Value investing in the current market part II

The heading on this blog post is misleading. Value investing will always adhere to the same principles, no matter what the current market trend is. So what’s the basic principle of a value investment? According to Graham, it is an operation that promises to preserve the principal, and in addition deliver a satisfactory return. Any other purchase is not an investment, but speculation. A promise here is not a solid guarantee, but something, after a carefully study, that can be estimated as more or less certain.

Some factors that makes a company more resilient in hard times is sufficient earnings to cover its debt with a large margin, and a dominant size in its industry.

A few quotes from the book:

  • “It is our view that stock-market timing cannot be done, with general success, unless the time to buy is related to an attractive price level, as measured by analytical standards.”
  • “Similarly, the investor must take his cue to sell primarily not from so- called technical market signals but from an advance in the price level beyond a point justified by objective standards of value.”
  • “Yet we cannot avoid the conclusion that the most generally accepted principle of timing—viz., that purchases should be made only after an upswing has definitely announced itself—is basically opposed to the essential nature of investment. Traditionally the investor has been the man with patience and the courage of his convictions who would buy when the harried or disheartened speculator was selling. If the investor is now to hold back until the market itself encourages him, how will he distinguish himself from the speculator, and wherein will he deserve any better than the ordinary speculator’s fate?”

So Graham believes the number one priority of an investment is to avoid a loss. Avoiding serious loss is a precondition for sustaining a high compound rate of growth. Taking a high risk, in hope of a high return, focusing on the upside, instead of the potential downside is dangerous.

Graham and Dodd also said that: “in terms of forecasting the course of stock prices, book value was “almost worthless as a practical matter.” However Graham frequently found securities that, solely on the basis of their assets and after putting them to hard study, met the safety-of- principal test.

On valuation:

  • companies with stable earnings are easier to forecast and hence preferable
  • the more volatile a firm’s earnings, the more cautious one should be in estimating its future and the further back into its past one should look. Graham and Dodd suggested 10 years.
  • A firm’s average earnings can provide a rough guide to the future; the earnings trend is far less reliable. (Average earnings takes into account business cycles)
  • both the balance sheet and the statement of cash flow will throw significant light on the number that Wall Street pays the most attention to, the reported earnings.
“Cooking the books”

Where this book is outdated is on cash flow statements. The income statement gives the company’s accounting profit; the cash flow statement reports what happened to its money. Companies that try to cook the books such as Enron or Waste Management can always dress up the earnings statement, at least for a while. But they can’t manufacture cash. Thus, when the income statement and the cash flow statement start to diverge, it’s a signal that something is amiss. As an example, when Lucent technology “sold” their PBX to customers in developing countries. It was, in effect, loaning them out pending payment. Though these “sales” were booked into earnings, once again, the cash flow statement didn’t lie.

Here I have tried to state som of the more general rules of the book. It is by no means exhaustive, but things I have found useful. Perhaps sometime later, I will dive into more details, in another post.

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