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.”
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