Security Analysis: Chapter 5: Classification of Securities

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 5: Classification of Securities.

Securities are customarily divided into the two main groups of bonds and stocks, with the latter subdivided into preferred stocks and common stocks.

Graham opposed the traditional classification of securities because:

1. Preferred stocks are often bought with the purpose of fixed income and safety of principal, which is more closely resembles the purpose of bond investors.
2. Bond form is associated with safety - even though the safety depends on the debtor corporation's ability to meet its obligations, rather than the legal protection offered by the bond form.
3. The proliferation of securities with features that deviate from the standard patterns.

Graham proposed a new classification method as follows:

1. Securities of the fixed-value type. (e.g. A high-grade bond or preferred stock.)
2. Senior securities of the variable-value type.
1. Well-protected issues with profit possibilities. (e.g. A high-grade convertible bond.)
   
2. Inadequately protected issues. (e.g. A lower-grade bond or preferred stock.)
   
3. Common-stock type. (e.g. A common stock.)

Graham's proposed classification does not depend on the legal form of the security, but, rather, the characteristic of the security.

Securities of the fixed-value type are high-grade bonds or preferred stocks that are expected to maintain their principal value.

Senior securities of the variable-value type is divided into two sub-types. Well-protected issues with profit possibilities can include a high-grade convertible bond or preferred stock. It can also be a high-grade straight bond that has been priced irrationally low by the market, where the investor will expect to make a profit on capital gains. Inadequately protected issues include lower-grade bonds and preferred stock, where the value may rise or fall depending on the financial status of the corporation.

Common-stock type securities include not only common stocks, but senior securities that exhibit common-stock type characteristics. A senior convertible bond selling at 200 would qualify in that you may reasonably suffer capital loss, but may also expect gains from the convertible feature is the company does exceptionally well.

I think Graham's goal is not just for us to reclassify securities, but rather to think about the characteristics of the security and not to make assumptions about the security's characteristics based on its name and legal form.