Security Analysis – Book Of The Month (1/2)

The Security Analysis, written by Benjamin Graham and David Dodd, was the textbook that Warren Buffett used in college, when he studied under Ben Graham. Buffett attributes his investment success and valuation skills to this book. Some of you might have heard of the book called the Intelligent Investor, which was a spin-off of the ideas found in the Security Analysis. I started reading this book (1940, Second Edition) at the beginning of the year, and it took me 5 months to read through all the chapters (727 pages). This book has a wealth of information and important takeaways. I could talk about the notes I took on each page of this book, but it might become a little too lengthy to read for you guys. So, I’ve decided to split the takeaways from this book into 2 parts. This week, I will talk about the key takeaways form the first half of the book, and next week, I will talk about the key takeaways from the second half of the book. The first half of the book is about survey and approach to investing, fixed value investments, and senior securities with speculative features. Without further ado, let’s dive in.

• Intrinsic Value Versus Price – Graham and Dodd explain the difference between intrinsic value and price. They go further and explain the relationship between intrinsic value and earnings power. This concept can be summarized in Warren Buffett’s quote from 2008 Berkshire Hathaway’s letter to shareholders, “Long ago, Ben Graham taught me that ‘Price is what you pay; value is what you get.’ Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.” Graham and Dodd talk about how you can use the past earnings to get a rough idea of what the future earnings might look like, and use that information to determine the intrinsic value of the stock.
• Analyze The Qualitative and Quantitative Factors – Graham and Dodd explain that when surveying and analyzing a business, an investor should focus on both qualitative and quantitative factors. Qualitative factors deal with matters such as the nature of business, the relative position of the individual company in the industry, the character of the management, and finally, the outlook for the unit, for the industry, and for business in general. On the other hand, quantitative factors focuses on the company’s statistical exhibit included in the income account and balance sheet; Graham and Dodd advice to look at capitalization, earnings and dividends, assets and liabilities, and operating statistics.
• Invest In Highest Yielding Obligation – In the book, Graham and Dodd say, “Safety depends upon and is measured entirely by the ability of the debtor corporation to meet its obligations… High coupon rate is not adequate compensation for the assumption of substantial risk of principal.” The authors looked at how the values of fixed assets could become worthless when companies defaulted/liquidated. Graham and Dodd asked investors to only invest in companies that meet every test of strength and soundness, and then purchase its highest yielding obligation bonds. So, if you find a financially stable company, it is better to invest in that company’s junior unsecured bond that pays a higher yield rather than to invest in its senior bond; since that stable company can easily pay for all its obligations, investor is better off investing in the issue that gets him the highest return on his investment. Investor shall focus and analyze the company, rather than scrutinizing the terms and conditions of the bond issue. 
• Fixed Charge Coverage – One of the quantitative factors that Graham and Dodd focus on when analyzing all the bonds is the number of times fixed charges are earned.
  Fixed charges = gross income – net income.
  Times fixed charges earned = gross income / (gross income – net income). 
  So, the fixed charge coverage gives the investor an idea of the company’s obligations in relationship to its income. Graham and Dodd summarize the minimum quantitative requirements suggested for fixed-investments at the end of Chapter 11, page 156. 
• Guaranteed Securities – Graham and Dodd show that bonds bearing a joint and several guarantee are likely to have special advantages. Moreover, they say that an investor should favor bonds that carry the guaranty of a number of substantial enterprises as compared to guaranty of a single company. Graham and Dodd advised to look into the relationship of parent company’s obligations towards their subsidiaries. If a bond is backed by the parent company, investor shall look at the consolidated income account of the parent company to understand the stability and safety of that investment. If the bond is not guaranteed by the parent company, then focus on subsidiary’s statement alone. 
• Speculative features – There are three kinds of senior issues with speculative privileges – convertible, participating, and subscription. Dodd and Graham say “A bond that meets all the requirements of a sound investment and in addition possesses an interesting conversion privilege would undoubtedly constitute a highly desirable purchase.”  Additionally, a convertible bond should not be converted by the investor; it should either be held or sold. Investors should get out of the investment when the bond prices advance 25-35% above par value, since at those levels the bond price has gone out of the investment range. Lastly, Graham and Dodd show how warrants seem to provide the security of principle and the ability to maximize profits. 

The authors say, “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  substantial change for the worse in the future, afford probably the only sound basis available for the selection of a fixed-value investment.” Said differently, invest in companies with great historical records, stable business models, and moats. Graham and Dodd also say, “It is undoubtedly true that it is more profitable to select the right company than to select the issue with the most desirable terms.” So, at the end of the day, an investor needs to focus on the fundamentals of the business. It is the fundamentals that will govern the future security prices. 

Hope you learned a little and found this blog post helpful. We talked about the key takeaways from the first half of the Security Analysis book, written by Benjamin Graham and David Dodd. As always, you can sign up for our free mailing list here.  You can sign up for our paid subscription services here. Like us on our Facebook page here. Thank you!

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