book-notes

Here are some interesting books I have read and my notes for remembering their content

This project is maintained by heyjiawei

Sell to optimist. Buy from pessimist.

The “Defensive” investor emphasize on mistake avoidance.

The “Enterprising” investor emphasize on willingness to devote time to select securities that are more attractive than the average.

What everybody knows

Successful investment lies in industries that are most likely to grow in the future. Then, identifying promising companies in these industries.

What he will clarify

“Discipline” is the tendency to measure or quantify

Be conservative on companies that cash in on “growth”.

Prefer the usual, down to earth companies over riskier ‘growth’ targetted companies.

Virtues of simple portfolio policy

Before venturing to riskier grounds:

Correcting myths:

Stocks become more risky as their prices rise. They become less risky (not more) as their prices fall.

The bear market is bad when you cannot outlast it (due to your age or when you are close to retirement).

What is the appropriate portfolio for the non-professional investor?

He emphasize that an investor operates through through analysis and promises safety of principal and adequate returns. A speculator does not.

For common stocks,

When is speculation unintelligent?

Speculation can reap high profits (akin to gambling). Its like trying your luck.

Never add more money to this speculative fund just because the market has gone up and profits are rolling in.

It’s actually the time to take your money out of your speculative fund.

Never mingle your speculative and investment operations in the same account.

Never mingle your speculative and investment in part of your thinking.

He suggest the following portfolio makeup for the defensive investor:

  1. 50 - 50 bonds and common stocks

The ratio can vary 25% to 75%.

If you are super risk adverse, rebalance once the ratio is over by 5%.

Do so in the inverse relationship to the action of the market.

Investors cannot hope for better than average results by buying new offerings, or ‘hot’ issues of any sort, or those recommended for a quick profit.

On the contrary, shares of important companies with a long record of profitability operations and strong financial condition have a higher chance of obtaining better than average results.

For the defensive investor:

  1. Purchase the shares of well-established investment funds as an alternative to creating your own common-stock portfolio.

Utilize a common trust fund. If you have substantial funds, use the services of a recognised investment counsel firm.

  1. Use dollar cost averaging

Buys more shares when the market is low than when it is high and thus, likely to end up with a satisfactory overall price for all his holdings.

For the enterprise investor:

  1. Follow policies which are inherently sound and promising
  2. Follow policies not popular on wall street

The search for undervalued stock is not worth the enterprise investor effort unless they can earn 5% before tax.

What stock to purchase?

Only purchase those whose you see value in their business.

The techniques:

Short streaks could be luck. Over time, they won’t hold.

The turnover rate for stocks is getter faster. People used to hold it longer and now, they hold it less than a year.

The investor and inflation

Inflation reduces purchasing power and holders of stocks share the belief:

He applies various measurements to the inflation factor to reach a conclusion on what is a reasonable expectation for investors. Using the numbers, he checks whether there is a persuasive reason to believe that common stocks are likely to do much better in future years than they have i n the last 5 and one-half decades?

Common stocks may do better in the future than in the past, but this is not certain

There are 2 time elements in investment results.

The first covers what is likely to occur over the long term future (say next 25 years).

The second is what is likely to happen to the investor, both financially and psychologically, over shorter intermediate period (5 years or less).

From the statistics, there is no time connection between inflationary conditions and the movement of common-stock earnings and prices.

The average dividend return is about 3.5% on the market value of his stock plus appreciation of 4% annually from reinvested profits.

Inflation effect on common stock capital (i.e. equity capital - common stocks earning power or businesses earning power) is quite limited.

There could be other influences affecting profitability of corporations as a whole:

  1. Rise in wage rates exceeds gains in productivity
  2. Need for huge amount of new capital could hold down the ratio of sales to capital employed.

Corporate debt, profits and earnings on capital

Corporate debt raise faster than profits (before taxes)

Raise in interest rates can cause adverse economic factor and problems for individual enterprises.

Utility companies on inflation

People think utility companies are the primary victims of inflation but the unit cost of gas, electricity, etc. have advanced less than the general price index. These are still cheap in comparison as their rate increase at a slower pace.

This puts the utilities companies in a strong strategic position for the future. Also, by law, the rate they charge is required to allow them to get an adequate return on their capital, so they can protect shareholders from inflation.

If you just go for common stocks, don’t expect more than 8% for those purchased at 1971 price level. It is guaranteed that earnings for the future will not grow at a uniform rate of 4%, or any other figure. They will fluctuate.

So you will run a risk of having unsatisfactory results for over periods of years (possibly 25 years). You will also likely be led astray by exhilarating advances or distressing declines.

Investing to fight inflation

If you purchase common stocks to fight inflation and expect returns to match that of inflation,

Alternative of purchasing commons stocks (to hedge inflation)

Disclaimer, they don’t have much expertise in these ‘things’ area

Do:

  1. Avoid purchasing gold directly as its storage and insurance cost is costly.

Seek out well - diversified mutual funds specializing in this and charging > 1% in annual expenses

  1. Real estate is subjected to inflation and errors as well.

To hedge inflation

Lessons from stock market history:

Historically, stocks did no better than bonds. Anyone who claims It in the long term, record, stocks is guaranteed to outperform bond is ignorant.

If prices of stocks keep going up, can they keep going up?

Why do you assume that stocks are guaranteed to make money in the long run?

If every investor believes that stocks are guaranteed to make money in the long run, market ends up being wildly overpriced and future returns cannot be high!

Profits that companies are finite. And so price that investors pay for stocks should be finite.

If the market returns have been rosy… enthusiasm will likely cause investors to buy high and sell low (due to market crash)

The stock Market’s performance depends on these factors:

  1. real growth (i.e. rise in companies earnings & dividends)

  2. Inflationary growth

  3. speculative growth or decline

General Portfolio for the defensive investor:

Bonds have 2 choices - taxable or tax free

Preferred stock

They are less secure than bonds because they only have a secondary claim on a company assets if it goes bankrupt.

If the company is healthy enough to deserve my investment,

Why is it paying a fat dividend on its preferred stock instead of issuing bonds and getting a tax break?

Likely the company is not healthy and it’s bonds is bad.

Should you purchase short term or long term bond ? Both or intermediate.

Investment merit of common stocks.

In 1949,the argument was:

  1. Common stocks offered a considerable degree of protection against erosion of investor dollar caused by inflation whereas bond offered no protection

  2. Common stocks have higher average return to investors over the years. Average dividend income exceed the yield on good bonds.

High prices of stocks affect dividend yield:

A stock’s yield is the ratio of cash dividend to the price of one share of common stock.

When stock price increase and dividend yield stays constant, it means dividend yield drops.

Rules for common stock component (for the defensive investor)

  1. Adequate but not excessive diversification. A minimum of 10, maximum of 30
  2. Companies selected should be large, prominent & conservatively financed.
  3. Companies must have a long record of continuous dividend payments.
  1. Should impose some limit on the price of the stock he would pay for In relation to the stock’s average earnings over, say, the past 7 years.

Why no growth stocks for the defensive investor?

Rule of 72: To estimate the length of time money takes to double, divide its assumed growth rate into 72 i.e. 6% growth rate takes 12 yrs to double

Portfolio changes for the defensive Investors

If you are an enterprising beginner,

  1. Do not try to beat the market

  2. Study security values & initially test out your judgement price versus values in the smallest possible, sums!

“Risk’ and ‘safety of securities:

Safety:

Risk:

But the idea of risk is often extended to apply to the possible decline of the price of a security. Even though the decline may be cyclical or temporary in nature,the holder may be forced to sell at such times.

The risk attached to ordinary commercial business business is measured by the chance of it losing money. Not by what would happen if the owner were forced to sell.

The bona fide investor does not lose money merely because the market price of his holdings decline! Hence, the decline does not mean he is running a the risk of loss.

If a group of well selected common stock investment shows satisfactory overall return, as measured through a fair number of years, then this group of investment has proved to be safe.

We redefine risk as such:

We apply the concept of risk solely to a loss of value which is either realized through actual sale, or caused by significant deterioration in the company’s position, or, the result of the payment of an excessive price in relation to the intrinsic worth of the security.

What is the definition of “Large, Prominent & conservatively financed corporations”?

An industrial company’s finances are not conservative if the the common stock (at book value) represents at least half of the total capitalization, including all bank debt

These figures are from a 2006 book. Times have changed so adjust them appropriately

“prominent” means its rank should be among the first quarter or first third in size within its industry group.

Portfolio for the enterprising investor

Aggressive investor should start from the same base as defensive investor - high grade bonds & common stocks bought at reasonable prices.

Do not buy foreign government bonds.

Well-regarded foreign bonds seems good but when trouble comes, the owner of these foreign obligations have no legal or other means of enforcing his claim.

New issues (IPO and corporates choosing to offer new shares to the public) should be subjected to careful examination & unusually severe tests before they are purchased.

Typically, corporate offer of new shares to the public is done when it is favourable to the seller, sometimes, when the stock market is near a peak.

The historical market-cycle showed that more IPOs lead to a heated market & crashing.

In every case, public has gotten burned on IPOs.

A common scene in the market is that people purchase large cap/good company stocks.

As the market gets better, the prejudice against small companies weaken. The market built up cause large & quick profit from purchasing these small companies and this soon dulls the public critical thinking.

Instead, it brings out their acquisitive instinct because they enjoy excellent results.

Unfortunately, most of these small companies won’t last longer than 10 years.

When the market is to getting better (bull market), somewhere these common-stock floations make their appearance.

Their stocks are priced okay. As the market continues to rise, this type of financing grows more frequent & the quality of the companies become poorer. Price asked become exorbitant.

A tell tale point when this happens:

New common stocks of small & nondescript companies are offered at prices somewhat higher than the current level for many mid-sized companies with long market history.

A key fundamental value for investors in to the ability to resist salesman pitch during bull markets.

Steer year of speculative investment for every dollar you make. You will be lucky if end by losing only 2 (when the market crash).

These stocks may be excellent buys only when nobody wants them & they can be had at the fraction of their take worth.

Purchase relatively unpopular large company.

Go read up “Dogs of the Dow” approach, “Dow 10”

The relatively unpopular company:

Enterprising investors concentrate on the larger companies are going through a period of unpopularity.

So… why not small companies?

Large companies have resources in capital & brain power to carry through adversity & back to satisfactory earning base.

This concept is simple but when considering individual companies, a special factor of opposite import must sometimes be taken into account.

Companies that are inherently speculative because of widely varying earnings tend to sell both at a relatively high price and at a relatively low multiplier in their good years.

Conversely at low prices & high multipliers in their bad years.

This is because the market has sufficient scepticism to the continuation of unusually high profits to value them conservatively, and when their earnings is low, “next to nothing”

For such companies, avoid them in low-multiplier list.

In your low multiplier list, the requirement (to shun the above companies) is the price be low in relation to past average earnings or by similar test.

When this was tested again, the figures proved disappointing.

Though one bad instance should not vitiate conclusions based on 30 odd experiments.

But there is a new conclusion. Perhaps the aggressive investor should start with “low-multiplier’ idea but add other quantitative & qualitative requirements there to to make up his portfolio.

Purchase of bargain issues

→ Includes both bonds & preferred stocks selling well under par, as well as common stocks.

Two types of tests for bargain stock:

  1. By method of appraisal.

Largely relies on estimating future earnings & multiplying those by a factor appropriate to the particular issue.

If the resultant value is sufficiently above the market price, and the investor is confident of the technique employed, this stock can be tagged as a bargain.

  1. The value of the business to a private owner.

Value is often determined chiefly by expected future earnings, but more attention is paid to the realizable value of the assets, with particular emphasis on the net current assets or working capital

But finding bargains & purchasing them require:

  1. courage in depressed markets.

  2. Experience in market

  3. plausible techniques of value analysis

There are 2 major sources of undervaluation

  1. currently disappointing results

  2. protracted neglect or unpopularity

For stocks in this area its is hard to know whether they would go up again.

The investor cannot look at just fall in earnings & price for a sound basis for purchase.

The investor has to require an indication of a least reasonable stability of earnings over the past decade or more (i.e. no year of earnings deficit), sufficient size and financial strength to meet possible setbacks in the future.

The ideal combination is of a large and prominent company selling both well below its past average price and its past average price/earnings multiplier.

The type of bargain issue that can be readily identified is a common stock that sells for less than the company’s net working capital alone, after deducting all prior obligations.

Net working capital = a company's current assets (cash, market securities & inventories) minus its total liabilities (including preferred stock & long-term debt)

This would mean the buyer pays nothing at all for the fixed assets, building, machinery, etc. or good will items that might exist.

Bargain issue pattern in secondary companies

A secondary company is not the leader in a fairly important industry.

It is usually smaller in its fields but may equally well be the chief unit in an unimportant line.

By the way, any company that has established itself as growth stock is not considered “secondary”

Why buy secondary surpasses stocks?

If most secondary issues tend to be undervalued, why do you think you can profit from it?

If persist indefinitely, the investor won’t gain?

Substantial profits from the purchase of secondary companies at bargain prices arise in a variety of ways:

  1. The dividend return is relatively high

  2. the reinvested earnings are substantial in relation to the price paid & will ultimately affect the price

  3. A bull market is ordinarily most generous to low priced issues, so it tends to raise the typical bargain issue to at least a reasonable lover.

  4. during relatively featureless marked periods, a continuous process of price adjustment goes on so undervaluation might rise

  5. the specific factors that in many cases made for a disappointing record of earnings may be corrected by advent of new conditions, or the adoption of new policies, by a change in management.

Special situations:

Lawsuits can cause bargain opportunities.

But old wall street moto: ‘Never buy into a lawsuit suit’

Because stocks have been destroyed by liability lawsuits.

The majority of security owners should elect the defensive classification for they do not have the time, determination or mental equipment to embark upon investing as a quasi-business.

Be satisfied in the returns from a defensive portfolio (or even less) & resist the temptation to deviate into other paths.

The investor and market fluctuation:

Timing:

For the investor that holds on to stock or cash, is of no importance.

Timing is of no real value to the investor unless it coincides with pricing - it enables him to repurchase his shares at substantially under his previous selling price.

Realistically, this is hard. They would have done better by just buying and holding the DJIA.

Why is it hard?

During a long bull market, one would buy stocks at a good price but put them back again at a higher price.

Why isn’t this a good strategy?

Perhaps this “problem/strategy” is an inherent characteristic of forecasting & trading formulas in the field of business & finance

These formulas gain recognition because they worked well in the past ar over a period, or sometimes because they have been plausibly adapted to the statistical record of the past.

As their acceptance increase, their reliability diminish.

This happens to for 2 reasons:

  1. the passage of time brings new conditions which the old formulas no longer fits

  2. the popularity of a trading theory itself has an influence on the market’s behaviour which detracts in the long run from its profit making possibilities.

Buy low sell high approach:

“we are convinced that the average investor cannot deal successfully with price movements by endeavouring to forecast them”

During bull markers, there is sufficient variations in successive market cycles to complicate & frustrate the process of buy low sell high. Vice versa for bear markets.

It is unrealistic for the investor to endeavour this policy.

The recommended policy is to make provision for changes in the proportion of common stocks to bonds in the portfolio.

Formula Plans:

One such plan is that the investor does some selling of common stocks when the market advances substantially.

This means in a very large rise in the market level would result in the sale of all common stock holdings;

Others provided for retention of a minor proportion of equities under all circumstances.

This is double edge because they realised excellent profits but in a broad sense, the market ran away from them thereafter And their formula gave them little opportunity to buy back a common stock position.

The moral seems to be it any approach to moneymaking in the stock market which can be easily described and followed by many is by its terms too simple & too easy to last.

In any case, the investor may as well resign to the fate or probability that most of his holdings will advance 50% or more from their low point and decline the equivalent of one-third or more from their high point at various periods in the next 5 years.

The proportion of stocks to bonds re-balancing proposition is also a way to give the investor something to do so he/she doesn’t follow the crowd.

Business valuation vs stock market valuation:

The whole stricture of the stock market quotation contains a built-in contradiction.

The better a company’s record & prospects, the less relationship the price of its stocks will have to their book value.

The greater the premium above book value, the less certain the basis of determining as intrinsic value. i.e. the more this ‘value’ will depend on the changing moods & measurements of the stock market.

The more successful the company, the greater are likely to be the fluctuations in the price of its shares i.e. the better the quality of a common stock, the more speculative it is likely to be.

The conclusion is that for the conservative investor in common stocks, if he pays some special attention to the selection of his portfolio, it might be best 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

A word of caution:

The investor should demand, in addition, a satisfactory ratio of earnings to price, a sufficiently strong financial position, & the prospect it its earnings will at least be maintained over the years.

This is not hard to find under all but dangerously high market conditions. once you forgo brilliant prospects - i.e. better than average expected growth.

The investor’s primary interest must be in acquiring & holding suitable securities at suitable prices.

It is far from certain to the typical investor should regularly hold off buying until low market levels appear because this may involve a very long wait, very likely, the loss of income & possibly missed investment opportunities.

On the whole, it may be better for the investor to do his stock buying whenever he has money to put in stocks, except when the general marked level is much higher than can be justified by well established standards of value.

If he wants to be shrewd, he can look for ever present bargain opportunities in individual securities.

Fluctuations in Bond prices:

Note that bond prices do not fluctuate in the same (inverse) proportion as the calculated yields because their fixed maturity value of 100% exerts a moderating influence.

However, for very long maturities, prices and yields change at close the to the same rate.

Which to choose, short term or long term bonds?

For most investors, try to compromise between these extremes and be assured that neither their interest rate for return nor their principal value will fall below a stated minimum over, say, 20 year period.

Investing in investment Funds:

  1. Is there a way by which the investor can assure himself of better than avg. results by choosing the right funds?

  2. If not, how can he avoid choosing funds I will give worst than avg. results?

  3. Can he make intelligent choices between different types of funds? eg. balanced versus all-stock, open-ended versus closed-end, load us no-load?

Keep away from extraordinary popular delusions. i.e. performance funds.

If you want to put money in investment funds, buy a group of closed-end company. Shares at a discount of say 10-15% from asses value instead of paying a premium of 9% above asset value for shares of an open-ended company.

Assuming that future dividends & changes in assets values continue to be the same for the 2 groups, you will obtain one-fifth more for your money from closed-end shares.

But if you own closed-end shares you can never be sure what price you can sell them for.

Assuming the dis. on closed-ended shares does widen, how likely will you be worse off with those shares than with an otherwise equivalent purchase of open-ended shares Quite rare.

Investment in Balanced Funds:

It would be logical for the typical investor to make his bond-type investments directly rather than to have them form part of a mutual-fund commitment.

The average income by balanced funds is lower than if your purchased bonds directly.

The investors & his advisers:

The reason people invest is to make money. In seeking advice, they are asking others to tell them how to make money. That has some element of naivete. When non business people rely on others to make investment profits for them, they are expecting a kind of result for which there is no counterpart in ordinary business affairs.

The job of an advisor is one that uses his training & experience to protect his clients against mistakes & to ensure they obtain the results to which their money is entitled.

Investment Counsel & Trust services of Banks:

The freely truly professional investment advisers - like well established investment counsel firms who charge substantial annual fees-are quite modest in their promise.

For the most part, they place their client’s funds in standard interest & dividend paying securities. They rely mainly on normal investment experience for their overall results.

Their primary aim is to conserve the principal value over the years & produce a conservatively acceptable rate of income.

Financial Services:

So-called financial services are organizations that send out bulletins to their subscribers on subjects covering the state & prospects of business, be behaviour and prospect of Securities markets, information & advice regarding individual issues.

Those that work on “advice” has no real significance.

There is a pervasive attitude that tends to impair what could otherwise be more useful advisory work - the view that a stock should be bought it the near-term prospects of the business is favourable & should be sold it these are unfavourable - regardless of the current price.

Such superficial principle often prevents the service from doing sound analytical job of ascertaining whether the stock appears over or undervalued at the current price in light of its indicated long-term future earning power.

The intelligent investor will not do their buying & Selling solely on the basis of recommendations received from a financial service.

Once this point is established, the role of the financial service then becomes a useful one of supplying information & offering suggestions.

Dealing with Brokerage houses:

The investor should use his intelligence not only in formulating the financial policies but also in the associated details. Use a reputable broker to execute his/orders. Deal only with a member of NYSE unless you have compelling reasons to use a non-member firm.

Investment Bankers:

Pay attention to the advice & recommendations received from investment banking houses, especially those with excellent reputation.

Have sound & independent judgement to bear upon these suggestions

Summary:

For the defensive investor, the security analyst of any reputable stock exchange house can make up a suitable list of common stocks (high grade bonds & common stocks of leading corporations) and can certify to the investor whether or not the existing price is a reasonably conservative one as judged by past experience.

For the aggressive investor, he will corporate actively with his advisers. He will want their recommendations explained in detail & will insist on passing his own judgement upon them.

This type of investor will gear his expectations and the character of his security operations to the development of his own knowledge and experienced in the field. Only in the exceptional case, where the integrity & competence of the advisers are proven, should he act upon their advice.

Security Analysis for the lay investor : General Approach

Security analysis limits itself to examination & evaluation of stocks & bonds.

Financial analysis comprise of security analysis work, and the determination Of investment policy (portfolio selection), and a substantial amount of general economic analysis.

In dealing with common stocks the security analyst rarely apply standards of value.

Most of the time, they are contented with a summary of past performances, a more or less general forecast of the future - with particular emphasis on the next 12 months - and a rather arbitrary conclusion.

Here we point out a troublesome paradox:

Mathematical valuations have become most prevalent precisely in those areas where one might consider them least reliable.

For the more dependent the valuation becomes on anticipation of the future- and the less it is tied to a figure demonstrated by past performance - the more vulnerable it becomes to possible miscalculation and serious error.

A large part of the value found for a high-multiplier growth stock is derived from future projections which differ markedly from past performance - except in the growth rate itself.

There are 2 basic questions underlying the selection of investments.

  1. what are the primary tests of safety of a corporate bond or preferred stock?
  2. what are the chief factors entering into the valuation of a common stock?

Bond analysis:

Security analysis on bonds is concerned with the safety (i.e. quality) of Bond issues and investment-grade preferred stocks.

The chief criterion used for corporate bonds is the number of times that total interest charges have been covered by available earnings for some year 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.

Today, many mutual funds invest in corporate bonds. They are well diversified & convenient. Purchase a low cost bond fund & leave the total labour of credit research to its managers.

Look up earnings-coverage test.

Other tests that are applied:

  1. size of enterprise
  2. Stock / Equity Ratio
  3. Property value

Stock / Equity Ratio:

This is the ratio of the market price common stock to the total face amount of the debt, or the debt plus preferred stock.

It is a rough measure of protection or ‘cushion’ afforded by the presence of a common stock that must first bear the brunt of unfavourable developments. This factor includes the market’s appraisal of the future prospects of the enterprise.

Property Value:

The asset values, as shown on the balance sheet or as appraised, used to be chief security consideration for bond protection.

Experience has show that in most cases safety resides in earning power and if this is deficient the asset lose most of their reputed value.

Asset value is important for security bonds and preferred stocks in three enterprise groups:

  1. Utility public utilities (because rates depend largely on the property in investment)

  2. real-estate concerns.

  3. investment companies.

How dependable are tests of safety that are measured by past & present performance?

The answer can only be found on experience.

They are not quite ready to suggest that the investor count on an infinite continuation of this favourable situation so they don’t suggest relaxing your standards of bond selection in the industrial or any other group.

Common Stock Analysis:

The stock valuation is ordinarily found by estimating the average earnings over a period of years in the future and then multiplying that estimate by an appropriate “capitalization factor”.

The now-standard procedure for estimating future earning power starts with average past data for physical volume, prices received, and operating margin.

Future sales in dollars are then projected on the basis of assumptions to the amount of change in volume & price level over the previous base.

These estimates, in turn, are grounded first on general economic forecasts of gross national product, and then on special calculations applicable to the industry & company in question.

Forecast on individual companies tend to be more off mark than group estimates.

Ideally, the security analyst should pick out 3 or 4 companies whose future he thinks he knows best and concentrate his own and his client’s interest on what he forecasts for.

Unfortunately, individual forecast is a subjected to a chance of error.

This is the reason for wide diversification - it is more dependable and reputable.

Factors affecting capitalization rate:

Though average future earnings are suppose to be the chief determinant of value, the security analyst takes into consideration other factors & these factors will enter his capitalization rate.

  1. General long term prospects - what we think will happen in the future of x industry.

  2. Management - quite fluffy. He thinks the management factor is most useful when (and only in these cases) recent change has taken place that has not yet had the time to show its significance in the actual figures.

  3. Financial Strength & Capital Structure - stock of a company with a lot of surplus cash and nothing ahead of the common is better than a stock of the same earnings per share but riddles with large bank loans, senior securities

A modest amount of bonds or preferred stock is not a disadvantage.

Incidentally, a top-heavy structure - too little common stock in relation to bonds and preferred - may under favourable conditions make for a huge speculative profit in the common.

  1. Dividend Reward.

high quality is marked by an uninterrupted record of dividend payments (of 20 years at least) going back over many years.

  1. Current dividend rate - Most difficult.

The majority (in 1969) of companies have come to follow what is called a standard dividend policy.

This meant the distribution of about two thirds of their average earnings, except that in the periods of high profits and inflationary demands for more capital the figure tended to be lower.

However, the dividend payout ratio has dropped significantly since then, as American tax law discourages investors from seeking, & corporates from paying.

How interest rates will affect valuation:

A given schedule of expected earnings, or dividends, would have a smaller present value if we assume a higher interest rate than if we assume a lower interest rate structure.

when interest rates are high, the amount of money you need to set aside today to reach a given value in the future is lower - since these high interest rates will enable it to grow at a more rapid rate.

Thus, a rise in interest rates today makes future stream of earnings or dividends less valuable - Since the alternative of investing in bonds has become relatively more attractive.

A two part appraisal process:

Suggest that analyst work out first on the security’s past-performance value (i.e. past 7 years), which is based solely on the past record. It would indicate what the stock would be worth absolutely, or as a percentage of the DJIA or of the S&P composite, if it is assumed that its relative past performance will continue unchanged in the future (i.e. the next 7 years).

This process could be carried out mechanically by applying formula, that gives individual weights to pass figures for profitability, stability and growth, and also for current financial condition.

The second part of the analysis consider to what extent the value based solely on past performance should be modified because of new conditions expected in the future.

He thinks, eventually the intelligent analyst will confine himself to those groups in which the future appears reasonably predictable of where the margin of safety of past-performance value over current price is so large that he can take his chances on future variations.

These predictable industry groups are ideally not overly dependent on unforeseeable factors as fluctuating interest rates or the future direction of prices for raw materials like oil or metals. Possibilities might be industries like gaming, cosmetics, alcohol beverages, nursing homes, waste management.

Things to consider about per share earnings:

2 pieces of advices:

  1. Don’t take a single year’s earnings seriously.

  2. If you do you pay attention to short term earnings, look out for booby traps in the per-share figures.

Company Financial Statements may try to downplay losses by parking them as one-off or future losses? (not a loss yet)

By anticipating future losses the company escapes the necessity of allocating the losses themselves to an identifiable year.

They can also try to write off losses to bad years felt by all in the industry.

These are usually in the footnotes!

The more serious the investor take earnings per share figures as published, the more necessary for them to be on their guard against accounting factors of one kind and another that may impair the the comparability of the numbers.

The things to look out for in company financial statements & would be cover ups:

  1. use of special charges.

  2. Reduction in the normal income tax deduction by reason of past losses

  3. Dilution factor implicit in the existence of substantial amounts of convertible Securities or warrants.

  4. The method of treating depreciation-chiefly as between the “straight-line” and the “accelerated” schedules

  5. The choice between charging off research and development costs in the year they are incurred or amortizing them over a period of years

  6. The choice between the FIFO and LIFO methods of valuing inventories.

In his opinion, the proper mode of calculation:

  1. First consider the indicated earning power on the basis of full income tax liability and derive some broad idea of the stock’s value based on that estimate

  2. To this should be added some bonus figure representing the value per share of the important but temporary tax exemption the company will enjoy

  3. Allowance must be made for possible large scale dilution

Recent history - and a mountain of financial research - have shown that the market is unkindest to rapidly growing companies that suddenly report a fall in earnings.

Great expectations lead to great disappointment if they are not met. A failure to meet moderate expectation’s leads to a much milder reaction. Thus, one of the biggest risk in owning growth stocks is not that their growth will stop, but merely that it will slow down. In the long run, that is not a risk, but a virtual certainty.

Picking stocks comparisons criteria:

  1. Profitability -ratio of operating income to sales should be positive.
  2. Stability- Measured by the maximum decline in per share earnings in any one of the past ten years, as against the average of the three preceding years. No decline translates into 100% stability. Moderate shrinkage on poor years should be measured relative to DJIA

  3. Growth: earnings growth per share.
  4. Financial Position:

    • ratio of current assets to current liabilities.
    • long-term debt
    • dilution from convertible preferred shares.
  5. Dividends - record of no interrupted payment.

  6. Price History

    • percentage advance in the price of stocks, measured from the lowest to the highest points.
    • low price should be adjusted for subsequent stock splits.

Stock selection for the Defensive Investor

The defensive investor has 2 choices of approach:

  1. The DJIA-type of portfolio (S&P)
  2. the quantitatively tested portfolio

Apply a set of standards to each purchase, to make sure that he obtains

A. a minimum quality of in the past performance and current financial position of the company.

B. A minimum quantity in terms of earnings and assets per dollar of price.

Here is the summary for quality & quantity criteria suggested for the selection of specific common stocks:

  1. Adequate size of enterprise.

  2. Sufficiently strong Financial Condition

Industrial companies current assets should be at least twice current liabilities (so called 2:1 current ratio). Also, long-term debt should not exceed the net current assets (or working capital)

For public utilities, should not exceed twice the stock equity (at book value)

  1. Earnings stability

There must be some earnings for the common stock in each of the past 10 yrs.

  1. Dividend Record

Uninterrupted payments for at least the past 20 years.

  1. Earnings Growth

A minimum increase of at least one third in per-share earnings in the past 10 years using 3-year averages at the beginning and end.

  1. Moderate Price/Earnings Ratio

Current price should not be more than 15 times average earnings of the past 3 years.

  1. Moderate Ratio of Price of Assets

Current the price should not be more than 1.5 times the book value last reported.

As a rule of thumb, suggested: product of the multiplier times the ratio of price to book value should not exceed 22.5

Investing in stocks of Financial Enterprises:

Financial companies are the banks, insurance companies, savings & loan associations - no helpful remarks.

Selecting stocks considerations:

The current price of a stock reflects both known facts and future expectations

A) prediction (or projection)

A.k.a the qualitative approach emphasizes on prospects and other non-measurable, highly important factors that go under the heading of Quality

B) protection

A.k.a the quantitative or statistical approach emphasizes on measurable relationships between selling price and earnings, assets, dividends and so forth.

It is also an extension to bond security analysis and the preferred method for Graham - where he is unwilling to accept prospects and promises of future compensation for the lack of sufficient value in hand.

Stock selection for the Enterprising investor:

For the enterprising investor, we must consider the possibilities of individual selections which are likely to prove move profitable than an across the board average.

It’s hard to get better than average results than the DJIA, even if the portfolio is similar to that of DJIA

This is evident from the record of numerous investment companies “funds” which have seen been in operation for many years.

Why is this so?

First explanation he can think of:

The stock market in fact reflect in the current prices not only all the important facts about the companies past prices, their current performance, but also what ever expectations can be reasonably formed to their future.

The market movement that subsequently take place - and they are often extreme-is the result of new developments and probabilities that could not be reliably foreseen. This would make the price movement essentially fortuitous and random.

The second possibility:

Perhaps the security analysts are handicapped by a flaw in their basic approach to the problem of stock selection. They seek the industries with the best prospects of growth, and the companies in these industries with the best management and other advantages.

The implication is that they buy into such industries and such companies at any price, however high, & they will avoid less promising industries and companies no matter how low the price of their shares

This would be the only correct procedure if the earnings of the good companies were to grow at a rapid rate of indefinitely in the future, for then, in theory, their value would be infinite.

And if the less promising companies were headed for extinction, no salvage, the analyst would be right to consider them unattractive at any price.

In truth, extremely few companies are able to show uninterrupted period of growth for a long time. Some also have a variation of ‘rags to riches and back’ been repeated on almost a cyclical basis.

Summary of Graham - Newman Methods:

Arbitrages: The purchase of a security and the simultaneous sale of one or more other securities into which it was to be exchanged under a plan of reorganization, merger, of the like.

Liquidations: Purchase of shares which were to receive one or more cash payments in liquidation of the company’s assets.

Operations of these 2 classes were selected on the basis of

  1. a calculated annual return of 20% or more

  2. our judgement that the chance of a successful outcome was at least four out of five.

Related Hedges: The purchase of convertible bonds or convertible preferred shares, and the simultaneous sale of the common stock into which they were exchangeable.

The position was established at close to a parity basis (?)

Net-current - Asset (or Bargain) Issues:

The idea here is to acquire as many issues as possible at a cost for each of less than their book value. In terms of net-current-assets alone i.e. giving no value to the plant account and other assets.

Graham stopped:

  1. The purchase of apparently attractive issues - based on their general analysis - which was not obtainable at less than their working capital value alone

  2. ‘unrelated’ hedging operations.

Where can you get data on companies?

S&P publish an annual monthly stock Guide. You can try requesting this from your broker.

Winnowing with the stock guide:

How to look for an Indication that the stock is cheap?

It has low price in relation to recent earnings.

Now apply the following additional criteria

  1. Financial conditions. a) current assets at least 1.5 times current liabilities. and b) debt not more than 110% of net current assets (for industrial companies)

  2. Earnings stability: no deficit in the last 5 years covered in the stock guide

  3. Dividend record: same current dividend

  4. Earnings growth: last year’s earnings more than those of 1966

  5. Price: less than 20% net tangible asset.

No limit on size of enterprise.

From these criteria, you can search until 15 stocks and create a small “portfolio” with it.

Is there / can there be a single criteria for choosing common stocks?

Could a single plausible criterion be used to good advantage - such as low price/earnings ratio, or a high dividend return, or a large asset value?

2 methods that gave quite consistently good results a) the purchase of low-multiplier stocks of important companies (such as the DJIA list)

The choice of a diversified group of stocks selling under their net-current-asset value (or working-capital value)

From his portfolio studies, the results showed 3 groups that did better than S&P composite.

  1. Industries with the highest quality ranking (A+).

It is worth remarking that the S&P rankings showed up very well in this single test. In every case a portfolio based on a higher ranking did better than a lower-ranking portfolio.

  1. Companies with more than 50 million shares outstanding showed no change on the whole, as against a small decline for the indexes.

  2. Strangely, stocks selling at a high price per share (over 100) showed a slight (1%) composite advance.

Based on various tests on book value, contrary to their investment philosophy, companies that combined major size with a large good-will component in their market price did very well as a whole in the 2.5 year holding period.

By “good-will” component they mean the part of the price that exceeds the book value.

In Graham’s terms, a large amount of goodwill can result from 2 causes:

A. A corporate can acquire other companies for substantially more than the value of their assets, or its over stock can trade for substantially more than its book value.

It is clear that there will be considerable momentum attached to companies that have large amounts of ‘good will’

It is difficult to judge to what extent the superior market action shown is the due to ‘true’ or objective investment merits and to what extent to long established popularity.

In general, their tests indicated that in general, random lists based on a single favourable factor did better than random lists chosen for the opposite factor.

This shows, that results support their recommendation that the issues selected meet combination of quantitative or tangible criteria.

Convertible Issues and warrants

In the overall picture, the convertible issues rank as much more important than the warrants.

  1. so, how do they rank as investment opportunities and risks?

  2. how does their existence affect the value of the related common-stock issues?

Convertible Issues are claimed to be especially advantageous to both the investor and the issuing corporation. The investor receives the superior protection of a bond or preferred stack, plus the opportunity to participate in any substantial rise in the value of the common stock.

The issuer is able to raise capital at a moderate interest or preferred dividend cost, and if the expected prosperity materializes the issuer will get rid of the senior” obligation by having it exchanged into common stock. Thus, both sides of the bargain will fare unusually well.

But this is not the. Convertible Issues are like any other form of Security, their form itself guarantees neither attractiveness nor unattractiveness.

The ideal combination is a strongly secured convertible, exchangeable for a common stock which itself is attractive, and at a price only slightly higher than the current market.

By nature of the securities market, you are more likely to find such an opportunity in Some older issue which has developed into a favourable position rather than in a new flotation.

Case studies of Destruction:

  1. companies that were not doing well but stock prices still high. (overpriced ‘tottering giant’)

People never questioned than this company never paying taxes?

  1. Head-over-heels expansion and head-over-heels debt series of acquisition under a company name can cause huge sales but also enormous debt.

Always look at their quarterly reports through each year. They tried to throw all possible charges and reserves into one bad year.

  1. A merger which a tiny firm overtook a big one

  2. An IPO of shares wth in a basically worthless company.

A comparison of companies (pair):

  1. Home Products vs Hospital supply

They were both ‘billion-dollar good-will` companies, representing different segments of the rapidly growing & immensely profitably health industry’ profitable

They lad the following favourable points in common:

When comparative price is taken into account, Home offered much more money in terms of current (or past) earnings and dividends.

The very low book value of Home illustrates a basic ambiguity or contradiction in Common Stock analysis. On one hand, the company is earning a high return on its capital - which in general is a sign of strength and prosperity.

On the other hand, it means that the investor at the current price would be especially vulnerable to any important adverse change in the company’s earnings situation.

Conclusions:

The clear-cut view is that both companies were too rich at their cument prices to be considered by the investor conservative investor.

This does not mean the companies were lacking in promise. They (their price) contained too much ‘promise’ and not enough actual performance. They both hold too much good-will valuation and it is a mystery how many years of future earnings it would take to ‘realize’ that goodwill factor in the form of dividends or tangible assets.

Gambler's fallacy:

Investors believe that an overvalued stock must drop in price purely because it is overvalued. Just as a coin does not become more likely to turn up heads after landing on fails for 9 times in a row, an overvalued stock (or stock market) cau stay overvalued for a surprising long time. That makes short-selling, or betting that stocks will drop too risky for mere mortals.

Shareholders & managements: Dividend Policy

Shareholders are justified in raising questions of the competence of the management When

  1. Results are unsatisfactory themselves.

  2. Are poorer than those obtained by other companies that appear similarly situated

  3. Have resulted in an unsatisfactory market price of long duration.

Poor management can cause low market price and low market price attract attention of companies interested in diversifying their operations. (I.e. take overs)

It is a rule with few exceptions, that poor management is not changed by the action of Public stockholders, but only by the assertion of control by an individual or compact group.

Dividend Policy & Shareholders

In our current time (2023), the better the past record of growth, the readier investors and speculators have become to accept a low pay-out.

In many cases of growth favourites, the dividend rate - or even the absence of any dividend - seems to have no effect on the market price.

The market’s appraisal of cash-dividend policy appears to be developing like so:

At the other extreme, stocks seen as ‘growth stocks’ are valued primarily in terms of the expected growth rate over the next decade. And the cash-dividend rate is more or less left out of the reckoning.

However, the following is not a clear-cut guide to the situation in all common stocks, and perhaps not in the majority of them.

For one, many companies occupy an intermediate position between growth and non-growth companies.

It is hard to say how much importance should be ascribed to the growth factor in such cases, and the market’s view thereof may change radically from year to year.

Secondly, it is paradoxical to expect a company experiencing slower growth to be more liberal with their cash dividends

He feels that:

The principle behind option Grants:

Option grants to are arguably to align the interests of managers with outside investors.

As an outsider shareholder, you want managers to be rewarded only if the company’s stock earns superior returns. Nothing else could be fair to you and the other owners of the company. Why?

Say if Apple stock rises by just 5% annually through the beginning of 2010, if Apple’s stock earns no better than half the long-term average return the overall stock market, the CEO will be very rich. This clearly doesn’t align with the shareholders interest.

What about the argument that companies can put spare cash to better use by buying back their own shares?

When a company repurchase some of its stock, that reduces the numbed of its outstanding shares. Even if its net incomes stays flat, the company’s earnings per share will rise since its total earnings will be spread across fewer shares.

That, in turn should lift the stock price.

Additionally, a buyback is tax-free to investors who don’t sell their shares. So it increases the value of their stock without raising their tax bill.

And if the shares are cheap, spending cash to repurchase them is an excellent use of the company’s capital.

But that is theory.

In the real would, stock options is now a huge part of executive compensation. This means it would jack up the number of shares outstanding and shrink earnings per share

To counteract the dilution, they must repurchase the shares in the open market.

Keep in mind

  1. companies get a tax break when executives and employees exercise their stock options

  2. Executives favour heavily compensated with stocks have a vested interest in stock buybacks because options increase in value as the price fluctuations of a stock grows more extreme. Dividends dampen volatility of a stock price.

Margin of Safety:

The margin of safety is how you cushion your losses or potential losses.

If the margin is a large one, it is enough to assume that future earrings will not fall far below those of the past in order for an investor to feel sufficiently protected against the vicissitudes of time.

The margin of safety for bonds may be calculated, alternatively, by comparing the total value of the enterprise with the amount of debt.

There are instances where a common stock may be considered sound because it enjoys a margin of safety as large as that of a good bond.

This will occur, for e.g, when a company has outstanding only common stock that under depression conditions is selling for less than the amount of bonds that would safely be issued against its property and earning power.

The philosophy of investment in growth stocks parallels in part and in part contravenes the margin of safety principle.

Growth stock buyer relies on an expected earning power that is greater than the average shown in the past. He (the investor) substitute these expected earnings for the past record in calculating his margin of safety.

In theory, there is no reason why carefully estimated future earnings should be less reliable guide than the bare record of the past.

So the growth-stock approach may supply as dependable a margin of safety, provided the calculation of the future is conservatively made, and provided it shows a satisfactory margin in relation to the price paid.

The danger in growth-stock is that the market has a tendency to set prices that will not be adequately protected by a conservative projection of future earnings.

It is a basic rule of prudent investment that all estimates, when they differ from past performance, must err at least slightly on the side of understatement.

If the average price of growth stocks is too high to provide an adequate margin of safety for the buyer, then a simple technique of diversified buying in this field may not work out satisfactorily.

Theory of diversification:

Even with a margin in the investor’s favour, an individual security may work out badly.

The margin guarantees only that he has a better chance for profit than for loss. not that loss is impossible.

To sum up:

Investment is most intelligent when it is most businesslike.

If a person sets out to make profits from security purchases and sales, he is embarking on a business venture of his own, which must be run in accordance with accepted business principles if it is to have a chance of success.

  1. know what you are doing - know your business.

For investors, do not try to make business profits out of securities - that is, returns in excess of normal interest and dividend income - unless you know as much about security valves as you would need to know about the value of merchandise that you propose to manufacture or deal in.

  1. Do not let anyone else run your business unless you can supervise his performance with adequate care and comprehension or you have unusually strong reasons for placing implicit confidence in his integrity and ability.

  2. Do not enter upon an operation - e.g. manufacturing - unless a reliable calculation shows that it has a fair chance to yield a reasonable profit. In particular, keep away from ventures where you have little to gain and much to lose. Your Operations for profit should not be based on optimism but on arithmetic.

That means, for every investor, when he limits his return to a small figure (bond or preferred stock), he must demand convincing evidence that he is not risking a substantial part of his principal.

  1. Have the courage of your knowledge and experience.

You are right not because the crowd disagrees with you, but because your data and reasoning are right.