Security Analysis 1934 Feature

Investing in Shares 101: 2 Value Investing

In The rest by tony1 Comment

Dr Tony Stewart is a scientist and analyst by training. He has run a strategic market research business and has an extensive background in statistical analysis. At the beginning of his investment career, he read widely and undertook courses on investing run by the Securities Institute of Australia. He has invested in the Australian stock market for thirty years.

ORT_Logo Breadtag Sagas ©: Author Tony, 1 October 2021


Investing in Shares 101: 2 Why Value Investing?

Approaches to Investing in Shares

1 The Bogus Concept of a Free Market

Unfortunately, there is a lot of ideology involved with stock markets. This is primarily associated with the wealthy trying to assure themselves and others that whatever they do to acquire their wealth is honest and good for us all. Much of this ideology is associated with the concept of the free market, which has been around for a long time.

Fitzherbert, quoted in article 1 Basics, criticises the academic theories (espoused even by nobel laureates) called efficient-market theories from the 1970s and 1980s (based on free market ideology). The efficient-market theories were debunked by the early 1990s, but have continued in different guises under the banner of neo-liberalism. They are nonsense!

Now, I’m not suggesting you abandon your political beliefs or change your dinner party conversation, or your detailed knowledge of economic theory. I don’t want to interfere with your outside life.

Benjamin Graham, The Intelligent Investor 1949

Benjamin Graham, The Intelligent Investor 1949

When you deal with the share market you need to be clear headed and clear thinking not driven by ideology or clouded with emotion. I mentioned Dr Turf in 1 Basics. Whenever you engage in buying or selling shares, or anything to do with the stock market, just don’t put a pumpkin on your head. It makes it too hard to see!

Leave the free market or efficient-market theory for when you are bullshitting with your mates.

Also continuing with the horse racing analogy, if you want to speculate on daily swings in the market, getting out and going to the racetrack is probably healthier because both involve gambling.

2 Charting or Technical Analysis

Charting or technical analysis is still practiced widely and to the uninitiated appears to be a sensible approach to share trading based on mathematics or statistics. It is not!

Charting is nonsense. It is nonsense because it depends on finding patterns in the near randomness of daily transactions on the stock exchange and our inability to predict the movements of individual shares with any confidence. Hopefully, when I talk about Nassim Nicholas Taleb, randomness and black swans below it will all become obvious.

Benjamin Graham, Wikimedia

Benjamin Graham, Wikimedia

I think of technical analysis in the same way as I think of homeopathy. Homeopathy is widely practiced in our communities as alternative medicine, but it is incapable of doing good or harm because of Avogadro’s number. The dilutions in homeopathy go beyond the capability of there being any active molecules left in the solution on which the medications are based.

3 The Value-orientated Approach

Graham & Dodd

The value-oriented approach has been around forever, but the most famous exponents in the US are known as the superinvestors, an approach pioneered by Benjamin Graham and his colleague David Dodd in the USA. They wrote a famous book called Security Analysis in 1934. (There are other similar investors elsewhere around the world.)

David LeFevre Dodd, Columbia University Archives

David LeFevre Dodd, Columbia University Archives

Graham lost much of his money in the 1929 Stock Market Crash, which focused his developing ideas on downside risk. Warren Buffett a follower of the superinvestor school, who worked briefly for Graham, said of The Intelligent Investor 1949 by Benjamin Graham: by far the best book on investing ever written. (He has also said much the same of Security Analysis 1934.)

The key elements of Graham’s Value Investing were buying shares in companies that appear under-priced by some form of fundamental analysis, other key concepts were the ideas of intrinsic value and margin of safety (inspired by his experience in 1929).

Warren Buffett the most famous contemporary follower of Graham and Dodd in the USA showed how Graham and others (he knew) had out-performed the S&P 500 by huge amounts in a famous talk entitled: The SuperInvestors of Graham and Doddsville, at Columbia University in 1984, celebrating the 50th anniversary of Graham’s famous first text with Dodd.

Security Analysis

Security Analysis

Warren Buffett

Rather than using Buffett’s examples in his talk, the table of Buffett’s company Berkshire Hathaway’s performance against the S&P 500 since 1965 proves the point. Berkshire Hathaway’s gross performance was 100 times that of the S&P 500 (with dividends included). Or in more prosaic terms Berkshire Hathaway’s compounded annual gain (a relatively complex calculation) was 20% per year versus the S&P 500 gain of 10.2% per year. These are massive differences. No one else, except super investors investing on the value method, gets anywhere near these results.

Berkshire Hathaway vs S&P 500

Berkshire Hathaway versus S&P 500

Why doesn’t everyone follow-the-method? Buffett when asked about the dangers from competition replies in the last paragraph of the talk above that the Graham and Dodd book 1934 had been out for 50 years but:

I have seen no trend toward value investing in the 35 years that I’ve practiced it. There seems to be some perverse human characteristic that likes to make easy things difficult.

Warren Buffett 2010, Aaron Friedman

Warren Buffett 2010, Aaron Friedman

Buffett tends to become involved in purchasing whole companies or significant holdings in them and also helps to advise or control the key ones. Nevertheless, the principles apply equally to small investors. And, value investing is more based on principles than a rigid method.

Although, Hagstrom’s book below does give a detailed analytical approach and methodology to Buffett’s means of choosing companies to invest in.

Buffett has also extended and improved upon the Graham and Dodd principles. Perhaps his main advice is to buy stocks to hold forever. He is not one to suggest share trading in a big way.

Buffett was also influenced by Philip Fisher in California who wrote a famous book on investing in 1958. Buffett said: I’m 15 percent Fisher and 85 percent Benjamin Graham. (Forbes, 1969 from Hagstrom, and elsewhere)

Hagstrom, The Warren Buffet Way, 1994

Hagstrom, The Warren Buffett Way, 1994

Robert G Hagstrom (see the books section below) distils Buffett’s main principles as:

  1. Purchase businesses with excellent long-term prospects.
  2. Purchase businesses at a large discount to their intrinsic value.
  3. Purchase businesses with a high return on invested capital.
  4. Purchase businesses with competent honest managers.

Retail Investing

This is not everything. How to define intrinsic value requires work and some experience on the part of the investor. However, these ideas are the core to what value investing is all about. It is also amazing to me that all professionals engaged in buying and selling shares don’t follow-it.

Point 4 has been possible for Warren Buffett but is a vexed issue for the retail investor. Nevertheless, one should never forget the management of companies as a consideration, even if you have no control over them.

Managers of decent companies sometimes appear to go crazy and destroy the company that has traded successfully for years: Adelaide Steamship and Burns Philp are examples in Australia, Enron in the USA. As a retail investor it is exceedingly difficult plan for such things.

Mary Buffet, Buffetology 1999

Mary Buffett, Buffettology 1999

Mary Buffett (see below) emphasises the importance of investing from a business perspective in real companies and not following the vagaries of price on the stock market.  I covered this in 1 Basics. Your share purchase is buying you ownership in a real company, you should never forget this! Sure you want to buy at an attractive price, but you are not buying a piece of paper that goes up and down on a daily basis. I sometimes forget this too but not that often, because I know that it is crucial to my long-term investment strategy.

4 Contrarian Investing or Avoiding the Groupthink

The Contrarian Approach

To have a contrarian view on buying and selling shares seems a contradiction in terms. But then, value-investing wouldn’t make sense either. However, when one begins to think of a stock market not as an efficient or free market, but one driven by greed and fear then it may begin to make some sense.

Similarly, my bold statement in the previous article on 1 Basics that many mum and dad investors (retail investors) frequently perform better than professionals would not make sense in an efficient-market.

Hagstrom 1994, Back Cover

Hagstrom 1994, Back Cover

Groupthink

Another of Benjamin Graham’s key early contributions was to point out that irrationality and groupthink was often rampant in the stock market. 

More recent studies have shown that groupthink is by far the safest option for professionals on the stock market, as you are seldom punished if you fail with the crowd, but are usually punished if you stick you neck out, even if you are right. And, remember they aren’t risking their own money. There is more to it than that of course.

Psychologically one is always influenced by the views of the group and it is difficult to go against them, even when you think they might be wrong. Groupthink is a characteristic of group behaviour that allows otherwise intelligent people to commit themselves to foolish action. A corollary is that people can convince themselves to adopt a course that each of them knows individually is wrong.

The book 2010 and the film 2015 The Big Short showed the bravery and common sense of those who predicted that Wall Street was spiralling towards catastrophe in 2007. But, it also showed to some extent the pain and anguish the major players (contrarians) went through as well.

Buffetology 1999, Back Cover

Buffettology 1999, Back Cover

When Joe Kennedy’s shoeshine boy in 1929 gave him some stock tips, he supposedly exited the market before the Crash.

My first experience in the stock market was exactly this. I was 19 and a friend working casually in the stock market advised me to cash in on a mining share. It was at the end of the resources boom in Australia with the Poseidon share price at its height. I invested $140 in a mining company and lost everything within a few months. The money seemed a lot to me at the time and put me off the stock market for years.

The phenomenon is related to the irrational exuberance of crowds, stock bubbles and investment fashions. Don’t be sucked in!

Final Word

Before the Dot.com bubble burst in 2000, there were several articles about Warren Buffett that he was old-fashioned, had lost his touch and didn’t understand the new technology (lazy journalism and not the first time in his career). One published only a couple of months before the beginning of the end of the Dot.com bubble commented that Berkshire Hathaway shares were near a 52-week low as proof. I doubt that Warren Buffett lost a night’s sleep over it, because he has always contended that it is not the fluctuating share price that is important but the intrinsic value of the company and whether it is trading at an attractive value, and that applied to Berkshire Hathaway as to any company.

5 Fooled by Randomness

Randomness

Brownian motion is a phenomenon first described by botanist Robert Brown in 1827 for the apparently random walk of pollen grains immersed in water. Albert Einstein published two pivotal papers in 1905 and 1908 using brownian motion to prove the existence of molecules. One century later this lesser known work by Einstein has become even more important in particle physics.

Fooled By Randomness, My Copy 2007

Fooled By Randomness, My Copy 2007

Many people have noted that on a daily basis the rise and fall of share prices, although related to the whole market, also exhibits a style of random walk or similar phenomenon akin to brownian motion. What this means is that predictions of market behaviour on a daily basis and even in the short to sometimes the medium term are frankly unknowable.

Nassim Nicholas Taleb

Nassim Nicholas Taleb wrote Fooled by Randomness: the hidden role of chance in life and in the markets 2001 and The Black Swan: the impact of the highly improbable in 2007.

Taleb is mathematical statistician, he has been a mathematical finance practitioner, a hedge fund manager, derivatives trader and risk analyst. Hence his experience and knowledge are hard to dismiss.

However, his books are popular accounts and his arrogance and acerbic wit turn some off. He is also a fierce critic of economists and statisticians, which makes him unpopular with professionals. Despite all this, his thesis is brilliant and a true indictment of much financial analysis.

Fooled By Randomness 2004 Back Cover

Fooled By Randomness 2004 Back Cover

Taleb sets forth the idea that modern humans are often unaware of the existence of randomness. They tend to explain random outcomes as non-random.

Human beings:

  • overestimate causality, e.g., they see elephants in the clouds instead of understanding that they are in fact randomly shaped;
  • tend to view the world as more explainable than it really is.

Charting and technical analysis outlined above are a classic example of attempting to define a random result as non-random.

Other misperceptions of randomness he includes cover survivorship bias and other things. Of the former, we see winners and try to learn from them, while forgetting the huge pool of losers associated with the winners. (Wikipedia)

Because of randomness in the fluctuations of the market, the type of analysis undertaken by traders is mostly unknowable. Taleb gets us to imagine 1000 traders at the beginning of their careers. When each fails, they get fired and purely by chance, after several years, you get a few survivors who are treated as geniuses.

Black Swans

The basis of his second book is black swans, which are unpredictable events that are rare, but when they occur everything changes (one example is a stock market crash, the GFC is another).

The Black Swan 2007

The Black Swan 2007

When a black swan event or discontinuity (technical term) happens, even the genius survivors are fired. And, a new generation comes on board.

Taleb says amusingly that in one era of his being a trader, the other traders were mostly all young American MBAs, then a black swan event occurred and they were fired. The next generation were similarly brilliant Russian physicists and mathematicians. They eventually failed too, as could have been predicted, but he said, while they lasted they were much more interesting companions than the MBAs.

The thing that Taleb’s insights show us is that, not only are the markets unpredictable on a short term basis, but in the long term black swan events or discontinuities are inevitable too. 

What does this mean? It means that a strategy (based on past experience) that gives you small gains annually, for say ten years, may look impressive, but not when the black swan event in the 11th year makes you lose massively more than your slow ten year accrual strategy.

This is another reason why a careful strategy based on value investing and minimising risks (which retail investors can pursue, because they are not pulling down big salaries based on constant activity) can result in long-term gains, despite the vagaries of the market and the occasional black swan.

6 Final Take Home

  • Value-investing is the only relevant approach to stock market investing.
  • You can’t begin to invest in the stock market in a sensible practical way without some hard work. You are going to have to learn to read and understand annual reports and other things.
  • Although, value-investing should be your guide. Unless, you are going to spend the rest of your life studying, you are going to have to take some short-cuts.
  • Try to remain calm and don’t get caught up in the exuberance of crowds, or put too much weight on what the professionals are telling you. Read and digest, but treat everything you learn with a grain-of-salt.
  • Patience, and slowly, slowly are essential traits. Never plunge-in in case you miss-the-boat. In my experience that never ends well.
  • Buy to hold. Trade when you have to but the ultimate aim is to develop a portfolio of good companies to keep. These days I only invest in large or blue-chip companies because I don’t believe that penny stocks or small-caps are worth the effort. Even in a small stock exchange, like the ASX in Australia, there are more large-cap stocks than you can ever research. Similarly, the late 20th century and 21st century are technically turbulent environments with rapid technological change and climate change as salient characteristics. In this type of environment, large-cap stocks are volatile enough in terms of survival and price: there is enough action, without needing to discover the next new new thing.
  • Be very clear that on a daily and short-term basis the stock market is random and unpredictable. Black swans are relatively rare, but over time they always happen. Strategies that don’t take account of black swan events can only be successful in the short term. What Benjamin Graham learned from the 1929 Stock Market Crash was that a Margin of Safety is an essential element in value-investing.

7 Comment

My next article Share Investing 101: My Experiences is about my own experiences, successes and mistakes in stock market investing. I hope I’ll consolidate some of the concepts in 1 Basics and in this article by providing my real life experiences.

I hope you are not disappointed that I haven’t given you a practical step-by-step method to share investing. Unfortunately, it’s more complicated than that and you are going to have to find things out and do some work on your own. The two recommended books on Warren Buffett below and the Berkshire Hathaway website are a good starting point and actually sufficient alone (especially the two books) to give you everything you need to know. As is assiduously following my advice, until you are ready to reject some things I say, and to start out on your own.

My cousin Lesley just sent me her rare copy of John Rothfield Dr Turf’s Guide to better Punting 1987. I’ve re-read it! If Warren Buffett had been interested in horse racing, his advice would have been very similar to John Rothfield’s. Dr Turf provides a comprehensive guide to everything you must know and do to punt professionally on horses. The only negative I can think of is that gambling on horse racing is gambling. Whereas to my mind, investing in shares is wealth generation, if you follow my advice above. As mentioned, the only positive I can think of for horse racing is that going to the races is healthier. It gets you outdoors!

8 Books

The Initial Super Investors

Benjamin Graham and David Dodd Security Analysis 1934

Benjamin Graham The Intelligent Investor 1949

I’ve read these two but wouldn’t recommend them as necessary.

Philip Arthur Fisher Common Stocks and Uncommon Profits 1958.

I haven’t read Fisher (actually I think I have) but his take homes are: 1 buy to keep forever, 2 investigate the business economics of any company you want to invest in (future prospects and management capability), 3 qualitative investigation (‘scuttlebutt’ from reliable sources and extensive interviews of customers, vendors, ex-employees and within the company where possible), and 4 because the qualitative approach requires such intensive effort, concentrate on a few enterprises, i.e., don’t diversify.

These books are still readily available and worth reading but they are academic (certainly Graham) and only for the dedicated investor. Studying Buffett will give you as much and more. You’ll get this readily from Hagstrom and Mary Buffett. Hagstrom and to a lesser extent Mary Buffett give good summaries of Fisher’s ideas. Mary Buffett also mentions: Edgar Smith 1924, Lawrence N. Bloomberg, John Burr Williams and John Maynard Keynes (Hagstrom too), all 1930s. But, you’ll get this and more by studying Buffett.

Wikipedia on Benjamin Graham

Wikipedia on David Dodd

Wikipedia on Philip Fisher

Warren Buffett

Robert G Hagstrom The Warren Buffett Way 1st Edn 1994, 2nd Edition 2004, 3rd Edition 2013.

Hagstrom gives an excellent historical account of Buffett and his investing and a detailed analysis company by company of why Buffett invested in them (with detailed quantitative analysis of each).

Wikipedia on The Warren Buffett Way

Warren Buffet's Home, Omaha, Nebraska, Wikimedia

Warren Buffett’s Home, Omaha, Nebraska, Wikimedia

Mary Buffett and David Clark Buffettology 1999

Mary Buffett gives a slightly more comprehensive guide to Buffett investing than Hagstrom. But, Hagstrom provides more evidence and also some insights into Buffet’s mistakes.

I’ve read several Warren Buffett books. These two are the best from the point of view of learning about value investing. They are also very readable.

Both provide a step-by-step guide to how to invest. Mary Buffett also provides calculations you can do on a specific financial calculator, but any financial calculator or writing your own formulas on a spreadsheet will do as well. Hagstrom provides specific examples of calculations in his Appendices. Although, to follow the Hagstrom methodology is less step-by-step it isn’t difficult.

Both are complementary. But you also need to read Warren Buffett and Charlie Munger’s views in the extensive annual information provided on the Berkshire Hathaway website (see below).

Wikipedia on Warren Buffett

Every year Warren Buffet’s and Charlie Munger’s personal wisdom is given letters to shareholders and in Berkshire Hathaway’s Annual Report. These are delightful, easy to read and the advice is priceless. You should access and read at least a few.

Letters

The Annual Reports have the same information and more (ignore the Quarterly Reports).

The table in this article on Berkshire Hathaway’s Performance versus the S&P 500 from 1965, p4 2020 AnnReport, available as a download.

Nassim Nicholas Taleb

You’d think without Taleb that it is pretty bloody obvious that moment-to-moment and day-to-day movements of shares and the stock market tend to be random. But, then it is in no one’s interest, particularly those whose job it is to identify trends, to admit the obvious.

Nassim Nicholas Taleb Fooled by Randomness: the hidden role of chance in life and in the markets 2001

Nassim Nicholas Taleb The Black Swan: the impact of the highly improbable 2007

Both books are easily readable by the non-expert. They are witty and arrogant (reminiscent a little of Malcolm Gladwell in style). I liked that, others may not. But, the underlying concepts are true and unassailable. (Yes, there is exaggeration in there too!)

Wikipedia on Nassim Nicholas Taleb

Wikipedia on Fooled By Randomness

Wikipedia on The Black Swan

Goodreads on Fooled by Randomness with warts and all comments

Goodreads on The Black Swan gives both the good and bad reviews

Other

Michael Lewis The New New Thing: A Silicon Valley Story 1999

I used the words new new thing in reference to this book in the text. The book is mainly the story of an entrepreneur James Clark the founder of several billion dollar Silicon Valley companies. It is a story of success but also of darkness and proof that not all endeavours in the tech company age are either obviously good or honourable.

Goodreads on The New New Thing

I should say also that if I’d had the chance to buy shares on the US stock exchange (without having to repatriate the money to Australian Dollars) I’d be a happy shareholder of Apple and Alphabet (Google) even though I have reservations about both companies.

Overseas investing is much easier today! But, unless you have overseas bank accounts in different currencies and you choose when to move money from one currency to another at a decent exchange rate, it is a mugs game and only serves to enrich the financial institutions involved.

Venture capitalism is a proven way to make money but you need a lot to start with and have to be prepared to risk it. You also need networks (such as in Silicon Valley).

My experience (and sadly I have quite some) is that for the retail investor investing in start-ups and early stage technology innovators, no matter how good the technology, is always a mistake.

I haven’t given the reference to The Big Short. It is extremely well-known. And, it doesn’t add anything to the type of research you need to do for share investing.

A final word on charting. If you’ve ever been engaged in statistical curve fitting, its obvious that charting is wishful thinking. First, lines drawn by sight rarely coincide with statistical curve fits. Second, defining where a breakout occurs from a trend line is simply mystical, except in hindsight. Third, you are always looking at what happened in the past, which is just dangerous in investing!

Sorry about the old white men. It is unavoidable!


Key Words: free market, efficient-market theory, ideology, stock market, pumpkin head, charing, technical analysis, value-investing, value-orientation, Benjamin Graham, David Dodd, superinvestors, Warren Buffett, Berkshire Hathaway, Graham & Dodd principles, Philip Fisher, long-term prospects, intrinsic value, high returns, honest managers, retail investor, Adelaide Steamship, Burns Philp, Enron, contrarian view, groupthink, stock bubbles, irrational exuberance of crowds, investment fashions, stock market crash, GFC, dot.com bubble, psychology, the Big Short, fooled by randomness, Brownian motion, Einstein, Nassim Nicholas Taleb, randomness, survivorship bias, black swans, discontinuity, turbulent environment, Charlie Munger, annual reports, patience, slowly slowly, blue-chip, mid-caps, penny stocks, volatile, Margin of Safety, John Rothfield, Dr Turf, Robert G Hagstrom, Mary Buffett, Buffettology, Michael Lewis, Silicon Valley, overseas investing


posted in Canberra in Pandemic Lockdown

 

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