17 October 2006

The Accountant’s Investment Edge

Accountants have nearly all the tools
they need to be GREAT investors.
If only they knew it

Balance sheets can tell all kinds of interesting stories.

A friend of mine once asked me what I thought of a company he worked with. I did some digging and the next time we met, I asked him: “Is the boss sleeping with his secretary?”

“How did you figure that out?” he asked me.

“Well,” I told him, “according to the latest annual report, a woman whose job description is ‘secretary’ is getting an enormous salary, plus stock options and all kinds of other benefits. I could hire a good chief executive for what she’s getting paid.”

Nuggets of Gold

Not all companies have such scandalous tidbits hidden away in the fine print. But the ability to read a balance sheet and a profit and loss statement — especially if you can read between the lines — is a powerful way to dig up listed companies with hidden nuggets of gold. And just as importantly, weed out the dross.

It was these tools that the legendary investor, Benjamin Graham — author of the classic book, The Intelligent Investor — primarily used to build his fortune. These same tools are major weapons in the armory of his star student, Warren Buffett.

Graham analyzed companies’ annual reports to find stocks that were selling below their intrinsic (or “break-up”) value. He didn’t visit company managements; he didn’t even want to know what products the companies sold; he was only interested in the numbers.

Of course, there is a danger in this approach. There are often very good reasons why a company’s stock is selling below its net worth. Maybe it’s just because the market has hammered it down. But perhaps the industry is in decline, the management is incompetent, a new competitor with a superior product is decimating the company’s sales...there’s a host of possible reasons.

By relying purely on annual reports, Graham had no idea why a company was cheap. So he could — and did — buy stocks that declined, taking a loss.

Nevertheless, his investments returned profits of 17% a year, on average, over several decades.

How did he achieve this when, clearly, some of the stocks he bought turned out to be losers?

He bought a large number of cheap stocks, knowing that while he’d lose money on some of them, he’d make more money on the rest.

To help ensure that outcome, he’d only buy companies with histories of steady management, rising profits and regular dividends. All information you can find in annual reports.

This would weed out many (though not all) of the companies that were cheap because they deserved to be.

And he had another, crucial rule: he would only buy a stock selling for less than half its liquidation value, which he called his “margin of safety.”

Stocks like that are a lot harder to find today than they were in the 1930’s, 40’s and 50’s when Graham was active. But not impossible: Walter Schloss, a contemporary of Buffett’s who was also a Graham disciple, continued to follow Graham’s style with great success until he retired in 2002 at the age of 85.

Clearly, mastery of an accountant’s tools are essential for anyone who wishes to successfully invest in stocks.

But if that is all you needed, you wouldn’t be able to hire an accountant for love or money. They’d all be sunning themselves in the south of France watching their investment profits roll in.

Being able to unravel the secrets hidden in an annual report maybe a necessary talent, but discovering what appear to be good investments is not enough. One thing needed to turn them into profits is an investment system: a method or a set of rules that tells you what to do once you’ve found an investment that looks promising.

Your Personal Style

We’ve seen, in brief, Benjamin Graham’s method. Every successful investor has his own approach that suits his personal style. Warren Buffett, for example, began his investing career in the 1950’s as a Graham “clone.” Today, while some of the criteria he applies today are different from Graham’s, he still aims to buy below intrinsic value. But he now defines intrinsic value as the discounted present value of a company’s future earnings, not its break-up value.

Sir John Templeton is also a former Graham student. But he didn’t just look for the cheapest stocks in the United States; he searched for the cheapest stocks in the entire world, and made a fortune for himself and his investors in the process.

George Soros — whose success owes nothing to Graham or Buffett — has an entirely different and speculative approach. Even so, Soros’s investment system is composed of the same 12 building blocks as Graham’s and Buffett’s.

What’s more, so are the investment approaches of Bernard Baruch, Carl Icahn, Peter Lynch, Philip Fisher and all the other successful investors I’ve studied and worked with.

Even successful investors in real estate, antiques and collectibles, not to mention commodity and currency speculators — totally different markets — owe their success to having a system comprised of the same essential elements.

(Whats your style? My Investor Personality Profile will help you find out.)

Beware of the Great “Story”

The majority of investors focus purely on the first of the 12: what to buy. As a result, people often fall into the trap of buying a stock because it has a great “story.”

A Vancouver stock promoter I met many years ago noticed that some newly-listed companies took off, while others that had pretty much the same financials stagnated or even fell.

By analyzing pairs of such companies, he discovered that the company with the sexy sizzle was the one that caught the attention of the media, that got brokers and investors hot under their collars and excited enough to open their wallets.

When he promoted companies like this – even when they had more story than substance – he could bank a handsome profit.

The boring stodgy company – that made bricks, or industrial parts no-one had ever heard of – was the one that went nowhere. Even when it was the company that was the better investment.

Finding what looks like a great investment is not enough. Indeed, a great company is a terrible investment if you pay too much for it.

Even more important is another component of a complete investment system: every great investor has a clearly defined exit strategy. He knows all the factors that will cause him to sell an investment before he puts a penny on the table. He is, of course, clear about when he would take a profit.

But how often does the market move as you expect it to? That’s the exception, not the rule. The great investor is like a boy scout: he’s fully prepared.

Next time you make an investment, try this exercise. Write down what you will do if everything goes according to plan. Then, think of every possible thing that could go wrong — and for each of those contingencies, write down what you would do. That will give you a sense of what it means to have a complete exit strategy.

If the market collapses, the treasurer runs off to Paraguay with the company’s money, the boss appoints his incompetent son as the chief executive, or any one of a myriad possible other things go wrong, you won’t have to scratch your head and wonder what to do.

Like the great investor, you’ll already know.

Developing a complete investment system also goes a long way to help you overcome feelings of fear and anxiety that sometimes trip investors up. Often, those feelings arise when an investor is really uncertain about whether he’s doing the right thing. Having an investment system — and following it — means you’ve had to do your research properly, so that uncertainty should disappear.

For example, if you’ve discovered a company with hidden assets on its balance sheet — say, property held at its cost 20 years ago, way under its market value today — you’ll know it’s a bargain. You’ll be like the supermarket shopper who sees her favorite soap on sale at 50% off. She doesn’t call her analyst for an opinion; she doesn’t even think twice as she loads up her trolley and buys as much as she can.

You’ll feel much the same. Like Warren Buffett, Benjamin Graham, Sir John Templeton and Carl Ichan — you’ll know a bargain when you see one.

Indeed, when you think about it, it seems obvious that the accountant’s tools underlie the success of the great investors. Add a reasoned investment approach, and the willingness to act on it, to that powerful foundation and you have all the ingredients required for investment success. If not investment greatness.

Some suggested reading: It is relatively straightforward to turn the ability to analyze companies into a successful investment strategy. To help you devise a suitable approach and implement successfully, I highly recommend Benjamin Graham’s The Intelligent Investor — “By far the best book on investing ever written,” says Warren Buffett — as a starting point. In my own book, The Winning Investment Habits of Warren Buffett and George Soros, you’ll find, among other things, the only outline of a complete investment system I’ve ever seen (you can read excerpts online at www.inversebooks.com). And The Warren Buffett Way by Robert Hagstrom is the probably the best introduction to the methods used by the world’s richest investor.

And if the last thing you want to do after getting home from work is read another balance sheet, you might want to investigate a completely different approach. Take a look at Market Wizards and New Market Wizards, which are interviews with some of the greatest traders of our generation.

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