WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK. FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON
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 13, 2011
Monday, June 6, 2011
Al Frank (1)
WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK. FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON
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 Amazon.com. 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.
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 Amazon.com. 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.
Monday, May 30, 2011
Stocks and Used Cars
WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK. FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON
Awhile ago I had a discussion about stocks with one of my daughters. I suggested to her that, in this time of low interest rates, it might make some sense to look for stocks paying dividends at rates (based on their current market price) that were greater than the interest rates available on government bonds, bank savings accounts and certificates of deposit. We talked about companies with sufficient financial strength to continue and, hopefully, increase their dividends in the future. I explained to her that if she could buy a company's stock for $33 per share which is paying an annual dividend of $1 then she would receive a dividend with a rate of return to her of 3% per annum. That rate far exceeds current short term interest rates currently offered by the US government and financial institutions. I told her that once she had locked in her purchase price, any increase in the dividend would result in an even higher rate of return over time.
I pointed out to her one stock which I had purchased many years ago. The company has increased its dividend every year since then. Based on the price I paid back then and the dividend paid today, the dividend rate for me today is over 10%. Obviously, there is always the chance a company might have to reduce or suspend its dividends if it is suffering financial problems, but an investment in a financially strong company lowers that possibility.
I identified for her a few companies which were paying decent dividends with a 3% rate of return. I was surprised when she said that she would not buy a couple of the stocks I mentioned because she did not want to "support" those businesses. She thought she would be buying the stock directly from the companies, thereby giving them her money to use in a type of business she could not support.
I explained that, unless she purchased a stock in a company's public offering, she was buying from another investor and the transaction had no effect on the company's business in any way. Stocks are like used cars. A car manufacturer makes no money when someone buys one of their used models from a dealer or a private party. This raises a good point.
Most used car purchasers now ask for the Carfax ® report on the vehicle they are considering. In addition, there is a wealth of knowledge about car models available on line. Thankfully, the days of walking onto a car lot and blindly picking out a vehicle based on little more than the salesman's persuasive patter are long since over. A stock purchaser can and should do the same. He or she should check out the company before buying its shares.
There are several well respected sources of financial information on companies and their stocks. One of the most widely known is the Standard & Poor's Report. An S&P report on a company is several pages of information about the industry in which the company operates, the business and financial state of the company (including most of the financial metrics Ben Graham looked for) and other important information an investor should know before committing to a purchase. S&P has reports on almost all of the stocks in the market. If you have an account with a broker, online or otherwise, you should be able to obtain these reports for no charge.
Like the Carfax ® report, the S&P report is essential in order to make a good decision. You should devote as much time and study to a stock purchase as you would to buying a used vehicle.
In the next blog, we will return to fundamental analysis and learn about another value investor, Al Frank. Mr. Frank was famous for his investment letter, The Prudent Speculator.
Comments are always welcome.
Awhile ago I had a discussion about stocks with one of my daughters. I suggested to her that, in this time of low interest rates, it might make some sense to look for stocks paying dividends at rates (based on their current market price) that were greater than the interest rates available on government bonds, bank savings accounts and certificates of deposit. We talked about companies with sufficient financial strength to continue and, hopefully, increase their dividends in the future. I explained to her that if she could buy a company's stock for $33 per share which is paying an annual dividend of $1 then she would receive a dividend with a rate of return to her of 3% per annum. That rate far exceeds current short term interest rates currently offered by the US government and financial institutions. I told her that once she had locked in her purchase price, any increase in the dividend would result in an even higher rate of return over time.
I pointed out to her one stock which I had purchased many years ago. The company has increased its dividend every year since then. Based on the price I paid back then and the dividend paid today, the dividend rate for me today is over 10%. Obviously, there is always the chance a company might have to reduce or suspend its dividends if it is suffering financial problems, but an investment in a financially strong company lowers that possibility.
I identified for her a few companies which were paying decent dividends with a 3% rate of return. I was surprised when she said that she would not buy a couple of the stocks I mentioned because she did not want to "support" those businesses. She thought she would be buying the stock directly from the companies, thereby giving them her money to use in a type of business she could not support.
I explained that, unless she purchased a stock in a company's public offering, she was buying from another investor and the transaction had no effect on the company's business in any way. Stocks are like used cars. A car manufacturer makes no money when someone buys one of their used models from a dealer or a private party. This raises a good point.
There are several well respected sources of financial information on companies and their stocks. One of the most widely known is the Standard & Poor's Report. An S&P report on a company is several pages of information about the industry in which the company operates, the business and financial state of the company (including most of the financial metrics Ben Graham looked for) and other important information an investor should know before committing to a purchase. S&P has reports on almost all of the stocks in the market. If you have an account with a broker, online or otherwise, you should be able to obtain these reports for no charge.
Like the Carfax ® report, the S&P report is essential in order to make a good decision. You should devote as much time and study to a stock purchase as you would to buying a used vehicle.
In the next blog, we will return to fundamental analysis and learn about another value investor, Al Frank. Mr. Frank was famous for his investment letter, The Prudent Speculator.
Comments are always welcome.
Monday, May 23, 2011
Ben Graham On Accounting
WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK. FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON
At the end of the last blog I mentioned accounting. I never took an accounting course in school and felt that I was no worse for it. However, when I became interested in the stock market, I realized that I needed to know some accounting in order to invest. I made the mistake of buying an introductory college accounting textbook. I couldn't make it past page 13. It sat on the shelf with a dogeared page 13 for several years before I threw it out.
Fortunately, I discovered Ben Graham's short book on financial statements geared for investors, The Interpretation of Financial Statements. It was published in 1937, just three years after the publication of Security Analysis. I imagine he did this for his students who had not majored in accounting. I have used it as a reference book to look up terms I needed to understand. Over the years with the help of Graham's book, I have learned the investment terms necessary for understanding a company's financial position. An individual investor needs to understand a limited number of accounting principles to be able to glean needed investment information from a company's balance sheet, income (profit/loss) statement and cash flow statement.
In the last blog, I listed five of the financial characteristics that Graham used when analyzing a company. He included three terms, current assets, current liabilities and net tangible assets which require some familiarity with accounting. Those and others are clearly explained in his book. Current assets are defined as cash, cash equivalents (assets immediately convertible into cash), receivables due within one year and inventories. Inventories, for a manufacturing concern, would include raw materials, goods in process of manufacture and finished goods. Sometimes packing and shipping supplies are included. These assets are usually stated at the lower of cost or market value. Current liabilities are claims payable to third parties within one year. Tangible assets are all physical and financial assets, such as factories, inventory, cash, accounts receivable and investments. Intangible assets include items such as good will, intellectual property such as patents, trademarks and the like. Although trademarks and patents obviously help generate a company's earnings (think of the words Coca Cola in their distinctive script), it is hard to establish a value for them. Mr. Graham usually excluded them from his valuation of assets when analyzing a company. He defined net tangible assets as a company's tangible assets less all of the company's liabilities. He included both current and long term debts. The one year period for calculating current assets and current liabilities begins as of the date of the financial statements in which they appear.
I promised that the discussion of accounting terms would be short, so I will stop here. If an individual intends to invest in common stocks and does not have an accounting background, he or she will need to get a copy of this book. An investor with accounting training will benefit from this book as well, since it focuses on the aspects of financial statements which are most important for an investor.
A hardcover version of the 1937 edition was republished by HarperBusiness, a division of HarperCollins Publishers, with an introduction by Michael Price in 1998. It is still in print.
Comments, as always, are welcome.
At the end of the last blog I mentioned accounting. I never took an accounting course in school and felt that I was no worse for it. However, when I became interested in the stock market, I realized that I needed to know some accounting in order to invest. I made the mistake of buying an introductory college accounting textbook. I couldn't make it past page 13. It sat on the shelf with a dogeared page 13 for several years before I threw it out.
Fortunately, I discovered Ben Graham's short book on financial statements geared for investors, The Interpretation of Financial Statements. It was published in 1937, just three years after the publication of Security Analysis. I imagine he did this for his students who had not majored in accounting. I have used it as a reference book to look up terms I needed to understand. Over the years with the help of Graham's book, I have learned the investment terms necessary for understanding a company's financial position. An individual investor needs to understand a limited number of accounting principles to be able to glean needed investment information from a company's balance sheet, income (profit/loss) statement and cash flow statement.
In the last blog, I listed five of the financial characteristics that Graham used when analyzing a company. He included three terms, current assets, current liabilities and net tangible assets which require some familiarity with accounting. Those and others are clearly explained in his book. Current assets are defined as cash, cash equivalents (assets immediately convertible into cash), receivables due within one year and inventories. Inventories, for a manufacturing concern, would include raw materials, goods in process of manufacture and finished goods. Sometimes packing and shipping supplies are included. These assets are usually stated at the lower of cost or market value. Current liabilities are claims payable to third parties within one year. Tangible assets are all physical and financial assets, such as factories, inventory, cash, accounts receivable and investments. Intangible assets include items such as good will, intellectual property such as patents, trademarks and the like. Although trademarks and patents obviously help generate a company's earnings (think of the words Coca Cola in their distinctive script), it is hard to establish a value for them. Mr. Graham usually excluded them from his valuation of assets when analyzing a company. He defined net tangible assets as a company's tangible assets less all of the company's liabilities. He included both current and long term debts. The one year period for calculating current assets and current liabilities begins as of the date of the financial statements in which they appear.
I promised that the discussion of accounting terms would be short, so I will stop here. If an individual intends to invest in common stocks and does not have an accounting background, he or she will need to get a copy of this book. An investor with accounting training will benefit from this book as well, since it focuses on the aspects of financial statements which are most important for an investor.
A hardcover version of the 1937 edition was republished by HarperBusiness, a division of HarperCollins Publishers, with an introduction by Michael Price in 1998. It is still in print.
Comments, as always, are welcome.
Monday, May 16, 2011
Benjamin Graham (3)
WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK. FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON
Benjamin Graham wanted to find several characteristics in a company before he would consider purchasing its stock. If he was able to purchase a company's stock with a price below what those metrics showed the company to be worth, he had the "margin of safety" he was always looking for. If the stock price is already low, then the chance of a further significant decline is diminished. To put it bluntly, Graham wanted to buy stocks on the cheap.
He looked for companies undervalued by the market. A quick measure of this is the price/earnings (p/e) ratio, which is the market price of the stock divided by the earnings per share (usually for the prior four quarters). This ratio shows what investors in the market are willing to pay for each $1 of company earnings. The lower the ratio, the cheaper the stock. Another way to look at the p/e ratio is to think of the ratio in years. If the company earned $2 per share in the last year and the price is $30 per share today (p/e of 15), it will take 15 years for the company to earn the price of the share if earnings remain the same. Remember, this is earnings, not dividends.
Graham was able to find such stocks over many years in every kind of market. Graham also looked at the converse of the p/e ratio - the earnings/price ratio. He recommended that the investor look for a company with an earnings/price ratio equal to or greater than the prevailing interest rate for high grade (AA or better) corporate bonds. This comparison of the earnings/price ratio to the interest rate of high quality corporate bonds actually served to establish the p/e ratio he was looking for in a company. As an example, let's assume that the prevailing interest rate for bonds rated AA or above is 6% (6 divided by 100). He would then look for a company with a p/e ratio which was the converse of 6%; a p/e ratio of 17 (100 divided by 6). In a 6% bond market, Mr. Graham advised the investor to limit his or her investments to companies with a p/e ratio of 17 or less. This is simple math, but it serves to protect the investor from making expensive purchase mistakes. As the earnings/price ratio changes in the market, so does the p/e ratio. So too, the companies meeting that test will change.
In addition to investing based on the p/e ratio, Mr. Graham recommended limiting your investing to companies with the following additional financial benchmarks: (i) current assets which exceeded current liabilities by 150%; (ii) debt of not more than 110% of current assets; (iii) earnings which were growing for each of the last five years (no losses in any year); (iv) a record of increasing dividends over a good number of years; and (v) a price which was less than 120% of the net tangible assets.
Being able to calculate these measures requires a certain level of familiarity with accounting terms. Not to worry. We will talk briefly, I assure you, about accounting terms in the next blog.
Comments are always welcome.
Benjamin Graham wanted to find several characteristics in a company before he would consider purchasing its stock. If he was able to purchase a company's stock with a price below what those metrics showed the company to be worth, he had the "margin of safety" he was always looking for. If the stock price is already low, then the chance of a further significant decline is diminished. To put it bluntly, Graham wanted to buy stocks on the cheap.
He looked for companies undervalued by the market. A quick measure of this is the price/earnings (p/e) ratio, which is the market price of the stock divided by the earnings per share (usually for the prior four quarters). This ratio shows what investors in the market are willing to pay for each $1 of company earnings. The lower the ratio, the cheaper the stock. Another way to look at the p/e ratio is to think of the ratio in years. If the company earned $2 per share in the last year and the price is $30 per share today (p/e of 15), it will take 15 years for the company to earn the price of the share if earnings remain the same. Remember, this is earnings, not dividends.
Graham was able to find such stocks over many years in every kind of market. Graham also looked at the converse of the p/e ratio - the earnings/price ratio. He recommended that the investor look for a company with an earnings/price ratio equal to or greater than the prevailing interest rate for high grade (AA or better) corporate bonds. This comparison of the earnings/price ratio to the interest rate of high quality corporate bonds actually served to establish the p/e ratio he was looking for in a company. As an example, let's assume that the prevailing interest rate for bonds rated AA or above is 6% (6 divided by 100). He would then look for a company with a p/e ratio which was the converse of 6%; a p/e ratio of 17 (100 divided by 6). In a 6% bond market, Mr. Graham advised the investor to limit his or her investments to companies with a p/e ratio of 17 or less. This is simple math, but it serves to protect the investor from making expensive purchase mistakes. As the earnings/price ratio changes in the market, so does the p/e ratio. So too, the companies meeting that test will change.
In addition to investing based on the p/e ratio, Mr. Graham recommended limiting your investing to companies with the following additional financial benchmarks: (i) current assets which exceeded current liabilities by 150%; (ii) debt of not more than 110% of current assets; (iii) earnings which were growing for each of the last five years (no losses in any year); (iv) a record of increasing dividends over a good number of years; and (v) a price which was less than 120% of the net tangible assets.
Being able to calculate these measures requires a certain level of familiarity with accounting terms. Not to worry. We will talk briefly, I assure you, about accounting terms in the next blog.
Comments are always welcome.
Monday, May 9, 2011
Benjamin Graham (2)
WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK. FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON
Ben Graham, in his book The Intelligent Investor, contrasted what he felt was an investment with what he termed speculation. An investment involved thorough analysis of a company with the investor looking for safety of principal and an "adequate return." In other words, find a company whose stock will, in all probability, not result in a loss as opposed to a company whose stock may "promise" unusually large returns; returns that are very rarely realized. He was very strict about this definition, saying that anything else was mere speculation.
If he had been the manager of a baseball team, he would have trained the players to hit singles and doubles. He would have coached them to avoid swinging for home runs. The player must first get on base before he can score a run. Hitting for the fences, although exciting when it happens, usually results in a large number of strike outs. The big home run hitters also sport the highest number of strike outs. The slugger goes back to the dug out and waits for his next at bat. The investor goes to his or her bank to get more money.
Mr. Graham advised an asset allocation between high quality bonds and common stock, with the percentage of bonds being never below 25% nor more than 75% of the portfolio. Common stocks make up the difference. Mr. Graham felt that the easiest method was to divide the portfolio between 50% in bonds and 50% in stocks. He recommended that if the percentages between the two investment categories changed due to market movements by as much as 5%, it was time to rebalance the portfolio by selling bonds and buying stocks or vice versa in order to retain the desired percentages. In effect, this is a very easy form of market timing; however, very difficult to do. If the stock component of the portfolio has appreciated to such an extent that the portfolio is out of balance, the individual investor will find it psychologically difficult to "leave the party" and sell the gainers.
I have always liked the age related method of allocating the bonds and stocks in an individual investor's portfolio. The investor subtracts his or her age from 100. The percentage of your portfolio in bonds would be your age, and the percentage in stocks would be the difference. This form of asset allocation seems a little better tailored to the individual and his or her stage of life. Young investors have ample time to recover from market losses. Older investors, sadly, do not. A retired investor should safe guard his or her portfolio from market gyrations with a larger percentage of interest bearing instruments. Those, of course, should be high grade corporate bonds or US Treasuries, both of a short duration. If an investor finds that he or she needs cash and is forced to liquidate bonds, there is the possibility of a capital loss if interest rates have increased sharply above the interest rate being paid on the bond to be sold. The value of a bond fluctuates inversely with the prevailing interest rates available in the market. If a lower interest rate prevails in the market, the value of a bond with a higher rate goes up. If a higher interest rate is available to investors, the value of a bond with a lower rate must go down.
Like Phillip Carret, Benjamin Graham recommended a diversified stock portfolio. He suggested a portfolio with a minimum of ten and a maximum of thirty different companies. Investors should only consider companies which were "large, prominent and conservatively financed." The companies he liked would have a continuous record of paying dividends for not less than ten to twenty years. As a general rule, Mr. Graham looked for a stock with a price/earnings ratio not to exceed 20 times the company's last twelve months' earnings nor 15 times its average earnings for the past three years.
Mr. Graham described a company worthy of investment as being "large, prominent and conservatively financed." He admitted his description was indefinite, but he believed that it provided a general sense of what he was looking for. In the next blog we will learn some of the financial metrics Ben Graham used to identify those types of companies.
Feel free to leave your comments, which will be promptly posted and replied to next Friday.
Ben Graham, in his book The Intelligent Investor, contrasted what he felt was an investment with what he termed speculation. An investment involved thorough analysis of a company with the investor looking for safety of principal and an "adequate return." In other words, find a company whose stock will, in all probability, not result in a loss as opposed to a company whose stock may "promise" unusually large returns; returns that are very rarely realized. He was very strict about this definition, saying that anything else was mere speculation.
If he had been the manager of a baseball team, he would have trained the players to hit singles and doubles. He would have coached them to avoid swinging for home runs. The player must first get on base before he can score a run. Hitting for the fences, although exciting when it happens, usually results in a large number of strike outs. The big home run hitters also sport the highest number of strike outs. The slugger goes back to the dug out and waits for his next at bat. The investor goes to his or her bank to get more money.
Mr. Graham advised an asset allocation between high quality bonds and common stock, with the percentage of bonds being never below 25% nor more than 75% of the portfolio. Common stocks make up the difference. Mr. Graham felt that the easiest method was to divide the portfolio between 50% in bonds and 50% in stocks. He recommended that if the percentages between the two investment categories changed due to market movements by as much as 5%, it was time to rebalance the portfolio by selling bonds and buying stocks or vice versa in order to retain the desired percentages. In effect, this is a very easy form of market timing; however, very difficult to do. If the stock component of the portfolio has appreciated to such an extent that the portfolio is out of balance, the individual investor will find it psychologically difficult to "leave the party" and sell the gainers.
I have always liked the age related method of allocating the bonds and stocks in an individual investor's portfolio. The investor subtracts his or her age from 100. The percentage of your portfolio in bonds would be your age, and the percentage in stocks would be the difference. This form of asset allocation seems a little better tailored to the individual and his or her stage of life. Young investors have ample time to recover from market losses. Older investors, sadly, do not. A retired investor should safe guard his or her portfolio from market gyrations with a larger percentage of interest bearing instruments. Those, of course, should be high grade corporate bonds or US Treasuries, both of a short duration. If an investor finds that he or she needs cash and is forced to liquidate bonds, there is the possibility of a capital loss if interest rates have increased sharply above the interest rate being paid on the bond to be sold. The value of a bond fluctuates inversely with the prevailing interest rates available in the market. If a lower interest rate prevails in the market, the value of a bond with a higher rate goes up. If a higher interest rate is available to investors, the value of a bond with a lower rate must go down.
Like Phillip Carret, Benjamin Graham recommended a diversified stock portfolio. He suggested a portfolio with a minimum of ten and a maximum of thirty different companies. Investors should only consider companies which were "large, prominent and conservatively financed." The companies he liked would have a continuous record of paying dividends for not less than ten to twenty years. As a general rule, Mr. Graham looked for a stock with a price/earnings ratio not to exceed 20 times the company's last twelve months' earnings nor 15 times its average earnings for the past three years.
Mr. Graham described a company worthy of investment as being "large, prominent and conservatively financed." He admitted his description was indefinite, but he believed that it provided a general sense of what he was looking for. In the next blog we will learn some of the financial metrics Ben Graham used to identify those types of companies.
Feel free to leave your comments, which will be promptly posted and replied to next Friday.
Monday, May 2, 2011
Benjamin Graham (1)
WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK. FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON
Like Philip Carret, Ben Graham believed that the best approach for an investor was to view his or her stock portfolio as a business and to purchase stocks in a businesslike manner. He advised the individual investor to ignore the fluctuations of the market and to value a stock strictly on the financial condition of the company.
Mr. Graham likened the market to a voting machine in which investors cast their cash ballots for the most popular investment candidates. He felt that ultimately the market becomes a weighing machine, i.e. a scale, measuring the economic "weight" or value of stocks and setting prices accordingly. He advised investors to find the stocks with market prices below the financial worth of the companies they represent. He wanted individual investors to buy those stocks and wait for the market to accurately "measure" the company's value. At that point the market would bid the company's stock price up to or beyond the company's value calculated by the investor, resulting in a profitable sale.
By finding companies worth more than their market price by a significant amount, the investor could enjoy Graham's "margin of safety", thereby avoiding substantial losses. Ben Graham recommended viewing a stock not as a market bet, but rather, as a minority ownership in a business. The price paid for that ownership, if too high, would never lead to a profit because the business could not ultimately justify the amount paid. The true investment value of the stock is based on "how much" the investor pays for it at the time of purchase.
An excellent example of this was the price commanded by Cisco Systems, Inc. in the late 1990's. Cisco is the world's largest manufacturer of computer networking routers and switches. Cisco's stock price was over $50 per share at the peak of its popularity during the Internet bubble. When the bubble burst, Cisco's market price plummeted with its popularity to as low as $18 per share. The financial condition of the company did not actually deteriorate as much as its stock price. Cisco's business continues to grow with the Internet, but it has not been quoted at a price much higher than the low to mid 20's since it touched $18 per share. I doubt any investors who bought Cisco during the bubble (assuming they still own it) will live long enough to see Cisco once again priced at $50 per share. The price paid today does, indeed, determine the profit to be made tomorrow.
In the next blog, we will learn some of the financial characteristics Mr. Graham looked for in companies in order to maintain his recommended "margin of safety."
Your comments are always welcome.
Like Philip Carret, Ben Graham believed that the best approach for an investor was to view his or her stock portfolio as a business and to purchase stocks in a businesslike manner. He advised the individual investor to ignore the fluctuations of the market and to value a stock strictly on the financial condition of the company.
Mr. Graham likened the market to a voting machine in which investors cast their cash ballots for the most popular investment candidates. He felt that ultimately the market becomes a weighing machine, i.e. a scale, measuring the economic "weight" or value of stocks and setting prices accordingly. He advised investors to find the stocks with market prices below the financial worth of the companies they represent. He wanted individual investors to buy those stocks and wait for the market to accurately "measure" the company's value. At that point the market would bid the company's stock price up to or beyond the company's value calculated by the investor, resulting in a profitable sale.
By finding companies worth more than their market price by a significant amount, the investor could enjoy Graham's "margin of safety", thereby avoiding substantial losses. Ben Graham recommended viewing a stock not as a market bet, but rather, as a minority ownership in a business. The price paid for that ownership, if too high, would never lead to a profit because the business could not ultimately justify the amount paid. The true investment value of the stock is based on "how much" the investor pays for it at the time of purchase.
An excellent example of this was the price commanded by Cisco Systems, Inc. in the late 1990's. Cisco is the world's largest manufacturer of computer networking routers and switches. Cisco's stock price was over $50 per share at the peak of its popularity during the Internet bubble. When the bubble burst, Cisco's market price plummeted with its popularity to as low as $18 per share. The financial condition of the company did not actually deteriorate as much as its stock price. Cisco's business continues to grow with the Internet, but it has not been quoted at a price much higher than the low to mid 20's since it touched $18 per share. I doubt any investors who bought Cisco during the bubble (assuming they still own it) will live long enough to see Cisco once again priced at $50 per share. The price paid today does, indeed, determine the profit to be made tomorrow.
In the next blog, we will learn some of the financial characteristics Mr. Graham looked for in companies in order to maintain his recommended "margin of safety."
Your comments are always welcome.
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