Monthly Archives: May 2013

Lessons from the Intelligent Investor Part 4: Passive vs. Active Investing

This is the fourth installment of my series devoted to Ben Graham’s influential book, “The Intelligent Investor”. Today I’ll be commenting on chapters 4 through 7, which explore the ideas of both defensive (passive) and enterprising (active) investors, and how their investment strategies should differ. I encourage you to pick up a copy of this book now, conveniently available from Amazon in e-book form.

Graham defines two classes of investors which he terms defensive and enterprising. In a broad sense, the defensive investor is one who does not have the desire or perhaps the ability to devote a significant amount of time to researching and managing his investments. The enterprising investor on the other hand, treats his investments as a business in itself and devotes a correspondingly larger amount of time and effort as a result.

Graham makes a few interesting points about these two types of investors:

  • The enterprising investor stands to earn a higher overall return over time as a reward for his efforts.
  • There is no middle-ground between defensive and enterprising strategies – investors must choose between one or the other.

The Defensive Investor

A defensive investor by Graham’s definition is limited both in the types of securities he can invest in, and with respect to portfolio allocation. Specifically, only high-grade bonds and high-grade common stocks can be purchased, and no more than 75% of the portfolio should be allocated to common stocks. Conversely no less than 25% should be in stock. In a market that is not tending toward the extremes in terms of valuation, the division should be 50-50. As the market becomes overvalued, the stock allocation of the portfolio would be reduced towards the 25% minimum, and vice versa during periods of extreme pessimism.

The aim of the defensive investor is the avoidance of extremes. During major bull markets, the investor will be satisfied with only about half of his portfolio reaping the rewards, but during market crashes he will not be losing any sleep knowing that most of his investment capital is safe.

The bond portion of the portfolio provides income and stability. Graham goes into great detail on the types of bonds that are suitable for the defensive investor, but suffice it to say that the options are all very conservative. One option available today that was not available at the time the book was written is bond funds or ETFs. This provides a means of adequate diversification between bonds of varying terms and yields, even for a small portfolio. One that I follow myself is the PIMCO Total Return ETF (BOND).

Regarding the selection of stocks for the remainder of the portfolio, there are some rules to follow:

  • Adequate diversification is required – between 10 & 30 stocks.
  • Only large-cap stocks should be purchased, and even then only those that do not carry substantial debt.
  • Stocks selected should only be of those companies with a long history of continuous dividend payments – at least 20 years.
  • P/E ratio must be no greater than 25 times the average of the past seven years earnings, and no more than 20 times the trailing twelve months (ttm) earnings.

It’s interesting to note that the last rule is designed to specifically exclude the vast majority of growth stocks, which are to be avoided by the defensive investor for reasons of volatility and unpredictability. Graham suggests dollar-cost averaging as the means for the defensive investor to allocate new funds to his portfolio, whereby an equal dollar amount be invested at a fixed interval, whether that be annually, or monthly for example.

The defensive category applies to probably in excess of 90% of individual investors today, whether they know it or not. Most individuals simply do not have the time, nor the inclination to devote the necessary effort to actively manage an aggressive portfolio. As a result, most people nowadays are fully invested in mutual funds – letting someone else manage their portfolio for them. An alternative however is a passive investment strategy such as Dividend Growth Investing, which I have recently discussed here on Stockodo and have devoted a portion of my portfolio towards.

The Enterprising Investor

What Graham is really referring to when he uses the word enterprising is active. This class of investors treat their portfolio as a business, and devote a disproportionally large amount of time and effort to managing it. As a result, these investors should expect higher returns than the defensive investor.

Being active however, doesn’t give free license to buy anything and everything. There is still a sense of conservatism required as follows. The following types of investments are to be avoided, even by the enterprising investor:

  • High yield junk bonds.
  • Foreign bonds.
  • Any form of day-trading.
  • IPOs.

Instead, the enterprising investor is to focus on growth stocks, bargain stocks, and unpopular large companies. Graham also touches on special types of circumstances such as arbitrage, but this is really outside the scope for most investors.

Growth Stocks: While these stocks are to be avoided by the defensive investor, an enterprising individual is encouraged to include them in his portfolio to achieve higher than normal returns. The idea being that the active investor can invest the time and effort necessary to select only quality growth stocks that not only have performed well in the recent past, but will continue to do so in the future.

Unpopular large companies: Large by this definition follows the same criteria as that for defensive investors above, except now we are specifically attempting to identify those companies that have temporarily fallen out of favor – the key word being temporary. This could be the result of a poor earnings report, pending lawsuit, or some other form of pessimism. These types of problems tend to get overblown, and the stock price can become quite undervalued as a result. I am always on the lookout for these types of opportunities. Check out my recent article on Caterpillar (CAT) for an example.

Bargain Issues: This is where intrinsic value forecasting comes into play. We attempt to purchase stocks or much less than their true value, as measured by any number of criteria. Graham has his own methods which will be explored more fully in a future article. The key point to remember is that a stock’s price is not the same thing as its value. Specifically, we want to look for opportunities to buy stock where its true value is at least 50% more than its current price. Price usually tends to gravitate back towards its true value over time, and that is what we’re attempting to capitalize on.

Which type are you?

I consider myself to be an enterprising investor, as I enjoy researching my investments and conducting stock analysis myself. I routinely employ such techniques as discounted cashflow analysis, EPS growth valuation methods, and actively manage my portfolio. That said, I do allocate a portion of my portfolio to a more passive approach, namely a dividend growth strategy.

What type of investor are you? Do you fit squarely into one of Graham’s two categories, or somewhere in between?

 

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Free Discounted Cash Flow (DCF) Spreadsheet

I’ve had several requests to make my discounted cash flow (DCF) spreadsheet publicly available. As a refresher, DCF analysis is a method of forecasting the cash flows that a company generates into the future, and then discounting them back to a present day value. This value can then be used to determine what the current stock price should be (called its intrinsic value), and a comparison can be made against its actual trading price. It might be an indication that a stock is undervalued if it is currently trading at less than its intrinsic value. Many investors would then consider this a buy signal and initiate or add to a position.

Spreadsheet: Stockodo Discounted Cash Flow Spreadsheet

There are many methods to conduct a DCF analysis, some more complex than others. There’s often a tradeoff between complexity and accuracy, and I therefore prefer to take more thorough approach to my analysis. Use the link above to access my spreadsheet on Google docs. Feel free to make a copy for yourself and use it in your own analysis. Standard disclaimers apply as to the use of information arising from this spreadsheet.

 

This spreadsheet looks at a 20 year period consisting of the prior ten years and future ten years from today. The historical information is entered manually using data from websites such as GuruFocus. As historical data is entered, percentages of revenue are calculated. We look at these numbers to identify trends, and then enter our forecast percentages into the future column. This then performs the reverse operation to calculate the future metrics. Any number in blue text is intended to be a user input. For a refresher on DCF analysis in general, I suggest you check out my previous article on the topic. The spreadsheet is prepopulated with an analysis I recently conducted on Chevron (CVX). You may also be interested to see how DCF analysis fits into an overall strategy of evaluating a company.

Once all data is entered, the next step is to choose a minimum acceptable rate of return (MARR), which is also called the discount rate. Typical values of MARR range from 9% – 15%. A long term growth rate must also be entered, usually in the range of 3-4%. This will then calculate the enterprise value of the company. The enterprise value includes all debt and excludes cash. We subtract and add these items in respectively to finally determine the company’s intrinsic value.

I hope you will find this spreadsheet useful. Please post some company valuations you come up with in the comments below!

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