Saturday, 4 January 2014

Benjamin Graham - The Intelligent Investor Part 3

This is where it gets exciting. We are going to move into the enterprising strategy this review and pitfalls and mistakes to avoid. Please head here for part 1, here for part 2 of the book review if you have not read the previous 2 parts. For the enterprising investor, there is generally no fixed guidelines as to the composition of his portfolio though it is recommended that he starts from the same base as a defensive investor. However, he can affords to be more aggressive in his research and put more work into building a portfolio of various asset classes.

Bonds are quoted in percentages of "par value," or 100
A bond priced at 80 is selling at 80% of its principal value. When price of bonds goes below 100, they are labeled as discount bond. When price of bonds goes above 100, they become premium bonds. The reason this is important is because a high yielding bond which is more risky (due to risk of default or delayed payments) which is selling below par value could be a good investment whereas a premium bond selling above par might have limited returns for the investor.

Scrutinizes foreign bonds and new issues, both bonds and equities extremely carefully
Investing in foreign bonds require extremely high level of research and sometimes luck. Moreover, with the fast changing economic climate, it would be wise to abstain from investing in foreign bonds. In addition, new issues are typically sold under favorable market conditions, which generates more benefits for the seller rather than the buyer. Therefore, do careful study before investing into these asset classes. Companies that IPOed tend to sell their shares at a price above intrinsic value due to speculation, therefore, it might be wise to wait for the issue to reach its true value before investing in it.

Trading is dangerous for an investor
In the book, transaction costs from trading (holding stocks for only a few hours at a time) is said to be a major contribution catalyst to wealth erosion. Therefore, the book advocated for a long-term investor as the only kind of investor. Only then can the investor emerge as a victor in the market.

IPO stands for a few interesting names:
  • It's Probably Overpriced
  • Imaginary Profits Only
  • Insiders' Private Opportunity
  • Idiotic, Preposterous, and Outrageous
The enterprising investor should have investment operations like this:
  1. Buying in low (bear) markets and selling in high (bull) markets
  2. Buying carefully chosen "growth stocks"
  3. Buying bargain issues of various types
  4. Buying into special situations
A growth stock can be categorised as on that has good performance in the past and is likely to continue in the future. However, equities with a solid track record and good prospects can be overpriced, leading to limited returns for the investor. Moreover, judgement of the future can turn out to be wrong. Companies usually experience increased growth until a certain stage before further expansion becomes exponentially more difficult.

3 recommended fields for the enterprising investor
To obtain better than average results over the long run, the investor should have a strategy that incorporates the following principles: underlying business must be sound, and the strategy should be different from the policy followed by most other investors and speculators. There are 3 different investment approaches that meet the 2 principles:
  • A large company that is relatively unpopular
Since there are many stocks which show excellent growth that are overvalued, it is logical to expect that large companies suffering from unsatisfactory developments or temporary setbacks can be undervalued. The key is to concentrate on larger companies that are going through a period of unpopularity. Even though small companies might also be undervalued for similar reasons, large companies usually have more resources to make a comeback from its decline and the market is likely to favor the comeback from large companies relative to a small company. Starting to look into companies with low P/E ratio is a good idea, but other quantitative and qualitative requirements should also be considered.
  • Purchase of bargain issues
A bargain issue is one that is intrinsically worth more than it is selling for. As a rough guideline, the book mentions the price as being 50% lower than its intrinsic value. There are 2 methods to detect a bargain stock, namely the method of appraisal and value of business to a private owner.

The method of appraisal requires an estimation of future earnings and multiplying them by a factor appropriate to the particular asset. If the resultant value is adequately above the market price, and the investor has confidence in his analysis, the stock can be labeled as a bargain

The second method is often determined by expected future earnings as well, in which the results might coincide with the first. However, the second method pays more attention to the realizable value of the assets, focusing on net current assets or working capital.

Having the wisdom to invest in depressed markets is not only one of experience but also application of plausible techniques of value analysis. Using a credible value analysis technique, it will be possible to seek out worthwhile investments even when current earnings and immediate prospects are poor. Two major sources of undervaluation arises from (1) currently disappointing results and (2) protracted neglect or unpopularity.

A mere falling in price and earnings is not a solid indication of undervaluation. There has to be reasonable stability of earnings over the past decade, no years of deficits in earnings plus the company being of sufficient size and financial strength to meet any possible temporary damages to its underlying business. A most common bargain indicator is one in which a company's share price sells for less than the company's net working capital per share. Net working capital by Graham refers to a company's current assets (cash, inventories etc) minus total liabilities (preferred stocks and long term debt included).

Bargain issues in secondary companies
Secondary companies are companies that are not leaders in fairly important industries. Companies which are small usually fit into this category (normally Catalist listed companies in SGX), as well as the main company in an unimportant industry. However, there is an exception and that extends to growth stocks. Stocks of secondary companies tend to rise in value faster than stocks of primary and strong companies, thus presenting a possibility of undervaluation. However, with more investors looking at stocks of secondary companies, overvaluation remains a threat as well.
  • Special situations or distressed companies
Bargain issues might be common in distressed companies affected by lawsuits. Since the investing public tend to shy away from companies involved in lawsuits, it would be logical to assume that these equities might be undervalued by the markets. However, the scope of exploring this field of study is beyond the scope of this book.

Determine what kind of investor you are, enterprising or defensive
Often, many investors try to find a middle ground between being enterprising and defensive in their portfolio. However, there is no such thing as a middle ground, you are either enterprising or defensive. If you are defensive and tries to be enterprising, you might make some bad investment decisions due to a lack of technical knowledge or security experience.

It is advised for a defensive investor to avoid these few asset classes at par value:
  • Foreign bonds
  • Ordinary preferred stocks
  • Secondary common stocks
An enterprising investor however, should buy into these issues provided they are 2/3 of the appraised value of the various assets. Of course, this should be done with caution and a skilled technique in analysing the fair value of the security.

A great company is not a great investment if too much is being paid for the stock
Growth stocks are worth buying when prices are reasonable. However, once the price/earnings ratio goes above 25 or 30, the odds of an equivalent performance in its share is likely to be slim.

Profiteering from market fluctuations is possible through either of these two methods:
  • Timing
  • Pricing
Timing refers to the anticipation of the stock market, buying or holding when the market is trending upwards and selling or refraining from buying when the market is trending downwards. Pricing, in contrast is the buying of stocks when they are quoted below their fair value and sell them when they rise above their fair value. A simpler way to price stocks is just to make sure you do not pay too much for the stocks.

A publicised method of trading will not be effective
This happens primarily due to 2 reasons, one being the passage of time will render old formulas unusable and the other being popularity of a trading theory will in itself influence the stock market, which in the long run, decreases profit making opportunities.

Therefore, any investing or trading formula that is easily described and followed by a lot of people will be too easy and simple to last.

Characteristics of a bull market are as followed:
  • Historically high price level
  • High P/E ratios
  • Low dividend yields against bond yields
  • Much speculation using margin
  • Many IPOs with fundamentally poor companies
Some attributes of a good stock investment are as related:
  • Brought close to asset value
  • Satisfactory P/E ratio
  • Sufficient strong financial position
  • Prospect for relatively stable earnings
Bearing in mind 2 factors should help us in our investment journey. One is the acknowledgement that stock markets often go wrong which can be taken advantage of by an aware investor. The other is that businesses change in performance and quality over the years and an enterprising investor should take a hard look at the businesses from time to time.

Adding on to attributes of a good investment is the investor's inherent investment skills. A true investor is rarely forced to sell his shares. Worrying about unstable price movements in the market will only cause undue distress and mental anguish to the intelligent investor. Do not deceive yourself that there is no loss in value when your asset has no quoted market price.

Price fluctuations in the market is useful for the intelligent investor
The true investor benefits from the volatility of the market. When prices fall sharply, an opportunity to buy securities that are undervalued arises and when prices rise sharply, an opportunity to sell securities that are overvalued becomes possible. Other than that, it would be wise to ignore the daily fluctuations in the market. Value of the underlying asset is key to making a wise investment.

Key difference between speculators and investors
Speculators desire to anticipate and profit from the fluctuations in the market whereas an investor aim to acquire and retain equities or assets at reasonable and suitable prices.

Average market prices could signal managerial competence
To put it simply, a good management team produces and facilitates a good average market price whereas a bad management generate a bad average market price.

Do not make decisions based on market fluctuations
Fluctuations in the market are simply noises by the mass investing public. Do not ever buy or sell a stock just because the price has gone up or gone down. Do not make any investment decisions based on market fluctuations.

Price fluctuations of convertible bonds and preferred stocks are affected by these few factors:
  • Change in price of related common stock
  • Change in credit rating of the stock/company
  • Change in interest rates
Since these are highly volatile and rarely guarantee safety of principal, it might be worthwhile to observe them more depending on personal preferences and investment appetite.

You cannot control the market, but you can control these few bills:
  • Brokerage costs
  • Ownership costs
  • Expectations
  • Risk (how much to put into stock market and rebalancing)
  • Tax bills
  • Own behavior
To be an intelligent investor, you have to ignore the crowd and master your own investment journey. Do not try to trend follow and listen to the market.

Sign the Investment Owner's Contract in the book 
Sign the contract, and refer to it whenever you are thinking about making a move in the market.

With that, I end part 3 of my review of The Intelligent Investor by Benjamin Graham. To be honest, I am only 33% done with the book and my prior post announcing my intention to finish the book in 5 days was really naive. There is just too much content and nuggets of wisdom in the book for it to be finished in 5 days. After reading the book, I was able to understand my own investment mistakes even better. One significant incident was that I lost out a chance to realize an additional $1,000+ in profits just because I did not let my profits ride even though fundamental conditions of the business has not changed. I am truly more motivated than ever and will sacrifice my mental and physical limits for my investment career (which involves tons of studying and networking), and my family (this is of course still my priority). Anything else to me now is secondary.

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