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Investment Fundamentals: Then & Now


As in life, there are very few absolute truths in investing. The only constant in both cases is change.

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									                           Investment Fundamentals: Then & Now

                                By Theodor Tonca October 30, 2010.

As in life, there are very few absolute truths in investing. The only constant in both cases is change.

While the above statement is universally indisputable, what is less understood and even less
recognized is that throughout all this constant change and evolving market cycles the fundamental
precepts of investment have remained the same. When King Solomon charged a group of wise men
to invent him a sentence which should hold true and be appropriate at all times and situations. They
presented him the words:

“And this, too shall pass away.”

In much the same way Benjamin Graham boiled down the concept of investing in a few simple
words in the original 1934 edition of Security Analysis:

 “An investment operation is one which upon thorough analysis promises safety of principle and
 an adequate return. Operations not meeting these requirements are speculative.”

 The remainder of this paper will divulge the basic components which together constitute an
 investment operation, while highlighting common pitfalls along the way.

                                   Investment Operation Components

As numerous compilations of data over long term time periods (10 years or more) have shown,
including Michael Maubossin's study of over and under performing mutual funds between 1992-2002.
There are similar attributes and investment processes which set managers who consistently beat the
market apart from those who don't.

  – Investment Style. The value investing approach entails determining a company's intrinsic value
      before a purchase is ever made. The great majority of individuals who have consistently
      outperformed the market, be they Warren Buffett through Berkshire Hathaway or Peter Lynch
      via the Magellan Fund espoused an intrinsic value approach to investing.

      Market Folly #1: Poor quality securities. One of the primary hazards confronting investors
      as history has taught comes from purchasing securities of inherently low quality at times of favorable
      business conditions.

      One needs to look no further than the recent run up and subsequent crash of real estate prices and
      mortgage backed securities in 2008 for evidence of this.

  – Portfolio Concentration. Diversification can be a great thing, but too much of it especially
    uniform diversification as taught by conventional portfolio theory can be very risky. The key
    is to understand each business which comprises your portfolio as if it were your own, ideally
    one will concentrate over 50% of their assets in a group of five-ten companies which they
fundamentally understand well.

Market Folly #2: Paying too high a price for high quality securities. All prudent investment begins
with margin of safety which as we know is large at one price, small at a higher price and non-existent at
some still higher price. The difference between market price and determined or appraised value is one's
margin of safety, needless to say the larger this margin is the better as then it will be able to withstand
unfavorable market conditions and worse then average luck.

Portfolio Turnover. In this case I believe the old axiom: “Traders make their brokers money,
while investors make themselves money” holds strikingly true. After all, even the best
individual traders in the world only make money approx. 50% of the time.

The average turnover for managed mutual funds currently stands at approx. 85% which means
that funds are turning over about half of their holdings every year. While this number has
certainly come down from an average turnover of approx. 110% in the late 90's, it is still well
above a respectable number as studies have shown that portfolio's with a turnover of above 30%
typically under-perform the market over the long term.

 Market Folly #3: Speculating in stocks rather than buying businesses. This is defined as buying a
stock merely on the hopes that it will continue to go up rather than purchasing a minority stake in
business based on what it is worth.

Geography. Despite common belief, most market out-performers have historically hailed from
areas outside of the big east coast financial center of New York. Warren Buffet from Omaha,
Philip Fisher from California, Peter Lynch, Boston. Without reading too much into this trend
I would make the simple assertion that being away from the conscientious thinking that
permeates Wall Street enables one to think and act independently.

In conclusion, I hope the principles outlined above which have been around more nearly a
century now will enable more people to clearly see that despite booms and subsequent busts,
high or low interest rates and ever changing economic environments these principles will always
remain the same. While astute investors change their behavior to adapt to a changing
environment, what does not change are the fundamentals of investing.

Sources: The Intelligent Investor By Benjamin Graham | The Warren Buffett Way 2nd Edition By R.G.
Hagstrom | The Motley Fool: Turnover & Cash Reserves By Bill Barker | More than you know: Finding
Financial Wisdom in Unconventional Places By Michael Mauboussin

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