I recently finished reading Good Stocks Cheap by Kenneth Jeffrey Marshall. Kenneth Jeffrey Marshall is a very smart guy who has an MBA from Harvard Business School and teaches value investing at Stanford University and the Stockholm School of Economics. He also teaches asset management at the University of California, Berkeley.
In short, I thought this was one of the best modern books on investing that I’ve ever read.
The book doesn’t really set forth any new concepts or ways to think about investing (although some of the specific formulas that Marshall uses were new to me). But rather, the book draws from all the various value investing material out there – from Security Analysis to The Intelligent Investor to Common Stocks and Uncommon Profits to Warren Buffett’s Shareholder Letters. Marshall very effectively draws together all of these various concepts that have been hanging out there and summarizes them in his “Value Investing Model”.
Marshall stood on the shoulders of giants to write Good Stocks Cheap. The end product is a book that should be one of the first books for new value investors. The book is also a great read for experienced value investors, who will likely gain a clearer understanding of investing just from the way that Marshall has organized all of these various value investing concepts.
Read on for my own personal notes and takeaways from Good Stocks Cheap.
Marshall defines speculating as “the purchase of something now in the hope that it can be sold at a higher price later.” He defines value investing as “acting on the observation of a clear difference between price and worth.”
Marshall has written this book for people who manage their own money and he presents investing as a trade, like plumbing or barbering, that’s only useful when it works. To that end, Marshall discusses investing in a very simple, straightforward manner – without oversimplifying any concepts. He also provides helpful real-world “case studies” throughout the book, bringing the concepts he is talking about to life.
The Value Investing Model
The book is centered around Marshall’s “Value Investing Model”, a framework that he use to make investments. The model does three things:
- First, it makes it likely to make investments that will produce above-market rates of returns.
- Second, it makes it unlikely to make investments that will produce below-market rates of returns.
- Lastly, it makes it possible that you might miss out on some investments that would have produced above-market rates of return.
The model begins with three questions that you must ask of any investment, in order:
- Do I understand it?
- Is it good?
- Is it inexpensive?
Then the model makes sure that you don’t do anything BUT ask and answer those three questions by making sure you’re aware of the cognitive biases that could thwart the process.
Overall, the model draws from three disparate disciplines: Finance, Strategy, and Psychology.
Part I: Foundations
- Why don’t we hear more about value investing?
- Why stocks?
- What is the difference between price and value?
- How to measure your own investment performance?
Part II: The Value Investing Model
- Understanding the Business
Define the business along 6 parameters:
- What are the products or services?
- Who are the customers?
- What is the industry?
- What is the form/structure/business model?
- What is the geography of operations?
- What is the company’s status (market leader, declining, etc.)?
Don’t be misled by product familiarity, marketing messages, mission statements, company aspirations.
- Introduction to Accounting
- Capital Employed, Operating Income, Free Cash Flow, Book Values and Shares
- Past Performance
In this chapter, Marshall introduces 7 ratios he uses to analyze companies.
- Future Performance
This was my favorite chapter. If a business has been good in the past, then the next step is to see if it’s likely to remain so. We can’t use accounting ratios in this case – instead we have to turn to strategic analysis.
Marshall discusses four qualitative tools that you should use to assess a firm’s prospects.
The first is “breadth analysis”: Are the company’s customers concentrated (i.e. only a few large customers) and are the company’s suppliers concentrated (or do they have the power to become more consolidated). The business isn’t good unless the answer to BOTH questions is “no”.
The second tool is “forces analysis” or Porter’s 5 forces:
- Bargaining power of customers
- Bargaining power of suppliers
- Threat of substitutes
- Threat of new entrants
The third tool is “moat identification” A moat is a barrier that protects a business from competition. If a company has a moat (moats are rare), then that moat has a source. There are six potential sources (a company only needs to have one source of a moat):
- Switching costs
- Ingrainedness (into the supply chain or channel)
The fourth tool is “market growth assessment”. This is pretty much straightforward: Is the company’s market growing or not?
Marshall defines four price metrics that should be used to determine whether a stock is inexpensive or not, which basically compare price to FCF, operating income, book value, and tangible net asset value.
If a company is understandable and good – but it’s not inexpensive, then you must wait for it to become inexpensive. The waiting is made easier once you realize the difference between action and progress and the option value of cash (if you carry enough cash in your portfolio, you have the option to take advantage of opportunities when they come your way.
- Risk is Driven by the Price You Pay
Here Marshall introduced the concept of margin of safety.
- Behavioral Finance Concepts
In this chapter, Marshall defines 20 different cognitive biases that could cause investor misjudgment or misaction (e.g. anchoring, confirmation bias, impetuosity, etc.).
Part III: Maintaining Your Portfolio
Finally, Marshall concludes the book with several chapters on portfolio construction (he prefers a concentrated portfolio of good stocks over a diversified portfolio of mediocre ones), when to sell, how to generate ideas, how to match your investments to your values, and reminds you of Warren Buffetts two rules: Rule #1: Never lose money; Rule #2: Never forget Rule #1.
- Portfolio Construction and Selling
- Generating Ideas
- Morality in Investing
- Capital Preservation
As I mentioned in the introduction to this article, this was one of the best books on value investing that I’ve read. Whether your a new investor or an experienced value investor, you should definitely give this book a read. It will certainly help you learn everything you need to know about value investing and will help you make a lifetime of smart investment choices.
I want to leave you with some parting thoughts from Marshall on value investing and investing in general, which I thought were very powerful.
According to Marshall, value investing is more about money. He’s seen that value investing has other benefits as well.
- For one, it keeps him engaged with the world. Suddenly, shopping, the news, traffic, all the little things of life become relevant to making investing decisions and have deeper meaning.
- Second, value investing is truth seeking. It takes inherently hazy situations and chases the facts. Marshall seas a realness in that.
- Third, it rewards a long-term perspective. It compels investors to consider how enterprises – and therefor how civilization itself – will develop over time.
Finally, Marshall says (I added the bold for emphasis):
“Money just doesn’t produce life’s great joys. Those come from loved ones, from health, and from other sources that don’t care much about geometric means, depreciation schedules, or enterprise values.
But an absence of money can keep one from the great joys. And therein lies value investing’s promise. It gives one the freedom to fully embrace what really matters…
That, I think, is what rich is.”
If you haven’t done so already, head on over to Amazon and check out a copy of Kenneth Jeffrey Marshall’s great new book Good Stocks Cheap. You won’t be disappointed!
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