This post is based on Chapter 50 of the Sixth Edition of Security Analysis – ‘Discrepancies between Price & Value’. It’s an invaluable chapter that provides a systematic method for investors to seek investment opportunities in the market, something that is not covered extensively in The Intelligent Investor.
Most financial analysts and investors expend the greater part of their time and effort on determining the future prospects of selected companies; that much is a given. What most people fail to note is that Graham’s method was different. His focus was on the previous performance record of the business itself, and he placed little emphasis on attempting to predict the future performance of the selected business. Although this distinction may seem subtle, it carries significant repercussions for the way an investor should shape his research process.
Although Buffett and Graham shared a common way of thinking, the method by which each investor implemented his strategy was poles apart, as is night and day. Whilst Graham was content to focus his efforts on finding statistically cheap companies that had a high probability of generating a return greater than the market averages, Buffett concentrated his research on finding businesses with sustainable competitive advantages since he was buying into the future cash flow that the business would generate.
There is no “right” method per-se; each investor has to contend with the strengths and weaknesses of each approach. For the purpose of this discussion, I will be focusing on what Graham refers to as “secondary issues” as this is the key area of my investment research.
During normal markets, where prices are neither too high nor too low, there are more often than not a great number of “secondary issues” i.e. small-to-mid capitalization companies which possess:
1) High current and average earnings relative to market price
2) Reasonable satisfactory exhibit of earnings, selling at a low price relative to their net current asset value (NCAV) whereby NCAV is defined as Current Assets – Total Liabilities
Indeed Graham had such success with (2) that he made the systematic buying and selling of businesses vending below their NCAV his main priority.
The benefit of investing in these issues is that they are often overlooked and ignored by most institutional and retail investors. One must realize that institutional investors by sheer virtue of their size
, can only invest in a small number of businesses listed. It would not be cost-effective or practical for them to build up stakes in smaller capitalization companies. Furthermore, with such little attention focused on them, many of these companies are often mispriced, therefore providing ample opportunity for exploitation by astute investors.
In a nutshell, you can be sure that the majority of investors will expend the best part of their effort attempting to locate the next Apple or Microsoft by means of predicting the company’s future prospects. These investors will then try to purchase company shares at unattractive valuations in the process.
Those who choose to invest by making a commitment to a diversified group of “bargain issues” with only moderate prospects are few indeed. However, my own personal view is that such a technique has provided investors with more than a satisfactory return since its inception and I have thus made it the foundation of my own work.
I highly recommend my readers to pick up a copy of Security Analysis to enjoy a fuller discussion of the points made by Graham & Dodd.
Value Investing: Tools and Techniques for Intelligent Investment by James Montier [Book]