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Cover Story - Jul 01, 2005

Warp of the Worlds

Mark Robertson
Managing Partner

I recently finished reading a book written by one of the most highly respected investment educators of all time. Lamenting recent stock market shock waves, in his own words, "In the field of common stocks, the necessity of taking price into account is more compelling, because the danger of paying the wrong price is almost as great as that of buying the wrong issue. We shall point out later that the new-era theory of investment left price out of the reckoning, and that this omission was productive of most disastrous consequences." The author was clearly disturbed about the behaviors observed during recent stock market (see accompanying graph) and disturbing trends in governance.

The Great Disillusionment

We know now that as the millenium ended the investing world was being watched closely by intelligences supposedly greater than average man. The experts proved to be fallible, again. We know now that as enterprises busied themselves about their various concerns they were scrutinized and studied, perhaps almost as narrowly as a man with a microscope might scrutinize the transient creatures that swarm and multiply in a drop of water.

With infinite complacence people went to and fro over the earth about their little affairs, serene in the assurance of their dominion over this small, spinning fragment of solar driftwood. In some circles, it became difficult to distinguish whether investing was something based on chance or design.

Yet across an immense ethereal gulf, minds that are to our minds as ours are to the beasts in the jungle, intellects vast, cool and unsympathetic, regarded this earth with greedy eyes and slowly and surely drew their plans against us.

In the early years of the 21st century came the Great Disillusionment. Although business was better following a recession, the market carnage was far from forgotten. Sales were picking up. By virtue of retirement investment plans and the like, more people were involved than ever before.

16-Year Trend for General Stock Market

"...experience [before and after the peak] inspires questions both new and disturbing. We called things 'investments' that covered the crassest and most unrestrained speculation. Heavy losses sustained by conservative investors warrant serious questions about whether there is such a thing as a sound and satisfactory investment. We return to fi rm ground in the [time-honored] wisdom that WHEN TO BUY AND SELL is as important as WHAT to buy."

No, the accompanying graphic does NOT chart the market of the late 1990s. The chart and quotes are from a text written by Benjamin Graham and David Dodd in 1934 entitled, "Security Analysis." Some of you also recognized these opening paragraphs as a slight paraphrase of the Orson Welles radio presentation of "War of the Worlds" from October 1938.

The More Things Change...

To the best of my knowledge, no Martians are on the rampage on the outskirts of Grovers Mill, New Jersey some 67 years later. But in some ways I feel like we've witnessed a bit of a time warp when looking at the stock market charts for 1920-1935 and how favorably they compare to the picture from 1990-2005. The scales and the names of the "guilty" have changed, but the magnitude and disruption witnessed seem pretty similar.

Graham was deeply troubled by the events of 1929-1933. Twenty years of experience on Wall Street had taught Graham that an overemphasis on the superficial and the temporary is at once the delusion, nemesis and demise for the typical investor. He lamented that "some matters of vital significance, e.g. the determination of the future prospects of an enterprise, actually received little attention in the book," focusing instead on opportunities of fairly extreme undervaluation.

Vital Future Prospects

At Manifest Investing, the vital future prospect for any investment is the projected annual return (PAR). We make an evaluation of the growth and profitability characteristics for the companies that we study. The result, when combined with a projected average P/E ratio, generates a nominal price expectation for five years from now. We combine the annualized price appreciation with the forecasted average dividend yield to produce the projected annual return expectation.

This approach is quite similar to the thinking of Graham's star student, Warren Buffett. Buffett's advice: When investing in a company, study it, learn all you can about it, and understand where the company will be in 5-10 years and if you buy the stock, hold it. What if the stock market were going to be "closed" for the next five years? Think in terms of how the business operates. How are sales increased? How profitable is the business? How likely is it that the business will remain or increase its profitability? Buffett says, "Don't lose focus on the quality of individual companies." Build a vision as to where you expect your company to be in 5-10 years and cast that vision over your portfolio.

Graham wrote Security Analysis to explore "concepts, methods, standards, principles and, above all, logical reasoning." To this day, practitioners of fundamental analysis use what's called a discounted cash flow (DCF) analysis in an attempt to determine the fair value of a stock. The quest is for stocks that are selling at a price lower than their fair value.

DCF is a little complicated for anybody with a math phobia, but let me make an attempt to describe what it is. The value of a business can be broken down into two components. The first component is the value of current assets (after paying all liabilities.) This is the book value, or equity, for the enterprise. One way to visualize this is to think of your residence. Your house has a "street value" that you could sell it for. Most of us also have a mortgage. The book value is the market value of your house minus the balance owed to the bank.

The second component is the sum of future cash flows from the business, corrected for the time value of money. In other words, a forecast of future annual profits is made and adjusted to present day dollars, using a figure for the time value of money.

DCF analysis takes the sum of book value and the discounted cash flows and estimates a current value for the stock. This is how the majority of professional investors attempt to evaluate which stocks are on sale.

Now, think about Buffett's encouragement to close our eyes and imagine a stock market closed for five years. Then, think about the method used to establish our projected annual return (PAR) and our "expected income statement." Building the vision of a price, five years out, and measuring the expected return allows us to identify which stocks are on sale at any given time.

I don't know about you, but I take great comfort in knowing we're thinking about investing, on the wings of Graham and Buffett, all the time.

Mark Robertson is founder and managing partner of Manifest Investing, a source for research and portfolio management focusing on strategic long term investors.

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