Investment Selection – The Intelligent Investor Book Review (Chapters 11, 12, & 13)

Investment Selection: Emotion or Logic

This is Part 6 of our book review of  The Intelligent Investor, Revised Edition, Updated with New Commentary by Jason Zweig (affiliate link). Part 6 covers Chapters 11, 12, and 13.

You may find the Introduction and relevant links at: The Intelligent Investor Book Review in 30 Minutes.

Security Analysis for the Lay Investor –       Chapter 11

In investment selection, it is most accurate to be able to make judgments based on past performance. The greater the amount of assumptions that have to be made about the future, the greater the possibility of misjudgment or error.

In bond analysis the most reliable benchmark for safety is the earnings-coverage test. How often, and by how much, has the company earnings covered interest charges over a considerable period of time (Graham uses 7 years). In addition, you want to consider the size of the enterprise, the stock/equity ratio, and bond security (assets).

In common stock analysis the valuation of the company is compared to the current price to determine whether the stock is an inviting purchase. Of course an investor should seek a margin of safety. In other words: purchase the stock for less than its real value.

The average future earnings should be the biggest consideration of value. However, investment selection should also take into account a required rate of return (capitalization rate).

The capitalization rate may differ depending on the quality of the investment. Graham lays out five elements for the security analyst to consider: general long term prospects, competence of management, financial strength and capital structure, dividend record, and current dividend rate.

Making assumptions about the future creates greater risk. The more an investor relies on future expectations, the greater the margin of safety he must require. But there is risk in only looking at past results too.

In order to mitigate this problem, Graham recommends a two-part appraisal process. First, establish a “past-performance value” based solely on history. Then contemplate how much of an adjustment needs to be made to valuation based on future assumptions.

In the commentary, Jason Zweig adds modern illustrations of Grahams points. He provides interesting examples of problems to watch for, as well as good signs to be observant of.

Things to Consider About Per-Share Earnings – Chapter 12

Graham is adamant about not putting any importance in short term earnings. The more an analyst relies on short term results, the greater the risk, and the more due diligence that is required.

Earnings that are averaged over a long period of time (Graham uses 7 – 10 years) provide a more reliable indicator of the future health of a company than short term earnings. The shorter the time period of analysis the greater the scrutiny required of special charges, income tax anomalies, dilution factors, depreciation changes, etc.

Jason Zweig, in the commentary, laments that even Graham would be shocked at the size and degree that corporations pushed the limits of fraudulent accounting in recent years. He provides great examples and pointers for avoiding these kinds of companies.

A Comparison of Four Listed Companies – Chapter 13

Graham uses this chapter to provide historical examples of investment selection in action. He details fundamental ratios that shed light on performance and price. The leading factors of performance are profitability, stability, growth, financial position, dividends, and price history.

The attitude of the investor is important in common stock investment selection. A value approach will be more skeptical of high multiple valuations based on expected high future growth or short term earnings. Many times the lower multiple valuation with slower stable growth will be the long term winner.

Continue to Part 7:

Comparisons & Thoughts on Value – The Intelligent Investor Book Review (Chapters 16, 17, 18, & 19)

Disclaimer
While Arbor Investment Planner has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability, or completeness of third-party information presented herein. The sole purpose of this analysis is information. Nothing presented herein is, or is intended to constitute investment advice. Consult your financial advisor before making investment decisions.