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.
“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.”
“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.
“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.
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.
“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.
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.