Benjamin Graham Lesson 3 Analysis

In analysis, you search the facts about the security and make conclusions based on them. These conclusions should be based on a sensible logic and the principles planned before the analysis. Analysis takes time. It can take anything from hours to months. Depending on how far you need to go in the analysis. Most of the time, you should understand quickly that there is no need for further examination. Most analyses never get to the point, in which there is a decision to be made, whether to sell or buy the security. You have to accept this ”waste of time” as part of the analyses. There is no way to avoid this. All the greatest investors make their own research about the securities. And they make their own conclusions. You can only get better in analysing securities by practicing. It is a skill like most of the components of successful investing.

Different securities need different analyses. For example, corporate bonds and stocks need to have different kinds of analysis. Bond analysis is focused on the company´s economical survivability. When you analyse stocks, you are interested in the future profits of the business and the price you have to pay for them. You need to use a lot more time to analyse the future profits than the economical survivability. Graham was particularly interested in bonds and stocks. Graham´s primary sources were financial reports from the companies. His analyses focused on the companies, their businesses, financial situations, results and competitors. He also analysed the industries they were focused on and their future prospects.

All the analyses are made in uncertainty. Nobody can predict the future precisely. Randomness has an effect on the correctness of the analysis. You need to evaluate the past, the present, and the future of the business. Future is the hardest part. Past and present give some clues about the future. Unrealistic expectations about the future of the businesses will likely cause the biggest failures in analysing them. Evaluation of the future cash flows must be done with different assumptions. The purpose of the evaluations is to define the range for the present values of the future cash flows. According to Graham, all the analyses should be based on preplanned principles. They should work in all the time periods, exclusive the great catastrophes. You cannot use only one method in every analysis.

Graham divided analysis into two different parts: Qualitative and Quantitative analysis. Qualitative analysis describes business at a common level. It means evaluating business through the quality of the directors and the future of the business and its industry. Qualitative analysis describes the security primarily through the numbers. It describes the security through the income statement, balance sheet, dividends, statistics of the business and the capital structure. It is easier to analyse the quantitative factors. Some of the qualitative factors are hard to evaluate. For example, the abilities of the directors are sometimes based on opinions rather than facts. You need to consider both, the qualitative and quantitative factors for making any useful conclusions. Qualitative analysis should confirm the quantitative analysis, and vice versa. Without this happening, conclusions are not very useful.

Two main limitations in analysing businesses

There are two main problems in doing the analysis. First, it takes time to analyse a business. Finding the necessary information about the business takes time. Going through it to find all the important things about it, like competition, future prospects of the industry, takes from days to even weeks. Many investors cannot spend so much time. Second problem is the bandwith of the brain. You and I have our own limitation about how much information we can process. Depending on the research the optimal amount of different pieces of information in decision making is between five and twelve. Too much information have been found to lead to bad selection of what are the most important things you should know. When you have an information overload, you start focusing on the less important things.

There are many tools to overcome these problems. You can specify the requirements for businesses, which you want to analyse in advance. For example, no net debt, no losses in the last five years, etc. And then you can use a stock screener which helps you to find those businesses. This saves a lot of time. The amount of businesses to analyse will be diminished. You can also use spreadsheet programs like Excel to combine some factors from the income statement or balance sheet into bigger ensemble. For example, you can design a system which collects all the relevant information of all small components over certain factor of the business like financial strength. You can combine these smaller components like net debt, cash, and so on, into bigger ensemble that describes the financial strength as a whole. Then you don´t have to consider so many pieces of information. This also saves time.

I hope you will take some time and choose a business you are interested in. I would like you to figure out the most important facts about the business. Then I hope you will analyse these facts. Do it shortly.

© Tommi Taavila 2018

Benjamin Graham Lesson 2 Investor as a business owner

Do you ever find yourself wondering if some stock goes up or down in the future? When you do this, can you also see that you are right for some time? Did you ever started to think what an investing genius you were? And suddenly, the price has gone fast to other direction without any reason. You have probably experienced this at some point of your investing career. Some people might even stop investing at this point. These kinds of mistakes are familiar even for the most experienced investors. And these mistakes can be fatal. The best cure for these kind of mistakes is seeing yourself as a business owner.

Stock market is not a roulette wheel, where you can choose from the red, black and green colors and expect to win with the correct color. It look likes that in the short run, but in the long run it is a whole another game. Thinking stock as a share of a company´s future profits and the possible future appreciation of its assets is the best way to play this game. At least, for most of us. Some people are great in predicting prices, but they are very rare. Considering yourself as a business owner, helps you to ignore the short-term predictions about the prices. Both, stock ownership and the betting in the roulette can give you hope for the better future. Most of the time, stock gives you a legal right for the better future. And a roulette wheel gives you a right to have a chance for the better future. Both of them can be smart choices with the right price. Unfortunately, I am sure you have never heard about the casino where the roulette wheel gives you the price you should pay. If you find one, please let me know.

You should think yourself as an owner of a company before and after purchasing a stock. By doing so, it is easier to concentrate on the present value of the cash the business generates in the future and on the appreciation of its balance sheet. It is even better if you can consider yourself as the owner of the whole business. This view makes it also harder for you to seek action by selling shares in the near future. And it helps you to concentrate on the numbers in the company´s income statements and balance sheets from the past. They are your main sources for finding the right price for buying or selling shares.

For a business owner, the short-term changes in prices or even in earnings are mostly insignificant. Short-term changes in earnings mostly depend on the business cycle. After the business has reached the top of the cycle, most of the businesses start delivering smaller quarterly earnings than before the top of the cycle. Best businesses grow their earnings at this point too or the earnings decline is very small. When you think yourself as an owner, you see things differently. You probably expect to see this decline in earnings at some point. When you are concentrated on the share price only, you probably sell at this point of pessimism without considering the future of the business.

Owning the whole company mental model also helps you to analyze the whole business, company´s financial position, and their development through a longer period. Checking the historical improvement of the company´s income statement and balance sheet becomes more important. And you get a better view for the uncertain future. This also helps you to define a better price range for the whole company and its shares. This increases your probabilities of getting better investment returns. In the long run, share prices follow closely the changes in business. When you think like an owner, you invest in for decades. Your success depends on the long term changes in the company´s earnings power and the value of its assets and how much you paid for them. When you think this way in all the investing operations, luck becomes irrelevant in the long run.

When you see yourself as a business owner, you also understand that the company directors are your employees. Graham saw most of the investors like lambs, waiting for butchering without any resistance. Most of the owners do not say anything, when they see directors working into their own advantage and against the interest of owners. Directors are legally obligated to protect the interests of the owners, not their own. Many directors do not think this way. They use the money, which belongs to the owners, the way they want, without any consideration about the owners.

On average, directors know more about the business than the owners. This doesn´t mean that the owners should accept anything they do for the business. For example, the excessive amount of share options for directors, or acquisitions that are too expensive are harmful for the owners. Still, you can see these things often. Most of the owners do not give their opinion by voting against them. This is a bad policy. A better policy is finding other owners who think like you do and try to get the message to the directors. When you think yourself as an owner, you avoid investing into these companies. And you also evaluate the decisions the directors have made from the owner´s point of view, when you have already invested to the company.

I want to give you something to think about. Choose a business, in which you are interested. Learn about its cycles by going through its income statements and balance sheets from the previous years. Figure out which is the normal length of the business cycle, what are the reasonable profit margins, earnings and growth prospects. And make a justifiable estimate about the right price for the whole business in your head. You can also use a calculator if the numbers are too hard figure without it. Do not check shareprices before you have made an estimation! It is better not to check them at all. The idea of this exercise is not to calculate the exact price for the business. It is for getting familiar with this mental model.

Copyright © Tommi Taavila 2018

Benjamin Graham Lesson 1 Definition of Investing

Benjamin Graham´s definition of investing is:

”An investment operation is one which, upon thorough analysis, promises safety of a principal and a satisfactory return”.

Investing is not an exact science, as we can see from the definition. Different components of the definition, promising safety of a principal, a satisfactory return, and a thorough analysis are interwoven. It is hard to achieve safety of a principal and a satisfactory return without a thorough analysis. Safety of a principal means protecting yourself from losses, which obey the reasonable probabilities. Graham thought that the most important function of investing is keeping your principal safe. Avoiding serious losses is the most important thing for an investor. Graham preferred investing in bonds and stocks. Company´s ability to make profit and its relation to its financial responsibilities told Graham how safe were the investor´s principal. Graham also thought that the paid price had to be reasonable. Graham also thought that individual investments could deliver losses. This is one reason why he favored diversification.

Graham defined a satisfactory return as ”Any investment return that an investor is willing to accept, when he functions with a reasonable intelligence”. A satisfactory return depends on the security. An intelligent investor cannot aim to reach for the moon. The historical real stock market returns have been annually around 7 per cent on average, when dividends are invested in stocks. All the other asset classes have even lower average annual returns. When you think about satisfactory returns, you have to consider historical returns too. Unreasonable expectations for investment returns will eventually lead to losses of principal.

The safety of a principal and a satisfactory return are related to the price you pay. This price is defined with a thorough analysis. Defining this price is not an exact science. You need to define the price range. For example, a price range between 15 and 20 dollars a share. This is important. A thorough analysis means you need to think about many variables. You cannot be sure about the future. You need to have a range for the price. A thorough analysis means investigating all the essential facts. I will get back to this process after the next lesson.

I have a question for you to think about: ”What kind of annual real returns would be satisfactory for you in the next ten years? Think about the historical 7% annual returns in stocks and consider what you can get. Use any clues you can and want to find.

- Tommi Taavila ©2018

Benjamin Graham

Benjamin Graham was born in Great Britain. He was also called A Dean of Wall Street. He moved to United States, when he was a one year old. His father died, when he was nine. His family business went bankrupt a year later. His mother lost all of her money by investing in US Steel, when he was thirteen. This was his first experience with financial markets. These, aforementioned experiences, left an impression to him. They had effects on his investing and his principles for decades.

Graham was a polymath. When he graduated, he was offered teaching positions from three different academical departments: Philosophy, Mathematics and, English. He didn´t accept any of them. He went to work on Wall Street, even though he had no education for finance. His emotional education came from studying mathematics, especially geometry. This required deep and precise think for making conclusions. The biggest joy to him was developing his mind in many areas of expertise alongside investing.

His biggest achievements in finance were two books: Security Analysis and Intelligent Investor. Most of their content are still relevant after decades. Some of the principles, methods, and concepts are still used among the modern day investors. The best known concepts are Margin of Safety and MR. Market. Graham concentrated on stocks and bonds. His investment returns were not the greatest. He did better than market indices. Unfortunately, I haven´t found his investment results from the whole investing period. I have his returns from two periods: 1925-1935 and 1948-1976. Compared to returns from S&P-index, the annual returns are:

1925-1935 Graham 6.0% vs S&P 5.8% and

1948-1976 Graham 11.4% vs S&P 7.1%

In the first period, Graham didn´t get any better results than market averages, but the second period was much better. When investing into S&P index between 1948-1976 would have made you about 6.8 times your money, investing with Graham would have made you 20.5 times your money. Graham didn´t try to maximize his investment returns. He was mainly interested in keeping his money safe. Getting better returns than market indices was a byproduct. You can see this from his investment returns. Graham wasn´t one of the greatest investors. But he was maybe the greatest intellectual mind in investing. He had some thinking defects about businesses. For example, he believed that competition will eventually correct the highest profit margins into normal levels in all businesses. He missed the concept of durable competitive advantage. His most profitable investment GEICO is one example of a company like this.

Lessons from Benjaming Graham

Lesson 1. Graham´s definition of investing

Lesson 2. Investor as a business owner

Lesson 3. About analysis

Lesson 4. Qualitative analysis

Introduction

Every day, thousands of extremely intelligent, hard-working people work long hours in Wall Street, London and other money centers of the world. Most of them get mediocre investment returns. Their clients do even worse, because they pay some part of their less than average returns to these professionals. In worst case, these professionals create weapons of financial mass destruction. The investment vehicles so complicated that nobody can understand them, including their creators. Majority of investing professionals belong to these aforementioned, high paid groups. I don´t know if these facts are tragic or scary. These people have enormous potential of doing good things in some other area of expertise and then they waste it for mediocre results in the financial markets.

A very small minority of investment professionals have proven track record of outsucceeding most of the professionals with significant margins for at least over ten years and/or they have created universal and timeless investing principles. They are the best skilled, most knowledgeable, and wisest investors we have seen. These people do things differently. There is no other possibility, because consensus view is in the prices in financial markets. Betting against consensus doesn´t mean you are right. There has to be a well thought reason to do this. To get better probabilities of getting better than mediocre investment returns, you need to understand how and why the best investors do things differently. These lessons are for you to learn these reasons.

There are basically two reasons why most of the professionals do not get better results for themselves and their clients. First, financial markets work that way as a system. System in which most professionals work, has a tendency of concentrating on the basis of consensus view. It is probably right in the short term. And short-term success is what most professionals are measured and paid for. Betting against consensus is what gets you fired, unless you are right. Acceptable mediocrity is therefore better for the professional. Second, the most important attributes for the best investment success are certain character traits. Most of these character traits work better in the long-term.

The most famous and maybe the best investor in the history of the world, Warren Buffett, defines investing as ”Transferring your current purchasing power to someone else´s use, in order to have a probable bigger purchasing power in the future”. All these lessons are for getting better probability of increasing your purchasing power in the future. All of these great investors have this goal or a goal for getting better probability of not losing purchasing power. All the investors have these goals. Principles and methods can be different. These lessons are for increasing probabilities for the long-term investors. They are unlikely to work in the short term.

These lessons are about the investment principles of the wisest and most skilled investors on earth and how to use these principles. I will cover their investing mistakes too. And what I believe are their blind spots in thinking about business and investing. Methods of using principles may vary, but fundamental truths are the same. Most of the situations occurring are just one of those. These situations have repeated through history. Most of them are not completely similar, but very close to each other. History doesn´t repeat, but it rhymes. You can apply certain principles only when similarities of things happening right now are very close to what happened before.

All the principles are not for you. You are different compared to these investors. You have to make a decision, whether individual principles are good match for your values, character and abilities. I will try to help you by giving my opinions to whom these principles can work for. Do not accept any principle or my opinion about it without thinking independently. Ask two questions:

1. Does this principle or method match with my values, character and abilities?
2. What should I do about it?

Nobody can use all the principles. Choose with creat care. You don´t need to have the same principles as these great investors. Have your own principles and design them for your values, character and abilities. Whatever you choose, operate with chosen principles. Use them, when you are sure about the right timing.

These lessons are trying to be designed to be as simple as possible, but no more simpler. Investing is an activity, in which oversimplification, as well as overcomplexification, lead to completely wrong answers. One of the important intellectual characteristics of these great investors is the ability to simplify complex things as much as possible. It is one of the hardest things to do in life. These lessons have no complex mathematical formulas. Simple calculations are all you need. The amount of investing terms is kept minimal. They are only used, when it is the only way of explaining things. These lessons are not for the people who have started investing. Some of the terms are not explained, because I assume you are aware of what they mean. These lessons need independent thinking too. Without any knowledge or experience about investing they may only confuse the reader.

All the investors I introduce have their own lessons. You should go through the lessons investor by investor. I will post lessons mostly once a week. Going through them too fast may cause you trouble in understanding them. Each lesson requires lots of thinking. They contain one question to think about as a homework. The exceptions are the introductions about the investors. Lessons are in particular order for a reason. You should go through them in the right order, which is the order I am presenting them. I don´t recommend skipping any lessons, unless you are sure they are not useful to you. Some of the lessons have more advanced and detail-oriented information about the previous lessons. Some of the lessons may seem shallow, but deeper understanding requires thinking them thoroughly and independently.

These posts have lessons at least from the next investors: Benjamin Graham, Philip A. Fisher, Warren Buffett, Peter Lynch, John M. Templeton, Ray Dalio, Jim Rogers, John C. Bogle. Possibly from Charlie Munger Carl Icahn and William J. O´Neil. These lessons are mostly based on sources you can find from here. I recommend you to check them yourself, depending on the amount of freetime and interest you have. The best lessons are from the investors themselves. There are no misinterpretations between them and my understanding about the lessons.

Feedback is welcome. I am not a native English speaker. Any feedback about the language is very useful. And all the comments and feedback about the lessons are welcome and useful too. You can send comments about the posts or send some e-mail to tommisalmanack@mail.com.

© Tommi Taavila 2018

Sources

Benjamin Graham

Security Analysis 6th edition (Kindle)

The Intelligent Investor, Revised Edition (Paperback)

Rediscovered Benjamin Graham Selected Writings (hardcover)

Benjamin Graham Father of Financial Analysis (Kindle)

Einstein of Money (Kindle)

Daniel Levitin, The Organized Mind

This list will be updated