In the 11th chapter of "The Intelligent Investor," Benjamin Graham introduces us to securities analysis and financial analysis.
First, he distinguishes between the two types of analysts. Security analysts, he says, are generally limited to the examination and evaluation of stocks and bonds. Financial analysts would do the same work, plus add a broader view in determining investment policy, including portfolio selection and general economic analysis.
At the time this edition of the book was published, in 1973, he says more attention was being given to the valuation of growth stocks. Graham, never a fan of growth stocks, notes many analysts have used mathematics to make “fairly definite projections of expected earnings running fairly far into the future.” Such projections are used to support valuations.
He then points to a “troublesome paradox,” which is that mathematical valuations are being used most often in cases where they are the least reliable. Graham says:
“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.”
Graham says this chapter serves the needs of nonprofessional investors, who should understand what a security analyst is discussing and be able to know the difference between “superficial and sound analysis.”
Thus armed, readers are led into bond, preferred and common stock analysis.
- For corporate bonds, the main criterion is the coverage of total interest charges, the number of times it is covered, based on earnings for a set number of years in the past.
- For preferred stocks, the criterion is the number of times both bond interest and preferred dividends are covered.
- For stocks, analysis generates a valuation that can be compared with the current price. That valuation comes from estimating average earnings over a period of years in the future, then multiplying it by an “appropriate” capitalization factor.
Graham gives significant attention to the capitalization factor, with a section of its own and describing each of the five elements:
- First, there are general, long-term prospects for a company. He says strong opinions exist on both sides of any analysis. He gives an example from the 1965 edition, which compared multipliers for chemical companies in the Dow Jones Industrial Average and oil companies. Despite prevailing faith in the chemical companies, oil stocks outperformed them. Long-term forecasts are as much an art as a science (or perhaps there is no science at all).
- Second, there is the management issue, how effectively the board and senior executives have used shareholders’ capital. While Graham provides few details about the characteristics of good management, contemporary investors have a number, the most important of which is allocation of that capital.
- Financial strength and capital structure come up third on Graham’s list. He compares a company with surplus cash and no other claims (such as preferred shares) to a company with the same earnings per share but carrying a large debt load and senior securities. Obviously, the former will be a better choice.
- Fourth is the dividend record; he says, “One of the most persuasive tests of high quality is an uninterrupted record of dividend payments going back over many years.” Graham says he likes a record of continuous dividend payments over the previous 20 years or more. What’s more, defensive investors might create a stock portfolio based on names passing this test.
- Fifth and finally, Graham lists the current dividend rate. He called this the most difficult to evaluate, at least before the adoption of a standard dividend policy. That standard was along the lines of two-thirds of average earnings; most important for Graham is finding a relationship between dividend rates and earnings. Today, there is more diversity in dividend policy, including many prominent companies that pay no dividends at all, choosing instead to reinvest in faster-than-average reinvestment.
That brings us to Graham’s thoughts on capitalization rates for growth stocks specifically:
“Most of the writing of security analysts on formal appraisals relates to the valuation of growth stocks. Our study of the various methods has led us to suggest a foreshortened and quite simple formula for the valuation of growth stocks, which is intended to produce figures fairly close to those resulting from the more refined mathematical calculations. Our formula is:
“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.”
There are limits to such projections and valuations. Graham observes that the valuations of expected growth stocks must be on the lower side if it is to be assumed growth rates will be realized. He points out a company expected to grow at 8% or more each year indefinitely would receive an infinite valuation.
Analysts should handle this paradoxical point by introducing a margin of safety into their calculations. In addition, investors trying to establish further growth rates should also consider future interest rates. Then, there is the issue of industry analysis, in which Graham has little faith:
“Our own observation, however, leads us to minimize somewhat the practical value of most of the industry studies that are made available to investors. The material developed is ordinarily of a kind with which the public is already fairly familiar and that has already exerted considerable influence on market quotations.”
Graham finishes the chapter by recommending a two-part appraisal process. In the first part, analysts determine “past performance value,” based solely on the past record. In the second part, an analyst works out how the past performance value should be adjusted because of new conditions that may arise in the future.
Turning to the present, analysis has been changed in one important way. Because of the computing and internet revolutions, there is now an abundance of quantitative and qualitative analytical material. For example, there are literally thousands of websites that provide first-hand experiences and resources (including some of questionable value).
There are also functional websites, such as GuruFocus, that contain a vast body of knowledge through the selection and development of analytical tools.
But while we have seen great changes in analytical tools and resources, the human element still figures most prominently. Knowing which tools and resources to use, and when, remains a fundamental question. Fortunately, Graham is helping us along.
(This review is based on the 1973 revised edition of “The Intelligent Investor”; republished in 2003 with chapter-by-chapter commentary by Jason Zweig and a preface by Warren Buffett (Trades, Portfolio). For more articles in this series, go here.)