Part 1 – The heritage
1-The value path
I started my quest for the investor’s Holy Grail (i.e. beating the market) by looking to the value master: Benjamin Graham. What did I learn from Mr. Graham? Most of all, I learned the distinction between price and value.
Putting it in simple terms, price is the current quotation of any stock, value is the real worth of that stock given a competent and accurate appraisal. The most important aspect is that value and price might be deeply different during some periods. Those are the moments when the opportunities truly arise. It is when the value is bigger than price, that the timing is right to buy.
If we think about this for a moment we can see that the spotlight turns to the value estimation. What is this? Boring economic theory tells us that the value of any given stock is the present value of every future cash-flow available for the stockholders. Graham said that you will have to read tons of financial statements, from where you will extract lots of financial ratios, then you will compare them with the ratios of other companies and finally you will buy the one with the best value ratios. To know more about Benjamin Graham: Security Analysis.
The problem with this approach is that financial ratios are like a static photo of a dynamic reality. This means that you might be looking to a ratio screaming that your stock is cheap, when in the reality the company you are looking at is going down the hill. Financial ratios won’t show it because they lag reality. Therefore you might think that you are buying a dirty cheap stock, when you are really buying into problems.
2-The growth path
Philip Fisher had a better answer to this problem. He said for you to go around asking questions to ex-employees, suppliers, clients and finally to the top management. Basically, you will gather unconventional information that will give you an updated picture of the company. Then, you will buy any company that exhibits evidence of being a hatchery of new lines of successful products. If the company is able to keep bringing to market profitable products, then the company will produce growing cash-flows well into the future, which will increase the shareholder value over time.
Mr. Fisher stated that the companies that will provide extraordinary returns do not exhibit this behavior yet in their financial statements, therefore, there is no use in looking there hoping to get a good appraisal of the company’s worth. The companies who already exhibit signs of good financial performance are already under the radar of institutional investors and, therefore, handsomely priced which cuts our hopes of doing extraordinarily well. The bulk of P. Fisher’s investing approach can be found in his masterpiece: Common stocks uncommon profits.
3-The Warren’s path
Now we have to put these philosophies in perspective, Graham first wrote “Security Analysis” in the 30’s and Philip Fisher first wrote “Common Stocks and Uncommon Profits” in the 60’s. There isn’t an eternal right answer. In the end of the 50’s, Warren Buffet started to interiorize that Graham’s method wasn’t working anymore like in the good old days. Under the influence of his partner Charlie Munger, he slowly started to shift to an approach closer to what Fisher presented us. However, Buffet has not fully applied Fisher’s approach. Warren looked more into simple businesses with sound economics, unlike Fisher, who would always be looking for technological companies with competent managements always on the verge of introducing a product, or a line of products that the market was salivating for. Buffet was (mostly) against this, since he saw too much uncertainty in the process of a company developing and introducing entirely new products. Buffet still has preference for companies with established branded products that are perceived as cash cows for years to come (although in the last couple of years even this behavior has been altered, Buffet recently invested in IBM and Intel). I have read some books about Warren’s methods, but I believe that the best insights will be present in his unauthorized biography: The Snowball.
4-The practical path
So which one is the right philosophy? Well, my guess is neither. Each one has its virtues and its defects.
Clearly, Graham knew that a company’s stock depends on the underlying businesses to go on. The main reason why Graham was so successful during his days comes from the fact that during the years following the Great Depression, the companies had an excess of liquidity that created lots of opportunities in companies trading below working capital per share. The 70’s and the 80’s brought the end to this phenomenon trough the rise of leverage buy-outs and the mainstream optimization of the capital and debt mix.
Philip Fisher believed that when the financial statements reveal the truth it is too late for the prospective investor. However, Fisher’s method of going around asking questions is not fitted for many investors.
Finally Buffet doesn’t like to take chances and during the last decades he was able to collect enough stable businesses with growth prospects, selling at fair prices. Today, he is more focused in leveraging his reputation in order to obtain tailored deals that allow him terms that nobody else can obtain, while entirely swallowing the occasional corporation.
After looking at the presented picture the question is: what techniques can the common investor use to be successful in the financial markets?