WS: INTELLIGENT INVESTOR VI

INTELLIGENT INVESTOR VI

Three Recommendations for Enterprising Investors

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.


The Relatively Unpopular Large Company

If we assume that it is the habit of the market to overvalue common stocks which have been showing excellent growth or are glamorous for some other reason, it is logical to expect that it will undervalue-- relatively, at least-- companies that are out of favor because of unsatisfactory developments of a temporary nature. This may be set down as a fundamental law ot the stock market, and it suggests an investment approach that should prove both conservative and promising.

The key requirement here is that the enterprising investor concentrate on the larger companies that are going through a period of unpopularity. While small companies may 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.

A remarkable demonstration of the soundness of this thesis is found in studies of the price beahvior of the unpopular issues in the Dow Jones Industrial Average. In these it was assumed that an investment was made each year in either the six or the ten issues in the DJIA which were selling at the lowest multipliers of their current or previous year's earnings. These could be called the "cheapest" stocks in the list, and their cheapness was evidently the reflection of relative unpopularity with investors or traders. It was assumed further that these purchases were sold out at the end of holding periods ranging from one to five years. The results of these investments were then compared with the results shown in either the DJIA as a whole or in the highest multiplier (i.e., the most popular) group.

The detailed material we have available covers the results of annual purchases assumed in each of the past 53 years. In the early period, 1917-1933, this approach proved unprofitable. But since 1933 the method has shown highly successful results. In 34 tests made by Drexel & Company of one-year holding-- from 1937 through 1969-- the cheap stocks did definitely worse than the DJIA in only three instances; the results were about the same in six cases; and the cheap stocks clearly outperformed the average in 25 years. The consistently better performance of the low-multiplier stocks is shown (Table below) by the average results for successive five-year periods, when compared with those of the DJIA and of the ten high-multipliers.












The Drexel computation shows further that an original investment of $10,000 made in the low-multiplier issues in 1936, and switched each year in accordance with the principle, would have grown to $66,900 by 1962. The same operations in high-multiplier stocks would have ended with a value of only $25,300; while an operation in all thirty stocks would have increased the original fund to $44,000.

The concept of buying "unpopular large companies" and its execution on a group basis, as described above, are both quite simple. But in considering individual companies a special factor of opposite import must sometimes be taken into account. Companies that are inherently speculative because of widely varying earnings tend to sell both at a relatively high price and at a relatively low multiplier in their good years, and conversely at low prices and high multipliers in their bad years. In these cases the market has sufficient skepticism as to the continuation of the unusually high profits to value them conservatively, and conversely when earnings are low or nonexistent. (Note that, by the arithmetic, if a company earns "next to nothing" its shares must sell at a higher multiplier of those miniscule profits.) It would be quite easy to avoid inclusion of such anomalous issues in a low-multiplier list by requiring also that the price be low in relation to past average earnings or by some similar test.

Purchase of Bargain Issues

We define a bargain issue as one which, on the basis of facts established by analysis, appears to be worth considerably more than it is selling for. The genus includes bonds and preferred stocks selling well under par, as well as common stocks. To be as concrete as possible, let us suggest that an issue is not a true "bargain" unless the indicated value is at least 50% more than the price. What kind of facts would warrant the conclusion that so great a discrepancy exists? How do bargains come into existence, and how does the investor profit from them?

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.

At low points in the general market a large proportion of common stocks are bargain issues, as measured by these standards. It is true that current earnings and the immediate prospects may both be poor, but a levelheaded appraisal of average future conditions would indicate values far above ruling prices. Thus the wisdom of having courage in depressed markets is vindicated not only by the voice of experience but also by application of plausible techniques of value analysis.

The same vagaries of the market place that recurrently establish a bargain condition in the general list account for the existence of many individual bargains at almost all market levels. The market is fond of making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks. Even a mere lack of interest or enthusiasm may impel a price decline to absurdly low levels. Thus we have what appear to be two major sources of undervaluation:

(1) currently disappointing results and
(2) protracted neglect or unpopularity.

However, neither of these causes, if considered by itself alone, can be relied on as a guide to successful common-stock investment. How can we be sure that the currently disappointing results are indeed going to be only temporary? True, we can supply excellent examples of that happening. The steel stocks used to be famous for their cyclical quality, and the shrewd buyer could acquire them at low prices when earnings were low and sell them out in boom years at a fine profit.

If this were the standard behavior of stocks with fluctuating earnings, then making profits in the stock market would be an easy matter. Unfortunately, we could cite many examples of declines in earnings and price which were not followed automatically by a handsome recovery of both.

The many experiences of this type (Graham supplies several from the 1950s and 1960s) suggest that the invesetor would need more than a mere falling off in both earnings and price to give him a sound basis for purchase. He should require an indication of at least reasonable stability of earnings over the past decade or more-- i.e., no near of earnings deficit-- plus sufficient size and financial strength to meet possible setbacks in the future. The ideal combination here is thus that of a large and prominent company selling both well below its past average price and its past average price/earnings multiplier. This would no doubt have ruled out most of the profitable opportunities in companies since their low-price years are generally accompanies by high price/earnings ratios. But let us assure the reader now-- and no doubt we shall do it again-- that there is a world of difference between "hindsight profits" and "real-money profits."

A type of bargain issue that can be most readily identified is a common stock that sells for less than the company's net working capital alone, after deducting all prior obilgations. (By "net working capital," Graham means a company's current assets such as cash, marketable securities, and inventories minus its total liabilities including preferred stock and long-term debt.) This would mean that the buyer would pay nothing for all the fixed assets-- buildings, machinery, etc., or any good-will items that might exist. Very few companies turn out to have an ultimate value less than the working capital alone, although scattered instances may be found. The surprising thing, rather, is that there have been so many enterprises obtainable which have been valued in the market on this bargain basis. A compilation made in 1957, when the market's level was by no means low, disclosed about 150 of such common stocks.

BARGAINS IN SECONDARY COMPANIES and SPECIAL SITUATIONS...

...to be continued...


Credits: This article is extracted (with modifications) from Ben Graham's 1973 edition of The Intelligent Investor, Chapter 7.

POSTED :15 Jun 2006