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Stepan Lavrouk
Stepan Lavrouk
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Graham and Dodd’s Hidden Gems: 3 General Approaches to Investment, Part 2

How to find value according to the authors of 'Security Analysis'

February 09, 2019 | About:

In part one of this mini-series, we examined a passage of Graham and Dodd’s "Security Analysis," in which the authors outlined three different approaches to investment: betting on broad market expansion, selecting stocks on the basis of growth and selecting stocks based on the margin-of-safety principle. We explored the similarities between the first approach and index investing, as well as the problems an investor faces when attempting to select the correct growth stock. Today, we will complete the discussion of this chapter by looking at the third approach, Graham and Dodd’s favored one.

Two ways to find value

“The third approach to common-stock investment is based on the margin-of-safety principle. If the analyst is convinced that a stock is worth more than he pays for it, and if he is reasonably optimistic as to the company’s future, he would regard the issue as a suitable component of a group investment in common stocks. This attack on the problem lends itself to two possible techniques. One is to buy at times when the general market is low, measured by quantitative standards of value. Presumably the purchases would then be confined to representative and fairly active issues. The other technique would be employed to discover undervalued individual common stocks, which presumably are available even when the general market is not particularly low. In either case the “margin of safety” resides in the discount at which the stock is selling below its minimum intrinsic value, as measured by the analyst.”

In other words, there are two ways to buy value: either wait for a broad market sell-off or go shopping for individually undervalued assets. Let’s examine both methods. In the first case, the authors suggest a simple system: drawing a line of best fit through a chart of stock prices that represent the overall market over some long period of time, say 10 years. An alternative could be to use a 200-day moving average. Then determine a "buying point" some percentage below the trend line, and a "selling point" above it.

The authors identify a number of problems that an investor following our simple system might have. First, as these points are necessarily arbitrary, you risk missing out on opportunities by being too conservative. Obviously this is going to be a concern when choosing an entry point for an individual stock too, but at least with individual equities you are able to finesse your decision based on the peculiarities of the stock in question.

Second, past performance is not indicative of future success. Just because a trend has held true in the past does not mean that it will continue to do so in the future. Third, it is just psychologically quite difficult to buy when the market goes down and to sell when it goes up.

The second way to buy value is to purchase individual stocks. This method has the advantage over the first of being applicable during extended bull markets, although of course bargains are harder to come by in such an environment. Graham and Dodd went on to state that because of “the stock market’s obsession with companies that have unusually good prospects of growth,” there is an abundance of cheaply priced companies with average prospects for the future, and that is where value should primarily be looked for.

Summary

Graham and Dodd closed out the chapter by saying that the two methods discussed in part one buying the market and buying high-flying growth stocks should not be considered proper investment, as they are necessarily speculative in nature. This flies in the face of a lot of modern thinking, which champions index investing and promotes growth stories with often unrealistic expectations attached. To quote Graham and Dodd one more time:

“Trading in the market, forecasting next year’s results for various businesses, selecting the best media for long-term expansion — all these have a useful place in Wall Street. But we think that the interests of investors and of Wall Street as an institution would be better served if operations based primarily on these factors were called by some other name than investment.”

Disclosure: The author owns no stocks mentioned.

About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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