Book Summary: A Modern Approach to Graham & Dodd Investing by Thomas P. Au

21 Mar 2017

 

 

 

 

In this summary, you will learn

 

  • How to apply Graham and Dodd’s 1930s investing approach to contemporary markets; and

  • Why most of their methods still work.

 

Take-Aways

 

  • Invest in value, not in growth. Value does not lie.

  • Benjamin Graham and David Dodd developed an investment methodology in the 1930s that is remarkably relevant today. Their advice includes:

  • Look for companies with prices lower than book value or, in the case of rapidly growing companies, not much above book value.

  • Do not overpay for the promise of future growth; that way lies folly.

  • Pay attention to cash flow, sales and earnings in that order.

  • Recognize that today’s companies have many off-balance sheet assets and liabilities and do not ignore them when you analyze investments.

  • Nothing in investments is new. Distrust chat about a "new economy" or a "new era."

  • Buy when everyone else is pessimistic and sell when everyone else is optimistic.

  • If you do not have time to analyze stocks, purchase an index mutual fund.

  • Graham and Dodd may be more relevant to international investing than to investing in the U.S., because many foreign markets are at a level of development comparable to America in the 1930s.

 

Summary

 

The Birth of Graham and Dodd Investing

 

David Dodd and Benjamin Graham began to develop an approach to investing that looked at a stock as a share in a business, not as a speculative instrument. They aimed to answer such questions as:

  • What stock price would make this company a bargain?

  • What buying price would make capital safe and an eventual profit likely?

  • What constitutes a safe buffer in a stock?

 

“Although Graham and Dodd investors are seldom the biggest winners, they tend to walk away with good gains at the end of the day because they have avoided large losses.”

 

An estimate of a stock’s value might be off by a few dollars either way, but a 50% discount to estimated value provides a good, wide margin of error for the investor.

 

Stock prices involve two kinds of risk:

 

  1. Quality Risk - The risk that a company may decline or go bankrupt.

  2. Price Risk - The risk that the price at which you buy a stock will prove to have been the historic high, from which the price descends.

 

An investor can profit even by purchasing the stocks of nearly dead companies, providing the price is right. If the book value (the value of a company’s net assets) is two or three times the stock price, the investor is in a reasonably good position even if the firm goes bankrupt. But the odds are against an investor consistently making money by purchasing the stocks of firms trading at or near their historic highs. Graham and Dodd’s approach depends on buying stocks that are priced low relative to the value of their underlying assets.

 

 

The Value Investors’ Criteria
 

Graham and Dodd looked at a few clear, telling criteria to determine whether a company constituted a good investment or not:

 

  • Book Value - Their first, most basic criteria was that the price of the company’s outstanding stock be less than the value of its net assets (book value).

  • Liquidity - Ideally, the price of the firm’s shares should be less than its net liquid assets (cash, receivables, unsecured debt and inventory less accounts payable). Effectively the investor buying at this price would get something for nothing.

  • Profits - The firm should be profitable. Profits might be low or dropping, but some level of profit assures the investor that the firm is alive and will stay alive, at least for a while.

  • Dividends - Graham and Dodd looked to dividends to provide a baseline return on their investments. If the dividends were less than earnings, the investor was receiving a genuine return, because the underlying investment was increasing in value even as the investor received dividends. If, as sometimes happened in those days, the dividends exceeded earnings, the investor was essentially participating in the liquidation of the company via dividends. At the right price, this could still be a profitable investment strategy.

  • Margin of Error - To allow for a substantial buffer against bad fortune or erroneous estimates, Graham and Dodd demanded a dividend yield (dividend/stock price) of at least 66% of the yield on AAA bonds or an earnings yield ratio (earnings per share/stock price) double the interest rate on AAA bonds.

 

What Has Changed Since Graham’s and Dodd’s Day?
 

Investors cannot simply take Graham’s and Dodd’s criteria and apply them successfully in today’s market for two primary reasons:

 

  1. Financial reports are different and contain far more information - Income statements are more detailed, the footnotes are more revealing and today’s statement of changes in financial position did not exist in the 1930s. Therefore, the Graham and Dodd focus on balance sheet analysis is somewhat outmoded. Cash flow analysis did not exist in the 1930s, but it is now a prominent feature in the investment landscape. The cash flow analyst uses a required rate of return or discount rate to assess in today’s dollars the value of a company’s future cash flows.

  2. Economic development has changed the nature of the economy - Once, hard assets were the primary source of value. Now information and intangible assets are the major sources of value, although they often do not appear on balance sheets. In the modern economy, a somewhat higher price to book (P/B) or price to earnings (P/E) ratio may be appropriate.

 

Cash Flow
 
“A value investor ... distrusts too much growth on the theory that all companies cannot be above average."
 

Investors pay cash for stocks in order to earn more cash than they paid. This basic proposition seems self-evident, yet many investors do not pay close attention to the cash they get in exchange for the cash they pay. Part of the blame rests with confusing accounting standards that allow firms to report earnings that include a large non-cash component and to report cash expenses in ways that seem to minimize their impact on profits.

 

The earnings, or profit, number is important, but since it contains many non-cash items, investors should always double check earnings against cash flow. If a firm is reporting big profits, but its cash account is not growing, the investor should raise a quizzical eyebrow.

 


Assets and Investors

 

Graham and Dodd’s approach to investing focused tightly on the balance sheet. Hard assets still matter to investors, though they are not as important as they used to be. Graham and Dodd looked at the book value of a company (assets minus liabilities) to get a sense of its break-up or liquidation value. All other things being equal, a company operating with a large amount of debt is riskier than a company operating with little or no debt. However, investors have become somewhat more tolerant of debt than they once were. In fact, contemporary financial theory notes that because tax authorities treat debt differently than equity, managers may be irresponsible if they do not borrow. A company that raises capital by borrowing gets to deduct the interest it pays on the borrowed money from its tax bill. But a company that issues stock, instead, gets no tax benefit.

 

“The question of whether an investor should buy the equity or the debt securities of a firm ought to be considered in light of the trade-off between one's needs for returns and safety.”

 

The fact that stock issues and debt are two ways to raise money suggests an interesting possibility: buying a company’s bonds instead of its stock. Sometimes this makes sense. If a company is teetering on the threshold of bankruptcy, professional investors often buy the debt (usually at a steep discount to face value) knowing that holders of common stock usually lose their investments in bankruptcy court while debt holders may have a reasonable chance of recovering something. They may recover just a nickel on the dollar, but if they paid only a penny on the dollar, they will have made a good investment.

 

The emergence of new financial engineering techniques means that many companies now have so-called "off balance sheet" assets and liabilities that did not exist in Graham’s and Dodd’s day. Read the footnotes to financial statements carefully to identify all of a firm’s assets and liabilities. Conduct a thorough evaluation of the company’s book value.

 

“The problem with cost cutting is that it leads to rates of earnings 'growth' that are unsustainable in the longer term. In the long run, earnings growth can only come from sales growth.”

 

The growing importance of so-called "intangible" assets has made some modification of the original Graham and Dodd formula advisable. They did not believe in paying more than book value simply to buy growth potential, and their skepticism was warranted. Yet, companies that deliver an extraordinary return on equity because of substantial "intangible" assets are special cases. With companies that deliver a return on equity greater than 15%, the value investor should seek a price equal to or less than the product of: (Book Value) x (ROE/15%).

 

 

Earnings and Sales

 

Investors who rely on accounting earnings instead of cash flow may face other problems. For example, most companies do not report the cost of options issued to compensate executives as an expense. In such cases, the "real" cost of management is not reflected on the income statement. Relying on sales figures also can be problematic. Enron, for example, reported high sales by counting among current sales some of the contract revenue it expected to receive over several months or years. Because of such practices, investors should regard reported sales and earnings numbers skeptically and inquisitively - but they should look at them.

 

Earnings growth is desirable; even Graham and Dodd would have considered it a positive. Earnings in line with reasonable expectations (even with the occasional disappointment) deserve an investor’s approbation. But do not overpay for earnings growth. Investors overpay when they buy a stock with a P/E ratio that is wildly out of line with that of the market as a whole. During the dot-com bubble, some firms with negligible sales and earnings sold at such high stock prices that their P/E ratio was more than 5,000. This means that, at current earnings, it would take the company 5,000 years to earn its market capitalization.

 

Sales analysis is useful and provides a sobering check on earnings. Investors should ask:

 

  1. Are sales growing because the company is increasing prices or increasing volume?

  2. What profit margin is the firm earning on its sales?

  3. Are most sales to repeat customers or to new customers?

  4. Does the company have the capability to ramp up production without a substantial increase in expenses?

 

“There are two things that determine whether an investor comes out ahead. The first is the frequency of the wins, and the second, the size of the wins.”

 

 

 

 

 

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