Category Archives: Investment philosophy

Benjamin Graham on dollar-cost averaging

In Chapter 5 (The Defensive Investor and Common Stocks) of The Intelligent Investor, Benjamin Graham, the father of value investing, touched on various aspects of defensive investment, among which was dollar-cost averaging, an application of a “formula investment”.

Elaborating, he said: “The New York Stock Exchange has put considerable effort into popularizing its ‘monthly purchase plan’, under which an investor devotes the same dollar amount each month to buying one or more common stocks.”

“During the predominantly rising-market experience since 1949 the results from such a procedure were certain to be highly satisfactory, especially since they prevented the practitioner from concentrating his buying at the wrong times,” added Benjamin Graham.

The father of value investing cited a comprehensive study of formula investment plans in which the author Lucile Tomlinson presented a calculation of the results of dollar-cost averaging in the group of stocks making up the Dow Jones industrial index. The average indicated profit at the end of 23 ten-year buying periods was 21.5 per cent, exclusive of dividends received. There were of course some instances of a substantial temporary depreciation at market value.

The author of the study said: “No one has yet discovered any other formula for investing which can be used with so much confidence of ultimate success, regardless of what may happen to security prices, as Dollar Cost Averaging.”

When it comes to stocks, Berkshire Hathaway looks for wonderful companies

“Woody Allen once explained that the advantage of being bi-sexual is that it doubles your chance of finding a date on Saturday night,” Warren Buffett said in his FY2015 letter to Berkshire Hathaway. Why did the Berkshire Hathaway chairman say this?

“In like manner – well, not exactly like manner – our appetite for either operating businesses or passive investments doubles our chances of finding sensible uses for Berkshire’s endless gusher of cash. Beyond that, having a huge portfolio of marketable securities gives us a stockpile of funds that can be tapped when an elephant-sized acquisition is offered to us,” Mr Buffett continued.

A stockpile of funds from marketable securities?

Yes a stockpile. “Berkshire increased its ownership interest last year in each of its “Big Four” investments – American Express, Coca-Cola, IBM and Wells Fargo. We purchased additional shares of IBM (increasing our ownership to 8.4% versus 7.8% at yearend 2014) and Wells Fargo (going to 9.8% from 9.4%). At the other two companies, Coca-Cola and American Express, stock repurchases raised our percentage ownership. Our equity in Coca-Cola grew from 9.2% to 9.3%, and our interest in American Express increased from 14.8% to 15.6%. In case you think these seemingly small changes aren’t important, consider this math: For the four companies in aggregate, each increase of one percentage point in our ownership raises Berkshire’s portion of their annual earnings by about $500 million.”

The legendary investor’s subsequent FY2016 letter to Berkshire Hathaway shows the stakes in these Big Four as at end-2016 were: American Express 16.8%, Coca-Cola 9.3%, IBM 8.5% and Wells Fargo 10%. Apple Inc stocks also came into Berkshire Hathaway’s radar screen, with the group owning a stake of 1.1%, which, according to a CNBC report on Feb 27, 2017, had grown in January 2017 to 2.5%. “At this point, Buffett owns US$17 billion worth of the tech giant’s stock,” said the report.

What does Berkshire Hathaway look for in marketable securities?
On the Big Four in the FY2015 letter, Mr Buffett said that the four investees possess excellent businesses and are run by managers who are both talented and shareholder-oriented. “Their returns on tangible equity range from excellent to staggering. At Berkshire, we much prefer owning a non-controlling but substantial portion of a wonderful company to owning 100% of a so-so business. It’s better to have a partial interest in the Hope Diamond than to own all of a rhinestone,” said Mr Buffett.

The Berkshire Hathaway chairman said that if Berkshire’s yearend holdings were used as the marker, its portion of the “Big Four’s” 2015 earnings amounted to US$4.7 billion. “In the earnings we report to you, however, we include only the dividends they pay us – about $1.8 billion last year. But make no mistake: The nearly $3 billion of these companies’ earnings we don’t report are every bit as valuable to us as the portion Berkshire records.”

The earnings of Berkshire’s investees retain are often used for repurchases of their own stock – a move that increases Berkshire’s share of future earnings without requiring it to lay out a dime. “The retained earnings of these companies also fund business opportunities that usually turn out to be advantageous. All that leads us to expect that the per-share earnings of these four investees, in aggregate, will grow substantially over time. If gains do indeed materialize, dividends to Berkshire will increase and so, too, will our unrealized capital gains.”

This investment philosophy gives Berkshire Hathaway a significant edge, explained by Mr Buffett this way: “Our flexibility in capital allocation – our willingness to invest large sums passively in non-controlled businesses – gives us a significant edge over companies that limit themselves to acquisitions they will operate.”

Seven stock investing mistakes to avoid: Pat Dorsey

It takes many great stock picks to make up for just a few big errors, says Pat Dorsey, author of The Five Rules for Successful Stock Investing. So even before one goes into any analysis process, care should be taken to avoid seven easily avoidable mistakes.
Here is Pat Dorsey’s list of seven mistakes to avoid:
1. Swinging for the fences.
2. Believing that it is different this time.
3. Falling in love with products.
4. Panicking when the market is down.
5. Trying to time the market.
6. Ignoring valuation.
7. Relying on earnings for the whole story.

Benjamin Graham Theory Of Diversification

In investment, having a margin of safety itself is not sufficient.  Why is this so?

Benjamin Graham, the founder of value investing, uses the simple basis of the insurance-underwriting business to explain the need for diversification. He said that  diversification is the companion of margin of safety. In other words, margin of safety and diversification go side by side.

Benjamin Graham put it this way:  “Even with a margin in the investor’s favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss  –  not that loss is impossible. But as the number of such commitments is increased, the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses. That is the simple basis of the insurance-underwriting business.”

The founder of value investor added that diversification is an established tenet of conservative investment.

Benjamin Graham uses the arithmetic of American roulette to explain when diversification is foolish.  In American roulette,  most wheels use “0” and “00” along with numbers “1” through “36”. There are therefore 38 slots. A person betting $roulette1 on a single number will be paid $35 when he wins but the chances are 37 to one that he will lose. The player thus has a “negative margin of safety”. The more number he bets on, the smaller his chance of ending with a profit.  If he regularly bets $1 on every number (including 0 and 00), he is certain to lose $2 on each turn of the wheel.  Diversification in this case is therefore foolish.  Suppose the winner received $39 profit instead of $35. In this case, he would have a small but important margin of safety. Therefore the more numbers he wagers on, the better the chance of gain.

Bottom line: What Benjamin Graham was saying is that margin of safety goes hand in hand with diversification.


 

Margin of Safety: Secret of Sound Investment

Benjamin Graham's teacher and friend. Mr Graham used Mr. Market as the character to personify the behavior of the stock market. Photo: Wikipedia.
Benjamin Graham – Wikipedia

Benjamin Graham (May 8, 1894 – September 21, 1976), the father of value investing, in his book, The Intelligent Investor, summed up the secret of sound investment in three words: margin of safety. Warren Buffett, Benjamin Graham’s most famous disciple, explained his mentor’s margin of safety concept this way (Source: The Superinvestors of Graham-and-Doddsville by Warren E. Buffett): “You don’t try and buy businesses worth $83 million for $80 million. You leave yourself an enormous margin (of safety). When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing.”

In Chapter 20 (“Margin of Safety” as the Concept of Investment”) of The Intelligent Investor, Benjamin Graham summed up the chapter by saying: “Investment is most intelligent when it is most businesslike”.

“If a person sets out to make profits from security purchases and sales, he is embarking on a business venture of his own, which must be run in accordance with accepted business principles if it is to have a chance of success,” said Benjamin Graham. In other words, view a corporate security as an ownership interest in a specific business enterprise.

Benjamin Graham listed four sound business principles and explained how they were related to the securities investor:

(1) “Know what you’re doing – know your business.” Benjamin Graham said that the investor should not try to make “business profits” out of securities – that is, returns in excess of normal interest and dividend income – unless “you know as much about security values as you would need to know about the value of merchandise that you proposed to manufacture or deal in”.

(2) “Do not let anyone else run your business, unless (1) you can supervise his performance with adequate care and comprehension or (2) you have unusually strong reasons for placing implicit confidence in his integrity and ability.” For the investor, it means understanding the conditions under which he will permit someone to decide what is done with his money.

(3) “Do not enter upon an operation – that is, manufacturing or trading in an item – unless a reliable calculation shows that it has a fair chance to yield a reasonable profit. In particular, keep away from ventures in which you have little to gain and much to lose.” The enterprising investor should make sure that his operations for profit should not be based on optimism but on arithmetic. For every investor who limits his return to a small figure, such as in a conventional bond or preferred stock – he needs to ask for convincing evidence that he is not risking a substantial part of his principal.

(4) “Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it – even others may hesitate or differ.” “In the securities world, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand,” said Benjamin Graham.

Related post: Benjamin Graham’s theory of diversification


Benjamin Graham on stock selection for the defensive investor

The Intelligent Investor Chapter 14 – Stock Selection for the Defensive Investor

1.  Adequate Size of the Enterprise

The idea is to exclude small companies which may be subject to more than average vicissitudes especially in the industrial field.

(I) Not less than S$100 million of annual sales for an industrial company and, not less than $50 million of total assets for a public utility.

(Note:  These figures in 2015 are approximately $600 million and $300 million respectively. Veteran investment writer Jason Zweig in his accompanying commentary for Benjamin Graham’s The Intelligent Investor, Chapter 14 said: “Nowadays, “to exclude small companies,” most defensive investors should steer clear of stocks with a total market value of less than $2 billion.” Jason Zweig  also said: “However, today’s defensive investors – unlike those in Graham’s days – can conveniently own small companies by buying a mutual fund specializing in small stocks.”).

2. A Sufficiently Strong Financial Condition
According to Benjamin Graham, for industrial companies, current assets should be at least twice current liabilities – a so-called two-to-one current ratio. Also, long-term debt should not exceed the net current assets (or working capital). For public utilities, the debt should not exceed twice the stock equity (at book value).

3. Earnings Stability
Some earnings for the common stock in each of the past ten years.

4. Dividend Record
Uninterrupted payments for at least the past 20 years.

5. Earnings Growth
A minimum increase of at least one-third in per-share earnings in the past ten years using three-year averages at the beginning and end.

6. Moderate Price/Earnings Ratio
Current price should not be more than 15 times average earnings of the past three years.

7. Moderate Ratio of Price to Assets
Benjamin Graham said that current price should not be more than 1.5 times the book value last reported. However, a multiplier of earnings below 15 could justify a correspondingly higher multiplier of assets. “As a rule of thumb,” he said, ” we suggest that the product of the multiplier times the ratio of price to book value should not exceed 22.5 (this figure corresponds to 15 times earnings and 1.5  times book value. It would admit an issue selling at only 9 times earnings and 2.5 times asset value, etc.).”