The Intellligent Investor: Ch. 7 (What to buy)

[DesertCat]

This is the first chapter Ben lays out his ideas on things the enterprising investor should buy. He starts by discussing formulas for timing the market, and even though he's partial to the idea, admits that the prior 24 years provides little evidence they work. Then he discusses specific areas to research.

1) Growth Stocks
Note he references a study that shows growth funds beating the market by a small amount for the prior ten years. One important issue that Ben misses here is "survivorship bias". These funds were picked after the fact, ignoring growth funds that were in existence at the beginning of the study that failed and closed their doors before it's end. I would bet it's very likely that a proper study would have shown that growth fund trailed the market for that period.

But ben's point is that even with all the smart people and resources at these funds, they struggle to beat the market. His point is that if it's that hard, what makes you think you can do better? His recommendation is if you incorporate growth stocks into your portfolio, don't overpay for them. Try to keep your PE ratio to 20 or below.

Note: Ben does doesn't use "forward earnings", or even last years earnings. He likes to use average earnings for the last 3, 5, or even 7 years to establish true "earnings power" and not get fooled by one great year. That's a difficult concept to use, and may not be the right approach with a company in hypergrowth growing 20%+ a year, but it's one you should consider esp. with slow growth companies.

2) Unpopular Large Companies
Ben lays out an idea similar to "Dogs of the Dow", i.e. buy the cheapest Dow stocks each year and assume they'll rebound to reasonable valuations. I personally am not a fan of this approach, it's worked from time to time, but like all "patterns" in the market never works perfectly. And I think this idea is much better suited to a defensive investor, than an enterprising investor willing to do their homework (though he says that you should do your homework to filter only the best opportunities from the list).

3) Purchase of bargain issues
Ben's telling you that smaller stocks are generally undervalued, and offer lots of opportunities for finding very attractively priced investments, though sometimes they'll get caught up in a mania and the reverse will be true. In fact, right now small cap stocks have been on a mighty run for the last three years or so, but eventually they'll fall from favor again.

This is one of my favorite themes. Small cap stocks are less researched by professionals, which gives the talented amateur a much bigger "edge" in finding high return investments. But small caps are also riskier, it's virtually impossible for Cokes business to disappear, but Joe's cola company could be wiped out by a lawsuit, loss of distribution, or many other reasons.

He finally brings up his famous "net assets" stocks. The ultimate value stocks are ones where they have enough easily liquidatable assets (net assets) to pay all liabilities, and still have enough cash left to buy back all the shares of stock at current prices. If the business is actually profitable, and the management reasonably intelligent, you almost can't lose. Unfortunately, except for a brief comeback during the internet collapse, these stocks have been very hard to find for the last thirty years.

4) Special Situations, i.e. workouts and arbitratee.
My favorite area. The most common form of special situation is merger arbitrage, where you buy the shares of a company being purchased, for slightly less than the purchase price, and earn a handsome annualize return in the few weeks until closing. If the deal doesn't fall through Other forms include tender offers, recapitalizations, even bankruptcies.

One present day example is USG. It is exiting from bankruptcy and in order to fund it's obligations to asbestos lawyers, it's offered every shareholder the right to buy one additional share for each share they owned, at a price of $40, when USG was trading a little over $60. The documents they filed made it pretty easy to see that out of bankruptcy USG would be worth much more than $60 per share. So buying one share today at $60 actually meant you were buying 2 shares for $100, that together might be worth $200 or more. The stock subsequently hit $120 a few months later.

At the end of the chapter, Ben makes one very important observation. If you are going to be an enterprising investor, you must be able to value companies well. You can't give it a half effort, because making mistakes won't just mean a lower return, they actually might mean a large loss.