To continue our series on the two types of investment strategies Benjamin Graham outlines in The Intelligent Investor (defensive and enterprising), we’ll jump into part one of Graham’s enterprising investor: the risks.
Before we start, let’s take a moment to consider how Graham differentiates the defensive and enterprising investor. The defensive investor, which we wrote in our last post is a patient investor and an investor who doesn’t have the time, interest, or capital (think doctor, widow, or early 20s investors) to really analyze the stock market and pick out names which may outperform the overall market. The defensive investor is wise, they recognize that frequent trading negatively effects their portfolio returns, they commonly buy ETFs which will likely outperform their individual stock choices, or favor well-known blue chip stocks.
However, I’d take a bet that the majority of this blog’s followers are likely students of the market. We know we can buy an S&P and or other market-wide ETFs, leverage dollar cost averaging by adding more money to our portfolio regularly, and sleep comfortably with the reasonable expectation of tremendous long-term returns. But… there’s just something, well, boring about that strategy. Could we not invest a little more of our time to find high-quality stocks at good prices? Would we not be able to squeak out a few more percentage points of return most years by developing and managing our portfolios more closely? Of course we can, but before we cannon ball into the deep end, it’s worth taking a look at some of the risks and pitfalls Graham warns us that enterprising investors can fall for.
Those Who Do Not Remember the Past are Condemned to Repeat It
“Any well defined and protracted market situation of the past may return in the future.”
Benjamin Graham, The Intelligent Investor
There are a number of major stock market events we can all call to mind – the Great Depression, the run on banks, Black Monday, the Oil Embargo, the dot-com bubble, the 2007-2008 financial crisis; and the list goes on. Every investor knows the stock market is cyclical, yet prices don’t get driven to their all-time highs and bearish lows without a flock mentality. What objective, first-person signs can we look for to recognize over-valuations (feel free to add your ideas in the comments!)?
Here’s a short list of market signals I’ve seen personally:
- In the midst of the dot-com bubble, my mom (who despite this story is actually a wise investor!) joined an all-women’s investment club of realtors and house wives. Please don’t misunderstand my point as a criticism of women (many studies have found that women are better investor’s then men), but the take away was that people who were never before interested in investing began to hear about how much people were making and flocked to the market.
- In late 2011-2012, gold was breaking record highs every month, and it seemed every TV commercial break included a commercial for buying gold or trading in your old gold.
- In the lead-up to the 2007-08 financial crisis, we heard endless stories of people flipping homes and new homes being built.
- “Experts” talking about paradigm shifts in a particular market. In the dot-com bubble there were plenty of market analysts talking about how the internet has changed the game, earnings and P/E ratios no longer mattered nor did sound business plans. Similarly, in the darkness of the recent financial crisis, investors became overly-weary of the housing market and began to think there was a shift where long-term housing appreciation could be stalled or fall. We wrote in our December 2008 Real Estate Outlook (not to toot our own horn =)) that the fear was overblown.
Benjamin Graham’s Intelligent Investor Risks to Look Out For
My own experience is all well and good, but what risk factors does Ben Graham outline in the Intelligent Investor?
We don’t discuss bonds often in this blog, mostly because interest rates are currently at artificial lows. However, Graham’s advice for bonds is extremely relevant today, he warns that when bond market yields are low, investors often look to steal an extra 1-2% in yield buy purchasing low grade bonds. In exchange for over-reaching for 1-2% yield, we can risk the entire loss of our principal.
IPOs: Graham’s Favorite Stock Market Factor
Graham counsels us that while investors generally prefer to invest in blue-chip companies, as bull markets rage investors become less selective and more aggressive. As a result, companies which investors would never have taken an interest in begin to receive more attention. A quantifiable response to investor’s becoming less selective are the number of private companies which become attracted to the high valuations the stock markets appetite may award them with, and the lower quality threshold the stock market demands for an Initial Public Offering (IPO).
Stock Market IPOs By Year, 1990-2016
I created the above chart of IPOs for 1990-2016 using Univerisity of Florida’s Jay R. Ritter’s data, Prof. Ritter uses a tight definition of IPOs which I believe is more helpful for getting a sense of where we are in the current bull cycle by excluding some noise, “follow-on offerings, oil & gas partnerships or unit trusts, ADRs (9 offerings), REITs”, etc.
The 74 IPOs in 2016 was the lowest IPO total since 2009! By Graham’s standards, this relatively low IPO output last year would indicate that the current bull market is far from over. At the same time, there has been some reporting in the last few years that private companies are shying away from the high-pressure and myopic stock market, as this Business Insider article details. Could this mean a paradigm shift is causing the slowdown of IPOs and Graham’s indicator is losing its value? With any paradigm shift, I’m doubtful, I believe greedy human nature, and genuine working capital advantages of going public will continue to make IPOs are useful indicator in the years to come.
If you are interested in tracking IPO data, the best available source I found on the web is Renaissance Capital’s IPO Stat Center. Please keep in mind they don’t have as tight a definition of IPO as Prof. Ritter, but they have more information on proceeds raised, filing activity, pricing activity, and a breakdown of IPOs by sector. Watch this space.