Chapter 51—Discrepancies between Price and Value (Continued)

One Minute Summary:

This chapter gave additional reasons for discrepancies between price and value of a security, such as seasoned and unseasoned issues, contractual and non-contractual comparables, and special supply and demand circumstances.

Chapter in Detail:

Seasoned issue—an issue of a company has a high reputation among investors due to its long and successful operating history. The price of a seasoned issue may exhibit price inertia even when its financial statements or future prospects have been weakened.

Unseasoned issue—an issue that usually belongs to the industrial field. Unseasoned issues are very sensitive to adverse developments of any nature. Therefore, during a business storm, a group of unseasoned issues is likely to suffer more than a group of seasoned issues, which speculative opportunities may arise for a security buyer.

Misuse of comparables—an issue is quantitative preferable to others in a similar industry does not imply that issue is a sound purchase. The issue must be considered as attractive on a stand-alone basis.

Contractual related comparables—when a senior issue is more preferable than its junior securities based on quantitative factors, one should consider switching to the senior issue as a sound investment. Any improvement in the business should reflect a better return than one made in the common stock.

Special supply and demand factors—short-term speculative purchases due to temporary excitement in an issue, or its related industry.

Practical Application:

1. Washington Mutual (WaMu) as a seasoned issue—an analyst may examine WaMu’s financial statements and reveal significant information about its financial position. At the peak of WaMu’s operation, the option ARMs and subprime mortgage represent over 50% of its loan portfolio.
2. Buy an issue that you can fully understand its business fundamentals, unless a significant, demonstrable discrepancy exists between its current price and value.

Three Quotes:

1. “We have warned against an overready acceptance of a purely quantitative superiority. The future is often no respecter of statistical data.” Pp. 691
2. “He buys by reputation rather than by analysis and he holds tenaciously to what he has bought. Hence holders of long-established issues do not sell them readily, and even a small decline in price attracts buyers long familiar with the security.” Pp. 688
3. “These disparities [of prices between senior and junior securities] arise from the frequent failure of the general market to recognize the effect of contractual provisions and often also from a tendency for speculative markets to concentrate attention on the common stocks and to neglect the senior securities.” Pp. 693

Three questions to the group to test understanding:

1. Why price inertia exists?
2. In valuing comparables between companies in the same industry but with different capital structure, how would the analyst account for the differences?
3. When an industrial issue appears to be undervalued from its comparables, what would be the best course of action?

Clarifications & Group Discussion:

1. Would you consider expanding your investment horizon to include more senior securities?
2. What other additional factors may contribute to discrepancy between price and value?
3. Do we have more “seasoned” industrial issues today?
4. Technical analysis is a form of special supply and demand?

Chapter 43—Significance of the Current-Asset Value

Chapter 43—Significance of the Current-Asset Value

One Minute Summary:
This chapter is about using current asset value as an approximation of a company’s liquidation value—book value of current assets should be adjusted to reflect liquidation value. Companies that are selling under liquidation value usually demonstrated unsatisfactory earnings trend, which may continue to operate at a loss and nullify the intrinsic value to below price paid. As a result, the analyst should examine companies that have reasonable basis of earning improvement based on past records and future prospects.

New terminology / Concepts / Ideas / Technical Items / Useful Examples:
• During liquidation, non-current assets are to experience the most shrinkage; thus, as a safety measure, current asset value provides a rough measure of the liquidating value.
• History may serve as an indication of future. In the chart, Manhattan Shirt would likely to yield better results since its net current asset was reduced by 10% during a very difficult period, compared to 60% of Hupp Motor.

Additional comments:
• Liquidating/market value for real estate, buildings, machinery, equipment, nonmarketable investments, intangibles, etc are more easily obtainable today. If the analyst is confidence about his/her source of information, the percentage of liquidating value to book value can be adjusted higher than what is suggested by the chapter.

Practical Application:
• Past history of a bargain issue should be examined to determine whether an investment in such issue will yield satisfactory results in the future.
• To be considered as an attractive investment, these bargains must have potential catalysts in either improvement in future earnings, potential sale or merger, or liquidation distribution.

Three Quotes:
1. “Common stocks that (1) are selling below their liquid-asset value, (2) are apparently in no danger of dissipating these assets, and (3) have formerly shown a large earning power on the market price, may be said truthfully to constitute a class of investment bargains.” Pp. 570
2. “…voluntary withdrawal from an unprofitable business, accompanied by the careful liquidation of the assets, is an infinitely more frequent happening among private than among publicly owned concerns.” Pp. 559
3. “Dividends paid to common-stock holders do not in themselves make the stock any safer. The directors are merely running over to the stockholders part of their own property; if the money were left in the treasury, it would still be the stockholder’s property.” Pp. 573

Three questions to the group to test understanding:
1. What kind of liabilities may be off balance sheet?
2. How would you go about to confirm the book value of current assets on the balance sheet?
3. How would you value the capitalization structure when the debt instruments (preferred or fixed coupon debts that have a convertible feature into common stocks)?

Clarifications & Group Discussion:
1. Case study of Bennett Environmental Inc.

2. What essences should we take away from this chapter since the “net-nets” are less obvious in today’s market?

3. Today, some businesses may have their intangible assets understated. Would you consider “mark-up” the value of these assets? If yes, how would you assess the value, and should the intangibles be considered as a current asset?

4. Would you apply similar discount percentage to the book value for different asset classes suggested by the chapter?

Chapter 37—Significance of the Earnings Record

Chapter 37—Significance of the Earnings Record

One Minute Summary:

The chapter goes over the significance, as well as pitfalls, of the earnings record.

Chapter in Detail:

Earnings record is used to as a starting point to judge a company’s future earning power. Because a long history of earnings demonstrate some quantitative and qualitative factors of a company, earnings record must cover a number of years to gauge a company’s future earning power For example, a stable rising trend of earnings over a period of 20 years may suggest that the company exhibited favourable prospects during various business cycles.

However, there are a number of key points that should be considered with the company’s earnings record:

1. If there is a quantitative trend, the trend needs to be coupled with supporting qualitative factors:

a. Industry characteristics

b. Inherent stability of the company

c. Future outlook, etc.

2. Valuation should not be based on current earnings.

a. A single year of earnings may only demonstrate the company’s earning power during a particular point of a business/industry cycle

3. Distinctions between average and trend of earnings.

a. Trend may be deceptive

i. Poor prior results

ii. Future competition

iii. Sensible business man approach

4. Deficits should be considered as a qualitative factor

a. A wide variation in the earnings record decrease the representative character of the average

5. Intuition vs. sound analysis

a. Identified qualitative factors should be based on sound reasoning

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

· Intuition vs. Sound reasoning

Additional comments:

· Pension liability and its future impact on the earning power of a corporation should also be considered

· Ignore the share data and look strictly at the total value, e.g. total earnings vs. market cap/enterprise value

Practical Application:

· The analyst should survey the up-to-date and future corporate developments of a company. For example, a company may issue a large quantity of purchase rights as part of an equity financing deal that would be dilutive to future earnings.

· Positive trend of earnings may be deceptive by accounting applications and easily exaggerate the stock price of a company. It’s important to take a private businessman’s perspective and insist on paying a reasonable price based on demonstrated earnings power in the past and confirming that such trend would at least remain in the future.

Three Quotes:

1. “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... [However,] 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 valuation and selection of securities.”

2. “The analyst cannot follow the stock market in its indiscriminate tendency to value issues on the basis of current earnings. He may on occasion attach predominant weight to the recent figures rather than to the average, but only when persuasive evidence is at hand pointing to the continuance of these current results.”

3. “The divergence in method [of valuing a company’s share price] between the stock market and the analyst...does not mean that the analyst is convinced that the market valuation is wrong but rather that he is not convinced that its valuation is right.”

Three questions to the group to test understanding:

1. What kind of non-cash items can impact an income statement?

2. What are some hidden expenses that may not be reported on an income statement?

3. With a significant write-off of assets, what impact will this have on a company’s future income statements?

Clarifications & Group Discussion:

1. Case study of Decker’s Outdoor Corp.

2. What kind of qualitative factors should we look for to support the quantitative data?

3. When a company is sold at what seem like a generous valuation in relation to the average of past earnings record and future prospects, should the analyst take action and short the stock, or should he/she ignore such development and spend his/her time to identify other undervalued stocks?

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?