The Four Pillars of Investing: Ch 1, 2

by Mr. Cheap

Based on Mike’s Four Pillars blog, I decided I should grab a copy of Bernstein’s 4 Pillars and read through it (he named his blog after it, so how bad can it be? :-) ). There seems to be ton’s of good stuff in it already (I’m on chapter 2), that I decided I’d actually do a write up on chapters in chunks so that I don’t miss any of the big trends in this book (basically a good way to force me to use the knowledge I’m reading about).

While risk & reward going hand-in-hand is clichéd, there’s certain implications to this that are ignored by the investing community as a whole. Bernstein does an excellent job of presenting the idea, then pushing the implications into some interesting territory. He makes the assertion that its a bad idea to invest in “good” companies, since they will already have had their price pushed up to a level that will be tough for them to deliver ever increasing superior returns. With the possibility of bad fortune existing for any company, you’re often getting a meager return for the risk you’re accepting. He gives the example of Walmart being a “good” growth company and Kmart being a “bad” value company. Because investors aren’t interested in owning Kmart, those who buy it stand to do well if the company can get their act together and manage their business better (whereas, there’s not a lot of improvements or streamlining that Walmart can do). Another way to view this is with value companies, the bar is a lot lower for them to increase their performance, even if just by emulating the “growth” companies in their sector.

He also pushes this idea into the large-cap (big companies) versus small-cap (small companies) world, and provides convincing stats that although small-caps companies are far more volatile, the average return rewards investors for this volatility. Equally he shows how investors are rewarded for investing in riskier emerging as opposed to established markets.

He wryly points out that anyone who promises you large returns with total safety is very likely trying to scam you (which has certainly been my experience).

He lays out the grand goal of asset allocation such that portfolio volatility is minimized while returns are improved by accepting volatility from the components that make up your portfolio.

Starting Ch 2 he lays out the idea that some of the ideas require thinking about and suggests that the reader move through his book at a slow pace and think through the concepts. There’s something comforting about an author who says “this is going to be confusing, don’t worry about it, just take it slow”. When I reach a concept that doesn’t seem clear, I don’t feel stupid or that I’m missing something, since I’ve been primed for it. I just slow down (or plow through the section and plan to re-read).

It’s nice that he’s gentle with us.

He lays out the idea of a discounted valuation model for an ongoing income stream (basically how to determine the PRESENT value for something that will pay you in the FUTURE). After teaching the procedure and calculation, he shows how useless it is (what the hell?!?!) then shows us how to rearrange the formula and actually use it for something worthwhile (well, that’s ok then). Basically he makes a good case that the true return of a stock or a market is the dividend yield + dividend growth rate (and anything above or below this is the “speculative return”). This is known as the Gordon Equation.

So far I’ve really been enjoying this book, it seems to be packed with some really interesting ideas, and I’m looking forward to the rest of it.

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{ 4 comments… read them below or add one }

1

Relative valuations of companies within the same sector (e.g. Walmart and Kmart) are usually pretty efficient, although not necessary so between sectors. Just look at banks versus tech companies in 1999/2000. This isn’t a 20/20 hindsight, because virtually all value investors steered clear of the unsustainable high PEs of tech stocks.

2

Thanks for the link!

Obviously I enjoyed the book quite a bit but one comment I’d like to make is that he is pretty steadfast (absolute?) on the assertion that higher risk = higher reward. I’ll agree that statement makes sense in theory over the very long run but in reality it may not always be perfectly true. He uses the example of small cap vs large cap (as u mentioned) but the data he uses stretches over quite a few decades as I recall. Even if that trend continues in the future – the time period involved is so large that it might be irrelevant for most investors.

Mike

3

Thanks for the link!

Mike

4

Just ignore the second comment – I had multiple comments going in multiple browsers and clearly it didn’t work.

Mike

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