Tag Archives: The Intelligent Investor

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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Lessons from the Intelligent Investor Part 3: State of the Market in 2013

It’s been a while since I’ve posted another entry in my ongoing series for Benjamin Graham’s excellent book, “The Intelligent Investor”. My previous articles have covered chapters 1 & 2. Today I’ll be covering the topics Graham discusses most prominently in chapter 3 — more specifically, a detailed look at the overall state of the market today in 2013.

There are really two trains of thought in the investing world at the moment, with the market now making all-time highs on a daily basis. One is that the market is being irrational and has become overvalued. Investors who share this view are staying away. There are others however that believe the recent run-up over the past few months is just the beginning of an extended bull market. Let’s use some Graham-style logic to assess the situation for ourselves.

I encourage you to read along as we cover Graham’s book from beginning to end. You can pick up an e-book version from Amazon to jump in right away.

Graham’s focus in this chapter was to evaluate the attractiveness of the market at the time of the book’s writing in 1972. We will use the same thought process in an attempt to evaluate where we’re at currently in early 2013. The first thing Graham noted was the fact that there had been over 19 distinct bear-bull market cycles over the prior 100 years – usually occurring every 3 – 5 years on average. We see this same pattern today with extreme market downturns over the past decade in 2001/2002 and again in 2008/2009. The rates of growth in each of this periods varied wildly however.

Graham’s analysis ended in the early 70’s when the book was last published. Let’s pick up where he left off and look at the period between 1970 and 2013:

 

There were nine bear-bull market cycles during the last 43 years, or one complete cycle every 4-5 years on average. Secondly, we notice that market advances last longer than downturns — 4 years vs. 1 year on average respectively. Finally, gains during advances outpace declines during bear markets quite handily. The average advance in the table above was about 120% while the average decline was about 33%.

This is all fine and dandy, but what can we infer about the market today? First we should note that it has now been nearly four years since the last major market decline ended in 2009 and we’ve seen gains of nearly 130% over that period. Comparing against the historical data above, on average our bull run should be coming to an end soon. We are pretty much bang on as far as the usual length and size of market advances go. This lends some credibility to the train of though that says we’re in for a downturn soon.

Now let’s ignore market cycles and look at the past four decades individually, as summarized in the following table:

 

Graham noted that only two decades of the entire century prior to 1972 showed a decline in average earnings and stock prices. We can see from our table that the market is as predictable as it was previously, with none of the last four decades showing a decline in either. In fact, both earnings and price have increased at an accelerated pace over the past 40 years.

Let’s compare two very simple gauges of market valuation to the past: the average PE ratio and average dividend yield. These two are not mutually exclusive as they are both affected by changes in the stock price, but it is interesting nonetheless.

Prior to 1970 the average PE ratio for the entire market typically ranged from a low of 10 to a high of 17. Take a look at the 1990s… an average PE of 20! This would have been a good indication of the crash to come in 2001. It’s interesting to note though that from 2001-2010 the average PE ratio remained at the historically high level of 17.

Average dividend yield was much higher on average in the past as well. Before 1970 dividend yields typically fell in the 4% – 6% range. From 1970 – 1990 dividend yields were at the low end of this range at around 4%. More recently however, yields have averaged under 2% at all time lows. This is due in part to companies not paying as much of their earnings out in the form of dividends, as evidenced by the lower average payout ratio shown in the table. Higher prices are equally to blame however.

At the time of this writing, the S&P 500 index is making all-time highs at a level just below 1,600. Let’s try to determine whether this is overvalued, fairly valued, or undervalued, using the analysis Graham uses in table 3-3 in his book. The following table presents today’s picture, along with representative data every 5 years since 1970:

 

The S&P 500 is currently trading at 16.4 times earnings over the past twelve months, and about 17.2 times the average earnings over the past 3 years. This is toward the upper end of the spectrum, leaning towards being overvalued. It isn’t a solid indication however. Just look at the PE ratios in the 90s — a high PE didn’t stop the market from engaging in the largest bull market in history. Another way to look at valuation is the inverse of PE, called earnings yield. Earnings are currently yielding about 5.8% against a historical range of 4.3% – 12%.

Dividend yields are below average as well, returning just 2% currently. This is an improvement over the prior decade, but much less than the 3-5% yields that were the norm previously. Again, this is an indication of overvaluation.

Finally, let’s compare stock yields to bonds. High grade bonds (10-yr treasuries used in the table above) are at all time lows, yielding just 1.86% today. The earning’s yield from stocks are over three times bonds and even dividends alone are slightly higher. This is very interesting, because despite stocks appearing to be overvalued at the moment, their potential return compared to bonds is at an all time high as well!

Jason Zweig raises an interesting point in his commentary following chapter 3, paraphrased here:

Stock market performance is really driven by only three factors: i) Real growth in earnings & dividends, ii) Inflation, and iii) Speculation by investors which drives prices higher or lower.

Jason postulates that real EPS growth has historically averaged about 2% per year. Inflation over the past decade has averaged about 2.5%. The S&P 500 is currently offering a dividend yield of 2%. Adding these together, we can therefore expect that on average over the long term, the stock market should increase by about 6.5% per year. Fear and greed obviously cause substantial deviations from that average, and that is our goal as value investors to identify those periods (and which one is which!).

In conclusion, I believe that we are due for a market correction based on valuation and the historical duration and size of market cycles. On the other hand, just because the market is overvalued doesn’t mean it is going to suddenly become rational in the near future – especially considering the relative yields of stocks and bonds at the moment. The question arising from all of this is how to change your investment strategy based on this information. My strategy will be to remain conservative, only choosing stocks that appear to be undervalued, and to also be prepared to liquidate a good portion of my portfolio at the first signs of a major correction. There are plenty of potential catalysts for this correction on the horizon, including a financial crisis in Europe, a war in North Korea, and a major economic slowdown in China.

Sources:

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Lessons from the Intelligent Investor Part 2: Inflation

Pile of BooksThis is part 2 of my series dedicated to the teachings from one of the best value investment books of all time, “The Intelligent Investor” by Benjamin Graham. I encourage you to pick up a copy of the book and read along. Today I’ll be discussing Inflation, a topic which Graham has dedicated chapter 2 to in his book. Graham, more than any other investor in history preached the importance of not losing money. Usually this is taken in the context of minimizing risk in a particular investment, but applies equally to the often invisible capital erosion effect of inflation. For today’s young investors, inflation often doesn’t play a part in investment decisions. While this is due in part to a lack of understanding of the mechanics, it’s also due to the fact that inflation has averaged just 1% (or thereabouts) for the recent past. Continue reading

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Lessons from The Intelligent Investor: Part 1

Pile of BooksI am currently reading The Intelligent Investor by Benjamin Graham for the third or fourth time — I can’t quite remember. Every time I read through I pick up more and more of his teachings. This book is widely considered one of the best books ever written for value investors, and it’s easy to see why.

This post will be the first of a series. I plan to share my learnings, thoughts, and ideas with you here as I read through this book one more time. Specifically I am reading the revised edition with commentary by Jason Zweig. This edition contains the full fourth edition updated by Graham in 1971/72 and since this was quite some time ago now, Jason does an excellent job of translating some of the ideas to the present day. If you have a copy of this book, I encourage you to read along and share your comments below! Continue reading

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