Benjamin Graham Lesson 4 Qualitative factors in analysis

Graham´s expertise was not in a qualitative analysis. For example, he missed a durability of competitive advantage concept. Graham examined a company´s market share, its physical, geographical and functional features, the quality of the company´s directors, and finally a company´s, industry´s and common financial expectations. An analyst has to examine qualitative features from many different sources. He has to go through all the company´s press releases and annual reports. He has to check some expert opinions, trade magazines, competitors´ annual reports, etc. Sometimes, sources are opinions. An industry expert may give his opinion about the company or its directors. Different people can have different opinions about quality. Using individual sources can produce wrong conclusions. Graham thought qualitative analysis was less useful, because it was hard to him.

The qualitative functional features are the dependency of capital, competitive environment, regulations, the raw materials need, the need for research and development investments, etc. All these factors have an effect on the earnings prospects for the future. These factors change along industry´s and common financial cycles. You need to analyse these factors partly through the numbers. Graham thought that it was hard to find any useful information by analysing the industry. Every industry have many details to analyse. Analyst need to decide which pieces of information are the most important ones. Most of the industry´s numbers are known by everyone. Graham thought that the best informational advantages were found from the industries, which were going through changes. Bigger changes equal bigger risks and opportunities. If you didn´t understand these changes, Graham would recommend you to analyse other industries.

Graham believed that high profit margins in all the industries were going to be diminished in the long run into normal levels. This was going to happen because eventually these markets would get more competitors. They would bring lower profit margins. He thought there were no durable competitive advantages. Products like Coca Cola, have kept their competitive advantages for decades. There are no changes in the horizon. Graham also believed that all the biggest market shares would diminish through years.

He believed that the stability of the business was the most important qualitative factor. It means resistance to change and makes evaluating the future earnings prospects easier. Stability of the business doesn´t mean that future profits will stay the same as in the past in most of the earnings units. For example, the turnovers and the profit margins of the individual companies can have lots of variations. Companies with bigger market shares are more stable than companies with smaller ones. Increasing earnings are good signs. You can only make assumptions about the future from the earnings history.

All the businesses have their natural turnover and profit cycles. Without understanding them, analyst gets less accurate predictions about the future and the quality of the business. All the businesses need to be evaluated through their natural business cycles. A trend in earnings prospects can be over before the analyst notices it. Analysis cannot be based solely on the assumptions about the trends business is going through. But it can be a baseline in evaluating the future of the business. Graham thought that an investor should take into consideration changes in the future. But instead of trying to take advantage of them, he should protect himself from the changes.

Financial strength and capital structure have an effect on the quality of the business. Having a significant amount of cash or its equivalents and a reasonable amount of debt are factors of quality. A reasonable amount of debt gives leverage to the company. Too much debt, especially debt that has to be paid soon can become lethal to the company. Worst kind of debt comes from the banks. Big debts from them are the worst kind of debts for companies.

The abilities of the directors are hard to measure. Some of your ideas about directors are based on rumors and presumptions. Most outsiders cannot really know the directors without working with them. The best proof of the quality of the directors is found by comparing the success of the company with other companies in the same industry. This comparison should be made for the longer time period, like many years. It takes time to make changes for the companies. The best conclusions can be made, when the directors of different companies have managed to stay in their positions many years. You shouldn´t make any conclusions without having a possibility to see the track records of the directors.

Graham thought that members of the board of directors belonged to the five groups:

1. Directors who are mainly interested in their own good.
2. Investment bankers, whose first objective is to make money for their bank.
3. Normal bankers, whose aim is to keep their loans running
4. Persons, who are doing business with the company
5. Some people who are actually interested in owner´s assets

He also thought that most of the people in the fifth group have created friendships with other board members to get their position in the board. One of the most important qualitative factors is how the directors treat shareholders. All the profits from the business belongs to the owners. Directors should maximize the earnings of the owners in the long run. Graham believed that one factor of quality is how many consecutive years has the company paid dividends. Directors shouldn´t maximize the amount of cash in the business without finding profitable investment possibilities. They shouldn´t pay too much dividends either. Directors shouldn´t also pay themselves too much.

The owners shouldn´t suffer, when the business is growing. Acquisitions should happen only, when it maximizes the earnings of the owners in the long run. One factor of the quality of the directors is the way they pay for the acquisitions. Most of the times, it is not smart to use company´s stocks as a payment method. Graham also thought that most of the acquisitions should be paid with cash. Using your own stocks should happen seldom, and as a smaller part of the payment. You can also use quantitative analysis to see how the owners are treated. Most of these qualitative factors should be confirmed by the numbers in the income statements and balance sheets.

I hope you will find time to think about some company and its qualitative factors and compare them to its competitors. It will be beneficial to you.

©Tommi Taavila 2018

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