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Sunday, Oct 03, 2004

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In a large portfolio there may be free-riding stocks

D. Murali

WITH a line as simple as `common sense is the heart of investing and business management' begins the intro to How to Think like Benjamin Graham and Invest like Warren Buffett, by Lawrence A. Cunningham, published by Tata McGraw-Hill Publishing Co Ltd ( But common sense is not what one sees commonly, so we hear people say that a stock or market is over or undervalued — an empty statement, says the author. It is more accurate to say overpriced or underpriced, says the author, because price is different from value.

That's a piece of priceless wisdom of great value, but we find "quotes of prices command constant attention in the mad, modern market". If you're quote obsessed, you'd end up trading "analysis for attitude, minds for myopic momentum, intelligence for instinct". Get out of such a Q culture, as Cunningham calls it, to focus on value first, "and then compare value to price to see if an investment holds the promise of a good return".

Guard yourself against information volatility, both positive and negative. The real villain of negative information volatility are "the cobwebs of Web sites that pump out unfiltered information on the Internet with unbridled abandon, particularly on bulletin boards and chat rooms." Remember these quotations: "Much bad advice is given free," is what Ben Graham has said. "Acting on `inside' tips will break a man more quickly than famine, pestilence, crop failures, political readjustments, or what might be called `normal accidents'," is a sting from Edwin LeFevre.

"Avoid starting a portfolio on day one with a dozen diversified stocks," because you may not find so many stocks on a single day "that are offered at prices substantially lower than their values". Investment knitting does not need diversification, points out Cunningham. "Ending up with a concentrated portfolio is sometimes perfectly fine." With a large portfolio, you may not spot a bad performer, and so suffer from a version of the free rider problem; "the less likely it is that you will catch and punish (sell) those which are free riding on your wealth and devouring it."

Chapter 6, `apple trees and experience', has a parable to explain how business value is appraised. It begins with a wise old man who owned an apple tree. He wanted to retire to a new climate and so decided to sell the tree, for `the best offer' in response to an ad he places in The Wall Street Journal. The old man's interactions with different bidders is a must-read for any accounting student.

Choose your `circle of competence' and operate accordingly, advises another chapter. First, have "a basic understanding" of the business you want to invest in. Else, "all you are really doing is guessing, hoping, maybe even praying that things work out your way." Omit from your circle businesses that are too tough for you to figure out or the ones that change too rapidly to keep up with, advises Cunningham. Yet, your boundaries must change over time.

You make the call, beckons the book. "A business is worth the present value of the future cash flows it generates from now until doomsday," and there can be many opinions on what PV is because it lies "in the eye of the beholder". So, when you gaze into "the cloudy crystal ball of valuation", don't expect accuracy, and don't fly "blindfolded". Your goal is simple: Get a wide gap "between the price you pay and the value you buy". That is "the cornerstone of intelligent investing", as Buffett puts it.

Chapter 10, "making (up) numbers", observes wryly: "No amount of rule making — from accounting, auditing, or elsewhere — can ensure the integrity of financial reporting." Therefore, be prepared for "imaginative, unorthodox, creative, and even fraudulent financial reporting". There is something trickier when dealing with `nonfraudulent' cases: use of smoothing techniques "to massage the whole range of financial numbers".

In chapter 12, there is a `son-in-law' standard of Buffett: "His test for whether an investment meets the requirement is whether managers are `men you would be pleased to see your daughter marry'." Does this make sense? It does, argues Cunningham. Study the annual letters that the chiefs write to shareholders because they contain "remarkable clues about trustworthiness".

Here's the tip: "The managers with whom intelligent investors should entrust their wealth are those who adopt the investor's perspective no matter how large the corporation or how many shareholders it has."

The book concludes with `the V culture' where there are three branches, viz. finance, accounting, and governance. Finance is one part science and the other part art, reminds the author. "Fluency in accounting gives you a huge investment edge." The first two are "fragile grounds" if the managerial trustworthiness is not there.

Ready to cross the RSTU chasm to move from Q to V?

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In a large portfolio there may be free-riding stocks

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