Chapter 15: Stock Selection for the Enterprising Investor

**Quick update** Thanks for reading, I’ve compiled this entire series into an electronic copy that you can take offline → here

Welcome back to the Intelligent Investor series. In this chapter of The Intelligent Investor, we address individual selections that are likely to prove more profitable than an across-the-board average. As we look at making winning decisions , it should be relatively easy to go from a moderate “average” DJIA type portfolio to a portfolio of winners just by applying particular logic. However, the proof and data suggest that this is a very challenging thing to do. We see many funds that, over time, have not been successful at beating the S & P or DJIA averages — proving the difficulty of having a list of only winners. Here’s the list of preceding posts if you’d like to get caught up:

• Intro and Chapter 1 , Chapter 2, Chapter 3, Chapter 4, Chapter 5, Chapter 6, Chapter 7, Chapter 8, Chapter 9, Chapter 10, Chapter 11, Chapter 12, Chapter 13, Chapter 14

Graham provides that there are two reasons that making winning selections is difficult; these will be the points we seek to combat using his methodologies.

Difficulty of winning selection — Reason 1:

The possibility that the stock market does in fact reflect in the current price, not only all the important facts about the company’s past and current performance, but also whatever expectations can be reasonably formed as to their future. In essence, this theory holds that any market swings must be the result of new developments and probabilities that could not have been reliably foreseen. Therefore, Graham states that the work of a security analyst would then be the impossible task of trying to predict the unpredictable.

Difficulty of winning selection — Reason 2:

The analysts are constantly seeking the current best companies based on financial positioning , management and earnings. Few companies are able to show a high rate of uninterrupted growth for long periods of time. This means the analysts’ requisite of strong earnings over long periods of time is flawed in two ways : The earnings growth usually won’t last, if they did , the upside would be limitless. The second flaw is that because the analyst is buying in at a good time, the price is likely to be at a premium, with no room for a downside (margin of safety ) when the next bear-cycle comes.

Following these reasons, Graham reiterates the difficulty of choosing the right stocks. He admits that there may yet be opportunities for investors willing to follow specific methods that are not generally accepted on Wall Street.

Graham moves to describing the techniques he used in his business in 1939. He stuck with:

• Self liquidating situations
• Related Hedges
• Working-Capital Bargains
• Some control operations

He liked the results , and thought highly of the fact that “related hedges” turned good profits in a bear market when the undervalued issues were not doing well.

Sketched example of Graham’s use of hedging with related industries to his undervalue picks. In this example, the end result is a gain of 200% on undervalue , 20% on hedge, and our hedge reduces our worst loss during a “more bear” market from -80% to -30% , saving us by 50% because of the hedge

Graham notes that he cannot offer one particular style for all aggressive investors, but suggests that they consider all of the reasonable market that fits their parameters at an original paring of results. Then to consider adding more weight to a considerable plus factor to offset a small black mark in an other factor. Find your ability to properly evaluate stocks for market value and your risk tolerance, then develop a macro strategy for your portfolio balance goals. Either way, do not pay a high price for a stock (in relation to earnings and assets) because of such enthusiasm for an industry or speculation. The better way is to look for cyclical enterprises , when the current situation is unfavorable, the near-term prospects are poor, and the low price fully reflects the current pessimism.

Furthermore, Graham offers we may have opportunities with companies that have good financials but don’t appear to hold any charm for the public. See Chapter 13. He recommends a method to finding good companies that might meet our “secondary company requirements”.

First, we will gather all the data from S & P guides (or similar); your data must have net-asset-value per share (Book-Value per share). We’ll then test the following (Graham makes a preliminary list of stocks w/ a PE multiplier of less than 9 at the end of 1970) :

1. Financial Condition: Current assets of at least 1.5x current liabilities (1.5 current ratio). Debt not more than 10% net current assets for industrial companies.
2. Earnings Stability: No deficit in the last five years covered in the stock guide
3. Dividend Record: Some current dividend
4. Earnings Growth: Last year’s earnings more than those of five years prior
5. Price: Less than 120% net tangible assets

Note: There is no lower-limit on size of enterprise here. “Small companies may afford enough safety if bought carefully and on a group basis”.

He also notes, if we want, we can add another mechanical criterion by considering only issues ranked by S&P as average or better in quality. Note however, this can be used to lower a risk but it cuts out some potentials. Graham offers that we really should avoid comprising a majority of our portfolio with second-quality issues unless they are demonstrable bargains- the reason: in a bull market, second-quality issues tend to be more overvalued than top quality. Therefore, during a price slide, the second-quality falls harder and takes longer to recover.

Bargain issues , or Net-current asset stocks:

Here Graham speaks about the ability for the intelligent investor to be able to buy “bargain issues” when their price is below net-current asset value. In this case, he notes that while it is hard to find issues of this type during a bull-market, it can be done much more easily during a bear decline. During a decline, the investor should look to acquire a diversified group of common stocks at prices less than the applicable net current assets alone — after deducting prior claims and counting as zero the fixed and other assets.

Graham remarks that in their bear market, even if they removed the companies that reported net losses the last 12 months, they’d still have enough issues to choose from to make a diversified list.

Graham re-assures the reader that, in fact, we can make money on value investing, however we must be able to:

• find enough of them to make a diversified group
• not lose patience if they fail to advance as soon after you buy them.

The Commentary

Zweig opens by reiterating that the majority of investors would do better in an index fund, he states however, that we’d be better to practice our techniques by paper trading for a year and tweaking and confirming our successes and failures before choosing to be choosey. If you rack up wins and have the stomach for individual stock selection, then continue to consider balancing your portfolio with something of a 90/10 split index fund / stock picks.

He has an interesting bit about where to look to find the right stocks. We can either go with a wholly financial approach and use only metrics to determine buys or ,we can look at some examples of other notable investors who tend to become interested in a stock only once its fallen in price. Or we could even look at Buffet Style , focusing on “owner earnings” or rising ROIC (Returns on Invested Capital)

The Intelligent Investor — Graham commentary by Zweig

Ideally, the investor will develop what suits him, likely a mix of everything we’ve covered. Zweig’s commentary is insightful and fits my goals and analysis considerations:

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 subsidiary. (The “Management discussion and Analysis” may also be helpful). Then Search a news database like Factivia, ProQuest, or LexisNexis for examples of other firms in the same industries that have recently been acquired. Using the EDGAR database, to locate their past annual reports, you may be able to determine the ratio of purchase price to 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’re investigating. 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.

Basically, use some data-points to bring the stock to the surface, then, analyze its finances, competition, core businesses and other factors with adjustments for industry and standard competitive “necessities”, then begin to build in the right buy price to you, with a margin of safety. If you are at, or under said price, consider as if you’re going to become an owner, for potentially 10 years. if things check out, it looks good to make a buy, but not until your process indicates you’re logically on the correct path and have the data to back it.

Continue to analyze management and the financials for readability. Are there many “nonrecurring” or “unusual expenses” etc. Then check and see if management has done what they set out to do, over time. Or are they only paying themselves giant bonuses? Are they building value in the company from the inside-out, or are they only growing through acquisition?’

Zweig’s final words that describe the Great Investors:

1. They are disciplined and consistent, refusing to change their approach even if unfashionable
2. They think a great deal about what they will do and how they do it, but pay very little attention to what the market is doing

As I continue to work through the chapters, my goal is to post on each chapter’s central tenets. If you find something out of place, or care to strike up a discussion feel free to comment or find me on twitter @DavidCappelucci.

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-David