There have been several articles that use Benjamin Graham's legendary text on value investing - the Intelligent Investor - as a compass for investing. This book inspired me to start a $10,000 retirement portfolio. My investing timeline is 30 years, investing $5000 per year and re-investing dividends. To identify value, I follow a logic similar to an analysis of glass and specialty goods manufacturer Corning (GLW) found here, or this exceptional article here with a detailed value discussion that includes dividend champion insurance company AFLAC (AFL). Both authors make picks based on detailed analysis of these companies' subdued fundamentals and they do so based on several years of financial data.
However, several readers have pointed out that companies like GLW and AFL can remain stagnant and result in a position as part of your portfolio that under-performs other indices. How and when do you decide to initiate a position? When is GLW ready to pop and bring us those 15-20% upswings we crave?
I'd like to explore the psychology behind these value calls further. I argue that in asking this question we're missing one of the most fundamental (no pun intended) theses of value investing. It is easy to confuse value investing and market timing, among other strategies, which is a sin that would have Benjamin Graham rolling in his grave. Value investors don't just browse through quarterly reports. They meticulously review annual reports to analyze long term growth prospects over a period of years. They don't pay much attention to analyst estimates. They pick apart company financials over 3, 5, or 10 years rather than worry about intervening days or months. They don't just buy and hold - they are constantly buying, using dollar cost averaging to avoid paying too much at any given time. They sell, years or decades later, when the forces suppressing these great holdings have changed.
First let's analyze why we need to distinguish between value investing and market timing, or technical analysis. The thesis of the Intelligent Investor is based around this distinction. As Graham argues, the idea that we can time the market can lead to serious decline in the long run. As a recent example, read the coverage of Apple (AAPL) and the bull thesis that the tech stock had massive upswing potential.
For the newer version of Graham's book he points to Xerox between 1999 and 2001 for an example of how the cracks in a firm's valuation can break apart (See also AOL (AOL), Cisco (CSCO), JDS Uniphase (JDSU), Lucent (ALU), and Qualcomm (QCOM)). The Dot Com bubble is full of these lessons. The speculator bought in when these companies were the "next biggest thing" and they bought shares based on feeling rather than fact.
Worse, think about the hundreds of companies that have completely disappeared during a recession, which do not even factor into our day to day analysis of stock market risk. It is a sobering reality for speculative investment. In my lifetime I fully expect market declines to happen again and again.
Likewise, by contrast during the Great Recession, leading financial authorities and investors trying to time the downswings in 2008-9 based on investor sentiment were wrong repeatedly that the "worst is over" until the worst actually was over. Hindsight is a powerful and misleading part of human nature.
The assumption is that we can somehow time the bottom and get in before the great bull-run, which will lead to outstripping the returns of Mr Market and the thousands of fund managers out there. The other false assumption is that we can somehow predict the top and invest right up until the moment the bubble pops. Trying to do so may profit a few, but tens of thousands will rack up extensive long term losses.
The speculator is interested in anticipating and profiting from fluctuations in the market. However, the value investor sees things differently. He wants to get great companies at great discounts: "Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies."
Graham encourages the intelligent investor to stop focusing on market timing. Delete your stock alerts, emails, daily updates and hourly peeks at your portfolio. Get away from routinely checking the latest prices. To become a value investor, forget about Wall Street trends, technical analysis, and stop buying and selling in the short term. There is no certainty in trying to base your financial policy on buying at low levels during bear markets and selling at high levels during bull markets. This is where most investors scratch their heads. How can we forget about all of that?
The real thesis of Graham's investing knowledge lies in a single paragraph:
The true investor is scarcely ever forced to sell his shares, and at all other times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that the price is favorable to him. Thus the value investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons' mistakes of judgment.
When asked what keeps most individual investors from succeeding he had a simple answer: "The primary cause of failure is that they pay too much attention to what the stock market is doing currently." Their basic advantage is that they can do what they want and choose whether to ignore Mr Market's constant temptation to come and trade. The intelligent investor never buys a stock because it is going up, and never sells a stock because it is going down.
Our analysis needs to include these ingredients:
- the company's "general long term prospects"
- the quality of its management
- its financial strength and capital structure
- its dividend record
- and its current dividend rate
What Graham is getting at is that value investing is not for the faint hearted: it is an opt-in, opt-out strategy. If you can't stomach watching 50% of the value of your portfolio vanish because the market has mood swings that suppress the inherent value of your holdings, then you would be better placed investing in an index fund, or actively managed fund with low fees. If you don't have the time to evaluate stocks with sufficient rigor, then invest in an index fund. Subscribing to some of the principles, i.e. analyzing key statistics and going through the balance sheets, while also watching closely to gauge what the sentiment is on Wall Street is, for the value investor, a losing strategy. The value investor is driven by value, not trends. He buys shares in a company on the grounds that he could fall asleep for twenty years, like Irving's famed Rip Van Winkle, and miss the Revolutionary War. He never buys a stock because it is going up, and never sells a stock because it is going down.
I argue that by trying to be "Speculator" and "Value Investor" at the same time we are transforming our basic advantage into a basic disadvantage. We're allowing the Market to dictate our decisions. We're refusing to buy those value companies (GLW, AFL) because of a fear that there are other opportunities for us in the market that will outstrip their return in the short term. Instead we should be thinking, are there other companies that represent better value?
Too many of us ask, what sector is going to be hot this year? Is it commodities, technology or real estate? Health care? What we really should be concerned about is what companies, at this moment in time, represent the best value for money. How do I identify those undervalued companies. And how do I acquire them at a fair price.
We come full-circle to investing in value. Now for the defensive investor, one needs to make time to investigate financial statements (note the plural), P/E, P/B, asset values, cash flow, ROE and so on - over a period of years. After all if we're going to be part owners in a company we need to know something about it. We need a rational logic for judging these holdings, regardless of what the word on the street is. For this Graham gives us seven guidelines for identifying value:
1. Adequate size
2. A sufficiently strong financial condition
3. Continued dividends for at least the past 20 years
4. No earnings deficit in the past ten years
5. Ten-year growth of at least one-third in per-share earnings
6. Price of stock no more than 1.5 times net asset value
7. Price no more than 15 times average earnings of the past three years
When you know the companies you want to buy, I would add three more of Graham's key principles for purchasing them:
1. Dollar Cost Averaging - spreading stock purchases over regular intervals (weeks, months) to avoid paying too much
2. Diversify portfolio between an index/mutual fund, bonds and stocks - never have more than 75% in stocks
3. Write an investment contract - a single piece of paper that states the rules that you follow, and do not waver from it
By following these principles I have managed a healthy return. For me the power comes from regular monthly installments and reinvested dividends. This is my way of saying, "Mr Market, I'm not going to predict your every move, but when you have a value I want to know about it."
What camp are you in?
To make it clear what I mean, I conclude with a reference to Warren Buffett's massive bet with Protege Partners LLC, a New York based hedge fund. This truly is a mammoth competition between old school value, of which I am a proponent, and new school ideology. The wager is meant to show whether stocks (in the form of an index fund) can outperform a hedge fund between 2009 and 2017. Warren Buffett has recently taken the lead. This means that he has - quite simply - put his money in an index fund that tracks the market in 2009 and forgotten about it. No thousands of hours of detailed research and sleepless nights - no ongoing fees; he could have done it between the hours of breakfast and lunch. Now, once again, his simple and effective strategy is producing a better return than some very smart and dedicated people.