Why Wall Street underperforms Graham & Dodd investors - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Why Wall Street underperforms Graham & Dodd investors 

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In this issue:
» Brokerages believe commodity bull run has come to an end
» US Mint seeing unprecedented demand for gold coins
» 8-year low debt to GDP for US
» What do the new rules for FDI in retail imply?
» ...and more!

No business school curriculum is complete without the study and application of the key tools of security analysis. Beta, the capital asset pricing model, or covariance in returns among securities are some mathematical tools that the graduates swear to. It therefore becomes a necessity to turn such priceless knowledge into something of utility. And we have hoards of Wall Street analysts pouring over endless market data. Their best attempt to manipulate market data with the mathematical tools has met limited success. Even on instances where such studies have proven to have negative utility, Wall Street has defended them. After all, to a man with hammer, everything looks like a nail.

But the men who have defied such practice, and done so successfully, are the disciples of Graham and Dodd. Not just Buffett, but many others who took to Graham's style of investing chose to stay away from complex financial modeling. Their approach to investing, though different, was based on the key principles influenced by Benjamin Graham. That is focus on two key variables - price and value.

One of them, Walter Schloss, never went to college. But he took a course from Graham at night in the New York Institute of Finance. Over the next 28 years, Schloss' partnership firm beat the returns of the benchmark S&P index 7.5 times! Buffett famously described this man as "He never forgets that he is handling other people's money and this reinforces his normal strong aversion to loss. And from this flows an attraction to Margin of Safety principle".

Another Graham disciple Tom Knapp was chemistry major and a war veteran before he turned into an investment manager. With the help of co-Graham student Ed Anderson he founded the Tweedy Brownie partnership in 1968. This fund too outperformed the benchmark Dow Jones and S&P by 5 times each between 1968 and 1983.

Thus while his fellow Graham disciples may not have come close to matching Buffett's credentials, their achievements are illustrious nevertheless. What really sets them apart is the fact that they have lived up to the promise of making their investors richer. Much richer! Something that the Wall Street and other main street guys can hardly boast of, and probably never will! A lesson or two for those who wish to succeed in the art of security analysis.

Do you think, complex financial models can do a better job of valuing stocks that the simple principles of value investing? Please share your comments or post them on our Facebook page / Google+ page

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01:35  Chart of the day
While interest rates, fuel prices and record low GDP growth rates have played havoc with the growth rate in demand for auto, the volumes have only one way to go. If the penetration of passenger vehicles in India is anything to go by, the potential for a pickup in demand is enormous. Just 11 out of every 1000 people own cars in India as against 26 in China and 125 in Brazil. Even when compared to other Asian economies on a purchasing power parity basis, the growth of auto sector in India, though cyclical, looks very promising.

Source: CRISIL

Has the commodity supercycle come to an end? At least Goldman Sachs thinks so. And Citigroup and UBS AG as well as Credit Suisse Group AG. Indeed, there's a whole galaxy of big Wall Street brokerages out there who believe that the decade-long bull market in commodities has come to an end. And this has not just to do with supply finally catching up with demand but also lower global economic growth, especially in China. You would recall that one of the key reasons we had a commodity bull run was because of China's humungous appetite. But with the dragon nation now keen to move from an investments driven model to a more consumption driven one, its appetite has certainly diminished. Besides, the economies of the developed world are not in the best of shapes either to fill up the gap left behind by China. Of course, there are some who argue that the current weakness is just a short term blip and the outlook for commodities would once again turn bright. We don't quite agree. The global economy is in a phase where it is trying to correct excesses of the past. And until these excesses are corrected, which we think will take quite some time, commodities could remain subdued.

Gold and silver prices have dipped down to 2 year lows. This would suggest that everyone has turned a net seller for the two metals. But the world's largest producer of gold and silver coins has seen demand going up. The head of the US Mint has recently stated that it is seeing unprecedented demand for gold and silver coins. To the extent that the Mint is rapidly buying all the coins that its suppliers can make. This suggests that while prices of paper gold may have dipped, the price of physical bullion is bound to go up. When supply is limited and demand is going up so sharply, prices are bound to follow. And when prices of the metal go up, then prices of the paper metal should go up too. After all paper gold is nothing but a function or derivative of physical gold. This is why investors would do well to hold at least 5% of their portfolios in gold.

Debt to Gross Domestic Product (GDP) ratio is a measure of leverage. Higher the measure higher is the risk for non-repayment. In the US, debt to GDP ratio stood at 0.93 times for the first quarter. This is lowest level ever since fourth quarter of 2005. These are ominous signs for US. Declining debt to GDP ratio means the reliance of an average American on debt has decreased. It could also mean that the overall net worth of the residents has increased. In the case of US, both of these have happened. The household net worth of average American has increased by about US$ 3 trillion due to increase in housing and stock prices. At the same time household debt figure is declining due to fall in mortgage debt requirement. It may be noted that mortgage debt has been declining in the 18 of last 20 quarters. Nonetheless, consumer debt and corporate debt has been increasing. However, the fall has more than offset the rise in the other two areas here.

But what does a falling debt to GDP ratio actually signify for US? A declining ratio de-facto indicates that economic activity has increased. And reliance on debt has decreased. Low reliance on debt signals that spending habits have witnessed a change. Increasing GDP is more due to the fiscal and monetary policy tools undertaken by the government. However, it would be interesting to see if this trend continues in the future as well.

Six months have passed since the Government opened doors for FDI in multiband retail. Yet not a single foreign retailer has volunteered to enter this segment. This was mainly due to lack of clarity on Government's rules on retail sector investment. As trade deficit continues to deteriorate, the Government has come up with further details to woo foreign retailers. With this, it aims to address two main concerns of foreign retailers. The recent details suggest that in order to set up supermarkets, the foreign companies will have to put 50 % of their investments in green field back-end infrastructure. This could be across states, even where multi brand retail is not allowed. However, acquisition of supply chain and other assets will not qualify. Further, the foreign companies will need to source at least 30% of the retail sales value from local small industries. This will not consider farm produce, but only manufactured and processed products. Also, franchises and online selling will not be allowed.

The rules will ensure genuine sourcing from small industries and addition of fresh capacities. However, it has left certain Indian retail groups disappointed who were hoping to sell their stake in front end stores to foreign retailers. While details are welcome, we believe it is still too vague for foreign retailers to set foot in multibrand space.

There have been several reasons why India's GDP growth in FY13 was the slowest in a decade. One of them has been lack of investments and capital expenditure in a highly uncertain environment. Indeed, lack of reforms and political infighting in the country meant that not only Indian companies, but foreign players too were reluctant to pour money into India. The government did introduce reforms in the latter half of the fiscal. But a question mark still exists over the implementation of these.

The lack of confidence in India is echoed by none other than leading industrialist Mr Kumar Mangalam Birla. As per an article in the Financial Times, the head of the Aditya Birla Group has stated that worsening conditions in Asia's third-largest economy would see his company delay capital expenditure. But it would continue to seek investment opportunities abroad. One of the biggest problems for India has been on the infrastructure front. There is always a delay in the completion of projects. This has been due to problems relating to land acquisition and the process of obtaining clearances. This has made the prospect of investing in India quite cumbersome. Mr Birla acknowledges that the government has probably become more aware of the problem now. But on the implementation front a lot leaves to be desired. There is no doubt that government will have to take more initiative. Otherwise, forget foreign investment coming into India, we may end up seeing more and more Indian companies seeking opportunities overseas.

Buying interest in select pharma and IT heavyweights helped the key indices in Indian equity markets feature as the sole gainers in Asia today. The BSE Sensex was trading higher by around 65 points at the time of writing. Other major Asian markets closed lower while markets in Europe have opened in the positive.

04:50  Today's investing mantra
"I have pledged - to you, the rating agencies and myself - to always run Berkshire with more than ample cash. We never want to count on the kindness of strangers in order to meet tomorrow's obligations. When forced to choose, I will not trade even a night's sleep for the chance of extra profits." - Warren Buffett

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    Equitymaster requests your view! Post a comment on "Why Wall Street underperforms Graham & Dodd investors". Click here!

    1 Responses to "Why Wall Street underperforms Graham & Dodd investors"

    Rajagopalan Ramesh

    Jun 7, 2013

    Yes, I fully agree with the views expressed in the article. I myself have been trying to evolve a mathematical / statistical model to identify and evaluate the multibaggers. But picking multibaggers is a multi-dimensional approach, more of an art than of a science like mathematics. You can draw an anology to Dimen's (CEO of JP Morgan) "Value at Risk" approach, where the various facets of Risk Management of Bank's financial exposures on a given day to be quantified by a single figure so as to be placed before CEO every day by 4pm. This was born out of a highly complex mathematical-cum-statistical model, when credit derivatives were in use liberally at that time. Stock-picking is one such area where a multi-pronged fundamental analysis including a host of qualitative factors like Quality of management, corporate governance etc., is required to be handled carefully and patiently. Experience and patience are necessary add-ons for an effective fundamental anlaysis. More than probability oriented statistics, parameters which form part of Fundamental Analisis are more useful with a combination of good qualitative analysis as well. In addition, Macro economic indicators also guide us in our success of stock-picking.
    (Rajagopalan Ramesh)

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