WS: INTELLIGENT INVESTOR IX

INTELLIGENT INVESTOR IX

Stock Selection for the Enterprising Investor

In the previous article we discussed stock selection for a defensive investor. Our emphasis in selection has been chiefly on exclusions-- advision to avoid poor quality businesses, high PE ratios, etc (or just buy an index fund). In this article, addressed to the enterprising investor, we must consider the possibilities and the means of making individual selections which are likely to prove more profitable than an market index.

What are the prospects of 'beating the market' successfully? Graham always expressed "some grave reservations" on this score. At first blush the case for successful selection appears self-evident. To get average results-- e.g., equivalent to the market index-- should require no special ability of any kind. All that is needed is a portfolio identical with, or similar to, those prominent index component stocks. Surely, then, by the exercise of even a moderate degree of skill-- derived from study, experience, and native ability-- it should be possible to obtain substantially better results than the "dumb" index.

Yet there is considerable and impressive evidence that this is very hard to do, even though the qualifications of those trying it are of the highest. The evidence is provided by funds, which employ the best and brightest analysts and money managers, yet have a dismal track record against the "dumb" index. (Some recent studies of equity funds show that only 1 or 2 out of 10 funds can consistently beat the index over a number of years.) This does not invalidate the value of funds, for they do help many individual investors achieve near-market returns, which is far better than the average individual investor does on their own. However, the record of funds does indicate that 'beating the market' is in fact extremely difficult.

Why should this be so? Graham came up with two explanations. First is the possibility that the stock market does in fact reflect in the current prices not only all the important facts about the companies' past and current performance, but also whatever expectations can be reasonably formed as to their future. If this is so, then the diverse market movements which subsequently take place-- and these are often extreme-- must be the result of new developments and probabilities that could not be reliably foreseen. This would make the price movements essentially fortuitous and random. To the extent that this is true, the work of the stock analyst-- however intelligent and thorough-- must be largely ineffective, because in essence he is trying to predict the unpredictable.

The second possibility is of a quite different sort. Perhaps many of the security analysts are handicapped by a flaw in their basic approach to the problem of stock selection. They seek the industries with the best prospects of growth, and the companies in these industries with the best management and other advantages. If they buy these stocks, however high, and avoid less promising industries and companies no matter how low the price of their shares-- then the favored stocks will see prices rise to infinity and lesser companies will be headed for extinction.

The truth about our corporate ventures is quite otherwise. Extremely few companies have been able to show a high rate of uninterrupted growth for long periods of time. Remarkably few, also, of the larger companies suffer ultimate extinction. For most, their history is one of ups and downs, of change in their relative standings-- "rags to riches and back" stories of a cyclical nature.

Given all this, how does the enterprising investor go about making individual stock selections? Graham suggests that he first accept that he is taking on a difficult task. Readers of The Intelligent Investor (or this article), however intelligent and knowing, could scarcely expect to do a better job of portfolio selection than the top analysts in the world. But if it is true that a farily large segment of the stock market is often discriminated against or entirely neglected in the standard analytical selections, then the intelligent investor may be in a position to profit from the resultant undervaluations.

But to do so, warns Graham, will require one to follow methods not generally accepted on Wall Street (or in Raffles Place), since those that are so accepted do not seem to produce the results everyone would like to achieve. It would be rather strange if-- with all the brains at work professionally in the stock market-- there could be approaches which are both sound and relatively unpopular. Yet Graham's own career and reputation (and that of his many students, including Warren Buffett) have been based on this unlikely fact.

A Summary of the Graham-Newman Methods

Arbitrages: The purchase of a security and the simultaneous sale of one or more other securities into which it was to be exchanged under a plan of reorganization, merger, or the like.

Liquidations: Purchase of shares which were to receive one or more cash payments in liquidation of the company's assets. Operations of these two classes (arbitrages & liquidations) were selected on the twin basis of (a) a calculated annual return of 20% or more, and (b) our judgment that the chance of a successful outcome was at least four out of five.

Related Hedges: The purchase of convertible bonds or convertible preferred shares, and the simultaneous sale of the common stock into which they were exchangeable. The position was established at close to a parity basis-- i.e., at a small maximum loss if the senior issue had actually to be converted and the operation closed out in that way. But a profit would be made if the common stock fell considerably more than the senior issue, and the position closed out in the market.

Net-Current-Asset (or "Bargain") Stocks: The idea here was to acquire as many issues as possible at a cost for each of less than their book value in terms of net-current-assets alone-- i.e., giving no value to the plant account and other assets. Our purchases were made typically at two-thirds or less of such stripped-down asset value. In most years we carried a wide diversification here-- at least 100 different issues.


Graham hesitates to prescribe his own diet for any large number of intelligent investors. Obviously, the professional techniques he followed are not suitable for the defensive investor, who by definition is an amateur. As for the aggressive investor, perhaps only a small minority of them would have the type of temperament needed to limit themselves so severaly to only a relatively small part of the world of securities. Most active-minded practitioners would prefer to venture into wider channels. Their natural hunting grounds would be the entire field of securities that they felt (a) were certainly not overvalued by conservative measures, and (b) appeared decidedly more attractive-- because of their prospects or past record, or both-- than the average stock.

In such choices they would do well to apply various tests of quality and price-reasonableness along the lines of what Graham proposed for the defensive investor. But they should be less inflexible, permitting a considerable plus in one factor to offset a small black mark in another. For example, one might not rule out a company which had shown a deficit in a year such as 1970, if large averge earnings and other important attributes made the stock look cheap. The enterprising investor may confine his choice to industries and companies about which he holds an optimistic view, but Graham counsels strongly against paying a high price for a stock (in relation to earnings and assets) because of such enthusiasm.

Secondary Companies...

... to be continued...


Credits: This article is extracted, with modifications, from Ben Graham's 1973 edition of The Intelligent Investor, Chapter 15.

POSTED :21 Jun 2006