Security Analysis: Chapter 1 Summary

Security Analysis is a "must have" book for any serious investor written by Benjamin Graham, David Dodd and recommended by Warren Buffett

As I am reading the Security Analysis, I wanted to share with you the key points and lessons learned I learned coming out of the book “Security Analysis” written by Benjamin Graham and David Dodd, and recommended by Warren Buffett.

Chapter Title: The scope and Limitations of Security Analysis. The Concept of Intrinsic Value. 

Analysis is a careful study of available facts with an attempt to draw conclusions based on principles and logic. 

Before 1927, the advance of security analysis was based on financial reports and statistical data. But in 1927, the analytical approach was abandoned. Although facts and figures were still emphasized, these were manipulated by “a sort of pseudo-analysis” to draw imaginary values. The market crash in 1929 was not a surprise. 

Security analysis suffered discrediting. The the period of 1927 and 1933 is an extraordinary case and can scarcely provide a valid criterion for judging the usefulness of security analysis.

Three functions of security analysis:

• Descriptive function

  • Gathering facts relating to an issue and presenting them in a coherent way.

  • Seek to reveal strengths and weaknesses of an issue and compare them to that of others of similar characters. 

• Selective function

  • Express judgment and determine whether an issue should be bought, sold, hold. For example:

    • In 1922, Wright Aeronautical Corporation stock was traded at $8 per share. The dividend was $1 and earnings was over $2 per share. It had more than $8 per share in cash assets. In this case, analysis would established that the intrinsic value was above the market price.

    • In 1928, the same stock was traded at $280 per share. Earnings was $8 per share. Dividend was $2. Net asset value was less than $50 per share. In this case, analysis would shown that the intrinsic value was far less than the market price.

  • Intrinsic value vs price

    • Intrinsic value is justified by the facts, e.g., the assets, earnings, dividends. They are not the book value which is calculated as the total asset minus the total liability.

  • Intrinsic value vs earning power

    • Intrinsic value was determined by earnings power of an issue, but the average of earnings is an arithmetical result and can hardly represent expected future earnings. That means the concept of earnings an the intrinsic value derived from the average earnings “cannot be safely accepted as a general premise of security analysis”.

  • The role of intrinsic value in the work of analyst

    • Security analysis does not need to find the exact intrinsic value of an issue. It needs to establish whether purchase is justifiable.  

  • Principal obstacles to success of the analyst 

    • Inadequacy or incorrectness of the data (least important because of regulations).

    • The uncertainties of the future.

    • The irrational behavior of the market.

  • The relationship between intrinsic value and market price

    • The market is not a “weighing machine”, on which the value of each issue is recorded using an exact and impersonal mechanism. Rather the market is a “voting machine”, whereon countless individuals register choices which are the product partly of reason and partly of emotion.

• The critical function

  • Judgments are based on applying standards an facts. One must be a critic of accounting policies, management decisions.

Security analysis is a scientific method but just like law and medicine, individual skills and chance are important factors in determining success or failure.