Two Competing Investment Philosophies
If you watch Mad Money, or read some of Jim Cramer’s books, he’ll spell out in great detail how he ran a successful hedge fund through the 80’s and 90’s. Despite the stupidity of his TV show, he does follow a systematic approach to investing. Basically he chooses sectors that are growing, then chooses businesses that are first or the best in that sector, while carefully avoiding “paying too much”. He looks at profitability, quick and current ratios, cash-flow – all to select the stock most likely to be at the top in the end. He places a strong emphasis on the PEG ratio – or the expected Price/Earnings divided by the expected Growth. If it’s > 2, the stock is expensive and you should avoid buying, or sell, when it gets to that point.
Another older successful philosophy is the Value approach, originally spelled out by Benjamin Graham and David Dodd in Security Analysis, originally written in 1934 and updated 5 times since (the latest 6th edition is over 700 pages and re-published in 2009). Warren Buffet wrote the introduction.
The Value approach places emphasis on ignoring any expectations for growth and relies heavily on how a company has performed in the past. It has 7 solid rules to identify the companies that, should a recession hit, will still be around and profitable during the bad times as well as the good. They’re simple enough: size of company, liquidity to cover debts, some past growth, and a low price relative to its book value and its current earnings.
Where these philosophies are the same, both try to identify profitable companies that will serve the investor well in capital appreciation and risk. Where they significantly differ is in regard to the future. Graham would put little to no emphasis on any forecasts, as people are just as likely to be right as to be wrong. And should they be wrong, they will lose money – to be avoided at all costs. Reducing risk while still realizing capital gains is what the investor requires. Forecasting, and its detrimental hit to a portfolio’s value, is speculation.
Investment is not successful speculation. Speculation is buying a horrible or hugely overpriced stock, knowing all the risks of doing so. Investment is buying part of a company at a reasonable price to insure against loss of principal.
