Saturday, October 07, 2006

NRao on Intelligent Investor - Chapter 1

Chapter 1 Investment versus Speculation: Results to be Expected by the Intelligent Investor

The aim of this chapter is developing appropriate portfolio policy for the individual, nonprofessional investor. It is not meant for the professionals in securities like brokers and dealers.

What do we mean by “investor”?

To explain the term investor, Graham reiterates the definition from the textbook, Security Analysis. “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

Graham wants a clear distinction between investment and speculation in common stocks. He advises Wall Street as an institution to reinstate this distinction and to emphasize it in all its dealings with the public. But as Jason Zweig (He wrote a commentary on Intelligent Investor) commented Wall Street wants trades and it encourages speculation under various names and pretexts.

The reader of this book will gain a reasonably clear idea of the risks that are inherent in common-stock commitments-risks which are inseparable from the opportunities of profit that they offer, and both of which must be allowed for in the investor’s calculations. Graham wants every investor to be aware the risks associated with the stocks.

He states that there is no longer such a thing as a simon-pure investment policy comprising representative common-stocks-in the sense that one can always wait to buy them at a price that involves no risk of a market or “quotational” loss large enough to be disquieting. In most periods the investor must recognize the existence of a speculative factor in his common-stock holding. The speculative factor could be the stock in speculators’ hands. Any time he may run away from it selling at any price. It is investor’s task to keep this component within minor limits, and to be prepared financially and psychologically for adverse results that may be of short or long duration.

A rare advice by Graham on speculation:

Graham’s books are not meant for speculators. In this instance, he says speculation is necessary and unavoidable, for in many common-stock situations there are substantial possibilities of both profit and loss, and the risks therein must be assumed by someone. But there is intelligent speculation as there is intelligent investing. But there are many ways in which speculation may be unintelligent.

Of these the foremost are:

(1) speculating when you think you are investing;
(2) speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; and
(3) risking more money in speculation than you can afford to lose.

Jason Zweig is more concrete and recommends ten percent of your portfolio as a limit for speculative component.

Graham says strongly “Never mingle your speculative and investment operations in the same account, nor in part of your thinking.”

Results to be Expected by the Defensive Investor

The future of security prices is never predictable.

Sometimes, the expectations may be less favorable for stocks against bonds. But, we cannot be certain that bonds will work out better than stocks from those levels.

There is always the possibility …of accelerating inflation, which in one way or another would have to make stock equities preferable to bonds payable in a fixed amount of dollars. There is the alternative possibility that business will become so profitable, without stepped up inflation, as to justify a large increase in common-stock values in the next few years. Finally, there is the more familiar possibility that one may witness another great speculative rise in the stock market without a real justification in the underlying values. Any of these reasons, and perhaps others which were not mentioned, might cause the investor to regret a 100% concentration on bonds even at their more favorable yield levels.

Hence, the basic compromise policy for defensive investors is that at all times they should have a significant part of their funds in bond-type holdings and a significant part also in equities. It is still true that they may choose between maintaining a simple 50-50 division between the two components or a ratio, dependent on their judgment, varying between a minimum of 25% and a maximum of 75% of either.

It should be remembered that between 1949 and 1969 the price of the DJIA had advanced more than fivefold while its earnings and dividends had about doubled. Hence the greater part of the impressive market record for that period was based on a change in investors’ and speculators’ attitudes rather than in underlying corporate values.

Graham is very skeptical of the ability of defensive investors generally to get better than average results and he extends this skepticism to the management of large funds by experts.
He repeats his warning that the investor cannot hope for better than average results by buying new offerings, or “hot” issues of any sort, meaning thereby those recommended for a quick profit.

The defensive investor must confine himself to the shares of important companies with a long record of profitable operations and in strong financial condition. (An analyst worth his salt could make up such a list.)

The defensive investor can try these alternatives:

The first is the purchase of the shares of well-established investment funds as an alternative to creating his own common-stock portfolio.

He might also utilize one the “common trust funds,” or “commingled funds,” operated by trust companies and banks in many states; or if his funds are substantial, use the services of recognized investment-counsel firm. This will give him professional administration of his investment program along standard lines.

The third is the device of “dollar-cost averaging,” which means simply that practitioner invests in common stocks the same number of dollars each month or each quarter. In this way he buys more shares when the market is low than when it is high, and he is likely to end up with a satisfactory overall price for all his holdings.

Results to be Expected by the Aggressive Investor

It is no difficult task to bring a great deal of energy, study, and native ability into Wall Street and to end up with losses instead of profits. These virtues, if channeled in the wrong directions, become indistinguishable from handicaps.

The ways in which investors and speculators generally endeavor to attain better than average results include:

1. Trading on the market. This usually means buying stocks when the market has been advancing and selling them after it ahs turned downward. .. A small number of professionals frequently engage in short selling.

2. Short term selectivity. This means buying stocks of companies which are reporting or expected to report increased earnings, or for which some other favorable development is anticipated.

3. Long-Term Selectivity. Here the usual emphasis in on an excellent record of past growth, which is considered likely to continue in the future. In some cases also the “investor” may choose companies which have not yet shown impressive results, but are expected to establish a high earning power later.

Graham expressed a negative view about the investor’s overall chances of success in the above three methods.

According to him, to enjoy a reasonable chance for continued better than average results, the investor must follow policies which are (1) inherently sound and promising, and (2) are not popular in Wall Street.

In theory, it is possible to find some approaches to get better than average results, and there are broad reasons to think that it can be achieved in practice as well. Everyone knows that speculative stock movements are carried too far in both directions, frequently in the general market and at all times in at last some of the individual issues. Furthermore, a common stock may be undervalued because of lack of interest or unjustified popular prejudice.

Hence it seems that any intelligent person, with a good head for figures, should have a veritable picnic in Wall Street, battening off other people’s foolishness. But somehow it doesn’t work out that simply. Buying a neglected and therefore undervalued issue for profit generally proves a protracted and patience-trying experience. And selling short a too popular and therefore overvalued issue is apt to be a test not only of one’s courage and stamina but also of the depth of one’s pocketbook. Graham concludes: “The principle is sound, its successful application is not impossible, but it is distinctly not an easy art to master.”

There is also a fairly wide group of “special situation,” which may bring an annual return of 20%, with a minimum of overall risk to those who knew their way around in this field. They include inter security arbitrages, payouts or workouts in liquidations, protected hedges of certain kinds. The typical case is a projected merger of acquisition which offers substantially higher value for certain share than their price on the date of the announcement. But with the multiplication of merger announcements came a multiplication of obstacles to mergers and of deals that didn’t go through, and some operations are resulting in losses in these once-reliable operations. Perhaps, there is more competition now.

A third and final example of these opportunities (though not recently available) is the purchase of bargain issues easily identified as such by the fact that they were selling at less than their share in the net current assets (working capital) alone, not counting the plant account and other assets, and after deducting all liabilities ahead of the stocks. In 1975 a list was published showing nearly 200 issues of this type available in the market. In various ways practically all these bargain issues turned out to be profitable, and the average annual result proved much more remunerative than most other investments. But this opportunity virtually disappeared from the stock market in the next decade.

However, at the low prices of 1970 there again appeared a considerable number of such “sub-working-capital” issues and despite the strong recovery of the market, enough of them remained at the end of the year to make up a full sized portfolio.

Graham has warned initially that enterprising investment is possible in theory and but very difficult in practice. But he concludes the chapter on an optimistic note saying the enterprising investor under today’s conditions still has various possibilities of achieving better than average results. The huge list of marketable securities must include a fair number that can be identified as undervalued by logical and reasonably dependable standards. These should yield more satisfactory results on the average than will the DJIA or any similarly representative list.

He says, “ In our view the search for these would not be worth the investor’s effort unless he could hope to add, say, 5% before taxes to the average annual return from the stock portion of his portfolio.”

The chapter end with the sentence, “We shall try to develop one or more such approaches to stock selection for use by the active investor.”
Saturday, 7 Oct 2006

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