1.

Investing

Investors intend to be long-term owners of the companies in which they purchase shares. Having
selected a company with desirable products or services, efficient production and delivery
systems, and an astute management team, they expect to profit as the company grows revenues
and profits in the future. In other words, their goal is to buy the greatest future earnings stream
for the lowest possible price.

On May 26, 2010, speaking before the Financial Crisis Inquiry Commission, Warren Buffett
explained his motive in buying a security: “You look to the asset itself to determine your decision
to lay out some money now to get some more money back later on…and you don’t really care
whether there’s a quote under it [at] all.” When Buffett invests, he doesn’t care whether they
close the market for a couple of years since an investor looks to a company for what it will
produce, not what someone else may be willing to pay for the stock.

Investors use a valuation technique known as “fundamental or value analysis.” Benjamin

Graham is credited with the development of fundamental analysis, the techniques of which have
remained relatively unchanged for almost a century. Graham was primarily concerned with the
metrics of companies.

According to Professor Aswath Damodaran at the Stern School of Business at New York
University, Graham developed a series of filters or screens to help him identify under-valued
securities:

1. PE of the stock less than the inverse of the yield on Aaa Corporate Bonds
2. PE of the stock less than 40% of its average PE over the last five years

3. Dividend yield greater than two-thirds of the Aaa Corporate Bond Yield

4. Price less than two-thirds of book value

5. Price less than two-thirds of net current assets

6. Debt-equity ratio (book value) has to be less than one

7. Current assets greater than twice current liabilities

8. Debt less than twice net current assets

9. Historical growth in EPS (over last 10 years) greater than 7%

10. No more than two years of negative earnings over the previous decade

Warren Buffett, a disciple and employee of Graham’s firm between 1954 and 1956, refined
Graham’s methods. In a 1982 letter to shareholders of Berkshire Hathaway, he cautioned
managers and investors alike to understand “accounting numbers are the beginning, not the end,
of business valuation.”
Buffett looks for companies with a strong competitive advantage so the company can make
profits year after year, regardless of the political or economic environment. His perspective when
he decides to invest is always long-term. As he explained in another shareholder letter, “Our
favorite holding period is forever.”

Morningstar considered Philip Fisher as “one of the great investors of all time” – as such it is not
surprising that he concurred with Buffett and Graham, preferring a long holding period. In a
September 1996 American Association of Individual Investors (AAII) Journal article, Fisher is
credited with the recommendation that “investors use a three-year rule for judging results if a
stock is under-performing the market but nothing else has happened to change the investor’s
original view.” After three years if it is still under-performing, he recommends that investors sell
the stock.

Investors seek to reduce their risks by identifying and purchasing only those companies whose
stock price is lower than its “intrinsic” value, a theoretical value determined through fundamental
analysis and comparison with competitors and the market as a whole. Investors also reduce risk
by diversifying their holdings into different companies, industries, and geographical markets.

Once taking a position, investors are content to hold performing stocks for years. Fisher held
Motorola (MOT) from his purchase in 1955 until his death in 2004; Buffett purchased shares of
Coca-Cola (KO) in 1987 and has publicly said that he will never sell a share.

Some market participants might consider an investing philosophy based on conservative stocks
with long holding periods to be out-of-date and boring. They would do well to remember the
words of Paul Samuelson, Nobel winner in Economic Sciences, who advised, “Investing should
be more like watching paint dry or grass grow. If you want excitement, take $800 and go to Las
Vegas.”