Dusting off a classic: book review of Security Analysis

Standard

Inscription in beginning of book: “Many shall be restored that now are fallen and many
Shall fall that now are in honor.” — HORACE. Ars Poetica.

In the fourth edition of their investing classic, Security Analysis: Principles and Technique (pub. 1962; prev. ‘34, ‘40, ‘51), Graham & Dodd (and newly joined co-author, Sidney Cottle) faced an environment in which their conservative approaches to common stock investment left them with increasingly fewer opportunities due to the 1950s bull market. They acknowledged their dilemma, which is one value investors will face time and again: stick to your bread-and-butter, “old and highly conservative standards” and risk both the charge of “old-fogyism,” and the possibility of missing important changes to the underlying structure of common stock values; or embrace the general optimism and the long-term expectations of growth, which are used to justify market levels, and risk repeating the practices, and probably the errors, of bull markets past.

Almost eerily (considering the sad similarity to current U.S. economy), the authors state in the preface: “The government has assumed large responsibilities in preventing or remedying mass unemployment. This Federal involvement is a new factor, and we consider it important in its potential effect on the business cycle and stock values.” Note that they did not regard the factors of “inflation” and “population ‘explosion’” as being as new as many had then thought. Later in the book, the authors conclude:

“We believe it reasonable to adopt a somewhat more generous approach to the valuation of common stocks than appeared justified in our previous edition. The conclusion is based on the assurance — not formerly present — of massive Federal intervention to prevent a serious business depression. This appears now to be a basic tenet of both political parties. While one cannot yet be positive as to the effectiveness of Federal action, it seems logical to expect that deficit spending and possible renewed inflation will be found preferable to painful deflation.” (pg. 422)

The greatest value of Security Analysis, in the reviewer’s opinion, is the margin-of-safety concept — the distinguishing characteristic of true investment; the most fundamental quantitative concept in security analysis, according to Graham & Dodd, et al. The analyst (or investor) is to place prime emphasis upon the presence of a large margin of safety for the security, which should be able to absorb whatever adverse developments are reasonably likely to occur. Thus, be prepared for some deterioration of corporate finances during a recession, but expect that financial strength is ample and average earnings justify fully the purchase or recommendation of the security.

Security Analysis provides the reader with page-after-page of instruction on investment approaches, financial statement analysis, and fixed-income securities and common stock analysis. Sections I find especially interesting are:

  1. The discussion of cash flows (the authors noted the then recent emergence of cash flows as a key concept in security analysis, but were skeptical of their efficacy for valuation purposes). For instance, are cash flows really a better guide to profitability; how much is maintenance capex; are amortization charges being reinvested and creating higher returns?
  2. Net-current-asset value, including its use as a gauge for market levels. While modern investors experienced a sample of what Graham did during the Great Depression, imagine a market awash with common stocks selling for less than their net cash assets! Note that my next book review will be of Martin Whitman’s (famed value investor and founder of the Third Avenue Value Fund) Value Investing: A Balanced Approach. While he recognizes that Security Analysis shares many of the same sentiments as true “value investing” and offers investors timeless caveats, he finds Graham & Dodd’s approach narrow in some respects, and unnecessarily concerned with the exogenous, in others.
  3. Discussion of stockholders and management.  There is some really good material here and earlier editions offer even more. I’ll end this review with one of their more poignant passages.

Needless to say that Security Analysis is required reading. The hyperlinked title to the left and atop leads to Amazon’s search results for said title. Any edition is worthwhile, although the 6th edition may be of most interest given the additional material by some leading modern value investors such as Seth Klarmin and Glenn Greenberg. The leather-bound edition apparently comes with a CD-ROM containing chapters removed to make space for the new material. The regular hardback version is a cheaper alternative.

On “stockholders and management”:

“The heedlessness and inertia of American stockholders as a class have long been notorious. This laxity has invited exploitation, and a certain amount of it has inevitably followed. The consequences have been more serious than the loss of money by investors. We think the flow of equity capital has at times in the past been sensibly retarded by the fact that many possible venturers have a feeling that they are helpless to control their capital after it has been committed into common stocks, and that they cannot reply upon receiving a square deal from those who will control it. In our view the establishment of sound attitude by stockholders who realize that they are owners of the business is the best way to remove this distrust and thereby to promote the flow of the public’s money into free enterprise. (pg. 667)