In this mini-series, I will summarize Benjamin Graham and David Dodd's masterpiece - Security Analysis. The book was first published in 1934, but it is still considered the Bible of value investing. Warren Buffett himself has said that the book is a roadmap to investing that I have now been following for 57 years. As most people know, Benjamin Graham was the teacher and Warren Buffett was his investing padawan. And I imagine that they practice the force of value investing daily during those years together.
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This summary will be a little bit different than traditionally. The book consists of 900 pages and, considering the merits of Graham, compressing that into just five takeaways seemed like ... a waste, to be honest. So you'll get no less than 20 takeaways instead, in four posts. The outline will be as follows: In this, which is the first post, I will give a brief introduction to Security Analysis. In the second post, I will present a very useful tool for the investor in any security - that of being able to decipher an income statement and a balance sheet. In the third, I will talk about stocks - how to identify true bargains in the market. Finally, in the fourth blog, I will talk about other types of securities, such as bonds, preferred stocks and senior securities with participation rights. These first two posts will give you the tools you need in order to utilize the takeaways from post three and four about specific securities in an optimal way. Without further ado, let's get to it!
Takeaway Number 01: Investment vs Speculation
What's the difference between an investor and a speculator? Is it that the former wears a tie and is working in some fancy office at some fancy street in cities like, New York London or Stockholm, and the latter is gambling with his mortgage at the casino? Nah, I think we need a more useful definition than that. Distinguishing between investing and speculation lies at the very heart of security analysis, because it's absolutely essential for the sake of your portfolio returns to understand which one you are engaged in. As a matter of fact, Benjamin Graham would call most of the aforementioned tie-wearing Wall Streeters speculators. It's just that they cover their gambling really well with "Speculation in Stocks of Strong Companies".
Here's what Benjamin Graham and David Dodd says: "An investment operation is one which, upon thorough analysis, promises safety of principle and a satisfactory return. Operations not meeting these requirements are speculative." This quote probably raises more questions than it gives answers, so let's break it down.
By "Thorough Analysis", Benjamin Graham refers to the importance of a careful study of available facts, with the attempt to draw conclusions from that with sound logic and based on established principles. For instance, buying Netflix at a price of 140 times its highest reported yearly earnings is speculation, not investment, as the valuation clearly relies on expectations about the future, rather than available facts.
"Safety" in the security markets, is never achievable under all circumstances, but the investor must protect himself under all normal, or reasonably likely conditions. Benjamin Graham is famous for coining the expression "Margin of Safety", which allows for protection by insisting that the value of a security should be bought only when it can be obtained with a margin to the price. For example, buying Apple at $210 per share, if you think that it's actually worth $220 per share, would be considered speculation. You should always factor in the possibility of being wrong in your analysis, but more on this in The Intelligent Investor.
A "Satisfactory Return" is truly subjective. Any return that the investor is willing to accept will actually do here, as long as he acts with some kind of intelligence. If it's possible to acquire US Treasury bills at a 5% annual return, but for some reason he decides to invest his money in micro-cap mining stock, at an expected 4% return, it would fail to be regarded as an investment operation, even if he has safety and a thorough analysis in place.
In summary, or perhaps in addition: an Investment Operation is one that can be justified based on both quantitative and qualitative grounds. But more on this in takeaway number three. Going back to the previously mentioned Netflix case. This does not mean that the analyst is convinced that the market valuation of Netflix is wrong, but rather that he is not convinced that its valuation is right. He would call a substantial part of the price a speculative component, in the sense that it is paid, not for demonstrated, but for expected results.
BenjamÃn Graham provides an excellent chart of how the price of a security is determined and points out which components that may be regarded as investment and which that are speculative. In the case of Netflix, a great portion of the current market cap of almost $170B is Made up of the market factors, which are 100% speculative, and the future value factors, which are part speculative and part investment. Only a small portion is made up of true investment value, which Benjamin Graham refers to as the intrinsic value factors.
Takeaway Number 02: Classification of Securities
So, we now have a brief understanding of what the difference between an investment and a speculation is. We are going to focus on the former in this series. There are many different types of securities that could qualify for investment purposes though, and we will now outline them briefly.
The Traditional Classification is Bonds, Preferred stocks, and Common stocks.
Bonds have an unqualified right to fixed interest payments, an unqualified right to the repayment of the loan (or principal amount), but no other participation rights in either assets nor profits.
A preferred stock, despite its name, is more like a bond than a stock. It has a stated dividend, but nothing must be paid if the common stock doesn't receive anything either. It has the right to its principal if the company goes bankrupt, and gets money before any common stockholder. Like the bond, it doesn't participate in any excess profits made by the company.
The common stock has the right to all assets and profits in excess of everything paid to bond and preferred stockholders. This class of security is what people typically refer to when they talk about "Stocks". Because common stocks basically aren't promised anything, many mistakenly think that stocks are always speculative, and that bonds are always investments. This is not true. A bond holder is promised that he'll be repaid, but that promise is only as good as the financial position of the company that's making it. Rather than organizing securities according with their titles, Benjamin Graham suggests that securities should be organized based on their normal behavior after purchase. Why? Because then, the categories can be treated similarly from an investment perspective.
The suggestion is: The first category is made up of securities of the fixed value type. It consists of high-grade bonds and preferred stocks and the assumption is that you more or less should be able to forget about these and collect the interest payments.
The second category is made up of senior securities of variable value. It's divided in two parts: Issues of high grade, but that at the same time have profit possibilities, such as convertible bonds, and issues of inadequate quality such as low grade bonds and preferred stocks.
The last category is common stocks. We'll examine these categories in greater detail in the third and fourth post of this series.
Takeaway Number 03: Quantitative analysis Vs Qualitative Analysis
In takeaway number one, we learned that an investment operation must be able to be justified both on quantitative and qualitative grounds. We're now going to decipher what that means in practice. An analysis should be thorough for it to be considered an investment operation. The issue is that, already in Graham's days, the supply of information of a single security was typically more than an analyst could plow through, and Graham only lived to see the very beginning of the information age. The supply of information has increased exponentially during the last decades. Needless to say, an investor can only consume so much of it. The depth of his analysis should therefore depend on his invested amount, as that is a good indicator of how much value additional analysis can add. If Warren Buffett can increase his yearly returns by 1%, that would mean about $800 million more in income that year. If the average Swede can increase his return by the same percentage, he will only increase his income by approximately $1,900. Depending on how much time he must invest to achieve that extra return, it may or may not be time well spent.
Information is of Two Types - Quantitative and Qualitative.
Quantitative data may be divided into: capitalization; earnings and dividends; assets and liabilities; and operating statistics. and Qualitative information are things such as: quality of management; customer preferences and trends; competitive landscape; and technological change.
This book is heavily tilted towards the quantitative data. After all, it's called value investing, and Benjamin Graham states that: "The former [quantitative data] are fewer in numbers, more easily obtainable and much better suited to the forming of definite and dependable conclusions." Moreover, quantitative data typically reveals a lot about the qualitative factors as well. Is the management competent? Well, have the earnings, assets and dividends of the company increased under their lead? In that case yes, very competent! With that said ... Quantitative data are useful only to the extent that they are supported by the qualitative survey of the enterprise. The intelligent investor should insist on having both a quantitative and a qualitative validation of his investments.
Takeaway Number 04: Obstacles for the Analyst
There are three primary obstacles that makes successful security analysis more difficult than it might seem at first glance. These are: Inadequate or incorrect data, Uncertainties of the future, and Irrational behavior of the markets. We will discuss the first point in much greater detail in a second post, when we dive into the two major financial statements of a company - the income statement and the balance sheet. For now, it will be sufficient to say that data in company reports, may not always present the situation in a useful manner to the investor. In general, when you suspect that you've encountered a company that pursues questionable accounting principles, avoid all securities of that company. "You cannot make a quantitative deduction to allow for an unscrupulous management. The only way to deal with such situations is to avoid them." Have a look at this list of companies. What do you think the common denominator is? If you said: "they were all fortune 500 companies back in 1955, but are no longer on the list", well done! As a matter of fact, in 2014, 88% of companies on the fortune 500 list from 1955 had been replaced, either by going out of business, being surpassed by new companies or by being acquired by other major players. These were some of the companies with the greatest profit margins, the greatest earning trends, with the best financial positions. But in investing, the future is often no respecter of statistical data.
Even if the investor concludes that there's a discrepancy between the true so-called "Intrinsic Value" of a security and its price, the market may not realize its mistake. And after holding on to that same security for years, during which the market remains irrational, the investor may have to witness how his original theses no longer holds true, whereupon he will have to sell that security off with a loss.
Takeaway Number 05: Investing is the search for exceptional cases
So .. Investing seems like it's quite tough. Is it even so that the factors mentioned in the previous takeaway nullifies any effort of the analyst? The answer is yes. In most cases, but not all. The intelligent investor will have to analyze a whole bunch of companies. In most cases, he will conclude that its securities can't be bought with the aforementioned margin of safety, and at the same time yield a satisfactory return. But eventually, he will find investments where both are obtainable. Security analysis isn't an exact science. You should only act in exceptional cases. Benjamin Graham gives a great example of this in the common stock of Wright Aeronautical, that was priced at $8 per share back in 1922 when it had, for some time, been earning $2 per share, and had more than $8 per share in cash only. It would have been difficult at this point to decide whether Wright Aeronautical was worth $20 or perhaps even $40, but luckily, that wasn't necessary to conclude that it was attractive to buy the stock at $8. "It's easy to see that a man is heavier than he should be without knowing his exact weight." Because of this, the buyer of securities shouldn't be interested inexactitude, but rather, in reasonable accuracy. After all, the analyst is dealing with data representing the past, which, as we've discussed already isn't always respected by the future.
Here's a quick summary: An investment operation is one which, upon thorough analysis, promises safety of principle and a satisfactory return. There are many different types of securities suitable for investment operations. They are, however, not bought under the same premises. Quantitative data must always be validated by qualitative observations. The incorrectness of data, uncertainties of the future, and irrationalities of markets, complicate the work of the analyst but they do NOT nullify it. One of the greatest advantages of the analyst is that he can (and should) only act in exceptional cases. In the next I will present the most important aspects of analyzing an income statement and a balance sheet. After that, I will present the ins and outs of common stock investment, and lastly, that of senior securities. Cheers!