Friday, 10 January 2014

Benjamin Graham - The Intelligent Investor Part 4

We have officially entered the complexities of investing profitably in this review. Please click here for part 1, here for part 2 and here for part 3 of the previous reviews. This book is really an investment classic and should be read and reread several times over to maximize our investment perspectives.

Usefulness of investment funds (to the defensive investor) are as written but not limited to:
  • Promote good habits of savings and investment
  • Protected individuals against costly mistakes in the stock market
  • Income and profits from stocks are aligned with overall returns from the market
  • Comparatively, it is estimated that the average individual who put his money into investment fund shares has fared better than the average person who handles his own investments
Before making any investments, always be extra careful:
  • This extends to investments in mutual funds, exchange traded funds etc
  • Ask oneself if better than average results can be assured by choosing the right funds, performance funds?
  • If not, how can one avoid choosing a fund that will garner worse than average results?
  • How to make a decision between the different types of funds?
  • Does the fund's performance justifies all fees required by the fund in handling your money?
Hot funds have several characteristics that might not be attractive to the average investor (as determined by financial scholars):
  • The stock picked by funds does not justifies the high cost of research and trading
  • A fund's expenses is inversely related to its returns 
  • The more frequent a fund trades its stocks, the less it tends to earn
  • Highly volatile funds are likely to stay highly volatile
  • Funds with high past returns are unlikely to remain winners for long
However, I would argue that funds with a protracted period of high past returns are likely to remain winners like Berkshire Hathaway and many other funds operated by investment legends like George Soros, Peter Lynch and more.

There are a few reasons why fund's superior performances do not last forever and these factors are self explanatory:
  • Migrating managers due to some form of poaching
  • Asset elephantiasis
  • Rising expenses, including trading and administrative expenses
  • Sheepish behavior, also known as herding (following behavior) since fund managers do not want to look stupid if they did not ride on a profit opportunity while other fund managers did
Adding on to the point about sheepish behavior, once a fund grows to a certain size, the manager will tend to be less risk taking as they do not want their fees to be affected. This will affect the initial strategy used to get the fund to the size in the first place, affecting overall returns.

Buying into an index fund could be one of your wisest investment
As shown from the various factors behind a fund's lacklustre performance, it would be wise to purchase an index fund via dollar cost averaging. This way of investing has been advised by both Benjamin Graham and Warren Buffett due to an index fund's low expenses. For example, a typical stock fund incur operating expenses of 1.5% and trading costs of 2% while an index fund incur just 0.1% in trading costs and 0.2% in expenses. Moreover, their long term returns usually beat the returns of many stock funds.

The only demerit behind index fund is that they are boring and one cannot go around boasting about how they are owing one of the most spectacular fund to their friends and families. Yet, by buying into an index fund, one is guaranteed to beat the vast majority of investment professionals and individual investors alike.

A good fund (beats the index) usually has the following characteristics:
  • Managers are the biggest shareholders of the fund
  • The fund tends to be cheap (not all expensive funds are superior performers)
  • The fund manager dared to be different (prevent herding) 
  • The fund is shut to new investors (to prevent asset elephantiasis)
  • They do not advertise (Plato said in The Republic that the best rulers are those who do not want to govern)
After the above few factors, look at the fund's expenses, riskiness of the fund, manager's reputation and then past performance in the order listed.

Know when to sell your fund by taking into account of these few phenomena:
  • A sharp and unexpected change in strategy ("value" fund loading up technology stocks or "growth" fund buying blue chips stocks)
  • An increase in expenses
  • Large and frequent tax bills as a result of irresponsible trading
  • Sudden abnormal returns like a fund losing excessively or winning spectacularly when it has previously been getting conservative returns
Seek to form an independent investment decision
One should never buy or sell solely based on the recommendations received from financial service firms like investment banks, financial research firms etc. Instead, the role of the financial service firm becomes more of a knowledge provider in helping one make investment decisions.

Seek help for your investment portfolio under these situations:
  • Tremendous losses (compare with the market average)
  • Failed budget plan
  • Widely diversified portfolio (a diversified portfolio is good, before you start placing every stock inside)
  • Major life changes like having sick parents, a new child
Under these situations, an experienced investment professional will be able provide a peace of mind to you such that you are able to concentrate on your day to day tasks. Of course, as with other advices laid out in this and previous reviews, always be cautious and know what you are buying. There are many questions you should ask your financial advisor should you decide to hire one and do refer to the official book for the complete list. The basic principle is to always understand what you are getting into and whether the advisor is trustworthy enough.

A security analyst will apply standards of safety as shown below accordingly:
  • Past average earnings
  • Capital structure
  • Working capital
  • Asset values
The list is not conclusive and is subject to more factors. With regards to growth stocks, much emphasis has been placed on valuing them in recent years, whereby the technique used are often sophisticated and complicated. However, there is a certain paradox that comes with using techniques to value growth stocks and that is mathematical valuation has become most prevalent in an area where one might consider it to be the least realisable. This is because anticipation of the future takes a far higher weight than past performance.

Apply the "poorest-year" test for a wise selection of bonds in your investment portfolio
As opposed to the 7 years average test, one should use the "poorest-year" test to gauge the attractiveness of a bond purchase. As shown to the left, it would suffice if the bond purchase met either of the 2 test. Moreover, when considering the poorest-year test, one should also take into account of factors like size of enterprise, stock/equity ratio, and property value. These factors are to ensure the validity of the bonds when the company goes into bankruptcy, preserving at least principal values. Do also be extra careful about overbonded firms as interest payments have a serious effect on net earnings. A low interest rate environment should not be expected to last forever and hence, the intelligent investor must exercise extra caution when making his investments in bonds.
The idea behind common stock analysis is a valuation technique based on past and present
A valuation of the stock should be made with respect to past and future average earnings. That estimate should then be multiplied by an appropriate "capitalization factor". Estimating future earnings start with average past data for items like physical volume, prices received and operating margin. Future sales are then estimated based on changes in volume and price level. There are a few factors that might affect the capitalization factor and will be explored as shown:
  1. General long term prospects
  2. Management
  3. Financial strength and capital structure
  4. Dividend records
  5. Current dividend rate
Capitalization rates for growth stock is calculated from this formula:
Value = Current (Normal) Earnings * (8.5 plus twice the expected annual growth rate)
Interest rates affect the value of future growth as well
Expected earnings and dividends would have a smaller present value given that higher interest rate is assumed in the future.
Following the various points in this review, a lot of the content in the book after the above point is mainly discussion based, analysing the significance of per share earnings and actual per share earnings.
With that, I will officially end part 4 of my review and there is around 38% of the book left to go. I really need to master the art of valuation soon before my university curriculum starts and I also need to find a solid internship. I really have to become much much more focused and stop any time wasting activities. 

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