Although financial markets have been transformed in ways unimaginable since Benjamin Graham and David Dodd published the first edition of "Security Analysis" in 1934, the lessons that can be learned by gleaning its pages are timeless. A review of only a few of the underlying principles upon which their value investing philosophy is based will reveal whether the stock being analyzed is Facebook (FB, Financial) or Boeing (BA, Financial), whether the market is in the throes of a roaring bull market or in a cyclical downturn. Analysts can benefit greatly by incorporating these maxims in their quest for ascertaining a stock’s intrinsic value.
One of the underlying tenets of "Security Analysis" as Seth Klarman (Trades, Portfolio) appropriately noted in the Preface to the sixth edition is that, “The real secret to investing is that there is no secret to investing…that so many people fail to follow this timeless and almost foolproof approach enables those who adopt it to remain successful.”
For the past decade, with the caveat of exactly how one defines certain terms that form the basis of the analysis or comparison, many within the investment community contend that value investing has failed to keep up with growth or momentum investing.
A roaring, historically unprecedented, 10-year bull market that has heavily favored the tech stock sector would seem to validate such a proposition. However, there is nothing in the lessons enumerated in Security Analysis that contain any suggestion by its authors of an inherent bias towards one sector versus another. What is paramount for successful investing is the relationship between price and value.
A central thesis that underlies their entire treatise on value investing is Graham and Dodd’s approach or consistent methodology for apprising whether a contemplated purchase of a security can be characterized generally as either an exercise in speculation or a bona fide investment. Put another way, will the investor receive “value” for his money? This paradigm for investing is useful even today, regardless of which sector or particular stock is fancied by Wall Street or which have shown the best overall returns. Klarman supports this contention, “Generations of value investors have adopted the teachings of Graham & Dodd and successfully implemented them across highly varied market environments, countries, and asset classes.”[i]
Although some analyst and fund managers today may be quick to dismiss the teachings of Graham and Dodd as a Depression-era, industrial-heavy fixed asset anachronism in today’s world of computer chips, the internet and social media, this opinion largely misconstrues the lessons that can be learned by a close reading of the book and a judicious application of its principles to today’s investment environment.
In a sense, one of the reasons "Security Analysis" is considered a classic, is that its authors anticipated the fact that since the future is imponderable, investment principles based on sound concepts would have permanent application due to the unchanging factors of human nature, risk-reward and certain immutable principles of finance. The authors made this clear when they stated:
“Our governing aim, however, has been to make this a critical rather than a descriptive work. We are concerned chiefly with concepts, methods, standards, principles, and, above all, with logical reasoning.”[ii]
Thus, the authors were chiefly interested in formulating a sound methodology, based on sound first principles and not attempts to definitively provide a quantitative study of the how to ascribe value to a company’s common stock. The authors explain why they wrote the book in this manner.
“In dividing our space between various topics, the primary but not the exclusive criterion has been that of relative importance Some matters of vital significant, e.g., the determination of the future prospects of an enterprise, have received little space, because little of definite value can be said on the subject.”[iii]
This is an acknowledgement of one of the central precepts of Graham and Dodd’s concept of value investing, that trying to predict definitively, the long-term future of any enterprise is a fool’s errand bound to ensnare investors, regardless of their particular investment objectives. This maxim is part and parcel of the authors' humility and honesty, in their view, that no matter how sophisticated the modern day techniques of security analysis, ascertaining the long-term trend of a company’s earnings is as fraught with risk today as it was back in 1934.
An example of the authors skepticism about the ability to accurately predict the likely direction of corporate earnings was their heresy in proclaiming earning trend analysis was less a quantitative endeavor and more a qualitative factor.
“We shall point out that the placing of preponderant emphasis on the trend is likely to result in errors of overvaluation or undervaluation. This is true because no limit may be fixed on how far ahead the trend should be projected; and therefore, the process of valuation, while seemingly mathematical, is in reality psychological and quite arbitrary. For this reason, we consider the trend as a qualitative factor in its practical implications, even though it may be stated in quantitative terms.”[iv]
Rather than offer a perspective on how to value common stocks, Graham & Dodd decided to provide guidance based on tenets that can be uniformly applied no matter what the prevailing investment climate.
“We have striven throughout to guard the student against overemphasis upon the superficial and the temporary. Twenty years of varied experience in Wall street have taught the senior author that this overemphasis is at once the delusion and the nemesis of the world of finance.”[v]
Graham and Dodd’s teachings offer for the securities analyst or investor, irrespective of their individual investment preferences, indispensable guidance that transcend the vagaries of an ever-changing market.
Disclosure: I have no positions in any of the securities referenced in this article.
[i]Benjamin Graham & David Dodd, Security Analysis, Sixth Edition, (India: McGraw Hill, 2008) Preface To The Sixth Edition, xvi
[ii]Ibid, Preface To The First Edition, xliii
[iv]Ibid, pp. 85-86