Monday, June 22, 2009

Graham and Lao-Tzu

Not sure if it is just me. Reading some of Graham’s philosophy reminds me of Taoism and Lao-Tzu. Using no-change to combat ten thousand changes, cycles and repetitions, no rules etc. More than a handful of Tao philosophy is actually reflected in Value Investing. Well someone did come out with a book called Tao of Buffett.

Combating ten thousand changes

Graham thinks that it is futile to predict the future. Nobody has been able to do it. So what he does is to assume that what has occurred will continue, with relatively high probability. This has of course been well mastered by Buffett, his prodigy. Hence their preference for brick and mortar businesses that basically face little changes over the years (unlike technology or growth sectors).

This is also exemplified by his preference for 10 year valuations. Which I think is probably one of the most important concepts from the Intelligent Investor. You see, on Wall Street today, most people, when they talk about valuations: ie PER and PBR. They talk about Share Price today divided by the Earnings Per Share next year for the company.

Graham uses an average of 10 years’ worth of EPS in order to determine if the stock is cheap. Basically, he is saying that if the average annual EPS over the next 10 years is the same as the previous 10 years, and if the price is cheap (ie PER of less than 15x), then the stock should be a BUY.

This makes whole lot of sense for someone who really thinks about buying a business for REAL right? Think about it, if you are going to buy that coffeeshop down the road. The owner says the shop will earn $500k next year. So you will pay 15x of $500k for the shop (ie $7.5 mn)? Or would you be more willing to buy from the other owner who showed you his average earnings for the past 10 years, amounting to $300k per year?

For one, the average earnings would usually be lower than next year’s earnings forecast. Especially if the forecast is made by a 23-year-old analyst from the brokerage firm. Or in the coffeeshop case, the owner who wants to cash out.

In any case, nobody ever gets their forecast right? So Graham simply uses the past and assume that the future is going to be like that. Using no-change to combat ten thousand changes. Bu Bian Ying Wan Bian.

More Taoism to come.
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