Tag Archives: hyperinflation

Graham on Growth Stock Investing Part 1; Readings on Hyperinflation

Graham said that investors should stay away from growth stocks when their normalized P/Es go above 25. On the other hand, when the product of a stock’s normalized P/E and its price-to book ratio is less than 22.5—Normalized P/E x (price/book) is less than 22.5—it is at least a good value. So, if a normalized P/E is below 14 and the price/book is below1.5, the stock should be attractive.

One of the common criticisms made of Graham is that all the formulas in the 1972 edition of The Intelligent Investor are antiquated.  The best response is to say, ”Of course they are!” Graham constantly retested his assumption and tinkered with his formulas, so anyone who tries to follow them in any sort of slavish manner is not doing what Graham himself would do, if he were alive today.  –Martin Zweig

We continue our discussion from the last post: http://wp.me/p2OaYY-1pv

Graham on Growth Stock Investing 

Graham displayed extraordinary skill in hypothesis testing. He observed the financial world through the eyes of a scientist and a classicist, someone who was trained in rhetoric and logic. Because of his training and intellect, Graham was profoundly skeptical of back-tested proofs. And methodologies that promote the belief that a certain investing approach is superior while another is inferior. His writing is full of warnings about time-period dependency….Graham argued for slicing data as many different ways as possible, across as many different periods as possible, to provide a picture that is likely to be more durable over time and out of sample.

Now we want to hear what Ben Graham has to say about valuing growth.  Graham later described his way of thinking as “searching, reflective, and critical.” He also had “a good instinct for what was important in a problem….the ability to avoid wasting time on inessentials….a drive towards the practical, towards getting things done, towards finding solutions, and especially towards devising new approaches and techniques.” (Source: The Memoirs of the Dean of Wall Street, 1996). His famous student, Warren Buffett, sums up Graham’s mind in two words: “terribly rational.”

Graham in the Preface to Security Analysis, 4th Edition

We believe that there are sound reasons for anticipating that the stock market will value corporate earnings and dividends more liberally in the future than it did before 1950. We also believe there are sound reasons for giving more weight than we have in the past to measuring current investment value in terms of the expectations of the future. But we recognize that both views lend themselves to dangerous abuses.  The latter has been a cause of excessively high stock prices in past bull market. However, the danger lies not so much in the emphasis on future earnings as on a lack of standards used in relating earnings growth to current values. Without standards no rational method of value measurement is possible.

Editor:  Note that when Graham wrote those words (1961/62) the bond yield/stock yield ratio was changing. In the early 1940s and 1950s for example, stock dividend yields were fully twice AAA bond yields, meaning that investors were only willing to pay half as much for one dollar of stock income as they were willing to pay for one dollar of bond income. In 1958, however, stock and bond yields were equal, meaning investors were at that time willing to pay just as much for a dollar of stock income as for a dollar of bond income.  And in recent years, investors have come to think so highly of equities, that they are now (March 1987) willing to pay three times as much for a dollar of stock income as they are for a dollar of bond income.   The main points you should extract from this and the following posts on Graham’s discussion of growth stock investing is his thinking process.  Graham was adaptable. Ironically, Graham was known for his net/net investing but he made most of his money owning GEICO.

Newer Methods for Valuing Growth Stocks (Chapter 39 of Security Analysis, 4th Ed.)

PART 1 of 4 (entire article to be posted as a pdf next week)

Historical Introduction

We have previously defined a growth stock as one which has increased its per-share for some time in the past at faster than the average rate and is expected to maintain this advantage for some time in the  future. (For our own convenience we have defined a true growth stock as one which is expected to grow at the annual rate of at least 7.2%–which would double earnings in ten years, if maintained—but others may set the minimum rate lower.) A good past record and an unusually promising future have, of course, always been a major attraction to investors as well as speculators.  In the stock markets prior to the 1920s, expected growth was subordinated in importance, as an investment factor, to financial strength and stability of dividends. In the late 1920s, growth possibilities became the leading consideration for common stock investors and speculators alike. These expectations were though to justify the extremely high multipliers reached for the most favored issues. However, no serious efforts were then made by financial analysts to work out mathematical valuations for growth stocks.

The first detailed basis for such calculations appeared in 1931—after the crash—in S.E. Guild’s book, Stock Growth and Discount Tables. This approach was developed into a full-blown theory and technique in J.B. William’s work, The Theory of Investment Value, published in 1938. The book presented in detail the basic thesis that a common stock is worth the sum of all its future dividends, each discounted to its present value. Estimates of the rates for future growth must be used to develop the schedule of future dividends, and from them to calculate total recent value.

In 1938 National Investor’s Corporation was the first mutual fund to dedicate itself formally to the policy of buying growth stocks, identifying them as those which had increased their earnings from the top of one business cycle to the next and which could be expected to continue to do so. During the next 15 years companies with good growth records won increasing popularity, but little effort at precise valuations of growth stocks was made.

At the end of 1954 the present approach to growth valuation was initiated in an article by Clendenin and Van Cleave, entitled “Growth and Common Stock Values.”[1] This supplied basic tables for finding the present value of future dividends, on varying assumptions as to rate and duration of growth, and also as to the discount factor. Since 1954 there has been a great outpouring of articles in the financial press—chiefly in the Financial Analysts Journal—on the subject of the mathematical valuation of growth stocks. The articles cover technical methods and formulas, applications to the Dow-Jones Industrial Average and to numerous individual issues, and also some critical appraisals of growth-stock theory and of market performance of growth stocks.

In this chapter we propose: (1) to discuss in as elementary form as possible the mathematical theory of growth-stock valuation as now practiced; (2) to present a few illustrations of the application of this theory, selected from the copious literature on the subject; (3) to state our views on the dependability of this approach, and even to offer a very simple substitute for its usually complicated mathematics.

The “Permanent – growth-rate” Method

An elementary-arithmetic formula for valuing future growth can easily be found if we assume that growth at a fixed rate will continue in the indefinite future. We need only subtract this fixed rate of growth from the investor’s required annual return; the remainder will give us the capitalization rate for the current dividend.

This method can be illustrated by a valuation of DJIA made in a fairly early article on the subject by a leading theoretician in the field.[2]  This study assumed a permanent growth rate of 4 percent for the DJIA and an over-all investor’s return (or discount rate”) of 7 percent. On this basis the investor would require a current dividend yield of 3 percent, and this figure would determine the value of the DJIA. For assume that the dividend will increase each year by 4 percent, and hence that the market price will increase also by 4 percent. Then in any year the investor will have a 3 percent dividend return and a 4 percent market appreciation—both below the starting value—or a total of 7 percent compounded annually. The required dividend return can be converted into an equivalent multiplier of earning by assuming a standard payout rate. In this article the payout was taken at about two-thirds; hence the multiplier of earnings becomes 2/3 of 33 or 22.[3]

It is important for the student to understand why this pleasingly simple method of valuing a common stock of group of stocks had to be replaced by more complicated methods, especially in the growth stock field. It would work fairly plausibly for assumed growth rates up to say, 5 percent. The latter figure produces a required dividend return of only 2 percent, or a multiplier of 33 for current earnings, if payout is two-thirds. But when the expected growth rate is set progressively higher, the resultant valuation of dividends or earnings increases very rapidly. A 6.5% growth rate produces a multiplier of 200 for the dividend, and a growth rate of 7 percent or more makes the issue worth infinity if it pays any dividend. In other words, on the basis of this theory and method, no price would be too much to pay for such common stock.[4]

A Different Method Needed.

Since an expected growth rate of 7 percent is almost the minimum required to qualify an issue as a true “growth stock” in the estimation of many security analysts, it should be obvious that the above simplified method of valuation cannot be used in that area. If it were, every such growth stock would have infinite value. Both mathematics and prudence require that the period of high growth rate be limited to a finite—actually a fairly short—period of time. After that, the growth must be assumed either to stop entirely or to proceed at so modest a rate as to permit a fairly low multiplier of the later earnings.

The standard method now employed for the valuation of growth stocks follows this prescription. Typically it assumes growth at a relatively high rate—varying greatly between companies –for a period of ten years, more or less. The growth rate thereafter is taken so low that the earnings in the tenth of other “target” year may be valued by the simple method previously described. The target-year valuation is then discounted to present worth, as are the dividends to be received during the earlier period. The two components are then added to give the desired value.

Application of this method may be illustrated in making the following rather representative assumptions: (1) a discount rate, or required annual return of 7.5%;[5] (2) an annual growth rate of about 7.2% for a ten-year period—i.e., a doubling of earnings and dividends in the decade; (3) a multiplier of 13.5% for the tenth year’s earnings. (This multiplier corresponds to an expected growth rate after the tenth year of 2.5%, requiring a dividend return of 5 percent. It is adopted by Molodovsky as a “level of ignorance” with respect to later growth. We should prefer to call it a “level of conservatism.” Our last assumption would be (4) an average payout of 60 percent. (This may well be high for a company with good growth.)

The valuation per dollar of present earnings, based on such assumptions, works out as follows:

  1. Present value of tenth year’s market price: The tenth year’s earnings will be $2, their market price 27, and its present value 48 percent of 27, or about $13.
  2. Present value of next ten years’ dividends: These will begin at 60 cents, increase to $1.20, average about 90 cents, aggregate about $9, and be subject to a present-worth factor of some 70 percent –for an average waiting period of five years. The dividend component is thus worth presently about $6.30.
  3. Total present value and multiplier: Components A and B add up to about $19.30, or a multiplier of 19.3 for the current earnings.


[1] Journal of Finance, December 1954

[2] See N. Molodovskiy, “An appraisal of the DJIA.” Commercial and Financial Chronical, Oct. 30, 1958

[3] Molodovsky here assume a “long-term earning level” of only $25 for the unit in 1959, against the actual figure of $34. His multiplier of 22 produced a valuation of 550. Later he was to change his method in significant ways, which we discuss below.

[4] David Durand has commented on the parallel between this aspect of growth stock valuation and the famous mathematical anomaly known as the “Petersburg Paradox.”

[5] Molodovsky’s later adopted this rate in place of his earlier 7 percent, having found that 7.5% per year was the average over-all realization by common-stock owners between 1871 and 1959. It was made up of a 5 percent average dividend return and a compounded annual growth rate of about 2.5% percent in earnings, dividends, and market price.

Part 2: Valuation of DJIA in 1961 by This Method…….stay tuned.

 

HYPERINFLATION

Audio Interview: http://www.econtalk.org/archives/2012/10/hanke_on_hyperi.html

A History of Hyperinflation Hanke on Hyperinflations

Great Hyperinflations in World History

October 26 2012 3 Trillions Reasons for Concern   (Conditions today)

Opportunities hard to find: http://www.gannonandhoangoninvesting.com/

QE3 Could Be Highly Inflationary; Investors’ Responses

Unintended Consequences

Plosser also warned that QE3 “could be highly inflationary.” http://www.philadelphiafed.org/about-the-fed/senior-executives/plosser/ “I don’t think it would occur immediately,” he said. “Inflation is going to occur when excess reserves of this huge balance sheet begin to flow outside into the real economy.  I can’t tell you when that’s going to happen.”

Bernanke and other Fed officials say that the Fed will be able to contain the outflow of reserves into the economy and thereby limit wage-price pressures by raising the rate of interest it pays on excess reserves.  But Plosser said the  interest rates on excess reserves (“IOER”) and reserve draining tools cannot be relied upon.

“How fast will we have to do that (raise the(IOER)?” he asked.  “How rapid will it have to go up? We don’t have a clue.   Raising the IOER where you have a trillion and half or two trillion dollars in reserves, we have absolutely zero experience with it.”

“We have the tools to do it, but we don’t know the consequences of the tools,” Plosser said. “If the IOER doesn’t work and we have to sell assets, MBS, how will that affect housing?” he asked. “Will we be able to unwind from this at a pace that doesn’t disrupt the economy?”

—–

The Fed’s problem: If those funds start to move out of excess reserves and into the economy rapidly, the Fed will have to take counter measures, such as boosting interest rates on excess reserves (IOER) or liquidating some of their mortgage-backed securities. Plosser is entirely correct, no one knows how high interest rates will have to be raised to stop the flow into the economy. It could very well end up a tiger by the tail situation, the higher the Fed boosts rates, the higher nominal rates climb (Sort of the reverse of what is going on now.

You as an investor need to watch to see if the Fed’s new money printing of $40 billion per month ends up in the system (through bank loans) or as excess reserves. Further, excess reserves themselves have to be monitored to see if any of those funds start to enter the system. In other words, if any increases in required reserves occur, it could result in an Artificial boom to the stock market and economy, but also be price inflationary.

Several Commentaries on the Fed’s Actions

James Grant

The Fed has committed to open-ended expansion of dollars to suppress interest rates. Now it is suppressing the interest rates, muscling the yield curve, and allocating credit. And it is in the business of price control. Price controls have never worked.  Read more: TheWhysAndWhereforesOfQE3_GRANTS

Robert Rodriquez of FPA, All In! FPA Comment on Fed Policy Sept 2012

David Stockman

Uploaded by ReasonTV on Jan 3, 2011

At the very start of the “Reagan revolution,” David Stockman exposed the myth that Ronald Reagan and the modern Republican Party are dedicated to small government.

Since writing The Triumph of Politics he says he has “completed his homework” by reading libertarian economists such as Ludwig von Mises, Friedrich Hayek, and Murray Rothbard. He thinks TARP was a big-government boondoggle and the bailouts of GM and Chrysler unconscionable. Stimulus spending is a hoax. He sees the abandonment of the gold standard in favor of floating exchange rates as the root cause of both the country’s fiscal problems and the 2008 financial crisis. He says that Rep. Ron Paul (R-Texas) is the only politician today “who gets it” and he’s hopeful that Paul’s growing power may begin to shed light on “the scholastic arrogance” of the Federal Reserve. He’s still against the welfare-warfare state and he thinks government should be cut down to size.

Interview: http://youtu.be/86i7FtGXUP0?t=50s

Stockman, “The Bernanke doesn’t have a clue as to why our economy has been failing. The reason it has failed, 130 million payroll jobs today is the same as 1999. So after 13 years of serial booms and busts we haven’t added one job! It has offered free money to Wall Street over and over. A massive speculation.  These actions will bring the chaos of booms and busts.

We need a fundamental change of policy. Extract the Fed from the group of WS. Special interests who provide windfall gains to a small circle of cronies while the rest of the middle class and poor struggle with the mess that we have.

A lecture by David Stockman on Sound Money: http://youtu.be/CAkdB-2qFHY  (65 minutes). Stockman quote: “Two party free lunch competition” He hits the insiders of both the Republican and Democratic parties equally hard. Another dissertation on crony capitalism.

Hyperinflation

Bolivia: http://youtu.be/xF_vfpGb1b4

Zimbabwe: Hyperinflation in Zimbabwe

Confidence in the Fed: http://youtu.be/R5lZPWNFizQ Alan Greenspan critiquing his devastating policies.

 

Volatility at World’s End or the Alchemy of Risk

Volatility at World’s End

Deflation, Hyperinflation and the Alchemy of Risk

Artemis Capital Q12012_Volatility at World’s End

The above 18 page report will help you understand how huge debts can either cause deflation or hyperinflation. A thought-provoking read that I highly recommend.

Thoughts?

Earlier I posted on hyperinflation here:http://wp.me/p1PgpH-1h

When NO ONE accepts a fiat currency then the inflation is infinite. No amount of paper currency–even by the ton–will be used as a medium of exchange. ….Back to barter we would go until a new medium of exchange is found or used.

Current Market Situation

http://scottgrannis.blogspot.com/2012/05/eurozone-update.html

http://scottgrannis.blogspot.com/2012/05/what-tips-say-about-future.html

Outstanding Video on the Dangers of Hyperinflation

The Adam Fergusson of When Money Dies is interviewed here: http://lewrockwell.com/orig12/fergusson1.1.1.html

This video is particularly relevant today given the rapid monetary growth from our Federal Reserve.

Yes, we want to invest from the bottoms up but never ignore current conditions.

Inflation, Hyperinflation and Investing with Klarman, Buffett and Graham

Investing and Inflation

Americans are getting stronger.  Twenty years ago, it took two people to carry ten dollars’ worth of groceries. Today a five year-old can do it. – Henry  Youngman.[1]

The best investing article on investing this editor has ever read:

http://www.scribd.com/doc/65198264/Inflation-Swindles-the-Equity-Investor

If you  grasp what Buffett is saying, your results will improve. Inflation is the major  concern of any investor. You should measure your investment success not just by  what you make in nominal terms but by how much you keep after inflation. Take out a dollar from your purse or wallet. You  are taking a dollar today to invest  in a claim in a capital good (stock or bond of a company) to be able to consume  the same or more goods and services in the future.

An  interesting blog discusses Buffett’s above article and comments further on
inflation here: http://www.valueinvestingworld.com/2009/06/warren-buffetts-comments-on-inflation.html  and click on the pdf file (100 pages) which
aggregates all of Buffett’s writings on inflation and investing. http://www.chanticleeradvisors.com/files/107293/Buffett%20inflation%20file.pdf.

After reading those  articles, take a minute to download the 50-year charts on

Proctor & Gamble (PG): http://www.scribd.com/doc/65206655/Proctor-Gamble-50-Year-Chart

Coke (KO): http://www.scribd.com/doc/65206606/Coke-50-Year-Chart-SRC

US Steel (X):  http://www.scribd.com/doc/65207037/US-Steel-50-Year-Chart-SRC

Goodyear Tire & Rubber: GT: http://www.scribd.com/doc/65207109/GT-50-Year-Chart-SRC

I recommend going to www.srcstockcharts.com and consider
subscribing to their 35-year or 50-year stock charts as a way to understand the
long-term cyclicality of businesses. You might be amazed at the differences in
performance and persistence between good and bad businesses. As the world
focuses more on the short-term, I urge you to develop more long-term analysis.
Stocks are theoretically perpetual ownership interests unlike bonds.  It’s silly to focus on next quarter’s earnings and think that will have a major impact on intrinsic values.

Four companies is not a statistical relevant example size. Also, one has to be careful of hindsight bias and fitting a theory to the facts, but how does Buffett’s
article tie into these empirical results? What can you use from your analysis
to become a better investor? Thoughts? Hint: I learned to go where the living is easy not to solve tough problems.

Understanding the dangers of inflation is critical now
because of the monetary and credit distortions building up in the world’s
monetary system as the links below will show. A true understanding will require
a huge effort, but you have no choice if you wish to understand the challenges
and conditions you face as an investor.

Many traditional value investors believe an investor should avoid macro forecasting and just do bottom-up company-specific analysis.  I don’t believe you need to forecast markets but one must understand the current dangers and risks confronting him or her when valuing businesses. Not to have been aware of the unusual credit conditions in the housing market during 2003 to 2007 would have meant attaching unusually high normalized earnings to homebuilding stocks while in a housing bubble.

Hindsight bias? A stopped clock is always right twice? Several investors were screaming from the rooftops about the  bubble building in housing. Go here for a ten minute clip: http://www.youtube.com/watch?v=tZaHNeNgrcI.
For a more in depth analysis of the causes of the housing bubble by the same
analyst: http://www.youtube.com/watch?v=jj8rMwdQf6k.
By the way, the point is not the successful prediction but the reasoning behind his analysis. If you don’t understand economics you are like a one-legged man in an ass-kicking contest. Thanks Mr. Munger.

No greater value investor than Seth A. Karman in his introduction to Security Analysis, 6th Edition (2009) writes on pages, xxxii to xxxiii:

Another important factor for value investors to take into account is the growing propensity of the Federal Reserve to intervene in financial markets at the first sign of trouble. Amidst severe turbulence, the Fed frequently lowers interest rates to prop up securities prices and investor confidence. While the intention of the Fed officials is to maintain orderly capital markets, some money managers view Fed intervention as a virtual license to speculate. Aggressive Fed tactics, sometimes referred to as the “Greenspan put” (now the “Bernanke put”), create a moral hazard that encourages speculation while prolonging overvaluation. So long as value investors aren’t lured into a false sense of security, so long as they can maintain a long-term horizon and ensure their staying power, market dislocations caused by Fed action (or investor anticipation of it may ultimately be a source of opportunity.

TODAY

Now for the current (2011):

A  monetary tsunami is coming: http://mises.org/daily/5597

Defining inflation: http://mises.org/daily/908

Just don’t believe what you read, go to the primary sources:

Current Money Stock Measures which are rising as fast as they did in the 1970s: http://www.federalreserve.gov/releases/H6/Current/

You need understanding to place those statistics into context.  The effects of inflation are rising prices in general or a decreased decline in some prices absent money printing. The effects are not just a result of the increased supply of money but the demand to hold money.

The pernicious effects of inflation:

http://mises.org/resources.aspx?Id=7215a07f-1a67-475e-90af-5789b7c82223

http://www.lewrockwell.com/paul/paul728.html

Why gold prices are so high: http://mises.org/daily/5652/Why-Are-Gold-Prices-So-High

HYPERINFLATION

I am not  implying impending hyperinflation but understand the worst case scenario. The US has suffered two hyper-inflations (The
Confederate Greenback and the US Continental Dollar). The dollar’s exchange
value has declined as shown here: http://mykindred.com/cloud/TX/Documents/dollar/
and for further clarification go here: http://www.financialsensearchive.com/fsu/editorials/dollardaze/2009/0223.html

As  investors we must also be prepared to understand worst case scenarios like hyperinflation. See video http://www.youtube.com/watch?v=DzV9WZhhKrM&feature=related.  The Weimar hyperinflation destroyed the
wealth of Germany’s middle class. The social devastation helped usher
in http://www.youtube.com/watch?v=VCwV75obpYk&feature=related
Hitler. May we never forget the lessons of history.

BOOKS

THE best book on understanding the causes and effects of hyperinflation is The Economics of Inflation by Constantino Bresciani-Turroni, download the book here: http://mises.org/books/economicsofinflation.pdf

When Money Dies: The Nightmare of Deficit Spending, Devaluation, and Hyperinflation in Weimar Germany by Adam Fergusson (1975, Reprint
2010). This is the “narrative description” of Bresciani’s book. The horror. Finally, another good read: Fiat Inflation in  France by White: http://mises.org/books/inflationinfrance.pdf

If you live in the USA or Europe and are not aware of the current dangers and what could happen, you are living a high-wire  act.


[1] Intelligent Investor, Chapter 2: The Investor and  Inflation by Benjamin Graham.