Wednesday, May 18, 2011

Au, A Modern Approach to Graham and Dodd Investing

I have to give Thomas P. Au credit. In a world in which newsletters flaunt triple-digit returns and so-called educators tantalize prospective students with riches easily won and it seems virtually everyone cherry picks the dates that demonstrate outsized returns, Au the value investor showcases his trades in 1999. It shouldn’t come as a shock given the runaway market that year that he underperformed the S&P 500. And A Modern Approach to Graham and Dodd Investing (Wiley) was published only five years later, in 2004. So score one for integrity, zero for marketing skills.

Au’s “real-time experiment,” which occupies a single chapter, humanizes an otherwise fairly dry, earnest book. The tone may reflect the decade the author spent at Value Line, I don’t know, but even though Au writes clearly and is willing to tackle some big-picture issues, his book is easy to put down and hard to pick up again. And that’s a shame because he has some ideas that might prove useful to the twenty-first century value investor.

Here I’ll share two.

Although there is no single formula to determine when a stock is attractive, Au thinks that the investor’s best bet is the investment value formula: investment value (price) = book value + (10 * dividends). As corollaries to the concept of investment value, Au suggests that “A purchase cannot be considered a bargain unless it is undertaken at roughly one half of investment value” and “An acquirer is often willing to pay roughly twice investment value for control of a company.” (p. 123) As caveats, there must be a satisfactory leverage ratio (normally debt less than 30% of capital) and satisfactory earnings (ROE of at least 10-12%).

A case in point from history—and, on a personal note, an investment that paid my salary for a year and a summer many years later. “In the late nineteenth century, Andrew Carnegie turned a ‘small’ fortune for his day, of about $1.5 million, into a very large fortune of his time. He bought an interest in a steel company at a bargain price, watched it double to investment value, compounded it at roughly 15 percent per year for a period of roughly 30 years, and sold his holdings to J.P. Morgan at about twice the going market price, the premium that Morgan was willing to pay for control in order to fold Carnegie’s steel company into what became U.S. Steel.” (p. 124) You can do the math, but basically Carnegie realized a more than 256-fold return ($1.5 million invested, $412 million return). Not too shabby. Alas, the investor who bought U.S. Steel in 1900 and miraculously lived another hundred years would have had no return on his investment.

For those who want to stay fully invested in stocks but change strategies depending on market conditions, Au describes nine market scenarios—high and rising, high and stable, high and falling, moderately priced and rising, moderately priced and stable, moderately priced and falling, low and rising, low and stable, and low and falling. “Of these nine scenarios, Graham and Dodd-type investing has a clear advantage in the three stable scenarios by emphasizing dividend income, and the three falling scenarios by focusing on capital preservation. It is also robust in two of the three rising scenarios, when stocks are low and moderately priced. Its clear disadvantage is in the high and rising scenario, which was the case in the late 1990s.” (p. 215)

Still better off is the investor who can time the market, knowing when to add to his stock portfolio and when to go to cash or bonds. Au offers some timing suggestions, including the notion of generational cycles. “A stock market cycle of 30-odd years … encompasses one strong and one weak generation.” “Strong generations, such as the Baby Boomers, run the American economy in overdrive. Weak generations, like the preceding Silent generation and succeeding Generation X, rein in the excesses of the strong generations.” (p. 307) As is often the case with long cycles, the timing of the next peak and trough is tricky. A complete 80-year generational cycle “would predict a crisis and possibly a war around the year 2021. This is close to the right time frame, but at the rate events are progressing, the climax could come just a bit earlier, in the mid- to late teens.” (p. 308) There will undoubtedly be more crises to come, but I would consider the recent financial crisis one that came far too early by generational cycle standards.

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