Passive Investing Guide (Ben Graham School)

26 January, 2007 at 11:02 am | Posted in Uncategorized | 1 Comment

The Lazy Investors’ Guide to Passive Investing
by AJ Cilliers
“To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.”
Warren Buffett, in the preface to the 4th edition of Benjamin Graham’s investment classic “The Intelligent Investor”.

In the previous edition of Marketviews we provided ten tips for beginning investors. Amongst other things, we advised you to “buy low and sell high,” have an investment strategy, avoid excessive trading and forget about trying to time the market. This month we are going to tell you how to incorporate all of this advice into a simple strategy known as “passive investing.”

Passive investing was the brainchild of Benjamin Graham, who at various times was a highly successful investor (and the acknowledged “father” of Value Investing), a university professor, an author and the mentor of another fairly successful dabbler in financial markets, Warren Buffett. (In case you didn’t know, Warren Buffett is the second-wealthiest man on the planet, not far behind Bill Gates). Buffett credits much of his investment success to the principles taught by Graham.

Benjamin Graham’s Investment Strategy

Graham realized that most people i gnore the advice to “buy low, sell high.” The main reason for this is that investors are often lured into the stock market during the final phases of a bull run, and as a result “buy high.” When the inevitable correction or crash follows, these same investors panic and sell, often at levels well below those at which they entered the market.

Graham designed a simple yet brilliant strategy to counter these tendencies – a strategy “to take emotion out of your investing decisions.” The main thrust of Graham’s advice can be stated as follows:

Graham suggested that you should split your investment portfolio between shares and bonds, never holding less than 25% in bonds and never more than 75% in shares. A conservative investor might prefer a 50/50 split between shares and bonds, while a more aggressive investor could favour a 75/25 share to bond ratio. Graham then provided the following guidelines for share selection:

  • There should be adequate though not excessive diversification. The minimum number of shares should be ten, and the maximum thirty;
  • Each company selected should be large, prominent and conservatively financed;
  • Each company should have a record of at least ten years of continuous dividend payments;
  • The investor should place a limit on the price he or she will pay for a share in relation to its average annual earnings per share over the past 5 to 7 years. (On the JSE, this should be about 15 times the average historical earnings as described, or about 10 to 11 times the earnings of the most recent 12-month period. However, see the more specific advice later in the article on how to avoid paying too much for a share).

The investment in bonds should also be diversified so as to include long, medium and short-term bonds. (Investing in individual bonds takes a large amount of capital, even more so if you are looking to establish a diversified bond portfolio. The most practical solution is to invest in a bond unit trust fund, which automatically builds in the required diversification).

Once you have decided on your share/bond split (based on your risk profile), you then select your shares and bonds and invest your funds accordingly. (The title of this article flippantly suggests that passive investing is for lazy investors. I’m afraid that was poetic license – some work is required, as you will have to do a fair amount of initial research to identify the shares for your portfolio. After that, it does get easier!)

Let us say you decide on a 50/50 share/bond split. Having done so, you now sit back and do nothing for six months. Then, six months down the line, you take a look at the value of your portfolio and re-calculate the share-to-bond ratio. If the stock market has been rising, you may find that the value of your portfolio is now 60% shares and 40% bonds. You must then sell off some of your shares and re-invest this money into bonds, so that you once again have a 50/50 split.

As a rule, you should sell a proportion of all of the shares in your portfolio when you re-balance, unless you have good reasons for selling only certain shares. Research shows that people have a tendency to sell only shares that have risen in price, and to hang on to shares that have not moved or have fallen in price. In this way, you may sell your “stars” and hang on to your “dogs.” If, however, you become convinced that you should not have included a particular share or shares in your portfolio, then you can offload a larger proportion of these when re-balancing.

Can you see the beauty of this system? You are now taking profits as the stock market rises (“selling high”), but should the reverse be true and you are faced with a falling market, you would then be moving out of bonds and into shares, thereby “buying low.” You are also taking emotion out of the equation, as you should only re-balance your portfolio on specific, pre-determined dates. Of course, you may also choose to play a more active role in managing your portfolio. Should the stock market be powering upwards at an alarming rate, you may want to re-balance your portfolio more regularly. Just remember that transaction costs reduce your earnings – Graham suggests the passive approach to remove emotion from the equation, but also to prevent you from trading too frequently. You just need to measure your trading costs against your gains when deciding whether to re-balance or not, if you are actively managing your portfolio.

If you follow Graham’s system, you do not have to concern yourself with market timing – you will only re-balance on your agreed anniversary date. This also eliminates the danger of too-frequent trading. If you are looking to build a nest egg and do not need the periodic dividend income, then dividends can be re-invested in your share and bond portfolios as they are received.

As mentioned previously, Graham’s system presumes that you have the time and inclination to study companies and their financial statements, so as to make informed decisions about the shares that you are buying. If this is not the case, remember that you can still apply Graham’s system by investing in share unit trusts instead of in specific shares – this allows for easier diversification, and you can still re-balance periodically by moving between your share and bond unit trusts.

What if you are not in the market at present, wish to invest in shares, but are concerned about overpaying in an “expensive” market? A good way to test for overpricing is to compare the dividend yield on a share that you are interested in, to the average after-tax yield on bonds. If you can buy a share for R100, and it is paying annual dividends of R5 per share, your dividend yield is 5%. (This is an after-tax yield, as dividends are not taxable). If the average bond rate (which you can calculate from the bond rates quoted daily in the financial pages of your newspaper) is, say, 7.5% and your marginal tax rate is 35%, then (ignoring the allowable tax-free deduction) the yield on bonds would be 7.5% x (1-0.35) = 4.875%. In this case you are slightly better off with the shares, and should invest accordingly. If, on the other hand, you would have been better placed with the bonds, then that is a good indication that the share might be overpriced. In this case it is best to do your market research in the meantime, to identify promising shares, but to keep your investment in bonds or even the money market until you can identify suitably-priced shares.

If this all sounds a bit tame to you, remember that you are allowed to devote 10% of your available investment funds to a “mad money” account. These funds can be applied to long shots and questionable shares that you might have a hunch about. However, if you are to sleep well at night, you had better have the other 90% of your investments in a more solid portfolio!

Questions from Investors:

A number of questions typically arise from the issues raised in the above article. Two of the more frequent questions are:

Q1: What exactly is Value Investing?

Financial theory says that the value of any share is equal to the “present value” of all of the future cash flows attributable to that share. The present value in turn is determined by discounting those future cash flows at the risk-adjusted rate of return required by the shareholder. This sounds extremely complicated, and we will simplify and expand upon these issues in a future article.

In essence, the future cash flows attributable to the shareholders in a company are the cash profits after interest and tax that the company will (hopefully!) make each year, less any of these profits that will be reinvested in business assets so as to grow the business. The risk-adjusted rate of return required by shareholders was discussed in our last issue, and can typically be calculated by using the Capital Asset Pricing Model.

The discounted value of the future cash flows (per share) gives you the maximum price that you should pay for the share now, based on the future expected cash profits per share (after reinvestments), and ensuring that you earn a compound return on your investment which is equal to your required rate of return.

So, if your required rate of return on a share is 14% per annum, and the sum of the discounted future cash flows per share (after reinvestment) comes to R100, then by paying R100 for the share you will get exactly a 14% compound return on your investment, assuming the future cash flow and reinvestment assumptions are valid. Warren Buffet calls this the intrinsic value of a share.

This is all good and well, but I am sure that you will all have noted that this intrinsic value depends upon a number of variables, not the least of which is a forecast of future annual cash flows per share. We often can’t forecast the weather a few days in advance, so what chance do we have of forecasting cash flows, you may ask?

A good question. However, the reality is that greed often drives share prices up to unrealistic heights, while fear eventually pulls them down to unrealistically low levels. By unrealistically low levels we mean below the intrinsic value of the share, even if that intrinsic value is based on conservative cash flow forecasts. So it can be that the shares of good companies with solid annual earnings are priced at relatively low levels. These are the shares targeted by value investors – shares in solid companies which are trading at a discount to their intrinsic values.

Value investors are in it for the long term. They know that, while in the short term the price of a share might not reflect the fundamental economic performance of the underlying company, in the long term it will. Therefore, by buying when fear has driven the price of a good company’s share below its intrinsic value, they know that they will reap the long-term benefits when the share price rises toward its higher, intrinsic value.

Q2: You use a dividend yield calculation to determine whether a share is overpriced. Are dividends that important? What about growth in the share price?

There are two schools of thought regarding growth shares, value shares and dividends. The difference in investment philosophy represented by each view is probably driven by the risk profile of the investors who subscribe to either value investing or growth investing.

Growth investors are not too fussed about dividends. They know that a fast-growing company needs capital with which to fund that growth. So, instead of expecting dividend payouts, they are quite happy for the company to reinvest all profits back into the business to help finance the growth. By doing this successfully, the growth company will also grow its share price. The investor is relying on this increased share price to provide her return – when she sells the share one day, the difference between the price at which she bought and the price at which she sells will provide her required rate of return. A good example of a successful growth share is Microsoft, which did not pay any dividends for a couple of decades after its establishment.

The danger, of course, is that the share price might crash before the investor sells. She then has to wait a lot longer for the share price to recover, if it ever does. At best she may end up with a return below her required rate, and at worst she may lose her entire investment. This happened during the boom of the 1990’s, when numerous internet companies saw their share prices rocket then plummet when investors lost confidence in their prospects. Many of these young companies disappeared forever, taking the hopes and cash of investors with them.

The bottom line is that growth companies are generally young, are often at the cutting edge of technological development and do not have the track record of the older, less exciting but more reliable “blue chips.” They are consequently a lot riskier than the blue chips. Another factor is that growth investors ideally like to invest in growth companies before that growth is apparent to the rest of the market. This means investing at an even earlier stage of the company’s lifecycle, when the share price is still low. Future prospects are even more uncertain at this stage, which further increases the risk of the investment.

Because Graham believed that the first rule of investing was to protect your capital against loss, he urged value investors to invest in large, stable and conservatively financed companies (i.e. companies without too much debt on the balance sheet). These are not high-growth companies! Because they have stopped growing, or are growing at a much slower rate, they do not need to reinvest all of their profits and are in a position to pay out a large part of these profits as cash dividends.

Cash dividends are real – once received they cannot disappear overnight as share price growth can do. Because we are not great at predicting the future, dividends are the only guaranteed return – share price growth may occur, but it may not. Conservative investors prefer not to take this chance.

The dividend yield method of appraising a share price is a useful method of deciding whether a value share is overpriced or not, because you are comparing the dividend yield on a “safe” share with the after-tax yield on a “safe” fixed income investment like a bond. As far as a growth share is concerned, using an earnings yield method based on the share’s PE may be more appropriate. Growth shares invariably have high Price: Earnings ratios, as investors are prepared to pay a higher price in terms of current earnings because they believe that earnings are going to grow substantially in the future. So a growth company with earnings of R1 per share and a PE ratio of 25 will have a share price of R25.

To work out the percentage earnings yield which this represents, you can divide 100 by the PE ratio. 100 divided by 25 gives us 4. This means that the annual return on the share is 4%, (before tax) based on the full earnings per share (not dividends per share – these would be even lower, if paid at all). It is important to remember at this point that the market calculates the price of R25 on the future cash flows which the share is expected to earn. In other words, if the company achieves its expected growth in future, the share price will stay at R25. Only if the company grows more than expected should the share price rise. So, if you buy at R25 and growth is as expected, you may not get any return in the form of share price growth, and possibly no return in the form of dividends for many years to come.

Should you go for Growth, or for Value plus dividends? At the end of the day it’s all going to come down to your risk profile. Remember, though, that compromise is possible and you might wish to include both value and growth shares in your portfolio. The percentage of each would then be determined by the degree of risk you wish to take.



1 Comment »

RSS feed for comments on this post. TrackBack URI

  1. Please let me know if you’re looking for a writer for your blog.
    You have some really great posts and I think I would be a
    good asset. If you ever want to take some of the load
    off, I’d absolutely love to write some material for your blog in exchange for a link back to mine.

    Please shoot me an email if interested. Thanks!

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s

Blog at
Entries and comments feeds.

%d bloggers like this: