January 21, 2015 by calminvestor | 0 comments

Security Analysis by Benjamin Graham and David Dodd is probably the most mentioned book when it comes to value investing. First published in 1934, it was used as a required reading textbook in the course by the same name at Columbia Business School (apparently, now only the excellent preface to the 6th edition by Seth Klarman The timeless wisdom of Graham and Dodd is compulsory ). The immense value of the book is in that it remains relevant, as a framework to think about investments, over 80 years after it was first published.

Having heard all the revered references to this book, I first dived into Security Analysis expecting to see a clearly laid out method for deriving that elusive animal called intrinsic value of a firm based on taking a magnifying glass to a companys financial statements. But not quite. While the book does spend time on the key things to look out for on income statements and balance sheets to find what might make a company less or more attractive, it does not go as far as to prescribe a single model view of the world. I was surprised by two things, both due to my own ignorance (less by the 1st and more by the 2nd):

1. Half of the book deals with fixed income securities or bonds and preferred stocks. Common stock investing was termed as speculation and heavily disclaimered as being not suitable for the majority of retail investors
2. Unlike experts in any field who have a pithy explanation for everything under the sun this is easily explained by. the authors of this book frequently say we dont know why when it comes to discussing instances of share prices diverging from their intrinsic values as computed by their conservative methods

They refer to this unpredictability repeatedly to hammer home the need to rely on tangible past performance more than optimistic predictions when approaching equity investing. I think the humility as brought out in the 2nd point above is what makes this book the classic that it is, a philosophy I referred to in my post on humble decision-making .

While the book abounds in insights, here are the top 3 takeaways I found, with select excerpts from the book:

1. Intrinsic Value has nothing to do with market price

(all text in quotes is directly from the book) We must recognize, however, 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. 

There is no spoon. Just because one might put together a complex excel model that factors in every line item on the companys balance sheet, its a mistake to assume that the resulting number is what every market participant should agree to, eventually.

And therefore

Security analysis does not seek to determine exactly what is the intrinsic value of a given security. It only needs to establish that the value is adequate. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient. Just like it is 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.

So while a completely arbitrary guess about the right stock price, picked on the basis of numerology, or one determined after careful and conservative assessment of financial performance and industry analysis are both wrong, only one has a better chance of identifying the bargains and the white elephants.

2. Price-Earnings ratios are arbitrary

Security analysts cannot presume to lay down general rules as to the proper value of any given common stock. Practically speaking, there is no such thing. The bases of value are too shifting to admit of any formulation that could claim to be even reasonably accurate. The whole idea of basing the value upon current earnings seems inherently absurd, since we know that the current earnings are constantly changing. And whether the multiplier should be ten or fifteen or thirty would seem at bottom a matter of purely arbitrary choice.

This one raises a few eyebrows given Price-to-Earnings is the most frequently discussed valuation metric in financial media. I even did a post on trying to predict future index returns based on current P/E. Another way to think about the above statement is that, at a company level, earnings per share are susceptible to accounting gimmicks and hence shouldnt be taken as the sole basis for deciding on (un)suitability of a stock.

Hence the prices of common stocks are not carefully thought out computations but the resultants of a welter of human reactions. The stock market is a voting machine rather than a weighing machine. It responds to factual data not directly but only as they affect the decisions of buyers and sellers.

Just because a stock has been bid up 75% in three weeks, doesnt mean its worth jumping in.

We would suggest that about 20 times average earnings is as high a price as can be paid in an investment purchase of a common stock

we submit a corollary of no small practical importance, that people who habitually purchase common stocks at more than about 20 times their average earnings are likely to lose considerable money in the long run. This is the more probably because, in the absence of such a mechanical check, they are prone to succumb recurrently to the lure of bull markets, which always find some specious argument to justify paying extravagant prices for common stocks.

You can almost see the shrug of the shoulders with which the authors set that self-confessed arbitrary limit of 20x earnings as a cut-off. While the cut-off itself is unimportant, the takeaway is that the more one pays for a stock, by some predetermined standard, the more likely that it will lose money.

3. Predicting anything, especially the future, is difficult

In addition to emphasizing strongly the current showing of a company, the stock market attaches great weight to the indicated trend of earnings. There is a two-fold danger in the magnification of the trend; the first being that the supposed trend might prove deceptive, and the second being that valuations based upon trend obey no arithmetic rules and therefore may too easily be exaggerated

Hence instead of taking the maintenance of a favourable trend for granted, as the stock market is wont to do, the analyst must approach the matter with caution, seeking to determine the causes of the superior showing and to weigh the specific elements of strength in the companys position against the general obstacles in the way of continued growth.

As of this writing, Page Industries shows a stock price of ₹11,609 where each share shows earnings of ₹156. i.e. 74x earnings. Another company, Jubilant Foodworks trades at ₹1,378 while making ₹17 per share i.e. P/E of 81. Both these companies are in high-growth areas with significant scope for future expansion.

But to the value investor, the risk in projecting this high growth rate into the future to arrive at a fair purchase price is all too evident. Hence he focuses on companies with demonstrated performance and has the patience to wait for the right price before investing.

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