Security Analysis: Chapter 2: Fundamental Elements in the Problem of Analysis. Quantitative and Qualitative Factors

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 2: Fundamental Elements in the Problem of Analysis. Quantitative and Qualitative Factors.

Four Fundamental Elements

In all such questions, four major factors may be said to enter, either expressly or by implication. These are:

1. The security.
2. The price.
3. The time.
4. The person.

More completely stated, [...] Should security S be bought (or sold, or retained) at price P, at this time T, by individual I?

The Person
A wealthy person who's trained in finance should not invest the same way as a poor person who doesn't have a clue about finance.

You should take into account your financial situation and your risk/volatility tolerance before you invest. I have seen too many people invest more money in the stock market than they should. Get your personal finance in order before you start doing security analysis and investing!

The Time
Security analysis is practiced under the assumption of a "normal" economic environment. But, depending on the economic environment, a security may be attractive at one time and unattractive at another time (e.g. bonds when interest rates are high vs low).

I don't think Graham is advocating timing the market/economy here. Rather, he just wants us to understand that the economic environment is changing constantly and beware of "reversion to mean" (which he discusses later).

The Price
High-grade bonds are usually priced fairly accurately, so price is not as important a factor as for other securities. On the other hand, low-grade/junk bonds, convertible bonds, preferred stocks, common stocks, options and derivatives are much more susceptible to mispricing, so the price is an important factor when considering the purchase of these securities.

The Security: Character of the Enterprise and the Terms of the Commitment
"Character of the enterprise" refers to the business behind the security. "Terms of the commitment" refers to the price, provisions, and status of the security. For common stocks, there aren't much "provisions" to worry about. But for bonds and preferred stocks, the provisions covering a security can significantly affect its attractiveness.

Relative Importance of the Terms of the Commitment and the Character of the Enterprise
Graham argues that it is better to invest in an attractive business on unattractive terms for an untrained buyer. Over a long period, an untrained buyer is less likely to lose money investing in an attractive enterprise, even if he overpaid for it.

As security analysts, we should know better that any security can be attractive at the right price. The risk of buying overpriced security of an excellent enterprise is that expected returns will be below par. In addition, we may have misjudged the attractiveness of the enterprise (think Lehman Brothers, AIG, etc.) because of the problem of "driving by looking through the rear view mirror).

Qualitative and Quantiative Factors in Analysis

Analyzing a security involves an analysis of the business. Such a study could be carried to an unlimited degree of detail; hence practical judgment must be exercised to determine how far the process should go.

I recall reading somewhere that Warren Buffett thought it was "disgusting" how easy it was for Walter Schloss's to earn above average return. If we follow Walter Schloss's approach to buying stocks (i.e. buying hundreds and thousands of statistically cheap stocks until return to fair value), I'd imagine that we can do "less" research than if we follow Warren Buffett's approach (i.e. buying quality stocks at fair prices to hold for the long term).

Graham reminds us that not all data are useful for analysis. We must judge whether the data is relevant or useful - some data may be useful for analyzing one type of businesses and less relevant for the analysis of another type of businesses.

Quantitative vs. Qualitative Elements in Analysis
Quantitative elements are more easily obtained and analyzed. Qualitative elements are harder to come by and is practically impossible to appraise accurately.

Qualitative factor: Nature of business, future prospects, and management
Most people have ideas about what constitute "good business", but the nature of a business and its future prospects are often misjudged. In addition, most people have a hard time judging the quality of the management. These qualitative factors are often double-counted because the effect of a good business and a good management should already be reflected in the company's good operational results!

The Trend of Future Earnings
We should not project earnings trend into the future. Past earnings trend is just that, the past, and does not say anything about the future. When a trend become noticeable, conditions may have become ripe for a change in trend.

Graham's solution is to use past averages as a rough index as to what may be expected in the future. He does not project whether the earnings will be higher or lower in the future.

Qualitative Factors Resist Even Reasonably Accurate Appraisal

Needless to say, the analyst must take possible future changes into account, but his primary aim is not so much to profit from them as to guard against them. Broadly speaking, he views the business future as a hazard which his conclusions must encounter rather than as the source of his vindication.

Inherent Stability a Major Qualitative Factor
Graham gives the example of a chain groceries store vs a motor company, where, from a period of results (1922-1930), the motor company appears to have far higher (26x) interest coverage compared with the chain store (6x). Even though Graham says that quantitative factors are easier to obtain and analyze, he urges us to look beyond the numbers and consider the inherent characteristics of the businesses, and perhaps why the numbers are the way they are. From the way the businesses operate, the chain store is inherently a more stable business that can afford lower interest coverage. The motor company, despite its high interest coverage for the period covered, is an inherently unstable company and can suffer dramatic changes in earnings. In 1933, the motor company went bankrupt.

Summary

In the mathematical phrase, a satisfactory statistical exhibit is a necessary though by no means a sufficient condition for a favorable decision by the analyst.

P.S. This post was featured in the Festival of Stocks # 112 at The DIV-Net.