Indonesian Stock Market » Benjamin Graham

Central to Benjamin Graham’s teaching is the ability to calculate Intrinsic Value.

bullbear — Wed, 16 Feb 2011 10:38:00 +0000

Investment Policy (Based on Benjamin Graham)
http://myinvestingnotes.blogspot.com/2008/08/investment-policies-based-on-benjamin.html

Central to Benjamin Graham’s teaching is the ability to calculate Intrinsic Value.

His value investing approach: Buy at a discount to intrinsic value. Your gain comes from market realising the true intrinsic value given time.

Philip Fisher’s growth investing approach: Buy at fair value, i.e. buy at intrinsic value. With earnings growth, you will realise a higher price for the shares.

In buying at a discount to intrinsic value, the value is in the bargain price, and the favourable upside reward / downside risk ratio.

In buying a growth stock at fair price, the value is in the earning power of the company. This creates the value in the stock although you are acquiring this at a fair price. Of course, if you can acquire it at a bargain price, the better.

Warren Buffett uses both strategies and cleverly grouped Philip Fisher’s growth investing approach as value investing too, calling value investing and growth investing as sides of the same coin. He is pragmatic.

In either approaches, overpaying for a stock will be detrimental to your financial health.

Develop the Value Investing Mind-Set

bullbear — Sat, 22 Jan 2011 05:55:00 +0000

Value investors must think long term and not think that making a quick profit is their first priority. You must realize that you won’t be investing in the same types of stocks as your friends, and you won’t be able to compare quarter-to-quarter returns.

You’ll also need to enjoy digging into the annual reports of the companies that interest you and be prepared to analyze everything you see. Successful value investors are those who enjoy researching and learning everything about a company before diving in and investing.

The key tools you’ll need as a value investor are:

Patience to wait for the market to realize you found a gold mind in a beaten-down stock.
Discipline to spend the time researching your choices and not get caught up in the mob mentality as people push stocks higher and higher above their true value.
Desire to learn all you can about choosing the right industries to explore, picking the right stocks within those industries that are unjustifiably beaten down, and then having the courage to wait until the market realizes what a great investment it is missing.
Ability to check your emotions at the door. Don’t get emotionally involved in your stocks. Your value portfolio is way to make money. Don’t fall in love with it or the stocks in it.
Expectation of adequate profits but not extraordinary performance. Historically the average annual return for stocks in any 20-year period is about 10 to 12 percent per year. That doesn’t mean you’ll earn that amount each year: some years will be higher, some lower, but that’s the average return you should expect with a long-term stock portfolio.
Ability to calculate what a stock is worth, based on careful analysis of the business. Don’t gamble on how much the stock may go up because someone else is foolish enough to pay that. Eventually, the fools disappear and you could be left holding the bag.
Ability to think for yourself. Unless you’ve found a friend who is also dedicated to the idea of becoming a value investor, don’t count on those around you for support. You must learn to think for yourself.

In the preface to Benjamin Graham’s The Intelligent Investor, Warren Buffet writes, “To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.”

Most stock investors lose money because they invest in companies that seem good at a particular point in time, but are lacking the fundamentals of a long-lasting stable company.

bullbear — Wed, 19 Jan 2011 23:20:00 +0000

The high CAGR in the early years of the investing period, due to buying at a discount, tended to decline and approach that of the intrinsic EPS GR of the companies over a longer investment time-frame.

Chapter 20 – “Margin of Safety” as the Central Concept of Investment

A single quote by Graham on page 516 struck me:

Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.

Basically, Graham is saying that most stock investors lose money because they invest in companies that seem good at a particular point in time, but are lacking the fundamentals of a long-lasting stable company.

This seems obvious on the surface, but it’s actually a great argument for thinking more carefully about your individual stock investments. If most of your losses come from buying companies that seem healthy but really aren’t, isn’t that a profound argument for carefully studying any company you might invest in?

Are You an Intelligent Investor?

bullbear — Tue, 18 Jan 2011 15:48:00 +0000

Graham believed someone could be an intelligent investor in two ways:

ACTIVE OR ENTERPRISING INVESTORS – These types of investors have a lot of time to spend on building and managing their portfolios and also have a high risk tolerance. They must continually research, select, and monitor a dynamic mix of stocks, bonds, or mutual funds.

PASSIVE OR DEFENSIVE INVESTORS – These types of investors don’t have a lot of time to spend on a portfolio or can’t tolerate much risk. They must create a permanent portfolio that runs on autopilot and requires no further effort. This type of passive portfolio won’t be very exciting, but it will get you steady returns over your lifetime.

Ben Graham: The chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.

bullbear — Mon, 17 Jan 2011 23:19:00 +0000

Chapter 20 – “Margin of Safety” as the Central Concept of Investment

A single quote by Graham on page 516 struck me:

Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.

Basically, Graham is saying that most stock investors lose money because they invest in companies that seem good at a particular point in time, but are lacking the fundamentals of a long-lasting stable company.

Some passive advice from Benjamin Graham

bullbear — Fri, 24 Dec 2010 23:40:00 +0000

Benjamin Graham, Mr. Buffett’s mentor, is required reading for anyone who is serious about active investing. He died in 1976 and, during that year, he said the following:

“I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook Graham and Dodd was first published; but the situation has changed a great deal since then. In the old days, any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost.”

Intrinsic Value: The Right Price to Pay

bullbear — Mon, 25 Oct 2010 04:00:00 +0000

A GREAT COMPANY AT A FAIR PRICE’

Nobody really knows the specific principles that Warren Buffett applies when deciding the price he will pay for a share investment. We do know that he has said on several occasions that it is better to buy a ‘great company at a fair price than a fair company at a great price’.

This tends to agree with the view of Benjamin Graham who often referred to primary and secondary stocks. He believed that, although paying too high a price for any stock was foolish, the risk was higher when the stock was of secondary grade.

PATIENCE

The other thing that Warren Buffett counsels, when deciding on investment purchases, is patience. He has said that he is prepared to wait forever to buy a stock at the right price.

There is a seeming disparity of views between Graham and Buffett on diversification. Benjamin Graham was a firm believer, even in relation to stock purchases at bargain prices, in spreading the risk over a number of share investments. Warren Buffett, on the other hand, appears to take a different view: concentrate on just a few stocks.

WHAT WARREN BUFFETT SAYS ABOUT DIVERSIFICATION

In 1992, Buffett said that his investment strategy did not rely upon spreading his risk over a large number of stocks; he preferred to have his investments in a limited number of companies.

‘Many pundits would therefore say the [this] strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it.’

NO REAL DIFFERENCE BETWEEN BENJAMIN GRAHAM AND WARREN BUFFETT

The differences between Graham and Buffett on stock diversification are perhaps not as wide as they might seem. Graham spoke of diversification primarily in relation to second grade stocks and it is arguable that the Buffett approach to stock selection results in the purchase of quality stocks only.

BERKSHIRE HATHAWAY HOLDINGS

In addition, consideration of Berkshire Hathaway holdings in 2002 suggests that although Buffett may not necessarily believe in diversification in the number of companies that it owns, its investments certainly cross a broad spectrum of industry areas. They include:

Manufacturing and distribution – underwear, children’s clothing, farm equipment, shoes, razor blades, soft drinks;
Retail – furniture, kitchenware
Insurance
Financial and accounting products and services
Flight operations
Gas pipelines
Real estate brokerage
Construction related industries
Media

INTRINSIC VALUE

Both Warren Buffett and Benjamin Graham talk about the intrinsic value of a business, or a share in it. That is, to buy a business, or a share in it, at a fair price. But, having regard to the possibility of error in calculating intrinsic value, the careful of investor should provide a margin of error by only buying the business, or shares, at a substantial discount to the intrinsic value.

Buffett is said to look for a 25 per cent discount, but who really knows?

DEFINING INTRINSIC VALUE

Buffett’s concept, in looking at intrinsic value, is that it values what can be taken out of the business. He has quoted investment guru John Burr Williams who defined value like this:

‘The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.’ – The Theory of Investment Value.

The difference for Buffett in calculating the value of bonds and shares is that the investor knows the eventual price of the bond when it matures but has to guess the price of the share at some future date.

DISCOUNTED CASH FLOW (DCF)

This method of valuation is often referred to as the Discounted Cash Flow (DCF) valuation method, but, as Buffett has said in relation to shares, it is not easy to predict future cash flows and this is why he sticks to investment in companies that are consistent, well managed, and simple to understand. A company that is hard to understand or that changes frequently does not allow for easy prediction of future earnings and outgoings.

WHAT WARREN BUFFETT SAYS ABOUT PREDICTING FUTURE CASH FLOWS

In 1992, Warren Buffett said that:

‘Leaving question of price aside, the best business to own is one that over an extended period can employ large amounts of capital at very high rates of return. The worst company to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return.’

It is well worth reading Buffet’s analogy relating DCF to a university education in his 1994 Letter to Shareholders.

So, it would seem that the intrinsic value of a share in a company relates to the DCF that can be expected from the investment. There are formulas for working out discounted cash flows and they can be complex but they give a result.

EXPLANATIONS OF DCF

The best explanation that we have read of DCF is by Lawrence A Cunningham in his outstanding book How to think like Benjamin Graham and invest like Warren Buffett.

A good online explanation is available here.

HOW WARREN BUFFET DETERMINES A FAIR PRICE

The real secret of Warren Buffett is the methods that he uses, some of which are known from his remarks, and some of which are not, that allow him to predict cash flows with some probability.

Various books about Warren Buffett give their explanations as to how he calculates the price that he is prepared to pay for a share with the desired margin of safety.

Mary Buffett and David Clarke pose a series of tests, based on past growth rates, returns on equity, book value and government bond price averages.

Robert G Hagstrom Jnr in The Warren Buffet Way gives explanatory tables of past Berkshire Hathaway purchases using a DCF model and owner earnings.

Ultimately, the investor must decide upon their own methods of arriving at the intrinsic value of a share and the margin of error that they want for themselves

www.buffettsecrets.com/price-to-pay.htm

The Great Investing Wisdom Wall Street Forgot

bullbear — Sat, 23 Oct 2010 09:58:00 +0000

By Matt Koppenheffer
October 22, 2010

When you hear the phrase “value investing,” Warren Buffett most likely comes to mind. But hopefully, you also think of Ben Graham — the father of value investing. Considering that some of the world’s most successful investors carry Graham’s flag, there’s good reason for Fools like us to be obsessed with the concept.

Graham had a plan
But with thousands of stocks out there, how do we separate the value plays from the throwaways? In The Intelligent Investor, Graham lays out a basic framework for winnowing through the sea of stocks to get to the good stuff.

1. Financial stability. Graham wanted investors to be sure they weren’t investing in castles made of sand, so he put requirements on prospective investments’ balance sheet strength and record of past earnings.

2. Growth. You wouldn’t have caught Graham dead chasing the high-flying stocks of the day, but he did want to see that over the long haul, earnings were at least moving in the right direction.

3. Valuation. This, of course, is what Graham is probably best known for — requiring that a stock be selling for less than it’s really worth. While a simple valuation ratio can’t tell you the whole story, it may signal a stock that’s definitely not a deal.

4. A dividend.

Did you catch that last part?
That wasn’t a typo; whether you are a defensive or enterprising investor, Graham thought it necessary that you stick to companies that pay a dividend.

Dividends have largely been relegated to a dark corner on Wall Street, but Graham didn’t equivocate. The safest stocks would have “uninterrupted payments for at least the past 20 years,” but every investment should have “some current dividend.”

When you think about it, this makes perfect sense. Graham’s whole approach to investing in stocks revolves around thinking and acting like a businessperson, and treating your stock holdings as ownership shares in a business, not gambling slips. When businesspeople buy a piece of a business, they expect to know how much profit will be sent back their way.

http://www.fool.com/investing/general/2010/10/22/the-great-investing-wisdom-wall-street-forgot.aspx

How Can Value Investors Apply Philip Fisher’s Investment Principles?

bullbear — Thu, 30 Sep 2010 15:42:00 +0000

Published on April 25, 2009 at 12:23 pm

I first read Philip A. Fisher’s classic book on investing several years ago after first reading everything I could find written by Benjamin Graham and Warren Buffett. I picked up Common Stocks and Uncommon Profits primarily because of a quote by Warren Buffett on the cover of my copy. That quote carries a strong endorsement: “I am an eager reader of whatever Phil has to say, and I recommend him to you. — Warren Buffett”. What is fascinating is that the investment approach described by Fisher is, at first glance, about as different from Benjamin Graham’s approach as one can imagine. If Graham is known as the father of value investing, Fisher is equally well recognized as the father of growth investing. I believe that the combination of both approaches has been responsible for the amazing growth of Berkshire Hathaway over the past four decades.

Common Stocks and Uncommon Profits was published in 1958, about a decade after Graham published The Intelligent Investor. Both men had experienced the years of the Great Depression and proposed detailed systems for investors to capture the substantial returns offered by well chosen stocks while avoiding the pitfalls that can result in permanent loss of capital. Yet there were substantial differences in approach. While Graham’s advice for the enterprising investor relied on securing interests in companies with well established track records generally at low valuations, Fisher was much more open about the concept of seeking out truly outstanding businesses and being willing to pay higher valuations in exchange for the prospect of much higher returns.

Fisher also believed in what he referred to as “Scuttlebutt”. Essentially, scuttlebutt involves seeking out information about a business from both published sources as well as through the “business grapevine”. By speaking to the management of a prospective investment, competitors, suppliers, and customers, one can often assemble a view of the business that a pure quantitative analysis could not reveal. In recent years, speaking to company management has grown more difficult with the implementation of “Regulation Fair Disclosure” and other measures intended to promote simultaneous disclosure of all relevant facts. However, Fisher’s main point is still valid in terms of looking beyond the numbers to gain a better understanding of the nature of a business.

Checklists For Better Decision Making

Fisher devotes the bulk of his book to convenient checklists that investors can use to analyze a business.

Many of these are in fact quantitative in nature, such as an examination of whether a business has a worthwhile profit margin. However, the majority of the items in his list are more qualitative and focus on such factors as whether management has the right people in research and development, the quality of the sales organization, and overall management depth and integrity. Many of these points are very “forward looking” in nature and intended to measure the kind of growth an investor can project based on qualitative factors.

In addition to providing guidelines for what to purchase, Fisher addresses issues such as when to sell and provides a number of important pointers related to common mistakes, including excessive diversification, buying into promotional companies (think of the dot com bubble), using superficial criteria such as the “tone” of an annual report, and more.

Reading this book reveals many differences in approach between Fisher and Graham, but I would say that the most important difference is that Fisher is much more willing to pay higher valuations for companies with bright future prospects than Graham would be willing to pay. Graham generally avoided “paying up” for projected growth and demanded track records of past performance as well as the presence of book value prior to making commitments. Many growth stocks lack meaningful tangible book value and much of the value associated with such companies reside in brand equity and other forms of goodwill.

See’s Candies: Buffett’s Watershed Investment
According to Roger Lowenstein’s excellent 1995 biography of Warren Buffett, The Making of an American Capitalist, the purchase of See’s in 1971 was not one that Buffett was initially “sold” on when presented with the opportunity. See’s Candies was offered for $30 million and was hardly a Graham style investment. According to Alice Schroeder’s recent Buffett biography, The Snowball, See’s had only $5 million in tangible asset value at the time. Berkshire shareholders can probably credit Charlie Munger, Berkshire’s Vice Chairman, for convincing Buffett to make this investment. Buffett eventually agreed to a $25 million purchase of See’s and based the logic of the purchase on See’s earnings power and brand equity. The valuation paid was approximately 11.4 times trailing earnings. Buffett believed that See’s had significant additional pricing power that was not being leveraged and could sell for premium prices compared to other candies such as Russell Stover.

Let’s see what Buffett had to say about See’s Candies in his 2007 annual letter to shareholders:

We bought See’s for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million. (Modest seasonal debt was also needed for a few months each year.) Consequently, the company was earning 60% pre-tax on invested capital. Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories. Last year See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses.

Clearly See’s Candies is a business that is today worth many times the amount paid to acquire the company in 1971, and it is not a business that requires a high level of invested capital. The value of See’s is the earnings power of the business and that earnings power does not come from tangible equity. It comes from intangible assets, and specifically from the brand equity of the business.

Practical Application of Fisher’s Techniques
What can value investors take away from Philip Fisher’s book and from Warren Buffett’s application of these concepts? I believe that the evidence is overwhelming that buying a business like See’s is far more attractive than buying “cigar butt” investments that are quantitatively cheap but either dying or offering average prospects for the future. However, the big caveat is that any investor seeking the higher payoffs accruing to intangible assets like brand power must be very sure in his analysis to avoid buying into the sort of promotional stocks that Fisher warned us to avoid. In short, knowing your “circle of competence” is critical to avoid paying up for illusory growth and taking the risk of permanent loss of capital. Losing capital permanently is much less likely with Graham’s quantitative approach, but that approach also entails higher turnover and lower potential returns compared to a successful application of Fisher’s techniques.

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http://www.rationalwalk.com/?p=1207

Enthusiasm on Wall Street Is Dangerous

bullbear — Fri, 06 Aug 2010 15:55:00 +0000

Graham warned “. . . that while enthusiasm may be necessary for great accomplishments elsewhere, in Wall Street it almost invariable leads to disaster.”

He didn’t explain his rationale for this view, but enthusiasm destroys our critical faculties and leads us to believe we have a “sure thing”. Coupled with greed, thinking an investment is a sure thing is most dangerous. We tend to bet heavily on the stock, forgetting the legendary Bernard Baruch’s warning that every investment is something of a gamble. Moreover, enthusiasm leads a person into speculation, which Graham greatly deplored.