Security Analysis for the Lay Investor: General Approach
This is the eleventh discussion of the ModernGraham Book Club’s reading of The Intelligent Investor by Benjamin Graham (affiliate link). In last week’s discussion, we discussed the tenth chapter, which considered the types of investment advisers to which an Intelligent Investor may turn. This week we will discuss the eleventh chapter, which is titled “Security Analysis for the Lay Investor: General Approach.” I encourage you to purchase the book (preferably by clicking the link to Amazon, because a purchase through that link will help support the club) and join in with us as we read through a chapter each week; however, even if you don’t have the book I think you will find our discussions to be very useful in your own understanding of value investing, and you can still bring a lot to the discussion from your own experiences as an investor. Whether this is the first day you’ve ever been interested in investing, or you have decades of experience with the stock market, we’d love to hear your thoughts in the comments below!
Please feel free to leave a comment on this post with your own responses to the questions, along with any other thoughts you have, and return throughout the next couple of days to see what others have said. If you find something that has been said by another commentator interesting, feel free to respond to them with another comment. We’ve had some great discussions throughout the book club, so keep it up!
ModernGraham’s Comments
Ben
In Chapter 11, Graham explores some of the basic details of how an Intelligent Investor should go about analyzing his potential investments. I have found this chapter to be one of the most inspiring in terms of developing the ModernGraham approach. One of the key takeaways is that “the more dependent the valuation becomes on anticipations of the future – and the less it is tied to a figure demonstrated by past performance – the more vulnerable it becomes to possible miscalculation and serious error.” This sentence alone explains one of the most important features of the ModernGraham approach, which is that the analysis be based on factual historical data and minimize the level of forecasting.
Graham provides some general guidance for how to analyze individual bond offerings, but I think the more important part of the chapter today is found in the section on common-stock analysis. Graham explains that any worthwhile analysis of a common stock will be based on the determination of the intrinsic value for comparison to the market price. He further explains that the intrinsic value is found in the value of the future earnings but reminds the reader that since the analysis must minimize the reliance on estimates of the future, those estimates should be based on past performance with a built-in safety margin. It is also important to remember that the future must be discounted to the present based on a capitalization rate. In addition, the ModernGraham valuation model comes directly from this chapter, and in the newer editions with commentary from Jason Zweig, the formula is found on page 295.
Heather
In chapter 11, Graham establishes the basis for much of what we do here at Modern Graham. Through explaining that you cannot judge a stock solely on its past performance and giving multiple examples that prove his point, Graham sets up the reader for an understanding of why his methods are essential to any investor. Researching the long term prospects, quality of management, financial strength, and dividends are key components to establishing the worthiness of a stock.
One thing that struck me while reading this is the endless nature of research. For example, quality of management can be analyzed with a brief overview of recent actions taken or can involve an in-depth analysis of each executive. With both the uncertainty of the stock market and the speed at which key members of a corporation can be replaced, neither method is fully sufficient. This is where the formula that Graham lays forth can be of some assistance as it allows for research to be undertaken, while still keeping the process simple. I’m curious to see how this unfolds in later chapters though, as I am not fully sold yet on how one formula can encompass so much.
Discussion Questions
Please leave a comment below and feel free to answer any of these questions, or just give your general thoughts.
- What quote from this chapter do you think best summarizes the point Graham is making?
- If you invest directly in bonds, which factors provided by Graham in this chapter do you currently use?
- Graham provides some commentary on analyzing management performance (though he puts more depth into the topic in a later chapter). How do you think this compares to how investors view management today?
- What did you think of the chapter overall?
Next Week’s Discussion: Chapter Twelve
Chapter Title – Things to Consider About Per-Share Earnings
When reading the next chapter, try to think about how the concepts Graham presents in the chapter could apply to your own investments, whether you consider yourself a Defensive Investor or an Enterprising Investor.
What are some other ways to participate?
If you are a blogger, you can give your thoughts in a post on your own site, link to the discussion here on ModernGraham, and I will be sure to let our readers know that the conversation is going on over at your site as well.
In addition, you can use the hashtag #MGBookClub in social media to talk about the book on Twitter or Facebook!
1. What quote from this chapter do you think best summarizes the point Graham is making? Although Ben got to the heart of the matter with the quote he sited, I found these three brief but sequential statements by Dr. Graham particularly important in the process of making investment decisions:
1) “We suggest that analysts work out first what we call the ‘past-performance value’ which is based solely on the past record”
2) “The second part of the analysis should consider to what extent the value based solely on past-performance should be modified because of new conditions expected in the future”
3) “Eventually the intelligent analyst will confine himself to those groups in which the future appears reasonably predictable, or where the margin of safety of past-performance value over current price is so large that he can take his chances on future variations – as he does in selecting well-secured senior securities.”
2. If you invest directly in bonds, which factors provided by Graham in this chapter do you currently use? I am not a bond investor but if I were I would follow Dr. Graham’s advise as closely as I do for stock selection.
3. Graham provides some commentary on analyzing management performance (though he puts more depth into the topic in a later chapter). How do you think this compares to how investors view management today? Don’t know about other investors but for me, as for Dr. Graham, the evidence is in the company’s performance.
4. What did you think of the chapter overall? More rock-solid sound advise for those striving to profit in securities.
Ben,
I also found it interesting that the footnote regarding the formula Value = E x (8.5 + 2Gr) states: “7. Note that we do not suggest that this formula gives the ‘true value’ of a growth stock, but only that it approximates the results of the more elaborate calculations in vogue”
I find that interesting too, and that is one of the key reasons why I use a margin of safety in the determination of the actual rating. To be considered “undervalued” a company must be trading at less than 75% of its estimated value.
1. What quote from this chapter do you think best summarizes the point Graham is making?
“We suggest that analysts work out first what we call the “past-performance value,” which is based solely on the past record…The second part of the analysis should consider to what extent the value based solely on past performance should be modified because of new conditions expected in the future.”
“If the reader finds the subject interesting he should pursue it systematically and thoroughly before he considers himself qualified to pass a final buy-or-sell judgment of his own on a security issue.”
I found these two quotes to be the most important. You need to measure what the company has proven they can do, and adjust for things you can expect in the future. If you find a security interesting, then you should evaluate it systematically and thoroughly. The hard part is finding and screening for the security that is worth spending your time on. Much of what Graham suggests goes above simply doing calculations and into a full blown Strengths Weaknesses Opportunities and Threats analysis. In grad school, this analysis normally came to a 50 page report on a company, and that can equal paralysis by analysis.
2. If you invest directly in bonds, which factors provided by Graham in this chapter do you currently use?
I do not currently invest directly in bonds. I prefer to invest in bond index funds. I look for average duration and coupon. It makes sense to see how much cash they have to cover their interest charges.
3. Graham provides some commentary on analyzing management performance (though he puts more depth into the topic in a later chapter). How do you think this compares to how investors view management today?
Followers of Graham should follow the same analysis. I think that investors are generally rational, but it does seem that many follow a herd. I think investors have more information, and they can reach a judgment more quickly. Herding will still always happen.
4. What did you think of the chapter overall?
This is one of the most important chapters in the book because it gives the road map to analyzing a company. I have flash carded it, and I keep reading it because of that. I strive to incorporate the ideas in this chapter in ever investing decision I make.
1. What quote from this chapter do you think best summarizes the point Graham is making?
“Unfortunately, it appears to be almost impossible to distinguish in advance between those individual forecast which can be relied upon and those which are subject to a large chance of error.”
2. If you invest directly in bonds, which factors provided by Graham in this chapter do you currently use?
I don’t currently own bonds, but I may in the future following Graham’s methodology.
3. Graham provides some commentary on analyzing management performance (though he puts more depth into the topic in a later chapter). How do you think this compares to how investors view management today? I think you can only rely on performance. However, Buffett offers a warning that combining great management with a bad industry and the industry’s reputation will win.
4.What did you think of the chapter overall?
I think this chapter is laying the groundwork for future chapters.
1. What quote from this chapter do you think best summarizes the point Graham is making?
“The security analyst deals with the past, the present, and the future of any given security issue. He describes the business; he summarizes its operating results and financial position; he sets forth its strong and weak points, its possibilities and risks; he estimates its future earning power under various assumptions, or as a “best guess.” He makes elaborate comparisons of various companies, or of the same company at various times. Finally, he expresses an opinion as to the safety of the issue, if it is a bond or investment grade preferred stock, or as to its attractiveness as a purchase, if it is a common stock.”
2. If you invest directly in bonds, which factors provided by Graham in this chapter do you currently use?
Do not currently invest in bonds.
3. Graham provides some commentary on analyzing management performance (though he puts more depth into the topic in a later chapter). How do you think this compares to how investors view management today?
I think Graham’s analysis of management still holds up as pretty reasonable and today there still seems like “…a great deal is constantly said on this subject, but little that is really helpful.”
4. What did you think of the chapter overall?
I enjoyed the chapter, especially the part about factors affecting the capitalization rate:
– General long-term prospects
– Management
– Financial strength and capital structure
– Dividend record
– Current dividend rate
Also, the part about capitalization rates for growth stocks and the formula for valuing growth stocks, is as Graham writes “… a foreshortened and quite simple formula for the valuation of growth stocks.”
Value = Current (Normal) Earnings × (8.5 plus twice the expected annual growth rate)
“The growth figure should be that expected over the next seven to ten years.”
This post has also been published at http://hurricanecapital.wordpress.com.
Have you read the note on page 585
7. Note that we do not suggest that this formula gives the “true value” of a growth stock, but only that it approximates the results of the more elaborate calculations in vogue.
Patrick,
Yes I have read that note and I agree with it. No formula will provide the exact value of a company, but this formula does an excellent job of estimating the value. When combined with a margin of safety, the overall result will be useful. On ModernGraham, any company rated “Undervalued” must be trading at least 25% below its estimated intrinsic value. This allows a greater chance of being accurate with the assessment.