Monday, April 25, 2011

The Godfathers: Don Corleone, James Brown & Benjamin Graham


Don Corleone was the original Godfather, the head of a New York Mafia family in Mario Puzo's 1969 best selling book of the same name.  James Brown, the iconic singer, was known as the Godfather of Soul.  Benjamin Graham could, rightfully, claim the title of Godfather of Value Investing, the core of fundamental stock analysis.

Ben Graham was born Benjamin Grossbaum in London in 1894.  His family emigrated to New York when he was one year old.  The Grossbaum's comfortable life style came to an end as the result of the father's death in 1903 and the subsequent decline of the family porcelain business.  The final blow to the family's fortunes came in the stock market crash of 1907.  His mother had been trading stocks on margin and was wiped out.  The family name was changed to Graham as a result of anti-German sentiments in America during World War I, which was not an uncommon practice during that period.

Mr. Graham graduated from Columbia University at the age of 20.  He worked successfully on Wall Street for decades first as an analyst and then as a partner in an investment firm.  He also taught at Columbia and at the New York Institute of Finance.  Mr. Graham coauthored a text book, Security Analysis, with David Dodd which was published in 1934.  The book he is best remembered for, The Intelligent Investor, was published for individual investors in 1949.  He revised the book four times, with the last edition being published in 1973.

It seems to me that people are shaped by the times in which they live.  Young Graham was undoubtedly affected by his mother's failures in the stock market.  I would guess that he promised himself not to repeat her mistakes.  When Benjamin Graham started his investing career, there was not much information readily available about public companies.  Analysts needed to be part detective in order to gain a clear idea of the financial condition of companies and their businesses.  Mr. Graham excelled at this, and his efforts resulted in large profits for his investment firm.  This success lent credence to his teachings about stock analysis, which he felt should be based on financial facts gleaned from business records, not on emotion and market rumor.

His primary message to individual investors was to seek a "margin of safety" in all of their stock investments.  He advised investors to find a publicly traded company with a market price significantly below the intrinsic value of the company as determined by his form of financial analysis.  He wanted them to always ask "how much" they were paying for the stocks they bought.

In his Introduction to the book, Mr. Graham recounts an article he had written for a women's magazine in which he had advised the readers to buy their stocks just as they bought their groceries, based on price; not as they purchased their perfume.  One of Mr. Graham's most famous passages in The Intelligent Investor is his description of Mr. Market.  If you look at my blog on January 10, 2011, you can read his timeless approach to the market and the movement of stocks traded in it.

I read the fourth and final edition of The Intelligent Investor in the early 80's and its message resonated with me then and continues to shape my investments to this day.  In the interest of full disclosure, I pattern my investment purchases on his teachings.  There is a revised edition of the book still available today.  The revised edition, with the full text of the 1973 edition plus commentary by Jason Zweig, a noted financial writer, and an additional preface by Warren Buffett, was published by HarperBusiness Essentials, a division of HarperCollins Publishers in 2003.  If, as you learn more about fundamental analysis, you find that it appeals to you as an investment strategy, you need to start with this book.  You can order one online by clicking the Amazon link above.

We will explore Benjamin Graham's methods and his recommended way of investing in the next blog.  As always, your comments are welcome.

Monday, April 18, 2011

Philip L. Carret (3)


We will conclude our study of Philip Carret and his1930  book, The Art of Speculation, with his final six rules for investing:

7.  Avoid "inside information" as you would the plague.
Looking at the psychological aspects of "tips", Mr. Carret said that they appealed to an investor's vanity since such confidential news sets the recipient apart from the rest of the market.  He recommended that the investor view him or herself as being the thousandth rather than the first or second person to get the story.  Such lack of self pride would, in Mr. Carret's words, be "well rewarded."

8.  Seek facts diligently, advice never.
Mr. Carret tells the story of a gentleman who was offered the chance to purchase a significant (1/6th) interest in a new technology company of the time, American Telephone & Telegraph, for $10,000.  He sought the advice of a friend in a similar industry, the president of Western Union Telegraph Co., who advised him to save his money.  His friend viewed the new invention, the telephone, as impracticable.  The president also advised him that Western Union owned patents which gave it a better claim to the invention.  The gentleman, unfortunately, took his friend's advice.  And, as they say, the rest is history.

9.  Ignore mechanical formulas for valuing securities.
Although Mr. Carret recognizes that some measures of a company are helpful, he warns against "unintelligent use of a convenient yardstick of values."  He gives the example of the price earnings ratio, which is calculated by dividing a stock price by the prior year's per share earnings.  The result represents the price earnings ratio.  The higher it is, the more expensive the stock appears to be.  Mr. Carret says this ratio is a good start, but the investor can not rely on it alone.  Intelligent analysis will always come down to careful consideration of all aspects of both a stock and the company which has issued it.

10.  When stocks are high, money rates rising, business prosperous, at least half a given fund should be placed in short-term bonds.
This rule recognizes the cyclical nature of the stock market.  When the market in general and an investor's particular stocks have greatly risen in value, an investor should anticipate a drop at some point.  This can be seen as a form of market timing in which the investor tries to "buy low and sell high."  Mr. Carret is suggesting that at what appears to be a market top, the cautious investor should sell his or her stock and put the proceeds into income producing securities to wait out the imminent and inevitable fall in prices.

11.  Borrow money sparingly and only when stocks are low, money rates low or falling, and business depressed.
When Mr. Carret wrote the articles which became his book many individual investors bought their stocks on margin, which means that they put up only a small portion of the purchase price and borrowed the balance from the brokerage house who sold him the stock. If the stock went up in price, then the profits, after repaying the loan, would be larger than if the investor only bought what he or she could afford.  The problem was that if the stock went down enough to wipe out the small "equity" held by the investor, the loan was called and the investor would be sold out of the stock by the broker to recoup the loan, resulting in a loss of the entire investment.  He is recommending that an investor should borrow on a limited scale and only on occasion.  I personally believe that investing on margin is not something for the individual investor.  If you own stocks outright, a small decline in price will not affect your holdings.

12.  Set aside a moderate proportion of available funds for the purchase of long-term options on stocks of promising companies whenever available.
Mr. Carret is describing the type of security known as option warrants which are usually offered to investors in bonds and preferred stock issues.  These can be sold separately from the bonds or preferred stocks they come with.  He says that they  were offered in many instances to give the broker selling the bonds or preferred stock a "talking point" since they had little initial value and their chances of appreciation were "microscopically small."  However, he felt this was a cheap way to get in on the ground floor of a "promising company."  This seems a game best left to the "professionals on a closed track", as the TV car commercials warn.

There are two types of history books.  The first type is written by a present day historian about events which occurred in the past.  The second and, I feel, more interesting type is one written by someone living through the events.  Mr. Carret's The Art of Speculation is one of the latter.  His very readable book talks about the market from a then current perspective; now, a historical one for us.  The book is still in print today, a testament to its continuing value and relevance.  It is well worth reading for the beginning investor.

Your comments are always welcome.

Monday, April 11, 2011

Philip L. Carret (2)


In his classic, The Art of Speculation, Mr. Carret listed his twelve precepts for fundamental "value" investing.  We will look at the first six of them in this blog.  They are as follows:

1.  Never hold fewer than ten different securities covering five different fields of business. 
This provides a minimum amount of diversification; the old rule against keeping all of your eggs in one basket.

2.  At least once in six months reappraise every security held.
Mr. Carret suggests that you look at each stock in your portfolio and ask whether you would buy the same stock for the same price it is selling at today.  The price you paid for the stock is irrelevant in this exercise.  You are looking at the investment anew.   If your answer would be no, then he recommends selling it and reinvesting the proceeds.  The time period is long enough to prevent the investor from falling into the trap of over trading, a guaranteed road to losses.
3.  Keep at least half the total fund in income-producing securities.
 At the time Mr. Carret wrote this, income-producing securities, corporate or government bonds paying interest, were considered a higher grade of investments than common stocks that did not pay any dividend.  The risk of loss was considered significantly smaller.  The investment quality of the bonds was the attraction, not the income itself.  In down markets, bonds retained more of their value than stocks.  However, bonds can lose value as a result of interest rate changes in the market.

4.  Consider yield the least important factor in analyzing any stock.
Mr. Carret explains that the speculative investor is mainly interested in an increase in the market value of the stock he or she purchases.  The dividend income is not the goal.  If the investor needs income from the funds, Mr. Carret considered that a sign the investor could not afford to speculate in the first place.  I agree with this rule, but I feel it may not necessarily apply to an investor in retirement.  At that point, the investor is presumably looking for some income as well as appreciation.

5.  Be quick to take losses, reluctant to take profits.
The underlying assumption for his statement is that the investor is looking for a long term increase in the value of his or her investment portfolio, not quick trading profits.  You will hear the old adage, "You'll never go broke taking profits," from your broker who, of course, makes a living on the commissions earned from your frequent buying and selling.  The other beneficiary of frequent trading profits is the tax man, who will expect his "commission" to be paid as well. 

6.  Never put more than 25% of a given fund into securities about  which detailed information is not readily and regularly available.
In the 1920's before there were federal securities regulations, there were few if any requirements that public companies provide financial information about their business to the public.  Only the large shareholders, directors and officers knew what was really going on.  The individual investor back then had to work hard to learn much of anything about the state of affairs of the companies in which he or she had invested.  Such is not the case today.  US and many other countries' securities laws require companies to file periodic reports about the results of operations with the Securities & Exchange Commission (SEC) in the USA or the equivalent in other countries.  These reports, at least in the US, are available to investors at little or no charge.  The reporting requirements are usually not as stringent for smaller public companies, so this advice still holds true today.  If you can't easily and readily learn about a company's business operations and results on a regular basis, you probably should not invest in its stock.

 We will learn the other six rules next Monday.

As always, your comments are welcome.

Monday, April 4, 2011

Philip L. Carret (1)


Philip L. Carret was one of the early proponents of "value" investing, one of the forms of fundamental analysis.  He wrote a series of articles for Barron's, a weekly financial publication, in 1926.  Those articles became a book, The Art of Speculation, which was first published in 1930.  One of Mr. Carret's many claims to fame was his founding in 1928 of the Fidelity Mutual Trust (now the Pioneer Fund), one of only five investment trusts (now we call them mutual funds) on Wall Street at the time.  The Pioneer Fund continues today, making it the third oldest mutual fund on Wall Street.  Like the Pioneer Fund, Mr. Carret had one of the longest careers on Wall Street, remaining active in the markets for more than 70+ years.  He was one of the few people on Wall Street who experienced first hand the market crashes of both 1929 and 1987.  At the time he wrote his articles in 1926, the term "speculation" had some of the same negative connotations that still exist today.  This is what he had to say:

What, after all, is speculation?  The redoubtable Webster gives a number of definitions.  Among them we find (1) "mental view of anything in its various aspects; intellectual examination"; (2) "the act or practice of buying land or goods, etc., in expectation of the rise of price and of selling them at an advance."  To the second he added the complacent observation that "a few men have been enriched but many have been ruined by speculation."  According to Webster, the motive is the test by which we must distinguish between an investment and a speculative transaction.  The man who bought United States Steel at 60 in 1915 in anticipation of selling at a profit is a speculator according to Webster, though he may have changed his mind about selling and added the stock to his list of permanent investments.  On the other hand, the gentleman who bought American Telephone at 95 in 1921 to enjoy the dividend return of better than 8% is an investor, though he may have succumbed to the temptation of a 10-point profit a few weeks later.  Although the outcome of the transaction may contradict the original intention of the party chiefly interested, it is obviously impossible to omit the factor of motive in defining speculation.

Mr. Carret maintained that speculation is just a point on the investment spectrum.  He provided the following insight:

Your articles deal with speculative investment rather than with speculation," said an astute observer of both fields of activity when he had read the greater part of this book in serial form.  To this charge the writer was forced to plead guilty.  After all it is by no means easy to draw the line between investment and speculation, between speculation and gambling.  If one is to discuss the topic of speculation and perhaps thereby induce some readers to attempt it who might otherwise have left speculation alone, it is much more helpful to the average reader, much less dangerous to the reader who might misinterpret what he reads, to discuss that sort of speculation which is on the borderland of investment than the more dangerous and less useful type of speculation which borders on gambling.  Perhaps the best sort of speculation, and the kind that is most likely to be successful, is that which regards it as the business management of a fund.  What does the manager of a business do?  He controls men, materials and money, seeking to handle them in such a way that the business will produce a profit.  Conceiving the speculator as manager of a business it will be seen that he also controls men, materials and money.  The money is the starting point of his business, the materials are the securities which he buys and sells, the men are the directors and managers of the companies in whose securities he invests.

We will return to Mr. Carret's classic on investing in the next blog to learn about his twelve precepts for the speculative investor.  The sixth printing of The Art of Speculation by Philip L. Carret, published in 1995 by Fraser Publishing Company, remains in print today.

Comments are always welcome. On April 7th, this upcoming Thursday, I will be a guest on Lake Effect, a radio program on the Milwaukee public radio station, WUWM, 89.7 FM.  I will be talking about this blog site.  You can listen to the podcast after 11:00 am Milwaukee time on WUWM.COM.