Monday, July 31, 2017

The 2 Books That Every Stock Investor Needs To Read

I was recently asked a question about what my favorite value investing books. I had two that popped into my head immediately. Here is a little back story to my foray into the world of value investing and my life would never be the same after I read these books. I have never said in my life that a book was fucking life changing, but these books have made investing more fun than I could ever have imagined. So much so my pit bull has one's name.

When I first started off my career at the stable and wonderful Bear Stearns, I reread the quintessential value investing book that I had read when I was 13 or 14 years old. That book is written by Benjamin Graham and David Dodd and called, The Intelligent Investor and it was like I was a child again learning that fire was actually hot when you touched it. I wish I would have understood what I was reading 7 years earlier because I felt cheated. Reading this book again on a whim was the catalyst that put me on the path of only being a value investor. Where literally no other type of investing mattered any longer. Not that University taught me anything about investing, but this book taught me everything that Graham had taught Warren Buffett at Columbia University. Graham, who after he lost almost everything in the Crash of '29 become what he is now referred to, "The Father of Security Analysis", sadly many people do not listen to what he has to say any longer, mainly because the companies in his book are no longer around and the economic situations are long out dated also value investing is not fancy or sexy so many investors want to focus on the sexy growth stocks that seem at first glance to make a lot of money, yet you never will catch a falling knife as these stocks usually fall like a boulder. See Graham preached patience and buying quality companies with solid earnings, high moats, and a large margin of safety. He mentioned buying companies in industries that you know and not just buying the hottest trend.  You don't buy companies that may or may not grow at a very quick rate, but have no revenue, EBITDA, or any type of profit since they will be the first ones that investors will capitulate from in any form of market weakness. Graham, in his infinite wisdom, preached buying bonds and preferred stocks due to the added security of having a coupon and being first and second in the worse case scenario of the company going out of business, whereas common stockholders were last and usually left with no compensation at all. The worst mistake that Graham made after the crash was to not hire Warren Buffett right away. YES, you read that right. The only pupil to receive an A in Graham's class at Columbia.  Graham said no to Buffett on multiple occasions. He saw the value in Warren yet he Wall Street was less diversified back then and he wanted his fund to look a certain way.

I digress, anyway, I was the only one in the office to read the book, well at least on my team and that book and his Security Analysis "Bible" as well as his financial statement book helped me establish myself at a young age as someone to go to that would put the effort and patience into my stock picks with a large amount of research to back up my picks or more often than not my non picks. I moved from just going to university and being a wealth manager to all of that plus the team of seven senior financial advisors research analyst. I would have to put together "fund" type portfolios for our clients that would keep our teams clients expenses down.  That book taught me that I didn’t need to pick a new stock everyday or always have an idea. I was rather boring because it showed that a great company could be a terrible investment and a mediocre company bought at a wonderful price could be a great investment.  Intelligent Investor showed me the parameters of what a great company was and also what a great stock of a good company looked like, as well. Graham, who I named my rescue pit bull after, said "This past ability to earn in excess of interest requirements constitutes the margin of safety that is counted on to protect the investor against loss or discomfiture in the event of some future decline in net income."

My second favorite book was and still is Seth Klarman’s Margin of Safety. I used to walk down to the NY Business Library on Madison Ave every single day for a month to read and take a ridiculous amount of notes of that book. I was only allowed to do so behind the desks at an hour at a time. After a few weeks my new friends would give me two hours and that is how I spent the month of July in 2008. I had so much gratitude to the NYC public library because they were the only ones who had that book from Maine to the Carolina's and it was going for $2,000+ for a used copy.

That book was sort of like an extension of The Intelligent Investor and also a much updated version. They both are about the basis of value investing and why having a margin of safety is key to a good investment. They both also showed you how to actually invest using the techniques, but Seth’s were companies and time frames that I actually knew such as the Savings and Loan Crisis and not the years after the Great Depression. The main difference in The Margin of Safety was that Klarman used a relatively new technique of discounting the cash flows of the company. However, it allowed you to understand that if you didn’t do your due diligence over and over again that you could lose your complete investment since things change much faster these days then they did during Graham's hey day, but buy and hold was the key to large capital appreciation. Klarman explained VaR and DCF along with patience, buy and hold, and the margin of safety.

All of these books has made me a much better investor since reading them, rewriting them, and rereading them and I believe that those books are the reason that I was one of a few people in my office to beat the Dow and S&P 500 in the 2008 market crisis as well as beat the indices handily from 2007-2017. Again, it really showed me that I didn’t need to invest in everything new and hot. They showed me that stocks that look cheap monetarily, more often than not, are the most expensive yet even worse the most dangerous to your portfolio. It also pounded home that you need to have that substantial margin of safety as well as the book value being half of terminal or enterprise value.  Graham showed me that the margin of safety helps against Mr. Markets bipolar mood swings and shows you to buy when a stock hits the parameters and Mr. Market is really depressed about the future of the company prospects even though Mr. Market was very happy about those same prospects just the day before. Therefore, you are now buying at a discount and nothing has changed except the sun went down once.  So, by waiting for Mr. Market to be depressed for no good reason you end up getting a good company at a great price. This is where patience comes in handy because the market can be very inefficient because growth investors may not be happy for a moment that the growth hasn't happened as quickly as Mr. Market would like it to be. So, they sell it to you at a very discounted price. Same goes the other way when Mr. Market gets excited and wants to buy the company from you at an inflated price that is way over-valued and that is great for the investor.

Warren Buffett once said, "If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you’d need. If you’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay; but if it’s over the Grand Canyon, you may feel you want a little larger margin of safety." That is the margin of safety in a nut shell.  Klarman mentions in his book, "By always buying at a significant discount to underlying business value, and giving preference to tangible assets over intangibles. (This does not mean that there are not excellent investment opportunities in businesses with valuable intangible assets.) Since investors cannot predict when values will rise or fall, valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value as well as to other methods.”

What I took from the book was this tidbit "What then will we aim to accomplish in this book? Our main objective will be to guide the reader against the areas of possible substantial error and to develop policies with which he will be comfortable".  For indeed, the investor’s chief problem and even his worst enemy is likely to be himself. And, “The fault, dear investor, is not in our stars – and not in our stocks – but in ourselves” We use the margin of safety as a way to protect our investments from our human behavior and greed. This has given me a heads up against a lot of my colleagues because I am never, ever chasing any stocks and sometimes I may leave money on the table and value investing is a very lonely endeavor, but just look at the richest investors and you shall see that they are all value investors.

Daniel Wachtel

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