Security Analysis Series: Chapter 41 Summary

“Low-Priced Common Stocks. Analysis of the Source of Income”

Chapter Summary

  • Speculatively capitalized common stocks generally are found in the “low-priced” category. Graham defines this as sub-$20 companies. (pg 520).
  • As he discussed in the previous chapter, low-priced common stocks “can advance so much more than they can decline.” It is far simpler for a stock to advance from 10 to 40 than 100 to 400. Graham backs this anecdote with a study from the University of Chicago, which puts forth that in a bull-market, low-price stocks gain on average more than high-priced stocks, and do not cede their gains as much in following recessions. (pg 521).
  • Graham argues that many losses are made in the low-price range of stocks due to the fact that many of these low-price stocks are not genuine, but “pseudo-low”. A genuine low price shows value is in relation to assets/earnings etc. A “pseudo-low” refers to heavily diluted companies that do not trade in relation to their true value. (pg 522).
  • A speculative, or leveraged position “may arise from any cause that reduces the percentage of gross available for the common to a subnormal figure”. This effectively can include high operating costs and other fixed charges. Graham provides the example of two theoretical copper producers, one a high-cost, high-volume producer, the other a low-cost, low-volume. At lower copper prices the low cost producer trades at a higher price; but when the copper price advances, the higher cost producer, due to volume, sees a greater rise in share price. Thus, when prices of a product are likely to rise, it is the high-cost producer that should be more attractive to an analyst. (pg 526).
  • Rather than applying blanket financial multipliers (such as P/E) to companies in an entire industry, Graham suggests analyzing the specific assets of companies in order to determine if these multipliers are appropriate. Certain sources of earnings are more stable that others. An example might be bond income as compared to rental income. (pg 528).
    • These sources of income can be detected and analyzed by examining information from the balance sheet. (pg 532).

Chapter Thoughts and Analysis

  • Graham’s conclusion that an intelligent investor ought to be targeting high-cost, high-volume producers in light of an momentary price increase makes this book more than worth its weight in gold. In the mining industry, for example, there is so much focus on reducing cost per unit, when in reality it is the company with higher costs and more volume potential that offer the true value in price up-swings.
  • The assertion that low-price stocks tend to advance further than high-priced seems a bit arbitrary, and citing a single study from 1936 certainly doesn’t confirm this as truth. More research ought to be done, as theoretically speaking, there should be no true difference. There could also be a number of different reasons for this; perhaps it is the case that low-priced companies advance more because they tend to be more speculative in their capital structure.
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