Welcome to session 20 of the Investing for Beginners podcast. In today’s episode, we are going to discuss chapter 8 from Benjamin Graham’s Intelligent Investor. This is easily one of the best books on investing ever written and is a classic must read for any investor serious about learning how to invest and not speculate.
Written by Benjamin Graham in the early 1950s it has been a huge influence on many investors, including the great Warren Buffett. In fact, he credits this book enabling him to create large returns for his new shareholders and was a tremendous influence on him.
- Timing the market versus pricing
- Speculator versus investor
- Dow Theory
- Characteristics of a Bull Market
- Succesful Stock Paradox
- Mr. Market
This week we will discuss one the chapters that he says have had the biggest influence on him. Chapters 8 and 20 he credits with opening his eyes to the possibilities of making money with a margin of safety.
Andrew: This is one of Warren Buffett favorite chapters, and it explains kind of how the market works, and it gives an excellent overview of how to understand the stock market and how it can relate to investing strategy.
Dave: The first thing we are going to talk about tonight is timing versus pricing or investor versus speculator. One of the things that Graham talks about at the beginning of this chapter is that market timing is a fool’s game. There is not much that you can do about trying to time the market.
Investors are people that are going to be looking for the intrinsic value of a price and trying to make a decision based on when that intrinsic value is going to give them an advantage in the long run for buying that company. They are not necessarily worried about whether it could be purchased today or tomorrow. It could be a year from now, or a year and a half from now, or longer. It really depends on what the intrinsic value is of that company, and what the price is versus the market.
A speculator is someone who is going to be buying based on what the time is, so they are impatient. They are looking to try to purchase the company now and get out of it in the short term. With the goal to make money in that near future. That is what Graham considered a speculator.
Those are two the differences between those terms.
Andrew: The whole speculator being impatient. I like how in the entire chapter Graham brings up dividends. He doesn’t talk about dividends much in the rest of the book, but he talks about and relates it to this.
As a long term investor, you are going to be somebody who wants to hold a stock as possible because you’ll collect dividends along the way. Whereas a speculator, as you said is going to try to pick up quick profits, and sees a year with no profits as lost time.
There is a big gap there, and I think that there are some parallels that Graham makes here in the beginning and in this chapter about focusing on not only being a long-term investor but also being a long-term investor for yield or more specifically dividend yield. Just tracking those dividend payments that you receive into your portfolio.
And I think it’s something that might be missed by a lot of value investors, but I believe that dividends are obviously a huge factor in investing. I go on and on about them every single episode because of the importance I think they play.
Dave: they are, they are critical to making significant returns, and we do talk about them a lot, but that is because we like them, and they are our best friend in the investing world. #00:04:54-8#
The next subject that Graham tackles in this chapter are the Dow Theory, and this is one of Andrew’s specialties, so I am going to turn it over to him.
Andrew: What Graham did, and he uses the Dow Theory to make an example of why the timing, aka, a speculator is not the way to go versus the pricing and intrinsic value of an investor. We are talking about those two different ball camps at the beginning of the chapter.
What the Dow Theory is based on the efficient market hypothesis, which is kind of funny because we have bashed that approach in a previous episode. Number two it is a very technical based as well, so it talks about finding uptrends, downtrends.
It uses wording like intermediate trends, just all these things that have to do with peaks and valleys, troughs. However, people like to define these charts. What ended up happening for a lot of the investors. At the beginning of the Dow Theory, back in the late 1800’s early 1900’s there was a period of about 30 years where using the Dow Theory really would have outperformed the market, would have given you fantastic returns. #00:06:37-1#
In a sense, was a way to capitalize on timing the market because in those times it was able to buy low during a bear and then sell high during a bull market. Just the way these indicators were created and these trends lines were created it was able to do that for investors for decades.
The problem is it eventually got popular, so a lot more investors ended up gravitating towards the Dow Theory and using the Dow Theory. And sure enough, once some system becomes popular in the stock market it loses that advantage. What Graham saw, and I don’t know what the specific dates were, but you can look in the book. I think it was sometime between the 30s and the 60s were investing based on the Dow Theory was resulted in a bad performance compared to buying and holding for the long-term.
You can’t get a better example than that; it’s just a perfect example of you think you are so smart, and you think you can be so cute and outsmart the market until the day you can’t. The problem with the Dow Theory is, of course, it relies on timing, instead of relying on what we can control.
Which is what a stock is priced, and how that relates to what the business is worth. Versus the market is telling me the price is going to continue to go up for a while. Now we see a little bit of reversal, or we see some tops to the market. We are going to try to predict where the price is going to go in the bottom.
That can work for a while, but mostly you are putting yourself in the timing camp versus the pricing camp. As you can see with how the Dow Theory played out, it didn’t work out for a lot of investors, and you’ll see too, which we will talk about next. It is a couple of fantastic pages; Benjamin Graham gives an overview of bull markets. I will let Dave talk about what Graham talked about what were the pieces of a bull market.
He also talked about stock market history over ten cycles and how getting in at a great buy-low in a bear market and then selling high in a bull market. It worked out well except again when it didn’t. For a while, these bear and bull markets were very predictable, and out of nowhere, you got a 20-year bull market or some crazy bear market that completely broke the cycle of all the previous ones that they had seen.
Mind you this is in the 20s, 30s, and 40s, which is amusing because we saw similar things way past when Graham wrote about these ideas. For reference when the market boomed in the 70s and 80s and then how in the 90s we saw this kind of bubble that we had never seen before.
The market has proven to use over all these occasions; it can trick you into thinking you can predict and you can get out when things go bad. Or you can get in when things are wrong and this idea that you can just time it, and it will work until it.
the dow theory proved that and the way that these difference bull and bear markets can with unexpected results. Investors who traded in that way missed out on that 20 bear market that I talked about. They were following what they saw in the past and what worked.
That is why Graham has so much invested in being away from safety concerns. Focusing on pricing and what you can control, not trying to predict where the market is going to go.
Dave: Isn’t it amazing how he wrote these books back in the 30s, 40s, during the Depression, World War 2, and all these horrible times. There were so many things going on, and he was able to predict all these things, it is just amazing to me. Even though he was writing back in the “old times,” he was able to forecast all these ideas and thoughts that are still relevant today.
Moving on to the bull market characteristics that you mentioned earlier. The first thing he talked about was historically high prices, which right now we are in the thick of. There’s the perma-bears, people that are always predicting that the sky is falling. They talk about historically high prices, and about that is the high P/E ratios. The current P/E ratio is the highest in the history of the stock market so that we can check that one off the list.
The other characteristic is the low dividend yield versus bonds. And that has been reversing a little bit lately because of the rising interest rates which have driven the bond yields down. The bond market is coming off a thirty-year bull market of its own, and there has been an outflow from bonds since the recent rising interest rates.
As you see a rise in stock prices, you will naturally see a decrease in dividend yields. #00:13:05-5#
Some of these signs recently have led some market experts to predict that the current bull market may be coming to an end, certainly with the rising interest rate environment that is something to consider.
Speculation on margin is something that I am not that familiar with, but it involves borrowing money to bet on margins of pricing. This can create better returns but is extremely risky, because if the bet goes wrong, you are in serious trouble. This is caused by the low-interest rate environment, and the speculators will gamble that their returns will be better than the interest rates that they borrow, thus earning them a better return.
The other item that he comments on is many bad IPOs, which Andrew and I have spoken about in several sessions. Our thoughts on Snapchat are very telling, and it seems to be telling out as the stock continues to flounder along. There haven’t been a lot of IPOs in recent years, and the few that have occurred have all been poor, at best.
The problem with IPOs is they make money for the owners, not the shareholders. Maybe eventually they will, but it takes a while for all that the bear fruit. With the rising stock market, it is easy for things to get frothy and IPOs can be especially dangerous.
Bull markets go in cycles; they will go up and down through the years. Right now we are in an up cycle with this current bull market, which I believe is now the longest in history. The continuation of this bull market is one of the reasons that analysts are predicting a down cycle soon, but nobody can predict exactly when that will happen. Just like you can’t predict prices, you can’t predict when a period will end and why.
Andrew: I talked about how Graham went over all the different stock market history. This is something that again was a fundamental principle to understand. When I create my Seven Steps ebook, it is that free ebook that you can get from my site. The second step is summarizing how the stock market works and trys to condense everything that Graham revealed. And other well known value investors have talked about and seen.
One thing that Graham did say, was that while you can’t necessarily predict the pricing and the timing. And you can’t try to guess your way into timing the market. What you can do is, he says in the book just to feel like you are doing something. He says you can change and adjust your allocations because he like to teach and everybody has their different opinions on this, even guys that follow Graham don’t necessarily follow this point. For the average investor, it might be a little bit more difficult because what he talks about is splitting your portfolio into a mix of stocks and bonds.
Buying an individual bond is different than the purchase of a bond fund. You can get exposure to bonds through a bond fund, but it is not going to be the same thing as far as your coupon and your payments and the price. Compared to a bond fund which holds a variety of bonds.
I mentioned that it is not something that the average investor can do. A lot of them because many bonds are $10,000 worth just to buy one bond. You want a diversified portfolio of bonds, and you are going to need more than one. The bonds themselves don’t trade nicely with the brokers as the stocks do. And trying to just screen for bonds a nightmare because you will just get all these bonds that will want hundreds of thousands of dollars, and even million dollar lots.
What Graham says is one thing you can do is change your allocation between your stocks and bonds. If you see more a bull market where you have a sense that the timing may go sour. He says at that time you can go less into stocks, more into bonds. And you can do the same thing vice versa, and that’s one way to still stay in the pricing camp, while also using your intuition or putting some action into some of the things that you are seeing in the market, day in and day out.
He doesn’t say it is a requirement, but he says it is something that you can do as a peace of mind type of thing.
Moving forward he talks about the difference between being and investor who’s a private investor or an angel investor and compares that to someone who is a common stock investor. He talks about how the private equity guy would value a business based on, imagine you are Mark Cuban or any of the other guys on Shark Tank, if you are going to look at a business. You are going to ask how much is this business, because you may or may not hope that this company goes public eventually. In the meantime, as a private equity guy, you don’t get to sell whenever you want to. It is going to come down to how much profit the business is making and how much of that profit is available to you. And the assets themselves and if that value of the assets is growing.
I’m obviously no expert on private equity, but those are the general and most basic ideas of being an investor in business in that way. Graham likes to make the distinction that it is kind of funny because it is the stock market and you can sell every day, and that value is more moving than not. That people move away from having a business mindset and they look towards a more stock mindset. And they let the prices that are being quoted and change every day; investors will let that change their views of what a company or business is actually worth.
When in reality there is no difference between valuing a business and valuing a business that is on the stock market. Except, if anything on the stock market you have an advantage because you can sell anytime you want, where the private equity guy cannot.
And Graham says the most informed part of that is while you can sell whatever day you want, you never have to have to sell. If you have a stock that you are holding and you bought it and you felt like you got a very fair price for it, or a significant discount on that value. If that investment crashes 25 to 50%, you haven’t lost that money yet and the more confident you are in your analysis of what that business is worth, and the longer period you can have to wait it out.
You have an advantage over the private equity guy because you can choose if you want to sell or not. For the investor who doesn’t want to sell then he is not subject to what the market thinks that it is worth. He is subject to when he got in and at what price he paid, he can hold until forever.
Graham talks about tracking your dividend payments and track how much that is returning to you. And then also track how the business you perceive the business is increasing, separate that from how the market sees the business. That way you’ll know that even if the market is punishing the stock you don’t have to sell and you don’t take that loss unless you are wrong later on.
He sees that as a significant advantage that the average investor has and that if they can make this distinction between business valuation and stock market valuation, then they can likely do very well for themselves.
Andrew: One great way that I think is a great example that Graham presents in the book. It proves what he talks about with the whole valuation difference. And also hammers down the point that once you hear it, you get it.
What Graham did was talk about a company called the Great Atlantic & Pacific Tea Company, a grocery store company. It was one of those stocks that were extremely overpriced and came out shooting off the gate, solid. At one point the price was at $494, it ended up crashing to $36 a few years later. But what was interesting was at its $36 price there was so much pessimism surrounding the stock. Investors looked at a stock like that and said there were these particular taxes that are going to cripple the profitability of the business. This is what people saw in the future for the business, they also saw a short term in the net earnings and it happened at a time when the market was depressed, a bear market.
This stock took a beating at that $36 price. Graham talks about how it was a prime example of a stock he would like to buy. For one the market cap was $126 million and just the cash that they had on the books was $85 million. If you think about that you are paying $126 to get $85 in cash right away, not to mention if the business even continues to sustain. People were pricing the stock to fail and the net asset value, which we call book value, shareholder’s equity, this was $134 million. You were paying to get more net assets than not.
Even if the company went bankrupt and you got any of their assets, you would have gotten $134 million for your $126 million. Today we refer to that as a price to book below one. It was a great company with a great price for that time. Later on, Graham goes on to say that the price doubled and then stabilized somewhere around $70. At that point at that price, the P/E shot up to around a 30.
What he says about all that is very attractive, at the $70 price people were very optimistic, you can see it with the P/E ratio. They were more optimistic even though the earnings in the short term were declining. There was no real indication that the business was going to grow much more in the future and the price was costly, with a P/E of 30.
Sure enough, the stock crumbled after that and never really recovered. Even during the time, it went from $30 to $70; the dividend payments were always inconsistent and small, it was very awkward.
Graham uses this as an example that a business can be right or wrong for an investor depending on when you buy it. It is not this binary thing where this stock is bad and this one is good. Buy the good stock and sell the bad stock. One stock, same company, not that great difference in their business results. But a big difference in how you invest in it based on when you got in, that is not a timing issue that is a price thing.
If you go to the $36 about all the other business metrics, it will be a great value. You contrast that to the $70 where the P/E was very high, and business results were kind of deteriorating. You could have seen that there was not the same value that there was in the past. You just saw how the market could be irrational and for whatever reason liked it, in the beginning, hated in the middle and ultimately it at the end. It just goes to show when you buy based on price and value it’s much more important than many other aspects.
This can apply to a vast myriad of different companies.
Dave: I think you are right on the money on the pricing and how that is very important. It is interesting with his thoughts of how the ups and downs of the market. And you go in and out of liking a company and everything and is still relevant today.
The next topic was my friend, Mr. Market. This is a section that Graham talks a little bit about and is something Warren Buffett talks about extensively in his Superinvestors of Graham and Doddsville, which we have discussed in past sessions.
I am going to read a little bit from the book here:
“Let us close this section with something of a nature of a parable. Imagine that in some private business you own a small share that costs you a $1000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away from him, and the value he proposes seems to you a little short of silly.”
I think that is really awesome and to me actually explains the ups and downs and the craziness of the market. The wild fluctuations that you see every day, the earnings reports come out every three months or so. Sometimes there is news about something good or wrong happening with the company, but very often there’s honestly nothing happening on a day to day basis that would cause the stock market to fluctuate so wildly.
Mr. Market illustrates that point perfectly, and he shows up every day at your office selling you his wares. Sometimes he is super cheap on his prices and you can get some great bargains, other times he has extremely high prices and you can say pass, unless you are selling for a profit.
To me, Mr. Market perfectly illustrates the ups and downs of the market, and the wild swings from day to day. Also, he helps lay out the irrationality of the market, as we have discussed in the past. There is so much insanity that goes on in a day to day basis and I think that is one of the things that can be frustrating about the market.
As value investors, we try hard not to be involved in the irrationality and we try to stay away from the emotional investing and I think that is what Mr. Market brings to the table to help us understand that point.
Andrew: I love that Mr. Market metaphor something that Graham presented, and it is often quoted. I was just reading the “Little Book that Beats the Market” and if feels like every value investing book that you pick up they always refer to Mr. Market.
It’s just an excellent summary of how the stock market moves and if you can see not as this final scoreboard but this highly emotional, bipolar system. I wrote this email about this subject the other day, this guy is just a lunatic and just throwing out prices and if you can pick up and understand what’s crazy and what’s normal.
The best way to differentiate is to have a camp based on the price and value versus the timing of the market. You do that and there’s the advantage, and where the average investor can make a name for themselves. Because the rest of the market is going crazy, trying the Dow theory, technical trading. You are not going to win in that game, but if you stop looking at it as some competition, and stop looking at what the market presents you at face value, instead understand that there are businesses behind these numbers. Understand that the market itself is a lunatic.
There are opportunities because Mr. Market is a madman, there will be a chance to get into great companies at great prices. As value investors that are something that we can all take advantage of and kind of sums up a lot of what Graham teaches throughout the whole rest of the book.
I want to close now with the great paradox that he talks about. I just love the way that he says this. He says the better a company does, the more the price fluctuates, and the more that the prices are ranging, the farther away it is getting away from it’s net asset value. Away from its book value and getting a higher multiple.
In that case, the better a company is doing, the more it is earning and growing. the more likely you are speculating, because of the farther away and the more expensive it gets at the price, the more that you’re falling into that timing camp once again.
Dave and I love to talk about stocks like Amazon, Facebook, Netflix, Chipotle, all these stocks that are super high P/E and we don’t disparage their businesses. We are not trying to say that these are a terrible business, that management is awful, or that they are not creating jobs. What we are disparaging in those situations is that the market is overpricing extensively.
What Graham says with the paradox, what’s interesting is that unfortunately, that’s the nature of the beast, that’s just the way that the game goes. The better a company does, the more the market tends to rally around it and bid it up to high prices.
What he says is you’re more likely to see more opportunities in the common performing stocks. The ones that are from a business perspective are still growing but ordinarily. Compared to the brilliant companies, the ones that are changing the world and growing substantially.
Taking that all into consideration and focus on what you can control, the price you are paying, and try to stay away from the various traps and pitfalls that can happen with the market. Once you have this understanding, you can apply that to the rest of your approach.