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Security Analysis: Sixth Edition, Foreword by Warren Buffett (Security Analysis Prior Editions): Principles and Technique
“A roadmap for investing that I have now been following for 57 years.” ―From the foreword by Warren E. Buffett The 1940 edition of Security Analysis is considered the bible of value investing. McGraw-Hill continues its proud tradition with this new sixth edition that will serve as a touchstone for a new generation of investors. The leading “Masters” of value investing have updated Graham and Dodd’s classic work with more than 200 pages of new commentary: Seth A. Klarman, president of The Baupost Group, L.L.C. and author of Margin of Safety James Grant, founder of Grant's Interest Rate Observer, general partner of Nippon Partners Jeffrey M. Laderman, twenty-five year veteran of BusinessWeek Roger Lowenstein, author of Buffett: The Making of an American Capitalist and When America Aged and Outside Director, Sequoia Fund Howard S. Marks, CFA, Chairman and Co-Founder, Oaktree Capital Management L.P. J. Ezra Merkin, Managing Partner, Gabriel Capital Group . Bruce Berkowitz, Founder, Fairholme Capital Management. Glenn H. Greenberg, Co-Founder and Managing Director, Chieftain Capital Management Bruce Greenwald, Robert Heilbrunn Professor of Finance and Asset Management, Columbia Business School David Abrams, Managing Member, Abrams Capital The accompanying CD-ROM contains additional chapters from the original 1940 edition. “Benjamin Graham is the father of investment analysts everywhere, originally sparking the debate for a credential to professionalize the industry which led to the CFA Charter. He transformed the practice of financial analysis from trade to science, starting with his groundbreaking book, Security Analysis, first published in 1934. This edition, with new commentary by some of today’s finest investors, belongs on every investment professional’s shelf.” ―Jeffrey J. Diermeier, CFA, president and CEO, CFA Institute About the Author Benjamin Graham is considered to be the founder of value investing and taught at Columbia University’s Graduate School of Business. David L. Dodd was a colleague of Graham’s at Columbia University, where he was an assistant professor of finance. Excerpt. © Reprinted by permission. All rights reserved. Security Analysis Principles and TechniqueBy BENJAMIN GRAHAM DAVID L. DODD McGraw-Hill Copyright © 2009 The McGraw-Hill Companies, Inc. All right reserved. ISBN: 978-0-07-159253-6 Contents Chapter One The Scope and Limitations of Security Analysis. The Concept of Intrinsic Value Analysis Connotes the careful study of available facts with the attempt to draw conclusions therefrom based on established principles and sound logic. It is part of the scientific method. But in applying analysis to the field of securities we encounter the serious obstacle that investment is by nature not an exact science. The same is true, however, of law and medicine, for here also both individual skill (art) and chance are important factors in determining success or failure. Nevertheless, in these professions analysis is not only useful but indispensable, so that the same should probably be true in the field of investment and possibly in that of speculation. In the last three decades the prestige of security analysis in Wall Street has experienced both a brilliant rise and an ignominious fall—a history related but by no means parallel to the course of stock prices. The advance of security analysis proceeded uninterruptedly until about 1927, covering a long period in which increasing attention was paid on all sides to financial reports and statistical data. But the "new era" commencing in 1927 involved at bottom the abandonment of the analytical approach; and while emphasis was still seemingly placed on facts and figures, these were manipulated by a sort of pseudo-analysis to support the delusions of the period. The market collapse in October 1929 was no surprise to such analysts as had kept their heads, but the extent of the business collapse which later developed, with its devastating effects on established earning power, again threw their calculations out of gear. Hence the ultimate result was that serious analysis suffered a double discrediting: the first—prior to the crash—due to the persistence of imaginary values, and the second—after the crash—due to the disappearance of real values. The experiences of 1927–1933 were of so extraordinary a character that they scarcely provide a valid criterion for judging the usefulness of security analysis. As to the years since 1933, there is perhaps room for a difference of opinion. In the field of bonds and preferred stocks, we believe that sound principles of selection and rejection have justified themselves quite well. In the common-stock arena the partialities of the market have tended to confound the conservative viewpoint, and conversely many issues appearing cheap under analysis have given a disappointing performance. On the other hand, the analytical approach would have given strong grounds for believing representative stock prices to be too high in early 1937 and too low a year later. THREE FUNCTIONS OF ANALYSIS: 1. DESCRIPTIVE FUNCTION The functions of security analysis may be described under three headings: descriptive, selective, and critical. In its more obvious form, descriptive analysis consists of marshalling the important facts relating to an issue and presenting them in a coherent, readily intelligible manner. This function is adequately performed for the entire range of marketable corporate securities by the various manuals, the Standard Statistics and Fitch services, and others. A more penetrating type of description seeks to reveal the strong and weak points in the position of an issue, compare its exhibit with that of others of similar character, and appraise the factors which are likely to influence its future performance. Analysis of this kind is applicable to almost every corporate issue, and it may be regarded as an adjunct not only to investment but also to intelligent speculation in that it provides an organized factual basis for the application of judgment. 2. THE SELECTIVE FUNCTION OF SECURITY ANALYSIS In its selective function, security analysis goes further and expresses specific judgments of its own. It seeks to determine whether a given issue should be bought, sold, retained, or exchanged for some other. What types of securities or situations lend themselves best to this more positive activity of the analyst, and to what handicaps or limitations is it subject? It may be well to start with a group of examples of analytical judgments, which could later serve as a basis for a more general inquiry. Examples of Analytical Judgments. In 1928 the public was offered a large issue of 6% noncumulative preferred stock of St. Louis-San Francisco Railway Company priced at 100. The record showed that in no year in the company's history had earnings been equivalent to as much as 1Â1/2 times the fixed charges and preferred dividends combined. The application of well-established standards of selection to the facts in this case would have led to the rejection of the issue as insufficiently protected. A contrasting example: In June 1932 it was possible to purchase 5% bonds of Owens-Illinois Glass Company, due 1939, at 70, yielding 11% to maturity. The company's earnings were many times the interest requirements—not only on the average but even at that time of severe depression. The bond issue was amply covered by current assets alone, and it was followed by common and preferred stock with a very large aggregate market value, taking their lowest quotations. Here, analysis would have led to the recommendation of this issue as a strongly entrenched and attractively priced investment. Let us take an example from the field of common stocks. In 1922, prior to the boom in aviation securities, Wright Aeronautical Corporation stock was selling on the New York Stock Exchange at only $8, although it was paying a $1 dividend, had for some time been earning over $2 a share, and showed more than $8 per share in cash assets in the treasury. In this case analysis would readily have established that the intrinsic value of the issue was substantially above the market price. Again, consider the same issue in 1928 when it had advanced to $280 per share. It was then earning at the rate of $8 per share, as against $3.77 in 1927. The dividend rate was $2; the net-asset value was less than $50 per share. A study of this picture must have shown conclusively that the market price represented for the most part the capitalization of entirely conjectural future prospects—in other words, that the intrinsic value was far less than the market quotation. A third kind of analytical conclusion may be illustrated by a comparison of Interborough Rapid Transit Company First and Refunding 5s with the same company's Collateral 7% Notes, when both issues were selling at the same price (say 62) in 1933. The 7% notes were clearly worth considerably more than the 5s. Each $1,000 note was secured by deposit of $1,736 face amount of 5s; the principal of the notes had matured; they were entitled either to be paid off in full or to a sale of the collateral for their benefit. The annual interest received on the collateral was equal to about $87 on each 7% note (which amount was actually being distributed to the note holders), so that the current income on the 7s was considerably greater than that on the 5s. Whatever technicalities might be invoked to prevent the note holders from asserting their contractual rights promptly and completely, it was difficult to imagine conditions under which the 7s would not be intrinsically worth considerably more than the 5s. A more recent comparison of the same general type could have been drawn between Paramount Pictures First Convertible Preferred selling at 113 in October 1936 and the common stock concurrently selling at 15. The preferred stock was convertible at the holders' option into seven times as many shares of common, and it carried accumulated dividends of about $11 per share. Obviously the preferred was cheaper than the common, since it would have to receive very substantial dividends before the common received anything, and it could also share fully in any rise of the common by reason of the conversion privilege. If a common stockholder had accepted this analysis and exchanged his shares for one-seventh as many preferred, he would soon have realized a large gain both in dividends received and in principal value. Intrinsic Value vs. Price. From the foregoing examples it will be seen that the work of the securities analyst is not without concrete results of considerable practical value, and that it is applicable to a wide variety of situations. 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. We must recognize, however, that intrinsic value is an elusive concept. In general terms it is understood to be that value which is justified by the facts, e.g., the assets, earnings, dividends, definite prospects, as distinct, let us say, from market quotations established by artificial manipulation or distorted by psychological excesses. But it is a great mistake to imagine that intrinsic value is as definite and as determinable as is the market price. Some time ago intrinsic value (in the case of a common stock) was thought to be about the same thing as "book value," i.e., it was equal to the net assets of the business, fairly priced. This view of intrinsic value was quite definite, but it proved almost worthless as a practical matter because neither the average earnings nor the average market price evinced any tendency to be governed by the book value.
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