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Rely on the basics

Rely on the basics

Prolific writer and academic Lawrence A Cunningham uses his immense knowledge of the financial world to come out with an insightful book, says Sharadh Manian.

Everything should be made as simple as possible, but no more so”—Berkshire Hathaway, Vice-Chairman, Charlie Munger, often mentions this Einstein quote to undermine stock market theories. It is this mantra Lawrence Cunningham chooses to emphasise through this book. If there is a simple and right way to reap benefits from the markets it is to apply common sense and not resort to practising theorised market concepts and trends while investing. The bottom line: common sense is uncommonly used.

An average investor may be mislead into expecting bulleted investment tips on picking stocks by the gurus. However the teacher-student duo of Benjamin Graham and Warren Buffett from Columbia University would scorn at this title (Graham if he was alive). Their investment strategies have favoured just one method—to dig up the financial data and not historical market prices while picking stocks. This book is in fact a primer on developing common sense to pick undervalued stocks. Written in a pedantic style it presents a structured argument to convey the main idea behind the book—that there exists a differential between the price and the intrinsic value of the stock, that it is important to evaluate intrinsic value rather than go by the market price while investing, and that this intrinsic value depends on business fundamentals rather than market frenzy.

There are three sections in this book. The first part “A Tale of Two Markets” is devoted to explaining popular theories, trends and thumb rules which have governed stock markets over the years. This part also tracks the history and then criticises major market theories—efficient market theory, modern portfolio theory and capital asset pricing model. It later discusses volatility in stock prices and what causes it. For the investor it is important not to be overcome by the news overload which dominates the current electronic trading age. This section with its academic and technical content may not appeal much to the lay investor. However, Cunningham has tried hard, and successfully, to explain them with anecdotes. If one can patiently browse through this section he can appreciate commonly used jargon in stock trading with some effort.

The second part titled “Show Me the Money” deals with concepts of business valuation and how one can calculate the intrinsic stock value which is different from the market price. It begins with a beautifully crafted parable on valuation of an apple tree. It is here that the rationale of Graham and Buffett comes handy.

Criticising the irrationality and speculative behaviour exhibited by investors, Cunningham suggests using Graham’s value-investing approach of evaluating businesses based on their financial statements, nature of business, growth prospects and keeping a margin of safety at the same time. He advises the small investor to avoid joining the speculative herd in the quest for short-term profits and think of himself as a part owner of the business.

While you may be investing in companies through stock markets, what will fetch you returns are the companies’ performance measured beyond the periphery of the trading ring. He cites Buffett’s “circle of competence” and investing only in businesses which you understand.

The final section titled “In Managers We Trust” deals with analysing the top management practices and strategies of the company whose stock interests you. This deals with issues such as corporate governance and the son-in-law test: evaluating the manager as you would evaluate your prospective son-in-law. It goes on to mention accounting procedures and how one should check about the trustworthiness of the management in not manipulating the balance sheets before investing.

The jargon and bizarre style may put one off initially but the merit of the book is reflected in the middle section which defines the omnipotent toolkit an investor should use in dealing with valuation of companies. The universality of the ideas in the book can be evaluated in the wake of the accounting frauds which have plagued American boardrooms in recent times.

This book is an attempt to educate the small investor in escaping the speculative culture which lays emphasis on the market quote and the ticker for the stock rather than the basics of the business. Market analysis should be replaced by business analysis to help the small investor sail safely in the stormy seas of the stock markets. An Indian investor will equally benefit from the book. For the uninitiated, it offers the range of stock market options. It is easy to be a part of the market frenzy today and follow the trend in using stock price as an indicator of the success of the company but one should remember the caveat Graham famously mentioned once: “In the short run the market is a voting machine, while in the long run it is a weighing machine.”