Security Analysis: Chapter 2 Summary
Security Analysis is a "must have" book for any serious investor written by Benjamin Graham, David Dodd and recommended by Warren Buffett
Welcome back to the Security Analysis series. In this chapter of “Security Analysis”, Graham and David focused on the elements in security analysis, both quantitative and qualitative. Check out the list of preceding chapters if you’d like to get caught up:
Chapter 1 Summary: The scope and Limitations of Security Analysis. The Concept of Intrinsic Value
Chapter 2 Title: Fundamental Elements in the Problem of Analysis. Quantitative and Qualitative Factors
The objective of security analysis is to answer the following questions:
What security should be bought, sold or retained at what price and when by who?
Four major elements in security analysis:
The security: often times attractive securities are sold at a high price and unattractive securities are traded at a low price. Experiences show that less money has been lost by most investors though paying a high price on an attractive security than paying low price on an unattractive security. Thus, the principle for untrained investors is “Do not put money in a low-grade enterprise on any terms”. The principle for security analysts is “Nearly every issue might conceivably be cheap in one price range an dear in another”.
The price: paying a wrong price for a security is like buying a wrong security. The new-era theory has left price out of reckoning which produces disastrous consequences.
The time: the time factor may affect the conclusion in various ways. All securities are influenced to some extent by the current view of a business and its outlook. Security analysis should concern itself as much as possible with the methods which are valid at all times under all ordinary conditions.
The person: consider the financial position of the intending buyer, their individual competence, temperament, preferences.
Qualitative and quantitative factors in analysis:
To analyze a business, the analyst should consider both quantitative factors and qualitative factors including:
Quantitative factors
Capitalization
Earnings and dividends
Assets and liabilities
Operating statistics
Qualitative factors
The company’s position in the industry
The character of the management
The outlook for the business and the industry in general
Inherent stability
Quantitative factors are more useful than qualitative factors since they are fewer in numbers, easier to obtain, much better suited to forming definitive conclusions. Qualitative factors deal with the nature of the business and the characteristics of the management, both are hard to deal with intelligently.
The trend of future earnings
There is an increasing trend of using future earnings to value a business. It is natural to think that a business with a good record can keep increasing earnings in the future, but these expectations often fail to be realized. Some people mistakenly believe it is mathematically sound but future earnings in fact are just assumptions. The trend of future earnings may be repeated but it should not be considered more useful than past data.
Emphasizing on the trend often times results in errors (overvaluation or undervaluation) in security analysis because trends are arbitrary and there is no limit to how far the trends should be projected. Thus, we treat trend as a qualitative factor, something that analyst take into account but his primary aim is not to “profit” from them as to “guard against” them.
Inherent stability
A major factor in qualitative factors is inherent stability. For stability, it means resistance to change and hence greater dependability for the results in the past. For example, company A has maintained its earning power with little changes over the past 30 years, whereas company B’s earnings fell off sharply during the same period of time.
Conclusion
The analyst must pay attention to the judgment of the market place and the business itself. He must have his own viewpoint. Do not be misled by data and know that the value of data varies. For example, 5 year earnings of a railroad company may be sufficient to determine whether an investment is sound, but 5 year earnings of an oil production company is not sufficient for it require two factors; price and production and they may change radically in the future.