“Classifications of Securities”
- “Safety depends upon and is measured entirely by the ability of the debtor corporation to meet its obligations.” (pg 113).
- Safety is not dependant on the title of a security, or the obligations themselves, but rather on the ability of the entity to meet those obligations.
- Expanding on the idea above, bonds in a brand new business are just as risky as the common stock of that same business. Again, it is not the investment vehicle that determines risk and safety. (pg 113).
- Graham goes on to define bonds, common-stock, and preferred-stock. (pg 114).
- He then suggests a reclassification of securities in the following way. (pg 116):
- 1. Fixed Value Securities (high-grade stock, preferred stock)
- 2. Senior Securities of Variable-Value Type
- A. Well Protected Issues with Profit Possibilities (convertible bonds)
- B. Inadequately Protected Issues (lower grade bonds/preferred stock)
- 3. Common-Stock Type (Common Stock)
- The purpose of this reclassification is to enhance the idea that a securities owner should not pay for what he is “legally entitled to demand”, but rather “what he is likely to get”. (pg 119).
Chapter Analysis and Thoughts
- The singular driving theme of this entire chapter is the idea that there is a difference between legal title and expected outcomes in reality. The intelligent investor should not rely on the names or entitlements of securities, but the predicted outcome.
- This is the final chapter in the “Survey and Approach” section of Security Analysis. And its theme serves well to the overall value-investing approach. An intelligent investor can not be lazy in refusing to do proper due diligence on the terms, title, and expected outcome of a security.
“Distinctions Between Investment and Speculation”
- The definition of investment is: “Upon thorough analysis, [an investment] promises safety of principal an a satisfactory return. Operations not meeting these requirements are speculative.” (pg 106).
It is also: “justified on both qualitative and quantitative grounds.” (pg 107).
- “Thorough analysis” refers to the study of facts towards safety and value;
- “Safety” refers to protection against loss under normal/reasonable circumstances;
- “Satisfactory return” refers to appreciation of principal.
- Graham rejects more classical definitions of “investment”, such as “putting money in a business”, or anything involved in the field of finance, so as to allow a differentiation between speculation and investment. (pg 100).
- Graham rejects the many classical differences between investment and speculation, such as safety vs. risk, short-term vs. long-term, income vs. profit, and outright purchases vs. purchases on the margin. (pg 102-105).
- A fascinating theoretical case is given where an investment can be made in the short-term on margin, netting a guaranteed profit of $100 per 3 months. This flies in the face of traditional thinking on investing vs. speculating. (pg 108).
- Graham points on that while speculation is largely based on the whims of future events, investment is subject to the same treatment of future uncertainties. However, intelligent investing involves guarding against the future, as opposed to profiting from it. (pg 109).
- Intelligent vs. unintelligent speculation involves taking a risk that is justified by logical pros and cons, as compared to a risky, uninformed decision that is not justified. (pg 110).
Chapter Analysis and Thoughts
- The difference between intelligent speculation and investment seems negligible. Everything involves some degree of risk; why is it that one decision that is backed with the support of logic is considered speculation, likely because it is far more risky, while a different, less risky decision that is also backed by logic is to be considered investment?
- There seems to be a certain degree of arbitrariness to Graham’s philosophy. There are certainly grey areas. For example, what qualifies a decision as being informed, or backed by logic? At what level of risk does investment turn to speculation? What amount of protection is sufficient for an investment to be considered “safe”?
- But perhaps it is important to keep in mind that value-investing philosophy doesn’t need to be precise and definitive in itself. We can readily operate and select investments from within the spheres of his definitions, even if there are no strict borders to those spheres. One will likely know intuitively when he is investing, and when he is gambling; there is no need to press Graham for more specificity.
- Graham’s idea of “guarding against the future”, as opposed to looking to capitalize on it, is very interesting. It is difficult for me to reconcile this protective outlook with the fact that intrinsic value must necessarily be related to future cash flows. It illuminates his more cautious nature, and I’m not entirely certain if that caution is a part of the value-investing canon, or if it is his personal preference.
“Sources of Information”
- Annual reports are the greatest source of information an investor can access due to the Income Statement, Balance Sheet, and MD&A.
- The Income Statement is not complete without…
- Sales, net earnings, depreciation, interest charges, non-operating income, income taxes, dividends paid, and surplus adjustments.
- The Balance Sheet is generally thought to be complete, in the sense that companies don’t pick and choose what they present.
- This doesn’t imply by any means the the Balance Sheet is impervious, as shifting of values via accounting policies is a frequent way to alter the view of financial data, for better or for worse. (pg 96).
- Alternative sources of information are available if you look. Graham cites rating agencies, other official reports, and direct requests for information from the companies.
Chapter Analysis and Thoughts
- Sadly, much of this chapter is largely irrelevant today simply due to the discrepancy between the date of authorship and modern times. The advent of the internet has allowed for extreme ease of access to information. If Graham was rejecting value-investing techniques as a method of earning extra returns by the 1970’s, he would be rolling in his grave if he knew how the internet has theoretically made markets that much more efficient… But have they truly done so?
- The last source, “direct requests for information”, is of important note. I am not aware of the willingness of companies to offer detailed information to investors who request it, however, there certainly is no harm in trying. And additionally, those that offer the information at request must be given some level of credit for their honesty as compared to those who reject the same requests.
- As mentioned before, the internet offers a massive wealth of information. One can find investing takes on any kind of company. Thus it seems, these days, a key aspect of securities analysis is selecting and screening information to decide what is relevant, and what is truthful.
“Fundamental Elements in the Problem of Analysis. Quantitative and Qualitative Factors”
- The four fundamental elements:
- 1. The security
- 2. Price
- 3. Time
- 4. The person
- “Should security S be bought (or sold, or retained) at price P, at this time T, by individual I?” (pg 75).
- The person…
- Has tax-consideration elements; but namely the risk-tolerance, temperament, and time-preference are the keys.
- The time…
- Relative yields at different points in time make certain securities more attractive than others.
- The price…
- Price has relatively differing importance across different security types. For example, fixed income might be more concerned with the safety of the issue rather than the price.
- In common stocks, paying the wrong price is perhaps worse than buying the wrong issue.
- Price is half of the fundamental value-investing formula of price and value. While it may not always reflect the reality of value, it is a reality of its own and must not be ignored.
- The security…
- What terms, in what business/industry, in what investment vehicle are we making the purchase?
- An attractive enterprise on unattractive terms is not better than an unattractive enterprise on attractive terms. (pg 79).
- KEY QUOTE: “Nearly every issue might conceivably be cheap in one price range and dear in another.” (pg 80).
- The lynchpin of value investing is the relation of price to value, and this quote summarizes that concisely. Graham cites stocks that were of unquestionable status in their industry, only to collapse to a price below their net asset value a few years later.
- Security analysis is necessarily limited in its detail. Judgement is required to determine how much research is needed, and it should be correlated to potential return. It takes a significant amount of work to find an unquestioned bargain in common stocks. (pg 81).
- Information and data is relative to the type of enterprise that is under study; impressive earnings in one industry might simply not be so comparatively to another. (pg 82).
- There exists quantitative, and qualitative elements to analysis:
- Qualitatively of importance are the “character of management” and also the nature of the business. The nature of the business, be it favourable or not so, is subject to rapid and frequent change. Abnormal levels of profit, either for better or worse, will likely be levelled out eventually. This is a supply and demand question. In terms of management, it is acceptable to pay a premium on management, but not to pay “twice”, in paying for good management, as well as their produced impressive earnings. (pg 84).
- “Trend” is also a qualitative factor largely (to be discussed further later). It is exceptionally difficult to quantify trend; we must base intelligent investment on facts, not expectations of facts.
- One final qualitative factor is the concept of stability. Stability is something to value, but varies from industry to industry, and is also difficult to quantify. Graham cites as an example the automobile industry: in itself is relatively stable, however individual companies are not so, as demand is capable of shifting quickly to another company/model. The grocery chain industry, on the other hand, is stable through and through.
- Quantitative factors are analyzed in much later chapters.
Chapter Analysis and Thoughts
- Not only does data vary with the “type of enterprise”, the relative value of data or information varies from security to security. The safety of principal in a fixed income investment may not require remarkable earning power if the debt is easily covered by assets, and vice versa for common stock investment. Appropriate weightings to information must be made in accordance with both the security and the industry itself; and perhaps, even on a company to company micro level.
- What premium are we/should we be paying for stability in an industry? And why should we necessarily be paying this premium? On the other hand, industries particularly renowned for their stability are perhaps to be avoided for the very characteristic that Graham prizes. This is for two reasons:
- Firstly, stability is naturally an attractive aspect to risk averse investors. Thus, the herd mentality involved with defining an industry or company as stable will naturally bring about a certain percentage premium that would have to be paid in order to compensate for the causation in higher demand from stability. And as Graham would likely put forth himself, industries that are neglected for any reason ought to be paid extra attention to in seeking quality value, unstable industries included.
- This is another excellent example of why I believe higher margins can be made in inherently unstable industries like resource juniors. While they are clearly still dictated by the laws of supply and demand, making excess returns by virtue of industry instability perhaps fairly small, profit is made on the margin. Any excess rents generated, especially in light of the long run, can make the difference between a profitable investment and an unprofitable one. This idea may have to be expanded upon in its own article.
- Graham’s appreciation of the human element in investing is extremely insightful. Often investing ideas exist in the realm of pure theory, with no human variables considered. However, human variables are too impactful to be ignored. What is one’s risk tolerance? One’s time preference? Stomaching a devastating loss in an investment is difficult emotionally, and becomes even more stressful when consideration of joint or family finances is given.
- Lastly, the primary human aspect in investing must be humility. Are you willing to constantly challenge yourself, and your thesis? Because any applicable ideas developed in the realm of theory are necessarily affected by your ability to adapt your thesis in the face of new circumstances. So in this sense, the human element drives the theoretical, and not vice-versa as conventionally thought.
- The idea of paying a premium for management “twice” according to Graham is fascinating. And it is indeed logical; growing earnings of a company bring about price premiums, while accreditation of the management team for those earnings bring about the second premium.
- What is of far more interest to me is not the paying of management premiums twofold, but not paying a premium for management at all. If a roaring earnings report brings about double charging for management, the opposite logically must be that for a depressed industry or company with poor earnings, high quality management teams are available at no extra cost. This is exceptionally tantalizing for the junior resource industry at the moment.
- An important caveat to this point is to consider whether the market truly is attributing the success or failure of earnings to management, so as to not make a mistake in adjusting value calculations based on poor assumptions.
“The Scope and Limitations of Security Analysis. The Concept of Intrinsic Value”
- Analysis is the study of available facts with the attempts to draw conclusions based on sound logic. That logic is applied via the scientific method, though in a relatively inexact way. (pg 61).
- There exists three functions of security analysis: descriptive, selective, and critical.
- 1. Descriptive: Collection, organization, and presentation of relevant facts. (pg 62).
- 2. Selective: Value judgements are made based on description. The judgements include deciding to buy, sell, retain, or exchange. (pg 62).
- 3. Critical: The application of standards to descriptive facts, used in determining the “soundness and practicability” of the securities at hand. One must be a critic of accounting policies, management decisions, etc. (pg 74).
- The difference between the intrinsic value and the price of a security is the primary concern of an analyst. This is the primary axiom of the whole value thesis. The collection, selection, and analytical interpretation of facts are made in this light. (pg 64).
- Note that intrinsic value is not akin to book value. It is an imprecise measure of what a price will tend towards in the long run given all available facts. This sounds inexact as a concept, and it is. Graham seems more eager to describe what intrinsic value is not, rather than what it is.
- Intrinsic value essentially cannot be calculated exactly, but rather as a range to which a security is valued fairy, below, or above its relative price.
- Obstacles to success include accuracy of facts, uncertainty of future, and irrational behaviour of the market. (pg 68).
- “Tardy Adjustment of Price Value” is a real danger in that returns can be wasted in years that they can’t compound due to a refusal of price to adjust. (pg 70).
- KEY QUOTE: “The market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities. Rather should we say that the market is a voting machine, whereon countless individuals register choices which are the product party of reason and party of emotion.” (pg. 70).
- Analysis is of more use in situations for investment as compared to speculation. Graham compares this to a gambler who is able to reverse his odds, and win slightly against the house. If he bets it all on one number in roulette, his analysis is of little use despite offering a slight edge, as luck plays the primary role in determining the outcome. (pg 73).
Chapter Analysis and Thoughts
- Graham’s description and analysis of his gambler analogy is partially correct, but largely not so. He is correct insofar as the gambler endangers his outcome – in reality – to a large increase in variance by placing his bet on one number. However, theoretically there is no real change in the expected value of the bet. The gambler’s edge via analysis still provides him profit in the long run. Thus, Graham is wrong that this implies analysis is moot in situations of luck, but rather is proving the need for diversification to reduce variance. If we apply this idea to the junior resource sector, where variance is extreme, we find those who apply value concepts earning above average returns on investment.
- The key quote essentially epitomizes the efficient markets argument as compared to Graham’s value perspective. However, here he is simply stating his view, not justifying, and indeed it is an idea that must be explored further. It is particularly interesting that Graham himself discarded his own investing philosophy as irrelevant in the face of modern finance. This debate must be explored further, and is likely worthy of its own blog post of research.
- The application of the economic concept of “utility” in finance and security analysis might be an interesting development to the field, and the argument listed above. The voting machine’s use of non-“rational” information to price can, and almost by necessity does, lead to discrepancies between price and value. For example, investing (or speculating, in the Graham sense) in a company such as Apple because you are a large fan of their products most definitely affects the process of markets in reaching price equilibrium. But where does this utility-based decision fit in to the theoretically efficient markets that are supposedly strictly efficient due to risk-reward? There is no regard for risk-reward, only price and utility. And perhaps it is at least partly in this way that value investors have been able to squeeze out profits above the normal market rate of return.
- It is troubling that Graham cannot formulate a more precise definition of intrinsic value, as the concept is so central to his philosophy. Even in the summary provided above, it is primarily my own wording of his elusive discussion on the topic. Hopefully as I advance further in the book, it will become more clear as to exactly what the concept is.
In the following weeks and months, I will be writing a series of chapter summaries with accompanied analysis on Graham and Dodd’s “Security Analysis”. The overall goals of the series are as follows:
- Improve both my security analysis and writing abilities.
- Provide a tangible product for an audience to interpret, critique, and benefit from.
- Stimulate original thinking in analysis areas.
- Signal to employers that my extra-curricular readings provide real knowledge, which translate into these blog posts.
In addition to these goals, I feel the need to stress why exactly I am choosing to allocate my time towards the practice of security analysis. It must be stressed that we live in fascinating financial times. This uniqueness of the modern financial picture, and the existential crisis it is currently battling internally, plays a large role in my desire to uncover the mechanisms that underlie it. Let that desire burn forth.