Two different approaches to security analysis: the way of prediction (or projection) and the way of protection

Our statement that the current price reflects both known facts and future expectations was intended to emphasize the double basis for market valuations.

Corresponding with these two kinds of value elements are two basically different approaches to security analysis.

• To be sure, every competent analyst looks forward to the future rather than backward to the past, and he realises that his work will prove good or bad depending on what will happen and not on what has happened.
• Nevertheless, the future itself can be approached in two different ways, which may be called the way of prediction (or projection) and the way of protection.
  

Those who emphasize prediction will endeavour to anticipate fairly accurately just what the company will accomplish in future years - in particular whether earnings will show pronounced and persistent growth.

• These conclusions may be based on a very careful study of such factors as supply and demand in the industry - or volume, price and costs - or else they may be derived from a rather naive projection of the line of past growth into the future.
• If these authorities are convinced that the fairly long-term prospects are unusually favourable, they will almost always recommend the stock for purchase without paying too much regard to the level at which it is selling.
• Such, for example, was the attitude with respect to the air-transport stocks - an attitude that persisted for many years despite the distressingly bad results often shown after 1946. We have commented on the disparity between the strong price action and the relatively disappointing earnings record of this industry.

By contrast, those who emphasize protection are always especially concerned with the price of the issue at the time of study.

• Their main effort is to assure themselves of a substantial margin of indicated present value above the market price - which margin could absorb unfavourable developments in the future.
• Generally speaking, therefore, it is not so necessary for them to be enthusiastic over the company's long-run prospects as it is to be reasonably confident that the enterprise will get along.
  

The first, or predictive, approach could also be called the qualitative approach, since it emphasizes prospects, management, and other nonmeasurable, albeit highly important, factors that go under the heading of quality.

The second, or protective, approach may be called the quantitative or statistical approach, since it emphasizes the measurable relationships between selling price and earnings, assets, dividends, and so forth.

• Incidentally, the quantitative method is really an extension - into the field of common stocks - of the viewpoint that security analysis has found to be sound in the selection of bonds and preferred stocks for investment.
  

In our own attitude and professional work, we were always committed to the quantitative approach.

• From the first we wanted to make sure that we were getting ample value for our money in concrete, demonstrable terms.
• We were not willing to accept the prospects and promises of the future as compensation for a lack of sufficient value in hand.
• This has by no means been the standard viewpoint among investment authorities; in fact, the majority would probably subscribe to the view that prospects, quality of management, other intangibles, and "the human factor" far outweigh the indications supplied by any study of the past record, the balance sheet, and all the other cold figures.
  

Thus this matter of choosing the "best" stocks is at bottom a highly controversial one.

• Our advice to the defensive investor is that he let it alone.
• Let him emphasize diversification more than individual selection.

Incidentally, the universally accepted idea of diversification is, in part at least, the negation of the ambitious pretensions of selectivity.

• If one could select the best stocks unerringly, one would only lose by diversifying.
• Yet within the limits of the four most general rules of common-stock selection suggested for the defensive investor there is room for a rather considerable freedom of preference.
• At the worst the indulgence of such preferences should do no harm; beyond that, it may add something worthwhile to the results.
• With the increasing impact of technological developments on long-term corporate results, the investor cannot leave them out of this calculations.
• Here, as elsewhere, he must seek a mean between neglect and overemphasis.

Ref: Intelligent Investor by Benjamin Graham