Tag: Security Analysis

Graham's Enterprising Investor Risks
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The Enterprising Investor: The Risks

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?

Bond Risks

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

IPOs By Year 1980-2016

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.

Defensive Investing - The Tortoise & The Hare
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Graham’s Stock Market Strategy for the Defensive Investor

To begin our series on the two types of investment strategies Benjamin Graham outlines in The Intelligent Investor (defensive and enterprising), we’ll start with Graham’s guidelines for the defensive investor.

I like to think of the defensive investment strategy along the lines of the The Tortoise and the Hare:

Hare ran down the road for a while and then and paused to rest. He looked back at Slow and Steady and cried out, “How do you expect to win this race when you are walking along at your slow, slow pace?”

Hare stretched himself out alongside the road and fell asleep, thinking, “There is plenty of time to relax.”

Slow and Steady walked and walked. He never, ever stopped until he came to the finish line.

The animals who were watching cheered so loudly for Tortoise, they woke up Hare.

Hare stretched and yawned and began to run again, but it was too late. Tortoise was over the line.
After that, Hare always reminded himself, “Don’t brag about your lightning pace, for Slow and Steady won the race!”

As silly as drawing investment advice from a children’s fable seems, there are a lot of parallels between the strengths of defensive investing and the tortoise’s winning strategy. Yes, the tortoise may not have a hot year where his portfolio is on fire; but he also won’t be subject to the same or greater downside risk. While the hare counts down the minutes to their latest hot stock’s earnings call, only to find out the value of the stock options they purchased have been crushed; the tortoise may be thinking up his dinner plans on the drive home from work, oblivious and unanxious at his blue chip’s stock’s earnings which just hit Wall Street expectations.

The tortoise will seldom have exciting stocks to brag about at dinner parties, but he will slowly but surely grow his investments while focusing on his main source of income – his career.

So what are the four rules for defensive stock picking?

  1. Reasonable Diversification – Graham recommends holding 10-30 names at any given time. Too few names, and the risk of any one stock plummeting can derail your portfolio, too many names and all the work you do in choosing quality stocks will become diluted.

    I would add that diversification requires a bit more thought than simply the number of stocks in your portfolio, having 20 gold stocks would still be a risky proposition. In a recent podcast interview with Howard Marks the founder of Oaktree Capital Management, Mark’s suggested a novel defensive investment strategy I – since none of us can consistently accurately predict the future, develop a portfolio which will do well in a range of outcomes we can imagine instead of betting the farm on one potential outcome. Mark’s noted that over the last 20 years, his flagship fund has never been above the 40th percentile in returns, but the fund has also never been below the 25th percentile in returns; and amazingly enough over the 20 years his cumulative return is above the 95th percentile.

    Returning to the topic over-diversification, while Graham didn’t have this intention when he first published TII in 1949, his warnings about over-diversification seem to dip into 21st century debate over active vs passive investing. Buying an S&P 500 ETF would give you a portfolio of 500 stocks, far more than the 10-30 names Graham recommended. Does this mean that Graham would be against index funds? The Motley Fool investigated the subject and concluded he would support index funds.

    We will revisit Graham’s views on index funds and passive investing in a future article. However, I do believe the new craze of passive investing deserves some reflection. Is it truly “passive”? An investor still decides the ETFs they want to purchase, sometimes by market – US, Global, Europe, Emerging, other times by sector – financial, technology, utilities, etc. Then the “passive” investor may still face the same challenges of active investors – they may interrupt or disrupt their returns by following the herd and pouring money into ETFs when they are most expensive; or they may sell in fear when the market takes a turn.

  2. Stock’s should be “large, prominent, and conservatively financed.” Graham defined large as a company with a market of at least $50 million, but because that number was established in his ‘72 edition, we’ll use Investopedia’s definition of a blue-chip stock as a market cap above $5 billion. A defensive stock is considered “prominent” if it is above the 65th percentile in it’s industry.

  3. A defensive stock should also have a long record of dividends. Graham recommends a stock having a dividend history of longer than 10 years, at which point a company has established a track record of consistent profits and returns for the company’s investors.

  4. Set a maximum Price-to-Earnings ratio that you are willing to pay for stocks. Graham recommends a maximum P/E of 20.

    Interesting, especially in a chapter outlining defensive investing strategy, Graham doesn’t rule out growth stocks, which he defines as stocks which are poised to double their earnings in 10 years (7.1% per year). Graham writes, “obviously stocks of this kind are attractive to buy and to own, provided the price paid is not excessive.” Using Graham’s open definition of defesinve stocks, I believe a case can be made for Facebook, the poster-child of growth stocks, based on today’s valuation. Even though Facebook has an incredible market cap of $441 billion and a P/E of 43 (as of April 28, 2017); their earnings growth over the last 3 years is an astronomical 90% per year, from $1.5 billion in 2015 to over $10 billion in 2016. While a 90% growth rate is unsustainable, even a 20% per year growth rate over the next ten years would lead Facebook’s earnings to be rise from $10 billion per year to $62 billion per year, which given a more conservative 20 P/E makes the stock a $1.2 trillion company. Although Graham might not have, I would exempt FB from Graham’s third requirement for dividends, as I believe Facebook’s return on investing moneyin their own business is higher than the return a shareholder would find with dividends. In sum, Is Facebook’s P/E high by traditional standards, yes; is it excessively priced based on its track record and prospects for growth? I don’t believe so.

Finally, Benjamin Graham closes his advice for the defensive investor by recommending an annual review of our portfolio. If we choose high-quality companies, at reasonable prices, we remove both the need and the risk over micromanaging and over-trading our portfolios. In a poignant (if not slightly depressing) paper by U.C. Berkley, “Do Investors Trade Too Much?” they wrote:

“This paper tests whether the trading profits of discount brokerage customers are sufficient to cover their trading costs. The surprising finding is that not only do the securities that these investors buy not outperform the securities they sell by enough to cover trading costs, but on average the securities they buy underperform those they sell.”

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Benjamin Graham on Market Behavior

In Security Analysis, Benjamin Graham emphasizes the importance of not only focusing on a firm’s potential and accounting statements, but to also pay great attention to the business cycle. Individual investors should research and create their own one year outlook for the market.

Almost any security may be a sound purchase at some real or prospective price and an indicated sale at another price.

– Benjamin Graham, Security Analysis

Think Long-Term

However, Graham also stresses that day-to-day and month-to-month fluctuations of the market should be ignored. Instead, investors should focus on the major shifts in market sentiment and estimating what stage of the business cylce we are in. Clearly today we are in a brutal bear market that has brought down the S&P 500 over 40% year to date. But we have to ask ourselves, what inning of this bear market are we in? Where do we see the strongest values in the market?

Benjamin Graham on Investing in Bear Markets

In a typical case of bear-market hysteria or pessimism the investor would be better off if he were not able to sell out so readily; in fact, he is often better off if he does not even know what changes are taking place in the market price of his securities.

– Benjamin Graham, Security Analysis

Graham’s sentiment on holding onto securities in a bear market could have taken a huge chunk out of someone’s portfolio this year, I know holding onto crashing stocks has severly hurt my portfolio. However at this state of the bear market I believe the above quote is appropriate.

It is ill-advised at this moment in time to liquidate investments into weakness. Your portfolio may depreciate in the coming months, but sometimes you have to take a 3 month deep breath and try your best to not follow your stock prices on a daily basis and just enjoy your dividend yields! To do this you have to be sure that your portfolio is filled with strong, value stocks with years of consistent earnings growth. Ignoring equity prices does not mean you should ignore the latest news from stocks you own. Shares should be sold if there is a fundamental shift in the companies’ long-term outlook.

Even though Warren Buffet’s 2 month-old investment in Goldman Sachs (GS) at $115 a share has fallen almost in half to $65 a share, I’m willing to bet he is sleeping well at night knowing he is invested in a first-in class company (although the investment banking class may be gone forever) and enjoying a 10% dividend yield from his preferred stock.

Don’t Purchase a Stock at Any Price

Finding the strongest values is no easy task, and Benjamin Graham gives some bull market advice that is worth remembering once this cycle changes gears. “Don’t purchase stocks at any price.” He writes that great companies don’t necessarily indicate a great investment if their stock price is comparatively high. Be a patient investor and wait until the company drops to an attractive level. For instance during a bull market in 2006 you could have bought Microsoft (MSFT) at a high of $30.19 or a low of $21.92 (or today at $19.15!) – a 27% variation. If a stock price of a company you have been watching continues to soar far above the intristic value (you can use my post on the Dividend Growth Model to estimate intrinsic value) you give the company, don’t feel like you missed the boat, in the long-term the price very well will come down to levels you like or their earnings will improve to increase your valutation.

When to Invest In Small Cap Stocks

Graham also notes that small cap stocks are more sensitive to swings in the overall market. Your position in small caps should be minimized in your portfolio if you have a weak outlook for the coming year and your small cap positions should be increased in bull markets. This sentiment is supported decades after Graham’s writing, consider comparing SPDR DJ Wilshire Small Cap Growth (DSG) which retreated 49% YTD vs. SPDR DJ Wilshire Large Cap Growth (ELG) which declined only (only!?) 43% YTD.

Beware of Bull Markets

Beware of “bargains” when most stock prices are high. An undervalued, neglected stock may continue to be neglected through the end of the bull market and may potential be one of the hardest hit stocks in the following bear market.

Market Environment, Potential Value, and Intristic Value Produce Market Price