Benjamin Graham and David Dodd’s Security Analysis, which is widely regarded as the bible of value investing, was published in 1940. There is a consensus among contemporary practitioners that, while the examples given in the book are somewhat dated, the lessons conveyed are timeless. In the foreword to the sixth edition, Warren Buffett stated the following: “[Graham and Dodd] laid out a roadmap for investing that I have now been following for 57 years. There’s been no reason to look for another.” If this testimonial from the world’s greatest investor does not impress the excellence of this book on aspiring value investors, nothing will. In a series of articles, I will attempt to convey what I perceive to be the central tenets of each chapter in Security Analysis in the hope that readers will be inspired to explore the book themselves and not rely on my subjective interpretation.
Applying the scientific method to a pseudo-scientific field
The scientific method involves several steps. First, a theory is proposed, from which testable hypotheses are derived. Second, the hypotheses are tested. Third, conclusions are reached through careful analysis of the results, and the theory is either falsified or supported. It should be no surprise that the scientific method is best suited to scientific fields such as biology, physics, or chemistry. However, Graham & Dodd sought to apply it to the field of security (stock or bond) analysis, which is part science, part art. This inherent limitation may detract from the usefulness of an analytical process in reaching dependable conclusions, but it does not mean that analysis is useless. Rather, as in the professions of law and medicine, it is assumed to be essential but not all-encompassing, since other subjective assessments are still necessary.
“Analysis connotes the careful study of available facts with the attempt to draw conclusions therefrom based on established principles and sound logic. It is part of the scientific method. But in applying analysis to the field of securities we encounter the serious obstacle that investment is by nature not an exact science. The same is true, however, of 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 the same should probably be true in the field of investment and possibly in that of speculation.”Graham & Dodd, Security Analysis
The distinction between market value and intrinsic value
Market value can be observed in the form of the market quotation of a stock. In contrast, intrinsic value must be subjectively determined by an analyst. It is defined by Graham & Dodd as the value which is “justified by the facts, e.g., the assets, earnings, dividends, definite prospects, as distinct, let us say, from market quotations established by artificial manipulation or distorted by psychological excesses.” A central tenet of Security Analysis is that a significant divergence between market and intrinsic value of at least 1/3 and ideally 1/2 in either direction presents an opportunity for investors. To elaborate, if intrinsic value substantially exceeds market value, the stock or bond could be purchased at a discount (i.e., with a margin of safety) since it is undervalued – the potential upside is relatively larger than the downside. Vice-versa, if the market value exceeds intrinsic value significantly, the security could be shorted. Graham & Dodd’s theory is based on two assumptions. First, that the market value is “frequently out of line with the true [intrinsic] value” and second, that there exists “an inherent tendency for these disparities to correct themselves“. In other words, value investing assumes that the market is an inefficient, unreasonable voting machine in the short-term, and a rational, efficient weighing machine that reflects intrinsic values in the long-term.
The hazards of assuming intrinsic and market value will converge
“Undervaluations caused by neglect or prejudice may persist for an inconveniently long time, and the same applies to inflated prices caused by over enthusiasm or artificial stimulants.” With this, Graham and Dodd warn that, while market rationality and appropriate pricing should be assumed in the long-term as a general rule, the correction of mispricings may either take longer than expected or never manifest at all. The reason relates to human psychology. Undervalued companies are undesirable and avoided by the masses whilst glamour firms entice excessive optimism and speculation. Throughout this period of patient waiting, the intrinsic value as calculated by the analyst may change considerably, such that the initial reasoning for the investment is no longer applicable. An analyst should seek to protect himself from this scenario by investing exclusively in stable companies, favouring popular firms where changes in prospects will be accompanied by a swift market response, focussing on value firms when the market is fairly valued, and proceeding with caution in times of extreme volatility.
Calculating intrinsic value
The puzzle is how to determine intrinsic value. Before we delve into this, let us briefly consider the attractiveness of Wright Aeronautical Corporation – an example given in the book – at two different prices. At $8 per share, the firm is undeniably attractive:
“In 1922, prior to the boom in aviation securities, Wright Aeronautical Corporation stock was selling on the New York Stock Exchange at only $8, although it was paying a $1 dividend, had for some time been earning over $2 a share, and showed more than $8 per share in cash assets in the treasury. In this case analysis would have led to the recommendation of this issue as a strongly entrenched and attractively priced investment.”Ibid
At another price, specifically $280, the investment is decidedly unattractive;
“consider the same issue in 1928 when it had advanced to $280 per share. It was then earning at the rate of $8 per share, as against $3.77 in 1927. The dividend rate was $2; the net-asset value [total assets minus total liabilities] was less than $50 per share. A study of this picture must have shown conclusively that the market price represented for the most part the capitalisation [pricing in] of entirely conjectural future prospects – in other words, that the intrinsic value was far less than the market quotation.”Ibid
Even without knowing how to calculate intrinsic value, we can see that we are getting a far better deal in the first scenario than in the second. No matter the quality of a company, the price is the deciding factor.
To continue, the authors state that, although book value (assets minus liabilities) was initially perceived as an appropriate proxy for intrinsic value, it “proved almost worthless as a practical matter because neither the average earnings nor the average market price evinced [demonstrated] any tendency to be governed by the book value”. Moreover, even if there had been a close relationship between book value and the earnings and market price of a firm, the measure would have excluded the earnings of a firm entirely, which are obviously a substantial component of intrinsic value. Analysts at the time gravitated towards the other extreme, and swapped book value as an indicator of intrinsic worth for a calculation of earnings power. Customarily, this would involve a simple multiplication of the average historical earnings per-share of a firm by ten, to reflect ten years worth of future earnings – the outcome was assumed to be the intrinsic value.
An obvious problem with this approach is that, in the case of firms with unstable, fluctuating earnings, the average would be unrepresentative of typical business conditions. View the table below, which gives the hypothetical earnings per-share of a firm with such characteristics.
Can we assume that the firm in question will earn an average of $9.50 per-share in the future? Absolutely not. The reason is that the individual figures making up the average vary widely, from a $17.40 loss to a $26.90 gain. An intrinsic value derived from this average must therefore be considered “equally accidental or artificial“.
Intrinsic value is a flexible concept
Since a vast number of firms are subject to cyclical fluctuations in their earnings, we are fortunate that intrinsic value incorporates an element of flexibility. The analyst does not need to figure out the exact intrinsic value of an investment – it is sufficient to establish an approximate range of possible values. Naturally, this range would “grow wider as the uncertainty of the picture increased“, but if the price is high or low enough, a reliable judgement could still be made. For instance, in the case of the hypothetical firm with unreliable earnings described in the above table, the intrinsic value may lie somewhere between $30 to $130 – an extremely wide range – but a price of $10 or $180 would make the investor’s decision simple enough.
“security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish either that the value is adequate – e.g., to protect a bond or to justify a stock purchase – or else that the value is considerably higher or lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient. To use a homely simile, it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age or that a man is heavier than he should be without knowing his exact weight.”Ibid
Three obstacles in the path of an analyst’s success
- Incorrectness of the data. Concealment of undesirable financial elements by means of accounting gimmicks is more common than blatant misstatement. Regulatory bodies such as the SEC have succeeded in reducing these, but the analyst should still remain vigilant and strive to identify them. Some are bound to slip by and will cause an imprecise assessment of intrinsic value and thus a poor investment.
- Future uncertainty. Even a “conclusion warranted by the facts and by the apparent prospects [regarding a firm] may be vitiated [upset] by future developments.” Nonetheless, investors are forced to rely on the past record of a firm as a rough indication of its prospects.
- The irrational behaviour of the market. According to Graham & Dodd, the market and the future present the same type of difficulties: “Neither can be predicted, or controlled by the analyst, yet his success is largely dependent on them both.” An analyst’s judgement is only vindicated if the market value of a firm eventually reflects its intrinsic value, hence why he is dependent on the rational decision-making of other market participants.
Security analysis has three functions
- The descriptive function. This function involves the “marshalling [of] the important facts relating to an issue [a stock or bond] and presenting them in a coherent, readily intelligible manner“. In Graham’s time, this involved the procurement and analysis of statistical manuals. In modern times, the process is far easier – platforms such as TradingView allow us to screen for stocks that match certain criteria and extract their financials. Besides the gathering of quantitative data, qualitative factors should also be considered, such as the strengths and weaknesses of a security relative to others and any other elements that may influence its future performance.
- The selective function. An analyst should judge whether a stock should be purchased, sold, or passed over for another, based primarily on his assessment of intrinsic value and its relation to market price.
- The critical function. This point in the chapter is quite unclear, since we would assume that the above two functions comprise the critical function. Essentially, Graham & Dodd state that an analyst should concern himself with the “soundness and practicability of the standards of [stock] selection” and ensure that a stock is adequately protected i.e., that a margin of safety exists in the form of the stock trading at a significant discount to intrinsic value. Corporate policies affecting the owner, such as buybacks, capital structure, managerial compensation, and expansion plans should also be considered.
Analysis and speculation
Graham and Dodd also comment on whether the analytical process can increase the odds of success in a speculative operation, which is defined as the conscious onboarding of risk, in contrast to the expected safety of an investment. The authors refute this assumption on the basis that the speculator faces several disadvantages relative to the investor, namely:
- Commissions (transaction costs), interest charges, bid-ask spreads.
- The tendency of the average speculative loss to exceed the average profit.
- The analytical factors underlying speculation are at risk of sudden change.
- The outcome of a speculative bet depends more on unknown factors than an investment does, and these are likely familiar only to the insiders, which “loads the dice against the analyst”.
- The value of analysis decreases as the element of chance increases: “[in regard to speculation] it is as though the analyst and Dame Fortune were playing a duet on the speculative piano, with the fickle goddess calling all the tunes.”
“Even if we grant that analysis can give the speculator a mathematical advantage, it does not assure him a profit. His ventures remain hazardous; in any individual case a loss may be taken; and after the operation is concluded, it is difficult to determine whether the analyst’s contribution has been a benefit or a detriment.”Ibid
Reading Security Analysis is undoubtedly a prerequisite for serious value investors. There’s something refreshing and assuring about reading the masterwork yourself and not through the lens of another writer. You can purchase the book through my Amazon affiliate link. Stay tuned for the second chapter!