Category Archives: Dow’s Value Theory

This is the second in a series of reviews of Graham and Dodd's investment classic Security Analysis. This book is credited with providing Warren Buffett and his disciples with the acumen to pick stocks that generate long-term wealth. Although the section of the book that we chose to review is probably the smallest, we feel it is worth examining.

The following paragraph is a continuation of the previous excerpt that we reviewed recently regarding investment timing.

“There are two other major questions of investment timing. The first is whether the investor should try to anticipate the movements of the market-endeavoring to buy just before an advance begins or in its early stages, and to sell at corresponding times prior to or at the onset of a full-scale decline. We state dogmatically at this point that it is impossible for all investors to follow timing of this sort, and that there is no reason for any typical investor to believe that he can get more dependable guidance here than the countless speculators who are chasing the same will-o’-the-wisp. Furthermore, the major consideration for the investor is not when he buys or sells but at what price (Benjamin Graham, David L. Dodd, Sidney Cottle. Security Analysis, Fourth Edition. 1962. Page 70.).

We can’t understand how Graham and Dodd could expect an investor to recognize the upper range of a bull market when they “dogmatically” believe it is impossible to “anticipate the movements of the markets…”.  Also perplexing is the belief that buying at a specific price is unassociated with timing of some sort. After all, if a stock is currently overvalued but otherwise “sound” and the price remains the same, then over time the stock will become more fairly valued or undervalued. This suggests that price is better at some times than others. A stock that you wouldn’t buy today because the price is expensive will soon become a stock that is less expensive, in due time.

related article: Graham and Dodd on Market Timing: I

The following is our critique of a passage of the investment "bible" Security Analysis by Graham, Dodd, and Cottle. This book is credited with providing Warren Buffett with the knowledge and background on how to accurately assess stocks. Although we know this book is basically about number crunching, our concern is how this book treats the question of timing of the purchase of stocks. In this regard, Security Analysis says the following:

“Timing Consideration in Investment Policy- The old rule for the ordinary investor was that he should buy sound securities when he had funds available. If he waited for lower prices he would be losing interest on his money; he might “miss his market,” even if prices declined, in any case, he was turning himself into a stock trader or speculator. Much of this view retains its validity. However, the time when the investor should clearly not buy common stocks is during the upper range of a bull market. (Benjamin Graham, David L. Dodd. Sidney Cottle. Security Analysis, Fourth Edition. 1962. Page 70.).”

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"Wall Street offers many opportunities to those who know values and possess some capital. But until people learn that some stocks are cheap at $200 per share an others dear at 2 cents per share, and until people learn that those who really know something about the market do not need to peddle their information for a living, it is to be feared that much money will continue to be lost both in and out of Wall Street (Dow, Charles H. Review & Outlook. Wall Street Journal. September 10, 1902.).”

In the short run the market is a voting machine, In the long run it is a weighing machine

"Whether the market goes up or down a few points in any one month does not alter the fact that if extraordinary increases in earnings radically changes the value of a certain stock, the price of that stock will perhaps slowly but with certainty adjust itself to its new value (Dow, Charles H. Wall Street Journal. Review and Outlook. October 25, 1900)."

Dividends are a reward after earnings have been applied to improving prospects

“It may be said that only a part of these gains in earnings can be fairly credited to dividend accounts.  That is true, because it has been deemed wise to take a portion of the earnings in each of the cases above named for betterments (Dow, Charles H.Wall Street Journal. Review and Outlook. October 12, 1900)."

Charles H. Dow defines what Industrials stocks are

"The stocks of trust companies and banks are simply industrial stocks... (Dow, Charles H.Wall Street Journal. Review and Outlook. October 12, 1900)."

Charles H. Dow says slow and steady wins the race

"Confidence has to be earned and has been truthfully pronounced a plant of slow growth (Dow, Charles H. Wall Street Journal. Review and Outlook. October 12, 1900)."

Charles H. Dow once said, “the growth of the business of the country accrues on the old stocks.”

We thought we’d compare this idea of Dow’s with the portfolio of Warren Buffett to see how accurate this concept might be.  Below is the list of companies held by Warren Buffett from the 2012 Annual Report (page 106-107).

Based on the companies in Warren Buffett’s stable, it appears that Charles Dow was right.  Warren Buffett doesn’t seem to be holding any companies that have IPO’d in the last 5 years.  In addition, this list of companies excludes the newspaper and real estate offices that are being accumulated throughout the country.

The concept of Dow Theory is widely associated with technical analysis.  While there's no denying of such a view, investors shouldn't overlook the fact that Charles H. Dow emphasized the concept of value investing in much of his writings.  In his Wall Street Journal editorial on February 25, 1902, Dow stated:

"The one sure thing in speculation is that values determine prices in the long run. Manipulation is effective temporarily, but the investor establishes price in the end.  The object of all speculation is to foresee coming changes in values. Whoever knows that the value of a stock has run ahead of price and is likely to be sustained can buy that stock with confidence that as its value is recognized by investors, the price will rise (Sether, Laura. Dow Theory Unplugged. 2009. page 81)."

This begs a follow-up question of what is considered of value?  In the previous quote, Dow didn't speak of price-to-earnings ratio (P/E) or price-to-book value (P/B).  However, one measure of values that Dow mentions often in his writing is dividends.  In the book Charles H. Dow and the Dow Theory, by George W. Bishop, Jr., it is noted that Dow makes many references to dividends and its impact on values, as indicated below:

"Determine the stock or stocks to trade in. They should be railroad stocks, dividend payers, not too low, nor too high, fairly active, and for the bull side below their value; for the bear side above their value. Values are determined roughly by earnings available for dividends."

It becomes clear that the oldest tool we can and should use in our investment playbook is based on the actual dividend.  Furthermore, not only should a stock provide income in the form of dividend but have a large enough margin of safety to withstand market cycles in case earnings start to decline.

Warren Buffett said the most important concept he learn from Benjamin Graham was a margin of safety.  This concept, margin of safety, was made popular in the book The Intelligent Investor which was published in 1949. However, Dow spoke of such concept in a specific manner in many of his editorials.  Specifically, his writings indicated that the greatest margin of safety can be had in what we know as the dividend payout ratio.  It is one of the aspects our team highlights in our dividend watch list.  The quote below is from the Wall Street Journal editorial on January 28, 1902 and might be one of the best examples on the concept:

Nothing strengthens a stock more than margin of safety in dividend earnings, and nothing weakens a stock more than doubt in regard to the stability of dividends.  It is unquestionably better for a stock that a company should pay 5% and earn 10% than to pay 9% and earn 10%, because, in the latter case, the small margin of safety must be a great element of weakness in the price (Sether, Laura. Dow Theory Unplugged. 2009. page 352).

All of the examples above provide some of the highlights of Dow's writing.  While holding the perception of Dow Theory as a "system" for reading charts, many fail to recognize the inherent discussion of values and fundamentals in the work of Charles H. Dow.

The purpose of this article is to demonstrate how Dow Theory approaches the question of the fair value of a stock. Most investors often hear of an analyst giving a fair value for a stock. Seldom is there ever a full description of the meaning of fair value or how exactly fair value is arrived at. Even when there is a description of how fair value is arrived at most investors have a hard time understanding what exactly it means if a stock they own goes from undervalued or overvalued to fair value.

Another name for fair value is intrinsic value. One source that we would derive our definition of intrinsic value is in Security Analysis by Graham and Dodd. According to a 1962 edition of Security Analysis:

“A general definition of intrinsic value would be ‘that value which is justified by the facts, e.g., assets, earnings, dividends, definite prospects, including the factor of management.’ The primary objective in using the adjective ‘intrinsic’ is to emphasize the distinction between value and current market price, but not to invest this ‘value’ with an aura of permanence. In truth, the computed intrinsic size is likely to change at least from year to year, as the various factors governing that value are modified. But in most cases intrinsic value changes less rapidly and drastically than market price and the investor usually has an opportunity to profit from any wide discrepancy between the current price and the intrinsic value as determined at the same time.

“The most important single factor determining a stock’s value is now held to be the indicated average future earning power, i.e., the estimated average earnings for a future span of years. Intrinsic value would then be found by first forecasting this earning power and then multiplying that prediction by an appropriate ‘capitalization factor.’”

Graham and Dodd. Security Analysis. McGraw-Hill. New York. 1962. Page 28.

The challenge with the definition of intrinsic value is the “facts” as described by Graham and Dodd. First, the valuing of assets could be done above or below their true worth. Second, earnings could be managed or manipulated in a fashion that is inconsistent with the company’s true health. Third, a company’s prospects are subject to vagaries in the market and therefore are not definite. Fourth, depending on the compensation method used for the company’s management, those in charge may act in a fashion that is counter to the continued growth of the company. The only certainty is the payment of dividends that have already taken place. In my experience observing stocks, I have seen the change in management, earnings, prospects and assets but never the change in ex postdividend payments.

Even within the definition of intrinsic value, Graham and Dodd submit to the fact that we cannot expect current conditions to exist into perpetuity. Additionally, the idea of forecasting into the future, “over a span of years,” a company’s earning potential seems to be more hopeful than anything else. The fair value of the company can decline with little more reason than a significant decline in stock price.

The spurious nature of intrinsic value can be demonstrated in what is known as an impairment charge. Recently there have been two Dividend Achievers that have had impairment charges which have significantly reduced the fair value of the company. In one instance, Supervalu (SVU) noted in their Form 10-Qfiling that the “retail food operating loss for the third-quarter and year-to-date ended November 29, 2008 reflects the preliminary estimate of goodwill and asset impairment charges of $3,250,000 related to the write-down of goodwill and other intangible assets required by Statement of Financial Accounting Standards (SFAS) number 142.” What this means is that because the stock price fell so much in such a short period of time, the company was forced to adjust their fair value lower due to SFAS rule number 142.

In another example, Nacco Industries (NC) stated in their 4th quarter earnings callthat, “during the quarter, the company wrote off the goodwill on its books. Because the company stock price at year end was significantly below the company’s books by tangible assets and its book value of equity, accounting rules effectively required the company taking non-cash write-off of goodwill and certain other intangible assets totaling $436 million or 431.6 million net of taxes of $4.1 million the company recorded those pretax charges as follows…” Again, this is an example of accounting rules (SFAS rule No. 142) determining the change in the value of the stock’s fair value.

Although these were “legitimate” changes to the fair value of the companies, one cannot overlook the fact that much of the fair value can be based on interpretation. Also, the timing of the changes can occur at times that are not consistent with the decline in earnings or future prospects. In the two prior examples these declines in fair value were based on the declines in stock price due to the market panic from 2007 to 2009.

Most fundamental analysis of stocks has been done based on the Graham and Dodd method which was codified in 1934 after the stock market crash from 1929 to 1933. Before 1929, there were other methods for determining a company’s fair value. One method that I have studied extensively is the Dow Theory method. Most followers of Dow Theory might not realize it but the “50% Principle,” as coined by E. George Schaefer but elaborated in great detail by Charles H. Dow, is the method for arriving at a stock’s “fair value.”

From a Dow Theory perspective, a company’s fair value is as simple to determine as the prior period of increase or decline in the stock price. However, understanding the nuances will allow for better interpretation of the meaning of fair value according to Dow Theory.

According to Dow Theory, fair value is arrived at based on one half the previous increase in the stock’s price or one half the previous decrease in the stock price. In the example above, I have selected IBM to show how fair value works according to Dow Theory.

In section A, I have indicated that the rise in 1993 to the peak in 1999 had an established fair value based on the prior decline from 1987 to 1993 (red line.) The prior declining period set fair value for IBM at $34. When IBM went from $10 up to $34 the company’s stock was considered at fair value. Any further increase in price was considered overvalued. Theoretically, any investor who bought the stock below $34 should accept that any further increase in price is icing on the cake.

Because the stock rose from $10 to $140 in the period from 1993 to 1999, a new fair value was established at $75. Section B carried the fair valuation of $75 indicating that anyone who bought the stock below $75 was getting a bargain.

In section C, I have indicated that the decline from 1999 to the trough in 2002 established a new fair value for the following increase at $97. In section C, from the 2002 low to the 2008 high, the fair value became $92. In section D, after the decline from July 2008 to November 2008 the new fair value became $100 in section E.

Each time a stock completes a major decline or increase, a new fair valuation can be established. For the cautious investor, the fair value for the next increase is derived from the previous decline and the increase that preceded the previous decline. This establishes a range that an investor would determine where a stock is fairly valued. A real-time fair value can be determined based on the most recent price trend however, an investor has to accept that, without a turn in the price (confirmation), the position is at significant risk. Belowis an attempt to demonstrate how the process works.

In July 2008, an analyst issued a strong buy report on Lowe’s (LOW) when the stock was trading at $18.90. At the time, the analyst indicated Lowe’s had a fair valuation of $32.27 using an assortment of Graham and Dodd methods. However, if using the Dow Theory method for determining fair valuation, an investor would have arrived at a fair value of $26.92.

Old high of $34.93 set on 2/20/07

[($34.93-$18.90)/2]+$18.90=$26.92

Subsequent to the report that was issued at $18.90, LOW closed at $27.36 on September 8, 2008 and then traded down from that point until it rested at the $13 level in March of 2009. Using the Dow Theory method for fair valuation, an investor would have sold the stock on the approach to $26.92 and then waited to see what would have developed from there. My personal modification to this method is to move on to a different stock altogether.

Unfortunately, a person who followed the analyst recommendation of expecting the stock to go to $32.27, or fair valuation, would have held on regardless of the stock never getting to $32 and instead declining back to $18.90 and below.

Now with LOW at $13, the new fair value, according to Dow Theory, based on the old high of $34.93, is $23.97. Well, from the $13 level, LOW traded up to $24.17 and has since reversed to the downside at the current price of $23.13. Again, the investor following the Dow Theory method would have sold the stock as it approached the $23.97 level.

Anyone who had based their purchase of LOW on July 2008 using the analyst’s future fair value of $32 would have not seen the price come close to predicted fair value.

While not infallible, the Dow Theory method addresses the most primary elements seen by all investors, the price movement. Although background in Graham and Dodd never hurt anyone, fundamentals are, at times, a distraction from what the most uninitiated gambler can see without having to crack open a single investment report. Additionally, an equal number of investors and speculators are on either side of the fair value range. This gives incentive to either buy, hold or sell the stock based on crossing the fair value plane.

Some would ascribe the Dow Theory 50% principle to the use of Fibonacci counts however, R.N. Elliot’s popularization of the application of Fibonacci’s to stock prices didn’t catch on until long after the establishment of Dow Theory. The use of Dow’s Theory in determining fair value gives investors the opportunity to see exactly how much the market discounts everything. It is clear that buying and selling a stock in such a short period of time is considered diametrically opposed to the Graham and Dodd method. However, it would benefit all who wish to obtain a reasonable approximation of fair value to consider the Dow Theory approach.

• Moves to the downside project fair values for the upside. Moves to the upside project fair value for the downside

*This is a repost of our  January 19, 2010 article (found here).

“The best way of reading the market is to read from the standpoint of values. The market is not like a balloon plunging hither and thither in the wind. As a whole, it represents a serious, well-considered effort on the part of farsighted and well-informed men to adjust prices to such values as exist or which are expected to exist in the not too remote future. The thought with great operators is not whether a price can be advanced, but whether the value of property which they propose to buy will lead investors and speculators six months hence to take stock at figures from ten to twenty points above present prices.

"In reading the market, therefore, the main point is to discover what a stock can be expected to be worth three months hence and then to see whether manipulators or investors are advancing the price of that stock toward those figures. It is often possible to read movements in the market very clearly in this way. To know values is to comprehend the meaning of movements in the market."

Source: Hamilton, William Peter. Stock Market Barometer. Page 38.

“The lack of attention paid to the price as it relates to values, in the case of the recommendation of DISH, may cost an investor a decline of 30% before a material gain is achieved unless the company is bought by a larger institution.”

“The best way of reading the market is to read from the standpoint of values. The market is not like a balloon plunging hither and thither in the wind. As a whole, it represents a serious, well-considered effort on the part of farsighted and well-informed men to adjust prices to such values as exist or which are expected to exist in the not too remote future. The thought with great operators is not whether a price can be advanced, but whether the value of property which they propose to buy will lead investors and speculators six months hence to take stock at figures from ten to twenty points above present prices.

 

"In reading the market, therefore, the main point is to discover what a stock can be expected to be worth three months hence and then to see whether manipulators or investors are advancing the price of that stock toward those figures. It is often possible to read movements in the market very clearly in this way. To know values is to comprehend the meaning of movements in the market."

Source: Hamilton, William Peter. Stock Market Barometer. Page 38.

“Like its service, DISH’s also shares seem attractively valued. At 10 times trailing earnings, the stock trades at a 33% discount to its five-year average and 47% below the average cable or satellite stock.

 

"Should DISH meet the 2011 consensus profit estimate of $3.16 per share and its P/E simply holds steady, the shares stand to gain 30% by early next year. DISH also boasts widening profit margins, and steady sales growth.”

“…The main problem with earnings is that earnings are a guess and relative to the other to components of Graham and Dodd investing [balance sheet and dividends] they are a speculation. Everyone can read a balance sheet and you can know what the balance sheet is, or at least was, as of the last quarterly report. Everyone can look at the dividend rate and the dividend rate conveys information because it is the board of directors best guess as to how much the company can pay out of its earnings while still retaining enough earnings to keep the company going. So you observe those two factors and you should base most of the value of the stock on those two factors. As far as I’m concerned, earnings are gravy or maybe it is the desert, assets and dividends are the dinner.

 

“But we live in a instant gratification society or what I call a junk food society, where everyone is so interested in the quality of desert, in this case earnings, that they forget to think about what the quality of dinner will be, in this case assets and dividends. The worst thing that happens with earnings is that you try to chain link them, instead of looking at the absolute earnings, you then tend to focus on the rates of change. When you start to look at the rates of change you create these instruments called derivatives. Which is very apt because these derivatives are really a play on the rate of change and not on the absolute levels or earnings, cash flow, dividends, or assets.

 

“The consequences [of derivatives] can be found with a gentleman by the name of Nick Leeson at Barings, he put a 200 year-old financial institution out of business or you could also think about Long Term Capital [Management] and you had a [two] Nobel Prize winner[s] on staff and he was thinking in calculus terms and the problem with these quant types is that they’re good at calculus but they forget arithmetic and algebra that the person on the street understands. So they get into the stratosphere and they come up with some arcane formula that is understandable only to others like them and they lose track of the real world. That’s the extreme version of looking at momentum and derivatives.”

"The point of importance for those who deal in industrial stocks is whether the capitalization of the companies into which they propose to buy is moderate or excessive, when compared with the aggregate earnings of the various concerns forming the combination in a period of depression. It is probable that consolidated companies will be able to earn as much in the next period of low prices as the companies forming the combine were able to earn in the last one; hence the very foundation of investments in industrials should be knowledge of what these companies earned, say in 1893 to 1896, making, perhaps, reasonable allowances for economies under consolidation. Where the earnings so shown would have provided dividends for industrials now active, the fact must be regarded as a very strong point in favor of those stocks."

• When trying to value a company remember that the earnings are the dessert, the focus should be on the main course, the assets and dividends.
• Compare current earnings to the worst earnings from prior years, the farther back the data the better.
• Thomas Au, A Modern Approach to Graham and Dodd Investing, John Wiley & Sons, (New Jersey, 2004).
• Interview with Thomas Au on the FinancialSense Newshour With Jim Puplava
• George W. Bishop Jr., Charles H. Dow: Economist, Dow-Jones & Company (Princeton, 1967), page 11.
• Peter Wyckoff, Wall Street and the Stock Markets, Chilton Book Company, (Philadelphia, 1972), page 38.