Forum Archive Index - February 2003

[Travis Morien <travismorien@yahoo.com>]

--- Morgy <morgy40@xtra.co.nz> wrote:
> Travis
> 
> You have written inter alia as follows,
> 
> "As a value investor I seek to predict the future
> return from owning a business, using mathematics
> identical to that used to value a bond.  Based on my
> assumptions of future profits, which for some
> businesses are certainly more predictable than stock
> prices, I can calculate with a reasonable degree of
> certainty what the "yield to maturity" might be from
> buying that business/bond at that particular price.
> If I find that a stock has a yield to maturity that
> is
> very high, say 15 or 20%pa over a ten year period, I
> consider this an outstanding opportunity and wish to
> lock in that profit by buying today."
> 
> 
> 
> 
> 
> Here is what Benjamin Graham has to say about your
> method, I have lifted the
> quote and associated passage from a article on a web
> site that was posted
> yesterday entitled Bubble Troubles Part 3 It Ain't
> Over Yet for the Stock
> Market  by Jim Puplava
>
http://www.financialsense.com/stormwatch/oldupdates/2002/0927.htm
> 
> 
> The problem with forecasted earnings is that they
> are highly unreliable and
> subject to constant change. The father of securities
> analysis, Benjamin
> Graham, did not believe in predicting earnings for
> stocks. In his last book,
> The Intelligent Investor, Graham urged investors to
> look at stocks based on
> their investment merit with value measures. Benjamin
> Graham was an eminent
> security analyst. The fact that he declined to
> predict earnings reflects his
> long experienced view that he did not have much
> confidence in his own
> ability or in others in making predictions,
> especially long-term ones.
> Graham felt that profit forecasting was too
> inaccurate to be useful for
> intelligent investing. Ben Graham believed that
> future earnings were already
> incorporated into market prices. Using forecasted
> earnings for valuation
> measures gave way to the danger of double-counting
> for good earnings
> prospects. Commenting on their inherent inaccuracy,


I'm well aware of Graham's methodology, I own a copy
of The Intelligent Investor and both the new and
classic editions of Securities Analysis.  I'm as
hardcore a Graeme-o-phile as they come.

Let me explain Graeme's position to you, as stated in
The Intelligent Investor.

Graeme believes that the first step one should make in
valuing a company is to figure out what it would be
like if the company remained just as it is.  He
doesn't explicitly recommend discounting methods and
instead proposes a simplified earnings capitalisation
formula.

Step number one, assume the company will be the same
in the future as it was in the past, that growth will
continue at more or less the same levels etc.  Step
two: modify your analysis to take into account your
views on the company, preferably by assuming less
impressive performance in the future.

He talks of favouring low PE stocks because it is much
easier for a company to grow slowly than to grow fast.
 He is dubious about the concept of forecasting high
rates of growth long into the future (to say the
least) and instead prefers companies without so much
expectation built into them.

Not once in The Intelligent Investor does he say you
shouldn't forecast earnings, because all investors
need to do a certain amount of forecasting when
working out a fair value for a company.  His main
gripe is with those that forecast sustained levels of
very high growth or drastic improvements in
performance.  He never says you should not attempt to
form a realistic opinion about the future growth, just
not to be too bullish about it.

As an example, the valuation of CSL in mid 2001 was
based on the assumption that the company could grow
earnings at 50%pa for the forseeable future.  Graeme
would not condone this, though he would not argue
against the assumption that some other stock could
grow at 6%pa if that was more or less in line with
historical performance.
> 
>  Graham wrote,
> "In forty-four years of Wall Street experience and
> study I have never seen
> dependable calculations made about common-stock
> values, or related
> investment policies that went beyond simple
> arithmetic or the most
> elementary algebra. Whenever calculus is brought in,
> or higher algebra, you
> could take it as a warning signal that the operator
> was trying to substitute
> theory for experience, and usually also to give to
> speculation the deceptive
> guise of investment."

I suggest you read up on bond valuations.

Time value of money concepts such as present value,
net present value, future value and internal rate of
return are absolutely fundamental to finance.  They
don't involve calculus or higher algebra.

Graeme is criticising academic concepts such as
capital asset pricing model and option pricing models
and all that stats that gets bandied about by MPT
exponents.  You want high maths, I can show you plenty
of such stuff.
> 
> Graham, Benjamin, The Intelligent Investor: A Book
> of Practical Counsel,
> Harper Collins, 1985, p. 321
> 
> 
> I came across the above passage while reading the
> associated article (the
> article not being relevant to your thread in any
> way) and having read your
> email from earlier today and being highly amused at
> your ability to
> "predict"  future value based on "assumptions" of
> future profits it sort of
> jumped out at me.
> There are a lot of unemployed analysts around at the
> moment who also assumed
> future profits based on there predictive
> assumptions.

Tell me this, given that it is a simple matter to
apply a very basic formula that takes mere seconds to
do in Excel, would it not be a good idea to check if a
price for a stock is reasonable by plugging in the
price and earnings of the stock you want to buy?

If you plugged in the data for CSL in mid 2001 and
found that if the company didn't raise EPS by 50%pa
for many years the stock price would collapse, would
you have felt good about that purchase?

If you perform the same analysis on another stock and
fins that the stock needs to grow its earnings by a
mere 1%pa to give you a 15% return including dividends
and capital gains, would you not wish to check that
company out in greater detail?

If you aren't making assumptions about future
earnings, then what in God's name *are* you basing
your purchase decision on?  

Travis
www.travismorien.com


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