Edward Quince’s Wisdom Bites: Are You Intelligent? Chapter 17

This chapter is really Graham’s attempt to highlight how all those who participate in what we call “Wall Street” can miss seeing things that are “extremes” when it comes to creating negative outcomes for investors.  Graham highlights 4 companies, one that as an example of the system neglecting the “most elementary” warnings of financial weakness, the second an example of careless lending enabling reckless expansion, the third highlighting some accounting chicanery in M&A and the last an example of extremely inflated price of a stock offering which the public still bought.

While the specifics of the examples above are beyond the scope of my import in this series, when discussing the fourth and final example, Graham offers one of my favorite quotes from the book, stating: “The speculative public is incorrigible. In financial terms it cannot count beyond 3. It will buy anything, at any price, if there seems to be some “action” in progress.  It will fall for any company identified with “[fill in your fad of the day]” when the particular fashion is raging.”

If you think we’ve evolved since the 1970s then I’ve got a blog to sell you. Human nature remains undefeated. Humans will buy a jpeg of a monkey, a coin sold based on a viral video, will bet on eight leg parlays, you name something with some “action” and we’ll be there, price and risk be damned.

Commenting on Commentary on Chapter 17

Zweig updates Graham’s four “extremes” with more recent (year 2000’s) corporate examples. Some of the examples may provide us with stories that sound familiar today.  For example, Zweig discusses Lucent Technologies, a stock that went from $51/share to $1.26/share in 2 years time. The point of this example was that all the warning signs were there; they were just ignored. 

One warning sign Zweig highlights is “customer financings” in which Lucent had lent or guaranteed their purchasers financing of purchases of their products. Isn’t this a story we hear with the AI buildout today?  Suppliers funding their own buyers, recycling cash flows, so called “circular financing”.  The story today might be one based more on equity investments and less on debt funding, but the risks are likely very similar.

Another of Zweig’s four examples of extremes is the IPO of eToys in 1999, an IPO that history regards as an example of the tech bubble top.  The story is one of investors buying a narrative where no price was too high.  A narrative that ultimately collapsed when the reality of the company losing nearly $400 million in less than two years time.

Perhaps the lesson is simple, human nature remains undefeated.

“The wisdom god, Woden, went out to the king of the trolls, got him in an armlock, and demanded to know of him how order might triumph over chaos. “Give me your left eye,” said the troll, “and I’ll tell you.” Without hesitation, Woden gave up his left eye. “Now tell me.” The troll said, “The secret is, ‘Watch with both eyes.”

-John Gardner

 

Edward Quince’s Wisdom Bites: Are You Intelligent? Chapter 16

 We concluded chapter 15 with some general advice for selecting stocks, but seemingly out of nowhere Graham jumps to a chapter titled ‘Convertible Issues and Warrants’. It is not my place to be Graham’s editor and discuss the merits of the placement of this chapter, but it is likely that after discussing stocks, Graham was turning his attention to these ‘hybrid’ instruments that carried stock exposure.

While my purpose is not to examine these instruments, I will provide a brief overview. Warrants are simply stock options, the right to buy common shares at a stipulated price.  Convertible issues are bonds or preferred shares that offer the investor the “bond like” protection in terms of paying a coupon/dividend, plus the opportunity to participate in the upside of any substantial rise in value of the common shares.

Graham discusses some of the challenges with owning these instruments, the details of which I will skip. With respect to convertibles he summarily concludes: “Our general attitude toward new convertible issues is thus a mistrustful one.”  His starting point for stock option warrants is that they are: “a near fraud, an existing menace, and a potential disaster.” He bemoans the dilution impact of options and their general misunderstanding by issuers and investors alike.

If I were to take one thing from Graham in this chapter, it’s really his skepticism for new financial innovations, especially those created and marketed during bull markets.

How did Zweig decide to tackle this somewhat technical and arcane discussion?

Commenting on Commentary on Chapter 16

Like Graham, Zweig tackles convertible bonds first, describing them as offering less income and more risk than other bonds or a “worst of both worlds” investment, caveating that it really depends on how you are using convertible bonds in your portfolio construction.  His points here really boil down to: 1) understanding that most convertible bonds are more “stock-like” than bond-like and might be “stocks for chickens” and 2) to understand the intricacies of the specific issues you own including things like any call protection and other specific redemption features.

Moving to stock options, Zweig highlights a strategy that is still prevalent today, writing covered calls to generate income.  What is a covered call strategy?  It is when an investor owns shares of an underlying stock and sells a call option which gives someone the right to buy those shares from you at a higher price in the future.  You, the call writer, pocket income in the form of the option premium which could be viewed as an enhancement to your portfolio providing some protection against stock prices falling.  However, if the price of the stock underlying the option increases you have set a maximum return you can earn from that stock as the holder of the call option will buy your stock from you at the now below market price set at the inception of the contract.

Nowadays there are a number of popular covered call ETFs available. Zweig cautions investors against “surrendering most of your upside”.

For me context is key here, if you’re going to use convertibles and options in your investment portfolio it’s really all about knowing what you own in terms of the exposure these products present and why you own them.

It is one, if not the shortest commentary Zweig provides, so we won’t bemoan it.  

Next we turn to a couple of case studies that Graham believed showed different extremes that all investors should be warned about.

“That which thou southwest is not quickened, except it die.”

-1. Corinthians, XV:36

Edward Quince’s Wisdom Bites: Are You Intelligent? Chapter 15

After concluding our last post with Graham’s advice to “defensive” or lay investors in which one could argue is a case for indexing, Graham’s text moves to “Stock Selection for the Enterprising Investor.”  Graham starts off with a warning, expressly saying that “To get average-results - e.g. equivalent to the performance of the DJIA [modernly any index] - should require no special ability of any kind [just own the stocks in the index]...Yet there is considerable and impressive evidence to the effect that [successfully beating the market] is very hard to do…”

Graham provides some explanations as to why beating the market is hard. He starts with an explanation of what we would call “the efficient markets hypothesis” and then reminds us that maybe the problem is that while security analysts are actually good at identifying promising companies they simply buy them at too high of prices or extrapolate growth to be infinite and conversely overlook too many undervalued companies extrapolating extinction for too many companies.  Nevertheless we won’t get into all the arguments why beating index returns is hard to accomplish.

Graham does offer up some ideas of ways he has approached attempting to beat the market, listing out things he had successfully employed in his Graham-Newman partnership, including arbitrages, liquidations, hedges, bargain issues, all of which he couches as specialist opportunities.  When it comes to picking listed stocks he starts with a simple idea to look for “cheap” stocks via low P/E ratios as a starting point then adding additional criteria such as financial condition, earnings stability, dividend record, earnings growth, and additional valuation metrics.  Again the details of his discussions is not what we’re after here in this blog.

We’ll turn to Zweig, whose job has been to modernize and summarize the heart of Graham’s teachings.

Commenting on Commentary on Chapter 15

Zweig starts off with a reminder that trying to pick stocks and beat the market is unnecessary and inadvisable for most, you’re better off just buying an index fund/ETF.  

But for those who want to venture into stock picking, Zweig offers up the following:

First, practice. Run a “paper” portfolio, see how you do.  There are several websites that offer investors a risk-free way to test their trading ideas.  

Then, if you think you’re onto something, consider legging in, create a portfolio that is not more than 10% of your total portfolio.

Zweig provides some metrics that professionals of the time liked to look at, such as Return on Invested Capital (ROIC) and reiterates that some level of evaluation of the management of the various companies you are considering seems wise.  

His is advice mimics what I said in the last post, if you’re going to go it on your own, you should at least make every effort to both (a) identify the characteristics that those companies that have created this extraordinary wealth in the past share in common and (b) identify the characteristics of the most successful investment managers have in common.

As Zweig concludes:
“No matter which techniques they use in picking stocks, successful investing professionals have two things in common: First, they are disciplined and consistent, refusing to change their approach even when it is unfashionable. Second, they think a great deal about what they do and how they do it, but they pay very little attention to what the market is doing.”  (Remember the parable of Mr. Market - go see the post on Chapter 8).

“It is easy in the world to live after the world’s opinion; it is easy in solitude to live after our own; but the great man is he who in the midst of the crowd keeps with perfect sweetness the independence of solitude.”

 

Edward Quince’s Wisdom Bites: Are You Intelligent? Chapter 14

 In these past couple of chapters Graham has started to open the toolbox and discuss some of the tools of ‘Security Analysis’.  While we haven’t delved into the specific application of these tools to analysis, I think we’ve covered a few important points that should be applicable to both the professional and amateur analyst:

1. Fundamentally the objective of all analysis is the same: prospects for future cash flows, their timing, and associated capitalization, with a reminder that even the best prospects for the future can be permanently impaired by poor management and leverage (Chapter 11)

2. There are many ‘booby traps’ in analyzing the financial information presented by companies (Chapter 12)

3. A great company can be a terrible investment if purchased at too high a price (Chapter 13)

As discussed previously, Graham did not believe every investor should be so ‘enterprising’ to venture into trying to construct their own hand-picked investment portfolio, but he wanted to make sure these ‘defensive investors’ also understood some of the basic principles of stock selection. 

He wanted to make sure that when the defensive investor was buying a portfolio of diversified stocks of leading companies he was not doing so at a price "unduly high as judged by applicable standards.”  So Graham uses this chapter as an attempt to provide some metrics that might be useful for the lay investor.  

Mind you Graham was writing in 1970s, before the ease of index investing, but for me he offers a couple main points worth remembering at all times:

1. We should consider whether the price of an investment offers an ‘adequate factor of safety’ which is absent when ‘too large a portion of the price must depend on ever-increasing earnings in the future.’

2. One way to consider whether a price might provide some margin of safety is to look at the Price to Earnings ratio both outright but compare its inverse Earnings to Price ratio (i.e. Earnings Yield) and compare that to the yield you could obtain simply investing in high-grade bonds, from there ask “do I think the likely return of this investment is to exceed what I could earn by taking less risk”?  Again, it’s what Graham calls ‘the way of protection’, simply looking for ways to avoid overpaying for an investment.   We’ve ultimately touched on this in every chapter, so it’s clearly a central theme of the book.

3. Diversify, there are simply too many things that can happen to advise the defensive investor to not hold more than one stock.

That’s my high-level read of the chapter, but what says Jason Zweig.

Commenting on Commentary on Chapter 14

Zweig’s first step is to modernize the whole discussion, stating simply: “A low-cost index fund is the best tool ever created for low-maintenance stock investing.”  Today a defensive investor does not have to worry much about individual stock selection, they can buy the whole market and owning the whole market maximizes your odds that you will own the winners.  

Perhaps you might be familiar with the work of Hendrik Bessembinder, “Do Stocks Outperform Treasury Bills?” (2018), if not the headline result was that over the period 1926 - 2016 only about 4% of U.S. listed stocks accounted for the entire wealth creation of the U.S. stock market, the other 96% failed to provide the investor with returns greater than U.S. T-Bills.  Do you think you could consistently find and hold that 4% population?  If you owned an index fund you would have.  Diversification protects you.

There’s not really much to add here, if you don’t think you can consistently identify the winners, consider indexing, if indexing is not for you at least consider identifying the characteristics that these firms that have created this extraordinary wealth in the past share in common and try to buy stocks on that basis.

Graham is teaching us that price matters, this directly informed the early investing Warren Buffett did, but truly great investing is about more than buying ‘cheap businesses’, long-term returns tend to be highly skewed, a tiny fraction of truly great businesses can generate most of the market’s wealth over time.  Bessembinder’s work lines up with the evolution of Warren Buffett’s investing, an evolution informed and empowered by the genius of Charlie Munger, one that moved from simply buying cheap to buying truly wonderful businesses at reasonable prices. The price still matters, but you really need to own businesses capable of sustaining high returns on invested capital and reinvesting those returns over time, holding those companies and letting them compound.

“He that reseth upon gains certain, shall hardly grow to great riches; and he that puts all upon adventures, doth oftentimes break and come to poverty; it is good therefore to guard adventures with certainties that may uphold losses.” 

-Sir Francis Bacon

Edward Quince’s Wisdom Bites: Are You Intelligent? Chapter 13

If you’re going to invest in specific securities it is very likely that you will not simply examine a single security/company, but that you will want to understand how that security/company looks relative or in comparison to other securities/companies.  In this chapter, Graham compares four listed companies.  The companies themselves are irrelevant for our discussion, but what the chapter offers is an insight into how Graham thinks about analysis.

It’s a discussion Graham shares in the following chapters, but for now he focuses on profitability, stability (past declines in earnings), growth, financial position, dividends, and price history.  

Without getting into all of the details, what stands out to me is that Graham’s thinking shows that price matters, warning that “the careful investor wants to be reasonably sure in advance that he is not committing the typical Wall Street error of over enthusiasm for good performance in earnings and in the stock market.”

So what did Zweig take away from this chapter?

Commenting on Commentary on Chapter 13

Likely realizing the four companies that Graham discussed would feel irrelevant to the reader of the 2000’s, Zweig offers up analysis of 4 stocks using their 12/31/1999 numbers.  Like Graham he picked for companies starting with the letter “E”, Emerson Electric (the only stock from Graham’s original 1970 list), EMC Corp., Expeditors International of Washington and Exodus communications.

In case you’re curious about the journey of these companies and stocks over the last 25 years, here’s a quick summary:

Company	Trading Today?	What Happened?
Emerson Electric (EMR)	✅ Yes	Outstanding long-term compounder
EMC Corporation (EMC)	❌ No	Acquired by Dell in 2016
Expeditors International of Washington (EXPD)	✅ Yes	Exceptional compounder
Exodus Communications (EXDS)	❌ No	Bankrupt after the dot-com crash

It’s interesting that Emerson Electric was a stock that Graham was cautious about back in 1970, not because of the business, but because of the price the shares were trading at.

I won’t belabor the discussions around these companies, the point Zweig and Graham are both making is that a great company can still be a bad investment if purchased at too high a price.

The inverse can also hold true, seemingly boring companies can be excellent investments at the right price.

Just like in Graham’s era, Zweig’s writing highlights that investors fall into the one of the same behavioral traps time in memoriam.  We overpay for exciting narratives, we pay handsomely for the future in advance.

“In the Air Force we have a rule: check six. A guy is flying along, looking in all directions, and feeling very safe. Another guy flies up behind him (at “6 o’clock”) and shoots. Most airplanes are shot down that way. Thinking that you’re safe is very dangerous! Somewhere, there’s a weakness you’ve got to find. You must always check six o’clock.

-U.S. Air Force Gen. Donald Kutyna

 

Edward Quince’s Wisdom Bites: Are You Intelligent? Chapter 12

 After introducing the topic of ‘Security Analysis’, Graham moves towards a further examination of earnings. Remember there are really only three things that matter for the analyst, are there to be future earnings, when will they arrive, and how they should be capitalized.  Earnings are the lifeblood of the company and the lifeblood of an investors’ returns.  "The absolute most that the owners of a business, in aggregate, can get out of it in the end - between now and Judgment Day - is what that business earns over time."  The “in aggregate” part there is important, but I won’t harp on explaining it.

Graham has already spent plenty of time bemoaning simple extrapolations of the past and he extends that to his discourse on earnings per share, stating:”first, don’t take a single year’s earnings seriously. Second, is if you do pay attention to short-term earnings, look out for booby traps in the per-share figures. If our first warning were followed strictly, the second would be unnecessary.”

What are these “booby traps”? Graham lists a few such as: special charges, reduction in normal income tax due to past losses, the dilution factor implicit in convertibles and warrants/options, the method of depreciation, the treatment of R&D, the inventory method, etc.    Suffice to say, accounting can be tricky.

To avoid placing too much emphasis on the short-term and attempt to remove some of the noise of these “booby traps” Graham was a fan of looking at average returns over a long period of time and comparing recent earnings growth trends to the company’s previous growth trends, often 10 years earlier.  Something that is likely impossible to do for newer, early stage companies.

Zweig takes Graham’s “booby traps” and updates them for some of the traps investors face in the 21st century.

Commenting on Commentary on Chapter 12

The biggest trap that Zweig highlights is the use of “pro forma” or “as is” earnings numbers.  These measures are simply the earnings that GAAP (accounting rules) proscribe with numerous adjustments.  The idea of pro forma numbers was to ‘help’ investors by removing the short-term, non-recurring, items that were otherwise making earnings noisy.  As occurs with many decent ideas, things can get taken too far.  Zweig describes pro forma earnings as: “enabling companies to show how well they might have done if they hadn’t done as badly as they did.”

Zweig explores a few cases of ‘abuses’ in accounting to make the point that “the intelligent investor should be sure to understand what, and why, a company capitalizes.” (capitalizes means the company spends money on something but doesn’t call that spending an expense)

The key takeaway for me in this chapter is that if you plan to invest in a given stock security on the basis of what would be necessary to call your investment ‘intelligent’ or ‘enterprising’ you’ll need to do a lot of reading up on the company’s financial statements, digging into the footnotes, understanding accounting policy elections and how they might be impacting earnings.  After all, if it was easy, everyone would be doing it.

“You can get ripped off easier by a dude with a pen than you can by a dude with a gun.” - Bo Diddley

Edward Quince’s Wisdom Bites: Are You Intelligent? Chapter 11

As we progress we move from topics like defining investing, to strategic asset allocation, and through the general topic of investment selection, deployment and investment advice. Against that backdrop Graham moves to the topic of “Security Analysis”, the “examination and evaluation of stocks and bonds.”  It is a movement in the discussion from the general to the specific and specifically what should the “lay investor” do when it comes to possibly selecting an individual stock or bond to include in their portfolio.

Graham has lofty standards when it comes to security selection and to scrutinize whether an investment is sound enough he believes you need a strong analysis of the past average earnings, the capital structure, asset values and of course the blanket “other matters.”  And as we’ve seen with most things that Graham has written in this book there is always the word of caution: “...we must point out a troublesome paradox here, which is that the mathematical valuations have become the most prevalent precisely in those areas where one might consider them least reliable.  For the more dependent the valuations become on anticipations of the future-and the less it is tied to a figure demonstrated by past performance-the more vulnerable it becomes to possible miscalculation and serious error.”

Graham’s protege, one Mr. Warren Buffett, simplifies all security analysis down to an application of Aesop’s fable about a bird in hand being worth two in the bush.  To value you any asset you must answer three questions:

1. How many birds are in the bush?

2. When will they come out? 

3. What is the risk-free rate?

It’s a question of the evaluation of the certainty of future profits, when they arrive and how to capitalize them (discount back to today) and whether that math is good enough for you to part with the cash you have today (the bird in hand).

Without getting into Discounted Cash Flows we’ll turn to what Zweig thinks about this chapter.

Commenting on Commentary on Chapter 11

So how do you attempt to answer the three questions posed above?  A logical starting point is to start thinking about the company’s long-term prospects and in doing so you need to try to get a fundamental understanding of what makes the company you are evaluating generate profits and grow.  Are the long term growth prospects reliant on debt or acquisitions, or do they come from things like a strong brand, a near monopoly in their industry, some other intangible source, etc.

If you can ferret out a solid understanding of the company, you realize its ability to maintain and sustain growth and profitability might be hindered or advanced by the quality of its management. Analyzing a management team can be tricky, but Zweig suggests evaluating factors like whether it seems like management is just out for maximizing their own compensation, whether they are true operators of the business or merely promoters.  Clearly there is some subjectivity here.

After covering growth and management the 3rd of Graham’s 5 factors in security analysis that Zweig discusses is “financial strength and capital structure”.  For Zweig this topic is somewhat simple, generate more cash than you use so owners have some earnings.  The complicating factors are sometimes determining what exactly is the appropriate measure of earnings and what exactly are the appropriate measures of how much cash is leftover for owners. Without getting into the nitty gritty, it’s thinking about things like funding depreciation and amortization and stock options and extraordinary items.  But no discussion of capital structure can be complete without a discussion around debt vs. equity.  For Zweig he recommends focusing on companies with long-term debt no greater than 50% of total capital.

The bigger picture question you should consider asking is both whether and how the choice of capitalizing a company with debt and equity matters for the value of the firm?

After all in the words of the immortal philosopher Yogi Berra as retold by famed economist Merton Miller:

“It's after the ball game, and the pizza man comes up to Yogi Berra and he says, 'Yogi, how do you want me to cut this pizza, into quarters?' Yogi says, 'No, cut it into eight pieces, I'm feeling hungry tonight.' Now when I tell that story the usual reaction is, 'And you mean to say that they gave you a [Nobel] prize for that?'"

--Merton H. Miller, from his testimony in Glendale Federal Bank's lawsuit against the U.S. government, December 1997

You can also consult Howard Marks’ “Dynamite Equation” as a helpful aid. Hint: “levered portfolios face a downside risk to which there isn’t a corresponding upside: the risk of ruin. The most important adage regarding leverage reminds us to “never forget the six-foot-tall person who drowned crossing the stream that was five feet deep on average.” To survive, you have to get through the low points, and the more leverage you carry (everything else being equal), the less likely you are to do so. "

A lesson apparently that hedge fund ‘Situational Awareness’ and its founder Leopold Aschenbrenner apparently just learned the hard way.

I will skip Graham’s final two factors in security analysis that focus on dividends, but suffice to say ultimately you as an owner need some way for the company's earnings to come back to you, dividends and buybacks are two of those ways.

“Would you tell me, please, which way I ought to go from here?”  

“That depends a good deal on where you want to get to,” said the Cat

-Lewis Carroll, Alice’s Adventures in Wonderland

 

Edward Quince’s Wisdom Bites: Are You Intelligent? Chapter 10

The previous chapter largely was focused on investment managers, the people and entities that manage investment funds, the focus of this chapter moves to investment advice.  On this topic, Graham provides: 

“Our basic thesis is this: If the investor is to rely chiefly on the advice of others in handling his funds, then either he must limit himself and his advisers strictly to standard, conservative, and even unimaginative forms of investment, or he must have an unusually intimate and favorable knowledge of the person who is going to direct his funds into other channels.”

My read there is that either you find an advisor you really trust or you really put some strict guardrails around your advisor lest you risk potentially being taken advantage of.

The full read of Graham here is not anti the seeking of advice, but simply a reminder that the investor should be cognizant of their own frontier of knowledge and the incentives of those providing advice. Graham also seems to believe that “Perhaps the chief value [advisers offer] to their clients lies in shielding them from costly mistakes.

Commenting on Commentary on Chapter 10

Zweig outlines a number of reasons an investor may want or need to turn to a professional financial advisor for help.  Reasons range from gaining a better understanding of the rate of return needed to meet your goals, assistance with defining a savings rate, to simply having emotional support or someone else to blame.  He also provides some signposts of characteristics that you might want to consider a second opinion, that list includes: struggles with budgeting, experiences of big losses, portfolios constructed with no rhyme or reason, and major life changes.

Of course once you believe you want or need advice the question is how to find the right advisor for you.  Zweig’s advice is to do your homework, including reviewing information filed with the SEC such as form ADV and using BrokerCheck to search for disciplinary action.  He also provides the reader with a list of “words of warnings” to look out for when having a conversation with a prospective adviser, Zweig’s list is long, but the short version is to be wary of things that sound salesy and too good to be true.

A good adviser in any field should take the time to really get to know about their client’s goals and charge a fair fee for their work. 

I think I would summarize this chapter as when shopping for financial advice you are shopping for “trust”.  There are two major components of trust:

• Credibility - track record, credential, adherence to a code, brand

• Professionalism - values, competency, integrity

You should be looking for evidence of these and other traits and ensure that these traits are combined with a solid value proposition.  There is no sustainable trust without value.

“I feel grateful to the Milesian wench who, seeing the philosopher Thales continually spending his time in contemplation of the heavenly vault and always keeping his eyes raised upward, put something in his way to make him stumble, to warn him that it would be time to amuse his thoughts with things in the clouds when he had seen to those at his feet. Indeed she gave him good counsel, to look rather to himself than to the sky.” - Michel de Montaigne