Security Analysis Series: Chapter 38 Summary

“Specific Reasons for Questioning or Rejecting the Past Record”

Chapter Summary

  • In this chapter, Graham will be approaching the idea of “possible unfavorable changes in the future”, and the steps an analyst can take to be able to be aware of such changes. He uses mining companies in a variety of examples.
  • Having an understanding of a company’s ore reserves is extremely important. This extends not only to quantity, but also quality. The ore grade may change throughout the course of the life of the mine, thus revenue achieved in previous periods may not be an accurate prediction of future revenue. (pg 488).
    • For a producing mine, earnings reports must be taken in conjunction with remaining ore deposits. Future operations are entirely dependant on those reserves, and thus earnings are as well. (pg 490).
  • New projects will not necessarily transition seemlessly into future earnings. If the bulk of future earnings are based on projections for new projects, the analyst must approach these projections with great skepticism. Numerous risks are greatly enhanced with a new mine as compared to an old mine. Graham suggests the treatment of the projects as “two separate enterprises” in order to properly treat and value them. (pg 490).
  • Future price for products must also be considered to some extent. Graham puts forth that an analyst “can truthfully say very little about future prices.” However, an understanding of the economic context of a price can be very helpful in analysis. He provides the example of zinc prices in World War 1, which were heavily dependant on the war. (pg 491).
    • Pricing is also affected by number of producers in the market. An industry that develops numerous low-cost producers will serve to bring the average price for the entire industry lower. Adjusting calculations for these developments is needed. (pg 492).
  • Beware of heavily “hyped-up” near-term earnings. They are subject to heavy speculation from the general investing population. (pg 495).

Chapter Thoughts and Analysis

  • One item that is obvious, but still pertinent to point out, is that one needs to update cash flow models according to new information. Changes in mineral reserves, resources, rate of production, grade, etc., will naturally change value calculations. It may take effort to constantly stay up to date with new developments for a company, but that is part of what separates the intelligent investor from the herd.
  • Graham’s discussion of inflated zinc prices due to the first World War is difficult to draw any remarkable conclusions from, in my opinion. How/when do we incorporate the amount of demand from a temporary situation (such as war) into our calculations? Couldn’t this temporary situation turn out to be perpetual? Ultimately, I think the solution is to make an educated guess based on absorbing all the information we can. It may be “prophetic” in Graham’s terms, but the alternative is to make no adjustment to our calculations altogether, which seems a worse approach in regards to analysis.

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