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.
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:
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.