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.


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