Analysis is extracting information from available facts using established principles and sound logic. Almost all science is based upon some starting points (facts) upon principles and logic are applied to gain insights. That’s how medicine works. Also, mathematics. But not investing.
Analysis to securities is a bit tricky. Like math and medicine, securities have a lot of factors that play a critical role. But unlike math and medicine, securities cannot be treated to The Scientific Control. The Scientific Control is the method of keeping all the variables that affect the result constant except one variable. We observe the changes in result caused by changing that particular variable. In Math, this is achieved through Partial Differentiation. In Medicine, this method is used in Randomized Control Trials.
Both micro-economic and macro-economic factors play crucial roles in influencing securities. Security Analysis does not have the liberty of The Scientific Control as many factors are not under direct control. As a consequence, both skill and chance begin to play vital roles.
If chance plays a vital role, should we give up on Security Analysis? Benjamin Graham tackles the same problem in the very first chapter of his book — Security Analysis. He divides the operation of analysis into 3 functions — Descriptive, Selective and Critical.
The Descriptive Function of analysis should bring all the facts of an issue in a digestible form. The analyst should be sure that the facts presented are facts, the whole facts and nothing but the facts. A more penetrating type of descriptive function should bring opportunity costs also into consideration. It should also ensure that similar securities are brought for comparison.
The Selective Function of analysis should apply established principles and sound logic to the security under question in hopes of answering following questions.
Should I buy, sell or keep this particular security?
What situations would lead to change in my position on this particular security?
How likely are those situations to manifest themselves?
The Critical Function of analysis is more esoteric in nature. In this function, one analyses the tools and logic used in reaching the conclusion. Thus, by the end of this function, one is sure of the answer as well as the method of deriving the answer.
We realize that Security Analysis loses out on Scientific Method and becomes a discipline where both skill and chance play a role. Security Analysis is therefore done to maximize the former and minimize the latter.
