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Strategies & Market Trends : Graham and Doddsville -- Value Investing In The New Era -- Ignore unavailable to you. Want to Upgrade?

To: porcupine --''''> who wrote (1071)	12/24/1998 12:25:00 PM
From: FACTUAL	Respond to of 1722

I have just discovered this thread and would like to present my theory for investing and invite comments. I have thought long and hard about Warren Buffets methodology which greatly appeals to me, particularly the advice that you should try and only buy twenty or so stocks in your lifetime. Part of my portfolio which is not presented here for discussion is large consumer based on the theory that the value of time grows with increasing GNP and as one needs to make reasonable quality decisions quickly, brands take on a high significance. But that is not what I would like to discuss. I have spent the last decade buying stocks ( five so far ) which pose what I call an interconnection problem in the software industry. As is well known in the early 1900 when rural phone companies tried to offer long distance, they had to interconnect with the Bell System- a negotiation in which one side had all of the advantages. Today, due to the effect of network externalaties, interconnection problems can be excercabated. Thus if you want to write applications for PCs, you have to interconnect to Windows. If you want to make internet equipment for enterprises or carriers you have to interconnect to IOS ( network management software from Cisco ), if you want to write enterprise software applications you will have to interconnect to SAP's R3 package, in systems software you have to work with Unicenter and in storage with EMC. This line of thinking has led to a portfolio with Microsoft, Cisco, EMC, SAP and Computer Associates. The last two stocks have not fared very well in the recent past ( though quite well over any reasonable time frame like a decade ), SAP due to an expected business tail off as IT expenditures will come down as we get closer to Year 2000 and Computer Associates for their controversial management. ( Based on Buffet's belief that one should not buy stock in a company whose management is not one you would care to associate with, CA should be sold. ). The idea here is that even if management lost fifty IQ points overnight the interconnection problem stays and shareholders will hugely benefit. The value here is recognizing the power of the interconnection and not to be swayed by the technological quality of the product ( which is apparently abysmal in all of the above cited technologies ), Of course the assesment that a particular stock presents an interconnection issue is central-failure here would be devastating. The only way that I can see these interconnection issues going away is some far reaching paradigm change- an advancement in technologies in these fields is unlikely to have any impact. I would appreciate critical comments on the theory and the stocks currently selected, as well as potential candidates where this theory may apply. Thanks

To: porcupine --''''> who wrote (1071)	12/26/1998 12:51:00 PM
From: porcupine --''''>	Respond to of 1722

GADR: All Stocks, All The Time? (1/3) ------------------------------------ Graham and Doddsville Revisited -- "The Intelligent Investor in the 21st Century" (12/24/98) ******* "The underlying principles of sound investment should not alter from decade to decade, but the application of these principles must be adapted to significant changes in the financial mechanisms and climate." (Benjamin Graham) ******* [A query regarding famed Contrarian David Dreman's newsletter (see: Message 6366543 gave rise to a lively exchange about the merits, and demerits, of holding an all-stock portfolio, all-of-the-time. These postings, and other comments, have been edited to give the appearance of a virtual conversation among Wayne, Berney, Wren and Reynolds.] Dreman's Newsletter ----------------------------- Wren: I recently received a package advertising the David Dreman Value Stock Report. Dreman was on Wall Street Week recently. He has written a column in Forbes for a number of years, and manages money. The Kemper Dreman mutual fund has a very good record. Has anyone had experience with Dreman's newsletter? Reynolds: The track records of Graham and Buffett are the only ones I have taken much note of. Readers familiar with the record of Dreman's newsletter are invited to share this information. What I recall mainly from Dreman's appearance on WSW was his advice that investors hang in with 100% stock portfolios, not try to time the Market. And, if I recall correctly, he likes Boeing. Bargains Aren't Always Available --------------------------------------------- Wayne: I have problems with an all-stocks, all-the-time investment strategy, even though you can justify it, if you want to, by looking at multi-decade studies of stock vs. the alternatives. Reynolds: Well, that's a pretty good beginning for justifying an investment strategy. Wayne: [But,] it implies that you can always find stock bargains that will produce greater returns than the alternatives at any snapshot in time. This is simply not true. Reynolds: In an absolute sense, that's correct. But, there are always relative bargains in the stock market -- that is, bargains relative to other stocks. As long as you buy stocks that are undervalued relative to other stocks, there are very few real-life, long-term scenarios in which there would be higher returns from trying to time your way back and forth between the stock market and cash, bonds, real estate, precious metals, etc. Wayne: [Also,] it leaves you in a situation where you can't take advantage of the truly great bargains that pop up during corrections and panics, in either the overall market, or in a particular sector. Reynolds: That's true. And, some of Buffett's greatest gains came from getting out of the stock market before the Bear Markets of 1973 - 1974 and late-1987, and aggressively getting back in afterwards. But, as Graham pointed out, for the average investor to do so is as likely as finding money growing on trees. Nonetheless, I must admit that Graham would have agreed with you on this. One of the major disagreements between himself and Buffett was Buffett's belief that if prices were low enough, an all-stock portfolio would be justified. Graham couldn't accept this. So, he certainly would not have accepted Dreman's conclusion that an all-stock portfolio is the safest course -- regardless of price. Currently, Stocks Have Lots Of Downside Risk And Little Upside Potential ----------------------------------------------------------------- Wayne: For example, one could argue that stocks are presently discounting returns of between 5.75% - 7.5%, with the lower range being the more likely in my view. Furthermore, a PE contraction is a distinct, profit-erasing possibility. That means that an investor is surrendering returns of 1% - 2% annually by staying in bills and notes. Even during this relentless rise in the market, there have been 3 sharp pullbacks in the last year or so that provided opportunities to buy some stocks at levels where the discounted return was much higher and a P/E expansion was a very good possibility. This more than makes up for losing 1% - 2% over a period of even a couple of years, and it avoids facing the risk of a P/E contraction that would more than wipe out that 2%. Reynolds: You make a very persuasive argument, in the best tradition of fundamental analysis. But, couldn't the same argument, with basically the same numbers, have been made 3 or more years ago? And yet, as things have turned out (at least for now), money sitting in cash and bonds for the past 3 years would have left on the table a total of around 100%. It is true that even more money could have been made by getting in and out at just the right prices. But, getting in and out of stocks requires subjective judgments that are most likely to be overly pessimistic when it is time to buy, and vice versa. I believe that this is at the core of Dreman's case, and I am inclined to agree. Wayne: ... There have been periods where the gap between stocks and bonds/cash has been as high as 8%. A 100% investment strategy would certainly been appropriate at that time. Reynolds: No doubt about it, I wish the Market's P/E were 10 rather than 30. Taking Advantage Of The "Spread" Is Not Timing ----------------------------------------------------------------- --- Wayne: What I'm describing may seem like market timing, but it isn't. It is setting the standard for investment at a level where the spread between the expected return on the stock and its alternative is high enough to cover all the associated risks. This includes the risk of missing opportunities like we had just a few weeks ago. Some companies I am familiar with were selling at 30% discounts to their values on a long-term normalized basis, and an even greater discount if you think low interest rates and inflation are a permanent state of affairs. This more than made up for losing a couple of percent for awhile, and gave me a P/E expansion pop because the market recovered so quickly. If Certain Times Are Chosen, But Not Others, It's Timing ----------------------------------------------------------------- Reynolds: The Value Investing fraternity can call it whatever it wants. But, as language is normally understood, choosing to buy or sell at certain times and not at other times is timing. Wayne: So, your position is that selling an overvalued security is market timing unless the proceeds are immediately placed back into the market? Reynolds: Right. When you get down to it, there are only two ways to completely avoid Market timing: 1) buy whenever the funds to do so are available -- and hold forever; or 2) never get into the Market at all. A famous example of the first category is the Lexington Corporate Leaders mutual fund. Founded in 1935, the fund began with 30 of America's leading corporations. None of the original holdings have been sold, and no new stocks have been added to their portfolio. Yet, the fund has a very respectable track record over that period -- even compared to Indexing (which didn't become feasible for the small investor until 1974). Naturally, this fund hasn't outperformed the combined track records of Graham and Buffett over that span. But, I believe it has outperformed the average mutual fund, or the average individual investor who has been moving in and out of stocks, regardless of selection criteria. No One But Reynolds ----------------------------- Wayne: I don't know anyone besides Reynolds that holds that view of what Value Investing is [i.e., that Value Investing is a form of timing] . Reynolds: True, which is a reason I feel this is worth emphasizing: Value Investing does not solve the problem of timing. It ignores it -- which is not the same as solving it. Wayne: In every other discussion I have had on the subject, market timing was always considered to be the act of buying or selling based on where the investor thought the market or security price was heading. Bull Market/Bear Market, etc. Reynolds: Everyone buys and sells securities based upon where they think the security's price is ultimately going. Even in the case of a pure dividend play, no one purchases with indifference to a permanent decline in share price. Wayne: When I sell, I always assume what I sold will continue going up. It's just that I expect to get a better rate of return over the next 5 - 10 years on the alternative investments where I place the proceeds. Reynolds: Interesting -- when I buy, the stock always keeps going down! But, this is just another way of saying that no one, regardless of investment criteria, can reliably get in at the very bottom and out at the very top. When a stock is out of favor, and thus undervalued, it's likely to remain out of favor for a while -- until Mr. Market gets around to recognizing its value, and repricing it accordingly. Likewise, selling an overpriced stock doesn't mean it won't become more overpriced. But, by choosing to buy at a time when a security is underpriced, and to sell at a time when it is overpriced, one is still timing. Graham Called It "Pricing" ------------------------------------- Berney: In The Intelligent Investor (p. 95), Graham writes: "Since common stocks, even of investment grade, are subject to recurrent and wide fluctuations in their prices, the intelligent investor should be interested in the possibilities of profiting from these pendulum swings. There are two possible ways by which he may try to do this: the way of timing and the way of pricing. By timing we mean the endeavor to anticipate the action of the stock market -- to buy and hold when the future course is deemed to be upward, to sell or refrain from buying when the course is downward. By pricing we mean the endeavor to buy stocks when they are quoted below their fair value and to sell them when they rise above such value. A less ambitious form of pricing is the simple effort to make sure that when you buy you do not pay too much for your stocks. This may suffice for the defensive investor, whose emphasis is on long-pull holding; but as such it represents an essential minimum of attention to market levels....." "Except, perhaps in dollar-cost-averaging plans begun at a reasonable price level." Reynolds: Every discipline has its own vocabulary and, in certain cases, uses words in ways that vary from their common meanings. Value Investing is no exception. But, I try to use ordinary language in discussing investment concepts. I feel that if I haven't expressed a concept using words according to their everyday meaning, then I still haven't made it clear to myself. In the passages Berney cites, Graham explains the meanings he attributes to the words "timing" and "pricing". It may appear that the two are mutually exclusive categories -- that one is either timing or pricing, but never both. But, in the way language is normally used, the distinction between "timing" and "pricing" is similar to the distinction between "sex" and "oral sex" (an analogy Graham would have appreciated). The former is not necessarily a case of the latter ... but the latter is invariably an instance of the former. I think it is important for me to bear this in mind to avoid deceiving myself into thinking that I have solved the problem of timing just because I am seeking out bargains. Pricing = Long-Run Timing ------------------------------------ I understand Graham's distinction to be the difference between: 1) shorter-term timing based upon the momentum of, for example, earnings, price, volume, etc.; and 2) longer-term timing based upon, for example, low price-to-book value, low P/E, etc. Whether the criterion is technical, like price in relation to volume, or fundamental, like price in relation to book value or earnings, both are systems for buying, or selling, at some times, rather than at others. But, I agree that the distinction Graham is making is a valid and important one. For, although both methods employ timing, each looks at the problem from opposing perspectives. The so-called timer asks the question, "Is this the right time to buy?", and assumes that if so, the fundamentals will take care of themselves. By contrast, the Value Investor asks, "Are these assets and earnings available for a bargain price?", and assumes that if so, the timing problem will sort itself out. These two approaches exemplify Graham's famous dictum: In the short run the Market is a voting machine, and in the long run it is a weighing machine. In my view, neither is necessarily superior to the other. Usually investors are temperamentally more or less suited to one or the other, though in some cases they are comfortable with both approaches. Presumably, most of us are here because we're more confident in our judgments about a company's long-term fundamentals than in trying to closely time Mr. Market's moodswings. But, unless we just buy-and-hold forever (as Buffett does with his core holdings), none of us completely escapes the problem of timing. Berney: Elsewhere (p. 98), Graham states: "We are convinced that the average investor cannot deal successfully with price movements by endeavoring to forecast them." In fact, in numerous references, he refers to the act of trying to forecast price movements (market timing) as speculating. Wayne: Thanks, Berney ... there's something unsettling for me about being classified a "timer" when I have no idea what's going to happen next! Reynolds: That's another reason why I'm making so much of an issue of this -- because none of us can really know "what's going to happen next". Therefore, there is always timing risk. Calling timing something other than "timing" does not remove the risk. Value Investing seeks to finesse the problem by focusing on price, and letting the timing take care of itself. But, the problem of timing doesn't go away. Value Investing's response is to say: This stock is so cheap that even if goes it down tomorrow, or the next day or the day after that -- nevertheless, it will eventually go up at some point in the future that will justify having purchased it at this time and at this price. This is a proposition that I find "unsettling", though, as a Value Investor, unavoidable. Peter Lynch likes to say that he makes the most money in the 3rd, 4th, and 5th years of an investment. But, this is another way of saying that investing based upon fundamentals typically gets the timing wrong for the first year or two. It is axiomatic that a Value Investor must have confidence that he or she is right about an out-of-favor stock, and the patience to wait for Mr. Market to eventually agree. But, it is also axiomatic that no one is right all the time. This places the Value Investor directly upon the horns of a dilemma: An investor unwilling to wait for Mr. Market to confirm his valuation of a company's stock does not have the temperament for Value Investing. Yet, someone who waits the 3 to 5 years that Lynch found necessary for his investment judgments to achieve their greatest payoff will fall way behind the 8-ball when those judgments are mistaken, as they inevitably will be at times. Further, the judgment may have been correct when originally made. But suppose that a couple of years after the purchase has been made, "the facts change", as Lynch would put it. Nowadays, 2 years is plenty of time for facts to change. In this case, the Value Investor should sell. But, this leaves the investor with an investment that has been underperforming for 2 years. Clearly, price notwithstanding, it was the wrong time to buy. By contrast, the so-called "market timer", if adhering to his or her discipline, will quickly retreat from a losing position, rather than spending years hoping to be proven "right", perhaps fruitlessly. Further still, the Value Investor might turn out to have been right all along, yet still underperform Mr. Market. Suppose a stock is selling for 30% less than its net tangible book value. In theory, this is a no-lose bet, since even in bankruptcy the company's net assets can be sold off for more than the company's current market price. Yet, though this company loses as much money in bad years as it makes in good years, it manages to keep its doors open through occasional, but recurrent, sacrifices by workers, management, suppliers, creditors, and even the taxing authorities. Thus, the company remains "undervalued" indefinitely, at least as measured by asset value. This is exactly what happened to Buffett with the original Berkshire Hathaway textile makers. Finally, suppose a Value Investor correctly calculates that XYZ Corporation, a textbook publisher, has an Intrinsic Value of $60, though its share price is $40. The investor purchases shares of XYZ accordingly. Nine months later, due to Mr. Market's continuing pessimism regarding its short-term prospects, XYZ's price has sunk to $30. While our investor is pondering whether to load up on more shares of XYZ, a wildly overpriced wireless e-commerce company, WebCell.com, acquires XYZ in exchange for $35 worth of its stock. Our investor wants no part of WebCell.com's stock, and sells his shares of XYZ for just under $35. As the years pass, WebCell.com eventually shuts down its money losing wireless e-commerce operation, but continues to mint money from its textbook publishing subsidiary, XYZ. Our investors "pricing" was correct, but his timing was wrong. Graham, of course, was not unaware of these difficulties. They have no simple solution. Berney: Wayne, I believe there is a fine line between "timing" and only investing when the valuations are reasonable. Certainly, Graham was not advocating a buy and hold strategy -- and clearly stated this. He noted that one should buy when valuations were reasonable and sell when valuations were unreasonable.... However, as Wren pointed out, emotions frequently get in the way. It was not until July 1997 that IBM exceeded the high set in August 1987. Wal-Mart is my favorite. It is in a small group of 20% of the S&P that has done everything that could be expected. They have achieved revenue and EPS growth for 6 straight years. Nonetheless, the stock closed at $32 in December, 1992, and did not see that valuation again until June 1997. I could cite numerous other examples of quality companies whose stock became overly valued and it took years to recover..... Reynolds: Let's look at IBM in 1987 and Wal-Mart in 1992 as two examples of dollar-cost-averaging with the worst possible timing and pricing. [cont'd in next posting]

To: porcupine --''''> who wrote (1071)	12/26/1998 12:58:00 PM
From: porcupine --''''>	Read Replies (1) \| Respond to of 1722

GADR: All Stocks, All The Time? (2/3) ---------------------------------------------- Bettie and Big Blue ------------------- Suppose that in 1987, a single mom of moderate means, Bettie, begins investing to finance the future education of her young daughter, Amaryllis. Bettie has no time to do investment research. But, she is sure that computers are the growth industry of the future; she knows that IBM is the biggest computer company; and she knows that the company she works for won't buy anything but IBM equipment. While watching Wall Street Week, Bettie learns about how to buy common stocks commission-free, through a dividend reinvestment program (DRIP). The fact that in early 1987 every single panelist on WSW is bullish on IBM confirms her intuition about the stock. So, commencing in January, she starts a DRIP with IBM. Every month $100 is automatically transferred from her checking account to a special trust account, where shares of IBM, including fractional shares, are purchased monthly and credited to Bettie. To keep the calculations simple, I've assumed that the monthly price Bettie paid equals the average of IBM's high and low price for that calendar year. I've also assumed that quarterly dividends were reinvested at that same average price for the whole year. As Berney indicated, the high point for IBM shares for the coming decade was reached in August of 1987, just 7 months after Bettie began accumulating IBM shares. Vast sums were lost over the next 6 years as institutions and individuals bailed out of IBM, which had been, until then, the Market's "bellweather stock". Though the DJIA did quite nicely overall during this period, IBM declined an astonishing 77% -- a magnitude almost on a par with that of the Dow's decline during the worst span of the Great Depression. However, unlike much of Wall Street, Bettie did not lose a cent. In fact, she didn't even lose a minute's sleep. There wasn't much time to follow Big Blue's travails, or even watch WSW, since she was already occupied with work and parenting. She just continued with her program of automatically buying and holding $100 of shares of IBM every month. Though there are several more years before she begins college, Amaryllis has already let her mother know that she has a particular college in mind. Examining her latest quarterly statement, our single mom figures she will have about 330 shares of IBM at the end of the year. At IBM's recent price of 182, this amounts to over $60,000. The cash Bettie has laid out totals $14,400, so her profit is more than $45,000. And, the cash was not even expended all at once -- it was allocated in monthly increments of $100 over a period of 12 years. Bettie's average annual return on the sums invested is roughly 22%. No Model Portfolio Theory. No alpha, beta, gamma, delta, or epsilon. Not even vega. No worrying about which of IBM's special charges against earnings will have future cash consequences and which are merely reflections of abstract accounting concepts. No pondering the cash flow significance of purchased in-process research and development. No worrying about what the long-term return on risk-free bonds will be in a disinflating world economy or what an appropriate risk premium should be for a boom and bust industry with constantly falling prices. No timing, pricing, allocating, or apportioning. No selling, no watching and waiting, no "on the one hand, but on the other hand ..." None of the kind of stuff we go through every day. It was completely automatic -- automatic transfer of bank account funds, automatic purchase of shares, automatic reinvestment of dividends. Figuratively speaking, Bettie was investing blindfolded with her hands tied behind her back -- and still made 22% per year for 12 years. Did Buffett do better than Bettie over this period by "pricing" his way out of the Market before the crash of 1987 and pricing his way back in afterwards? Yes. Did Wayne do better than Bettie? Well, as a long time shareholder of Berkshire Hathaway, he probably did. Did all but a handful of professional money managers underperform Bettie from 1987 through 1998? You bet. And, dollar-cost-averaging works in reverse as well. When college for Amaryllis is just 2 or 3 years off, Bettie can begin selling shares of IBM monthly, via her DRIP account, for a tiny commission. The fraction of her portfolio she sells every month can be apportioned so that she is selling shares right up to the time Amaryllis is ready to pay the tuition on her 4th year of college. The monthly proceeds of these sales, along with her usual $100, can be used to buy CD's. By selling in this way, Bettie need not worry about timing or pricing. She merely sells a fixed number of shares automatically every month. In some months Mr. Market will pay less, and in some months he will pay more. On average, Bettie will receive a good sales price, just as on average she received a good purchase price when she was in her accumulation phase. Harvey and Sam ---------------------- Harvey's is another hypothetical case, this one having to do with Wal-Mart. Harvey graduated from High school in Pine Bluff, Arkansas back in 1991. After graduation, he began working full-time at an auto-and-truck service station. His high school sweetheart, Frieda, got a job at the nearby Wal-Mart. Working at Wal-Mart was not for Jay -- he would never have been able to conform to all the rules Wal-Mart employees have to follow. And, he didn't particularly care for shopping at all, unless it was for tools, which he could get at Sears. But he knew that Wal-Mart founder Sam Walton had become the richest man in America, at that time. So, Harvey decided that rather than be Sam's employee or his customer, he was going to become Sam's partner. He would buy stock in Wal-Mart, just like Frieda was already doing. Harvey didn't know anything about stock brokers, except that he didn't particularly trust them. And, unlike Bettie, he didn't even watch Wall Street Week, as he preferred going to the Tractor Pull at the Pine Bluff racetrack on Friday evenings. So, he made a number of phone calls to Wal-Mart and explained that he wanted to buy stock in the company, but that he only had $100 to invest. He was eventually connected to the Wal-Mart Investor Relations Department in Bentonville. They mailed him the forms for registering in their DRIP. Harvey bought his first share of Wal-Mart from Frieda, and she helped him fill out the DRIP enrollment forms. He made his first monthly contribution in January of 1992. The following year, Sam Walton seemed to lose his Midas touch. Sales kept rising, but the newly parsimonious shoppers of the 1990's, and the plethora of retail stores from coast-to-coast, were whittling away at Sam's profit margins. Then, old age finally brought about Sam's retirement. Not long afterwards, Wal-Mart reported its first quarter of declining earnings in 25 years. For the next three years profits were basically flat. The stock's price fell 44% over this span. In the meantime, Frieda got admitted to an out-of-state college. Harvey and Frieda agreed that their relationship would continue as before, whenever Frieda was back in Pine Bluff. But, both of them knew that it wouldn't. Eventually, Frieda married someone she met at school. Even so, Harvey and Frieda remained friends. Though Harvey had lost Frieda, he was determined to win at investing. He figured that if he hung in with investing the way he would doggedly look for a short circuit in a truck's electrical system, that he would make his money back. From knowing Frieda, Harvey knew that Wal-Mart stores had a lot of customers, and that, managerially speaking, Wal-Mart ran a very tight ship. If Wall Street didn't agree, as judged by the stock's 3-year downward slide, Harvey figured that was just one more thing for Wall Street to be wrong about. So, Harvey stayed the course with his investment strategy of making $100 monthly purchases of Wall-Mart stock. Around the end of 1995, after the Fed had rapidly tightened short-term rates, the nation seemed to be headed for recession. Manufacturing output was in decline, as was manufacturing employment. Consumer debt and consumer bankruptcies were at cyclical highs, and rising. Though all but forgotten now, this apparent prelude to recession was not a favorable environment for discount retailing. A dozen or so large retail chains went into bankruptcy, affecting around 3000 stores. This meant that the surviving chains were competing against some 3000 stores that were dumping inventory at going-out-of-business prices, while being protected by the bankruptcy courts from having to pay creditors. And then, a funny thing happened. Going into a decent, though by no means exceptional, holiday season, retailing stocks began to move sharply upwards -- based upon little more than optimism that the worst was over. On the strength of its holiday season sales, K-mart, the Wal-Mart of decades past, was able to get the financing to pull back from near bankruptcy. K-mart's success at avoiding disaster in early 1996 seemed to confirm the growing optimism about retailing. And at Wal-Mart, same store sales and profits, as well as margins, began to rise again, as they have ever since. Looking at his most recent DRIP statement, Harvey figures he'll own 250 shares of Wal-Mart by the end of 1998. At WMT's recent price of 81, Harvey's shares are worth $20,250 -- a compound annual growth rate of almost 25%. Harvey still doesn't watch Wall Street Week. And, he has never even heard of GADR. He just keeps making his $100 monthly purchases of Wal-Mart. But, being pleased with the results so far, he's thinking about raising his monthly purchases to $200. What Does This Have To Do With Graham? ----------------------------------------------------------- Some readers may be wondering what this has to do with Graham. Indeed, IBM was one of Graham's favorite examples of the kind of stock the intelligent investor should not buy. Graham was generally skeptical about the profit potential of hi-tech stocks, or growth stocks of any sort, because of too much competition, too rapid product cycles, and P/E's that are usually too high. Further, though Graham thought highly of dollar-cost-averaging, he recommended that new investors (like Bettie and Harvey) avoid beginning a program of dollar-cost-averaging when prices were high. Graham feared that a subsequent decline in prices would cause the new investor to sell. Feeling burned by the experience, the new investor might never again invest in stocks. Hence his use of the qualifying phrase "begun at reasonable prices" in the footnote to the passage from p. 95 of The Intelligent Investor, quoted above. Interestingly, many small investors who are saving for retirement through 401(k)'s and similar retirement plans seem to be accepting with equanimity significant short-term declines in their portfolio value. Indeed, rather than selling on the dips, a substantial number of small investors are buying on the dips. It is an open question, though, whether they would continue to do so were there a general market decline of the magnitude and duration of IBM's travails from 1987 through 1993. What Else Does This Have To Do With Graham? ----------------------------------------------------------------- - In addition to dollar-cost-averaging, Graham recommended that conservative investors (ones seeking safety of principal and freedom from bother) confine themselves to "leading companies in important industries". Whatever Graham's reservations about IBM, he would have agreed that IBM is a leading company in an important industry. Indeed, if one examines prosaic criteria such as sales and profits, it could be argued that IBM is the leading company in the important industry. And, Wal-Mart replaced Woolworth (now Venator) on the DJIA because Wal-Mart has become the nation's leading retailer. Since 2/3 of U.S. economic activity is consumer generated, retailing is surely an important industry. [cont'd in next posting]

To: porcupine --''''> who wrote (1071)	12/26/1998 1:02:00 PM
From: porcupine --''''>	Read Replies (1) \| Respond to of 1722

GADR: All Stocks, All The Time? (3/3) ------------------------------------ Why Revisit Graham and Doddsville? ------------------------------------------------- Berney: I believe that, due in large measure to this medium of communication [computer networks], cycles that took months and years in the past to complete are now being completed in weeks. Just my humble observation. Reynolds: Berney, you have identified the very core of the case for revisiting Graham and Doddsville in the first place. The way I understand the quote from Graham at the top of every issue of GADR (see above), the laws of supply and demand do not change, but the political and economic conditions in which these laws operate do change. Note that Graham begins the quote that you cited with the premise: "Since common stocks, even of investment grade, are subject to recurrent and wide fluctuations in their prices ..." In my view, that premise no longer applies to the same degree that it once did -- at least not for those stocks that Graham would consider "investment grade". Market swings (and those of the overall economy) have been less frequent, of shallower amplitude, and of shorter duration in the post-World War II era than those of the eras preceding it. Whether it's called the "New Era", the "Information Age", or the "3rd Era of Value Investing", the point is that the widespread availability of information and the speed with which labor and capital markets respond to this information are at an all time high. Therefore, the Market has never been more efficient. Indeed, the Market had already become so efficient in the latter years of Graham's life (the mid-1970's) that he began to wonder aloud whether it was still possible to outperform the Market averages. Buffett was disappointed and concerned by Graham's late-life misgivings. As things turned out, the apprentice wound up outperforming the master. But, he did not do so by slavishly following Graham's techniques developed in the 1920's and 1930's. Instead, Buffett developed techniques of his own for identifying undervaluation. Buffett Couldn't Wait ----------------------------- There's an anecdote I've shared before that I think is worth repeating. Back in the 1950's, around the time that Graham retired and Buffett went out on his own, the DJIA finally exceeded 381, the level it had first achieved shortly before the 1929 Crash. As the Dow approached and then rapidly surpassed 381, concern was so widespread about the possibility of another Crash that Congress held hearings, at which Graham spoke as an honored guest. Under the circumstances, Graham suggested to Buffett that he wait for the next significant decline before investing his clients' funds in the stock market. Buffett has subsequently quipped, "I would still be waiting." Historically, there had been an inverse correlation between the dividends on stocks and the interest on bonds, i.e., as the one rose, the other declined. On this basis, Graham had calculated that stocks in the mid-1950's were greatly overpriced. But, whether it's called "pricing", "valuation", "Contrarianism", "bargain-hunting", or "whatever", the bottom line is that the mid-1950's were the wrong time to be sitting in cash waiting for a major decline in the Dow. 9200 is No Bargain -------------------------- I concede that the Market is unsustainably expensive. There are many fundamental factors that would justify sending out a message entitled "SELL EVERYTHING" (as one timing guru famously did when the Dow was around 5800). Even after some recent back-tracking, the S&P 500 is selling at a stratospheric 32 times trailing earnings. The broad Market's P/E can be justified on a fundamental basis only if earnings are temporarily at depressed levels, or if the future is guaranteed to be all but perfect. Obviously, neither is the case. The S&P 500's 1998 earnings are flat, if not negative, relative to 1997 -- a growth rate of zero. As to the coming year, I do not foresee a U.S. recession in 1999. But, with half the world already in recession, I don't foresee 1999 as the kind of banner year required to justify the current P/E of 32. The Real Issue -------------------- The issue I'm addressing, though, is not whether the Market is overvalued. Obviously, it is overvalued. Rather, the issue is: What should the intelligent investor do about it? Specifically, are the valuation parameters that would take us out of the Market at this time certain to provide a clear signal as to when (or at what price) it is time to buy again? Do we know -- with the same level of confidence that long-term dollar-cost-averaging affords -- that Mr. Market will eventually offer us that price? Further, do we know that we will actually reenter the market, if and when that price level is attained? Or will the more negative news that would no doubt accompany a depressed price level cause us to recalculate a lower reentry point -- keeping us out of the Market that much longer? I would be very surprised if the Market does not fall significantly, say 10% or 15%, from current levels. But, that would still leave the Dow overpriced by historical standards. At Dow 7000, a drop of 24%, the Dow's P/E would be a shade under 19 -- still at the high end of the historical range. At Dow 6000, a decline of 33%, the Dow's P/E would be 16 -- still no bargain. To get back to the historical P/E norm of 15, the Dow has to fall to 5550. And, there are those who point out that today's earnings are significantly inflated by past write-offs of current costs, off-income-statement options payments to corporate executives, etc. So let's shave the published earnings data by 10%. This gets the Dow down to 5000, to support a P/E of 15. But that still leaves no margin of safety. To have a 30% margin of safety, relative to historical P/E's, would require the Dow to decline to 3500. This represents a decline of around 62% from the Dow's recent close of 9202. A 62% Market decline would be one of the greatest Market declines of the past 2 centuries, and by far the greatest of the post-World War II period. Yet, there would still be a case to be made that the Market would be overvalued at 3500. For there would no doubt be a concomitant deterioration of economic fundamentals accompanying a 62% decline in the Dow. Therefore, a greater "equity risk premium" would have to be assigned to stocks in relation to bonds. As can be seen, there is no end to this game -- no absolute point at which one can say without any lingering doubts: Now the Market is truly undervalued. I recall that when the Dow actually was at 3500, the Bears were already roaring at the top of their lungs. Indeed, there were plausible-sounding Bears, like WSW's Monte Gordon, when the Dow was approaching 2000! Yet, there is no guarantee that the Dow will ever see 7000 again, much less 3500. The Market could oscillate between 7100 and 10,000 for the next 10 years -- a not dissimilar pattern to that of the 1970's. At what point does an advisor say, "Sorry, I was wrong to advise waiting for the Dow to fall to 3500 (or 5000 or 7000, etc.) -- it's time to get back into stocks, even though the Dow's P/E is still overvalued." Who would still be listening? Wayne: I don't believe an investor should ever be looking at the aggregate Market level to determine whether or not to invest, unless he/she is buying the whole Market, e.g., an Index fund. What investors should do is buy individual stocks that meet a definition of "Value" that offers greater expected returns than alternative investments, with an appropriate Margin of Safety. Conversely, they should sell those investments that are not priced to return an adequate rate of return. The cash level the investor will hold is a result of these actions, and is determined by the individual investor's ability to find alternative stock investments that offer Margin of Safety after any sale. In an extremely high Market, it is possible that no stock alternative can be found that meets the definition of a "good value". In this situation, the investor should accumulate cash. That is what I am doing and that is what Buffett is doing. Reynolds: And, you are doing it very well. What I am trying to do, though, is in some small way provide the average investor with "practical counsel", as Graham called it in his subtitle to The Intelligent Investor. As a practical matter, I do not believe that the average investor has the time to duplicate the efforts of investors like yourself and Buffett. And, I think it is unrealistic to believe that Mr. Market can be beaten unless an investor is willing to make a commitment of time and effort at least as great as that required for any part-time job. After all, Mr. Market is working at his job 24/7. Yet, how many individual investors have the time to do the research necessary to arrive at the independent conclusion that, as you put it, "no stock alternative can be found that meets the definition of a 'good value'"? Automatically dollar-cost-averaging, though, requires no such commitment of time. I believe that Graham would concur on the significance of this last point. Tempus Pecunia Est --------------------------- The issue of how much to discount the time expended, or saved, by choosing an active investment strategy instead of a passive one reminds me of my favorite story about Buffett. Graham's original choice to assist him in writing the last edition of The Intelligent Investor was Adam Smith, then already a bestselling author. However, the task eventually fell to Buffett, who was hardly known outside of business circles at the time. Fast forward to a few years ago. Smith had become the host and producer of his first Public Television series, and Buffett had recently surpassed Sam Walton to become the richest man in America. In the midst of a television interview that had been otherwise unexceptional, Smith threw a change-up that was high and inside, by asking Buffett when a stock should be sold. This was more than an innocent question. Buffett is widely known for his buy-and-hold-forever policy toward his "permanent" holdings like Coke, Gillette, and American Express. But, the whole premise of Value Investing is contained in the passage Berney quoted from THE INTELLIGENT INVESTOR, above: "By pricing we mean the endeavor to buy stocks when they are quoted below their fair value and to sell them when they rise above such value." Therefore, there must be times when a security is overvalued, or at least fairly valued, and hence a candidate for sale. It would be absurd to suggest that securities could be permanently "undervalued". Obviously it would be the valuation model that was mistaken, if it were never confirmed by the security's Market price. (However [there is always a "however" in investing], it could be the case that the amount of a security's overvaluation might never exceed the taxes that sale of the security by a particular investor might incur.) Buffett had been the very picture of the Billionaire-at-ease-with-himself, until Smith asked him this question. Suddenly, Buffett looked like a human contortionist as he twisted and turned in his seat. The best he could manage was to mutter something along the lines of: We like buyin'em more than sellin'em. Buffett Turns The Table -------------------------------- Near the end of the interview, Smith lobbed up a powder puff question. He asked Buffett what advice he would give to someone seeking to duplicate his investment achievements. I don't like to criticize the way another man makes his living, but I have no doubt that if, say, Albert Einstein and Leonard Bernstein were still alive, they would be pestered with similar inanities by the likes of Charlie Rose, Barbara Walters, et al. In the event, Buffett replied in a completely matter-of-fact tone: Learn everything you can about every publicly traded security. Smith's voice broke like Bart Simpson's as he exclaimed: "But, that's over 27,000 securities!" Buffett shot back with a cool bordering on the curt: "Start with the A's." In other words, as a practical matter, few have the time to do justice to Graham and Buffett's methods, bestselling books to the contrary notwithstanding. Buffett has modestly said that his results required neither great intellect, nor great business acumen. To my knowledge, he has never said they did not require a great deal of time. Nor did Graham. By contrast, automatically dollar-cost-averaging into an Index fund, once established, requires no time at all. And, as they say, time is money. Summary ------------ What all of this illustrates is the power of combining two easy-to-understand-and-apply investing criteria: dollar-cost-averaging with leading companies in important industries. As noted above, Graham would never have recommended an all-stock portfolio (nor, for that matter, an all-bond portfolio) to the average investor. So, he certainly would not have recommended a one-stock portfolio! And, he did not recommend beginning a program of dollar-cost-averaging at lofty price levels, because of his concerns about investor psychology. Yet, even in the extreme examples provided by IBM in 1987 and Wal-Mart in 1992 of one-stock portfolios, with purchases begun just prior to steep and prolonged price declines, by dollar-cost-averaging in leading companies in important industries, an investor is very likely to obtain far better results that all but a fraction of other investors, professional or otherwise. It is no problem to find a list of leading companies in important industries. Dow Jones & Company and Standard & Poor's have already done it for you, by publishing the DJIA and the S&P 500, respectively. The former is comprised of 30 leading companies in important industries, the latter is a broader list representing 500 such companies. Since the S&P 500's establishment in 1926, the two Indexes have produced almost identical results, when viewed over the long haul. There are several no-load, low management-fee mutual funds for both of these Indexes. Graham and Buffett have demonstrated that by "pricing", gifted individuals like themselves can outperform Indexing over the long term. However, I am skeptical that the average investor is likely to do better by "pricing" than he or she would do by dollar-cost-averaging into an Index fund. Advice --------- First, decide (or re-decide) whether you are more comfortable being a "conservative" or an "enterprising" investor. Graham's definition of the conservative investor is "one interested chiefly in safety of principal and freedom from bother". The "enterprising" investor is one who seeks to outperform Mr. Market at his own game. GADR's advice remains what it has been all along: Be a conservative investor and dollar-cost-average into an S&P 500 or DJIA Index fund. In the long run, you are all but assured of beating 90% or more of all the professional money managers on Wall Street, or anywhere else. Simple. As we have cautioned every year, Indexing will not be as profitable over the long term as it has been in the recent past. Nevertheless, all historical evidence suggests that 20 or more years of dollar-cost-averaging into an Index fund will not only outperform every other asset class (bonds, real estate, cash, etc.), it will also outperform all but a small fraction of portfolios, of whatever description, that have been actively managed by professionals. Those investors who feel that Indexing is not "interesting" enough can find plenty of interesting times ahead by dollar-cost-averaging into GADR's Model Dow Value Portfolio components: AT&T, Boeing, GM and IBM. In GADR's opinion, this portfolio is still undervalued, and thus suitable for the enterprising investor. Furthermore: 1) there is virtually no possibility of any of these 4 companies going bankrupt, and 2) this concentrated portfolio of leading companies in important industries does not require a lot of ongoing monitoring, notwithstanding the interesting times ahead. The long-term rise in global demand for transportation and information technology will serve this portfolio well -- with or without monitoring. Thus, it pretty neatly fits Graham's requirements for the conservative investor: safety of principal and freedom from bother. As such, it is something of a hybrid -- a portfolio for "conservative enterprising" investors. Graham's choice of the term "enterprising" was not accidental. Trying to outperform Mr. Market should be viewed as any other business enterprise would be: Patience and endurance are required. There will inevitably be missteps along the way. The influence of luck, good and bad, will not be negligible. And, in the end, no amount of effort, however intelligent, can guarantee success. That's what "risk" means. Graham believed, and GADR concurs, that the enterprising investor's odds of success or failure will correlate with the amount of time spent at this endeavor. Those enterprising investors who do not have this time are advised to employ someone who does. In this regard, the world's greatest money manager may be employed by anyone who has the $2,140 to purchase a share of Berkshire Hathaway, Class B, based upon Wednesday's closing price. It is noteworthy that Buffett works for what is no doubt the world's lowest management fee, on a percentage basis. Dividing Buffett's $100,000 salary by Berkshire's $75 billion market capitalization implies that his unparalleled asset management skills cost shareholders about .0000013% annually -- surely a bargain if there ever were one. Furthermore, short-term re-adjustments in Index fund portfolios may have created a buying opportunity in this unique company. For details, see Wayne's posting at: Message 6924897 . Personally, I don't see how Berkshire could be undervalued if Buffett himself does not think it is undervalued. But, don't let my excessive literalism interfere with your chance to have Buffett manage your assets. Those enterprising investors who seek more excitement still would be well served to construct a portfolio from among the picks of Axel and Berney (see: web.idirect.com and Message 6514887 ). All of their selections are leading companies in important industries. ******* For a free e-mail subscription to GADR, reply to: gadr@nyct.net In the subject header, type: SUBSCRIBE. The GADR Reader's Forum is on Silicon Investor, at: Subject 19528 ***** Graham and Doddsville Revisited Editor: Reynolds Russell, Registered Investment Advisor web.idirect.com Web Site Development/Design: ariana <brla@earthlink.net> Consultants: Axel Gunderson, Wayne Crimi, Bernard F. O'Rourke, Allen Wolovsky In addition to editing GADR, Reynolds Russell offers investment advisory services. His goal is to provide clients with total returns in excess of those produced by the S&P 500. His investment strategy applies the principles of Value Investing established by Benjamin Graham to the circumstances of today's economy and securities markets. For further information, reply via e-mail to: gadr@nyct.net ******* "There are no sure and easy paths to riches in Wall Street or anywhere else." (Benjamin Graham) (C) Reynolds Russell 1998.