Security Analysis (Graham & Dodd)

(Zen Buddha Silence by Marilyn Barbone)

(Image:  Zen Buddha Silence by Marilyn Barbone.)

January 22, 2017

This week, I am reviewing Security Analysis (McGraw Hill, 6th edition), by Benjamin Graham and David L. Dodd.  This blog post contains even more quotations than usual because the book is 730 pages (though I only read 75% of it, and have yet to look at the accompanying CD).

As with the other great value investors, it’s worth spending a long time soaking up the lessons of Graham and Dodd.

 

THINKING FOR YOURSELF

David Abrams, in his Introduction to Part VII, writes that the most important point from Security Analysis is this:  “look at the numbers and think for yourself.  All the great investors do, and that’s what makes them great.” (p. 631)

Or as Ben Graham has said:

You’re neither right nor wrong because the crowd disagrees with you.  You’re right because your data and reasoning are right.

 

KINDNESS AND GENEROSITY

I’ve always been deeply impressed by the kindness and generosity of many value investors, including Warren Buffett and Charlie Munger.  This is a part of the value investing tradition started by Ben Graham and David Dodd.  As Warren Buffett writes in the Forward:

In the end, that’s probably what I admire most about the two men.  It was ordained at birth that they would be brilliant; they elected to be generous and kind.

The way they behaved made as deep an impression on me – and many of my classmates – as did their ideas.  We were being taught not only how to invest wisely; we were also being taught how to live wisely.

 

TIMELESS WISDOM

Seth Klarman writes in the Preface to the 6th Edition – The Timeless Wisdom of Graham and Dodd:

In 1992, Tweedy, Browne Company LLC, a well-known value investment firm, published a compilation of 44 research studies entitled, ‘What Has Worked in Investing.’  The study found that what has worked is fairly simple: cheap stocks (measured by price-to-book values, price-to-earnings ratios, or dividend yields)  reliably outperform expensive ones, and stocks that have underperformed (over three- and five-year periods) subsequently beat those that have lately performed well.  In other words, value investing works!  I know of no long-time practitioner who regrets adhering to a value philosophy; few investors who embrace the fundamental principles ever abandon this investment approach for another.  (xvii)

Klarman says value investing is an art, not a science.  And there are always aspects of the future that nobody can foresee.  Even the best investors tend to be wrong about one-third of the time.  “In the end, the most successful value investors combine detailed business research and valuation work with endless discipline and patience, a well-considered sensitivity analysis, intellectual honesty, and years of analytical and investment experience.” (xviii-xix)

Klarman observes that not all value investors are alike.  Some invest in obscure micro caps, while others invest in large caps.  Some invest globally, while others focus on a single market sector like energy.  Some use a quantitative approach, while others assess “private market value.”  Some are activists, while others look for catalysts already in place (such as a spin-off, asset sale, repurchase plan, or new management).

Finally, human nature never changes.  Capital market manias regularly occur on a grand scale… Even highly capable investors can wither under the relentless message from the market that they are wrong.  The pressures to succumb are enormous;  many investment managers fear they’ll lose business if they stand too far apart from the crowd.  Some also fail to pursue value because they’ve handcuffed themselves (or been saddled by clients) with constraints preventing them from buying stocks selling at low dollar prices, small-cap stocks, stocks of companies that don’t pay dividends or are losing money, or debt instruments with below investment-grade ratings.  Many also engage in career management techniques like ‘window dressing’ their portfolios at the end of calendar quarters or selling off losers (even if they are undervalued) while buying more of the winners (even if overvalued).  Of course, for those value investors who are truly long term oriented, it is a wonderful thing that many potential competitors are thrown off course by constraints that render them unable or unwilling to effectively compete.  (xxi-xxii)

While bargains still occasionally hide in plain sight, securities today are most likely to become mispriced when they are either accidentally overlooked or deliberately avoided.  Consequently, value investors have bad to become more thoughtful about where to focus their analysis…. (xxiii)

Today’s value investors also find opportunity in the stocks and bonds of companies stigmatized on Wall Street because of involvement in protracted litigation, scandal, accounting fraud, or financial distress.  The securities of such companies sometimes trade down to bargain levels, where they become good investments for those who are able to remain stalwart in the face of bad news.

Value investors, therefore, should not try to time the market or guess whether it will rise or fall in the near term.  Rather, they should rely on a bottom-up approach, sifting the financial markets for bargains and then buying them, regardless of the level or recent direction of the market or economy.  Only when they cannot find bargains should they default to holding cash. (xxiv-xxv, my emphasis)

….

Another important factor for value investors to take into account is the growing propensity of the Federal Reserve to intervene in the financial markets at the first sign of trouble.  Amidst severe turbulence, the Fed frequently lowers interest rates to prop up securities prices and restore investor confidence.  While the intention of Fed officials is to maintain orderly capital markets, some money managers view Fed intervention as a virtual license to speculate.  Aggressive Fed tactics, sometimes referred to as the ‘Greenspan put’ (now the ‘Bernanke put’), create a moral hazard that encourages speculation while prolonging overvaluation…

Selling

…Selling is more difficult because it involves securities that are closer to fully priced.  As with buying, investors need a discipline for selling.  First, sell targets, once set, should be regularly adjusted to reflect all currently available information.  Second, individual investors must consider tax consequences.  Third, whether or not an investor is fully invested may influence the urgency of raising cash from a stockholding as it approaches full valuation.  The availability of better bargains might also make one a more eager seller.  Finally, value investors should completely exit a security by the time it reaches full value;  owning overvalued securities is the realm of speculation.  Value investors typically begin selling at a 10% to 20% discount to their assessment of underyling value – based on the liquidity of the security, the possible presence of a catalyst for value realization, the quality of management, the riskiness and leverage of the underlying business, and the investors’ confidence level regarding the assumptions underlying the investment.  (xxxviii)

Value investing is a get rich slow approach.  Because of innate psychological tendencies on the part of many investors, value investing is likely to continue to work over time:

The foibles of human nature that result in the mass pursuit of instant wealth and effortless gain seem certain to be with us forever.  So long as people succumb to this aspect of their natures, value investing will remain, as it has been for 75 years, a sound and low-risk approach to successful long-term investing.  (xl)

 

HISTORICAL BACKDROP

James Grant writes about the historical backdrop in the Introduction to the Sixth Edition:

Security analysis itself is a cyclical phenomenon;  it, too, goes in and out of fashion, Graham observed.  It holds a strong, intuitive appeal for the kind of businessperson who thinks about stocks the way he or she thinks about his or her own family business.  What would such a fount of common sense care about earnings momentum or Wall Street’s pseudo-scientific guesses about the economic future?  Such an investor, appraising a common stock, would much rather know what the company behind it is worth.  That is, he or she would want to study its balance sheet.  Well, Graham relates here, that kind of analysis went out of style when stocks started levitating without reference to anything except hope and prophecy.  So, by about 1927, fortune-telling and chart-reading had displaced the value discipline by which he and his partner were earning a very good living.  It is characteristic of Graham that his critique of the ‘new era’ method of investing is measured and not derisory… (11)

Grant mentions Graham’s critique of John Burr Williams’s The Theory of Investment Value.  “The rub, he pointed out, was that, in order to apply Williams’s method, one needed to make some very large assumptions about the future course of interest rates, the growth of profit, and the terminal value of the shares when growth stops.”  As Graham writes:

One wonders whether there may not be too great a discrepancy between the necessarily hit-or-miss character of these assumptions and the highly refined mathematical treatment to which they are subjected.

Grant, in similar manner to Buffett, notes the unmistakable humanity of Graham (and Dodd):

Graham’s technical accomplishments in securities analysis, by themselves, could hardly have carried Security Analysis through its five editions.  It’s the book’s humanity and good humor that, to me, explain its long life and the adoring loyalty of a certain remnant of Graham readers, myself included.  Was there ever a Wall Street moneymaker better steeped than Graham in classical languages and literature and in the financial history of his own time?  I would bet ‘no’ with all the confidence of a value investor laying down money to buy an especially cheap stock.  (18-19)

 

THE ESSENTIAL LESSONS

Roger Lowenstein authored the Introduction to Part I:

In 25 years as a financial journalist, virtually all of the investors of this writer’s acquaintance who have consistently earned superior profits have been Graham-and-Dodders.  (40)

It took Graham 20 years – which is to say, a complete cycle from the bull market of the Roaring Twenties through the dark, nearly ruinous days of the early 1930s – to refine his investment philosophy into a discipline that was as rigorous as the Euclidean theorems he had studied in college.  (41)

The changes in the marketplace have been so profound that it might seem astonishing that an investment manual written in the 1930s would have any relevance today.  But human nature doesn’t change.  People still oscillate between manic highs and depressive lows, and in their hunger for instant profits, their distaste for the hard labor of serious study and for independent thought, modern investors look very much like their grandfathers and even their great-grandfathers.  Then as now, it takes discipline to overcome the demons (largely emotional) that impede most investors.  And the essentials of security analysis have not much changed.  (42-43)

Finding Bargains

Individual stocks are often cheap when a whole industry or group of securities has been sold down indiscriminately. (50)

In 2001, for instance, energy stocks were cheap (as was the price of oil).  Graham and Dodd would not have advised speculating on the price of oil – which is dependent on myriad uncertain factors from OPEC to the growth rate of China’s economy to the weather.  But because the industry was depressed, drilling companies were selling for less than the value of their equipment.  Ensco International was trading at less than $15 per share, while the replacement value of its rigs was estimated at $35.  Patterson-UTI Energy owned some 350 rigs worth about $2.8 billion.  Yet its stock was trading for only $1 billion.  Investors were getting the assets at a huge discount.  Though the subsequent oil price rise made these stocks home runs, the key point is that the investments weren’t dependent on the oil price.  Graham and Dodd investors bought into these stocks with a substantial margin of safety. (51)

Forecasting Flows

In estimating future earnings (for any sort of business), Security Analysis provides two vital rules.  One, as noted, is that companies with stable earnings are easier to forecast and hence preferable.

The second point relates to the tendency of earnings to fluctuate, at least somewhat, in a cyclical pattern.  Therefore, Graham and Dodd made a vital (and oft-overlooked) distinction.  A firm’s average earnings can provide a rough guide to the future; the earnings trend is far less reliable…

An investor in U.S. securities thus faces a challenge unimaginable to Graham and Dodd.  Where the latter suffered a paucity of information, investors today confront a surfeit…

 

INTRINSIC VALUE

Graham defines intrinsic value as follows:

In general terms it is understood to be that value which is justified by the facts, e.g., the assets, earnings, dividends, definite prospects, as distinct, let us say, from market quotations established by artificial manipulation or distorted by psychological excess.  But it is a great mistake to imagine that intrinsic value is as definite and as determinable as is the market price. (64)

For Graham, net asset value and earnings power were two primary ways of estimating intrinsic value.  And net asset value often meant liquidation value, largely because Graham was writing during the Great Depression.  He returns to this concept later in the book.

By earnings power, Graham means normal earnings, or what today is referred to as normalized earnings:  what the company can safely be assumed to earn in a “normal” economic environment.  Net asset value – especially liquidation value – is not necessarily more precise than earnings power.  But net asset value is less subject to change than earnings power.

Regarding earnings power, Graham writes:

But the phrase ‘earnings power’ must imply a fairly confident expectation of certain future results.  It is not sufficient to know what the past earnings have averaged, or even that they disclose a definite line of growth or decline.  There must be plausible grounds for believing that this average or this trend is a dependable guide to the future.  Experience has shown only too forcibly that in many instances this is far from true.  This means that the concept of ‘earnings power,’ expressed as a definite figure, and the derived concept of intrinsic value, as something equally definite and ascertainable, cannot be safely accepted as a general premise of security analysis.  (65)

Intrinsic value, whether based on asset value or earnings power, is always an estimate.  But in many cases, an estimate is all that is needed:

The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security.  It needs only to establish either that the value is adequate – e.g., to protect a bond or to justify a stock purchase – or else that the value is considerably higher or considerably lower than the market price.  For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient.  To use a homely simile, it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age or that a man is heavier than he should be without knowing his exact weight.  (66)

It would follow that even a very indefinite idea of the intrinsic value may still justify a conclusion if the current price falls far outside either the maximum or minimum appraisal.  (67)

Human emotion often plays a significant role in determining stock prices:

…the market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with specific qualities.  Rather should we say that the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion.  (70)

 

QUANTITATIVE vs. QUALITATIVE FACTORS

Nearly every issue might conceivably be cheap in one price range and dear in another. (80)

Not only can one overpay for a good business.  But what appears to be a good business may not remain a good business.

Many of the leading enterprises of yesterday are today far back in the ranks.  Tomorrow is likely to tell a similar story.  The most impressive illustration is afforded by the persistent decline in the relative investment position of the railroads as a class during the past two decades.

Graham always emphasizes skepticism and independent thinking:

The analyst must pay respectful attention to the judgment of the market place and to the enterprises which it strongly favors, but he must retain an independent and critical viewpoint.  Nor should he hesitate to condemn the popular and espouse the unpopular when reasons sufficiently weighty and convincing are at hand. (81)

Graham writes that quantitative factors are more easily analyzed than qualitative factors:

Broadly speaking, the quantitative factors lend themselves far better to thoroughgoing analysis than do the qualitative factors.  The former are fewer in number, more easily obtainable, and much better suited to the forming of definite and dependable conclusions.  Furthermore the financial results will themselves epitomize many of the qualitative elements, so that a detailed study of the latter may not add much of importance to the picture.  (81-82)

The qualitative factors upon which most stress is laid are the nature of the business and the character of management.  These elements are exceedingly important, but they are also exceedingly difficult to deal with intelligently.  (83)

Most businesses and industries experience reversion to the mean, according to Graham:

Abnormally good or abnormally bad conditions do not last forever.  This is true not only of general business but of particular industries as well.  Corrective forces are often set in motion which tend to restore profits where they have disappeared, or to reduce them where they are excessive in relation to capital.

The best measurement of management is a superior track record over time.  It’s important not to double count the quality of management:

The most convincing proof of capable management lies in a superior comparative record over a period of time.  But this brings us back to the quantitative data.

There is a strong tendency in the stock market to value the management factor twice in its calculations.  Stock prices reflect the large earnings which the good management has produced, plus a substantial increment for ‘good management’ considered separately.  This amounts to ‘counting the same trick twice,’ and it proves a frequent cause of overvaluation. (84)

But while a trend shown in the past is a fact, a ‘future trend’ is only an assumption.  The factors that we mentioned previously as militating against the maintenance of abnormal prosperity or depression are equally opposed to the indefinite continuance of an upward or downward trend.  By the time the trend has become clearly noticeable, conditions may well be ripe for a change. (84)

During the Great Depression, many companies were trading below liquidation value because their earnings were weak or inconsistent.  Given this extended bad economic environment, it stands to reason that Graham emphasized definite values – such as liquidation values – as opposed to future earnings.  Again here:

Analysis is concerned primarily with values which are supported by the facts and not with those which depend largely upon expectations.  In this respect the analyst’s approach is diametrically opposed to that of the speculator, meaning thereby one whose success turns upon his ability to forecast or to guess future developments.  Needless to say, the analyst must take possible future changes into account, but his primary aim is not so much to profit from them as to guard against them.  Broadly speaking, he views the business future as a hazard which his conclusions must encounter rather than as the source of his vindication. (86)

It follows that the qualitative factor in which the analyst should properly be most interested is that of inherent stability.  For stability means resistance to change and hence greater dependability for the results shown in the past…. in our opinion stability is really a qualitative trait, because it derives in the first instance from the character of the business and not from its statistical record.  A stable record suggest that the business is inherently stable, but this suggestion may be rebutted by other considerations.  (87)

In the mathematical phrase, a satisfactory statistical exhibit is a necessary though by no means a sufficient condition for a favorable decision by the analyst.  (88)

 

STOCKHOLDERS ARE OWNERS

It must never be forgotten that a stockholder is an owner of the business and an employer of its officers.  He is entitled not only to ask legitimate questions but also to have them answered, unless there is some persuasive reason to the contrary.

Insufficient attention has been paid to this all-important point.  The courts have generally held that a bona fide stockholder has the same right to full information as a partner in a private business.  This right may not be exercised to the detriment of the corporation, but the burden of proof rests upon the management to show an improper motive behind the request or that disclosure of the information would work an injury to the business.

Compelling a company to supply information involves expensive legal proceedings and hence few shareholders are in a position to assert their rights to the limit.  Experience shows, however, that vigorous demands for legitimate information are frequently acceded to even by the most recalcitrant managements.  This is particularly true when the information asked for is no more than that which is regularly published by other companies in the same field.  (98)

 

INVESTMENT vs. SPECULATION

An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return.  Operations not meeting these requirements are speculative.

… We speak of an investment operation rather than an issue or a purchase, for several reasons.  It is unsound to think always of investment character as inhering in an issue per se.  The price is frequently an essential element, so that a stock (and even a bond) may have investment merit at one price level but not at another.  Furthermore, an investment might be justified in a group of issues, which would not be sufficiently safe if made in any one of them singly.  In other words, diversification might be necessary to reduce the risk involved in the separate issues to the minimum consonant with the requirements of investment.  (This would be true, in general, of purchases of common stocks for investment.)

In our view it is also proper to consider as investment operations certain types of arbitrage and hedging commitments which involve the sale of one security against the purchase of another.  In these operations the element of safety is provided by the combination of purchase and sale.  This is an extension of the ordinary concept of investment, but one which appears to the writers to be entirely logical.  (106)

 

NEW VALUATION BENCHMARK IN 1962…  and 2016?

J. Ezra Merkin, in the Introduction to Part III, writes that a new valuation benchmark was established in 1958:

A few years later, in 1958, equity dividend yields fell below bond yields for the first time.  A sensible investor putting money to work at the time could hardly credit the change as part of a permanent new reality.  To the contrary, it must have seemed a mandate to short the stock market.  Think of all the money lost over all the years by the true believers who have argued: ‘This time is different.’  Yet the seasoned professionals of that time were cautious and wrong, and the irreverent optimists were right.  This time, it really was different.  From the safe perspective of a half century, it seems incontrovertible that a new valuation benchmark had been established. (287-288)

In 1963, Ben Graham gave a fascinating lecture.  Graham stated that, because of a permanently more stimulative policy by the U.S. government, the U.S. stock market should be valued 50% higher than before.  Here is a link to the lecture:  http://www.jasonzweig.com/wp-content/uploads/2015/03/BG-speech-SF-1963.pdf

This is relevant today.  If U.S. interest rates return to 3%, 4%, 5%, or more within the next decade or so, then the S&P 500 Index today is quite overvalued (based on measures such as the CAPE and the q-ratio).  However, if U.S. interest rates stay near 0% for several decades, then the S&P 500 Index today may not be overvalued at all.  Very low rates, if extended far enough into the future, would actually make the S&P 500 undervalued today.  As Warren Buffett has noted, near-zero rates for many decades would eventually lead to a normal P/E level of 40, 50, or even higher.

Currently the high debt levels and relatively slow growth in the U.S. mean that rates could stay near zero for a long time.  (This may be more true for Europe and Japan.)  On the other hand, there could be an economically significant innovation explosion – perhaps driven by artificial intelligence, renewable energy, and/or space colonization – in which case the U.S. would grow faster, debts would come down, and interest rates would move higher again.

 

THE DIVIDEND FACTOR

In the Introduction to Part IV, Bruce Berkowitz explains how to calculate the intrinsic value of any business:

… That’s the amount of cash an owner can pocket after paying all expenses and making whatever investments are necessary to maintain the business.  This free cash flow is the well from which all returns are drawn, whether they are dividends, stock buybacks, or investments capable of enhancing future returns.  (339)

Free cash flow is what Buffett calls owner earnings, because it represents what can be taken out of the business without impairing its competitive position.  Intrinsic value can thus be estimated by all future free cash flow or by all future dividends.  Berkowitz writes:

Graham and Dodd were among the first to apply careful financial analysis to common stocks… With bonds, the returns consist of specific payments made under contractual commitments.  With stocks, the returns consist of dividends that are paid from the earnings of the business, or cash that could have been used to pay dividends that was instead reinvested in the business.

By examining the assets of a business and their earnings (or cash flow) power, Graham and Dodd argued that the value of future returns could be calculated with reasonable accuracy.  (340)

To value equities, we at Fairholme begin by calculating free cash flow.  We start with net income as defined under Generally Accepted Accounting Principles (GAAP).  Then we add back noncash charges such as depreciation and amortization, which are formulaic calculations based on historical costs (depreciation for tangible assets, amortization for intangibles) and may not reflect a reduction in those assets’ true worth.

Even so, most assets deteriorate in value over time, and we have to account for that.  So we subtract an estimate of the company’s cost of maintaining tangible assets such as the office, plant, inventory, and equipment;  and intangible assets like customer traffic and brand identity.  Investment at this level, properly deployed, should keep the profits of the business in a steady state.

That is only the beginning.  For instance, companies often misstate the costs of employees’ pension and postretirement medical benefits…

Companies often lowball what they pay management.  For instance, until the last several years, most companies did not count the costs of stock option grants as employee compensation, nor did the costs show up in any other line item…

Another source of accounting-derived profits comes from long-term supply contracts.  For instance, when now-defunct Enron entered into a long-term trading or supply arrangement, the company very optimistically estimated the net present value of future profits from the deal and put that into the current year’s earnings even though no cash was received…

Some companies understate free cash flow because they expense the cost of what are really investments in growth…

All of these noncash accounting conventions illustrate the difficulty of identifying a company’s current free cash flow.  Still, we are far from done.  My associates and I next want to know (a) how representative is current cash flow of average past flow, and (b) is it increasing or decreasing – that is, does the company face headwinds or ride on tailwinds?  (341-342)

 

THE THEORY OF COMMON-STOCK INVESTMENT

Speculation, in its etymology, meant looking forward;  investment was allied to ‘vested interests’ – to property rights and values taking root in the past.  The future was uncertain, therefore speculative;  the past was known, therefore the source of safety.  (354)

Another useful approach to the attitude of the prewar common-stock investor is from the standpoint of taking an interest in a private business.  The typical common-stock investor was a business man, and it seemed sensible to him to value any corporate enterprise in much the same manner as he would value his own business.  This meant that he gave at least as much attention to the asset values behind the shares as he did to their earnings records.  It is essential to bear in mind the fact that a private business has always been valued primarily on the basis of the ‘net worth’ as shown by its statement.  A man contemplating the purchase of a partnership or stock interest in a private undertaking will always start with the value of that interest as shown ‘on the books,’ i.e., the balance sheet, and will then consider whether or not the record and prospects are good enough to make such a commitment attractive.  An interest in a private business may of course be sold for more or less than its proportionate asset value;  but the book value is still invariably the starting point of the calculation, and the deal is finally made and viewed in terms of the premium or discount from book value involved. (355)

Broadly speaking, the same attitude was formerly taken in an investment purchase of a marketable common stock.  The first point of departure was the par value, presumably representing the amount of cash or property originally paid into the business;  the second basal figure was the book value, representing the par value plus a ratable interest in the accumulated surplus.  Hence in considering a common stock, investors asked themselves: ‘Is this issue a desirable purchase at the premium above book value, or the discount below book value, represented by the market price?’

… We thus see that investment in common stocks was formerly based upon the threefold concept of:  (1) a suitable and established dividend return, (2) a stable and adequate earnings record, and (3) a satisfactory backing of tangible assets.  Each of these three elements could be made the subject of careful analytical study, viewing the issue both by itself and in comparison with others of its class.  Common-stock commitments motivated by any other viewpoint were characterized as speculative, and it was not expected that they should be justified by a serious analysis. (356)

In the bull market leading up to 1929, people had developed a completely different attitude.  In the new-era theory, the value of a stock depended entirely on what it would earn in the future.  From this dictum the following corollaries were drawn:

  • That the dividend rate should have slight bearing upon the value.
  • That since no relationship apparently existed between assets and earnings power, the asset value was entirely devoid of importance.
  • That past earnings were significant only to the extent that they indicated what changes in the earnings were likely to take place in the future.

One reason for the new-era theory of common stocks was that a long historical record of dividends or earnings was not found to be a good guide to the future of a business.  Some businesses – after a decade of prosperity – went into insolvency.  Other companies – after being small or unsuccessful or of doubtful repute – quickly became large businesses with strong earnings and the highest rating.  As Graham explains:

In the face of all this instability it was inevitable that the threefold basis of common-stock investment should prove totally inadequate.  Past earnings and dividends could no longer be considered, in themselves, an index of future earnings and dividends.  Furthermore, these future earnings showed no tendency whatever to be controlled by the amount of the actual investment in the business – the asset values – but instead depended entirely upon a favorable industrial position and upon capable or fortunate managerial policies.  In numerous cases of receivership, the current assets dwindled, and the fixed assets proved almost worthless.  Because of this absence of any connection between both assets and earnings and between assets and realizable values in bankruptcy, less and less attention came to be paid either by financial writers or by the general public to the formerly important question of ‘net worth,’ or ‘book value’;  and it may be said that by 1929 book value had practically disappeared as an element in determining the attractiveness of a security issue. (357-358)

Another part of the new-era theory of common stocks was that common stocks were the most profitable long-term investment.  The record showed that common stocks produced both higher income and greater principal profit than standard bonds.  Thus, according to Graham, the new-era theory was as follows:

  • The value of a common stock depends on what it can earn in the future.
  • Good common stocks are those which have shown a rising trend of earnings.
  • Good common stocks will prove sound and profitable investments.

Graham comments:

These statements sound innocent and plausible.  Yet they concealed two theoretical weaknesses that could and did result in untold mischief.  The first of these defects was that they abolished the fundamental distinctions between investment and speculation.  The second was that they ignored the price of a stock in determining whether or not it was a desirable purchase. (359)

In essence, then, the new-era theory of investment was “old-style speculation”:  Common stocks were preferred to bonds, capital gains were preferred to dividends, and future estimates were more important than past records.  And most incredibly of all, the desirability of a common stock “was entirely independent of its price.”  Paying $100 per share for earnings of $2.50 per share was typical.  And the same reasoning was used as a basis to pay $200, $1,000, or any price for the same $2.50 per share in earnings.  Graham continues:

An alluring corollary of this principle was that making money in the stock market was now the easiest thing in the world.  It was only necessary to buy ‘good’ stocks, regardless of price, and then to let nature take her upward course…  (360)

Graham found it ironic that the investment trusts of the day completed adopted the new-era view of investments.

…The investment process consisted merely of finding prominent companies with a rising trend of earnings and then buying their shares regardless of price.  Hence the sound policy was to buy only what every one else was buying – a select list of highly popular and exceedingly expensive issues, appropriately known as ‘blue chips.’  The original idea of searching for the undervalued and neglected issues dropped completely out of sight.  Investment trusts actually boasted that their portfolios consisted exclusively of the active and standard (i.e., the most popular and highest priced) common stocks.  With but slight exaggeration, it might be asserted that under this convenient technique of investment, the affairs of a ten-million dollar investment trust could be administered by the intelligence, the training and the actual labors of a single thirty-dollar-a-week clerk.

The man in the street, having been urged to entrust his funds to the superior skill of investment experts – for substantial compensation – was soon reassuringly told that the trusts would be careful to buy nothing except what the man in the street was buying himself.

Thus, investors were deceiving themselves based on the long-term superior record of stocks as compared to bonds.  Here is the problem with that argument, says Graham:

… This would be true, typically, of a stock earning $10 and selling at 100.  But as soon as the price was advanced to a much higher price in relation to earnings, this advantage disappeared, and with it disappeared the entire theoretical basis for investment purchases of common stocks.  When in 1929 investors paid $200 per share for a stock earning $8, they were buying an earning power no greater than the bond-interest rate, without the extra protection afforded by a prior claim.  Hence in using the past performances of common stocks as the reason for paying prices 20 to 40 times their earnings, the new-era exponents were starting with a sound premise and twisting it into a woefully unsound conclusion. (362)

 

NEWER CANONS OF COMMON-STOCK INVESTMENT

Is it possible to tell when a stock price is too high?

… We think that there is no good answer to this question – in fact we are inclined to think that even if one knew for a certainty just what a company is fated to earn over a long period of years, it would still be impossible to tell what is a fair price to pay for it today.  It follows that once the investor pays a substantial amount for the growth factor, he is inevitably assuming certain kinds of risks;  viz., that the growth will be less than he anticipates, that over the long pull he will have paid too much for what he gets, that for a considerable period the market will value the stock less optimistically than he does.

Graham argues that it’s advantageous to buy unpopular stocks at prices that are low or at prices that accord with private market value (what a prudent business man would pay for the business if it were private):

On the other hand, assume that the investor strives to avoid paying a high premium for future prospects by choosing companies about which he is personally optimistic, although they are not favorites of the stock market.  No doubt this is the type of judgment that, if sound, will prove most remunerative.  But, by the very nature of the case, it must represent the activity of strong-minded and daring individuals rather than investment in accordance with accepted rules and standards.

… we repeat that this method may be followed successfully if it is pursued with skill, intelligence and diligent study.  If so, is it appropriate to call such purchases by the name ‘investment’?  Our answer is ‘yes,’ provided that two factors are present:  the first, already mentioned, that the elements affecting the future are examined with real care and a wholesome scepticism, rather than accepted quickly via some easy generalization;  the second, that the price paid be not substantially different from what a prudent business man would be willing to pay for a similar opportunity presented to him to invest in a private undertaking over which he could exercise control. (371-372)

 

THE EARNINGS FACTOR IN COMMON-STOCK VALUATION

In the Introduction to Part V, Glenn Greenberg writes:

[Security Analysis] is the more remarkable because it was written during the uniquely depressed circumstances of 1934, a nation of 25% unemployment with most businesses struggling to survive.  Yet Graham and Dodd were able to codify the principles that have inspired great investors through 75 years of remarkable prosperity.  Their insights are as applicable now as ever.  (396)

Graham holds that past earnings are an important, but not very reliable, guide to the future:

… This is at once the most important and the least satisfactory aspect of security analysis.  It is the most important because the sole practical value of our laborious study of the past lies in the clue it may offer to the future;  it is the least satisfactory because this clue is never thoroughly reliable and it frequently turns out to be quite valueless.  These shortcomings detract seriously from the value of the analyst’s work, but they do not destroy it.  The past exhibit remains a sufficiently dependable guide, in a sufficient proportion of cases, to warrant its continued use as the chief point of departure in the valuation and selection of securities.  (472)

When Graham discusses earnings power, he means normal earnings:

The concept of earnings power has a definite and important place in investment theory.  It combines a statement of actual earnings over a period of years, with a reasonable expectation that these will be approximated in the future, unless extraordinary conditions supervene.  The record must cover a number of years, first because a continued or repeated performance is always more impressive than a single occurrence and secondly because the average of a fairly long period will tend to absorb and equalize the distorting influences of the business cycle.

A distinction must be drawn, however, between an average that is the mere arithmetical resultant of an assortment of disconnected figures and an average that is ‘normal’ or ‘modal,’ in the sense that the annual results show a definite tendency to approximate the average. (472)

According to Graham, a qualitative study of the nature of the business – e.g., its competitive position – is an important part of determining normal earnings:

In order for a company’s business to be regarded as reasonably stable, it does not suffice that the past record should show stability.  The nature of the undertaking, considered apart from any figures, must be such as to indicate an inherent permanence of earning power.  (474)

Given the importance of normal earnings, it follows that current earnings are not a primary basis for estimating intrinsic value.  Graham writes:

The market level of common stocks is governed more by their current earnings than by their long-term average.  This fact accounts in good part for the wide fluctuations in common-stock prices, which largely (though by no means invariably) parallel the changes in their earnings between good years and bad.  Obviously the stock market is quite irrational in thus varying its valuation of a company proportionately with the temporary changes in its reported profits.  A private business might easily earn twice as much in a boom year as in poor times, but its owner would never think of correspondingly marking up or down the value of his capital investment.

This is one of the most important lines of cleavage between Wall Street practice and the canons of ordinary business.  Because the speculative public is clearly wrong in its attitude on this point, it would seem that its errors should afford profitable opportunities to the more logically minded to buy common stocks at the low prices occasioned by temporarily reduced earnings and to sell them at inflated levels created by abnormal prosperity.

… We have here the long-accepted and classical formula for ‘beating the stock market.’  Obviously it requires strength of character in order to think and to act in opposite fashion from the crowd and also patience to wait for opportunities that may be spaced years apart.  But there are still other considerations that greatly complicate this apparently simple rule for successful operations in stocks.  In actual practice the selection of suitable buying and selling levels becomes a difficult matter…. (476-477)

Graham makes it clear that most of the time, abnormally low current earnings later recover to normal levels, while abnormally high current earnings later revert to more normal levels.  However, sometimes low earnings do not recover, and sometimes high earnings remain high or go higher.  Thus, the analyst must carefully assess each situation in order to determine the approximate level of normal earnings, and whether this level has changed from before.  Yet to be conservative, argues Graham, if normal earnings are higher than in the past, the analyst should use the past level as a basis for estimating intrinsic value.

If earnings show a downward trend, that often will create an irrationally low stock price.  In these cases, Graham argues that one should view such a business as a sensible businessman would:  considering the pros and cons, what would the enterprise be worth to a private owner?

 

PRICE-EARNINGS RATIO’S FOR COMMON STOCKS

A given common stock is generally considered to be worth a certain number of times its current earnings.

Subsequent to 1932 there developed a tendency for prices to rule higher in relation to earnings because of the sharp drop in long-term interest rates. (497)

Intrinsic value is an estimate rather than an exact figure.  Net asset value is an estimate.  And current earnings change all the time.  Moreover, investor emotions are a component of stock prices:

… Hence the prices of common stocks are not carefully thought out computations but the resultants of a welter of human reactions.  The stock market is a voting machine rather than a weighing machine.  It responds to factual data not directly but only as they affect the decisions of buyers and sellers.  (497)

Graham explains the conditions under which current earnings may be considered normal earnings.  Graham also explains when the analyst may even set future normal earnings as higher than at any time in the past:

… His fundamental basis of appraisal must be an intelligent and conservative estimate of the future earning power.  But his measure of future earnings can be conservative only if it is limited by actual performance over a period of time.  We have suggested, however, that the profits of the most recent year, taken singly, might be accepted as the gage of future earnings, if (1) general business conditions in that year were not exceptionally good, (2) the company has shown an upward trend of earnings for some years past and (3) the investor’s study of the industry gives him confidence in its continued growth.  In a very exceptional base, the investor may be justified in counting on higher earnings in the future than at any time in the past.  This might follow from developments involving a patent or the discovery of new ore in a mine or some similar specific and significant occurrence.  But in most instances he will derive the investment value of a common stock from the average earnings of a period between five and ten years.  This does not mean that all common stocks with the same average earnings should have the same value.  The common-stock investor (i.e., the conservative buyer) will properly accord a more liberal valuation to those issues which have current earnings above the average or which may reasonably be considered to possess better than average prospects or an inherently stable earnings power.  But it is the essence of our viewpoint that some moderate upper limit must in every case be placed on the multiplier in order to stay within the bounds of conservative valuation.  We would suggest that about 20 times average earnings is as high a price as can be paid in an investment purchase of a common stock.

Most of the time, average earnings based on five or ten years is a reasonable estimate for normal earnings.  But the analyst should also make adjustments for companies with better than average prospects and for companies with more stable earnings.

Graham suggests that 20 times earnings is as high a price as a conservative investor should ever pay for an investment (as opposed to a speculation):

… it is difficult to see how average earnings of less than 5% upon the market price could ever be considered as vindicating that price.

Given that 20 times earnings is the upper limit, it is natural to ask what the typical multiple might be.  Graham answers:

… This suggests that about 12 or 12 ½ times average earnings may be suitable for the typical case of a company with neutral prospects.  We must emphasize also that a reasonable ratio of market price to average earnings is not the only requisite for a common-stock investment.  It is a necessary but not a sufficient condition.  The company must be satisfactory also in its financial set-up and management, and not unsatisfactory in its prospects. (499)

 

EQUITY STUBS

… there is some tendency for speculatively capitalized enterprises to sell at relatively high values in the aggregate during good times or good markets.  Conversely, of course, they may be subject to a greater degree of undervaluation in depression.  There is, however, a real advantage in the fact that such issues, when selling on a deflated basis, can advance much further than they can decline. (512-513)

Graham gives an example of 400-bagger (American Water Works and Electric Company).  Because the company was highly indebted, when gross revenues grew about 160%, per share earnings increased dramatically more.

Highly indebted companies tend to sell at very low prices when their earnings are abnormally low, which often creates an investment opportunity:

The overdeflation of a speculative issue … in unfavorable markets creates the possibility of an amazing price advance when conditions improve, because the earnings per share then show so violent an increase. (517)

In effect, the equity holder of a highly indebted enterprise operates with relatively little capital relative to the debt holders.  The equity holder in this case may have a similar downside to the debt holder, but dramatically higher upside.  Graham says the equity holder has a “cheap call” on the future profits of the highly indebted enterprise.

 

LOW-PRICED STOCKS

Low-priced stocks seem to have an “inherent arithmetical advantage” because they can increase much more than they can decrease.  What often creates a low-priced stock is when current profits are low in relation to the size of the enterprise.  Thus, like an equity stub, a low-priced stock can be thought of as a “cheap call” on the future profits of the enterprise.

Graham notes that unusually high operating or production costs can have the same effect as high debt levels:

The speculative or marginal position may arise from any cause that reduces the percentage of gross available for the common to a subnormal figure and that therefore serves to create a subnormal value for the common stock in relation to the volume of business.  Unusually high operating or production costs have the identical effect as excessive senior charges in cutting down the percentage of gross available for common…. (525)

 

PART VI:  BALANCE-SHEET ANALYSIS

In the Introduction to Part VI, Bruce Greenwald notes how Graham and Dodd define intrinsic value:

that value which is justified by the facts, e.g., the assets, earnings, dividends, [and] definite prospects, as distinct, let us say, from market quotations established by market manipulation or distorted by psychological excesses. (64)

If perfect information were possible, then intrinsic value would be identical to true value.  But Graham and Dodd understood that there are always uncertainties, both with regard to current information and with regard to the future.  Therefore, intrinsic value must be an estimate.  But even as an estimate, intrinsic value plays a vital role, as Greenwald explains:

… It served first of all to organize examination and use of the available information, ensuring that the relevant facts would be brought to bear and irrelevant noise ignored.  Second, it would produce an appreciation of the range of uncertainty associated with any particular intrinsic value calculation.  Graham and Dodd recognized that even a very imperfect intrinsic value would be useful in making investment decisions. 

The purchase of securities should then be made only at prices far enough below the intrinsic value to provide a margin of safety that would offer appropriate protection against this ‘indistinctness’ in the calculated intrinsic value.  In essence, what Graham and Dodd required was that an investor, as opposed to a speculator, should know as far as possible the value of any security purchased and also the degree of uncertainty attached to that value.  (536)

Greenwald identifies four areas that Graham and Dodd describe as being useful for balance sheet analysis:

…First, the balance sheet identifies the quantity and nature of resources tied up in a business.  For an economically viable enterprise, these resources are the basis of its returns.  In a competitive environment, a firm without resources cannot generally expect to earn any significant profits.  If an enterprise is not economically viable, then the balance sheet can be used to identify the resources that can be recovered in liquidation and how much cash the resources might return.

Second, the resources on a balance sheet provide a basis for analyzing the nature and stability of sources of income… earnings estimates will be more realistic and accurate if they are supported by appropriate asset values…

Third, the liabilities side of the balance sheet, which identifies sources of funding, describes the financial condition of the firm…

Fourth, the evolution of the balance sheet over time provides a check on the quality of earnings…

A balance sheet is a snapshot of a company’s assets and liabilities at a particular time.  It can be checked for accuracy and value at that moment.  This places significant constraints on the degree to which the assets and liabilities can be manipulated.  In contrast, flow variables such as revenue and earnings measure changes over time that by their nature are evanescent.  If they are to be monitored, they must be monitored over an extended period.  In 1934, and today, this fundamental difference accounts for the superior reliability (in theory) of balance sheet figures.  (538-539)

Greenwald discusses the net-net approach advocated and used by Graham and Dodd.  If current assets minus all liabilities is positive, and if the stock can be purchased below that level, then the downside is typically limited, while the upside is often substantial.  There were many net-nets during the Great Depression, but there are far fewer these days, although occasionally they show up during bear markets and/or in foreign markets.  (Value investors bought net-nets in South Korea some years ago.)  Despite the virtual disappearance of net-nets, Greenwald observes that the general lessons still hold:

However, the broader lessons that led Graham and Dodd to focus on the balance sheets of firms continue to apply, with extensions that are much within the spirit of their original approach.  First, it is now recognized that for economically viable firms, assets wear out or become obsolete and have to be replaced.  Thus, replacement value – the lowest possible cost of reproducing a firm’s net assets by the competitors who are best positioned to do it – continues to serve the role that Graham and Dodd recognized.  If projected profit levels for a firm imply a return on assets well above the cost of capital, then competitors will be drawn in.  That, in turn, will drive down profits and with them the value of the firm.  Thus, earnings power unsupported by asset values – measured as reproduction values – will, absent special circumstances, always be at risk from erosion due to competition.  Both ‘safety of principal’ and the promise of a ‘satisfactory return,’ therefore, require that ‘thorough’ investors support their earnings projections with a careful assessment of the replacement values of a firm’s assets.  Investors who do this will have an advantage over those who do not, and they should outperform these less thorough investors in the long run.  (541-542)

 

SIGNIFICANCE OF BOOK VALUE

Book value often means asset value, or tangible asset value, or tangible book value.  Graham introduces his definition of net-nets based upon current-asset value, which is current assets minus all liabilities.  A net-net is when the stock can be purchased below current-asset value.  Later, Graham discusses financial reasoning versus business reasoning:

We have here the point that brings home more strikingly perhaps than any other the widened rift between financial thought and ordinary business thought.  It is an almost unbelievable fact that Wall Street never asks, ‘How much is the business selling for?’  Yet this should be the first question on considering a stock purchase.  If a business man were offered a 5% interest in some concern for $10,000, his first mental process would be to multiply the asked price by 20 and thus establish a proposed value of $200,000 for the entire undertaking.  The rest of his calculation would turn about the question whether or not the business was a ‘good buy’ at $200,000.  (555-556)

Graham explains the reasons why buying above tangible book is often not a good idea, while buying below tangible book is often a good idea:

There are indeed certain presumptions in favor of purchases made far below asset value and against those made at a high premium above it.  (It is assumed that in the ordinary case the book figures may be accepted as roughly indicative of the actual cash invested in the enterprise.)  A business that sells at a premium does so because it earns a large return upon its capital;  this large return attracts competition, and, generally speaking, it is not likely to continue indefinitely.  Conversely in the case of a business selling at a large discount because of abnormally low earnings.  The absence of new competition, the withdrawal of old competition from the field, and other natural economic forces may tend eventually to improve the situation and restore a normal rate of profit on the investment.  (557)

Graham then points out that while this is often true, it is not certain enough to be used categorically.  Rather, Graham advises that the analyst work to understand each individual case in order to act sensibly.

 

CURRENT-ASSET VALUE

Graham begins by noting that with regards to unprofitable businesses, the liquidation of private businesses is “infinitely more frequent” than the liquidation of public businesses.  When Security Analysis was written, during the Great Depression, there were many public businesses selling below liquidation value.

Graham outlines a conservative way to calculate liquidation value:

A company’s balance sheet does not convey exact information as to its value in liquidation, but it does supply clues or hints which may prove useful.  The first rule in calculating liquidating value is that the liabilities are real but the value of the assets must be questioned.  This means that all true liabilities shown on the books must be deducted at their face amount.  The value to be ascribed to the assets, however, will vary according to their character.  The following schedule indicates fairly well the relative dependability of various types of assets in liquidation.  (560)

In a table, Graham explains that cash assets are valued at 100% of book value, receivables at roughly 80%, inventories at roughly 66.7%, and fixed assets at approximately 15%.  Of course, notes Graham, there is a wide range in most of these categories depending upon the business or industry in question.

Graham tries to explain the wide availability of businesses below liquidation values:

…Evidently the phenomena of 1932 (and 1938) were the direct out-growth of the new-era doctrine which transferred all the tests of value to the income account and completely ignored the balance-sheet picture.  In consequence, a company without current earnings was regarding as having very little real value, and it was likely to sell in the market for the merest fraction of its realizable resources.  Most of the sellers were not aware that they were disposing of their interest at far less than its scrap value.  Many, however, who might have known the fact would have justified the low price on the ground that the liquidating value was of no practical importance, since the company had no intention of liquidating.  (563)

Graham holds that the wide availability of businesses selling below liquidation values was highly illogical.  If a business is worth more than its liquidation value, then steps should be taken to realize this higher value.  If a business is worth more in liquidation than as a going concern, then it should be liquidated.

Part of the problem is that there is a conflict of interest between the managers and the owners (stockholders).  The managers of a given business typically prefer that the business be continued rather than liquidated, since they want to retain their jobs and benefits.  On the other hand, unless steps can be taken to improve the value of the business as a going concern, the stockholders benefit if the business is liquidated.

As far as the attractiveness of investing in net-nets, Graham observes that the chief danger is that the net asset value will be dissipated.  But this only happens occasionally.  Usually something happens that causes a net-net to be a profitable investment.  Often the normal earnings power of the company is restored, either by general improvement in the industry or by a change in operating policies (as well as, in some cases, new management).  Sometimes a sale or merger occurs because another business is able to utilize the assets more efficiently.  Sometimes the company is liquidated, either partially or fully.

Net-nets are statistically very good investments, but the analyst still must be careful, says Graham:

… the securities analyst should exercise as much discrimination as possible in the choice of issues falling within this category.  He will lean toward those for which he sees a fairly imminent prospect of some one of the favorable developments listed above.  Or else he will be partial to such as reveal other attractive statistical features besides their liquid-asset position, e.g., satisfactory current earnings and dividends or a high average earning power in the past.  The analyst will avoid issues that have been losing their current assets at a rapid rate and show no definite signs of ceasing to do so.  (568-569)

 

STOCKHOLDER-MANAGEMENT RELATIONSHIPS

It is a notorious fact… that the typical American stockholder is the most docile and apathetic animal in captivity.  He does what the board of directors tell him to do and rarely thinks of asserting his individual rights as owner of the business and employer of its paid officers.  The result is that the effective control of many, perhaps most, large American corporations is exercised not by those who together own a majority of the stock but by a small group known as ‘the management.’… (575-576)

… Certain elementary facts, once well-nigh forgotten, might well be emphasized here:  Corporations are in law the mere creatures and property of stockholders who own them;  the officers are only paid employees of the stockholders;  the directors, however chosen, are virtually trustees, whose legal duty it is to act solely in behalf of the owners of the business.

To make these general truths more effective in practice, it is necessary that the stock-owning public be educated to a clearer idea of what are the true interests of the stockholders in such matters as dividend policies, expansion policies, the use of corporate cash to repurchase shares, the various methods of compensating management, and the fundamental question of whether the owners’ capital shall remain in the business or be taken out by them in whole or in part.  (590)

 

PART VII:  ADDITIONAL ASPECTS OF SECURITY ANALYSIS

In the Introduction to Part VII, David Abrams writes:

… as Graham and Dodd understood, how markets work, how companies are run, and how people – both investors and corporate managers – tend to act in certain situations never change.  (617)

… every successful investor I’ve ever known makes a calculation that compares an asset’s purchase price to its present or future value.  (618)

Abrams describes his own evolution from overconfident and ignorant to humble and knowledgeable:

I realized that, in all likelihood, the guy on the other side was probably smarter than I was.  Embarrassed by my own ignorance, I vowed to wade into new situations with a greater respect for those on the other side of the trade and with more humility about the limits of my own knowledge.  Never again would I be the patsy.  That approach has served me well throughout my career.  (624)

Graham and Dodd knew that market forecasting doesn’t work:

In market analysis there are no margins of safety;  you are either right or wrong, and if you are wrong, you lose money. (703)

Abrams says that the most important point in Security Analysis is the following:

look at the numbers and think for yourself.  All the great investors do, and that’s what makes them great.

 

DISCREPANCIES BETWEEN PRICE AND VALUE

Long before behavioral economics was invented, Graham and Dodd (and also Keynes) understood the significant role of human emotions in determining market prices:

Our exposition of the technique of security analysis has included many different examples of overvaluation and undervaluation.  Evidently the processes by which the securities market arrives at its appraisals are frequently illogical and erroneous.  These processes, as we pointed out in our first chapter, are not automatic or mechanical but psychological, for they go on in the minds of people who buy or sell.  The mistakes of the market are thus the mistakes of groups or masses of individuals.  Most of them can be traced to one or more of three basic causes:  exaggeration, oversimplification or neglect.  (669)

How does one find cheap stocks?

Since we have emphasized that analysis will lead to a positive conclusion only in the exceptional case, it follows that many securities must be examined before one is found that has real possibilities for the analyst.  By what practical means does he proceed to make his discoveries?  Mainly by hard and systematic work.  (669)

Graham writes of opportunities in obscure or ignored stocks:

… although overvaluation or undervaluation of leading issues occurs only at certain points in the stock-market cycle, the large field of ‘nonrepresentative’ or ‘secondary’ issues is likely to yield instances of undervaluation at all times.  When market leaders are cheap, some of the less prominent common stocks are likely to be a good deal cheaper.

Graham gives the example of a market leader (Great Atlantic and Pacific Tea Company) that ended up selling below liquidation value:

… Here, then, was a company whose spectacular growth was one of the great romances of American business, a company that was without doubt the largest retail enterprise in America and perhaps in the world, that had an uninterrupted record of earnings and dividends for many years – and yet was selling for less than its net current assets alone.  Thus one of the outstanding businesses of the country was considered by Wall Street in 1938 to be worth less as a going concern than if it were liquidated.  Why?  First, because of chain-store tax threats;  second, because of a recent decline in earnings;  and, third, because the general market was depressed.

We doubt that a better illustration can be found of the real nature of the stock market, which does not aim to evaluate businesses with any exactitude but rather to express its likes and dislikes, its hopes and fears, in the form of daily changing quotations.  There is indeed enough sound sense and selective judgment in the market’s activities to create on most occasions some degree of correspondence between market prices and ascertainable or intrinsic value… But, on enough occasions to keep the analyst busy, the emotions of the stock market carry it in either direction beyond the limits of sound judgment.  (673-674)

As noted earlier by Seth Klarman, litigation, scandal, accounting fraud, or financial distress often create bargains for the intrepid – those who can ignore bad news and remain focused on long-term fundamentals.  Graham writes about these types of dislocations.  Here is Graham on litigation:

The tendency of Wall Street to go to extremes is illustrated… by its tremendous dislike of litigation.  A lawsuit of any significance casts a damper on the securities affected, and the extent of the decline may be out of all proportion to the merits of the case.  (681)

Graham gives several examples where the potential impact of the lawsuit was tiny, and yet the stock had irrationally declined a large amount.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees.  The Boole Fund has low fees. 

 

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

 

 

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

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