Edward Quince’s Wisdom Bites: Are You Intelligent? Chapter 20

We've reached the end. It's time we all learn Graham's secret.

The secret to sound investment is “MARGIN OF SAFETY”, so writes Graham in the opening paragraph of chapter 20.  As he says, “it is the thread that runs through all of the preceding discussion of investment policy.”  

So what is “margin of safety”, it is “rendering unnecessary an accurate estimate of the future.  If the margin is a large one, then it is enough to assume that future earnings will not fall below those of the past in order for an investor to feel sufficiently protected against the vicissitudes of time.”  

When considering this concept for common stock investments, Graham spoke of identifying the margin of safety as related to the earnings power of the company relative to the going rate for bonds.  You can probably just call this a sufficient “risk premium”.  Graham would consider the earnings yield (E/P) relative to risk-free rates, and if the earnings yield was 50% or more greater than the risk-free rate, Graham would consider that a very good margin of safety.

Graham goes on to caution that true earnings power typically can only come from observation over many years.  It is a note of caution against “growth stocks” and investors relying on optimistic projections of future earnings as the basis of “earnings power” when considering margin of safety.  He doesn’t dismiss growth stocks outright, simply cautions that some level of conservation is necessary in underwriting their future earnings.

Go all the way back to Chapter 1, remember that Graham defines investing as requiring deliberate protection against serious loss, any operation that fails to include that criteria is “speculation” in Graham’s book, thus Graham states: “we say that to have a true investment there must be present a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, persuasive reasoning, and by a body of actual experience.”

Enterprising investing, or the business of investing is a tough business, Graham sets a high, business-oriented bar for those who are seeking to truly manage a stock portfolio.

But what about the rest of us, those who don’t want to try to hurdle that bar?  Graham’s advice is simple, stay the path of narrow defensive investment.  “To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.”

Commenting on Commentary on Chapter 20

Zweig opens up his commentary with a simple question: “What is Risk?”  People posit many answers, but Zweig offers up simple advice, that investment risk is the possibility of losing all or most of your money.

Zweig reminds readers that risk is not simply about probabilities, it's equally about consequences.  He cites one of my favorite quotes from Bernstein’s book “Against The Gods”, stating: “In making decisions under conditions of uncertainty, the consequences must dominate the probabilities. We never know the future.”

The central theme of Graham’s teaching here is that investing isn’t just about getting the analysis right, you have to ensure that if you’re wrong you can survive. 

In years of thinking about risk, I think an often overlooked aspect of “risk” is the setting of goals, it’s knowing what you want to achieve.  I feel like this is fundamental to providing context to risk and it seems clear that misspecification of goals is a risk we don’t talk enough about, it is the entire framing for how much return you might need and evaluation of various paths to reach that goal. “Taking a risk on the unknown for its own sake is a bad risk strategy.”

My lay advice: Know your goals, mitigate unwanted risk, prepare and position the best you can for when the unknown or unexpected occurs, because life is uncertain, but remember without risk there is no return.

“If we fail to anticipate the unforeseen or expect the unexpected in a universe of infinite possibilities, we may find ourselves at the mercy of anyone or anything that cannot be programmed, categorized, or easily referenced.”

• Agent Fox Mulder, The X-Files

 

Edward Quince’s Wisdom Bites: Are You Intelligent? Chapter 19

 As we proceed, Graham turns his attention to the role of shareholders’, specifically that they are owners of the company.  In the role of owner the shareholder should be able to question management decisions and be entitled to their share of earnings through dividends or otherwise. 

In his writing in this chapter, Graham displays some semblance of being an “activist” investor, urging investors to make their presence felt at annual meetings, and a plea that shareholders pay careful attention to the proxy material sent to them.  Graham was not entirely opposed to the idea of an individual shareholder or small group attempting a hostile takeover of a poorly managed company, believing that “only by the assertion of control by an individual or compact group” could poor management teams be changed.

Much of what Graham wrote in this chapter has been modernized and is largely irrelevant under today’s financial regulations, but Zweig provides some additional insights that remain valid today.

Commenting on Commentary on Chapter 19

Zweig reminds readers that owners of stock are owners of business, yet as Graham bemoaned, they often fail to act that way.  Most shareholders give their wealth away to someone else to manage (i.e. they make the investment)  without validating the stewards (i.e. management) are proper stewards of that wealth, often finding that management has wasted his wealth.

So how can we be more intelligent owners? It starts with two simple questions we can ask about the companies we own: (1) Is the management reasonably efficient (are they running the business profitably given its size and relative to its competitors)? (2) Are the interests of the average outside investor given proper recognition?

And if management isn’t doing a good job, hopefully you have explored whether the company's governance has any mechanism for shareholders to replace them.  In today’s marketplace many prominent companies have divorced economic ownership from control. In Graham’s time the governance model was shareholders elect the board of directors who appoint and replace management.  In today’s environment with many dual-class structures, the founder (often CEO) controls the board of directors and management.

The important takeaway from this is that knowing the governance structure is an important factor to consider before buying a stock and thinking about alignment of interest. Does the founder have substantial wealth at risk, is there any independent oversight, how is succession handled, etc.?   

None of this is to say dual-class structures are bad, let’s be realistic, most shareholders are owners through mutual funds and ETFs and generally feel like they have no practical influence on any individual company, but with any governance structure the goal is to avoid risks that could lead to the inability for your capital to continue to compound.

As for owners getting their fair share of earnings, both Graham and Zweig argue that a management decision to retain earnings rather than pay it out to shareholders isn’t necessarily valuable, with Zweig citing how often early 2000s tech companies argued against paying out their profits whilst ultimately putting that cash to work in unproductive ventures.  The point is you should question whether “management knows better than the shareholders how to use the money”  rather than defaulting to an assumption that “daddy knows best.”  The takeaway is that management should distribute excess capital unless it can demonstrate a compelling reason to retain it.  That compelling reason can be a track record of strong returns on invested capital.

In terms of how to distribute capital, gone are the days of dividends being the primary means of returning capital, now buybacks play a major role in returning value.  Remember however that when a company buys back its shares it is essentially saying they believe that owning their own stock is the best investment available to them at the time and as we’ve discussed when considering any stock purchase, the price matters.

If you want to evaluate management of a company you invested in today, perhaps you can ask one simple question, “If I owned 100% of this business, what would I do with the cash?”  

Remember shareholder returns aren’t solely about what the business earns, but also about what management does with those earnings. Governance sits a level above that and is an important consideration.

Next we’ll move to one of the most important chapters in the entire book, one focused squarely on the concept of “Margin of Safety”. 

“The most dangerous untruths are truths slightly distorted.” 

-G.C. Lichtenberg

Edward Quince’s Wisdom Bites: Are You Intelligent? Chapter 18

I admit, the first time I read chapter 18 I wasn’t a huge fan.  It is a chapter which Graham selects 8 pairs of companies that appear next to each other on the stock-exchange list in an effort to display “the many varieties of character, financial structure, policies, performance, and vicissitudes of corporate enterprises, and of the investment and speculative attitude found on the financial scene.”  It’s not that the aim of the chapter is not worthwhile, it’s just that for the modern reader sometimes it can be hard to “care” about 16 companies of which only 4 of the original tickers still are around today.  

However, if you follow the stories of these companies over the years subsequent to Graham’s writings you can find many corporate twists of fates and perhaps it is a reminder that a company no longer trading under its own symbol does not mean the company went out of business.

If you want to, you can use these 8 paired companies as a way to evaluate Graham’s investment philosophy.  If you, or your favorite AI, follow the 55 years since Graham reviewed these companies, you will find that: 

• Graham’s “margin of safety” proved wise

• Paying a premium for a superior growth company can be dangerous, though if that company truly was superior and your long-term is long enough, it can still be a winner (contrary to Graham’s philosophy).

• And in general it is complicated to evaluate the Graham’s investing scorecard in hindsight

Rather than me trying to explain the points here, we’ll turn to Zweig, as he is masterful in distilling the lesson embedded in the chapter.

Commenting on Commentary on Chapter 18

The core message that Zweig distills is that there are good companies and bad companies, but there is no such thing as a permanently "good stock."  Stock prices fluctuate, there are times stocks are a bargain and times they are expensive.  Ultimately the relationship between a stock’s price and its underlying business value matters.

“As Graham liked to say, in the short run the market is a voting machine, but in the long run it is a weighing machine.”

The lesson is that you should know whether you are buying the business or buying a story about the business.  It is the difference between investing and speculating, it is the difference in trying to identify businesses whose value is increasing versus those whose price or social velocity is going up.

What is also interesting here is that while Graham displays that he is a master at identifying and limiting downside risks, his “margin of safety”, there may be a cost to that approach and that comes in the form of occasionally missing out on some companies that are truly great compounders.

Again it is a reminder that while the price you pay for a business definitely matters, the answer is not necessarily that you should buy “cheap companies”.  It is the evolution of Buffett’s cigar butt investing to buying wonderful businesses at reasonable prices.

When you look back at companies over horizons like 25 years or 50 years, you see that a lot can happen, both to the company’s actual business and to its share price. From that lens you can see that a defining characteristic of Graham’s investing is one that you see in various forms from other great investors and that characteristic is survival.  No one is going to be right about every investment and sometimes “right” might not show up in the share price for a long time, but one thing will likely always be true and that is to be wrong in the ways that you can survive.

“The thing that hath been, it is that which shall be; and that which is done is that which shall be done; and there is no new thing under the sun. Is there any thing whereof it may be said, See, this is new? It hath been already of old time, which was before us.”

• Ecclesiastes, I: 9-10

 

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