The intelligent investor

Listened to "The Intelligent Investor" last night again to calm me down. Benjamin Graham divided investors into the 'defensive investor' and the 'enterprising investor'. The defensive investor seeks to achieve normal stock return without too much effort. The enterprising investor seeks to achieve abnormal profit by seeking out intelligent opportunities and exploit them.

Graham suggested that by holding a diversified list of stocks of the largest company should be the method employed by the defensive investor. Today, this could be achieved by purchasing a low cost index fund or ETF.

The enterprising investor would however need to put in a lot more effort to achieve above average results. Empirically, most funds fail to outperform their benchmark. Given the huge resources asset managers have at hand, it could come to a surprise to many that why they can't do better than their benchmark. A benchmark is afterall simply an index of stocks chosen by a committee which exhibits certain basic characteristic (size, industry representation, profitability,etc). However, human nature would probably preclude exceptional performance. Its uncomfortable being alone. To outperform the average, by definition, would mean one has to be alone in certain decisions at times. Thus there are many closeted index hugger who simply over/under weigh certain stocks and HOPE to achieve alpha while charging obscene fees.

The author also suggests the experience told him that one is unlikely to be BOTH a defensive investor and a enterprising investor. A enterprising investor's behaves like a businessman tending over his share of businesses which he owns a minority stake. A successful enterprising investor is a successful businessman. How many successful businessman have you heard saying that 'if i put in less effort, i'll still be successful, just less so than i'm currently is.' If success in investing and in business is dichotomous, then one can't be both a successful defensive investor and successful enterprising investor.

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I was reviewing Accounting Theory today and i'm really glad that SMU offers this course and Prof JJ teaches it.
In one session, he asked us (i) what is capital, (ii) what is income, (iii) Is income capital?

If we loosely define capital as what owners contribute to the firm, and income is simply revenue less expenses as we learn in all Financial accounting 101/3 course, then how do we reconcile (iii) Is income capital. We all know that income for a period is equivalent to ending capital less beginning capital adjusted for any capital contribution. Thus if we can't measure beginning and ending capital, how can we then 'measure' income?

We 'closes' income and all items on the profit and loss statement to the "retained earnings" on the balance sheet. If Income is a measure of 'flow/unit time', and balance sheet is a point in 'time', does it make sense to add income to balance sheet? Imagine you ask someone how much distance did he travel, and he adds speed (flow/unit time) to time!!! Accountants have implicitly multiplied the net profit by ONE unit time to allow it to be added to the balance sheet.

Is depreciation expense a asset? if i tell prof gan that, i think he'll faint :) but prof jj gave us the example that we can allocate depreciation expense to WIP, and WIP stays as an asset on you balance sheet until you sell it. So this 'expense' can be an 'asset'. Haha.

And if there's anyone who truly think that accounting is unbiased and judgement free, they would have to take this course. The very fact the many powerful corporations spent millions lobbying for certain accounting treatments tells us that there is real economic consequences when firms adopt different accounting treatments. The lobbying against the expensing of stock options during the mid 90s till early part of this decade is a telling story. Warren Buffett was the lone (and unheard...or heard but unheeded) voice (from major corporations) that believe that options should be expensed. But powerful VCs, pension plans and dotcom startups lobbied against it. It took the bursting of the dotcom bubble and the enron, worldcom debacle to wake SEC up to push for changes.

Accounting is a not a judgement free. Even if the accountants prepare it with the highest integrity, we still gotta read financial statements with a kidney failure inducing pinch of salt. Without thinking through all these issues, how can one be an Intelligent Investor?