Benjamin Graham and David Dodd’s "Security Analysis" is notable for more than just its list of specific instructions for value investors. It also offers a more general framework for thinking about the markets and the different ways in which one might go about investing in common stock. The authors identified three distinct general approaches to investment: betting on secular expansion, selecting stocks on the basis of growth and selecting stocks based on the margin of safety principle. We will cover the first two in part one, and leave the third for part two.
Secular expansion as a basis for selection
“May the ownership of a carefully selected, diversified group of common stocks, purchased at reasonable prices, be characterized as a sound investment policy? An affirmative answer may be developed from any one of three different kinds of assumptions relating to the future of American business and the policy of selection that is followed. The first will posit that certain basic and long-established elements in this country’s economic experience may still be counted upon. These are (1) that our national wealth and earning power will increase, (2) that such increase will reflect itself in the increased resources and profits of our important corporations, and (3) that such increases will in the main take place through the normal process of investment of new capital and reinvestment of undistributed earnings.”
When "Security Analysis" was first written, there were no index funds, so the only way to bet on economic growth as a whole was to buy whatever basket of stocks the investor thought best represented a cross-section of American industry. Nevertheless, the basic principle here is identical to the world envisioned by Jack Bogle in 1974 - just buy the market and count on economic growth to continue decades into the future.
It is interesting that, nowadays, this is treated as gospel - we may have recessions here and there, but, broadly speaking, most people expect stocks will be higher in 10 years than they are now. In the 1930s, when Graham and Dodd were writing the book, this seemed far from certain. The authors concluded that “the investor cannot safely rely upon a general growth of earnings to provide both safety and profit over the long pull.”
Individual growth as a basis of selection
“Those who would reject the suggestion that common-stock investment may be founded securely on a general secular expansion may be attracted to a second approach. This stresses the element of selectivity and is based on the premise that certain favored companies may be relied on to grow steadily. Hence such companies, when located, can be bought with confidence as long-term investments.”
Graham and Dodd identified three problems an investor needs to solve when tackling growth companies. The first is to define what a growth stock actually is. The authors refer to growth companies as companies whose “earnings move forward from cycle to cycle.” The issue here is that during a bull market, most companies will naturally grow their earnings. The real test of a business’ potential is whether it is capable of weathering the lean times.
The second problem for the growth investor is to identify growth companies. As the authors pointed out, most companies go through three main stages in their life cycle - an initial period of “setbacks and struggles,” a “halcyon period of prosperity and persistent growth” and a “final phase of supermaturity.” Trying to find that sweet middle period is the hard part - invest too early and you may get a dud, but invest too late and you may miss the growth stage.
The third problem identified by Graham and Dodd is the central problem of all investment - does the price of the stock discount potential future growth? If the market is already counting on future growth to take place, then it is unlikely the investor will be able to purchase shares at an attractive valuation. Once an investor pays the growth premium, he is assuming the risk that expectations may not be met.
Summary
Graham and Dodd clearly thought both approaches posed significant problems and increased risks for invested capital. They used this as an opportunity to introduce their preferred approach, which we will explore in part two: selection based on margin of safety.
Disclosure: The author owns no stocks mentioned.
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