Boganmeldelse af Benjamin Graham og David Dodds "Security Analysis"

Book Summary

Security Analysis: Principles and Techniques

June 18, 2017

This post is also available in: Dansk

Abstract

  • The objective of security analysis is to 1) present important facts regarding a stock or bond in a fashion that is both informing and useful for a potential owner; and 2) to reach reliable conclusions based on facts and standards concerning a security’s safety and attractiveness relative to the current price range.
  • Graham and Dodd define investing as such: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
  • There are two types of investors: 1) the defensive, and 2) the enterprising. The former’s portfolio consists of a diversified list of leading stocks bought at a reasonable price. The enterprising investor has a clear understanding of market value vs. intrinsic value, which is why this type of investor is able to analyse individual stocks in an attempt to uncover and cash-in on deviations between price and value.
  • There are two types of factors that go into an analysis of a security: 1) quantitative, and 2) qualitative. Capital structure, earnings power, divind payments and operational efficiency should be included in the former domain. The qualitative domain is more ‘fluffy’; it covers the company’s ‘nature’, market position(s), an assessment of the management team etc. Quantitative data is only useful if it’s supported by a qualitative analysis.
  • Earnings power is the most pivotal term in the book. The authors stress the importance of assessing a company’s true future earnings based on the the past earnings history (adjusted for one-time occurrences) as well as its exposure to e.g. cyclical swings.

Where should I begin? This 1,000 page monster of a book is regarded as a religious scripture to value investors, just like Benjamin Graham’s other masterpiece, The Intelligent Investor. Many regard Security Analysis as the kickstart to the philosophy, we now know as value investing. Let’s get to it!

The hunt and the method
Part I of Security Analysis, “Survey and Approach”, is the book’s weight worth in gold. In chapter 1, Benjamin Graham and David Dodd teach us that the objective of security analysis should be to 1) present important facts regarding a stock or bond in a fashion that is both informing and useful for a potential owner; and 2) to reach reliable conclusions based on facts and standards concerning a security’s safety and attractiveness relative to the current price range.

In length of this fundamental insight comes their definition of investing, which should be seen as the antipole of investing’s dangerous cousin, speculation: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

The analyst must in other words embark on independent analyses based on logic, facts and healthy principles to determine if their is sufficient safety in e.g. a company’s balance sheet as well as assessing the company’s outlooks based on its earnings power and franchise value vis-a-vis the current price. Such does the investor ensures that he/she will not suffer a permanent loss of capital.

Are you the aggressive type?
What constitutes an “adequate return”? As mentioned, this is a subjective matter, as it depends on one’s risk appetite as well as the effort one wishes to dedicate to one’s portfolio. Ben and David divide investors into two groups: 1) the defensive, and 2) the enterprising (or aggressive).

The former’s portfolio should consist of bonds and a diversified list of leading stocks bought at a reasonable price. The authors argue that a 50-50 split between the two components is suitable for most. This investor should experience “reliable, but unspectacular return with minimal effort and capabilities.” This investor type builds his/her wealth not by frequent buying and selling of securities, but by owning and holding one’s securities in an attempt to benefit from their longterm capital gains and dividends.

The enterprising investor’s strategy is reserved for those who have a clear understanding of the difference between market value and intrinsic value, which is why one is able to apply the margin of safety principle (read Margin of Safety) to determine whether a buy or sell decision should be made.

In essence, the defensive investor focuses on acquiring stakes in index fonds when the markets seem cheap based on historical levels. The enterprising investor ventures into analyses of individual stocks to determine whether or not a deviation between price and value is present.

Quantitative and qualitative factors in security analysis
Ben and David explains that there are two domains of factors that should go into the analysis of a security: 1) quantitative, and 2) qualitative.

The former concerns a company’s capital structure, earnings power, dividend history, its division of assets and liabilities as well as operational efficiency (profit margins, return on capital etc.).

The qualitative factors are more ‘fluffy’. These include  the business’ ‘nature’, its market position(s), industry-specific concerns (e.g. cyclicality, political concerns etc.), operational characteristics, an assessment of the management, etc.

In chapter 37, Ben reminds us that quantitative data is only useful in conjunction with a qualitative analysis of the business. One of the recurring themes in the book is stability. The authors suggest one asks oneself whether the combination of quantitative and qualitative factors ensures a predictable and safe future for the business. This point is alfa omega: Based on one’s analysis, can one expect that the company in the years ahead, regardless of cycle swings and crises, can maintain stability in its earnings power?

The good ol’ days
Following a ton of chapters regarding bond analysis, the reader arrives at part IV, which concerns stock analysis. Ben and David starts out by comparing investors’ mentality before the war vs. after.

Before the war, investors in the public markets were mainly business men. These professionals regarded a stock investment with the same care and dedication as if he/she were to acquire the entire company. Such a careful, prudent and conservative guy or gal would start-off by reviewing what the real value of the company’s books is. In other words, what is the ‘true’ value of the company’s balance sheet (e.g. by writing down ‘overvalued’ assets). Then, the prudent investor would consider whether the gap between true book value and the price was justifiable based on the company’s future prospects, brand value, stakeholder relations etc. Put differently, is the ‘premium’ – the gap between the company’s liquidation value and market price – worth paying up for?

After the war, a mentality changed occurred. Ben and David dubbed this “the new era”. Investors now focused exclusively on earnings trends – nothing else. One disregarded companies’ dividend history, asset values and true earnings power (note the difference between earnings trends and earnings power). One based buying decisions solely on whether or not one believed a company’s earnings would surprise positively next quarter or year.

In my view, it’s obvious which paradigm dominates the modern world of finance. A lot of stocks are traded ever-higher solely on high expectations for the future – just take a look at Amazon’s P/E of +200, Tesla and Netflix. There’s no way a conservative valuation of any of these companies could justify their market prices. Ben and David, of course, recommends one stick with the “pre war” mindset – that of the business man.

The importance of earnings power
As touched upon in the previous section, the authors underscore the importance of stable earnings power throughout the book. All of part V (chapters 31-41) focuses on this aspect. The most important questions to settle are 1) whether the company can showcase a healthy earnings history through cycles and crises, a) and whether this can be expected to continue going forward. The authors recommend you dive into the past 5-10 years’ earnings and adjust for one-time income streams, costs and write-downs. If a stable, true earnings history is uncovered, you should venture into a quantitative and qualitative analysis of the true earnings power. You should then multiply this number with a suitable capitalization multiplier. Ben recommends applying a 8.5 multiplier for a zero growth business, and a maximum of 20 for the unstoppable growth rocket. If the true earnings power is estimated to be $10, and you find that 15 is a suitable multiplier based on the company’s growth prospects, the intrinsic value is $150. 

I could go on and on reviewing this book. It is a true masterpiece. The above is but a microscopic extract. The book becomes extremely concrete in terms of analysing a business’ earnings power as well as guidelines to assess the balance sheet’s true value. There is also a sharp discussion on the factors that make price and value to deviate from one another. It’s truly packed with wisdom! A blessing to all value investors!

This post is also available in: Dansk

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