Fin 4201/ Baseball Analogy “Best way to hit a home run: Don’t swing at everything; wait for a fat pitch.” “Best way to outperform the market: Don’t load up on hundreds of stocks; wait for the few outstanding opportunities.”

Fin 4201/ The three wise men Benjamin Graham Philip Fisher Charles Munger

Fin 4201/ Ben Graham, “ He was my God. ” Warren Buffett

Fin 4201/ Ben Graham Graham is considered the dean of financial analysis. He was awarded that distinction because “before him there was no (financial analysis) profession and after him they began to call it that.” Adam Smith (1972) Two celebrated works: Security Analysis, coauthored with David Dodd, originally published in The Intelligent Investor, originally published in 1949.

Fin 4201/ Ben Graham, At age 20 graduated from Columbia University with a Bachelor of Science degree. Interested in Mathematics and Philosophy. Started a career on Wall Street as a messenger in a brokerage firm. By 1919, at age 25, he became a partner and was earning an annual salary of $600,000. In 1926, formed partnership firm – Graham Newman (Buffett worked here for a few years). Dissolved the partnership and retired in 1956.

Fin 4201/ Ben Graham He was financially ruined by the 1929 crash. From 1928 to 1956, while at Graham-Newman, Graham taught night courses in finance at Columbia. With the counsel of David Dodd, also a professor at Columbia, Graham produced Security Analysis what became the classic book in value investing.

Fin 4201/ Ben Graham Two important contributions: 1.Distinction between Investment and Speculation. 2.A systematic (quantitative) approach to investment and the concept of Margin of Safety.

Fin 4201/ Investment vs. Speculation “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” Investment in bonds can also be speculative. What is important is a quantitative approach to investment.

Fin 4201/ Three reasons for the Crash of 1929 Manipulation of stocks by the exchanges and investment firms. Practice by banks of lending money for the purpose for buying stocks. Uncontrolled optimism that was driving it all. The first two have been solved to a large extent.

Fin 4201/ Three approaches to investment The cross-section approach The anticipation approach The margin of safety approach

Fin 4201/ The cross-section approach Equivalent to today’s index investing or passive investing. Problem: By definition, you cannot earn more than the index/market.

Fin 4201/ The anticipation approach - two sub-segments Short-term selectivity – Invest in the near term favorable stocks. Problems: 1.Sales and earnings are often volatile and the anticipation of near-term economic prospects could easily be discounted in the stock price. 2.The value of an investment is what that investment can expect to return to an investor over a long period of time.

Fin 4201/ The anticipation approach - two sub-segments Growth stock approach – Invest in companies with sales and earnings growth faster than the average. Problems: 1. Determining whether the existing price discounts the growth aspect or not. 2.Determining the stage of company’s life cycle: Development Rapid expansion Mature growth Decline

Fin 4201/ The margin of safety approach After deciding what to buy, the investor has to decide when to buy. There are two options: 1. Buy when everything is selling cheap (in a bear market). 2. Buy when the particular stock is trading below its intrinsic value, irrespective of the market condition. Graham believed that the first approach is futile. The second approach is better.

Fin 4201/ Margin of safety in case of bonds Margin of safety = Earnings - Fixed charges This margin will protect the bond holders in case of an unexpected decline in the earnings.

Fin 4201/ Margin of safety in case of stocks “When a stock is priced well below its intrinsic value, a margin of safety automatically exists.” What is Intrinsic value? “that value which is determined by facts.” facts - company’s assets, its earnings and dividends, and any future definite prospects. Intrinsic value is an elusive term, an exact value is difficult to determine. A range of values would be sufficient to gauge the margin of safety.

Fin 4201/ The art and science of financial analysis Quantitative factors - a thorough analysis of Balance sheets Income statements Earnings and dividends Assets and liabilities

Fin 4201/ The art and science of financial analysis Qualitative factors – not easily analyzed but essential ingredients in the intrinsic value Management capability Nature of the business

Fin 4201/ Margin of safety Graham believed that there is little margin of safety if the qualitative factors make a major part of the intrinsic value. Two approaches for higher margin of safety: 1. buy a company for less than two-thirds of its net asset value (NAV); 2. focus on stocks with low price-to-earnings (P/E) ratio

Fin 4201/ #1) How to calculate NAV? No weight to a company’s plant, property, and equipment. Deduct all of the company’s short and long- term liabilities.

Fin 4201/ #2) What was he looking for? Deep out of favor stocks, believing that they were priced “unjustifiably low.” Two assumptions Markets prices were wrong Mean reversion “Many shall be restored that now are fallen, and many shall fall that now are in honor.” (Horace)

Fin 4201/ Used-cigar-butt approach “You find these well-smoked, down-to-the- nub cigars, but they’re free. You pick them up and get one free puff out of them. Anything is a buy at a price.” Warren Buffett

Fin 4201/ Buffett on Graham’s investment style “(Graham) wasn’t about brilliant investments and he wasn’t about fads or fashion. He was about sound investing, and I think sound investing can make you very wealthy if you’re not in too big of a hurry. And it never makes you poor, which is better. ”

Fin 4201/ Buffett and Graham “Next to my dad, Ben Graham had more impact certainly on my business life than any other individual.” Buffett was first an interested reader of Graham, then a student, an employee, a collaborator, and, finally, Graham’s peer.

Fin 4201/ Quickie Quiz – Markets DJ Index Nasdaq

Fin 4201/ Quickie Quiz 2 – Currencies 1 Dollar = ?? Euro Dollar = ?? Yen

Fin 4201/ Quickie Quiz 3 – Interest Rates Ten Year Treasury = ?? % Investment Grade Corporate = ?? %

Fin 4201/ Causality? Does Buffett buys the best companies? Or Do these companies become the best because of something that Buffett does?

Fin 4201/ Buffett’s Influence Quality of corporate governance Financial credibility Financial stability Brand recognition and credibility

Fin 4201/ Philip Fisher Graduated from Standford’s Graduate School of Business Administration. Started as an analyst at the Anglo London & Paris National Bank in San Francisco. In less than two years, he was made head of the Bank’s statistical department. Started his investment advisory firm, Fisher & Company in 1931.

Fin 4201/ Fisher believed that superior profits can be made by investing in companies with above average potential, and aligning oneself with the most capable management. He devised a point system to identify good companies.

Fin 4201/ “Investment success depends on finding companies that can sustain above-average growth, in both sales and profits, over a period of several years. Short-term results are deceptive.” Fisher was looking for companies that had an ability to grow sales and profits, over the years, at rates greater than the industry averages.

Fin 4201/ Two types of companies Fortunate and able Fortunate because they are able

Fin 4201/ Fortunate and able Example: Aluminum Company of America (Alcoa) *Able - Great founders. Foresaw the commercial use for their product and worked aggressively. *Fortunate – Air transportation was growing rapidly.

Fin 4201/ Fortunate because they are able Example: Dupont It started as a mining company, producing blasting powder. Management capitalized on the knowledge gained in manufacturing gun powder to launch new products – including nylon, cellophane etc.

Fin 4201/ Essential qualities 1. Investment in research & development 2. Strong marketing 3. Low break even; lowest-cost producers 4. Ability to grow without raising new equity 5.Superior management

Fin 4201/ Superior management “Superior management is the key to superior market performance.” 1.Does the management have a long-term target of consistent performance? 2.Does the business have a management of unquestionable integrity and honesty?

Fin 4201/ Superior management 3. How managers communicate with shareholders? 4.How is the relationship between management and employees? 5.Finally, examine the specific characteristics of a company: its business and management aspects, and how it compares to other businesses in the same industry.

Fin 4201/ Scuttlebutt approach Scuttlebutt approach means uncovering about a company as much as possible. Sources of information – customers, vendors, former employees, competitors, research scientists, government employees, and trade association executives.

Fin 4201/ Scuttlebutt approach Basic idea – get a cross-sectional view of the company. Since this is a time consuming exercise, Fisher’s portfolio was heavily concentrated in a few stocks. Somewhat similar to Buffett’s circle of competence.

Fin 4201/ Charles Munger “Charlie-and-I”

Fin 4201/ Charlie Munger Born January 1, Son of a lawyer and grandson of a federal judge. Graduated from Harvard Law School in 1948.

Fin 4201/ Charlie Munger – “Charlie-and-I” In 1962 started a law firm Munger, Tolles, Hills & Rickershauser. First met Buffett in 1959 and left law practice in 1965 Became vice-chairman of Berkshire in 1978 He is the chairman of Wesco financial.

Fin 4201/ Charlie’s Choice “Look for companies that generate high cash earnings and require low capital expenditure.” “It is far better to pay a fair price for a great company than a great price for a fair company.”

Fin 4201/ See’s candy, 1972 Turning point in the history of Berkshire Hathaway Charlie convinced Buffett it was a good buy at three times the book value.

Fin 4201/ Put it all together… it spells success Graham = buy cheap, margin of safety, ignore management and sector (Quantitative) Some of WB’s investments were cheap for a reason – Berkshire Hathaway textiles is an example. Graham saw stocks as investments = Long-term Fisher = More business and management focused Qualitative Charlie = move WB from to 50-50