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by Eric
Englund
…to
suppose that the value of a common stock is determined purely
by a corporation’s earnings discounted by the relevant interest
rates and adjusted for the marginal tax rate is to forget
that people have burned witches, gone to war on a whim, risen
in defense of Joseph Stalin and believed Orson Welles when
he told them over the radio that the Martians had landed.
~ James Grant
An
investment operation is one which, upon thorough analysis
promises safety of principal and an adequate return. Operations
not meeting these requirements are speculative. ~ Benjamin Graham and David L. Dodd
In
general, Americans feel pretty darned smart when it comes
to handling money. Since the stock market crash of October
19, 1987, the Dow Jones Industrial Average has gone from 1,738.40
to a March 14, 2005 closing price of 10,804.51. Granted, many
people lost money when the dot.com and telecom bubbles burst,
yet Americans remain unshaken in their collective belief that
staying in the stock market will make them wealthy in the
long run. To be sure, you will hear the mantra that "stocks
always go up in the long run" from diverse sources ranging
from star Wall Street analysts (such as Abbey Joseph Cohen)
to your next-door neighbor. What a dream world America has
become where we can read the business pages, watch CNBC, "invest"
in can’t-lose stocks, and then grow wealthy, over time,
without much thought or effort. When examining
this prevalent mindset, using Graham and Dodd’s distinction
between investing and speculation, I must conclude that most
Americans are speculators not investors. This position is
easy to defend.
An
important aspect of investing is to have the mindset of a
business owner. In 1983, Warren Buffett conveyed 13 owner-
related business principles for Berkshire Hathaway’s shareholders
to embrace. The first principle is potent yet simple in that
Warren Buffett and Berkshire’s vice chairman – Charlie
Munger – view Berkshire Hathaway "…as a conduit
through which our shareholders own the assets." Mr. Buffett
further explains that
Charlie
and I hope that you do not think of yourself as merely owning
a piece of paper whose price wiggles around daily and that
is a candidate for sale when some economic or political
event makes you nervous. We hope you instead visualize yourself
as a part owner of a business that you expect to stay with
indefinitely, much as you might if you owned a farm or apartment
house in partnership with members of your family.
Indeed,
having an ownership mindset is a step toward becoming an investor,
yet, on a stand-alone basis, does not quite get you there.
For if an individual is truly an investor in a business,
he would have a basic understanding of its operations, its
assets and liabilities, its profitability, and its cash flow.
Moreover, an investor would quickly grasp the power of the
following quote from Ludwig von Mises’ magnum opus Human
Action:
Monetary
calculation is the guiding star of action under the social
system of division of labor. It is the compass of the man
embarking upon production. He calculates in order to distinguish
the remunerative lines of production from the unprofitable
ones, those of which the sovereign consumers are likely
to approve from those which they are likely to disapprove.
Every single step of entrepreneurial activities is subject
to scrutiny by monetary calculation. The premeditation of
planned action becomes commercial precalculation of expected
costs and expected proceeds. The retrospective establishment
of the outcome of past action becomes accounting of profit
and loss. (Emphasis added)
A
tool businessmen use to determine the success or failure of
past actions is a financial statement. A businessman
and an investor should have a firm understanding of all the
entries in a company’s balance sheet, the income statement,
and in the statement of cash flows (which are the three key
components of a financial statement). Via analyzing the company’s
financial statement, a businessman can directly correlate
whether his company's capital base (i.e., the company's net
worth as reflected in the balance sheet) is expanding or contracting
depending upon if the company turned a profit or made a loss.
Such monetary calculation assists a businessman in deciding
to maintain or change a business plan based upon satisfying
the ever-sovereign consumer.
The
analysis doesn’t stop here. Businessmen and investors will
also take a keen interest in deriving the following (among
others) from the financial statement:
- Working
capital
- Quick
ratio
- Liquidity
- Debt
to equity ratio (i.e., leverage)
- Return
on equity
- Total
debt service coverage
- Inventory
turnover
- Accounts
receivable turnover
This
may look complicated and, to a certain extent, it is. Yet,
to be a true investor, such "thorough analysis"
– as mentioned above by Graham and Dodd – is essential.
Conversely, if someone cannot read a financial statement (i.e.,
a balance sheet, an income statement, and a statement of cash
flows), then when it comes to purchasing common stock in publicly
traded companies, such a financially illiterate person
is inherently a speculator, not an investor. After all,
such a speculator has no idea how to value a business
and merely owns a "piece of paper whose price wiggles
around daily." With financial illiteracy being the overwhelming
norm in America (let’s face it, public schools have miserably
failed at teaching basic accounting, finance, and economics),
I believe I have successfully defended my position that most
American "investors" are simply speculators.
Now
to bring a bit of politics into the picture here. President
Bush is touting an "ownership society" in which
Social Security reform is a cornerstone – thereby allowing
for personal Social Security accounts where individuals can
"invest" funds into the stock market. I would counter
that President Bush is, not surprisingly, abusing the English
language. After all, with a financially illiterate populace
(thanks again public schools), I assert that President Bush
is essentially doing nothing different from CNBC, the stock
brokerage firms, and the Wall Street Journal in that
he is promoting a "speculator society." Of course,
the key difference here is that the federal government will
be coercing Americans to speculate at gunpoint.
For
those who feel that they fit the mold of being a speculator,
yet want to make the effort to become an investor, there is
hope. Let me give you a crash course. The first step to take
is to read Benjamin Graham and David L. Dodd’s classic book
Security
Analysis. This book will teach you how to read a financial
statement. The next step is to read The
Intelligent Investor by Benjamin Graham. As Warren
Buffett stated, it is "By far the best book on investing
ever written." Enough said. Finally, you must gain an
understanding of Austrian economics. Two excellent introductory
books are Economics
for Real People: An Introduction to the Austrian School
by Gene Callahan and The
Austrian Theory of the Trade Cycle and Other Essays
produced by the Ludwig von Mises Institute. Keep in mind that
it was the "Austrians" who correctly identified
and explained the dot.com and telecom bubbles that left
so many stock portfolios in tatters. By combining Graham and
Dodd with Austrian economics, you will have the tools necessary
to become a successful investor. After all, long-term wealth
accumulation requires a great deal of thought and effort –
not the opposite as promoted by America’s financial pop culture.
March
16, 2005
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