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 purchase that doesn’t 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 issuer’s financial strength and ability to pay to determine its bonds’ safety.
• Preferred stocks should meet all the safety tests required of bonds.
• You can profit from purchasing some bonds and preferred stocks that do not qualify as investment grade if they sell below their intrinsic value.
• Privileged issues have the safety of preferred stocks, but they also have the upside potential 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 and asset values.
• Each of the elements in valuation — assets, earnings power, and growth — is useful in its own right. Still, the best insights into a firm’s value come from comparisons among them, especially the direct comparison between the asset value and the EPV.
• If the EPV is substantially greater than the asset value, that difference is due to superior management or competitive advantages
• don’t make investments into things that have an NPV of less than zero

Scope and Limits of Security Analysis

• Security analysis is the process of deciding which securities are sound investments. True investments keep the principal safe and deliver an acceptable return. Any purchase that does not meet these criteria is speculation.

• common obstacles to analyst

  • inadequate or incorrect data
  • uncertainties of future
  • irrational behaviour of the market
  • “in the short term, market is a voting machine, but in the long term, it tracks value.”

• 3 functions of analysis

  • Descriptive function
    • collecting important facts and presenting them in an understandable manner. This would reveal:
      • reveal strong and weak points
      • make comparisons with similar issues
      • appraise for future performance
  • Selective Function
    • express specific judgment by determining whether an issue should be bought, held, sold, etc.
    • common approach is to analyze the company’s ability to earn and make payments to the investor.
    • Intrinsic value is the estimated valuation based on the analyst’s opinion of the intrinsic worth of the security from different sources of information such as assets, earnings, dividends, growth, management, etc…
      • the value of a business can be analyzed from the perspective of multiple earnings (P/E ratio, “earnings power”). It is cautioned that valuing a business solely from the earnings power is risky and uncharacteristic of wise analysts.
  • Critical Function
    • “Analytical judgments are reached by applying standards to facts.”
    • should seek adequate protective provisions (margin of safety) in bonds and preferred stocks.
    • must be alert to the misrepresentation by accountants and management’s bad practices.

• Market analysis, in contrast to security analysis, attempts to forecast prices of individual securities or the action of the whole market without referring to underlying facts about individual companies. One type of market analysis, called technical analysis, refers only to past market values to predict future values. The second type of analysis refers to indices of economic activity outside the market that, presumably, have some influence over security prices. Neither of these kinds of market analysis has proven effective, and both essentially promote speculation over reasoned, fact-based investment.

• Intrinsic value is an important concept for security analysis. However, “intrinsic value is an elusive concept. In general terms, it is understood to be that value justified by the facts…the assets, earnings, dividends, definite prospects, as distinct…from market quotations established by artificial manipulation or distorted by psychological excess.” Although investors cannot calculate an exact intrinsic value for a given security because so many variables are involved, a careful examination can determine whether the price the market quotes is appropriate. Securities that meet stringent safety tests and appear to be selling well below their intrinsic value can often be profitable investments.

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

Criteria for Investing in Fixed-Value Securities

• Bonds are not automatically safe investments because of their form. Instead, the soundness of a bond investment derives from the issuer’s ability to pay, which is, in turn, based on its financial strength. Therefore, the investor considering purchasing a bond should ask the following questions: Is the value of the company’s business more than its 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 a company’s resilience in hard times: dominant size within its industry and sufficient earnings to cover its bond interest by a large margin. Bonds of companies that do not meet these requirements are not considered investment grade, even if the yield is highly attractive. A high yield cannot compensate for failure to pay.

• Preferred stocks combine the limited return of bonds with the instability of common stocks. Despite these unattractive features, preferred stocks can be safe investments if they meet the same safety requirements as a bond, and their margin of safety is large enough that management is unlikely to suspend preferred dividends. The stability of the company exceeds that required for a bond investment. These stringent requirements limit the number of investment-grade preferred stocks to a very select group.

• Income bonds, also called adjustment bonds, should be subject to the same strict investment criteria as preferred stocks. Guaranteed issues occupy a position between bond debt and preferred stocks. Prospective investors must carefully examine the terms of the guarantee and evaluate the guarantor’s financial strength. Even with fixed-value investments, investors should periodically evaluate their holdings. There is no such thing as a permanent investment.

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

Principles for selection of fixed-value investments

• avoid compromising the assumed risk for an increased reward to minimize the loss of principal
  • if the risk is assumed, it should be in the form of paying a lower price (therefore lowering the principal required to acquire the security) instead of accepting a higher coupon or dividend.

safety is not measured by Lien but by the ability to pay

• safety is measured by the ability of the issuer to meet obligations - not by contractual rights
• in theory, if a business fails, the bondholder recovers his money from assets, but that often fails because:
  • property values shrink when the business fails
  • there is difficulty in establishing legal rights
  • there are inherent delays in receivership
• to avoid trouble is better to seek protection after it occurs
• debt should bed assessed from the cashflow statement
  • “good” debt is when the company is using financed capital for an opportunity or expansion that might require a quick entry into the market
  • “bad” debt is when the business is required to borrow to sustain operations.

obligation possibility should be assessed in terms of depression, not prosperity

• bonds should be bought on their ability to withstand a depression or recession; relative safety is found in companies of a) dominant size and b) substantial margin or earnings over bond interests.
• presumption of safety based upon either the character of the industry or the amount of protection
• Investors should look for industries least likely to be affected by depression.
• investment practice recognizes the importance of the character of the industry. historically, some industries and public utilities have been more stable than others, and equally, their degree of stability has altered with time. This changing dynamic must be considered when assessing an organization’s ability to continue meeting future payments on fixed-income securities
• depression performance as a test of merit.
• various causes of bond collapses
  • the excessive funded debt of utilities: defaults were caused by over-extended debt, not by lack of earnings
  • stability of railroad earnings overrated: such as diminished earnings and a failure to recognize changes in transportation methods
  • unavailability of sound bonds is no excuse for buying poor ones. The investor should never be tempted by the lack of a good opportunity to venture into a poor one.
• there are two incorrect theories:
  • that issuing a bond is a statement of financial weakness
  • bonds are only issued when companies cannot issue stock
• proper theory of bond financing: A reasonable amount of funded debt is an advantage (typically rooted in the company’s ability to quickly take their product or service to market). If the company needs to issue debt to pay its bills and expenses, this is a signal that the bond is unsafe.
• the significance of the foregoing to the investor: whenever money is available, it is invested. When higher-yielding securities disappear from the market, analysts need to accept a lower-yielding security to ensure the protection of the principal instead of choosing more yield in a second-rate issue.

Unsound to sacrifice safety for yield

• lack of safety is not compensated by a high dividend or coupon
• no mathematical relationship between yield and risk: prices and yields often depend on popularity. Graham suggests that the public’s familiarity with the issuing company and its ability to be quickly sold on the market is an essential factor in the market price of bonds
• the factor of cyclical risks: an insurance company spreads the risk over a large field; the investor has only a small field and cannot afford a program entailing a small sample size with a significant risk
• risk and yield are incommensurable. Graham mentions, yet again, that the analyst should not pay a par value for a risky bond that has a high yield. Instead, he should pay a considerable discount below the par value, minimizing his principal risk.
• a reversal of customary procedure is recommended: don’t start with inspecting the safest fixed-income issues on a list and work down. Instead, start with the security that represents a minimum safety threshold and work up on the list. This way, the analyst protects themselves from going deeper into the list - likely resulting in the purchase of an unsafe issue.

definite standards of safety must be applied

• Graham recommends implementing similar rules and regulations that savings banks use for fixed-income investments since they are required and obligated by law to minimize their risk exposure.
• Graham recommends New York Savings Bank as the baseline, but the rules should be regarded loosely and amended if new metrics prove more useful and secure

bond investments criteria

nature and location of the business

• obligations of foreign governments
  • Graham agreed with the decision to disallow the purchase of foreign bonds for the following reasons:
    • the factor of political expediency
    • the foreign trade argument
    • the individual record argument: it is suggested some countries are more creditworthy than others. Graham argues that only Canada, Holland, and Switzerland demonstrated “unquestionable investing ratings” during his era
    • two-fold objection to purchasing foreign government bonds. Generally speaking, foreign bonds should be avoided for two reasons
      • the basis for obtaining credit is fragile
      • the past performance is unsatisfactory. Graham then provides Canada as the sole exception to his doubts
• bonds of foreign corporations: in theory, no company should do better than the country it is located because the government could declare state ownership.

size of the business

• small companies and municipalities are vulnerable, and their bonds should not be considered suitable for the conservative investor.
• NYSB criteria example. Municipal bonds required a population of 10000 in adjacent states and 30000 elsewhere; railroads had to have 500 miles of track and annual operating revenues of 10 million nominal dollars, etc…
  • Graham agrees that the issuer should be of reasonable size, and he also suggests that the underlying theory of cash flow and the ability to repay the holder of the security is more meaningful
• industrial bonds and factor of size: Graham feels these bonds are safe if tested against strict standards. He recommends limiting selections to the six largest corporations in any particular industry.
• large size alone, no guarantee of safety; the size should not be applied to municipalities and utilities but only to industries.

terms of issue

• NYSB only accepts public utility bonds when secured by mortgages. An exception is made for unsecured railroad and income bonds if earnings and dividend records meet severe stipulated rules. Graham argues that the company’s ability to meet its obligations is the top consideration.
• income bonds in a weaker position than debentures. Debentures are required to make payments, whereas income bonds are not required. As a result, Graham believes the mandatory coupon payment for a debenture provides less risk to the holder than an income bond.
• standards of safety should not be relaxed because of early maturity if the same company issued and secured two different short-term and long-term bonds. The risk is no different for either bond if the short-term issue can’t be paid at maturity.

record of solvency and dividend payment

• the investor should ensure the bond issuer has a long record of financial stability and avoid those without a history of success. NYSBs require ten years’ history of payments on issues from other states and 25 years’ history from municipalities.
• Investors should not take higher returns for risk. Instead, they should pay a lower principal. For example, when a municipal government issues new bonds at higher interest rates because of the risk of default, the investor should be skeptical of such investments
• strict quantitative tests would focus on population size, the revenues received and current liabilities
• dividend record not conclusive evidence of financial strength
• balance sheet and income statement provide better clues about a company’s ability to meet future coupon payments than historical dividend performance.
• if the dividend is withheld or reduced to the common shareholders, the health of the bond may be in jeopardy

relation of earnings to interest requirements

• the safety of a bond can be evaluated by comparing the company’s earnings to its interest obligations
• total deduction or “Overall” Method
  • Graham suggests that all bonds depend on each other. He expects all issues to fail if the payment of one cannot be completed.
  • coverage ratio = earnings / total interests on all issues
• minimum requirements for earnings coverage. It’s different for each industry.
• period comprised of the earnings test. NYSB assesses the five previous years for determining the safety of an issue. Graham suggests that the most recent years are the most important
• the relation of the coupon rate to earnings coverage
  • effect of coupon rate on safety: good companies fetch lower interest rates than risky companies. This means that good credit produces better credit
  • effect of rising interest rates on safety
    • if the investor considers a rise in interest rates probable, he should not buy long-term low-coupon bonds, no matter how strong the company is. Inversely, if an investor considers a drop in interest rates, he should buy long-term bonds that meet significant levels of safety.

relation of the value of the property to funded debt

• the soundness of the bond rests on the ability of the issuing corporation to support its financial obligations and much less on the potential value of its property for a lien. With that in mind, there is no purpose in devising a minimal pledged level of property value to support the bond.
• special types of obligations
  • equipment obligations:
    • equipment trust certificates may be issued against specific items of use by the corporation, for instance, against, a car. Although these certificates promise safety at the time of sale, the debtor may only receive 50% of what he expects.
  • collateral-trust bonds
    • these are bonds secured by common stock or other bonds, often of the same corporation.
    • these bonds offer very little security if issued from the same corporation or subsidiary.
  • real estate bonds
    • the value of the property is often directly related to the corporation’s success.
    • property values and earning power are closely related. Graham forcefully cautions investors that this is not true for buildings that were erected for special purposes and manufacturing
    • the misleading character of appraisals
    • abnormal rental used as the basis of valuation
    • debt based on excessive construction costs: over-valuation led to over-building, raising construction costs. When the market caught up, the loan against the expensive costs could not be supported.
    • weakness of specialized buildings such as hospitals or factory
    • values based on initial rentals misleading: rentals obtained on a new building are higher than can be obtained for an old building. The duration of the bond issue needs to account for a declining premium for rent due to the age of the building
    • suggested rules of procedure
      • for single-family dwellings, the lender should be sure the amount lent is not more than two-thirds the value of the property as determined by the market assessment.
      • the lender should fully understand the costs associated with constructing the property and not exceed the mortgage by 50%
      • there should be a conservatively structured income account that accounts for vacancies and a building that doesn’t fetch the premium of a newly constructed property. This account should demonstrate quality coverage over the net income.

relation of stock capitalization to funded debt

• The amount of stock that follows all the different bonds issued by a company (senior and junior issues combined) will always be the resources that remain after all debts are fulfilled.

• standards prescribed by the new york law for the bonds of public utilities

  • all combined mortgage debt will be less than 60% of the assessed property value
  • capital stock (or the common stock and preferred stock combined) at book value will not be less than two-thirds of mortgaged debt.

• equity test of doubtful merit in the case of utilities

  • Graham states that many of the figures used on the balance sheets were unreliable during his era. He feels the test should be used if the company’s earnings are unreliable. In such cases, the analyst may want to increase the standards for test
    • 75% of the property value

• importance of a real-value coverage behind a bond issue

  • Graham encourages the analyst to ensure the “going concern value” (or the market price if the company could be sold as a whole unit) is substantially higher than the funded debt. He challenges the analyst to look at the value of the business itself instead of its pieces.

• shareholders’ equity measured by the market value of stock issues - a supplemental test

  • Graham states that a company with a large market price compared to its total debt is far safer than a company with a lower market price closely resembling its total debt.

• minima for the stock-equity test

  • public utilities -> earnings should be 1.75 times the debt’s interest. The market price of the stock should be at least 50% of the total debt
  • railroads -> earnings should be two times the interest of the debt. The market price of the stock should be 66% of the total debt
  • industrials -> earnings should be three times for industrials. The market price of the stock should be 100% of the total debt
  • these tests were developed to determine a bond’s safety, not common stock.

• income bonds equivalent to stock equity

  • since interest on income bonds (issues that aren’t required to pay coupons) is not a fixed charge, it should not be included in the total charges on which coverage is calculated. Similarly, the principal amount of such bonds is not to be included in the total funded debt. Instead, it is to be compared with the stock equity.

• significance of unusually large stock-value ratio

  • the consideration of a bond’s security is primarily based on its coverage ratio (earnings compared to fixed interest charges) and its stock value ratio to total bonded debt.
  • the coverage ratio provides the coverage of the coupon payment, and the ratio of stock value to total bonded debt indicates whether the par value can be repaid. The issue may still be safe when either of these ratios is uncharacteristically high while the other is low.

• stock-value ratio for railroad and public utility companies.

  • applying a stock value ratio to railroads and public utility companies is difficult because of rental obligations and preferred stock of subsidiaries that rank before the parent company’s bonds. Regardless of those difficulties, Graham states that close attention to the stock-value ratio would have prevented major mistakes by bond investors in 1935-1937

• stock-value test not to be modified to reflect changing market conditions

  • Analysts might be inclined to adjust the stock-value ratio with changing market conditions (because it uses the current market price). For example, during a bull market, market prices are higher, but the total debt of a bond is fixed. Therefore a ratio of 2:1 should potentially be increased to 3:1 during growing market prices. Graham suggests practical application is too challenging to implement.

• Summary of minimum quantitative requirements suggested for fixed-value investment

  • it’s important to note that the following recommendations were from the 1930s
  • the size of the issuing organization: Municipal bonds should be from a local government with more than 10000 tax-paying citizens. For businesses, they should produce annual gross revenues of $2 million for public utilities, $3 million for railroads, and $5 million for industrial
  • interest coverage is the comparison of earnings to fixed debt obligations. The seven years average interest coverage for each of the following enterprises is 1.75 times the fixed debt for public utility bonds, two times for railroad bonds, three times for industrial bonds, and 2 times for real estate bonds.
  • the value of the property: the fair value of the property should be more than 50% of the bond’s par value
  • the market value of the stock issues: This compares the company’s stock market price to its total bonded debt. The stock price should be at least 50% of a public utilities bonded debt, 66% of a railroad’s bonded debt, and 100% of an industrial’s bonded debt.

special factors in bond analysis

• Graham encourages investors to find companies with large working capital because it displays a healthy organization that can meet future debt obligations.

• parent company only vs consolidated return

  • Graham identifies his deep distrust for the parent company’s operational subsidiary relationship concerning how the income statement is reported. He briefly describes and shows on a chart how the coverage ratio is drastically different when the income statement is viewed from the consolidated report to the “parent company only” report.

• dividends on preferred stocks of subsidiaries

  • Graham provides an example where a parent company fails and goes into receivership. Before the failure, the parent company had a subsidiary paying a preferred share dividend. After the failure, the dividend was immediately discontinued. The event left the parent company’s bondholder (debenture holder) empty-handed. The example demonstrates the importance of thoroughly understanding this structure’s prioritization and having backed security.
    • subsidiaries’ bond interest
    • subsidiaries’ preferred dividends
    • parent company’s bond interest.

• minority interest in the common stock of subsidiaries.

  • the earnings of minority stock are usually deducted from the income statement after the parent company’s bond interest. Therefore, it does not reduce the margin of safety calculation. Graham suggests subtracting the minority interest before calculating the interest coverage for a more conservative estimate.

• capitalization of fixed charges for railroads and utilities

  • For example, the railroad industry may lease their cars from other businesses. These leases hold considerable fixed expenses on the company and ultimately impact the health of the bonds the company has issued.
  • after identifying this concern, Graham recommends a rule of thumb for multiplying the fixed charges on the income statement by 22. This would provide a capitalization of 4.5% on all the fixed charges. This was determined by taking the inverse of 22. It’s important to note that interest rates for railroad debts during 1938 were 4.5%. Therefore, this technique could be applied to any industry where fixed charges have numerous variables.
  • it would be important to adjust the capitalization rate based on the average rates for bonds in that industry.

• The working-capital factor in the analysis of industrial bonds

  • it’s important that a company has excess current assets compared to current liabilities. This excess is called working capital.

• 3 requisites for working capital

  • when assessing the working capital, Graham suggests three items should be evaluated
    • the cash holdings are ample
    • the ratio of current assets to current liabilities is strong
    • the working capital bears a suitable proportion of funded debt.
  • the general rule of thumb is that current assets should be double the current liabilities.
  • Graham challenges the industrial bond investor to find companies with enough working capital to cover all the bonds issued.
  • companies with large working capital should be favoured without significant working capital.

Criteria for Purchasing Senior Speculative Securities

• Some senior securities carry certain privileges that make them attractive purchases on a speculative basis, including:

  • “Convertible issues” – In some instances, investors can exchange convertible issues for common stock.
  • “Participating issues” – Investors can receive part of any increased dividend common stockholders earn.

  “Subscription-warrant issues” include option warrants to purchase common stock.

• These issues combine senior security’s increased safety and the common stock’s possible price appreciation. However, as with bonds, the attractive form does not mean that all securities of this type are safe. Only a limited number of such issues meet investment-grade safety requirements; the remainder belongs to the same category as common-stock investments because they share that category’s speculative features. When evaluating privileged issues, consider the amount of the profit-sharing benefits per dollar invested, the proximity of the event that will trigger profit-sharing advantages and the duration of the privileges.

Criteria for Investing in Common Stocks

• Common stocks, as a class, are much more speculative than senior issues. Yet they are important to the US financial system, and novice and expert investors eagerly follow their prices, so security analysts know how to deal with them. The false belief that common stocks were a good buy at any price – as long as the company’s earning trend was positive – partly fueled the crash of 1929. Clearly, the practice of making common-stock investments safer deserves further analysis, because the possibility of significant price appreciation will always lure investors to this type of security.

• Although the instability of common stock prices makes any given organization a dubious investment, portfolio diversification can somewhat offset this risk. Investors should subject their common stock portfolios to thorough analysis.

• Uncertainty regarding future growth is usually the main reason why value estimations based on present value calculations are so prone to error

theory of common stock investment

• investment in common stock is often speculative, and analysis may be inconclusive and unsatisfactory.
  • common stock is of basic importance and enormous interest
  • the owners of the common stock with to know their value
  • human nature often masks the logic behind an endless cycle of greed for profit.
• history of common stock analysis: over the previous 30 years (from 1910-1940), common stocks have become more favoured due to their substantial earnings and dividends. With more and more companies providing detailed financial information, investors have had statistical data to substantiate their investments. During 1927-1929, Graham says most investors neglected this analysis and purchased more common stock based on speculative greed for profit and prophecy
• analysis vitiated by two types of instability:
  • Graham suggests two types of instability will destroy the analysis of common stock:
    • instability of tangibles aspect
    • enormous importance placed on intangible aspects
• a company’s market price was generally stable and predictable if the companies had the following characteristics:
  • the company paid a reasonable and consistent dividend
  • earnings were stable and averaged a substantial margin over the dividend
  • each dollar of market price was backed by actual assets of equal value on the balance sheet - Or in other words, the book value was similar to the market price
• prewar (WW1) conception of investment in common stocks
  • before the world war, the analyst was primarily concerned with finding common stocks that paid consistent dividends and possessed stable earnings. Most emphases was placed on past performance and little on future earnings growth.
  • speculation characterized by an emphasis on prospects
  • the technique of investing in common stocks resembled that of bonds
  • buying common stocks is viewed as taking a share in a business
    • if a businessman were going to purchase an entire company outright, he would likely start with the net worth of all the assets (or equity on the balance sheet) and then consider if the choice produced adequate earnings for the price. After looking at the earnings that the company produced, the investor would decide if he was willing to pay a premium or discount to that par value (or book value)

newer cannons of common stock investment

• The new era theory
  • during the roaring 1920s, there was the idea that the value of common stocks was completely dependent on what they will earn in the future. This new thesis had three supporting insights:
    • the dividend holds a little emphasis on the value
    • the relationship between asset value and earnings power had little significance
    • the past earnings were of little significant value except when signifying momentum in growth
  • cases for this changed viewpoint
    • in short, Graham thinks that the drastic change in common stock valuation stemmed from unpredictable results often seen from using historical data and the irresistible potential for profits that had occurred.
    • in the early 1930s many liquidations occurred. These events often produced very little value for the companies’ fixed assets listed on their balance sheets. This experience also caused investors to abandon the emphasis on book value or net work of assets.
  • attention shifted to the trend of earnings
  • the common stocks as long-term investments doctrine
    • few key points
      • the value was based on what the common stock could earn in the future
      • good common stocks have rising earnings (or EPS)
        • what it excludes is the idea that a price is associated with the earnings one can expect to receive
      • relies on an improvement in the stock’s future performance.
      • therefore approaching speculative.
  • new era investment equivalent to prewar speculation
  • stocks regarded as attractive irrespective of their prices: non-sense
  • investment trusts came to resemble this new doctrine
    • analysis abandoned by investment trusts. Graham voices his disgust for the professional investor who didn’t safeguard the capital of their customers due to a lazy assessment of facts and risk analysis
  • a sound premise used to support an unsound conclusion
    • in 1924, a book by the name common stocks as long-term investments by Edgar Lawrence smith was published. The premise of the book is that common stocks outperform bonds because not all the earnings are paid to the owners as dividends. These retained earnings by the company make the value of the common stock increase in market price. Although Graham agreed with the basic tenants of Edgar’s thesis, he strongly disagreed with the exaggeration many investors took in their application of his ideas.
  • average vs trend of earnings
    • Graham suggests that earnings trends and earning averages are nothing more than speculative tools for analysts to predict future results. Companies that have accelerated growth demonstrate an untapped market for more competitors.

three general approaches

• secular expansion as basis

  • have a diversified portfolio of common stocks
  • when recessions occur, the investor can still benefit in the common stock markets by 1) diversifying their portfolio and 2) adamantly rejecting the common stock trade for excessive premiums.
  • Graham says the investor cannot rely on historical earnings growth to provide safety and profit in the long haul. Specifically, he’s talking about companies that are commonly referred to as “growth picks”

• individual growth as the basis of sections

  • use quantitative and qualitative factors to determine the value of common stocks similar to the techniques for bonds.
  • what are growth companies?
    • maybe a company whose earnings move forward from cycle to cycle.
    • maybe the company’s earnings grow at a faster rate than the general market
  • Can investor identifies them?
    • no, the typical investors can’t really determine when and where the company’s growth will eventually subside. As a result, there’s a strong chance that the investor might select the stock “at the top of the earnings wave”
  • does the price discount the potential growth?
    • it’s difficult to determine the price to pay for future earnings that haven’t been demonstrated yet.
    • it’s impossible to predict how much longer the earnings growth will take. One thing almost everyone can agree on is that high earnings growth (like 30%) is temporary and not sustainable.
  • may such purchases be described as investment commitments
    • can thorough analysis and thought to go into the selection of the growth stock?
      • maybe yes, as some growth investors do conduct themselves appropriately
    • is the price paid for the investment something that a reasonable person would pay if they could buy the whole business?
      • if a person is willing to pay more than 20% more for a common stock than he would for outright ownership of the entire business, the pick becomes speculative.
  • utilize even more effort than bonds to assess the future outlook of common stocks

• selection based on the margin of safety principle

  • factors complicating efforts to exploit general market swings
    • index of leading stocks was selected and analyzed as a group (like the S&P 500). Also, a base or normal value for the group of stocks could be determined by taking their average earnings and capitalizing them at the going long-term interest rate (like the 10 or 30-year federal bond). This is where Graham tells analysts that the intrinsic value of stocks is directly tied to interest rates.
      • this approach has three drawbacks
        • first, the general market patterns may be anticipated, but the buying and selling points may still be chosen poorly.
        • market behaviour may change in the future and not respond in the same manner as before
        • this approach requires a very determined and vigilant individual because his actions will be the opposite of human psychology.
  • the undervalued individual issue approach:
    • the likelihood of finding an individual common stock that possesses the qualitative factors and the quantitative factors (compared to price) is rare. if this type of stock issue is found, Graham says it should be classified as an investment, not speculation.
    • Graham says the most important way to view the purchase of common stock is if the investor could purchase the entire business at once.

1. Dividends

• Before investing in a common stock, investigate the firm’s dividend rate and its history of paying dividends. The dividend rate is important because a dollar of surplus earnings is worth more to the investor when the company chooses to pay it as a dividend instead of reinvesting it in the business. Generally, companies that pay higher dividends have higher stock prices. However, management can suspend common-stock dividends at any time, so it is important to view the company’s dividend history as an indication, but not a guarantee, of future income.

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

  • although stock dividends and stock splits create no real value for the holders, much speculation about the value of the companies after the division is likely to occur due to the lower price.

• periodic stock dividends

  • with a periodic stock dividend, the shareholder often receives a smaller and more reasonable stock dividend that adds value over time.
  • The company should not provide a periodic stock dividend if the amount exceeds the funds retained in earnings. The dividend could eventually exceed the company’s ability to retain earnings power, and the EPS slowly declined over a 10-year period, along with the market price.
  • Graham suggests the dividend should be dispersed as a preferred share.
    • it doesn’t weaken the business’s capital structure like the common stock dividend.
    • allows the company to retain earnings until a safe and manageable surplus is realized.
    • this technique gives management flexibility and control to pay the dividend as long as they choose.
    • once the retained earnings have been distributed, the obligation is no longer on the books once the company repurchases the preferred share.

• Graham suggests that the market price of common stocks will perform similarly if management pays a healthy and sustainable dividend.

• established principle of withholding dividends

  • Graham claims that two companies with the same general business model and the same earnings will trade at different prices if the dividend policy is different. The market will value the company with the higher dividend more favourably.
  • should a company pay a lower dividend to create stability for the owner with an assured payment, or should it pay a higher dividend and meet its obligation irregularly?

• the merits of “plowing back” earnings

  • there’re two reasons retained earnings are beneficial to the stockholder.
    • whatever was good for the company was good for the shareholder.
    • a company that retained earnings had more agility to remain competitive in difficult markets.
  • if a company sustains a favourable ROE over a long period, it means the management is properly investing the retained earnings and adding value to the shareholder.

• dividend policies arbitrary and sometimes selfishly determined

  • Graham suggests that many board members are executives and friends of executives with very large portions of shares. As a result, they might want to minimize their tax burden by receiving smaller dividends from the company.
  • leadership may seek a larger and more impressive sized business, therefore, using retained earnings to full fill their pursuit of an ever-growing business (which may or may not add more earnings)
  • management may seek the opportunity to purchase outstanding shares at lower prices with the retained earnings.
  • management that pays a small dividend can pay excessive salaries to executives and top-level employees.

• arbitrary control of dividend policy complicates the analysis of common stocks

• suggested principle for dividend payments: Graham strongly believes that a company should pay a large portion of their earnings to the shareholders. He says it’s more important for the shareholder to receive non-standard (or inconsistent) dividend rates at a higher return instead of a lower and more consistent dividend, which likely results in the company accumulating reserves that add little value.

2. Earnings

• To analyze earnings, carefully study the company’s income statement. While earnings are undoubtedly important, security analysts have accorded them too much weight in calculating a company’s investment soundness. Management can manipulate a company’s earnings in many ways. Therefore, always examine the firm’s income statement with a critical eye. For example, businesses can engineer nonrecurring charges and profits to produce a favourable earnings trend. A firm’s accountants also can generate perceived earnings by lowering or increasing the company’s reserves or by reporting subsidiaries’ results in different ways. Companies can also misleadingly present depreciation and amortization costs.

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

• Analysts should combine the information from the balance sheet and income statement to garner the best valuation.

• disadvantages of sole emphasis on earning power:

  • earnings statement has more variability than the balance sheet and therefore changes the value of the business, making it appear unstable. The income statement can be more misleading than the balance sheet.

• simplified statement of Wall Street’s Method of appraising common stocks

  • price = Current Earnings Per Share (EPS) x Quality Coefficient
  • how does the quality coefficient is determined?
    • probably by a whole host of factors such as dividend rate, history, size and reputation of the business. Graham suspects all these factors are dwarfed by the real factor, which is the earnings trend.

• earnings not only fluctuate but are subject to arbitrary determination

  • some of the techniques management can use to misrepresent earnings in the short term are the following
    • through allocating items to surplus (on the balance sheet) instead of revenue
    • through misrepresented amortization charges
    • through an amendment of the capital structure
    • through the use of large capital funds for items that don’t pertain to the business

• significance of foregoing to the analyst:

  • in the end, the analyst should be able to answer three questions:
    • what are the true earnings for the period studied?
    • what indications does the earnings record carry as to the future earning power?
    • what standards should be applied to the income statement to arrive at a reasonable valuation?

• criticism and restatement of the income account

  • the analyst will need to pay close attention to the ambiguous way the account rules can be applied
    • non-recurrent profits and losses. This is a one-time or highly infrequent profit or loss.
    • operations of subsidiaries and affiliates
    • reserves

• general observations on the income account

  • accounting rules permit management a range of choices in recording non-recurrent and special items, selecting between income and surplus. Such items may be:
    • profit or loss on sale of fixed assets
    • profit or loss on sale of marketable securities
    • discount or premium on the retirement of capital obligations
    • proceeds of life insurance policies
    • tax refunds and interest on refunds
    • gain or loss from litigation
    • extraordinary write-down of inventory
    • extraordinary write-down of receivables
    • the cost of maintaining non-operating properties
  • the above items must be separated from the ordinary operating results to indicate earning power clearly (what the company might be expected to earn if the business condition remained similar)

• non-recurrent items: profits or losses from the sale of fixed assets: these are not to be shown in current net income. They should appear in the surplus account

• profit from the sale of marketable securities

  • must be separated from ordinary operating results
  • methods used by investment trusts in reporting the sale of marketable securities: overall changes in principal value are the only measure of an investment trust’s performance, and this cannot be equated with recorded earnings of an industrial corporation.

• profits through the repurchase of senior securities at a discount

  • a corporation may buy back its securities at less than par value; any gain made is non-recurring and should be recorded as such. This was a feature of the depression years 1931-33

extraordinary losses and other special items in the income account

• as inventory losses are directly related to the conduct of the business, Graham suggests that they should not be treated as extraordinary
• manufactured earnings:
  • one example such as receivables and inventory written down to an artificially low “cost price,” which in turn will lead to a manufactured higher profit in the year to come. This illustrates the most vicious type of accounting manipulation: taking sums out of surplus and then reporting these same sums as income in the following years. The danger of this accounting method is that the public is not likely to recognize it, and even the expert analyst might have difficulty detecting it.
• reserves for inventory loss
  • companies continuously set aside reserves to absorb losses on inventory before they occur. The implication is that the income statement does not always reflect inventory losses.
• other elements in inventory accounting
  • the standard procedure is to take inventory at the close of the year, measured by the lowest cost price or market price.
  • last-in, first-out: measure the amount paid for the most recently acquired inventory. The theory behind this method is that a merchant’s selling price is related mainly to the current replacement price or the recent cost of the article sold. This method may be useful to reduce income tax if there is inventory fluctuation.
  • the normal stock or basic-stock inventory method: a more radical method of minimizing fluctuations is the company must possess a certain physical stock of materials from year to year. This “permanent stock” would therefore keep the same value and not be imposed on price changes. To permit the base inventory to be carried at an unchanging figure on the balance sheet, the practice is to mark it down to a very low unit price, so low that it should never be necessary to reduce it further.
• idle-plant expense: the cost of carrying non-operating properties is almost always charged against income. Graham suggests it should not. Doing so, it’s misleading to the expenses of the company’s core product or service. The analyst may properly consider the idle-plant expense as belonging somewhat different from ordinary charges against operating income, as these expenses, by nature, are not part of the company’s normal operations.
  • in theory, these expenses should be temporary since the management can terminate these losses at any time by disposing of the property. Therefore, if the company chose to spend the money, Graham does not deem it logical to consider these assets equivalent to a permanent liability.
• deferred charges
  • a business sometimes incurs expenses which apply to a number of years rather than a single 12-month period, such as:
    • organization expenses (legal fees, etc…)
    • moving expenses
    • development expenses (for new products, processes, opening up a mine, etc…)
    • discount on obligations sold
  • the company is allowed to spread these types of costs over an appropriate period of years (5 years is a customary period). It is entered upon balance sheets as deferred charges, which are written off by annual charges against earnings.
  • it is incorrect to write off these types of expenses in a single year and against a ‘surplus’ as net income for coming years would be overstated, followed by the understated operating expenses.
• amortization of bond discount
  • the discount should be amortized over the bond’s life by an annual charge against earnings.
  • the write-offs could be written against surplus to eliminate future annual deductions from earnings and in that way, to make the shares appear more valuable. This practice has aroused considerable criticism in recent years both from NYSE and from S.E.C

misleading artifices in the income account. Earnings of subsidiaries

• if the parent company has an unprofitable division, its losses must be shown as a deduction from normal earnings
• flagrant example of padded income accounts: on rare occasions, management would include earnings in the income statement that have no existence.
• balance sheet and income-tax checks upon the published earnings statements
  • to check upon the reliability of the published earnings is to look at the amount of federal income tax accrued. The taxable profit can be calculated from the income-tax accrual, which is compared in turn with the earnings reported to stockholders. The two figures should not necessarily be the same since the tax laws may give rise to some divergences. However, the wide differences should be noted and made the subject of further inquiry.
• one cannot make a quantitative deduction to allow unscrupulous management; the only way to deal with such situations is to avoid them.
• subsidiary companies and consolidated reports
  • consolidated reports occur when an enterprise controls one or more operational subsidiaries so that it can disclose companies’ financial reports as a ‘group’ or one entity.
  • the important part of consolidation is to ensure nothing is counted twice, for example, the subsidiary’s profit.
• special dividends paid by subsidiaries
  • parent companies can supplement their earnings through special dividends paid by their subsidiaries. This can be very misleading to an analyst, who needs to account for this in their evaluation process.
• broader significance of subsidiaries’ losses
  • should a subsidiary’s losses be represented on the parent company’s earnings?
  • should the analyst discount the value of the parent company if they own an unprofitable interest in another company?
  • it is clear from the standpoint of proper accounting that as long as a company continues to control an unprofitable division, its losses must be shown as a deduction from normal earnings.
  • if the amount involved is significant, the analyst should investigate whether or not the losses may be subject to early termination
  • the analyst may consider all or part of the subsidiary’s losses equivalent to nonrecurring items.

relation of depreciation and similar charges to earning power

• leading questions relative to depreciation

  • if a capital asset has a limited life, provisions must be made to write off the cost of the asset by charges against earnings distributed throughout the asset’s life.
  • three complications arise
    • accounting rules may permit a value other than cost to acquire the asset as the basis for amortization charges.
    • there are numerous ways a company can execute their depreciation/amortization charges from the balance sheet to the income statement.
    • sometimes, account rules allow companies to make depreciation charges which don’t represent the reality of assets depreciation over time. This makes the analysts’ job very difficult to assess capital expenditures.

• depreciation base other than cost

  • Graham suggests substituting the replacement value of all the fixed assets at a given date while everything prior is depreciated according to current accounting standards.
  • in most cases, companies don’t place much interest in ensuring their depreciation charges represent their assets’ ever-changing replacement costs.

• mark-downs to reduce depreciation charges

  • Graham believes that excessive write-downs of fixed assets are inexcusable and should not be condoned by the accounting profession. Accountants should refuse to certify a report containing such mark-downs.

• balance sheet-income account discrepancies

  • prevalent in the case of mining and oil companies, it is to mark up fixed assets and then fail to increase the corresponding depreciation charges on the income statement. This is done to benefit from the higher valuation in their balance sheet without accepting the burden of consequently higher depreciation charges against net income.

• the vast majority of industrial companies follow the standard policy or charing an appropriate depreciation rate against each class of depreciable assets.

• when the analyst knows that a company’s depreciation policy differs from the standard, there is a special reason to check the adequacy of the allowance. Comparison with a company in the same field may yield significant differences.

• depreciation charges are often an issue in mergers

• concealed depreciation, such as understated depreciation, hence overstating the earnings power.

• amortization charges of oil and mining companies

  • depletion charges of mining companies
    • depletion represents using capital assets by turning them into products for sale. It applies to companies producing metals, oil and gas, sulphur, timber, etc… As the holdings, or reserves, of these products, are gradually exhausted, their value must gradually be written off through charges against earnings.
  • independent calculation by investor necessary: in mining, the investor must ordinarily compute his depletion allowances for his share of the mining property.
  • depletion and similar charges in the oil industry:
    • in the oil industry, depletion charges are closer related to the actual cost of doing business. Large oil producers normally spend substantial sums of capital each year on new leases and wells. This is needed to make up for the shrinkage of reserves throughout continued production. In general, depletion charges are cash outlays to maintain reserves and production.
    • Graham then provides an assessment of how some oil companies would misrepresent the actual lifetime of the asset by extending or shortening the depletion and depreciation of their assets. This was typically exercised so the company could control the market price through earnings manipulation.
  • the meaning of these variations to the analyst and the investor
    • analyst should seek to apply a uniform and reasonably conservative rate of amortization that reflects the realities of fixed assets.
      • depreciation on tangible assets. This should always be applied to cost - or a figure substantially less than cost.
      • intangible drilling costs. Capitalizing these costs and then writing them off as oil is produced is the preferable basis for comparative purposes and to supply a fair reflection of current earnings.
      • property retirement and abandoned leases. A loss on the property should be charged against the year’s earnings rather than against the surplus.
      • depletion of oil reserves. The proper principle here is that the analyst should allow for depletion based on the current market values of the oil.
        • in the case of integrated oil companies, accept the company’s depletion figure as the best available.
        • In companies that are solely or virtually oil producers, the analyst can compute what the market is paying for the total developed oil reserves.

• other types of amortization of capital assets

  • leaseholds and leasehold improvements
    • if a lessee is renting a property at a large discount to the actual cost of owning the property - and the terms of the contract are over a long period - there may be significant value to account for.
    • oil lands are leased on a standard royalty basis, usually one-eighth of the production. Such leaseholds can be worth much more than the rental payments involved. If a company has paid money for a given leasehold, the cost is regarded as a capital investment that should be written off during the life of the lease. These charges are part of the rent paid for the property and must therefore be included in the current operating expense.
    • when the leased property is improved with assets fixed by the lease, the cost must be written down to nothing during the life of the lease. This is due to the landlord ultimately owning the property and the tethered asset when the lease expires. The annual expense for this purpose is called “amortization of leasehold improvements.” Chain-store enterprises, and consequently, the annual write-offs may be of significant importance in their income statements.
  • amortization of patent: in theory, a patent should be dealt with the same way as a mining property; i.e., its cost to the investor should be written off against earnings during its remaining life.
  • amortization of goodwill: in modern accounting. Goodwill is continually tested for impairment but isn’t amortized.

public utility depreciation policies

• inadequate depreciation revealed by transfer from surplus and reserves, such as in the case of Brooklyn Union Gas.
• variety of depreciation policies
  • Depreciation Proper
    • Straight-line method: each class of depreciable property is written down by equal annual charges during the period of its estimated life
    • sinking-fund method: the effect of this method is to make the deductions somewhat smaller in the earlier years and correspondingly higher in the later years. This is because depreciation is assumed to earn interest until the property is retired.
    • the overall method: single annual percentage to the entire depreciable property account is used, instead of varying rates to different classes of assets. The object is to arrive at a simple approximation of the actual depreciation.
  • retirement reserve methods
    • a retirement reserve intends to have funds available when an asset retires. Over any long period, proper depreciation and proper retirement allowances should yield the same results. In reality, the majority of retirement reserve policies operate simply to understate the current loss of property value and thus overstate the earnings.
    • various methods of calculating retirement reserves are:
      • percentage of gross. this method would tend to approximate a regular depreciation rate if the percentage taken were adequate. Generally, this is not the case.
      • fixed rate per unit of product. This method resembles the previous one and is subject to the same criticism. Instead of a percentage of gross product, an example used is $2.7 in depreciation for every thousand kilowatt-hours sold.
      • Overall percentage of Gross for maintenance and depreciation combined. By this method, the larger the amount spent for maintenance, the smaller the amount saved in reserve for depreciation.
      • discretionary deductions. The annual deduction is largely based on the judgement of the management. It might be the same or varying amount from year to year.
    • double accounting policies on depreciation.
      • regardless of what method is followed in the annual reports, practically every company follows the straight-line basis of depreciation in computing its income tax. As a result, the investor must determine whether the depreciation is representative of the linear or non-linear erosion that takes place on the value of the asset over time
      • Reasons for accepting, in general, the income tax base. Graham presents five major reasons for accepting the income tax figure rather than the income statement as the basis of depreciation:
        • the straight-line basis follows a definite and logical accounting theory. If there is an excessive deduction, the Treasure Department won’t’ accept it.
        • the inadequacy of the “retirement reserve” idea has been shown by the necessity in many cases of making large transfers from surplus to support the retirement reserve.
        • Since 1934, there has been an almost universal increase in retirement allowances. This can be perceived as a strong indicator that past allowances were too small and, therefore an overstatement of earnings.
        • some state commissions and federal commissions have now ordered companies within their jurisdictions to follow the income tax depreciation base.
      • instance when income tax basis should be rejected or questioned. while Graham generally believes in accepting income tax basis, there may be times when figures in the annual report should be accepted, or even seek the third basis.

amortization charges from the investor’s viewpoint

• problem indicated by hypothetical example

  • typical market appraisals
    • a company with less valuable assets in terms of accounting is worth considerably more than a company with a higher value asset. This is done by a single gesture of writing down company C’s assets to almost nothing immediately upon the purchase.
  • a more rational approach. A more practical approach would be to include the fair value of the respective assets and add that to the cash holdings. The investor might consider which depreciation method should be used.

• practical application of foregoing reasoning. depreciation is not a cash outlay but deducted as an expense on the income statement. As a result, the company reports no income, yet the cash account continues to grow because the displayed income is offset by depreciation charges.

  • How to determine the proper depreciation charge the investor or the analyst must come up with an estimate for depreciation which aligns with the actual conditions of the business (based on the discoverable facts).
  • concept of expended depreciation. The primary reason for reducing a company’s depreciation charges is that it doesn’t properly reflect the company’s cash flow. In short, as an asset’s life continues to get older, the value that it is listed on the company’s balance sheet will continue to decrease. As a result, an investor should see the value of tangible and intangible assets slowly decrease over time.
  • long-term depreciation a form of obsolescence. For instance, a plant may not be wearing out but rather being obsolete due to changes in the industry and the status of the corporation. This risk is rather due to the investment and not accounting. Hence it should be incorporated in the price and not in the depreciation, as it is a business risk. Therefore, the carrying value of the asset should be adjusted accordingly. The company’s management should conduct this value test for asset impairment quarterly.
  • Application of foregoing in determining earning power. For companies similar to a railroad, only the expended depreciation should be deducted from earnings due to maintenance, renewals and repair to a large degree.

• depreciation on apartment and office buildings. In short, the asset can’t be depreciated for more than the price paid to acquire it.

• inadequate allowance for depreciation. Assets should not be written down in large amounts early in the assets’ life to make the earnings power appear more abundant during the assets’ final years of life. This represents the true cash flow of the business.

• stock watering reversed. This manipulation of asset value by writing the book value up and down is interrelated with the value of the stock. This would inflate the stock prices by the higher book value of the fixed assets (known as stock watering)

• The purchases’ amortization calculation. Where the life of a mining property is limited, the investor’s calculation of amortization should be deducted from earnings. He can base this on three factors 1) the price paid for the mining property. 2) the earnings before depreciation and depletion 3) the minimum life of the mine, and alternatively, the probability of life.

• purchaser amortization of oil reserves. Depreciation and depletion charges per barrel are found by dividing the estimated remaining oil reserves into the net value of the properties on the books.

• purchaser’s amortization of patents. The question for the investor is how much she is paying for the patent when she buys the stock at a given price. This is the amount she must use for writing-off subsequent earnings.

• general rule. In reality, no single calculation shown above will represent stocks wholistically. For big companies, it is even harder since they have a bulk of patents and intangible items.

• special cases. In some special cases, when a company’s business primarily collects royalties on a patent or a group of patents, some finite provisions can be made. This provision must be related to the price the investor paid for his interest in the patent and not to the book value of the patent.

significance of earnings record

• concept of earning power: the average earnings per share should be seen over several years. One should notice if the observed years are all surrounded by the average. This is preferred to very volatile earnings, as repeated occurrences are more impressive than a single occurrence.
• quantitative analysis should be supplemented by qualitative considerations:
  • quantitative data is useful only to the extent that it’s supported by a qualitative survey of the enterprise
  • in the steel company example, while current and past earnings are one thing, Graham aims to calculate ‘normal earnings.’ He suggests that the national steel output and the market position should be considered as part of a qualitative analysis. Reported earnings cannot be viewed without relative factors.
• current earnings should not be the primary basis of appraisal
  • current earnings govern the market price of common stock prices more than the long-term average. While private businesses might earn twice as much as their average years, their local market price would never be purchased based on the extraordinary earnings year.
  • the market price typically corresponds very closely to the earnings regardless of the abnormalities in earnings.
  • As the speculative public shares its vision with Wall Street, it would seem logical to buy the cheap stock at temporarily suppressed earnings and sell them at inflated levels created by the opposite effect.
  • The classical formula for “Beating the Stock Market”
    • On Wall Street, the common assumption is that trends are likely to continue or persist regardless of qualitative circumstances. While the analyst, on occasion, can place pre-dominant weight on the recent earnings rather than the average, persuasive evidence has to be present.
    • this strategy is not simple because the market timing is hard, and the underlying values of stocks continuously change.
  • average vs trend of earnings
    • attitude of analyst where trends are upward. If a qualitative study of company A is positive, which it often should be, the analyst should base future results on a conservative estimate of what the company is currently producing.
    • attitude of analyst where trends are downward. The analyst must assign great weight to the unfavourable trend and the reasons why. However, one can’t make a hasty conclusion that this trend will persist either.
  • deficits a qualitative, not a quantitative factor: when a company reports a deficit for the year, it is customary to calculate the amount in dollars per share or with interest requirements. This is not a valid approach. Instead, the attention of the analyst should be directed elsewhere.
    • when an average is taken over a period that includes some deficits, some questions must arise as to whether or not the resultant figure is indicative of the earning power. This is especially true if the company has volatile numbers.
  • intuition not a part of the analyst’s stock in trade: Unless there is a reason to think otherwise, the record is accepted as a basis for judging the future.
    • analysis of the future should be penetrating rather than prophetic. In short, the investor should not be reliant on the company’s performance to improve to justify a premium price. Instead, the future results should be penetrated to the current capacity to earn and the price the market is trading the stock for.
  • large profits frequently transitory: when capital flows into new industries, it may result in overcapacity and keen competition - dragging profits down for individual companies in the long haul.

specific reasons for questioning and rejecting the record

• rate of output and operating costs
  • when analyzing an individual company, each governing element in the operating results must be studied for signs of unfavourable changes. Governing elements may vary, but if the analyst was assessing the general factors of a mining company, they might focus on areas like (1) the life of a mine, (2) annual output, (3) production costs and (4) selling price.
  • if the future earnings had to be supported by higher costs, it would make the current facts speculative and much riskier.
  • freeport sulphur company
    • the learning point is that a high valuation based on prospects is highly speculative. When the stock market moves away from sound sense and business experience, the common stock buyer will inevitably lose money
  • the future price of the product
    • change in status of low-cost producers: when analyzing the individual company, one must also look at the overall cost level and in which direction it can be expected to change. the cost price will be a determinant of the selling price.
  • anomalous prices and the price relationships in the history of the I.R.T system:
    • the analysis not only showed that the current selling price was far above the value of the stock. It also showed that when there is an upper limit of earnings or value being fixed, there is usually a danger that the actual figure could be less.
    • what happened afterwards for Interborough Rapid Transit System was that earnings were non-recurrent and temporary. As earning power declined, it ran quickly into severe financial problems.

price-earnings ratios for common stocks. Adjustments for changes in capitalization

• exact appraisal impossible:

  • before the bull market of 1927-1929, a price of 10 times earnings was accepted standard for measuring common stock.

  The idea of basing the valuation on current earnings is absurd since earnings are constantly changing. Stock market prices are not carefully computed but are the result of human reactions. A stock market is a voting machine rather than a weighing machine.

• limited functions of the analyst in the field of stock price appraisal

  • as facts and human behaviour change, the security analyst must not follow a general rule for his valuations. However, Graham proposes some limited functions:
    • he may set up a basis for conservative or investment valuation of common stocks, as distinguished from speculative valuations
    • he may point out the significance of (a) the capitalization structure; and (b) the source of income, as bearing upon the valuation of a given stock issue
    • he may find unusual elements in the balance sheet which affect the implications of the earnings picture.
  • a suggested basis of maximum appraisal for investment:
    • the profits of the most recent year might be accepted as an indicator of future earnings if (1) general business conditions in that year were not exceptionally good, (2) the company has shown an upward trend of earnings for some years past and (3) the investor’s study of the industry leaves him confident about its continued growth
    • note: a P/E of 20 equates to a 5% return - assuming earnings remain constant and are treated as a free cash flow to the shareholder
  • Higher prices may prevail for speculative commitments:
  • *other requisites for common stocks of investment grade and a corollary thereof: * as 20 times average earnings are the upper limit, the purchase price for ordinary businesses should be substantially less. 12 or 12.5 times average earnings can be considered a necessary multiplier but not a sufficient condition.
    • it must be emphasized that many other factors must be present, including the financial setup, not-unsatisfactory prospects and proper management.
    • An attractive common-stock investment is attractive speculation. This is true because if a common stock can meet the demand of a conservative investor, then he gets full value for his money, plus satisfactory prospects.
  • examples of speculative and investment common stocks
    • stocks sold at multiple considerably more than 20 times average earnings. In other words, they all require large future growth to justify the price.
    • stocks are speculative not because of the average earnings, but the speculative element of the instability of earnings
    • stocks that pass the quantitative tests of investment quality:
      • earnings have been reasonably stable
      • average earnings have a satisfactory ratio to market price.
      • financial setup is sufficiently conservative, and the working capital position is strong.
  • allowances for changes in capitalization
    • when dealing with records of earnings on a per-share basis, the analyst must adjust to changes in capitalization.
  • allowances for participating interests
    • when calculating earnings for the common shareholder, the participating interests must also be included. (participating interests is a new structure dividing income when it increases.)
    • similar allowances must be made for the effect of management contracts
  • general rule
    • the intrinsic value of a common stock preceded by convertible securities cannot reasonably be appraised at a higher figure than would be justified if all convertible securities were exercised in full. The same is the case if it is subject to dilution through the exercise of stock options or through participating privileges enjoyed by other senior security

capitalization structure

• principle of optimum capitalization structure

  • the optimum capitalization structure for any enterprise includes senior securities to the extent that they may be safely issued and bought for investment. The practical implication is that, under safe circumstances, no debt leads to an inefficient use of the shareholder’s capital. On the other hand, too much debt leaves no room for an appropriate margin of safety, as the interest coverage ratio is very small and risky
  • this safe environment may be composed of working capital of no less than the bond value and other conditions. Under such circumstances, a very conservative capitalization based only on the shareholders’ equity would make the shareholders’ dollars less productive.

• corporate practices resulting in a shortage of sound industrial bonds

  • investors generally prefer strongly funded corporation-issued bonds as these offer a wider range of choices and make the sale of unsound bonds less likely.

• the factor of leverage is speculative capitalization structure

  • speculative capitalized enterprises can be sold at high prices during good markets. On the contrary, the same venture might be undervalued during a depression.
  • the real advantage, however, lies in the fact that the stock can advance more than it can decline.

• speculative attractiveness of “shoestring” common stocks considered:

  • practical aspects of foregoing:
    • senior capital for the company should be held in preferred shares rather than in bonds, as this would limit the risk of bankruptcy during bad times, permitting the common stockholder to wait for better times (preferred shares can omit dividend payments, while bonds, in general, are obliged to pay out coupon payments)

low-priced common stocks. Analysis of the source of income.

• arithmetical advantage of low-priced issues

  • low priced stocks offer the advantage of being more likely to appreciate than decline. Securities are found to rise more readily from 10 to 40 than from 100-400, and because of this, the speculative public would rather buy into stocks of lower numerical value.

• some of the reasons most buyers of low-priced issues lose money:

  • the public may be buying lowed-priced stocks for the bad financial conditions.
  • A high number of shares are issued, which are priced higher than the actual value.
  • insiders’ desire to dispose of their assets, sometimes resulting in rigorous efforts to persuade the unwary public to buy them.

• low price coupled with speculative capitalization:

  • speculatively capitalized enterprises, according to Graham’s definition, are marked by relatively large amounts of senior securities and a comparatively small issue of common stock. Although the common share, in most cases, is sold at a low price, this is not always the case as long as the market value of common stock comprises only a small part of the enterprise value.

• large volume and high production cost equivalent to speculative capital structure

  • Graham shows how high production costs have the same effect as coupon payments for holders of senior securities. The simple effect is that the common stockholders have fewer earnings.
  • general principle derived. It can be derived from the example that when the price of copper increases, there will be a higher profit increase percentage-wise for the high-cost producer than for the low-cost producer. This will be reflected in the share price.

• sources of income

  • special phase: analysis must be conducted for the company based on the source of income from a specific asset and not on the business’s general nature.
    • northern pipeline company: breaking down the sources of income for this company, it can be seen that a substantial part of the income comes from the stable rental and interest earnings. This type of earnings must be evaluated based on the actual value of asset-producing income. Income from bonds should also be valued on a higher basis, compared to the rather volatile pipeline business showing a negative trend.
    • tobacco products Corporation of Virginia: this company was traded with a price-earnings of 10. All income came from a 99-year lease given to a high-quality company that could meet the obligation without question. This made the source of income from Tobacco Products Company of Virginia equivalent to a high-grade investment bond, and on this basis, the company would be deemed undervalued.

3. Asset Value

• To gauge asset value, inspect the business’s balance sheet. A firm’s book value per share equals 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 still should investigate the underlying value of a business’s assets before investing.

• The current-asset value – that is, current assets minus liabilities – is perhaps a more significant number. It excludes both intangible and fixed assets and is, therefore, a rough approximation of the company’s value should it go into liquidation. As a general rule, if a firm’s market price is below its liquidation value, the company has either been undervalued or should be liquidated. Investors who distinguish between the undervalued issues and those performing poorly due to fundamental unsoundness can realize a significant upside.

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

• there should be no discount from the amount stated on the company’s books for cash and marketable securities, provided the securities are short-term or marked to the market. The same holds for property, plant, and equipment

• the economic value of the assets is the reproduction costs of a new firm starting in the same industry.

  • we first find the current market prices for the securities. Then we must adjust the book value of the firm’s accounts receivable and inventory up or down to get more realistic reproduction costs

• it is important to note that goodwill represents a prior blunder that must be ignored when calculating a company’s intrinsic value.

• liabilities and equity are the sources of funds that support the assets, which are the uses to which those funds are put

• there are three types of liabilities

  • those that arise from the normal conduct of the business
  • those that arise from past circumstances that are not pertinent to a new entrant
  • the outstanding formal debt of the company.

• when we start with the reproduction cost of the assets and then subtract the first two categories of liabilities, we are left with the asset value of the whole enterprise.

• The defining characteristic of a franchise is that it enables a firm to earn more than it needs to pay for the investments that fund its assets. The intrinsic value of a firm is either the reproduction costs of the assets, which should equal the EPV or those assets plus the competitive advantages of the firm that underlie its franchise. The initial judgment that has to be made is whether the firm currently has a competitive advantage and, if so, how strong and sustainable it is

significance of book value

• balance sheet can provide the following guidance for the investor
  • it shows how much capital is invested in the business
  • it reveals the ease of stringency of the company’s financial condition; i.e., the working-capital structure
  • it provides an important check of the validity of reported earnings
  • it supplies the basis for analyzing the sources of income.
• computation of book value
  • (common stock + surplus items - intangibles) / number of shares outstanding
• treatment of preferred stock when calculating book value of common stock
  • in calculating the assets available for the common stock, the value of the preferred stock must be subtracted. Graham suggests we value preferred shares at par value plus back-end dividend payments and compare that to the market price. Whatever is highest (or most conservative) should be used.
• calculation of book value of the preferred stock:
  • when calculating the book value of a preferred stock issue, it is treated as a common stock, as shown in the equation above, and junior issues are left out.
• current asset value and cash asset value
  • the current asset value of a stock consists of the current assets alone, minus all liabilities and claims ahead of the issue. It excludes not only intangible assets but also fixed and miscellaneous assets (various assets of value not related to the business, such as coin collections and artwork).
  • the cash asset value of a stock consists of the cash assets alone, minus all liabilities and claims ahead of the issue. Other than cash itself, cash assets are defined as those directly equivalent to and held in a place of cash (such as certificates of deposit, and marketable securities at market value).
• practical significance of book value
  • the intention was to show the value of the business, but since it is far from reality, the carrying value (the number you can read from the balance sheet) has lost its significance. In most cases, the assets could not be sold at that value, and the earnings do not justify the figure.
  • The practice of writing up the book value of the fixed property or cutting it down to nothing to avoid depreciation charges has made the book value have questionable application.
  • even though Graham is very skeptical about using book value, he still believes that the book value deserves at least a fleeting glance before buying or selling shares.
  • a stock buyer should not know that the value of the stock is entirely related to the business in question, and what he gets from his money will be in tangible resources. A business that sells at a premium does so because it earns a large return compared to its capital. This large return attracts competition; generally speaking, it is not likely to continue indefinitely.
  • Graham mentions that companies with high intangibles might be less prone to competition and that small companies, in general, are likely to show a more rapid growth rate.

significance of current asset value

• Graham examines the following ideas:

  • the current asset value is generally a rough index of liquidating value
  • a large number of common stocks sell for less than their current asset value and therefore sell below the amount realizable in liquidation
  • the phenomenon of many stocks selling persistently below their liquidating value is fundamentally illogical. It means that a severe error is being committed, either: (a) in the judgement of the stock market, (b) in the company’s management policies, or (c) in the stockholders’ attitude toward their property

• liquidating value

  • the liquidating value of an enterprise is the money the owners would receive, in theory, if they sold all assets and paid off all debt in the company. They might sell all or part of it to someone else or turn the various assets into cash. Such liquidations are an everyday occurrence in private businesses but not for public companies.

• realizable value of assets varies with their character

  • in reality, a company’s balance sheet does not provide exact information about liquidation value, but it does supply valuable clues and hints. The first rule is that liabilities are real, but the value of the assets must be questioned. All liabilities shown on the books must be deducted at their face amount. The value of the assets, however, must vary according to the character. Cash, for instance, is worth the carrying value, while inventory might only be worth 50-75% compared to the market price.
  • object of this calculation: applying a general rule of thumb for a real-life company, it can be seen that the stock was undervalued as it sold for less than the company’s cash holding - even after deducting all liabilities. The aim of using current asset value as a liquidation measure is not to find the exact liquidation number but to establish a rough estimate.

• prevalence of stocks selling below liquidating value

  • at some time in 1932, over 40% of all industrial companies listed on the NYSE were quoted at less than their net current assets. Also, at that time, a considerable number sold for less than their cash asset value. That means that the owner would profit more by shutting the company down than by selling equity on a going concern basis.
  • one reason for the very low valuation is the high emphasis on the income statement. A company with no current earnings will be considered highly negative by the stock market. The seller might not know she was disposing of their interest in the company below liquidation value.

• local significance of this phenomenon

  • when a common stock sells persistently below its liquidating value, either the price is too low, or the company should be liquidated.
  • 2 corollaries may be deducted from this principle:
    • although the low price offers an attractive opportunity to buy, such a price should incite the stockholders to question whether it is in their interest to continue the business
    • such a price should incite the management to take all proper steps to correct the obvious disparity between market quotation and intrinsic value, including a reconsideration of its policies and frank justification to the stockholders of its decision to continue the business.
  • there is a range of potential developments which may result in establishing a higher market price:
    • the creation of earning power that moves in lock-step with the company’s assets (for instance, from a general improvement in the industry or a change in the company’s operating policies)
      • general improvement in the industry: when the textile business improved, the share of Pepperell increased more than eightfold in just two years
      • changes in operating policies: new lines of products, new sales methods, and reorganizing phases of production
    • a sale or merger, because some other concern can utilize the resources to better advantage and hence can pay at least liquidating value for the assets.
      • the white motor company suffered heavy losses and sold at a lower price than the liquidation value. An acquiring company found the big cash holding interesting, and the sales price was based on the current asset value.
    • complete or partial liquidation
      • complete liquidation: The investors of mohawk mining company received 2.5 times the cost of shares when it was decided to liquidate the company altogether. The liquidation value proved identical to the current asset value and could be directly derived from the balance sheet.
      • partial liquidation: sometimes, an effective higher market value can be created by partially liquidating parts of the business and distributing that wealth out to the shareholders.

• discrimination required in selecting such issues

  • there is no doubt that stocks selling well below their liquidation value provide undervalued securities - and consequently profitable opportunities for purchase. Regardless, the securities analyst should exercise as much discrimination when selecting between the prospects.
  • She can lean toward the five developments above (changes in operating policies, liquidation, etc…) if it is deemed that they may occur. Also, he can look at satisfactory current earnings and dividends or a high average earning power in the past. The analyst will avoid companies that are losing current assets rapidly and showing no sign of fixing the problem.

• bargain of this type: common stocks that (1) are selling below their liquid asset value, (2) are apparently in no danger of dissipating these assets, and (3) have formerly shown a large earning power on the market price, may be said to belong to a class of investment bargains.

• common stock representing the entire business cannot be less safe than a bond having a claim to only a part thereof

  • the argument was that the company would have to pay coupon payments to the bond holders, while the dividend payments were unsecure. Here, Wall Street confuses the temporary consistency of income with the safety principle. Dividends paid out to stockholders would not make the stock any safer. What is happening is that the stockholders turn over their property. A rational stock owner would not surrender complete ownership for a limited claim and 5-6% returns on the investment.

balance sheet analysis conclusions

• the common purpose of balance sheet analysis is not to find bargain investments but to detect financial weaknesses.
• working-capital position and debt maturities
  • basic rules concerning working capital: for the working-capital ratio, a minimum of $2 of current assets for $1 current liabilities was formerly a standard for industrial companies.
    • the second measure of financial strength is the “acid test,” which requires that current assets - exclusive of inventories - should be at least equal to the current liabilities. Failing these tests would make the security speculative and higher risk.
    • Archer-Daniels-Midland company is an exception to the rule. Even though it failed the acid test, this was not a call for concern. While payables increased (lowering both the working-capital ratio and the acid ratio as inventory increased), it represented regular seasoned practice in the industry.
  • large bank debt is frequently a sign of weaknesses
    • it is rare that weak financial positions are created only by accounts payable. Weak financial positions are almost always characterized by bank loans or debts due within a short timeframe.
  • the danger of early maturing funded debt: when a large bond issue is due soon, it can create serious financial problems, especially when operating results are unfavourable. Maturing funded debt is a frequent cause of insolvency and can be identified from the balance sheet.
• comparison of balance sheets over a period of time
  • as a check-up on the reported earnings per share.
  • to determine the effect of losses (or profits) on the company’s financial position
  • to trace the relationship between the company’s resources and earning power over a long period.
  • checking the effect of losses or profit on the company’s financial position
    • taking losses on inventories may strengthen financial position: some losses are represented solely by a decline in the inventory account (which might only be worth 50-75%) of the carrying value)
    • if the shrinkage in the inventory exceeds the losses, leading to an actual increase in cash or reduction in payables, it may be proper to say that the company’s financial position has been strengthened, even though it has been suffering losses.
    • based on liquidation value, the investor in Manhattan Shirt company would have increased the value during the depression due to the company turning assets into cash.
    • profits from inventory inflation: in the event of high inflation, the inventory will increase in value in terms of accounting.
      • U.S. Rubber is an example of an increase in earnings, partly made from heavy expenditures on a plant and a dangerous expansion in inventory from 1919-1920, with high inflation. Only looking at the increased reported earnings would the investor not have found this.
  • long-range study of earning power and resources
    • The significance of the foregoing figures
      • for the United states steel corporation, the effect of WWI is noticeable and has added a hefty sum to the earnings. However, the rate of earnings of investment capital has declined in the last decade.
      • this raises the question of whether the end of the war turned the industry into a relatively unprofitable business from a previously relatively prosperous one. It also raises the question of whether it is due to the high reinvestment, which led to overcapacity and, consequently, lower return.

stock-option warrants

• in the past, a stock-option warrant was attached to a bond or a preferred stock and carried privileges. It was not seen as an independent instrument or an important part of capitalization. Today, opinions are reversed, and it has even become a popular medium for speculators.

• a (detachable) option warrant is a transferable right to buy stock. The right can be described in detail by the following information:

  • (1) the kind of stock, (2) the amount, (3) the price, (4) the method of payment, (5) the duration of the privilege, and (6) anti-dilution provisions.

• the type of stock covered by the privilege. Nearly all option warrants can be converted to common stock for the issuing company. Very few have rights that apply to preferred shares. Warrants have no right to receive interest, dividends or payments on account of principal, nor do they have the right to cash any vote.

• resemblance to subscription “right”: warrants are in many ways similar to the subscription rights issued by the corporation to stockholders in connection with the sale of additional stock. Differences occur, however, in terms of the exercised price and the period. Subscription rights will typically always be exercised unless the stock price drops substantially, and it will generally happen within the 60 days that the rights typically run. Warrants, on the other hand, are seldom exercised in such a short period, as the stock purchase price is typically set higher than the current stock price at the time of issue. The duration is most often longer than a year.

• method of payment. Most option warrants require payment of the subscription price in cash.

• basis of trading in warrants: option warrants are bought and sold in the market similarly to common stocks. The standard rule of a warrant is the right to buy one share of the stock.

• examples of warrants issued for various purposes

  • attached to senior securities
  • as compensation to underwriters.
  • as compensation to promoters and management
  • issued in a merger or reorganization plan in exchange for other securities
  • attached to an original issue of common stock
  • sold separately for cash.

• warrants as a vehicle of speculation

  • qualitative element: Since a warrant’s value will only materialize from an increase in earnings, the prospects of increased earnings would make the warrant more attractive than its stability, characterized as low-priced common stocks with speculative elements.
  • quantitative considerations: the importance of low price
    • Graham feels that an option warrant has speculative attractiveness only if it possesses all three desirable qualities: low price, long duration, and option price close to the market.
  • a substantial part of an enterprise’s profits are distributed to operating managers, which is done without full disclosure. Stock options warrants have proven to be an excellent instrument for that purpose.

• dangerous device for diluting stock values.

  • as warrants give rights to buy the stock at a given price level when that price level is reached, earnings will be diluted for the common stockholder because they still must account for the cost to acquire the warrant
  • the original issue of common stock carrying warrants to buy additional stock does not give stockholders anything more than they would have without the warrant. Further, it violates an obvious rule of sound corporate financing. A properly managed business sells additional stock only when new capital is needed.

• cost of management: 3 items

  • buyers of stock at $34 per share were asked to pay for the management in 3 ways:
    • the $3 difference between the price the investor paid and the company paid. While this money would go to the investment banker as an underwriter’s fee, that premium is paid in the belief that the management was worth the difference.
    • The issue of the warrants had taken value away from the common stockholder of one-third of the appreciation.
    • the salaries the officers were to receive plus additional taxes.
    • the three items together may be said to absorb between 25 and 30% of the amount contributed by the public.

corporate pyramiding

• pyramiding in corporate finance creates a speculative capital structure utilizing a holding company or a series of holding companies. The organizers can control a large business with little or no capital through such construction. Often the intention is to “cash in” speculative profits and, at the same time, retain control.

• evils of corporate pyramiding

  • it results in the creation and sale to investors of large amounts of unsound senior securities
  • the common stock of the governing holding companies is subject to deceptively rapid increases in earning power during favourable years, which can lead to disastrous public speculation.
  • the position of control of someone who owns only a little or no capital is bound to lead to irresponsible and unsound management
  • it allows for deceiving accounting techniques regarding indicated earnings, dividend return, and book value. This will again lead to speculation.

• overstatement of earnings: holding companies can overstate their earnings power by valuing the stock dividends they receive from subsidiaries at an artificially high price. Earning power can also be overstated using profits made from the sale of stock of subsidiary companies

• distortion of dividend return: stock dividends can be paid out with a market value exceeding current earnings.

• exaggeration of book value. The exaggeration of book value may occur in cases where a holding company owns most of the shares of a subsidiary, consequently making it possible to manipulate the small amount of stock remaining in the market.

• some holding companies not guilty of excessive pyramiding

  • legitimate reasons for their creation include: permitting unified and economical operations of separate units, diversifying investment and risk, and gaining certain technical advantages of flexibility and convenience. Any holding company should always be considered on its merits.

discrepancies between price and value

• general procedure of the analyst

  • the first method is to conduct a series of comparative analyses of industrial groups along the lines described in the previous chapter. Such studies will give a fair idea of the standard of usual characteristics of that industry.
  • the second general method consists of scrutinizing corporate reports. A glance over hundreds of such reports may reveal between five and ten that look interesting enough from the earnings or current asset standpoint.

• can cyclical swings of prices be exploited

  • one can set up criteria to give an objective opinion of the price level of the stock market, then trade accordingly. While Graham argues the practicality of such a procedure is low and, under the Great Depression, would have made heavy demands upon human fortitude, he still finds the idea appealing. The reason is to look into such a procedure. One is more likely to buy at attractive intrinsic value levels.

• opportunities in “secondary” or little-known issues

  • the impermanence of leadership: the composition of the market leader group varies greatly from year to year, especially because of the recent shift of attention from past performance to assumed prospects.
  • opportunities in normal markets during a period when the market generally shows no definite signs of being too low or too high, stocks can still be found cheap on a statistical basis. These stocks generally fall into two classes:
    • those showing high current and average earnings about market price
    • those making a reasonably satisfactory exhibit of earnings and selling at a low price to the net-current asset value. These companies will most often not be large and well known.
    • the main drawback of a small company is its vulnerability to loss of earning power. Larger companies will be less prone to this. The counterargument is that successful smaller companies can multiply more impressively than those already in enormous size.

• market behaviour of standard and nonstandard issues

  • standard or leading issues almost always respond rapidly to changes in their reported profits - they tend to exaggerate the significance of year-to-year fluctuations in earnings
  • the action of less familiar issues depends largely upon the attitude of the professional market operators towards them. If interest in the issue is legitimate and speculative, the price will respond extremely.
  • relationship of the analyst to such situations when the general market appears dangerously overvalued to the analyst, he must exercise caution when it comes to unfamiliar common stocks. The same applies when stocks appear to be bargains. A severe decline in the general market will affect all stock prices adversely, and the less familiar issues may prove especially vulnerable.

• market exaggerations due to factors other than changes in earnings

  • dividend changes while there is no doubt that a dividend increase is a favourable development, a large increase in stock prices based solely on this is absurd.
  • mergers and segregations: studies into whether mergers and acquisitions aid in increasing earning power have, in general, indicated that no such effect could be found. Instead, there is reason to believe that the personal element in corporate management often stands in the way of advantageous consolidations. In light of this fact, it is surprising that the stock market tends to react positively to mergers and acquisitions in the short run.
  • litigation: a lawsuit of any significance is highly disliked by the stock market, often to the extent that it is out of proportion to the impact of the case in question. Developments of this kind may offer real opportunities to the analyst

• price-value discrepancies in receivership: Graham argues that the analyst can invest in securities after such difficulties have arisen because senior securities have been found to sell at too low prices. Cases of reorganization and other situations where liquidation or sale to outside interest ultimately result in cash distributions that can produce attractive analytical opportunities

• price patterns produced by insolvency certain price patterns tend to occur, especially if the receivership takes a long time. First, there is a tendency for the stock issue to sell too high, not only toward the bond issue but also toward their estimated value. For bond issues, the price typically declines over time, reaching the lowest point just before a reorganization plan is ready to be announced.

• opportunities in railroad trusteeships: in the years following 1932 and the following year, a large part of the country’s railroad mileage fell into the hands of the trustee. This provided shrewd investors with interesting opportunities as it put pressure on the price levels of securities.

• vulnerability of unseasoned issues

  • if the earnings power is maintained, the unseasoned issue would maintain the price, but even slight dissatisfactory development will lead to a severe price decline.
  • unseasoned industrial issues rarely deserve an investment rating: unseasoned industrial issues should only be bought on an admittedly speculative basis. This requires that the market price be low enough to permit a substantial rise, typically below 70.

• discrepancies in comparative prices: it is easier to determine whether issue A is better than issue B than to determine whether issue A in its own right is a good investment.

  • Graham gives two recommendations for selecting an issue to purchase (1) the issue to be bought is attractive in its own right, or (2) there is a definite contractual relationship between the two issues in question
  • for the first recommendation, a qualitative analysis must also be carried out to evaluate the future earning power.

• discrepancies due to special supply and demand factors can be due to special and temporary factors. As an example, Graham mentions a high-grade railroad issue that became priced relatively differently due to a heavy volume sale of another series

• united states savings bonds offer similar opportunity the disparity between US Government and corporate obligations has reappeared in recent years. In addition to their safety factor, there are also tax advantages, as well as the opportunity to liquidate in the market at any time, with no intermediate loss, due to the spread.

comparative analysis of companies in the same field

• one fact that the analyst should be aware of when conducting his analysis is whether or not he is looking at a homogenous industry. Homogenous companies respond similarly to a change in business conditions. In this case, an industry comparison is considered more dependable.

• it should be remembered, however, that a preferred stock is always less attractive, logically considered, than a common stock making the same showing.

• most recent numbers would require more attention, and secondly, the analyst should aim to learn as much as possible about the underlying reasons for the difference in performance.

• as a general rule, the less homogeneous the industry, the more attention must be paid to the qualitative factors when making comparisons.

• the analyst must consider qualitative factors and perhaps also allow for the lack of homogeneity. The comparative analysis technique may facilitate his task, but he must still expect to be wrong from time to time. Still, with intelligence and prudence, he should yield better results than the guesses of typical stock buyers.

• observations on the railroad comparison

  • whether the average period should be seven years, shorter, or longer is an individual choice. In theory, it should be long enough to cover all cyclical fluctuations but not so long that it includes totally out-of-date data.
  • numbers to compare/look for:
    • capitalization: fixed charges, effective debt (fixed charges multiplied by 22), preferred stock at the market (number of shares x market price), common stock at the market, total capitalization, the ratio of effective debt to total capitalization, the ratio of preferred stock to total capitalization, the ratio of common stock to total capitalization
    • income account: gross revenues, the ratio of maintenance to gross, the ratio of railway operating income (net after taxes) to gross, the ratio of fixed charges to gross, the ratio of balance for common to gross
    • calculations: number of times fixed charges earned, I.P. number of times fixed charges plus preferred dividends earned, earned on common stock per share, earned on common stock % of market price, the ratio of gross to the aggregate market value of the common stock, earned on preferred stock, per share, earned on preferred stock, % of market price, the ratio of gross to the aggregate market value of the preferred stock, credit or debit to earnings for undistributed profit or loss of subsidiaries
    • seven-year average figures
      • earned on common stock per share, earned on the common stock, % of the current market price of common, earned on preferred stock per share, earned on preferred stock, % of the current market price of preferred, number of times net deductions earned, number of times fixed charges earned, number of times net deductions plus preferred dividends earned, number of times fixed charges plus preferred dividends earned
    • dividends
      • dividend rate, the yield on common and preferred
    • trend figure
      • earned per share on common stock each year for the past seven years. (Where necessary, earnings should be adjusted to present capitalization)

• public utility comparison

  • variations in depreciation rates are equally as important as in railroad maintenance ratios.

• industrial comparison

  • net earnings must be corrected for any known distortion or omission. This includes undistributed earnings and losses of subsidiaries. Depreciation rates should only serve to locate vast discrepancies, and not be used for exact comparisons.
  • capitalization: bonds at par, preferred stock at market value (number of shares x market price), common stock at market value, total capitalization, the ratio of bonds to capitalization, the ratio of the aggregate market value of preferred to capitalization, the ratio of the aggregate market value of common to capitalization.
  • income account
  • gross sales, depreciation, net available for bond interest, bond interest, preferred dividend requirements, balance for common, margin of profit (ratio of 10 to 8), % earned on total capitalization (ratio of 10 to 4)
  • calculations
  • the number of times interest charges earned, I.P. number of times interest charges plus preferred dividends earned, earned on common, per share, earned on common % of market price, S.P. earned on preferred, per share, S.P. earned on preferred, % of market price, the ratio of gross to the aggregate market value of common, S.P. ratio of gross to the aggregate market value of preferred.
  • seven-year average
  • the number of times interest charges earned, earned on common stock per share, earned on common stock, % of the current market price.
  • trend figure
  • earned per share of common stock each year for the past seven years (adjustments in the number of shares outstanding to be made where necessary)
  • dividend rate/dividend yield on common, preferred
  • balance sheet
  • cash assets, receivables (fewer reserves), inventories (less proper reserves), total current assets, total current liabilities, notes payable (including “bank loans” and bills payable”), net current assets, the ratio of current assets to current liabilities, ratio of inventory to sales, ratio or receivables to sales, net tangible assets available for total capitalization, cash asset value of common per share (deducting all prior obligations), the net current asset value of common per share (deducting all prior obligations), the net tangible asset value of common per share (deducting all prior obligations)
  • supplementary data
  • physical output, number of units, receipts per unit, cost per unit, profit per unit, total capitalization per unit, common stock valuation per unit
  • miscellaneous: for example, number of stores operated, sales per store, profit per store, ore reserves, and the life of mine at the current (or average) production rate.

market analysis and security analysis

• 2 kinds of market analysis

  • the first kind of market analysis makes predictions exclusively from the past actions of the stock market. (the market is its own best forecaster)
    • implication of the first type of market analysis
      • often called technical analysis.
      • chart-reading cannot be a science
      • it has not proved itself in the past to be a dependable method of making profits in the stock market.
      • its theoretical basis rests upon faulty logic or else upon mere assertion.
  • the other type of mechanical forecasting is based on factors outside the market.

• disadvantages of market analysis as compared with security analysis

  • in market analysis there are no margins of safety; you are either right or wrong and if you are wrong, you lose money.
  • another disadvantage is that profits made by trading in the market are for the most part realized at the expense of others who are trying to do the same thing. The market analyst can therefore be hopeful of success only upon the assumption that he will be more clever or perhaps luckier than his competitors.

• prophesies based on near-term prospects.

  • the argument is that if the outlook favours increased earnings, the issue should be bought in the expectation that it will increase in price when the actual profit is reported.
  • Graham is skeptical of the ability of the analyst to forecast the market behaviour of individual issues over the near-term future. This does not matter if he bases his predictions on the technical position of the market, the general outlook for business, or the specific outlook for individual companies.
  • more satisfactory results are to be obtained by confining the positive conclusions of the security analyst to these fields:
    • the selection of standard senior issues that meet exacting safety tests.
    • the discovery of senior issues that merit an investment rating, but also have opportunities for appreciation in value.
    • the discovery of common stocks or speculative senior issues that appear to be selling at far less than their intrinsic value.
    • the determination of definite price discrepancies between related securities for which situations may justify making exchanges or initiating hedging or arbitrage operations.

• summary of our views on investment policies

  • investor of small means
    • investment for income
      • in 1940, United States Savings Bonds have safety and accumulated income.
    • investment for profit
      • 4 approaches are open to both the small and large investor
        • purchase of representative common stocks when the market level is clearly low, as judged by objective, long-term standards. This policy requires patience and courage and is by no means free from the possibility of grave miscalculation
        • purchase of individual issues with special growth possibilities, when these can be obtained at reasonable prices in relation to actual accomplishment. The investor must remember that, when growth is generally expected, the price is rarely reasonable.
        • purchase of well-secured privileged senior issues. A combination of adequate security with a promising conversion or similar right is rare but possible. A policy of careful selection in this field should bring good results, provided the investor has the patience and persistence needed to find her opportunities.
        • purchase of securities welling well below intrinsic value. Intrinsic value takes into account not only past earnings and liquid asset values but also future earning power, conservatively estimated. In other words, qualitative as well as quantitative elements.
      • there is logic in the belief that unless a man is qualified to advise others professionally, he should not prescribe for himself.
    • speculation
      • buying stock in new or virtually new ventures. The odds are so strongly against him that he might as well throw three-quarters of the money out of the window and keep the rest in the bank.
      • trading in the market: Graham believes that, regardless of preparation and method, success in trading is accidental and temporary, or else due to a highly uncommon talent.
      • purchase of “growth stocks” at generous prices. the chances of individual success are much brighter here than in the other forms of speculation. That said, as it is considered speculation, this approach is still inherently dangerous.
  • The individual investor of large means
    • although he has obvious technical advantages over the small investor, he suffers from three specific handicaps
      • the investor must not only consider United States Savings Bonds, but also the broader field of fixed-value investment. We believe that the strict application of quantitative tests, plus reasonably good judgement in the qualitative area should yield a satisfactory end result.
      • possible inflation is more serious to him than to the small investor. As stocks to some extent are inflation-proof, they can be held as a defensive measure.
      • the size of her investment unit is more likely to induce the large investor to concentrate on popular and active issues.
  • investment by business corporations
    • it seems fairly evident that other types of investments by business enterprises, be they in bonds or stocks, can offer an appreciably higher return only at the risk of loss and criticism.
  • institutional investment
    • an institution that can manage to get along on the low income provided by high-grade, fixed-value issues should confine its holdings to this field. It can be doubted if the better performance of common stock indexes over the past periods will, in itself, warrant the heavy responsibilities and the recurring uncertainties that are inseparable from a common-stock investment program.

The Relationship Between Owners and Managers

• The interests of shareholders and those of management do not always coincide. Most shareholders defer to the wisdom of management without demanding their rights as owners of the business. In the case of companies whose common stocks sell for less than the liquidating value, the shareholders may be best served by the liquidation of the company, but that would put management out of a job, so shareholders cannot depend on management to make the right decision. Investors need to educate themselves about management practices and consider these lessons when investing.

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

• it is the stockholders who own the company; the officers are only paid, employees. The directors are elected and virtually trustees whose legal duty is to act solely on behalf of the business owners.

implications of liquidating value, stock holder-management relationships

• interests of stockholders and officers conflict at certain points:
  • in some situations, the management may explicitly have interests in conflict with those of the shareholders
    • compensation to officers - salaries, bonuses, options to buy stock
    • expansion of the business - involving the right to larger salaries and the acquisition of more power and prestige by the officers
    • payment of dividends - should the money earned remain under the control of the management or pass into the hands of the stockholders?
    • continuance of the stockholders’ investment in the company - should the business continue as before, although unprofitable, or should part of the capital be withdrawn, or should the business be wound up completely?
    • information to stockholders - should those in control be able to benefit through having information not generally given to stockholders?
  • wisdom of continuing the business should be considered
    • management, by definition, is reluctant to return capital to investors, even though the capital might be more useful there. The reason is resource scarcity. For example, to pay the bills when the company has financial problems later.
    • whether or not the business should continue is a decision for stockholders, not management. A logical reason to consider this is when the market price is below the liquidation level. After all, that means that the market is wrong or the management is wrong in keeping the enterprise alive.
  • various possible moves for correcting market prices for shares:
    • if directors are convinced that continuation is preferable to liquidation, the reasons leading to this conclusion should be supplied. A new dividend policy is one solution to maintain the business and limit the risk for investors. The rate should be equivalent to the liquidation value to ensure that stockholders do not suffer due to this decision to keep the business alive. A third option could be to distribute excess cash back to stockholders.
  • liquidating an unprofitable business with substantial assets is almost certain to realize more than the existing market price. The reason is earnings govern that market prices; the liquidation process is based on assets.
  • repurchase of share pro rata from shareholders: if capital is no longer required, it can be advantageous to distribute it back through a share buyback.

Themes of value investing

Focusing on the differences between investing and speculating

• failure to distinguish one from another has led to tragedies.
• investments are bonds, outright purchases, permanent holding, for income, in safe securities.
• speculations are stocks, purchases on margin, for a “quick turn,” for profit, in risky issues.
• specific standards have to be applied to give meaning to the term “safety.”
• an investment operation promises the safety of the principal and a satisfactory return. Operations not meeting these requirements are speculative.
• an investment operation can be justified on both qualitative and quantitative grounds.
• investment is founded on the past and present, and speculation relies on the future to improve.
• for the investor, the future is to be guarded against rather than profited from.
• for the speculator, anticipates the future will be better than the past.
• “intelligent speculation” is taking a measured risk that seems justified after analysis
• “unintelligent speculation” is taking a risk without adequate examination of the situation
• safety is measured in terms of the ability of the issuer to meet obligations
  • that ability should be assessed in terms of depression, not prosperity
• high dividends do not compensate lack of safety
• Avoiding trouble is better than seeking protection after it occurs.
• a sound investment must be able to withstand adversity. Investors may favour enterprises that have withstood adversity.
• investment for profit, where growth is generally expected, the price is rarely reasonable.
• the investor of small means may opt to step out of his role and become a speculator. He may also opt to regret his actions.

Analysis skills

• The term analysis indicates a scientific and systematic study of facts, which results in logical conclusions. But investment is not an exact science, and success derives partly from personal skills and chance.
• analytical judgments are reached by applying standards to facts
• analyst must preserve a sense of proportion, analyze what matters and ignore what trivial

truth seeker

• there are three variables used to rank stocks: fundamental, growth, and profitability.
• the most common variables used to select stocks are those that relate the price of the shares to some essential company information: share price to earnings, share price to cash flow, share price to book value, share price to sales, or share price to dividends.

Quotes

There is very little altruism in finance.

“The typical American stockholder is the most docile and apathetic animal in captivity. He never thinks of asserting his individual rights as owner of the business.”

“Modern financing methods are not that far different from a magician’s bag of tricks; they can be executed in full view of the public without it being very much the wiser.”

“You cannot make a quantitative deduction to allow for an unscrupulous management; the only way to deal with such situations is to avoid them.”

“Undervalued investment issues may be discovered in any period by means of assiduous search.”

“The investor cannot safely judge the merits or demerits of a security by his personal reaction to the kind of business in which it is engaged.”

“An institution with securities of its own to sell cannot be looked to for entirely impartial guidance.”

“Needless to say, an investor is never forced to buy a security of inferior grade.”

“An investment in the soundest type of enterprise may be made on unsound and unfavorable terms.”

“Safety does not reside in titles, or forms, or legal rights, but in the values behind the security issue.”

“The fact that no good bonds are available is hardly an excuse for either issuing or accepting poor ones.”

“Whatever benefits a business benefits its owners, provided the benefit is not conferred upon the corporation at the expense of the stockholders.”

“Very frequently, the market’s appraisals are based on mob psychology, on faulty reasoning and on the most superficial examination of inadequate information.”

• quantitative data is useful only to the extent that’s supported by a qualitative survey of the enterprise

• the stock market is a voting machine rather than a weighing machine.

References

• novelinvestor summary
• https://www.youtube.com/watch?v=jMuX_-hE7SQ&ab_channel=TheSwedishInvestor