Reading: Chapter 28—Newer Canons of Common-stock Investment
One Minute Summary:
The chapter gives three general approaches to common-stock investment: secular expansion, individual growth and margin of safety principle.
- Secular expansion—investment is relied upon a growth of earnings in the general economy and such growth will be reflected in companies’ profits.
- Individual growth—investment is focused on well perceived companies that are thought to be capable of steadily earning growth; therefore, such companies are ideal as long-term investments.
- Margin-of-safety principle—investment is based on an analyst’s work to identify stock of a company that is selling below its minimum intrinsic value.
All approaches could be applied successfully but most likely by a few exceptionally talented individuals in the first two approaches due to human nature and market psychology.
Chapter in Detail:
It is argued that a sound common-stock approach includes all of the following:
- Investment should be purchased as a group base, since diversification of risk is a key to achieve favourable average result.
- Individual issues should pass qualitative and quantitative tests similar to the ones applied to fixed-value investments
- Compared to fixed value investment, common-stock investment should place a greater emphasis on the future outlook of the companies.
Secular expansion—index fund investing would be an example of this approach, where it is believed that a broad casual connection exists between a nation’s wealth and its companies’ future earning power. Often, it is believed that a nation’s wealth growth will continue to increase, and this expansion will lead to an increase in companies’ overall profits.
Investors should maintain wide diversification and insistence upon paying reasonable price to guard against the negative consequences from economic boom and bust cycles.
Individual growth—this approach can be followed successfully if it is pursued with skill, intelligence and diligent study. However, the following questions present why such operational is difficult in process.
1. What are growth companies?
The general conception is that companies with above average earning growths from cycle to cycle can be considered as growth companies, but it is difficult for an investor to selection appropriate periods to determine the validity of cycles and sustainability of the growth.
2. Can investor identify them?
Not an easy process because companies goes through stages of growths. A short operation history with exceptional growth cannot be used as a solid base for predicting future growths, and a long history of growth might suggest that the above average growth may be nearing its maturity before the unavoidable decline.
3. Price already factor in the future growth?
If an investor pays a substantial amount for the growth factor, he is inevitable assuming the risk that the growth will be less than he anticipates
Margin of safety principle—this approach is based on the analyst’s work, which is justified by an issue’s price, its qualitative and quantitative factors, as well as general market swing, to identify whether it is selling at a sufficient discount to its intrinsic value. This principle can be applied in two ways:
1. Purchase a group of active issues at times when the general market is low based on the following system:
a. Compose a diversified list of leading common stocks.
b. Evaluate a fair value for the group from their earning yields, compared to the long term interest rate.
c. Establish a buying point at some percentage below this fair value and a selling point above it.
Some difficulties include that the fair value estimation could be wrong, the buying and selling point may be badly chosen, and the human behaviour may hinder the operator’s chance for profit. A strong will is required as this approach is contrariety to the general market sentiment.
2. Purchase undervalued individual common stocks based on the following two types:
a. Purchase of issues with exceptional prospects at a price no higher than a similar private business.
b. Purchase of issues with satisfactory past records and prospects at a much discounted price than what a similar private business would be valued at.
New terminology / Concepts / Ideas / Technical Items / Useful Examples:
“Supermaturity”—the company has entered a stage with limited growth and an actually loss in market share and profits.
Discussion on what happened to the large and well-known growth companies from the example in this chapter.
[Feel free to present your input for this section to the group]
Issues Disagree With:
Based on the list of large, well-known growth companies in the chapter, it may be argued that companies with exceptional growth should be considered as investment candidate, even if it means paying a reasonable premium than what a private business man would offer at the time of acquisition.
Practical Application:
- A large company with reasonable prospects that survived a severe economy depression could be considered as strong enterprise for investment valuation.
Three Quotes:
- “Undoubtedly any of these three viewpoints (long-term growth, next year prospects, stock market trend) may be followed successfully…But we are not so sure that any of these approaches can be developed into a system or technique that can be confidently followed by everyone of sound intelligence...” p.375
- “Investment is conceived as a group operation, in which diversification of risk is depended upon to yield a favourable average result.” p.366
- (Can growth be used as a basis of investmet selection?) “Our answer is ‘yes,’ provided… [1.] the future are examined with real care and a wholesome of scepticism, rather than accepted quickly via some easy generalization; [2.] the price paid be not substantially different from what a prudent business man would be willing to pay…in private undertaking over which he could exercise control.” p.371-372
Three questions to the group to test understanding:
- Based on the concept of “value to a private investor,” what are the two types of investment in common stocks?
- Why should a private business be assigned with a discount rate relative to a similar public-traded company?
- What are three general approaches to common-stock investment, and what other approaches dominate today’s market?
Clarifications & Group Discussion:
- Should we pay more attention to the large and well-known companies that have demonstrated tremendous ability to expand over a long period as investment candidates?
- Would it be sensible to stash a list of companies that fits the description of question one and apply Buffett’s suggested philosophy of 20 ticket punch card; in addition, should an investor be willing to pay for a reasonable premium today or waiting for a reasonable price-point?
- Companies go through different stages of growth and eventually enter a final phase of “supermaturity.” Is this an advantage or disadvantage for growth companies with a long period of exceptional ability to expand?
- Using the concept of “value to a private investor,” which one is a better choice of the two investment types?
- Today, a conglomerate could have a number of different businesses under its coporate structure. Would this individual issue be considered as sufficient diversifcation?
