Security Analysis (Benjamin Graham and David Dodd)

Value investment approach that was praciced and popularized by the authors: buy companies for less than they are worth.

• Intrinsic value: discounted future earnings, dividends, assets, capital structure, etc.
• Market price matters too, especially if you will want to sell it. It tends to catch up with the fundamentals but not always and not quickly.
  • General market conditions,
  • Issue-specific factors: reputation, competition, management quality, etc.
• Analysis:
  • Quantitative: capitalization, earnings, dividends, assets + liabilities, operating statistics,
  • Qualitative: nature of business, prospects, management, earnings trend, stability.
• Sources of information:
  • Company statements,
  • SEC submissions,
  • Industry publications,
  • Rating agencies,
  • Requesting information directly from the company (because stock holders are owners).
• Investment vs. 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.
• Classes of securities and related strategy aspects:
  • Limited upside (partial summary): - Fixed-value: high-grade bond or preferred stock, - Avoid trouble rather than protect yourself in case of trouble. - Look for depression-resistance (based on real performance). - Variable value: high-grade convertible bond, lower grade bond or preferred, - Risk of loss of principle should be compensated by commensurate high returns.
  • Unlimited upside: common stock.
    • Not all stocks allow you to predict the future accurately enough to make a sound investment. However some do.
    • Approaches:
      • Rely on general growth: doesn't always work.
      • High growth companies at fair price: great, but quite difficult to identify those companies ahead of time.
        • Common stock vs. share in a private company: marketability might be valued higher than control but not by much, not >20%. Don't overpay!
      • Buying stocks for less than what they are worth with a good margin of safety.
        • General market swings (when everything is cheaper) -- kind of makes sense, but you're trying to predict the whole market and that's hard.
        • Picking individual undervalued stocks -- stuff that the market doesn't like right now (price < value of the company):
          • Dividend rate and record,
          • Earning power,
          • Balance sheet and asset value.
        • The authors prefer dividends to retained earnings: I think this is different in my situation because of taxes and transaction fees. More than 25% of dividends is essentially lost, so I prefer retaining, especially if the company is doing well. Otherwise share buybacks are better than dividends.
• Earning power:
  • It's important to assess both assets and earning power, just like you would do if you own the business.
  • Earning power is typically assessed on a multi-year basis noting both the amounts and the trend. Qualitative factors (moat, market leadership, changes in the company) are also important.
    • For digging deeper look at unit economics: production, sales, costs, margins for each product.
  • Watch out for non-recurring items and other shenanigans.
  • If you see deliberately misleading accounting practices, shun all securities of this company (unless you're willing to investigate deeply and take the risks). Things to watch out for:
    • Subsidiaries earnings.
    • Depreciation items.
  • When calculating P/E ratios also pay attention to capital structure of the company. Companies with the same P/E ratio but larger debts are more vulnerable to income decreases but they also benefit more from income increases. Taking reasonable debt (that can be cheaply serviced and is covered by assets) is usually considered an advantage. At the same time, it increases sensitivity to economic conditions, which could be good or bad.
• Balance sheet:
  • Value metrics: book value, current asset value, cash asset value.
  • Liquidation value: somewhere around current asset value.
    • If the company is trading below liquidation value, the market is undervaluing it or the company should be liquidated. Unfortunately the management doesn't always act in the interests of shareholders.
  • Capital position: Current ratio, Debts (including maturities).
  • Compare balance sheet over time to earnings over same time.
• Discrepancies between price and value:
  • Management compensation: options, shares, etc.
  • Recent changes: earnings, dividends, mergers and segregations.
  • Litigation.
  • Price intertia of old shares (long term owners don't want to sell, good number of buyers on dips from the long term price trend). Conversely, new shares are more volatile.
  • General market conditions (bubble, depression, etc.).
• Global investing:
  • Currency risk.
  • Accounting differences, availability of reports.
  • Availability and terms of listing.

What changed since 1940s:

• Spreadsheets -- much faster way to calculate all the ratios,
• More attention to business model, products, R&D, management quality,
• Focus on cashflow (instead of earnings and dividends),
• More news coverage of stock market, more heard mentality,

Other notes:

• Market prices of stocks are affected by the sentiment towards the company. It can change a lot without any significant change to the fundamentals. Market is a voting machine, especially in the short term.
• Bull markets are born in pessimism, grow on skepticism, mature on optimism, and die on euphoria (Sir John Templeton).
• Conclusion of Intro: Buy blue chips at attractive price during a market decline. Look for bargains in other times.
• The most important source of non-public information is the telephone.
  • Might not be the only thing in the current day and age but still quite relevant.