Intelligent Investor Chapter 15 Summary : Stock selection for the enterprising investor

Stock selection for the enterprising investor

  • For defensive investor, broad group of selections were talked about - against all issues of poor quality and also of very high quality with high price that may contain more speculative factor. For enterprising investor, there are possibilities of individual selections that are likely to be more profitable than broad average.
  • Years of evidence shows that mutual funds on average under-perform the market by margin equivalent to operating expense and trading costs. A random portfolio with equal investment in each stock performed better than a mutual fund with same risk. A fund sized 120 stocks from the S& P 500 may miss out on the 380 remaining stocks. Money Managers and analysts tend to look at companies with great prospects. Even if they apply criteria quoted in previous chapters, the more analysts look for such issues, the more rare they become paradoxically. So as stated earlier, enterprising investor can do better only when he has an unpopular but sound approach.
  • Graham-Newmann dealt with following:
    • Arbitrages: Purchase of a security and simultaneous sale of one or more securities into which it was to be exchanged in merger/re-organization.
    • Liquidation: Purchase of shares which were to receive cash payments from liquidation of company's assets- annual return>20% and high probability for successful outcome.
    • Related hedges: Purchase of convertible bonds/preferred shares and simultaneous sale of the common stock into which they were exchangeable. Did well in bear market.
    • Net current asset/bargain issues: Acquiring as many as possible that were selling at less than book value in terms of net current assets alone, giving no value to plant account and other assets. Typically 2/3rd of asset value.
    • They had to drop attractive issues as they were not found at bargain and unrelated hedging operations(from different companies-now restricted to public) because of unsatisfactory results.
  • Defensive investor can allow little offset in the criteria mentioned previously. Enterprising investor can confine himself to companies which finds optimistic without paying too much. Cyclical enterprises like steel shares are also good.

Secondary Companies:

  • Good past record and hold no charm for the public.
  • S& P Stock Guide is very useful. From the list of companies, filtering can be done.
    • List of stocks sold at less multiples.
    • Financial condition: current assets >=1.5*(current liabilities), debt<110%*(net current assets)
    • Earnings stability: no deficit in last 5 years.
    • Dividend record: some current dividend.
    • Earnings growth: last year earnings
    • Price < 120%*(net tangible assets)
    • S & P quality rating
  • Major size, good past record and intangible good will (popularity leads to public's expectation of good returns) all add a market momentum to such companies. The heart(Wallstreet) has it's own reasons that the reason doesn't understand. 
  • Quantitative approach is still preferred.
  • Bargain issues: Need enough of them for diversification and enough patience to wait over a period of time.
  • Special situations: Acquisitions and liquidations. But many don't come through because of several reasons. Need great skill in this.Not suggested for all.


  • Practice: Spend an year tracking and picking stocks (not with real money) This can be done using portfolio trackers. Compare your approach with leading money managers.
  • ROIC better than EPS: 
    • ROIC= Owner Earnings/Invested Capital
    • Owner Earnings=operating profit+ depreciation + amortization of goodwill - federal income tax - stock options cost - maintenance or capital expenditure - income generated by unsustainable rates of return on pension funds
    • Invested capital = total assets + past accounting charges that reduced invested capital - cash and short term investments
    • ROIC~ 10% is good.
  • Comparing with other acquisition data.
  • Stock options not more than 3% of shares outstanding.
  • Good management.
  • Warren Buffet ways- choosing companies with strong brand, easily understandable business, robust financial health, near monopoly and buying when they unfavorable. Managers who set and meet realistic goals, build their business within(rather from acquisition), allocate capital wisely, don't pay high checks to themselves. Steady and sustainable growth in earnings.

See Intelligent Investor Summary for other chapters summary.


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