Benjamin Graham about owners and inflation

 According to Graham, owners do not really care about their own interests. They let management act as they please when it is not in the owners' interest. Most owners never even consider the option of management acting against them. As a result, management controls the company and the owners as a larger group submit to its will. A company should always primarily act in the best interests of the owners and not give management the power to act the way they want. The owners, as a larger group, can decide how the company operates and, if necessary, get rid of managers who do not pursue their interests.

On average, managers know more about the company's business than the owners. This does not mean that they think in the owners' interest or that they are always capable of doing their jobs. Owners should not give managers the opportunity to act as they please, even though they are more likely to be right. Investors should investigate the actions of management if they find an attractive investment or owns part of the company. Many companies are poorly managed, which costs the owners lots of money.

The interests of owners and management are not always the same. In particular, compensation systems can destroy the value of a company. Options can generate significant income for management at the expense of owners. They can make management focus more on increasing the share price than on the value of the company. Options often create destructive incentives for managers, which hurts owners. Compensation systems that are higher than normal are always a red flag. The amount of compensation received by management is not directly proportional to their efficiency. Management can also grow the company in order to justify their increasing compensation.

In addition to the management team, listed companies also have a board of directors. The owners elect them at the general meeting. The board of directors must promote the interests of the owners. This works in theory, but in practice it is often overlooked. This is because management often proposes board members to the general meeting. In this case, board members can promote the interests of management because they receive a salary. This can happen if a board member does not promote management's interests. Often, the board of directors and the management team work in symbiosis, pursuing each other's interests while the owners are less concerned. Understanding the internal dynamics of the management team helps to understand whose songs the board representing the owners is singing.

The interests of the owners are not identical. In Finland, the owners of a listed company do not always follow the same line in terms of taxation. An ownership stake of more than 10% means tax-free dividends. This pushes the owners into different positions. It can change the dividend policy to favor large owners, which should reduce the attractiveness of the company as an investment. In the United States, on the other hand, the interests of the owners intersect, for example, when index funds own companies. There, the company management is allowed to decide, for example, on the management of pension assets, so index funds may have a conflict of interest with other owners. The management can threaten to transfer pension assets to another fund company if the index fund interferes with its proposals. This is one of the disadvantages of the growth of index funds.

The owner must guard his interests. Few owners do that. Individual owners can rarely influence the investment targets, but nothing prevents them from gathering a larger group of shareholders and thus influencing the company management or board. One option is always to sell the shares, but few owners do so even when there are reasons to do so.

Graham on inflation

Inflation is a creeping income trap. It eats away at investors’ returns year after year. About once a century it peaks, and once a century there is a longer period of deflation. Both are exceptional cases. They affect investors’ returns significantly in the short term, but over decades the effects of both even out. Graham’s Intelligent Investor states that from 1915 to 1970, the average inflation rate in the United States was 2.5%. In the 1970s and 1980s, inflation was much higher. After this exceptional period, inflation leveled off and has been roughly at the 1915-1970 levels.

From these starting points, we can conclude that inflation will probably be high at some point. This happened in 2021 and 2022. No one knows when that will happen gain. In the long run, stocks are the most effective inflation hedge, but in shorter time frames, there may be better alternatives. This applies especially to companies that can either increase their efficiency more than inflation destroys profits or companies that can raise the prices of their products more than costs rise. In the best case, a company can do both. Graham believed that assets on a company's balance sheet, such as real estate, machinery, and raw materials, protect investors more effectively than direct investments in gold or real estate.

When inflation becomes exceptionally high, most companies are unable to increase their earnings enough to offset the increase in costs caused by inflation. This increases the debts which increases costs. This makes bonds, among other things, more attractive alternatives. This exceptional situation will not continue for decades, but it makes bonds better options for investors than stocks. Investors need to monitor cost developments because it is not easy to notice the acceleration of inflation. It almost always takes a part of the investor's returns. Deflationary environments are an exception. At least the United States offers investors the opportunity to buy inflation-protected government bonds. Hedging against inflation is not free, so everyone should decide how much it is worth paying for it.

Benjamin Graham and manic-depressive Mr. Market

Manic-depressive Mr. Market can be your friend or your enemy. You can’t control it, but you can control how it affects you. Mr. Market offers a price at which you can either buy or sell shares. If you are not satisfied with the offer, he will come back to it later. This continues from moment to moment, and the real value of the investment is of little importance in the short term. Emotions drive Mr. Market, and you can’t do anything about them. You have to accept them.

A manic Mr. Market moves stock prices up, and a depressive one moves them down. Most of the time, he is almost right. In that case, you cannot determine with sufficient certainty whether the prices are reasonable. Mr. Market can steer prices in the wrong direction for years. Prices go higher and lower than few people believe. This is more the rule than the exception. The direction can change in the blink of an eye, and you cannot predict it. In the long run, Mr. Market is more right than wrong. By acting wisely, you can benefit from both directions. You can buy when the price is lower than the true value and sell when it is higher. Most of the time should be spent doing nothing. Sometimes Mr. Market offers opportunities, in which case it offers you a large margin of safety. In these cases, you need to be able to invest significant amounts. Take full advantage when you can, because you may have to wait years.

A wise investor never has to sell shares, but he sells them because the prices offered by Mr. Market are clearly higher than their true value. The market will go in the wrong direction whether you like it or not. Never invest money that you cannot afford to lose. Mr. Market offers an almost 100% guarantee that it will move some of your investments in the wrong direction and for a long time. If you cannot afford to lose money, it will lose it. As an individual investor, you are in a better position because you can choose, because you are taking advantage of the market. Large organizations are practically forced to take prices offered by Mr. Market all the time.

You need to control your actions. You can avoid unnecessary expenses and keep expectations of future returns reasonable, while others are hysterically chasing the price increases. Investors’ expectations matter. Usually, when the market goes up, so do expectations of returns. During the tech bubble in 1999, investors’ expected returns were 19% per year for the next decade. This meant that results would grow by about 5.7 times in ten years. It is worth noting that the US gross domestic product grew by six times in the last century. This estimate of future prices was completely absurd.

You can reduce Mr. Market’s influence on you by following his actions less often. Following him makes it easier for your subconscious to believe that the prices he offers represent real value. Your subconscious is constantly looking for clues in environment. By following prices, you create anchors for yourself, according to which you determine the value of your investments. At the same time, the calculations and their parameters of your analysis can guide you without realizing it towards the price determined by the market.

A rational investor always tries to keep extra cash to exploit the emotional turmoil of Mr. Market. Sometimes Mr. Market can offer so many attractive options that you have to use almost all your money. You need incredible control to exploit emotional turmoil, which is not easy when Mr. Market, with the help of other investors, offers assessments that contradict your views for years. No one can completely resist them. People are animals that crave action. Even Warren Buffett needs action sometimes, as his partner Charlie Munger has stated, among other things, about Buffett's Berkshire investment in Salomon Brothers.

Mr. Market can affect even patient investors when a large enough herd is running in the same direction. Graham’s story of the oilman at heaven’s gate illustrates the influence of the hordes well: Saint Peter informed the oilman that the places reserved for the oilmen were full. The oilman said, “Can I say four words to them?” Peter says, “Why not?” All the oilmen start rushing from heaven to hell. Peter says, “Well done, now there’s room for you here.” The oilman thinks for a while and says to Peter, “I think I’m going to hell, there may be some truth to the rumor after all.” Unfortunately, this is how we usually act, even though we resist the movements of the people for a long time.

Benjamin Graham and the margin of safety

Margin of safety is one of the most important concepts in investing. You get it by subtracting the true value of an investment from its market price. Margin of safety offers the opportunity to reduce the loss of capital by providing room for inaccuracy, bad luck, or mistakes. You need a margin of safety because valuations are imprecise at best, the future is uncertain, and you will make mistakes. Graham based his risk management principles on an adequate margin of safety, careful analysis, and diversification. Using a margin of safety with adequate diversification was his way of approaching investment risks.

It is possible to overpay for any investment. The probability of making a mistake decreases as the price paid decreases. Using a margin of safety does not guarantee success in individual cases. Although the margin is on the investor's side, individual investments can still result in losses. Take advantage of the concept every time you invest. The more assets you use a sufficient margin of safety for, the better the odds are in your favor. This principle also works strongly in the business of insurance companies.

All investments are based on uncertainty about the future. You can’t just focus on analysis. You need to protect yourself from loss if your analysis is wrong. The probability that you are wrong at least once is almost 100%. You can’t control the above factors. You can only control the consequences when you are wrong. That’s what a margin of safety is for. It limits losses. Even the most foolish investors can make money in a bull market, but they will probably lose it in a bear market, along with interest.

Margin of safety and company quality. There are differences in the way companies do business. A higher quality business can cost more. As a result, a slightly lower margin of safety is needed if quality is not taken into account in the valuation. In this case, there is no reason to mitigate the margin of safety. The predictability of companies slightly lowers their margin of safety. Less variable results can reduce the margin of safety. Many investors, such as Warren Buffett, only invest in companies whose results are consistent.

Graham's only starting point for calculating the margin of safety is the company's business income and profitability. This applies to both bonds and stocks. He did not calculate the margin of safety for both in the same way. He used two ways to calculate the margin of safety for bonds. The first way was to calculate how many times the company has made a profit in recent years compared to the interest it has paid on bonds and dividends on preferred shares. The second way was to compare the sale price of the entire company over a few years to its current liabilities. In this case, the sale price meant the market price of publicly listed assets. In the first way, the margin had to be three times. In the latter way, the price could be a maximum of two-thirds of the public listings. The latter method should be used mainly for companies that focus on owning publicly listed securities. Even then, the market price should be close to the total value of the securities.

In his book Intelligent Investor, Graham offers several options for calculating the margin of safety. When evaluating individual stocks, an investor should use a larger margin of safety than when creating a diversified portfolio. He calculated the margin of safety for an individual company by comparing the company's earnings yield to the interest paid on its potential loan. With an earnings yield of 9% and an assumed interest rate of 4%, the interest paid is 44% of the earnings yield, which provides a sufficient margin of safety. When an investor buys 20 different stocks, the margin of safety can be lower. In addition, Graham used a margin of safety, which he calculated from the balance sheet value, to create a diversified investment portfolio.

Many investors use too small margins of safety when buying stocks. I myself have been guilty of this mistake several times. The margins of safety used by top investors are larger than what most people use. Buffett's example of a sufficient margin came from the purchase of the Washington Post, when he had calculated the total value of the company at 400 million and the company's market price was 80 million. At that time, the market price was 1/5 of the value. In 1994, Buffett's partner Munger said that 1/3 of the real value is a safety margin that is enough for an old alcoholic. Philip Fisher talked about rational purchases when the market price of a company was 25% of its value. He did not directly talk about the safety margin.

In addition to using a margin of safety, you need to realistically assess how likely you are to be right and how you will act if you are wrong. Ask the following questions:

How much have I lost in the past when I was wrong, i.e. how much can I afford to lose?

How have I reacted to losses mentally? Have I panicked when I am losing?

Do I have other investments that will make me money when I lose this money?

Am I putting too much money into this investment? Can I afford to lose my money?

It is difficult to recover lost money. When you lose, you have to win a higher percentage than when you lose. When you lose a quarter of your money, you have to make a third of your money back to get back on your own. When you lose half of your money, you have to double it. Losses come much faster than gains.

Benjamin Graham, about valuation, capitalization factor and about making analyzes

After a lot of work and research into the company, the analyst has reached a situation where he needs to determine the true value of the company. For the valuation of companies that are growing their profits, Graham used the capitalization factor. To determine it, the analyst examines the general long-term outlook. This is influenced by the company's internal future prospects and the prospects of its business sectors. It is also influenced by the competence of the management, which is always a slightly biased view, the financial situation and dividend history, and the level of dividends.

The capitalization factor is difficult to determine if there are continuous changes in the business and management. In this case, the investor must take them into account in the margin of safety. The capitalization factor can really only be used for companies that are growing profits. The formula for valuation according to Graham is:

Value = earnings per share x (8.5+2* profit growth rate percent)

Note! Earnings per share are adjusted for non-recurring items. This is important to remember, because the growth rate percentage comes without the effect of non-recurring items. The size of interest rates also has an effect. The formula does not take into account future interest rates, because they are impossible to predict. It is simple because Graham did not come up with a better alternative. It does not take into account alternative interest rates that affect the present value of results. A sufficient margin of safety helps reduce the inaccuracies produced by using the capitalization factor.

In addition to the capitalization factor, Graham used balance sheet valuation for valuation. This method usually applied to companies that did not grow their results evenly or made losses from time to time. He conservatively added up the values ​​of the assets and thus obtained a value for the company. He determined the value only for tangible assets, such as factories, machinery, land, inventory, etc.

Three obstacles to using analysis

1. Insufficient or incorrect information

2. Uncertainties about the future

3. Unreasonable market behavior

Intentional falsification of information is rare. Misunderstandings often result from accounting tricks or from failure to assess the qualifications of qualitative analysis components, such as managers. Withholding information is less common, because the regulations on disclosure are strict. More often than not, unsavory information can be found in the footnotes or on the last pages of press releases. Graham recommends that you read both carefully. In addition, you should interpret management's speeches independently and not just believe them. If the management has a long history in the company, one must check the track record of speeches to the history of a company.

Predicting the future is difficult. The uncertainty of assessing it creates the biggest problem. The conclusions drawn from the analysis may be outdated when new information comes to light. Analysis of the future must be made on the basis that past events provide a rough guide to the future. The more questionable the assumption is, the less useful the analysis will be.

Market prices should not influence. The market can move prices much higher than the value for a long time. Prices do not directly affect the conclusions, but rather the benefits derived from them. If price remains overvalued for a long time, the investor will not be able to buy the investment at the desired price until the factors affecting the conclusions change. In this case, the analysis must be at least partially redone by adapting to the new situation.

Generally about analysis

Even a single analysis requires a huge amount of work. Analyses do not require higher mathematics or difficult calculations. Using them should serve as a warning signal to you if someone offers help and provides difficult mathematical formulas as explanations. The use of compound interest, the average, percentages, multiplication and division, and addition or subtraction is enough. Mathematics is supposed to give accurate and reliable results, but in the stock market these rules do not apply. Valuation is imprecise at best. Graham worked in the market for decades and, according to his words, never saw reliable analysis of stock values, other than using simple calculations.

The number of companies to be analyzed and the amount of work used can be reduced by creating precise preconditions for the companies under review. If the companies do not meet them, they can be left out of the analysis or the analysis can be stopped. I currently only study Finnish companies, so I am rarely in a situation where I need to analyze companies in more detail. When investing in companies on larger stock exchanges, I have to analyze larger volumes. In this case, it is even more important that the investor has defined the prerequisites for the companies he wants to value. There are many tools available that reduce the workload. There are several stock screeners on the market that look for stocks that meet the prerequisites.

You cannot skip your homework, i.e., analysis, if you want to make decisions about investments. Help from others can cause more problems than is useful. The only way to skip work is to invest in cost-effective index funds with time diversification. The first ones were founded around the time of Graham's death in the mid-1970s, so he did not have time to recommend them. Graham divides investors into those who are willing to do their work and those who are not. In the latter case, the risks increase too much. In this case, the only right way to invest is index funds.

Analyzing is a skill that cannot be learned without practice. There are no shortcuts to learning, so you must practice. Not all companies are analyzed the same way. You have to learn to understand how to analyze, for example, banks and consumer goods companies. Another option is to decide in advance which companies to focus on. If you do not know the industry well enough, you do not need to analyze the related business. Thinking about this in advance reduces workload.

Even the most careful analysis can be wrong, and even the best analysts make mistakes. Therefore, you should always consider the probability of being right. Focus on the following questions:

• How much have I practiced?

• What is the track record of my previous analyses?

• What is the typical success rate of other analysts?

The importance of doing analysis can be summed up in one sentence: If you can't determine the value of an investment with reasonable accuracy, you shouldn't invest in it. Every top investor does this or can determine that the value of an investment is clearly higher than the price. This is the most usual case for stocks. The analysis for other assets might have better possibilities to be right. There are no shortcuts, and listening to others will most likely lead to greater losses. 

Benjamin Graham: Comparing companies in the same industry

 In addition to examining a single company, the analysis should always include a comparison of several companies in the same industry. Quantitative analysis does not tell the whole story. In addition, qualitative analysis must be performed. The goal is not only to compare companies with each other. Examining companies in the same industry also tells about the opportunities offered by the industry. The end result may reveal that the business sector does not offer any company reasonable opportunities for long-term investments. Sometimes the analysis also offers a better investment target in the industry than the original company analyzed.

Entire business cycles offer the most reasonable time frame to examine. Usually, the length of a cycle varies from five to ten years. Using longer cycles can be a waste of time. Quantitative and qualitative analysis may require different time frames. It is difficult to assess the impact of management levels on the success of companies if there have been significant changes in the management of one of the companies being compared. This also applies to major changes in the business, i.e. large acquisitions or asset sales, which can make it difficult to make useful comparisons. All one-time items for companies should also be removed.

Graham thought that analysis should provide at least the following information when comparing companies:

• Price

• Number of shares

• Market value

• Debt

• Book value / Sales

• Profit margin

• Last earnings per share

• First earnings per share for the period under review

• Average earnings per share

• P/E ratio

• P/S ratio

• Dividend rate

• ROE

• Current ratio

• Tangible assets / debt

• Average EPS growth rate

• Average dividend payout ratio

• Number of tangible assets / market value

• Ratio of possible preferred shares or bonds to market value

• Possible special figures due to business sectors

Graham considered the P/E ratio to be the most important. Next comes the P/S ratio. Graham considered a P/E ratio higher than the average for the business sector to be a risk factor. According to Graham, when the market value is much lower than the turnover, the company has a good chance of improving results sharply as the general outlook for companies in the industry improves. Graham did not consider balance sheet comparisons to be significant factors when comparing companies if they did not show clear deviations, either in a good or bad direction. Graham left the significance of current results, average results and the profit trend to each investor to decide for himself. He focused most on the averages.

The final results of company comparisons mainly tell about the past, like other analyses. Therefore, you should remember that the company that did best in the past is not automatically a better performer in the future. This is more likely, but does not directly tell which company is the best investment target. It is easier to come to this conclusion if the companies operate in approximately the same geographical locations and sell almost identical products and services. This is the case when qualitative factors confirm the final results of the quantitative comparison.

Benjamin Graham Balance Sheet analysis part 3

It is easier to use the balance sheet to find weaknesses in a company's financial situation than strengths. The analyst must find evidence of the company's cash sufficiency on the balance sheet, whether the company has enough assets to cover its liabilities, or whether the company is in a situation where its debts are maturing. The balance sheet must provide evidence that the company has sufficient debt service capacity.

The assets found on the balance sheet has to be twice the amount of liabilities according to Graham. This value is not absolute. The company must be examined as a whole. Do not reject an investment based on this ratio alone, but also look at the result, for example. Sometimes the ratio should be at least three. Graham also measured the strength of the company's financial situation with the Quick ratio, which he called the acid test. In it, the company's current balance sheet value, excluding assets, should be at least equal to the amount of liabilities. If both tests are not passed, Graham said that the company's finances were not in sufficient condition. The tests also apply to the purchase of the company's bonds and preferred shares.

Financial difficulties in companies usually come from the maturing of bank loans or other short-term loans. These are not always signs of a company's poor financial situation. A reasonable amount of debt can act as leverage in increasing returns. In this situation, the analyst needs to investigate the situation further. The situation is rarely critical when the company is making a profit. The borrower also matters. The debt of a subsidiary or the short-term loan it provides to the company is not as critical to the financial situation as external financing. The greatest threats are large bonds that are maturing in the near future. Large debts that mature in the medium term can also become problems if the company's results are poor, so the investor must also assess their solvency.

Changes in balance sheet values ​​must also be studied in the long term. There are three aspects to the study.

1. Check whether the reported results are correct 

2. Determine what effects losses or profits have had on the financial situation

3. Investigate the connections between the ability to make a profit and the resources found on the balance sheet in the long term

The reported results are not always correct. In Graham's examples, distortion was made, for example, by taking assets from previously made surpluses into the balance sheet and not reporting these changes in the income statement. I do not know the laws well enough to say whether this is still possible. There are certainly other ways. Not all profits and losses are of the same value. For example, losses in inventory values ​​do not automatically weaken the balance sheet. Therefore, the reasons for companies' results should always be sought in the balance sheet.

It is worth examining the connection between the ability to make a profit and the resources found on the balance sheet over a longer period of time, but even then one should not go to extremes. The optimal period of examination is the length of an entire cycle. Sometimes it is difficult to know where a company is in the cycle, so the analyst may have to study the entire previous cycle and the current cycle up to the present day. In this case, the review period can be 5-15 years. The normal cycle is five to ten years. In the worst case, exceptional events, such as a major war, increase the review period. In this case, the changes in the balance sheet and profit-making ability from the previous cycle may be exceptional. In this case, the length of the review period may increase. Most often, the analysis has been completed long before this operation, so there is no need to be intimidated by the amount of work.

Benjamin Graham Balance sheet research part 2

Lesson 9 Balance sheet part 2

Current ratio was the most important figure for Graham, at least when he published the book Security Analysis. It measures the liquidity and financial buffers. He thought this ratio was a reasonably accurate view of how much money could the owners get by liquidating the company. There are three possible reasons and their combinations why the market cap is less than the possible liquidating value:

1. The price that market offers is too low
2. The company´s directors have made serious mistakes.
3. The owners have a wrong attitude toward there assets.

You should remember that debts are real and the value of assets has to be disputed. You also have to remember that there is no possibility to define the exact liquidation value. This value needs to be compared with the price the market is offering. If your valuation is close to the market price, you can´t make any conclusions. The liquidation is in the best use in the situation where the company or some of it´s parts need to be liquidated. When the company has economic difficulties, the most productive parts of the company will be sold in fraction of their real value. When there is no such need, the liquidation values are much higher.

Graham had some simple ways of valuing the company assets:

• Cash, cash equivalents and marketable securities 100% of book value
• Receivables 75-90%, approximately 80% on average
• Inventories 50-75%, approximately 2/3 on average
• Others like real estate, intangible assets, and machinery, 1-50%, 15% on average

Of course, these are just approximate numbers, but it is better to be roughly right than completely wrong. Getting these numbers is more an art than science, except the cash and marketable securities part of valuation. These numbers also depend on the industry. The values of Inventories in the electronics industry become obsolete very fast compared to some other industries. And the inventories of the oil refineries can become more expensive, when oil prices increases. Machinery can also become worthless before all the depreciation has affected the assets in the assets. Intangible assets are hard to evaluate. Sometimes brands are much more valuable than what is their worth in the assets. You can find more exact information from the Graham´s book Security Analysis.

It is hard to find businesses that has undervalued assets in modern days. Most undervaluations come from intangible assets and their values are hard to define. Most often, companies with undervalued assets are found after a longer decline of the market prices. Graham thought you should sell the business, if the price in the markets has been a lot more lower than the liquidation value. In this case, you should ask yourself that is there any basis for keeping a company public or what should the directors do to correct the undervaluation. This can happen in three ways of a combination of them:

1. Improving the earnings power. It can happen through the improvement of the business conditions of the industry or changing the business into more productive by having new directors or trusting the current ones. It is most probable that new directors can achieve this change.
2. Through mergers or acquisitions. Directors of the other company might have better chances to change the business into better direction. There can also have some synergies by having a bigger business.
3. A public offer for the company or for its parts

Stock price that is well below the liquidation value of the company doesn´t automatically mean that you should buy the stock of an individual company. Instead of buying individuals stocks, Graham recommended to buy a diversified portfolio in which all the stocks are bought below liquidation values. It is clear that not all these kind of stocks are worth buying. They won´t fulfill all the expectations. As an investor, you are still pretty much in the safe place, because you shouldn´t be too worried about losing all your money. Graham also mentioned that you should still be sure to do your homework before buying. These companies should have shown so much earnings power in the past compared to market price today that they are not destroying the assets in the balance sheet. For some reason Graham had an image that these companies were the most successful, when the market prices weren´t in their highs or lows.

I hope you can find some time to think about Graham´s simple ways of valuing the company assets. Do you find them applicable in today´s world?

-TT