Friday, April 2, 2010

The Intelligent Investor (Part 2): The Enterprising Investment

As noted in the previous post, the Intelligent Investors have these traits:

- They see stocks as businesses - when you buy a stock you become an owner of that company
- They recognize two basic patterns the market has in unsustainable optimism and unjustified pessimism - both extremes are wrong so maintain a level head during bubbles and crashes
- They understand future value is a function of present price - the higher price you pay, the lower the return you will be
- They maximize margin of safety - never overpaying for a stock and reducing risks
- They develop discipline and courage - recognizing that your biggest enemy is yourself and not to be swayed by the market or other people's moods. You decide your fate.

By looking at stocks as businesses, there is more of a tendency to know the management styles of the CEO and others within the company, the owner will know what the company's products and services are that they provide, the owner will know more about the company than just it's day to day movements on the stock market. So buy what you know.

The Intelligent investor moves from speculator to investor and that is a very important distinction to be made. Speculator cares more for ups and downs of the stock market and the moods it generates. The investor looks for solid companies that are cheap and a bargain. Investors look for value and undervalued companies.

Another is the two very different moods of the stock market. The unsustainable optimism as can be seen during the dot com bubble and the real estate bubble and the unjustified pessimism as seen with the dot com bubble bursting and the housing market bust. Both times we saw extreme attitudes during the flight upwards and the free fall downwards. The Intelligent Investor would look at the valuations of the companies and buy when the value of the company is greater than the price of the stock.

Graham has three tests for the Enterprising Investment:
- Relatively Unpopular Large Company (p.163) - not highly followed, over sold due to earnings or not very exciting company
- Bargains stocks - looking at future earnings and appraising if there is growth (p.166) and by looking at net current assets or working capital and comparing to valuations of company (p169)Graham gives a good formula to value whether a stock is undervalued: assets - liabilities > price x number of shares.

Graham likes using price to earning ratio (P/E) as well. It helps to see how companies are priced in relation to its earnings. For example: If a company is priced at $20 and it's earnings is 2.0, then its P/E is 10. Usually you can tell if a company is over valued by comparing its P/E with other P/Es in similar industries.

So by buying unpopular stocks and undervalue stocks you don't need to time the market or watch every millisecond. You know how much a company is worth and you develop courage and discipline to be patient in the midst of market fluctuations. This requires you to do research!

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