Book of Value
Book of Value

Book of Value

Graham and Dodd offered several criteria for evaluating bonds and stocks, developing along the way not just an analytical approach but also an outline of the psychological apparatus necessary for investing rationally. (LocationĀ 223)

He went a step further by formalizing the idea that the worth, or investment value, of a stock was the present value of future dividends (broadly conceived) and its eventual selling price. In doing so, Williams put the emphasis on future earnings and dividends and, therefore, on the ability of the underlying business to continue delivering profits and growth. (LocationĀ 227)

Clearly, Graham was a strong proponent of seeking and organizing information, and, as evident in Security Analysis, he was among the first to insist on mathematical logic in investment analysis. (LocationĀ 413)

Yet, investing is not a natural science, and the data that physicists and their kin work with are not characterized by the deep endogeneity that pervades the behavioral data implicit in financial models; we know that prices are recursively related to investor behavior. (LocationĀ 428)

In this book, I strive to bring investors back to investing and to revive the study of investments in the spirit of Graham and Williams, with a nod to Buffett and the many other brilliant investors who pay no heed to the abstract mathematics found in academic journals. (LocationĀ 449)

how to understand investing with the focus back on psychology and institutionsā€”to build portfolios one stock at a timeā€” (LocationĀ 456)

Countless more dollars whiplash the system in bonds, commodities, options, and futures. (LocationĀ 463)

research shows that many individual investors lose money because, perhaps disoriented by churn and noise in the markets, they trade too much. (LocationĀ 464)

Doing so means making connections between actions now and consequences later, in venues (the markets) that are incredibly complex and volatile. Itā€™s easy to make mistakes in investing, in other words, and those mistakes can be costly. (LocationĀ 466)

Many are seduced into believing that they can make an easy buck with a quick buy here and a hasty sell there. (LocationĀ 478)

skilled efforts to solve the fundamental problem of choice that investing presents. (LocationĀ 482)

Successful investing is more involved than meets the eye; more than anything, it requires adequate defenses against some very powerful internal and external obstacles to making good choices. (LocationĀ 485)

Over time and through trial and error, investors need to develop their own system of thinking to help sort information, focus attention, and provide consistency to decision making. (LocationĀ 492)

whereas those who are inclined to be cautious may be partial to slower analytical approaches. (LocationĀ 497)

Benjamin Graham, having learned caution from early setbacks, developed an intellectual approach and numerical benchmarks to carefully uncover undervalued stocks and bonds. (LocationĀ 501)

Philip Fisher used a systematic qualitative approach to evaluate future prospects of technology companies. (LocationĀ 503)

Successful investors essentially reap rewards for properly defining and solving the problem of investing in ways that are consistent with their own temperaments and the analytical skills they bring to the task. (LocationĀ 509)

That is, instead of focusing on the problem of chance, I recast investing as a problem of choice that requires judgments about the key uncertainties that may surround an investment prospect. (LocationĀ 524)

I look to the fundamental drivers of economic worth. Such a shift in orientation expands the investment horizon and encourages thoughtful commitments of capital to economically attractive opportunities. (LocationĀ 527)

As such, they both require making assessments about the odds; understanding the underlying math is essential in either case. (LocationĀ 529)

Typically, gamblers depend a great deal on luck. (LocationĀ 533)

The math of marginal odds is such that they require a very large volume of transactions for the endeavor to be profitable. (LocationĀ 534)

The math for such endeavors quickly becomes complex, and that is perhaps why mathematical finance has been so ascendant ever since the mathematicians, fascinated by the problem of chance, turned their attention to the financial markets. (LocationĀ 536)

as they prefer high odds of success that can deliver performance with just a few well-researched positions. (LocationĀ 538)

To the extent possible, investors work diligently to try to reduce reliance on luck and focus instead on the skills necessary for understanding the important drivers of economic performance and worth. (LocationĀ 540)

investors want to make good choices. Gamblers want to trade; investors want to invest. (LocationĀ 543)

But what is even more important is the ability to regulate emotions, think independently, and see clearly when making investment choices. (LocationĀ 545)

who have long wrestled with the problem of how we humans think and how we find our way through the perplexing world in which we live. (LocationĀ 554)

History books are filled with examples of highly intelligent people holding beliefs that in hindsight appear to be patently ridiculous. (LocationĀ 590)

In fact, whole fields of scientists, presumably some of the most educated in society, have often clung to a theory despite the existence of rapidly developing evidence to the contrary. (LocationĀ 595)

Beliefs have a tenacious hold on people, who often stubbornly resist even the most compelling counterevidence. It is now well understood that people with well-formed beliefs distort the selection, evaluation, and interpretation of data so as to justify their views. (LocationĀ 599)

Researchers have found that jurors often form initial impressions during or even before a trial begins, based on superficial cues such as the defendantā€™s demeanor. (LocationĀ 609)

This tendency to quickly form opinions based on only readily available information, and then to selectively seek and creatively use subsequent information to support initial opinions, is called the primacy effect. (LocationĀ 617)

The primacy effect, belief persistence, and confirmation bias strongly influence what choices we make and how we make them. (LocationĀ 620)

For investors whose success depends on making good choices about where to invest their money and where not to do so, such psychological hindrances can be costly. (LocationĀ 623)

When caught in a confirmation cycle, lightly held beliefs and opinions that are legitimately grounded in some verifiable facts may become much stronger than is warranted. (LocationĀ 627)

Researchers have argued that self-deception is all too common among investors and makes them vulnerable to predatory exploitation by shrewd firms and institutions. (LocationĀ 634)

In addition to belief persistence and confirmation bias, there is a tendency for people to be overconfident about their own abilities and to be too optimistic about the outcomes of their actions. (LocationĀ 653)

My intent is to highlight that the utility-maximizing rational investor is a caricature of theory; perfect rationality, even if we know what that means, holds only for normative models. (LocationĀ 657)

The sooner we acknowledge that we are biologically and psychologically predisposed to make poor choices, and that markets are more unpredictable than they are efficient, the better able we will be to accommodate our vulnerabilities when making investments and building investment programs. (LocationĀ 660)

Clearly, the euphoria and panic of the first decade of the century were not without precedence. Yet, unlike many others that are usually confined to a region, this particular upheaval was global. Instant news and rapid globalization had so connected the markets globally that what previously would have been somewhat contained now quickly spread throughout the world. (LocationĀ 684)

In order to understand what happens in the financial markets, therefore, it is instructive to look to the larger human experiences in which we, the people, participate through mass actions. Below, I briefly discuss two examples of mass follies (LocationĀ 708)

Then, in 1972, a cardiologist named Robert Atkins published a controversial book, challenging the prevailing wisdom that a low-fat diet was necessary for shedding excess weight. (LocationĀ 726)

Around 2001, almost 30 years after the publication of Dr. Atkinsā€™s first book, interest in low-carbohydrate diets began to grow for no discernable reason. (LocationĀ 737)

Prospering in this environment was, of course, Atkins Nutritionals, the company that Dr. Atkins had founded in 1989 to promote his theories. (LocationĀ 753)

For 600 years, those present seemed to feel that the rest of Europe had remained ungrateful for Prince Lazarā€™s ultimate sacrifice. (LocationĀ 800)

One is about butter, the other about guns. (LocationĀ 825)

Most dieters could not quite have grasped the science of dieting and the complexities of how different foods interact with the chemistry of the body. (LocationĀ 831)

Though extreme, the Atkins craze and the Balkan brutality are examples of behavior that is all too common in human affairs. (LocationĀ 840)

Human experience is social experience; people think alike and act alike in a wide range of social endeavors. Why should markets be any different? (LocationĀ 847)

The script that told us mortgage bonds were safe because homeowners wouldnā€™t default on their most significant investment helped fuel the housing bubble, the effects of which weā€™re still feeling years after it burst. (LocationĀ 853)

Those models derive from a fundamental script about price formation that runs through the economics profession: the efficient markets hypothesis. (LocationĀ 864)

Market efficiency, for instance, is a term of choice imposed by mathematically inclined financial economists and by operations researchers whose main preoccupation appears to be with optimizing physical systems; (LocationĀ 869)

Given the unpredictable ways in which people behave in different spheres, financial markets are perhaps more visceral than efficient. (LocationĀ 874)

Academic journals are highly skeptical of claims of markets not being efficient. (LocationĀ 885)

First, however, we must grasp how the inclination of people to herd and, by implication, of investors to get caught up in speculative manias, has been understood through history. (LocationĀ 888)

The big secret of modern societies is that armies of operators make a living using our habits and ways of thinking to influence what we believe, to shape which products and services we consume, which choices we make in local and national elections, which causes we choose to support and oppose, and where we look to invest. (LocationĀ 895)

We will learn that the practice of the dark arts is through the medium of language and symbols, through the clever use of words and images to focus our attention on some issues over others and then to integrate the message with our natural subconscious tendencies. Letā€™s start at the beginning. (LocationĀ 905)

They were skilled at arguing both sides of an issue. For this, many saw them as amoral, nihilist, and obstructionist, and accused them of using clever rhetoric to muddy the facts and lead people away from truth. (LocationĀ 916)

Sophists made a living instructing students on how to use words to produce desired emotions and effects in others. (LocationĀ 919)

Madison Avenue is more than just a street in New York; it is an intellectual home for the vast number of professionals in advertising and public relations everywhere. (LocationĀ 974)

The rapid rise of financial news media in the last few decades has brought Madison Avenue lock, stock, and barrel into the world of finance. (LocationĀ 978)

So, letā€™s turn to understanding how the techniques of mass suasion have developed over the last century in order to illuminate how and why investors are vulnerable to acting against their own interests, and what they can do about it. (LocationĀ 985)

Reminiscent of how the classical Romans saw them, crowds were seen as beasts that, if left unchecked, could destroy everything in their path, including the very institutions that made civilized social life possible. (LocationĀ 1013)

He was (and remains) a highly controversial figure and was rightly accused of being an elitist and a bigot because of his open contempt for all non-elites. (LocationĀ 1020)

Social controls restrained the animal within all humans, he argued. When in a crowd, however, humans become mad as their beastly impulses break through. (LocationĀ 1026)

A crowd needs affirmation of vaguely felt aspirations, for someone to give form to formless ideas and to stabilize those unconsciously fleeting images that torture peopleā€™s minds. Affirmation (LocationĀ 1048)

Bernays carried many of Le Bonā€™s ideas into politics and business in the United States; he was the one to coin the term ā€œpublic relationsā€ and was instrumental in developing the field through the mid-twentieth century. (LocationĀ 1070)

Bernays noted the immense success of the techniques of mass manipulation, such as that of the Committee on Public Information set up by the Wilson administration to gain support for Americaā€™s entry into World War I. (LocationĀ 1082)

The methods he had pioneered and used were now widely applied in politics, business, and elsewhere. (LocationĀ 1103)

To an average person, all this validated the suspicion that there was more to advertising than met the eye; it was a frightening thought that the seemingly free choices were not free after all. (LocationĀ 1145)

To that end, letā€™s say that you factor in nutrition, quantity, taste, aroma, color, presentation, and perhaps other considerations like with whom you eat and the environment in which you dine, and things such as service and comfort. (LocationĀ 1177)

Especially at high levels of intensity, these factors make us behave in a manner that is not in our own long-term interest, even though we know at the time that our immediate actions are not good for us in the long run. (LocationĀ 1185)

Perhaps the most well known of recent Ponzi schemes is the one operated by Bernie Madoff. Unlike the usual victims of such schemes who are poor, elderly, and uneducated, those whom Madoff swindled were wealthy and financially sophisticated: hedge fund managers, royalty in Europe, and affluent retirees. They all fell victim to an elaborate ruse. (LocationĀ 1221)

Reading through the SECā€™s website is sobering if for no other reason than seeing the frequency with which people in search of high returns are manipulated by unscrupulous operators. Even though the SEC was asleep at the wheel while Madoff built his fraudulent empire, the cases they do bring to light reveal the dangers we face from those who prey on our vulnerabilities. (LocationĀ 1236)

According to the FTC analysis, the most common tactic used by fraudsters is ā€œphantom fixation,ā€ which involves creating a phantom reward and telling oneā€™s marks that they have won something big. (LocationĀ 1251)

The second psychological tactic used by fraudsters is to create a perception of scarcity: insisting that the deal of a lifetime is available only for a limited time. The psychological trick here is to make the mark feel rushed, again inhibiting the ability to logically evaluate the veracity of the offer. (LocationĀ 1254)

The third psychological tactic used by fraudsters is to gain credibility in some way. As Le Bon long ago noted, prestige impresses people. (LocationĀ 1257)

The comparison may be genuine but is more likely to be fake, and fraudsters use it to create the impression that their offer is much better than anything else the mark could get. (LocationĀ 1260)

The fifth psychological tactic used by fraudsters is to create imaginary social proof by strongly hinting that there are lots of other people already buying the opportunity or waiting for a chance to buy (LocationĀ 1263)

Source credibility and phantom fixation were, for example, most common in investment frauds, although social proof and scarcity also played a role. (LocationĀ 1267)

Fraudsters often take advantage of our inclinations to trust others and take things at face value. This trust instinct is, of course, important for living a stable and happy life, but it is one that unscrupulous operators deftly exploit. (LocationĀ 1269)

Get on board now, they say, because the train is leaving the station; this a limited-time opportunity; this house will be snapped up, so buy now. (LocationĀ 1277)

Aside from direct one-on-one fraud operations against them, people also lose money because they are swayed on a large scale to make poor choices. (LocationĀ 1280)

theyā€™ve shown that investors have a strong desire to avoid regret, which leads them to sell their winners too (LocationĀ 1287)

soon but hold on to losers too long. (LocationĀ 1288)

in one study, their returns were lowered by as much as 7 percent per year compared with what they could have attained by simply purchasing a market index. (LocationĀ 1290)

IN THIS CHAPTER, I briefly review four thinkers who wrestled with and clarified the process with which to separate truth from falsehood. You may wonder why I am continuing with, even belaboring, abstract philosophy when this book is really about the very practical problem of investing wisely. Bear with me. (LocationĀ 1309)

By understanding how people over the centuries have tried to separate fact from illusion, investors can develop the mental processes necessary for separating genuine investment opportunities from those that only seem to be so. (LocationĀ 1313)

(1) terms that represent something, such as ā€œtreeā€ or ā€œstock,ā€ but donā€™t by themselves indicate right or wrong; (LocationĀ 1329)

(2) a major premise and a minor premise; (LocationĀ 1330)

(3) an inference that necessarily follows from a logical combination of the (LocationĀ 1330)

term with major and minor premises. (LocationĀ 1330)

Syllogism was also crucial to how Descartes developed his method. Calling his method deductive reasoning, Descartes extended Aristotleā€™s argument that a conclusion is valid if it necessarily follows from a set of two or more premises. That is, deductive reasoning involves drawing a conclusion based on a combination of existing statements that we take to be true. (LocationĀ 1338)

ā€œThose who simply assert the laws of nature do great injury to science and philosophy,ā€ Bacon wrote in the preface to the book. (LocationĀ 1361)

Once people adopt an opinion, they are drawn to all evidence that supports and agrees with that opinion, and they despise that which is contrary to their opinion. (LocationĀ 1369)

The only way to prevent such limitations from corrupting the scientific enterprise is to develop sound methods that systematically attend to them. (LocationĀ 1377)

Instead of ignoring the world around us, we need to develop methods to make sure that our data are not corrupt. A robust, data-driven method is the key. (LocationĀ 1384)

Wholly empirical, the Baconian (or scientific) method was different from deductive reasoning, which it sought to supplant. (LocationĀ 1388)

Yet, inductive reasoning, too, has drawn a strong contingent of skeptics who oppose it on two grounds. (LocationĀ 1393)

If there have been no devastating accidents in the nuclear arsenal of the American military, can we be sure that there will be no such accidents in the future, or even in the very next moment? (LocationĀ 1397)

The more white swans the Europeans saw over the centuries, the stronger became their taken-for-granted assumption that swans were of no other color. Yet, as is now widely reported, a Dutch explorer eventually discovered the black swan in the southern hemisphere. (LocationĀ 1399)

If stock prices have generally gone up in the long run, does it mean that they will always go up? Could past occurrences be the exception to the rule, not a reflection of future events? (LocationĀ 1404)

Reminiscent of Aristotleā€™s desire for separating good reasoning from false argumentation, Popper was concerned with ā€œdistinguishing between a genuinely empirical method and a nonempirical or even a pseudo-empirical methodā€”that is to say, a method which, although it appeals to observation and experiment, nevertheless does not come up to scientific standards.ā€4 (LocationĀ 1411)

To Popper, this was a grave problem: How do you distinguish claims based on legitimate empirical methods from those that may be corrupted by our many human frailties? (LocationĀ 1424)

What distinguishes science from nonscience, Popper reasoned, is not simply that one is empirical and the other not. The real difference is that we must clearly express scientific knowledge so that we may empirically falsify it. We must be able to take the risk of disconfirming our knowledge. The emphasis is still on observation and data, but the shift is in what to do with those data. (LocationĀ 1429)

The reason that psychoanalysis is not science, Popper wrote, is that therapists use data gathered during clinical sessions to apply or verify, rather than falsify, the basic premises of psychoanalysis. (LocationĀ 1433)

By insisting on falsification, Popper also made truth inaccessible. You can never be sure about the truth of a situation. (LocationĀ 1436)

All scientific laws or ā€œtruthsā€ are subject to the risk of disconfirmation, in other words, and all scientific knowledge is tentative by its very nature. (LocationĀ 1438)

Through the labors of a long line of thinkers, we now understand that good decisions require the careful application of logic, data, and doubt. (LocationĀ 1440)

Logic and data best serve the path to knowledge when we use them not to confirm but to challenge our beliefs. (LocationĀ 1442)

challenges or negates what we think we already know. Systematic empirical skepticism, or falsification, incorporates both careful logic and good data. (LocationĀ 1444)

As investors, we must take heed. (LocationĀ 1447)

I show how to set up an investment hunch as a thesis and how to then try to cast doubt on that thesis using both quantitative and qualitative data. (LocationĀ 1448)

IN SECURITY ANALYSIS, Benjamin Graham and David Dodd discuss the psychological problems of investment analysis, problems that become daunting because of the array of confusing cues emanating from the churn of the markets and the noisy coverage of the media. (LocationĀ 1454)

For instance, when discussing the principles of bond selection, the authors emphasize that bond selection is a negative art because, given the limited upside, losses can be costly without the corresponding potential for high gain. (LocationĀ 1458)

because the hope of gain intensifies confirmation bias, easily leading investors to throw caution to the wind and behave like speculators. (LocationĀ 1460)

Of course, data can be faulty and misleading, but a good analyst should have the skills to detect faults in the reported information. Investors must learn to make decisions based not on conjectures and vague premises but on guarded judgments grounded in good data. (LocationĀ 1466)

Instead of trying to verify that a given investment is good or bad, as we may be inclined to believe from hearsay, half-truths, and initial impressions, we must use sound, data-driven judgments to sort through to the core truths about an investment candidate. (LocationĀ 1470)

Disconfirmation is key, method is king, and a conservative orientation is indispensable for investing wisely. (LocationĀ 1472)

Graham wanted to solve the age-old problem of trying to make a buck without being run over by the herd; (LocationĀ 1480)

Popper used falsification as a line of demarcation between science and nonscience, arguing that while knowledge comes in many forms, scientific knowledge demands testability and empirical falsification. Similarly, (LocationĀ 1484)

Investments are opportunities that risk being rejected because they may not live up to specific criteria. (LocationĀ 1487)

they may be justified in one way or another, but they cannot formally be set up for refutation. (LocationĀ 1488)

Popperā€™s falsification is but one example of the larger principle of negation that has been a consistent theme in Western thought. (LocationĀ 1495)

rejecting an investment thesis on a single observation is naĆÆve. Instead, disconfirmation is a process that formalizes (LocationĀ 1502)

If it turns out, for instance, that the firm under consideration has low profitability or high financial leverage, these factors are not by themselves sufficient reasons to refute the investment thesis. (LocationĀ 1504)

It is important not to lose sight of the overall picture when applying this approach. (LocationĀ 1514)

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we have seen, the falsification framework exhorts investors to exercise disciplined skepticism that, when backed by sound logic and suitable data, seeks to disconfirm entrenched beliefs that could distort thought and corrupt analysisā€”forcing unforced investment errors. As a method rooted in the principle of negation, falsification encourages a cautious frame of mind with which to evaluate an investment thesis and see if the underlying idea is worthy of confident commitments of capital. (LocationĀ 1539)

Wise investing requires, in fact, a two-step mental process: (1) generating investment ideas; and (2) sorting good ideas from bad ones. (LocationĀ 1543)

In practice, falsification as he conceived it is too strong an instrument to apply to ideas in their infancy. (LocationĀ 1556)

cannot articulate it, is the fountain of creative thought. As students of investing, we must understand this inner world of discovery so that we may learn to nurture and shape the best ideas emerging from such a fountain into credible investment thesesā€”which we may then evaluate using the formal method of empirical skepticism. (LocationĀ 1561)

Direct awareness and the fringe sit atop deep layers of the unconscious, the incredible machinery of the brain of which we have no conscious awareness. Yet, the unconscious is strongly implicated in how we perceive and relate to the world around us. Both the fringe and the unconscious have strong bearing on focal awareness, on what we see and how we see it. (LocationĀ 1575)

With this background, letā€™s review how investors can bring creativity to the investment process. Actively seeking new ideas requires that we avoid rigidly fixating on just a few facts, instead fluidly scanning both focal and peripheral facts and being aware that some facts will remain outside our conscious awareness. (LocationĀ 1596)

Idea generation, furthermore, is not simply a dry analytical skill but invokes a sense of aesthetics, an artistic flair for making connections and generalizations, for fluidly moving between the abstract and the concrete, between theory and data, in ways that allow fresh insights into the seemingly mundane. (LocationĀ 1602)

At its most advanced level, creatively developing fresh insights about investment prospects requires mentally exploring patterns, combining them with other patterns or disaggregating them, and conceptually juggling ideas. (LocationĀ 1606)

This ability of the mind to shift or ā€œslipā€ between different, similar, and the same, allows generalizations and pattern sensitivity. (LocationĀ 1611)

the patterns that take shape may themselves be imaginary or incorrectly track a reality that ought to be grounding the investment process. (LocationĀ 1628)

Unlike the concrete figure in that example, however, the problem becomes more acute when the object of imagination is an idea or concept not directly in contact with any of our five senses. (LocationĀ 1630)

And on the other hand are the in-built biases, peculiarities, and breakdowns of mental processes. Our mental machinery is powerful but prone to serious error. (LocationĀ 1633)

Limitless wandering of the mind does not necessarily mean limitless possibilities. Uncontrolled slippage from idea to idea has the (LocationĀ 1638)

Hence, itā€™s important to control the idea-generation process by establishing a context or theme in which to contain our mental wanderings. Such containment does not have to be within airtight boundaries, as reaching elsewhere to make associations remains important, but some broad limits to wandering are necessary. (LocationĀ 1640)

We may think, for example, that the spectacular historical record of a company makes it a good investment candidate and resist changing that view even though the competitive landscape has significantly changed. (LocationĀ 1652)

investors must try to systematically leverage priming effects and avoid extreme fixedness or extreme slippage. This requires setting the conceptual context for one or more closely related investment themes, loosely defining the boundaries within which to explore those themes, and then using priming and analogy to critically evaluate central facts that define the (LocationĀ 1655)

must guide idea generation to channel the mind toward high-potential pathways. (LocationĀ 1664)

You may choose to be experimental and aggressive, or you may choose to act more defensively. (LocationĀ 1672)

itā€™s helpful to have a realistically skeptical and defensive orientation when moving on a pathway of ideas. (LocationĀ 1675)

Uncovering interesting and nonobvious patterns in the data, and the dynamics within those patterns, is what separates great investors from those who are merely good. (LocationĀ 1683)

Unlike football, investing involves a great variety of players acting out their hopes and fears in an abstract space and with much ambiguity about the rules. (LocationĀ 1690)

For this, investors require some ability to work with large quantities of data and to sort through multiple lines of narratives. (LocationĀ 1693)

High-level play in any field of endeavor demands strong pattern recognition as the price of entry. Investing is no different. (LocationĀ 1693)

Often, a sound major thesis emerges from mismatches in clearly identified macro patterns, such as those between patterns in supply of and demand for broad categories of products and services or commodities. (LocationĀ 1696)

Although these trends have been visible for some time, financial markets responded with a rapid drop in crude oil prices within a few months, from a high of over $110 per barrel to under $40 per barrel. (LocationĀ 1703)

Depending on how slow or fast the demand and supply patterns shift, mismatches can be imperceptible, except to those who remain deeply connected to the data. (LocationĀ 1715)

For those not paying close attention to the data and actively looking for pattern mismatches, such missed opportunities are perhaps a source of frustration. More committed investors can benefit, however, from staying close to data in their domain of expertise, and looking there for pattern mismatches. (LocationĀ 1719)

large-scale shifts in consumption behaviors, and technological evolution. These forces are complex and dynamic, suggesting that they are amenable not so much to statistical techniques but to good intuitions about trends in the data. (LocationĀ 1723)

Alert investors following such mismatches for pattern disruptions may be able to generate additional theses in areas where they feel competent. (LocationĀ 1731)

Based on these data, I develop the falsifiable investment thesis (Walmart) and try to systematically disconfirm it using both quantitative data and qualitative analysis. (LocationĀ 1736)

New investors often start out with wild, frenzied buying and selling. They are attracted to popular names, impressed by the seemingly infallible expertise of commentators, and fascinated by the thought of striking it rich. (LocationĀ 1747)

But they still chase too many ideas simultaneously and remain enamored of quick winsā€”buying when excited by the prospect of a sure thing and selling when gripped by fear of loss. (LocationĀ 1753)

Intermediate-level investors still donā€™t quite grasp the importance of organized buying and selling to build positions that transcend daily fluctuations in prices and periodic bouts of euphoria or panic. (LocationĀ 1755)

Hence, the most alert investors eventually recognize the importance of sound conceptual frameworks that help decipher the complexities of investing. (LocationĀ 1758)

It is about making sound positional plays such that each trade firms up the foundation of their investment program and sets them up for future investing actions, both deliberate and opportunistic. (LocationĀ 1761)

In order to accomplish this, advanced investors become interested in developing a methodā€”a conceptual frameworkā€”to guide them through the chaos of the financial markets. (LocationĀ 1763)

A large part of investing wisely is to understand and manage the errors that are inevitable when making decisions under uncertainty, as investment choices are apt to be. (LocationĀ 1768)

Hence, good investing requires broadly framing the kinds of errors that investors are likely to make in spite of good analysis. (LocationĀ 1771)

errors of commission and errors of omission. (LocationĀ 1773)

If it so happened that your investment did poorly, your purchase would have been a bad idea. That would put you in cell 2: you thought that the stock at price P was a good investment, but it turned out to be a bad one. (LocationĀ 1777)

You made a false-positive, or Type I, error: incurring an investment (LocationĀ 1786)

loss by mistakenly not disconfirming the thesis that this was a good investment. (LocationĀ 1786)

You made a false-negative, or Type II, error: you disconfirmed what was, in fact, a good investment, and you suffered the regret of not having invested. (LocationĀ 1789)

If you design loose filtering screens (in which the investment thesis is hard to disconfirm), then you increase your chances of committing a Type I error. (LocationĀ 1795)

Loosening the screens will allow more garbage into your investment program; conversely, tightening the filtering screens will squeeze out good opportunities. (LocationĀ 1797)

Reducing the chances of making a Type I error increases the chances of making a Type II error and vice versa. (LocationĀ 1800)

Your orientation toward errors of commission (Type I) or errors of omission (Type II) plays an important role in how you invest. (LocationĀ 1805)

If you find Type II errors acceptable but want to avoid Type I errors at all cost, for example, then your approach to investing is likely to be strongly defense oriented. (LocationĀ 1809)

and not enough on their own analysis of the facts at hand. (LocationĀ 1820)

Together, a focus on the short term and an inclination to copy others go hand in hand with the facts that prices are unpredictable in the near term and markets are incredibly noisy. These are reasons enough for people to succumb to blind imitation and, as a result, engage in gambling and unfettered speculation. (LocationĀ 1842)

The overwhelming noise and inclination to imitate together induce people to herd, perhaps with the thought that others might know something they themselves do not. (LocationĀ 1853)

Not doing careful analysis appears to have become so widespread that people hardly know much about what they trade or own. (LocationĀ 1856)

Fundamentally sound businesses produce good and growing profits over a period of time and, when carefully chosen, have the potential to create great wealth. (LocationĀ 1863)

But good managers and their enduring ability to generate strong returns on invested capital make good companies worth careful scrutiny. (LocationĀ 1865)

As opposed to gambling or speculation, investing requires that investors re-learn the art of looking, of honing in on important facts, and then cobbling together an array of clues into a well-informed thesis about each entry in their investment portfolio. (LocationĀ 1867)

companies, to know what to look for, to know how to dig up useful data, to interpret the data and make guarded judgments from their analysis, and to patiently wait for good results to come over time. (LocationĀ 1874)

they invest on the basis of sound data and analysis, with an eye for what could go wrong. (LocationĀ 1876)

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Investing is the search for divergence between valuation and sentiment and the ability to clearly see such divergence when it does occur. (LocationĀ 1886)

1.Ā Ā Ā Ā Ā Ā Estimates of the economic worth of a stock may be ascertained with a reasonable degree of confidence, although never with precision; Ā Ā Ā Ā Ā Ā Ā Ā Ā 2.Ā Ā Ā Ā Ā Ā Such estimates of economic worth must be made without factoring prevailing price into the equation, so that it may be possible to compare market price directly against worth; and Ā Ā Ā Ā Ā Ā Ā Ā Ā 3.Ā Ā Ā Ā Ā Ā Investors can make estimates of economic worth for some, but not for all, securities. (LocationĀ 1889)

So, you set up a formal thesis that the stock of the company is an attractive investment. (LocationĀ 1904)

If the disconfirmation is not successful, on the other hand, then you accept the thesis tentatively; still, you remain cautious and continue trying to disconfirm the thesis. (LocationĀ 1908)

This very risk of rejection makes it helpful for you to evaluate the investment as a possible opportunity. (LocationĀ 1912)

this process (LocationĀ 1913)

This means that even if you were ultimately to reject the investment thesis, the work you did greatly enhanced your understanding of the factors that contribute to the economic worth of the company you were evaluating. (LocationĀ 1914)

Disconfirmation is possible, on the other hand, for stocks whose approximate intrinsic worth investors can estimate with inputs based on a good understanding of the economics and leadership of the companies in question. (LocationĀ 1924)

That is, stocks whose worth is equated wholly and squarely with the quoted prices are purely speculative in character. (LocationĀ 1931)

model is opaque too complex to clearly articulate. Investible stocks, on the other hand, are those that have enough of a historical record and such information as would help ascertain the (LocationĀ 1933)

Ironically, the same stock could qualify both as a speculation and as an investment. An investible stock is one whose approximate value you may be able to estimate with credible data and analysis but without reliance on the prevailing market prices at which it is selling at a given time. (LocationĀ 1935)

In this scenario, you are an investor evaluating the legitimate opportunity. (LocationĀ 1939)

The ability to make and the very act of making reasonable estimates of economic worth separates investment from speculation. (LocationĀ 1941)

Estimates themselves are shaped by hope, fear, and greed; commentary by television personalities and the plethora of well-written, ā€œfreeā€ advice available in print and on the Internet all have powerful effects on investors trying to make estimates of economic worth.3 (LocationĀ 1943)

As John Burr Williams long ago pointed out in The Theory of Investment Value, economic fundamentals must play a role in pricing. (LocationĀ 1969)

Once robust estimates of economic worth are available, then it is a matter of comparing those with prevailing prices to see if the two are sufficiently divergent to create a possible opportunity to invest profitably. (LocationĀ 1972)

Some see value as a property that is good or desirable, recognizing that value changes with social norms. (LocationĀ 1982)

Others consider value as indicating something that is meaningfully different. (LocationĀ 1983)

As conventionally understood, the investment value of an asset is the net present value (NPV) of expected future cash flows. (LocationĀ 1988)

Since NPV depends on estimates of future flows as well as assumptions about the rate at which they ought to be discounted, worth and value are essentially subjective judgments of the analyst. (LocationĀ 1990)

Yet, subjectivity also means that intrinsic value is inherently unstable. (LocationĀ 1995)

As George Soros once noted, changes in price affect economic worth by way of the operations of the markets.5 For instance, the rising price of a stock increases the issuing companyā€™s debt capacity and also in other ways allows the raising of capital for productive endeavorsā€”which, when managed well, have the effect of raising prospects for stronger cash flows in the future. (LocationĀ 2004)

As prices and values pull each other on an upward trajectory, for instance, the cost of money begins to rise, and the set of productive opportunities begins to shrink, thus putting breaks on expansion. (LocationĀ 2023)

The circular relationship between cause and effect, between value and price, is what makes investing challenging. (LocationĀ 2037)

value is dynamically, if loosely, tethered to price via feedback loops, in normal times rising and falling gently with the ebb and flow of economic and psychological forcesā€”but at times breaking the band, so to say, when prices (LocationĀ 2046)

The power of analysis is in the fact that it forces investors to ground their decisions in the facts of the case, allowing them to control their impulses, to slow down before committing. (LocationĀ 2113)

It is more about maturity and emotional control than about complex mathematics. It is about using assumptions that are consistent with observable facts and are logically defensible. (LocationĀ 2123)

While the DCF technique is theoretically sound, note two shortcomings. First, since the outcome of such analysis is so much a function of assumptions and gut feel, you get widely varying NPV numbers depending on the assumptions. (LocationĀ 2234)

If so, you are mistaking uncertainty for risk, which, as once explained by economist Frank Knight,1 are two distinct concepts. You can quantify and measure risk, but you cannot do so for uncertainty, which indicates unknowns and unknowables. (LocationĀ 2251)

You cannot compute the probabilities for bag B, however, since you know neither the count nor the proportion of red and green balls. (LocationĀ 2258)

If you were an investor, you would reach for bag A because the odds are clear. (LocationĀ 2260)

As a speculator, on the other hand, you might be inclined to choose bag B, perhaps in the spirit of experimentation. (LocationĀ 2264)

That is, you approach bag B cautiously, getting information with each draw, hoping that the true proportions will become evident and be in your favor. (LocationĀ 2266)

Finally, as a gambler, you would favor bag C, where you cannot calculate the odds, but the prospect of drawing +$10 black balls is appealing; the chances of drawing āˆ’$10 white balls brings the excitement that makes the game worthwhile. You donā€™t know the risk but like the uncertainty and the possibility of a big payoff if you were to pick black. So, investors, (LocationĀ 2268)

As an investor, you want to know the risk as precisely as possible and shun situations that are clear gambles. (LocationĀ 2272)

Investment analysis, in other words, is the process of uncovering the odds built into a situation, so that you may commit resources where they are heavily in your favor. (LocationĀ 2281)

In practice, therefore, the statistical measures of risk are measures of how returns have behaved during a window of a few months in the recent past. (LocationĀ 2307)

Think about the odds of getting heads in a coin toss. Most people would place the odds as one in two, since each of the two possibilities appears equally likely. (LocationĀ 2331)

however, those odds assume that the coin is perfectly balanced, which may not be true. (LocationĀ 2332)

In the world of investing, where underlying distributions are unknown, where you form beliefs using inadequate or even missing data, where theories usually live in the dark shadow of confirmation bias, having a rigorous way of subjectively assessing probabilities is more helpful than the vain search for objectivity and precision. (LocationĀ 2344)

Where a keen understanding of the operations and fundamentals is missing, uncertainties remain high and drive down the valuation because of the need to use a high discount rate, as we will see in the next chapter. (LocationĀ 2350)

intrinsic valuation is high because of the justifiably low discount rate. (LocationĀ 2353)

Seeking to derive objective risk using market prices alone undermines the role of judgment in investment analysis, and it diverts resources away from careful analysis of the many business-related issues that are at the heart of making informed judgments. (LocationĀ 2354)

We see that investors rarely if ever face situations as well defined as bag A; (LocationĀ 2357)

In fact, investors typically face situations more like bags B or C and must then work diligently to figure out what is in those bags before committing to draw from them. (LocationĀ 2358)

The key is to form judgments conservatively and to update them in light of new information.7 Rigorous thinking, rather than precision, is the key to investing wisely. (LocationĀ 2363)

More importantly, we need a systematic way of updating our beliefs by seeking and being alert to new information. (LocationĀ 2366)

But simple formulations like these make investors vulnerable to mistakes or outright manipulation, as any formula, by definition, focuses attention on a narrow set of variables and hides broader considerations from view. Such vulnerability is especially likely if people are also prone to apply the formulae without fully understanding the assumptions or limitations in their derivation. (LocationĀ 2380)

But Graham used the formulation to illustrate the foolhardiness of trying to project the future and the rosy scenarios analysts sometimes conjure up to justify lofty valuations. (LocationĀ 2385)

After all, valuing a company requires estimating its projected future earnings and the appropriate rates with which to discount those earnings. (LocationĀ 2388)

As in other fields, the problems in investing exist on a continuum from very simple to incomprehensibly complex. (LocationĀ 2393)

Investors can, however, avoid complex problems and focus on simple ones and only gradually, if at all, move up the ladder of complexity. (LocationĀ 2394)

Instead of gullibility or senseless skepticism, investing requires a sensible middle ground where quantitative and qualitative approaches help guide judgments about economic worth and value. (LocationĀ 2397)

The purpose of analysis is not so much to get a single number indicating value but to grasp the essence of a situation and surface fundamental forces that may be driving economic worth. (LocationĀ 2399)

Assuming that the coupons of this bond are mostly reliable, you set the discount rate for future cash flows at a constant 4 percent. (LocationĀ 2409)

assume it has no maturity. That is, the bond has a perpetual coupon of $50 per year. (LocationĀ 2412)

One, you have no contractual assurance about the stream of future cash. (LocationĀ 2432)

Because of these differences, as an investor in stocks, you not only purchase protected future cash streams but mostly the ability of the company to continue constructing streams above those owed to bondholders. (LocationĀ 2433)

you want to evaluate the worth of their established cash flows beyond those owed to bondholders. (LocationĀ 2436)

future. For somewhat established companies or those in transition, your evaluation must include careful consideration of stable cash flows and those the company credibly promises to construct for future delivery. (LocationĀ 2438)

The discount rate (r) happens to be one of the most intractable problems in finance, and we will work through that in the pages that follow. (LocationĀ 2446)

Is cash dividend the correct quantity to discount? (LocationĀ 2448)

For simplicity, letā€™s assume that the company distributes all its earnings every year and all of these belong to shareholders. For Walmart, annual earnings as of January 2015 were $5.05 per diluted share. Assuming, once again, a perpetual discount rate of 10 percent and perpetual growth of 5 percent per year, we get (LocationĀ 2457)

So, while it may seem a simple mathematical formula, investors must understand the discount model in terms of abilities, prospects, and fundamental uncertainties about future performance. (LocationĀ 2469)

as slight variations in assumptions can make very large differences in the computed value. To see this, consider as above the estimated value of Walmart as $106.05 per shareā€”based on EPS = $5.05, r = 10 percent, and g = 5 percent. (LocationĀ 2474)

This sets up our null thesis as Price (P) = Value (V). That is, instead of assuming that the markets are always or mostly efficient, we set up the claim as a testable base proposition for all our analyses. (LocationĀ 2485)

That is, the earnings yield (EY = EPS/P) equates to a simple algebraic relationship between the discount rate (r) and the perpetual growth rate (g). (LocationĀ 2501)

EPS should be the earning powerā€”or the ability of the company to continue earning at a certain level well into the future. (LocationĀ 2503)

That is, if the company simply sustains the current level of earnings, then its stock is like a bond with a constant but perpetual coupon; the discount rate built into the current price is simply the yield, or the return on current price. (LocationĀ 2511)

How much greater than the implied growth rate should the historical growth rate be to refute the investment thesis that price is significantly below reasonable estimates of intrinsic economic worth? (LocationĀ 2536)

Since the long-term historical growth rate for Walmart in the above illustration is more than twice the implied growth rate, it appears that the market is undervaluing the company in relation to its historical performance. (LocationĀ 2541)

The inability to confidently refute the thesis is grounds for some caution, but we are still far from done. That is because we used an arbitrary discount rate (10 percent) to compute the implied growth rate. The next step is to understand how to home in on a more realistic discount rate, grounded in the specifics of the company in question. (LocationĀ 2545)

discussion that the implied growth rate (g) varies directly with the discount rate (r), (LocationĀ 2549)

When so computed, the discount rate is a direct linear function of market risk (Ī²), or the degree to which share prices vary with the overall market.6 This reliance on market risk assumes that stock prices fully reflect the underlying value of the company. For those interested in CAPM, any standard textbook should provide a detailed explanation of it. In my view, using CAPM (or other market-based formulations such as the multifactor model) to compute discount rates is problematic for two reasons. (LocationĀ 2552)

Using multiples of bond yields as proxy for uncertainties about future performance, although not perfect, has the advantage that the yields reflect independent judgments of the bond market about the uncertainties that the company faces. In other words, this allows us to obtain a perspective from outside the stock market and gives us a semblance of objectivity in our evaluations. (LocationĀ 2602)

We as investors are particularly interested, however, in the story of future cash flows. That is, we want to know what kinds of future cash flow the buyers and sellers are expecting, wittingly or unwittingly, when they choose to transact at prevailing prices. Do the prices reflect realistic assessments of future cash flows or a wild fantasy of people caught up in the moment? Itā€™s possible that prices tell us nothing about future cash flows but a whole lot about the mood of the moment. We need to know this. (LocationĀ 2612)

Doing so may require evaluation not only of a slowing historical growth rate but also some digging into the company to produce fodder for additional tests to update our assessment. (LocationĀ 2624)

Cautious investors should limit their search for investment value to companies that have a sufficient and credible record of operating performance. (LocationĀ 2642)

In the context of the hard sciences, we typically first develop a null hypothesis based on whatever theory (or belief) we may be testing and then go about trying to reject the null using carefully collated data. In investment analysis of the sort we are doing here, every situation is one-off, and we rarely, if ever, have repeat observations when evaluating a single investment. (LocationĀ 2663)

Note that we examine these subtheses after we have already found ourselves unable to refute the main investment thesis using the implied growth rates. (LocationĀ 2671)

First, with the yield tests, we ask whether the company in question is generating sufficient earnings. We try to refute the notion that the immediate return we would receive from following through on the thesis is better than putting our money in the bank or in corporate or treasury bonds, or perhaps in another stock. (LocationĀ 2675)

In particular, we ask, ā€œDoes the stock yield a return that is comparable to fixed investments such as bonds and bills, with which there is little or no uncertainty of getting back your principal?ā€ In other words, we try to refute the following subthesis (ST): (LocationĀ 2684)

A possibly more stable benchmark to use is the composite index of 10-year corporate bonds with a AAA or AA rating, or a very low risk of default. These bonds do not have the backing of the U.S. government but that of issuing corporations, typically among the healthiest financially. Moreover, the basket comprises bonds of not just one but several companies and, therefore, may represent the broader economy. (LocationĀ 2718)

Even though these Walmart 10-year bonds did not get the top rating, they had a lower average yield (3.29 percent) or marginally lower default/downgrade risk than the composite of AA bonds (3.36 percent). So, letā€™s use this information to see if we may be able to refute our subthesis for Walmart at the given price. (LocationĀ 2728)

Both high levels of debt and rapid increases in debt indicate potential problemsā€”unless the company can easily meet the obligations thus arising. (LocationĀ 2852)

we see that Walmart has the ability to pay off all interest-bearing debts in less than four years. (LocationĀ 2889)

In fact, as they grow their assets and equity, such companies only increase their debt capacity and take on more debt in order to fund ongoing operations and strategic activities. (LocationĀ 2892)

A word of caution: The amount of information you will encounter is likely to be overwhelming. You will quickly learn that the big problem of analysis is not the lack of information but too much of it; this information is also likely to be unstructured and unorganized. Itā€™s easy to get lost in the mass of data that companies are required to report, with reporting itself sometimes becoming convoluted and confusing. (LocationĀ 2926)

Just as we have tried to refute the investment thesis on the basis of implied growth, yield, stability, and strength, we are now ready to dive deep inside the company to look for hidden traps and pitfalls. These potential vulnerabilities are mostly qualitative and, although we may use some quantitative markers, evaluating them requires considerable subjective judgment. As is true with most professions that rely on a body of experiential knowledge, only with experience will an investor be able to make such judgments with confidence. But the basic elements of qualitative inquiry can be learned fairly quickly. (LocationĀ 2939)

The skills necessary for the next stage of analysis favor journalists over mathematicians, poets over quants. The objective of the qualitative analysis is to try to cast doubt on the defining narratives of the company. We will try to do so on three broad fronts. (LocationĀ 2949)

In this chapter, I discuss in particular the following items often buried in regulatory filings: (1) operating leases; (2) pension and post-retirement obligations; (3) litigation and lawsuits; (4) off-balance-sheet liabilities; and (LocationĀ 2972)

(5) quality of assets. (LocationĀ 2974)

Alternatively, the company could simply lease the new space from another party that owns the property. In this case, the space does not show up at all on either side of the balance sheet, and the company reports lease payments as periodic operating expenses on the income statement. (LocationĀ 2979)

recently agreed in principle to change the way companies account for operating leases, to require them to explicitly report them as liabilityā€”operating-lease obligationā€”with corresponding assets, on the balance sheet. (LocationĀ 2988)

Investors should look more closely at lawsuits that have the potential to put the company under or perhaps cost several yearsā€™ worth of cash flows. Issues such as conflict with other parties regarding key patents or large-scale fraud can be quite costly, as the resulting losses divert massive amounts of cash away from operations and shareholder-friendly activities. Such large, and sometimes potentially fatal, lawsuits also distract management from the business of running the company. (LocationĀ 3076)

The spread between the interest earned on long-term investments and the cost of short-term borrowed funds created the profits for the principals. This is no different, in principle, from your local bank taking demand deposits from you in exchange for very low interest rates and then turning around to make higher-interest loans for cars and mortgages. (LocationĀ 3109)

Soon enough, unable to sell the assets to generate liquidity, the SIVs started defaulting on their commercial paper. Such defaults set the panic even deeper. In just a few months, for instance, Victoria Finance, a $6 billion SIV managed by Ceres Capital Partners, had their credit rating slashed from AAA to below investment grade. Ceres Capital defaulted later in the year. Many other SIVs on both sides of the Atlantic began winding down or going out of business. (LocationĀ 3135)

liabilities. If the liabilities turn out to be different from what you see in the balance sheet, your ownership stake reduces accordingly. (LocationĀ 3160)

errors on the asset side of the balance sheet carry over to the equity account. (LocationĀ 3162)

In fact, the risks embedded in the assets sometimes become so great that some managers, under pressure to deliver on expectations, may begin to contort data and use deceptions that are virtually impossible for an average investor to catch. (LocationĀ 3181)

To recap: For investors practicing the fine art of investing wisely, a careful scrutiny of the balance sheet and associated risks is an indispensable part of due diligence. (LocationĀ 3202)

business is one that, on average and over time, consumes a dollar to produce a stream of cash that, when appropriately discounted, amounts to something more than a dollar. In evaluating how much to pay for such streams of cash, investors remain fundamentally interested in the ability of a business to make more from less. (LocationĀ 3213)

the metrics used to do so depend on who is measuring what. (LocationĀ 3217)

Do we measure returns to shareholders, returns on the capital deployed, or cash flows? Market returns or accounting measures? (LocationĀ 3220)

In reality, some businesses (e.g., day trading) may require daily measures of trading performance, whereas some others (e.g., large-scale construction projects) may need evaluation over the life of its project or across a business cycle. (LocationĀ 3223)

Bondholders typically want preservation of capital and an assured coupon through maturity. (LocationĀ 3235)

Equity investors should, therefore, cut through the complexities that surround performance measurement and keep their focus on economic performanceā€”on cash flows and the efficiency with which managers deploy the capital entrusted to them. (LocationĀ 3245)

equity. So, return on equity is mathematically equivalent to the product of profitability, asset efficiency, and financial leverage. (LocationĀ 3273)

Return on capital, which indicates the efficiency with which a company deploys capital is, again, simply a product of profitability, asset efficiency, and full financial leverage. (LocationĀ 3283)

Therefore, as discussed in chapter 15, investors should not take ROE at face value but examine closely how it is accomplished and what it might imply about profitability, operating efficiency, and especially debt burden. (LocationĀ 3319)

In fact, following the discount flow model, discussed in chapter 14, we can show that the intrinsic value (IV) of a company relates directly to ROE, along with book value (BV), growth rate (g), and discount rate (r), as follows: (LocationĀ 3324)

This is especially true with regard to the income statement and balance sheet because these follow the complex rules of accrual accounting. The measures of capital efficiency that we have used so far are constructed using variables from the income statement and the balance sheet, and, therefore, they are subject to quite a bit of managerial discretion and possible distortion. (LocationĀ 3336)

Hence, analysis of the statement of cash flows must always accompany income statement analysis. That is, adjustments for noncash revenues and noncash expenses allow us to see how cash flows in and out of the company. (LocationĀ 3375)

For a company in steady state, the CFFO is usually the primary source of cash, and it strongly influences what opportunities the company can pursue without having to raise external financing. (LocationĀ 3382)

What does the company do with operating cash? Skillful uses of operating cash can make a company strong over time; poor uses of this cash can break a good company in short order. (LocationĀ 3385)

Either way, capital expenditures and acquisitions together reflect reinvestments in the company to ensure future financial health. (LocationĀ 3392)

In this manner, some of the operating cash flows into the fixed assets to refresh or expand operations. (LocationĀ 3393)

flows. A thesis for a company that has trouble producing cash from operations may, in contrast, be refuted based on poor future prospects. To put all this in perspective, letā€™s again evaluate Walmart (figure 18.2). (LocationĀ 3410)

Note that operating cash was 74 percent more than reported net income. (LocationĀ 3413)

Note that CapEx is higher than the $9.2 billion depreciation expense during the year. (LocationĀ 3418)

Typically, itā€™s best to do such analysis with three- or five-year averages to avoid basing decisions on performance over just one year. (LocationĀ 3432)

Multiyear averages are more likely to reveal the true underlying economics and avoid aberrations based on short-term fluctuations in circumstances. (LocationĀ 3433)

its revenue and income growth is low to the point of being almost flat. (LocationĀ 3435)

For a skeptical investor trying to refute the investment thesis, these signs of slowing growth and hesitation in committing cash to operations and shareholders are worth noting. (LocationĀ 3437)

we are unable to refute the subthesis that Walmart has good economics. (LocationĀ 3439)

A business model articulates the mechanisms through which the company delivers products and services to make money. It clarifies one or more value propositions that the company aims to deliver to customers and the operating model to deliver those propositions in an economically efficient manner. (LocationĀ 3449)

desirability and distinctiveness. (LocationĀ 3452)

Certain key assumptions undergird the value propositions that define successful business models: they must evolve as a changing world makes those assumptions invalid. The essential premise of the big-box store model is that consumers want selection and low prices, and they will drive great distances for those. (LocationĀ 3507)

This was too little, too late, however. Online commerce had continued unabated in the meantime, and Internet retailers had sharpened their own models as well. (LocationĀ 3539)

Good investment prospects are not just about profit and loss in the short run: (LocationĀ 3553)

strong investment performance comes from businesses that home in on the fundamental problems they must solve for paying customers and then assemble, align, and concentrate resources to address those problems in a systematic way. (LocationĀ 3553)

companies create economic value when they consistently deliver well-articulated value propositions through well-executed operating models. (LocationĀ 3555)

selectively investing in companies that solve significant problems at a sufficiently large scale to make the efforts economically meaningful. (LocationĀ 3556)

companies that suffer low market valuations because of truly dim prospects. That is, a clear understanding of the business model of a company can help refute an investment thesis even if the price looks attractive in quantitative tests. (LocationĀ 3559)

For companies to continue being successful and attractive as investment opportunities, their business models must evolve to keep their products relevant in new environments. (LocationĀ 3563)

In addition, managers resist the disruptions that any overhaul requires, in part because itā€™s hard to let go of the familiar and in part because new directions bring new uncertainties. (LocationĀ 3571)

In some cases, particular investors may understand a business model clearly but also see enough instability and risk to keep them away from the company in question. (LocationĀ 3584)

A business model is best understood as the mechanismā€”value propositions plus combinations of assets, activities, and routinesā€”that consumes resources to produce cash flows greater than the original investment. (LocationĀ 3595)

Such future returns depend on the resilience of the model to sustain or shift its core elements in response to changing circumstances. (LocationĀ 3599)

(1) the value proposition of products in the particular markets where they are sold; (LocationĀ 3600)

(2) the resiliency of the operating capabilities necessary for creating, marketing, and distributing those products. (LocationĀ 3601)

As we saw in the case of Best Buy, however, even successful business models remain vulnerable because changes in the external environment are forever threatening the tight fit between a well-defined value proposition and its corresponding operating model. (LocationĀ 3635)

Itā€™s also possible that the company had determined that the high-margin business had run its course, and it was time now to commit a shift toward a low-marginā€“high-volume economic model. (LocationĀ 3649)

There was clearly an emerging disconnect between the continued emphasis on luxury branding and the operating model moving toward factory stores and discounted pricing. (LocationĀ 3653)

Fast-evolving technologies and rapidly shifting customer preferencesā€”from the instant gratification of buying in store to the convenience of online shopping and from low prices to less time to shopā€”do create significant challenges for Walmart going forward. (LocationĀ 3761)

Investors evaluating the Walmart investment thesis must take note of these facts. Even though quantitative analysis was not able to refute the thesis, qualitative analysis reveals an increased amount of debt (LocationĀ 3767)

in the balance sheet and a liberal (perhaps (LocationĀ 3769)

excessive) use of operating leases. (LocationĀ 3769)

Many managers are not keen on anyoneā€™s interests but their own. (LocationĀ 3795)

Evaluating managers can be difficult, especially if you donā€™t have direct contact with them. (LocationĀ 3811)

Big investors and institutions with large amounts of capital at stake may be able to hire specialists, such as forensic accountants and private investigators, to evaluate the background and character of top managers. (LocationĀ 3813)

(1) financial performance in the recent past; (LocationĀ 3879)

(2) the quality of the financial statements through which they present their accomplishments; (LocationĀ 3880)

(3) tangible evidence of their shareholder friendliness. (LocationĀ 3880)

return on equity (ROE) and return on capital (ROC) are both useful indicators. (LocationĀ 3888)

Operating cash flows have consistently been above net income, (LocationĀ 3956)

Walmartā€™s top earners was in line with what other large companies were paying in relation to annual net income. (LocationĀ 4043)

Two implications are usually derived from the math of computing portfolio variance: (1) the risk of a single stock does not matter that much; and (2) each buy or sell decision must be made in light of whatever stocks you already have in the portfolio. As we will see later, the second implication is certainly very helpful, but the first implication that the risk of any one stock does not matter is patently misleading. (LocationĀ 4199)

To his credit, Markowitz understood that the statistic for volatility is not risk. (LocationĀ 4217)

Using a statistic for risk certainly makes the math possible, but it stretches credulity to say that the way prices moved in the past is a perfect, or even good, indicator of the uncertainties of future cash flows associated with the company in question. (LocationĀ 4222)

Portfolio optimization and mathematical fine-tuning remain at the core of investment research, teaching, and practice. (LocationĀ 4236)

As I have shown, value investing differs from modern portfolio theory in its focus on subjectively but deeply understanding the wealth-creating mechanisms of businesses, and the difficulties and uncertainties that managers face as they construct and operate such mechanisms. (LocationĀ 4240)

From such a broader view, we may assess, if subjectively, the chances that the investment thesis will deteriorate or worsen drastically. (LocationĀ 4260)

Letā€™s, therefore, reconceptualize risk as the probability of (LocationĀ 4262)

except that instead of deriving risk from the variance of past returns, the emphasis now is on assessments on potential problems with the underlying companies. (LocationĀ 4279)

but several formal studies, including a seminal paper from half a century ago, show that well-constructed portfolios eliminate the bulk of company-specific risk with as few as 10 securities. (LocationĀ 4299)

Yet, nowhere in the conventional theory is the valuation of the component securities in the portfolio mentioned. (LocationĀ 4322)

Instead, the usual tools for portfolio construction rely on measuring correlations and covariances of past returns and take on faith that the markets are efficient and price everything correctly at all times. (LocationĀ 4323)

Concentrated portfolios do have a downside, however. They are usually quite volatile, and novice investors can have trouble staying the course in the face of sudden and massive fluctuations. (LocationĀ 4339)

A sensible way to think about investing is in terms of core portfolios comprising between five and ten companies. (LocationĀ 4422)

The chief emphasis in selecting companies for such a portfolio is on disconfirmation and defensive valuation; focus must remain on the fundamental strength of operations that enables good economic performance (cash flows) delivered over time. (LocationĀ 4426)

Investors can rarely go wrong buying great companies at good prices. (LocationĀ 4435)

When bought at attractive prices and in sufficient quantities to have a meaningful impact on portfolio performance, such companies also obviate the need for their constant monitoring. (LocationĀ 4444)

Once investors construct such a core portfolio, they then evaluate all other investment opportunities that come along in light of the improvements they might be able to make to the existing group of companies. When you have additional funds to invest, the most productive use of those funds is likely to be investment in companies already in the core portfolioā€” (LocationĀ 4453)

you may be able to allocate between 50 and 80 percent of your total investment to the core portfolio. (LocationĀ 4458)

You can then set aside the remainder for experimentation and opportunistic investments that may come about from periodic panic about the prospects of a sound company or more generally from market-wide (LocationĀ 4460)

Core portfolios reduce the noise that can overwhelm investors, improving the overall quality of the investment experience. (LocationĀ 4462)

In a way, the core portfolio is to a good investor as a defensive pocket is to a good quarterback. (LocationĀ 4467)

The difference is that a well-constructed core portfolio almost never collapses, as defensive pockets are prone to do in the face of aggressive opponents; you have all the time necessary to locate and evaluate additional investment candidates that will further strengthen investment performance. (LocationĀ 4469)

Such deterioration is often a long time in the making and is usually visible through periodic, perhaps quarterly, disconfirmation analysis of companies that may be undergoing discontinuous change. (LocationĀ 4472)

It brings investing back to business analysis and valuation of individual companies. (LocationĀ 4476)

Wouldnā€™t the focus on defensive valuation and caution remove from consideration those growth companies that have the potential to provide extraordinary returns? (LocationĀ 4483)

In trying to avoid the Type I error of potentially choosing a poor investment, cautious investors end up with a good number of Type II errors of not investing in what turns out to be a good investment. (LocationĀ 4486)

Earnings yields are usually very low and dividends mostly nonexistent for fast-growing companies, as they typically do not generate enough free cash flow to justify shareholder-friendly actions. (LocationĀ 4494)

Rapidly rising prices make growth companies highly visible and fodder for endless speculation in the media, thereby providing them the marketing exposure that other stocks donā€™t usually get. (LocationĀ 4497)

Mixed in with the speculative stocks, however, are the stocks of genuine growth companies with sound business models and competent leadership; but it is not easy to distinguish one from the other. (LocationĀ 4504)

There are many reasons why high-flying stocks come crashing down. (LocationĀ 4514)

Cautious investors can pursue risky growth from a defensive perch either by investigating the turnaround of good companies that previously got in trouble or by scrutinizing select companies that are leaders in emerging new sectors of the economy. (LocationĀ 4525)

Consider again a stock trading at $20 when conservative valuation puts it in the range of $50, and historical trend shows intrinsic valuation growing at an annual rate of, say, 12 percent. The intrinsic valuation of such a company could grow to about $100 in six years and therefore provide growth to the portfolio. That is, the undercurrents of business growth provide continuing opportunities for steadily rising prices even after the markets eventually correct the initial mispricing. (LocationĀ 4536)

While the mispricing of fundamentally sound companies can provide opportunities for growth, good companies do sometimes get in trouble and their prices fall to reflect worsening fundamentals. (LocationĀ 4558)

Among the many examples of faux growth is e.Digital, a Canadian producer of the earliest portable digital voice-recording devices. The company began in 1988 as 340520 B.C. Ltd., changed its name twice before listing in 1993, and then traded between $2 and $4 per share for many years. (LocationĀ 4602)

Throughout its rise and fall, e.Digital never reported operating profits. (LocationĀ 4607)

The fact that such companies donā€™t have a sustainable business does not seem to matter for those chasing fast-rising stock prices. (LocationĀ 4609)

As such, investors do get in trouble even when the companies in which they invest are excellent operators and dominant in their respective spheres of activity. Paying too much in the hopes of growing the portfolio can actually backfire when high prices come tumbling down, destroying the painstaking gains made elsewhere. (LocationĀ 4620)

In short, growth investing relies greatly on qualitative analysis, on judgments about the sources of value creation and the quality of the leadership in charge of executing a well-articulated strategy. Turnarounds and fast growth demand highly competent management, and the leadership of such companies need especially careful evaluation. (LocationĀ 4630)

growth opportunities may justify relaxing oneā€™s assumptions about uncertainty and growth in the discount flow model. But those assumptions still need to be reasonable given that real companies in the real world can only do so much. Unwisely chosen growth companies can create illusions of profits but are liable to produce significant losses. (LocationĀ 4635)

Identifying genuine growth opportunities can be very profitable for investorsā€”provided, of course, they use disconfirmation analysis and portfolio logic to turn the mathematical odds strongly in their favor. (LocationĀ 4650)

The main difference between the two is that the purchase of private companies does not engage the public equity markets, whereas the purchase of publicly traded companies requires a degree of sophistication about market operations. (LocationĀ 4667)

Portfolio performance was dependent on the performance of the largest investments; errors in judgment when selecting these companies would be very costly. The key to building such a concentrated portfolio is to avoid unforced errors by sparing no effort in due diligence. (LocationĀ 4678)

From public comments made by Buffett, a rough valuation based on the quality of a business and its leadership is usually the main driver of selections for and significant changes to the portfolio. (LocationĀ 4709)

Finally, over the last several years, IBM has been expanding its gross margins and holding steady on historically higher levels of operating margins and operating cash flow margins. (LocationĀ 4851)

Declining revenues create some doubt, but given the companyā€™s stated objective of moving away from hardware, these are understandable. We cannot refute the investment thesis on the basis of stability. (LocationĀ 4853)

Long-term investors in the company must evaluate the quality of its value propositions and operating model in each key business area. (LocationĀ 4857)

Paramount for investing successfully, as I have argued in this book, is a cautious temperament and a well-grounded approach that helps stabilize emotions, encourages focus on relevant facts, and facilitates careful analysis. (LocationĀ 4882)

third step in becoming a wise investor is to understand that, in many ways, investing is a ā€œhead game,ā€ in the sense that it requires considerable judgments about where to invest and when and when to stay put and how to fold. (LocationĀ 4900)

The fourth step for investing wisely is to develop an analytical strategy for correctly channeling our emotions and controlling our biases. (LocationĀ 4913)

friend is a lack of pressure to make decisions quickly. Time allows the cerebral cortex to kick in and avoid the destruction that reptilian reactions can impose on us; time allows us to calm our internal urges so that critical information can come into focus, so that we may see the interconnections and get true insight. (LocationĀ 4953)

Slowing down the decision-making process also allows investors to ask such meta-analytic questions like what is truly happening with this company? (LocationĀ 4957)

refutation and disconfirmation framework as resilient but malleable, and subject to modification. (LocationĀ 4970)

Independence of thought, diligence, emotional stability, caution, and patience are the hallmarks of a good temperament for investing wisely. (LocationĀ 4977)