New York Society of Security Analysts Presents Strategies of Great Investors

1. New York Society of Security AnalystsPresentsStrategies of Great Investors Instructor: John M. Longo, Ph.D., CFA Finance Department, Rutgers Business School Chairman of Investment Committee, The MDE Group November 15, 2005

2. Q: Why Can Using Public Information (on the Internet or elsewhere) Add Value Or Help Result In Superior Investment Performance?(* Let’s Have A Picture Reveal The Answer *)

3. Q: How Would You Describe The Woman In The Picture?

4. The Human Element In Stock Prices Two people can look at the same exact picture (or company) and come to completely opposite conclusions. Unlike the laws of physics (e.g. gravity, motion, etc.) there is no formula that can consistently forecast security prices – mainly due to the (irrational?) human element.

5. Mosaic Theory Mosaic Theory – Obtain bits and pieces of public information and weave them together into a new, unique picture that others do not clearly see.

6. Program Summary • No investment strategy works all the time. Studying the strategies of successful investors may help you discover the strategy that works best for you and may help you avoid costly mistakes. Find the strategy that best fits your skill set, resources, and personality type.

7. Nature Of Investment Strategies • What is Your Advantage? • Superior Information • Receive market-moving material before others (difficult in the Internet Age and in the presence of Insider Trading laws.) • Use of relevant information sources with limited distribution (e.g. obscure website, bulletin board, newsgroup, newsletter, etc.)

8. Nature Of Investment Strategies (cont’d) • What is Your Advantage? • Superior Execution of Strategy (Very Important With High Turnover Strategies) • Low transaction costs. • Minimal market impact when executing trades. • Direct access vs. agency execution. • Market vs. Limit Orders.

9. Nature Of Investment Strategies (cont’d) • What is Your Advantage? • Superior Interpretation of Public Information (Mosaic Theory) • Unique insight in interpreting publicly available information. • Use of superior technology to aggregate relevant, disparate information sources (e.g. multiple ECN and exchange data feeds). • Superior qualitative or quantitative proprietary models.

10. Nature Of Investment Strategies (cont’d) • Length of Strategy Effectiveness (Fleeting vs. Eternal, Static vs. Dynamic) • Successful strategies often self-destruct. • Successful investors attract attention. • People reverse engineer successful strategies. • Too much money chasing too few investment opportunities reduces returns. • Make plans for a new strategy before your existing one begins to falter.

11. Types of Strategies • Strategy Type: Quantitative vs. Qualitative • Qualitative: Flexible in dealing with all scenarios, but difficult to back-test and stress test strategy. • Quantitative: Easy to back-test and stress test strategy, but may backfire when operating in a new, unseen market environment (e.g. trading post 9/11) • Combination: Quantitative model that can be overruled or enhanced by human qualitative judgment.

12. Strategy Complexity • Strategy Complexity: Univariate vs. Multivariate • Occam’s Razor Principle: when choosing between two theories of similar explanatory power, the simpler method is preferred. • “You cannot earn excess returns unless you obtain information that is not already discounted in the market.” – Stephen Ross, renowned MIT Finance Professor.

13. Strategy Complexity (cont’d) “The people who profit from the market are those people who are able to identify the anomalies not yet seen by the market.” Sanford Grossman, Renowned Wharton Finance Professor and successful hedge fund manager.

14. Benjamin Graham Q: Who is this person? A: Benjamin Graham is known as the father of Value Investing and pioneered a rigorous, quantitative approach to Security Analysis. Graham was a successful money manager and also taught at Columbia University, where he and fellow faculty member David Dodd wrote Security Analysis – the “Bible” of Value Investing, first published in 1934.

15. Benjamin Graham (Cont’d) Q: Who is this person? (Cont’d) A: Warren Buffett and John Templeton were among the many successful investors who took Graham’s course. Graham was also a founding member of an organization of professional security analysts.This organization is now known as the New York Society of Security Analysts.

16. Benjamin Graham (Cont’d) Q: What are the main concepts of his strategy? A: Value approach with a “margin of safety.” Focused on quantitative measures of value and strongly preferred existing assets and current earnings over promises of future profits/returns.

17. Benjamin Graham (Cont’d) “To have a true investment, there must be present a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience.”  “Investment is most intelligent when it is most businesslike.”

18. Benjamin Graham (Cont’d) “Every corporate security may be best viewed in the first instance as an ownership in, or a claim against, a specific business enterprise.” Over the long-run performance of both companies and share prices generally revert to the mean.

19. Benjamin Graham (Cont’d) Order of preference in determining value: 1) Value of existing assets. 2) Value of current earnings power. 3) Value of potential growth – only in rare cases and if the growth is within the core competence or franchise of the firm and benefits from some sustainable competitive advantage.

20. Benjamin Graham (Cont’d) • “Net-Net” approach was a favorite strategy • “Net-Net” stocks -> Market Cap < (Current Assets – Current Liabilities) • In other words, the stock is trading below net cash value. • These stocks are difficult to find in the present market, but were more abundant during the Great Depression when Graham and Dodd first published their seminal work.

21. Benjamin Graham (Cont’d) • Recognizes the role of psychology in investing. • “The investor’s chief problem – even his worst enemy – is likely to be himself.” • Focuses on investment, not speculation • “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting the requirements are speculative.”

22. Benjamin Graham (Cont’d) • Regards growth stocks as a whole as too uncertain and risky a vehicle for the defensive investor. • “Of course, wonders can be accomplished with the right individual selections … But the average investor can no more accomplish this than to find money growing on trees. In contrast, we think the group of large companies that are relatively unpopular, and therefore obtainable at reasonable earnings multipliers, offers a sound if unspectacular area of choice by the general public.”

23. Benjamin Graham (Cont’d) • Seven quality and criteria suggested for the selection of common stock for the defensive investor: • Adequate size of the enterprise (Measured in sales, $100MM in 1971 dollars.) • A sufficiently strong financial condition (e.g. credit rating) • Earnings stability – positive earnings for 10+ consecutive years.

24. Benjamin Graham (Cont’d) • Seven quality and criteria suggested for the selection of common stock for the defensive investor: (Cont’d) • Dividend record – 20+ years is preferred. • Earnings growth – min increase of at least 1/3 in EPS in past 10 years using 3 years averages at the beginning and end. • Moderate P/E ratio -> current price should not be more than 15x average earnings over the past 3 years. • Moderate ratio of price to Assets • < 1.5 Book value (unless P/E < 15) orP/E * Price / Book <22.5 (= <15 P/E *1.5 Book)

25. Benjamin Graham (Cont’d) • “If you have formed a conclusion from the facts and if you know your judgment is sound, act on it – even though others may hesitate or differ.” (Ed. Note: Value investors are often contrarian, going against the crowd at large.)In the world of securities, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand.” • “To achieve satisfactory investment results is easier than most people realize. To achieve superior results is harder than it looks.”

26. T. Rowe Price, Jr. Q: Who is this person? A: T. Rowe Price, Jr. is one of the pioneers of Growth Investing. He was a successful fund manager and founded the large mutual fund company, T. Rowe Price. He is perhaps best known for his company life cycle approach to investing.

27. T. Rowe Price, Jr. (Cont’d) Q: What are the main concepts of his strategy? A: Corporations have life cycles. Buy when earnings are increasing / accelerating to maximize return and reduce risk.

28. T. Rowe Price, Jr. (Cont’d) • Price’s Goal: “To maintain purchasing power of both income and principal with the minimum risk of loss of principal and reduction of income.” (Ed. Note: This goal is somewhat inconsistent with investing in Growth stocks since many “blow up” when projections are missed and/or the expected growth does not materialize.)

29. T. Rowe Price, Jr. (Cont’d) • “Corporations, like people, have life cycles. Risks increase when maturity is reached.” • Three phases of the corporate life cycle: • Growth (growing faster than economy) • Maturity (at or near maximum earnings) • Decadence (experience long-term secular decline in earnings)

30. T. Rowe Price, Jr. (Cont’d) • There are greater gain possibilities and less risk of loss while the earnings trend is growing. • “Because the economic or business cycle runs concurrently with a company’s life cycle, it is difficult to determine in advance when earnings power is on the decline. Research and an understanding of social, political, and economic trends should enable one to recognize the change in long-term earnings trend of business.”

31. T. Rowe Price, Jr. (Cont’d) • Price on measuring industrial life cycles: • The two best ways of measuring the life cycle of an industry are: 1) unit volume of sales and 2) net earnings.

32. T. Rowe Price, Jr. (Cont’d) • According to Price, there are two major types of growth stocks. 1) Cyclical Growth (tied to economy – e.g. Autos in the 1950’s) 2) Stable Growth (not tied to the economy – e.g. Healthcare, Beverages, etc.) • An emphasis on Stable Growth should be preferred when the market seems expensive (see below on metrics to assess market valuation) and visa versa.

33. Phillip Fisher Q: Who is this person? A: Philip Fisher is one of the pioneers of Growth Investing. His work (along with Graham’s) has had a profound impact on Warren Buffett, arguably the greatest investor ever. Fisher was one of the first to do traditional fundamental analysis (beyond looking at a company’s financials) using his “scuttlebutt” method - talking to management, competitors, suppliers, former employees, etc. His son, Ken Fisher is a well-known investor and columnist for Forbes.

34. Phillip Fisher Q: What are the main concepts of his strategy? A: Identify Growth Stocks with rapidly growing sales and earnings. Enhance traditional fundamental analysis (i.e. analyze financial statements) with legwork or by uncovering “scuttlebutt” - talking to management, competitors, suppliers, former employees, etc.    

35. Phillip Fisher Q: What are the main concepts of his strategy? A: Identify Growth Stocks with rapidly growing sales and earnings. Enhance traditional fundamental analysis (i.e. analyze financial statements) with legwork or by uncovering “scuttlebutt” - talking to management, competitors, suppliers, former employees, etc.

36. Phillip Fisher • In Fisher’s seminal book on Growth Investing, Common Stocks and Uncommon Profits, he identifies 15 factors to look for when buying common stock: (emphasis added)  1) Does the company have products or services with sufficient market potential to make possible a sizeable increase in sales for at least several years?  

37. Phillip Fisher 2) Does management have a determination to continue to develop products or processes that will still further increase in total sales potential when the growth potential of currently attractive product lines have largely been exploited? 3) How effective are the company’s research and development efforts in reflection to its size? 4) Does the company have an above average sales organization?

38. Phillip Fisher 5) Does the company have a worthwhile profit margin? 6)  What is the company doing to maintain or improve profit margins? 7) Does the company have outstanding labor and personal relations? 8) Does the company have outstanding executive relations? 9)  Does the company have depth to its management? 10) How good are the company’s cost analysis and accounting controls.

39. Phillip Fisher 11) Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition? 12) Does the company have a short-range or long-range outlook in regards to profits? 13) In the foreseeable future, will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel?

40. Phillip Fisher 14) Does the management talk freely to investors about its affairs when things are going well, but “clam up” when troubles and disappointments occur? 15) Does the company have management of unquestionable integrity?

41. Phillip Fisher Fisher also discussed three reasons to sell a stock: (emphasis added) 1) When a mistake has been made in the original purchase and it becomes increasingly clear that the factual background of the particular company, is by a significant margin, less favorable than originally believed.

42. Phillip Fisher 2) Sales should always be made of the stock of a company which, because of changes resulting from the passage of time no longer qualifies … to about the same degree it qualified at the time of purchase (e.g. determination of management, market has changed) (Ed. Note: Sell when stock does not meet many of the 15 hurdles discussed above.) 3) Opportunities for attractive investment are extremely hard to find. (Ed. Note: perhaps suggesting the market is overvalued)

43. Phillip Fisher • Fisher advocated a moderately sized portfolio since owning too many stocks made it impossible to “watch all the eggs in all the different baskets.” • He felt buying a company without a detailed understanding of the business may be more risky than having limited diversification.

44. Warren Buffett Q: Who is this person? A: Arguably the greatest investor ever. Buffett was a student of Graham’s at Columbia, worked for Graham, and later set up his own investment partnership. He eventually closed his investment partnership in 1969 because he felt the market was overvalued. Since that time, he has used Berkshire Hathaway as his primary investment vehicle. Buffett consistently ranks among the Top 5 on Forbes’ list of the richest people in the world.

45. Warren Buffett Q: What are the main concepts of his strategy? A: Buffett describes himself as “15% Fisher and 85% Benjamin Graham.” He is predominantly known as a Value Investor who’s “favorite holding period is forever.”

46. Warren Buffett • Buffett: Synthesis of Benjamin Graham and Philip Fisher. • “I’m 15% Fisher and 85% Benjamin Graham.” • (Ed. Note: Buffett’s long time partner, Charlie Munger, brought Fisher to his attention.) • Buffett: First student of Graham, then employee of Graham, then collaborator/ peer.

47. Warren Buffett • Buffett’s approach – combine a qualitative understanding of the business and its management (learned from Fisher) with a quantitative understanding of price and values (learned from Graham). • Buffett called Graham’s “Net-Net” strategy the “cigar butt” approach (one or two puffs left, for a cheap price.) • According to Buffett, the last time it was easy to profit from Graham’s “Net-Net” strategy was 1973-74.

48. Warren Buffett • Buffett: • Says he cannot predict short-term market movements and does not believe that anyone else can. • Does not commit any resources to judging economic cycles (or politics). • Says there is no difference between buying a business and shares in a business. (concurs with Graham) • Looks for companies selling at attractive valuations.

49. Warren Buffett • Buffett (cont’d): • Looks for companies he understands with favorable long-term prospects, • Looks for companies that are operated by honest and competent people.

50. Warren Buffett • In his book, The Warren Buffett Way: Investment Strategies of the World’s Greatest Investor, Robert Hagstrom distilled Buffett’s approach to investing into a number of tenets or principles. (Ed. Note: Hagstrom did have access to and conversations with Buffett before publishing the book. Warren Buffett has never published a book on his investment philosophy, but writes a detailed letter to shareholders annually.)