growing.
  3. The market comes to recognize the value gap and reprices the company at its intrinsic value.
Here’s the excerpt:
“If we buy a company for half its appraised value, if the value grows 12% per year through business operations and intelligent capital deployment, and if the share price rises to reflect corporate worth in the fifth year, we will compound capital at 29% per year. (If the price approached appraisal more quickly, the return would be higher; if the process took more than five years, the return would be less.) The following hypothetical graph, based on these assumptions, illustrates this process.

For this compounding to work, we must buy the shares at steep discounts to solid corporate values, the business values must grow, and over time, the share prices must properly reflect the values. Patience and a reasonable time horizon are prerequisites.

Buy at steep discounts: All four Funds recently sold at the lowest price-to-value ratios in their histories. Said another way, our businesses as a whole are selling for about half of their intrinsic values. Recent corporate transactions imply that our appraisals are low, and therefore, the composite P/Vs actually may be more attractive than our conservative calculations, giving us a better prospective return. Even if our analytic conclusions are high by 20% (i.e. the P/V is actually 62.5%), the average annual return in the example is still 23% over five years.

Value growth: Our example assumes 12% annual growth in value over the five-year period. This value build-up is a function of a company’s profitability and its management’s capital allocation skills. We believe we own businesses which are sufficiently profitable and have management partners who can properly assess risks and returns when weighing whether to reinvest in their businesses, make acquisitions, or repurchase shares.

Price reflecting value: The gap between price and value can close in several ways: the market rises to reflect value; the company liquidates; mergers or acquisitions occur; management takes the business private; or aggressive share repurchase programs arbitrage price towards value. At today’s prices we AND our corporate partners are focused on being good stewards of your capital. In certain cases where we feel we can be helpful, we have elected to work closely with managements and their boards to help build value-per-share and/or to get value recognized. Many companies are liquidating all or part of their assets at fair value and reviewing how best to deploy or distribute the proceeds. A number of our holdings are in active merger discussions — some of our companies are putting themselves up for sale publicly; some are getting calls from private buyers; and some are receiving unsolicited offers. LBO activity has also increased with the decline of share prices. Share repurchases at the companies we own are being executed at a level that we have never seen, with many of our holdings reducing their outstanding shares by over 10% in a year’s period. We applaud these buybacks because they increase value-per-share substantially when executed at such undervalued prices, and because today’s repurchases represent the highest return and lowest risk capital allocation alternative at almost all of our companies.”

Buffett’s Favorite Market Valuation Metric

With the market rising approximately 50% from the March 9, 2009 low, I thought it was appropriate to look at what Buffett considers the “best single measure of where valuations stand”: the market value of all publicly traded securities as a percentage of GNP.

According to Buffett, “If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%–as it did in 1999 and a part of 2000–you are playing with fire.”

According to my calculations the ratio currently stands at 89.4%. Generally speaking stocks look neither under or overvalued at this level.

Here is my data.

Here are two Fortune articles on the subject if you want to read more on this:

“Warren Buffett On The Stock Market”

“Buffett’s metric says it’s time to buy”