Security Analysis: Chapter 1: The Scope and Limitations of Security Analysis. The Concept of Intrinsic Value

Please join me at the Security Analysis Book Club to read Security Analysis by Graham & Dodd, a must-read for anyone who is serious about value investing.

Chapter 1: The Scope and Limitations of Security Analysis. The Concept of Intrinsic Value.

Security analysis is not an exact science. Like law and medicine, individual skills (art) and chance (probabilities) are important factors in determining success or failure. But that doesn't mean you should just give up and invest blindly. Like a doctor who studies medicine and a lawyer who studies law, you must still study security analysis if you want to become a proficient investor.

Three Functions of Security Analysis
1. The Descriptive Function. Gather "the important facts relating to an issue and presenting them in a coherent, readily intelligible manner." This function reminds me of Value Line, Bloomberg, and Morningstar. This is the function of most junior analysts, who gather information for presentation to senior analysts and portfolio managers. Or, for individual investors, this is the first step you take in security analysis.

2. The Selective Function. A security analyst "seeks to determine whether a given issue should be bought, sold, retained, or exchanged for some other" based on his/her evaluation of the intrinsic value of the issue versus the market price. This is the function of portfolio managers and senior analysts that issue buy/sell recommendations. Or, for individual investors, this is what you do with the information you've gathered above.

3. The Critical Function. A security analyst must be critical - in making sure securities have adequate protective provisions and enforce them, in analyzing financial statements and accounting methods, and in all matters of corporate policies. This function reminds me of activist investors. Graham says that it is our job, as security analysts and investors, to hold the management accountable. We need to make sure the management avoid mistakes. We must correct corporate abuses. We must protect those who own the bonds and stocks - we must protect ourselves.

Intrinsic value
The problem with intrinsic value is that it is not a precise number. But you don't need to know the weight of a 500-pound man to know he's fat. Similarly, you don't need to know the exact intrinsic value of a security so long as you knows it's adequate.

Pitfalls
As security analysts, we must recognize and try to avoid the potential pitfalls of security analysis, including (1) inadequate or incorrect data, (2) uncertainties of the future, and (3) irrational behavior of the market.

Value trap
Some stocks may be persistently undervalued (i.e. value trap) or overvalued. Or, the intrinsic value may change over time and reach the market price, thus rendering your analysis invalid. To overcome this problem, in addition to Graham's points on investing in stable situations, popular issues, and investing in "normal" times, I believe the concept of a "catalyst" is also useful. A catalyst will bring the market price to the intrinsic value in a short time, thus helping us avoid the problem of value traps or changing intrinsic value.


The market voting machine

[T]he market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities. Rather should we say that the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion.

Analysis and speculation
Security analysis is useful for increasing our odds of winning, but it does not guarantee it. Graham, using a gambling analogy, advocates spreading your bets (diversification) so that your wins will likely outnumber your losses.

P.S. This post was featured in the 111th Festival of Stocks at Dividend Growth Investor.