Mr. Market: The Investor and Market Fluctuations

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” —Benjamin Graham

Mr. Market clearly did not feel that well today, taking down most of the stock market indices around the world. It remains to be seen what tomorrow has to offer. Until then, enjoy the reading (see link at the end of this post).

A great chapter to revisit and reread on a day like this is chapter 8—The Investor and Market Fluctuations—from the Intelligent Investor, written by Benjamin Graham back in 1949.

Indices

When asked what the best money advice he ever got was, it’s no surprise that Buffett turned to his holy bible, The Intelligent Investor, written in 1949 by value god Benjamin Graham.

“Chapters 8 and 20 have been the bedrock of my investing activities for more than 60 years,” he says. “I suggest that all investors read those chapters and reread them every time the market has been especially strong or weak.”

Source: Forbes

Click image below to start reading chapter 8 about Mr. Market from Benjamin Graham’s classic investment book The Intelligent Investor.

Q&A: The Intelligent Investor – Chapter 20: Margin of Safety as the Central Concept of Investment

TII1Below are my reflections and answers to the discussion questions posted at Modern Graham for chapter 20 – Margin of Safety as the Central Concept of Investment – of the Intelligent Investor written by Benjamin Graham.

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

“Thus, in sum, we say that to have a true investment there must be present a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience.”

2. What Safety Margins do you utilize in your investing?

Qualitative factors

  • A business I am able to understand, i.e., within my circle of competence
  • A business with a long-term sustainable competitive advantage
  • A business with a management that possess talent and integrity

Quantitative factors

  • An attractive price (when compared to a conservative estimate of intrinsic value)

3. What did you think of the chapter overall?

Great chapter. The concept of margin of safety is one of the cornerstones in investing to be applied by the investor.

Q&A: The Intelligent Investor – Chapter 18: A Comparison of Eight Pairs of Companies

TII1Below are my reflections and answers to the discussion questions posted at Modern Graham for chapter 18 – A Comparison of Eight Pairs of Companies – of the Intelligent Investor written by Benjamin Graham.

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

“Our preference for the analyst’s work would be rather that he should seek the exceptional or minority cases in which he can form a reasonably confident judgement that the price is well below value. He should be able to do this work with sufficient expertness to produce satisfactory average results over the the years.”

2. Pick two companies and do a comparison like Graham did here – i.e. look at the financials at some point in the past, and compare what happened to the companies since then. Do you find anything interesting to share with the group?

I have picked American Express (AXP) and Walmart (WMT) for a comparison at the end of January 2009. Financial numbers used for AXP as of December 31, 2008 and for WMT as of January 31, 2009.

Sources used are Morningstar.com, annual reports and Google Finance for historical price per share data.

See table below for a compilation of some key financials for AXP and WMT.

Both companies show a high return on equity for their respective last reported fiscal years, around 20%, consistent with prior years. Net margin for WMT was 3.4% compared to 9.5% for AXP.

The more interesting part here is the markets view of these companies. January 2009 was in the midst of the financial crisis. In January 2009 AXP had a price/earnings ratio of 7.1, i.e., an earnings yield of 14.1%, compared to WMT’s 15.1 and 6.6% respectively. Looking at price to book AXP was valued at 1.6 times and WMT at 2.8 times. AXP had a dividend yield of 4.3%, compared to and 1.9% for WMT.

From looking at these valuation metrics, AXP at the time seemed to offer more value than WMT. The question at the time was: How hard would AXP be hit by the on-going financial crisis? Without a more thorough analysis of AXP regarding this, it looked like the price per share in January 2009 provided a margin of safety. Looking at prior years earnings had been around 3 per share, so even if earnings per share was cut in half, the price/earnings ratio would rise to 15 times, a not to aggressive valuation.

Fast forward to fiscal year 2013 (the last reported fiscal year per July 24, 2014).

AXP showed earnings per share of 4.88 (+109% from 2008), book value per share of 18.32 (+79% from 2008), a dividend of 0.66 (-8% from 2008). Per July 24, 2014 AXP had a price/earnings ratio of 18.2 (93.15/5.11), a price/book of 4.9, a dividend yield of 1.0%.

WMT showed earnings per share of 4.88 (+56% from 2008), book value per share of 23.59 (+42% from 2008), a dividend of 1.88 (+114% from 2008). Per July 24, 2014 WMT had a price/earnings ratio of 15.7 (76.35/4.85), a price/book of 3.4, a dividend yield of 2.5%.

American Express Walmart
Price, January 30, 2009 16.63 47.12
Number of common shares 1,157 3,951
Market value of common 19,241 186,171
Debt 69,034 39,315
Total capitalization at market 88,275 225,486
Book value per share 10.21 16.64
Sales 28,365 405,607
Net income 2,699 13,400
Earned per share (diluted), 2008 2.33 3.13
Earned per share, 2003 2.33 1.79
Earned per share, 1998 1.57 0.77
Current dividend rate 0.72 0.88
Price/earnings 7.1 x 15.1 x
Price/book value 1.6 x 2.8 x
Dividend yield 4.3% 1.9%
Net/sales 9.5% 3.4%
Earnings/book value 22.8% 19.7%
Current assets/liabilities N/A 0.8 x
Working capital/debt N/A  Neg.
Growth in per-share earnings2008 versus 20032008 versus 1998 even+48% +75%+307%

3. Pick two companies and make a prediction – i.e. look at the financials and predict where each will be in 5 years.

Predictions are always the hardest part. So as an investor one better be careful and conservative when trying to form an opinion about any future developments for different businesses.

Looking at American Express and Walmart as of 2014, we see two stable and high-quality businesses, both of which I expect to be able to grow in the coming five years. See table below for different growth derived from using the Graham fomula and saving for growth. Right now, even if no bargains, both companies seem to offer decent returns for investor.

Reconnecting to the quote in the beginning of the post, neither American Express or Walmart at current market prices seem to offer a value well below price, rather, I think, a price fairly around value. Looking at the implied growth rate based on 3y. Avg. EPS, one has to ask if Walmart’s growth rate of 3.6% is on the low side.

3y Avg. EPS   FY2013 EPS   TTM, EPS  
AXP 4,30 6,4% 4,88 5,2% 5,11 4,7%
WMT 4,82 3,6% 4,88 3,5% 4,85 3,6%
Price per Share, SEK 52-week High/ Low Multiplier of TTM EPS  
AXP 91,93 96,24-71,47 18,0
WMT 75,97 81,37-71,51 15,7

4. What did you think of the chapter overall?

Great chapter and financial analysis by Graham. Always interesting with real examples and comparisons of different companies.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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 whose stock is mentioned in this article. 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.

Q&A: The Intelligent Investor – Chapter 17: Four Extremely Instructive Case Histories

The Intelligent InvestorBelow are my reflections and answers to the discussion questions posted at Modern Graham for chapter 17 – Four Extremely Instructive Case Histories – of the Intelligent Investor written by Benjamin Graham.

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

“Moral: Security analysts should do their elementary jobs before they study stock-market movements, gaze into crystal balls, make elaborate mathematical calculations, or go on all-expense-paid field trips.”

2. Do you think there are any exceptions to the rules that Graham mentions?

As always, I think there are exceptions. But, I also think that following the rules mentioned by Graham and always keeping some kind of a skepticism when looking at different kinds of businesses should help investors stay away from the worst pitfalls.

3. What steps have you taken to ensure you don’t buy companies like the ones in the chapter?

As a general rule, I do not invest in IPOs. I read quarterly and annual reports (for a company and its competitors). I also look for businesses that have been able to show high returns on invested capital (or high returns on equity achieved with no or low use of leverage) over the last 5 to 10 years, with consistent generation of free cash flow. Also look for a margin of safety, i.e., a reasonable price compared to intrinsic value among other things. Besides the financial analysis and valuation part, I try to be as humble as possible and to recognize the danger of behavioral biases that affects the decisions to buy (and sell) a business.

4. What did you think of the chapter overall?

Enjoyed the chapter since I think it was an interesting read due to the case studies Graham discusses and applies his analytical framework to.

Q&A: The Intelligent Investor – Chapter 16: Convertible Issues and Warrants

The Intelligent InvestorBelow are my reflections and answers to the discussion questions posted at Modern Graham for chapter 16 – Convertible Issues and Warrants – of the Intelligent Investor written by Benjamin Graham.

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

“Once more we assert that large issues of stock-option warrants serve no purpose, except to fabricate imaginary market values.”

2. How do you generally feel about convertible bonds?

Right now I haven’t looked at any convertibles, so not that exited.

3. Where do you think they could fit into an Intelligent Investor’s portfolio?

As any other investment, purchased at a good enough margin of safety.

4. What did you think of the chapter overall?

That convertibles are not something I will look into right now. So not that excited about the chapter overall.

Q&A: The Intelligent Investor – Chapter 15: Stock Selection for the Enterprising Investor

The Intelligent InvestorBelow are my reflections and answers to the discussion questions posted at Modern Graham for chapter 15 – Stock Selection for the Enterprising Investor – of the Intelligent Investor written by Benjamin Graham.

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

“But to the objective observer the failure of the funds to better the performance of a broad average is a pretty conclusive indication that such an achievement, instead of being easy, is in fact extremely difficult.”

2. What do you think of Graham’s original requirements for Enterprising Investors? Do you agree with the changes I’ve made for the ModernGraham approach?

To start with, I like Graham’s original requirements for Enterprising Investors. Regarding the changes you’ve made for the ModernGraham approach, I would say I agree with them and that they seem reasonable.

3. Are there any other “modernizations” you would make to Graham’s requirements?

Maybe a shift from net tangible assets to earning power could be deemed reasonable for some companies, and thus setting a maximum earnings multiplier. I’m not really sure what this maximum should be, maybe 25 times normalized earnings per share.

4. What did you think of the chapter overall?

Great chapter.

Q&A: The Intelligent Investor – Chapter 14: Stock Selection for the Defensive Investor

The Intelligent InvestorBelow are my reflections and answers to the discussion questions posted at Modern Graham for chapter 14 – Stock Selection for the Defensive Investor – of the Intelligent Investor written by Benjamin Graham.

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

“His second choice would be to apply a set of standards to each purchase, to make sure that he obtains (1) a minimum of quality in the past performance and current financial position of the company, and also (2) a minimum of quantity in terms of earnings and assets per dollar of price.”

2. What do you think of Graham’s original requirements for Defensive Investors? Do you agree with the changes I’ve made for the ModernGraham approach?

I think Graham’s original requirements for the defensive investor look reasonable.

  • Adequate Size of the Enterprise: I would stick to annual sales as a measure of a company’s size. Graham used $100 million back in the beginning of the 1970’s, which equals about approximately $600 million today (calculated at http://www.usinflationcalculator.com/). So, I think that it seems appropriate to use a sales range of $600 million to $2 billion. Maybe for the defensive investor a sales range of $1-1,5 billion is suitable.
  • A Sufficiently Strong Financial Condition: Agree.
  • Earnings Stability: Agree.
  • Dividend Record: Agree.
  • Earnings Growth: 1/3 growth during the last ten years is a bit low I think. Maybe increase growth in earnings to 1/2 or 2/3.
  • Moderate Price/Earnings Ratio: I think an earnings multiplier of 15 is desirable, at least not above 20. An earnings multiplier between 15 to 20 times seems reasonable.
  • Moderate Ratio of Price to Assets: Agree.

3. Are there any other “modernizations” you would make to Graham’s requirements?

No, not at the moment. Maybe consider raising the growth in earnings to 1/2 or 2/3.

4. What did you think of the chapter overall?

One of the best so far.