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Inflation as the Enemy of Investing

Mises Daily: Wednesday, February 24, 2010 by

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Applied Value
Investing cover

In this age of inflation, we are all forced to do many tasks that others could do better for us. The fact is that inflation impedes the process of civilization, which is brought about by the division of labor. While, without the central bank's continual monetary infusions, prices would gently fall as technology made all things and all people more efficient, we don't enjoy that luxury. Instead we're mowing our own grass, fixing the flappers in our toilet tanks, and managing our own retirement funds.

Now, pushing a mower requires little skill, is no more than an annoyance, and provides the benefits of fresh air and sunshine. But managing one's retirement funds is a different matter entirely. It is an especially cruel result of inflation that instead of simply being able to hoard money, people must "invest their money into the financial markets, lest its purchasing power evaporate under their noses," explains Jörg Guido Hülsmann in The Ethics of Money Production. "Thus they become dependent on intermediaries and on the vagaries of stock and bond pricing." And unfortunately most of us aren't neurologically wired well for the job.

But we can't just throw up our hands and trust the state to take care of us in our golden years. Saving money isn't enough. The state is continually making what you have saved worth less. And unless you're a government employee, most likely you're left with the assignment of making sure you have enough for when emergencies occur or you're unable to work.

The typical stockbroker went from selling shoes or cars to hustling stocks after passing the Series 7 exam. Your financial future is not his or her concern; generating sales commissions is. Of course there is plenty of free advice out there, from Jim Cramer to Suze Orman. But, you will likely get what you pay for. Finding good investments is very hard work. Buying them at the right price is even harder work. Having the patience to buy at the right time and sell at the right time is nearly impossible.

Austrian business-cycle theory can give investors ideas on when to invest and what to invest in, but the Austrian School provides little in the way of analyzing specific companies and stock prices. What Hayek and Mises are to the business cycle, Benjamin Graham and David Dodd are to value investing. In their famous treatise, Security Analysis, Graham and Dodd painstakingly lay out their method for valuing stocks, looking for deeply depressed prices.

"Saving money isn't enough. The state is continually making what you have saved worth less."

While the average amateur investor may be excellent in their own career field, it doesn't mean they know what to invest in, or how to pick stocks. In fact being very good at your field can give you the false sense that whatever stocks you pick or your broker picks for you must be good, because after all, you picked them and you picked your broker — and you're smart. So, no doubt those stock prices will go up.

But the smart and talented stock-picking neophyte is not investing at all but speculating. "An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return," Ben Graham wrote. "Operations not meeting these requirements are speculative." The vast majority of people just don't have the time or possess the patience to thoroughly analyze an investment opportunity. In The Millionaire Next Door, authors Thomas Stanley and William Danko point out that the average person tends to spend more time on purchasing a car than on looking at potential appreciating investments.

So for those who are interested in accumulating wealth and willing to put the time and hard work toward that end, Joseph Calandro Jr. has masterfully melded the work of Graham and Dodd with Austrian business-cycle theory. The result is a very readable how-to guide for value investing, aptly named Applied Value Investing: The Practical Application of Benjamin Graham and Warren Buffet's Valuation Principles to Acquisitions, Catastrophe Pricing and Business Execution.

One can see by the title that the book is not for someone looking to take the next step after Stock Investing For Dummies, but it's not the handful that the title implies. The beauty of Calandro's work is that he teaches value investing through case studies. The reader can follow along while the author does his own valuations of Sears, GEICO, and General Re. These of course are not made-up theoretical cases, but real-life deals made by value investors Eddie Lambert and Warren Buffett.

Calandro first provides the reader with the basics of Graham and Dodd valuation in order to be "approximately right rather than precisely wrong." The author does this by valuing Delta Apparel, Inc., as a potential investment in 2002. When his analysis indicated that Delta was undervalued, Calandro bought Delta stocks and immediately offered to resell them at a fairer, higher price. This exercise is all about making money, not falling in love with stocks and their stories.

Much of Graham and Dodd's analysis is in assigning different valuations to balance-sheet items to determine what the real value of a company is beyond the accounting. This requires much more art than science.

"Finding good investments is very hard work. Buying them at the right price is even harder work. Having the patience to buy at the right time and sell at the right time is nearly impossible."

A couple of reviewers of Applied Value Investing have taken Calandro to task for the assumptions he makes in his case studies. Although the author doesn't provide much explanation of many of his assumptions, readers should understand that the talent of investing comes through experience and training. Reading one book will not provide all the answers, but Calandro does give us a roadmap. Investors must still make their own judgments. These reviewers may not have made it to the book's conclusion, where the author reminds us that applied value investing is all about "identifying what you know and what you do not know, and then taking steps to quantify what you do know in a conservative yet rigorous manner so that a disciplined valuation can be formulated."

In chapter 5, the author draws upon an article he wrote for the Quarterly Journal of Austrian Economics to give the reader/investor insights into the best times to buy and sell from a macro perspective.Download PDF He breaks the business cycle into eight stages by "synthesizing [George] Soros's boom–bust model, Austrian business cycle theory (ABCT), and behavioral characteristics."

In an interesting appendix to the chapter, Calandro writes of Warren Buffett's criticism of the efficient-markets hypothesis (EMH), which is the Rational Expectations School of the investing world. EMH posits that prices on assets traded in the market already reflect all available information. The Oracle of Omaha refuses to donate money to his alma mater, Columbia, because of the school's research in the area of EMH.

After applying Graham and Dodd valuation to make a catastrophe valuation, the author applies his tools to firms' business strategies. Next he circles back and discusses the important aspects of each layer of value-investing analysis, emphasizing that the key to long-term success is "research, checking, rechecking and cross-checking of assumptions."

To conclude, the author tells the reader to ignore economists shilling for newspapers, TV shows, political parties, the government, or financial institutions. Calandro quotes renowned Fidelity Fund manager Peter Lynch, who said, "If you spend 13 minutes a year on economics, you've wasted 10 minutes." However, Calandro recommends, in addition to a number of other books, Murray Rothbard's America's Great Depression, Roger Garrison's Time and Money, Ludwig von Mises's The Theory of Money and Credit, and other Austrian titles. With all due respect to Peter Lynch, Mises — a real economist — wrote that economics "concerns everyone and belongs to all. It is the main and proper study of every citizen."

And while the practice of value investing the Graham and Dodd way is more prudent than throwing money at that stock tip you overheard at the bar the other night, always remember what Mises wrote in Human Action: "There is no such thing as a nonspeculative investment.… In a changing economy action always involves speculation. Investments may be good or bad, but they are always speculative."