Saturday, 17 May 2014

Benjamin Graham - The Intelligent Investor Part 5

This review will be my second last review of The Intelligent Investor by Benjamin Graham. Through the course of doing up this review, I have come to a single conclusion about learning. While it makes sense to do a book review on a book with general concepts, the marginal returns from doing one with abstract concept is minimal and tedious. This is because not only does one have to understand the concepts, but in trying to convey the essence for readers, takes up additional time, incurring opportunity cost to one's investment study journey. Therefore, I have decided to limit any future book reviews to 1 post instead of various parts like The Intelligent Investor by Benjamin Graham.

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
To determine a strong company, there are various key indicators:
  • Profitability
Take a look at their earnings on book value. A high rate of return on invested capital usually corresponds with an increase in earnings per share annually.
  • Stability
Stability is measured by the maximum decline in per share earnings in any of the past 10 years, as against the average of the 3 preceding years.
  • Growth
Compare against the index with respect to P/E ratio.
  • Financial Position
Ensure that the companies are in sound financial position. This is seen from their current ratio. Also ensure that companies have relatively low long term debts.
  • Dividends
A history of continuance without interruption signals a potentially strong company. Compare with respect to the P/E ratio and across competitors in the same industry group.
  • Price History
Price history is important in assessing whether the market is going to value the company at the right value once an investment is made.

Include the stocks into the investment portfolio once they meet the seven statistical requirements for a defensive investor:
  1. Adequate size
  2. A sufficiently strong financial condition
  3. Continued dividends for at least the past 20 years
  4. No earnings deficits in the past 10 years
  5. 10 year growth of at least one-third in per share earnings
  6. Price of stock not more than 1.5 times net asset value
  7. Price no more than 15 times average earnings of the past 3 years
(1) - Not less than $100 million of annual sales for an industrial company and not less than $50 million of total assets for a public utility
(2) - For industrial companies, current ratio of at least 2 (current assets/current liabilities). For public utility company, debt should not be more than two times the stock's equity at book value
(3) - Uninterrupted payments for at least the past 20 years (SGX is relatively new so make some reasonable adjustments yourself)
(4) - Some reasonable earnings
(5) - EPS growing at least by one third 
(6) - Current price should not be more than 1.5 times the book value of assets 
(7) - Current price should not be more than 15 times average earnings of the past 3 years

RULE: P/E ratio multiplied by book value should not exceed 22.5.

Predictive approach is known as the qualitative approach
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)
A summary of the Graham-Newman methods for the enterprising investor
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
Additional criteria towards stock picking for the enterprising investor
  1. Financial condition where current assets is at least 1.5 times current liabilities, and debt not more than 110% of net current assets
  2. Earnings stability where there is no deficits in the last 5 years
  3. Current dividend stream
  4. Earnings growth significant
  5. Price of share less than 120% of net tangible assets 
Two methods have found to consistently provide good results in the longer past
  1. Purchase of low multiplier stocks of important companies
  2. Diversified group of stocks selling under their net current asset value
Special situations might provide profit potential for the enterprising investor
There are many situations where one can actually make money. Some examples are mergers and acquisitions by buying the stock of the targeted company and selling the acquiring company's stock to hedge the risk, and by looking at book value per share during periods of liquidation (bankruptcy). However, due to the significant time and effort involved in studying merger arbitrage, it is discouraged for individual investors.

Some suggestions for success in the stock market
  • 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
A formula to determine operational efficiency:
ROIC = Owner Earnings / Invested Capital
where Owner Earnings is equal to:
Operating profit 
+ depreciation
+ amortization of goodwill
- federal income tax (paid at company's average rate) 
- cost of stock options
- "maintenance" (or essential) capital expenditures
- any income generated by unsustainable rates of return on pension funds (exercise discretion)
and where Invested Capital is equal to:
Total assets 
- cash (as well as short term investments and non-interest bearing current liabilities)
+ accounting charges that reduced invested capital 

The above formula shows what the company has been able to earn from its operating business and how efficiently shareholders' money is being used. ROIC of 10% is considered attractive. As with previous ratios and analysis, exercise your own discretion relative to industry and peers.

Stay away from complicated financial instruments and companies involved with them
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!

No comments:

Post a Comment