Q&A: The Intelligent Investor – Chapter 7: Portfolio Policy for the Enterprising Investor: The Positive Side

Below are my reflections and answers to the discussion questions posted at Modern Graham for chapter 7 – Portfolio Policy for the Enterprising Investor: The Positive Side – of the Intelligent Investor written by Benjamin Graham. The Intelligent Investor

1. What quote from this chapter do you think best summarizes the point Graham is making?

“There is no reason at all for thinking that the average intelligent investor, even with much devoted effort, can derive better results over the years from the purchase of growth stocks than the investment companies specializing in this area. Surely these organizations have more brains and better research facilities at their disposal than you do. Consequently we should advise against the usual type of growth-stock commitment for the enterprising investor. This is one in which the excellent prospects are fully recognized in the market and already reflected in a current price-earnings ratio of, say, higher than 20. (For the defensive investor we suggested an upper limit of purchase price at 25 times average earnings of the past seven years. The two criteria would be about equivalent in most cases.)”

2. What do you think of Graham’s suggestions of activities for Enterprising Investors?

I think that Graham’s recommendation here for the enterprising investor sounds reasonable. Of the three different investment approaches Graham suggests I have spent most, if not all, my time in the first two categories, i.e. the relatively unpopular large company and in purchasing bargain issues. Up until this day I have not engaged in any special situations, or as Graham calls them “Workouts”. Maybe that time will come. The main reason is that I have kept myself pretty busy doing the first two categories. So for me personally, this is more a question of time than anything else.

Graham states that “To obtain better than average investment results over a long pull requires a policy of selection or operation possessing a twofold merit: (1) It must meet objective or rational tests of underlying soundness; and (2) it must be different from the policy followed by most investors or speculators. Our experience and study leads us to recommend three investment approaches that meet these criteria. They differ rather widely from one another, and each may require a different type of knowledge and temperament on the part of those who assay it.”

Graham recommends the three investment approaches as follows:

  • The relatively unpopular large company: This is according to Graham “…an investment approach that should prove both conservative and promising.” This approaches implies that “…the enterprising investor concentrate on the larger companies that are going through a period of unpopularity.” A warning is also made regarding small companies that could “…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 and also of protracted neglect by the market in spite of better earnings. The large companies thus have a double advantage over the others. First, they have the resources in capital and brain power to carry them through adversity and back to a satisfactory earnings base. Second, the market is likely to respond with reasonable speed to any improvement shown.”
  • Purchase of bargain issues: Graham’s definition of a bargain issue is that “…an issue is not a true “bargain” unless the indicated value is at least 50% more than the price.” Graham then goes on and talks about how the investor can find these bargain issues.  “There are two tests by which a bargain common stock is detected. The first is by the method of appraisal. This relies largely on estimating future earnings and then multiplying these by a factor appropriate to the particular issue. If the resultant value is sufficiently above the market price—and if the investor has confidence in the technique employed—he can tag the stock as a bargain. The second test is the value of the business to a private owner. This value also is often determined chiefly by expected future earnings—in which case the result may be identical with the first. But in the second test more attention is likely to be paid to the realizable value of the assets, with particular emphasis on the net current assets or working capital.
  • Special situations, or “Workouts”: “The typical “special situation” has grown out of the increasing number of acquisitions of smaller firms by large ones, as the gospel of diversification of products has been adopted by more and more managements. It often appears good business for such an enterprise to acquire an existing company in the field it wishes to enter rather than to start a new venture from scratch. In order to make such acquisition possible, and to obtain acceptance of the deal by the required large majority of shareholders of the smaller company, it is almost always necessary to offer a price considerably above the current level. Such corporate moves have been producing interesting profit-making opportunities for those who have made a study of this field, and have good judgment fortified by ample experience.”

3. Have you limited yourself to these activities in your investments?

Guess I already answered this question above. But anyways, up until today I have limited myself to the first two of the investment approaches.

4. Do you think it is ever possible to time the market or profit from arbitrages?

I think that it’s possible, but also that the probability of succeeding is rather low, implicating that total returns from such market timing activities should not be expected to be satisfactory in the end.

An investor putting his time to such endeavors has stopped being an investor and become a speculator. So being an investor time is best spent in focusing the effort on finding great companies at fair prices for the long run. In doing so enterprising investors get the best odds out there when it comes to succeeding, that is to enjoy a satisfactory return and thus avoiding a permanent loss of capital.

5. How do you decide which growth companies will continue to perform well?

When talking about investing the question regarding future growth is the most difficult one, but also one of utmost importance due to the part it plays in the calculation of the underlying intrinsic value of a business. First, an investor will do best in trying to purchase stocks without paying up for the growth component inherent in the future prospects of the business. Second, if an investor pays up for growth this must be done on a conservative basis due to the speculative part always present through the uncertainties in future growth.

In his 1992 letter to shareholders Warren Buffett talked about value and growth as follows.

“…most analysts feel they must choose between two approaches customarily thought to be in opposition: “value” and “growth.” Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing.

We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.

In addition, we think the very term “value investing” is redundant. What is “investing” if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value – in the hope that it can soon be sold for a still-higher price – should be labeled speculation (which is neither illegal, immoral nor – in our view – financially fattening).

Whether appropriate or not, the term “value investing” is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics – a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield – are in no way inconsistent with a “value” purchase.

Similarly, business growth, per se, tells us little about value. It’s true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.

Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.”

To make decisions about growth I try to follow the fundamentals of the business and the industry that it’s in. Doing this I try to observe any signs and changes in major factors impacting the value of the business.

But as stated above, be careful when it comes to growth and remember the old adage If something sounds too good to be true, it probably is.”

6. What did you think of the chapter overall?

A great one. I especially like Graham’s discussion about the three different investment approaches.

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