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