Monday, June 27, 2011

Al Frank (4)


In addition to stock diversification, Al Frank also discussed time diversification, i.e., how long does an investor hold a stock he or she has purchased.  In these days of split second trades conducted by extremely fast computer programs, such an idea seems old fashioned.  Since few individual investors have the financial resources, time or ability to set up a computer programmed investment system for successful trading in and out of the market every minute, I believe the old fashioned way of investing is still relevant and preferable for the individual investor.  Mr. Frank discussed diversification as follows:

Diversification refers to stocks, industries and time.  Stock diversification is the spreading of individual stocks and corporate risk by obtaining as many different stocks in different industries as is reasonable and feasible with one's resources.  Time diversification is the holding of positions for as long as their fundamental analyses indicate their undervaluation and potential appreciation, because studies have shown market risk is thereby reduced.  Few investors seem aware that time diversification is more important than stock diversification.  Generally the longer you own a stock (of a viable business) the less risk you engender.

Mr. Frank wrote about a study published in the Journal of Portfolio Management, which measured the reduction of risk achieved by holding stocks for longer periods of time.  The study had the following results:

Testing portfolios varying in size from 1 to 100 stocks, with holding periods from six months to six years, "[The researchers] concluded that a 1-stock 'portfolio' held for one year was less risky than a 100-stock portfolio held for a single six-month period."  The authors also found that holding a 10-stock portfolio for four years was one-third as risky as holding a 100-stock portfolio for one year.  There is a common sense rationale for the statistical probabilities of time diversification.  For any relatively brief period, the market can have a selloff that carries most stocks down without regard to each of their corporation's fundamentals.  This is called market or systematic risk.  But over longer time periods, the aphorism "Value will out" tends to prove true. 

In order to hold a stock for a long time, the investor must have a very important trait: patience.  He or she must have the patience to weather the ups and downs of the market and to continue holding a stock despite its short term movements.  To have the necessary patience, the investor must believe in a system of investing.  Patience is only possible if the individual has confidence in his or her chosen investment strategy.  Mr. Frank summed it up as follows:

Maintaining our analytic methodology, portfolio strategy, and steadfast patience even though some of our stocks or the market in general takes a tumble are practical applications of rule utilitarianism.  When you believe in your system, in the long-term advancing nature of undervalued stocks and the market on average, then you are able to hold an undervalued stock through its recurring downward fluctuations in market price, even through a 50 percent or more decline in price.  In this regard, Buffet has pointed out that, "You ignore that possibility at your own peril.  In the history of almost every major company in this country, it has happened.  you shouldn't own common stocks if a decrease in their value by 50 percent would cause you to feel stress."

We will end our review of Mr. Frank's classic text on this note.  We will return to his book in the future since he also explains other investment strategies, but he remained committed to value investing as his core philosophy.

The material from Al Frank's New Prudent Speculator by Al Frank, copyright 1995 by Al Frank, is used with permission of the copyright holders, the heirs of Al Frank.

Your comments are welcome and will be posted upon receipt. 

Monday, June 20, 2011

Al Frank (3)


We ended the last blog with Mr. Frank's comments on diversification; i.e., not putting all of your eggs in one basket.  This mirrors the advice of the other authors we have looked at, Philip Carret and Benjamin Graham.  Al Frank stated that there are actually two types of diversification which the individual investor has to keep in mind.  In his book, Al Frank's New Prudent Speculator, he discussed the concept of diversification as follows:

There are two distinct schools of portfolio construction and management which can be summarized by the terms concentration and diversification.  Those who favor concentration believe in owning relatively few stocks at any one time.  Instead of putting many eggs in many baskets, the concentrationists put a few eggs in one basket.  They are very careful in the initial selection process, because if they are wrong in even one stock the impact on their equity would be significantly detrimental.  Some of them also believe that few can adequately analyze and understand more than a handful of corporations, let alone keep sufficient tabs on them after buying them.

Mr. Frank identified Gerald Loeb and Warren Buffet, two famous investors, as proponents of concentrated investing.  Although he obviously respected their investing track records, he did not agree with them.  He explained his position as follows:

In contrast to these estimable and successful gentlemen, I am a firm believer in diversification - almost the wider the better - in order to minimize individual corporate risk sometimes called unsystematic risk (as contrasted to market or systematic risk).  Even before I learned about risk reduction from diversification, I had an intuitive or common sense notion that if you only had a small percentage of your estate at risk in any one position, and if that position went against you badly, then you wouldn't be hurt much overall.  My initial sense of stock diversification was that I'd want at least 30 stocks, because 30 was the number that elementary statistics texts claim is a minimum meaningful population or number of events.  I find it interesting that my original, naive choice of having at least 30 stocks would turn out statistically to eliminate about 96 percent of individual stock risk.

Mr. Frank went on to warn his readers that just buying any 30 stocks was not the end of the exercise.  Those stocks had to also be in different industries; industries that did not, as a group, perform in similar ways in the market.  As an example, the oil exploration industry and the oil refining industry are connected for obvious reasons.  Economic events in the world will affect both industries in much the same way.  Indeed, events in one industry will have direct economic effects on the other.  Therefore, to own the stock of Exxon Mobil, the oil exploration giant, and also of Valero Energy Corporation, one of the largest oil refiners in the US, does not mean that the investor has achieved any meaningful diversification.  Although they are two separate companies, the fortunes of the global oil industry will impact them both at the same time.  Mr. Frank recommended an individual investor hold 30 stocks in at least 12 to 15 different industry groups in his or her portfolio.  An individual investor, when starting out, will not be able to immediately achieve this level of diversification, but can manage his or her portfolio over time to meet this level of stock diversity.

Mr. Frank also counseled that no individual stock in an investor's portfolio should exceed 5% of the portfolio's total value.  This rule is applied very easily to the investor's stock purchases when embarking on his or her investing career.  What this means is that the investor's initial goal would be to accumulate a minimum of 20 different stocks in almost as many different industries.  Once the investor's portfolio has been established, then the rule is applied with each subsequent purchase.  The 5% rule is really a simple way to maintain diversification.  If one stock grows in value to the point that it is overweighted in the portfolio, this is a sign that the investor should consider selling some of the position in order to regain portfolio balance.  He suggested the following:

Applying only to initial purchases, the 5 percent rule is waived in the case of appreciated stocks that are still significantly undervalued according to their fundamental corporate analysis.  I suggest you consider a 10 to 20 percent limit of any appreciated position in your portfolio.  The idea is to avoid the chance of being badly damaged if one or a few positions go sour, and if your "best stock" begins to represent more than 15 percent, a sharp (50 percent) drop in it would really set back the portfolio's overall performance.  Besides, you don't have to sell all or even most of the highly appreciated stock - just bring it down to 10 percent or less of the portfolio and reinvest the proceeds in other undervalued stocks, thus increasing stock diversification.

Mr. Frank also wrote about a second type of diversification in investing, i.e., time diversification.  We will investigate his concept in next week's blog.

The material from Al Frank's New Prudent Speculator by Al Frank, copyright 1995 by Al Frank, is used with permission of the copyright holders, the heirs of Al Frank.

Please feel free to leave a comment, which will be promptly posted to the site.

Monday, June 13, 2011

Al Frank (2)


One of the things I like about Al Frank's book, Al Frank's New Prudent Investor, is his repeated emphasis of the fact that investing need not be difficult.  Wall Street perpetuates the myth that it takes advanced degrees, a genius IQ and esoteric analysis of all sorts of business minutiae in order to succeed in the market.  He argued against that as follows:

There is no limit to the amount of inquiry and effort analysts can expend evaluating a corporation, but it is not necessary to go into great or subtle detail.  A selection of relatively gross measures is usually sufficient to make such evaluations and selections for successful stock speculation.

Mr. Frank listed seven criteria which he felt were good indicators of a corporation whose stock merited consideration.  He listed them as follows:

1. Price to earnings (P/E).  Normally, industrial stocks trading below 10 times earnings to 30 percent below their P/E norm (average P/E).

2. Price to sales or revenues (P/R).  Normally, stocks trading near their out-of-favor levels or below their accepted P/R levels.

3.  Price to book value (P/BV).  Normally, stocks trading below their book value per share of 30 percent below their book value norm.

4. Price to cash flow (P/CF).  Normally, stocks trading at less than six times cash flow or 30 percent below their cash flow norm.

5. Return on equity or net worth (ROE).  Normally, stocks trading at a 15 percent return on equity or better. (Likewise a return of 15 percent or better on the cost of shares).

6.  Market capitalization (market cap)Normally, stocks with a market capitalization of less than $200 million (computed as shares outstanding times price per share) are considered "small cap."  While returns on small company stocks (below $100 million in market cap) are significant over long time periods, I tend to buy bargains in value and growth of any size market-capitalization stock, especially as a mix can aid diversification (risk reduction) for those periods when large-cap stocks outperform small-cap stocks.

7. Return on assets (ROA).  Normally stocks trading for an ROA comparable to or higher than their historical ROA, although somewhat lower ROAs in stocks found to be otherwise undervalued may indicate room for improvement.  Pay attention to the trend of this component, as well as in all the other criteria.

When referencing an "average" ratio, its "norm" or the ratio's "accepted level", Mr. Frank means the average for that criteria for the previous 5 years.  This means an investor might have to do some digging, but it is worth the effort.  Looking at a 5 year average for a company's financial metrics minimizes the effect of what would be an abnormal ratio for a company due to any unusual economic or financial forces currently affecting it.

Mr. Frank was also a strong proponent of diversification, as reflected in his comment in criteria number 6 above.  Like Carret and Graham, he recommended a portfolio with a number of stocks.  He had the following to say about diversification:

I want to be widely diversified with many different stocks from several industries in my portfolio.  I want to have at least 25 or preferably 35 or more stocks in 15 to 17 different industries in a portfolio, so that when 5 or 10 stocks underperform, that result is offset by the good performance of the 15 or 25 others.

We will continue with Mr. Frank in the next blog.

The material from Al Frank's New Prudent Speculator by Al Frank, copyright 1995 by Al Frank, is used with permission of the copyright holders, the heirs of Al Frank.

Your comments are welcome and will be posted upon receipt. 

Monday, June 6, 2011

Al Frank (1)


Al Frank wrote his investment letter, The Prudent Speculator, for many years.  Individuals subscribed to his letter in order to learn his techniques for successful stocks selection and get his stock recommendations.  He put his investment advice together into a book, The Prudent Speculator: Al Frank on Investing , published in 1989.  Copies of the original book are still available on  I believe the revised edition, Al Frank's New Prudent Speculator, which was published in 1995, is still in print.  Mr. Frank started his book by posing the question that bedevils every beginning investor:

Given the multitude of information, possibilities, published "successful" methods, and strategies for speculating with stocks, how is one to choose?  The problem is especially vexing as apparently successful strategists dismiss their competitors' methods as seriously flawed or completely missing the point.  It is difficult to apply any of the numerous and conflicting systems when the skills involved seem to require a graduate degree in mathematics, accounting, or psychology.

Mr. Frank was a believer in fundamental analysis, specifically, value investing.  He approached investing in stocks by looking at the companies represented by the stocks.  He maintained that fundamental analysis was not that complicated and could be mastered by any individual investor willing to take the time to learn.  He described investing as follows:

Many people have been conditioned to believe that investing is an esoteric and highly skilled enterprise.  Obviously those who get paid to invest for others act as if they had irreplaceable training, high I.Q., insights and nonpublic information that gives them an advantage over the average wage earner.  Little could be further from the truth.  Successful investing involves only a handful or two of considerations that are available to anyone with a 6th-grade education.  You probably know most of them already.

Interestingly, Ben Graham felt the same way.  In his book, The Intelligent Investor, Graham advised his readers to avoid investing strategies which employed anything more complicated than some basic algebra.  This is a far cry from the investment gurus running funds today who tout their complicated  mathematical calculations run on high speed computers to search out investment opportunities.

Like Philip Carret and Benjamin Graham, Al Frank taught that simple analysis of the fundamentals of a company was the easiest way to make money in the stock market.  The essential message of all three of these value investors was the same:  an individual investor can learn how to succeed in the market on his or her own.

Keep in mind that successful investing for an individual investor is not the same as being a success on Wall Street.  A person is a success on Wall Street when he or she is able to attract the most money from people who have accepted the idea that they can not do their own investing.  The more money an investment fund manager can attract, the more fees and charges that fund manager earns.  Whether their investment strategy actually makes the most money for the investors is only important insofar as such success attracts yet more investor money, which translates into yet more fees.  As I have said all along in this blog, the folks on Wall Street are entitled to earn a living; however, the individual investor can save those fees and charges if he or she takes the time and makes the effort to learn.

We will continue with Mr. Frank in the next blog and learn more of his type of fundamental analysis.

The material from Al Frank's New Prudent Speculator by Al Frank, copyright 1995 by Al Frank, is used with permission of the copyright holders, the heirs of Al Frank.

Comments, as always, are welcome.