Wednesday, 27th January 2016

Security Analysis by Ben Graham

Written by George Traganidas Topics: Books, Stock Investing, Wealth Building

Security Analysis by Ben Graham

Ben Graham published the second edition of Security Analysis in 1940 and many investors still consider it one of the best investment books ever written. The book is about 800 pages long and by no means is an easy read. This has discouraged a lot of people from reading the book and learning from the “father of security analysis”. The book does a great job of laying out the investment philosophy of Ben Graham and how to think about investments and businesses. He outlines principles about investing in bonds, preferred shares, warrant and common stocks and uses a lot of examples from companies in that era to demonstrate his thinking.

Going through the whole book is a very laborious but rewarding experience. Even though some of the examples in the book are dated, because they refer to accounting standards and laws that were in place back then and have since changed, the underlying principles are still of great value. This post presents the basic points of Ben’s philosophy from the book. I have taken certain parts of the book that I believe provide valuable lessons and I post them here broken up by book section.

What you need to keep in mind is that Ben operated during the Great Depression in the USA and thus his thinking has been coloured by it. His main focus is on making sure that you do not lose any money and been very conservative. He does not aim to generate outsized returns, but mainly to preserve your capital and having it grow over time.

The summary of notes from the book is about 10 pages long themselves and can take a while to go through and digest. Even though this is well worth the time, if you are pressed on time I have highlighted in bold the most important points. If you are short on time you can just skim through it and only read the bold text.

SURVEY AND APPROACH

An investment is on operation that promises safety of principal and a satisfactory return.

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

Safety must be based on study and on standards.

Calculate a range of intrinsic value.

The more volatile a firm’s earnings, the more cautious one should be in estimating its future and the further back into its past one should look.

Earnings should cover many times the interest requirements – not only on the average but even at the time of severe depression.

Security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs to only establish either that the value is adequate (protect a bond or justify stock purchase) or else that the value is considerably higher or considerably lower than the market price. E.g. decide that a man is heavier than he should be without knowing his exact weight.

The analyst must proceed on the assumption that the past record affords at least a rough guide to the future. More useful assumption when applied to a business of inherently stable character and more useful when carried on under fairly normal general conditions than in the times of great uncertainty and radical change.

FIXED-INCOME INVESTMENTS

We suggest that securities be classified under the following headings:

  • Investment bonds and preferred stock
  • Speculative bonds and preferred stock
    • Convertibles, etc.
    • Low-grade senior notes
  • Common stock

Four principles for the selection of issues of the fixed-value type:

  • Safety is measured not by specific lien or other contractual rights, but by the ability of the issuer to meet all of its obligations
  • The ability should be measured under conditions of depression rather than prosperity
  • Deficient safety cannot be compensated by an abnormally high coupon rate
  • The selection of all bonds for investment should be subject to rules of exclusion and to specific quantitative tests corresponding to those prescribed by stature to govern investments of saving banks.

If any obligation of an enterprise deserves to qualify as a fixed-value investment, then all its obligations must do so. Stated conversely, if a company’s junior bonds are not safe, its first-mortgage bonds are not a desirable fixed-value investment.

A prudent and intelligent investor should be able to avoid the temptation of (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) and reconcile himself to accepting an unattractive yield from the best bonds, in preference to risking his principal in second-grade issues for the sake of a large coupon return.

Bonds should be bought on the basis of their ability to withstand depression.

Companies must have dominant size and substantial margin of earnings over bond interest. Also, smaller proportion of debt to going-concern value.

Bond security prices and yields are not determined by any exact mathematical calculation of the expected risk, but they depend rather upon the popularity of the issue. (Investors view of risk involved, degree of familiarity of the public with the company and the issue and the ease with which the bond can be sold)

Acknowledged risks of losing principal should not be offset merely by a high coupon rate, but be accepted only in return for a corresponding opportunity for enhancement of principal. While there may be no real mathematical difference between offsetting risks of loss by a higher income or by chance of profit, the psychological difference is very important.

It would be sounder procedure to start with a minimum standard of safety, which all bonds must be required to meet in order to be eligible for further consideration. Issues failing to meet these minimum requirements should be automatically disqualified as straight investments, regardless of the high yield, attractive prospects, or other grounds for partiality. Having this delimited the field of eligible investments, the buyer may then apply such further selective processes as he deems appropriate. He may desire elements of safety far beyond the accepted minima, in which case he must ordinarily make some sacrifice of yield. He may also indulge his preferences as to the nature of the business and the character of the management. But, essentially, 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.

We are convinced that a substantial margin of going-concern value over funded debt is not only important but even vitally necessary to assure the soundness of a fixed-value investment. Before paying standard prices for bonds of any enterprise, whether it be a railroad, a telephone company, or a department store, the investor must be convinced that the business is worth a great deal more than it owes. In this respect the bond buyer must take the same attitude as the lender of money on a house or a diamond ring, with the important difference that it is the value of the business as an entity which the investor must usually consider, and not that of the separate assets.

We advert once more to our controlling principle that bond investment is a negative art.

In examining the current-asset situation an industrial bond buyer should satisfy himself on the counts, viz:

  • That the cash holding are ample.
  • That the ratio of current assets to current liabilities is a strong one.
  • That the working capital bears a suitable proportion to the funded debt.

It is not feasible to fix definite minimum requirements for any one of these three factors, especially since the normal working-capital situation varies widely with different types of enterprise. It is generally held that current assets should be at least double the current liabilities, and a smaller ratio would undoubtedly call for further investigation.

It is not sound procedure to purchase a preferred stock at an investment price (e.g. close to par) when the presence of a substantial risk to principal is recognised, but when the risk is expected to be offset by an attractive dividend return. It would follow from this principle that the only preferred stock which can properly be bought for investment would be one which in the purchaser’s opinion carries no appreciable risk of dividend suspension.

What must be the qualification of high-grade preferred stocks? In the first place, it must meet all the minimum requirements of a safe bond. In the second place, it must exceed these minimum requirements by a certain added margin to offset the discretionary feature in the payment of dividends; i.e. the margin of safety must be so large that the directors may always be expected to declare the dividend as a matter of course. Thirdly, the stipulation of inherent stability in the business itself must be more stringent than in the case of a bond investment, because a company subject to alterations between large profits and temporary losses is likely to suspend preferred dividends during the latter periods even though its average earnings may far exceed the annual requirements.

In order that a preferred stock may be thoroughly sound, the burden it imposes must be so light that the company may just as readily carry that burden in the form of a bond obligation. We are led therefore, to the final conclusion that not only are sound preferred stocks exceptional but in certain sense they must be called anomalies or mistakes, because they are preferred issues which should really be outstanding as bonds. Hence the preferred stock form lacks basic justification, from an investment standpoint, in that it does not offer mutual advantages to both the issuer and the owner.

One of the basic principles of investment is that the safety of a security with limited return must never rest primarily upon the future expansion of profits. If the investor is positive that this expansion will take place, he should obviously buy the common stock and participate in its profits. In, as must usually be the case, he cannot be so certain of future prosperity, then he should not expose his capital to a risk of loss (by buying the preferred stock) without compensating opportunities or enhancement.

An outstanding record for a long period in the past , plus strong evidence of inherent stability, plus the absence of any concrete reason to expect a substantial change for the worse in the future, afford the only sound basis available for the selection of a fixed-value investment.

SENIOR SECURITIES WITH SPECULATIVE FEATURES

When the price of his bond has passed out of the investment range, he must sell it; most important of all, he must not consider his judgement impugned if the bond subsequently rises to a much higher level. The market behaviour of the issues, once it has entered the speculative range, is no more the investor’s affair than the price gyrations of any speculative stock about which he knows nothing.

The value of a common stock is said to be diluted if there is an increase in the number of shares without a corresponding increase in assets and earning power.

THEORY OF COMMON STOCK INVESTMENT. THE DIVIDEND FACTOR

Common-stock analysis is of positive or scientific value only in the case of the exceptional common stock, and that for common stocks in general it must be regarded either as a somewhat questionable aid to speculative judgement or as a highly illusionary method of aiming at values that defy calculation and that must somehow be calculated none the less.

A natural classification of the elements entering into the valuation of a common stock would be under the three headings:

  • The dividend rate and record
  • Income-account factors (earning power)
  • Balance-sheet factors (asset value)

ANALYSIS OF THE INCOME ACCOUNT. THE EARNINGS FACTORS IN COMMON-STOCK VALUATION

Profits or losses from the sale of fixed assets should be excluded from the year’s result in order to gain an idea of the “indicated earning power” based on the assumed continuance of the business conditions existing then.

Profits realised by a business corporation from the sale of marketable securities are also of a special character and must be separated from the ordinary operating results.

At times a substantial profit is realised by corporations through the repurchase of their own senior securities at less than par value. The inclusion of such gains in current income is certainly a misleading practice, first, because they are obviously nonrecurring and, second, because this is at best a questionable sort of profit, since it is made at the expense of the company’s own security holders.

From the analyst’s standpoint, either profit or expense in such special transactions involving the company’s own securities should be regarded as nonrecurring and excluded from the operating results in studying a single year’s performance.

Inventory losses are directly related to the conduct of the business and are, therefore, by no means extraordinary in the general character.

It is customary to refer with great respect to the “bloodless verdict of the market place”, as though it represented invariably the composite judgement of countless shrewd, informed and calculating minds. Very frequently, however, these appraisals are valued on mob psychology, on faulty reasoning, and on the superficial examination of inadequate information.

Our example suggests also a further check upon the reliability of the published earnings statements, viz., by the amount of federal income tax accrued. The taxable profit can be calculated fairly readily from the income-tax accrual, and this profit compared in turn with the earnings reported to stockholders. The two figures should not necessarily be the same since the intricacies of the tax laws may give rise to a number of divergences. We do not suggest that any effort be made to reconcile the amounts absolutely but only that very wide differences be noted and made the subject to further inquiry.

When an enterprise pursues questionable accounting policies, all its securities must be shunned by the investor, no matter how safe or attractive some of them may appear.

You cannot make quantitative deduction to allow for an unscrupulous management; the only way to deal with such situations is to avoid them.

The analyst should adjust the reported earnings for the results of non-consolidated affiliates, if this has not already been done in the income account and if the amounts involved are significant. The criterion here is not the technical question of control but the importance of the holdings.

Subsidiary companies and consolidated reports:

  • In the first instance, subsidiary losses are to be deducted in every analysis.
  • If the amount involved is significant, the analyst should investigate whether or not the losses may be subject to early termination.
  • If the result of this examination is favourable, the analyst may consider all or part of the subsidiary’s loss as the equivalent of a nonrecurring item.

The concept of earning power has a definite and important place in investment theory. It combines a statement of actual earnings, shown over a period of years, with a reasonable expectation that these will be approximated in the future, unless extraordinary conditions supervene. The record must cover a number of years, first because a continued or repeated performance is always more impressive than a single occurrence and secondly because the average of a fairly long period will tend to absorb and equalise the distorting influences of the business cycle.

In order for a company’s business to be regarded as reasonably stable, it does not suffice that the past record should show stability. The nature of the undertaking, considered apart from any figures, must be such as to indicate an inherent permanence of earning power.

The favourable trend of Company’s A results must certainly be taken into account, but not by a mere automatic projection of the line of growth into the distant future. On the contrary, it must be remembered that the automatic or normal economic forces militate against the indefinite continuance of a given trend. Competition, regulation, the law of diminishing returns, etc., are powerful foes to unlimited expansion, and in smaller degree opposite elements may operate to check a continued decline. Hence instead of taking the maintenance of a favourable trend for granted – as the stock market is wont to do – the analyst must approach the matter with caution, seeking to determine the causes of the superior showing and to weigh the specific elements of strength in the company’s position against the general obstacles in the way of continued growth.

Attitude of analyst where the earning trend is upward. If such a qualitative study leads to a favourable verdict – as frequently it should – the analyst’s philosophy must still impel him to base his investment valuation on an assumed earning power no larger than the company has already achieved in a period of normal business. This is suggested because, in our opinion, investment values can be related only to demonstrated performance; so that neither expected increases nor even past results under conditions of abnormal business activity may be taken as a basis.

Attitude of analyst where the earning trend is downward. Where the trend has been definitely downward the analyst will assign great weight to this unfavourable factor. He will not assume that the downcurve must presently turn upward, nor can he accept that the past average – which is much higher than the current figure – as a normal index of future earnings. But he will be equally chary about hasty conclusions to the effect that the company’s outlook is hopeless, that its earnings are certain to disappear entirely and that the stock is therefore without merit or value. Here again a qualitative study of the company’s situation and prospects is essential to forming an opinion whether at some price, relatively low, of course, the issue may not be a bargain, despite its declining earnings trend. Once more we identify the viewpoint of the analyst with that of a sensible business man looking into the pros and cons of some privately owned enterprise.

A given stock is generally considered to be worth a certain number of times its current earning. This number of times, or multiplier, depends partly on the prevailing psychology and partly on the nature and record of the enterprise.

Exact Appraisal Impossible. Security analysis cannot presume to lay down general rules as to the “proper value” of any given stock. Practically speaking, there is no such thing. The bases of value are too shifting to admit any formulation that could claim to be even reasonable accurate. The whole idea of basing the value upon current earnings seems inherently absurd, since we know that the current earnings are constantly changing. And whether the multiplier should be ten or fifteen or thirty would seem at bottom a matter of purely arbitrary choice.

But the stock market itself has no time for such scientific scruples. It must make its values first and find its reasons afterwards. Its position is much like that of a jury in a breach-of-promise suit; there is no sound way of measuring the values involved, and yet they must be measured somehow and a verdict rendered. Hence the prices of common stocks are not carefully thought out computations but resultants of a welter of human reactions. The stock market is a voting machine rather than a weighing machine. It responds to factual data not directly but only as the affect the decisions of buyers and sellers.

We would suggest that about 20 times average earnings is as high a price as can be paid in an investment purchase of a common stock. Although this rule is of necessity arbitrary in its nature, it is not entirely so. Investment presupposed demonstrable value, and the typical common stock’s value can be demonstrated only by means of an established, i.e., an average, earning power. But it is difficult to see how average earnings of less than 5% upon the market price could ever be considered as vindicating that price. Clearly such a price-earnings ratio could not provide that margin of safety which we have associated with the investor’s position. It might be accepted by a purchaser in the expectation that future earnings will be larger than in the past. But in the original and most useful sense of the term such a basis of valuation is speculative. It falls outside the purview of common-stock investment.

Higher Prices May Prevail for Speculative Commitments. The intent of this distinction must be clearly understood. We do not imply that it is a mistake to pay more than 20 times average earnings for any common stock. We do suggest that such a price would be speculative. The purchase may easily turn out to be highly profitable, but in that case it will have proved a wise or fortunate speculation. It is proper to remark, moreover, that very few people are consistently wise or fortunate in their speculative operations. Hence, we may submit, as a corollary of no small practical importance, that people who habitually purchase common stocks at more than 20 times their average earnings are likely to lose considerable money in the long run. This is the more probable because, in the absence of such a mechanical check, they are prone to succumb recurrently to the lure of bull markets, which always find some specious argument to justify paying extravagant prices for common stocks.

Other Requisites for Common Stocks of Investment Grade and a Corollary Therefrom. It should be pointed out that if 20 times average earning is taken as the upper limit of price for an investment purchase, then ordinarily the price paid should be substantially less than this maximum. This suggests that about 12 or 12 ½ times average earnings may be suitable for the typical case of a company with neutral prospects. We must emphasize also that a reasonable ration of market price to average earnings is not the only requisite for a common-stock investment. It is necessary but not a sufficient condition. The company must be satisfactory also in its financial set-up and management, and not unsatisfactory in its prospects.

From this principle there follows another important corollary, viz.: An attractive common-stock investment is an attractive speculation. This is true because, if a common stock can meet the demand of a conservative investor that he get full value for his money plus not unsatisfactory future prospects, then such an issue must also have a fair chance of appreciating in market value.

Examples of Speculative and Investment Common Stocks. Our definition of an investment basis for common-stock purchases is at variance with the Wall Street practice in respect to common stocks of high rating. For such issues a price of considerably more than 20 times average earnings is held to be warranted, and furthermore these stocks are designated as “investment issue” regardless of the price at which they sell. According to our view, the high price paid for “the best common stocks” make these purchases essentially speculative, because they require future growth to justify them. Hence common-stock investment operations, as we define them, will occupy a middle ground in the market, lying between the low-price issues that are speculative because of doubtful quality and well-entrenched issues that are speculative, none the less, because of their high price.

Specific and quantitative tests of investment quality:

  • The earnings have been reasonably stable, allowing for the tremendous fluctuations in business conditions during the ten-year period.
  • The average earnings bear a satisfactory ratio to market price.
  • The financial set-up is sufficiently conservative, and the working capital position is strong.

The intrinsic value of a common stock preceded by convertible securities, or subject to dilution through the exercise of stock options or through participating privileges enjoyed by other security holders, cannot reasonably be appraised at a higher figure that would be justified if all such privileges were exercised in full.

The optimum capitalisation structure for any enterprise includes senior securities to the extent that they may safely be issued and bought for investment.

BALANCE-SHEET ANALYSIS. IMPLICAITONS OF ASSET VALUES

Five types of information and guidance that the investor may derive from a study of the balance sheet:

  • It shows how much capital is invested in the business.
  • It reveals the ease or stringency of the company’s financial condition i.e. the working-capital position.
  • It contains the details of the capitalisation structure.
  • It provides an important check upon the validity of the reported earnings.
  • It supplies the basis for analysing the sources of income.

The book value per share of a common stock is found by adding up all the tangible assets, subtracting all liabilities and stock issues ahead of the common and then dividing by the number of shares.

Financial reasoning vs. Business Reasoning. We have here the point that brings home more strikingly perhaps than any other the widened rift between financial thought and ordinary business thought. It is an almost unbelievable fact that Wall Street never asks, “How much is the business selling for?” Yet this should be the first question in considering a stock purchase. If a business man were offered a 5% interest in some concern for $10,000, his first mental process would be to multiply the asked price by 20 and thus establish a proposed value of $200,000 for the entire undertaking. The last of his calculation would turn about the question whether or not the business was a “good buy” at $200,000.

The book value deserves at least a fleeting glance by the public before it buys or sells shares in a business undertaking. In any particular case the message that the book value conveys may well prove to be inconsequential and unworthy of attention. But this testimony should be examined before it is rejected. Let the stock buyer, if he lays any claim to intelligence, at least be able to tell himself, first, what value he is actually setting on the business and, second, what he is actually getting for his money on terms of tangible resources.

There are indeed certain presumptions in favour of purchases made far below asset value and against those made at a high premium above it. (It is assumed than in the ordinary case the book figures may be accepted as roughly indicative of the actual cash invested in the enterprise.) A business that sells at a premium does so because it earns a large return upon its capital; this large return attracts competition, and, generally speaking, it is not likely to continue indefinitely. Conversely in the case of a business selling at a large discount because of abnormally low earnings. The absence of new competition, the withdrawal of old competition from the field, and other natural economic forces may tend eventually to improve the situation and restore a normal rate of profit on the investment.

Although this is orthodox economic theory, and undoubtedly valid in a broad sense, we doubt if it applies with sufficient certainty and celerity to make it useful as a governing factor in common-stock selection. It may be pointed out that under modern conditions the so-called “intangibles”, e.g., good-will or even a highly efficient organisation, are every whit as real from the dollar-and-cents standpoint as are buildings and machinery. Earning based on these intangibles may be even less vulnerable to competition than those which require only a cash investment in productive facilities. Furthermore, when conditions are favourable the enterprise with relatively small capital investment is likely to show a more rapid rate of growth. Ordinarily it can expand its sales and profits at slight expense and therefore more rapidly and profitably for its stockholders than a business requiring a large plant investment per dollar of sales.
We do not think, therefore, than any rules may reasonably be laid down on the subject of book value in relation to market price, except the strong recommendation already made that the purchaser know what he is doing on this score and be satisfied in his own mind that he is acting sensibly.

The first rule in calculating liquidation value is that the liabilities are real but the value of the assets must be questioned. This means that all true liabilities shown on the books must be deduced at their face amount. The value to be ascribed to the assets, however, will vary according to their character.

We pointed out that a bond or preferred stock could not be worth more than its value would be if it represented full ownership of the company, i.e., if it were a common stock without senior claims ahead of it. The converse is also true. A common stock cannot be less safe than it would be if it were a bond, i.e., if instead of representing full ownership of the company it were given a fixed and limited claim, with some new common stock created to own what was left.

The choice of a common stock is a single act; its ownership is a continuing process. Certainly there is just as much reason to exercise care and judgement in being as in becoming a stockholder.

Careful buyers of securities scrutinise the balance sheet to see if the case is adequate, if the current assets bear a suitable ratio to the current liabilities, and if there is any indebtedness of near maturity that may threaten to develop into a refinancing problem.

Working Capital ratio. We are unable to suggest a better figure than the old 2-to-1 criterion to use as a define quantitative test of a sufficiently comfortable financial position.

“Acid test”, which requires that current assets exclusive of inventories be at least equal to current liabilities.

Ordinary the investor might well expect of a company that it meet both the 2-to-1 test and the acid test.

As in all arbitrary rules of this kind, exceptions must be allowed if justified by special circumstances.

ADDITIONAL ASPECTS OF SECURITY ANALYSIS. DISREPANCIES BETWEEN PRICE AND VALUE

The analyst must beware of trying to draw conclusions as to the relative attractiveness of two railroad stocks when one is speculatively and the other conservatively capitalised.

As a general rule, the less homogeneous the group the more attention must be paid to the qualitative factors in making comparisons.

More General Limitations on the Value of Comparative Analysis. It may be well once again to caution the student against being deluded by the mathematical exactitude of his comparative tables into believing that their indicated conclusions are equally exact. We have mentioned the need to considering qualitative factors and of allowing for lack of homogeneity. But beyond these points lie all the various obstacles to the success of the analyst that we presented in some detail in our first chapter. The technique of comparative analysis may lessen some of the hazards of his work, but it can never exempt him from the vicissitudes of the future or the stubbornness of the stock market itself or the consequences of his own failure – often unavoidable – to learn all the important facts. He must expect to appear wrong often and to be wrong on occasion; but with intelligence and prudence his work should yield better over-all results than the guesses or the superficial judgements of the typical stock buyer.

Our exposition of technique of security analysis has included many different examples of overvaluation and undervaluation. Evidently the processes by which the securities market arrives at its appraisals are frequently illogical and erroneous. These processes, as we pointed out in our first chapter, are not automatic or mechanical but psychological. For they go on in the minds of people who buy or sell. The mistakes of the market are thus the mistakes of groups or masses of individuals. Most of them can be traced to one or more of three basic causes: exaggeration, oversimplification or neglect.

General Procedure of the Analyst. Since we have emphasized that analysis will lead to a positive conclusion only in the exceptional case, it follows than many securities must be examined before one is found that has real possibilities for the analyst. By what practical means does he proceed to make his discoveries? Mainly by hard and systematic work. There are two broad methods that he may follow. The first consists of a series of comparative analyses by industrial groups along the lines described in the previous chapter. Such studies will give him a fair idea of the standard or usual characteristics of each group and also point out those companies which deviate widely from the modal exhibit. If, for example, he discovers that a certain steel common stock has been earning about twice as much on its market price as the industry as a whole, he has a clue to work on – or rather a suggestion to be pursued by dint of thoroughgoing investigation of all the important qualitative and quantitative factors relating to the enterprise.

The second general method consists in scrutinising corporate reports as they make their appearance and relating their showing to the market price of their bonds or stocks.

We doubt that a better illustration can be found of the real nature of the stock market, which does not aim to evaluate businesses with any exactitude but rather to express its likes and dislikes, its hopes and fears, in the form of daily changing quotations. There is indeed enough sound sense and selective judgment in the market’s activities to create on most occasions some degree of correspondence between market price and ascertainable or intrinsic value. In particular, as we pointed out in Chap. 4, when we are dealing with something as elusive and nonmathematical as the evaluation of future prospects, we are generally led to accept the market’s verdict as better than anything that the analyst can arrive at. But, on enough occasions to keep the analyst busy, the emotions of the stock market carry it in either direction beyond the limits of sound judgement.

Wall Street becomes easily enthusiastic over mergers and just as ebullient over segregations, which are the exact opposites. Putting two and two together frequently produces five in the stock market, and this five may later be split up into three and three. Such inductive studies as have been made of the results following mergers seem to cast considerable doubt upon the efficacy of consolidation as an aid to earning power.

The exaggerated response made by the stock market to developments that seem relatively unimportant in themselves is readily explained in terms of the psychology of the speculator. He wants “action” first of all; and he is willing to contribute to this action if he can be given any pretext for bullish excitement. (Whether through hypocrisy or self-deception, brokerage-house customers generally refuse to admit they are merely gambling with ticker quotations and insist upon some ostensible “reason” for their purchase.) Stock dividends and other “favourable developments” of this character supply the desired pretexts, and they have been exploited by the professional market operators, sometimes with the connivance of the corporate officials. The whole thing would be childish if it were not so vicious. The securities analyst should understand how these absurdities of Wall Street come into being, but he would do well to avoid any form of contact with them.

Litigation. The tendency of Wall Street to go to extremes is illustrated in the opposite direction by its tremendous dislike of litigation. A lawsuit of any significance casts a damper on the securities affected, and the extent of decline may be out of all proportion to the merits of the case. Developments of this kind may offer real opportunities to the analyst, though of course they are of a specialised nature.

Forecasting security prices is not properly a part of security analysis.

In security analysis the prime stress is laid upon protection against untoward events. We obtain this protection by insisting upon margins of safety, or values well in excess of the price paid. The underlying idea is that even if the security turns out to be less attractive than it appeared, the commitment might still prove a satisfactory one. In market analysis there are no margins of safety; you are either right or wrong, and, if you are wrong, you lose money.

The cardinal rule of the market analyst that losses should be cut short and profits safeguarded (by selling when a decline commences) leads in the direction of active trading. This means in turn that the cost of buying and selling becomes a heavily adverse factor in aggregate results. Operations based on security analysis are ordinarily on the investment type and do not involve active trading.

When a stock is recommended for the reason that next year’s earnings are expected to show improvement, a twofold hazard is involved. First, the forecast of next year’s results may prove incorrect; second, even if correct, it may have been discounted or even overdiscounted in the current price.

We are sceptical of the ability of the analyst to forecast with a fair degree of success the market behaviour of individual issues over the near-term future – whether he base his predictions upon the technical position of the market or upon the general outlook for business or upon the specific outlook for the individual companies. More satisfactory results are to be obtained, in our opinion, by confining the positive conclusions of the analyst to the following fields of endeavour:

  • The selection of standard senior issues that meeting exacting tests of safety.
  • The discovery of senior issues that merit an investment rating but that also have opportunities of an appreciable enhancement in value.
  • The discovery of common stocks, or speculative issues, that appear to be selling at far less than their intrinsic value.
  • The determination of definite price discrepancies existing between related securities, which situations may justify making exchanges or initiating hedging or arbitrage operations.


This is one of the few investment books whose concepts and ideas have survived such a long time. The laws and the reporting standards might have changed since then but principles like looking at a stock as part ownership of a business, doing your own individual analysis based on facts and buying with a margin of safety are as valid today as there were back then. Do not discard this book as old thinking. The lessons are as important today as they were then and they will be important even after 50 years. This is the basis.

Follow the practical way,
George

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