Security Analysis - Benjamin Graham and David Dodd

Security Analysis by Benjamin Graham and David Dodd 

Security Analysis, the revolutionary book on fundamental analysis and investing, was first published in 1934, following unprecedented losses on Wall Street.

Benjamin Graham and David Dodd chided Wall Street for its myopic focus on a company's reported earnings per share (eps), and were particularly harsh on the favored "earnings trends." They encouraged investors to take an entirely different approach by estimating the rough value of the operating business that lay behind the security. They have given actual examples of the market's tendency to irrationally under-value certain out-of-favor stocks.

The book is must read for any Stock Market Investor, fundamental analyst or equity research professional. 

Investment Policies (Based on Benjamin Graham)

Summary of Investment Policies

A. INVESTMENT FOR FIXED INCOME:
US Savings Bonds (FDs)

B. INVESTMENT FOR INCOME, MODERATE LONG-TERM APPRECIATION AND PROTECTION AGAINST INFLATION:
(1) INVESTMENT FUNDS bought at reasonable price.
(2) Diversified list of primary common stocks (BLUE CHIPS) bought at reasonable price. 

C. INVESTMENT CHIEFLY FOR PROFIT: 4 approaches are open to both the small and the large investors:
(1) Representative common stocks bought when the MARKET level is clearly LOW.
(2) GROWTH STOCKS, when these can be obtained at reasonable prices in relation to actual accomplishment – GROWTH INVESTING.
(3) Purchase of securities selling well BELOW INTRINSIC VALUE – VALUE INVESTING.
(4) Purchase of WELL-SECURED PRIVILEGED SENIOR ISSUES (bonds and preferred shares).
(5) SPECIAL SITUATIONS: Mergers, arbitrages, cash pay-outs.

D. SPECULATION:
(1) Buying stock in new or virtually new ventures (IPOs) .(2) TRADING in the market.
(3) Purchase of "GROWTH STOCKS" at GENEROUS PRICES.


_______________


For DEFENSIVE INVESTORS: Portfolio A & B
(Portfolio A: Cash, FDs, Bonds Portfolio B: Mutual funds, Blue chips)

For ENTERPRISING INVESTORS: Portfolio A & B & C
(Portfolio C: Buy in Low Market, Buy Growth stocks at fair value, Buy value stocks i.e. bargains, High grade bonds and preferred shares, Arbitrages)

For SPECULATORS: Portfolio D
(Should set aside a sum for this separate from their money in investing.)

________________
________________


Types of Investors

Graham felt that individual investors fell into two camps : "defensive" investorsand "aggressive" or "enterprising" investors.

These two groups are distinguished not by the amount of risk they are willing to take, but rather by the amount of "intelligent effort" they are "willing and able to bring to bear on the task."

Thus, for instance, he included in the defensive investor category professionals (his example--a doctor) unable to devote much time to the process and young investors (his example--a sharp young executive interested in finance) who are as-yet unfamiliar and inexperienced with investing.

Graham felt that the defensive investor should confine his holdings to the shares of important companies with a long record of profitable operations and that are in strong financial condition. By "important," he meant one of substantial size and with a leading position in the industry, ranking among the first quarter or first third in size within its industry group.

Aggressive investors, Graham felt, could expand their universe substantially,but purchases should be attractively priced as established by intelligent analysis. He also suggested that aggressive investors avoid new issues.


Click and read also:

****My Investment Philosophy, Strategy and various Valuation Methods

Are You an Intelligent Investor?

Knowing Yourself and Keep Investing Simple and Safe

Benjamin Graham's Writings over time

Year 1934 1st Edition Security Analysis

Year 1940 2nd Edition Security Analysis

Year 1949 1st Edition The Intelligent Investor

Year 1951 3rd Edition Security Analysis

Year 1954 2nd Edition The Intelligent Investor

Year 1959 3rd Edition The Intelligent Investor

Year 1962 4th Edition Security Analysis

Year 1973  4th Edition The Intelligent Investor

Security Analysis by Benjamin Graham and David Dodd pdf

Security Analysis, the revolutionary book on fundamental analysis and investing, was first published in 1934, following unprecedented losses on Wall Street.

Benjamin Graham and David Dodd chided Wall Street for its myopic focus on a company's reported earnings per share (eps), and were particularly harsh on the favored "earnings trends." They encouraged investors to take an entirely different approach by estimating the rough value of the operating business that lay behind the security. They have given actual examples of the market's tendency to irrationally under-value certain out-of-favor stocks.

The book is must read for any Stock Market Investor, fundamental analyst or equity research professional.

Investment Policies (Based on Benjamin Graham)

Summary of Investment Policies

A. INVESTMENT FOR FIXED INCOME:
US Savings Bonds (FDs)

B. INVESTMENT FOR INCOME, MODERATE LONG-TERM APPRECIATION AND PROTECTION AGAINST INFLATION:
(1) INVESTMENT FUNDS bought at reasonable price.
(2) Diversified list of primary common stocks (BLUE CHIPS) bought at reasonable price. 

C. INVESTMENT CHIEFLY FOR PROFIT: 4 approaches are open to both the small and the large investors:
(1) Representative common stocks bought when the MARKET level is clearly LOW.
(2) GROWTH STOCKS, when these can be obtained at reasonable prices in relation to actual accomplishment – GROWTH INVESTING.
(3) Purchase of securities selling well BELOW INTRINSIC VALUE – VALUE INVESTING.
(4) Purchase of WELL-SECURED PRIVILEGED SENIOR ISSUES (bonds and preferred shares).
(5) SPECIAL SITUATIONS: Mergers, arbitrages, cash pay-outs.

D. SPECULATION:
(1) Buying stock in new or virtually new ventures (IPOs) .(2) TRADING in the market.
(3) Purchase of "GROWTH STOCKS" at GENEROUS PRICES.


_______________


For DEFENSIVE INVESTORS: Portfolio A & B
(Portfolio A: Cash, FDs, Bonds Portfolio B: Mutual funds, Blue chips)

For ENTERPRISING INVESTORS: Portfolio A & B & C
(Portfolio C: Buy in Low Market, Buy Growth stocks at fair value, Buy value stocks i.e. bargains, High grade bonds and preferred shares, Arbitrages)

For SPECULATORS: Portfolio D
(Should set aside a sum for this separate from their money in investing.)

________________
________________


Types of Investors

Graham felt that individual investors fell into two camps : "defensive" investorsand "aggressive" or "enterprising" investors.

These two groups are distinguished not by the amount of risk they are willing to take, but rather by the amount of "intelligent effort" they are "willing and able to bring to bear on the task."

Thus, for instance, he included in the defensive investor category professionals (his example--a doctor) unable to devote much time to the process and young investors (his example--a sharp young executive interested in finance) who are as-yet unfamiliar and inexperienced with investing.

Graham felt that the defensive investor should confine his holdings to the shares of important companies with a long record of profitable operations and that are in strong financial condition. By "important," he meant one of substantial size and with a leading position in the industry, ranking among the first quarter or first third in size within its industry group.

Aggressive investors, Graham felt, could expand their universe substantially,but purchases should be attractively priced as established by intelligent analysis. He also suggested that aggressive investors avoid new issues.


Click and read also:

****My Investment Philosophy, Strategy and various Valuation Methods

Are You an Intelligent Investor?

Knowing Yourself and Keep Investing Simple and Safe

Sorry, the links below are no longer available.

Use the link to directly download the ebook in PDF format

http://books.expect-us.net/dl/Graham%20&%20Dodd%20-%20Security%20Analysis%20(6th%20ed).pdf

http://myinvestingnotes.blogspot.com/2013/09/security-analysis-benjamin-graham-and.html

** Insiders Can Alter Market Value as Their Needs Dictate

The value of the stockholdings of insiders is measured by what they can do with the business if and when they want to do it.

• If they need a higher dividend to establish this value, they can raise the dividend.
• If the value is to be established by selling the business to some other company, or by recapitalizing it, or by withdrawing unneeded cash assets, or by dissolving it as a going concern, they can do any of these things at a time appropriate to themselves.
  

Rarely if ever do (controlling) insiders suffer loss from an unduly low market price which it is in their power to correct.

• If by any chance they should want to sell, they can and will correct the situation first.
• In the meantime they may benefit from the opportunity to acquire more shares at a bargain level, or to pay gift (and prospective estate) taxes on a small valuation, or to save heavy surtaxes on larger dividend payments, which for them would mean only transferring money from one place where they control it into another.
  

To the extent that operating management and inside stockholders form a cohesive group - and this is more typical than not in corporate affairs - the insiders must be considered as opposed in a practical sense to the improvement of bad management.

• They are often opposed to the payment of an adequate dividend, because they save taxes by a low dividend and they have effective control over the undistributed earnings.
• A holding-company setup may be of great strategic advantage to them, and they can terminate its disadvantages whenever they wish.
• The same is true of the retention of excessive capital in the business.
  

Thus on many counts the insiders are likely to look upon corporate policies in ways diametrically opposed to the interests and desires of the typical outside stockholder.

• We believe that the public stockholder is entitled to have his legitimate interests preferred over the special interests of the insiders.
• Once the public has been asked to invest its money in the common stock of any company, the management and the controlling stockholders should recognize a continuing obligation to conduct the business in all respects as trustees for the public stockholders and to follow such policies as are conducive to satisfactory investment results by the ordinary, outside owner of their shares.
• This principle is in accord with the spirit of our laws. It has not been applied as yet to any extent in legal cases, because, we believe, the issues are somewhat subtle and they have not been presented to the courts with sufficient clarity and vigor.
  
  

Ref: Security Analysis by Graham and Dodd

Controlling Stockholders and the Outside Stockholders

There are some important differences of status and possible conflicts of interest between the controlling stockholders and the outside stockholders.

The basic point is that controlling stockholders are not dependent on either the dividend returns or the market price of the shares as the fundamental source of the value of their investment.

The outside stockholder is dependent on one or both of these factors.

This basic difference is of the greatest practical importance in corporate affairs, but so far it seems to have escaped both public notice and judicial notice.


Ref: Security Analysis by Graham and Dodd

The general concept of corporate insiders seems to view them as people who profit from their special knowledge of what is going on, and who benefit at times by being on both sides of business deals with the company.

Whatever its earlier validity, this idea has little present relevance to corporate affairs. Strict interpretation of the laws imputing a trustee's responsibility to those in control, plus constant watchfulness by the SEC, plus a great advance in ethical standards of personal conduct, have combined to eliminate the gross abuses of the past.

Poor Management a Double Liability in Unprofitable Business

It is a true remark that the determining factor in keeping an unprofitable business running is often the natural desire of the management to hold on to their jobs.

Unfortunately, poor-caliber management is more anxious to hang on than high-caliber management, since the latter can usually find other and perhaps better employment elsewhere.

Thus, good management can make most businesses successful, and if the obstacles to success are insurmountable it will try to work the situation out in whatever way will yield the best results to the stockholder. *

Bad management often makes an intrinsically good business unsuccessful; it bitterly opposes any move that will hurt its own position, whether the move be in the direction of

• improving the management,
• selling the business at a price far above the past market value, or
• discontinuing it altogether.

Ref: Security Analysis by Graham and Dodd

* The case history of Hamilton Woolen showed how a capable and conscientious management dealt with the problem of continuing a hitherto unsuccessful business. The question was twice put to the stockholders for a vote. In 1927, they voted to continue the business, with new policies, and the results were satisfactory for a time. In 1934, following a disastrous strike, they voted to liquidate the business and realised considerably more than its previous market value as a going concern.

Ref: Security Analysis by Graham and Dodd

The Question of Continuing the Enterprise

If a publicly owned business is consistently unsuccessful, should the stockholders move to dispose of it?

Does the answer depend mainly

• on business judgement,
• on ethics or
• on custom?

We think that what usually happens in such cases is dictated mainly by custom - by the stockholders' habit of letting things drift until something happens to change the picture.

The ethical question turns on the possible obligation of the owners toward society, the employees, or the management, which may require them to continue to operate the business even though it is unprofitable. This matter has not been thought through.

Economists say that the elimination of unprofitable enterprises is an important means by which the free-enterprise system adapts its output flexibly and efficiently to the public's wants. However, while society as a whole may lose rather than gain by the continuance of unprofitable businesses, the impact of discontinuance on local communities may be disastrous and cannot be ignored.

With respect to employees, no ethical obligation seems to interfere with drastic layoffs and discharges when demand declines. Whether a concern is successful or unsuccessful, the NUMBER of employees retained on the payroll is expected to be a matter of sound business judgement, and not of ethics.

The increasing power of labour unions has tended to impose uniform wage requirements on all companies in an industry, with the result that the less favourably situated units have no flexibility of contract and therefore little chance of working out a decent return for the owners. If ethical considerations are to dictate the continuance of such enterprises, it would seem that there should be some give-and-take between stockholders and employees.

Ref: Security Analysis by Graham and Dodd

The Holding-company Device

Disadvantageous Corporate Structure: The Holding-company Device

In the 1920s, there were many holding companies. These were enterprises organized to acquire voting control of previously existing concerns.

In most cases, the holding company issued its own senior securities (bonds and preferred shares) to pay in whole or part of the common shares it acquired. The process was repeated, in many instances, by the formation of new holding companies, with new layers of senior securities, to acquire control of existing holding companies. In this way, there were rapidly created a number of heavily pyramided capital structures - nearly all in the public-utility, railroad and "investment-trust" fields.

After the crash of 1929, most of these structures collapsed, with tremendous losses to speculators and misguided investors therein.

The moving spirits behind these astonishing examples of "high finance" were actuated by the twin motives of making enormous profits out of such corporate manipulations and of wielding personal power over great financial and industrial empires. Their motives were extremely popular with the public, until the day of reckoning, because there provided continuous fuel for the speculative fires.

As might be expected, the subsequent debacle created a complete revulsion of feeling. Holding companies became, and are still, highly unpopular with both investors and speculators.

For many years past, the existence of a holding company, instead of adding to the value of the underlying assets, has constituted a definite drawback and detriment. The market has been emphatic on this point. Holding-company securities have consistently sold at substantial discounts from the concurrent market value of the securities they own.

Discounts Disappear in Dissolution

All the evidence points clearly to the conclusion that, since 1929, a holding-company setup has been disadvantageous to the outside shareholders, and that they benefit significantly from the dissolution of such companies and the consequent direct ownership of the underlying securities.

It has been the standard experience that the shares sold at substantial discounts from their true value as long as the holding company continued as such,k and that these discounts disappeared when the holding company disappeared.

The attitude of managements in this matter deserves to be recorded. In nearly all cases, they opposed the dissolution of the holding companies; in a number of instances they waged bitter and costly legal battles, with their stockholder's money, to prevent the step. In their communications to stockholders they insisted that continuance of the holding companies would be to the stockholders' advantage.

We believe that most of their arguments were disingenuous and that in this matter they were defending their own interest - in some cases unconsciously, no doubt - in preference to that of the public stockholders.

We make these statements with considerable reluctance; but we believe it essential that the fact be brought home to stockholders, as forcibly as possible, that in matters in which management's interests may be opposed to the stockholders', the latter cannot rely upon receiving fair treatment from management and must be prepared to recognize and do battle for their own advantage.

A number of holding companies still existed at the end of 1950. The market persisted in its considered judgment, voiced through year-after-year prices, that such arrangements are detrimental to the outside stockholder. The fact they are permitted to continue we consider to be a monument to the inertia and bad judgment displayed by the American investor in his capacity as continuing shareholder.

Ref: Security Analysis by Graham and Dodd

Changes in Capital Structure

The preference for an all-common stock capitalization could in many cases prove disadvantageous for the owners of the business.

Not only might it prevent them from "maximising their gains", but more seriously, it might prevent them from earning enough on their capital to support or carry the investment.

We think there is an unanswerable argument in favour of a moderate amount of senior securities (bonds and preferred shares) if:

• (1) such senior securities might be conservatively created and bought for investment under established standards of safety; and
• (2) the use of senior capital is necessary to provide a satisfactory return on the common equity.

A company with only common stock outstanding may change toward the optimal structure by any of several means:

• 1. It may issue senior securities (bonds and preferred shares) pursuant to an expansion move, perhaps involving the acquisition of another business. (Example: Beaunit Mills Corporation changed from an all-common structure in March 1948 to a predominantly senior-security structure in March 1949.)
• 2. It can recapitalize, and issue new preferred stock and common stock - or even new bonds and common stock - in place of the old common. (Example: Ward Baking Company did this, via a new holding-company setup in 1924.)
• 3. It can declare a stock dividend, payable in new preferred shares. (Example: Electric Boat issued such a stock dividend in 1946.)
• 4. It can sell senior securities (bonds and preferred shares) and distribute all or part of the money to the common stockholders. (Example: In effect this was done in the recapitalization of Maytag Company in 1928.)

When a move of the fourth kind is made, it is almost always tied in with a merger or other corporate development - presumably because financial opinion is prejudiced against the sale of senior securities for cash to be distributed to common shareholders, regardless of the logic in the individual case.

Experience amply shows that once management is persuaded that the capital structure should be changed, to create a better earning power per dollar of common investment, it can readily find suitable means of accomplishing this end.

While this is a matter that may be of considerable importance to the stockholders of many companies, we do not think that they are likely to formulate and express independent views thereon until they have made considerable progress in self-education on other points affecting their interest.

Attention to this matter will repay careful thought by security analysts, managements, and enterprising stockholders.



Ref: Security Analysis by Graham and Dodd

Prorata Distributions of Capital the Fairest Arrangement

The basic questions are:

• whether any substantial amount of capital is redundant, and,
• whether the stockholders would benefit if such capital were returned to them.

If these were true, it becomes the duty of the directors to treat all stockholders fairly in the process.

A return of capital by a prorata distribution, would be the most direct and equitable way of accomplishing this.

However, valid tax considerations often dictate the alternative process of buying in shares.

It still remains the duty of the management to deal equitably with all the holders and to equalize as nearly as possible the position of those who sell and those who keep their shares.

Outside stockholders should insist on a policy of fairness, regardless of whether they would sell or not.

They are much more likely to benefit in the long run by having the principle of equitable treatment of all stockholders established, than by taking temporary advantage of the necessities or bad judgment of those who are willing to dispose of their holdings at a totally inadequate price.

Ref: Security Analysis by Graham and Dodd

Repurchases of Shares by Companies

Convincing evidence that many companies do in fact accumulate more capital than they need is seen in the prevalence of repurchases of stock in the open market.

A check in 1951 of companies listed on the New York Stock Exchange showed 430 (or 40.3%) holding shares of their own previously issued common and preferred stocks. A compilation by the Exchange in 1934 indicated 250 (or 32%) of the corporations held such stock in the treasury.

It is appropriate to mention that there are legitimate reasons (other than possession of surplus cash) for reacquiring stock, such as

• for retirement under sinking-fund provisions,
• to acquire assets which cannot be purchased for cash, and
• for distribution to employees as awards or
• for sale under company stock-purchase plans.

These repurchases as a whole present ethical questions which have not been thoroughly considered either by managements or stockholders.

It is assumed to be a "smart" thing to buy in stock at the lowest possible price, just as a smart buyer would purchase anything else.

For some reason, managements consider their duty lies only to those stockholders who do NOT sell, and that they have no obligation to deal considerately with anyone so disloyal or so speculatively minded as to want to dispose of his shares.

Furthermore, the argument runs, the company could refrain from buying shares at all, in which case those selling out would receive a still lower price. Hence, there can be no unfairness in paying a price, however small, as long as the seller could not do better elsewhere.


Ref: Security Analysis by Graham and Dodd

Returning Unneeded Capital to Stockholders

These 2 examples illustrated
http://myinvestingnotes.blogspot.com/2009/08/examples-of-companies-with-large.html

• how the problem of excessive capital tends to develop,
• what its unfavourable effects are for the stockholders,
• how difficult it is to persuade management to correct the situation, and
• how the stockholders benefit if and when it is finally corrected.
  

Evidently several things are needed in order that stockholders and managements both may come to view situations of this kind in a sensible and business-like fashion.

• First, the principle must be accepted that, WHEN THE RESULTS ON CAPITAL ARE UNSATISFACTORY, it is appropriate for stockholders to inquire whether too much of their capital is employed in the enterprise.
• Second, if the amount at risk appears prima facie to be more than the business requires, the stockholders should insist on factual and convincing reasons for its retention. They should not be satisfied with the usual generalizations about what is "good for the business," and the usual vague references to possible future opportunities or disasters. (Managements consider either as a sufficient excuse for holding on to what is there.)
• Third, if capital can be spared, they should insist that it be returned to stockholders on an equitable basis.

Ref: Security Analysis by Graham and Dodd

Examples of Companies with Large Working Capital

Northern Pipe Line Company



In 1926, this company had:



Total Equity: capital and surplus of $4,235,000,

represented by

Current Asset: $3,489,000 of cash assets, $33,000 of other current assets, and

Fixed Asset: $1,319,000 of net plant,

less

Total liabilities: $606,000.



Total business done was only about $500,000.



A good part of the net earnings of $375,000 ( $9.375 per share) came from investments in railroad bonds.



The stock sold for an average value of $2,880,000 ($72 per share for 40,000 shares), which was considerably less than the cash assets alone.



These cash assets had been accumulated mainly out of annual charges for depreciation.



Dividends had been generous in relation to earnings and amounted to $6 per share in 1926.



The business, formerly very prosperous, had lost a good part of the volume and, with it, its appeal to investors.



Clearly, the outside stock-holders were at a great disadvantage in having so much of their capital tied up in cash funds that were held by an unattractive enterprise.



The management claimed that it was necessary or advisable to retain this money, because some day they MIGHT want to build a new pipe line.



It required a strenuous proxy contest to change the management's thinking.



Later, cash distributions of $70 per share ($2,800,000) were made as a return of capital, and the stockholders' over-all position was greatly improved.



----



Colt's Manufacturing Company.



This company emerged from the war with over $10 million in working capital, largely cash; but in 1946 its sales were only $5.0 million, and in 1946-1948 it lost money in the aggregate.



In this instance, the management embarked on two unrelated lines of business, in order to find additional employment for the large plant facilities and current assets. (However, the funds committed were held down to modest figures.)



The new lines did not prove successful, at least as far as enabling the company to show an adequate return on the owner's capital.



The stock sold persistently for much less than the working capital alone. (In 1947 the average price was 31, against net current assets or working capital of over $50 per share.)



Large stockholding interests, having previously obtained places on the board and having studied the company's problems and possibilities with care, finally decided that the capital should be reduced substantially by repurchasing a large proportion of the outstanding stock.



In 1950, following a call for tenders of stock, 125,000 shares, or 64% of the total, were bought in at a price as high as the working-capital value of $53.



The remaining shares had the same prorata interest as before in the current assets, and a much larger interest in the plant. This move was unquestionably beneficial both to the stockholders who sold back and to those who retained their stock, which sold as high as 65 soon after the repurchase.

Ref: Security Analysis by Graham and Dodd

The Paradox of Large Working Capital in Mediocre Companies

1. A prosperous company would appear more likely to accumulate excessive capital than a nonprosperous one.

2. Strangely enough, this is not true. Most prosperous companies, in our dynamic economy, have been able to expand their business more or less steadily, and this expansion has supplied a satisfactory outlet for the retained earnings.

3. On the other hand, many concerns that have shown mediocre results over a long period of years will in one way or another end up by holding too much of their stockholders' capital.

• This is often the result of a persistently low dividend, together with some fairly large accumulation of profits in boom periods.
• Sometimes new capital is raised by stock sales which later turn out to be redundant.
• In frequent cases the accrual of substantial annual depreciation and depletion charges results in gradually transferring the fixed assets into cash, with a consequent excess of working capitals.

4. Consequently, the question whether too much capital is being used in the business becomes of practical moment to stockholders only in the case of nonprosperous companies. (After all, properous companies do not present problems to their stockholderss except in the matter of dividend policy.)

• It is an area in which the interests of stockholders and managements are likely to clash vigorously.
• The more dubious the company's prospects - which means generally the less satisfactory its past results - the more anxious management is to retain all the cash it can in the business;
• but the stockholders would be well advised to take out all the capital that can be safely spared, because these funds are much more valuable to them if in their own pockets, or invested elsewhere, than if left in a nonprosperous business.

Ref: Security Analysis by Graham and Dodd