Security Analysis Part I: Survey and Approach

The Purpose Analysis

The task of analysis is to carefully study the facts and draw conclusions based on sound logic and established principles. The craft of Security Analysis deals with four main elements:

1. The Security
2. The Price
3. The Time
4. The Investor

The underlying assumption of analysis is that the market price of securities will often deviate significantly from their intrinsic value, yet with time return to that value.

The task of the analyst is to calculate a range for the intrinsic value of a company. The intrinsic value constitutes investment value and speculative value.

Intrinsic Value = Investment Value + Speculative Value

The investment value of a company corresponds to cashflow it will almost undoubtedly produce in the future based on the stability of the enterprise and its track record. It’s important to note that stability is a qualitative characteristic not quantitative. Certain companies may show consistent past cashflow but a cursory examination of the enterprise will show that this is likely to vary widely in the future. Investment value is easier to calculate in stable businesses and is where analysis should focus.

Speculative value corresponds to an intelligently estimated amount relating to the future prospects of the enterprise and is likely to vary widely. The most qualified entity to decide on speculative value is the market not the analyst. The analyst may merely determine extremes at which the market is almost certain to be wrong. On the low side, if the price is substantially below the investment value, and on the high side if the amount cannot be intelligently justified. For anything in the middle (could easily be between 30–130 for a stock) the analyst must accept the market’s judgement, volatile as it is.

The analyst’s job is not to precisely determine a price, nor does he get rewarded for accuracy. His humble pursuit is merely to realize when the market is unequivocally wrong and act on it.

Hazards

Several hazards exist for the task of analysis. The future is by far the most important. The relationship of the analyst with the future should be to seek protection from what it may bring, not to profit by predicting it. This is similar to the way NN Taleb thinks about predicting.

Another hazard is to not confuse qualitative variables for quantitative. Trends and stability are qualitative variables that get confused for quantitative ones. Analyst must not expect a trend to continue just because it has existed in the past. It’s more likely that when a trend becomes apparent in the data it will be ripe for change. Similar to the observer effect in physics, knowing about a trend is sometimes enough to stop it. Competition will show up seeing profit and growth opportunities, and other investors will bid up the securities for that same trend.

Double counting of management is another common analytical error. Analysts will value management based on the great earnings they have created and then add a premium for the management on top of the valuation already originated in from those same earnings. So in essence they are counting management once in the earnings and then twice in the premium.

Tardy Adjustment is another important hazard. Many time the analyst may find a certain undervaluation of a security, but if the market takes a long time to return to intrinsic value this may end up being a bad investment even though the analyst was correct. Keynes apocryphally echoes this with his quip “Markets can remain irrational longer than you can remain solvent”. Moreover if it takes a while for the market to recognize the price other things may change that may damage the initial basis for the investment. The analyst must guard from this by looking for situations which are not subject to sudden change and where there is a clear path for the market to return to the intrinsic value. Popular securities the public is interested in are likely to return to intrinsic value without much prodding. Secondary securities may need a clear catalyst before it can be determined that investing on the basis of value is justified. Especially if the gap is modest.

Classification

Classification of investment types should be done on the characteristics of the security and the purpose of the buyer; not based on the title or legal claim status. A bond trading at a large discount can act like common stock whereas many preferred shares can trade like bonds.

Its basis is not the title of the issuer but the practical significance of its specific terms and status to the owner… emphasis is on what the owner is likely to get or is justified in expecting, under conditions which appear to be probable at the time of purchase or analysis.

Can be divided into three groups generally:

1. Securities with small to none expected capital appreciation, held solely for income characteristics. High quality bonds and preferred stocks
2. Securities with a moderate but capped potential for capital appreciation and important income characteristic. Convertible preferred, convertible bonds, bonds selling at a discount.
3. Securities who have significant capital upside, mainly common stocks or certain preferred or bonds selling at significant discount or trading solely on the basis of conversion/option rights

It’s interesting that here Graham echoes the recent trend of institutional investors building portfolios based on “factor exposures” instead of the title of the investment.