This Is Where Graham Says To Look For Investing Opportunities

May 11, 2018

This Is Where Graham Says To Look For Investing Opportunities

I’ll continue with my contemporary summary of Benjamin Graham’s book The Intelligent Investor as I believe that the combination of the everlasting wisdom in the book and a modern approach is all that an investor needs to reach great returns.

Today’s discussion is about Chapter 7 – Portfolio Policy for the Enterprising Investor: The Positive Side.

Today, we’ll turn from discussing how a defensive investor should invest to discussing how an enterprising investor should invest, one who devotes a fair amount of time in order to beat the market.




There are 4 things an enterprising investor has to focus on:

  • Buying low and selling high
  • Growth stocks
  • Bargains
  • Special situations

We will discuss the buying low and selling high strategy when summarizing the next chapter, chapter 8, alongside chapter 20 which every investor should read according to Buffett. Let’s see what Graham has to say about growth stocks.

Growth Stocks

A growth stock is defined as one that has grown better than the average and will continue to do so. We would all like to have invested in Netflix (NASDAQ: NFLX) a few years ago or to find the next Netflix to invest in.

Figure 1: NFLX’s stock price in the last 5 years. Source: CNN Money.

The problem with investing in growth stocks is twofold. Firstly, growth stocks have high prices where one can overpay and still not reach good returns even if right on the growth. Secondly, growth might stall which usually isn’t good news for a high-priced stock.

Graham statistically analyzed the performances of growth stocks and found that they underperform the market which I’ve also shown in my analysis of 90 years of data where value beats growth 94% of the time.

Another problem when investing in growth stocks is the volatility and holding for the long term. For example, we see the wonderful performance Apple (NASDAQ: AAPL) has had in the last 10 years, but I know no one who bought in in 2003 and held through all the huge ups and downs the stock has had (2009, 2013, and 2016).

Figure 2: AAPL is more than a hundred bagger, but who has held? Source: Google.



So, it might be easy to look back in hindsight at what has happened, but there’s a big survivorship bias there that many forget about. There were other growth stocks that were in the loop back then and investors didn’t really see great returns, think Blackberry (NYSE: BB) and Nokia (NYSE: NOK).

Figure 3: Blackberry’s stock price. Source: Google.

So, Graham is against chasing popular growth stocks as his idea is that to be better than the rest, one must be different than most investors and speculator, and be objective. The three investment approaches he recommends are the following:

  • The unpopular large company.
  • Bargain issues.
  • Special situations or “Workouts.”

The Unpopular Large Company

As the market usually overvalues growth and hot stocks, it also undervalues out-of-favor companies especially if there are short term issues.

Smaller companies might also go through a tough time, but Graham prefers larger ones as they have both the capital and brain power to improve the situation and the market usually quickly reacts to any kind of improvements. A typical example is Walmart, which we discussed yesterday, as the stock has quickly recovered from $56 to above $100 in the past two years.

Figure 4: WMT’s stock price in the last 3 years. Source: CNN Money.



Graham’s strategy with out-of-favor stocks is simple, just buy the blue chips that have the lowest PE ratio and are currently out of favor. This also implies those companies provide better value and a margin of safety which again leads to good returns over time.

However, be careful with cyclicals as they sell at low PE ratios in good times and high ratios in bad times when their earnings are close to nothing, valuations high, and stock prices low.

The conclusion is that if you buy out-of-favor stocks, you’ll do well.

Bargain Issues

A bargain issue is one that appears to be worth considerably more than what the stock is trading for. My experience with NSU was just such an example. Graham doesn’t consider a bargain as such if the value of the stock isn’t at least 50% higher than the stock price.

The two methodologies to see whether something is a bargain or not are intrinsic value and what the value is to a private owner and the realizable value of assets.

Further, what’s extremely important to watch is that, to quote Graham, “The market is fond of making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks.”

Lack of interest, and temporary low returns can lead to neglect and absurdly low prices and we can find such bargains in any market.

One of Graham’s favorite bargain assessment tools is net working capital. Net working capital is current assets (cash, marketable securities, and inventories) minus total liabilities. When you find a bargain that sells for less than its net working capital, you get the fixed assets for free.

I would add here that you have to be certain about the accounting and management behind the investment. Further, when the market is expensive as it is now, it will be harder to find such companies but when the market is cheap, the difficulty lies in the selection.

Another point that Graham touches on are small caps, but the first thing we have to look there is the market’s attitude towards such companies and secondly to look at dividend yields and reinvested earnings that cumulate over time. At this point in time, perhaps even small caps are overvalued, but we should take advantage of their inherent volatility.



Special Situations

Special situations mainly include arbitrage and workouts. On arbitrage, you buy into a merger or acquisition uncertainty where you reach a satisfying return if the deal goes through. The workouts consider special situations where there is a lawsuit or similar things that are uncertain but where a proper risk reward calculation might give you a good return even if the worst happens.

An investor has to be really dedicated to understanding such special situations, but it could lead to great profits if you do it when others don’t and understand the game.

Conclusion

Graham concludes by saying that an enterprising investor has to be a full time businessman when approaching investing. Either you are all in or it’s better to be a defensive investor with a low allocation to stocks during moments like now and a higher allocation to short term bonds.

Keep reading Investiv Daily as the next time we touch on Graham, we will discuss the most important chapter in the book, chapter 8, The Investor and Market Fluctuations.



Search