(Note: If you are just joining the seminar, please start by reading the Introduction)
When thinking about the income statement, it is very important to remember that it is just an estimate. In the accrual system of accounting, we try to match the timing of revenues with the timing of the benefits received by customers and of the timing of costs with revenues. As a result, there is necessarily leeway for management to influence what we see as investors.
That’s not necessarily a bad thing – after all the goal is to present the investor with a close approximation of economic reality. However, it can be misleading either due to management’s intent to mislead or simply due to the natural ebb and flow of business.
When we bring the Balance Sheet and the Cash Flow statements into our analysis, we get a much more complete picture of how the business is doing. For example, consider a company with Net Income of $100 last year. How sustainable is it?
Well, in isolation, that’s a hard question to answer. Now consider two scenarios:
That company has Book Equity of $1,000
That company has Book Equity of $500
Now we can see that Company #1 has a Return On Equity (ROE) of 10% and Company #2 a ROE of 20%. The typical public company has a ROE of around 10%, close to its cost of equity. The 20% ROE might be a sign that Company #2 is enjoying a temporary boom in profits that is not sustainable. Or it could be a superior business that has earned those returns. At the very least it gives you, as the analyst, something material to investigate.
The point is that bringing the Balance Sheet into our analysis is akin to looking at the world in 3D rather than 2D – you are going to notice much more depth.
I can’t do the topic of analyzing financial statements justice in these pages, so if you want to dive into this deeper, I highly recommend Howard Schilit’s Financial Shenanigans. You will be amazed at how creative management can get with financial manipulation.
In response to Question 1 dr. Solti-Tóth, László wrote:
Graham explains in several places in Security Analysis why it is impossible to have an exact appraisal of any given common stock. Here are some examples:
- The speculative factor is too large; therefore, an analysis is likely to prove inconclusive and unsatisfactory. [p. 348, 6th edition]
- The value itself is a range, not an exact number. [earlier in the book]
- The instability of tangibles and generally of typical businesses, and the dominant importance of intangibles [from Chapter 27] – I might add that this is a sign of the direct influence of the Great Depression on Graham.
[Please note that the importance of intangibles has increased even more since the book was written.]
- On p. 497 (6th edition) Graham states: “The bases of value are too shifting to admit of any formulation that could claim to be even reasonably accurate.”
I agree that value is not an exact number, but a range of possible outcomes, each with different probabilities.
However inaccurate our estimation of the value is, it should still serve the purpose of making a decision whether to buy, sell, ignore, or hold (and to what extent regarding position sizing) [this was also Graham’s conclusion in Chapter 1]. At the extremes of the market cycles our conclusions can be more definitive though.
In response to Question 2 Tibor V wrote:
Graham underlined the danger of projection and highlighted several reasons why we cannot be sure about a trend of profits shown in the past will continue in the future. Such as:
- Law of diminishing return;
- Increasing competition;
- Business cycles.
I think the past and the history are very good starting points to try to have an understanding about the company and for our analysis but we should avoid fooling ourself by projection past trend in the future, including in some cases a never-ending uninterrupted growth.
I share the point of view of Graham and I think that we can also add the following factors in respect of past trends:
- Change of the underlying paradigms and circumstances of the past in the future;
- Life cycle of the enterprise and industries;
- Changing regulation;
- Stability vs evolution of consumer preferences and perceptions about a company and industry;
- Expiration of concession rights, exploitation contracts, extension of natural reserves.
Having said that, the uncertainty and the pace of change/disruption should be factored in our analysis when we are thinking about the reliability of any projection made based on past trends.
The question should be also asked what we mean by the average earnings: Is it a 2Y, 5Y, 10Y average, including/excluding one-off items, impact of changes in GAAP/regulation, cycle.
Given that the number of variables, the uncertainty increase, we should level up also the requirement for margin of safety.
In response to Question 3 Tony wrote:
The challenges with growth investing include the sheer difficulty in identifying growth companies, the risk that short term good results or luck will be mistaken for a long term growth company, and that growth can reverse, “he may find this apparent strength to be the harbinger of coming weakness” (Pg. 370). He also mentions the law of diminishing returns and increasing competition. I agree and disagree. I don’t invest in fashion, in that industry I believe that strength is almost always the harbinger of coming weakness. However, economies of scale, network effects, high switching costs, barriers to entry, and regulatory capture can be powerful forces in certain circumstances. I think growth investing can be challenging, but I may be a bit more “pro growth” than Graham. Graham does state, “we must start with the emphatic but rather obvious assertion that the investor who can successfully identify such “growth companies” when their shares are available at reasonable prices is certain to do superlatively well with his capital” (Pg. 368). The difficult part is correctly identifying the growth companies and paying a reasonable price for them.
In response to Question 7 Tonkikh wrote:
Graham’s view: Quantitative earnings figures must be supplemented by qualitative business analysis. Even many years of stable financial results do not guarantee their continuation. An analyst needs to understand the nature of the business, its competitive position, and the reasons behind changes in earnings to assess the sustainability of its earning power.
The problem with historical averages is that they conceal trends and changes in the nature of the business. A company that earns money differently today than it did at the beginning of the period may end up with an “average” earnings figure that represents neither its past nor its future.
Our view: We believe that changes in a company’s operations are ultimately reflected in its financial indicators. Qualitative characteristics are difficult to measure and verify objectively, so interpreting them carries the risk of seeing causes and advantages that do not actually exist.
We do not reject qualitative analysis, but we believe it carries the risk of subjective interpretation. Quantitative indicators are recorded in financial statements and can be verified, so we give them priority in investment decisions.
We would rather miss a real advantage than see one that does not exist.
Week 4 assignment is to read the following and answer the questions below:
Security Analysis Chapters 42, 43, 44, 45 (starting at Comparisons of Balance Sheets over A Period of Time, pg. 598 in the 6th edition), 49, 50, 51 and 52
Question 1. What are the useful features of using book value as a valuation metric? What are its limitations?
Question 2. When does Graham believe book value to be of practical use to the security analyst? What do you think about that in the modern context?
Question 3. Describe how Graham approaches calculating a company’s liquidation value
Question 4. Perform Graham’s liquidation analysis for two stocks trading below tangible book value and show all work/assumptions
Question 5. What are some ways in which you can lose money by investing in a stock below its liquidation value?
Question 6. What is the importance of management when considering stocks that are selling below their liquidation value?
Question 7. Can you find a company that is currently trading at a sufficiently large discount to its liquidation value that if Graham were looking at it today, he would find it an attractive investment? If you can, show your work for why it’s attractive and justify your assumptions.
Question 8. How does Graham suggest we approach comparing companies in the same field? What are some limitations/pitfalls of such comparisons?
Question 9. How does Graham suggest we go about uncovering investment opportunities? How would you adapt his approach to the current environment?
Question 10. Where is Graham’s approach located on the different “dimensions” of an investment style? Try to find as many dimensions as you can and think about where Graham is on each. Use a scale of 1 to 10 and indicate what each extreme means for each dimension. Then think about where you would like to be on each (and why). If you need inspiration for dimensions, read this article.
Question 11. What is your overall assessment of Graham’s investment approach? Which aspects of it would you like to incorporate into your own? What changes do you want to make? Why? Q
Question 12. Find one security of any kind that you think that Graham would conclude currently has a large margin of safety based on his approach outlined in Security Analysis. Please provide a brief qualitative and quantitative analysis supporting your view that Graham would be proud of.
Now it’s your turn:
Submit your answers in the comments below this article with all your answers in a single comment. I will engage with some of the answers each week and highlight some of the ones I find most insightful in next week’s seminar assignment article. Please submit your answers by the evening of Thursday, November 5th.
Engage with the answers of some of your fellow seminar members in the comments below. Remember – the goal is to learn together. Be kind, be respectful and try to add to our learning as a community.
Feel free to ask any questions about the reading in your comment.
Until next week,
Gary
About the author
Gary Mishuris, CFA is the Managing Partner and Chief Investment Officer of Silver Ring Value Partners, an investment firm that seeks to apply its intrinsic value approach to safely compound capital over the long-term. He also teaches the Value Investing Seminar at the F.W. Olin Graduate School of Business.