Security Analysis: The Classic 1951 Edition

Abnormally good or abnormally bad conditions do not last forever.

In other words, the market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities. Rather should we say that the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion.

... Bond selection is primarily a negative art. It is a process of exclusion and rejection, rather than of search and acceptance.

While a trend shown in the past is a fact, a “future trend” is only an assumption.

Astute observers of corporate balance sheets are often the first to see business deterioration

The Interborough issues are an example of a rather special group of situations in which analysis may reach more definite conclusions respecting intrinsic value than in the ordinary case. These situations may involve a liquidation or give rise to technical operations known as “arbitrage” or “hedging.

As a rule of thumb, investors should spend the bulk of their time on the disclosures of the security under study, and they should spend significant time on the reports of competitors.

One example of a high-tech company that submits to a Graham type of analysis is Amazon.com. Though it does business exclusively on the Web, Amazon is essentially a retailer, and it may be evaluated in the same way as Wal-Mart, Sears, and so forth. The question, as always, is, does the business provide an adequate margin of safety at a given market price. For much of Amazon’s short life, the stock was wildly overpriced. But when the dot-com bubble burst, its securities collapsed. Buffett himself bought Amazon’s deeply discounted bonds after the crash, when there was much fearful talk that Amazon was headed for bankruptcy. The bonds subsequently rose to par, and Buffett made a killing.

I quickly convinced myself that the true key to material happiness lay in a modest standard of living which could be achieved with little difficulty under almost all economic conditions”—the margin-of-safety idea applied to personal finance.21

Investors still need to ask, how stable is the enterprise, and what are its future prospects? What are its earnings and cash flow? What is the downside risk of owning it? What is its liquidation value? How capable and honest is its management? What would you pay for the stock of this company if it were public? What factors might cause the owner of this business to sell control at a bargain price? Similarly, the pair never addressed how to analyze the purchase of an office building or apartment complex. Real estate bargains come about for the same reasons as securities bargains—an urgent need for cash, inability to perform proper analysis, a bearish macro view, or investor disfavor or neglect. In a bad real estate climate, tighter lending standards can cause even healthy properties to sell at distressed prices. Graham and Dodd’s principles—such as the stability of cash flow, sufficiency of return, and analysis of downside risk—allow us to identify real estate investments with a margin of safety in any market environment.

... investors are constitutionally averse to buying into a troubled situation.

In all of these instances he appears to be concerned with the intrinsic value of the security and more particularly with the discovery of discrepancies between the intrinsic value and the market price.

Principle of Optimum Capitalization Structure.

An investment operation is one that can be justified on both qualitative and quantitative grounds.

We must recognize, however, that intrinsic value is an elusive concept.

When values are determined chiefly by the outlook, the resultant judgments are not subject to any mathematical controls and are almost inevitably carried to extremes.

Analysis is concerned primarily with values which are supported by the facts and not with those which depend largely upon expectations.

A criterion based on adjectives is always ambiguous.

The trend is, in fact, a statement of future prospects in the form of an exact prediction.

Objective tests of managerial ability are few and far from scientific. In most cases the investor must rely upon a reputation which may or may not be deserved.

... the value of the pledged property is vitally dependent on the earning power of the enterprise.

The market made up new standards as it went along, by accepting the current price - however high - as the sole measure of value. Any idea of safety based on this uncritical approach was clearly illusory and replete with danger.

The essence of proper bond selection consists, ... in obtaining specific and convincing factors of safety in compensation for the surrender of participation in profits.

It is our view that stock-market timing cannot be done, with general success, unless the time to buy is related to an attractive price level, as measured by analytical standards. Similarly,

Security analysis, as a study, must necessarily concern itself as much as possible with principles and methods which are valid at all times—or, at least, under all ordinary conditions.

And I suspect that Graham and Dodd have been ignored by those who suffer from the misconception that trying to make serious money requires that one take serious risks.

We are convinced that the public generally will derive far better results from fixed-value investments, if selected with exceeding care, than from speculative operations, even though these may be aided by considerable education in financial matters.

Another modern development of relevance is the ubiquitous cable television coverage of the stock market. This frenetic lunacy exacerbates the already short-term orientation of most investors. It foments the view that it is possible—or even necessary—to have an opinion on everything pertinent to the financial markets, as opposed to the patient and highly selective approach endorsed by Graham and Dodd.

Principle for the securities analyst: Nearly every issue might conceivably be cheap in one price range and dear in another.

Texaco's unusual situation can be summarized in one sentence, often repeated by Graham and Dodd disciple Warren Buffett: A great investment opportunity occurs when a marvelous business encounters a onetime huge, but solvable, problem.