Security Analysis Series: Chapter 37 Summary

“Significance of the Earnings Record”

Chapter Summary

  • The previous chapters have focused heavily on an analysis of the accuracy and correctness of the income statement. This chapter focuses on the relevancy of the statement, and how we ought to extrapolate that data into our analysis. (pg 472).
  • Earning power as a concept “combines a statement of actual earnings, shown over a period of years, with reasonable expectation that these will be approximated in the future, unless extraordinary conditions supervene”. (pg 472).
    • Earning power must be proven over a number of years, as earning will average out in the long run given business cycle distortions.
    • Relative stability in earnings is also an important aspect of identifying earning power.
  • Quantitative analysis must be supplemented by the qualitative. (pg 474).
    • For example, companies with an “entrenched position” of competitive advantage in some way can be relied upon to have greater earnings power that a company with identical historical earnings, but does not have such a position.
  • Current year earnings can not be the primary object of an analysis of a company. Graham relates this to a private business owner who would not mark up the value of his business in a boom year. (pg 476).
    • The market generally tends to place extreme emphasis on near-term earnings. However, it takes “strength of character in order to think and to act in opposite fashion from the crowd”. (pg 476).
    • It is also true, though, that earning power can change from cycle to cycle. An analyst needs to determine what permanent changes to business occurred, and if these changes will continue to persist in the new cycle. (pg 477).
  • An average is a better indicator of earning power than a trend. (pg 478).
    • Trend in itself is a dangerous item, as general economic forces tend to operate against the trend. For example, increased competition, regulations, and the law of diminishing returns all serve to snuff out earnings trends.
    • Graham suggests when analysis provides a favourable verdict of a company, and the trend is upwards, the premium paid on the price for that trend ought to be considered a speculative attachment to the underlying investment. This is because the investor is paying “not for demonstrated but for expected results.” (pg 479).
    • When the trend is downwards, discounts, and thus an enhanced margin of safety, may be available to the investor. The key is finding out which market pessimism is justified, and which is not; IE accidental, or non-permanent price depressants. (pg 480).
  • Deficits “have no quantitative significance” according to Graham. This is because a deficit is simply relative to the number of shares outstanding. (pg 480).
    • For example, take two companies selling at $25 per share; A is losing $7 per share, B is losing $5 per share. If A issues 2 shares for 1, it is now losing $3.5 per share; it appears as though A is now less financially troubled than B, but in reality this is not the case. (pg 481).
    • An average period of deficits is a better indicator, however, it too must be analyzed on a qualitative basis.
  • The concept of “intuition” is essentially useless. Analysis ought to be based on reason, not emotion. (pg 482).
  • Analysis of the future “should be penetrating rather than prophetic.” (pg 482).
    • What is meant by this is that predictions shouln’t be made on trends, but rather whether or not business will “continue…pretty much as before.” (pg 482). This conservatism will bring about a greater margin of safety for investors.

Chapter Thoughts and Analysis

  • Graham’s emphasis (once again) on rejecting the idea of trend as a relevant piece of analysis in favour of averages may have some flaws, in my opinion. Over how many years does an average include earnings that are indicative of current earning power? Five, ten, or twenty? Clearly the answer is entirely contextual for each company. But this brings about difficulties in comparing averages between companies, if we are allowed to essentially cherry-pick the amount of years that are relevant to earning power.
  • Conceptually, Graham is very insightful that upward trends are likely to lead to self-combustion. The inverse tendency of a downward trend is also relevant. In the case of a downward trend, decreased incentives for competitors to enter the industry might bring about a reversal of that trend.
  • The application of “penetrating rather than prophetic” analysis of the future is exceptionally difficult. Even Graham’s penetrating analysis is not safe, particularly today; modern companies are constantly faced with the prospect of not being able to conduct business as usual. How safe and entrenched did taxi companies look before Uber took the world by storm? Thus, in my opinion, every investment thesis will involve some prophecy. We all have views on how the world operates, and in what direction prices will move. It is simply a matter of being correct in your prophecy by backing it with sound logic, and having the courage of your convictions.
  • The “strength of character” quote may be my favourite in the entire book.
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