squished's investment journal

squished18 · **Joined:** Thu Apr 05, 2007 8:01 am **Posts:** 243

An area where I like to read, research, and think about is investing. So thought I'd start a little journal here about my adventures in these matters.

For starters, I'd like to link to a series of lectures by Benjamin Graham: http://www.wiley.com/legacy/products/su ... e/bgraham/

squished18 · **Joined:** Thu Apr 05, 2007 8:01 am **Posts:** 243

From the first lecture...

"First, with regard to continuity: The extraordinary thing about the securities market, if you judge it over a long period of years, is the fact that it does not go off on tangents permanently, but it remains in continuous orbit. When I say that it doesn't go off on tangents, I mean the simple point that after the stock market goes up a great deal it not only comes down a great deal but it comes down to levels to which we had previously been accustomed. Thus we have never found the stock market as a whole going off into new areas and staying there permanently because there has been a permanent change in the basic conditions. I think you would have expected such new departures in stock prices. For the last thirty years, the period of time that I have watched the securities market, we have had two world wars; we have had a tremendous boom and a tremendous deflation; we now have the Atomic Age on us. Thus you might well assume that the security market could really have been permanently transformed at one time or another, so that the past records might not have been very useful in judging future values."

Does this statement remain true today? If I understand what Graham is saying here, it is that if you look at the overall trend of the stock market, it remains consistent. You might expect new technologies or methods to set the markets off in a different trend, but over the long term the markets have continued on a consistent trend over the long term.

Here's a useful chart to illustrate the point. This is a graph of the S&P 500 index from 1950 to current: http://finance.yahoo.com/q/bc?s=%5EGSPC&t=my

Looking at this chart, you could draw different conclusions. One way of looking this chart is that you could break the chart into two sections: the first section would go from 1950-1975 and the second from 1975-current. In this way, the first section follows a certain growth rate and then the trend follows a markedly different growth rate from 1975 onwards. A second way of looking at this same chart is to put a straight line from 1950 to current. Then note that from 1955-1970 the index was above the trend-line (over-valued), the period from the mid 70's to the late 80's was under the trend-line (under-valued).

No matter how you look at it, the Internet Bubble certainly stands out. That's the period around the year 2000. It was around that Internet Bubble that people started to talk about the new economy breaking rules of the old economy. In some ways, that meant certain people believed the markets would break out from the old trend-line. As we look back at that experience, we can see that no rules of the old economy were broken and they brought things back to reality by 2003.

The purpose of these discussions is to determine if there are "market inefficiencies" that present opportunities for investment that would yield better than average returns.

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squished18 · **Joined:** Thu Apr 05, 2007 8:01 am **Posts:** 243

Contuining to study the first lecture:

Quote:

One way of expressing the principle of continuity in concrete terms would be as follows: When you look at the stock market as a whole, you will find from experience that after it has advanced a good deal it not only goes down -- that is obvious -- but it goes down to levels substantially below earlier high levels. Hence it has always been possible to buy stocks at lower prices than the highest of previous moves, not of the current move. That means, in short, that the investor who says he does not wish to buy securities at high levels, because they don't appeal to him on a historical basis or on an analytical basis, can point to past experience to warrant the assumption that he will have an opportunity to buy them at lower prices -- not only lower than current high prices, but lower than previous high levels. In sum, therefore, you can take previous high levels, if you wish, as a measure of the danger point in the stock market for investors, and I think you will find that past experience would bear you out using this as a practical guide. Thus, if you look at this chart of the Dow Jones Industrial Average, you can see there has never been a time in which the price level has broken out, in a once-for-all or permanent way, from its past area of fluctuations. That is the thing I have been trying to point out in the last few minutes.

Another way of illustrating the principle of continuity is by looking at the long-term earnings of the Dow-Jones Industrial Average. We have figures here running back to 1915, which is more than thirty years, and it is extraordinary to see the persistence with which the earnings of the Dow-Jones Industrial Average return to a figure of about $10 per unit. It is true that they got away from it repeatedly. In 1917, for example, they got up to $22 a unit; but in 1921 they earned nothing. And a few years later they were back to $10. In 1915 the earnings of the unit were $10.59; in 1945 they were practically the same. All of the changes in between appear to have been merely of fluctuations around the central figure. So much for this idea of continuity?

Whoa, this is an interesting observation. So what Graham seems to be saying about continuity is that the DJIA was trading within a certain range and never broke out. It is important to note that Graham was making this lecture around 1945. Taking a look at the chart for the DJIA: http://finance.yahoo.com/q/bc?s=%5EDJI&t=my

We can see from this chart that his observation was true for what had come before. One could observe that the DJIA had indeed traded within a narrow range up until the mid-forties. However, if we look at what history showed us afterwords, we can see that the long-term trend was certainly upwards.

So was Graham wrong? Did he simply not have enough data to make the proper conclusion yet? Am I misunderstanding what he means by "continuity"?

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squished18 · **Joined:** Thu Apr 05, 2007 8:01 am **Posts:** 243

OK, moving on to "selectivity":

Quote:

The second thing that I want to talk about is selectivity. Here is an idea that has misled security analysts and advisers to a very great extent. In the few weeks preceding the recent break in the stock market I noticed that a great many of the brokerage house advisers were saying that now that the market has ceased to go up continuously, the thing to do is to exercise selectivity in your purchases; and in that way you can still derive benefits from security price changes. Well, it stands to reason that if you define selectivity as picking out a stock which is going to go up a good deal later on -- or more than the rest -- you are going to benefit. But that is too obvious a definition. What the commentators mean, as is evident from their actual arguments, is that if you buy the securities which apparently have good earnings prospects, you will then benefit market-wise; whereas if you buy the others you won't.

History shows this to be a very plausible idea but an extremely misleading one; that is why I referred to this concept of selectivity as deceptive. One of the easiest ways to illustrate that is by taking two securities here in the Dow-Jones Average, National Distillers and United Aircraft. You will find that National Distillers sold at lower average prices in 1940-1942 than in 1935-1939. No doubt there was a general feeling that the company's prospects were not good, primarily because it was thought that war would not be a very good thing for a luxury type of business such as whiskey is politely considered to be.

In the same way you will find that the United Aircraft Company through 1940-1942, was better regarded than the average stock, because it was thought that here was a company that had especially good prospects of making money; and so it did. But if you had bought and sold these securities, as most people seem to have done, on the basis of these obvious differential prospects, you would have made a complete error. For, as you see, National Distillers went up from the low of 1940 more than fivefold recently, and is now selling nearly four times its 1940 price. The buyer of United Aircraft would have had a very small profit at its best price and would now have a loss of one third of his money.

This is a fairly common practice, isn't it? When first investing, it seems "natural" to pick companies that have good prospects. Graham is saying here that this is actually not very effective. He goes on to say that this is too obvious and the data shows it is not effective. I guess he's saying that everybody can do this. When you're trying to pick stocks, buying stocks in a manner that everybody can do it means that you'll just end up with the same performance as everybody else. You won't actually beat the market. You would have been just as well off buying an index. (I don't think index funds were around in Graham's day.)

It is interesting to note that when people give/get "stock tips", the thing they usually end up talking about are the stocks prospects. If the company has great prospects as a business, they like the stock. If the company has poor prospects as a business, they hate the stock. If I understand Graham correctly, he is saying the prospects of the company (in and of themselves) are not an effective way of evaluating whether or not to purchase the business. So the question becomes, what is an effective method?

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MossySF · **Posted:** Mon Jul 30, 2007 8:50 am

squished18 wrote:

It is interesting to note that when people give/get "stock tips", the thing they usually end up talking about are the stocks prospects. If the company has great prospects as a business, they like the stock. If the company has poor prospects as a business, they hate the stock. If I understand Graham correctly, he is saying the prospects of the company (in and of themselves) are not an effective way of evaluating whether or not to purchase the business. So the question becomes, what is an effective method?

Put a dollar value on the company and if the share price is at a significant discount, that's your signal to buy. Of course, learning to put dollar values is the hard part.

radioheadok311 · **Joined:** Mon Jul 09, 2007 1:14 pm **Posts:** 58

I love reading Ben Graham but I think it is interesting to hear that Warren Buffett thinks that the last year that Ben Graham's style could profit was like 1972. If you want to see where Buffett's style evolved into more than just the numbers, look at Phillip Fisher, or read "The Warren Buffett Way." By far one of my favorite investment books. I know you aren't looking at analyzing Buffett, so if this isn't pertinent please disregard. Thanks for analyzing!

VinTek · **Joined:** Fri May 04, 2007 8:14 pm **Posts:** 982

radioheadok311 wrote:

Warren Buffett thinks that the last year that Ben Graham's style could profit was like 1972.

Graham himself came to that conclusion toward the end of his life, when he began leaning in the direction believing that index funds were the way to go. See the interview with him here.

As for Buffett, this article very succinctly illustrates where he deviates from Graham.

squished18 · **Joined:** Thu Apr 05, 2007 8:01 am **Posts:** 243

I believe this is the relevant part from the USNews article that VinTek posted:

Quote:

Graham, for instance, never cared much about the quality of the stocks he invested in as long as they were trading at a deep discount to their "intrinsic" value (based on a company's assets and other considerations, as opposed to a stock's market value). Graham described himself as a "cigar butt" investor—willing to buy stocks that Wall Street tossed aside if they had a puff or two of value left in them.

For his part, Buffett is much more concerned about the quality of the companies he searches for in Wall Street's bargain-basement bin, which may explain his reported recent investment in Kraft Foods. "Buffett has said that he would rather own comfortable businesses at a questionable price rather than questionable businesses at a comfortable price," Eveillard says. Or as Buffett has put it: "It's far better to own a significant portion of the Hope diamond than 100 percent of a rhinestone."

Anyone like to comment on why Buffett's strategy is an improvement upon Graham's?

If I understand this correctly, I'm not sure Buffett's quote is all that good at illustrating his own point. I would have said "It's far better to own the Hope diamond at a 10% discount than a rhinestone at a 50% discount."

One reason I would see in the advantage of Buffett's strategy is that there is a greater chance somebody else will come along and pay 150% the value for the Hope diamond. The chances of somebody coming along and offering you 150% the value of the rhinestone is far less. Translating this to real businesses, there are some businesses that people will often "overpay" for, when evaluated according to strict financial terms. Examples of these businesses include newspapers and sports teams.

So perhaps the lesson here is to try to find a business that people will sell for too cheap when conditions are bad and buy for too much when conditions are good. Maybe energy sector stocks fall in this category or utilities? When energy prices are low for extended periods of time, it seems these stocks look like the most depressing and boring companies in the world. Then when energy prices jump, they look like rock stars that will print money forever.

squished

squished18 · **Joined:** Thu Apr 05, 2007 8:01 am **Posts:** 243

radioheadok311 wrote:

I love reading Ben Graham but I think it is interesting to hear that Warren Buffett thinks that the last year that Ben Graham's style could profit was like 1972.

Any citation for this quote? I would like to see the context in which Buffett made this comment.

thanks,
squished

squished18 · **Joined:** Thu Apr 05, 2007 8:01 am **Posts:** 243

Time to take an example company and start to analyze it to see if it is a worthwhile investment. I started by using a stock filter offered by my brokerage. I looked for a small cap company ($1M to $10M market cap) that was profitable (P/E between 2 and 100). The company I chose is called Advent Wireless Inc.

The reason I chose a small company is for several reasons:
- relatively unknown, which means that there is a greater opportunity that this company has been overlooked and provide a greater chance of above-average gains (note that it also has a greater chance of below-average gains)
- a smaller company should be easier to understand; a simpler business model

Next, it was time to find out some financial details about this company. Searched for this company on www.sedar.com.

radioheadok311 · **Joined:** Mon Jul 09, 2007 1:14 pm **Posts:** 58

squished18 wrote:

radioheadok311 wrote:

I love reading Ben Graham but I think it is interesting to hear that Warren Buffett thinks that the last year that Ben Graham's style could profit was like 1972.

Any citation for this quote? I would like to see the context in which Buffett made this comment.

thanks,
squished

I'll look it up and get you a citation.

But basically, Graham liked to look at companies trading below net working capital (assets minus liabilities). This is (from what I understand) why Buffett thought this was not a good philosophy after 1972. You would be hard-pressed to find any company trading below its net working capital, and if you do, in this day and age, you will likely find that stock go to zero absent a miracle.

I don't want to discredit Graham at all, I am just saying parts of his investment philosophy are obsolete, hence why Buffett has said he is 85% Ben Graham and 15% Phillip Fisher (I will get a citation on this one as well).

Most of what I know about Buffett is from "The Warren Buffett Way." If you want to check my references, I highly recommend checking that book out.

squished18 · **Joined:** Thu Apr 05, 2007 8:01 am **Posts:** 243

Would anybody have any recommendations for software for tracking investment portfolio performance?

There are two mandatory features I am looking for. First, it needs to have the ability to give me an accurate compounded annual rate of return for any particular part of my portfolio for a given time frame. For example, I would like to get an accurate compounded annual rate of return for all my bond investments from January 2005 to present. This would have to take into consideration that I made bond purchases at different times within this period. It would also have to take into account the fact that some of the bonds matured within this period.

The second feature that this software needs to have is the ability to factor in tax considerations when calculating rates of return. For example, my ING cash account paid out a certain amount in interest last year. However, a certain portion of that interest has to be paid out in taxes. This affects my actual rate of return. Alternately, investments held within an RRSP (that's a 401k to the Yankees), should factor in a tax rate that will be paid when they are redeemed.

The ability to factor in inflation into these calculations would be a super bonus.

Basically, I am trying to answer questions like "did I make a wise decision when I chose to invest in a particular bond in November 2005, or was there a better option?" You see, YNAB seems to do a very good job of managing the expense side of personal financial management. I'm still looking for a package that does an excellent job of managing the income side of my finances.

thanks,
squished

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