On another note, please click here for part 1, here for part 2, here for part 3, here for part 4 of my reviews of the Intelligent Investor by Benjamin Graham.
There are a few tips to avoid accounting pitfalls:
- Read from backwards to discover the things the firm might want to hide
- Read the footnotes in order to gain a deeper understanding behind certain items
- Learn more from popular financial statements analysis textbooks and guidebooks
- Financial Position
- Price History
Include the stocks into the investment portfolio once they meet the seven statistical requirements for a defensive investor:
- Adequate size
- A sufficiently strong financial condition
- Continued dividends for at least the past 20 years
- No earnings deficits in the past 10 years
- 10 year growth of at least one-third in per share earnings
- Price of stock not more than 1.5 times net asset value
- Price no more than 15 times average earnings of the past 3 years
This approach involves trying to anticipate what the company will achieve in future years, hopefully accurately. Careful studies might be done to gauge possible factors that might affect the drivers of the company like earnings. This study emphasizes prospects, management, and other non-measurable factors that is necessary to analyze the growth of the company.
Protective approach is also known as the quantitative approach
Protective approach is concerned with the price of issue at the time of study. The main study is to assure oneself of substantial margin of indicated present value above market price, covering any possible future disruptions to the business. This approach scrutinizes the measurable relationships between selling price and earnings, assets, dividends and so forth.
Updates to Graham's criteria for stock selection
- Adequate size (should steer clear of stocks with a market capitalization of less than $2 billion)
- Current ratio of at least 2 (conservatively financed companies)
- Earnings stability (EPS has to be positive for at least a decade)
- Dividend record (Dividend payments tend to be a positive sign)
- Earnings growth (EPS grows by at last 1/3 over 10 years)
- Moderate P/E ratio (Only find stocks whose current price is no more than 15 times average earnings over the past 3 years)
- Moderate P/B ratio (Price to book ratio of no more than 1.5)
Here are some of the investment operations done by Graham-Newman Corporation between 1926 and 1956:
- Arbitrages: The purchase of a security and the simultaneous sale of one or more other securities considering the exchanges under reorganization, merger or something along the line
- Liquidations: Purchase of shares which were to receive one or more cash payments in liquidation of the company's assets fulfilling a calculated 20% annual return or more and the possibility of a successful outcome was at least 80%
- Related Hedges: Purchase of convertible bonds or convertible preferred shares, and the simultaneous sale of the common stock into which they were exchangeable. Position established at a close to parity basis
- Net Current Asset: Acquire as many equities as possible at a cost for each of less than their book value in terms of net current assets alone, giving no value to plant account and other assets. Purchases made were usually 2/3 or less of the stripped-down asset value
- Financial condition where current assets is at least 1.5 times current liabilities, and debt not more than 110% of net current assets
- Earnings stability where there is no deficits in the last 5 years
- Current dividend stream
- Earnings growth significant
- Price of share less than 120% of net tangible assets
- Purchase of low multiplier stocks of important companies
- Diversified group of stocks selling under their net current asset value
- Continual practice
- Use a stock screener, with the right criteria for search
- Study the management team
- Read Berkshire's annual reports
- Be disciplined and consistent
- Pay attention to what you do and how you do it, ignoring market noises
As a value investor, I will definitely not be buying a company that has issued many warrants, convertible bonds, preferred stocks. This is because the calculation involved in trying to determine a true value for the stock becomes immensely harder. Another reason is the fact that I do not understand these instruments very well. According to Graham, financial instruments like stock-option warrants are disasters waiting to happen. Equities are also worth less with warrants outstanding as value is being eroded away.
Study past company and stock occurrences to benefit from Graham's style of intelligent investing
Read up on as many stock happenings as you can. Find out more about company activities as well as how it can affect stock prices. When in doubt, stick to a conservative way of investing. Rule number 1 in investing from Warren Buffett is to never lose money and rule number 2 is never to forget rule number 1.
With that said, do keep an eye out for part 6 of The Intelligent Investor, the final and last instalment of the book review. I have learnt so much through the process of reviewing this book and am really glad that I have taken extra time to learn. I will also be doing reviews of Security Analysis, as well as other investment classics by famous investors like Peter Lynch. Do continue to support the site!