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The Intelligent Investor - summary |
The Intelligent Investor is considered by Warren Buffett to be "By far the best book on investing ever written", so if you're going to get serious about your investing it should be on your shopping list. But if you don't have time to read it, here's a summary of my learnings from it.
To invest successfully what's needed is:
a sound intellectual framework for making decisions
the ability to keep emotions from corroding your investment framework.
Investment results depend on the quality of your decision-making framework and the amplitudes of stock-market folly that prevail during your investing career.
Investing the same number of dollars each month or quarter.
Compare expected return of shares against that of bonds, and then the defensive investor would vary the proportion of shares in his portfolio from 25% to 75% (the remainder being invested in high-grade bonds):
Expected return of shares = current dividend yield + expected growth in earnings (arising from reinvestment of undistributed profit) + adjustment for whether the market is over/undervalued (compare dividend yield against historic normal level (which he believes is 3.5% to 4.5% for the US) - tax.
The investor should have an adequate knowledge of the historic relationshipo between the price level of the stock market, dividends and earnings.
"One fairly dependable sign of the approaching end of a bull swing is the fact that new common stock of small and nondescript companies are offered at prices somewhat higher than the current level for many medium-sized companies with a long market history."
For the defensive investor Graham suggests restricting himself to "leading issues of the type included in the 30 components of the Dow Jones Industrial Average" (for convience, as he was skeptical of the ability of defensive investors to beat the average results - today this could be achieved by investing in low cost ETFs or mutual funds/unit trusts). "The defensive investor must confine himself to the shares of important companies with a long record of profitable operations and in strong financial condition. Aggressive investors may buy other types of common stock, but they should be on a definitely attractive basis as established by intelligent analysis."
Recommended fields for enterprising investment:
Buy unpopular large companies: The market tends to undervalue "companies that are out of favour because of unsatisfactory developments of a temporary nature." "The key requirement here is that the enterprising investor concentrate on the larger companies that are going through a period of unpopularity. While small companies may also be undervalued for similar reasons, and in many cases may later increase their earnings and share price, they entail the risk of a definitive loss of profitability (large companies have the resources in capital and brain power to carry them through adversity and back to a satisfactory earnings base) and also of protracted neglect by the market in spite of better earnings." Set up a low-multiplier list of companies, with reference to average earnings over a period of time.
It may be best to focus on "issues selling at a reasonably close approximation to their tangible asset value, say at not more than a third above that figure". "The investor should demand, in addition, a satisfactory ratio of earnings to price, a sufficiently strong financial position, and the prospect that its earnings will be at least maintained over the years."
Purchase of bargain issues, where the estimated value is at least 50% greater than the price. Check value by (1) estimating future earnings and multiplying them by an appropriate factor, (2) calculate the realisable value of the assets, with particular emphasis on the net current assets or working capital. "The type of bargain issue that can be most 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 means a company's current assets (such as cash, marketable securities and inventories) minus its total liabilities (including preferred stock and long-term debt)."
Find a list of stocks that hit new lows for the past year, then download the most recent report from the company's website. From the current assets subtract total liabilities, including any preferred stock and long-term debt.
The enterprising investor will be wary of all new issues, including convertible bonds and preferred stock, and common stock with excellent earnings confined to the recent past. The enterprising investor is advised against the purchase at full prices of "(1) foreign bonds, (2) ordinary preferred stock, and (3) secondary common stocks". "By full prices we mean prices close to par for bonds or preferred stocks and prices that represent about the fair business value of the enterprise in the case of common stocks". "The enterprising investor is to buy them only when obtainable at bargain prices - which we define as prices not more than two-thirds of the appraisal value of the securities." "Secondary issues, for the most part, do fluctuate about a central level which is well below their fair value."
Have a way of calculating the underlying value of a stock, so that it plus or minus the required margin of safety can be compared with the market price:
estimate the average earnings over a period of years in the future is useful for ironing out the ups and downs of the business cycle
Collect average past data for physical volume, prices received and operating margin.
Make assumptions about future changes grounded first on general economic forecasts of gross national product, and then on special calculations applicable to the industry and company in question
Project future sales on the basis of assumptions as to the amount of change in volume and price level over the previous base
multiply the estimate of expected average earnings by an appropriate capilization factor. The capilization rate can vary over a wide range, depending on the 'quality' of the stock, taking into account:
General Long Term prospects: Download at least 5 years of annual reports, read them trying to figure out "What makes this company grow?" & "where do profits come from?". Beware of:
Serial acquirers - an average of more than 2 or 3 acquisitions a year is a sign of potential trouble. Check also the company's record as an acquirer - does it wolf down big acquisitions only to throw them up again later. Check acquisitions in the "Management's Discussion and Analysis" section, and cross-check it against the footnotes to the financial statements.
companies addicted to raising "cash from financing activities" (check "Statement of Cash Flows", which breaks down cash flow into "operating activities, "investment activities" and "financing activities") through borrowing or selling stock - they can make a sick company appear to be growing. If cash from operating activities is consistently negative, while cash from financing activities is consistently positive, the company has a habit of craving more cash than its own businesses can produce.
Companies depending on one customer (or a handful) for most of its revenues
Good signs are:
a company with a wide "moat" of competitive advantages - things which can widen the competitive moat are (1) a strong brand identity (e.g. Harley Davidson), (2) a monopoly or near , (3) economies of scale (the ability to supply huge amounts of goods or services cheaply), (4) resistance to substitution (e.g. most businesses have no alternative to electricity, so utility companies are unlikely to be supplanted soon)
company is a marathoner, not a sprinter - revenues and net earnings have grown smoothly and steadily over the previous 10 years. If earnings are growing at a long-term rate of 10% that may be sustainable, but the 15% growth hurdle most companies set themselves is delusional. And even higher rates are certain to fade. Are the managers planning long-term or short-term?
The company spends some money developing new business. In the long run, a company that spends nothing on R&D is at least as vulnerable as one that spends too much.
Management: "It is fair to assume that an outstandingly successful company has unusually good management. This will have shown itself already in the past record; it will show up again in the estimates for the next 5 years, and once more in the previously discussed factor for long term prospect. The tendency to count it still another time as a seperate bullish consideration can easily lead to expensive overvaluations. The management factor is most useful, we think, in those cases in which a recent change has taken place that has not yet had the time to show its significance in the actual figures." Read the past annual reports to see what forecasts the management made and if they fulfilled them or fell short. Managers should forthrightly admit their failures and take responsibility for them. Are the managers looking out for themself - what salaries are they paying themselves? Any company which reprices stock options for employees is a disgrace. Factor in the potential flood of new shares from stock options whenever you estimate a company's future value. Check whether directors are selling stock when you're buying. Do they spend their time managing the business or promoting it to the investing public? Are the accounting practices designed to make the accounts transparent or opaque?
Financial Strength & Capital Structure: "Stock of a company with a lot of surplus cash and nothing ahead of the common is clearly a better purchase (at the same price) than another one with the same per share earnings but large bank loans and senior securities."
Calculate owner earnings (net income + amortization + depreciation - capital expenditure), also subtract (1) any costs of granting stock options, which divert earnings away from existing shareholders into the hands of new owners, (2) any unusual, nonrecurring or extraordinary charges & (3) any "income" from the company's pension fund. If owner earnings have grown at a steady average of at least 6% or 7% over the last 10 years, the company is a stable generator of cash, and its prospects for growth are good.
How much debt does the company have? Long term debt should be less than 50% of total capital. In the footnotes of the financial statements, determine whether the long-term debt is fixed rate or variable (could become costly if interest rates rise). Look in the annual report for the "ratio of earnings to fixed charges".
If the company is not paying a dividend, the burden of proof is on the company to show that you are better off. If the firm has consistently outperformed the competition in good markets and bad, the managers are clearly putting the cash to optimal use. If, however, the stock is underperforming its rivals, then the managers may be misusing the cash by refusing to pay a dividend.
Companies that repeatedly split their shares - and hype these splits in breathless press releases - treat their investors like dolts.
Companies should buy back their shares when they are cheap not when they are at or near record highs.
Dividend record: "One of the most persuasive tests of high quality is an uninterrupted record of dividend payments going back many years. We think that a record of continuous dividend payments for the last 20 years or more is an important plus factor in the company's quality rating. Indeed the defensive investor might be justified in limiting his purchases to those meeting this test."
Current dividend rate (dividend payout ratio): "
A 2-part appraisal process:
First calculate a "past performance value" which is based solely on the past record assuming past performance will continue unchanged in the future (this includes the assumption that its relative growth rate, as shown in the last 7 years, will also continue unchanged over the next 7 years). This process could be carried out mechanically by applying a formula that gives individual weights to past figures for profitability, stability and growth, and also for current financial condition. Graham suggests "that the growth rate itself be calculated by comparing the average of the last 3 years with corresponding figures ten years earllier. Where there is a problem of special charges or credits it may be dealt with on a compromise basis."
The second part of the analysis should consider to what extent the value based solely on past performance should be modified because of new conditions expected in the future.
Eventually the intelligent analyst will confine himself to those groups in which the future appears reasonably predictable (these industry groups, ideally, would not be overly dependent on such unforeseeable factors as fluctuating interest rates or the direction of prices for raw materials like oil or metals. Possibilities might be industries like gaming, cosmetics, alcoholic beverages, nursing homes, or waste management), or where the margin of safety of past performance value over current price is so large that he can take his chances on future variations - as he does in selecting well-secured senior securities.
For growth stocks, Graham suggests a formula: value = Current (normal) earnings * (8.5 + 2*expected annual growth rate)....but this depends on interest rates.
the growth rate should be that expected over the next 7 to 10 years
In particular know how to calculate the tangible net asset value of a stock, and limit yourself to issues selling not far above it. Tangible assets include a company's physical property - like real estate, factories, equipment and inventories - as well as its financial balances - such as cash, short-term investments, and accounts receivable. Among the elements not included in tangible assets are brands, copyrights, patents, franchises, goodwill & trademarks.
Don't take a single year's earnings seriously. Pay attention to booby traps in the per-share figures:
allow for the effects of dilution - assume that conversions will be exercised if it should prove profitable to bondholders to do so, as well as the dilution caused by issuing stock options for executive compensation.
ensure that "special charges" are accounted for in the year to which they relate, and consider how they may recur. Malleable accounting rules permit managers to inflate reported profits by transforming normal operating expenses into capital assets - the intelligent investor should be sure to understand what and why a company capitalizes.
the reduction in the normal income-tax deduction by reason of past losses
method of treating depreciation, straight line or accelerated schedules (and especially watch for changes between the methods). Another factor, important at times, is the choice between charging off research and development costs in the year they are incurred or amortizing them over a period of years.
Aggressive revenue recognition is often a sign of dangers that run deep (e.g. recognising all the profit upfront even when all payments haven't been made)
"Pro forma" earnings are a way for comapnies to show how well they might have done if they hadn't done as badly as they did.
Changes in earnings from changes in pension fund valuations
One important advantage of such an averaging process is that it will solve the problem of what to do about nearly all the special charges and credits - they should be included in the average earnings.
Graham's "extended studies" lead him to conclude that an investor cannot count on an earnings rate much above about 10% on net tangible assets (this ties in with research by Adam Barth, published in 2005, that shows that "average earnings for the 30 companies included in the Dow Jones Industrial Average (DJIA) are 11% of the company's book value in any 20-year period between 1920 and 1986 (1920-39, 1921-40, 1922-41, etc.). 'Average earnings as a function of book value barely varies in the slightest, and has remained basically immune to inflation, wars, massive changes in the tax code or any other external facto.'").
"The current year's results of the company are generally common property on Wall Street; next year's results, to the extent they are predictable, are already being carefully considered. Hence the investor who selects issues chiefly on the basis of this year's superior results, or on what he is told he may expect for next year, is likely to find that others have done the same thing for the same reason."
Market value is different to book value, as the 10% return on book value can be adjusted to get a (lower) return on market value.
The defensive investor should have adequate but not excessive diversification, this might mean holding 10 to 30 stocks. Statistical requirements for inclusion in a defensive investor's portfolio:
Adequate size of the enterprise (in terms of sales & total assets)
A sufficiently strong financial position
for industrial companies current assets should be at least twice current liabilities, & long-term debt should not exceed the net current assets
for public utility companies it is not necessary that the ratio of current assets be twice that of current liabilities. An adequate proportion of stock capital to debt is required.
Continued dividends for at least the past 20 years
No earnings deficit in each of the past 10 years
Ten-year growth of at least one-third in per-share earnings (using 3 year averages at the beginning & end)
Price no more than 15 times average earnings of the past 3 years. Our basic recommendation is that the stock portfolio, when acquired should have an overall earnings/price ratio at least as high as the current high-grade bond rate (this would mean a P/E ratio no higher than 13.3 against an AA bond yield of 7.5%). In South Africa, you could check the rate on FRX15, a First Rand Bond maturing in 2015, at http://ficc.rmb.co.za/historicalRates.asp?product=Bonds&instrument=FRX15&rateDisplay=FRX15 or http://bondcalculator.jse.co.za/BondSingle.aspx?calc=Price+To+Yield
Price of stock no more than 1.5 times net asset value (or book value) last reported. However, a multiplier of earnings below 15 could justify a correspondingly higher multiple of earnings. As a rule of thumb Graham suggests that the product of the multiplier times the price to book value should not exceed 22.5 (this figure corresponds to 15 times earnings and 1.5 times book value).
Make a list of stocks selling at PE ratios of 9 or less
remove industrial companies with current assets less than 1.5 times current liabilities, or debt more than 110% of net current assets
Remove companies which had negative earnings at any time in the last 5 years
Remove companies which are not paying a dividend at the moment
Removes companies which have not seen an increase in earnings in the last 5 years
Remove companies whose price is greater than 120% of net tangible assets
Also look at the daily list of stocks hitting 52-week-lows (subscribe to the mailing list at www.sharenet.co.za to get this sent to you for free)
Arbitrage & liquidation operations on the twin basis of (a) a calculated annual return of 20% or more, and (b) our judgement that the chance of a successful outcome was at least 4 out of 5:
Arbitrage - the purchase of a security & the simultaneous sale of one or more other securities into which it is to be exchanged under a plan of reorganisation, merger, or the like.
For example, Borden announces it will acquire control of Borden by giving 1.5 of its shares in exchange for 1 share of Kayser-Roth. On the following day Borden closed at 26 and Kayser-Roth at 28. If you bought 300 shares of Kayser-Roth & sold 400 Borden at those prices and the deal was consumated on those terms a profit would have been made.
National Biscuit offers to buy Aurora for $11 in cash, the stock continued to trade at $9
Universal-Marion asks its shareholders to ratify its dissolution, and the treasurer indicates a book value of $28 per share, most of which is in liquid form. The share continued to trade at $21.
Liquidations - purchase of shares which were to receive one or more cash payments in liquidation of the company's assets.
Purchase of convertible bonds or convertible preferred shares and the simultaneous sale of the common stock into which they were interchangeable.
Net current asset (or bargain) issues - 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 (i.e. current assets - total liabilities). Purchases were typically made at 2 thirds or less of the stripped down asset value. If you can choose, look for those which reported a net profit in the last 12 month period.
Read back to front - the things the company doesn't want you to see are often buried near the back
Always read the footnotes - keep an eye out for how the company recognises revenue, records inventories, treats installments or contract sales & expenses its marketing costs. Watch for disclosures about debt, stock options, loans to customers and reserves against losses. Be sure to compare the footnotes with at least one firm that's a close competitor, to see how aggressive the firm's accountants are.
Two main questions:
Taxable or tax-free (mainly a matter of arithmetic, taking into account an investor's tax bracket)?
Shorter or longer maturities?
Government-backed securities offer the most safety from a credit risk perspective, but Graham warns not to purchase foreign bonds, as the owner has no legal means of enforcing his claim. New issues have a "special salesmanship behind them, which calls therefore for a special degree of sales resistance...Most new issues are sold under 'favourable market conditions' - which means favourable for the seller and consequently less favourable for the buyer."
"The typical preferred shareholder is dependent for his safety on the ability and desire of the company to pay dividends on its common stock. Once the common dividends are omitted, or even in danger, his own position becomes precarious, for the directors are under no obligation to continue paying him unless they also pay on the common. On the other hand the typical preferred stock carries no share in the company's profits beyond the fixed dividend rate...Experience teaches that the time to buy preferred stocks is when their price is unduly depressed by temporary adversity...In other words, they should be bought on a bargain basis or not at all."
Whilst the defensive investor will avoid inferior types of bonds and preferred stock, the enterprising investor will also avoid them "unless they can be bought at bargain levels - which means ordinarily at prices at least 30% under par for high coupon issues and much less for the lower coupons".
"It is unwise to buy a bond or a preferred which lacks adequate safety merely because the yield is attractive (Here the word 'merely' implies that the issue is not selling at a large discount)."
"It is more common sense to abstain from buying securities at around 100 if long experience indicates that they can probably be bought at 70 or less in the next weak market."
The chief criterion used to test the safety of corporate bonds is the number of times that available earnings has covered total interest charges over 7 years in the past. "We approve a 'poorest-year' test as an alternative to the 7-year average test. It would be sufficient if the bond or preferred stock met either of these criteria." It's recommended that the ratio of before tax earnings to total fixed charges over the last 7 years has averaged at least 4x for a public utility operating company, 5x for railroad, 7x for industrial and 5x for a retail concern (for preferred stock these ratios should cover twice the preferred dividends).
Look market value of junior stock (including common stock) to the total face amount of the debt, and asset values should also be tested.
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