of all guest columns written by Dennis C. Butler, CFA
Many people assume that in order to be a good investor it is necessary either to have one's finger on the pulse of the economy and the financial markets or to possess an unusual ability to find those companies that are destined to become the Microsofts of the future. It is important for the investing public to know that there is another way to pursue good returns that does not require such extraordinary talents, nor does it involve taking on unusual levels of risk.
The alternative investment approach to which we are referring is the one advocated by Benjamin Graham in his classic work, Security Analysis, first published in 1934. Graham and his followers (who formed what came to be known as the "value" school of investing) sought to purchase stocks at prices representing significant discounts to the underlying worth of the businesses whose ownership they represent. Evidence of a stock's undervaluation would include a low ratio of market value to balance sheet items such as net working capital (current assets minus all liabilities) or book value (net worth, or total assets minus liabilities), or a low multiple of average or "normalized" earnings. What might be termed Wall Street chatter -- market commentary, earnings forecasts, technical analysis -- was of little interest to these investors.
To see how this works, we'll look at an example taken from the investment activities of our friends at Kahn Brothers & Co., Inc., an investment advisory firm in New York that presently manages over $900 million of individual and institutional accounts. Founded by Irving Kahn, a close associate of Graham's for many years, Kahn Brothers is one of the few firms that adheres strictly to Graham's value methodology (at 91 Irving remains an active chairman, while his sons Tom and Alan run the business). Beginning in 1988, the Kahns bought shares in a Peabody, Massachusetts company called Analogic Corporation, which among other things makes CAT scanning equipment. Then selling for about $8 per share, Analogic's balance sheet showed almost $3.50 per share in cash and net working capital of around $6.00 per share. Book value was approximately $9.00. Debt stood at a modest $12 million and the company was buying back shares.
As for earnings, the record was positive (averaging about $0.61 per share over the three previous years), but erratic, and the stock price, as high as $31 at one time, had been in the mid-teens in recent years. The Kahns were impressed by a strong management team. Given the assets backing the shares, the positive record, and good management, it could be argued that the risk to the investor in buying Analogic at $8.00 was very small.
For the next two years Analogic proved to be a mediocre investment for the Kahns' clients as the stock price fluctuated between $8 and $11 per share and ended 1990 at $8. Meanwhile, cash and net working capital rose and repurchases reduced shares outstanding from about 15.5 million to 14 million. The subsequent two-year period saw some improvement as the price reached almost $15 and settled at $13 at 1992 year-end; shares outstanding dropped to 12 million and net working capital approached $9 per share while book value rose to nearly $13. Momentum gathered steam over the next few years: share prices reached $22 in 1995 and ended the year at $18.50, at which time the company boasted $8 per share in cash, $12.50 in net working capital and a book value of over $16. Earnings had shown some improvement as well, averaging $1.07 during the 93-95 period.
In 1996, Analogic attracted interest with the successful launch of a new portable CAT scanning device. The company's association with efforts to develop new bomb-detection equipment for airports also brought attention following the mysterious TWA Flight 800 disaster in July. The stock price surged to about $30, giving the Kahn group an annualized return over the eight-year period of nearly 18% -- not bad for an investment which carried only nominal risk.
The lesson in this example is that patience, experience and adherence to this proven investment approach produced good results with less risk when compared to strategies that rely heavily on forecasting. Patience is needed because time is usually required for sound investments to work their magic. Since good investments can be exceedingly difficult to find, experience makes the process of spotting such gems much easier. Finally, the time-tested value methodology provides the tools for rigorous analysis and in this case it enabled the Kahns to determine whether and why Analogic was attractive at $8 per share.
Numerous methodologies work for investors and it is not our intention to criticize any of them. However, the Kahns' traditional value approach makes sense to us because it relies on ascertainable facts as opposed to notoriously inaccurate forecasts. Its focus on two key considerations -- Price and Value -- heightens the investor's awareness of risk and dampens dangerous enthusiasms. For investors looking for a proven way to safeguard their wealth over the long term, it can be highly rewarding.
Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 23 years and has been published in Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html.
"Current low valuations reward the long-term view", an article by Dennis Butler, appears in the May 7, 2009 issue of the Financial Times (page 28). "Intelligent Individual Investor", an article by Dennis Butler, appears in the December 2, 2008 issue of NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. "Benjamin Graham in Perspective", an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or "What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:
Dennis C. Butler
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139
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