Security Analysis Series: Chapter 27 Summary

“The Theory of Common-Stock Investment”

Chapter Summary

  • Graham begins with three premises to common-stock investment theory: first, that it is important in the “financial scheme”, second, that owners/buyers desire to understand their value, and lastly, that logic and good sense can be but a screen for “underlying speculative greed”. (pg 348).
  • The chapter approaches the question of whether there is any actual value to common stock analysis; or in other words, whether markets are efficient or not. (pg 348-349).
  • Improving financial conditions have raised the attractiveness of common stocks as a class of investment, offering higher potential returns than other vehicles. (pg 349).
  • Before WW1, a good investment-grade common stock had a continued record of dividends, stable earnings, and equity backed by assets. (pg 351-352).
    • “The function of analysis was primary to search for elements of weakness” (pg 354).
    • Speculation was associated with the future, which is uncertain, whereas investment was associated with the past, which is definitive and knowable. (pg 354).
    • The investor’s standpoint was one of “take an interest in a private business.” (pg 355).
  • Postwar, this changed dramatically. The principle changed from valuations based on the past, to “the [valuation] of a common stock depends entirely upon what it will earn in the future.” (pg 356).
    • From that principle came the following conclusions (pg 356):
      • A) Dividends have a small effect on value.
      • B) Assets largely do not determine earning power, and thus are not important.
      • C) Former earnings records were only relevant in that they indicate changes likely to take place in the future.
    • A key focus was placed on the trend of earnings; or that the past was only useful to indicate where future earnings might possibly move. Increasing profit year over year is to be given great value (pg 358).
    • Stocks were regarded as “good” or “bad” businesses, with little attention offered to the actual price that must be paid for that business. (pg 359).
  • The past can be a very poor predictor for the future, proved countless times through countless companies. Thus, trend is a generally speculative figure to adhere to, and rather the average earnings over an extended period is more dependable for the basis of making investment. (pg 363).
    • Using trend as a predictor of the future is inadvisable for a number of reasons. Namely, increased competition with higher profits; the law of diminishing returns; and the business cycle skew trend to appear to be more favourable than it is actually is in reality. (pg 364).

Chapter Analysis and Thoughts

  • The use of trend in selecting common stocks, as noted by Graham, is exceptionally speculative, and inadvisable for all of the reasons he listed above. However, another reason to to avoid the use of trend in selection is precisely because it is so popular a concept in investing. Far and few are searching for companies, or industries that are on a downward trajectory, but rather those that are rising and growing rapidly. Thus, the advantage of the trend is immediately lost to herd-mentality, which will already have priced in the expected growth of the trend. In fact, the trend may actually be over-priced from exceedingly optimistic estimates by investors. Therefore, it ought to be companies and industries in decline that the intelligent investor should be alert to. These items almost certainly won’t be over-priced, but rather the opposite, leading to potential for margins of safety when sentiment turns around.
  • Personally, I do not reject the postwar theory of valuing stocks based on future earnings. And I don’t believe Graham actually does, either. Because theoretically, a company that has zero future earnings can only be worth its liquidation value discounted to the present. What I think Graham was actually rejecting was the concepts that emerged from that principle: for example, the (virtually) ignoring of assets and dividends. The truth is that future earnings are absolutely and necessarily dictated by the past, and present, which is why Graham places such an emphasis on understanding the balance sheet, and looking to historical earnings averages.
  • Graham never really approached market efficiency as a concept in this chapter, which it seemed like he was setting up to do. To me, the question of whether markets are efficient or not is critical to value-investing, and I’m slightly disappointed Graham didn’t discuss it in-depth. If markets are efficient, Graham wasted his effort writing the 700 odd pages on this book that he did! I suppose I should do further research (Buffet comes to mind), or toy around with a few ideas on the matter myself.
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