Monday, January 5, 2015

Security Analysis

Even among stock pickers, few investors will read Benjamin Graham and David L. Dodd’s book Security Analysis cover to cover. It contains many useful insights into investing but is not an easy read. Originally written in 1934, this classic is now in its sixth edition that adds modern introductions to each section including a Foreword by Warren Buffett. My main goal in reading it is to see if it re-sparks my passion for stock picking.

Security Analysis is like a bible for value investors. It contains many lessons backed up with numerous examples of real stocks and bonds to illustrate the points. Even value investors who have never read the book speak of it reverently. However, Benjamin Graham himself said the following in 1976:
“I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook ‘Graham and Dodd’ was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost.”
This intense competition among stock analysts has only intensified over the years since 1976. As I slowly came to understand how difficult it is to beat the market over the long term, I sold my individual stocks and switched to index investing. I picked stocks for about 12 years and had a good record solely because of one enormously lucky year.

In deciding to read Security Analysis in its entirety, I was interested to see if could tempt me to get back into the search for undervalued stocks. Before getting to the answer, let’s look at some parts of the book that caught my attention. There are far too many good lessons in this book to hope to cover more than a small fraction of them.

Modern Value Investing

In his preface to the sixth edition, Seth A. Klarman offers two reasons why value investing is still alive and well. One is that many investors are very short-term oriented making it easier for those with a longer-term focus. The other is that there are so many more securities today than there were back in 1934 that there are more opportunities to find something undervalued. These two points are certainly true. The question is whether they make much difference in the face of much greater competition from other value investors.

Definition of investment

Graham and Dodd distinguish investment from speculation or gambling as follows: “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return.” Does index investing satisfy this definition? The book does not address this question. I’d say that index investing over short time periods does not offer safety of principal. However, judging by long-term historical returns, indexing over a decade or more has preserved principal well and has given at least satisfactory returns.

Advice from investment counsel

“The chief disadvantage is the cost of the service, which averages about [0.5%] per annum on the principal involved. ... This charge would amount to about [one-seventh] or [one-eighth] of the annual income, which must be considered substantial.” I have to assume the authors would choke on mutual fund fees of 2% or more.

Projections

“There are several reasons why we cannot be sure that a trend of profits shown in the past will continue in the future. ... There is the law of diminishing returns and of increasing competition which must finally flatten out any upward curve of growth. There is also the ebb and flow of the business cycle, from which the particular danger arises that the earnings curve will look most impressive on the very eve of a serious setback.”

Misleading accounting

“The overwhelming majority of managements are honest, [but] loose or ‘purposive’ accounting is a highly contagious disease.” The authors go on to devote a large part of the book to showing how accounting practices mask the real financial results of companies. They also show how to undo these effects to get at the real results and examine the adjusted earnings record.

Dishonest Management

“You cannot make a quantitative deduction to allow for an unscrupulous management; the only way to deal with such situations is to avoid them.” An interesting accounting trick they describe goes as follows. A parent company gives cash to one of its operating companies and then takes some of it back as a dividend. Then the parent company treats the cash donation as a one-time event that doesn’t count against earnings but counts the dividend as income.

P/E limit

The authors say that paying more than 20 times average earnings is speculative and therefore not worthy of being called an investment. I wonder what they’d say about the generally higher P/E ratios that exist today.

Why most buyers of low-priced shares lose money

“The public buys issues that are sold to it, and the sales effort is put forward to benefit the seller and not the buyer.” The idea is that sellers push the bad low-priced stocks and not the good ones. In modern times, this applies to mutual funds. The most expensive funds are the most heavily pushed.

Apathetic Stockholders

“The typical American stockholder is the most docile and apathetic animal in captivity. He does what the board of directors tell him to do and rarely thinks of asserting his rights as owner of the business and employer of its paid officers. The result is that the effective control of many, perhaps most, large American corporations is exercised not by those who together own a majority of the stock but by a small group known as ‘the management.’” I’m not sure things are much better today.

Mergers and segregations

On the excitement generated when companies merge or a company splits into parts, the authors say “Wall Street becomes equally enthusiastic over mergers and just as ebullient over segregations, which are the exact opposite. Putting two and two together frequently produces five in the stock market, and this five may later be split up into three and three.”

Technical analysis or “charting”

“Chart reading cannot possibly be a science.” Any dependability of charting predictions “will cause human actions that will invalidate it. Hence thoughtful chartists admit that continued success is dependent upon keeping the successful method known to only a few people.”

The other side of trades

“In the typical case the [stock an analyst] elects to buy is not sold by someone who has made an equally painstaking analysis of its value.” This has certainly changed since this book was written. Today, stock market trading is dominated by professionals. When an individual investor makes a trade, odds are high that it is a pro on the other side of the trade.

Conclusion

I still find Graham’s 1976 remarks about the difficulty of succeeding at stock picking persuasive. I’ll admit to some nostalgia for my stock analysis days, but not much. I believe I will end up with more money after all costs by indexing rather than by picking stocks. Even if I had enough skill to beat the index, I estimate I’d have to beat it by about an average of 2% per year to justify the time required. However, a far more likely outcome would be trailing the index by an average of 2% per year, thereby effectively paying myself a negative wage. I’m still an indexer. However, even indexers will learn some lessons from this book if they have the patience for its length and extensive use of the passive voice.


9 comments:

  1. Hi Michael,
    Did you ever write about when you invest during the year? Lump sum or equal amounts every paycheck or monthly? For example we have our fresh tfsa amount available now for 2015. Do you have your etf's already picked out. Did you save up to drop it all in first day?
    As for picking a few stocks, if you have a solid plan in place why not allocate 5 % of your money and satisfy your curiosity? This should be a bit fun too as many of us spend a lot of time learning and implementing our long term plans? I once asked a friend who buys gold and silver why he purchased the coins that are many times the value of the metal itself as well. Many times these unique coins go on to be worth many times more like art. Plus that's what he said. His investments need to be fun sometimes too. Kind of stuck with me.

    ReplyDelete
    Replies
    1. @Paul: That's quite a list of questions.

      "Did you ever write about when you invest during the year? Lump sum or equal amounts every paycheck or monthly?"

      My income and expenses are fairly variable. I invest money whenever there is enough in one account to justify the cost of a trade (provided I have enough total emergency cash savings).

      "For example we have our fresh tfsa amount available now for 2015. Do you have your etf's already picked out. Did you save up to drop it all in first day? "

      I made TFSA contributions for myself and my wife on Jan. 2. I'll invest the entire amounts when the money shows up in the accounts this week. The ETFs I buy will be whichever ones are below their target allocation in my portfolio.

      "As for picking a few stocks, if you have a solid plan in place why not allocate 5 % of your money and satisfy your curiosity?"

      I have a hard time doing this knowing that I'll likely lose money for all the effort I expend. I have little interest in picking stocks the way most people do it: by overconfident guessing. I would read annual reports and study financial statements, which takes a lot of time.

      People can do what they like. Taking chances with a small fraction of your savings is better than risking it all. But the real driver for most active investors is the belief that they will outperform. I've lost that belief.

      Delete
    2. @MichaelJ: Do you ever think about the unintended consequences of index investing?

      Market-cap weighted indices cause buying of large companies and fuel boom-bust in individual secuities. With billions sloshing around in ETFs that only buy/sell indices, the effects become more pronounced.

      There are opportunities in companies that are outside the index (fewer buyers) and also in those that fall out of the index (forced selling).

      What else can you think of for unintended consequences?

      Delete
    3. @Anonymous: The biggest consequence of the rise of index investing is a reduction in available income for investment "helpers" of various types. I see no evidence that broad index ETFs cause instability. If indexing ever gets so large that it creates more opportunities for active investors, then there will be a natural shift away from indexing. However, we're nowhere near that point yet.

      Delete
  2. The problem with active stock investing, is you get a "Shooter's mentality" where you forget too quickly about your failures, and it doesn't stop you from making the same mistakes. I lost enough as an active (stupid in my case, I was in WAY over my head) investor, I am much safer in the Indexes for now.

    Interesting how as soon as something like Indexing becomes popular there are those looking to find an edge against it, I suppose that is just human nature?

    ReplyDelete
    Replies
    1. @Alan: You're right about this being human nature. Even among those who say they believe in index investing, they seem to want to believe in "improvements" around the fringes. It might be some market timing with shifts in asset allocation or other tweaks.

      Delete
    2. They may be right, but everyone now has a super computer to run those complex algorithms and timing tom-foolery, you aren't going to outfox any of the big trading houses, or any other serious investors (who have their own super computers). Maybe if someone came up with a method that relied on a pencil and paper?

      Delete
  3. Warren Buffett credits Ben Graham with teaching him everything he needed to succeed in investing, but Charlie Munger figures if Buffett had just stuck with Graham's methods, he'd be much worse off. Buffett/Munger of course started considering quality as a more important feature than cheap prices.

    I think Graham's background (managing money through the Stock Market Crash of 1929) made him a very cautious investor, which is actually a prudent, effective way to invest. It's like that old saw Buffett sometimes quotes: Rule 1: Don't lose money. Rule 2: See Rule 1.

    Congratulations on reading "Security Analysis". Not an easy read. I read "The Intelligent Investor" years ago, and found it dry. Faced with the advice to read "Security Analysis" I balked. Time is probably better spent reading Buffett's writing, which I know you have spent lots of time with too.

    ReplyDelete
    Replies
    1. @Gene: In Graham's defense, his approach was effective at the time. Buffett and Munger found a way to adapt to different times.

      I read Intelligent Investor years ago. It was a much easier read than Security Analysis IMO. The strength of Security Analysis is the way they draw useful lessons out of so many practical examples that would look like just a jumble of numbers to most people.

      Assuming I stick to index investing, the main value of having read this book is just being able to say that I read it. I don't regret spending the time, but I don't intend to apply many of the lessons.

      Delete