Tuesday, September 12, 2006

Protection (Vs) Prediction

“Life can only be understood backwards—but it must be lived forwards”—Soren Kierkegaard.

Just as a kid starts to lose interest when things become predictable we will lose interest if life ever becomes predictable. I think that if each one of us knew how is his life going to fare out he might not prefer living it over. But fortunately for us life is unpredictable.

When it comes investing if there is one thing that helps stock market to be liquid and create opportunities for investors, it is the unpredictability and the fact that people tend to approach it differently.

Protection (vs.) Prediction:

The best way to learn to handle uncertainty is to learn how successful investors did that and try to replicate it. And who better to listen to than Benjamin Graham himself,

“Every competent analyst looks forward to the future rather than backward to the past, and he realizes that his work will prove good or bad depending on what will happen and not on what has happened. Nevertheless, the future itself can be approached in two different ways, which may be called the way of prediction (or projection) and the way of prediction”

The Way of Prediction:

“The qualitative approach may supply as dependable a margin of safety as is found in the ordinary investment—provided the calculation of the future is conservatively made, and provided it shows a satisfactory margin in relation to the price paid”—Ben Graham.

One of the most important things to realize is that good investment and good business are two different things. A good investment might not translate into good investment because market has the tendency to price good businesses near their intrinsic values. And this is where the problem lies: by doing so they tend to value stocks based on the ‘best case scenario’ and not the ‘worst case scenario.’ I am reminded of the following quote by Walter Bagehot,

“People are most credulous when they are most happy”

On the other hand, value investors value a stock based on the ‘worst case scenario’ and there upon seek margin of safety. Buying securities at a discount to their earnings power value calculated conservatively is as far as I wish to go in predicting future when it comes to investing.

Earnings Power Value:

“(Earnings power is)…the amount that the firm can be expected to earn year after year if the business conditions prevailing during the period were to continue”—Ben Graham

Earnings Power Value = (Normalized Earnings/(r-g))

As Ben Graham puts it that one has to be very conservative about the future projections I prefer not to expect anything out of growth and would not pay for it either, so ‘g’ is out of the equation. And normalized earnings would be the average of the past 3 or 5 years’ free cash flow. The average earnings are used so as to remove the element of favorable and unfavorable business conditions of any given year which can lead us to overpay for the business. If the company does grow it can be considered as an icing on the cake. And to compensate for the extra effort put in (or extra risk taken as some might say), the discount rate(r) used is 2 times the current yield on AAA bond.

When a business is selling for less than two-thirds of the value thus calculated, it can be classified as a possible bargain. All such stocks cannot be classified as bargains without checking other important numbers such as current ratio, debt-equity ratio, interest coverage, ROE…In short the numbers should give a clear indication that the business will, at the least, survive if adverse business conditions are to develop.

The Way of Protection:

“In our own attitude and professional work we were always committed to the quantitative approach. From the first we wanted to make sure that we were getting ample value for our money in concrete, demonstrable terms. We were not willing to accept the prospects and promises of future as compensation for the lack of sufficient value in hand”—Ben Graham.

I would briefly discuss the valuation techniques that Benjamin Graham used to make sure that he was receiving much more in value than the price paid.

Cash Bargains:

This type of bargain arises when the market cap of a company falls below the amount of cash and equivalents in its possession, net of current liabilities and debt. The irrationality on the part of market to quote a business at such low levels is well illustrated in the following analogy used by Prof. Sanjay Bakshi,

“If you were to walk into this fine book store and make an offer to the owner that, "I want to buy your store for the amount of the cash in the till plus the money that you have in the bank or money market mutual funds", he will throw you out. But the stock market periodically allows you to make such kind of offers”

Debt Capacity Bargains:

"There are instances where an equity share may be considered sound because it enjoys a margin of safety as large as that of a good bond. This will occur, for example, when a company has outstanding only equity shares that under depression conditions are selling for less than the amount of the bonds that could safely be issued against its property and earning power. In such instances the investor can obtain the margin of safety associated with a bond with all the chances of large income and principal appreciation inherent in an equity share"—Ben Graham

This type of bargain arises when a debt free company is selling for less than the debt it can comfortably raise and service. I would use a hypothetical example to drive home the point.

5 year average EBIT

$ 40 m

Interest coverage


Interest it can serve

$ 10 m

Debt Capacity (@ 10% interest rate)

$ 100 m

Thus a company that has an EBIT of $ 40 m can easily raise $ 100 m of high quality bonds (Considering that we used 4 as the Interest cover). Benjamin Graham says that if such a company sells for less than $ 100 m then it can be classified as a bargain on the following basis,

"An equity share representing the entire business cannot be less safe and less valuable than a bond having a claim to only a part that of"—Ben Graham

Net-Net Working Capital Bargain:

“The idea here was to acquire as many issues as possible at a cost for each of less than their book value in terms of net-current assets—i.e., giving no value to the plant account and other assets. Our purchase were made typically at two-thirds or less of such stripped-down asset value”—Ben Graham.

This type of bargain can be spotted in industries that are experiencing bad times. They could also be going through what buggy whip industries underwent when automobiles came around (ie) extinction. So it would make sense to make sure that the problem is a temporary one.


I would like to end the write up using a quote that drives home the very essence of the article.

“The task of man is not to see what lies dimly in the distance, but to do what lies clearly at hand”—Thomas Carlyle


Blogger rajeev said...


10:36 AM  
Blogger Kamlesh said...

Well written. I invite you to join the value investing group La Warren Buffett

11:11 AM  

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