Much of Benjamin Graham’s classic tome The Intelligent Investor, which I am slogging through right now, centers on the problem of valuing stocks and bonds as complimentary investment vehicles.  Contrary to the conventional wisdom that young investors should invest most of their money in stocks and old investors should invest primarily in bonds, Graham suggests an ideal ratio of 25% bonds to 75% stocks when stocks are attractive, and the reverse when bonds are attractive.

Graham further argues that expected returns on individual stocks should be compared with prevailing bond rates by considering the historical returns of a stock and the likelihood that those returns will remain stable into the future.  To be honest, this philosophy sounded like a messy lot of work that was likely to return a steaming pile of boring stocks — public utilities, railroads and such.

In reality, it’s a quick way to whittle down the market into a manageable list of promising investments.  We begin with the Price to Earnings ratio, that great staple of every reliable stock screen.  Graham’s approach is somewhat different from the common practice of recommending a fixed P/E from which an investor should never deviate:

Our basic recommendation is that the stock portfolio, when acquired, should have an overall earnings / price ratio — the reverse of the P/E ratio — at least as high as the current high-grade bond rate.  This would mean a P/E ratio no higher than 13.3 against a [presumably 10-year, corporate] AA bond yield of 7.5%.

In other words, before beginning your stock screen, the investor should divide 100 by today’s bond rate to derive a target P/E for your screen.  As of this writing, the average yield on the 10-year corporate AA bond was 5.05%, which means the average P/E of your portfolio should not exceed 20.  You can still consider stocks with P/E ratios above 20, but for every stock with a P/E of 30, you must invest an equal proportion in stocks with a P/E of 10.  Ideally, the investor will base the P/E on the current price divided by 3-year trailing earnings.  At present, setting a P/E ratio of 20 will eliminate  roughly 70% of the NYSE.

Now that the investor knows the present yield of his equity bond, he must determine the bond’s risk.  With a traditional bond, determining risk is easy.  Just go by those ever reliable (sic) Moody’s ratings.  To determine the risk of equity bonds, we must look to a basket of accounting ratios:

• Annual Sales > $500 million (Graham’s original $100 million adjusted for inflation)
• Current ratio > 2
• LT debt / net current assets < 1
• 10 years of earnings, of which the last three year’s earnings should average at least 30% more than the first 3 years.
• 20 years of uninterrupted dividends
• Price to book * P/E < 22.5

This is fundamental investing in a nutshell: turn the prevailing bond rates on their head to see what your P/E target should be.  After that, all you have to determine is earnings stability.  Buffett’s innovation, it seems, was to worry less about earnings stability, and more about growth.

I found the book inspiring, and a little dangerous.  The key takeaways were:

1. Pay attention to spinoffs: they might make you rich
2. Follow the incentives.  If insiders are getting a piece of the action, you’ll want to be there.
3. When institutional investors exit, prepare your entrance (sometimes)

All good thoughts, in general.  The danger is that, to invest like Greenblatt (and with over a decade of 50% CAGR, you want to invest like Greenblatt), you have to do some mind-numbing work or, as Greenblatt puts it, you have to at least read the filings.  Let me repeat that: you have to do some mind-numbing work.

How is it that such huge investment opportunities could be laying out in plain site, anyone’s for the taking?  What better explanation than that these ‘opportunities’ are buried under a steaming pile of soul-crushing legal-eze?  And that’s really the point of both this book and Lewis’ The Big Short.  It’s also the point of Malcolm Gladwell’s excellent essay Open Secrets.

If you had only known where to look, and you had the toothpicks to keep your eyes open for a few all-nighters with the most boring reading of all time, you could have shorted Enron, gone long on the explosive corporate restructurings of the 90s and early 2000s, and then put everything in Credit Default Swaps in late 2007.  You’d be richer than Soros.

If you’re willing to try your hand at prospecting, there’s no better place to start than the SEC database of recent spinoff filings.  Read them, one by one.  Here are a few things to look for:

• What are the management stock options?  What’s the buy price?  How do they work?
• How big is the spinoff relative to the parent?  If it’s relatively small, institutions may initially unload it, and that’s when you’ll want to buy.
• To what extent will the spinoff unleash some previously obscured value?  If the parent has a low margin, but the spinoff margin is high, investors are likely to flood in.

I might see you on the other side.  Then again, I might sit this one out.

Beth Defalco of the Associated Press picked up on the hint of optimism — and the promise of a real story on a slow news day — by noting that the wage increase is one of the “encouraging trends” that we can all look forward to “this Labor Day.”  Not only is the recession not that bad, but we receive this happy news on a national holiday dedicated to the American worker!

Just as you were counting your blessings that you still had a job, now you have something new to worry about: should you ask for a raise?  (Tip: If your company recently experienced mass layoffs, etiquette specialists recommend you wait at least three weeks before confronting your boss.)

The correlation between unemployment rates and wages has long been known.  In a recent column in The New Yorker, James Surowiecki observed: “even during the early years of the Great Depression, manufacturing workers actually saw their real wages rise.”  Surowiecki draws the conclusion that wages are “sticky” during downturns because employers are afraid of an economic phenomenon known as “adverse selection.”  In other words, after laying off half the staff, your boss won’t cut your salary because he doesn’t want you to walk out the door.

In fact, this “trend” is nothing more than a statistical side-effect.  A deeper dive into the unemployment figures from the BLS reveals that the people losing their jobs right now are low-wage earners.  It is true that unemployment is on the rise across all classes, but the high-paid members of the “creative class” — such as senior managers and doctors — are only experiencing 4-5% unemployment, compared with working class unemployment of 15%.  Working class unemployment is also accelerating more rapidly than that of the creative class.

To understand how higher unemployment among the working class translates to a general increase in wages, it may be helpful to consider the labor dynamics of a simple island economy.  On our island, there are four workers making $25,000 a year and one supervisor making $50,000 a year.  Since there are no others on the island, we are at full employment.  Until, that is, a major recession rolls in, forcing the supervisor to lay off one of the workers.  Now unemployment is at 20%.

But something magical has happened to the average income of the small island economy.  Even though the salaries all stayed the same, the average income rose from $30,000 (before the layoff) to $31,250, an increase of 4%!

Of course, no one is better off in our island economy.  The wage increase is just a statistic.

Even though Warren Buffett (and his mentor, Benjamin Graham) had some early success buying stocks at a fraction of their underlying asset value, both investors, and particularly Buffett, focused more on acquiring stocks at a discount to earnings.

There are three big problems with book value:

1. Undervalued assets, by definition, are not valuable to the average investor.
2. Intangible assets aren’t factored into the price to book value.
3. Without mark to market accounting, the pricing of tangible assets is always questionable.

For the first problem, imagine you found out that an energy company with negative earnings is selling at $1 a share and owns a pipeline valued at $2 a share.  If you were a major investor like Graham or Buffett, you could buy enough of the company to get a seat on the board, and then you could force the company to liquidate.  If you’re a regular investor, though, that option isn’t at your disposal, and the management team may decide that they’d rather keep their jobs and run the company into the ground, rather than do the right thing for investors.

To illustrate the last two problems, let’s look at a couple of extreme examples;

Extreme example #1: Billy’s Coke machine

Billy is good friends with farmer Joe and Buddy, a beverage distributor.  Through these two contacts, Billy was able to set up a Coke machine at farmer Joe’s roadside market.  Farmer Joe covers the cost of electric for the machine, and he allows Billy to park the Coke machine on his property in exchange for a free weekly case of Coke.  Buddy charges Billy market rate for the all the Cokes (including farmer Joe’s case) but, because he’s a friend, he’s able to get the best bulk discount offered by the distributor.

What are Billy’s assets?  His most important assets are his relationships with Joe and Buddy, because they both allow him to operate a profitable business in a stable and secure marketplace.  However, neither of these relationships can go on the balance sheet, because they’re not tangible assets.  The only tangible asset Billy has is his old Coke machine, which he bought 10 years ago.  If he were using mark to market accounting, that Coke machine would be held on the books at its replacement value, which might be a thousand dollars if it’s in good working condition.  It is far more likely, though, that Billy is marking the machine at its original cost minus depreciation which, in this case, is $0.  In other words, Billy has no assets on his books.  As long as he’s selling enough Cokes to cover his costs, his price to book is infinite.

Extreme example #2: General Motors

In 2004, General Motors had $27 billion in net assets.  Less than a year later, they had spent down their net assets to zero, and now, after 4 more years of negative earnings, GM is more than $86 billion in the hole.  In 2004, GM would have been a bad buy at any price, even though it had positive net book value.

Book value is rarely helpful

For companies like Billy’s Coke machine, an investor might be scared off an otherwise good investment because of a high price to book value.  For companies like GM, a low price to book might lead an investor to toss money into a black hole.  In both cases, price to book is misleading.

But might it also be damaging?  I recently did a regression analysis of more than 3,000 stocks and found that the price-to-book ratio is positively correlated to Return on Assets, with a t-stat of 13.  In other words, when you pick a group of stocks with low price-to-book values, as sure as the sky is blue, that group will have a lower than average return on assets.  If you buy one of those companies, you’ll essentially be purchasing assets that are discounted because management doesn’t know how to make use of them.

So when is book value helpful to the average investor?

As I stated earlier, economists have demonstrated that low price-to-book stocks will, over time, outperform the market.  But they have also demonstrated that low price to earnings stocks will outperform the market.  PE and the Price to Book ratio apparently serve the same purpose (and may be redundant metrics in a screen).  Price to Book is just a blunter instrument.

My suggested inputs yesterday were:

1. CEO compensation
2. Number of SEC investigations in the past 10 years
3. Tax rate?
4. Number of lawsuits from employees, clients, or suppliers in past 10 years
5. Spread between cash flow and earnings
6. Corporate Honesty Index of other companies represented on the board

The spread between cash flow and earnings is the only factor that is easily quantifiable, and this number is useful because, if earnings are consistently above cash flow from operations, it’s possible that the company is claiming revenue on contracts that haven’t yet materialized (a la Enron).  If, on the other hand, cash flow is significantly above earnings, it’s possible that the company is cheating the government out of taxes.

Of course, there are legitimate ways to cut your tax bill, but at some point the government has to get its due.  And, increasingly, corporations are finding sneaky ways to shift the tax burden to the consumer.  Check out this quote from Berkshire Hathaway’s 2004 Annual Report:

Corporate income taxes in fiscal 2003 accounted for 7.4% of all federal tax receipts, down from a post-war peak of 32% in 1952. With one exception (1983), last year’s percentage is the lowest recorded since data was first published in 1934.

A corporation that shelters money from the government (and, in theory, saves more for shareholders), may not, ironically, be the kind of corporation that you want to entrust with your retirement.  That’s because cheating the government is a hard road.  Dropping a giant corporation’s tax rate by 1% could be the life’s work of a tax attorney or lobbyist.  If a company is willing to go to those measures, what kind of back flips will they do to squeeze shareholders?

The other factors on my list take a little more work, but thankfully there are a few resources available for investors:

Executive compensation database – The AFL-CIO’s CEO compensation database goes beyond SEC filings by estimating the value of additional perks, such as stock options and future bonuses.

SEC Litigation releases – The SEC does not make public its investigations until it decides to pursue a company in court, but once in court, those records are fairly easy to find on this page, and there’s even an xml feed.

2008 World’s Most Ethical Companies – Ethisphere collected this list of companies that were perceived to have the highest ethical standards in the following categories: “Corporate Citizenship and responsibility; Corporate governance; Innovation that Contributes to the Public Well Being; Industry leadership; Executive leadership and Tone from the Top; legal, regulatory and reputation Track record; and Internal Systems and Ethics/Compliance Program.”

The following companies also turned up in a more quantitative survey conducted by The Association for Investment Management and Research in 1994:

• National Fuel Gas
• Placer Dome
• Cummins Engine
• Southwest Airlines
• Safeco Corp

Dated?  Yes.  But honesty is one of those things that age well.

First off, though, let’s clear up any confusion about Liddy’s culpability.  In case anyone out there thinks this man is decent because he’s taking a $1 salary this year, remember that he’s just getting the same pay he always got, except this year his pay is in stock rather than cash (and he’ll be eligible for a giant bonus in 2010).  If you invested in AIG stock, chances are good that you have more invested in Liddy’s retirement than your own.

There are, of course, a number of things we could do to respond to this outrage, all with varying degrees of effectiveness:

We could refuse to pay our taxes

Thoreau did it, why can’t we?  Well, we saw how effective that policy was.  The Mexican-American War raged on while Thoreau rotted in jail.  Still, if enough of us refused, if we could somehow raise more than one voice against the wind, maybe the government would have to take its money back from AIG to keep the lights on in Washington.  And they can’t throw all of us in jail.

We could roll Ed Liddy’s house

AIG CEO Ed Liddy says the company is contractually obligated to pay out the bonuses that were promised before he took over, but does it not stretch credibility that one of the largest companies in the world did not tie its bonuses to performance?  Or is it possible that Liddy is responding to social pressure within his company to ‘keep the troops happy.’   If that’s the case, might he also respond to a little counter-pressure to keep us peasants happy?  Showing up to his house bearing torches might be extreme, but perhaps we could pop a banana in his tailpipe and prank call him: “Liddy, Geithner here, I’ve got $100 billion burning a hole in my pocket…any ideas?”

We could focus on our own problems

So Liddy and Paulson are spinless…what of it?  At least they’re not in my family.  My parents worked hard their whole lives and created real value for society in the process.  While they never had the kind of money that AIG execs rake in every year, they were always generous with me, even in the hard times.  They were an example to me of selflessness and courage, and if I can be a similar example to my kids, there will be fewer Liddys and Paulsons in the world.

We could work to create an economic climate that is toxic to the Liddys of the world

If you invested in AIG, you did so without knowing that this company was run by incompetent, dishonerable men.  You might also have recently invested in 3M (it was, after all, on a number of value screens), without knowing that Liddy also sits on the board of that company.  But now that you know the consequences of entrusting your life savings to people who see this as a big game (or ‘adventure’ as Jon Stewart recently remarked), you wish you had paid more attention to Philip Fisher’s rule to never invest in any company whose management does not have “unquestionable integrity.”

But how do you screen for unquestionable integrity?  Because it’s not easy, it’s one of those things that people ignore.  But what if it were easy?  What if, like Gross National Happiness, there were some way to quantify corporate honesty?  It could be a sliding scale of 0-100 (100 being a company like Berkshire Hathaway, whose officers take a reasonable salary and have an unblemished record putting the shareholder first, 0 being a company like AIG).

With a corporate honesty index, investors everywhere would have an easy way to check on their investments, and they would recognize that investing in a company with a low index is a bit like playing Russian Roulette with your retirement.  The PEs of those companies may be low, but the risk is astronomical.

Here, then, are some of the inputs for the Corporate Honesty Index:

1. CEO compensation
2. Number of SEC investigations in the past 10 years
3. Tax rate?
4. Number of lawsuits from employees, clients, or suppliers in past 10 years
5. Spread between cash flow and earnings
6. Corporate Honesty Index of other companies represented on the board

If you know of anything like this that already exists, or if you’d like to suggest other inputs, please comment below.

I discovered Fisher in a biography of Buffett, in which Buffett is quoted as saying that Fisher informed his investment decisions.  The most noted of Fisher’s rubricks is the concept that investments should be held for the long-term, where, at the very least, you can benefit from the tax and transactional savings.  But Fisher was also known for selling stocks early when he thought the fundamentals had changed.

Unlike Graham (who relied heavily on quantitative analysis to pick stocks with a wide margin of safety between the underlying value of the security and their price), Fisher took a broader, more qualitative approach to picking great companies.  Below are the big lessons from Fisher’s philosophy, which are outlined in further detail in his book Common Stocks and Uncommon Profits:

15 Points to Look for in a Common Stock

1. Does the company have products or services with sufficient market potential to make possible a sizeable increase in sales for at least several years?
2. Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?
3. How effective are the company’s research and development efforts in relation to its size?
4. Does the company have an above-average sales organization?
5. Does the company have a worthwhile profit margin?
6. What is the company doing to maintain or improve profit margins?
7. Does the company have outstanding labor and personnel relations?
8. Does the company have outstanding executive relations?
9. Does the company have depth to its management?
10. How good are the company’s cost analysis and accounting controls?
11. Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company will be in relation to its competition?
12. Does the company have a short-range or long-range outlook in regard to profits?
13. In the foreseeable future, will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders’ benefit from this anticipated growth?
14. Does the management talk freely to investors about its affairs when things are going well but “clam up” when troubles or disappointments occur?
15. Does the company have a management of unquestionable integrity?

Five Don’ts for Investors

1. Don’t buy into promotional companies.
2. Don’t ignore a good stock just because it is traded “over-the-counter.”
3. Don’t buy a stock just because you like the “tone” of its annual report.
4. Don’t assume that the high price at which a stock may be selling in relation to its earnings is necessarily an indication that further growth in those earnings has largely been already discounted in the price.
5. Don’t quibble over eighths and quarters.

Although the key factor in Buffett’s success seems to be the almost childish glee he seems to get in reading and memorizing financial statements, it is clear from his sometimes baffling decisions that he

Bush was lending his voice to a philosophy taught in elementary economics courses and business schools across America, a philosophy that appears to have come to an end.

In his The Origin of Economic Crises, George Cooper, a leading British economist, says that the efficient market theory is deceptively easy to understand because it perfectly describes the goods market, but when it comes to the asset market, the laws of supply and demand can no longer be relied on to keep an economy in equilibrium.

Cooper imagines a scenario in a small, one-bank town: each day, the bank “marks to market” all its assets, meaning that it follows the standard financial practice of constantly reassessing the value of its assets as new information becomes available.  Imagine that the bank owns all 1 billion of its shares, which it values at $1 a share.  If, one day, a lone horseman comes in to town and purchases 100 shares in the bank at $1.01 a share (the bank is entitled to a little profit, right?), the bank might decide to mark up the value of its securities to reflect the new demand generated by the cowboy.  Now shares are worth $1.01.  The bank still owns almost 1 billion shares, so that extra penny a share has driven up the value of its total holdings by 1 penny x 1 billion = $10 million.  Like the wings of the butterfly that stir a hurricane on the other side of the world, one man spends $101 and creates $10 million in wealth.

Where this really gets ugly is that the new wealth inspires others to invest, because unlike the goods market (where people buy things based on the fundamental value, or benefit, an item confers to the purchaser), people buy assets based on their likelihood to go up.  So as the price of doughnuts goes up, fewer people buy them, causing the supply to increase and the price to come down…but as the price of Google goes up, people just buy more Google.  That’s what Cooper calls the “paradox of gluttony,” the paradox being that gluttony (a bad thing for the economy) begets more gluttony.

Cooper’s phrase is an inversion of Keynes’ paradox of thrift: as people save money to prepare for bad times, there’s less money in the economy flowing around, causing the bad times to come.  Fear of a depression becomes a self-fulfilling prophesy.  Sound familiar?

For more on Cooper’s ideas, see also: Financial Instability Hypothesis, the Forgotten Economic Theory

When I was studying for my MBA a few years ago, the debate in every Finance case boiled down to two theories:

1. The market is efficient, that is, value and price are essentially the same thing and day-to-day fluctuations in value can be explained by the constant flow of new information into the market.  Giant changes in the value of a stock correspond to ‘shocks’ to the company or to the economy in general.  These shocks are random, and the best way to model future shocks is to flip a coin.
2. The market tends towards efficiency, but in the short-term it is driven by mass-psychology, and changes in stock price can be explained by the extent to which investors are distracted by, and over-react to, new information.  While the price of a stock may eventually reflect the inherent value of the underlying security, discrepancies between price and value are irrational, and the best way to model these future shocks is to ignore them.

Investors who subscribe to the efficient market theory attempt to explain the apparent randomness of the market by using the mathematics developed by Albert Einstein to explain the Brownian (or random) motion of particles.  In an interesting footnote to the history of economics, this work comprised Einstein’s doctoral dissertation.  Taken to its extreme, the efficient market hypothesis seems to argue that gambling and investing are indistinguishable.

Investors who subscribe to the second view follow the fundamentals analysis framework proposed by Benjamin Graham and perfected by Warren Buffett.

Both philosophies, like the wonderful one hoss shay, coexisted peacefully for one hundred years to a day.  At times, exceptions to either theory would provide fodder for proponents of the other school.  Benjamin Graham went broke during the Depression waiting for the market to recognize the underlying value of his various investments, and Merton and Scholes, the Nobel laureate efficient market theorists at the helm of Long Term Capital Management nearly brought the world economy to its knees in 1997.

With the current economic crisis, both philosophies seem to be falling apart at the same time.  Buffett has insisted that ‘now is the time to buy’ since the end of last year, even as the market continues to experience sharp declines.  Buffett’s philosophy is to search for the unsinkable ships of industry, and to largely ignore the icebergs floating around in the next economic cycle.

Meanwhile, the efficient market theorists keep insisting that the laws of supply and demand will eventually restore the economy to a steady state…and they largely ignore the problem of irrational exhuberence and irrational pessimism.  As the market falls, the efficient market theorists proclaim, stocks should become ever more desirable to investors.  The problem, of course, is that stocks actually become less desirable to investors as they fall, because each dip in the market is another piece of evidence against looking to equities as a viable investment for the future.

Enter a third economic theory, known as the Financial Instability Hypothesis.  Like Buffett and Graham, proponents of the Financial Instability Hypothesis reject the idea that the market is always stable.  But unlike Buffett and Graham, they recognize that the markets may never be stable (and, hence, an apocalypse is within the realm of possibility).  Hyman Minsky, the father of the theory, is also the namesake of the so-called Minsky Moment, that point of inflection when the credit markets begin to dry up.  While Minsky is getting all the credit for this forgotten theory, George Cooper, author of The Origin of Financial Crises, writes that “many of the essentials of Minsky’s theory had already been presented by Irving Fisher in 1933 and…by Keynes in 1936.”

So here we have a theory that was conceived in the Great Depression, and now that we’re in the midst of another economic meltdown, it’s suddenly in vogue again.  Just as the last veterans of the Depression retired from industry, just as we packed our elders off to the nursing home and dismissed their explanation of the Minsky Moment as, really, a Senior Moment, we find ourselves in another Depression, and one that threatens to be even worse than the first.

Cooper writes in the preface to his book, “history suggests that regulation designed for the last crisis does not prevent the next.”  And, indeed, we’re finding that the legislation that pulled our country out of the Great Depression is proving inadequate for the challenges of our current crisis.  So what is the answer…how do we keep this from happening again?

Cooper argues that you can’t have a functioning economy without a little instability.  The problem with the central banks is that they don’t act as myopic governors but, rather, cater to the political whims of their home country.  The US Federal Reserve jumps in whenever things look bad, but they don’t do much to combat irrational exhuberance.  In Europe, the opposite seems to be true: there, they dutifully take away the punchbowl just as the party is getting started, but they’re slow to react to downturns (case in point: the Fed lowered interest rates last year several weeks ahead of the EU, causing a momentary devaluation of the dollar).

The economy is inherently inefficient and unstable.  It may even spiral into chaos without constant attention by the central banks.  But central banks should not care whether the economy is growing or contracting.  Instead, they should only care about whether the economy is advancing to one extreme or another.