An interview with Gary Hamel was published in the Corporate Dossier of September 15 2006. I liked the following statement of Gary Hamel regarding democratization of creativity.
"Now, technology is democratising creativity. It's emancipating human imagination,.... I would argue that Apple, Adobe with photoshop and a blogger which makes the blogging software, these companies have done more to spur human creativity than most organisations."
I agree with the above statement as the facilities of internet and related applications like blogger have made a difference in my intellectual pursuits in both inward and outward communication. The facility for outward communication makes you motivated to do more. The facility for inward communication facilitates your learning and stimulates the brain to add on to the others ideas and output.
KVSSNRAO
Saturday, September 30, 2006
Monday, September 25, 2006
Ideas of Graham and Dodd - Part VII (Last Part)
25-9-06
PART VII
DISCREPANCIES BETWEEN PRICE AND VALUE
Page 684
Since we have emphasized that analysis will lead to a positive conclusion only in the exceptional case, it follows that many securities must be examined before one is found that has real possibilities for the analyst. By what practical means does he proceed to make his discoveries?
Page 685
A quick glance at a hundred of such reports may reveal between five and ten that look interesting enough from the earnings or current-asset standpoint to warrant more intensive study.
Page 691
Yet judging from observations made over a number of years, it would seem that investment in apparently undervalued common stocks can be carried on with a very fair degree of over-all success, provided average alertness and good judgment are used in passing on the future-prospect question- and provided also that commitments are avoided at times when the general market is statistically much too high.
Page 692
Market Behavior of Standard and Nonstandard Issues
Standard or leading issues almost always respond rapidly to changes in their reported profits-so much so that they tend regularly to exaggerate marketwise the significance of year-to-year fluctuations in earnings.
PART VII
DISCREPANCIES BETWEEN PRICE AND VALUE
Page 684
Since we have emphasized that analysis will lead to a positive conclusion only in the exceptional case, it follows that many securities must be examined before one is found that has real possibilities for the analyst. By what practical means does he proceed to make his discoveries?
Page 685
A quick glance at a hundred of such reports may reveal between five and ten that look interesting enough from the earnings or current-asset standpoint to warrant more intensive study.
Page 691
Yet judging from observations made over a number of years, it would seem that investment in apparently undervalued common stocks can be carried on with a very fair degree of over-all success, provided average alertness and good judgment are used in passing on the future-prospect question- and provided also that commitments are avoided at times when the general market is statistically much too high.
Page 692
Market Behavior of Standard and Nonstandard Issues
Standard or leading issues almost always respond rapidly to changes in their reported profits-so much so that they tend regularly to exaggerate marketwise the significance of year-to-year fluctuations in earnings.
The action of less familiar issues depends largely upon what attitude is taken towards them by professional market operators. If interest is lacking, the price may lag far behind the statistical showing. If interest is attracted to the issue, either manipulatively or more legitimately, the opposite result can readily be attained, and the price will respond in extreme fashion to changes in the company’s exhibit.
Page 694
Market exaggerations Due to Factors Other than Changes in Earnings
The inveterate tendency of the stock market to exaggerate extends to factors other than changes in earnings. Overemphasis is laid upon such matters as dividend changes, stock split-ups, mergers and segregations.
An increase in the cash dividend is a favorable development, but it is absurd to add $20 to the price of a stock just because the dividend rate is advanced from $5 to $6 annually.
The excited responses often made to stock dividends are even more illogical, since they are in essence nothing more than pieces of paper. The same is true of split-ups, which create more share but give the stockholder nothing he did not have before-except the minor advantage of a possibly broader market due to the lower price level.
Page 695
Wall Street becomes easily enthusiastic over mergers and just as ebullient over segregations, which are the exact opposite.
The exaggerated response made by the stock market to developments that seem relatively unimportant in themselves is readily explained in terms of the psychology of the speculator. He want “action,” first of all; and he is willing to contribute to this action ie he can be given any pretext for bullish excitement.
The tendency of Wall Street to go to extremes is illustrated in the opposite direction by its tremendous dislike of litigation.
Page 707
…the analyst should not urge a security exchange unless either (1) the issue to be bought is attractive, regarded by itself, or (2) there is a definite contractual relationship between the two issues in question.
Page 713
Market Analysis and Security Analysis
Forecasting security prices is not properly a part of security analysis.
However, the two activities are generally thought to be closely allied, and they are frequently carried on by the same individuals and organizations.
Endeavors to predict the course of prices have a variety of objectives and a still greater variety of techniques.
If as many believe, one can dependably foretell the movements of stock prices without any reference to the underlying values, then it would be sensible to confine security analysis to the selection of fixed-value investments only.
Many other people believe that the best results can be obtained by an analysis of the market position of a stock in conjunction with an analysis of its intrinsic value. If this is so, the securities analyst who ventures outside the fixed-value field must qualify as a market analyst as well and be prepared to view each situation from both standpoints at the same time.
Page 714
(Graham and Dodd recognized the existing practice of market analysis in a separate chapter and offered their views on various methods of market analysis in use at that time [around 1940]).
Two Kinds of Market Analysis
A distinction may be made between two kinds of market analysis. The first finds the materials for its predictions exclusively in the past action of the stock market. The second considers all sorts of economic factors, e.g., business conditions, general and specific; money rates; the political outlook.
Those who devote themselves primarily to a study of these price movements are know as “chartists,” and their procedure is often called “chart reading.”
Page 715
It must be realized that the vogue of such “technical study” has increased immensely during the past fifteen years.
Such consideration, we believe should lead to the following conclusions:
1. Chart reading cannot possible be science.
2. It has not proved itself in the past to be a dependable method of making profits in the stock market.
3. Its theoretical basis rests upon faulty logic or else upon mere assertion.
4. Its vogue is due to certain advantages it possesses over haphazard speculation, but these advantages tend to diminish as the number of chart students increases.
Page 716
The past earnings of a company supply a useful indication of its future earnings-useful, but not infallible. Security analysis and market analysis are alike, therefore, in the fact that they deal with data that are not conclusive as to the future. The difference, as we shall point out, is that the security analyst can protect himself by a margin of safety that is denied to the market analyst.
Page 718
The Second type of Mechanical Forecasting
As far as the general market is concerned, the usual procedure is to construct indices representing various economic factors, e.g., money rates, car loadings, steel production, and to deduce impending changes in the market from an observation of a recent change in these indices.
Page 719
Broadly speaking, therefore, the endeavor to forecast security-price changes by reference to mechanical indices is open to the same objections as the methods of the chart readers. They are not truly scientific, because there is no convincing reasoning to support them and because, furthermore, really scientific i.e., entirely dependable) forecasting in the economic field is logical impossibility.
Page 721
Prophesies based on Near-term Prospects
A good part of the analysis and advice supplied in the financial district rests upon the ner-term business prospects of the company considered. It is assumed that, if the outlook favors increased earnings, the issue should be bought in the expectation of a higher price when the larger profits are actually reported. In this reasoning, security analysis and market analysis are made to coincide.
If markets generally reflected only this year’s earnings, then a good estimate of next year’s results would be of inestimable value. But the premise is not correct.
(over the period 1902-1927), it is difficult to establish any definite correlation between fluctuations in earnings and fluctuations in market quotations (of United States Steel Corporation common).
Page 722
We are skeptical of the ability of the analyst to forecast with a fair degree of success the market behavior of individual issues over the near-term future-whether he base his predictions upon the technical position of the market or upon the general outlook for business or upon the specific outlook for the individual companies.
More satisfactory results are to be obtained, in our opinion, by confining the positive conclusions of the analyst to the following fields of endeavor (in case of equity shares):
The discovery of common stocks, or speculative senior issues, that appear to be selling at far less than their intrinsic value.
The determination of definite price discrepancies existing between related securities, which situations may justify making exchanges or initiating hedging or arbitrage operations.
Comments by KVSSNRAO
The second edition of Graham and Dodd published in 1940 is a 851 page book. The important ideas related to equity investment are presented in seven parts by me. I hope the readers of these seven parts will take up reading the full book of Graham and Dodd to understand the methodology of analysis advocated by them for investors and analysts. They made a brief comment that their analytical method can be used by small investors also but they advised the investor to consult a professional analyst for approval of his analysis. But as they repeated mentioned (it was there in one of the parts), an investor has to study a number of securities to find the one that satisfies their conditions. It is difficult for the investors to do analysis themselves. It will be more practical, if investors are given the responsibility to study the equity research report prepared by the analysts and agree with its analysis based investor’s knowledge of the analytical method. The simplicity of Graham and Dodd’s security analysis would be of immense help in this regard. Graham-Rao method is one of the attempts in this context.
Sunday, September 24, 2006
Ideas of Graham and Dodd Part VI (Current Asset and Cash Asset Values)
24-9-06
Page 537
Allowances for Changes in Capitalization
In dealing with the past record of earnings, when given on a per-share basis, it is elementary that the figures must be adjusted to reflect any important changes in the capitalization which have taken place during the period. In the simplest case these will involve a change only in the number of shares of common stock due to stock dividends, split-ups, etc. All that is necessary then is to restate the capitalization throughout the period on the basis of the current number of shares.
Page 540
The intrinsic value of a common stock preceded by convertible securities, or subject to dilution through the exercise of stock options or through participating privileges enjoyed by other security holders, cannot reasonably be appraised at a higher figure than would be justified if all such privileges were exercised in full.
Page 543
Principle of Optimum Capitalization Structure
The optimum capitalization structure for any enterprise includes senior securities to the extent that they may safely be issued and bought for investment.
Part VI of the Book
BALANCE-SHEET ANALYSIS. IMPLICATIONS OF ASSET VALUES
Page 567
By way of introduction to this section of our work, let us list five types of information and guidance that the investor may derive from a study of the balance sheet:
It shows how much capital is invested in the business.
It reveals the ease or stringency of the company’s financial condition, i.e., the working-capital position.
It contains the details of the capitalization structure.
It provides an important check upon the validity of the reported earnings.
It supplies the basis for analyzing the sources of income.
The book value per share of a common stock is found by adding up all the tangible assets, subtracting all liabilities and stock issues ahead of the common and then dividing by the number of shares.
In addition to the well-known concept of book value, we wish to suggest two others of similar character, viz., current-asset value and cash-asset value.
The current-asset value of a stock consists of the current assets alone, minus all liabilities and claims ahead of the issue. It excludes not only the intangible assets but the fixed and miscellaneous assets as well.
The cash-asset value of a stock consists of the cash assets alone, minus all liabilities and claims ahead of the issue.
Page 576
In any particular case the message that the book value conveys may well prove to be inconsequential and unworthy of attention. But this testimony should be examined before it is rejected. Let the stock buyer, if he lays any claim to intelligence , at least be able to tell himself, first, what value he is actually setting on the business and, second, what he is actually getting for his money in terms of tangible resources.
There are indeed certain presumptions in favor of purchases made far below asset value and against those made at a high premium above it.
A business that sells at a premium does so because it earns a large return upon its capital; this large return attracts competition, and, generally speaking, it is not likely to continue indefinitely.
Page 577
It may be pointed out that under modern conditions the so-called ‘intangibles,” e.g., good-will or even a highly efficient organization, are every whit as real from a dollars-and-cents standpoint as are buildings and machinery. Earnings based on these intangibles may be even less vulnerable to competition than those which require only a cash investment in productive facilities.
We do not think, therefore, that any rules may reasonably be laid down on the subject of book value in relation to market price, except the strong recommendation already made that the purchase know what he is doing on this score and be satisfied in his own mind that he is acting sensibly.
Page 578
The current-asset value is generally a rough index of the liquidating value.
Page 581
Our computations indicate that over 40% of all the industrial companies listed on the New York Stock Exchange were quoted at some time in 1932 at less than their net current assets. A considerable number actually sold for less than their cash-asset value.
In the recession of 1937-38 this situation was repeated on a smaller scale. Available data indicate that 20.5% of the industrial companies listed on the New York Stock Exchange sold in early 1938 at less than their net-current-asset value. (At the close of 1938, when the general price level was by no means abnormally low, a total of 54 companies out of 648 industrials studied sold for less than their net current assets.)
Page 583
Stocks selling below liquidation value are in many cases too cheap and so offer an attractive medium for purchase. We have thus a profitable field here for the technique of security analysis. But in many cases also the fact that an issue sells below liquidating value is a signal that mistaken policies are being followed and that therefore the management should take corrective action-if not voluntarily, then under pressure from the stockholders.
Page 587
There is scarcely any doubt that that common stocks selling well below liquidating value represent on the whole a class of undervalued securities. They have declined in price more severely than the actual conditions justify. This must mean that on the whole these stocks afford profitable opportunities for purchase. Nevertheless, the securities analyst should exercise as much discrimination as possible in the choice of issues falling within this category. He will lean toward those for which he sees a fairly imminent prospect of some one of the favorable developments listed above (Page 583). Or else he will be partial to such as reveal other attractive statistical features besides their liquid-asset position, e.g., satisfactory current earnings and dividends or a high average earning power in the past. The analyst will avoid issues that have been losing their current assets at a rapid rate and show no definite signs of ceasing to do so.
Page 583
The objection to buying these issues (*issues selling below current asset value - liquidating value) lies in the probability, or at least the possibility, that earnings will decline or losses continue and that the resources will be dissipated and the intrinsic value ultimately become less than the price paid. It may not be denied that this does actually happen in individual cases. On the other hand, there is a much wider range of potential developments which may result in establishing a higher market price. These include the following:
The creation of an earning power commensurate with the company’s assets. This may result from:
1. General improvement in the industry.
2. Favorable change in the company’s operating policies, with or without a change in management. These changes include more efficient methods, new products, abandonment of unprofitable lines, etc.
3. A sale or merger, because some other concern is able to utilize the resources to better advantage and hence can pay at least liquidating value for the assets.
4. Complete or partial liquidation.
Page 589
Common stocks that (1) are selling below their liquid-asset value, (2) are apparently in no danger of dissipating these assets, and (3) have formerly shown a large earning power on the market price, may be said truthfully to constitute a class of investment bargains. They are indubitably worth considerably more than they are selling for, and there is reasonably good chance that this greater worth will sooner or later reflect itself in the market price. At heir low price these bargain stocks actually enjoy a high degree of safety, meaning by safety a relatively small risk of loss of principal.
Page 537
Allowances for Changes in Capitalization
In dealing with the past record of earnings, when given on a per-share basis, it is elementary that the figures must be adjusted to reflect any important changes in the capitalization which have taken place during the period. In the simplest case these will involve a change only in the number of shares of common stock due to stock dividends, split-ups, etc. All that is necessary then is to restate the capitalization throughout the period on the basis of the current number of shares.
Page 540
The intrinsic value of a common stock preceded by convertible securities, or subject to dilution through the exercise of stock options or through participating privileges enjoyed by other security holders, cannot reasonably be appraised at a higher figure than would be justified if all such privileges were exercised in full.
Page 543
Principle of Optimum Capitalization Structure
The optimum capitalization structure for any enterprise includes senior securities to the extent that they may safely be issued and bought for investment.
Part VI of the Book
BALANCE-SHEET ANALYSIS. IMPLICATIONS OF ASSET VALUES
Page 567
By way of introduction to this section of our work, let us list five types of information and guidance that the investor may derive from a study of the balance sheet:
It shows how much capital is invested in the business.
It reveals the ease or stringency of the company’s financial condition, i.e., the working-capital position.
It contains the details of the capitalization structure.
It provides an important check upon the validity of the reported earnings.
It supplies the basis for analyzing the sources of income.
The book value per share of a common stock is found by adding up all the tangible assets, subtracting all liabilities and stock issues ahead of the common and then dividing by the number of shares.
In addition to the well-known concept of book value, we wish to suggest two others of similar character, viz., current-asset value and cash-asset value.
The current-asset value of a stock consists of the current assets alone, minus all liabilities and claims ahead of the issue. It excludes not only the intangible assets but the fixed and miscellaneous assets as well.
The cash-asset value of a stock consists of the cash assets alone, minus all liabilities and claims ahead of the issue.
Page 576
In any particular case the message that the book value conveys may well prove to be inconsequential and unworthy of attention. But this testimony should be examined before it is rejected. Let the stock buyer, if he lays any claim to intelligence , at least be able to tell himself, first, what value he is actually setting on the business and, second, what he is actually getting for his money in terms of tangible resources.
There are indeed certain presumptions in favor of purchases made far below asset value and against those made at a high premium above it.
A business that sells at a premium does so because it earns a large return upon its capital; this large return attracts competition, and, generally speaking, it is not likely to continue indefinitely.
Page 577
It may be pointed out that under modern conditions the so-called ‘intangibles,” e.g., good-will or even a highly efficient organization, are every whit as real from a dollars-and-cents standpoint as are buildings and machinery. Earnings based on these intangibles may be even less vulnerable to competition than those which require only a cash investment in productive facilities.
We do not think, therefore, that any rules may reasonably be laid down on the subject of book value in relation to market price, except the strong recommendation already made that the purchase know what he is doing on this score and be satisfied in his own mind that he is acting sensibly.
Page 578
The current-asset value is generally a rough index of the liquidating value.
Page 581
Our computations indicate that over 40% of all the industrial companies listed on the New York Stock Exchange were quoted at some time in 1932 at less than their net current assets. A considerable number actually sold for less than their cash-asset value.
In the recession of 1937-38 this situation was repeated on a smaller scale. Available data indicate that 20.5% of the industrial companies listed on the New York Stock Exchange sold in early 1938 at less than their net-current-asset value. (At the close of 1938, when the general price level was by no means abnormally low, a total of 54 companies out of 648 industrials studied sold for less than their net current assets.)
Page 583
Stocks selling below liquidation value are in many cases too cheap and so offer an attractive medium for purchase. We have thus a profitable field here for the technique of security analysis. But in many cases also the fact that an issue sells below liquidating value is a signal that mistaken policies are being followed and that therefore the management should take corrective action-if not voluntarily, then under pressure from the stockholders.
Page 587
There is scarcely any doubt that that common stocks selling well below liquidating value represent on the whole a class of undervalued securities. They have declined in price more severely than the actual conditions justify. This must mean that on the whole these stocks afford profitable opportunities for purchase. Nevertheless, the securities analyst should exercise as much discrimination as possible in the choice of issues falling within this category. He will lean toward those for which he sees a fairly imminent prospect of some one of the favorable developments listed above (Page 583). Or else he will be partial to such as reveal other attractive statistical features besides their liquid-asset position, e.g., satisfactory current earnings and dividends or a high average earning power in the past. The analyst will avoid issues that have been losing their current assets at a rapid rate and show no definite signs of ceasing to do so.
Page 583
The objection to buying these issues (*issues selling below current asset value - liquidating value) lies in the probability, or at least the possibility, that earnings will decline or losses continue and that the resources will be dissipated and the intrinsic value ultimately become less than the price paid. It may not be denied that this does actually happen in individual cases. On the other hand, there is a much wider range of potential developments which may result in establishing a higher market price. These include the following:
The creation of an earning power commensurate with the company’s assets. This may result from:
1. General improvement in the industry.
2. Favorable change in the company’s operating policies, with or without a change in management. These changes include more efficient methods, new products, abandonment of unprofitable lines, etc.
3. A sale or merger, because some other concern is able to utilize the resources to better advantage and hence can pay at least liquidating value for the assets.
4. Complete or partial liquidation.
Page 589
Common stocks that (1) are selling below their liquid-asset value, (2) are apparently in no danger of dissipating these assets, and (3) have formerly shown a large earning power on the market price, may be said truthfully to constitute a class of investment bargains. They are indubitably worth considerably more than they are selling for, and there is reasonably good chance that this greater worth will sooner or later reflect itself in the market price. At heir low price these bargain stocks actually enjoy a high degree of safety, meaning by safety a relatively small risk of loss of principal.
KVSSNRAO
24-9-06
Saturday, September 23, 2006
Important Points form Graham and Dodd - Part V
23-9-2006
Page 516
Intuition Not a Part of the Analyst’s Stock in Trade.-In the absence of indications to the contrary we accept the past record as a basis for judging the future. But analyst must be on the lookout for any such indications to the contrary.
The ability to see what is coming is of inestimable value, but it cannot be expected to be part of the analyst’s stock in trade.
He can be asked to show only that moderate degree of foresight which springs from logic and form experience intelligently pondered.
Analysis of the Future Should be Penetrating Rather than Prophetic.-Analytical reasoning with regard to the future is of a somewhat different character, being penetrating rather than prophetic.
Page 530
In previous chapters various references have been made to Wall Street’s ideas on the relation of earnings to values. A given common stock is generally considered to be worth a certain number of times its current earnings. This number of times, or multiplier, depends part on the prevailing psychology and partly on the nature and record of the enterprise.
Page 531
Exact Appraisal Impossible.-Security analysis cannot presume to lay down general rules as to the “proper value” of any given common stock. Parctically speaking, there is no such thing. The bases of value are too shifting to admit of any formulation that could claim to be even reasonably accurate.
But the stock market itself has no time for such scientific scruples. It must make its value first and find its reasons afterwards.
Hence the prices of common stocks are not carefully thought out computations but the resultants of a welter of human reactions. The stock market is a voting machine rather than a weighing machine. It responds to factual data not directly but only as they affect the decisions of buyers and sellers.
Limited Functions of the Analyst in Field of Appraisal of Stock Prices.-Confronted by this mixture of changing facts and fluctuating human fancies, the securities analyst is clearly incapable of passing judgment on common-stock prices generally.
There are, however, some concrete, if limited, functions that he may carry on in this field, of which the following are representative:
He may set up a basis for conservative or investment valuation of common stocks, as distinguished from speculative valuations.
He may point out the significance of: (a) the capitalization structure; and (b) the source of income, as bearing upon the valuation of a given stock issue.
He may find unusual elements in the balance sheet which affect the implications of the earnings picture.
Page 531
A Suggested Basis of Maximum Appraisal for Investment.- …the profits of the most recent year, taken singly, might be accepted as the gage of future earnings, if (1) general business conditions in that year were not exceptionally good, (2) the company has shown an upward trend earnings for some years past and (3) the investor’s study of the industry gives him confidence in its continued growth.
In very exceptional case, the investor may be justified in counting on higher earnings in the future than at any time in the past. This might follow from developments involving a patent or the discovery of new ore in a mine or some similar specific and significant occurrence.
But in most instances he will derive the investment value of a common stock from the average earnings of a period between five and ten years.
This does not mean that all common stocks with the same average earnings should have the same value. The common-stock investor (i.e., the conservative buyer) will properly accord a more liberal valuation to those issues which have current earnings above the average or which may reasonably be considered to possess better than average prospects or an inherently stable earning power.
But it is the essence of our viewpoint that some moderate upper limit in every case be placed on the multiplier in order to stay within the bounds of conservative valuation. We would suggest that about 20 times average earnings is as high a price as can be paid in an investment purchase of a common stock.
Page 533
We must emphasize also that a reasonable ratio market price to average earnings is not the only requisite for a common-stock investment. It is a necessary but not a sufficient condition. The company must be satisfactory also in its financial set-up and management, and not unsatisfactory in its prospects.
Page 516
Intuition Not a Part of the Analyst’s Stock in Trade.-In the absence of indications to the contrary we accept the past record as a basis for judging the future. But analyst must be on the lookout for any such indications to the contrary.
The ability to see what is coming is of inestimable value, but it cannot be expected to be part of the analyst’s stock in trade.
He can be asked to show only that moderate degree of foresight which springs from logic and form experience intelligently pondered.
Analysis of the Future Should be Penetrating Rather than Prophetic.-Analytical reasoning with regard to the future is of a somewhat different character, being penetrating rather than prophetic.
Page 530
In previous chapters various references have been made to Wall Street’s ideas on the relation of earnings to values. A given common stock is generally considered to be worth a certain number of times its current earnings. This number of times, or multiplier, depends part on the prevailing psychology and partly on the nature and record of the enterprise.
Page 531
Exact Appraisal Impossible.-Security analysis cannot presume to lay down general rules as to the “proper value” of any given common stock. Parctically speaking, there is no such thing. The bases of value are too shifting to admit of any formulation that could claim to be even reasonably accurate.
But the stock market itself has no time for such scientific scruples. It must make its value first and find its reasons afterwards.
Hence the prices of common stocks are not carefully thought out computations but the resultants of a welter of human reactions. The stock market is a voting machine rather than a weighing machine. It responds to factual data not directly but only as they affect the decisions of buyers and sellers.
Limited Functions of the Analyst in Field of Appraisal of Stock Prices.-Confronted by this mixture of changing facts and fluctuating human fancies, the securities analyst is clearly incapable of passing judgment on common-stock prices generally.
There are, however, some concrete, if limited, functions that he may carry on in this field, of which the following are representative:
He may set up a basis for conservative or investment valuation of common stocks, as distinguished from speculative valuations.
He may point out the significance of: (a) the capitalization structure; and (b) the source of income, as bearing upon the valuation of a given stock issue.
He may find unusual elements in the balance sheet which affect the implications of the earnings picture.
Page 531
A Suggested Basis of Maximum Appraisal for Investment.- …the profits of the most recent year, taken singly, might be accepted as the gage of future earnings, if (1) general business conditions in that year were not exceptionally good, (2) the company has shown an upward trend earnings for some years past and (3) the investor’s study of the industry gives him confidence in its continued growth.
In very exceptional case, the investor may be justified in counting on higher earnings in the future than at any time in the past. This might follow from developments involving a patent or the discovery of new ore in a mine or some similar specific and significant occurrence.
But in most instances he will derive the investment value of a common stock from the average earnings of a period between five and ten years.
This does not mean that all common stocks with the same average earnings should have the same value. The common-stock investor (i.e., the conservative buyer) will properly accord a more liberal valuation to those issues which have current earnings above the average or which may reasonably be considered to possess better than average prospects or an inherently stable earning power.
But it is the essence of our viewpoint that some moderate upper limit in every case be placed on the multiplier in order to stay within the bounds of conservative valuation. We would suggest that about 20 times average earnings is as high a price as can be paid in an investment purchase of a common stock.
Page 533
We must emphasize also that a reasonable ratio market price to average earnings is not the only requisite for a common-stock investment. It is a necessary but not a sufficient condition. The company must be satisfactory also in its financial set-up and management, and not unsatisfactory in its prospects.
KVSSNRAO
Thursday, September 21, 2006
Important Points from Graham and Dodd - Part IV
20-9-2006
Page 368
Selection based on Margin-of-Safety principle – If the analyst is convinced that a stock is worth more than he pays for it, and he is reasonably optimistic as to the company’s future, he would regard the issue as a suitable component of a group investment in common stocks.
Page 372
A natural classification of the elements entering into the valuation of a common stock would be under the three headings:
The dividend rate and record
Income account factors (earning power)
Balance sheet factors (asset value)
Page 402
…the Wall-Street method of appraising common stocks has been simplified to the following standard formula:
Find out what the stock is earning. (This usually means the earnings pre share as shown in the last report.)
Multiply these per-share earnings by some sutable ‘coefficient of quality” which will reflect:
the dividend rate and record
the standing of the company-its size, reputation, financial position, and prospects.
The type of business 9e.g., a cigarette manufacturer will sell ast a higher multiple of earnings than a cigar company).
The timer of the general market. (Bull-market multipliers are larger than those used in bear markets.)
The foregoing may be summarized in the following formula:
Price = current earnings per share * quality coefficient1
(Foot note 1 on page 403 Where there are no earnings or where the amount is recognized as being far below “normal,” Wall Street is reluctantly compelled to apply what is at bottom a more rational method of valuation, i.e., one ascribing greater weight to average earning power, working capital, etc. But this is the exceptional procedure.)
The result of this procedure is that in most cases the “earnings per share” have attained a weight in determining value that is equivalent to the weight of all the factors taken together. The truth of this is evident if it be remembered that the quality coefficient is itself largely determined by the earnings trend, which in turn is taken from the stated earnings over a period.
21-9-06
The past exhibit remains a sufficiently dependable guide, in a sufficient proportion of cases, to warrant its continued use as the chief point of departure in the valuation and selection of securities.
The concept of earning power has a definite and important place in investment theory. It combines a statement of actual earnings, shown over a period of years, with a reasonable expectation that these will be approximated in the future, unless extraordinary conditions supervene. The record must cover a number of years, first because a continued or repeated performance is always more impressive than a single occurrence and secondly because the average of a fairly long period will tend to absorb and equalize the distorting influences of the business cycle.
A distinction must be drawn, however, between an average that is the mere arithmetical resultant of an assortment of disconnected figures and an average that is “normal” or “modal,” in the sense that the annual results show a definite tendency to approximate the average.
Page 508
In studying earnings records an important principle of security analysis must be borne in mind:
Quantitative data are useful only to the extent that they are supported by a qualitative survey of the enterprise.
In order for a company’s business to be regarded as reasonably stable, it does not suffice that the past record should show stability. The nature of the undertaking, considered apart from any figures, must be such as ot indicate an inherent permanence of earning power.
Page 510
The market level of common stocks is governed more by their current earnings than by their long-term average. This fact accounts n good part for the wide fluctuations in common-stock prices, which largely (though by no means invariably) parallel the changes in their earnings between good years and bad.
(The above statement supports my contention in my classes that Security Analysis has at least four different categories of analysis: Analysis of Value; Analysis of Market Price, Analysis of Trend, and Analysis of Market Excess. Graham and Dodd’s book focuses on Analysis of Value either by absolute number or by a judgment that states the current value of the security is far above the current market price.)
Page 511
The analyst* cannot follow the stock market in its indiscriminate tendency to value issues on the basis of current earnings. He may on occasion attach predominant weight to the recent figures rather than to the average, but only when persuasive evidence is at hand pointing to the continuance of these current results.
* (Graham and Dodd mean analyst of value)
Page 512
…it must be remembered that the automatic or normal economic forces militate gainst the indefinite continuance of a given trend. Competition, regulation, the law of diminishing returns, etc., are powerful foes to unlimited expansion, and in smaller degree opposite elements may operate to check a continued decline. Hence instead of taking the maintenance of a favorable trend for granted-as the stock market is wont to do-the analyst must approach the matter with caution, seeking to determine the causes of the superior showing and to weigh the specific elements of strength in the company’s position against the general obstacle in the way of continued growth.
If such a qualitative study leads to a favorable verdict-as frequently it should-the analyst’s philosophy must still impel him to base his investment valuation on an assumed earning power no large than the company has already achieved in a period of normal business. This is suggested because, in our opinion, investment values can be related only to demonstrated performance; so that neither expected increases nor even past results under conditions of abnormal business activity may be taken as a basis.
(According to Graham and Dodd, an average for seven to ten years is the preferred way of calculating the earning power. But as they state in the above paragraph, the analyst make take an average of a shorter period, or a the current earnings figure or earnings figure of a more representative year provided he has strong reasons to demonstrate that the trend will continue)
…this assumed earning power may properly be capitalized more liberally when the prospects appear excellent than in the ordinary case, but we shall also suggest that the maximum multiplier be held to a conservative figure (say, 20, under the conditions of 1940) if the valuation reached is to be kept within strictly investment limits.
(The above condition was incorporated in the Graham-Rao Method of Analyzing Shares for Buy and Hold Investment.)
The divergence in method between the stock market and the analyst-as we define his viewpoint-would mean in general that the price levels ruling for the so-called “good stocks” under normal market conditions are likely to appear overgenerous to the conservative student. This does not mean that the analyst is convinced that the market valuation is wrong but rather that he is not convinced that is valuation is right. He would call a substantial part of the price a “speculative component,” in the sense that it is paid not for demonstrated but for expected results.
Attitude of Analyst Where Trend is Downward.- … Here again a qualitative study of the company’s situation and prospects is essential to forming an opinion whether at some price, relatively low, of course, the issue may not be a bargain, despite its declining earnings trend.
KVSSNRAO
6.45 a.m.
22-9-06
Page 368
Selection based on Margin-of-Safety principle – If the analyst is convinced that a stock is worth more than he pays for it, and he is reasonably optimistic as to the company’s future, he would regard the issue as a suitable component of a group investment in common stocks.
Page 372
A natural classification of the elements entering into the valuation of a common stock would be under the three headings:
The dividend rate and record
Income account factors (earning power)
Balance sheet factors (asset value)
Page 402
…the Wall-Street method of appraising common stocks has been simplified to the following standard formula:
Find out what the stock is earning. (This usually means the earnings pre share as shown in the last report.)
Multiply these per-share earnings by some sutable ‘coefficient of quality” which will reflect:
the dividend rate and record
the standing of the company-its size, reputation, financial position, and prospects.
The type of business 9e.g., a cigarette manufacturer will sell ast a higher multiple of earnings than a cigar company).
The timer of the general market. (Bull-market multipliers are larger than those used in bear markets.)
The foregoing may be summarized in the following formula:
Price = current earnings per share * quality coefficient1
(Foot note 1 on page 403 Where there are no earnings or where the amount is recognized as being far below “normal,” Wall Street is reluctantly compelled to apply what is at bottom a more rational method of valuation, i.e., one ascribing greater weight to average earning power, working capital, etc. But this is the exceptional procedure.)
The result of this procedure is that in most cases the “earnings per share” have attained a weight in determining value that is equivalent to the weight of all the factors taken together. The truth of this is evident if it be remembered that the quality coefficient is itself largely determined by the earnings trend, which in turn is taken from the stated earnings over a period.
21-9-06
The past exhibit remains a sufficiently dependable guide, in a sufficient proportion of cases, to warrant its continued use as the chief point of departure in the valuation and selection of securities.
The concept of earning power has a definite and important place in investment theory. It combines a statement of actual earnings, shown over a period of years, with a reasonable expectation that these will be approximated in the future, unless extraordinary conditions supervene. The record must cover a number of years, first because a continued or repeated performance is always more impressive than a single occurrence and secondly because the average of a fairly long period will tend to absorb and equalize the distorting influences of the business cycle.
A distinction must be drawn, however, between an average that is the mere arithmetical resultant of an assortment of disconnected figures and an average that is “normal” or “modal,” in the sense that the annual results show a definite tendency to approximate the average.
Page 508
In studying earnings records an important principle of security analysis must be borne in mind:
Quantitative data are useful only to the extent that they are supported by a qualitative survey of the enterprise.
In order for a company’s business to be regarded as reasonably stable, it does not suffice that the past record should show stability. The nature of the undertaking, considered apart from any figures, must be such as ot indicate an inherent permanence of earning power.
Page 510
The market level of common stocks is governed more by their current earnings than by their long-term average. This fact accounts n good part for the wide fluctuations in common-stock prices, which largely (though by no means invariably) parallel the changes in their earnings between good years and bad.
(The above statement supports my contention in my classes that Security Analysis has at least four different categories of analysis: Analysis of Value; Analysis of Market Price, Analysis of Trend, and Analysis of Market Excess. Graham and Dodd’s book focuses on Analysis of Value either by absolute number or by a judgment that states the current value of the security is far above the current market price.)
Page 511
The analyst* cannot follow the stock market in its indiscriminate tendency to value issues on the basis of current earnings. He may on occasion attach predominant weight to the recent figures rather than to the average, but only when persuasive evidence is at hand pointing to the continuance of these current results.
* (Graham and Dodd mean analyst of value)
Page 512
…it must be remembered that the automatic or normal economic forces militate gainst the indefinite continuance of a given trend. Competition, regulation, the law of diminishing returns, etc., are powerful foes to unlimited expansion, and in smaller degree opposite elements may operate to check a continued decline. Hence instead of taking the maintenance of a favorable trend for granted-as the stock market is wont to do-the analyst must approach the matter with caution, seeking to determine the causes of the superior showing and to weigh the specific elements of strength in the company’s position against the general obstacle in the way of continued growth.
If such a qualitative study leads to a favorable verdict-as frequently it should-the analyst’s philosophy must still impel him to base his investment valuation on an assumed earning power no large than the company has already achieved in a period of normal business. This is suggested because, in our opinion, investment values can be related only to demonstrated performance; so that neither expected increases nor even past results under conditions of abnormal business activity may be taken as a basis.
(According to Graham and Dodd, an average for seven to ten years is the preferred way of calculating the earning power. But as they state in the above paragraph, the analyst make take an average of a shorter period, or a the current earnings figure or earnings figure of a more representative year provided he has strong reasons to demonstrate that the trend will continue)
…this assumed earning power may properly be capitalized more liberally when the prospects appear excellent than in the ordinary case, but we shall also suggest that the maximum multiplier be held to a conservative figure (say, 20, under the conditions of 1940) if the valuation reached is to be kept within strictly investment limits.
(The above condition was incorporated in the Graham-Rao Method of Analyzing Shares for Buy and Hold Investment.)
The divergence in method between the stock market and the analyst-as we define his viewpoint-would mean in general that the price levels ruling for the so-called “good stocks” under normal market conditions are likely to appear overgenerous to the conservative student. This does not mean that the analyst is convinced that the market valuation is wrong but rather that he is not convinced that is valuation is right. He would call a substantial part of the price a “speculative component,” in the sense that it is paid not for demonstrated but for expected results.
Attitude of Analyst Where Trend is Downward.- … Here again a qualitative study of the company’s situation and prospects is essential to forming an opinion whether at some price, relatively low, of course, the issue may not be a bargain, despite its declining earnings trend.
KVSSNRAO
6.45 a.m.
22-9-06
Tuesday, September 19, 2006
Graham and Dodd 2nd Ed. Part III
The following ideas were converted by Graham into analytical method for defensive investors in his book 'Intelligent Investor.' I modified some of the criteria by introducing explicit growth criterion and integrating a current analytical idea of accepting PEG ratio of one as attactive for investment. That's how Graham-Rao method of Analysis for Buy and Hold Investment took shape.
Page 348
… the prewar relationship between analysis and investment on the one hand and price changes and speculation on the other may be set forth as follows: Investment in common stocks was confined to those showing stable dividends and fairly stable earnings; and such issues in turn were expected to maintain a fairly stable market level.
Page 349
The function of analysis was primarily to search for elements of weakness in the picture. If the earnings were not properly stated; if the balance sheet revealed a poor current position, or the funded debt was growing too rapidly; if the physical plant was not properly maintained; if dangerous new competition was threatening, of it the company was losing ground in the industry; if the management was deteriorating or was likely to change for the worse; if there was reason to fear for the future of the industry as a whole-any of these defects or some other one might be sufficient to condemn the issue form the standpoint of the cautious investor.
On the positive side, analysis was concerned with finding those issues which met all the requirements of investment and in addition offered the best chance of future enhancement.
To a lesser extent, the analyst sought to look into the future and to select the industries or the individual companies that were likely to show the most rapid growth.
… the prewar relationship between analysis and investment on the one hand and price changes and speculation on the other may be set forth as follows: Investment in common stocks was confined to those showing stable dividends and fairly stable earnings; and such issues in turn were expected to maintain a fairly stable market level.
Page 349
The function of analysis was primarily to search for elements of weakness in the picture. If the earnings were not properly stated; if the balance sheet revealed a poor current position, or the funded debt was growing too rapidly; if the physical plant was not properly maintained; if dangerous new competition was threatening, of it the company was losing ground in the industry; if the management was deteriorating or was likely to change for the worse; if there was reason to fear for the future of the industry as a whole-any of these defects or some other one might be sufficient to condemn the issue form the standpoint of the cautious investor.
On the positive side, analysis was concerned with finding those issues which met all the requirements of investment and in addition offered the best chance of future enhancement.
To a lesser extent, the analyst sought to look into the future and to select the industries or the individual companies that were likely to show the most rapid growth.
Narayana Rao
19-9-2006
Monday, September 18, 2006
Ideas, Opinions and Thoughts from Graham and Dodd - part II
From Graham and Dodd, Second Edition
Page 57
Investment or investing, … is “a word of many meanings.” Of these three will concern us. The first meaning, or set of meanings, relates to putting or having money in business. …
It accepts rather than rejects element of risk – the ordinary business investment is said to be made “at the risk of business.”
The second set of uses applies the term in a similar manner to the field of finance. In this sense all securities are “investments.” We have investment dealers or brokers, investment companies or trusts, investment lists. Here, again, no real distinction is made between investment and other types of financial operations such as speculation. It is a convenient omnibus word, with perhaps an admixture of euphemism - i.e., a desire to lend a certain respectability to financial dealing of miscellaneous character.
Alongside of these two indiscriminate uses of the term “investment” has always been a third and more limited connotation-that of investment as opposed to speculation.
Page 62 & 63
A Proposed Definition of Investment
An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculation.
The phrases thorough analysis, promises safety and satisfactory return are all chargeable with indefiniteness, but the important point is that their meaning is clear enough to prevent serious misunderstanding.
By thorough analysis we mean, of course, the study of the facts in the light of established standards of safety and value.
The safety sought in investment is not absolute or complete; the word means, rather protection against loss under all normal or reasonably expected conditions or variations. A safe bond for example, is one which could suffer default only under exceptional and highly improbable circumstances. Similarly, a safe stock is one which holds every prospect of being worth the price paid except under quite unlikely contingencies. Where study and experience indicate that an appreciable chance of loss must be recognized and allowed for, we have a speculative situation.
Page 64
“Satisfactory” is a subjective term; it covers any rate or amount of return, however low, which the investor is willing to accept, provided he acts with reasonable intelligence.
It may be helpful to elaborate our definition from a somewhat different angle, which will stress the fact that investment must always consider the price as well as the quality of the security.
…in our opinion the great majority of common stocks of strong companies must be considered speculative during most of the time, simply because their price is too high to warrant safety of principal in any intelligible sense of the phrase.
… we shall embody our principle in the following additional criterion of investment:
An investment operation is one that can be justified on both qualitative and quantitative grounds.
Page 66
Both investment and speculation must meet the test of the future; they are subject to its vicissitudes and are judged by its verdict.
For investment, the future is essentially something to be guarded against rather than to be profited from. If the future brings improvement, so much the better; but investment as such cannot be founded in any important degree upon expectation of improvement. Speculation, on the other hand, may always properly-and often soundly-derive its basis and its justification form prospective developments that differ from past performance.
Types of investments
It might be useful if some descriptive adjective were regularly employed, when care is needed, to designate the particular meaning intended. Let us tentatively suggest the following:
1 Business investment – Referring to money put or held in a business
2 Financial investment or investment generally – Referring to securities generally
3 Sheltered investment – Referring to securities regarded as subject to small risk by reason of their prior claim on earnings or because they rest upon an adequate taxing power.
4 Analyst’s investment – Referring to operations that, upon thorough study, promise safety of principal and an adequate return.
Unless we specify otherwise, we shall employ the word “investment,” and its relatives, in the sense of “analyst’s investment,” as developed in this chapter.
Page 68
It is important to recognize that such value (intrinsic value) is by no means limited to “value for investment”- i.e., to the investment component of total value-but may properly include a substantial component of speculative value, provided that such speculative value is intelligently arrived at. Hence the market price maybe said to exceed intrinsic value only when the market price is clearly the reflection of unintelligent speculation.
Generally speaking, it is the function of the stock market, and not of the analyst, to appraise the speculative factors in a given common-stock picture. To this important extent the market, not the analyst, determines intrinsic value. The range of such appraisal may be very wide, as illustrated by our former suggestion that the intrinsic value of J.I. Case common in 1933 might conceivably have been as high as 130 or as low as 30. At any point between these broad limits it would have been necessary to accept the market’s verdict-changeable as it was from day to day-as representing the best available determination of the intrinsic value of this volatile issue.
Page 57
Investment or investing, … is “a word of many meanings.” Of these three will concern us. The first meaning, or set of meanings, relates to putting or having money in business. …
It accepts rather than rejects element of risk – the ordinary business investment is said to be made “at the risk of business.”
The second set of uses applies the term in a similar manner to the field of finance. In this sense all securities are “investments.” We have investment dealers or brokers, investment companies or trusts, investment lists. Here, again, no real distinction is made between investment and other types of financial operations such as speculation. It is a convenient omnibus word, with perhaps an admixture of euphemism - i.e., a desire to lend a certain respectability to financial dealing of miscellaneous character.
Alongside of these two indiscriminate uses of the term “investment” has always been a third and more limited connotation-that of investment as opposed to speculation.
Page 62 & 63
A Proposed Definition of Investment
An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculation.
The phrases thorough analysis, promises safety and satisfactory return are all chargeable with indefiniteness, but the important point is that their meaning is clear enough to prevent serious misunderstanding.
By thorough analysis we mean, of course, the study of the facts in the light of established standards of safety and value.
The safety sought in investment is not absolute or complete; the word means, rather protection against loss under all normal or reasonably expected conditions or variations. A safe bond for example, is one which could suffer default only under exceptional and highly improbable circumstances. Similarly, a safe stock is one which holds every prospect of being worth the price paid except under quite unlikely contingencies. Where study and experience indicate that an appreciable chance of loss must be recognized and allowed for, we have a speculative situation.
Page 64
“Satisfactory” is a subjective term; it covers any rate or amount of return, however low, which the investor is willing to accept, provided he acts with reasonable intelligence.
It may be helpful to elaborate our definition from a somewhat different angle, which will stress the fact that investment must always consider the price as well as the quality of the security.
…in our opinion the great majority of common stocks of strong companies must be considered speculative during most of the time, simply because their price is too high to warrant safety of principal in any intelligible sense of the phrase.
… we shall embody our principle in the following additional criterion of investment:
An investment operation is one that can be justified on both qualitative and quantitative grounds.
Page 66
Both investment and speculation must meet the test of the future; they are subject to its vicissitudes and are judged by its verdict.
For investment, the future is essentially something to be guarded against rather than to be profited from. If the future brings improvement, so much the better; but investment as such cannot be founded in any important degree upon expectation of improvement. Speculation, on the other hand, may always properly-and often soundly-derive its basis and its justification form prospective developments that differ from past performance.
Types of investments
It might be useful if some descriptive adjective were regularly employed, when care is needed, to designate the particular meaning intended. Let us tentatively suggest the following:
1 Business investment – Referring to money put or held in a business
2 Financial investment or investment generally – Referring to securities generally
3 Sheltered investment – Referring to securities regarded as subject to small risk by reason of their prior claim on earnings or because they rest upon an adequate taxing power.
4 Analyst’s investment – Referring to operations that, upon thorough study, promise safety of principal and an adequate return.
Unless we specify otherwise, we shall employ the word “investment,” and its relatives, in the sense of “analyst’s investment,” as developed in this chapter.
Page 68
It is important to recognize that such value (intrinsic value) is by no means limited to “value for investment”- i.e., to the investment component of total value-but may properly include a substantial component of speculative value, provided that such speculative value is intelligently arrived at. Hence the market price maybe said to exceed intrinsic value only when the market price is clearly the reflection of unintelligent speculation.
Generally speaking, it is the function of the stock market, and not of the analyst, to appraise the speculative factors in a given common-stock picture. To this important extent the market, not the analyst, determines intrinsic value. The range of such appraisal may be very wide, as illustrated by our former suggestion that the intrinsic value of J.I. Case common in 1933 might conceivably have been as high as 130 or as low as 30. At any point between these broad limits it would have been necessary to accept the market’s verdict-changeable as it was from day to day-as representing the best available determination of the intrinsic value of this volatile issue.
Sunday, September 17, 2006
Interesting opinions, thoughts and Ideas of Graham and Dodd
I have an invitation to present the ideas and methods of Benjamin Graham to associates of two broking companies in Mumbai. To do this in a better manner, I started study of the 2nd edition of Security Analysis by Graham and Dodd. I thought it would be a good idea to post the ideas that I feel are important in this round of my study in this blog. I request the readers/viewers to present their reactions to these ideas.
From Security Analysis, Graham and Dodd, Second Edition, McGraw-Hill Book Company
Page 13
The numerous issues selling below net current asset value, even in normal markets, are a powerful indication that Wall Street’s favoritism has been overdone.
Page 15
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 be distinguish himself from the speculator, and wherein will he deserve any better than the ordinary speculator’s fate?
Page 16
Our search for definite investment standards for the common-stock buyer has been more productive of warnings than of concrete suggestions. We have been led to the old principle that the investor should wait for periods of depressed business and market levels to buy representative common stocks, since he is unlikely to be able to acquire them at other times except at prices that he future may cause him to regret. On the other hand, the thousands of so-called secondary companies should offer at least a moderate number of true investment opportunities under all conditions, except perhaps in the heyday of a bull market. This wide but quite unpopular field may present the more logical challenge to the interest of the bona fide investor and to the talents of the securities analyst.
Page 20
We must recognize, however that intrinsic value is an elusive concept. In general terms it is understood to be that value which is justified by the facts, e.g., the assets, earnings dividends, definite prospects, as distinct, let us say, from market quotations established by artificial manipulation or distorted by psychological excesses.
Page 21
Sometime ago intrinsic value (in the case of common stocks) was thought to be about the same thing as “book value,” i.e., it was equal to the net assets of the business, fairly priced. This view of intrinsic value was quite definite, but it proved almost worthless as a practical matter because neither the average earnings nor the average market price evinced any tendency to be governed by the book value.
Hence this idea was superseded by a newer view, viz., that the intrinsic value of a business was determined by its earning power.
This means that the concept of “earning power,” expressed as a definite figure, and the derived concept of intrinsic value, as something equally definite and ascertainable, cannot be safely accepted as a general premise of security analysis.
Page 22
Let us try to formulate a statement of the role of intrinsic value in the work of the analyst
which will reconcile the rather conflicting implications of our examples. The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish either that the value is adequate-e.g., to protect a bond or to justify a stock purchase-or else that the value is considerably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient. To use a homely simile, it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age or that a man is heavier than he should be without knowing his exact weight.
Page 29
In anticipation of amore detailed inquiry in a later chapter, we have assumed throughout this chapter that investment implies expected safety and speculation connotes acknowledged risk.
Page 37
The analyst must pay respectful attention to the judgment of the market place and to the enterprises which it strongly favors, but he must retain an independent and critical viewpoint. Nor he should he hesitate to condemn the popular and espouse the unpopular when reasons sufficiently weighty and convincing are at hand.
Page 43
It follows that the qualitative factor in which the analyst should properly be most interested is that of inherent stability.
But in our opinion stability is really a qualitative trait, because it derives in the first instance from the character of the business and not from its statistical record.
Page 44
To sum up this discussion of qualitative and quantitative factors, we may express the dictum that the analyst’s conclusions must always rest upon the figures and upon established tests and standards. These figures alone are not sufficient; they may be completely vitiated by qualitative considerations of an opposite import. A security may make a satisfactory statistical showing, but doubt as to he future or distrust of the management may properly impel its rejection. Again, the analyst is likely to attach prime importance to the qualitative element of stability, because its presence means that conclusions based on past results are not so likely to be upset by unexpected developments. It is also true that he will be far more confident in his selection of an issue if he can buttress an adequate quantitative exhibit with unusually favorable qualitative factors.
But whenever the commitment depends to a substantial degree upon these qualitative factors-whenever, that is, the price is considerably higher than the figures alone would justify-then the analytical basis of approval is lacking. In the mathematical phrase, a satisfactory statistical exhibit is a necessary though by no means a sufficient condition for a favorable decision by the analyst.
The numerous issues selling below net current asset value, even in normal markets, are a powerful indication that Wall Street’s favoritism has been overdone.
Page 15
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 be distinguish himself from the speculator, and wherein will he deserve any better than the ordinary speculator’s fate?
Page 16
Our search for definite investment standards for the common-stock buyer has been more productive of warnings than of concrete suggestions. We have been led to the old principle that the investor should wait for periods of depressed business and market levels to buy representative common stocks, since he is unlikely to be able to acquire them at other times except at prices that he future may cause him to regret. On the other hand, the thousands of so-called secondary companies should offer at least a moderate number of true investment opportunities under all conditions, except perhaps in the heyday of a bull market. This wide but quite unpopular field may present the more logical challenge to the interest of the bona fide investor and to the talents of the securities analyst.
Page 20
We must recognize, however that intrinsic value is an elusive concept. In general terms it is understood to be that value which is justified by the facts, e.g., the assets, earnings dividends, definite prospects, as distinct, let us say, from market quotations established by artificial manipulation or distorted by psychological excesses.
Page 21
Sometime ago intrinsic value (in the case of common stocks) was thought to be about the same thing as “book value,” i.e., it was equal to the net assets of the business, fairly priced. This view of intrinsic value was quite definite, but it proved almost worthless as a practical matter because neither the average earnings nor the average market price evinced any tendency to be governed by the book value.
Hence this idea was superseded by a newer view, viz., that the intrinsic value of a business was determined by its earning power.
This means that the concept of “earning power,” expressed as a definite figure, and the derived concept of intrinsic value, as something equally definite and ascertainable, cannot be safely accepted as a general premise of security analysis.
Page 22
Let us try to formulate a statement of the role of intrinsic value in the work of the analyst
which will reconcile the rather conflicting implications of our examples. The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish either that the value is adequate-e.g., to protect a bond or to justify a stock purchase-or else that the value is considerably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient. To use a homely simile, it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age or that a man is heavier than he should be without knowing his exact weight.
Page 29
In anticipation of amore detailed inquiry in a later chapter, we have assumed throughout this chapter that investment implies expected safety and speculation connotes acknowledged risk.
Page 37
The analyst must pay respectful attention to the judgment of the market place and to the enterprises which it strongly favors, but he must retain an independent and critical viewpoint. Nor he should he hesitate to condemn the popular and espouse the unpopular when reasons sufficiently weighty and convincing are at hand.
Page 43
It follows that the qualitative factor in which the analyst should properly be most interested is that of inherent stability.
But in our opinion stability is really a qualitative trait, because it derives in the first instance from the character of the business and not from its statistical record.
Page 44
To sum up this discussion of qualitative and quantitative factors, we may express the dictum that the analyst’s conclusions must always rest upon the figures and upon established tests and standards. These figures alone are not sufficient; they may be completely vitiated by qualitative considerations of an opposite import. A security may make a satisfactory statistical showing, but doubt as to he future or distrust of the management may properly impel its rejection. Again, the analyst is likely to attach prime importance to the qualitative element of stability, because its presence means that conclusions based on past results are not so likely to be upset by unexpected developments. It is also true that he will be far more confident in his selection of an issue if he can buttress an adequate quantitative exhibit with unusually favorable qualitative factors.
But whenever the commitment depends to a substantial degree upon these qualitative factors-whenever, that is, the price is considerably higher than the figures alone would justify-then the analytical basis of approval is lacking. In the mathematical phrase, a satisfactory statistical exhibit is a necessary though by no means a sufficient condition for a favorable decision by the analyst.
Narayana Rao
Sunday, 17 Sep 2006, 3.45 p.m.
Monday, September 11, 2006
GRAHAM - RAO METHOD OF EQUITY ANALYSIS FOR BUY AND HOLD INVESTMENT
Graham-Rao Method
The analytical criteria of Graham-Rao Method contain quality criteria and valuation criteria.
The quality criteria are:
1. The company must have an adequate size (Rs. 100 crore sales may be taken as adequate size for Indian companies).
2. The current assets should be at least twice that of current liabilities.
3. The total debt-equity ratio should not be greater than 1:1.
4. The company should have paid dividends for the last 10 years.
5. The company must have earned profits for the last 10 years.
6. There should be a growth in earnings per share (EPS) of 10 per cent per annum over the last seven years.
The two valuation criteria are:
1. The current price should not exceed 20 times the average EPS in the last seven years for companies with past seven-year growth higher than 20 per cent. For companies with past growth rate between 10 and 20 percent per annum, the multiplier has to be the growth rate itself. In other words fair value is the average EPS of the last seven years multiplied by the P/E ratio specified as above.
2. The current price should also not be more than 1.5 times the book value last reported.
The method requires 10-year data to analyse stocks. But the method is unambiguous and uses a limited number of ratios. Investors may complain about the 10-year data requirement; but they have to keep in mind that their hard-earned money has to be protected by committing it to companies with a good past record. Graham actually recommended dividend payment for 20 years.
Narayana Rao
12th September 2006
The analytical criteria of Graham-Rao Method contain quality criteria and valuation criteria.
The quality criteria are:
1. The company must have an adequate size (Rs. 100 crore sales may be taken as adequate size for Indian companies).
2. The current assets should be at least twice that of current liabilities.
3. The total debt-equity ratio should not be greater than 1:1.
4. The company should have paid dividends for the last 10 years.
5. The company must have earned profits for the last 10 years.
6. There should be a growth in earnings per share (EPS) of 10 per cent per annum over the last seven years.
The two valuation criteria are:
1. The current price should not exceed 20 times the average EPS in the last seven years for companies with past seven-year growth higher than 20 per cent. For companies with past growth rate between 10 and 20 percent per annum, the multiplier has to be the growth rate itself. In other words fair value is the average EPS of the last seven years multiplied by the P/E ratio specified as above.
2. The current price should also not be more than 1.5 times the book value last reported.
The method requires 10-year data to analyse stocks. But the method is unambiguous and uses a limited number of ratios. Investors may complain about the 10-year data requirement; but they have to keep in mind that their hard-earned money has to be protected by committing it to companies with a good past record. Graham actually recommended dividend payment for 20 years.
Narayana Rao
12th September 2006
Wednesday, September 06, 2006
Application of Graham Rao Analysis in January 2003 to "A" Group Stocks of BSE
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S.No. Company, 7 year Avg. EPS, 7 year growth rate, fair value, Price on 29/1/03
1 ABBOTT(I) 25.36 29.5 507.26 303.25
2 ADANIEXPO 31.92 18 574.56 135.55
3 AUROPHARMA 21.77 50 435.32 240.8
4 BEL 11.23 50 224.68 188.15
5 BHEL 19.96 11 219.60 188.6
6 BPCL 20.67 15.5 320.43 194.4
7 CONCOR 22.69 35 453.80 233.8
8 EMERCK 14.54 20 290.80 241.6
9 GAIL 10.58 18 190.48 69.9
10 GMDC 19.53 15 292.95 86.1
11 GSK CONSUMER 17.11 25.2 342.20 269
12 GTL 31.88 20 637.68 76.3
13 HCL-INSYS 12.24 39 244.80 90.8
14 HIND ZINC 1.82 19.5 35.49 17.9
15 HINDALC0 72.92 10 729.20 599.35
16 IBP 25.92 27.8 518.40 225.2
17 ICI 13.68 15 205.20 119.95
18 IOC 26.41 16 422.56 244.3
19 JB CHEMICALS 16.13 13.8 222.53 178.35
20 KOCHI REF. 11.94 12.9 154.03 45.5
21 LICHSGFIN 12.77 20 255.40 65
22 MOSERBAER 16.95 36 339.00 194.55
23 MRF 146.15 24 2923.00 874.1
24 MTNL 18.12 13 235.56 107.45
25 NEYVELI LIGNITE 2.70 18.8 50.80 25
26 NIIT 25.27 24.5 505.40 133.15
27 NOVARTIS 16.02 19 304.42 267.55
28 ONGC 24.06 18.5 445.11 376.75
29 P&G 24.45 22.9 489.00 394
30 PENTAMEDIA GR. 24.03 13.9 334.02 16.35
31 PIDILITE 13.75 25 274.92 241.55
32 PUNJABTRAC 13.36 36 267.16 144.65
33 ROLTA 8.66 34.5 173.20 70
34 SBI 30.17 17.5 527.94 283.45
35 SONATSOFTW 1.46 38.5 29.22 15.95
36 SSI 18.24 41.5 364.76 84.5
37 TATATEA 16.72 18.5 309.32 160.45
38 VSNL 34.77 23 695.40 90
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The above shares were identified as potential buys using Graham-Rao analysis in Januarry 2003. Each row contains 7 year averate EPS, 7 year growth rate in EPS, calculated fair value and market price on 29/1/03. In August 2006, it was found that this portfolio outperformed the BSE sensex. I prepared a working paper on the performance of this portfolio.
Narayana Rao
S.No. Company, 7 year Avg. EPS, 7 year growth rate, fair value, Price on 29/1/03
1 ABBOTT(I) 25.36 29.5 507.26 303.25
2 ADANIEXPO 31.92 18 574.56 135.55
3 AUROPHARMA 21.77 50 435.32 240.8
4 BEL 11.23 50 224.68 188.15
5 BHEL 19.96 11 219.60 188.6
6 BPCL 20.67 15.5 320.43 194.4
7 CONCOR 22.69 35 453.80 233.8
8 EMERCK 14.54 20 290.80 241.6
9 GAIL 10.58 18 190.48 69.9
10 GMDC 19.53 15 292.95 86.1
11 GSK CONSUMER 17.11 25.2 342.20 269
12 GTL 31.88 20 637.68 76.3
13 HCL-INSYS 12.24 39 244.80 90.8
14 HIND ZINC 1.82 19.5 35.49 17.9
15 HINDALC0 72.92 10 729.20 599.35
16 IBP 25.92 27.8 518.40 225.2
17 ICI 13.68 15 205.20 119.95
18 IOC 26.41 16 422.56 244.3
19 JB CHEMICALS 16.13 13.8 222.53 178.35
20 KOCHI REF. 11.94 12.9 154.03 45.5
21 LICHSGFIN 12.77 20 255.40 65
22 MOSERBAER 16.95 36 339.00 194.55
23 MRF 146.15 24 2923.00 874.1
24 MTNL 18.12 13 235.56 107.45
25 NEYVELI LIGNITE 2.70 18.8 50.80 25
26 NIIT 25.27 24.5 505.40 133.15
27 NOVARTIS 16.02 19 304.42 267.55
28 ONGC 24.06 18.5 445.11 376.75
29 P&G 24.45 22.9 489.00 394
30 PENTAMEDIA GR. 24.03 13.9 334.02 16.35
31 PIDILITE 13.75 25 274.92 241.55
32 PUNJABTRAC 13.36 36 267.16 144.65
33 ROLTA 8.66 34.5 173.20 70
34 SBI 30.17 17.5 527.94 283.45
35 SONATSOFTW 1.46 38.5 29.22 15.95
36 SSI 18.24 41.5 364.76 84.5
37 TATATEA 16.72 18.5 309.32 160.45
38 VSNL 34.77 23 695.40 90
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The above shares were identified as potential buys using Graham-Rao analysis in Januarry 2003. Each row contains 7 year averate EPS, 7 year growth rate in EPS, calculated fair value and market price on 29/1/03. In August 2006, it was found that this portfolio outperformed the BSE sensex. I prepared a working paper on the performance of this portfolio.
Narayana Rao
Tuesday, September 05, 2006
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