Security Analysis - Benjamin Graham [Podcast]

Security Analysis – Benjamin Graham by The Investors Podcast

In the foreword of Security Analysis Warren Buffett says that it’s one of the books that have changed his life. It’s packed with high level investing information that is as relevant today as ever. Preston and Stig couldn’t agree more. Actually they found the book so interesting that they decided to write their own 220 page summary of the book, and make it accessible for the investing community. Below is an example from the first chapter of Preston and Stig’s summary guide.

In this episode, you’ll learn:

Why Security Analysis is one of Warren Buffett’s three favorite books
Real case studies where Warren Buffett has directly applied skills acquired from Security Analysis
The highlights for each of the 7 major parts in Security Analysis
The difference in opinion between Benjamin Graham and Warren Buffett when it comes to dividends

Example of Preston and Stig’s Summary Guide

Chapter 1 of 52

Chapter 1 – Summary

The Scope and Limits of Security Analysis. The Concept of Intrinsic Value.

This chapter lays the core fundamentals of Security Analysis. As you can see, Graham immediately starts the book with the discussion of intrinsic value. Although he doesn’t define the details of the concept in this chapter, he indirectly implies that intrinsic value is the result of numerous variables. At the heart of the calculation is the meshing of Book Value and Earnings Power. Graham also discusses his opinion that the stock market is impossible to predict or determine in the short term. He makes a very important claim that that the value of your analysis decreases as the element for chance increases. This is a very important idea because it’s Graham’s scholarly way of saying: If you’re analyzing an unstable business, then you’re analysis might be worthless. He closes the first chapter by clearly describing Security Analysis as a practice of applying facts and identifying unknowns. Applying this practice to stable businesses will help the analyst to ultimately determine the elusive intrinsic value figure and protect their invested capital.

Chapter 1 – Outline

Preamble

The term Analysis indicates a scientific and methodical study of facts which results in logical conclusions. But investment is not an exact science, and success derives in part from personal skills and chance. Historically, the field of security analysis developed progressively to 1927, when it was corrupted by a “new era” that was followed by the 1929 market collapse. Analysts were discredited both for creating the crash and for not preventing it.

Three Functions of Analysis given under three headings:

1. Descriptive
2. Selective
3. Critical

1. Descriptive Function Descriptive analysis requires collecting all the important facts and presenting them in an understandable manner. Penetrating description will:

Reveal strong and weak points
Make comparisons with similar issues
Appraise for future performance

Such an analysis is appropriate not only for the investor but also for the speculator.

2. The Selective Function Of Security Analysis

Expresses specific judgement, by determining whether an issue should be bought, held, sold, etc.

Examples of Analytical Judgements. In this section, Graham provides a couple different examples of bonds and common stocks that traded at bargain prices and expensive prices. The method for determining this comparison was the company’s ability to earn and make payments to the investor. He showed that as the market price on the security changed in comparison to the company’s ability to earn, so did the intrinsic value of the investment. This analytical comparison would be the framework for Graham’s profound discussions on intrinsic value.

Intrinsic Value vs. Price. First, we establish the idea that intrinsic value is an elusive idea. We must remember it is only an estimate and not a firm fixed value. Valuation is based on the analyst’s opinion of the intrinsic worth of the security:

Assets
Earnings
Dividends
Definite prospects

Prior to the publication of Security Analysis, many believed the value of a business to be directly related to the book value. Graham cautions readers against that perception and argues more variables are obviously part of determining the intrinsic value of a business.

Intrinsic Value and “Earning Power.” In more recent times (about the time when Security Analysis was first published), Graham talks about the new metric for valuation, “earnings power”. This idea is that a multiple over the company’s earnings is the best way to value a business. This is often referred to as the P/E ratio. Graham also cautions readers that valuing a business solely from the earnings power is also risky and uncharacteristic of a wise analyst.

The Role of Intrinsic Value in the Work of the Analyst. The analyst does not attempt to determine a precise intrinsic value. Instead, he attempts to determine in relative terms whether a common stock or bond purchase provides enough safety to protect the principal invested. Graham then provides historical examples of companies that traded for extremely low prices compared to their earnings and health. He uses these examples to represent the idea that he didn’t know the exact intrinsic value, but definitely knew the picks were undervalued.

Flexibility of the Concept of Intrinsic Value. Graham discusses that the range for intrinsic value increases as the uncertainty for a business increases. For example, if a company is expected to have volatile numbers and they aren’t predictable, Graham says the intrinsic value could be as broad as $30 to $130 dollars. Although this large range is very difficult to predict, Graham suggests that if the market price falls below this range, the investment may still make practical sense.

More Definite Concept in Special Cases. Graham discusses a scenario where a company had issued two different bonds; One bond for 5% and another for 7%. Due to outside concerns, both bonds were trading on the market for about the same price. From a mathematical standpoint, the 7% bond obviously offers a much better return if both the bonds represent the same safety of repayment. Although this scenario is lucrative to the analyst, it’s uncommon and typically unimportant.

Principal Obstacles to Success of the Analyst.

Inadequate or incorrect data
Uncertainties of the Future: Graham suggests that predicting an organizations future performance is extremely difficult. He suggests that past performance is only a rough guideline of what to expect. Senior Securities (i.e. bonds and preferred shares), are somewhat protected against a company’s change in future earnings. Whereas common stocks are not. Also, companies that demonstrate stability, often reduce the risk for uncertainties.
Irrational Behavior of the Market: Graham encourages analysts to generally ignore market prices. The only time an analyst should concern himself with the prices is when they are trading uncharacteristically high or low. He briefly mentions the idea that many on Wall Street believe the market prices stocks efficiently. Graham obviously disagrees.

Hazard of Tardy Adjustment of Price Value. Since the market price of a particular pick may remain in or out of favor for an extremely long period of time, the analyst may face a hazard with implementing a value approach. By the time the security returns to the original value assessed by the analyst, other factors may have changed the initial estimate. Therefore it is important for the analyst to consistently review the reporting requirements of the company to prevent this from happening.

Relationship of Intrinsic Value to Market Price. The market is akin to a voting machine into which countless people insert their opinion. Those opinions are either based on emotion or reason. The results of those opinions in the short term are unstable and unpredictable.

Analysis and Speculation. Any belief that speculation can be made safe in the short term because competent analysis will predict the market price is doomed to failure. This is partly due to the factors described above and largely because of unknown elements which have not been and cannot be included in the analysis.

The Value of Analysis Diminishes as the Element of Chance Increases. Competent analysis provides an advantage but does not guarantee a profit. Analysis is therefore best suited to investment and not to speculation. Analysis may be considered an accessory to speculation but not a guide.

3. The Critical Function Of Security Analysis “Analytical judgements are reached by applying standards to facts.” The analyst should seek adequate protective provisions in bonds and preferred stocks. He must be alert to the misrepresentation by accountants. He must be familiar with the policies that management has set in place for the investment. His analysis is directed to the avoidance of mistakes, the correction of abuse, and the protection of the owner in the security.