Investment Lessons from "Security Analysis" by Benjamin Graham & David Dodd
AI's response in regular print | Beverly Hills, CFP®, Joe O'Boyle's in italics
“Investment Lessons from "Security Analysis" by Benjamin Graham & David Dodd”
“The financial system and markets are extremely complex and constantly changing. While we must never stop learning and being prepared for unpredictable events, we must also remember that there are certain bedrock principles that don’t change—and these are the great and enduring lessons of Graham and Dodd.” - Jamie Dimon, Chairman & CEO of JPMorgan Chase
"Security Analysis" by Benjamin Graham and David Dodd is a seminal book that provides a comprehensive framework for analyzing and valuing securities, particularly stocks and bonds. This influential work, first published in 1934, continues to be regarded as a cornerstone in the field of investment analysis. In their book, Graham and Dodd emphasize several key principles that form the foundation of their approach to security analysis.
Intrinsic value: The book emphasizes the concept of intrinsic value, which refers to the true worth of a security based on its fundamental factors, such as earnings, dividends, assets, capital structure and estimates for future cash flows. Graham and Dodd argue that investors should focus on buying securities that are priced below their intrinsic value to achieve long-term success. Graham & Dodd also share that “intrinsic value is an elusive concept” and that it would be a mistake to define intrinsic value of a business simply as the “book value” (the net assets of the business) or that intrinsic value can be determined solely by “earnings power”(because future earnings of a business are not certain).
"The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish that the value is adequate—e.g to protect a bond or justify a stock purchase—or else that the value is considerably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient. To use a homely simile, it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age or that a man is heavier than he should be without knowing his exact weight." — Graham & Dodd, Security Analysis (1934)
Price is not equivalent to value. The market price of a security does not necessarily reflect its intrinsic value. The two can, and often do, diverge significantly. Security analysis doesn't aim to calculate an exact value of a security. The goal is to ensure that the value is enough to provide a satisfactory return with an acceptable level of risk.
Warren Buffett defines intrinsic value as the discounted present value of future cash flows the business will generate over its lifetime. Buffet shares “If you were all knowing about the future and could predict all the cash that a business would give you between now and judgement day, discounted at the proper discount rate, that number is the intrinsic value of a business…
The only reason for making an investment and laying out money now is to get more money back in the future. The future cash flows aren’t printed on a stock certificate. That’s the job of the analyst to say this is what I think this business is going to pay out in the future…
It’s a question of how much cash it’s going to give you. It’s true if you’re buying a farm, it’s true if you’re buying an apartment house. For valuing any financial asset, the question is “how much are you going to get? when are you going to get it? and how sure are you?” If you’re going to buy the whole company, can we distribute enough cash to you, soon enough to make is sensible at present interest rates, to lay out that cash now. That’s what it gets down to. If you can’t answer that question, you can’t buy the stock.”
Warren Buffett also shared: “Intrinsic value is terribly important and very fuzzy. We do our best to invest in the kind of businesses where our predictions are of a highly probable nature. That leaves out all kinds of businesses. … That’s what the (investing) game is all about. Figuring out what those future cash flows are likely to be. When you feel you can’t come up with reasonable estimates in that respect, you move on to the next company.”Margin of safety: The authors stress the importance of having a margin of safety when investing. This means purchasing securities at a significant discount to their intrinsic value to protect against unforeseen risks or errors in judgment. A margin of safety helps investors mitigate potential losses and increases the chances of obtaining favorable returns.
Fundamental analysis: Graham and Dodd advocate for a thorough and rigorous analysis of a company's financial statements and business operations. By scrutinizing balance sheets, income statements, and cash flow statements, investors can assess a company's financial health, earnings stability, and growth prospects. This approach provides a foundation for informed investment decisions.
Contrarian thinking: The book encourages contrarian thinking, which means going against the crowd and being willing to invest in undervalued securities that others may overlook. Graham and Dodd argue that market inefficiencies and emotional biases can create opportunities for astute investors to profit from mispriced assets. Contrarian thinking requires patience, discipline, and the ability to think independently.
Long-term investing: Graham and Dodd also stress the importance of a long-term investment horizon. They caution against being swayed by short-term market fluctuations and speculative trading and instead advocate for focusing on a company's long-term prospects and underlying fundamentals. By adopting a long-term perspective, investors can avoid being influenced by temporary market noise and make more rational and informed investment decisions.
Graham and Dodd distinguished between "investment" and "speculation." According to them, an investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Any other operation not meeting these criteria was speculative. The fundamental difference between investing and speculation is that investing is based on thorough analysis, a focus on the safety of principal, and the potential for a satisfactory return. This distinction is vital when discussing the relationship of intrinsic value factors to market price.
Market Factors: These are external influences on a stock's price, often unrelated to the company's actual financial performance and fall under “speculative”.
Technical: These factors refer to price trends and patterns observed in the stock market, which often reflect the attitudes and behaviors of investors.
Manipulative: Manipulative factors refer to attempts to influence a stock's price without regard to its fundamental value, for example through stock price manipulation schemes.
Psychological: This involves market sentiment, or the general optimism or pessimism of investors, which can push stock prices above or below their intrinsic values.
Future Value Factors: These factors pertain to the company's potential for growth and profitability and fall under “investment”.
Management and Reputation: The quality of a company's management team can significantly impact its future performance. A company with a strong management team and a good reputation is more likely to succeed.
Competitive Conditions and Prospects: The competitive landscape within an industry can greatly affect a company's future earnings. Companies that are well-positioned against competitors are more likely to thrive.
Possible and Probable Changes in Volume, Price, and Costs: These refer to the anticipated changes in a company's operations and financial performance. For example, an increase in sales volume, changes in product pricing, or shifts in production costs could all impact a company's future earnings and, by extension, its intrinsic value.
Intrinsic Value Factors: These factors are related to the company's current financial condition and performance and fall under “investment”.
Earnings: This is one of the most important indicators of a company's financial health. Companies with consistent and growing earnings are often seen as more valuable.
Dividends: Dividends are a way for companies to distribute earnings back to shareholders. A history of consistent dividends can be a positive sign.
Assets: The value of a company's assets, both tangible and intangible, plays a significant role in determining its intrinsic value.
Capital Structure: The mix of debt and equity a company uses to finance its operations can impact its financial stability and growth potential.
Terms of the Issue: This refers to the specific terms and conditions of a security, such as the interest rate for a bond or the dividend rate for a preferred stock.
Others: Other factors may include macroeconomic conditions, industry trends, legal and regulatory environments, and more.
All these factors interplay to shape the attitudes of the public towards a particular security. These attitudes, in turn, dictate the bids and offers for that security, ultimately determining its market price. However, Graham and Dodd cautioned against over-reliance on the market price, which can be subject to short-term fluctuations that may not reflect the intrinsic value of the security. Instead, they championed the importance of thorough analysis and sound judgment in investment decisions.
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Joe O'Boyle is the founder and principal of O'Boyle Wealth Management, a full service financial planning and investment management firm, located in Beverly Hills, California. Joe O’Boyle was named to InvestmentNews 40 under 40 class of 2016, and has a catalog of financial planning and investing articles on Money.com & U.S. News. Disclosure information.