Value Investing

What is Investment Analysis?

“The public buys issues which are sold to it, and the sales effort is put forward to benefit the seller and not the buyer.”

Benjamin Grahamand David Dodd (Security Analysis, 1934)

Get The Full Series in PDF

Get the entire 10-part series on Charlie Munger in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues.


Don’t have time to read the full article? Download and Listen to the Audio Instead – here


Question.

Seth Klarman: Don’t Give Up On Value Ben Graham Is Still Relevant

Value Investors Must Read List - Papers From The Top .

If admitting future events to be uncertain, could the favourable and unfavourable developments be counted on to cancel out against each other, more or less, so that the initial advantage afforded by sound analysis will carry through into an eventual average profit?

 

Article Key Ideas

  • Investment Vs. Speculation aka Technical Analysis
  • Critical Function of Stock Analysis
  • Qualitative and Quantitative Factors involved in Investment Analysis

 

When Benjamin Graham and David Dodd released the first edition of Security Analysis in 1934, most analysts, working in Wall Street firms, were more interested in the prevailing trend of a stock price (in the form of stock price pattern), to determine whether it’s a good time to buy or sell a stock. (Source: Joe Carlen – The Einstein of Money)

Whereas, Graham and Dodd were more interested in the true underlying value of the stocks and bonds, as determined by their own analysis. Analysis that involves analyzing the underlying business (the assets, liabilities, income, and expenses etc.)

Today, there is almost an endless amount of second-hand investment analysis available across the internet sphere, and as Charles Brandes has written in the 2004 edition of Value Investing Today, “Be wary of adopting others’ optimistic views on particular companies even if they are professional analysts.”

Brandes was originally referring mostly to Wall Street buy-side analysts, but it equally applies to stock promoters, like the Motley Fool, whose income relies upon the public believing they have a crystal ball telling them of the next 10 bagger stock. As Brandes continued, “analysts have, on average, predicted an earnings growth rate nearly three times the actual rate.”

Joe Carlen who is author of the book The Einstein of Money, wrote the following, “An extensive Journal of Finance study published in 2003 (in the wake of various dot-com analyst coverage controversies) concluded that the brokerage houses that employ many of these allegedly independent professional analysts tend to prefer “relatively optimistic analysts presumably because they help promote stocks and hence generate investment banking business and trading commissions.” The Motley Fool was apparently caught up in this mess, promoting highly speculative tech stocks.

And Carlen further added, “However even in instances where analysts appear to be completely independent, it is likely that the publication or program that communicates their views relies on advertising dollars from brokerage firms and other entities that, in general terms would prefer that people buy as many securities as possible.”

 

Investment Vs Speculation

“Stocks are simply the conduit through which we own a company’s assets. When we invest our capital into a company’s stock, we enter into its particular business. [Hence] Analyzing a stock involves an analysis of the business.”

Benjamin Graham and David Dodd

 

Graham and Dodd taught investors who read their book Security Analysis, that the most fundamental concept of investment in common stocks is to view buying common stocks as taking a share in a business.

Graham and Dodd wrote, “The typical common-stock investor was a businessman [before World War 1], and it seemed sensible to him to value any corporate enterprise in much the same manner as he would value his own business. This meant that he gave at least as much attention to the asset values behind the shares as he did to their earnings records.”

This seems logical right?

The Story Of Benjamin Graham And Security Analysis

The share price of a stock is ultimately determined by underlying asset values and the earning power of those assets.

Bruce Greenwald wrote the introduction to part VI of the sixth edition of Security Analysis, and he opened with this:

“The enduring value of Security Analysis rests on the certain critical ideas developed by Graham and Dodd that were then, and remain, fundamental to any well-conceived investment strategy. The first of these is the distinction between “investment” and “speculation” as defined by Graham and Dodd:

An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.

The critical parts of this definition are “thorough analysis” and “safety of principal and a satisfactory return.” Nothing about these requirements has changed since 1934.”

So, 84 years ago, Graham and Dodd clearly defined the difference between investing and speculating. This is why technical analysis, the practice of being more interested in the prevailing trend of a stock price, which completely ignores the underlying business linked to the share price, is pure speculation.

It is built upon the assumption that an investor can make money predicting the movement of share prices based upon the merging pattern an individual stock makes.

There is no real analysis in technical analysis, for analysis implies the careful, thoughtful study of available facts with the attempt to draw sound conclusions therefrom based on established principles and sound logic. There are fund managers who mixed investment analysis with technical analysis, and if you were my brother or sister I would give this advice, don’t give them a single cent to invest on your behalf.

Are There Any Benjamin Graham Stocks Left In Today's Market?

Investment Analysis

How does one conduct an investment analysis on a stock?

Graham and Dodd acknowledged that investment analysis is not an exact science, which is true to Law and Medicine, for here also both individual skill (art) and chance are important factors in determining success or failure.

“Nevertheless, in these professions analysis is not only useful but indispensable, so that the same should be true in the field of investment and possibly in that of speculation.” Graham and Dodd

Analysing a business could be carried out to an unlimited degree of detail, so we need to apply practical judgement to determine the lengths an analyst goes to.

When the first and second edition of Security Analysis was written, in the 1930s, an investor didn’t have a lot of information to go on. There were the company reports that only included the Balance sheet and income statement (no cash flow statement), there were trade publications and government data too.

Compared to today, the investor is swimming in information. Keep in mind that more information is not better, as we need to separate the valuable information from the noise. And if you don’t know if a piece of information is valuable or noise, you’re in trouble.

When a business banker is considering a loan application by a small to medium size business, for instance, the banker will only assess the relevant information that may impact the repayment of the loan. They’ll assess the business cash flows, assessing the solvency of the business (liquidity ratios) and assess the asset being used as collateral. But the banker wouldn’t feel the need to go further and assess the clientele of the business or assess the level employee competency.

The problem with having more information is that it magnifies our confidence about an investment’s potential overlooking its potential risks, which has been proven by the psychologists Daniel Kahneman, Paul Slovic and Amos Tversky in a study titled Judgement under uncertainty: Heuristics and biases.

Benjamin Graham On Investment vs Speculation

What we need to do as investors, is learn to filter information and limit our analysis to the relevant information. But we will not know if the information is relevant and valuable until we first grasp the first principles of investing.

Qualitative vs. Quantitative Elements in Analysis

Quantitative elements include the businesses numerical data, found in:

  • The cash flow statement
  • The balance sheet
  • The income statement
  • The equity statement

The qualitative elements deal with such matters as:

  • The nature of the business
  • The relative position of the individual company in the industry;
  • The nature of the industry
  • The character of management

Graham and Dodd added that the quantitative factors lend themselves better to thoroughgoing analysis than do qualitative factors, and financial results will themselves epitomize many of the qualitative elements, so that a detailed study of the later may not add much of importance to the picture.

The qualitative elements are more difficult to appraise and be summed up neatly in an excel spreadsheet. Your personality type will be a factor in determining how much weight you place on either qualitative or quantitative data, which I learnt from Dr Jordan Peterson YouTube lectures.

Also broadly, the quantitative data is more rear-view mirror looking, as it represents the past transactions of the business, where qualitative analysis involves a more present and future looking.

Graham and Dodd advocated a heavy reliance on the quantitative factors over the qualitative factors, this may be due to their experiences investing during the great depression era. Which caused Graham, in particular, to be overly concerned with protecting his own capital.

Alice Schroeder recalls in her book titled The Snowball: Warren Buffett and the Business of Life, how Henry Brandt, who had been doing research for Buffett and whose job was to find scuttlebutt’s lead to Buffett famous investment in American Express.

Scuttlebutts is a term used by Phil Fisher, who said qualitative factors like the ability to maintain sales growth, good management, and research and development characterized a good investment.

Charlie Munger understood that Graham’s methods were too pessimistic, and he preferred the qualitative qualities of the great businesses over the quantitative qualities of poor companies selling cheap.

“Fisher’s proof that these factors could be used to assess a stock’s long-term potential was beginning to creep into Buffett’s thinking, and would eventually influence his way of doing business.” Alice Schroeder

Schroeder went on to observe that:

Benjamin Graham GEICO Buy Was Just A Simple Value Play

“Warren had ventured far from the worldview of his mentor, Ben Graham. The hard-nosed “quantitative” approach espoused by Graham was the world of the speed handicapper, of the cigar-butt stooper who worked from pure statistics. Come to work in the morning, flip through the Moody’s Manual or the Standard & Poor’s weekly report, look for cheap stocks based on a handful of numbers, call Tom Knapp at Tweedy, Brown & Knapp and buy them, go home when the market closed, and sleep well at night. As Buffett said of this, his favorite approach, “The more sure money tends to be made on the obvious quantitative decisions.” But the method had a couple of drawbacks. The number of statistical bargains had shrunk to virtually nil, and since cigar butts tended to be small companies, it did not work when large sums of money were involved.

While still working this approach, Buffett had had what he would later call a “high-probability insight” about American Express that confounded Ben Graham’s core idea. Unlike other companies whose value came from cash, equipment, real estate, and other assets that could be calculated and if necessary liquidated, American Express had little more than its customers’ goodwill…this method of the handicapper, of Phil Fisher, and it involved qualitative, as opposed to quantitative, assessments.

Buffett would later write to his partners that buying “the right company (with the right prospects, inherent industry conditions, management, etc.)” means “the price will take care of itself…This is what causes the cash register to really sing. However, it is an infrequent occurrence, as insights usually are, of course, no insight is required on the quantitative side-the figures should hit you over the head with a baseball bat. So the really big money tends to be made by investors who are right on the qualitative decisions.”

This new emphasis on a qualitative approach paid off in the stupendous results Buffett was able to announce to his partners at the end of 1965.”

You could be forgiven for thinking that the quantitative factors, the company’s assets, liabilities, expenses and income figures, are not relevant anymore, but both quantitative and qualitative elements are tied at the hip.

The return on investment ratio is used to identify a company’s competitive advantages, which involves both quantitative and qualitative elements.

An investor needs to know what return the company earns on their assets, and the amount the company needs to reinvest into plant, property and equipment to maintain sales revenues and the amount needed to grow sales revenues.

Graham and Dodd’s cigar-butt approach to investing focused solely on the quantitative value of the assets, and he was willing to purchase stock in a business that was selling well below the book value of the business. They weren’t concerned so much with the qualitative factors that increased the value of businesses over time, which Phil Fisher had identified. Phil Fisher gave the qualitative factors much more weight when deciding to purchase a stock, which Buffett learnt from his experience from American Express.

It is important to understand that both quantitative and qualitative elements play an important role in assessing a company. Your own investment analysis of the company will determine the weight placed upon each element.

Later in the series we will explore the different underlying economics of production-based businesses and knowledge-based businesses.

Benjamin Graham: Buying Good Stocks At Fair Prices

I’ll end with a Robert Hagstrom quote.

 “How we think about investing ultimately determines how we do it.”