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