From Graham To Buffett To Graham Again - Two Years of Value Investing

[juno.tay]

I have gotten a lot of good investing ideas from Valuebuddies and this article represents my way of giving back to the community.
First off, some background history, I been doing this intensively for about 2 years now, ever since I had the fortune of picking up a copy of Warren Buffett's biography, and then the Intelligent Investor. Since then, I have been consistently reading, studying and testing my ideas.

I started out focusing more on quantitative factors as dictated in The Intelligent Investor, than moving on to more qualitative factors as a result of Buffett's influence, and then coming a full circle back to Benjamin Graham, reaching a similar conclusion that Benjamin Graham did towards the end of his life.

Although I have the utmost respect for Warren Buffett, I think many investors do not realise that they do not have to invest like he does. The chief most reason is that Berkshire has in recent years, reached such a size that the universe of companies he can invest in is greatly limited. It is also one of the reasons why he stresses in his annual reports that going forward, investors should not expect a rate of return that he has managed to achieve in his earlier days.
Investment funds or unit trusts in Singapore face a similar problem. The universe of companies that they invest is much smaller than what the average investor can invest in. As such, you will realise that most of these funds have a great number of overlapping holdings.

Although I place value on the qualitative factors of businesses, I think that investors must maintain a healthy level of scepticism of their appreciation and appraisal of such factors as they are extremely hard to quantify, and more importantly, extremely prone to emotional misjudgement. Buffett likes to maintain a much higher level of concentration in a few select companies that are within his circle of competence.

From personal experience, the problem with this ideology is that the number of companies that are genuinely within a person's circle of competence, as opposed to his supposed circle of competence are few and far between. Furthermore, the average investor must realise that Buffett, aside from his high intellectual capacity, has spent close to his entire life studying and reading about companies in order to amass his knowledge. I think it is safe to say that the average investor does not even come close to equalling his ability.
Another way this problem manifests itself is through us making incorrect inferences.

For example, let us assume we look at Company X, which we find has a low profit margin or ROE. A typical discussion might go like this:

Company X has a low profit margin or ROE -> Thus according to what I learnt from Buffett, it's not a good company to invest in.

OR

Company Y has shown an increase in account receivables/inventories, which is a worrying sign.

The problem is that the average investor probably does not have the luxury of spending enough time to accumulate the amount of knowledge to make a qualitative judgement.

I think it may be interesting to many readers that towards the end of his days, Graham was very much against the ideas put forth in his early work, Security Analysis as much more in favour of buying a group of stocks that fulfilled 2 - 3 of the following criteria.

To me, this includes placing too much emphasis on excessively breaking down factors such as operating expenses, operating margins etc. Effectively, I believe that the level of detail you should be looking at can be aptly learned from The Intelligent Investor.

The first 5 are effectively valuation constraints, and the last 5 are safety criteria.

1) An earnings-to-price yield at least twice the AAA bond yield.
2) A price-earnings ratio less than 40 percent of the highest price-earnings ratio the stock had over the past five years.
3) A dividend yield of at least two-thirds the AAA bond yield.
4) Stock price below two-thirds of tangible book value per share.
5) Stock price two-thirds net current asset value.
6) Total debt less than book value.
7) Current ratio greater than two.
8) Total debt less than twice “net current asset value.”
9) Earnings growth of prior ten years at least 7 percent on an annual basis.
10) Stability of growth of earnings in that no more than two declines of 5 percent or more in the prior 10 years.

His own research, which was successively back tested and confirmed by others was that a portfolio of 30 stocks would consistently outperform the averages buy a large margin over a long period of time.

Like Graham, I am now generally in favour of such an approach for the average investor, which removes a big component of what I feel impairs investment returns, the human and emotional component.
Unlike US equities, I rarely discuss my holdings in Singapore as some of the companies I look at are highly illiquid. However, I would like to make the following observations:

1) For the investor willing to take the effort, I believe that there is a high probability that returns in Singapore will significantly exceed that you will get in more developed economies such as the United States.

This is unlike the US or UK where many of these opportunities have been arbitraged away, this has as of yet not happened in countries like Singapore. The number of investment opportunities in Hong Kong, Japan, and Korea are also significant.

My own thesis is that Graham has not had such a significant influence on these nations (especially non English speaking countries).

2) I recommend looking at smaller capitalization companies i.e. below 200 million. My own personal view is that the large cap companies are effectively fairly valued at current market prices.

I found a significant number of net-nets in Singapore selling at a considerable margin of safety, whereas I could find close to none in the United States.

To summarize:

1) I no longer believe that detailed fundamental analysis will benefit investors more than let's say buying a group of stocks bound by 2 - 3 criteria.

2) There are considerable investment opportunities among companies below 200$ million market cap.

Admittedly I have not strayed far from Benjamin Graham and his ideology, and your mileage may vary accordingly.

Cheers

[Musicwhiz]

Hi thanks for sharing, really appreciate it.

But to me it seems that 1) and 2) are contradictory? You need to do detailed fundamental analysis and dig deep into a Company's stakeholders and business model in order to uncover the gems below market cap of $200m (your criteria). But in 1) you say that it is futile to attempt this and that just buying a basket of stocks is sufficient.

I would agree that for the average investor (i.e. [lay]man on the street), it would suffice to purchase an index of stocks which mimic the major indices of whichever country (emerging or not); and just sit around and get a moderate rate of return.

But I do emphasize the point that if an investor has the knowledge base and is willing and able to spend a significant amount of time sniffing out good bargains, he would be more than amply rewarded in terms of both capital appreciation and dividend yield.

Graham was more of a quant, and believed in net-net. Buffett is more of an all-rounder who believed in great businesses and that numbers do not encapsulate everything about a business. There is much to learn from both, and I won't say one is better than the other. After all, Buffett buily upon Graham's original knowledge and modified his own investment style.

In my opinion, any serious investor out there should, too.

[juno.tay]

Hey there,

I wasn't very clear with what I considered detailed fundamental analysis.

In my opinion, all investors should acquaint themselves with the basics of fundamental analysis, especially with regards to accessing a companies solvency.

However, the question which is posed is how much analysis is enough? Should investors acquaint themselves with discounted cash flow models, with understanding what affects a companies profit margins, etc. The problem with these in my experience is that the margin of error becomes amplified as the human judgment required in accessing factors such as past growth rates or potential future growth.

I guess one has to align what one's goal are. If you below to a group of people (this includes me) who get an intellectual kick out of doing this, than there definitely exists the possibility of out-performing the market and such a basket of stocks, and not to mention the intangible rewards associated with it.

However, for what I surmise, the average investor is merely interested in obtaining for himself, the best possible rate of return on his capital invested.

Like you said, each investor has to come to terms with what his own intentions and interests are. As long as an investing methodology is based on sound principles, it should earn an adequate return. My only concern is that people who adopt a Buffett like investing approach may underestimate the amount of work he puts in and his sheer intellectual capacity that plays a big part in his returns.

Hi thanks for sharing, really appreciate it.

But to me it seems that 1) and 2) are contradictory? You need to do detailed fundamental analysis and dig deep into a Company's stakeholders and business model in order to uncover the gems below market cap of $200m (your criteria). But in 1) you say that it is futile to attempt this and that just buying a basket of stocks is sufficient.

I would agree that for the average investor (i.e. [lay]man on the street), it would suffice to purchase an index of stocks which mimic the major indices of whichever country (emerging or not); and just sit around and get a moderate rate of return.

But I do emphasize the point that if an investor has the knowledge base and is willing and able to spend a significant amount of time sniffing out good bargains, he would be more than amply rewarded in terms of both capital appreciation and dividend yield.

Graham was more of a quant, and believed in net-net. Buffett is more of an all-rounder who believed in great businesses and that numbers do not encapsulate everything about a business. There is much to learn from both, and I won't say one is better than the other. After all, Buffett buily upon Graham's original knowledge and modified his own investment style.

In my opinion, any serious investor out there should, too.

[freedom]

my understanding of Graham's value investing is much simpler and it has nothing to do with buy-and-hold. What I see from Graham is that when you see value with margin of safety, you buy, and you sell when value of your perception is realized. It does not matter that the whole process takes 1 second or 1 year. And Graham did not oppose arbitrage or short if that's where the value is, which a lot of people think it is trading, not investing....

Graham went further to explain how to discover/measure value and calculate margin of safety in Security Analysis and Intelligent Investors.

[d.o.g.]

Like you said, each investor has to come to terms with what his own intentions and interests are. As long as an investing methodology is based on sound principles, it should earn an adequate return. My only concern is that people who adopt a Buffett like investing approach may underestimate the amount of work he puts in and his sheer intellectual capacity that plays a big part in his returns.

Hear, hear. Graham hit the nail on the head when he declared that an investor's worst enemy is himself. As with many other things in life, people tend to look for shortcuts. So they seek out stock tips and magic formulas in the hope of obtaining big profits with minimal (or zero) work. Sadly, many learn the hard way that investing, like other things in life, seldom works that way. Some never learn.

Some hear "PE" and say, OK, as long as the stock we like has a PE below 10 (or 8 or 6 or whatever) we can buy it because we have a "margin of safety". So they buy property developers at the top of the market when they report record profits, just in time to participate in the bust that follows the boom. Or they buy companies whose profits were boosted by one-time events like property revaluation, asset disposals or debt forgiveness.

Some hear "dividend" and say, OK, as long as the stock we like pays us 5% more than the bank interest we have a "margin of safety" and have created a "retirement income". So they buy shipping trusts which are overleveraged and dealing with weak customers, just before the trusts are forced to cut payouts and seize ships from defaulting customers.

Some hear "P/B" and say, OK, as long as the stock we like sells for less than book value, we have a "margin of safety". So they buy manufacturing companies with obsolete machinery, just before the companies report heavy losses and take a massive writedown of the machinery to scrap value.

I could go on. But I think the point has been made. The quality of analysis done by the average investor is abysmal. Graham's principles as laid out in The Intelligent Investor are not hard to follow in theory for anyone of at least average intelligence and discipline. But in practice they prove a bridge too far for the average investor who has to juggle a career and family in addition to looking after his money. It is an unusual investor who is willing to apply Graham's principles and accept "not lousy" returns, even though in practice he is likely (but not guaranteed) to get "good" returns.

As usual, YMMV.

[Jared Seah]

"Like you said, each investor has to come to terms with what his own intentions and interests are. As long as an investing methodology is based on sound principles, it should earn an adequate return."

I believe the evaluation of our investment performance is the other equally important side of the coin; not just focusing on methodology of evaluating companies.

Evaluate ourselves like we are an investment holding company or investment fund. Our returns (or lack of) will be the sobering reflection in the morning.

Theoretical and rhetorical questions like - should I do individual stock-picking; should I give up and invest in passive index fund; should I trade less often; should I average up or down; is my methodology working; do I have time; etc - may find practical applications during our reflections in the silence of the night. Who understands our own fear and greed better?

Most of us will start our journey with "off-the-rack" methodology. Overtime, some will move on to "tailor-made".

Juno, thanks for sharing your own reflections on your 2 years' journey!


P.S. 10 years from now, I bet you will get new reflections which may differ from today. Just like Graham. We are all evolving and not static.

[honeyclover]

Graham simplified his methods at his age of 82.
http://blog.empiricalfinancellc.com/wp-c...m-1976.pdf

Such as using PE of 7 and ratio of shareholders' equity to total assets of at least 50 percent.
Then again he simplified his method based on his depth of experiences.
Even if using it, you won't know what's his other criteria/factors that is based on his past experiences.

i think best is to learn fundamental analysis &/or understanding graham's previous works before using his simplified method.

[dzwm87]

Some hear "PE" and say, OK, as long as the stock we like has a PE below 10 (or 8 or 6 or whatever) we can buy it because we have a "margin of safety". So they buy property developers at the top of the market when they report record profits, just in time to participate in the bust that follows the boom. Or they buy companies whose profits were boosted by one-time events like property revaluation, asset disposals or debt forgiveness.

It is also important for us to realise that low P/E does not equal to undervaluation. In fact, P/E for a particular time alone is always independent of valuation. Only relative P/E is a good enough gauge for undervaluation.

Thus the easy work is never a simple Share price / TTM EPS.. instead one has to dig deeper into comparable companies or historical comparison. The former then has to be judged on how similar different companies are (I realised most research report simply take companies in the same industries but in fact operates in different business, resulting in poorly calculated 'industry average P/E') while the latter will be based on a historical comparison of the company fundamentals - has its business deteriorated so that its low P/E is justified?

It is only when all the above has been justified that a low relative P/E will prove to be an indicator of undervaluation and with appropriate catalysts to be realised over time - reversion to mean will be a powerful weapon.

[freedom]

Those using PE for record profit or exceptional items can't say they are following Graham.

IIRC, there are chapters in Security Analysis about how to deal with favorable situation(like average how many years of earning instead of single year) or exceptional items (eliminate it) to calculate PE or all kinds of tricks management uses to hype the profit(write down PPE to near 0, so no depreciation or amortization charge), etc.

of course, using PE alone is definitely not enough. But like Graham said, buying a few real low PE companies(not hyped ones) should be able to give an investor reasonable return.

[FFNow]

Everyone evolves over the years as an investor as he/she learns more from experience especially. You can have all the theory in the world from reading books, going for courses, etc but the crunch time comes when you have actually purchased a company and are monitoring it. I started investing in June 2009 and within this short close to 3 years, I have evolved a lot and have learnt a lot, not just by reading books but doing what the books talk about and seeing if they are viable for myself. All investors evolve over the years just like one's outlook on life when he was in secondary school will be different than when he hits adult years and is capable of fathering a child.

Even Warren Buffett doesn't really follow the net-net method as it's purely quantitative. He incorporated Phil Fisher's qualitative methods too.