Security Analysis Series: Chapter 28 Summary

“Newer Canons of Common-Stock Investment”

Chapter Summary

  • In this chapter, Graham discusses various investing techniques and strategies, and analyzes their validity.
  • The trend of earnings “may prove a useful indication of investment merit.” This is opposed to it being the sole criterion for investing. (pg 366).
  • Diversification is the key to generating a favourable expected outcome, reducing variance. (pg 366).
  • Particular stocks are to be selected on the basis of a number of qualitative, and quantitative factors and tests. (pg 366).
  • If the fundamentals of a growing economy, and thus rising profits in the long run still maintain, then selection of a diversified group of stocks should theoretically yield a higher return than invested. (pg 367).
    • Graham points out that though this theory might be true, it is not necessarily so that the economy will advance in the same way it has historically. Caution is needed if this is the primary principle that an investor will rely on. (pg 368).
  • Graham then turns to the idea that specific “favored companies” can be chosen and relied upon to grow over the long-term. In other words, growth investing. (pg 368).
    • Graham points out that virtually all companies prior to the Great Depression grew cycle to cycle, and that they also failed to recover their losses via growth after the depression. (pg 369).
    • He also largely rejects the idea that these growth companies can be selected consistently outside of bull markets. Long periods of earnings growth increase the likelihood that the company is reaching its “saturation point”, while short periods of earnings growth increase the likelihood that the investor is being decieved by temporary prosperity. (pg 370).
    • Lastly, it is impossible to know exactly what price is fair to place on growth prospects given the randomness of the future. Paying a substantial amount for that growth is placing a large amount of risk on the unknowable. (pg 371).
  • Finally, Graham discusses his own investing technique, which he calls the “margin-of-safety principle”. (pg 372).
    • This principle is based on analysis that the stock is worth more than what he pays, and given a “reasonable optimism” for the company’s future, it is suitable for selection.
    • One can either buy individual stocks that are undervalued, or attempt to time the market for when it is generally considered low (though it is important to still conduct individual analysis on the securities purchased). Either technique offers a certain “margin of safety”, or a discount on the value relative to price.
      • Issues naturally arise when timing the markets. Specific buying and selling points, while at market lows, may still turn out to be poor. Additionally, the “character of the market” may fundamentally change as well, so that the past no longer predicates the future.
      • On this issue, Graham advises buying and selling “when the prevalent psychology favors the opposite course”. (pg 374).
    • On an individual basis, it is quite possible that average growth prospects, paired with a cheap price, will offer better returns than those with exceptional growth prospects. (pg 374).

Chapter Thoughts and Analysis

  • This chapter has particularly made me want to research growth investing further. I have realized that I know little to nothing about it, and I am somewhat skeptical of the ways that Graham has written it off. His ideas about “saturation points” are valid, as higher profits naturally draw greater competition; however, indeed there exists companies that have been able to grow dominantly in their competitive industry over very extended periods of time (see Microsoft, or now Apple). Additionally, Graham’s point that it is essentially impossible to determine what a fair price is to pay for growth is true. However, can’t the growth investor turn the table on him and argue that Graham can’t possibly determine what an acceptable margin of safety is?
    • To me, the difference between the two philosophies in relation to this question is that Graham’s philosophy is far more holistic, and therefore accurate in its determination of appropriate value, whereas the growth investor is essentially one-dimensional in his determination of what price is fair to pay for growth prospects. But perhaps I am mis-construing the growth position.
  • The entire system of value-investing seems to be only half of the picture. The other half is market timing. This is a topic that is fascinating to me, and must rely heavily on economics, supply and demand forces, and of course, luck. But I need to put more thought into the idea.
  • Graham’s advice on acting in the opposite manner of market psychology is valuable, and something I relate to, but in practice exceptionally difficult. It is easy in hindsight to see that in 2008, the fundamentals were blatantly showing an unsupported, dangerous bull market. But in the moment, when exceptional amounts of money can be made during that boom, it is obviously hard to step back and see. This is something I will have to wrestle with and experience for myself in the future.
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