Paul Graham: "How You Know" - How Reading Trains Our Mental Models

Paul Graham essay,

"I get an uneasy feeling when I look at my bookshelves. What use is it to read all these books if I remember so little from them? [...]

Reading and experience train your model of the world. And even if you forget the experience or what you read, its effect on your model of the world persists. Your mind is like a compiled program you've lost the source of. It works, but you don't know why."

I think he's right. I think it also helps to review books. Even the books I think are bad are worth reviewing. Books that are bad can even be worth reading. It was important to see how terrible The Outsiders book was, because competitors like it so much.

Value Investors Obsessed With "Compounders", ROE; Don't Care About Liquidation Value Or Margin Of Safety

Young Money did a post called "Two great posts from Credit Bubble Stocks":

"I find this fascinating because it shows how much valuation standards can change over time. Today, a company is praised for earning a high return on equity (ROE). In Graham's time, companies were praised for having significant assets, even if reporting significant assets depressed their stated ROE."

I sent this to Oddball Stocks, who responded with a great comment:

"It seems the high ROE trend has been born out of the crash of 2008. I don't remember anyone talking about it before then. Now I see things all the time saying 'they earn 4% on equity so they're only worth 40% of book value'. Of course that's insane, someone could purchase them and unlock the value. Or new management could unlock the value.

It seems since the crisis investors have lost their imagination. We have investors believing that anything good will go on forever; these are the growth companies. A company doesn't grow to the sky. Wells Fargo isn't going to grow at 15% a year for decades, if they do in something like 15 years they will be 100% of the banking market in the US. The other are value investors who can't imagine a bad company changing. Things happen, management changes, people change, things change. Nothing is static, yet we live in this static market. It's weird."

I would summarize this by saying that "value" investors are currently obsessed with "compounders" (i.e. "quality" businesses with high returns on equity, and they don't care about liquidation value or margin of safety.

I'm not saying you can never make money buying a high margin, high ROE business at over five times book value, but that's not value investing as the style was traditionally known.

To me (and to Graham), value investing is buying a consistently profitable bank at 60% of book, or closed end muni funds when they are trading at historic discounts to NAV.

Paul Graham On "Before the Startup," And The Startup Bubble

Paul Graham has written his first new essay in almost a year, "Before the Startup". It seems like his essays have had a long interruption, ever since he wrote one that was politically correct by 2010 standards by not politically correct enough by 2014 standards.

I like the new essay, and his thoughts on startups in general, but he is an uber-bull on startups.

I think the flaw in his thinking is that, while a startup may be making something that users want (all-important in his view), lots of people want things at a price of $0 that they wouldn't want at a price of $n>0.

I've never seen him write an essay about what type of products, originally given away for free, will subsequently be possible to charge for.

People say that these free products will be advertising supported. Let's see, if it's very cheap to start a website that will attract users who can be served ads, what does that say about: (1) the future prices of ad placement, (2) where the rents from advertising will go?

Being able to serve ads was historically a great business, but that was when there was a very high fixed cost and low marginal cost of serving the ads.

Google has a market cap of $400 billion and Facebook has a market cap of $200 billion; $600 billion combined. Google has EBIT margins of 23%, Facebook (which is a purer look at advertising margins) has EBIT margins of 36%.

Global advertising spending is about $550 billion. Only about a quarter of that is digital. That implies that digital advertising is creating about $50 billion in operating profit.

I get the impression that the glut of capital from VCs has led to something on the order of 5,000 startups. It seems as though what's left of the advertising pie isn't enough to justify the valuations at which these have raised money.

My other big problem with advertising-supported giveaway businesses, besides the nonexistent barriers to entry, is that advertising is a bet on middle class discretionary spending. We already know that global elites have decided to gut the middle classes. Do the VCs have a variant perception, or is it hard to see from inside their Silicon Valley bubble, just like it was hard to see the real estate bubble from inside Manhattan?

Review of The Rediscovered Benjamin Graham: Selected Writings of the Wall Street Legend by Janet Lowe

"A thing I would like to warn you against is spending a lot of time on over-detailed analyses... because you get yourself into the feeling that, since you have studied this thing so long and gathered together so many figures, your estimates are bound to be highly accurate. But they won't be." - Ben Graham
--

Reading The Rediscovered Benjamin Graham: Selected Writings of the Wall Street Legend, it occurs to me that investing truth lies near the intersection of Graham-style value and Prechter's theory of social mood. The two of them have much more in common than I realized. Graham actually said that "value standards don't determine prices; prices determine value standards"! He also wrote that,

"[I]nvestors have been willing to pay so much for so-called quality, and so much for so-called future prospects, on the average, that they have themselves introduced serious speculative elements into common stock valuations. These elements are bound to create fluctuations in their own attitude, because quality and prospects are psychological factors."

Ben Graham died in 1976. If he was alive, he would be 117 years old today. I wonder what he would have thought if he could have seen Conquer the Crash and the 2000 stock bubble. Something else interesting that he mentioned was that "even in years of considerable market and business changes the price of investment issues did not go through very wide fluctuations." By investment issues he means non-speculative stock purchases (e.g. net-nets) with a margin of safety.

That reminds me of Conrad and our other micro cap value trades. The share prices will be unchanged most days. Given the gyrations in almost all stocks, we now live in a world with few "investment issues!" And, by the way, an important Graham valuation indicator for the market was the relative abundance of net net opportunities.

Graham had an observation about inflation protection that is quite relevant today:

"It is impossible for any really large sums of money-say billions of dollars-to be invested in such tangibles [gold or commodities], other than real property, without creating a huge advance in the price level, thus creating a typical speculative cycle ending in the inevitable crash."

Of course, that is precisely the situation that the inflationists have created today, with silver trading for multiples of its cost of production.

I give this a 4/5, including a point for brevity and good editing.

Reviews of other Graham books:
Security Analysis: Sixth Edition, Foreword by Warren Buffett 4/5 (originally, now I think it should be 5)
Benjamin Graham, Building a Profession: The Early Writings of the Father of Security Analysis 3/5

Ben Graham on Noncumulative Preferred Stocks

The most attractive feature of preferred stock as a financing tool is that a company can defer the payment of dividends, whereas traditional debt requires the timely payments of principal and interest, and missing a payment is a default.

When a company suspends the payment of preferred stock dividends it is generally prohibited from paying common stock dividends until the preferred dividend has been reinstated. Depending on the terms of the preferred stock, the preferred stock dividends may or may not accrue in the interim.

If a preferred stock is "cumulative", any missed or suspended dividends accrue and must be paid back in full before dividends can resume on the common stock. A preferred stock lacking the cumulative feature is called "noncumulative," and any dividends passed are lost forever if not declared.

Preferred stocks as a class are less attractive than debt because the holders cannot compel payment of the coupons. However, this is tempered by the requirement (on cumulative issues) that the coupons be paid before any payment can be made to the common stockholders. Given that incentive alignment, the higher yields on preferreds than on debt can be said to compensate for the flexibility that companies have to defer dividends.

That is most certainly not the case with the noncumulative preferreds, something that Ben Graham wrote about nearly a century ago in Security Analysis:

"The drawback of not being able to compel the payment of dividends on preferred stocks generally is almost matched by the handicap in the case of noncumulative issues of not being able to receive in the future the dividends withheld in the past. This latter arrangement is so patently inequitable that new security buyers (who will stand for almost anything) object to noncumulative issues, and for many years new offerings of straight preferred stocks have almost invariably had the cumulative feature."( p.197)

Graham mentions a 1930 federal court holding that "while the noncumulative provision may work a great hardship on the holder, he has nevertheless agreed thereto when he accepted the issue."

So, if Ben Graham wrote in the 1930s that a particular type of security is so bad as to be unconscionable, it probably doesn't exist anymore right? Wrong. I've noticed that there are currently outstanding close to 200 different preferred stock issues, mostly issued by financial firms.

We're talking about highly leveraged financial firms, with ratios of total assets to market capitalization of between ten and seventy times! And people are willing to lend them money, on the basis that interest payments can be skipped and never repaid by the company, at single digit interest rates!  That's less than some conservatively financed E&P companies pay on their convertible securities!