Book Review: Benjamin Graham And The Power of Growth Stocks by Frederick K. Martin

Rod MacIver Blog, Book Reviews 8 Comments

Benjamin Graham And The Power of Growth Stocks is the most important investment book I’ve ever read. Employing the principles outlined in the book, the author’s firm (Disciplined Growth Investors) has generated exceptional results for his clients. One offers this summary in the book’s foreword:

When Frederick Martin “took over management of the (my firm’s) account in 1980, we had a total of $841,338 in the pension fund. Since then, some money has been added and some has been withdrawn, adding up to a total net addition to the original amount of $967,943. That means that, all in all, we have contributed a net total of about $1.8 million. Under Fred’s management, that sum had grown to $96.9 million as of April 30, 2011 – an increase of more than 5,000 percent.”

–        Craig R. Weflen, Administrator, Noran Neurological Clinic

Benjamin Graham of course wrote Security Analysis and The Intelligent Investor, two books widely considered to be classics of investment literature. He was also Warren Buffet’s professor, employer and mentor for twenty years. While primarily known for the principles of value investing that he developed during the 1930s, Graham’s most successful single investment was a growth stock, GEICO, which yielded a greater return than all of the other investments he made in his career combined. His investment firm put roughly a quarter of its investable assets into GEICO at $27 a share. It rose to the equivalent of $54,000 a share.

The two investment principles in the book that I find particularly fascinating and useful:

  1. Growth stocks tend to be more volatile than value stocks because their pricing reflects a prediction of future growth. When investors, in the aggregate, are optimistic, growth stocks trade at big premiums. When pessimistic, growth stocks often trade at values close to those of “value” stocks.
  2. Buying high-growth stocks of companies that offer something exceptional to their customers after a 30-50% decline from a market top has historically provided returns to investors way in excess of those of the overall market. Such an investment strategy requires doing battle with one’s own psyche – researching companies for years without investing, investing only every few years, holding for long periods of time, and buying during times of widespread negativity about the economy and the market.

The two investment principles espoused in the book that I find questionable and that I do not incorporate into my investment practices:

  1. Valuing a growth stock based on estimating earnings over the next seven to ten years is important to successful growth stock investing. (I don’t believe that most investors can reliably enough estimate future earnings or P/E ratios (which are highly-dependent on future interest rates) to be consistently useful.
  2. It is important to growth stock investing to purchase securities at a significant discount to the estimated present value of future earnings to insure a “margin of safety.” (I’m concerned that this rules out growth stocks with the best long-term prospects).

The book also offers:

  1. Important perspectives on how to identify companies that have sustainably high growth rates.
  2. Fascinating case studies of investments by the author’s firm, including those that worked out fabulously (Apple, for instance), were losers or mediocrities.
  3. The entire chapter “Newer Methods for Valuing Growth Stocks” from the 1962 edition of Security Analysis 1962 (a section unfortunately excluded from editions of Security Analysis after 2009). The chapter includes the simple mathematical formula Graham developed to value growth stocks, and a detailed analysis of appropriate P/E ratios for companies growing at various sustainable rates. I find the analysis fascinating, but do not accept the conclusions because I believe it to be too dependent upon future estimates of earnings and interest rates.

I offer this review in order to try to make a contribution to other members-readers of the MicroCapClub during this period when I am reluctant to offer opinions of specific small cap stocks due to concerns over the global economy, and stock market cycle.

For any reader interested in a longer version of this review, including extensive quotes from the book, and from Graham & Dodd’s Security Analysis, please contact me at [email protected].

If you liked this book review, you’ll enjoy I Passed on Berkshire Hathaway at $97 Per Share

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Comments 8

  1. Good review; will probably get this one.

    Regarding valuation, one of the best ways I have found is by calculating what growth is implied in the current price. This methodology uncovers, at times, stocks that look expensive based on traditional ratios, etc. For example, back in 2007/2008 I bought CMG (expensive on normal ratios) and KIRK (valued like going out of business) based, in part, on the above valuation technique as they both looked relatively cheap when looking at the implied growth rates. However, one would have been labeled growth and one deep value. It’s flexible beyond anything I have found.

  2. As Buffett said once that an imvestor needs to answer the following questions
    1) Hoe many birds are there in the bush?
    2) When are we going to get them?
    3) How sure are we of anove two?

    The 3rd questions leads one to look for marhin of safety and maybe, as you said, “rules out growth stocks with the best long-term prospects”, like Apple?

  3. When you are investing in micro cap and small cap stocks the growth is integral part of your intrinsic value. Investing in microcap for 30% or 40% discount from intrinsic value may not offer good risk-reward odds. You got to project normalized revenues and earnings at least 5 years in the future and then compute valuation and then discount back at your discount rate. You may conservatively compute the sustainable growth rate based on ROE and payout ratio.
    Another way to resolve this dilemma is by using the method suggested above by some one. Compute the implied growth in the current price and then see if you agree with the market. Often that is little easier than forecasting revenues.
    The best exposition of this issue is presented by Stephen Penman in his excellent book- Accounting for Value.

    1. Thoughts in response:

      1. Investing in any growth stock, microcap or other, based on discount to estimated value is problematic. In rising markets growth stocks with the biggest premium to value do best, in falling markets the opposite is true as market participants shed risk.
      2. Estimating future revenues and earnings is problematic. Yogi Berra said something like: predicting is difficult, particularly when it is about the future. The future will be determined by a combination of events, some based on current factors, some that will be influenced but not determined by current factors and some that will be completely random and thus currently unpredictable. And the pace of change in determining factors is accelerating — world markets, technology, even the spread of potentially devastating diseases as people travel more and more. Terrorism. Innovation. Creativity. We live in a world of faster and faster change, making the future more and more unpredictable.
      3. I don’t know what normalized revenues and earnings means. Average of the last five years, ten years? If average of past results, that approach is not likely to work with growth stocks.
      4. What does “your discount rate” mean? Do you mean my discount rate is different than yours, and unique to every investor? If so, that’s problematic. Discount rate is a concept from MBA textbooks that some find helpful but in my experience is an effort to bring certainty to an uncertain endeavor. I do value companies two ways, including a 6% discount rate applied to current free cash flow, but frequently take positions above and below that indicated value. It is perhaps 10% of the total investing decision, and only relevant if you think you know what the market is going to do over the next year or two.
      5. What does, “You may conservatively compute the sustainable growth rate based on ROE and payout ratio” mean? ROE and growth are different concepts. You can have a high ROE company with low growth, and as far as payout ratio goes, most growth stocks don’t pay a dividend.
      6. If you knew how to compute the future growth rate in the stock price, all other analysis would be unnecessary and, in fact, counterproductive. You’d fairly quickly become that richest investor in the world.

      Buffett’s biographer, friend and associate, Alice Schroeder, says that he values companies based on a 15% return calculated on current owner earnings versus price, although I do see a number of companies in his portfolio that he purchased at a lower current return of 15%. He doesn’t project earnings and revenues. Why? Because projections add uncertainty and risk. And seeking to achieve returns of over 15% means taking on more risk than he’s comfortable with. He wants steady growers not fast growers. That’s not my approach — I want fast growers — but it is important to my approach to recognize and plan for the greater risk that I have to therefore assume. Rosy predictions increase risk, but ironically, in growth investing, so do conservative assumptions. A growth portfolio based on conservative assumptions is a portfolio of second rate growth stocks.

      That’s what makes investing so fascinating and challenging. It’s all about uncertainty, risk.

      I’ll check out the book. Thank you.

      Good luck out there. The pool we swim in is full of crocodiles.

      Rod

      1. Thanks for your response. Just wanted to clarify further on few of my points. I have given my response to your points.
        1. What you say may be true. Personally I am in a value camp. I have bought micro and small cap growth stocks only if the valuation is good. I agree one may miss many opportunities. But I don’t want to pay the game of buying at any price in hope of selling it to next guy at even higher price. You may buy growth stocks if you think the market price does not factor in all the future growth and prospects and so the intrinsic value is much higher than current price and eventually price will meet the intrinsic value. Else no one will buy such stock. Method may differ but thought process has to be same.
        2. No one should have disagreement with your second point. So true. You want to buy businesses that will survive and thrive in this unpredictable and rapidly changing world. You do not want to buy businesses where intrinsic value may go down over a period. You want opposite to happen.
        3. I think that depends on the approach. I tend to buy the good growth companies when they hit a roadblock and price is crashed and near term outlook is clouded. My job as an investor is to check if the problems are temporary or permanent in nature. Will the situation improve in next 2-3 years and what would be the revenues and earnings in that situation. Nothing is perfect. You are just looking at various scenarios and checking if there is margin of safety. Your approach might differ. To each one his own.
        4. I know each market has their discount rates based on country, real and nominal interest rates, size of the firm, perceived company risk etc. I usually go by what Buffet does. I use my threshold desired return as my discount rate. I have certain expectation from my investments which may be different from others. When I use this discount rate I only consider abnormal return over the acceptable cost of capital. This valuation approach also charges cost of equity to earnings. I discount the left over earnings back to present at my threshold rate. Many may find it too conservative and restrictive. But I am fine with it because I find it offers good margin of safety. I am also investing in a market which is not that efficient. I can often find good opportunities. Good growth stocks which are usually micro or small cap where institutions cannot invest easily.
        5. High ROE and moderate growth is possible only when payout is high. I don’t understand how high ROE and low growth is possible otherwise. If you do not pay out then all that earnings will increase your equity and reduce ROE.
        6. Implied growth rate in the CMP is one of the checks on valuation. Basically you flip the discounted equation to look at it. You typically use various checks to see if current price is reasonable before you buy. One example might be scenario analysis where you may consider range of growth rates to check how the valuation looks. None of this is precise science. You are looking at valuation from different angles. Implied growth rate is something similar. if you get an implied growth rate that is way lower than what you think is reasonable even using conservative assumptions then you may have an opportunity. You are not looking for precise numbers only a sense of obvious under valuation.

        On Buffet I will go by what he himself has said. He has said few time s that he uses uniform discount rate (of 8-10% or so even when the interest rates are lower ). No discount rate selection based on higher or lower risk. He considers only those companies where he can predict to some degree the earnings 5-10 year down the line. So that means all are equally safe (or equal risk) stocks per his thinking. If you think of that then it is clear his comparison is going to be based on the growth rate if he is using DCF as he has claimed. Higher growth stock will have higher intrinsic value compared to lower growth stock…if the discount rate is same for both.

        1. First thanks for engaging in this discussion Girish. I learn from serious investors such as yourself, and from my own thinking process in responding to these important points you bring up.

          The crucial issues are (1) are you comfortable with the investment approach you are taking, and (2) is it working over a reasonable period of time. It sounds like the answer to both of those questions is yes, and if so, you are doing exactly what you should be doing.

          It is all about trying to bring a degree of certainty to a highly uncertain enterprise: investing. And doing it in such a way that one doesn’t sell at the wrong time. So it is about characteristic and pattern recognition. And then the discipline to stick to a valid plan or strategy, of which there are several.

          The return on equity criteria you outline is subject to less clarity, in my opinion. There certainly are high return on equity companies with high growth, but return on equity is subject to many variables, some of which are quite unpredictable. And management can improve return on equity simply by writing down the value of assets, for instance. Nothing else changes other than from an accounting perspective — same business, same revenue and net income, same assets — their value is just diminished on the balance sheet. New managements are particularly prone to this — done in a certain, widely-followed way, new management then can then generate more stable earnings than those achieved by the bums that just got thrown out. And as you mention, you can boost return on equity through dividends although a truly exceptional company does shareholders a favor by reinvesting earnings into the business.

          And debt plays a role, especially during a period of low interest rates. Ford Motor company has a TTM return on capital of 4.5% and a TTM return on equity of 25.74%. That’s due to the debt in its credit subsidiary, and is a potential problem. Ford has boosted sales by offering zero percent financing. When interest rates rise, and that’s inevitable in my opinion, it may be subject to a double whammy — higher cost of capital and lower sales. So return on equity can be a trap. Yet another trap in a minefield of traps.

          There are important subtleties in your description of Buffett’s approach ie investing in companies with predictable earnings. That’s not the same as actually basing one’s investment decisions on forecasting earnings. Not even Buffett can do it reliably — for instance newspapers and energy stocks. Salomon Brothers. Or investing in the distressed bonds of US Air. Or more recently Bank of America and IBM.

          Obviously his winners far outweigh his losers, but my point is just that I read stuff all the time about how Buffett does this or that (for instance describing him as a value investor which he rarely is — much more often he’s a quality investor at a reasonable or fair price), and even sometimes what he says or writes, but when I study his portfolio I see lots of examples of both investments that don’t fit his outlined criteria, and more often lots and lots of differences between how others describe his approach and what he actually does. Regardless of what anyone says, he doesn’t follow a recipe. And his approach continues to evolve. He does have a truly exceptional understanding of how businesses work, and he has exceptional self-control — control over his emotions, incredible patience with most of his investments — and he works well with others, which many great investors don’t, which enables him to successfully manage good managers.

          It is a mistake in investing, I believe, to seek certainty and black and white absolutes — the real world is too nuanced and complicated for absolutes to work. Still, we need some kind of investment philosophy and guidelines on which too make decisions or failure is virtually guaranteed. And that is a certainty.

  4. I always think of other stuff right after I hit the send button. Sometimes I can edit my comments, sometimes I can’t, on this forum. I probably don’t understand how it works.

    But stock buybacks also boost return on equity. Ironically, the more per share a company pays to buy back its own stock, the higher the artificial boost to ROE.

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