Wednesday, 17 December 2008

Analytical Judgments in Value Analysis

Six Examples of Analytical Judgments.

A series of six quite diverse examples were used by Graham in Security Analysis (1951 Edition) to illustrate the scope of value analysis.

Example 1: United States Savings Bonds and high-grade bond issues in the year 1950.
The broadest and perhaps the most important judgment that security analysis can make in the year 1950 is that United States Savings Bonds, Series E and Series G, are so much more attractive than other high-grade bond issues that the individual investor of moderate income should buy nothing but these for the bond portion of his portfolio.
(In the higher income brackets, the alternative purchase of tax-free state and municipal issues may be indicated.)
This recommendation is grounded on careful calculation, and it can be put forward with a maximum of confidence in its validity.

Example 2: Average price level of DJIA in 1947 – 1949
The security analyst, studying the well-known group of 30 leading stocks comprising the Dow-Jones Industrial Average, could express the opinion that they constituted a sound investment purchase, in the aggregate, at the average price level of about 175 prevailing in 1947 – 1949.
This judgment would be based mainly on an estimate of average future earning power plus consideration of standard interest rates. It assumed a much higher level of business activity than in prewar years.
There was some danger that this opinion would prove incorrect, but the hazard here was probably no greater than that involved in most careful business judgments involving the future. Hence the security analyst could feel he was discharging a sound and useful function in making this evaluation and in advising accordingly.

Example 3: Inherent nature of market behavior of income bonds as a class (Income Mortgage 4 ½% bonds of Chicago & North Western Railway in 1946)
In 1946 the Income Mortgage 4 ½% bonds of Chicago & North Western Railway sold as high as 98 ¼. A competent analyst would have suggested their sale at that price.
The reasoning did not relate to any specific projections of the earnings of the North Western, but rather to the inherent nature and the characteristic market behavior of income bonds as a class. They are subject to wide fluctuations in price, responding emphatically to changes in business conditions or sentiment.
The upper limit could not be much above 100, because of their limited coupon and their call price of 101 1/8. On the other hand, past experience showed that their low quotation could easily prove to be 50% below the current market. The case for selling was thus pretty conclusive.
(It so happened that the price of this issue fell to 60 within six months.)

Example 4: Wright Aeronautical Corporation. Here is a set of three examples, referring to common shares in the same enterprise at different times (in 1922, 1928 and December 1947).

1922 (prior to the boom in aviation securities, $8 per share)
In 1922, prior to the boom in aviation securities, Wright Aeronautical Corporation stock was selling on the New York Stock Exchange at only $8, although it was paying a $1 dividend, had for some time been earning over $2 a share, and showed ore than $8 per share in cash assets in the treasury.
In this case analysis would readily have established that the intrinsic value of the issue was substantially above the market price.

1928 ($280 per share)
Again, consider the same issue in 1928 when it had advanced to $280 per share. It was then earning at the rate of $8 per share, as against $3.77 in 1927. The dividend rate was $2; the net-asset value was less than $50 per share.
A study of this picture must have shown conclusively that the market price represented for the most part the capitalization of entirely conjectural future prospects – in other words, that the intrinsic value was far less than the market quotation.

December 1947 (Curtiss-Wright Corporation, the successor enterprise)
Curtiss-Wright Corporation, the successor enterprise, had class A stock selling at 18 ½ and common stock selling at 4 ½. The combined market price of the two issues was under $50 million.
The total net assets of the company were about $130 million; the net current assets about $106 million, and the cash assets alone $87 million.
Earnings had been poor in the postwar period, but the company was clearly undervalued at a price below the cash and government bonds on hand.

Example 5: Comparative merits of two security issues (Graham-Paige Motors Convertible and Its common stock)
Many analytical judgments turn upon the comparative merits of two security issues.
A simple and satisfactory example of these is provided by Graham-Paige Motors Convertible 4s selling at 102 in May 1946 as against the common stock simultaneously selling at 13 ¼. Each $1000 bond was convertible into 76.9 shares of common stock (76.9 x 13 ¼ = $1018.9).
Hence the bonds were selling for slightly less than the current market value of the shares for which they could be exchanged.
The common stock was paying no dividends and had shown very small earnings.
Obviously the bonds were a better purchase than the common stock, since they offered the same opportunities for profit, by reason of their conversion privilege, and they were much better protected against loss.
Sequel: Both the bonds and stock declined sharply in price after May 1946. The bondholder’s principal shrinkage was much less than the stockholder’s; and he has received full interest (to the end of 1950) while the stockholder received only one dividend of 45 cents during this period.

Example 6: “Arbitraging” the securities of railroads going through reorganization in 1941-1945.
During 1941-1945, profits at the annual rate of 20% or better could be made by “arbitraging” the securities of railroads going through organization. The operation consisted of buying existing bonds and selling against them the “when-issued” securities to be exchanged for them under the reorganization plan. The indicated proceeds were always substantially more than the cost.
The major risk involved was that of failure of the plan to be carried out; the minor risk was that consummation would be delayed so long as to make the operation relatively unattractive.
An experienced security analyst could have appraised these risks intelligently, and could have determined that most of the arbitrage operations were well worth entering upon.

Also read:
The Estimate of Future Earning Power
Analytical Judgments in Value Analysis
Securities Not Suited to Valuation Analysis

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