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. Last week, I blogged about the key takeaways form the first half of the book, and this week, I will talk about the key takeaways from the second half of the Security Analysis (1940, Second Edition). The second half of the book is about the theory of common stock investment, analysis of the income account, balance sheet analysis, and other aspects of security analysis. Without further ado, let’s dive in.
- When to condemn a stock? Graham and Dodd say, “If the earnings were not properly stated; if the balance sheet revealed a poor current position, or the funded debt was growing too rapidly; if the physical plant was not properly maintained; if dangerous new competition was threatening, or if the company was losing ground in the industry; if the management as deteriorating or was likely to change for the worse; if there was reason to fear for the future of the industry as a whole – any of these defects or some other one might be sufficient to condemn the issue from the standpoint of a cautious investor.” As investors, it is important for us to understand that regardless how great the future prospects of a stocks may me, we have to focus on the data on hand first. After all, as Graham and Dodd say, “Speculation, in its etymology, meant looking forward; investment was allied to “vested interests” – to property rights and values taking root in the past.“
- Income Account – Graham and Dodd state that in order for a purchase to be considered an investment, the maximum P/E multiple paid for that purchase should not be greater than 20. If one purchases a stock with P/E of more than 20, then he is paying a premium for the price of a “speculative component”, which is the price paid not for demonstrated but for expected results. The authors say, “There is an inevitable tendency to regard the gains made in good times as part of the “earning power” and to value the shares accordingly. This results of course in an absurd overvaluation, to be followed by collapse and a correspondingly excessive depreciation.” Additionally, they say, “People who habitually purchase common stocks at more than 20 times their average earnings are likely to lose considerable money in the long run.” Graham and Dodd suggest that about 12 times average earnings may be suitable for the typical case of a company with neutral prospects. Moreover, the company must also be satisfactory in its financial set-up and management, and “not unsatisfactory” in its prospects. The authors point out that an upward trend cannot go on forever, and that every company eventually hits a saturation point.
- Capitalization Structure – The division of a company’s total capitalization between senior securities and common stock has an important bearing upon the significance of the earning power per share. In other words, the total value of a company is equal to the value of common stock plus the value of senior issues such as bonds. Regardless of the earnings, the company is obligated to pay interest (fixed charges) on the bonds issued. So, if a company is “top heavy” i.e. if a company has large amount of bonds (debt), then those fixed charges eat into the earnings left over for the common shareholder. Those senior issues act as leverage – during prosperous times, the common shareholder is going to see a higher increase in earnings per share, and during detrimental times, the common shareholder is going to see a greater decrease in earnings per share. Graham and Dodd lead us to an important principle, both for the security buyer and for corporate management, i.e., “The optimum capitalization structure for any enterprise includes senior securities to the extent that they may safely be issued and bought for investment.” The message that Graham and Dodd are trying to convey here is that the company issuing the senior security should be capable of paying off that debt, and that by having senior securities, common shareholders also benefit from the borrowed capital.
- Balance Sheet Analysis – Graham and Dodd covered many topics from calculating book value to various ratios to analyze when reviewing balance sheets. Overall, they wanted investors to understand this: “Corporations are in law the mere creatures and property of the shareholder who own them; the officers are only the paid employees of the stockholders; the directors, however chosen, are virtually trustees, whose legal duty it is to act solely in behalf of the owners of the business.” Graham and Dodd would also like investors to be aware of matters such as dividend policies, expansion policies, the use of corporate cash to repurchase shares, the various methods of compensating management, and the fundamental question of whether the owners’ capital shall remain in the business or be taken out by them in whole or in part.
- Security Analysis – In the last part of the book, the authors discuss about how security analysis (analyzing fundamentals) is different from market analysis (predicting future moves), and how security/fundamental analysis is superior to technical/chart analysis. Graham and Dodd say, “In security analysis the prime stress is laid upon protection against untoward events. We obtain this protection by insisting upon margin of safety, or values well in excess of the price paid. The underlying idea is that even if 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.“
Overall, I found this book to be very informative. Although some of the practices are no longer valid due to GAAP standard, I greatly enjoyed the way Graham and Dodd approached and analyzed various securities. I learned about how to look at a company, analyze the stability of that company, analyze different issues (senior, junior, preferred, common) of a company, approach towards margin of safety, investing in speculative issues, etc. A lot of the topics covered in this book have been echoed by Warren Buffett over the years; Specifically, investing in companies that are financially stable, have a moat (competitive advantage), and have a great management. In conclusion, I will leave you with these statements from Graham and Dodd, “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 shareholder.“
Hope you learned a little and found this blog post helpful. We talked about the key takeaways from the second half of the Security Analysis book, written by Benjamin Graham and David Dodd. You can read the key takeaways from the first half of the book here. 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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