Lowenstein & Lowe: Fundamental Analysis, Value Investing, and Growth Investing

TLDR 

This book series teaches the strategies, tactics, and principles that have contributed to the wealth creation of some of history's greatest investors, how these ideas came about, and how readers can improve their financial futures by learning various investment styles, such as growth and value investment strategies. The following summary brings to light key parts of each chapter to provide the reader with a thorough overview of the book's topics.

 

The Father of Value Investing

Benjamin Graham is considered the father of modern investing, as many money managers and analysts have based their thinking on his principles. Those who have followed his approach have consistently achieved 20% annual returns. Before Graham's ideas, investing was more speculative and relied on tips, guesswork, or insider information. He introduced a new approach to investing, known as fundamental analysis, which transformed the industry by turning investors into professionals who rely on in-depth analysis of a company's financials instead of gambling. Before his influence, the stock market was in a "dark age" controlled by corporate raiders and speculators. 

Graham is renowned for his expertise in analyzing companies and his contributions to the field of investing. He was able to secure private equity funding and invested on behalf of those investors. He would buy out shares of companies in order to gain a seat on the board and work towards increasing profits for shareholders. One of his greatest mistakes was exposing himself to margin debt during the stock market crash of 1929. He felt pressure for more significant returns, which lead to him barely surviving through the worst four-year period in the stock market. Although he had predicted the crash, he was unable to protect his investors because of this mistake. After this experience, he vowed to never be tempted by greed and borrow again.

Building Value Investing Principles

The traditional method of monitoring the stock market through ticker watching, or technical analysis, involves conforming to the majority's actions or attempting to assess what the crowd is going to do. The catch is that the crowd is attempting to predict those movements as well, so this whole process is deemed nonsensical by Graham. His idea of value investing calls for purchasing stocks at a price below their intrinsic value, as opposed to speculating on potential market trends. Economic cycles, characterized by their repetitive nature, often result in extreme prices that are unsustainable long-term. It is important to note that the market ultimately rewards value investing in the long term, and the price extremes will gravitate back to the company's approximate intrinsic value. Knowing a company's intrinsic value does not require precision, as the investor's primary concern is identifying when a stock is priced significantly below it. A margin of safety provides a buffer for the investor, mitigating any future potential losses. These methods were outlined in his seminal work, "Security Analysis," authored by both Graham and David Dodd, with this book outlining his overall methodology of investment decisions that others could replicate.

Tactics from this book were instrumental in allowing Graham to recoup losses during the Great Depression. He mentions that it is crucial for investors to specialize in areas in which they possess a high degree of expertise, and to avoid being swayed by the prospect of quick gains on Wall Street. The key to success lies in capitalizing on one's strengths and competencies in order to achieve optimal returns. The stock market can be likened to a private partner in a business, with the value of a company fluctuating based on the perceived worth of market participants. These perceptions are subject to change, with prices rising when the market's sentiment is positive and declining when the sentiment is negative. Warren Buffett, a well-known and successful investor, was a star pupil of Graham at Columbia University. It was through his education under Graham that he was introduced to GEICO, a company that stood out due to its unique business model. GEICO cut out the middlemen at the time, and its customer base consisted mainly of government employees with a low rate of accidents and claims. This resulted in the company being unusually profitable. GEICO serves as a prime example of a successful value investment, and one of the best decisions Buffet ever made.

Buffett Expanding Graham's Principles

Graham's investment approach, which relied heavily on strict numerical criteria for determining stock purchases, had its limitations. Even Buffett, who was heavily influenced by Graham's teachings, was frustrated with his mentor's lack of consideration for intangible factors, such as the strength of a company's management. This is exemplified by Graham's decision to pass on investing in Xerox, which has been considered one of the greatest investments of all time, as he believed that the stock was not selling at a sufficiently low price or with a large enough margin of safety. This strict adherence to numerical criteria and focus on protecting capital, likely stemming from his experience during the Great Depression, may have hindered Graham's ability to identify and capitalize on market opportunities. 

At this point, Buffett began to achieve results that surpassed those of any investor before him. At the start of his career, he never had a negative year and consistently yielded massive returns. In 1996, his exceptional investing skills transformed the stock price of Berkshire Hathaway from $7.60 per share to $34,100 per share. He acknowledged that he learned a lot from Graham and credited him as a significant contributor to his success. Buffett believed that good businesses are those that have a strong franchise, such as a Hershey bar compared to a carton of milk. It is the power of the franchise and brand power, not just tangible assets, such as the association between Disney and Snow White. He was able to expand upon Graham's ideas, while only abandoning a few due, such as purchasing companies based on a discount to net working capital or purchasing companies under their book valuation. A big idea Buffett rejected was diversification. He was a proponent of investing a significant portion or even 100% of a portfolio in a single stock if it was a good deal, which went against Graham's ideas. Graham eventually died in 1976 at the age of 82, and he believed that security analysis was on its way out. He believed that the influx of professional analysts had created too few opportunities. Luckily he was wrong, as many of his disciples were able to identify value in different ways than he acknowledged. Efficient market theorists argue that no one can consistently outsmart the market, but this has been disproven by the success of a group of investors, including Buffett, who have consistently outperformed the market throughout the years. The market is not a weighing machine basing its price solely on company fundamentals, it is a voting machine where countless people make decisions based on various reasons, mostly emotional. Speculation may appeal to many, such as chart reading methods, but it does not require the patience, discipline, or study that sound investing does. This may not be easy or quick, but the success of these super investors has shown that it consistently works.

Two Investing Strategies: Growth & Value

Value investing is a strategy that involves purchasing securities at a price below their intrinsic value and holding them until the market recognizes the value and the price increases. Once the security is trading above its intrinsic value and becomes overvalued, the investor should sell it and look for other opportunities. Graham, who is considered the father of value investing, averaged a return of 17% per year from the Great Depression and through two world wars. This does not include the earnings from his most successful investment, GEICO. After his retirement, Graham's investors turned to his protégé, Warren Buffett. He earned an annual return of 29.5% per year until the partnership was dissolved. Another strategy is growth investing, where the individual investor aims to outperform the market by selecting growing sectors and healthy companies that are consistently increasing and then selling when it is apparent that the growth has slowed down. The growth investing strategy is based on the idea that companies have life cycles and that business change is inevitable. The goal is to identify young, growing companies and hold them until they have reached maturity. Patience is essential for this strategy, as it can be well rewarded if the right companies are selected. T. Rowe Price developed the growth stock theory in the 1930s, which was controversial at the time, but ultimately generated substantial profits.

Value Investing

Value investors aim to purchase securities at a price below their intrinsic value, repeatedly. They are always on the lookout for bargains and view shares as ownership in the underlying company. They focus on exploiting the difference between the market price of a security and its intrinsic value, regardless of the overall market sentiment or economic conditions. Graham does not attempt to predict the future growth of a company. He does not consider technical factors such as support and resistance levels or macroeconomic factors. He believes that value ultimately determines stock prices in the long run. The first challenge for a value investor is to identify when a stock is undervalued, and the second challenge is to determine when the stock's price has exceeded its intrinsic value and should be sold. Buffett has stated that intrinsic value is a number that is difficult to pinpoint, but essential to estimate. He himself has never done detailed calculations, he says that if the company's earning power doesn't jump out at you, it probably isn't enough. Peter Lynch, another successful value investor, argues that the future value of a company is determined by its earnings and assets. Value investing rewards investors who can evaluate a company's risks more accurately than the market. Graham taught six essential business factors to evaluate a company's performance, which helps give a well-rounded view of the company. These factors are profitability, stability, growth, financial position, dividends, and price history. By evaluating these factors, value investors are able to determine a company's intrinsic value and make informed investment decisions. It's important to note that value investing requires a long-term perspective and a disciplined approach, as well as a willingness to hold on to undervalued stocks even when the market may be bearish or sentiment may be negative.

1. Profitability: A company's profitability can be evaluated through its operating income as a percentage of sales. High and sustainable profit margins are considered ideal.

2. Stability: To evaluate a company's stability, an investor can compare the average earnings per share (EPS) from the last 10 years to the average EPS from the last 3 years.
3. Growth: A company's growth can be evaluated by analyzing the rise in both sales and earnings. However, it's important to note that sales growth without earnings growth may indicate a problem with the fundamental business or management. Additionally, even if both sales and earnings are on the rise, other industry companies may be growing at a faster rate.
4. Financial Position: The debt ratio is a key indicator of a company's financial position. A solid company should typically have double the assets it has in debt. Additionally, borrowing should not exceed more than half of shareholders' equity. It's important to note that acceptable debt levels vary depending on the industry.
5. Dividends: A long history of consistent dividend payments without interruption is considered important. Additionally, dividends should be set at a fixed percentage of profit and show an upward trend.
6. Price History: The company's price history can indicate its durability and reliability in an ever-changing marketplace.

Value investors aim to purchase securities at a price below their intrinsic value. A classic value bargain is identified when a stock's earnings yield is twice that of the average AAA bond. Graham made significant profits by purchasing stocks at or below the company's net current assets value. This approach commonly referred to as the "used cigar butt" style of investing, involves identifying companies that are nearing bankruptcy and have one "free puff" left in them. However, it is important to note that this style of investing carries a high level of risk, as the company can easily either go bankrupt or survive the situation. Investors must thoroughly research these companies by comparing their share price, shares outstanding, earnings, and assets to similar companies, while also evaluating the market capitalization, which is the true asking price of the company and represents what the market would require to purchase all of the stock, to determine if the company still appears to be a bargain. Peter Lynch also shared his five ways to identify if a company can grow and increase its earnings: reducing costs, raising prices, expanding into new markets, selling more of its products to its existing market, and revitalizing, closing, or disposing of losing operations.

A way to determine a stock's position in its price cycle is to evaluate its dividend yield and price history. If a stock is trading at a higher yield, it may indicate that it is undervalued and may be a good time to purchase. Individual investors can often outperform institutional investors due to regulations and the large amounts of money they have to invest. Most true bargains are not available in large blocks, making it difficult for institutional investors to take advantage of these opportunities, giving the edge to retail investors.

Graham pioneered the concept of buying stocks at low prices and waiting for the market to recognize their value, as seen in his successful investment in GEICO. In his book, Security Analysis, he emphasized the importance of identifying growth companies when their shares are available at reasonable prices. This concept was further developed by Price's growth stock theory, which challenged the conventional view that a stock is a cyclical investment. His theories were based on the idea that change is inevitable and that the growth investor should identify publicly traded companies well-positioned to benefit from new developments, such as major shifts in economic conditions, business practices, or government policy. Even famous value investors like Warren Buffett have adopted some of Price's concepts, stating that successful investors should anticipate change and go where the puck is going, not where it is.

Growth Investing

Growth investing involves identifying companies that are growing faster than the overall economy and have the potential to continue growing despite changes in business cycles. It is important for growth investors to adapt to the changing economic environment, for example, shifting investments into inflation-resistant assets when the time comes. Inflation can be seriously detrimental to the price of growth stocks since they tend to perform well when inflation is low, but with long-term investment horizons, investors will benefit from riding the bad cycles out.

Price and Graham were both successful investors, but they had different attitudes toward which factors influence investment performance. While Graham was interested in economic and social matters, he did not include them in his investment equation. In contrast, Price's outlook was often based on his analysis of social, political, and economic trends. He believed in getting in on investment opportunities early and identifying growth companies before they become popular. There are two main ways to detect great growth stocks according to Price, the first way is to figure out which industries have brilliant futures and then to buy a sprinkling of the strongest companies in those industries. The second way is to watch for specialized growth companies. Price suggested several criteria for identifying a growth industry, which included high-quality research and development, limited competition, few government regulations, well-paid employees with low labor costs, a strong possibility for a higher return on invested capital, and superior growth in EPS. He also looked for companies with strong R&D that held valuable patents and trademarks, and preferred industries with a record of exceptional research and development in both products and markets. He also sought industries where competition is limited, and where the high entry cost of a new competitor makes it easier to dominate the market. He also avoided public utilities and other heavily regulated industries. Growth investors prioritize the growth rate of earnings over the stock's price-to-earnings (PE) ratio, but they still consider it. The belief is that the ratio should not exceed the sustainable percentage growth rate and preferably be lower. A company may sell at an unusually high PE ratio because investors expect phenomenal growth. To determine if an extraordinarily high multiple is justified, some investors adjust current earnings by the PE ratio and factor in expected inflation in the future. They also evaluate a stock's PE ratio by studying the range of the ratio over the past few market cycles. The stock multiple should not exceed 33% higher than the lowest PE multiple during those periods. This historical analysis is particularly important when an investor thinks the market may be at the beginning or end of a bull or bear phase, as it helps to put the share price in perspective.

Growth investing has several subsets that require special attention such as initial public offerings (IPOs), emerging growth stocks, and high technology stocks. IPOs can be rewarding but are very risky, and it is important to analyze the company's track record. Emerging growth investing takes the growth investing philosophy to its extreme, and high technology stocks can be seen as a specialized area of growth investing. Emerging companies face many pitfalls, including competition from larger companies, market saturation, and regulatory changes. For this type of investing, an investor must have the nerve to handle risk, the foresight to ride out tough times, and a big commitment to researching, buying, and tracking investments. Growth stocks are very volatile, and investors without a stomach for risk should avoid investing in them. They typically outperform value stocks at the mature stages of a bull market, also faring poorly during market corrections. It is important for investors to be prepared to wait at least 10 years to cash out these types of investments, because short-term investors may be caught up in the volatility.

Market volatility was even acknowledged by Graham, who often used the fictional character of Mr. Market to describe Wall Street's behavior. Mr. Market is characterized by wild mood swings, so investors must be objective and not buy or sell based on Mr. Market's terms. It's important to remember that many investors lose money by holding onto a stock to break even, instead of getting out when the situation has objectively changed. To determine if growth may be over, investors should look for a decline in return on invested capital. 

Final Notes 

To summarize, each strategy has its own merit and far outperforms solely technical analysis. As Warren Buffett demonstrated, expanding upon the core principles is necessary for an ever-changing environment, including what we see today. Many of Buffett's techniques cannot be used in the present market, so it is up to investors to build upon his style, even combining investment approaches to enhance capital gains. Overall, however, each investor should choose a strategy that best suits their temperament and it is important to assess investments with discipline, common sense, and a sober perspective, especially at times when emotions can carry us away.