Warren Buffett’s Ground Rules

“…I would rather have nine partner out of ten mildly bored than have one out of ten with any basic misconceptions.”

—Warren Buffett, January 18, 1963

Ground Rules, Partners, and Reasonable Expectations

I am currently reading Warren Buffett’s Ground Rules: Words of Wisdom from the Partnership Letters of the World’s Greatest Investor, authored by Jeremy Miller. This book contains, for the first time, a compilation of Warren Buffett’s Partnership letters, and Buffett’s own words written to his partners about his investment principles, for example his view on diversification strategy, compounding interest, preference for conservative rather than conventional decision making, and his goal and tactics for bettering market results by at least 10% annually. Demonstrating Buffett’s intellectual rigor, they provide a framework to the craft of investing that had not existed before: Buffett built upon the quantitative contributions made by his famous teacher, Benjamin Graham, demonstrating how they could be applied and improved.

I have read the Buffett Partnership Letters before, and they are well worth reading. In one of the letters, dated January 18, 1963, Buffett lays out his “Ground Rules.” These rules provide a great example of how to make sure that partners have reasonable expectations about what results could be expected from the Partnership itself, and Buffett himself as the sole investment manager. For this reason I wanted to put the rules up on the blog to keep them with me on my investing journey.

“The Ground Rules” written by Buffett in a letter to his partners in the beginning of 1963 are as follows.

The Ground Rules

Some partner have confessed (that’s the proper word) that they sometimes find it difficult to wade through my entire annual letter. Since I seem to be getting more long-winded each year, I have decided to emphasize certain axioms on the first page. Everyone should be entirely clear on these points. To most of you this material will seem unduly repetitious, but I would rather have nine partner out of ten mildly bored than have one out of ten with any basic misconceptions.

  1. In no sense is any rate of return guaranteed to partners. Partners who withdraw one-half of 1% monthly are doing just that—withdrawing. If we earn more than 6% per annum over a period of years, the withdrawals will be covered by earnings and the principal will increase. If we don’t earn 6%, the monthly payments are partially or wholly a return of capital.
  2. Any year in which we fail to achieve at least a plus 6% performance will be followed by a year when partners receiving monthly payments will find those payments lowered.
  3. Whenever we talk of yearly gains or losses, we are talking about market values; that is, how we stand with assets valued at market at yearend against how we stood on the same basis at the beginning of the year. This may bear very little relationship to the realized results for tax purposes in a given year.
  4. Whether we do a good job is not to be measured by whether we are plus or minus for the year. It is instead to be measured against the general experience in securities as measured by the Dow-Jones Industrial Average, leading investment companies, etc. If our record is better than that of these yardsticks, we consider it a good year whether we are plus or minus. If we do poorer, we deserve the tomatoes.
  5. While I much prefer a five-year test, I feel three year is an absolute minimum for judging performance. It is certainty that we will have years when the partnership performance is poorer, perhaps substantially so, than the Dow. If any three-year or longer period produces poor results, we all should start looking around for other places to have our money. An exception to the latter statement would be three years covering a speculative explosion in a bull market.
  6. I am not in the business of predicting general stock market or business fluctuations. If you think I can do this, or think it is essential to an investment program, you should not be in my partnership.
  7. I cannot promise results to partners. What I can do is that:
    1. Our investments will be chosen on the basis of value, not popularity;
    2. That we will attempt to bring risk of permanent capital loss (not short-term quotational loss) to an absolute minimum by obtaining a wide margin of safety in each commitment and a diversity of commitments, and
    3. My wife, children and I will have virtually out entire net worth invested in the partnership.

To read the full Buffett Partnership letter quoted above, click here.

To read a sample from the book Warren Buffett’s Ground Rules, click here.


Wal-Mart: From Zero to 11,453 (Part I)

“…most everything I’ve done I’ve copied from somebody else.” —Sam Walton, Made in America: My Story

A Retail Fairy Tale

Sam Walton’s Made in America: My Story is a great read, and definitely a book to read for everyone with an interest in business, a book to read for business owners as well as investors. So if you haven’t already read this book, add it to your reading list.

The Walmart journey began in Arkansas from where it expanded to become a massive enterprise. In 1972 Walmart was listed on the New York Stock Exchange (WMT). That year Walmart had 51 stores and sales of $78 million.

As of today and looking at fiscal year 2015 Walmart generated revenues of $486 billions from its 11,453 stores, operating income of $27 billion, equal to an operating margin of 5.6 %, profit before tax of $25 billion. Diluted earnings per share from continuing operations and book value per share was $5.1 and $24.1 respectively. Dividends paid out to shareholders during fiscal year 2015 amounted to $1.90 per share.

To get some perspective of Wal-Mart’s track record I have put together some key data to be able to track operations over time.


With these impressive operating data in mind (from annual reports) showing Walmart’s growth from 1970 to 2015, we’ll leave the numbers for now and move on to the book that this post was supposed to be all about.

Learning to Value a Dollar and Starting on a Dime

In Made in America: My Story Sam Walton shares his view on Walmart, from its beginning and how it all started out, the ups and downs and also his thoughts on, among other things, business strategy and operational efficiency.

Following are a few quotes that i especially appreciated and marked when I read chapter one Learning to Value a Dollar and chapter two Starting on a Dime (underlinings added by me). 

Pricing Strategy: Profit Margin, Asset Turnover and Return on Capital

I’ll never forget one of Harry’s deals, one of the best items I ever had and an early lesson in pricing. It first got me thinking in the direction of what eventually became the foundation of Wal-Mart’s philosophy. If you’re interested in “how Wal-Mart did it,” this is one story you’ve got to sit up and pay close attention to. Harry was selling ladies’ panties—two-barred, tricot satin panties with an elastic waist—for $2.00 a dozen. We’d been buy

ing similar panties from Ben Franklin for $2.50 a dozen and selling them at three pair for $1.00. Well, at Harry’s price of $2.00, we could put them out at four for $1.00 and make a great promotion for our store.

Here’s the simple lesson we learned—which others were learning at the same time and which eventually changed the way retailers sell and customers buy all across America: say I bought an item for 80 cents. I found that by pricing it at $1.00 I could sell three times more of it than by pricing it at $1.20. I might make only half the profit per item, but because I was selling three times as many, the overall profit was much greater. Simple enough. But this is really the essence of discounting: by cutting your price, you can boost your sales to a point where you earn far more at the cheaper retail price than you would have by selling the item at the higher price. In retailer language, you can lower your markup but earn more because of the increased volume.

Bud Walton on Expense Management

That Newport store was really the beginning of where Wal-Mart is today. We did everything. We would wash windows, sweep floors, trim windows. We did all the stockroom work, checked the freight in. Everything it took to run a store. We had to keep expenses to a minimum. That is where it started, years ago. Our money was made by controlling expenses.

That, and Sam always being ingenious. He never stopped trying to do something different.

Lease Agreements: The Importance of an Option to Renew

Every crazy thing we tried hadn’t turned out as well as the ice cream machine, of course, but we hadn’t made any mistakes we couldn’t correct quickly, none so big that they threatened the business. Except, it turned out, for one little legal error we made right at the beginning. In all my excitement at becoming Sam Walton, merchant, I had neglected to include a clause in my lease which gave me an option to renew after the first five years.

And our success, it turned out, had attracted a lot of attention. My landlord, the department store owner, was so impressed with our Ben Franklin’s success that he decided not to renew our lease—at any price—knowing full well that we had nowhere else in town to move the store. He did offer to buy the franchise, fixtures, and inventory at a fair price; he wanted to give the store to his son. I had no alternative but to give it up. But I sold the Eagle Store lease to Sterling—so that John Dunham, my worthy competitor and mentor, could finally have that expansion he’d wanted.

It was the low point of my business life. I felt sick to my stomach. I couldn’t believe it was happening to me. It really was like a nightmare. I had built the best variety store in the whole region and worked hard in the community—done everything right—and now I was being kicked out of town. It didn’t seem fair. I blamed myself for ever getting suckered into such an awful lease, and I was furious at the landlord. Helen, just settling in with a brand-new family of four, was heartsick at the prospect of leaving Newport. But that’s what we were going to do.

I’ve never been one to dwell on reverses, and I didn’t do so then. It’s not just a corny saying that you can make a positive out of most any negative if you work at it hard enough. I’ve always thought of problems as challenges, and this one wasn’t any different. I don’t know if that experience changed me or not. I know I read my leases a lot more carefully after that, and maybe I became a little more wary of just how tough the world can be. Also, it may have been about then that I began encouraging our oldest boy—six-year-old Rob—to become a lawyer. But I didn’t dwell on my disappointment. The challenge at hand was simple enough to figure out: I had to pick myself up and get on with it, do it all over again, only even better this time.

Wal-Mart: Annual Report, 1972

For Walmart, 1972 was the first year as a publicly traded company. Click image below to read the 1972 annual report.

Learn More About Walmart and its History

If you want to know more about the history of Walmart, check out the following sources:

Jeff Bezo’s Reading List

“Read books are far less valuable than unread ones. The library should contain as much of what you do not know as your financial means, mortgage rates, and the currently tight real-estate market alow you to put there.” —Nassim Nicholas Taleb, The Black Swan

Read, Read, Read, Read and Hope to Have a Few Insights

Below, a few book tips taken from the appendix Jeff’s Reading List as published in The Everything Store: Jeff Bezos and the Age of Amazon. 

Emphasis added by my. Also, book covers added by me and they’re not included in the book as referenced above.

Appendix: Jeff’s Reading List

Books have nurtured Amazon since its creation and shaped its culture and strategy. Here are a dozen books widely read by executives and employees that are integral to understanding the company.


The Remains of the Day, by Kazuo Ishiguro (1989).

Jeff Bezos’s favorite novel, about a butler who wistfully recalls his career in service during wartime Great Britain. Bezos has said he learns more from novels than nonfiction.

Sam Walton: Made in America, by Sam Walton with John Huey (1992).

In his autobiography, Walmart’s founder expounds on the principles of discount retailing and discusses his core values of frugality and a bias for action—a willingness to try a lot of things and make many mistakes. Bezos included both in Amazon’s corporate values.

Memos from the Chairman, by Alan Greenberg (1996).

A collection of memos to employees by the chairman of the now- defunct investment bank Bear Stearns. In his memos, Greenberg is constantly restating the bank’s core values, especially modesty and frugality. His repetition of wisdom from a fictional philosopher presages Amazon’s annual recycling of its original 1997 letter to shareholders.

The Mythical Man-Month, by Frederick P. Brooks Jr. (1975).

An influential computer scientist makes the counterintuitive argument that small groups of engineers are more effective than larger ones at handling complex software projects. The book lays out the theory behind Amazon’s two-pizza teams.


Built to Last: Successful Habits of Visionary Companies, by Jim Collins and Jerry I. Porras (1994).

The famous management book about why certain companies succeed over time. A core ideology guides these firms, and only those employees who embrace the central mission flourish; others are “expunged like a virus” from the companies.

Good to Great: Why Some Companies Make the Leap… and Others Don’t, by Jim Collins (2001).

Collins briefed Amazon executives on his seminal management book before its publication. Companies must confront the brutal facts of their business, find out what they are uniquely good at, and master their flywheel, in which each part of the business reinforces and accelerates the other parts.

Creation: Life and How to Make It, by Steve Grand (2001).

A video-game designer argues that intelligent systems can be created from the bottom up if one devises a set of primitive building blocks. The book was influential in the creation of Amazon Web Services, or AWS, the service that popularized the notion of the cloud.

The Innovator’s Dilemma: The Revolutionary Book That Will Change the Way You Do Business, by Clayton M. Christensen (1997).

An enormously influential business book whose principles Amazon acted on and that facilitated the creation of the Kindle and AWS. Some companies are reluctant to embrace disruptive technology because it might alienate customers and undermine their core businesses, but Christensen argues that ignoring potential disruption is even costlier.


The Goal: A Process of Ongoing Improvement, by Eliyahu M. Goldratt and Jeff Cox (1984).

An exposition of the science of manufacturing written in the guise of the novel, the book encourages companies to identify the biggest constraints in their operations and then structure their organizations to get the most out of those constraints. The Goal was a bible for Jeff Wilke and the team that fixed Amazon’s fulfillment network.

Lean Thinking: Banish Waste and Create Wealth in Your Corporation, by James P. Womack and Daniel T. Jones (1996).

The production philosophy pioneered by Toyota calls for a focus on those activities that create value for the customer and the systematic eradication of everything else.

Data-Driven Marketing: The 15 Metrics Everyone in Marketing Should Know, by Mark Jeffery (2010).

A guide to using data to measure everything from customer satisfaction to the effectiveness of marketing. Amazon employees must support all assertions with data, and if the data has a weakness, they must point it out or their colleagues will do it for them.

The Black Swan: The Impact of the Highly Improbable, by Nassim Nicholas Taleb (2007).

The scholar argues that people are wired to see patterns in chaos while remaining blind to unpredictable events, with massive consequences. Experimentation and empiricism trumps the easy and obvious narrative.

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.

Joel Greenblatt’s All-Time Favourite Books

“To be a successful investor over the long term, you must also pretty much enjoy the journey.” —Joel Greenblatt, You Can Be a Stock Market Genius, p. 265

In his book You Can Be a Stock Market Genius Joel Greenblatt shares a book list of his all time favorites. If you haven’t read all of these books yet, maybe you should add them to your reading list? Feel free to share any insights from any of the books if you’ve already read them.


No. (Just kidding.) There are no books that I would recommend that exclusively discuss the special-investment situations found in this book. However, there are books that can give you excellent background information on the stock market and on value investing. All of this information can be helpful when applied to investments in the special-situation area. So, if you have the time and the inclination, here is a list of my all-time favorites:

David Dremen, The New Contrarian Investment Strategy (New York: Random House, 1983).

Benjamin Graham, The Intelligent Investor: A Book of Practical Counsel (New York: HarperCollins, 1986).

Robert Hagstrom, The Warren Buffett Way: Investment Strategies of the World’s Greatest Investor (New York; Wiley, 1994).

Seth A. Klarman, Margin of Safety (New York: Harper Business, 1991).

Peter Lynch and John Rothchild, One Up on Wall Street (New York: Simon & Schuster, 1993) and Beating the Street (New York: Simon & Schuster, 1994).

Andrew Tobias, The Only Investment Guide You’ll Ever Need (revised and updated edition) (New York: Harcourt Brace, 1996).

John Train, The Money Masters (New York: HarperCollins, 1994).



Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.

Q&A: Case Study on Dempster Mill Manufacturing Company

“When control of a company is obtained, obviously what then becomes all-important is the value of assets, not the market quotation for a piece of paper (stock certificate).” —Warren Buffett


In this post I lay out my answers to the questions posted at CSInvesting.org as part of the DEEP VALUE course and the case study on Dempster Mill Manufacturing Company. Feel free to comment and share your own views, reflections and take-aways.

I do not think that these questions are that easy. But I have tried to come up with decent answers, since by not trying I won’t learn anything. So, take it for what it is and feel free to share our own thoughts, preferably over at the comment section at CSInvesting where you will find many others who also participate in the DEEP Value course.

How did Buffett find this investment and what ways did he reach an intrinsic value?

Buffett found Dempster since the “figures were extremely attractive.” In other words, a low price compared to book value.

How many margins of safety did he have?

When Buffett first acquired stock in Dempster the most important margin of safety was most likely in the great discount between price and book value.

Later on when Buffett realized that current management didn’t succeed he had Harry Bottle to take over as CEO. This provided sort of a second margin of safety, a great manager or management team is never a negative. And in Harry Bottle Buffett found himself a great CEO able to run the business in a way Buffett himself thought was most likely to create the most value. I put Harry as second, because I think that he was more important than any potential future improvement in earning power. The earning power was more likely to be an outcome of great operating management.

Third, possible improvement in earning power.

What “type” of investment is this—is earning power below Asset Value?

The investment in Dempster started out as a net asset value investment, this due to the great discount between price and book value. Buffett also wrote that “the figures were extremely attractive.” It wasn’t the qualitative aspects of Dempster that was the main reason why Buffett started acquiring stock, it was all based on the great discount to book value per share.

When Buffett started purchasing Dempster stock the earning power value was a lot lower than the value of the assets, even compared to net current asset value and Buffett’s valuation applying different discounts to each balance sheet item.

Buffett wrote that Dempster had “…earned good money in the past but was only breaking even currently.” Earning power value clearly had taken a hit, and was probably a big reason for the stock price trading at such a big discount to book value. As Graham & Dodd wrote in Security Analysis when discussing Westinghouse Electric and Manufacturing Company position; “…the stock sold for much less than the net current assets alone, presumably indicating widespread doubt as to its ability to earn any profit in the future.”

Buffett may have had some expectations for the earning power to come back and help support a higher stock price, even if this was far from a sure thing. The margin of safety was in the low price compared to book value. If earning power would be restored, that would serve as a bonus I think.

Dempster (1)

Is this a franchise? Why or why not is this occurring?

Dempster was not a franchise. Buffet wrote that “The operations for the past decade have been characterized by static sales, low inventory turnover and virtually no profits in relation to invested capital.” Not the characteristics to be expected from a franchise. Buffett also wrote that Dempster was in a “fairly tough industry,” and it also had “unimpressive management.”

If earning power was to be restored it would probably, even in the best case, only support the net asset value, thus no excess returns and no earning power value greater than the asset value. This would indicate a business without any franchise value, i.e., no sustainable competitive advantage—or moat.

Was Buffett lucky in this investment? Why or why not?

I think luck always plays some part. But Buffett started to purchase stock due to the margin of safety he deemed to be present. So even if Harry Bottle had not come along, Buffett might have been able to sell out without making a loss. When already invested and taking control he used his skill as a business owner in a pretty good way I think, mostly through Harry Bottle taking care of the daily operating activities.

How would Graham approach an investment like this?

Not really sure about this one. Graham also invested in businesses situations that could be compared to Dempster. But even if Graham did so, maybe the most likely way he would look at Dempster would be purely quantitative. From what I can see, Dempster never was a pure net-net during the time Buffett was an owner. So maybe Graham would have stayed away from it.

What would have been the big difference between Graham and Buffett concerning Dempster Mills?

That Graham never would have bought because the stock wasn’t cheap enough to provide a margin of safety to an estimated liquidation value (current asset minus total liabilities). But I’m not really sure about this one. Will be interesting to see the comments to this question.

So, now I shall start reading the comments to see what all other participants have to say about these questions. Even though the case study was posted a few days ago I have not read any comments that’s been posted, since this would sort of “anchor” my own answers.

BTW. Today I received my King Icahn book in the mail. Look forward to start reading. But will wait until John says go.

All for now!

James Montier on The Trinity of Risk

“Despite risk appearing to be one of finance’s favourite four-letter word, it remains finance’s most misunderstood concept. Risk isn’t a number, it is a concept or a notion. From my perspective, risk equates to what Ben Graham called a ‘permanent loss of capital’. Three primary (although interrelated) sources of such danger can be identified: valuation risk, business/earnings risk, and balance sheet/financial risk. Rather than running around obsessing on the pseudoscience of risk management, investors should concentrate on understanding the nature of this trinity of risks.” —Jamies Montier

The Trinity of Risk: A Tool In Assessing the Probability of a Permanent Loss of Capital

VI1In his book Value Investing: Tools and Techniques for Intelligent Investment, James Montier writes that “…the permanent loss of capital can be split into three (interrelated) sets of risks: valuation risk, business/earnings risk, and balance sheet/financing risk.”

James ends the chapter and puts it all together by saying that “These three elements (intertwined as they are) can all lead to a permanent loss of capital. Ultimately, I would argue that risk is really a notion or a concept not a number. Indeed the use of pseudoscience in risk management has long been a rant of mine.”

The Trinity of Risk

Elements of the Trinity of Risk

Valuation Risk “Valuation risk is perhaps the most obvious of our trinity. Buying an asset that is expensive means that you are reliant upon all the good news being delivered (and then some). There is no margin of safety in such stocks.”
Business/Earnings Risk “As Graham put it. ‘Real investment risk is measured […] by the danger of a loss of quality and earnings power through economic changes or deterioration in management.'”
Balance Sheet/Financing Risk “Balance sheet/financing risk is the last of our triumvirate. As Graham noted: ‘The purpose of balance sheet analysis is to detect … the presence of financial weakness that may detract from the investment merit of an issue.’ In general, we have found that these risks get ignored by investors during the good times, but in a credit constrained environment they suddenly reappear on the agenda. We would suggest that rather than vascillating between neglect and obsession with respect to the balance sheet, a more even approach may well generate results.”

Element #1: Valuation Risk

“As Graham wrote, ‘The danger in … growth stock(s) [is that] for such favoured issues the market has a tendency to set prices that will not be adequately protected by a conservative projection of future earnings.’ In other words, buying expensive stocks leaves you vulnerable to disappointment.”

“As Figure 11.1 shows, the US equity market is currently just below ‘fair value’ – not yet at truly bargain basement prices. I have no idea whether this major recession will take us to truly bargain valuations, but serious bear markets have normally only ended when we are trading on 10×10-year moving average earnings. This is consistent with the S&P 500 at 500!”


“This top-down valuation work is supported by looking at the percentage of stocks trading at Graham and Dodd PEs greater than 16×. You may well ask why 16×? The answer as ever lies in the writings of Graham who opined.

We would suggest that about 16 times is as high a price as can be paid in an investment purchase of a common stock … Although this rule is of necessity arbitrary in its nature, it is not entirely so. Investment presupposes demonstrable value, and the typical common stock’s value can be demonstrated only by means of an established, i.e. an average, earnings power. But it is difficult to see how average earnings of less than 6% upon the market price could ever be considered as vindicating that price.”

Element #2: Business/Earnings Risk

“The second source of risk from our perspective concerns business and earnings risk. As Graham put it.

Real investment risk is measured not by the percent that a stock may decline in price in relation to the general market in a given period, but by the danger of a loss of quality and earnings power through economic changes or deterioration in management.

In an environment which is increasingly being acknowledged as the worst since the Great Depression, a loss of ‘earnings power through economic changes’ must be a concern for investors. Graham warned that markets were ‘governed more by their current earnings than by their long-term average. This fact accounts in good part for the wide fluctuations in common-stock prices, which largely (though by no means invariably) parallel the changes in their earnings between good years and bad.’

Graham went on.

Obviously the stock market is quite irrational in thus varying its valuation of a company proportionately with the temporary changes in reported profits. A private business might easily earn twice as much in a boom year as in poor times, but its owner would never think of correspondingly marking up or down the value of his capital investment.

The challenge facing investors in this environment is to assess whether any changes in earnings power are temporary or permanent. The former represent opportunities, the latter value traps.

Keep an eye on the ratio of current EPS to average 10-year EPS. Stocks which look ‘cheap’ based on current earnings, but not on average earnings, are the ones that investors should be especially aware of, as they run a greater risk of being the sort of stock where the apparent cheapness is removed by earnings falling rather than prices rising.

Figure 11.4 shows the percentage of stocks in the large cap universe that have current EPS of at least twice 10-year average EPS. This serves as our proxy for earnings risk. In the USA, only one-third of stocks find themselves in this situation (as befits the country first into this crisis). The UK comes out as the worst on this measure, with 54% of stocks having current EPS of at least twice 10-year average EPS. In Europe and Japan, 42% of stocks are in this position. It appears to us that earnings and business risk are far more absent in these markets. The good news is that, given the lower valuations mentioned above, this may already be partially discounted.”

Element #3: Balance Sheet/Financial Risk

“The third of our unholy trinity of risks is balance sheet/financial risk. As Graham opines, ‘The purpose of balance-sheet analysis is to detect … the presence of financial weakness that may detract from the investment merit of an issue.’

Investors tend to ignore balance sheet and financial risk at the height of booms. They get distracted by earnings, and how these cyclically high earnings cover interest payments. Only when earnings start to crumble do investors turn their attention back to the balance sheet.

Similarly leverage is used to turn little profits into big profits during the good times, and many investors seem to forget that leverage works in reverse as well, effectively a big profit can rapidly become a loss during a downswing.

There are lots of ways of gauging balance sheet risk. Our colleagues in the quant team have long argued that the Merton Model and distance to default provide a useful measure of these dimensions. Being a simple and old-fashioned soul I turn to a measure that has served me well in the past during periods of balance sheet stress: good old Altman’s Z.

Altman’s Z score was designed in 1968 to predict bankruptcy using five simple ratios.”

Altman’s Z-score

Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 0.999X5

X1 = Working Capital/Total Assets. Measures liquid assets in relation to the size of the company.
X2 = Retained Earnings/Total Assets. Measures profitability that reflects the company’s age and earning power.
X3 = Earnings Before Interest and Taxes/Total Assets. Measures operating efficiency apart from tax and leveraging factors. It recognizes operating earnings as being important to long-term viability.
X4 = Market Value of Equity/Book Value of Total Liabilities. Adds market dimension that can show up security price fluctuation as a possible red flag.
X5 = Sales/Total Assets. Standard measure for turnover.

“A Z score below 1.8 is considered a good indication of future problems. While only a first step, I have often found this measure useful for flagging up potentially troubling situations.

Figure 11.5 shows the percentage of large cap firms across countries which have Altman Z scores below 1.8. The measure obviously won’t work for financials or utilities so they have been excluded from our sample.

Roughly speaking, we find very similar levels of balance sheet risk across countries. Somewhere between 20 and 25% of companies appear to have Z scores below 1.8, suggesting a high probability of financial distress.”

Further Reading

  • See here for full PDF of the article FINANCIAL RATIOS, DISCRIMINANT ANALYSIS AND THE PREDICTION OF CORPORATE BANKRUPTCY, Edward I. Altman (Published in The Journal of FINANCE, September 1968)
  • See here for the Wikipedia page about Altman’s Z-score

The Value Investing Trinity of Risk

So, use the trinity of risk when analyzing and assessing the probability of a risk of permanent loss of capital.


Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.

The Theory of Investment Value (Part 1)

A New Book that is Old: The Theory of Investment Value, Written by John Burr Williams

Today I received a book, that I ordered a few days ago, delivered to my front door by the postman. The book was John Burr Williams’ The Theory of Investment Value from 1938.

I have just read a few pages today, but already noted a few interesting things. In the beginning of the book Williams writes about price and value, and also about speculation and investment. Two familiar topics that Benjamin Graham also discussed, for example in his book The Intelligent Investor.


Below are two quotations, the first one about real worth and market price and the second about the definition of an investor. Boldings are my own.

“Separate and distinct things not to be confused, as every thoughtful investor knows, are real worth and market price. […] Our problem, therefore is twofold: to explain the price as it is, and to show what price would be right.”

“As will be shown later, the longer a buyer holds a stock or bond, the more important are the dividends or coupons while he owns it and the less important is the price when he sells it. In the extreme case where the security is held by the same family for generations, a practice by no means uncommon, the selling price in the end is a minor matter. For this reason, we shall define an investor as a buyer interested in dividends, or coupons and principal, and a speculator as a buyer interested in the resale price. Thus the usual buyer is a hybrid, being partly investor and partly speculator. Clearly the pure investor must hold his security for long periods, while the pure speculator must sell promptly, if each is to get what he seeks.”

Deep Value Investing: Finding Bargain Shares With Big Potential (Free Sample)

Deep Value Investing: Free Book Excerpt

Click here for a free sample of Deep Value Investing: Finding Bargain Shares With Big Potential.

Below is an interview from The Manual of Ideas with the author Jeroen Bos.

Book description below taken from the publisher of the book, Harriman House.

DVI1“Let the market come to you

Deep Value Investing by Jeroen Bos is an incredibly candid and revealing guide to the secrets of deep value investment. Written by an investor with a long and remarkable track record, it shares for the first time the ins and outs of finding high-potential undervalued stocks before anyone else.

Deep value investing means finding companies that are genuine bargains that can pay back phenomenally over the long term. They are firms so cheap that even if they were to close tomorrow their assets would pay you out at a profit. But if they can turn things around, the rewards will be many times greater …

These were the favourite shares of Benjamin Graham, author of ‘The Intelligent Investor’. Inspired by Graham’s classic and with a long history of discovering these great value stocks – sometimes known as ‘bargain issues’ or ‘netnets’ – author and investor Jeroen Bos reveals:

– how to use only publicly available information to discover these shares and filter the gold from the dross

– everything he did when analysing, purchasing, monitoring and selling more than ten recent successful deep value investments

– the complete philosophy behind deep value investing, and the ins and outs of this strategy in practice

– what can go wrong and how to minimise the chances of it happening to you.

Deep value investing has a better track record than almost any other approach to the market. Even better, it doesn’t require minute and technical knowledge of a company, nor is it fixated on earnings or often-unreliable future projections.

It’s all about the balance sheet and patience. This makes it the perfect investing approach for those who want to see phenomenal stock market returns without wasting time or commission costs.” (Source: Harriman House)

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. This article is informational and is in my own personal opinion.

Four Books Warren Buffett Particularly Treasure

“My intellectual odyssey ended, however, when I met Ben and Dave, first through their writings and then in person. They laid out a roadmap for investing that I have now been following for 57 years. There’s been no reason to look for another.”—Warren Buffett

Warren Buffett’s Forward to the Sixth Edition of Security Analysis

SAGD1“There are four books in my overflowing library that I particularly treasure, each of them written more than 50 years ago. All, though, would still be of enormous value to me if I were to read them today for the first time; their wisdom endures though their pages fade.

Two of those books are first editions of The Wealth of Nations (1776), by Adam Smith, and The Intelligent Investor (1949), by Benjamin Graham. A third is an original copy of the book you hold in your hands, Graham and Dodd’s Security Analysis. I studied from Security Analysis while I was at Columbia University in 1950 and 1951, when I had the extraordinary good luck to have Ben Graham and Dave Dodd as teachers. Together, the book and the men changed my life.

On the utilitarian side, what I learned then became the bedrock upon which all of my investment and business decisions have been built. Prior to meeting Ben and Dave, I had long been fascinated by the stock market. Before I bought my first stock at age 11—it took me until then to accumulate the $115 required for the purchase—I had read every book in the Omaha Public Library having to do with the stock market. I found many of them fascinating and all interesting. But none were really useful. My intellectual odyssey ended, however, when I met Ben and Dave, first through their writings and then in person. They laid out a roadmap for investing that I have now been following for 57 years. There’s been no reason to look for another.

WB2Beyond the ideas Ben and Dave gave me, they showered me with friendship, encouragement, and trust. They cared not a whit for reciprocation—toward a young student, they simply wanted to extend a one-way street of helpfulness. In the end, that’s probably what I admire most about the two men. It was ordained at birth that they would be brilliant; they elected to be generous and kind.

Misanthropes would have been puzzled by their behavior. Ben and Dave instructed literally thousands of potential competitors, young fellows like me who would buy bargain stocks or engage in arbitrage transactions, directly competing with the Graham-Newman Corporation, which was Ben’s investment company. Moreover, Ben and Dave would use current investing examples in the classroom and in their writings, in effect doing our work for us. The way they behaved made as deep an impression on me—and many of my classmates—as did their ideas. We were being taught not only how to invest wisely; we were also being taught how to live wisely.

The copy of Security Analysis that I keep in my library and that I used at Columbia is the 1940 edition. I’ve read it, I’m sure, at least four times, and obviously it is special.

But let’s get to the fourth book I mentioned, which is even more precious. In 2000, Barbara Dodd Anderson, Dave’s only child, gave me her father’s copy of the 1934 edition of Security Analysis, inscribed with hundreds of marginal notes. These were inked in by Dave as he prepared for publication of the 1940 revised edition. No gift has meant more to me.”

4BWBDisclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. This article is informational and is in my own personal opinion. Always do your own due diligence and contact a financial professional before executing any trades or investments.