The Intelligent Investor: The Definitive Book On Value part 42 pptx

COMMENTARY ON CHAPTER 15 It is easy in the world to live after the world’s opinion; it is easy in solitude to live after our own; but the great man is he who in the midst of the crowd keeps with perfect sweetness the inde- pendence of solitude. —Ralph Waldo Emerson PRACTICE, PRACTICE, PRACTICE Max Heine, founder of the Mutual Series Funds, liked to say that “there are many roads to Jerusalem.” What this masterly stock picker meant was that his own value-centered method of selecting stocks was not the only way to be a successful investor. In this chapter we’ll look at several techniques that some of today’s leading money man- agers use for picking stocks. First, though, it’s worth repeating that for most investors, selecting individual stocks is unnecessary—if not inadvisable. The fact that most professionals do a poor job of stock picking does not mean that most amateurs can do better. The vast majority of people who try to pick stocks learn that they are not as good at it as they thought; the lucki- est ones discover this early on, while the less fortunate take years to learn it. A small percentage of investors can excel at picking their own stocks. Everyone else would be better off getting help, ideally through an index fund. Graham advised investors to practice first, just as even the greatest athletes and musicians practice and rehearse before every actual per- formance. He suggested starting off by spending a year tracking and picking stocks (but not with real money). 1 In Graham’s day, you would 396 1 Patricia Dreyfus, “Investment Analysis in Two Easy Lessons” (interview with Graham), Money, July, 1976, p. 36. have practiced using a ledger of hypothetical buys and sells on a legal pad; nowadays, you can use “portfolio trackers” at websites like www.morningstar.com, http://finance.yahoo.com, http://money.cnn. com/services/portfolio/ or www.marketocracy.com (at the last site, ignore the “market-beating” hype on its funds and other services). By test-driving your techniques before trying them with real money, you can make mistakes without incurring any actual losses, develop the discipline to avoid frequent trading, compare your approach against those of leading money managers, and learn what works for you. Best of all, tracking the outcome of all your stock picks will pre- vent you from forgetting that some of your hunches turn out to be stinkers. That will force you to learn from your winners and your losers. After a year, measure your results against how you would have done if you had put all your money in an S & P 500 index fund. If you didn’t enjoy the experiment or your picks were poor, no harm done—selecting individual stocks is not for you. Get yourself an index fund and stop wasting your time on stock picking. If you enjoyed the experiment and earned sufficiently good returns, gradually assemble a basket of stocks—but limit it to a maximum of 10% of your overall portfolio (keep the rest in an index fund). And remember, you can always stop if it no longer interests you or your returns turn bad. LOOKING UNDER THE RIGHT ROCKS So how should you go about looking for a potentially rewarding stock? You can use websites like http://finance.yahoo.com and www.morningstar.com to screen stocks with the statistical filters sug- gested in Chapter 14. Or you can take a more patient, craftsmanlike approach. Unlike most people, many of the best professional investors first get interested in a company when its share price goes down, not up. Christopher Browne of Tweedy Browne Global Value Fund, William Nygren of the Oakmark Fund, Robert Rodriguez of FPA Capi- tal Fund, and Robert Torray of the Torray Fund all suggest looking at the daily list of new 52-week lows in the Wall Street Journal or the similar table in the “Market Week” section of Barron’s. That will point you toward stocks and industries that are unfashionable or unloved and that thus offer the potential for high returns once perceptions change. Christopher Davis of the Davis Funds and William Miller of Legg Commentary on Chapter 15 397 398 Commentary on Chapter 15 FROM EPS TO ROIC Net income or earnings per share (EPS) has been distorted in recent years by factors like stock-option grants and accounting gains and charges. To see how much a company is truly earning on the capital it deploys in its businesses, look beyond EPS to ROIC, or return on invested capital. Christopher Davis of the Davis Funds defines it with this formula: ROIC = Owner Earnings Ϭ Invested Capital, where Owner Earnings is equal to: Operating profit plus depreciation plus amortization of goodwill minus Federal income tax (paid at the company’s average rate) minus cost of stock options minus “maintenance” (or essential) capital expenditures minus any income generated by unsustainable rates of return on pension funds (as of 2003, anything greater than 6.5%) and where Invested Capital is equal to: Total assets minus cash (as well as short-term investments and non-interest- bearing current liabilities) plus past accounting charges that reduced invested capital. ROIC has the virtue of showing, after all legitimate expenses, what the company earns from its operating businesses—and how efficiently it has used the shareholders’ money to generate that return. An ROIC of at least 10% is attractive; even 6% or 7% can be tempting if the company has good brand names, focused management, or is under a temporary cloud. Mason Value Trust like to see rising returns on invested capital, or ROIC—a way of measuring how efficiently a company generates what Warren Buffett has called “owner earnings.” 2 (See the sidebar on p. 398 for more detail.) By checking “comparables,” or the prices at which similar busi- nesses have been acquired over the years, managers like Oakmark’s Nygren and Longleaf Partners’ O. Mason Hawkins get a better handle on what a company’s parts are worth. For an individual investor, it’s painstaking and difficult work: Start by looking at the “Business Segments” footnote in the company’s annual report, which typically lists the industrial sector, revenues, and earnings of each sub- sidiary. (The “Management Discussion and Analysis” may also be helpful.) Then search a news database like Factiva, ProQuest, or LexisNexis for examples of other firms in the same industries that have recently been acquired. Using the EDGAR database at www.sec.gov to locate their past annual reports, you may be able to determine the ratio of purchase price to the earnings of those acquired companies. You can then apply that ratio to estimate how much a corporate acquirer might pay for a similar division of the company you are inves- tigating. By separately analyzing each of the company’s divisions this way, you may be able to see whether they are worth more than the current stock price. Longleaf’s Hawkins likes to find what he calls “60-cent dollars,” or companies whose stock is trading at 60% or less of the value at which he appraises the businesses. That helps provide the margin of safety that Graham insists on. WHO’S THE BOSS? Finally, most leading professional investors want to see that a com- pany is run by people who, in the words of Oakmark’s William Nygren, “think like owners, not just managers.” Two simple tests: Are the company’s financial statements easily understandable, or are they full of obfuscation? Are “nonrecurring” or “extraordinary” or “unusual” charges just that, or do they have a nasty habit of recurring? Longleaf’s Mason Hawkins looks for corporate managers who are Commentary on Chapter 15 399 2 See the commentary on Chapter 11. “good partners”—meaning that they communicate candidly about problems, have clear plans for allocating current and future cash flow, and own sizable stakes in the company’s stock (preferably through cash purchases rather than through grants of options). But “if man- agements talk more about the stock price than about the business,” warns Robert Torray of the Torray Fund, “we’re not interested.” Christopher Davis of the Davis Funds favors firms that limit issuance of stock options to roughly 3% of shares outstanding. At Vanguard Primecap Fund, Howard Schow tracks “what the com- pany said one year and what happened the next. We want to see not only whether managements are honest with shareholders but also whether they’re honest with themselves.” (If a company boss insists that all is hunky-dory when business is sputtering, watch out!) Nowa- days, you can listen in on a company’s regularly scheduled conference calls even if you own only a few shares; to find out the schedule, call the investor relations department at corporate headquarters or visit the company’s website. Robert Rodriguez of FPA Capital Fund turns to the back page of the company’s annual report, where the heads of its operating divi- sions are listed. If there’s a lot of turnover in those names in the first one or two years of a new CEO’s regime, that’s probably a good sign; he’s cleaning out the dead wood. But if high turnover continues, the turnaround has probably devolved into turmoil. KEEPING YOUR EYES ON THE ROAD There are even more roads to Jerusalem than these. Some leading portfolio managers, like David Dreman of Dreman Value Management and Martin Whitman of the Third Avenue Funds, focus on companies selling at very low multiples of assets, earnings, or cash flow. Others, like Charles Royce of the Royce Funds and Joel Tillinghast of Fidelity Low-Priced Stock Fund, hunt for undervalued small companies. And, for an all-too-brief look at how today’s most revered investor, Warren Buffett, selects companies, see the sidebar on p. 401. One technique that can be helpful: See which leading professional money managers own the same stocks you do. If one or two names keep turning up, go to the websites of those fund companies and download their most recent reports. By seeing which other stocks these investors own, you can learn more about what qualities they 400 Commentary on Chapter 15 Commentary on Chapter 15 401 WARREN’S WAY Graham’s greatest student, Warren Buffett, has become the world’s most successful investor by putting new twists on Graham’s ideas. Buffett and his partner, Charles Munger, have combined Graham’s “margin of safety” and detachment from the market with their own innovative emphasis on future growth. Here is an all-too-brief summary of Buffett’s approach: He looks for what he calls “franchise” companies with strong consumer brands, easily understandable businesses, robust financial health, and near-monopolies in their markets, like H & R Block, Gillette, and the Washington Post Co. Buffett likes to snap up a stock when a scandal, big loss, or other bad news passes over it like a storm cloud—as when he bought Coca-Cola soon after its disastrous rollout of “New Coke” and the market crash of 1987. He also wants to see managers who set and meet realistic goals; build their businesses from within rather than through acquisition; allocate capital wisely; and do not pay themselves hundred-million-dollar jackpots of stock options. Buffett insists on steady and sustainable growth in earnings, so the company will be worth more in the future than it is today. In his annual reports, archived at www.berkshirehathaway. com, Buffett has set out his thinking like an open book. Probably no other investor, Graham included, has publicly revealed more about his approach or written such compellingly readable essays. (One classic Buffett proverb: “When a management with a reputation for brilliance tackles a business with a reputa- tion for bad economics, it is the reputation of the business that remains intact.”) Every intelligent investor can—and should—learn by reading this master’s own words. have in common; by reading the managers’ commentary, you may get ideas on how to improve your own approach. 3 No matter which techniques they use in picking stocks, successful investing professionals have two things in common: First, they are dis- ciplined and consistent, refusing to change their approach even when it is unfashionable. Second, they think a great deal about what they do and how to do it, but they pay very little attention to what the market is doing. 402 Commentary on Chapter 15 3 There are also many newsletters dedicated to analyzing professional port- folios, but most of them are a waste of time and money for even the most enterprising investor. A shining exception for people who can spare the cash is Outstanding Investor Digest (www.oid.com). CHAPTER 16 Convertible Issues and Warrants Convertible bonds and preferred stocks have been taking on a predominant importance in recent years in the field of senior financing. As a parallel development, stock-option warrants— which are long-term rights to buy common shares at stipulated prices—have become more and more numerous. More than half the preferred issues now quoted in the Standard & Poor’s Stock Guide have conversion privileges, and this has been true also of a major part of the corporate bond financing in 1968–1970. There are at least 60 different series of stock-option warrants dealt in on the American Stock Exchange. In 1970, for the first time in its history, the New York Stock Exchange listed an issue of long-term war- rants, giving rights to buy 31,400,000 American Tel. & Tel. shares at $52 each. With “Mother Bell” now leading that procession, it is bound to be augmented by many new fabricators of warrants. (As we shall point out later, they are a fabrication in more than one sense.)* In the overall picture the convertible issues rank as much more important than the warrants, and we shall discuss them first. There are two main aspects to be considered from the standpoint of the investor. First, how do they rank as investment opportunities and risks? Second, how does their existence affect the value of the related common-stock issues? Convertible issues are claimed to be especially advantageous to both the investor and the issuing corporation. The investor receives the superior protection of a bond or preferred stock, plus the opportunity to participate in any substantial rise in the value of the 403 * Graham detested warrants, as he makes clear on pp. 413–416. common stock. The issuer is able to raise capital at a moderate interest or preferred dividend cost, and if the expected prosperity materializes the issuer will get rid of the senior obligation by hav- ing it exchanged into common stock. Thus both sides to the bargain will fare unusually well. Obviously the foregoing paragraph must overstate the case somewhere, for you cannot by a mere ingenious device make a bar- gain much better for both sides. In exchange for the conversion privilege the investor usually gives up something important in quality or yield, or both. 1 Conversely, if the company gets its money at lower cost because of the conversion feature, it is surren- dering in return part of the common shareholders’ claim to future enhancement. On this subject there are a number of tricky argu- ments to be advanced both pro and con. The safest conclusion that can be reached is that convertible issues are like any other form of security, in that their form itself guarantees neither attractiveness nor unattractiveness. That question will depend on all the facts surrounding the individual issue.* We do know, however, that the group of convertible issues floated during the latter part of a bull market are bound to yield unsatisfactory results as a whole. (It is at such optimistic periods, unfortunately, that most of the convertible financing has been done in the past.) The poor consequences must be inevitable, from the timing itself, since a wide decline in the stock market must invari- ably make the conversion privilege much less attractive—and often, also, call into question the underlying safety of the issue itself.† As a group illustration we shall retain the example used in 404 The Intelligent Investor * Graham is pointing out that, despite the promotional rhetoric that investors usually hear, convertible bonds do not automatically offer “the best of both worlds.” Higher yield and lower risk do not always go hand in hand. What Wall Street gives with one hand, it usually takes away with the other. An investment may offer the best of one world, or the worst of another; but the best of both worlds seldom becomes available in a single package. † According to Goldman Sachs and Ibbotson Associates, from 1998 through 2002, convertibles generated an average annual return of 4.8%. That was considerably better than the 0.6% annual loss on U.S. stocks, but substantially worse than the returns of medium-term corporate bonds (a our first edition of the relative price behavior of convertible and straight (nonconvertible) preferreds offered in 1946, the closing year of the bull market preceding the extraordinary one that began in 1949. A comparable presentation is difficult to make for the years 1967–1970, because there were virtually no new offerings of non- convertibles in those years. But it is easy to demonstrate that the average price decline of convertible preferred stocks from Decem- ber 1967 to December 1970 was greater than that for common stocks as a whole (which lost only 5%). Also the convertibles seem to have done quite a bit worse than the older straight preferred shares during the period December 1968 to December 1970, as is shown by the sample of 20 issues of each kind in Table 16-2. These Convertible Issues and Warrants 405 7.5% annual gain) and long-term corporate bonds (an 8.3% annual gain). In the mid-1990s, according to Merrill Lynch, roughly $15 billion in convert- ibles were issued annually; by 1999, issuance had more than doubled to $39 billion. In 2000, $58 billion in convertibles were issued, and in 2001, another $105 billion emerged. As Graham warns, convertible securities always come out of the woodwork near the end of a bull market—largely because even poor-quality companies then have stock returns high enough to make the conversion feature seem attractive. TABLE 16-1 Price Record of New Preferred-Stock Issues Offered in 1946 No decline 7 0 Declined 0–10% 16 2 10–20% 11 6 20–40% 3 22 40% or more 0 12 37 42 Average decline About 9% About 30% Price Change from Issue Price to Low up to July 1947 “Straight” Issues Convertible and Participating Issues (number of issues) . Second, how does their existence affect the value of the related common-stock issues? Convertible issues are claimed to be especially advantageous to both the investor and the issuing corporation for the conversion privilege the investor usually gives up something important in quality or yield, or both. 1 Conversely, if the company gets its money at lower cost because of the conversion. of the convertible financing has been done in the past.) The poor consequences must be inevitable, from the timing itself, since a wide decline in the stock market must invari- ably make the conversion