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Author: ZenvestorB Big red star, 1000 posts 10+ Year Anniversary! Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 441  
Subject: Chap 8 Business Value Date: 3/10/2001 3:55 AM
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Hi Everybody,

Here's a continuation on Chapter 8 dealing with Business Valuations vs. Stock Market Valuations.

II states,

" The holder of marketable shares has a double status, and with it the privilege of taking advantage of either at his choice. On the one hand his position is analogous to that of a minority stockholder or silent partner in a private business. Here his results are entirely dependent on the profits of the enterprise or on a change in the underlying value of its assets. On the other hand, the common stock investor holds a piece of paper which can be sold in a matter of minutes at a price which varies from moment to moment.

The whole structure of valuation based upon stock market quotations contains a built in contradiction. The better a company's record and prospects, the less relationship the price of the shares will have to book value. But the greater premium above book value, the less certain the basis of determining it's intrinsic value - i.e., the more this value will depend on the changing moods of the stock market.

Thus we reach the final paradox, that the more successful the company, the greater are likely to be the fluctuations in the price of its shares. This really means that, in a very real sense, the better the quality of a common stock, the more speculative it is likely to be.

The previous discussion leads us to a conclusion of practical importance to the conservative investor in common stocks. It might be best for him to concentrate on issues selling at a reasonably close approximation to their tangible-asset value. Purchases made at such levels, or lower, may with logic be regarded as related to the company's balance sheet, and as having a justification or support independent of the fluctuating market prices.

A caution is needed here. A stock does not become a sound investment merely because it can be bought at close to its asset value. The investor should demand, in addition, a satisfactory ratio of earnings to price, a sufficiently strong financial position, and the prospect that its earnings will at least be maintained over the years.

Once the investor is willing to forgo brilliant prospects - i.e., better than average expected growth - he will have no difficulty in finding a wide selection of issues meeting these criterion.

The investor with a stock portfolio having such book values behind it can take a much more independent and detached view of stock market fluctuations than those who have paid high multiples of both earnings and tangible assets. As long as earning power of his holdings remain satisfactory; he can give as little attention as he pleases to the vagaries of the stock market. More than that, at times he can use these vagaries to play the master game of buying low and selling high."

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A common complaint of Graham's value methodology is that it is often equated with "cigar-butt" investing or buying the cheapest situations without regard to the continuity of the underlying business operations. Many of these complaints relate to Graham's use of tangible-asset value as a basis for investment valuation.

I think that the emphasis placed on Graham's method as "cigar-butt" based is, quite frankly, deceptive and misguided. As Graham mentions in Chapter 8, the book valuation is not necessarily an absolute measure of an attractive situation but can be considered as a relative measure of the amount of "stability" a current market quote contains in relation to the amount of speculative expectation.

Graham is very specific in mentioning that the book value must be assessed in connection with historical earnings, financial soundness, and future prospects.

By including book value, I believe that Graham incorporates some extra conservatism to ones view of a companies earnings, soundness, and prospects. In essence, providing possibly the base value of an investment if one's impressions of earnings, soundness, and prospects turn out to be totally incorrect.

This fits in with one of Graham's many conservative quotes,

"Evidently it is not only the tyro who needs to be warned that while enthusiasm may be necessary for great accomplishments elsewhere, in Wall Street it almost invariably leads to disaster"

So my take on Graham's methodology as related to "cigar-butt" investing is that though there is a place for that type in special situations or liquidations, the methodology offers much more than simply looking for the cheapest asset based situation.

I always thought that a telling example is demonstrated in II, Chapter 18, Page 256, relating to Pair 5 in which though International Harvester has really compelling numbers ( about half book, about 10x eps, and 7%+ div yield), Graham defers the opportunity.

ZB
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