Graham and Dodd’s "Security Analysis"Â is widely considered by many to be the Bible of value investing. But, much like the Bible, few people have actually read it cover to cover. This veritable tome contains over 500 pages (with the updated sixth edition containing a further 200 pages of commentary by well-known value investors), so this is unsurprising. This multi-part series will aim to extract some nuggets of wisdom from the great masters that you may have missed.
Some of the specific advice may seem somewhat dated to the retail investor -- the focus on fixed income investment ahead of stock, an environment with much higher real interest rates, and a far less transparent market were all features of their time -- but the general principles shine through and are still applicable today.
Today we will look at the authors' advice for small investors, what would today be called individual retail investors. Graham and Dodd considered that a small investor could do one of three things: invest for income, invest for profit or speculate. The first two we will discuss here in part one. Speculation will be dealt with in part two.
Investment for income
“In this case the only sensible investment for safety and accumulated income, under present conditions, is found in United States Savings Bonds. Other good investments yield little if any more, and they have not equal protection against both ultimate and intermediate loss. Straight bonds and preferred stocks ostensibly offering a higher return are almost certain to involve an appreciable risk factor.”
Nowadays, with Series EE Savings Bonds paying a paltry 0.10% annual interest rate, this type of extreme defensiveness seems excessive. But you must remember that at the time of writing, investing was significantly riskier than it is now, due to much laxer securities laws and a less stringent reporting process for company management. In the modern era of federal deposit insurance, we can consider holding money in a savings account as analogous to Graham and Dodd’s recommendation.
Investment for profit
Graham and Dodd identified four distinct approaches for small investors aiming to make a profit off their investments:
“Purchase of representative common stocks when the market level is clearly low as judged by objective, long-term standards. This policy requires patience and courage and is by no means free from the possibility of grave miscalculation. Over a long period we believe that it will show good results.”
This means looking at the market as a whole and aiming to buy a wide range of stocks when prices are depressed, for example in early 2009.
“Purchase of individual issues with special growth possibilities, when these can be obtained at reasonable prices in relation to actual accomplishment. Where growth is generally expected, the price is rarely reasonable. If the basis of purchase is a confidence in future growth not held by the public, the operation my prove sound and profitable, it may also prove ill-founded and costly.”
The authors are referring to what would today be called growth investing, with one important caveat: only investing in stocks that have significant growth potential but are currently flying under the radar. This is not the same as chasing a high-flying stock that has been hyped by the financial media; actually it is more like value investing.
“Purchase of well-secured privileged senior issues. A combination of really adequate security with a promising conversion or similar right is a rare but by no means unknown phenomenon.”
A strategy that may be more complicated to execute, as it requires the investor to understand the technical aspects of conversion, which may vary from company to company. However, it is precisely this asymmetry of information that can give a diligent investor willing to do the hard work the advantage over the general public.
“Purchase of securities selling well below intrinsic value. Intrinsic value takes into account not only past earnings and liquid asset values but also future earnings power, conservatively estimated - in other words, qualitative as well as quantitative elements.”
This is what most of us would immediately recognize as classical value investing -- finding solid companies that are trading below their intrinsic value as measured by price-book, price-earnings, free cash flow or any number of other metrics.
Summary
Graham and Dodd ended this discussion with the following words:
“In our view, the search for and the recognition of security values of the types just discussed are not beyond the competence of the small investor who wishes to practice security analysis in a nonprofessional capacity, although he will undoubtedly need better than average intelligence and training.”
A positive thought to end on -- Graham and Dodd believed that with hard work and a little common sense, the average retail investors could do well in the markets over a long period of time. We will address their views on speculation as an investment strategy in the next piece.
Disclaimer: The author owns no stocks mentioned.
