The Best Of Graham & Dodd’s Security Analysis

Part I: Survey And Approach

Chapter 1 The Scope And Limits Of Security Analysis. The Concept Of Intrinsic Value

“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.”

 

We must recognize…that intrinsic value is an elusive concept. In general terms it is understood to be that 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. But it is a great mistake to imagine that intrinsic value is as definite and as determinable as is the market price.”

 

“The essential point is that 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… or else that the value is considerably higher or considerably 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.”

 

“Undervaluations caused by neglect or prejudice may persist for an inconveniently long time, and the same applies to inflated prices caused by overenthusiasm or artificial stimulants.”

 

“In other words, the market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities. Rather should we say that the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion.”

 

“It is only where chance plays a subordinate role that the analyst can properly speak in an authoritative voice and accept responsibility for the results of his judgments.”

 

Chapter 2 Fundamental Elements In The Problem Of Analysis. Quantitative And Qualitative Factors

“Nearly every issue might conceivably be cheap in one price range and dear in another.”

 

“The analyst must pay respectful attention to the judgment of the market place and to the enterprises which it strongly favors, but he must retain an independent and critical viewpoint. Nor should he hesitate to condemn the popular and espouse the unpopular when reasons sufficiently weighty and convincing are at hand.”

“It is natural to assume that industries which have fared worse than the average are ‘unfavorably situated’ and therefore to be avoided. The converse would be assumed, of course, for those with superior records. But this conclusion may often prove quite erroneous. Abnormally good or abnormally bad conditions do not last forever. This is true not only of general business but of particular industries as well. Corrective forces are often set in motion which tend to restore profits where they have disappeared, or to reduce them where they are excessive in relation to capital.”

“Objective tests of managerial ability are few and far from scientific. In most cases the investor must rely upon a reputation which may or may not be deserved. The most convincing proof of capable management lies in a superior comparative record over a period of time.”

“But while a trend shown in the past is a fact, a ‘future trend’ is only an assumption.”

 

“Analysis is concerned primarily with values which are supported by the facts and not with those which depend largely upon expectations. In this respect the analyst’s approach is diametrically opposed to that of the speculator, meaning thereby one whose success turns upon his ability to forecast or to guess future developments. Needless to say, the analyst must take possible future changes into account, but his primary aim is not so much to profit from them as to guard against them. Broadly speaking, he views the business future as a hazard which his conclusions must encounter rather than as the source of his vindication.”

 

Chapter 3 Sources Of Information

“Although it is true that the registration statements are undoubtedly too bulky to be read by the typical investor, and although it is doubtful if he is even careful to digest the material in the abbreviated prospectus (which still may cover more than 100 pages), there is no doubt that this material is proving of the greatest value to the analyst and through him to the investing public.”

“It must never be forgotten that a stockholder is an owner of the business and an employer of its officers. He is entitled not only to ask legitimate questions but also to have them answered, unless there is some persuasive reason to the contrary.”

 

Chapter 4 Distinctions Between Investment And Speculation

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

 

“An investment operation is one that can be justified on both qualitative and quantitative grounds.”

 

Chapter 5 Classification Of Securities

“From the foregoing discussion [Graham’s case for a new classification of securities] the real character and purpose of our classification should now be more evident. Its basis is not the title of the issue, but the practical significance of its specific terms and status to the owner. Nor is the primary emphasis placed upon what the owner is legally entitled to demand, but upon what he is likely to get, or is justified in expecting, under conditions which appear to be probable at the time of purchase or analysis.”

 

Chapter 6: The Selection Of Fixed-Value Investments

“In exchange for limiting his participation in future profits, the bondholder obtains a prior claim and a definite promise of payment, while the preferred stockholder obtains only the priority, without the promise. But neither priority nor promise is itself an assurance of payment.”

“Since the chief emphasis must be placed on avoidance of loss, bond selection is primarily a negative art.”

“In the past the primary emphasis was laid upon the specific security, i.e., the character and supposed value of the property on which the bonds hold a lien. From our standpoint this consideration is quite secondary; the dominant element must be the strength and soundness of the obligor enterprise. There is here a clearcut distinction between two points of view. On the one hand the bond is regarded as a claim against property; on the other hand, as a claim against a business.”

“As a practical matter it is not so easy to distinguish in advance between the underlying bonds that come through reorganization unscathed and those which suffer drastic treatment. Hence the ordinary investor may be well advised to leave such issues out of his calculations and stick to the rule that only strong companies have strong bonds.”

Security Analysis Chapter 7: The Selection Of Fixed-Value Investments: Second And Third Principles

“Any bond can do well when conditions are favorable; it is only under the acid test of depression that the advantages of strong over weak issues become manifest and vitally important.”

“…there is no such thing as a depression-proof industry…

“The distinction to be made, therefore, is not between industries which are exempt from and those which are affected by depression, but rather between those which are more and those which are less subject to fluctuation. The more stable the type of enterprise, the better suited it is to bond financing and the larger the portion of the supposed normal earning power which may be consumed by interest charges.”

“The fact that no good bonds are available is hardly an excuse for either issuing or accepting poor ones. Needless to say, the investor is never forced to buy a security of inferior grade. At some sacrifice in yield he can always find issues that meet his requirements, however stringent; and…attempts to increase yield at the expense of safety are likely to prove unprofitable.”

“A reasonable amount of funded debt is of advantage to a prosperous business, because the stockholders can earn a profit above interest charges through the use of the bondholders’ capital.”

“It appears to be a financial axiom that 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. But a prudent and intelligent investor should be able to avoid this temptation, and reconcile himself to accepting an unattractive yield from the best bonds, in preferences to risking his principal in second-grade issues for the sake of a large coupon return.”

“Security prices and yields are not determined by any exact mathematical calculate not the expected risk, but they depend rather upon the popularity of the issue. This popularity reflects in a general way the investors’ view as to the risk involved, but it is also influenced largely by other factors, such as the degree of familiarity of the public with the company and the issue (seasoning) and the ease with which the bond can be sold (marketability).”

“In life insurance the relation between age and mortality rate is well defined and changes only gradually. The same is true, to a much lesser extent, of the relation between the various types of structures and the fire hazard attaching to them. But the relation between different kinds of investments and the risk of loss is entirely too indefinites, and too variable with changing conditions, to permit of sound mathematical formulation.”

“For the individual is not qualified to be an insurance underwriter. It is not his function to be paid for incurring risks; on the contrary it is to his interest to pay others for insurance against loss.”

Security Analysis: Chapter 22 Privileged Issues

“Such issues [senior securities with speculative features] must therefore be considered as the most attractive of all in point of form, since they permit the combination of maximum safety with the chance of unlimited appreciation in value… Despite this impressive argument in favor of privileged senior issues as a form of investment, we must recognize that actual experience with this class has not been generally satisfactory.”

 

“Although there is indeed no upper limit to the price that a convertible bond may reach, there is a very real limitation on the amount of pro?t that the holder may realize while still maintaining an investment position. After a privileged issue has advanced with the common stock, its price soon becomes dependent in both directions upon changes in the stock quotation, and to that extent the continued holding of the senior issue becomes a speculative operation.”

 

“A privileged senior issue, selling close to or above face value, must meet the requirements either of a straight ?xed-value investment or of a straight common-stock speculation, and it must be bought with one or the other quali?cation clearly in view.”

 

“Generally speaking, there should be no middle ground. The investor interested in safety of principal should not abate his retirements in return for a conversion privilege; the speculator should not be attracted to an enterprise of mediocre promise because of the pseudo-security provided by the bond contract.”

 

“Where an intermediate stand is take, the result is usually confusion, clouded thinking, and self-deception.”

 

“In the typical case, a convertible bond should not be converted by the investor. It should be either held or sold.”

 

“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 judgment impugned if the bond subsequently rises to a much higher level. The market behavior of the issue, 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.”

 

Security Analysis: Chapter 23 Technical Characteristics Of Privileged Senior Securities

“The attractiveness of a pro?t-sharing feature depends upon two major but entirely unrelated factors: (1) the terms of the arrangement and (2) the prospects of pro?ts to share.”

 

“As between the two factors, it is undoubtedly true that it is more pro?table to select the right company than to select the issue with the most desirable terms… But in analyzing privileged issues of the investment grade, the terms of the privilege must receive the greater attention, not because they are more important but because they can be more defnitely dealt with.”

 

“In examining the terms of a pro?t-sharing privilege, three component elements are seen to enter. These are: a. The extent of the pro?t-sharing or speculative interest per dollar of investment. b. The closeness of the privilege to a realizable pro?t at the time of purchase. c. The duration of the privilege.”

 

“The reluctance to sell one good thing and buy another, which characterizes the typical investor, is one of the reasons that holders of high-priced convertibles are prone to convert them rather than to dispose of them.”

 

Security Analysis: Chapter 24 Technical Aspects Of Convertible Issues

“The effective terms of a conversion privilege are frequently subject to change during the life of the issue. These changes are of two kinds: (1) a decrease in the conversion price, to protect the holder against “dilution”; and (2) an increase in the conversion price… for the bene?t of the company.”

 

“The competitive pressure to take advantage of a limited opportunity introduces an element of compulsion into the exercise of the conversion right which is directly opposed to that freedom of choice for a reasonable time which is the essential merit of such a privilege. There seems no reason why investment bankers should inject so confusing and contradictory a feature into a security issue. Sound practice would dictate its complete abandonment or in any event the avoidance of such issues by intelligent investors.”

 

“There are also bond issues convertible into either preferred or common or into a combination of certain amounts of each. Although any individual issue of this sort may turn out well, in general it may be said that complicated provisions of this sort should be avoided (both by issuing companies and by security buyers) because they tend to create confusion.”

 

“The unending ?ood of variations in the terms of conversion and other privileges that developed during the 1920’s made it dif?cult for the untrained investor to distinguish between the attractive, the merely harmless, and the positively harmful. Hence he proved an easy victim to unsound ?nancing practices which in former times might have stood out as questionable because of their departure form the standard.”

 

Security Analysis: Chapter 26 Senior Securities Of Questionable Safety

“There seems to be much logic to the view that if one decides to speculate he should choose a thoroughly speculative medium and not subject himself to the upper limitations of market value and income return, or to the possibility of confusion between speculation and investment, which attach to the lower priced bonds and preferred stocks.”

 

“There are two directly opposite angles from which a speculative bond may be viewed. It may be considered in its relation to investment standards and yields, in which case the leading question is whether or not the low price and higher income return will compensate for the concession made in the safety factor. Or it may be thought of in terms of a common-stock commitment…”

 

“Differences in opinion may properly exist in the minds of investors as to whether or not a given issue is adequately secured, particularly since the standards are qualitative and personal as well as arithmetical and objective.”

 

“A senior issue cannot be worth, intrinsically, any more than a common stock would be worth if it occupied the position of that senior issue, with no junior securities outstanding.”

 

The Best Of Graham & Dodd’s Security Analysis Part IV: Theory Of Common- Stock Investment. The Dividend Factor

Security Analysis – Chapter 27 The Theory Of Common-Stock Investment

“We must begin with three realistic premises. The ?rst is that common stocks are of basic importance in our ?nancial scheme and of fascinating interest to many people; the second is that owners and buyers of common stocks are generally anxious to arrive at an intelligent idea of their value; the third is that, even when the underlying motive of purchase is mere speculative greed, human nature desires to conceal this unlovely impulse behind a screen of apparent logic and good sense.”

 

“As far as the typical common stock is concerned — an issue picked at random from the list — an analysis, however elaborate, is unlikely to yield a dependable conclusion as to its attractiveness or its real value. But in individual cases, the exhibit may be such as to permit reasonably con?dent conclusions to be drawn from the processes of analysis.”

 

“The impressive new concept [trend of earnings] underlying the greatest stock-market boom in history appears to be no more than a thinly disguised version of the old cynical epigram: ‘Investment is successful speculation.’”

 

“The man in the street, having been urged to entrust his funds to the superior skill of investment experts — for substantial compensation — was soon reassuringly told that the trusts would be careful to buy nothing except what the mani n the street was buying.”

 

“The accepted assumption that because earnings have moved in a certain direction for some years past they will continue to move in the that direction is fundamentally no different from the discarded assumption that because earnings averaged a certain amount in the past they will continue to average about that amount in the future.”

 

Security Analysis – Chapter 28 Newer Canons Of Common-Stock Investment

“Without seeking to prophesy the future, may it not suf?ce to declare that the investor cannot safely rely upon a general growth of earnings to provide both safety and pro?t over the long pull?…Our caution today would appear, at least, to be based on bitter experience and on the recognition of some newer and less promising factors in the whole business picture.”

 

“It follows that once the investor pays a substantial amount for th growth factor, he is inevitably assuming certain kinds of risk; viz., that the growth will be less than he anticipates, that over the long pull he will have paid too much for what he gets, that for a considerable period the market will value the stock less optimistically than he does.”

 

“Of more practical importance is the question whether or not investment can be successfully carried on in common stocks that appear cheap from the quantitative angle and that — upon study — seem to have average prospects for the future. Securities of this type can be found in reasonable abundance, as a result of the stock market’s obsession with companies considered to have uniquely good prospects of growth.”

 

“Because of this emphasis on the growth factor, quite a number of enterprises that are long established, well ?nanced, important in their industries and presumably destined to stay in business and make pro?ts inde?nitely in the future, but that have not speculative or growth appeal, tend to be discriminated against by the stock market — especially in years of subnormal pro?ts — and to sell for considerably less than the business would be worth to a private owner.”

 

“Their [Wall Street’s] emphasis is mainly on long-term growth, prospects for the next year, or the indicated trend of the stock market itself. Undoubtedly any of these three viewpoints [discussed in the chapter] may be followed successfully by those especially well equipped by experience and native ability to exploit them. But we are not so sure that any of these approaches can be developed into a system or technique that can be con?dently followed by everyone of sound intelligence who has studied it with care.”

 

“Trading in the market, forecasting next year’s results for various businesses, selecting the best media for long-term expansion — all these have a useful place in Wall Street. But we think that the interests of investors and of Wall Street as an institution would be better served if operation based primarily on these factors were called by some other name than investment.”

 

Security Analysis – Chapter 29 The Dividend Factor In Common-Stock Analysis

“The dividend rate is a simple fact and requires no analysis, but its exact signi?cant is exceedingly dif?cult to appraise. From one point of view the dividend rate is all- important, but from another and equally valid standpoint it must be considered an accidental and minor factor.”

 

“A basic confusion has grown up in the minds of managements and stockholders alike as to what constitutes a proper dividend policy. The result has been to create a de?nite con?ict between two aspects of common-stock ownership: one being the possession of a marketable security, and the other being the assumption of a partnership interest in a business.”

 

“One of the obstacles in the way of an intelligent understanding by stockholders of the dividend question is the accepted notion that the determination of dividend policies is entirely a managerial function, in the same way as the general running of the business.”

 

“Boards of directors usually consist largely of executive of?cers and their friends. The of?cers are naturally desirous of retaining as much cash as possible in the treasury, in order to simplify their ?nancial problems; they are also inclined to expand the business persistently for the sake of personal aggrandizement and to secure higher salaries.”

 

“The heavy surtaxes imposed upon large incomes frequently make it undesirable from the standpoint of the large stockholders that earnings be paid out in dividends. Hence dividend policies may be determined at times from the standpoint of the taxable status of the large stockholders who control the directorate.”

 

“Dividend policies are often so arbitrarily managed as to introduce an additional uncertainty in the analysis of a common stock. Besides the difficulty of judging the earning power, there is the second difficulty of predicting what part of the earnings the directors will see ?t to disburse in dividends.”

“Experience would con?rm the established verdict of the stock market that a dollar of earnings is worth more to the stockholder if paid him in dividends than when carried to surplus.”

 

“The common-stock investor should ordinarily require both an adequate earning power and an adequate dividend. If the dividend is disproportionately small, an investment purchase will be justi?ed only on an exceptionally impressive showing of earnings… On the other hand, of course, an extra-liberal dividend policy cannot compensate for inadequate earnings, since with such a showing the dividend rate must necessarily be undependable.”

Stockholders are entitled to receive the earnings on their capital except to the extent they decide to reinvest them in the business. That management should retain or reinvest earnings only with the speci?c approval of the stockholders. Such “earnings” as must be retained to protect the company’s position are not true earnings at all. They should not be reported as pro?ts but should be deducted in the income statement as necessary reserves, with an adequate explanation thereof.”

 

“A compulsory surplus is an imaginary surplus.”

 

“Dividend and reinvestment policies should be controlled not by law but by the intelligent decision of stockholders.”

 

“Individual cases may well justify retention of earnings to an extent far greater than is ordinarily desirable. The practice should vary with the circumstances; the policy should be determined and proposed in the ?rst instance by the management; but it should be subject to independent consideration and appraisal by stockholders in their own interest, as distinguished from that of the corporation as a separate entity or the management as a special group.”