Wednesday, October 22, 2014

Two great posts from Credit Bubble Stocks

Credit Bubble Stocks has two older posts that deserve to be reposted.

The first is a review of Benjamin Graham: Building a Profession, which is a collection of Graham's articles and speeches.

The book's highlight is its discussion of Computing-Tabulating-Recording Co., which was a predecessor of International Business Machines. Graham liked C-T-R because he had extensive experience using its products, which knew were high-quality, and because its stock traded at only 7x earnings. He urged his boss to buy C-T-R's stock, but his boss flatly refused:

So early in 1916 I went to the head of my firm, known as Mr. A.N., and pointed out to him that C.-T.-R. stock was selling in the middle 40s (for 105,000 shares); that it had earned $6.50 in 1915; that its book value-- including, to be sure, some nonsegregated intangibles-- was $130; that it had started a $3 dividend; and that I thought rather highly of the company's products and prospects.

Mr. A.N. looked at me pityingly. "Ben," said he, "do not mention that company to me again. I would not touch it with a ten-foot pole. (His favorite expression.) Its 6% bonds are selling in the low 80s, and they are no good. So how can the stock be any good? Everybody knows there is nothing behind it but water."

By water, Graham's boss meant that its tangible assets had been written up to make its property, plant & equipment look more valuable than they really were.

I find this fascinating because it shows how much valuation standards can change over time. Today, a company is praised for earning a high return on equity (ROE). In Graham's time, companies were praised for having significant assets, even if reporting significant assets depressed their stated ROE. Then, 7x earnings was considered too expensive for a company that had minimal real assets. In 2011, when Graham's most famous disciple invested in IBM, it traded at 13x earnings and its tangible book value was negative. These days, a company with negative tangible equity and low-rated bonds is considered to have an efficient capital structure.

CBS's second post presents a theory of why breadth declines at the end of bull markets:

The problem with low-information momentum investing is that since you don't have a theory of the value of your holdings, you have to put a lot of thought into stop loss rules that get you out of the position when the momentum fades. Mr. UES has a stop loss rule to dump anything that goes down 10 percent from his purchase price or subsequent high price. 

I've noticed that when he blows out of a stock that "isn't working" anymore, he'll push most of the proceeds into ideas that are "still working" - going up.

This is what creates narrowing breadth at the end of a rally!

This reminds me of a story I read in high school, Joseph Addison's The Vision of Mirza. The story describes a bridge that's shrouded in mist at both ends. The length of the bridge that's visible has numerous trap doors: as people walk from one end to the other, they gradually fall through the traps and into the water below. Many people start at the beginning of the bridge, but no one reaches the end.

The Vision of Mirza was meant to be a metaphor for death and the evanescence of human life. Less dramatically, it's also a metaphor for the stock market. The beginning and end of a bull market are often impossible to identify in advance. They're shrouded in mist, if you will. And few of the stocks that have strong momentum at the beginning of the bull market maintain that momentum for the bull's entire duration.

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