Monday, December 1, 2008

The Intelligent Investor: Chapter 18

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.

This is a long and detailed chapter. To do it justice, I would have to reproduce great portions of it, and I think that is beyond the scope of this review. Instead, I will outline some of the key points from the comparisons, without getting into detail about the different pairs of companies.

Look for companies with long histories of dividend payments, prudent investing and moderate growth through conservative debt financing.

Stay away from conglomerates comprised of unrelated companies, that have achieved phenomenal growth through interesting financing methods.

Look for companies selling at a bargain compared to their asset backing (book value). Look for companies with comfortable working capital. Low multiplier companies tend to outperform high multiplier companies.

Be careful when looking at previous growth. Small companies are capable of growing at greater rates than large companies, and as these small companies grow, their growth curves will flatten out. The market may overreact to the previous growth and overvalue the company, believing such growth is sustainable, and this will destroy any bargain opportunities.

Graham’s general observations suggest that, while it is logical for companies with better growth records and higher profitability to command higher multiples of earnings, the intelligent investor must be careful in considering whether the specific differentials in earnings multiples are justified. In many cases, the market becomes overly optimistic and may ignore the underlying soundness of the company while pushing the price high on mere speculation alone.

Again, it is better for most investors to just focus on companies with low P/E multiples. This is a message Graham continuously repeats throughout the book. Zweig does a good job of summarizing this: “If you buy a stock purely because its price has been going up - instead of asking whether the underlying company’s value is increasing - then sooner or later you will be extremely sorry. That’s not a likelihood. It is a certainty.”

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