Security Analysis: Second Edition and First Edition Prefaces

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.

Preface to the Second Edition (Pages vii - viii)

Background
Graham wrote the second edition against the backdrop of World War II. The war introduced uncertainties (as the credit crisis has now), but Graham says that the foundations and methods of security analysis should not be changed. What we need to do in times of uncertainty is to ensure we have a sufficient margin of safety.

Interest rates
George from Fat Pitch Financials asked about Graham's comment:

The persistence of low interest rates justifies a fresh approach to that subject

on Gannon On Investing's post. I'll attempt to answer that here.

I think George was thinking about the evaluation of common stocks. Low interest rates will affect the risk-free rate for common stock valuations, but we will not approach the practice of security analysis any differently than if the interest rates are high.

On the other hand, bond prices are significantly affected by interest rate changes. Should interest rate rise from its persistently low levels, the bond principal may fall significantly. As described in the Introduction, the solution is buy US Savings Bonds and bonds with near-term maturity.

Preface to the First Edition (Pages ix - x)
Target audience

This book is intended for all those who have a serious interest in security values. It is not addressed to the complete novice, however, for it presupposes some acquaintance with the terminology and the simpler concepts of finance.

I've never had formal training on accounting, finance, or investing, but I have read many books on these subjects. These subjects are interconnected, and I don't yet know how to tell a beginner to start "here" and step-by-step build their knowledge from entry-level to advance-level concepts.

If you are just starting out, you will just have to build your latticework of mental models as you go along. So, if you have any questions about the terminology and concepts when reading the book, please let me know and I will try to point you in the right direction. (Google might be useful too.)

Forecasting

Some matters of vital significance, e.g., the determination of the future prospects of an enterprise, have received little space, because little of definite value can be said on the subject.

If you want to learn how to forecast income to perform discounted cash flow analysis, you are out of luck. Graham deems forecasting to be of little value and, instead, emphasizes the analysis of past performances. Warren Buffett will say that it's analogous to driving by looking in the rear view mirror. I believe Graham understands that we are extremely poor forecasters, thus he emphasizes more on analyzing the past. (Read up on "behavorial finance" to understand why we are such poor forecasters.)

The theory and practice of security analysis
Unlike many university professors, Benjamin Graham was a money manager and practices what he preaches. That's why, he said:

We are concerned chiefly with concepts, methods, standards, principles, and, above all, with logical reasoning. We have stressed theory not for itself alone but for its value in practice. We have tried to avoid prescribing standards which are too stringent to follow, or technical methods which are more trouble than they are worth.

I look forward to learning and practicing security analysis with you as we read this book. If you encounter any problem or question while analyzing a stock now, please leave a comment so we can discuss and learn together!