Part 1: Mutual Funds (20 marks)
Part 2: Investment Portfolio Review (45 marks total)
Your response to Part 2 should be between 750 and 1250 words, with complete calculations shown where required. Based on the stocks of the two companies you chose in Last Assignment Preparation and worked on in Assignment, answer the following questions:
End Share Price – Beginning Share Price + Dividends Received (if any)/Beginning Share Price.
Part 3: Learning from the Masters (35 marks total)
Your response to Part 3 should be no more than 1000 words, with complete calculations shown where required. Use the lesson notes from Lesson 6 to answer the following questions. If appropriate, you may use tables to present information.
Lesson 6: Learning from the Masters
Note 1: Benjamin Graham
Benjamin Graham began a career on Wall Street at the age of 20. By 1919, he was 25 years old and earning $600,000 annually. In 1926, he formed an investment partnership, Graham-Newman, where a list of prominent investors (including Warren Buffett) later worked. Graham is remembered as the founder and father of value investing. He might also be credited with the development of rigorous security analysis. His book The Intelligent Investor is regarded as a classic for investors. In 1934, he collaborated with David L. Dodd to write Security Analysis. It has since become known as Graham and Dodd’s Security Analysis, and its fifth edition was revised by three prominent professionals and academics, Sidney Cottle, Roger F. Murray, and Frank E. Block.
Graham thought extensively about the meaning of investment versus speculation. When he started his career, stocks were considered a speculation, while bonds were considered an investment. The great crash of 1929 showed that bonds can be as speculative as stocks. In Graham’s opinion, it was the intention of the investor, more than the character of the transaction, that would determine whether a transaction is an investment or a speculation.
Graham (1973) defined an investment operation as “one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative” (p. 1). In other words, for a security to be considered an investment, there must be some degree of safety of principal and a satisfactory return. Analysis determines the degree of safety and the promise of income. Graham held that the value of an investment is not its earnings this month, or next month, or in the next quarter, nor what its sales volume will be next quarter; rather, its value is determined by what an investor can expect to receive over a long period of time. He described three phases of analysis (1973, pp. 145–146):
Graham looked to buy undervalued stocks, those selling below their intrinsic value. He reasoned that a margin of safety existed for the common stock if the price of the stock was below its intrinsic value, which he determined from factual information such as the company’s assets, earnings, dividends, and any definite future prospects. Future earnings power is the determining factor in ascertaining the attractiveness of a stock and also a limiting factor for accuracy. Graham ventured into subjective territory when he advocated that a company’s intrinsic value can be found by estimating the future earnings and multiplying them with an appropriate capitalization factor. This methodology forms the basis for most modern financial analysis. The variety of methodologies employed by analysts shows how widely this method can range. For Graham, the difference between the intrinsic value (calculated) and the price of the company share should be large enough to create a margin of safety. Graham liked stocks with a low price to earnings (P/E) ratio and a low price to book value (market value to book value) ratio. Net asset value was Graham’s starting point. He liked to buy companies for less than two-thirds of their net asset value (preferring net current assets) and to focus on low P/E stocks with some net asset value. He also considered other factors beyond financial statement “facts,” including management capability and the nature of the business.
Graham looked at the past record of his potential investments, and the further back he could look, the better. If an analyst reviewed the company’s record of earnings and saw that it was able to annually earn five times the fixed charges, then its bonds possessed a margin of safety and its stock could be considered. He did not expect the analyst to accurately predict future earnings. For Graham, a reasonable estimation would suffice if the margin between earnings and fixed charges was large enough.
Graham found that growth stocks—stocks growing their sales and earnings at an above-average rate—were difficult to deal with and created a dilemma for investors. How do investors define the stage of growth in the corporate or product life cycle? If the investor buys during the company’s rapid growth stages, the growth may turn out to be temporary. If the investor can accurately pinpoint a growth company, what price should he or she pay? Graham said that to get a margin of safety, one should purchase the shares of a company when the overall market is trading at a low price or is in a corrective phase, or one should purchase the stock when it trades below its intrinsic value even while the market is not cheap. But how do you know whether the market is cheap or not? If purchasing is restricted to when the market is fairly valued, you often cannot purchase a growth stock for long periods.
Graham brought discipline to stock investing and he helped bring stock into the public realm of investing from its previous relegation to “speculation.” He believed an analysis mindset could only truly exert itself if the mind of the investor focused on the security and the company, rather than on the market. We will encounter this theme often as we look at other famous investment figures.
Lesson 6: Learning from the Masters
Note 2: Philip Fisher
Philip Fisher formed his own investment-counselling firm in 1931. He reasoned that every investor with any money left after the crash was probably unhappy with his current broker, so he viewed this situation as an opportunity for a newcomer to enter the field. Also, business was slow at the time, so business people had time to chat. Fisher is the author of Common Stocks and Uncommon Profits (originally published by Harper and Brothers in 1958). He believed that he could make superior profits—firstly, by investing in companies with above-average potential and, secondly, by aligning his investments with the most capable management (Fisher, 1996).
Note that these two factors mirror the two intrinsic factors that Graham found difficult to depend on. In contrast, Fisher relied and focused on them. He looked for companies that had the ability to grow sales and profits over the years at rates above the industry averages. He liked products and services that could grow and gain in sales for at least several years. Fisher considered research and development, as well as strong sales and marketing competence, to be very important factors. As he considered which companies to invest into he developed some additional tenets:
Finally, Fisher advocated that an investor should invest in his or her circle of competence, a theme we hear often from successful investors. Philip Fisher was a long-term holder of technology growth stocks. He held Texas Instruments for many years, from before it went public until long into its listed life.
Fisher advocated that the long-term investor should concentrate on young growth stocks, which could be identified by
He also recommended that you sell when you have made a mistake in your assessment of the company, when the company deviates from the traits that convinced you to purchase it, or if you see an opportunity to reinvest your funds in a more attractive company.
Lesson 6: Learning from the Masters
Note 3: Warren Buffett
After Ben Graham’s death, Warren Buffett assumed the reputation as the leading value investor, and his name has become synonymous with value investing. Warren Buffett is Chairman and CEO of Berkshire Hathaway, which is an investment holding company. Charlie Munger is Vice Chairman of Berkshire Hathaway and is Warren’s closest associate. With help from Munger, Buffett synthesized the characteristics of Graham and Fisher in developing an approach that combined the qualitative and quantitative approaches. He has, however, purchased stocks that would not strictly have met Graham’s standards for value. Stocks in which Buffett has invested large sums include American Express, The Washington Post Company, Capital Cities, ABC, and the Coca-Cola Company.
Buffett realized that absolute adherence to the quantitative guidelines laid out by Graham was leading him to unprofitable investments. Graham recognized the importance of the qualitative factors of management capability and nature of the business but was reluctant to rely on them. In contrast, Buffett has come to rely significantly on his judgment in these two areas and has bought many firms for their strength in these areas along with a strong quantitative analysis signal.
Robert G. Hagstrom, Jr. (1994) wrote a book that analyzes Buffett’s investing patterns. In it, he states:
Even today, Buffett continues to embrace Graham’s primary idea, the theory of the margin of safety.… What Buffett learned from Graham was that successful investing involved the purchase of stocks when the market price of those stocks was at a significant discount to the underlying business value. (p. 46)
Sir John Templeton (discussed in the next lesson note) alluded to the difficulty of applying a strictly quantitative method as suggested by Graham when he noted the huge growth in the investment advising business. The number of analysts sifting for quantitative bargains has increased exponentially with ever-increasing computing power and more comprehensive data bases.
Buffett began to study Philip Fisher’s writing as early as 1969. Charlie Munger helped Buffett move toward Fisher’s investment philosophy, which was to
Buffett strongly values the “margin of safety” concept taught by Graham and mixes in Fisher’s appreciation for the value of a better business and strong management. In many of Berkshire Hathaway’s purchases of private corporate interests, the current management (often family based) is retained to run and grow the business. For instance, See’s Candies was purchased in 1972 for $25 million when the asking price was $40 million and the company had $10 million in cash. Buffett believed that See’s manager, Chuck Huggins, was responsible for the long-term record of success, so he kept Huggins on as manager. Huggins managed the growth of the company in subsequent periods with a focus on product quality and customer service; in 1993, See’s had revenues of $102 million and returned to Berkshire $24.3 million in net operating earnings (Hagstrom, 1994, p. 11).
Buffett shares Graham’s view that the market is driven by the emotions of its participants and that such sentiment will often have a more pronounced effect on a company’s stock price than will its fundamentals. The objective for the investor is to avoid being caught up in fear and greed. An investor should seek only to acquire companies at reasonable prices.
As well, Buffett agrees with Graham’s assessment of forecasting. Stock market forecasting and timing is difficult, if not impossible.
Buffett did not anticipate the periods in which the market was likely to go up or down. Rather his goals were modest. “We simply attempt,” he explained, “to be fearful when others are greedy and to be greedy only when others are fearful.” (Hagstrom, 1994, p. 52)
Portfolio insurance involves constantly rebalancing a portfolio between risky and risklessassets to maintain its capital or ensure it does not fall below a minimum level. Buffett does not think much of this concept. Hagstrom (1994) notes that Buffett considers portfolio insurance to be as absurd as asking investors to
… consider the rationale of a landowner who, after buying a farm, instructs his real estate agent to begin selling off plots the minute a neighbouring farm is sold at a lower price. Or whether a large pension fund owning shares in General Electric [or other blue-chip stock] is logical in selling portions of its investments just because the last quoted share price was a downtick or in buying shares because of an uptick. (p. 53)
Buffett views the stock market simply as a market that is there to serve the buyers and the sellers and not as a price-setting guide.
Buffett views inflation as inevitable, given the lack of constraints on government spending. The constant increase in money supply will push inflation higher. Inflation will erode profit, gains, and asset value over time until the demand for an inflation premium revises costs incurred. Income taxes with no inflation still leave the investor with a profit unless the taxes are raised to 100%.
Knowing that he will not benefit from inflation, Buffett instead seeks to avoid those businesses that will be hurt by inflation. Companies that require large amounts of fixed assets to operate are hurt by inflation. Companies requiring little in fixed assets are, Buffett says, still hurt by inflation but hurt a little less. And the ones that are hurt the least are those with a significant amount of economic goodwill. (Hagstrom, 1994, p. 60)
Economic goodwill is the perception of value received or reputation. A company with a good or strong reputation (often referred to as “brand”) can garner premium prices. Today, Toyota and BMW are examples of companies with strong brand reputations. Buffett believes that investors should view themselves as business analysts, rater than market analysts, macroeconomic analysts, or even security analysts.
Investing in a good company is usually an easy decision. If a decision to purchase a business is not easy, Buffett will not purchase the company. He does not make purchases or sales often. While most investors cannot resist the temptation to constantly buy and sell, Buffett’s success lies in his inactivity. Buffett’s great success may be attributed to a dozen or so of his best decisions. Otherwise his performance would be no better than average. Peter Lynch (see Lesson Note 5) has noted that if an investor has one or two “ten baggers” or thirty baggers in his or her investing history, he or she will likely have outperformed the market.
Hagstrom (1994, pp. 77–122) discusses 12 tenets that guide Buffet’s investing decisions:
Lesson 6: Learning from the Masters
Note 4: Sir John Templeton
Sir John Templeton founded Templeton Investment Management. Until his death in 2008 at age 95, he devoted himself to his foundation and to managing his own fortune. He sold his fund company to the Franklin Group in 1999 but his flagship fund still invests using the principles he established for it.
Templeton started his career on Wall Street in 1937 and made his reputation as a value investor on a global basis. His stated goal was never to just make money for himself but to earn it for others. He is well known for his statement, “History shows that time, not timing, is the key to investment success.” He has also noted that while he greatly admired Warren Buffett, he felt Buffett was short sighted by investing only in the United States.
Templeton’s great innovation was to expand his horizon and invest globally. Note that he used the term global instead of international because the latter term would exclude domestic stocks. He felt free to buy a cheap stock wherever he could find it. He formed the Templeton Growth Fund in 1954 and produced exemplary returns during the time he owned and managed it. Another oft-repeated quote attributed to Sir John surmises that “to buy when others are despondently selling and sell when others are avidly buying requires the greatest fortitude and pays the greatest reward.”
In 1939, John Templeton borrowed money to buy $100 worth of every NYSE stock trading under $1 per share. He bought 104 names and he notes that three years later he had a profit on 100 of the 104. He sold high during the Internet boom, bought Ford near bankruptcy in 1978, and was early into Japan and early to sell. He bought Japanese stocks at a P/E of 3 and started seriously selling when P/Es reached a market average of 30.
While his flagship stock fund is called the Templeton Growth Fund, Templeton was always a value investor. He did, however, insist on companies with an above-average growth rate (20%). Combining this filter with strict value purchase criteria led to great results and probably pushed a global strategy just to find enough attractive companies to buy. Templeton analyzed companies, not markets, and always sought cheap companies.
Templeton liked “maximum pessimism.” Logically, you can buy at the lowest price only when pessimism is highest. When crises hit a country or region, Templeton looked for bargains. He bought solid companies if they were inexpensive, but while he insisted on quality, he was perfectly happy to buy tiny companies if he found value.
Patience was a virtue to Templeton. He believed in giving a purchase time to work out and held stocks on average four years. He would hold as long as six years waiting for a stock to reflect the fair intrinsic value of the business. If disappointed, Templeton quietly exited the stock holdings.
Templeton held diverse portfolios. He was never a focus investor (one who focuses on sectors or few companies). Instead, he held a widely diversified portfolio. Templeton was similar to Benjamin Graham in that he used results data based on a period of time longer than the twelve-month earnings figure commonly used by analysts. He favoured five years of history and advocated longer periods if available. His reason for using longer earnings histories was to eliminate normal cyclical downturns.
Templeton looked for low P/E ratios and healthy operating profit margins. He bought cheap stocks but not bad ones. He always had an exit strategy and would sell all stocks in his portfolio as soon as they became fairly priced. He looked at companies for their fire sale price (often book value) as his ultimate downside risk.
Templeton believed in flexibility. He would change his strategy to adjust for new events. He felt that the world is in a state of constant change and that the investor must change with it. He found value investing difficult in his later years, partly because of the proliferation of investment analysts and also because of the ready availability of information.
While Buffett happily invested from Omaha, Templeton set up his funds in the Bahamas. He felt that being away from New York made him a better investor and freed him from the impulses of the mob. He didn’t trust rules. He always tinkered with his system, improving it and testing it to ensure its current validity. He noted that in order to buy stocks at a bargain price, you have to do the opposite of what the crowd was doing. He felt that he could do this better from Nassau than New York—an analyst in New York goes to the same presentations, events, and meetings as everyone else, which makes it difficult to deviate from the crowd.
Templeton’s principles for investment success can be summarized as follows (Franklin Templeton Investment Management Limited, 2006):
Some of Templeton’s investment criteria included looking at P/E ratios in relation to other comparable companies, looking for rising operating profit margins, a good liquidation value, and an average growth rate of earnings showing consistency. He would not buy companies whose earnings slipped two years in a row.
Lesson 6: Learning from the Masters
Note 5: Peter Lynch
Peter Lynch made his name managing the Fidelity Magellan Fund for 13 years (until May 31, 1990). His returns beat those of most of his contemporaries and he wrote a number of books on his experiences and his stock-picking practices. Lynch joined Fidelity upon graduating from Boston College in 1969. In 1977, he took over the Magellan fund, which had $22 million in assets. Thirteen years later, that figure was $14 billion. Lynch was widely diversified and successfully held purchases for years. Over half his stock choices were self-admitted mistakes, but he sold them within months. Magellan is not restricted to a particular management style (e.g., value or growth) nor industrial sectors or geographical areas.
Lynch believes that individual investors can compete with the professionals by using common sense and sticking to what they can understand (a familiar refrain with our successful investors). He believes that one can spot investment opportunities all around—for example, in the mall, in the classroom, at work, and on the playground.
In his book One Up on Wall Street, Lynch (1989) outlines six categories into which companies generally fall (pp. 99–118):
Lynch believes that if you hold cash, you cannot gain a reasonable return, so he advises potential investors to consider investing at least in stalwarts. Cyclicals are generally too hard to time and slow growers are not profitable enough.
He also believes that you have to be able to tell the story behind your stock choice: why it interests you, what it needs to do to succeed, and the obstacles to its success. He also suggests that you check the key numbers. Look for companies whose growth products are a sufficient portion of sales to make a difference and whose balance sheet shows a strong cash position and manageable debt. Look for a high pre-tax profit margin and a P/E ratio below the forecast EPS growth (a low PEG). PEG = (P/E)/Annual EPS growth. According to Lynch, the P/E ratio of a fairly priced company will equal its growth rate, so its PEG will be 1. In other words, P/E = G, where G is the earnings growth rate. Note that this is just a rule of thumb and G must represent a period of greater than five years, preferably ten.
Lynch advises that you keep an eye on the stocks you own, not on the economy or the market. An investor’s performance will be based on the stocks held, not on the economy or market. Sell stalwarts when their PEGs reach 1.2 to 1.4 or their long-term growth rate slows. Sell fast growers if the scope for growth/expansion narrows or disappears.
In his book Beating the Street, Lynch (1993) states that “you can’t see the future through a rear view mirror” (p. 41) and “the key to making money in stocks is not to get scared out of them” (p. 36).
He notes that the very best way to make money in a market is in a small growth company that has become profitable for a couple of years and goes on growing.
Lynch has not changed his views since leaving the Magellan fund. In an interview with Money Magazine writer Glenn Coleman, Lynch states “I’ve found that when the market is going down and you buy funds wisely, at some point in the future you will be happy. You won’t get there by reading ‘Now is the time to buy’ ” (Coleman, 2003, p. 1).
In an interview on PBS Frontline (1997), Lynch notes that “I think the secret is if you have a lot of stocks, some will do mediocre, some will do okay, and if one or two of ’em go up big time, you produce a fabulous result.”
During his career, Lynch tried to stay aggressive, always looking for a better stock rather than trying to justify and defend past purchases. He tried to be flexible and buy the unusual if he believed in it. For instance, he bought Taco Bell when general market investors would not look at a small restaurant company.
Lesson 6: Learning from the Masters
Note 6: Kenneth Fisher
Kenneth Fisher, son of Philip Fisher, worked in his father’s firm for a year after graduating from college in 1972. He then set up and now runs his own firm, which is based on a hybrid value/growth investing philosophy that both resembles and differs from his father’s investment philosophy. Kenneth Fisher prefers stocks that are cheap due to their bad image but that are actually better stocks than investors view them to be. He then sells when the reputation and price return to more normal levels.
Fisher also looks for “super companies” that can internally fund growth at well above average rates. According to his book Super Stocks, Fisher (1984) has determined that a super company has the following attributes (p. 106):
In addition to these critical attributes, we would expect high margins, high market share, superior management, leading products, and a quality image (Fisher, 1984, p. 106).
Fisher explains that a super company is not necessarily a super stock if it is already fairly priced or overpriced. He explains his use of price sales ratios (PSRs) to evaluate promising stocks. He uses this measure to get around some of the limitations of P/E ratios in looking at growth stocks in particular. We could also note that earnings numbers are much further downstream than revenue numbers and subject to much more variation due to accounting conventions and choices. The PSR is the aggregate market value of a company (its share price times the number of outstanding shares) divided by its sales. In this frame of reference, a super stock is a super company bought at a low PSR relative to the company’s size. Fisher says that a super stock represents a business that can generate internally funded future long-term average growth of from 15% to 20%, will generate after-tax profit margins above 5%, and is bought at a PSR of 0.75 or less (pp. 36–37).
Fisher also looks to price research ratios (PRRs) for companies in industries where research and innovation pave the road to growth. PRR is the market value of the company divided by the corporate research expenses for the last 12 months. The lesson is not to pay too much for research. The issue, according to Fisher, is what a company will earn from its research, and for that the key is marketing. Once an investor can determine marketing capability, valuing research becomes relatively easy (pp. 59–60). Fisher advises against purchasing a super company with a PRR greater than 15.0 but likes super companies with PRRs of 5.0 to 10.0, provided they meet PSR tests (p. 60). Alternatively, a company with a PSR of less than 0.75 would be disqualified with a PRR of 25.0, which implies it is not spending enough on research to maximize its future (p. 61).
We have looked at the value approach, which buys underpriced low P/E stocks, and the growth stock approach, which looks for companies that are growing at an above-average pace believing that the price will eventually follow; however, both of these approaches leave us wanting when we look at groups of companies (e.g., technology) and young growth companies. Fisher thus proposed adding the PSR to the mix of evaluation tools. Note that the use of price sales ratios is fairly common today but was not widely prevalent when Fisher wrote his book. He notes (p. 35):
I like the concept of multiples … I just don’t like price-earnings multiples. I prefer other multiples—particularly sales multiples. I choose to value stocks in terms of Price Sales Ratios (PSRs), actual and potential profit margins, and Price Research Ratios (PRRs).
A company recognized as a growth stock may have a PSR of 5.0, 10.0, or higher. It then is not a super stock. Buyers will not make superior profits buying and holding it. PSRs measure popularity relative to business size. Sales are generally fairly stable and good companies rarely suffer catastrophic sales declines. The price of stocks vary considerably with market psychology, thus creating opportunity.
Fisher has a number of rules for using PSRs to make money with super stocks (pp. 43–44):
PSRs can also be applied to non–super stocks and companies; in these cases, PSR won’t tell an investor what to buy, but what to avoid. Historically, buying high PSR stocks leads to substantial losses or comparatively small gains.
Fisher provides the following table to relate P/E ratios to PSRs.
Implied P/E Ratios under Varying Profit Margins and PSRs
Profit Margin (percent)
Note. Adapted from Super Stocks (p. 40), by K. L. Fisher, 1984, Homewood, Il: Dow Jones-Irwin.
For example, when a company sells at 1.0 times sales and earns 7.5% after tax, it implies a P/E ratio of 13.33 (Fisher, p. 40).