April 26, 2015

I’m Working My Way Through the 6th Edition of Security Analysis

There are a handful of books I re-read to refresh some of the timeless lessons I think are important.  One of them, which you can probably tell from some of my recent posts, is Security Analysis.  I recently started my way through the updated Sixth Edition, based on the 1940 text, and the clarity of thought never ceases to amaze me.  While the specific operations they document are no longer viable for any reasonable sum of capital – Graham and Dodd lived a time when companies were trading for less than the cash they had in the bank, which happens rarely these days as the economy is much better than it was during the Great Depression.  One of the latest firms was Nintendo, which came very close in the not-to-distant past. – the underlying philosophical approach to analysis is a goldmine for anyone who wants to intelligently manage his or her net worth.

Benjamin Graham Security Analysis Sixth Edition

An excellent illustration is the detailed discussion concerning the measurement of safety of preferred stock dividends.  Simply calculating the number of times the earnings cover the dividend is not sufficient.  A business earning $10 million with $1 million in preferred stock dividends is not necessarily more secure than another business earning $3 million with $1 million in preferred stock dividends, even though the margin of safety appears larger in the former.  The authors draw a real-world case study from First National Stores vs. Studebaker.  Between 1922 and 1930, a fairly long time period, Studebaker enjoyed preferred dividend coverage of 26.2x, while First National Stores only 6.3 times.

Yet, First National Stores was a large retail operation with a diversified geographic footprint, a diversified retail mix, and a diversified customer base.  Studebaker designed and sold cars, with the fashion of a particular model having a great influence on the profits in any given fiscal year.  When the Great Depression hit, First National Stores continued to service its preferred stock dividend, with the owners’ wealth remaining fully intact despite some large quotation losses in the interim, while Studebaker ended up resulting in a near total loss of principal.

Today, you see investors repeat this mistake in ways that might not seem evident at first.  Consider the utility industry.  Every intelligent analyst in the utility sector knows that a diversified power generating company, with multiple plants operating under multiple regulatory agencies, is inherently safer than a rock-solid, single-power generating facility that could be wiped out in a natural disaster or catastrophic accident, even if the former has a higher debt load and a lower net worth per share, yet the shares of each will often trade at roughly the same valuation.  In this case, the more profitable, financially stronger enterprise is actually a riskier holding because it contains within it the possibility of wipe-out risk.  (Some, but not all, of this can be explained by the investor’s ability to diversify himself across multiple utility companies.)

Revisiting Security Analysis also leads me to appreciate the value of a good business.  While Graham insists good companies are inherently difficult to identify, take a look at the list he prepared 74 years ago:

Ben Graham list of good businesses

Coca-Cola, Abbott Laboratories, and General Electric are the three firms that make the cut.  A person who picked up the 1940 edition and built a portfolio of those three equities, then passed them on to his or her children and grandchildren as if they were a family business, would have grown exceedingly wealthy.  There’s something amusing about all of those decades of Wall Street brain power, wasted, obsessing over 1/8th ticks in share prices or the short-term direction of interest rates, when all it really would have taken is to write a few large checks.

One of my favorite passages remains the reminder that obsessively measuring mint and rue for tithes is, itself, an indication that you’re cutting it too close.

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 – e.g., to protect a bond or to justify a stock purchase – 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. – Page 66, Chapter 1: The Scope and Limitations of Security Analysis.  The Concept of Intrinsic Value

They go on to provide a framework for thinking about asset purchases, encouraging the analyst to ask the following before making a portfolio decision:

“Should security S be bought (or sold, or retained) at price P, at this time T, by individual I?

And then expanding:

Instead of asking, (1) In what security? and (2) At What price? let us ask, (1) In what enterprise? and (2) On what terms is the commitment proposed?

It seems like such a simple thing, but that refocusing of the task at hand can save an investor from enormous grief and loss.  Even if one never bought a direct stock or bond, and instead managed a private company, the discipline instilled by examining any outlay of capital could result in far greater wealth accumulation or, at the very least, far lower risk.

  • Jordi T

    I’m interested in reading Security Analysis for the first time. Which edition do you recommend? The 6th edition or one of the early editions? I’ve heard that the latest editions have changed quite a lot compared to the ones Graham wrote himself. Thanks!

    • http://www.joshuakennon.com/ Joshua Kennon

      Hands down, The 2nd Edition, 1940 publication. The 1940 edition is better than the 1934 edition, in my personal opinion, because 1.) Graham and Dodd made some improvements over the 1934 edition as it was their second time at bat, giving them a chance to upgrade and expand what they wished they had in the first book, and 2.) it was enough time after the fallout of the Great Depression you got to see the whole cycle from prosperity to destruction to recovery. The other editions are also good (except, perhaps, the 5th, which, while still okay, was written later by different authors and has some conclusions I find questionable).

      If you prefer an original copy, you can often find them for sale on eBay, sometimes for reasonable prices ranging from $299 to $700. There are quite a few up for sale at the moment, which is a stroke of good luck. Sometimes, there are periods where you can’t find them at all. Most of my original editions came from eBay after stalking the listings for many years.

      Eventually, you’ll want to read them all because they have differences in examples, which might prompt some side dissertation that is useful, but the 1940 edition is unquestionably my favorite.

      The recent 6th edition I’m working my way through now is a REPRINT of the 1940 edition, with expanded commentary from a lot of very intelligent people, with Graham and Dodd’s original appendices put on an accompanying CD-ROM that is included in the book. You can get a hardcover copy for dirt cheap – $43.50 – at Amazon at the moment, it just won’t read like the original book did since the chapters are broken up with side-essays from other authors that update Graham’s examples to real-world illustrations in today’s markets or offer additional commentary into Graham’s life.

      • Jordi

        Thanks a lot for the explanation! I finally bought the 1940 reprint.

        • Connelly Barnes

          Thanks for this explanation Joshua. I have the 6th edition. I might try to get the 1940 reprint also.

  • Carl

    I second Jordi T’s motion.

    • Anon

      What motion? Those were questions. A motion would be: “I propose that Joshua recommend an edition of Security Analysis.”

      • Carl

        Hey, Anonymous Internet Police, I was being cheeky with the King’s. Lighten up.

        • Anon

          LOL, I might start using that.

        • Carl

          Beware the A. I. P., rumor has it they’ve been linked to the K. G. B., Al Qaeda, and Milli Vanilli. I’d aim for an apprenticeship with the Digital Grammar Guild instead. If they bring you into the fold you get a dictionary printed on uterine vellum with ink containing the ashes of both Merriam and Webster and bound in unicorn hide. It’s quite the analog touch for an organization that trades in ones and zeros.

  • Tyler Phillips

    It looks like there’s a small error in your first Graham quotation.

    “…security analysis does seek to determine exactly what is the intrinsic value of a given security. ”

    Should be does NOT.

  • Steve

    I wonder how one would do in the longterm building a portfolio of Coke, Abbott and GE in 2014? Coke and GE seem reasonable anchors and relatively reasonably priced.

    I always thought of Abbott as a risky healthcare innovation type stock – but I admit I’ve never examined it closely.

    • Anon

      Warning: Abbott recently spun over half of itself off. You should look at ABT and ABBV.

    • http://www.joshuakennon.com/ Joshua Kennon

      It was already mentioned in this thread by Anon, but you wouldn’t look at Abbott Laboratories by itself anymore because it recently split into two separate companies, one called Abbott Laboratories and one called AbbVie. One is a pharmaceutical firm, the other holds the medical and health care device business.

      If you were to put together a, say, $300,000 portfolio of those three stocks, you would actually buy something more akin to this (not exactly, but we’ll keep it simple):

      Coca-Cola: $100,000
      General Electric: $100,000
      AbbVie: $57,910
      Abbott Laboratories: $42,090

      Given the enormous scale, scope, and diversification across the two firms, I don’t think they are nearly as speculative as one would imagine. In fact, I have shares of all of those stocks in my extended family’s portfolio (e.g., I’ve had my mother-in-law buy shares of AbbVie, and my father buy shares of Abbott Laboratories based on the prices that were available at the time they were making purchases). They all own Coke and GE.

  • FratMan

    Do you ever read newspaper articles from a few decades ago and mourn the slide in our country’s quality of journalism?

    I sinned by reading an old New York Times article and a recent Yahoo piece in rapid succession.

    • http://www.joshuakennon.com/ Joshua Kennon

      It happens at least several times a week, and I still haven’t come to accept it. The last time was a few days ago, when I was reading a detailed account of a court case. One of the parties was quoted as saying a particular sentence, which the reporter attributed to them without any explanation that it was an allusion, almost word-to-word, to a famous political quote from one of the founding fathers that, in the context of the case at hand, was somewhat problematic. The way it was written, I get the very strong feeling the reporter didn’t have a clue what the original passage was or why it was penned; something every 8th grader should know. I don’t think I saved the link because I was so disgusted with the ignorance, but if I come across it I’ll send it to you.

  • David

    Joshua, could you list the handful of investing books you re-read to stay fresh each year? Is applied value investing one of them?

  • http://www.netnethunter.com/ Net Net Hunter

    I’ve read the 1951 ed. 2 or 3 times, and I’m now going through it again. I also read the 6th ed and it’s interesting to see their thoughts evolve.

    BTW, nice bookmark!