Thursday, March 15, 2012

Ben Graham: Better Than Average Expected Growth

From Chapter 8 of The Intelligent Investor by Benjamin Graham:

A stock does not become a sound investment merely because it can be bought at close to its asset value. The investor should demand, in addition, a satisfactory ratio of earnings to price, a sufficiently strong financial position, and the prospect that its earnings will at least be maintained over the years. This may appear like demanding a lot from a modestly priced stock, but the prescription is not hard to fill under all but dangerously high market conditions. Once the investor is willing to forgo brilliant prospects—i.e., better than average expected growth—he will have no difficulty in finding a wide selection of issues meeting these criteria.

Shares of businesses with exciting growth prospects (and usually a great story) often sell at a substantial premium to their current value.

There's always exceptions, of course, but pay for promise not yet realized and watch out below if things don't go quite as well as hoped.

Businesses with big growth opportunities attract competition* and wider range of future outcomes.

In contrast, it's usually not difficult to find publicly traded shares of a business with sound economics if unexciting growth prospects (and likely an even less exciting story) selling at an attractive price relative to current value. If shares are bought at or near the right price, satisfactory or better returns can be achieved even if nothing particularly good happens to the business.

Now, a bit of stable growth from a business with durable competitive advantages is certainly nice. It's just that getting in the habit of paying a premium for potential opens the door to an unacceptably high probability of permanent capital loss.

Graham later in the chapter added that an investor...

...can take a much more independent and detached view of stock-market fluctuations than those who have paid high multipliers of both earnings and tangible assets.

Being detached from market price action is a lot easier when shares of an enterprise are primarily owned for long run profit-producing capacity.

I'm guessing many get this at some level though it seems less practice it.

It's certainly not due to a lack of IQ. There's no shortage of informed and intelligent market participants.

Sir Isaac Newton made the case for this as well as anyone with his participation in the folly of the South Sea Bubble.

His genius did nothing to prevent him from being totally wiped out by it.

Adam

Related posts:
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 2009

* The tobacco industry comes to mind. Who'd want to take on the established players in the U.S. cigarette market?
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