Tools of the trade

Balance sheets can tell all kinds of interesting stories. A friend of mine
once asked me what I thought of a company he worked with. The next time we met,
I asked him: ‘Is the boss sleeping with his PA?’ According to its latest annual
report, the company was paying a woman with the job description of ‘secretary’
an enormous salary, plus stock options and all kinds of other benefits. It could
have hired a good chief executive for what she was taking home.

Not all companies have such scandalous titbits hidden away in the fine print.
But as most accountants already know, the ability to read between the lines of a
balance sheet and profit and loss statement is a powerful way to dig up listed
companies with hidden nuggets of gold. And just as importantly, weed out the

It was these tools that legendary investor Benjamin Graham primarily used to
build his fortune. These same tools are major weapons in the armoury of his star
student, Warren Buffett. Graham analysed companies’ annual reports to find
stocks that were selling below their intrinsic (or ‘break-up’) value. He didn’t
visit company managements; he didn’t even want to know what products the
companies sold; he was only interested in the numbers.

Of course, there is a danger in this approach. There are often very good
reasons why a company’s stock is selling below its net worth. The industry could
be in decline, the management incompetent, a new competitor with a superior
product might be decimating the company’s sales.

By relying purely on annual reports, Graham had no idea why a company was
cheap. So he could, and he did, buy stocks that declined, taking a loss.
Nevertheless, his investments returned profits of 17% a year, on average, over
several decades.

How did he achieve this when, clearly, some of the stocks he bought turned
out to be losers? Because he knew that while he’d lose money on some of the
large number of cheap stocks he bought, he’d make even more on the rest. To help
ensure that outcome, he would only buy companies with histories of steady
management, rising profits and regular dividends. It’s all information you can
find in annual reports.

Graham had another, crucial rule: he would only buy a stock selling for less
than half its liquidation value, what he called his ‘margin of safety’. Stocks
like that are a lot harder to find today than they were in the 1930s, 1940s and
1950s, but not impossible.

Discovering what appear to be good investments is not enough. One thing
needed to turn them into profits is an investment system: a method that tells
you what to do once you’ve found an investment that looks promising.

Every successful investor has an individual approach that suits their
personal style. Warren Buffett, for example, began his investing career in the
1950s as a Graham ‘clone’. While some of the criteria he applies today are
different from Graham’s, he still aims to buy below intrinsic value. But he now
defines intrinsic value as the discounted present value of a company’s future
earnings, not its break-up value.

Sir John Templeton, also a former Graham student, didn’t just look for the
cheapest stocks in the US; he searched for the cheapest stocks in the entire
world, and made a fortune for himself and his investors in the process. George
Soros has an entirely different and speculative approach. Even so, it is
composed of the same 12 essential elements as Graham’s and Buffett’s.

And yet the majority of investors focus purely on the first of the 12: what
to buy. As a result, people often fall into the trap of buying a stock because
it has a great ‘story’.

A Vancouver stock promoter I met many years ago noticed that some newly
listed companies took off, while others that had pretty much the same financials
stagnated or even fell. By analysing pairs of such companies, he discovered that
the company with the edge was the one that caught the attention of the media,
and got brokers and investors excited enough to open their wallets.

When he promoted companies like this, even when they had more story than
substance, he could bank a handsome profit. The boring stodgy company that made
bricks or industrial parts no-one had ever heard of was the one that went

Finding what looks like a great investment is not enough. Even a great
company is a terrible investment if you pay too much for it. Even more important
is having a clearly defined exit strategy: knowing all the factors that will
cause you to sell an investment before you put a penny on the table, and being
clear about when to take a profit. Seeing the market move as you expect it to is
the exception, not the rule. The great investor is like a Boy Scout: he’s fully

Next time you make an investment, try writing down what you will do if
everything goes according to plan. Then think of every possible thing that could
go wrong and for each of those contingencies, write down what you would do. That
will give you a sense of what it means to have a complete exit strategy.

Then, if the market collapses, the treasurer runs off to Paraguay with the
company’s money or the boss appoints his incompetent son as the chief executive,
you won’t have to scratch your head and wonder what to do. Like the great
investors, you’ll already know.

Developing a complete investment system also goes a long way to help you
overcome the feelings of fear and anxiety that sometimes trip investors up.

For example, if you’ve discovered a company with hidden assets on its balance
sheet – say, property held at its cost 20 years ago, way under its market value
today – you’ll know it’s a bargain. You’ll be like the supermarket shoppers who
see their favourite soap on sale at 50% off. They don’t call their analysts for
an opinion – they just buy the lot.

When you think about it, it seems obvious that the accountant’s tools
underlie the success of the great investors. Add a reasoned investment approach,
and the willingness to act on it, to that powerful foundation and you have all
the ingredients required for investment success – if not investment greatness.

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The Practitioner