Hi,

I am a junior member and this is my first post here at e-investing.in

I have read the following books.

1. One Up on Wall Street - Peter Lynch.
2. Beating the Street - Peter Lynch.

I found both the books instructive and informative.

The following books are in my TODO list.

1. The Intelligent Investor - Benjamin Graham (just started reading).
2. Security Analysis - Benjamin Graham.
3. Security Analysis And Business Evaluations - Jeffrey C. Hooke.

However I have a few questions esp. about Graham's books.

1. Are the principles still sound after more than 50 years of its initial writing?

2. If they are still valid, how relevant are they for the Indian market?

Also, it would you great if you guys suggest any books or blogs to read.

- Arun

I won't say that Graham's principles are no longer relevant, but I can say that things have changed since Graham wrote his books.

1. Firstly, Graham wrote his books when the US economy (as well as the world economy) was dominated by manufacturing.

In that era, a company's ability to do business and make profits depended a lot on its physical assets.

Part VI of "Security Analysis" is fully devoted to valuation of assets.

Those principles are still valuable for someone who wants to analyze manufacturing companies.

Buy what about a company like Infosys?

What are the real assets of Infosys?

Is it the buildings and computers that Infosys owns?

No.

Infosys' real assets are its people, its relationships with clients and its expertise in various fields.

It is these assets that have created enormous wealth of investors for last two decades.

For such companies, one will have to overlook Graham's principles on asset valuation and concentrate on earnings potential of the company.

2. It is almost impossible to apply Graham's principles to find undervalued stocks today, except in extreme bear markets.

Why is it so?

The reason is simple.

Graham wrote his books in an era, where money supply was very restricted and the dollar was pegged against gold.

Graham's forte was finding undervalued stocks and bonds.

Buffett's approach is totally different.

Yes, Buffett does looks for undervalued assets, but he looks into the future too.

Graham was a advocate of buying undervalued assets and selling them when they became fairly valued.

For Buffett, numbers are not everything. He looks at quality too.

Buffet defines "undervalued" by looking at numbers as well as quality.

Buffett doesn't sell good quality stocks just because they become overvalued. He holds his stocks for an extended period, if he thinks there is growth potential in them.

In today's age of high liquidity, it makes much more sense to study Buffett than study Graham.

3. Half of Graham's "Security Analysis" is about bonds and other fixed income instruments.

An Indian investor must read this portion too, but he shouldn't expect to make a lot of money by using these principles in bond markets.

In India, there is no bond market for retail investor. Bond markets are dominated by the institutions. A few bonds and debentures trade on the stock exchanges, but these are priced very efficiently and there is rarely any significant undervaluation.

4. Graham's "Security Analysis" contains a chapters on balance sheet analysis and on income statement analysis.

Something is missing?

Yes. .

There is nothing about cash flow statements.

Today's investors including Buffett give a lot of weight to cash flow statements.

Some even say the cash flow statement is more important than the other two - balance sheet and income statement.

To be a successful investor, you will have to learn to interpret and analysis cash flow statements.

5. Some changes have also happened in the way companies are run today.

e.g. Graham gave a lot of weight to liquidity of a company.

In today's world, companies try to maintain optimum liquidity.

Inadequate liquidity is bad, but having excessive liquidity is also not considered good as it reduces the final returns that the company makes on its assets.

I have given this example earlier too. Hero Honda is always has a negative working capital.

There is always a cost associated capital - whether it's debt capital or equity capital.

By running its business with a negative working capital, Hero Honda saves a lots of money.

Because of its strong financial position, vendors and suppliers readily give credit to the company.

Hero Honda's management knows that in any extreme situation, Hero Honda can very easily get bank loans to meet its liquidity requirements.

Thus they keep running the company with negative working capital.

It doesn't make sense for the company to block money in short-term assets when suppliers/vendors are willing to finance its working capital at no cost.

Graham was against investing in companies with inadequate liquidity, but management students are asked to study Hero Honda's working capital management.

It doesn't matter if Hero Honda doesn't meet Graham's investing criteria, it's still considered one of India's best managed companies.

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I had replied to this earlier, but looks like that got deleted in the database issue.

Anyway here goes:

1) Yes the principles are still sound.

Every time, there is a bubble (say the internet bubble of the late 90's), some wise men in the industry & govt say that we are in a "New Economy" now, so the old economy principles are no longer valid. But then the bubble crashes & the wise men are rendered not so wise.

2) Why would they not be relevant in the Indian market? What's different about the Indian market?

Graham's books are the best.

1) People -> A good majority of Infosys's people are very similar to the skilled workers in a factory. They are replaceable. I don't see much difference between assembly line programmers & skilled workers in a factory. There may be a lot of key people in the organisation who are very valuable, but that is similar to manufacturing companies who would have also have a lot of key engineers, designers & other people.

2) Relationships with clients -> I don't see why this isn't important in manufacturing.

3) Expertise in various fields -> Again, same is true in manufacturing in also. And in both, expertise can be hired in a different field if needed.

Infosys's Price/BV Ratio is around 7.5 today. Likewise you will find a lot of non software large cap blue chip companies with such high Price/BV Ratio. Just take your own Hero Honda example - it's Price/BV Ratio is around 10, I think. As per Graham, this means that these companies aren't cheap at current prices.

There are other stocks in the software sector where are available at lower Price/BV ratios.

Take for eg. PCS - even at today's highly inflated markets, it has a Price/BV ratio of around 2.

Well, Buffett swears by Graham's principles.

Read Buffett's essay "The super investors of Graham & Doddsville"

-> http://en.wikipedia.org/wiki/The_Superinvestors_of_Graham-and-Doddsville

What he basically says here is

- Walter Schloss, Tom Knapp, Warren Buffett, Bill Ruane, Charlie Munger, Rick Gruein, Stan Perlmeter are all Graham Disciples. They all pick stocks which are different from each other, but they all follow principles built on the basis of Graham's principles.

And if you feel Graham doesn't value future growth potential, you are mistaken. Graham defines intrinsic value of a stock based on it's future growth potential. However, he doesn't buy a stock just because it has very good growth potential. He buys it only if it is priced at a discount to it's intrinsic value after considering it's growth potential.

Basically, just because a company is good doesn't meant it's a good buy.

I found it useful to analyze companies whose fixed deposit you are going to invest in.

I have two more questions to ask. If these questions sound silly please bear with me; I am a novice investor.

1. Fundamental analysis gives extreme importance to the financial statements of the companies. Since the company (plus the auditing organization) has complete control over what the statements can look like, as an investor, is it okay to base our judgment primarily on these statements? If we have to be cynical about the statement's validity, how else can we determine the real worth of the company?

2. Why did Graham not give much importance to cash flow statement. I am sure he would not have *missed it by chance*. Because obviously when investing in any company one of the first things that anybody would want to know is how much cash is coming in and how much is going out.

- Arun

I don't think Graham gave any such conditions about book value of stocks.

I just went through "Security Analysis" and this is what I found.

The concluding lines of Chapter 42:

Let me give you an example.

Suppose I am a money manager and manage other people's money.

I just tell people what stocks to buy and what to sell.

I start a company with Rs 10 lac.

I take that Rs 10 lac and make a fixed deposit with it.

From the interest of that fixed deposit, I rent an office, computer and internet connection.

Thus, I start my business.

Suppose there is only 1 share of my company. Thus, my initial book value is Rs 10 lac.

Agreed?

After first year of profit, I make a net profit of Rs 1 lac.

Now, I don't need any additional cash.

I distribute it all as dividend.

Thus, no earnings are retained and my book value remains at 10 lac.

Second year, I make Rs 2 lac of profit and again distribute it all as dividend.

Third year, the figure rises to 5 lac.
Fourth year, the figure rises to 10 lac.
Fifth year, the figure rises to 100 lac.
Sixth year, the figure rises to 10000 lac.

All profits are distributed as dividends and thus book value of the company of the company remains constant.

Will you say this company will be over-valued at 20 times book value (200 lac)?

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Financial statements are something that every investor must read before investing in a company, but there are other things to look at too.

No company exists in isolation.

Economic environment, competition and regulations affect each and every business.

It is important to know what the income statement and balance sheet of a company looks like, but it is equally important to be able to predict what these statements will look like in future.

No one can predict what these statements will look like in future with 100% accuracy and therefore having a "margin of safety" is important.

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If a company is manipulating its financial statements, it's not possible to establish the true value of the business - at least not from the three basic financial statements.

Some financial experts may be able to guesstimate the real worth of such a company, but I don't think we are qualified to undertake any such task.

If you are novice investor, it is best to stay away from companies that you don't trust.

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Cash flow statement is a very recent concept.

It was made mandatory in 1987 in US (FAS 95).

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He does so in "The intelligent investor"
- P/E. He gets the cheap P/E value by considering what alternate safer investments he has
as compared to stocks. Suppose he can get an investment grade bond paying 7%, then he
would buy a stock at a maximum of 100/7 = 14.3 P/E
- Price/BookValue. He recommends a max ratio of 1.5. He willing to consider a stock at
a higher P/BV as long it's P/E compensates for it. i.e. P/E * P/BV less than 22.

By my naive questions on this forum, you must know that I am not very knowledgeable in this. I try to follow the system blindly.
Secondly, your example seems rather theoritical. Between 5 & 6th years, your profits grew by 9900% and you did so without any increase in expenditure or assets.