Wednesday, September 24, 2008

The Intelligent Investor: Chapter 7

The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.

While the last chapter discussed the things that the enterprising investor should NOT do, this chapter outlines the things that an enterprising investor SHOULD do.

There are four possible ways the enterprising investor may try to make money:

  1. Buy in low markets and sell in high markets
  2. Buy carefully chosen growth stocks
  3. Buy stocks that are a bargain
  4. Buy into “special situations”
With regard to the first option - buying in low markets and selling in high markets - Graham shows that this is easier said than done. There is no mathematical basis for evaluating whether the market is high or low, and generally to make such a determination requires a great deal of experience. Without any reliable mathematical guide, Graham urges ordinary investors to stay away from this.

The second option - buying growth stocks - is also discounted. Graham looks at the performance of funds that invest solely in growth stocks and showed that they underperformed the market. If the fund managers, with greater research facilities, time and experience than the average intelligent investor cannot properly select growth stocks, what chance does the intelligent investor have? Also, Graham notes that growth stocks as a class have a tendency toward wide fluctuations in market prices due to the market’s overreaction to their earnings.

Graham suggests that the intelligent investor place a maximum price-earnings ratio of 25 on the stocks he purchases, and of course, the lower the better. Note that Graham uses average price-earnings which lowers the odds that you will overestimate a company’s value based on temporary bursts of sales. Zweig points out that the current practice of calculating price/earnings on future expected sales is anathema to Graham’s philosophy.

The fourth option, buying into special situations, deals with companies that are the target of acquisition, or companies that will emerge from restructuring at a higher price. While there is a great deal of money to be made, this class of investing requires expert knowledge of the situation and is thus not recommended for the intelligent investor.

This leaves the third option - buying bargain stocks - as the only remaining method, and it forms the basis for Graham’s Value Investing philosophy. The general example given for value investing is buying something with an intrinsic value of more than $1.00 for $0.50. Graham discusses three ways for enterprising investors to do this:

Value Play #1. The Relatively Unpopular Large Company
Since we know that the market will overvalue companies that show strong growth or are “hot” (e.g. tech stocks in 2000), we can expect that the market will likewise undervalue companies that are out of favour for some reason. So, Graham says there is a value play in investing in large companies that are going through a period of unpopularity. He recommends large companies because small companies have the risk of completely losing profitability and protracted neglect by the market despite improved earnings. Large companies have the resources to carry them back to improved earnings, and the market is more likely to recognize a comeback-kid and respond with improved valuations.

Graham looks at the low-multiplier companies on the DJIA over the 1937 - 1969 period to show how the low-multiplier companies significantly outperformed the high-multiplier companies.

Graham cautions that the low-multiplier is not enough for a definitive purchase decision - you must supplement this with other quantitative or qualitative analyses of the company.

Value Play #2. Purchase of Bargain Issues
A bargain issue is one which appears to be worth at least 50% more than the current price. There are two methods of determining the intrinsic value:

  1. Appraisal Method - estimate future earnings and then discounting them back to find the value per share.
  2. Private-Owner Valuation - estimate the value of the company to a private purchaser. This focuses more on the net realizable value of the assets. Net Working Capital is also important.
In identifying companies for further analysis, focus on those that have (1) currently disappointing results and (2) protracted neglect or unpopularity. These are most likely to be undervalued.

You need more than poor results. You are looking for reasonable stability in the past and reason to believe that there is sufficient size and strength for the company to recover in the future. Look for large, prominent companies selling below past average price and past average price/earnings multiple.

In some cases, the share price is valuing the company at less than its net working capital (current assets less current liabilities) and so a purchase of the company at that price would mean the fixed assets are being purchased for free. The long term trend will likely be for the price to move up to a value in excess of the net working capital, to take into account the net assets.

Often, companies that are secondary in an industry are more likely to be undervalued than the industry leader. These can provide a great opportunity, as secondary companies often have high dividend returns, and a bull market will ordinarily be most generous to low-priced issues like these. Additionally, acquisition is a more common possibility in consolidating industries, which would lead to a substantial premium over the purcahse price.

Value Play #3. Bargains in Special Situations
As mentioned above, these are for experts. Often, a lawsuit or something has caused the share price to fall disproportionately low, creating a bargain situation.

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