Thursday, January 21, 2010

Chapter 8: The Investor and Market Fluctuations

Short term bonds have less fluctuations than long term bonds. Stocks are certainly no exception. Investors should be aware of such possible fluctuations and be ready to profit from it. This can
be achieved either by time or pricing.

Timing involves a forecast of the stock market's direction. Pricing involves comparison of a stock's price to its fair value. Due to the very nature of timing, it is possible to be become a speculator instead of an investor. A few people can indeed make money via timing, but for the majority, timing is generally not a money-making option.

Buy low, sell high: In theory, it is possible to buy stocks after a market correction has occurred and sell after a market has advanced. On practical terms though, it is not possible to expect an investor to wait for a correction just so that he/she could buy stocks.

Every investor must expect to experience fluctuations in the stock market. Stocks of smaller companies fluctuate more than of big companies. But this does not mean small companies will fare poorly over a long period of time. As the market advances, it is recommended that an investor sell stocks and move into bonds and do the opposite as the market declines.

Business and stock market valuations: An investor can consider business valuation as a fractional owner of the underlying business. On the other hand, market valuation is dictated by the daily quotes. In general, good quality stocks can lead to increased speculation on market valuations. An investor who thinks as a fractional owner can consider the stock market as a business partner, "Mr. Market". Mr. Market provides quotes everyday and it is up to the investor to act accordingly.

Tuesday, November 11, 2008

Chapter 7: Portfolio policy for the enterprising investor: positive side

An enterprising investor has the following characteristics:

1. Buy low, sell high.
2. Buy well researched growth stocks
3. Buy bargain stocks
4. Buy “special situations"

“Buy low, sell high” idea appears simple in nature. But in order to take advantage of market fluctuations, an investor needs to have mental competence to buy stocks with depressed prices in a bear market.

A growth stock, by definition, is expected to perform better than the market average. Thus, it would seem only natural for an investor to buy only growth stocks. Unfortunately, there are two problems. The first is that growth stocks sell at high prices and it is easy for an investor to overpay. The second is that, the anticipated growth might not occur in future.

Since markets tend to overvalue growth stocks, it is logical to assume that markets tend to undervalue stocks that are out of favor. However, it is possible that stocks of small companies are undervalued for a reason and they may never regain their highest prices. Large companies with undervalued stocks, on the other hand, have financial and human capital to bring them back to a satisfactory earnings base.

Purchase of bargain stocks
A stock is considered a bargain if it sells for more than 50% discount to its value. But how is value determined? The first method to evaluate is by appraisal which relies on estimating future earnings and then multiplying these earnings by an appropriate factor. The second method to evaluate is to consider the worth of the underlying business to a private owner. This method puts emphasis on net current assets or working capital.

Tuesday, October 14, 2008

Chapter 6: Portfolio policy for the enterprising investor: negative approach

Both aggressive and defensive investors should start from the same foundation i.e. high-grade bonds and high-grade stocks which have been bought with margin of safety. With enough business justification, an aggressive investor can also venture into other kinds of investments. The selection of the investment can be based on competence, interests and preferences.
Having said that, an aggressive investor should avoid inferior bonds, foreign bonds, new stocks (IPOs) and convertibles. Second-grade bonds, even with discounted prices, compete with reliable stocks. Thus, enterprising investors might as well invest in high-grade bonds selling at a discount. This way, he will have both income and a high probability for price appreciation. Just to give an example on how lethal second-grade bonds can be, Ben Graham mentions ten income bonds lost a third of its value in 1947 even though the underlying businesses had better earnings in the same year. Thus it is never a good idea to buy second-grade bonds at par just to earn a slightly higher interest when there is a possibility of complete wipe-out of the principal. However, it might make sense to buy the bonds under par.

Investors should not be concerned with high-grade foreign government bonds such as from Australia. However, during times of trouble, an investor often has no legal means of enforcing claims.

Investors should be cautious of new issues as they are sold in optimum conditions for the underlying businesses. There is also a special "salesmanship"
that goes with the new issues.

Thursday, October 2, 2008

Chapter 5: The Defensive Investor and Common Stocks

Rules for the defensive investor:
1. In order to have diversification, an investor should have 10 to 30 different stocks.

2. The underlying company should be large and managed conservatively. "Large" can be defined as market capitalization of 10B$ in today's market.

3. The underlying company should have a long track of paying dividends.

4. Maintain margin of safety on the purchase price of a stock. As an example, set a limit of 25 times average earnings over the past 7 years and less than 20 times of the earnings in the last 12 months.

By reading point #4 above, by definition, a growth stock is expected to continue with increase in per-share earnings in the future and this increase is already factored in the stock price. Therefore, there is a speculative element in buying growth stocks.

Concept of "risk"
Risk and safety can be applied in different context when it comes to stocks and bonds. When a bond defaults on its interest and principal payments, it has deemed unsafe. Likewise, when there is a reduction of dividend on an underlying stock, that stock is deemed unsafe since there were expectation of dividend payments.

The concept of risk applies to a decline in the stock price even though the decline may be temporary. But this may not be a true risk in the general sense of the word. True risk occurs when there is a possibility of losing money either through an actual sale or a deterioration in the underlying business.

Sunday, September 28, 2008

Fourth chapter: General portfolio policy, the defensive investor

There is an old principle out there that low risk takers should be content with a matching low returns on their investments. However, Ben Graham says that the rate of return depends on the intelligent efforts an investor is willing to undertake. Passive investors, who want both safety and freedom, should expect minimum return. An active investor with intelligence and skill can realize maximum return.

A defensive investor should allocate his funds in 2 areas : high-grade bonds and high-grade stocks. He should not have less than 25% or more than 75% in common stocks with the rest in bonds. Therefore, a common medium point would likely be 50%-50%. The percentage in stocks can go up if the market goes down and the investor sees bargains.
In real life though, most of the investors face a tough time buying bargain stocks during a bear market because they would have to go against the very human nature that produces market bulls and bears. Due to this reason, Ben Graham recommends a 50%-50% oversimplified investment portfolio.

Bonds : as far as bonds go, there are many considerations that need to be accounted for. For instance, should an investor buy taxable or tax-free bonds, long term maturity or short term? The decision can be based on the difference in yields compared to the investor's tax bracket. As an example, if the investor is in the maximum tax bracket, he will be better off buying tax-free municipal bonds than corporate bonds which will be subject to taxes.

The choice on long term to short term maturities depends on factors such as a steady, but lower annual yield (for long term) and the opportunity cost for a possible gain in principal value (again for long term).

Ben Graham has provided examples of savings bonds such as Series E and Series H and I will not elaborate them on this article since bonds may have drastically changes after so many years.

Monday, September 22, 2008

Third Chapter: A century of stock market history

The third chapter shows the manner in which stocks have advanced through many ups and downs in the past century. It shows the stock market picture in terms of 10-year averages with respect to earnings, dividends and stock prices. From 1900 to 1970, there are 3 patterns each covering a third of the 70 years. The first pattern begins in 1900 and finishes in 1924. Annual advance in this period averaged approximately 3% (S&P).

The Great Depression began in 1929 and there were irregular fluctuations in the stock market till 1949. The annual advance was 1.5% (S&P). 1949 marked the end of the second pattern.

The third pattern was in the midst of a great bull market from 1949 to 1968. Annual advance rate was 11% to early 1966 (S&P).
Such a return caused investors to expect similar results in the future and on the contrary, the market declined 36% by 1970 (S&P).

As far as earnings and dividends go, only 2 decades out of the 9 decades had a decrease in earnings (1891-1900 and 1931-1940). There is no decade after 1900 that shows a decrease in average dividends. The rates of growth in all these periods were far from a steady number. An investor can't tell what gain he/she would expect in future by looking at these different periods.

By looking at the past-century history of the stock market, there is no guarantee of any return going into the future. Each investor must make his own decision and accept his investing responsibility. The investor should not borrow money to buy stocks. He should also reduce stock holdings in his portfolio to a maximum of 50% of the portfolio. The other 50% would go to bonds.

Friday, September 19, 2008

Second chapter : The investor and inflation

Inflation usually relates to an increase of prices of commodities over a certain period of time. Inflation erodes the return on an investment and income. There is no direct correlation between inflation and earnings rate on capital. Earnings have shown no tendency to increase with inflation. If anything, as the corporate debt increases, interest rates will increase too. So, debt has become the real problem of a company.
Having said that, there is no guaranteed way of using common stocks as a hedge against inflation. The only thing guaranteed is that average market value of a stock will not grow at any uniform rate.

There can be other alternatives for hedging against inflation like real estate. Evidently, even real estate is subject to fluctuations as being experienced in the US. Serious problems can be avoided by buying real estate with a margin of safety in a right location.

Conclusion is that, an investor can't put all his eggs in one basket and must have some kind of insurance against inflation.