Ben Graham and the Growth Investor by CFA Institute

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Microsoft in the 1990s: A Growth Investor’s Dream

Ben Graham And The Growth Investor

Benefits of Growth Investing

  • Asymmetric reward-risk. Worst-case, investment goes to zero. Best-case, unlimited upside. During 1990s, a hypothetical $10K investment grew to almost $1 million
  • Defer capital gains taxes—your principal compounds faster
  • Save money on commissions, bid-ask slippage costs
  • Trade less, which improves investing results
  • No “exquisite timing” required; you can build a position over many years

But: Growth Stocks = Low Subsequent Returns

Ben Graham And The Growth Investor

Also, Value Beats Growth (EBIT/TEV)

Ben Graham And The Growth Investor

The Growth Trap – Three (3) Obstacles:

1. Poor earnings quality

GAAP income statement has four (4) structural limitations. So, just because a company is profitable in the accounting sense of the word does not mean that it has authentic earnings power.

2. Competitive advantage wanes

Successful companies attract imitators—good for consumers, bad for owners.

3. Premium to intrinsic value

We predict by extrapolation, so growth stocks often get pushed beyond intrinsic value (fair worth).

Obstacle #1: Poor Earnings Quality

  • To create comparability, all U.S. companies follow generally accepted accounting principals (GAAP)
  • GAAP is Robert’s Rules of Order for corporate America
  • When you open an annual report, 10-K or 10-Q and look at financials statements, that’s GAAP
  • Many investors take GAAP net income at face value; they think net income and EPS is a “hard” number…

Wrong! GAAP P&L’s Four (4) Structural Limitations

  1. Omits investment in fixed capital , so when capex is greater than depreciation, the net cash drain is excluded
  2. Omits investment in working capital, so when receivables and inventory grow faster than payables and accrued expenses, the net cash drain is excluded.
  3. Intangible growth-producing initiatives like R&D, promo/advertising, employee education, etc. are expenses (i.e., not investments) even though the benefits will last for several accounting periods.
  4. Stockholders’ equity is free even though owners have an opportunity cost.

How Fix? In the 1990s Two Alternate P&L’s Emerged

Ben Graham And The Growth Investor

Quandry?

  • When use free cash flow income statement?
  • When use Economic Value Added?
  • Well, reading Ben Graham gives me an idea…

See full slides below.