Making money the Graham way!

Mar 14, 2014

In this issue:
» India's exports likely to fall further
» Slowdown in China likely to drag world economy
» Mark Faber suggests to exit stocks
» Time to invest in cyclical stocks?
» ...and more!

Value investing is one of the most widely followed and successful strategies in the world. Contrary to efficient market hypothesis, value investing is mainly the art of buying stocks that trade at deep discount to their intrinsic values. First established by Benjamin Graham, it has introduced the world to great investors like Warren Buffet, Walter J. Schloss and Irving Kahn. Infact, most of these have been mentored by Mr. Graham himself. His books -'The intelligent investor' and 'Security Analysis', are considered as two of the best books on investing. Even after decades, they are highly relevant and valued. Let us discuss his approach to investing and the reasons behind its success.

Mr. Graham believed that the markets in the short term can be irrational. This leads to deviation in the prices away from the fundamental values. However, over the long term, fundamentals catch up and get fully reflected in the stock prices. As such, he focused on selecting under valued stocks and holding them over long term till they reached their intrinsic value.

That brings us to another important question. How can one be sure about the intrinsic value and decide if the stock is undervalued? It is this aspect that sets him apart from other value investors like Buffett. Mr. Graham, to arrive at intrinsic value, mainly focused on historical numbers and quantitative factors. Unlike Buffett who focuses on qualitative aspects like management efficient, moat etc, Graham's selection of stocks avoided any kind of subjectivity. It has its advantage of avoiding the bias and uncertainty that creeps in from the use of qualitative aspects and future estimates of financial performance.

One can get an insight on Graham's philosophy through his "cigar butt theory" that involves buying dirt cheap stocks irrespective of fundamentals. This involves buying companies that are out of favor currently but could be good turn around prospects. While the current valuations of such stocks may reflect short term pessimism, over the long term , an improvement in the business prospects lead to good investment returns.

Yes, there is a considerable risk involved in this approach as one may get stuck with so called value traps over the long term. However Graham, who first introduced the concept of margin of safety theory does not overlook this aspect. To minimize risks, he suggests diversifying holdings across 25-30 stocks instead of building a concentrated portfolio.

Well, we've been hard at work to create a strategy with exactly this approach in mind and we are happy to announce that our efforts have borne fruit in the form of a totally unique portfolio recommendation service that will invest mostly in the most neglected area of markets i.e. and small and micro caps. While we will be out with the details shortly, at its core is an approach that even Benjamin Graham would be proud of.

As a matter of fact, the strategy has taken most of its inspiration from Graham. The one unique thing that we would like to highlight about this strategy is that it tries to take advantage of the overall market valuations. Therefore if the markets are cheap, maximum money will be invested in stocks and when they are expensive, maximum money will go towards bonds. Besides, the stocks are also not going to be the run of the mill ones. But only those that are trading at deep discount to their intrinsic values and come equipped with strong balance sheets.

We know this sounds interesting and has perhaps made you look for more details on the service. Rest assured, we will come out with the same shortly. All you have to do is keep an eye out for our mails and then fast make up your mind. If 286 other subscribers beat you to this, you could potentially be at a huge loss as this is an exclusive service and we would be every strict in terms of the numbers of new subscribers we would like to take on board.

Do you think one can beat markets over the long term using Graham's way of investing? Share your views in the in the Equitymaster Club. Or post your comments below.

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 Chart of the day
India's current account deficit (CAD) narrowed sharply to 0.9% of GDP in 3QFY14. For the month of February, the absolute trade deficit was down to 5 month low of US$ 8.1 bn. And this was predominantly due to restrictions on gold imports and not due to rising exports. In fact, export growth, as a measure to tame CAD, is likely to face challenges in future. The February growth number for exports already reflects that. In the month of February, exports declined 3.7% YoY. This is believed to be a secular decline for months to come. That's because EU's scheme which gives preference to exports from developing countries will no longer be applicable to India henceforth. This obviously shall hurt export volumes of India. Further, rupee appreciation from here can make the matters even worse. As such, future export growth is under cloud. Another worrying factor is inability to check imports. While restrictions on gold imports have helped curb the overall deficit, non-gold and non-oil imports are a cause of worry. Though they too have declined but the pace of their decline has been modest. Thus, there are doubts whether the current decline in CAD can be sustained. Prima facie, it appears to be a difficult task.

Absolute Trade Deficit Down to 5 Month Low

If there were any doubts that the Chinese economy is slowing down, data released with respect to industrial and retail activity would help dispel it further. As reported in various business dailies, industrial output rose 8.6% YoY in the January-February period. This is down from a 9.7% increase in December and is the slowest since 2009. Growth in fixed-asset investment also reduced to 17.9% YoY, the weakest pace since 2002, down from 19.6% last year as a whole. Indeed, it is likely that GDP growth for the first quarter of 2014 could be lower than the 7.7% rate logged in during the same period in 2013. Overall, China has pegged a 7.5% growth in GDP for 2014. Given that China is one of the largest consumers of raw materials in the world, the slowdown there has had a telling effect on commodity prices as well. For instance, both copper and iron ore have seen a significant correction in prices. Since growth continues to stagnate in the developed world and the emerging markets most notably China are slowing down, the overall GDP growth rate for the world economy is most likely to be tepid this year.

If you were to choose between a Wall Street CEO and Marc Faber when it comes to view on US stocks, who will it be? Well, the vote has to go to the person who does not have a vested interest in any further jump in US equities. Therefore when the Morgan Stanley CEO recently opined that he remains very bullish on US economy as well as its stocks, we took it with a pinch of salt. After all, the gentleman's perks depend on the continued growth of the US economy and he does have a personal axe to grind here.

Take Marc Faber on the other hand. He is more of an investor and hence would want to be more on the right side of any trade rather than just be a cheerleader for the sake of it. And things are certainly not looking good as per Faber. He is actually of the view that now would be a good time to exit the market. As per him, the euphoria behind US stocks is only six months old and such speedy jumps in index levels without a correction usually lead to more than just a correction. He therefore advises investors to exit stocks and get into the safety of cash. While we leave up to you to follow whoever you wish to, we can't help but agree with Faber. Not only are US stocks expensive but the economy is also not fundamentally strong as per us. Its recent performance has more to do with money printing than any real recovery. As a result, bad news can come from any quarters taking the markets down with it.

One of the biggest failures of the UPA government, during its second term, has been its inability to curtail runaway inflation. In fact, besides corruption, this is the biggest grudge that Indian voters are holding against it. In that case, should the fall in CPI (consumer inflation) be a cause for rejoicing? Or for that matter should the UPA II be patting its back at the fag end of its term? Well, if the inflation hawk RBI's outlook is anything to go by, it will be premature to start rejoicing. On the contrary, the central bank is more likely to hold on to high interest rates even in the upcoming policy review. Those hoping for lower interest rates may thus remain disappointed. This may also spell bad news for banks who are hoping for some relief on restructured loans. Leveraged corporates and NPA burdened banks may have to live with steep interest costs for some more time.

Ever since the market crash of 2008, cyclical stocks have largely been out of favour. On the other hand, defensive sectors such as FMCG, healthcare and technology have delivered strong returns. But in recent times, a change of trend seems to be underway. Cyclical stocks seem to be gaining favour with investors. As per Economic Times, the BSE Capital Goods (+44.9%) and CNX Infrastructure (+16.7%) indices have both outperformed the broad markets over the last six months. On the other hand, sectoral indices such as BSE FMCG (-2.6%) and BSE Healthcare (+8.8%) have delivered muted performance.

Is this the right time to buy cyclical stocks? Well, there cannot be a black and white answer on this. The rally in cyclical stocks is driven by hopes of economic revival post the general elections. If you're going to invest purely on this premise, then be prepared for surprises. In our view, one should invest not based on probable events. Be it cyclical or defensive stocks, the basic motive of an investor should be to buy value. With this mindset, we believe you can indeed look out for cyclical stocks that have strong fundamentals, lean balance sheets and lucrative valuations.

In the meanwhile, Indian stock markets remained weak. At the time of writing, the benchmark BSE Sensex was down by 180 points (-0.8%). Engineering and banking were the biggest losers. Most of the major Asian stock markets were trading lower led by Japan and Hong Kong. Majority of the European indices had also opened on a weak note.

 Today's investing mantra
"If you don't study any companies, you have the same success buying stocks as you do in a poker game if you bet without looking at your cards."- Peter Lynch

Editor's Note: We wish our readers a very Happy Holi! Please note that there will be no issue of The 5 Minute Wrapup on Saturday (15th Mar, 2014) and Monday (17th Mar, 2014).

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Mar 17, 2014


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