Naive Investor Chapter 5: The Comparative Language

Before looking at various Investment Classes, let's get familiar with the basic terminology (and concepts) that allow us to conduct if not 'a thorough analysis' at the very least a better analysis than your doing now. We're all new to this.

Earnings

Investments are 'productive' they produce something. That something is called 'earnings' you may hear economists or financial analysts giving the example of widget factories. Think of an olive tree. You buy an olive tree it grows olives. The olives are the earnings. Simple as that. For something to be classed as an investment it has to produce earnings in some capacity. Crucially though, the earnings cannot be simply changes in the sale price of the asset. Better known as 'Capital Appreciation' if the investment is rational then the change in price (see next term) will reflect an underlying change in the earnings potential. Thus Bonds earn interest, paid to the investor in coupons, Cash earns interest (paid by the bank), Companies earn profits (Cash) paid to the owners as dividends, Property earns rent etc.
One can 'invest' in commodities like Gold, Oranges, Wheat, Wool etc. that don't actually earn anything but have a price determined by their utility. I actually don't know much (and have little interest in finding out) about this area but seems to me they are fundamentally speculative to hold because you are watching for changes in price based on 'supply and demand', that is to simply sit and hold the 'asset' doesn't generate any earnings coming your way.

Price

Benjamin Graham has a friend 'Mr. Market' who is characterised by his erratic mood swings, from unbounded optimism to abject pessimism. He comes and knocks on your door every day and gives you a torrent of prices for which he will buy and sell everything you own between you. The aim of investing is not to let Mr. Market infect you with his moods. He is there to be taken advantage of.
Price is simply the going rate that people are trading their ownership stake in any given investment. It is an abstract representation of the current worth of the future benefits (earnings) of an investment. The prices being offered may be at a premium or a discount. Investment being concerned with earnings, you are looking for the discount not the premium. We treat price as a function of earnings, a very simple mathematical function too. Multiplication. If earnings are zero the price is zero. From then on we just multiply earnings by 20 or so.
Price can depart from a relationship with earnings, these are called asset bubbles. Here the whole concept of price gets fuzzy, but you need functionally to know little more than 'the going rate people will sell/buy their stake for'. Keeping that in mind price always has a degree of uncertainty built into it, earnings are never Guarunteed. Your Cash in a bank may have it's interest rates lowered to 0% (as per current popular monetary policy), your property may have no tennants to pay rent, your business may operate at a loss, your olive tree may die.
As Benjamin Graham says if a company was certain to grow its revenues by 8% per year it's value would be infinite and no price too high to pay for it. Curiously and this is a good tidbit to remember speculation and speculative bubbles tend to factor more certainty that earnings will increase indefinitely IN to the price, not OUT of the price.

The Price/Earnings (P/E) Ratio

Remember above how we said in investment price is a function of earnings? Well that's the P/E ratio. Or specifically we can write it as:

P = kE + 0

Where P = Price, E = Earnings, k = Our unknown multiplier and the '0' represents our hypothetical starting value, that is when Earnings are 0, the price should be 0. Of course the P/E ratio is going to give us the value of 'k' the unknown multiplier, hence why investors are fundamentally interested in the Price Earnings ratio.

P/E = k

The higher 'k' is the lower your 'Margin of Safety' and the worse the deal is. Now before moving on I just want to clarify two interesting statements that relate to both price and earnings.

'investors judge the market price by established standards of value, while speculators base [their] standards of value upon the market price.'

If you learn nothing else, it is the importance of this statement. Basically a 'high' price doesn't necessarily mean a good investment. Using the principle of symmetry a 'low' price doesn't necessarily mean a bad investment. More crucially to distinguishing investment from speculation an increasing price doesn't necessarily mean a good investment, nor does a decreasing price mean a bad investment.
Put simply, there is no conclusions to be drawn from looking at movements in price alone. You have to look at the underlying value of the investment, largely its earning potential based on its earning history and then thorough analysis of everything that may change between history and the future. Enter the next important statement.

'There are no good and bad companies, just good and bad prices.'

On superficial examination this statement seems to tell you the investor to indeed watch the prices, not the value of the underlying company (or more generally asset), but it is good advice. It is yet another reminder that price is a function of earnings (for our purposes). A 'bad' price has a P/E ratio that is high (say 40 or more) whether the underlying company is good or bad. A 'good' price is one with a low P/E ratio (say 20 or below).
There are numerous historical examples of companies whose share have traded below their book value. That is to say if the company liquidated (stopped trading and sold off all their assets) you would get more money for your stake in the company than what you paid for the company.
A bad company at a discount price is a better investment than a good company at a premium price. I cant resist the temptation to talk here about property, a fine example is that a sound land monopoly at a 'historically high price' is still a terrible investment, because the property price has already above and beyond incorporated any future earning potential (rent with rent increases).
In summary, if you determine that a company upon thorough analysis is a good one with reasonable long term prospects of earning power and it has a P/E ratio of 600, don't buy it, because the price has already wiped out any gains you can hope to make in earnings over the next decade. Conversely if you find a company that looks like it is going to have to lock its workers out tomorrow and sell off the plant to repay its debt, and it's P/E ratio is 0.5, buy it, because after its debts are paid off you will pocket the change from the sale of its equipment.
Always, Always, ALWAYS treat Price as a Function of Earnings.

Risk

Risk is one of those central concepts of investment and indeed seems to be one of the central concepts of our times whether it is how we pick investments right through to how we raise our children.
Thus while prices and earnings are all well and good we don't invest in something that is heading backwards in time (if that was the case ENRON would be a great investment right now), and thus we must come to terms with an uncertain future.
Risk is the variation either positive or negative from our expected results. Keep in mind that you can make good mistakes and bad mistakes, with your prediction.
All sorts of things can happen, your company may owe its success to one central visionary CEO and her vigorous enforcement of her personal disciplines on the entire company. She slips on a spilt frapacino and falls in front of her morning train becoming CEO jam. Your farm is hit by a tornado carrying your livestock out into the Pacific ocean and your daughter to the magical land of OZ. Many of you would be surprised to learn that a bushfire burning down your house and killing your loved ones will INCREASE the value of the property (given the lowering of its council rates based on Capital Improvements which are no longer existent).
This is risk.
DON'T take it lightly.
That said, if it wasn't for risk there would be no profit to be made, ever. Often called EMT (Efficient Market Theory) it says that no price can be taken advantage of because thousands (probably now millions) of investors like you have been pouring over the exact same data and information as soon as it is disseminated, therefore it is unlikely that you will have a 1 in a million insight that no other professionals did. Which is true if evaluating risk is as simple as plugging numbers into a statistical regression model. But these things are not so great at evaluating managerial talent, public sentiment or even spotting accounting tricks. (ENRON again being a fine example of the latter, Warren Buffett being a fine counter example of the first).

I would point to a cliche that is a cliche because it is empirically true 'taking no risk is the greatest risk of all' putting all your money in cash under the mattress will protect you against any investment losses AS WELL AS any investment profits. Inflation or burglers will no doubt take care of the rest. Just as if you never cross a street you will be simultaneously protected from being hit by a bus and eating in order to survive (discounting home delivery) thus ensuring your untimely demise rather than protecting against it.

My one and only advice as to risk is to always ALWAYS remember that it is always, ALWAYS your call to take it. To illustrate what I mean unambiguously about this look at a regulated, standardised rating of risk: Standard & Poor's securities rating. In this AAA means the highest rating for a security (S&P have determined it has a very low risk of failing/defaulting). Then take two AAA rated (as per 2006) investment options (called 'securities') A US Federal Reserve Bond rated at AAA paying 5% interest and A Collatoralised Debt Obligation (CDO) rated at AAA paying 14% interest.
We have two different interest rates (earnings) rated as the same risk, by a professional risk rating institution. Obviously they are both 'low' risk (by the rating). So do you take the chopped up bits of undocumented homeloan repayments or the lower paying Sovereign Debt from the bank that sets monetary policy, and determines money supply?
Apparantly there is a class action lawsuit against Standard & Poor's for incorrectly assessing the risk of CDO's at AAA (which triggered the financial crisis) I don't know who will win the case, maybe the plaintiffs will have damages awarded. Better yet to not be in the pickle in the first place. So don't just take some expert rating of AAA or 'low' or 'high' risk as having made the decision for you. It is your call.
Stick with the other cliche 'if its too good to be true, it usually is [not true]'. Another useful rule of thumb is 'if it promises more profits it has to be higher risk'. (In the above example you would have thrown out the AAA rating because of the difference in interest payments).

Liquidity

Liquidity is the ease with which you can transfer your investment (generally) into cash. First and foremost is there a market place where you can sell the asset? With a physical asset like Property there's the property market. With a financial asset like a Bond, Option, Share etc. is there a market where you can trade them?
Then it becomes a question of effort - its relatively easy to turn a share into cash compared to a property. You can buy and sell millions of shares in a day with very little effort, it may take you a month (or 6) to sell a property.
Cash is generally deemed the most liquid. Since its already in the bank, you just have to withdraw it. Proceeds from the sale of any other type of asset will be paid in cash, to your bank, overnight at the fastest and then you have to withdraw it the next day.
Liquidity effects risk, because it reduces (or increases) your options depending on how tied up your money is. There are bonds that 'mature' (pay back your principal) in 150 years and so on, which is to say technically your money will be tied up for that time as well (even though it is longer than even record human lifespans) however you can buy and sell bonds on the market and sometimes a company may offer to buy back the bond.
You can also have things like a company suddenly becoming a dud, a well known dud and you own shares in it. Even if you are willing to sell out for 5c in the dollar, it may be the case that the prospects are so bleak and so well known that nobody will buy it off you even at 5c in the dollar. Your money may be tied up into oblivion.
Liquidity is important and can often be overlooked. Divisibility is another issue that effects Liquidity. Ownership in a company may be divided up 100,000 that means they have issued 100,000 ordinary shares. If the company is worth $1,000,000 then each ownership stake is worth $10. $10 is much easier to trade than $1,000,000 given that there's a lot more people who can afford it. Keep in mind that it is much easier to divide and sell an ownership claim in a company than it is with a property, you generally sell all or nothing. You can easily sell half your shares and keep half.

Frequency of Payments

Your bank may pay you your interest every quarter. Your tennants may pay rent every month. Your bond may pay you a coupon every year. Your company may pay dividends every quarter, year or never.
You have to consider the regularity with which your earnings will flow back to you. The cashflows in other words. If you are dependant on those earnings as your primary source of income it becomes very important.
Also remember (particularly with shares) that the owner OWNS the earnings, you can demand a company pay dividends, it is up to the management to satisfy you that they can produce better outcomes by retaining earnings than you could yourself.
Likewise, a bond's cashflows are likely to be fixed and regular, a properties regular so long as you have occupancy, dividends you may go by historical payments as indicative but companies are not obliged to pay them (unless the shareholders collectively demand it) or they simply may have no earnings to pay.

Opportunity Cost

Often silent, opportunity costs are a big nasty one. While it is to say they are silent when making the initial investment they can scream at you in retrospect. When buying don't analyze the investment in isolation. You have to consider it against every other (or more practically, a selection of) investment choices.
A decision to buy Pepsi is a decision not to buy Coke. A decision to buy Property is a decision not to buy Shares (with that money). We tend when purchasing to make one sided decisions, aka we buy property and forget we are thus deciding not to buy everything else. This everything else is the opportunity cost of the purchase.
It is called the 'Opportunity Cost' because up until you make the purchase you have the opportunity to buy anything for the same amount. Once you make the purchase those opportunities dissappear, they were cost you by your decision.
Unfortunately the opportunity cost is noticed at the point that it should be ignored. Namely, after a year you learn that the managed fund you also considered outperformed the one you chose. More frequently, the managed fund you didn't even consider outperformed the one you chose (because it was the top performer last year).
You need to weigh in the opportunity cost to any investment decision if for no other reason than to consciously decide and take responsibilty (in much the same way that risk should ALWAYS be your call).
That way it helps protect yourself against your greedy narcissistic me-too naive emotions. So when something outperforms your investment (which it almost always certainly will) you can say 'Good for them, but I know why I made my decisions (and I considered them at the time.)'
If nothing else it will stop you from endlessly chasing bandwagons and racking up considerable transaction costs and tax obligations in the mean time. If done properly it will give you the courage of your convictions to take informed risks. 'I am foregoing the somewhat hollow promises of 14% to take the more conservative and reliable promise of 8%' and so fourth, it may end up that that decision costs you 6% but you informed yourself of the risks and decided that 8% was enough for you not to risk it.

Conclusion

Obviously a lot more can be said, and a lot more needs to be done before you call it a 'thorough analysis' to meet Benjamin Graham's investor criterion, but these are things to look at as a start. I'll now start analysing the different investment classes under these headings (except for maybe opportunity costs).