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Perishable Thoughts —
Stock-Market Fundamentals

Jim Prevor’s Perishable Pundit, October 15, 2008

With the fluctuations in the stock market, one could do much worse than to pull out what every investor should have: A dog-eared copy of Security Analysis Sixth Edition, Foreword by Warren Buffett (Security Analysis Prior Editions). Here is what Warren Buffet had to say about the book:

It is rare that the founder of a discipline does not find his work eclipsed in rather short order by successors. But for over forty years after publication of the book [”Security Analysis”] that brought structure and logic to a disorderly and confused activity, it is difficult to think of possible candidates for even the runner-up position in the field of security analysis.

The book was written by Benjamin Graham and David Dodd. But the book that Buffett reserves his highest praise for is The Intelligent Investor by Benjamin Graham, which Buffett declared to be “the best book about investing ever written.” Buffett’s admiration for Graham is so substantial he named his son, Howard Graham Buffett after his teacher. Both books are filled with intriguing quotes, but we thought this one was a good one to look at today:

“The investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizable declines nor become excited by sizable advances. He should always remember that market quotations are there for his convenience, either to be taken advantage of or to be ignored.”

Benjamin Graham
The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel (Revised Edition)

You can see the text here.

Warren Buffett frequently repeats an allegory taught to him by Benjamin Graham that tells the story of Mr. Market. The idea is that every single business day, Mr. Market knocks on the door and offers a price for one’s shares of stock. He will buy or sell. Sometimes his offer strikes one as fair, other times excessive and other times ridiculously low. But one is free to accept his offer, reject his offer or ignore the man. He still comes back the next day with another offer.

The point of the story is that things — including shares of stock that represent a proportional ownership in a business — have an intrinsic value. Mr. Market can be irrational but that doesn’t change the value of the underlying business. So if the market is irrational on the low side, one can choose to load up and buy shares; if the market is irrational on the high side, one can elect to sell — or one can do what Buffett mostly does — just hold onto shares in good companies and not worry about the gyrations of the market.

In one version of this parable that Warren Buffett has repeated, it is suggested that one consider oneself the owner of candy store with an irrational partner. One day the city is digging up the street and so there is no business. The partner gets depressed and offers to sell his shares for a song or buy yours for the same pittance. A week later a bus filled with school children breaks down in front of the candy store and business booms. The irrational partner offers to buy or sell at a very high price. Once again, one can take advantage of the irrational partner’s depression, take advantage of his mania or ignore him all together.

Although there is an academic disagreement over whether Graham & Dodd’s approach makes sense or whether, as Modern Portfolio Theory proclaims, it is impossible for investors to outwit the market and so investors such as Warren Buffett are simply Triple Sigma Events — incidences that defy probability — we have both come to appreciate the truth of Graham & Dodd and its irrelevance to most people most of the time.

The kind of fundamental analysis Graham & Dodd propose and that Warren Buffett endorses is the only sensible kind of investing. Technical analysis and things such as this are mysticism.

The problem is that the prerequisite for Graham & Dodd is having money one doesn’t need. In other words, the only way people can “neither be concerned by sizable declines nor become excited by sizable advances,” as Graham urges, is if this is money set aside for some future generation.

We have all been trained by recent experience to “buy on dips,” but statistics are a funny thing and even if we know that “one day” this Graham & Dodd value will be recognized and a share price will rebound, we certainly have no way of knowing if that will be in time for the next tuition payment or to pay for a daughter’s wedding or quickly enough to pay for one’s retirement.

One of the things that has happened is that many people have come to believe they should be able to make a living off their investments. We think this is a fairly new phenomenon. Yes there were always “coupon clippers” who lived off the interest of their bonds, but these were either people of enormous means who generated substantial incomes from large portfolios or modest-living pensioners making due on a pension and fixed income.

Today there are plenty of twenty-somethings who set out to make a living day-trading. Because these people have inadequate capital to make a living, they try to use leverage. Margin debt is the most obvious. Many, though, trade various options and, if they write these instruments, unless they carefully hedge every position they may be, in effect, using leverage.

This is significant because our Intelligent Investor quote becomes irrelevant if one is on margin. Now one cannot be indifferent to the stock price. If it drops, the broker will sell you out and leave you with no stock and, quite possibly, no money.

One reason the stock market is a risky place today is even if one is not using leverage, one can’t be sure that the companies one is buying are not.

We read here that the mighty, AAA-rated General Electric has about $90 billion in commercial paper outstanding. Commercial paper is short-term debt issued by companies.

Yet General Electric has no business that requires it to raise a lot of short-term debt. It did so because that was the cheapest source of funds. In effect, what General Electric was doing was borrowing short and lending long by, say, buying aircraft to lease to airlines for 30 years.

Doing this, though, put General Electric at the mercy of the markets. All that had to happen was for investors to say that, “No, we don’t want your paper. Please give us back our money.” All the sudden, GE could find itself without liquidity and thus unable to pay its debts.

Now the solution is obvious and makes us think that the secular case for stocks may be weak for some time to come.

General Electric needs to raise equity. Now it did that by selling $3 billion in Preferred Stock to Warren Buffett’s Berkshire Hathaway and raised another $15 billion in common stock sales. It also stopped buying back shares and cut its dividend by 10%.

One could suggest that General Electric could avoid delay, do a rights issue with its shareholders and raise $100 billion to get out of the commercial paper market all together. The obvious objection is this would cause hardship for current shareholders who would either have to come up with more money or be diluted out of their holdings.

There is, however, another issue that speaks more to the future. If GE needs to deleverage — and here we use GE as an example as it will be true of almost all companies — the company will provide a significantly lower return on equity than it has in the recent past.

Right now trailing twelve-month earnings for GE are running at $2.15 a share. The company has a stock market capitalization of a bit over $200 billion and shares closed Tuesday night at $20.85. If the shareholders pitched in $100 billion, thus getting GE out of the commercial paper market, the company’s earnings would barely improve since GE was probably paying only very low interest on this commercial paper. So the company would have the same earnings but much more equity. If it sells preferred to Buffett and pays a 10% dividend, as it did, its cash flow will go down since it was not paying 10% interest on commercial paper.

So we have three big factors that will restrain stock markets: First, companies need to deleverage so every time stocks pop up and things look a bit brighter, they will try to sell stock. Second, a big prop under the market has been company buy-backs. Firms that need to deleverage won’t buy back stock. Many, such as GE, paid much higher prices to buy back stock over the past several years than they just sold stock for this week. This will sour boards on buy-backs for a time. Third, the newly recapitalized companies will not put the new capital to work at very profitable ventures but will, instead, replace very inexpensive debt.

Of course, the stability brought about by this recapitalization will allow Graham & Dodd to work again. If we go back to our quote we see the main points:

“Investor” — This is neither a ”get-rich-quick” scheme nor a substitute for having a job or income.

“Portfolio of sound stocks” — Use fundamental analysis to determine you own quality companies.

“Expect their prices to fluctuate” — Remember Mr. Market is there to serve you. You own a piece of a business… if you believe that business is sound and management is both wise and honest, then the wild fluctuations in market price tell you more about markets than your investment.

The key is to put oneself in a position so that the gyrations of the market don’t matter. Then one can invest by identifying opportunities and waiting for the world to see them as well.


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