Security Analysis Series: Chapter 39 Summary

“Price-Earnings Ratios for Common Stocks. Adjustments for Changes in Capitalization”

Chapter Summary

  • The P/E multiple is ultimately a function of public opinion, due to the price aspect of the ratio. Thus an analyst must approach it with a degree of caution in applying it to his analysis. The precise value of an enterprise cannot possibly be formulated by an analyst, due to the constant amount of change that is involved with the company. The P/E multiple itself is but “a matter of purely arbitrary choice” due to the constant changing in aspects related to earnings. (pg 497).
    • “The stock market is a voting machine rather than a weighing machine. It responds to factual data not directly but only as they affect the decisions of buyers and sellers.” (pg 497).
  • Given this problem of impreciseness, the analyst is limited to three items: (pg 497).
    • A) Set up a basis for “investment valuation” of common stocks;
    • B) Point out the influence of capital structure and sources of income in relation to value;
    • C) Find unusual elements in the balance sheet which affect the implications of earnings.
  • If general business conditions were not exceptionally good, and there exists and upward trend of earnings, and the industry can be expected to continue to grow, an analyst might be able to use the most recent year’s profits might be an accurate portrayal of future earnings. (pg 498).
  • On an investment basis, a P/E ratio of about 20x is “as high a price as can be paid”. (pg 498).
    • While arbitrary, Graham believes that it “is difficult to see how average earnings of less than 5%” can possibly vindicated. There can be virtually no margin of safety in these cases.
    • Graham suggests that a neutral-prospect company might have a P/E ratio of approximately 12. (pg 499).
  • Stocks might be speculative, among other reasons, due to a highly irregular record of earnings, or a high price in relation to earnings. (pg 500).
  • It is appropriate to adjust capitalization for any possible future increases in equity, namely in exercising conversions or warrants. These can seriously hamper upside price potential. It is also important, in these adjustments, to make the changes to book values and asset/liability values in all aspects of the accounting, not just the equity. (pg 504).
  • Graham’s finally word on his general rule:
    • “The intrinsic value of a common stock preceded by convertible securities, or subject to dilution through the exercise of stock options or through participating privileges enjoyed by other security holders, cannot reasonably be appraised at a higher figure than would be justified if all such privileges were exercised in full.” (pg 506).

 

Chapter Thoughts and Analysis

  • Graham’s quote on the market being a voting machine rather than a weighing machine once again relates to the economic concept of utility in investing. Markets aren’t perfectly efficient, only understanding risk/reward and price. Rather, risk, reward, and price are factors in a holistic equation that can also involve personal bias to a great extent.
  • It seems mostly questionable to simply accept recent year earnings due to normal business conditions, expected industry growth, and upward earnings trends. While I am certain Graham would caveat this acceptance with numerous other quantitative and qualitative factors, it just seems very out of character for him to somewhat make a statement this casual.
  • In a modern context, diluted earnings (earnings where all conversions, warrants, etc. are calculated into equity) are a standard metric, found on all relevant income statements of companies faithful to IFRS.

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.

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.

Security Analysis Series: Chapter 34 Summary

“The Relation of Depreciation and Similar Charges to Earning Power”

Chapter Summary

  • The basic idea behind depreciation is that the earning power of fixed assets reduce over time, thus we write-off that cost by amortizing and charging against earnings. (pg 453).
  • Graham takes three issues with the above concept (pg 453):
    • 1. Accounting rules vary in their use of a base for depreciation.
    • 2. Companies can find ways to warp reported depreciation accounting rules to their gain.
    • 3. There can exist times when an “allowance that may be justified from an accounting standpoint” will not satisfy that same allowance from an investor’s standpoint.
  • Due to the market’s great importance placed on earnings, companies often willingly mark down assets for the purpose of reducing depreciation charges. (pg 455).
    • The inverse can also happen, where mark-ups occur but cost is still maintained as the depreciation base.
      • “…no company should use one set of values for its balance sheet and another for its income account.” (pg 456).
  • Calculating the % of depreciation charged to the appropriate fixed asset account, or total fixed assets, allows for a handy comparison year-over-year, or company to company. (pg 460).
  • On occasion, companies can actually expense capital expenditures, rather than capitalize them. This leads to lower depreciation charges, and even lower reported earnings. Graham provides an example where a change in accounting policy served to double earnings, largely due to the company starting to capitalize, rather than expense capital expenditures. (pg 463).
  • Mining and oil companies must charge expenses for the depletion of their reserves. An independent calculation of depletion expense “based on the amount that he has paid” is necessary. It is necessarily difficult, and one must carefully study and understand the estimated life of the resources in his calculations.
    • Oil is slightly different from mining, in that new wells “may yield as high as 80% of their total output during the first year”, which brings drastic variation in earnings, and the subsequent writing-off of the entire reserve in almost a single year. Thus, if the property is not written off rapidly via depletion, earnings and property will both be dramatically overstated. (pg 465).
    • As a solution to the aforementioned problems, Graham recommends that mining and oil depreciation on tangible assets be compared to relatively similar resources, while intangible drilling costs ought to be capitalized, as opposed to expensed in a single year (though this is the less conservative approach, it supplies the most accurate picture of earnings). Adjustments to accounting are necessary to make comparisons in situations where they differ. (pg 468).
      • For depletion of integrated oil companies, Graham suggests accepting their figure, while sole oil producers are apt to be comparable against competitors. (pg 469).
    • Property retirement losses and costs ought to be charged against earnings, rather than surplus; this is because property retirement is to be expected and recurrent in these businesses. (pg 468).
  • Leasehold improvements may have substantial capital value in certain situations where a lease is for a considerable period of time; thus capitalization and amortization is appropriate in some circumstances (such as grocery store chains). (pg 470).
  • Patents are capitalized based on book value, which typically has no relevance to the true value of the asset. But in theory, they should be capitalized and amortized across the life of the patent, even if accounting standards currently use a fairly arbitrary base. (pg 471).

Chapter Thoughts and Analysis

  • The most valuable piece of advice in this chapter, at least to me, is the concept of comparing depreciation charges as a % of fixed assets across companies and years, which will allow the establishing of industry standards. These standards can then be used to determine what companies apply their rates conservatively, how it affects their earnings, and other consequences of their policy choices.
    • Obviously a case by case analysis is necessary. It is quite logical that more poor quality fixed assets ought to be charged against earnings faster than the high quality assets of another company. Or, in the mining industry for example, depletion charges will vary from project to project, naturally. Perhaps it is the case that in order for one to determine if depletion or depreciation charges are appropriate, advanced knowledge of the industry is necessary. This lends itself to Buffett’s idea of investing in what you know.
  • It is highly important to understand that Graham’s advocacy of capitalizing drilling costs in the oil sector does not apply to all drilling costs, in either the oil or mining industry. The idea of capitalizing exploration drilling costs in the mining industry is ludicrous, as the drilling cost has no bearing on the fundamental value of the body, other than for the purpose of revealing enhanced knowledge of the resource. But it is the knowledge provided by the costs, not the costs themselves, that determine the value.
  • Graham’s point that retirement costs in the oil and mining industries are a standard part of a business, and thus ought to be charged to earnings, is excellent. Today’s accounting standards cover these costs through “Asset Retirement Obligation” liability accounts, however. But perhaps the existence of unreported future obligations in retirement also ought to be considered in further research.

Security Analysis Series: Chapter 33 Summary

“Misleading Artifices in the Income Account. Earnings of Subsidiaries”

Chapter Summary

  • Management can play tricks with earnings via subsidiaries; Graham provides one example of write-ups to goodwill and trademarks of a subsidiary being deducted from expenses. (Note this surely is not legal today, but in extraordinary cases similar action by management can be caught in the same manner.) (pg 435).
  • Expenses that are subsequently capitalized, no matter the justification, ought to be subject to extreme scrutiny and adjusted accordingly. (pg 437).
  • Graham suggests taxable income of the corporation be compared with earnings reported to shareholders. Significant differences between the two figures ought to be investigated, as the two numbers should be relatively correlated. (pg 437). Page 438 offers a good example chart of the correlation.
  • The capitalization of leaseholds, whether from a subsidiary or main company, is also questionable. “[They] are essentially as much a liability as they are an asset…an obligation to pay rent for premises occupied.” Any capital value ascribed to the leasehold is also highly intangible, thus this appreciation in most cases ought not to be recorded on a balance sheet, and especially not on an income statement. (pg 439).
    • Additionally, if the leaseholds had appreciated in value, then “the effect should be visible in larger earnings realized”, thus recording the appreciation on an income statement would be akin to double counting the value. (pg 440).
    • Keeping a close eye on depreciation/amortization figures is also important in cases of fixed asset appreciation. (pg 440).
  • A company following extremely questionable accounting practices “must be shunned” by investors, no matter how attractive it may seem. (pg 441.)
    • “You cannot make a quantitative deduction to allow for an unscrupulous management”. (pg 441).
  • Stock dividends, particularly in closely held companies with subsidiaries, are also subject to dramatic manipulation. The stock price of the subsidiary is strongly controlled by the parent, thus, a stock dividend from the subsidiary to the parent should be reviewed to determine if it is an effective pyramid scheme for earnings. (pg 443).
  • Study the “degree of consolidation” for parents and their subsidiaries. It is key to understand the different levels of ownership in all aspects of the business when considering making an investment. (pg 444).
  • Special dividends paid by subsidiaries to parent companies are a method of concealing bad earnings. (pg 447).
  • A certain allowance to earning power of the parent must be made in situations where subsidiaries are generating a loss, as that loss is generally non-permanent, whether through sale of the subsidiary or improvement of profitability. Graham suggests that if the subsidiary can be wound up without “an adverse effect upon the rest of the business”, it is more logical to view the loss as temporary; however, if the subsidiary is important strategically for the business, this obviously hurts earning power. (pg 449).
    • If it is predicted that continued operations of the unprofitable subsidiary is likely, a deduction from earnings is appropriate.

Chapter Thoughts and Analysis

  • It is quite interesting that GAAP standards have developed since Graham’s time to allow the capitalization of leases under certain requirements, of which are fairly arbitrary in my opinion. An analyst could determine value much more accurately by determining for himself if it is appropriate to capitalize, rather than applying GAAP’s broad, unspecific standards. I would personally think justification of capitalization would be reserved for only clear-cut cases of extremely long-term leaseholds, but perhaps a reduced percentage of capitalization value would be appropriate in other, less obvious cases.
  • As with the former chapter, some of Graham’s accounting examples are dated. But it is the spirit; the analytical mind-set of breaking down each accounting aspect applied to a company’s financial statements that remains relevant today.
  • I am curious to research whether or not Graham’s concept of matching reported earnings to taxable income is still valid. My suspicion is that it is, due to the slow rate of change in taxation policy; however, further investigation is warranted.
  • In my opinion, it is unfair to reject a company entirely because of questionable accounting. It would be more accurate to demand a greater margin of safety from the company. Particularly in the case of companies where an accounting scandal is uncovered, the natural reaction of the market would be to panic and exit the position. This could make for some interesting discounts on a value-investing basis. However, extreme caution should certainly be exercised in these cases to determine if the scandal was a one-off, or more structural an issue.

Security Analysis Series: Chapter 32 Summary

“Extraordinary Losses and Other Special Items in the Income Account”

Chapter Summary

  • Historically, companies varied greatly in their treatment of extraordinary losses and special items. For example, in the 1932 depression, companies charged inventory write-downs to surplus, while in 1938 a majority charged write-downs to income. (pg 424).
    • However, inventory losses are “by no means extraordinary”, as they are a part of general business. This shall be treated with in detail in a later chapter.
  • Earnings can be “manufactured” with great ease. For example, an inventory write-down charged to surplus a year prior will serve to inflate profit by the amount written down in the following year. The hit to surplus is hardly accounted for by mainstream investors, while a boost in earnings will have a significant affect on price. (pg 425).
  • Reserves created for inventory losses, typically charged to surplus, require an adjustment to ensure those inventory losses are properly (at least partially) charged to income. “…in no year does the income account reflect the inventory loss, although it is just as much a hazard of operations as a decline in selling prices.” (pg 426).
    • See page 427 for an example of the type of adjustments Graham would make to compare earnings given inventory losses in previous years.
  • Inventory costing methods, such as FIFO, LIFO, or averaging, affect profits in a particular year in different ways; however, in the long-run, the variance is eliminated. (pg 429).
  • Idle plant expenses charged to income presumably are only temporary, or at least can be terminated at will by management. Thus, it is more appropriate to adjust them to be charged to surplus, rather than be considered a permanent drag on income. (pg 430).
  • Deferred charges, if charged to surplus, understate operating expenses for a large period of time, thus exaggerating income in a serious way. (pg 432).
  • The amortization of a bond discount is “part of the cost of borrowing money”, and thus should be amortized over the life of the bond with charges against earnings, rather than surplus. (pg 433).

Chapter Analysis and Thoughts

  • Strictly speaking, some of this analysis is dated. For example, charging the amortization of a bond discount against surplus is no longer the standard; rather the discount is established as a contra-liability, which is then amortized and charged to interest expense over the course of the bond. However, Graham is insightful for his time in recognizing items such as this. Overall, it seems he sets the example of treating any item charged to surplus with great scrutiny.
  • This chapter is the first quantitative, mechanical advice Graham offers for valuation. And again, while not all of his quantitative recommendations are valid in this day and age, it is more his analytical process of identifying cause/effect relationships on financial statements that the analyst must channel.
  • The discussion of idle-plant expense as a non-temporary affect to earning power should perhaps be treated with a touch of caution. Questions must be asked, such as what is the reason for idleness, what solutions are management proposing on the issue, and in what time frame can one realistically expect it to be resolved. The answers to these questions may justify a partial charge to income.

Security Analysis Series: Chapter 31 Summary

“Analysis of the Income Account”

Chapter Summary

  • Placing valuation entirely on earnings power is seriously limiting. A businessman does not evaluate his enterprise by solely looking at earnings, and ignoring the financial resource that generated them. (pg 409).
  • Earnings statements are particularly subject to wilder swings and changes than on balance sheets. This creates a “degree of instability” in valuation. (pg 410).
  • Graham cites Wall Street’s method of appraisal as “Price = Current EPS x Quality Coefficient”, where the quality coefficient is a multiplier based on various factors, such as the dividend rate, reputation, type of business, etc. (pg 411).
    • Graham rejects this method, believing EPS to have not only extreme variance, but also a great degree of arbitrariness, and inaccuracy to it.
      • This is due to:
        • Charging to surplus rather than income;
        • Over/under estimating amortization;
        • Varying capital structure;
        • Capital reserves not deployed in the business;
    • In regards to making appropriate adjustments to the accounting, Graham believes “That this work may be of exceeding value cannot be denied.” (pg 412).
      • Perfection is not required, but merely a “more nearly correct version of the past” in these adjustments.
  • Thus, in Graham’s system, there are three aspects to income account analysis: (pg 412).
    • 1. The accounting aspect – “What are the true earnings for the period?”
    • 2. The business aspect – “What indications does the earnings record carry as to the future earning power of the company?”
    • 3. The investment finance aspect – “What elements in the exhibit can contribute to a reasonable valuation of the shares?”
  • The goal of the analyst is to determine earning power; thus, we seek the “ordinary” operating results of the business. The income account is open to criticism on many accounts to find what is “ordinary”, but particularly: (pg 413).
    • 1. Nonrecurrent profits and losses…
      • Inclusion of the sale of fixed assets to income. (pg 415).
      • Profit from the sale of marketable securities (given that is not the normal business of the company). (pg 416).
      • Repurchase of senior securities trading below par, including the gain in net income; or, conversely, retiring senior securities above par and charging the loss to surplus. Particularly egregious to consider these items as income, as it comes at the expense of the company’s security holders in the first place. (pg 420).
      • Other nonrecurrent items include insurance proceeds, or accumulated interest on tax refunds.
    • 2. Operations of subsidiaries or affiliates, to be discussed in a later chapter.
    • 3. Reserves, to be discussed in a later chapter.

Chapter Thoughts and Analysis

  • The concept of heavily relating earning power to the underlying financial assets of a company is a key area where Graham departs from the mainstream, in my opinion. As opposed to placing primary emphasis on the trend and history of the income account, Graham wants to investigate the underlying cause of earnings. While this may seem obvious, my suspicion is that the mainstream doesn’t practice this particularly often.
  • The idea that a company might also be undervaluing their assets or understating their income voluntarily, or even accidentally, is something that never occurred to me. How often does this happen in actuality, though? Might there be management teams that purposely skew numbers this way? The first instance that might come to mind is a company understating, or writing down fixed assets in order to reduce depreciation/amortization charges, boosting the income account. Obviously it will be difficult to determine whether or not these write downs are valid without exceptionally advanced knowledge of the assets and industry.
  • Also of interesting note is that Graham recommends the lay-investor not purchase securities of any banks or insurance companies because of the inability to understand the vast complexities of their accounting policies and income. This is remarkable, as it seems as though banking stocks are considered a stable store of value in the mainstream today!

Security Analysis Series: Introduction to Part V Summary

“The Quest for Rational Investing”, by Glenn H. Greenberg

Chapter Summary

  • Globalization has brought intensified competition, and modernization has brought industry disrupting technologies, increasing the challenges in determining future earning power. (pg 397).
  • Greenberg’s investing process involves a calculation of a company’s expected rate of return. That includes the somewhat obvious steps of analyzing competitors, margins, capital structure, and asking questions that need to be answered in order for the business to grow. (pg 397).
  • Today, free cash flow (cash flow – capital expenditures), as opposed to earnings, is the primary metric used to evaluate a company’s investing merits.
    • Earnings are “seldom synonymous with cash available for shareholders”, which is essentially the fundamental aspect of investing. “How much cash will I get back, and how fast?” (pg 398).
  • Greenberg cites a company his firm purchased, Ryanair, that had declined 30% since the initial investment. He argues that “nothing has happened that makes us believe that long-term value of our investment has diminished.” Moreover, the difficult business conditions should serve to force out other competitors, and discourage new entrants. (pg 399).
  • Accounting adjustments are absolutely crucial to valuation. Stock options being accounted for as a current expense, even when out of the money, is one example.
    • Other examples include derivatives, hedging, pensions, leases, and profit recognition. (pg 400).
  • After analyzing the historical record, the true challenge lies in determining how useful that record is to determine future earnings. IE, Graham’s qualitative aspect. (pg 400-401).
  • Greenberg believes “aversion to boredom, a tendency for emotions to overwhelm reason, and greed” are the reason Graham’s wisdom is generally ignored. Naturally, the intelligent investor must avoid these. (pg 404).

Chapter Thoughts and Analysis

  • In my opinion, Greenberg doesn’t add much in the way of original thought in this introduction as compared to other introductions.
  • His list of accounting adjustments in his valuation process is quite useful as a lead to potentially investigate. Finding those balance sheet/income statement discrepancies is a simple, surefire way to contribute to a margin of safety.
  • The modern use of “free cash flow” as compared to earnings is the other key aspect of this introduction that is valuable. I would be curious to see to what extent successful modern value investors involve earnings in valuation, and how transferrable Graham’s lessons in the following chapters (which focus on earnings) are to free cash flow.

Security Analysis Series: Chapter 29 Summary

“The Dividend Factor in Common-Stock Analysis”

Chapter Summary

  • The dividend rate and record is considered primary aspect of valuation by some, and not so by others. (pg 376).
    • These two views are summarized by Graham as follows:
      • 1. Dividend Return as a Factor in Common-Stock Investment
        • “The prime purpose of a business corporation is to pay dividends to its owners.” (pg 376).
        • Markets tend to reflect this viewpoint, paying a higher price to companies that pay out more as opposed to having higher earnings.
      • 2. Withholding Earnings Creates Value
        • Management can be justified in withholding earnings, IE not paying dividends, to strengthen the company’s financial position. (pg 378).
        • However, stock owners tend to despise this viewpoint; they prefer dividends today, as opposed to the potential of supposed future returns by withholding. (pg 378).
  • Graham generally deems that a conservative dividend policy, or withholding more earnings than not, is objectionable in most circumstances. (pg 380).
    • Saving up earning in surplus to protect the dividend rate for future bad times “often fails to safeguard even the moderate dividend rate”. (pg 380).
    • What benefits the company benefits the stockholder, so long as that benefit does not come at the expense of the stockholder. And it is not certain that plowing back earnings is typically to the stockholder’s advantage, particularly considering the compound interest forsaken on the amounts not paid out. (pg 381).
  • The “despotic powers given the directorate over the dividend policy” are extremely vulnerable to being abused. (pg 382).
    • They can also be determined by the substantial shareholders that control the company/management.
  • If stock can not be sold at par or an advantageous value, management of “watered stock” may seek to build assets through withholding earnings. (pg 393).
  • Graham’s experience in the market confirms that “a dollar of earning is worth more to the stockholder if paid him in dividends than when carried to surplus”. (pg 384).
    • However, “an extra-liberal dividend policy cannot compensate for inadequate earnings.” (pg 385).
  • Various definitions established… (pg 385).
    • Dividend Rate: amount of dividends paid per share (in $ or as a % of $100).
    • Earnings Rate: amount of annual EPS (in $ or as a % of $100).
    • Dividend Yield: ratio of dividend paid to market price.
    • Earnings Ratio: ratio of earnings to market price.
  • Graham thus concludes the previous analysis with the following principle: “Management should retain or reinvest earnings only with [stockholder approval]. Such ‘earnings’ retained to protect the company’s position are not true earnings at all. They should be…deducted in the income statement as necessary reserves…A compulsory surplus is an imaginary surplus.” (pg 386).
  • Concluding that a liberal dividend policy is attractive, Graham recognizes the paradox: “Value is increased by taking away value.” He believes this paradox is addressed in his earlier analysis. (pg 387).
  • Reiterating, dividends withheld are not true “profits”, but reserves that had to be plowed back in order to protect the business. (pg 388).

Chapter Analysis and Thoughts

  • Graham’s distaste – to put it lightly – for the North American system of management is on full display in his quote about their “despotic” powers. While I still need to conduct further research, I have been unable to find a single quote by him in which he views management teams in a positive light. And while I am unsure of his views on the value of management, I personally think there exists massive value in selecting companies with quality management teams. Human capital is not listed on the balance sheet, and it is my suspicion that investors, especially in cyclical bear markets, ignore that value.
  • I think Graham fails to address the larger issue presented by his analysis. While it is true that there exists a compounded opportunity cost to earnings withheld by a company, isn’t it also true that those same earnings put to surplus ought to generate compounded interest themselves? Moreover, isn’t the entire purpose of investing in a company to earn a rate of return above the market average, which is presumably what a dividend paid out would earn? If we are doubting a company’s ability to earn that above-average rate of return, why invest in the company at all? Thus, I believe Graham has contradicted himself in this chapter.
  • The idea of a “compulsory surplus” being “imaginary”, or without value is also inaccurate in my view. Surely it offers some cushion to bear markets, or a potential area of which management can draw funds from to invest in capital in the future; however, I think Graham is on to something. That is, if management deems it necessary to establish that protection, the investor must proceed with a certain deal of caution.

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.