Reading: Chapter 28—Newer Canons of Common-stock Investment

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.

1. Secular expansion—investment is relied upon a growth of earnings in the general economy and such growth will be reflected in companies’ profits.
2. 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.
3. 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:

1. Investment should be purchased as a group base, since diversification of risk is a key to achieve favourable average result.
2. Individual issues should pass qualitative and quantitative tests similar to the ones applied to fixed-value investments
3. 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:

1. Based on the concept of “value to a private investor,” what are the two types of investment in common stocks?

2. Why should a private business be assigned with a discount rate relative to a similar public-traded company?

3. What are three general approaches to common-stock investment, and what other approaches dominate today’s market?

Clarifications & Group Discussion:

1. 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?

2. 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?

3. 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?

4. Using the concept of “value to a private investor,” which one is a better choice of the two investment types?

5. Today, a conglomerate could have a number of different businesses under its coporate structure. Would this individual issue be considered as sufficient diversifcation?

Reading: Chapter 21 – Supervision of Investment Holdings

One Minute Summary:

Supervision of fixed value investment is necessary. However, to achieve an additional 1 to 2.5% yield on top of the U.S. government bonds, an investor is required to buy the right securities and monitor their corporate developments. Yet, with all the effort entailed, he/she is still exposed to a chance of loss. If the spread between corporate bonds and government bonds are within a limited range, say 1% to 2.5%, government savings bonds would a better choice, unless the investor is educated enough to speculate or identify investment opportunities.

New terminology / Concepts / Ideas / Technical Items / Useful Examples:

“Gilt-edged securities”—securities that are thought to have the highest level of quality.

Additional thoughts:

Currently, for 10 Year bonds: US Treasury—3.57%; AAA Corporate—4.24%; A Corporate—5.41%; BBB Corporate—6.52%. From the suggested practice, an investor should consider US Treasury bond much the same way it was 70 years ago.

Practical Application:

Large interest coverage—the margin of safety—is an excellent quantitative trait in fix-value investments. However, an operating loss would immediately eliminate that margin of safety. Therefore, earning stability from the issuing corporation is an essential requirement for fixed-value investments.

Three Quotes:

1. “It is doubtful if trading in bonds, to catch the market swings, can be carried on successfully by the investor…we are convinced that any combined effort to advise upon the choice of individual high-grade investments and upon the course of bond prices is fundamentally illogical and confusing”

Type	U.S. bond market (CY2009)	NYSE/AMEX/NASDAQ combined (Jan 2010)
Average daily trading value	$815 billion	$71 billion

2. “The degree of safety enjoyed by the issue, as shown by quantitative measures, must be so far in excess of the minimum standards that a large shrinkage can be suffered before its position need be called into question.”

3. “If only small investors would resolutely reject…an ostensible “sure income return” of 4 to 6%, and thankfully take advantage of the 2.90% available on United States Savings Bonds, we are convinced that they would save an enormous amount of money, trouble and heartbreak.”

A question to the group to test understanding:

1. Why some investors (retail or institutional) must consider types of fixed-value investment?

Clarifications & Group Discussion:

1. Superiority of United States Savings Bonds—has this changed?

2. Why has bond trading become such a dominate force?

3. Systematic supervision—how are you addressing this requirement with your investment?

4. Sources of investment advice—if most sources are terrible by design, why is their popularity in perpetual growth?

5. If a company lacks inherent earning stability, but has a history of large interest coverage. Would you consider purchasing its corporate bonds, and if yes, at what price point?

Security Analysis Chapter 6 Summary

Reading: Chapter 6 - The Selection of Fixed-Value Investments

One Minute Summary:

The chapter gives an overview of different types of fixed-value investment.

1. “High-grade straight bonds and preferred stocks.”

2. “High-grade privileged issues, where the value of the privilege is too remote to count as a factor in selection.”

3. “Commons stocks which through guaranty or preferred status occupy the position of a high-grade senior issue.”

In addition, the chapter outlines four principles for the selection of fixed-value issues.

1. “Safety is measure not by specific lien or other contractual rights, but by the ability of the issuer to meet all of its obligations.”

2. “This ability should be measured under conditions of depression rather than prosperity.”

3. “Deficient safety cannot be compensated for by an abnormally high coupon rate.”

4. “The selection of all bonds for investment should be subject to rules of exclusion and to specific quantitative tests corresponding to those prescribed by statute to govern investments of savings banks.”

Chapter in Detail:

When purchasing a bond, the primary focus should be the enterprise’s earning power and not on the promise and protection of the bond. Bond buyer should take similar approach as equity investors to identify the soundness of the issuing enterprise and exclude bonds that do not meet the standards of safety.

The chapter proposes four principles for selecting individual bonds (see the section above) and focuses on the first principle—“Safety not measured by lien but by ability to pay.” The lien itself is insufficient to make a sound purchase in a bond based on the following reasons:

1. The pledged properties are rarely adaptable to other form of business uses; therefore, should the enterprise failed itself, the pledged assets are likely to suffer a significant drop from its appraised value.

2. The bond holders rarely own the actual pledged assets, unless the realizable value is substantially less what the holders are entitled to. Most of the time, the bond holders took new securities of the reorganized enterprise with a lesser value.

3. Bond holders have to wait for a long period of time during the receivership for the property to foreclose, and an even longer period of time to receive his or her shares among different classes of bond and stock holders. The bond holders are likely to face a significant depressed quoted value for the duration of the receivership and an uncertain outcome to the final disbursement.

Consequently, the chapter offers following position in regard to bond selection:

1. Purchase should focus on an enterprise with plentiful resources to meet its interest payments, even if the bond itself has a lower priority and is less secured than a higher secured bond in a weak enterprise.

2. Identify an enterprise that meets every test of financial strength and soundness, and then select the highest yielding bond offered by that enterprise—this would usually imply selecting the junior rather than the first lien bonds.

3. Among different enterprises, bonds with senior liens should be preferred when the yield among all class of bonds are similar. Junior issues should be considered when they have a substantial yield advantage or asset protection compared to other enterprises based on the following conditions:

a. The protection for the total debt of the issuing enterprise is more than sufficient.

b. The protection for the total debt of the issuing enterprise is considerably higher than senior bonds in other enterprise with similar yields.

New terminology / Concepts / Ideas / Technical Items / Useful Examples:

Underlying Bonds—small size bonds that are secured by a lien on an especially important component of the issuer’s business system. Historically, the railroad industry usually issued this kind of bond. Currently, some underlying bonds are issued as a first lien on mortgage claims.

Additional thoughts:

Bonds in receivership should be considered even if the timing is uncertain, given the facts that the enterprise can fulfill its commitments after reorganization.

Practical Application:

1. The Seaboard-All Florida Railway (Seaboard) First Mortgage 6s—this example was used to illustrate that lien is no guarantee against shrinkage in the value of the pledged asset. The bond, which originally sold for $25 million at 98 1/5 in 1925 and due in 1935, had a first lien on approximately 475 miles on newly constructed and finished lines. Seaboard went into receivership in 1931, and the bond was selling as low as 1 cent on the dollar. The bond had raised its market value to 3.875 cents on the dollar at the end of 1939.

Three Quotes:

1. “Soundness of the best investment must rest not upon legal rights or remedies but upon ample financial capacity of the enterprise.”

2. “It is a process of exclusion and rejection, rather than of search and acceptance. In this respect the contrast with common-stock selection is fundamental in character. The prospective buyer of a given common stock is influenced more or less equally by the desire to avoid loss and the desire to make a profit.”

3. “But neither priority nor promise is itself an assurance of payment. This assurance rests in the ability of the enterprise to fulfill its promise, and must be looked for in its financial position, record, and prospects.”

Three questions to the group to test understanding:

1. What are the differences between bond and equity in terms of return and safety?

2. What is a debenture, why should it be considered?

3. What is the difference between straight bonds and preferred stocks?

Clarifications & Group Discussion:

· “The value of the pledged property is vitally dependent on the earning power of the enterprise,” would you agree or disagree?

· Why has corporate bonds been neglected among retail investors as an individual investment candidate?

· When should we consider switching between fixed value investments and equity investments?

Security Analysis Chapter 4 Summary

Reading: Chapter 4—Distinctions Between Investment and Speculation

One Minute Summary:

The chapter distinguishes the differences between investment and speculation operations. Acquiring an asset will only be considered as an investment when the reasoning to purchase is based on “the study of facts in light of established standards of safety and value.” The standards of safety and value should be based on tangible data with assurance that the purchased asset will have sufficient resources and earning power to promise the safety of the initial investment, with any amount of return that the investor is willing to accept.

Chapter in Detail:

The chapter analytically examines the common distinctions between investment and speculation and offers a sound concept for the definition of investment.

The following chart summarizes the commonly accepted distinctions between the two terms; however, these criteria should not be applied as the difference between the two:

Investment	Speculation
1. In bonds.	In stocks.
2. Outright purchases.	Purchases on margin.
3. For permanent holding.	For a “quick turn.”
4. For income.	For profit.
5. In safe securities.	In risky issues.

Why they should not be used to generalize the two terms:

1. Bonds vs. Stocks. – Poorly secured bond could be categorized as one of the most utterly form of speculation; common stocks can be rated as investment quality.

2. and 3. Outright vs. Marginal Purchases; Permanent vs. Temporary Holding. – The purchase method or intention does not make the transaction an investment. The speculator could be buying a penny mining stock outright and plan to hold it permanently; such operation is still speculative after all.

4. and 5. Income vs. Profit; Safety vs. Risk – A focus solely on income does not make the transaction an investment because profit for strong enterprises could rise steadily over the years and compensate the investors by higher share price. With the fifth distinction, safety should be judged in tangible data, as well as time tested standards, and not based on the current market psychology. An overpriced security is risky no matter how safe it appears relative to its comparables.

The proposed distinction between investment and speculation is as follows:

“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” This can also be coined as an “Analyst’s investment.”

And

“An investment operation is one that can be justified on both qualitative and quantitative grounds”

Any planned purchase that cannot qualify as an “analyst’s investment” is automatically considerate as a speculative operation.

New terminology / Concepts / Ideas / Technical Items / Useful Examples:

1. Analyst’s Investment – Operations that, upon thorough study, promise safety of principal and an adequate return.
2. Sheltered Investment – Securities regarded as subject to small risk by reason of their prior claim on earnings or because they rest upon an adequate taxing power.
3. Intelligent Speculation – Taking of a risk that appears justified after careful weighing of the pros and cons.
4. Unintelligent Speculation – Risk taking without adequate study of the situation.
5. Standards of Safety – Resources and earning power of an institution is sufficient to cover the investor’s contribution.

Issues Disagree With:

If a business has demonstrated outstanding relationship with its customers, labour, and/or suppliers, an analyst should consider this intangible qualitative factor as part of his or her test for standards of safety.

Practical Application:

1. Avoid the Chinese stocks that are trading at multiples of 50 and above.

2. Utilize online resources such as Capital IQ and EDGAR to access industry and company profiles for fact findings.

3. Document the analysis and the reasoning of safeness.

Three Quotes:

1. “It is important to recognize that such value (“intrinsic value”) is by no means limited to “value for investment”…, but may properly include a substantial component of speculative value, provided that such speculative value is intelligently arrived at. Hence the market price may be said to exceed intrinsic value only when the market price is clearly the reflection of unintelligent speculation.”
2. “The concept of safety can be really useful only if it is based on something more tangible than the psychology of the purchaser. The safety must be assured, or at least strongly indicated, by the application of definite and well-established standards.”
3. An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.

Three questions to the group to test understanding:

1. What are the types of “investment”?

2. What is the relation of the future to investment and speculation?

3. What would be considered as standards of safety?

Clarifications & Group Discussion:

1. Is speculation wrong?

2. How to determine if an operation is an “intelligent speculation”?

3. What should be considered as “Standards of Safety”?

4. What would be considered as an adequate or “thorough” analysis?

Security Analysis Book Study Group

I am fortunate to know a group of dedicated value investors based in Vancouver, and we are currently in the process of going through Security Analysis by Benjamin Graham, the Dean of Wall Street. I will be publishing my own chapter summary that I am assigned to. I believe this is a valuable exercise, and I hope to share some of the experience to whomever that might stumble on to this little space.

Reading: Introduction to the Sixth Edition—Benjamin Graham and Security Analysis: The Historical Backdrop

One Minute Summary:

The chapter gives a brief historical overview of the U.S. economy and Wall Street since the Great Depression, as well as the Dean of Wall Street himself.

Chapter in Detail:

· Between the publication of the first (1934) and second (1940) edition of Security Analysis, the U.S. economy and the U.S. financial industry were in a terrible shape.

o DJIA had lost 87% of its value from its peak in 1929 to trough in 1932; unemployment rate was approximately 25%.

o DJIA again lost 50% of its value from 1937 to 1938; unemployment was 18.8%.

o NYSE, the exchange itself, was running at a loss every year from 1933 to 1940, with the exception of 1935 with a small nominal profit.

o Total share volume traded was 207.6 million in 1940—about two hours worth of trading in today’s market or 18.5% of 1929.

o One in five NYSE-listed industrial companies was under its net current assets value.

o Merrill Lynch & Co. only required a single floor at 40 Wall Street for the entire company; Morgan Stanley only occupied a single floor as well at 2 Wall Street, and it was the leader for corporate securities underwriting in 1936 —with originations worth of $195 million.

· Major federal regulations of the securities markets were introduced in the 1930’s.

o Public companies need to publish quarterly and annual report to stockholders.

o Institutions regulating the securities markets were established, along with federal insurance of bank deposits.

· Benjamin Graham, the Dean of Wall Street.

o Intrinsic value, defined by Graham, is “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.”

o Graham stated that since the future is unknown, an investor must defend himself or herself again that unknown by paying less than the “intrinsic” value of a stock (“Margin of Safety”).

New terminology / Concepts / Ideas / Technical Items / Useful Examples:

“Nexting” – Animals learn to recognize patterns around their world and use the knowledge to expect what would happen next. Humans are masters of this ability and often mistakenly believe the knowledge is a sound base for future predictions; however, “Nexting” is really just combining the experience of the present and past to arrive at a conclusion for the unknown future. This term is coined by Daniel Gilbert, author of “Stumbling on Happiness” and a Harvard psychology professor. Benjamin Graham understood the foolishness of projecting current experience into the unpredictable future; thus, he urged adhering to the concept of “Margin of Safety”—purchase of a stock significantly below its intrinsic value. In the chapter, an example of “Nexting” is the prediction made in 1939 by Alvin Hansen and Joseph Schumpeter, two Harvard economics professors, that U.S. would experience continued decline in population growth; this idea was echoed by Chelcie Bosland, assistant professor of economics at Brown, in his publication of “The Common Stock Theory of Investment” (1937) that U.S. population growth would stop by 1975.

Use of Leverage – In 1929, Graham-Newman partnership had $2.5 million capital. They had $2.5 million in long/short hedged positions, as well as $4.5 million in long positions. Graham realized later that the stocks they owned, no matter how cheap they appeared to be, were imminent to major financial blows. Even after a careful selection of stocks, the partnership showed a cumulative loss of 70% from the fourth quarter 1929 to the end of 1932.

Issues Disagree With:

N/A

Practical Application:

1. Consider stocks that are under its net current assets value.

2. Special situation, Graham and Klarman’s specialty: assesses the liquidation value of a company with insolvency potential. After a thorough analysis, acquire the stocks if the market value is significantly below the liquidation value.

3. Apply long/short strategy when applicable situation arise. In the chapter, the example involved with a company faced with insolvency. Graham would enter a long position in the liquidating company, again after thorough analysis, that had a much higher liquidation value than its market value, and subsequently, short the stocks of companies in which the liquidating company owns.

Three Quotes:

1. “I blamed myself not so much for my failure to protect myself against the disaster I had been predicting (the 1929-1932 market collapse)…as for having slipped into an extravagant way of life which I hadn’t the temperament or capacity to enjoy. I quickly convinced myself that the true key to material happiness lay in a modest standard of living which could be achieved with little difficulty under almost all economic conditions.” –Benjamin Graham

2. “Even when the underlying motive of purchase is mere speculative greed, human nature desires to conceal this unlovely impulse behind a screen of apparent logic and good sense. To adapt the aphorism of Voltaire, it may be said that if there were no such thing as common-stock analysis, it would be necessary to counterfeit it.” –Benjamin Graham

3. “If an investor had purchased 100 shares of the 20 most popular dividend-paying stocks on December 31, 1901, and held them through 1936, adding, in the meantime, all the melons in the form of stock dividends, and all the plums in the form of stock split-ups, and had exercised all the valuable rights to subscribe to additional stock, the aggregate market value of his total holdings on December 31, 1936, would have shown a shrinkage of 39% as compared with the cost of his original investment.” –Robert A. Lovett

Three questions to the group to test understanding:

1. What is “intrinsic” value and how is it determined?

2. What would be an example of the “aphorism of Voltaire” we have seen in the past decade?

3. Why is “Margin of Safety” an important investment concept?

Clarifications & Group Discussion:

1. 10 times earnings, 20 times earnings, or 50 times earnings – Are we creating another New Era theory or time has really changed?

2. Use of Leverage — Should leverage be used? If yes, on what level?

3. The Great Depression – Is this an anomaly?

4. Think about stocks the way a businessperson would think about his or her own family business — Is this the case in today’s market or its relevance has disappeared?

5. Nexting – How can we avoid the folly in making future predictions?