Benjamin Graham is a great author. His ideas are relayed so smoothly in Security Analysis that even my ADHD diagnosed, 15 year old self was able to use the book as a tool to further solidify my interest and knowledge in the world of investing. When recommending the book to others, I cite it as the reason for my interest in becoming an Investment Banker.
When I first picked up the book as a High School Freshman in 2015, I had already gained a relatively respectable level of knowledge in the facet due to a mix of experience (thanks to my luck in Cryptocurrencies, which carried through to securities trading) and study (thanks to an obsession brought about by The Wolf of Wall Street.) Or so I thought. The information had me look at investing through a more academic paradigm, a buzzword loathed in the Jim Cramer content I had been reading before.
This is how Benjamin Graham became my role model in economics. Before I dive into any book, I get to know the author. It turns out the book I was holding was written by the "father of value investing." Anyone who's had to go through one of my ramblings on investing could see that his work has influenced me greatly. His investment philosophy stressed greatly a few key concepts:
- Investor Psychology
- Diversity of the Portfolio
- Fundamental Analysis/Intrinsic Value
- Contrarian Buying/Selling
- Weight on the Balance Sheet
"Intrinsic Value" is the central idea in his Security Analysis work, and he defines a formula (the Benjamin Graham formula) for calculating it:
V = E x (8.5 + 2g)
Where E is 12-month trailing earnings, 8.5 is the P/E base for a no-growth company, and g is the reasonably expected 7 to 10 year growth rate. One should note, in my opinion, that the formula takes no account of interest rate, and therefore the calculation is only valid over a period of unchanged interest. Otherwise, I've found it to be a rather meaningful metric.
Reading Security Analysis Today
It's important to note that the book represented financial analysis as a new idea. Since the reception of this work, the unprecedented universal application of technology has taken place and proven the "efficient market" theory to be mostly correct. It is now much easier to find an undervalued of mis-priced stock. We must keep this in mind in our reading, and differentiate the action we must take today from what we mustn't. This fact is my purpose in writing this reader's guide. The commentary of the newest edition is particularly helpful in doing this, so I include it here.
Part I: Survey and Approach
If I have seen further, it is by standing on the shoulders of giants.
The introduction to part one praises the book as relaying the knowledge which prevents investors from falling for such traps. It argues against the traditional risk-reward mindset, asking the reader to make avoiding serious loss their first priority. Warren Buffet is used as an example touting this notion. Buffet himself, of course, did study directly under Graham. His approach remained consistent of his master's, but his adaptability to the changing times is what made him so successful. This combination of adaptability and discipline is what makes a great investor after all. Here, investing is described as a discipline in which skill and chance play a role. The goal is to personally maximize the first and minimize the second. This fact doesn't change, nor does human nature, which is what makes the book such a classic.
When Graham and Dodd warned against “the capitalization of entirely conjectural future prospects,” they could have been referring to the finde-siècle saga of Internet Capital Group (NYSE:ICG), which provided seed money to Web-based start-ups, most of which were trying to start online businesses. It put money in some 47 of these prospects, and its total investment was about $350 million. Then, in August 1999, ICG itself went public at a price of $6 a share. By year-end, amidst the frenzy for Internet stocks, it was trading at $170. At that price, it was valued at precisely $46 billion. Since the company had little of value besides its investments in the start-ups, the market was assuming that, on average, its 47 seedlings would provide an average return of better than 100 to 1. Talk about capitalizing hope! Most investors do not realize a 100-for-1 return even once in their lifetimes. Alas, within a couple of years ICG’s shares had been reappraised by the market at 25 cents
The universality of learning from history knows no disciplinary bounds. The lesson here is that securities operate on promises, or better yet belief in promises. This can be true loosely with all forms of equity. Safety in investment can only be based on a set of standards, along with study, and nothing else.
I suspect the authors deliberately refrained from defining intrinsic value, lest they convey the misleading impression that the value of a security can be precisely determined.
It is true that we are very limited in our ability to forecast anything. This is why value investing is such a rewarding mindset. One can't feasibly arrive at an accurate price prediction for a given stock at any point in the future, but one may accurately forecast growth in the (verifiable) conviction that a company has the ability to sustain and increase its value. Such precision required in forecasting is regardless unnecessary in value investing, the point after all being to pay as far below intrinsic value as possible. Speculation is the enemy of the value investor, and buying a stock at what is thought to be fair value is speculation that it is valued as such. Therefore, buying a stock at fair value can be seen as overpaying, and a stock should only be bought when there is relative certainty that it is undervalued.
The threshold of an Investment, as differentiated from speculative action, is as follows:
- Economic potential, as broadly measured with intrinsic value
- The company's ability to meet the safety of principal test
- The greed-fear environment in the given industry
- The trading value in comparison to, generally as a percent of, the book value
- The broader economic and law conditions underlying the security
- The trading value in comparison to the value of assets
- The book value of a company's healthy subsidiaries
And is not:
- The explicit book value, which is an arithmetic computation of what has been invested in an asset
To forecast earnings with any degree of confidence is extremely difficult. The best guide can only be what a company has earned in the past. But capitalism is dynamic.
One simply cannot forecast earnings in certain sectors. In technology, where pace changes as rapidly as product, a given company in the sector is at a great risk of being outperformed and therefore missing out on profit. Such a sector as fast food, however, may have rather predictable earnings. Burger King has a solid brand which is unlikely to change from a year-to-year basis, save explicit events.
This is not to say technology is impossible to analyze - far from it. Such companies as Amazon are rather easy to forecast earnings for. It depends ultimately, then, on niche. While a broadly missioned company in technology, such as one who focuses on artificial intelligence, has these difficulties, Amazon may be foretasted in the same way most retailers are.
As vital rules, we can prefer companies with stable earnings over those with erratic ones, and we may find a rough guide to the future in average earnings, due certainly to the cyclical nature of them. Thus, trends become the enemy, and averages become the friend. A short-term trend carried far enough into the future will yield any desired result.
Companies that try to cook the books such as Enron or Waste Management can always dress up the earnings statement, at least for a while. But they can’t manufacture cash. Thus, when the income statement and the cash flow statement start to diverge, it’s a signal that something is amiss.
Companies may lie, but cash flow cannot! Be wary of receivables on balance sheets. In fact, on a more personal note, I take a sharpie to the balance sheets I print up and mark them out after taking one good look at them. A huge spike in them, however, especially in a developing or struggling company, is a sign is mischief. Never be complacent in thinking one of the companies in your portfolio is above such a practice.
Graham supplemented the published financials (though they were his primary source) with a highly eclectic mix of trade and government publications.
If you'll recall, I earlier mentioned that underlying economic and law conditions can separate speculation from investing, to the distaste of some of my peers in value investing. If you're researching a uranium stock, read up on uranium law from government sources and research economics which would impact uranium. You may replace "uranium" with any topic of your choosing, truly, but the principal remains the same. As part of this study, an investor must also spend significant time understanding the disclosures of a security under study, as well as its competitors. This is my way of getting into a comfort zone before making a significant investment.
There is a certain kind of conviction that can be gleaned only from hearing management answer unscripted questions. Be forewarned, though; some executives will lie.
This my favorite quote of the entire introduction. I can tell you from personal experience that my telephone has served as my favorite investment tool. I'll call a highly-structured company, come off as someone important, and come away with more information in 5 minutes than you will find anywhere else. Information gathering as a method in the book is rather dated, but ironically due to the premium placed on any kind of inside information today, something you may very well thank the internet for as it provides quick access to "suitable" public information, this idea is at its most actionable today.
I don't care to go so far as to contact executives for the same reason that Graham doesn't: however more knowledgeable, they are not as trust-able as those on the lower rungs. It is my conviction that knowledge and trustability are functions of an inverse on the corporate ladder. Whatever your trust in a company, in employing this method you must assume the risk of being lied to, and scale this accordingly. Personally, I will individually contact multiple lower-level management personnel, low enough on the rung to oversee a specific niche in operation of their company, their title ending in "of the ____ department."
The older a company gets, the more marginal influence the executives have on the success of the company. I pay a lot of attention to the CEO and board of a young company, but about half as much attention and study for every twenty years a company is in business. I draw allusion to the office of President of the United States in this respect; George Washington was a much more influential and outright powerful leader than the last five presidents combined. The point here is that this tactic applies best to older companies. Remember that you're not seeking to know the person from this call, just the company, or a specific operation within the company.
Management in any regard should never be too flashy. Investors may flock to a stock due to a celebrity CEO such as Roberto Goizueta, a man as talented as he was popular. The stock rises and is then double-counted as it is concluded that the rise in stock price was the result of great management, further inflating the price. In the end you've got a cycle of false new paradigms creating a speculative bubble, as we saw with Roberto's Coca-Cola in the 1990s.
Note: I love to use Coca-Cola as an indicator, something we'll see in my later works.
The suggestion that Goizueta was a magically talented guru was a warning signal. Rather than prove that Goizueta had the power to levitate earnings in the future, it raised questions about the quality of the earnings he had achieved in the past. As reality caught up with Coca-Cola, the stock went into a decadelong funk.
Up Next: Chapter One: The Scope And Limitations Of Security Analysis. The Concept Of Intrinsic Value