We are first and foremost value investors. That is, we seek to take advantage of the irrationality of the stock market by purchasing when prices are low and selling when prices are high. In order to make this strategy work we must determine what a fair price should be, also known as the "intrinsic value."Toward this end, we adhere to the teachings of Benjamin Graham, best known as Warren Buffett's college instructor, mentor, business partner and friend. Graham, and his business partner David Dodd, authored two master works, "Security Analysis" published in 1937 and "The Intelligent Investor" published in 1949. These widely accepted and authoritative writings are the bedrock upon which our investment strategy is built.
In practice, we use publicly available data and stock screeners to identify a group of about 25 public companies that meet our financial criteria. From this group we select a small basket of companies, typically maintaining positions in 6 to 12 of these companies. We actively manage this portfolio by selling companies that offer a significant premium over intrinsic value, and buying those that the market offers at a discount plus a margin of safety. We employ a proprietary form of relative analysis, trading primarily with the goal of owning more shares of these good companies.
Benjamin Graham offers investors an escape from price volatility. He wrote, "Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market."
Graham's favorite allegory is that of Mr. Market, an obliging fellow who turns up every day at the shareholder's door offering to buy or sell his shares at a different price. Often, the price quoted by Mr. Market seems plausible, but sometimes it is ridiculous. The investor is free to either agree with his quoted price and trade with him, or ignore him completely.
The most commonly used metric for determining value of U.S. stocks is P/E (price to earnings ratio). Numerous studies and value investors claim that high P/E ratios tend to result in lower future returns. Yet, due to price and earnings volatility, P/Es change quickly and at times irrationally. The PE(10) (price divided by the average of the past ten year’s earnings) was popularized in Robert Shiller’s book Irrational Exuberance. Shiller continues to post the PE(10) data for the S&P earnings publicly.
The dividend yield (divided to price ratio) is based on dividends rather than earnings. Importantly, dividends are harder to manipulate than earnings. They are either paid or unpaid and are not as subject to interpretation, channel stuffing, accounting determinations, or other subjective measures.
ARE YOU AN INVESTOR OR A SPECULATOR?
"Our text is directed to investors as distinguished from speculators, and our first task will be to clarify and emphasize this now all but forgotten distinction."
"In the past we have made a basic distinction between two kinds of investors to whom this book was addressed – the 'defensive' and the 'enterprising'. The defensive (or passive) investor will place chief emphasis on the avoidance of serious mistakes or losses. His second aim will be freedom from effort, annoyance, and the need for making frequent decisions. The determining trait of the enterprising (or active, or aggressive) investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average."
1 The Intelligent Investor by Benjamin Graham (1973) with commentary by Jason Zweig (2003), page 1
2 Ibid, page 6
As Warren Buffet stated in Berkshire Hathaway's 1993 letter to shareholders, “Academics, however, like to define investment 'risk' differently, averring that it is the relative volatility of a stock or portfolio of stocks - that is, their volatility as compared to that of a large universe of stocks. Employing data bases and statistical skills, these academics compute with precision the 'beta' of a stock - its relative volatility in the past - and then build arcane investment and capital-allocation theories around this calculation. In their hunger for a single statistic to measure risk, however, they forget a fundamental principle: It is better to be approximately right than precisely wrong.
In Berkshire's 1993 letter to shareholders, Warren Buffet discusses diversification eloquently, "The strategy we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. In stating this opinion, we define risk, using dictionary terms, as "the possibility of loss or injury."
INSIGHTS FROM A MASTER INVESTOR
Understanding Investments a Few Minutes at a Time, a book by Daniel Dower, is a series of deliberately short summaries of investment related topics. It is designed to make it easy to read a few minutes at a time without requiring in depth study.
Best of all, the book is 100% free of charge! We think it's a great way to introduce you to this powerful investing knowledge. You can get the book for free by going to his website: