Chapter 8: The Investor and Market Fluctuations

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“The happiness of those who want to be popular depends on others; the happiness of those who seek pleasure fluctuates with moods outside their control; but the happiness of the wise grows out of their own free acts.” — Marcus Aurelius 

• There exist two theoretical ways to capitalize on the pricing pendulum swings of common stocks:
  1. The way of Timing
     • Endeavor to anticipate the action of the stock market (easy to end up as a speculator)
     • A great deal of brain power goes into this field & some people can make money at it. But absurd to think that general public can
     • Timing strategy gains advantage only if waiting allows a purchase at a significantly lower price that outweighs the cost of missed dividend payments (for long term value investors, timing is only important if it coincides with pricing & allows the purchase of value stock at a lower price than previously possible). 
  2. The way of Pricing
     • Endeavor to buy stocks when they are quoted at a level below their fair value & sell stocks when they are quoted above their fair value
• Commonalities of Bull Markets
  1. Historically high price level
  2. High price/earnings ratios
  3. Low dividend yield against bond yields
  4. Much speculation on margin
  5. Many offerings of new common stock issues of poor quality
• Formula Plans: The essence of all formula plans is to automatically sell a portion of common stocks when the market advances significantly (dollar cost averaging is a notable exception). This has worked for certain historical periods but risks a higher than desired sell out level in extended bull markets. Many investors are not willing to sit on the sidelines in these periods and buy back in at higher riskier levels
• “The moral seems to be that any approach to money making in the stock market which can be easily described & followed by a lot of people is by its terms too simple and too easy to last”
• Market Fluctuations 
  • It is probable that your portfolio will advance 50% or more from its low point AND decline the equivalent 33% or more from its high point over the next 5 years
  • A substantial rise in the market is reason for satisfaction but also prudent concern (are my holdings now overvalued?)
• Business Valuation vs Stock-Market Valuation
  • The shareholder can price his holdings using market quotation (can be sold in seconds at price that constantly varies) or as a minority owner in a business (value depends on pro-rata share of profits of enterprise or change in the underlying value of its assets)
  • If you invest in companies selling above their net asset value (or book value/balance sheet value — take all assets, subtract liabilities & soft assets such as goodwill, trademarks and other intangibles) you are more reliant on the price quotations to validate your commitments 
  •  Stock market contains built in contradiction — The better a companies record & prospects the more inflated its price will be in relation to book value (the level of which will depend on changing moods in the market). Thus the more successful a company, the greater the likelihood of price fluctuation. 
    • A large price decline for a stock does not necessarily mean a lack of confidence in a company. It can instead be a reaction to the belief that an inflated valuation was reached
  • A stock is not necessarily a good purchase just because it can be bought at or near book value. You also need good earnings to price, strong financial position, & belief that earnings will be maintained moving forward
    • Most businesses change in character over the years. Some for the better, others for worse
• Mr. Market
  • Mr. Market does not price stocks as a an appraiser would. Instead when stocks are rising he happily pays more than their objective value & when they are decreasing he is desperate to dump them for less than their true worth
  • Mr. Market’s job is to provide us with prices. Our job as investors is to decide whether or not it is wise to act on them.
  • Unlike some large funds & money managers, an individual investor has the luxury to decide NOT to follow the market. If you follow every unjustified market decline you are taking an advantage (the ability to think for yourself) and allowing it to become a disadvantage (although you should sell if something has fundamentally changed about the a companies future prospects OR to utilize tax loss harvesting strategies)
    • With Billions under management large funds must gravitate towards the biggest stocks for necessary liquidity (or buy MANY small stocks and lose their focus)
    • The more successful a fund, the more capital inflow. This makes continued returns harder (less & less ability to purchase unique stocks or explore new creative ideas)
    • Most managers get bonuses for beating the large indexes. Therefore they buy companies when they are added (if they do not and it goes up they will look foolish, but the downside risk is minimal as no one will blame them for adding the stock)
  • “The primary cause of [investors] failure is that they pay too much attention to what the stock market is currently doing” 
  • When Mr. Market makes stocks cheap they become targets for wholesale acquisition (takeover)
• The true investor is rarely if ever forced to sell his shares (if bought correctly he/she can be confident in their holdings without checking the current price level)
• Speculators wish to anticipate and profit from market fluctuations. Investors wish to acquire and hold suitable securities at suitable prices
• Benjamin Graham Financial Network (BGFN)
  • To avoid reacting irrationally to temporary market declines envision the hypothetical BGFN 
  • “SALE! Stocks fall 50% putting them at bargain levels for astute investors! Hopefully they will continue to fall creating even more opportunity!”
  • Also remember that absolute rather than % changes can sound way scarier than they are. A “200 point decline!” Is less than a 1% change at the DOWs current level of ~25,000. 
• Bond Prices fluctuate inversely to current interest rates (low yields correspond to high prices and vice versa) but fixed maturity value of 100 % exerts a moderating influence
  • Price fluctuation of convertible bonds & preferred stock are the result of: 
    1. Variations in the price of related common stock
    2. Variations in the credit standing of the company
    3. Variations in general interest rates

Chapter 9: Investing in Investment Funds

“Bright, energetic people — usually quite young — have promised to perform miracles with other “other people’s money” since time immemorial.” — Benjamin Graham

• One option available to defensive investor is to invest in investment-company shares
  • Open Funds/ Mutual Funds: Funds that are redeemable on demand by the holder, at net asset value (as of 2018 the mutual fund industry was worth 17.7 Trillion (8,042 companies) vs. 50.6 Billion in 1970 (356 companies) & 6.56 Trillion in 2020 (8,279 companies)). These funds must be registered with SEC. Most are actively selling new shares
  • Closed Funds:  Non-redeemable shares. Number of shares generally remains constant
    • Closed funds typically sell at a discount to net asset value (not as marketable) while open load-funds sell at a 5-10% premium to net asset value (to cover sales commissions). Investment results are generally equivalent, thus the low fee, below market option is likely to lead to better results even if the discount margin grows when he/she goes to sell (an argument sales people of open funds will often deploy)
  • Load vs No-Load Funds: Load funds add a selling charge or commission ($1000 investment in 5% load fund would end up being an investment of only $950). No-load funds do not charge this and rely only on the traditional investment counsel fees 
  • Types of Funds: Funds specialize by asset type (bond vs common stock), category (growth stocks or technology stocks) or by their objective (income, price stability etc)
  • Most mutual funds operate under special provisions of income tax law & must pay out all ordinary income (dividends & interest received less expenses). Can also pay out realized long term profits on sales of investments with capital gains dividends.  A newer form of fund called a “dual-purpose fund,” (closed fund) splits these streams of income into a preferred & common share. The preferred share holder receives any ordinary income and the common stock holder will receive all profits on security sales
  • Funds typically preform in line with the market average. However they offer a place for consistent conservative investment with little thought (it would be hard to criticize the mutual fund market as a whole for not out preforming the market — they make up such a large portion of the market as a whole that this result is to be expected ~18 Trillion of 34 Trillion equity market (along with a roughly 23 Trillion dollar debt market. 14.4 Trillion US Treasury debt, 8.8 Trillion corporate bonds, $3.8 Billion in municipal bonds) in 2018). 
  • Over 10 year periods the DOW & S&P can diverge by fairly large margins. Over longer intervals of 25-50 years their returns have tended to converge
  • A fund can offer excellent value even if it does not outperform the market by offering an economical way to diversify
  • Don’t pick a fund merely on past results. In general: 
    1. The average fund does not pick stocks well enough to overcome cost of researching & trading them
    2. The higher a funds expenses, the lower its returns
    3. The more frequently a fund trades its stocks the less it tends to earn
    4. Highly volatile funds are likely to stay volatile 
    5. Funds with high past returns are unlikely to remain winners for long
    6. The most lucrative sector of any given year can be among the worst performers the following year
  • Why don’t more funds remain winners?
    1. Top stock pickers are highly sought after & leave to rival funds
    2. Assets under management grow too large & prohibit the continuation of winning strategies (or at the very least can increase acquisition costs)
    3. Managers that have a reputation for success (often from risky strategies) do not want to ruin their reputation and “play it safe.”
  • What to look for in a fund for above average results:
    1. Managers have “skin in the game,” or are among the largest shareholders
    2. They are cheap (low expenses)
    3. They dare to be different
    4. The limit their size
    5. They don’t advertise (don’t need to because of good reputation)
    6. Finally after checking for the above you can look at past performance
  • When to sell — Give your fund time to preform (the performance of most funds falters simply because the type of stock they prefer temporarily goes out of favor). However be wary of the following red flags: 
    1. A sharp & unexpected change in strategy 
    2. An increase in expenses 
    3. Large & frequent tax bills
    4. Suddenly erratic returns 

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