First is: Don’t take a single year’s earnings seriously. The second is if you do pay attention to short-term earnings, look out for traps in per-share figures.

Allowance for conversion rights – and the existence of stock-purchases warrants – can reduce the apparent earnings by half, or more.

Losses, charged off before they actually occur, can be charmed away, as it were, with no unhappy effect on either past or future “primary earnings”. In some extreme cases they might be availed to make subsequent earnings appear nearly twice as large in reality – by a more or less prestidigitous treatment of the tax credit involved.

The reader should note ingenious aspect of the Aluminium Company of America example cited by the author. By anticipating future losses the company escapes the necessity of allocating the losses themselves to an identifiable year. Hence it is a fact that certain companies which have had large losses in the past have been able to report future earnings without charging the normal taxes against them. Tax credits resulting from past years losses are now being shown separately as “special items”, but they will enter into future statistics as part of the final “net-income” figure. However, a reserve now set up for future losses, if net of expected tax credit, should not create an addition of this sort to the net income of the later years.

Hence the true earnings in picture should be the one obtained after dilution less that part of the special charges attributable in the current fiscal year.

 

Different Factors affecting per-share earnings 

The use of special charges, which may never be reflected in the per-share earnings, the reduction in the normal income-tax deduction by reason of past losses, and the dilution factor implicit in the existence of substantial amounts of convertible securities or warrants. Other item that has significantly affected reported earnings in the past is the method of treating depreciation. Still, another factor, important at times, is the choice between charging off research and development costs in the year they are incurred or amortizing them over a period of years. Finally, the author mentions the choice between the FIFO and LIFO methods of valuing inventories.

In the author’s opinion, the proper mode of calculation would be first to consider the indicated earning power on the basis of full income – tax liability, and to derive some broad idea of the stock’s value based on the estimate.

 

Use of Average Earnings

One important advantage of an averaging process is that it will solve the problem of what to do about nearly all the special charges and credits. They should be included in the average earnings.

 

 

 

 

* Note – Chapter 10 – The Investor and his Advisory has been skipped due the generic theoretical text. For more information on the chapter please refer to the latest edition of the book *

This chapter chiefly emphasises on the work of the security analyst which generally deals with the valuation of different security after consideration of multitude of parameters discussed later in the unit.

The author brings up a noteworthy point about the current market mindset of increased dependency on the valuations derived from mathematical calculations based on anticipations of the future making it more vulnerable to possible errors and miscalculations. On the contrary, the author cites decreased dependency of valuations tied to past company performances.

 

Bond Analysis 

What are the primary test of safety of corporate bond or preferred stock?

The chief criterion used for corporate bonds is the number of times total interest have been covered by available earnings for some years in the past. In the case of preferred stocks, it is the number of times that bond interest and preferred dividends combined have been covered. A minimum coverage test can be used in place of the seven year average test.  In a changing interest rate environment, the author suggests a percentage earned on the principal amount of the debt requirement. Hence the  equivalent “poorest year” requirement could be set at about two-thirds of the seven year requirement.

In addition to the earnings-coverage test, a number of others are also generally applied. Some are:

1. Size of the Enterprise.  – Minimum standard in terms of volume of the business.
2. Stock / Equity Ratio. – Ratio is market price of common stock issues to the total face amount of debt plus preferred stock. Higher is better.
3. Property Value – Considered chief security and protection for a bind issue. Worst scenarios about property values should be considered for viability.

 

Common Stock Analysis 

The ideal form of common stock analysis leads to a valuation of the issue which can be compared with the current price to determine whether or not the security is an attractive purchase. This valuation, in turn, would ordinarily be found by estimating the average earnings over a period of years in the future and then multiplying that estimate by an appropriate “capitalisation factor”.

It is almost impossible to distinguish in advance between those individual forecasts which can be relied upon and those which are subject to a large chance of error. At bottom, this is the reason for the wide diversification practiced. For it is undoubtedly better to concentrate on one stock that you know is going to prove highly profitable rather than dilute your results to a mediocre figure, merely for diversification sake.

 

Factors Affecting Capitalisation Rate  

Capitalisation Rate may vary over a wide range depending upon the quality of the issue. Hence there may be two companies with same expected earnings but different value.

Consideration that enter into divergent multipliers:

1. General Long-Term Prospects – Distinctions made by markets over long term prospects of an enterprise or an industry are often soundly based, but when dictated mainly by past performance they are s likely to be wrong as right.
2. Management – Until objective, quantitative and reasonably reliable tests of managerial competence are devised and applied, this factor will be continued to be looked through a fog. It is fair to assume that outstandingly successful companies has unusually good management.
3. Financial Strength and Capital Structure – Stock of a company with a lot of surplus cash and nothing ahead of the common is clearly a better purchase than one with large bank loans and senior securities.
4. Dividend Record – Uninterrupted record of dividend payments going back many years is most desirable for defensive investors.
5. Current Dividend Rate – Execution of Standard Dividend Policy which included two-third of average earnings.

 

Capitalisation Rate for Growth Stocks 

Value  =  Current (Normal) Earnings x (8.5  + 2 x Expected Annual Growth Rate )

The valuations of expected high – growth stocks are necessarily on the low side, if we were to assume these growth rates will actually be realised. In such cases, what the valuer actually does is introduce margin of safety into his calculations.

 

Industry Analysis 

There are hazards connected with investment conclusions derived chiefly from such glimpses into the future, and not supported by presently demonstrable value. Yet there are perhaps equal hazards in sticking closely to the limits of value set by sober calculations resting on actual results.

Eventually the intelligent analyst will confine himself to those groups in which the future appears reasonably predictable or where the margin of safety of past-performance value over current price is so large that he can take his chances on future variations – as he does in selecting well-secured senior securities.

In this unit, the author focuses on probable options a defensive investor has if he is to put his money in investment-company shares. Such funds can be classified based on portfolio allocation – stock funds, bond funds; purpose – which could be growth or capital gains, income – which focuses on dividend and interest income, price stability.  Such funds are also classified based on if their shares are readily traded in the open market or not; called open and closed funds respectively. Another distinction is the method of sale – Load or No-load funds which charge fees based on the net asset value of the transaction or fixed annualized fees.

Major questions relevant to a defensive investor are:

1. Is there any way by which the investor can assure himself of better than average results by choosing the right funds?
2. If not, how can he avoid choosing funds which will give him worse than average results?
3. Can he make intelligent choices between different types of funds? eg. – balanced versus all stock, open-end vs closed-end, load vs no-load?

 

Investment-Fund Performance as a Whole

On a comparative basis, we would hazard the guess that the average individual who put his money exclusively in investment-fund shares in the past ten years fared better than the average person who made his common-stock purchases directly.

The investor in mutual-fund shares may properly consider comparative performance over a period of years in the past, say at least five, provided the data do not represent a large net upward movement of the market as a whole.

 

Performance Funds

The foregoing account by the contains the implicit conclusion that there may be special risks involved in looking for superior performance by investment-fund managers. All financial experience up to now indicates the large funds, soundly managed, can produce at best slightly better than average results over the years. If they are unsoundly managed they can produce spectacular, but largely illusory, profits for a while, followed inevitably by calamitous losses. There have been instances of funds that have consistently outperformed the market averages for say ten years or more. But these have been scarce exceptions, having most of their operations in specialized fields, with self-imposed limits on the capital employed – and not actively sold to the public.

 

Close-End vs Open-End Funds

The author arrives at one of the few clearly evident rules for investors’ choices. If you want to put money in investment funds, buy a group of closed-end shares at a discount of, say, 10% to 15% from asset value, instead of paying a premium of about 9% above asset value for shares of an open-end company. Assuming that the future dividends and changes in asset values continue to be about the same for the two groups, you will thus obtain about one-fifth more for your money from the closed-end shares.

 

Investment in Balanced Funds

It would appear more logical for the typical investor to make bond-type investments directly, rather than to have them form part of a mutual-fund commitment. The better choice for the bond component would be the purchase of United States savings bond, or corporate bonds rated A or better, or tax-free bonds, for the investor’s bond portfolio.

 

https://www.wsj.com/amp/articles/what-warren-buffetts-teacher-would-make-of-todays-market-11557500454

The author provides an excellent example of his philosophy by citing the Great Atlantic & Pacific Tea Co. ( one of the most revered staple giants in the 18th century America) example by relating it share price fluctuations and it’s underlying business fundamentals.

 

The A. & P. share price fluctuations over time :

1929 – $500 per share

1932 – $104 per share

1936 – $120 per share

1937 – $80 per share

1938 – $36 per share

1939 – $117.5 per share

1961 – $705 per share

1970 – $ 210.5 per share

1972 – $180 per share

2002 – $8.06 per share

 

If these fluctuations got you excited, you are probably making the same mistake as everyone else. Here is the timeline again with factors affecting the fluctuations versus underlying A&P’s business fundamentals.

 

1929 – $500 per share ( just before great depression)

1932 – $104 per share    ( Great Depression hits. Although company profits remain strong)

1936 – $120 per share    ( Bear Market persistently affects share price )

1937 – $80 per share

1938 – $36 per share      ( Shares selling under sub- working capital !!! Reasons – news of probable special taxes, fallen profits in the previous year, general market depressed.)

Pause here. Put yourselves in the shoes of the investor. You bought A. & P. shares last year in 1937 at $80 dollars when Price to 5-year average earnings ratio was 12, in our affordable range. And share fell more. What do you do next?

The author suggests scrutinizing the business picture before proceeding. With the actual reasons mentioned for the decline in share prices in 1938, the underlying earning power was still strong and the P/E ratios slid as the prices declined. In such a scenario, it only makes buying more shares attractive.

1939 – $117.5 per share ( Back up! but should you care?)

1961 – $705 per share ( P/E reaches 30 )

1970 – $ 210.5 per share

1972 – $180 per share ( prices are down again, is it a potential buying opportunity? Not really ! Earnings keep falling)

2002 – $8.06 per share

 

TWO CHIEF MORAL from the example :

First, The market often over and underestimates! Prudent minds take advantage of that.

Second, Businesses do change in character and quality. Hence it is important for the investor to keep an eye on that from time to time.

Important Note: A true investor is scarcely ever forced to sell his shares due to price fluctuations unless the prices offered are juicy enough to suit his expectations from the investment. There is a psychological advantage in owning business interest that has no quoted market. BUT, it is self-deception to keep telling yourself that you have suffered no shrinkage in value merely because your securities have no quoted market at all. In a nutshell, as discussed in the previous text; price fluctuations only provide entry and exit points for a true investor. At other times he is better off forgetting about the stock market and paying attention to dividend returns and to the operating results of his companies.

On an ending note, the investor should not wait long enough until a low market level appears. This leads to loss of income and possible missing of investment opportunities. Such operations should only be avoided when the general market is outrageously overvalued. ALTHOUGH, if the investor wants to be shrewd he can look for the ever-present bargain opportunities in individual securities.

 

AND LASTLY, BUT MOST IMPORTANTLY; IT IS ONLY THE LACK OF ALERTNESS AND INTELLIGENCE AMONG THE RANK AND FILE OF SHAREHOLDERS THAT PERMITS THIS IMMUNITY TO EXTEND TO THE ENTIRE REALM OF MARKET QUOTATIONS, INCLUDING THE PERMANENT ESTABLISHMENT OF A DEPRECIATED AND UNSATISFACTORY PRICE LEVEL. GOOD MANAGEMENTS PRODUCE A GOOD AVERAGE MARKET PRICE AND BAD MANAGEMENT PRODUCE BAD MARKET PRICES!

The following text has been regarded as one of the best commentary offered by Ben Graham to succeed as an investor. It helps the reader to become cognizant of the framework and the mindset necessary to make rational investment decisions. The writer starts off the chapter by embracing the fact that all investments are prone to price fluctuations except cash and cash equivalents. But on the contrary, such price fluctuations gives them the upper hand compared to cash to achieve more gains over time.

Market Fluctuations as a Guide to Investment Decisions 

There are two possible ways to profit from this pendulum strings – the way of timing and way of pricing. The author is convinced that the intelligent investor can derive satisfactory results from the way of pricing than the way of timing because if he places his emphasis on timing, he ends up having the same result as a speculator.  Also in the context here he entitles the one emphasizing on pricing as an investor. Hence for an investor what advantage does he have to keep his money uninvested until he receives some trustworthy signal that the time has come to buy? He enjoys an advantage only if by waiting he succeeds in buying later at a sufficiently lower price to offset his loss of dividend income. This implies that timing is of no real value for an investor until it coincides with pricing – i.e unless it enables him to repurchase his shares at substantially under his previous selling price.

Buy-Low-Sell-High Approach 

Although shrews investors can use their significant brainpower to identify signal to determine an ongoing bullishness and bearishness of the general market to buy in the later and sell in the former. But these signals are determined from the hindsight market conditions and there have been variations to these indicators and hence any deviations from the calculations can put pressure on the investor.

After citing some examples, the author concludes with the following – It seems unrealistic to us for the investor to endeavor to base his policy on the classic formula – i.e to wait for demonstrable bear market levels before buying any common stocks. Our recommended policy has, however, made provision for changes in the proportion of common stocks to bonds in the portfolio, if the investor chooses to do so, according as the level of stock prices appears less or more attractive by value standards.

Formula Plans

On a conclusion, the moral seems to be that any approach to moneymaking in the stock market which can be easily described and followed by a lot of people is by its terms too simple and too easy to last.

Market fluctuation of the investor’s portfolio 

To resist the human nature of reacting to these variations in prices, the author suggests some kind of mechanical method for varying the proportion of bonds or stocks in the investor’s portfolio. The chief advantage is that the formula will give him something to do. As the market advances he will from time to time make sales out of his stockholdings, putting the proceeds into bonds; as the market declines he will reverse the procedure. If he is the right kind of investor he will take added satisfaction from the thought that his operations are exactly opposite from those of the crowd.

Business Valuations versus stock- Market Valuations 

An investor’s position is analogous to that of a minority shareholder or silent partner in a private business. Here his results are entirely dependent on the profits of the enterprise or on a change in the underlying value of its assets. He would usually determine the value of such a private business interest by calculating his share of net worth as shown in the most recent balance sheet.

In present-day investing, the whole structure of stock market quotations contains a built-in contradictions. The better a company’s record and prospects, the less relationship the price of its shares will have to their book value. But the greater the premium above book value, the less certain the basis of determining its intrinsic value – i.e more this value will depend on the changing moods and measurements of the stock market.  Thus we reach a paradox, that the more successful the company, the greater are likely the fluctuations in the price of its shares.

The discussions in the text lead us to a conclusion of practical importance to the conservative investor in common stock. If he is to pay some special attention to the selection of his portfolio, it might be best for him to concentrate on issues selling at a reasonably close approximation to their tangible-asset value – say, at not more than one -third above that figure. Purchases made at such levels, or lower, may with logic be regarded as related to the company’s balance sheet, and as having a justification or support independent of the fluctuating market prices. The premium over the book value that may be involved can be considered as a kind of extra fee paid for the advantage of stock-exchange listing and the marketability that goes with it. Caution is needed here, in addition to low price to book ratio, investor should also demand for a satisfactory price to earnings ratio, a sufficiently strong financial position, and the prospect that its earnings will at least be maintained over the years.

Summary 

Fluctuations in Bond Prices

 

Operations in Common Stock

The characteristic activities an Enterprising Investor pursues to obtain a better than run of the mill investment return are:

1. Buy low, Sell high

2. Buying carefully chosen “Growth Stocks”

3. Buying bargain issues of various types

4. Buying into “special situation”

General Market Policy – Formula Timing

Not really as simple as it sounds. There isn’t and there never will be a single formula that perfectly predicts buying and selling points for you and even if it does probably it’s increasing popularity will dimish its effectiveness. As the one using it won’t be betting against any odds here and will be doing what everyone else is doing. The only general formula that Graham suggests is the 50-50 portfolio policy.

Growth Stock Approach

Picking companies that have outperformed in the past and expected to do so in the future. Sounds simple enough but really isn’t. Two reasons – first, common stocks with good results sell at higher prices. Second, they might not perform as anticipated in the future. Implication put forth is no outstanding rewards comes from diversified investment in growth stock companies compared to common stocks generally.

Consequently, the author advises against any usual type of growth stock commitment. That is when excellent prospects are fully recognized by the company and is trading at P/E  > 20. ( for the defensive the author suggests an upper purchase limit of P/E of 25 with earnings calculated on a seven-year average basis.)

Although the point being argued profoundly that great wealth is achieved from single company investments are almost always realized by individuals who have a close relationship with the particular company. For an investor without such close personal contact or control will always be wavering about his funds being allocated in just one medium.

Three Recommended Fields for “Enterprising Investment”

A policy of selection or operation should:

-Pass the rational tests of underlying soundness.                                                                          –Different from other common investing/speculating policies

1.First field – The Relative Unpopular Large Company

Large companies going through a period of unpopularity qualifies as a field of enterprising investment. Reasons being that large companies have a double advantage over others. First, they have the resources to carry them through adversity. Second, markets react quickly to any signs of improvements in large companies.

When considering individual large companies instead of a group; a special factor must be taken into account. Companies with widely varying earnings tend to sell at a relatively high price and low P/E during good years and low price and high P/E during bad years. This occurs because market values them conservatively knowing the inherent volatility of the company’s earnings and that they will return back to normal levels.

Finally, it would be easier to avoid inclusion of such anomalous issues from low multiplier list by requiring that the price be low in relation to past average earnings or some similar tests.

On an ending note for this field of enterprising investment policy, the investor should start with the “low-multiplier” idea, but add other quantitative and qualitative requirements to it.

2. Purchase of Bargain Issues

An issue worth more than it is selling for on the basis of facts established by analysis is a Bargain.  Intrinsic Value should be atleast 50% more than the price.

How can you tell that a bargain exists?

a. Method of appraisal –  Estimated future earnings discounted by a factor appropriate for the issue and if the resultant value obtained is sufficiently greater than the market price.

b. Value of business to a private owner – In addition to expected future earnings, more attention is paid to the realizable value of assets, with particular emphasis on net current assets and working capital.

How do bargains come into existence?

Two major reasons – Currently disappointing results and protracted neglect or unpopularity

A third reason cited by the author is the market’s failure to recognize the true earnings picture. In the example of the Northern Pacific Railway, the reason was earnings power concealed by accounting methods peculiar to railroads.

However, neither of these causes considered alone can be a reliable guide to successful common stock investment. How can we be sure? He / She could require an indication of at least reasonable stability of earnings over the past decade or more – i.e no year of earning deficit plus sufficient size and financial strength to meet possible setbacks in the future. The ideal combination here is thus that of a large and prominent company selling well below its past average price and its past average price/earnings multiplier  This would rule out speculative examples of companies like Chrysler since their low price years are accompanied by high price/earning multiplier.

The type of bargain issue that can be easily identified is the one selling for less than its Net Current Asset Value / Net Working Capital. NCAV = Current Assets ( Cash, cash equivalent, inventories)  minus total liabilities (including preferred stock and long-term debt). This would mean that the buyer would pay nothing at all for the companies fixed assets like property, plant and equipment and other goodwill items.

Bargain Issue Pattern in Secondary Companies –  the author defines a secondary company as the one that is not a leader in a fairly important industry. Exception being, any company that has established itself as a growth stock is not ordinarily considered “secondary.”  The events after the great depression of 1929 has led to a partial sentiment amongst investor about the lifetime of a secondary company has kept price down significantly in this sector. Contrary to the general sentiment the author professes that a typical middle size company is a large one when compared with the average privately owned business. There is no sound reason why such companies should not continue indefinitely in operation, undergoing the vicissitudes characteristics of the economy but earning on the whole a fair return on invested capital.

If most secondary issues tend to undervalued, what reason has the investor to believe that he can profit from such a situation? For if it persists indefinitely, will he not always be in the same market position as when he bought the issue?  Author’s answer – Substantial profits from purchase of secondary companies at bargain prices arise in a variety of ways. First, high dividend return. Second, substantial reinvested earnings. Third, the effects of a bull market on an undervalued issue. Fourth, probability of realization of the true value of the company at any given point in time. Fifth, change in factors that led to disappointing earnings. And lastly the new trends of acquisitions of smaller companies by larger ones.

Specific bargain opportunities into bonds and preferred themselves when the interest rates are low and the issues are available at large discounts from the amount of their claim.

Special Situations or “Workouts”

The trend of acquisitions of smaller companies by larger companies with an intend to diversify has led to the growth of such Special situations. Hence the premium offered by the acquirer to the shareholders of the acquiree has led to interesting profitable opportunities.  Other arbitrage operations involving reorganization of stressed companies has also led to impressive profitable operations giving the orchestrator has sufficient knowledge and experience.  Lastly, bargain opportunities are also created by the prejudice persistent on the street pertaining to avoid investing in companies undergoing complicated legal proceedings.

Broader Implications of our Rules for Investment

The average well-selected secondary company may be fully as promising as the average industrial leader. What the smaller concern lacks in inherent stability may be readily made up in superior possibilities of growth. Financial history says clearly that the investor may expect satisfactory results, on the average, from secondary common stock only if he buys them for less than their value to a private owner, that is, on a bargain basis. ( if am not wrong here, a secondary public company’s share would most probably behave like a private counterpart of similar size and hence value of a share of a private enterprise is worth more to the controlling party than the non-controlling party )