Security Analysis: Introduction: Problems of Investment Policy

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.

Introduction: Problems of Investment Policy (Pages 1 - 15)
Security analysis is not a theoretical subject - it is to be used to make investment decisions.

Volatility
The first thing to understand is that the economy and stock market prices are volatile. To think that investments will grow at a steady rate of 10% is just silly - yet that is how most do their financial planning!

A. Investing in high-grade bonds and preferred stocks
You can't just buy high-grade bonds and preferred stocks with your eyes shut and put them away and forget them! You need to worry about these issues:

1. Safety of interest and principal. Before you buy in, you must determine that the company will be able to pay the interests and repay the principal at maturity. But that's not the end! You must continue to monitor the company's financial health and sell if the issue no longer meets the requirement on safety of interest and principal.
   
   
2. Future interest rates and bond prices. Graham warns about interest rates rising from a persistently low level and its effect on bond prices. An investor may suffer 25% loss in principal in addition to missing out on the higher interest rates available on new issues. On the other hand, the opportunity cost of waiting for a rise in interest rates before investing does not justify such practice.
   
   Graham's solution to this dilemma is to invest in US Savings bonds. Your principal is guaranteed and you can redeem these bonds at your discretion.
   
   An alternative solution is to buy bonds with near-term maturities because (1) these bonds are not as susceptible to a fall in bond prices because of rising interest rates; and (2) you may be able to wait till maturity and redeem your principal with only a small opportunity cost from lower bond yields (versus the higher prevalent interest rates).
   
   
3. The value of the dollar. The purchasing power of bond interests you receive (which is constant) will fall with inflation. If you expect significant inflation, then you should buy stocks and commodities. To balance your risks, you should have at least have a portion of your portfolio in stocks.

B. Speculative bonds and preferred stocks

The broad principles underlying the purchase of speculative senior issues remain, in our opinion, the same as they always were: (1) A risk of principal loss may not be offset by a higher yield alone but must be accompanied by a commensurate chance of principal profit; (2) it is generally sounder to approach these issues as if they were common stocks, but recognizing their limited claims, than it is to consider them as an inferior type of senior security.

The high yield offered by speculative/junk bonds and preferred stocks alone do not justify investment in them. It's a fallacy to think that higher yields (or, for that matter, higher discount rates for common stocks) compensate for higher risks of capital loss.

To make a profitable investment, you must buy speculative bonds and preferred stocks at a sufficient discount so you can participate in capital gains. For someone who bought junk bonds at par and see the company go into bankruptcy, a move of bond prices from 10c on the dollar to 20c won't mean much to him - he still suffers from capital loss. But if you bought the same junk bond at 10c on the dollar, the the move to 20c means you have a capital gain of 100%!

When Graham says to approach this category of investments as common stocks, he means you should not invest in hopes of a large and steady interest income (i.e. focusing on how the company can give you money). You should approach it like a common stock, where you'd want to see the improving financial health, increasing asset values, and increasing ability to generate earnings and cash (i.e. focusing on how the company can make itself "wealthier").

If the company does become financially healthier, the bond prices should rise rapidly towards intrinsic value. The disadvantage of speculative bonds and preferred stocks is that your gain is limited - unlike common stocks, which have unlimited potential. The advantage is that you know what par value is and its intrinsic value is easy to calculate - whereas common stocks is susceptible to irrational exuberance.

C. The problem of common-stock investment
The problem many people have is confusing good companies with good investments and investing with speculation. The qualitative standard of a company is important, but the quantitative standard (i.e. price) of the company is just as important in investing. At one price, a "good" company's stock is ab investment, but at very high price, the same stock may be speculative. Similarly, at one price, a "secondary" (not-so-good) company's stock is speculative, but at a very low price, the same stock may be a good investment. The combination of good companies at fair prices and secondary companies at cheap prices should offer sufficient investment opportunities for investors.

It was little short of nonsense for the stock market to say in 1937 that General Electric Company was worth $1,870,000,000 and almost precisely a year later that it was worth only $784,000,000. Certainly nothing had happened within twelve months’ time to destroy more than half the value of this powerful enterprise, nor did investors even pretend to claim that the falling off in earnings from 1937 to 1938 had any permanent significance for the future of the company. General Electric sold at 64 7/8 because the public was in an optimistic frame of mind and at 27 1/4 because the same people were pessimistic. To speak of these prices as representing “investment values” or the “appraisal of investors” is to do violence either to the English language or to common sense, or both.

Timing the market
Graham argues against timing the market - trying to buy or sell a stock based on technical analysis and "signals". Should any charting method works for a period of time, other will try to follow that method and neutralize the usefulness of that method. With technical analysis, you are always trying to keep one step ahead of everyone else but you have no way of knowing whether you are until you have completed the sale.

If you buy or sell stocks based on an objective standard of value, you are, by definition, ahead of everyone else. You have identified value where others have missed it. If your analysis and valuation is accurate, the time you make money is when you buy. You are robbing the seller by without him realizing by exchanging something of greater value (buying the stock at a discount) with something of lower value (your cash). After that, your selling is just a function of exchanging things of equal value with the buyer (i.e. exchanging stock at intrinsic value with cash).

Conclusions
Investing in investment-grade bonds and preferred stock is a relatively straight forward practice in that you screen companies for their ability to pay interests and repay the principal at maturity. The harder-to-handle issue is future interest rates and inflation.

Investing in speculative bonds and preferred stocks and investing in common stocks are more of a challenge in that you are attempting to place a value based on an uncertain future. I believe that this challenge, if mastered and properly implemented, can put you on the road great wealth.

P.S. This post was featured in the Festival of Stocks #110 at College Analysts.