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: 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

dempster

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!

Are You Stuck In the Past? Or Is Benjamin Graham Still Relevant in 2015?

Is Benjamin Graham still relevant in 2015? Or is he not? Maybe just to some extent, or is Benjamin Graham more relevant now than he has ever been before?

Maybe these are just another redundant questions, or could they be the most important ones to ask yourself. Asking questions often means trying to find new answers, new answers regarding circumstances not considered earlier, or as a way of questioning your own beliefs and the way you look at things around you.

Why am I asking this question to myself—Is Benjamin Graham still relevant in 2015? Does it really matter? Maybe not everyone. But to all of us trying to improve our value investing skills by following the investment concepts laid out by Benjamin Graham, the question is of utmost relevance I believe. Why? Because if they are not relevant today in 2015, we have to go looking for other sources of knowledges to serve as our main guide out in the investing sphere.

Albert Einstein said:

The important thing is not to stop questioning. Curiosity has its own reason for existing.

John Maynard Keynes said:

When my information changes, I alter my conclusions. What do you do, sir?

Keynes also said:

The difficulty lies not so much in developing new ideas as in escaping from old ones.

From the above quotes, we should keep in mind the importance of “not to stop questioning” from Einstein, and also that we always have to be prepared to “alter [our] conclusions” when “[our] information changes” from Keynes. But, this may be easier said than done, as implied by the last Keynes quote, that the greatest danger when it comes to new ideas, even if our new ideas are hard to come by, might be escaping from the old ones. Why is that?

In his speech—The Psychology of Human Misjudgment—at Harvard Bussiness School in June 1995 Charlie Munger was, among other kinds of biases, talking about the bias from commitment and consistency tendency as (emphasis added) “…a superpower in error-causing psychological tendency: bias from consistency and commitment tendency, including the tendency to avoid or promptly resolve cognitive dissonance. Includes the self-confirmation tendency of all conclusions, particularly expressed conclusions, and with a special persistence for conclusions that are hard-won.”

Charlie also said that (emphasis added) “The human mind is a lot like the human egg, in that the human egg has a shut-off device. One sperm gets in, and it shuts down so that the next one can’t get in. The human mind has a big tendency of the same sort … According to Max Plank, the really innovative and important new physics was never really accepted by the old guard. Instead, a new guard came along that was less brain-blocked by its previous conclusions. And if Max Plank’s crowd had this consistency and commitment tendency that kept their old conclusions intact despite disconfirming evidence, you can imagine what the crowd that you and I are a part of behaves like … What people are shouting out they are pounding in.” 

The most important thing (as Howard Marks would have said) is to:

  1. Never stop asking questions.
  2. Be aware of the consistency and commitment bias and how it affects us.
  3. Be willing to change your mind when the facts change. The “truths” of yesterday may, or will certainly, not be the “truths” of today or the future.

So, is Benjamin Graham relevant? I do think so. Of course not everything he said or put down on paper or in his books is relevant, but the main ideas still seem to serve the ones willing to listen rather good.

For the article that sparkled my mind about the topic of this post, see Net Net Hunter’s article Is Benjamin Graham Still Relevant in 2015?

To read about some of the concepts of Benjamin Graham, see here:

Another great read is What Has Worked in Investing from Tweedy, Browne Company LLC.

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.

Ben Graham’s Net Nets: Seventy-Five Years Old and Outperforming

Ben Graham’s Net Nets: Seventy-Five Years Old and Outperforming

Abstract

NN1The strategy of buying and holding “net nets” has been advocated by deep value investors for decades, but systematic studies of the returns to such a strategy are few. We detail the returns generated from a net nets strategy implemented from 1984 – 2008, and then attempt to explain the excess returns (alpha) generated by the net nets strategy. We find that monthly returns amount to 2.55%, and excess returns using a simple market model amount to 1.66%. Monthly returns to the NYSE-AMEX and a small-firm index amount to 0.85% and 1.24% during the same time period. We conclude by examining potential factors to explain the excess returns on the net nets strategy. We examine the market risk premium, small firm premium, value premium, momentum, long-term reversal, liquidity factors, and the January effect. Of the various pricing factors, we find only the market risk premium, small firm premium, and liquidity factor are significant. We also note about half of the returns are earned in January. However, inclusion of these factors still does not explain the excess return available from the net nets strategy. Thus, we are left with a puzzle.

Links

See here for full PDF.

See here for Tobias Carlisle’s blog Greenbackd.

Disclosure: I wrote this article myself. 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. Always do your own due diligence and contact a financial professional before executing any trades or investments.

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.

Danny DeVito Explaining Value Investing Benjamin Graham Style (Other People’s Money)

Danny DeVito Explaining Value Investing Benjamin Graham Style (Other People’s Money)

One More From Other People’s Money by Danny DeVito

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.

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 19: Shareholders and Management: Dividend Policy

TII1Below are my reflections and answers to the discussion questions posted at Modern Graham for chapter 19 – Shareholders and Managements: Dividend Policy – of the Intelligent Investor written by Benjamin Graham.

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

“Shareholders are justified in raising questions as to the competence of the management when the results (1) are unsatisfactory in themselves, (2) are poorer than those obtained by other companies that appear similarly situated, and (3) have resulted in an unsatisfactory market price of long duration.” 

2. Do you consider yourself to be adequately active in your management role as an owner of your investments?

Yes.

3. In your opinion, will the general investor ever become more involved in management?

Sad but true, I do not expect that to happen, even though I hope I’m wrong here.

4. What did you think of the chapter overall?

Not much to say about this chapter. Important issues, even though a more extended discussion would have been great.

Both the choice and evaluation of management, and capital allocation considerations in forms of dividends are very important areas for each and every investor to assess and evaluate, and the chapter provides at least a glimpse of some important things that always should be considered.

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.