Showing posts with label descriptive function of security analysis. Show all posts
Showing posts with label descriptive function of security analysis. Show all posts

Wednesday 17 December 2008

The Scope and Limitations of Security Analysis

The Scope and Limitations of Security Analysis

Analysis connotes the careful study of available facts with the attempt to draw conclusions therefrom based on established principles and sound logic. However investment is by nature not an exact science. Therefore, both individual skill (art) and chance are important factors in determining success or failure.

Graham wrote (Security Analysis, 1951 edition):
“The market and business cycles since 1933 – like those before 1927 – have provided a suitable proving ground for security analysis.
However, in the years of 1927-1933, both the advance and the decline in stock prices were so extreme during this period that the conclusions suggested by informed and conservative security analysis were found to have little practical utility. This was the more true because the business depression of the early 1930’s was so unexpectedly severe as to vitiate many conclusions regarding safety and value that had been reasonable in the light of past experience.”

The quality and quantity of the published corporate data has added to the scope and dependability of security analysis.

Three Functions of Security Analysis

The functions of analysis may be described under three headings: descriptive, selective, and critical.

1. Descriptive Function.

Descriptive analysis limits itself to marshalling the important facts relating to an issue and presenting them in a coherent, readily intelligible manner. But there are gradations of accomplishment, and of related skill, in this descriptive function.

The least imaginative type is found in the familiar and indispensible statistical presentations of the various security manuals and similar descriptive services. (These include Fitch, Moody’s and Standard & Poor’s.) Here the material is accepted essentially in the form supplied by the company; the figures are set down for a number of successive years; then certain standard calculations are added – e.g., earnings per share, number of times fixed charges were earned.

A more penetrating descriptive analysis can often go much farther than this in presenting the published figures. In many cases the latter need various kinds of adjustment in order to bring out the true operating results in the period covered, and particularly in order to place the data of a number of companies on a fairly comparable plane. Here the analyst must consider such matters as contingency reserves, special allowances for depreciation, “LIFO” versus “FIFO” inventory accounting, non-recurring gains and losses, nonconsolidated subsidiaries, and many other possible items.

On a still higher level of analysis would rank the evaluation of favourable and unfavourable factors in the position of the issue. This might include consideration of the changes in the company’s position over a long period of years, also a detailed comparison with others in the same field, also projections of earning power on various assumptions as to future conditions. The analyst who can do these jobs well will undoubtedly be ready to go forward to the stage of decision and selection.

2. The Selective Function.

The senior analyst must be ready to pass judgment on the merits of securities. He is expected to advise others on their purchase, sale, retention, or exchange.

Many laymen believe that if a security analyst is worth his salt he should be able to give good advice of this sort about any stock or bond issue at any time.

This is far from true. There are times and security situations:
· that are propitious for a sound analytical judgment;
· others which he is poorly qualified to handle;
· many others for which his study and his conclusions may be better than nothing, but still of questionable value to the investor.

Furthermore, we should acknowledge that there are some serious differences of opinion among practicing security analysts as to the basic approach to the selective function.

3. The Critical Function of Security Analysis.

The principles of investment finance and the methods of corporation finance fall necessarily within the province of security analysis. Analytical judgments are reached by applying standards to facts.
· The analyst is concerned, therefore, with the soundness and practicability of the standards of selection.
· He is also interested to see that securities, especially bonds and preferred stocks, be issued with adequate protective provisions, and more important still – that proper methods of enforcement of these convenants be part of accepted financial practice.
· It is a matter of great moment to the analyst that the facts be fairly presented, and this means that he must be highly critical of accounting methods.
· Finally, he must concern himself with all corporate policies affecting the security owner, for the value of the issue which he analyses may be largely dependent upon the acts of the management. In this category are included questions of capitalization setup, of dividend and expansion policies, of managerial competence and compensation, and even of continuing or liquidating an unprofitable business.

On these matters of varied import, security analysis may be competent:
· to express critical judgments,
· looking to the avoidance of mistakes,
· to the correction of abuses, and
· to the better protection of those owning bonds or stocks.