Value Investing

The Best Of Graham & Dodd’s Security Analysis Part II: Fixed-Value Investments

The Best Of Graham & Dodd’s Security Analysis Part II: Fixed-Value Investments by Total Goon Move

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This is part two of a seven part series and contains quotes from the Sixth Edition of Security Analysis.

Security Analysis Chapter 6 - The Selection Of Fixed-value Investments

“In exchange for limiting his participation in future profits, the bondholder obtains a prior claim and a definite promise of payment, while the preferred stockholder obtains only the priority, without the promise. But neither priority nor promise is itself an assurance of payment.”

- p.143 -

“Since the chief emphasis must be placed on avoidance of loss, bond selection is primarily a negative art.”

- p.143 -

“In the past the primary emphasis was laid upon the specific security, i.e., the character and supposed value of the property on which the bonds hold a lien. From our standpoint this consideration is quite secondary; the dominant element must be the strength and soundness of the obligor enterprise. There is here a clearcut distinction between two points of view. On the one hand the bond is regarded as a claim against property; on the other hand, as a claim against a business.”

- p.144 -

“As a practical matter it is not so easy to distinguish in advance between the underlying bonds that come through reorganization unscathed and those which suffer drastic treatment. Hence the ordinary investor may be well advised to leave such issues out of his calculations and stick to the rule that only strong companies have strong bonds.”

- p.153 -

Security Analysis Chapter 7 - The Selection Of Fixed-value Investments: Second And Third Principles

“Any bond can do well when conditions are favorable; it is only under the acid test of depression that the advantages of strong over weak issues become manifest and vitally important.”

- p.154 -

“…there is no such thing as a depression-proof industry…”

- p.155 -

“The distinction to be made, therefore, is not between industries which are exempt from and those which are affected by depression, but rather between those which are more and those which are less subject to fluctuation. The more stable the type of enterprise, the better suited it is to bond financing and the larger the portion of the supposed normal earning power which may be consumed by interest charges.”

- p.155 -

“The fact that no good bonds are available is hardly an excuse for either issuing or accepting poor ones. Needless to say, the investor is never forced to buy a security of inferior grade. At some sacrifice in yield he can always find issues that meet his requirements, however stringent; and…attempts to increase yield at the expense of safety are likely to prove unprofitable.” — p.161 —

“A reasonable amount of funded debt is of advantage to a prosperous business, because the stockholders can earn a profit above interest charges through the use of the bondholders’ capital.”

- p.162 -

“It appears to be a financial axiom that whenever there is money to invest, it is invested; and if the owner cannot find a good security yielding a fair return, he will invariably buy a poor one. But a prudent and intelligent investor should be able to avoid this temptation, and reconcile himself to accepting an unattractive yield from the best bonds, in preferences to risking his principal in second-grade issues for the sake of a large coupon return.”

- p.163 -

“Security prices and yields are not determined by any exact mathematical calculate not the expected risk, but they depend rather upon the popularity of the issue. This popularity reflects in a general way the investors’ view as to the risk involved, but it is also influenced largely by other factors, such as the degree of familiarity of the public with the company and the issue (seasoning) and the ease with which the bond can be sold (marketability).”

- p.164 -

“In life insurance the relation between age and mortality rate is well defined and changes only gradually. The same is true, to a much lesser extent, of the relation between the various types of structures and the fire hazard attaching to them. But the relation between different kinds of investments and the risk of loss is entirely too indefinites, and too variable with changing conditions, to permit of sound mathematical formulation.”

- p.165 -

“For the individual is not qualified to be an insurance underwriter. It is not his function to be paid for incurring risks; on the contrary it is to his interest to pay others for insurance against loss.”

- p.165 -

“While there may be no real mathematical difference between offsetting risks of loss by a higher income or by a chance for profit, the psychological difference is very important. The purchaser of low-priced bonds is fully aware of the risk he is running; he is more likely to make a thorough investigation of the issue and to appraise carefully the chances of loss and of profit; finally — most important of all — he is prepared for whatever losses he may sustain, and his profits are in a form available to meet his losses.”

- p.166 -

“The security buyer who can afford to take some risk should seek a commensurate opportunity of enhancement in price and pay only secondary attention to the income obtained.”

- p.167 -

“…bond selection should consist of working upward from definite minimum standards rather than working downward in haphazard fashion from some ideal but unacceptable level of maximum security.”

- p.168 -

Security Analysis Chapters 8 & 10 - Specific Standards For Bond Investment

“Investment theory should be chary of easy generalizations.”

- p.171 -

“In the final analysis, a foreign-government debt is an unenforceable contract. If payment is withheld, the bondholder has no direct remedy. Even if specific revenues or assets are pledged as security, he is practically helpless in the event that these pledges are broken.”

- p.173 -

“There is no mathematical means of determining exactly at what point a company or a municipality becomes large enough to warrant the investor’s attention. The same difficulty will attach to setting up any other quantitative standards… It must be borne in mind, therefore, that all these ‘critical points’ are necessarily rule-of-them decisions, and the investor is free to use other amounts if they appeal to him more. But however arbitrary the standards selected may be, they are undoubtedly of great practical utility in safeguarding the bond buyer from inadequately protected issues.” — p.177 —

“Whether the gross receipts of an electric company are twenty millions or a hundred millions has, in all probability, no material effect on the safety of its bonds; and similarly a town of 75,000 inhabitants may deserve better credit than would a city of several million.”

- p.179 -

“Real estate loans should not be made on buildings erected for a special or limited purpose, such as hotels, garages, etc. Commitments of this kind must be made in the venture itself, considered as an individual business.”

- p.189 -

Security Analysis Chapter 15 - Technique Of Selecting Preferred Stocks For Investment

“For in any corporation the bond interest alone is obviously earned with a larger margin that the bond interest and preferred dividends combined. This fact has created the impression among investors (and some writers) that the tests of a sound preferred stock may properly be less stringent than those of a sound bond. But this is not true at all. The real point is that where a company has both bonds and preferred stock the preferred stock can be safe enough only if the bonds are much safer than necessary. Conversely, if the bonds are only just safe enough, the preferred stock cannot be sound.”

- p.194 -

“Experience shows that noncumulative dividends are seldom paid unless they are necessitated by the desire to declare dividends on the common; and if the common dividend is later discontinued, the preferred dividend is almost invariably suspended soon afterwards.”

- p.198 -

“…form, title, or legal right are relatively immaterial, and…the showing made by the individual issue is of paramount importance.”

- p.200 -

Security Analysis Chapters 16 & 17 - Income Bonds And Guaranteed Securities

“The contractual position of an income bond (sometimes called an adjustment bond) stands midway between that of a straight bond and a preferred stock…However, it should be pointed out that income bonds are almost always given a long maturity date, so that the right of repayment is not likely to be of practical importance in the typical case studied.”

- p.202 -

“It may be said that individual income-bond issues my be found illustrating almost every step in the range of variation between straight preferred and ordinary bonds.”

- p.203 -

“No special investment quality attaches to guaranteed issues as such. Inexperienced investors may imagine that the word “guaranteed” carries a positive assurance of safety; but, needless to say, the value of any guaranty depends strictly upon the financial condition of the guarantor. If the guarantor has nothing, the guaranty is worthless.”

- p.208 -

“From the standpoint of fixed-value investment, nothing of importance may be taken for granted. Hence a subsidiary bond should not be purchased on the basis of the showing of its parent company, unless the latter has assumed direct responsibility for the bond in question. In other cases the exhibit of the subsidiary itself can afford the only basis for the acceptance of its bond issues.”

- p.228 -

Security Analysis Chapters 18 & 19 - Protective Covenants And Remedies Of Senior Security Holders

“Receivership is a dreaded word in Wall Street; its advent means ordinarily a drastic shrinkage in the price of all the company’s securities, including the bonds for the ‘benefit’ of which the receivership was instituted.”

- p.230 -

“The success of a bond investment depends primarily upon the success of the enterprise and only to a very secondary degree upon the terms of the indenture.”

- p.252 -

Security Analysis Chapter 21 - Supervision Of Investment Holdings

“The disadvantages of ignorance, of human greed, of mob psychology, of trading costs, of weighting of the dice by insiders and manipulators, will in the aggregate far overbalance the purely theoretical superiority of speculation in that it offers profit possibilities in return for the assumption of risk.”

- p.255 -

“The owner’s natural reluctance to accept a large loss is reinforced by the reasonable belief that he would be selling the issue at an unduly low price, and he is likely to find himself compelled almost unavoidably to assume a speculative position with respect to that security.”

- p.257 -

“The degree of safety enjoyed by the issue, as shown by quantitative measures, must be so far in excess of the minimum standards that a a large shrinkage can be suffered before its position need be called into question. Such a policy should reduce to a very small figure the proportion of holdings about which the investor will subsequently find himself in doubt. It would also permit him to make his exchanges when the showing of the issue is still comparatively strong and while, therefore, there is a better chance that the market price will have been maintained.”

- p.257 -

“The investor should not be stampeded into selling out holdings with a strong past record because of a current decline in earnings.”

- p.258 -

“The investor should not be his own sole consultant unless he has training and experience sufficient to qualify him to advise others professionally. In most cases he should at least supplement his own judgement by conference with others.”

- p.259 -

This Concludes Part II Of VII.

Security Analysis

Security Analysis: Sixth Edition, Foreword by Warren Buffett (Security Analysis Prior Editions) by Benjamin Graham

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