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On Ben Graham, Bank Stocks, and Tom Brown

I wrote a response to Jason Zweig’s column on Ben Graham and bank stocks. Now, Tom Brown of Bankstocks.com has done the same. I have to admit, Tom’s article is better than mine. Both take Zweig to task for his explanation of why Ben Graham wouldn’t be a buyer of bank stocks today. However, Tom’s post does a better job of presenting the opportunities and challenges in analyzing bank stocks today:

Zweig’s premise seems to be that no one inside or outside a financial services company can ever reasonably value the institution’s assets–particularly if the assets are secured by real estate at a time when real estate values are declining on average. The stock’s valuation? Irrelevant. Investor sentiment? Beside the point. Rather, Zweig sees the companies as no more than black boxes. By his logic, Graham-style investors (as opposed to speculators) would never own these companies. But we know as a matter of fact that that is not true.

Graham saw every investment as a black box – and that didn’t trouble him. A lot of investors spend a lot of their time worrying about the inner workings of the companies they own – Graham never did. He didn’t look inside the “system”, i.e. the company itself; instead he looked only at the outputs – the financial statements. He spent almost no time worrying about a business’s management, corporate culture, or future prospects. He didn’t worry about competitive advantages. He looked to the balance sheet first. When he moved on from there to consider earnings, his usual approach was to rely heavily on the past record in an attempt to discover what “normal” earnings might look like.

Graham was a rear view mirror guy. His margin of safety was based on making purchases at prices that would’ve worked well in the past. He liked sure things. For instance, he knew that NCAV stocks were sure things – and subsequent research continues to support that claim. I mentioned NCAV stocks in my previous post, because they are perhaps Graham’s most characteristic investment category. They combine elementary arithmetic and logic in a potentially lucrative but almost certainly safe investment operation. Also, unlike much of what he wrote about in The Intelligent Investor and Security Analysis, Graham actually made NCAV investments during his Wall Street career.

Before we can answer what Graham would do today, we need to know what he did do in his own lifetime. When writing about Graham, one needs to consider three separate categories: what Graham practiced, what Graham preached, and what Graham’s principles were.

What Graham Practiced

In the Intelligent Investor, Graham lists the five successful techniques his partnership employed from 1926 – 1956: arbitrage, liquidations, related hedges, net-current asset issues, and control investments.

Control Investments
Graham does not discuss control investments in any of his books; however, GEICO is a well-known example of a Grahamian control investment.

Arbitrage
Buffett has discussed this techniques in some detail. See especially Buffett’s discussion of Berkshire’s purchase of Arcata …

Festival of Stocks #99

Welcome to the ninety-ninth Festival of Stocks. The Festival of Stocks is a weekly blog carnival dedicated to highlighting the best recent posts on stock market related topics.

I am proud to present this week’s best entries to the Festival of Stocks. The articles are listed by category. I have included my review of Don Keough’s new book “The Ten Commandments for Business Failure” among the links below.

Enjoy.

Stock Analysis

Number Check on Sears by Circle of Competence

“With its market price declining daily, giving me the opportunity to pick up even more shares, I thought I’d present a very rough look at how the market is valuing Sears (SHLD) right now, putting reasonable numbers to a rather abstract investment idea.”

USG Earnings Conference and Notes by College Analysts

“From a purely operational standpoint, USG’s results were objectively poor but very good contextually. Wallboard volume shipments were down 11% quarter-over-quarter and plant utilization sits just under 70%; until capacity recovers into the mid-80%s, USG won’t have the operating leverage to put up big EPS numbers, and that day is still far off.”

United Technologies Dividend Analysis by Dividend Growth Investor

“UTX is a dividend achiever as well as a component of the S&P; 500 and Dow Jones Industrials indexes. It has been increasing its dividends for the past 14 consecutive years. From 1998 up until 2007 this dividend growth stock has delivered an annual average total return of 17.20 % to its shareholders.”

A.H. Belo: A Value Stock or a Value Trap? by Lollapalooza Investing

The new Lollapalooza Investing blog provides a detailed analysis of A.H. Belo.

Have Your Cake…? By Bootstrap Investing

“I’ve actually been an owner of Cheesecake Factory shares for a couple of years now. But the recent market malaise (aka storm, destruction and rampaging bear as quoted in the financial press) has given us an opportunity to purchase shares at prices not seen since just after the new millennium.”

Commentary

“Dear Bill…” A Letter to Bill Miller by Cheap Stocks

“How is it possible that you are down 32% year to date, or 39% over the past year? Looking back, do you think that your positions were too concentrated in financials? Yes, Bill, I know hindsight is 20/20, and I sound a bit like Captain Obvious here, but Bear Stearns, Washington Mutual, Citigroup, Merrill Lynch, Freddie Mac, AIG, Countrywide? Where was your risk control?”

Jim Grant on the Absence of Outrage by Controlled Greed

Actually, I think people are so irked at $4.00 and up gas prices — and worried about further increases — that their focus is fixed there. And Grant suggests this could be the factor consuming populist anger at the moment.

My Strategies for Weathering a Bear Market by My Wealth Builder

Another way I hedge is to take some profits with a stock that has risen significantly, selling 20 to 50%, and sometimes 100%, of a position to lock in some gains. I recently did this with …

On a Starbucks Shuttered

They say you don’t know what you’ve got ‘til it’s gone.

I don’t know who they are; but I know of what they speak.

I recently lost a coffee place (not a Starbucks). It was a traumatic experience.

Last year, my eye doctor asked if I did a lot of reading at work: “Mostly SEC filings”, I said. “That’ll do it”, he replied, “You have what I like to call computer eyes”. And so, for the first time in my life, I became acutely aware of the occupational hazards of investing.

Now, a few times a month, I take a couple hours off to venture outdoors. Yes, I know the sun’s demonic rays cause cancer; but they also cure electronic induced ennui. Sounds fair to me.

There’s one coffee place I always go. I take my Kindle with me (hopefully there’s no such thing as Kindle eyes), order a double espresso (and since this isn’t a Starbucks I actually say the words “double espresso”), give the cashier three singles, get ninety-five cents back and drop it all in the tip jar (I’m not generous; I just hate change).

Then, I take a table (yes, it’s the same table every time – I told you I hate change) and stay there reading until I feel guilty I only paid three dollars and I’m hogging their table.

At that point, I usually stay another hour.

If my behavior is typical of their customers, it’s not entirely surprising that I should’ve come upon the sight I saw last week, though it came as quite a shock to me.

The place was empty. The tables gone. The signs gone. Everything gone.

This was a change. I did not like it. But I soldiered on. Off I went to the nearest coffee place (again, not a Starbucks). The trek was slightly less than half a block. There I found a handwritten sign in the window:

Closed for vacation. Back next month.

Another change. I did not like it. At that point, I realized it was a summer day, I was hot, and I probably didn’t want coffee anyway. So I walked another half block to a deli, bought a Cherry Coke, gave the cashier two singles, got eighty-three cents back and dropped it all in the tip jar (again, I’m not generous; I just hate change).

I haven’t related this most boring of stories to you for no reason.

Much modern writing (even some blog writing – wink, wink, nudge, nudge) drips with sarconihilism, that especially astringent strain of sarcasm bordering on nihilism. In such writing, not only is nothing sacred – nothing is above casual, comedic contempt. It is occasionally hilarious, often elitist, and indubitably dishonest.

It makes fun of life’s littlest pleasures, especially the ordinary. Starbucks is a frequent target; the coffee chain is nothing if not ordinary:

The green aprons, the blond wood, the safari-themed coffee art and the chalkboards. From Chula Vista, Calif., to Bangor, Me., all Starbucks are more

Book Review: The Ten Commandments for Business Failure

Review by Geoff Gannon

Yesterday, I scampered off (virtually) to Amazon.com, found Don Keough’s new book, and clicked the “Buy Now” button.

Through the sorcery of modern book selling – one minute, nine dollars and ninety-nine cents later – Don Keough’s words were in my hands.

I froze.

Seeing the big, bold print of that title page on my Kindle, I froze. Here was a business book by Don Keough. Yet for some reason I expected the worst. The title was not encouraging: “The Ten Commandments for Business Failure”. It sounded like a book I’d read a few hundred times before.

Would this be a saccharine sleigh ride through Coca-Cola’s golden (Goizueta) years? Or just another listless list of managerial platitudes?

Evenly divided between anticipation, trepidation, and vacillation I pressed the “NEXT PAGE” button and embarked on my journey with Mr. Keough.

At least, I thought it was to be with Mr. Keough, until I read the first few words of the foreword:

“It has been an article of faith for me that I should always try to hang out with people who are better than I. There is no question that by doing so you move yourself up. It worked for me in marriage and it’s worked for me with Don Keough.”

That voice, of course, is Mr. Buffett’s. Warren’s cameo will be appreciated by all business readers, but those of the investing ilk will savor it most. And this is a worthwhile book for investors – though only indirectly so.

Don Keough has written a general business book, not a managerial handbook. As he writes in his introduction:

“…there has never been a shortage of speakers and writers willing to dispense tried and true advice on how to succeed in business without really trying.”

This is not that book.

Nor is this the book for the starry-eyed entrepreneur, the middle manager looking to get ahead, or the executive who wants to become a “leader”. This is not a self-help book.

It’s a business book – and a damn good one. The lessons within provide insights into businesses both good and bad and are as useful to the investor as they are to the executive.

Keough knows the kind of book he’s writing and tells us at the outset who his audience is:

“While these commandments can be applied to any business at any stage in its development, they are mainly intended for businesses and business leaders who have already attained a measure of success. In fact, the more you have achieved the more the commandments apply to you.”

His years at Coke made Keough extremely well-qualified to write a book on how to screw up a sure thing.

Keough’s advice is simple, maybe even trite:

“You will fail if you quit taking risks, are inflexible, isolated, assume infallibility, play the game close to the line, don’t take time to think, put all your faith in outside experts, love your bureaucracy, send

On Ben Graham and Bank Stocks

Jason Zweig writes the Intelligent Investor column for The Wall Street Journal. I’m sorry to say this week’s column is especially unintelligent.

When asked whether Graham would be buying financial stocks today, Zweig says no, and gives the following reason:

You cannot even pretend to be protected against loss while real estate prices – – the wobbly foundation for most financial stocks – – are still crumbling.

False.

You can do more than pretend to be protected – and Graham would have. Crumbling real estate prices alone would not have deterred Graham. He liked to use long-term averages and estimates of what normal conditions would bring. He relied heavily on the past as an indicator of the future. Real estate prices will recover at some point. Even if they don’t anytime soon, land still has value and Graham would have done his best to conservatively estimate that value. He could’ve used estimates based on prices from many years ago, replacement costs, rents, or the value of unimproved land. Then he would have lopped off some of that price and – voila – there’s your margin of safety.

No. The crumbling real estate market wouldn’t have fazed Graham.

Graham wouldn’t have bought financial stocks for a very different reason: they simply aren’t cheap enough.

I know it’s hard to believe, but as Zweig points out, on average, financial stocks are still trading above book value.

Remember, 1.1 times book is still 110% of a bank’s equity. Graham bought net current asset value stocks at less than 67% of their net current asset value (NCAV).

A lot of people think NCAV stocks (or “net/nets”) are risky. Some may be. However, there was one study showing that net/nets sought bankruptcy protection less frequently than non-net/nets. That’s not as shocking as it sounds. Unlike low price to book stocks, low price to NCAV stocks have a built in tendency to be overcapitalized.

Why?

Because there’s no need to have a positive net current asset value at all. Many public companies don’t.

Take Anheuser-Busch. It has about $3.1 billion in book value and NEGATIVE $12.1 billion in net current asset value. Even if BUD’s stock price fell to two bucks a share tomorrow, it would not trade below its net current asset value, because it has no net current asset value. To have a net current asset value, the company would have to be overcapitalized.

Other companies, especially companies with very high inventory needs and rapidly declining sales, can trade below NCAV without actually having much financial wiggle room. However, most companies end up in NCAV territory with strong balance sheets and weak statements of income and cash flow.

The NCAV stocks that fail tend to do so in slow motion and through extreme pig-headedness. Had management wished to, they could have exited unprofitable businesses, stopped treating the company as their own personal piggy bank, or wound down the business at some point without ever facing insolvency. A bankrupt (former) NCAV stock is usually …

Security Analysis: Introduction (Part 1)

The introduction to Security Analysis is a treasure trove of Grahamian thought. It is impossible to fully plumb the depths of this Grahamian gold mine in a single post. Therefore, I have separated my comments into two posts. This post explores the opening paragraph of the introduction with special attention to Graham’s style.

We should begin with the most general point made in Graham’s introduction: It is impossible to completely separate analysis and action, theory and practice. Therefore, while the title of Graham’s book is Security Analysis, the scope is necessarily wider:

Although, strictly speaking, security analysis may be carried on without reference to any definite program or standards of investment, such specialization of functions would be quite unrealistic. Critical examination of balance sheets and income accounts, comparisons of related or similar issues, studies of the terms and protective covenants behind bonds and preferred stocks – these typical activities of the securities analyst are invariably carried on with some practical idea of purchase or sale in mind, and they must be viewed against a broader background of investment principles, or perhaps of speculative principles.

This is vintage Graham. In many ways, it is a sort of cold open into the book and the mind of the man who wrote it. He begins with a logical and overly literal opening sentence; to Graham, “strictly speaking” means speaking strictly – nothing more or less. He adds a word we wouldn’t think necessary – “definite” – but in Graham’s mind it is a necessary and meaningful modifier. Finally, he interjects his personality with the word “quite”, which we will see repeated again and again throughout Security Analysis (Graham was born in Britain).

Next, we have a catalogue. The activities Graham lists are all activities he’ll cover in Security Analysis. If you wonder what Graham means by security analysis, look no further than these lines. He lists three main activities: “critical examination” of corporate financial statements, “comparisons of related or similar issues”, and finally “studies of the terms” of senior securities.

This is an especially excellent introduction for the modern reader, because we learn just how different Graham and his book are from what we might expect – and we learn our lesson well within the first few sentences.

What is the most unusual feature of this paragraph? Can you find the words almost no other writer would have included?

I’ll give you a hint. In Graham’s list of activities undertaken by the security analyst, there are two words that stick out like a sore thumb – a seemingly redundant sore thumb – can you find them?

Here they are:

“Critical examination of balance sheets and income accounts, comparisons of related or similar issues, studies of the terms…”

These two words tell you more about Graham and Security Analysis than anything else in that opening paragraph.

Why?

Because they are peculiar. What tells most is often what is said least. The appearance of these extra words in this sentence is something almost …

Upcoming Festival of Stocks

Attention Investment Bloggers:

I’m hosting this week’s Festival of Stocks (on Monday).

Please send me your best post of the last week.

Thank you.…

20 Questions for Jeff of Circle of Competence

Jeff, author of Circle of Competence, is a young and learning investor not yet out of college. He derives his investing framework from Superinvestors ranging from Ben Graham and John Maynard Keynes to Joel Greenblatt and Eddie Lampert. Jeff believes the most effective approach to investing is that of a business owner and entrepreneur looking for misunderstood businesses selling very cheaply with little risk of capital impairment.

Visit Circle of Competence

1. Are you a value investor?

No doubt. There’s no other approach I’ve ever been comfortable with. The thing is, value investing, as we tend to think of it, is not the only path to investing success. I’ve read about plenty of individuals who have been successful trading, making macro calls, and reading tea leaves for all I know. Value investing, business investing, is the one I hit it off with, so I’m with it for better or worse.

2. What is value investing?

Value investing is this really simple approach that’s not so easy to practice. In my eyes, value investing is a mentality that assets have some value independent of their selling price. They might be the same, they might not be, but if you can find the ones selling for some large amount less than they’re worth, there’s an opportunity to make a ton of money down the road. Buffett, Graham, Klarman, I mean these guys have proved this thesis true over and over with their successes. It takes some hubris, a confidence that you’re right and everyone else is wrong, and the courage to basically not let your humanity interfere with rationality. That’s the toughest part of value investing.

3. What is your approach to investing?

I’m basically just looking to own a small handful of companies that I know pretty well, selling for way less than they are worth. I want to find 5-10 companies where I can be extremely confident that I know what the heck is going on. It’s the only approach to investing that makes sense to me. I approach investing like I was a control investor, a buy-out specialist, or an entrepreneur. To find these opportunities, I’m search for companies that are being subject to some devil: neglect, myopia, or misunderstanding. If I can find a solid business with a solid balance sheet, run by competent management, being subject to one of those devils, and it’s something that I understand, I’m probably researching or buying it. That means spinoffs, small caps, distressed businesses, companies with multiple divisions; all of these are fair game. I want to find situations where the risk I’m being asked to take is out of whack with the potential upside. I’m okay with an investment that doesn’t make me any money. I’m not okay with losing money.

4. How do you evaluate a stock?

I don’t really evaluate stocks. I (try to) evaluate businesses. As I said before, I’m thinking like a control investor. What is the company worth now, and what is it going …

On Liquid Courage

There are two recent pieces on morality and credit worth reading. One is written by David Brooks; the other by Jim Grant.

Brook’s piece is good; Grant’s is better. Brooks takes the matter as far as he can. He sees the importance of the everyday examples that constitute a culture; but fails to see the overwhelming importance of incentives – incentives that have been both perverse and pervasive throughout the third millennium.

(The borrower) and the lenders were not only shaped by deteriorating norms, they helped degrade them. Despite all the subterranean social influences, there still is that final stage of decision-making when individual choice matters. Each time an avid lender struck a deal with an avid borrower, it reinforced a new definition of acceptable behavior for neighbors, family and friends. In a community, behavior sets off ripples. Every decision is a public contribution or a destructive act.

Great.

Unfortunately, he goes on to write:

Meanwhile, social institutions are trying to re-right the norms. The government is sending some messages. The Treasury and the Fed are trying to stabilize the system while still ensuring that those who made mistakes feel the pain.

Brooks is out of his depths here.

Ultimately, the pain will come in the form of inflation. It has to. Either the Fed will realize it has assumed weaknesses that are mostly illusory – or the Fed will cure those weaknesses the only way it can. Either the Fed’s balance sheet will turn out to be solid, or the Fed will have to counterfeit that solidity.

Unlike Brooks, Grant resorts to numbers:

In June 2007, Treasury securities constituted 92% of the Fed’s earning assets. Nowadays, they amount to just 54%. In their place are, among other things, loans to the nation’s banks and brokerage firms, the very institutions whose share prices have been in a tail spin. Such lending has risen from no part of the Fed’s assets on the eve of the crisis to 22% today. Once upon a time, economists taught that a currency draws its strength from the balance sheet of the central bank that issues it. I expect that this doctrine, which went out with the gold standard, will have its day again.

John Bethel of Controlled Greed recalls a past phrase from Grant – “the democratization of credit and the socialization of risk”. There is no clearer example of this phenomenon than the weakening of a public balance sheet to strengthen private balance sheets.

The first part of that phrase is as important as the second. When do you hear someone told they shouldn’t buy that house or take out that student loan? Is anyone ever told they can’t afford to own a house, or attend a four-year school?

No. These are the new unalienable rights. Unfortunately, they still have to be paid for out of pocket. No amount of money is too much to spend on your education or your abode…

But if that’s true, what difference does the …

Blogger Roundtable: July 2008

Note: My continuing weekly commentary on Benjamin Graham’s Security Analysis is being bumped for this roundtable; the commentary will appear here tomorrow morning. Sorry for the inconvenience.

This is a new format for Gannon On Investing – a pseudo-roundtable, where the same questions were posed to different bloggers simultaneously (via email). In this first post, we have answers from the authors of four of my favorite blogs: Fat Pitch Financials (GEORGE), Cheap Stocks (JON), Bill Rempel (BILL), and Controlled Greed (JOHN).

Performance

How have you fared so far in ’08?

George: It’s been a rough year for my portfolios so far. My Fat Pitch Financials Portfolio, which tracks my longer term value investment picks, is down 15.9% year to date (as of July 11th). My Special Situations Real Money Portfolio is down 6.7% year to date.

Jon: It’s been very challenging, especially the past month. Even some of the illiquid names I hold have started to come under pressure.

Bill: YTD as of 7/18 close, -1.67%.

John: My portfolio is down 12% through June 30th of this year.

What’s been your greatest success this year?

Bill: I’m not viewing the individual trade results as being composed of individual successes or failures. I view the process as one of methodology applied consistently, with individual trade results being somewhat randomly distributed over time, around an average result for that system. That holds true for relative value traders, GARP traders, cigar-butt traders, special situation traders, and other types of system traders. Sticking to a chosen system is the “success.” Currently I trade one of the four systems I track; in time, with a larger account, I’ll probably trade two simultaneously.

George: In my Fat Pitch Financials Portfolio, my position in Western Union (WU) seems to be holding up the best so far.

My greatest success this year in my Special Situations Real Money Portfolio was my investment in JACLYN INC (JLN) that I bought for $7.65 on April 4, 2008 and I was cashed out (since this company went private) for $10.21 per share on May 22nd.

John: ArmorGroup International, which traded in London, got taken over by a UK company called G4S for a gain this year of 147%. You’ll remember I talked about ArmorGroup in the “20 Questions” interview we did previously. I originally bought the company in September 2006. My gain from start to finish was 61.3%, or more than 36% on an annualized basis.

Jon: The launch of the Cheap Stocks 21 Net/Net Index, the first index that tracks a basket of companies trading below net current asset value has had some very interesting results. Since inception (2/12/08), it’s up more than 9%, while the closest benchmark, The Russell Microcap Index is down 10%. Pico Holdings has also made a very nice recovery

What’s been your greatest failure this year?

John: General Motors (GM), down 51.8% through June 30.

George: I recently made a big mistake not selling a stock immediately when its …