security analysis graham

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Security Analysis

Benjamin Graham and David DoddMcGraw-Hill 1996725 pages[@]

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Take-Aways When deciding whether to invest in a company, carefully analyze its soundness.

True investments keep the principal safe and deliver an acceptable return. Any purchasethat doesnt is speculation.

Investors often profit by buying securities that are selling below their intrinsic value.

The three main classes of security are investment bonds and preferred stocks,speculative bonds and preferred stocks, and common stocks.

An issuers financial strength and ability to pay determine its bonds safety.

Preferred stocks should meet all the safety tests required of bonds.

You can profit from the purchase of some bonds and preferred stocks that do notqualify as investment grade if they are selling below their intrinsic value.

Privileged issues have the safety of preferred stocks, but they also have the upsidepotential of common stocks.

Portfolio diversification can offset the variability of common stock prices.

As an investor you should evaluate common stocks based on dividends, earnings andasset values.

This summary is restricted to the personal use of HNG ON THIN HUY ([email protected])

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Book: getab.li/2552

Security Analysis getAbstract 2014 2of5

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getabstractWhat You Will LearnIn this summary, you will learn:r1) What security analysis is and how it differs from market analysis; 2) How fixed-value securities, senior securities with variable value and common stocks differ; 3) How to apply the guidelines ofsecurity analysis to each of these three types of security.

getabstractReviewA book that has been in continuous print since its first edition in 1934 obviously has timeless relevance. In theintervening decades since their books initial publication, Benjamin Graham and David Dodds principles of valueinvesting have made fortunes for countless investors. Warren Buffett calls this book his Bible. Much has changed onWall Street since the 1930s, but the concept of investing in undervalued companies has not. In addition to its lucidexplanation of investment basics, the book is a fascinating picture of a time when policy makers still were absorbingthe lessons of the Great Depression: The Securities Act of 1933 had just changed the rules of financial disclosure,and most public companies were manufacturers, mines, railroads or utilities a stark contrast to todays blue-chipportfolio. getAbstract recommends this book to students of financial history and to serious investors who want tocut through modern Wall Street jargon.

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Summarygetabstract

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getabstractAn investment inthe soundest type ofenterprise may bemade on unsound andunfavorable terms.

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getabstractSafety does not residein titles, or forms, orlegal rights, but inthe values behind thesecurity issue.

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What Is Security Analysis?Security analysis is the process of deciding which securities are sound investments. Trueinvestments keep the principal safe and deliver an acceptable return. Any purchase thatdoes not meet these criteria is speculation.

Security analysis has three functions:

1. Descriptive function It presents the relevant facts in an intelligible fashion andcompares various securities.

2. Selective function It judges whether an investor should buy, sell, hold onto orexchange a security.

3. Critical function It monitors corporate policies, management and companystructure on an ongoing basis.

Market analysis, in contrast to security analysis, attempts to forecast prices of individualsecurities or the action of the whole market, without referring to underlying facts aboutindividual companies. One type of market analysis, called technical analysis, refers onlyto past market values in order to predict future values. A second type of analysis refersto indices of economic activity outside the market that, presumably, have some influenceover security prices. Neither of these kinds of market analysis has proven effective and bothessentially promote speculation over reasoned, fact-based investment.

Intrinsic value is an important concept for security analysis. However, intrinsic value isan elusive concept. In general terms, it is understood to be that value which is justifiedby the facts...the assets, earnings, dividends, definite prospects, as distinct...from marketquotations established by artificial manipulation or distorted by psychological excess.Although investors cannot calculate an exact intrinsic value for a given security because




getabstractThe fact that no goodbonds are availableis hardly an excusefor either issuing oraccepting poor ones.

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getabstractNeedless to say, aninvestor is never forcedto buy a security ofinferior grade.

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getabstractThe investor cannotsafely judge the meritsor demerits of asecurity by his personalreaction to the kind ofbusiness in which it isengaged.

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getabstractAn institution withsecurities of its own tosell cannot be lookedto for entirely impartialguidance.

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so many variables are involved, careful examination can determine whether the price themarket quotes is appropriate. Securities that meet stringent safety tests and appear to beselling well below their intrinsic value often can be profitable investments.

Securities traditionally fall into two categories: stocks and bonds. This classification isinadequate, because it pays more attention to the form of the security than to its safetyand purpose. The various types of securities may be more accurately classified into threegroups, each of which has its own criteria for what constitutes a sound investment: fixed-value securities, including high-grade bonds and preferred stocks; variable-value seniorsecurities, including speculative bonds and preferred stocks; and common stocks.

Criteria for Investing in Fixed-Value SecuritiesBonds are not automatically safe investments because of their form. Rather, the soundnessof a bond investment derives from the issuers ability to pay, which is, in turn, based onits financial strength. Therefore, the investor who is considering purchasing a bond shouldask the following questions: Is the value of the companys business more than the value ofits debts? Can the company meet its financial obligations even in the worst-case scenario,such as a recession or depression?

Although no company or industry is depression-proof, two factors contribute to acompanys resilience in hard times: dominant size within its industry and sufficient earningsto cover its bond interest by a large margin. Bonds of companies that do not meet theserequirements are not considered investment grade, even if the yield is highly attractive. Ahigh yield cannot compensate for failure to pay.

Preferred stocks combine the limited return of bonds with the instability of commonstocks. Despite these unattractive features, preferred stocks can be safe investments if theymeet the same safety requirements as a bond, their margin of safety is large enough thatmanagement is unlikely to suspend preferred dividends, and the stability of the companyexceeds that required for a bond investment. These stringent requirements limit the numberof investment-grade preferred stocks to a very select group.

Income bonds, also called adjustment bonds, should be subject to the same strictinvestment criteria as preferred stocks. Guaranteed issues occupy a position betweenbond debt and preferred stocks. Prospective investors must carefully examine the termsof the guarantee and evaluate the guarantors financial strength. Even with fixed-valueinvestments, investors should periodically evaluate their holdings. There is no such thingas a permanent investment.

Although many bonds and preferred stocks do not meet the requirements that wouldqualify them as investment grade, some issues in this category may nevertheless be worthpurchasing, because they are selling at a discount to their intrinsic value. Investors must takecare to avoid issues that are selling at a discount for other reasons for example, becausethe company is financially unsound.

Criteria for Purchasing Speculative Senior SecuritiesSome senior securities carry certain privileges that make them attractive purchases on aspeculative basis, including:

Convertible issues In certain cases, investors can exchange convertible issues forcommon stock.




getabstractWhatever benefits abusiness benefits itsowners, provided thebenefit is not conferredupon the corporationat the expense of thestockholders.

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getabstractUndervaluedinvestment issues maybe discovered in anyperiod by means ofassiduous search.

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getabstractVery frequently, themarkets appraisalsare based on mobpsychology, onfaulty reasoningand on the mostsuperficial examinationof inadequateinformation.

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getabstractYou cannot makea quantitativededuction to allowfor an unscrupulousmanagement; the onlyway to deal with suchsituations is to avoidthem.

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Participating issues Investors can receive part of any increased dividend thatcommon stockholders earn.

Subscription-warrant issues These include option warrants to purchasecommon stock.

These issues combine the increased safety of a senior security and the possible priceappreciation of common stock. However, as with bonds, the attractive form does notmean that all securities of this type are safe. Only a limited number of such issuesmeet investment-grade safety requirements; the remainder belong to the same category ascommon-stock investments, because they share that categorys speculative features. Whenevaluating privileged issues, consider the amount of the profit-sharing benefits per dollarinvested, the proximity of the event that will trigger profit-sharing advantages and theduration of the privileges.

Criteria for Investing in Common StocksCommon stocks, as a class, are much more speculative than senior issues. Yet they areimportant to the US financial system, and novice and expert investors alike eagerly followtheir prices, so security analysts know how to deal with them. The false belief that commonstocks were a good buy at any price as long as the companys earning trend was positive partly fueled the crash of 1929. Clearly the practice of making common-stock investmentssafer deserves further analysis, because the possibility of significant price appreciation willalways lure investors to this type of security.

Although the instability of common stock prices makes any given organization a dubiousinvestment, portfolio diversification can offset this risk to some extent. Investors shouldsubject their common stocks portfolios to thorough analysis.

Examine the following three crucial factors:

1. DividendsBefore investing in a common stock, investigate both the firms dividend rate and its historyof paying dividends. The dividend rate is important, because a dollar of surplus earningsis worth more to the investor when the company chooses to pay it as a dividend instead ofreinvesting it in the business. Generally, companies that pay higher dividends have higherstock prices. However, management can suspend common-stock dividends at any time, soit is important to view the companys dividend history as an indication, but not a guarantee,of future income.

Extraordinary stock dividends (stock splits), on the other hand, are largely illusory, becausethey give investors nothing they did not already own. An improvement on this practice isfor companies to pay periodic stock dividends, representing a return to the shareholders ofsurplus earnings reinvested in the business.

2. EarningsTo analyze earnings, carefully study the companys income statement. While earningsare undoubtedly important, security analysts have accorded them too much weight incalculating a companys investment soundness. Management can manipulate a companysearnings many ways. Therefore, always examine the firms income statement with a criticaleye. For example, businesses can engineer nonrecurring charges and profits to producea favorable earnings trend. A firms accountants also can generate perceived earningsby lowering or increasing the companys reserves, or by reporting subsidiaries results




getabstractModern financingmethods are not thatfar different from amagicians bag oftricks; they can beexecuted in full viewof the public withoutit being very much thewiser.

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getabstractThe typical Americanstockholder is the mostdocile and apatheticanimal in captivity.He never thinks ofasserting his individualrights as owner of thebusiness.

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getabstractThere is very littlealtruism in finance.

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in different ways. Companies can also present depreciation and amortization costs in amisleading manner.

Investors must pay attention to more than current earnings. They should consider both theearnings trend and the long-term earnings average preferably seven to ten years, puttingmore weight on the latter number. The analysts job is not predicting the future of a trendor intuiting possible price changes; it is making decisions based on facts.

3. Asset ValueTo gauge asset value, inspect the businesss balance sheet. A firms book value per shareequals the total value of its tangible assets divided by the number of shares outstanding.Wall Street has almost entirely superseded the importance of asset value with earnings.Although rules of thumb for the proper ratio of market price to book value vary, you stillshould investigate the underlying value of a businesss assets before investing.

The current-asset value that is, current assets minus liabilities is perhaps a moreimportant number. It excludes both intangible assets and fixed assets and is, therefore,a rough approximation of the value of the company should it go in to liquidation. As ageneral rule, if a firms market price is below its liquidation value, the company has eitherbeen undervalued or it should be liquidated. Investors who can distinguish between theundervalued issues and the ones performing poorly due to fundamental unsoundness canrealize a significant upside.

In addition, examine the balance sheet to make sure that the company has an adequatecash position, that its current assets (exclusive of inventories) at least equal its currentliabilities, and that it does not have a large amount of debt maturing soon, which couldcreate refinancing problems.

The Relationship Between Owners and ManagersThe interests of shareholders and those of management do not always coincide. Mostshareholders defer to the wisdom of management without demanding their rights as ownersof the business. In the case of companies whose common stocks sell for less than theliquidating value, the shareholders may be best served by the liquidation of the company, butthat would put management out of a job, so shareholders cannot depend on management tomake the right decision. Investors need to educate themselves about management practicesand take these lessons into account when making investments.

Remember, however, that analysis connotes the careful study of available facts with theattempt to draw conclusions therefrom based on established principles and sound logic.It is part of the scientific method. But in applying analysis to the field of securities, [youwill] encounter the serious obstacle that investment is by nature not an exact science. Still,professional analysis is not only useful, but indispensable.

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About the Authorsgetabstract

getabstractBenjamin Graham, who died in 1976, is considered the father of modern security analysis. The founder of thevalue school of investing, Graham influenced Warren Buffett and others. He was also the co-author of The IntelligentInvestor and The Interpretation of Financial Statements. Grahams protg, economist and investor David Dodd,was an assistant professor of finance at Columbia University in New York City.



security analysis graham

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