Wednesday, December 31, 2008

Commandments for the individual investor

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Commandments for the individual investor

Wednesday, 03 March , 2004, 15:07

Commandments for the individual investor

Benjamin Graham, the father of value investing. Graham’s own books are investment classics. Securities Analysis (first published in 1934) and The Intelligent Investor (first published in 1949) continue to sell steadily. In addition to this legacy, he has permanently influenced many successful investors, including Warren Buffett, the wealthiest man in America; William Ruane, founder of the super-successful Sequoia Fund; and well-known investor Walter Schloss.

Ben was a prophet in a very specialized but important realm of life. He preached commandments that any investor can use as stars when navigating the vast and mysterious seas of the investment world. An individual investor, who is not under pressure to shoot comets across the heavens but would like to earn a smart and substantial return, especially can benefit from Ben’s guidance. In greatly simplified terms, here are the 14 points Graham most consistently delivered in his writing and speaking. Some of the counsel is technical, but much of it is aimed at adopting the right attitude:

1. Be an investor, not a speculator

“Let us define the speculator as one who seeks to profit from market movements, without primary regard to intrinsic values; the prudent stock investor is one who (a) buys only at prices amply supported by underlying value and (b) determinedly reduces his stock holdings when the market enters the speculative phase of a sustained advance.”

Speculation, Ben insisted, had its place in the securities markets, but a speculator must do more research and tracking of investments and be prepared for losses if they come.

2. Know the asking price

Multiply the company’s share price by the number of company total shares (undiluted) outstanding. Ask yourself, if I bought the whole company would it be worth this much money?

3. Rake the market for bargains

Graham is best known for using his “net current asset value” (NCAV) rule to decide if the company was worth its market price.

To get the NCAV of a company, subtract all liabilities, including short-term debt and preferred stock, from current assets. By purchasing stocks below the NCAV, the investor buys a bargain because nothing at all is paid for the fixed assets of the company. The 1988 research of Professor Joseph D. Vu shows that buying stocks immediately after their price drop below the NCAV per share and selling two years afterward provides an excess return of more than 24 percent.

Yet even Ben recognized that NCAV stocks are increasingly difficult to find, and when one is located, this measure is only a starting point in the evaluation. “If the investor has occasion to be fearful of the future of such a company,” he explained, “it is perfectly logical for him to obey his fears and pass on from that enterprise to some other security about which he is not so fearful.”

Modern disciples of Graham look for hidden value in additional ways, but still probe the question, “what is this company actually worth?” Buffett modifies the Graham formula by looking at the quality of the business itself. Other apostles use the amount of cash flow generated by the company, the reliability and quality of dividends and other factors.

4. Buy the formula

Ben devised another simple formula to tell if a stock is underpriced. The concept has been tested in many different markets and still works.

It takes into account the company’s earnings per share (E), its expected earnings growth rate (R) and the current yield on AAA rated corporate bonds (Y).

The intrinsic value of a stock equals:

E(2R + 8.5) x Y/4

The number 8.5, Ben believed, was the appropriate price/to/earnings multiple for a company with static growth. P/E ratios have risen, but a conservative investor still will use a low multiplier. At the time this formula was printed, 4.4 percent was the average bond yield, or the Y factor.

5. Regard corporate figures with suspicion

It is a company’s future earnings that will drive its share price higher, but estimates are based on current numbers, of which an investor must be wary. Even with more stringent rules, current earnings can be manipulated by creative accountancy. An investor is urged to pay special attention to reserves, accounting changes and footnotes when reading company documents. As for estimates of future earnings, anything from false expectations to unexpected world events can repaint the picture. Nevertheless, an investor has to do the best evaluation possible and then go with the results.

6. Don’t stress out

Realize that you are unlikely to hit the precise “intrinsic value” of a stock or a stock market right on the mark. A margin of safety provides peace of mind. “Use an old Graham and Dodd guideline that you can’t be that precise about a simple value,” suggested Professor Roger Murray. "Give yourself a band of 20 percent above or below, and say, “that is the range of fair value.”

7. Don’t sweat the math

Ben, who loved mathematics, said so himself: “In 44 years of Wall Street experience and study, I have never seen dependable calculations made about common stock values, or related investment policies, that went beyond simple arithmetic or the most elementary algebra. Whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience, and usually also to give speculation the deceptive guise of investment.”

8. Diversify, rule #1

“My basic rule,” Graham said, “is that the investor should always have a minimum of 25 percent in bonds or bond equivalents, and another minimum of 25 percent in common stocks. He can divide the other 50 percent between the two, according to the varying stock and bond prices.” This is ho-hum advice to anyone in a hurry to get rich, but it helps preserve capital. Remember, earnings cannot compound on money that has evaporated.

Using this rule, an investor would sell stocks when stock prices are high and buy bonds. When the stock market declines, the investor would sell bonds and buy bargain stocks. At all times, however, he or she would hold the minimum 25 percent of the assets either in stocks or bonds — retaining particularly those that offer some contrarian advantage.

As a rule of thumb, an investor should back away from the stock market when the earnings per share on leading indices (such as the Dow Jones Industrial Average or the Standard & Poor’s composite index) is less than the yield on high-quality bonds. When the reverse is true, lean toward bonds.

9. Diversify, rule #2

An investor should have a large number of securities in his or her portfolio, if necessary, with a relatively small number of shares of each stock. While investors such as Buffett may have fewer than a dozen or so carefully chosen companies, Graham usually held 75 or more stocks at any given time. Ben suggested that individual investors try to have at least 30 different holdings, even if it is necessary to buy odd lots. The least expensive way for an individual investor to buy odd lots is through a company’s dividend reinvestment program (DRP).

10. When in doubt, stick to quality

Companies with good earnings, solid dividend histories, low debts and reasonable price/to/earnings ratios serve best. “Investors do not make mistakes, or bad mistakes, in buying good stocks at fair prices,” Ben said. “They make their serious mistakes by buying poor stocks, particularly the ones that are pushed for various reasons. And sometimes — in fact, very frequently — they make mistakes by buying good stocks in the upper reaches of bull markets.”

11. Dividends as a clue

A long record of paying dividends, as long as 20 years, shows that a company has substance and is a limited risk. Chancy growth stocks seldom pay dividends. Furthermore, Ben contended that no dividends or a niggardly dividend policy harms investors in two ways. Not only are shareholders deprived of income from their investment, but when comparable companies are studied, the one with the lower dividend consistently sells for a lower share price. “I believe that Wall Street experience shows clearly that the best treatment for stockholders,” Ben said, “is the payment to them of fair and reasonable dividends in relation to the company’s earnings and in relation to the true value of the security, as measured by any ordinary tests based on earning power or assets.”

12. Defend your shareholder rights

“I want to say a word about disgruntled shareholders,” Ben said. “In my humble opinion, not enough of them are disgruntled. And one of the great troubles with Wall Street is that it cannot distinguish between a mere troublemaker or “strike suitor” in corporate affairs and a stockholder with a legitimate complaint that deserves attention from his management and from his fellow stockholders.” If you object to a dividend policy, executive compensation package or golden parachutes, organize a sharcholder’s offensive.

13. Be Patient

“... every investor should be prepared financially and psychologically for the possibility of poor short-term results. For example, in the 1973-1974 decline the investor would have lost money on paper, but if he’d held on and stuck with the approach, he would have recouped in 1975-1976 and gotten his 15 percent average return for the five-year period.”

14. Think for yourself

Don’t follow the crowd. “There are two requirements for success in Wall Street,” Ben once said. “One, you have to think correctly; and secondly, you have to think independently.”

Finally, continue to search for better ways to ensure safety and maximize growth.

Do not ever stop thinking.