SECURITY ANALYSIS (BY BENJAMIN GRAHAM)

Summary

This video script explores the distinction between investment and speculation, emphasizing the importance of thorough analysis for portfolio returns. It introduces Benjamin Graham's definition of investment as a safe operation with a satisfactory return, contrasting it with speculative activities. The script delves into security classifications, the balance of quantitative and qualitative analysis, and the challenges analysts face, such as data inaccuracies and market irrationalities. It concludes by highlighting the role of the intelligent investor in exceptional cases, advocating for a combination of careful analysis and a margin of safety.

Takeaways

• 👔 The distinction between investing and speculation is crucial for portfolio returns, and even Wall Street professionals can be speculators if they're not following a thorough analysis process.
• 📚 'Thorough analysis' means careful study of available facts to draw sound logical conclusions, which is essential for an investment to be considered safe and promising a satisfactory return.
• 💹 Speculation often relies on future expectations rather than current facts, such as buying a stock at a high price-to-earnings ratio without a solid basis in established company performance.
• 🛡️ 'Margin of safety' is a principle introduced by Benjamin Graham, suggesting that securities should be purchased at a price that offers a buffer against potential analysis errors.
• 📈 A 'satisfactory return' is subjective and depends on the investor's acceptance, but it should be intelligently considered in relation to the risk taken and alternative investments available.
• 📊 Investment operations should be justified by both quantitative (hard data like earnings and assets) and qualitative (soft data like management quality and market trends) analysis.
• 🏦 Securities can be traditionally classified into bonds, preferred stocks, and common stocks, each with different rights and risks, but Benjamin Graham suggests a different classification based on their behavior post-purchase.
• 📉 The future is uncertain, and even the most thorough analysis cannot predict market movements or company changes, which is why investors must be prepared for the irrationality of markets.
• 🔍 Successful security analysis faces obstacles like inadequate data, future uncertainties, and market irrationality, but these challenges can be managed with careful and exceptional case analysis.
• 🎯 Investing is about searching for and capitalizing on exceptional cases where the margin of safety and satisfactory return are clearly obtainable, despite the inherent complexities of security analysis.

Q & A

What is the primary distinction between investment and speculation according to Benjamin Graham?

According to Benjamin Graham, the primary distinction between investment and speculation is that an investment operation is one that, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these criteria are considered speculative.

Why is thorough analysis important in distinguishing between investment and speculation?

Thorough analysis is crucial because it involves careful study of available facts, allowing an investor to make sound decisions based on logic and established principles. Without thorough analysis, one cannot reliably determine whether an operation promises safety and satisfactory returns, thus falling into speculation.

What does Benjamin Graham mean by 'margin of safety' in investing?

The 'margin of safety' refers to the principle of buying securities only when they are available at a price significantly below their intrinsic value. This margin provides protection against errors in analysis or unforeseen market conditions, ensuring the investment is safer.

How does Benjamin Graham define a 'satisfactory return'?

A 'satisfactory return' is subjective and depends on what the investor is willing to accept. However, the key is that the return should be aligned with intelligent investment decisions, rather than speculative choices with higher risks.

Why is it incorrect to assume that bonds are always investments and stocks are always speculative?

It is incorrect because the categorization should be based on the behavior and quality of the security rather than its title. A bond's promise of repayment is only as good as the company's financial position, and similarly, stocks can be investments if they are purchased with a margin of safety and sound analysis.

What types of securities does Benjamin Graham classify as suitable for investment?

Benjamin Graham suggests classifying securities based on their normal behavior after purchase. These include high-grade bonds and preferred stocks as fixed value types, senior securities of variable value, and common stocks.

How does quantitative analysis differ from qualitative analysis in investment?

Quantitative analysis involves numerical data such as earnings, dividends, assets, and liabilities, while qualitative analysis includes factors like management quality, customer preferences, and competitive landscape. Both types of analysis are necessary to validate an investment operation.

What are the three primary obstacles to successful security analysis?

The three primary obstacles are inadequate or incorrect data, uncertainties of the future, and irrational behavior of the markets. These factors can complicate the work of the analyst but do not nullify the effort to find sound investments.

What is the significance of finding 'exceptional cases' in investing?

Investing should focus on identifying exceptional cases where securities can be purchased with a margin of safety and promise satisfactory returns. This approach minimizes risk and avoids speculation, making the investment more reliable.

Why is it important for an investor to be interested in reasonable accuracy rather than exactitude?

Reasonable accuracy is more practical in investing because the analyst deals with historical data, which may not always predict the future accurately. Focusing on reasonable accuracy allows the investor to make sound decisions without getting bogged down by the need for exact figures.

Outlines

00:00

🔍 Investment vs. Speculation: The Essence of Security Analysis

This paragraph delves into the distinction between investing and speculating, emphasizing the importance of thorough analysis for sound investment decisions. It references Benjamin Graham and David Dodd's definition, which hinges on safety of principle and satisfactory returns. The concept of 'margin of safety' is introduced, suggesting that investments should be made when there is a clear value above the purchase price. The paragraph also clarifies misconceptions about the nature of bonds and stocks, highlighting that neither is inherently speculative or safe without proper analysis. It concludes by defining an investment operation as one justified by both quantitative and qualitative grounds.

05:03

🏦 Classification of Securities: A Traditional Overview

The second paragraph provides a traditional classification of securities, including bonds, preferred stocks, and common stocks, detailing their rights and characteristics. Bonds offer fixed interest payments and loan repayment rights without participation in company profits. Preferred stocks, similar to bonds, offer dividends and priority in bankruptcy but no excess profit participation. Common stocks, often referred to as 'stocks,' provide rights to assets and profits beyond what is owed to bond and preferred stockholders. The paragraph challenges the common misconception that bonds are always investments and stocks are speculative, advocating for a behavior-based classification of securities proposed by Benjamin Graham.

10:09

📊 Quantitative vs. Qualitative Analysis: Balancing Investment Insights

This section discusses the importance of both quantitative and qualitative analysis in investment operations. Quantitative data includes capitalization, earnings, dividends, assets, liabilities, and operating statistics, which are deemed more reliable for forming dependable conclusions. However, the paragraph stresses that quantitative data is only useful when supported by qualitative insights, such as management quality, customer preferences, competitive landscape, and technological changes. The intelligent investor should seek both types of validation for their investments, acknowledging the limitations of information overload and the value of focused analysis.

15:15

🚧 Obstacles in Security Analysis: Navigating Data, Uncertainty, and Market Behavior

The fourth paragraph outlines the three primary obstacles faced by security analysts: inadequate or incorrect data, uncertainties of the future, and irrational market behavior. It warns against companies with questionable accounting practices and suggests avoiding their securities altogether. The paragraph also touches on the high rate of turnover among Fortune 500 companies, illustrating the unpredictability of the future. Despite these challenges, it emphasizes that the analyst's role is not nullified, as they can focus on exceptional cases where both safety and satisfactory returns are achievable.

💼 The Role of the Analyst: Exceptional Cases and Reasonable Accuracy

The final paragraph reinforces the idea that while investing is challenging due to data inaccuracies, future uncertainties, and market irrationalities, these factors do not invalidate the analyst's work. It highlights the advantage of acting only in exceptional cases, where the margin of safety and satisfactory returns are evident. The paragraph uses the example of Wright Aeronautical to illustrate the concept of reasonable accuracy in investment decisions, suggesting that the analyst need not be exact but should aim for a clear understanding of a security's value. It concludes with a summary of key takeaways and a teaser for upcoming videos on income statements, balance sheets, and securities analysis.

Keywords

💡Investment

Investment refers to the act of committing money or capital to an endeavor with the expectation of obtaining a profit. In the context of the video, investment is distinguished from speculation based on the principles laid out by Benjamin Graham and David Dodd, emphasizing thorough analysis, safety of principal, and a satisfactory return. The script uses the example of buying Netflix at a high valuation to illustrate what constitutes speculation rather than investment.

💡Speculation

Speculation is the act of investing in ventures where the outcome is uncertain, often based on predictions of future performance rather than current facts. The video script contrasts speculation with investment, noting that even Wall Street professionals might be engaging in speculation under the guise of investing in strong companies. The script suggests that buying a stock like Netflix at a high earnings multiple is speculative due to the reliance on future expectations.

💡Thorough Analysis

Thorough analysis is the process of carefully studying available facts to draw logical conclusions based on established principles. The video emphasizes that this is a fundamental aspect of investment, as opposed to speculation. The script mentions that Benjamin Graham considered 'thorough analysis' essential for distinguishing between investment and speculation, and it is the basis for making informed decisions about the safety and return of an investment.

💡Margin of Safety

Margin of safety is a concept introduced by Benjamin Graham, which suggests that an investment should be made only when the value of a security can be obtained at a price that offers a buffer against the possibility of being wrong in one's analysis. The script explains that this concept is crucial for protecting investors under normal or reasonably likely conditions and is a hallmark of a true investment operation.

💡Intrinsic Value

Intrinsic value is an estimate of the true value of a company based on its underlying assets and earnings power, independent of market price fluctuations. The video script discusses how only a small portion of Netflix's market cap is made up of intrinsic value factors, with the rest being speculative. This concept is central to understanding what constitutes a true investment, as per Graham's principles.

💡Quantitative Analysis

Quantitative analysis involves the use of numerical data, such as capitalization, earnings, dividends, assets, liabilities, and operating statistics, to evaluate an investment. The video script notes that quantitative data is crucial for forming definite and dependable conclusions about an investment's viability. However, it also emphasizes that quantitative data must be supported by qualitative observations for a complete analysis.

💡Qualitative Analysis

Qualitative analysis assesses non-numerical factors such as management quality, customer preferences, competitive landscape, and technological changes that can impact an investment. The script explains that while quantitative data is important, it is only useful when supported by qualitative insights, which provide a more holistic view of the enterprise's potential for success.

💡Security Analysis

Security analysis is the investigation of a company's financial health and prospects to determine the intrinsic value of its securities. The video script highlights that distinguishing between investment and speculation lies at the heart of security analysis, which is essential for understanding the nature of the portfolio returns one is engaged in.

💡Bonds

Bonds are debt securities that represent a loan made by an investor to a borrower (typically corporate or governmental). The video script explains that bonds offer fixed interest payments and a promise to repay the principal amount, but they do not offer participation rights in company assets or profits. The script also notes that the classification of bonds as investments or speculations depends on their behavior after purchase.

💡Preferred Stocks

Preferred stocks are a type of equity security that has characteristics of both common stocks and bonds. The script describes preferred stocks as having a stated dividend but no obligation to pay it if the company does not pay dividends to common stockholders. They have a higher claim on assets and earnings in the event of bankruptcy compared to common stocks but do not participate in excess profits.

💡Common Stocks

Common stocks represent ownership shares in a company and come with the right to participate in the company's assets and profits after bond and preferred stockholder claims are met. The video script clarifies that common stocks are often mistakenly considered speculative due to their lack of guaranteed returns, but they can also be investments if purchased with a margin of safety and offering a satisfactory return.

Highlights

Investment vs. speculation: Distinguishing between the two is crucial for portfolio returns.

Benjamin Graham's perspective on investment differs from common stereotypes.

A definition of investment operation according to Graham and Dodd: safety of principle and satisfactory return.

Importance of thorough analysis and sound logic in investment decisions.

Speculation in Netflix's high valuation based on future expectations rather than facts.

The concept of 'margin of safety' in investing introduced by Benjamin Graham.

Investment requires a balance between quantitative and qualitative analysis.

The subjective nature of what constitutes a 'satisfactory return' in investing.

Classification of securities: Bonds, Preferred stocks, and Common stocks.

Common misconceptions about the inherent nature of bonds and stocks in terms of investment vs. speculation.

Graham's suggestion to classify securities based on their behavior post-purchase.

The three categories of securities based on fixed value, variable value, and common stocks.

Quantitative vs. qualitative analysis in investment operations.

The significance of both quantitative data and qualitative observations in validating investments.

Challenges faced by analysts: Inadequate data, future uncertainties, and market irrationalities.

The advantage of acting only in exceptional cases in security analysis.

Investing as a search for exceptional cases where margin of safety and satisfactory return are obtainable.

The example of Wright Aeronautical stock illustrating the concept of reasonable accuracy in investing.

Summary of key takeaways on investment operations, types of securities, and the role of analysis.

Transcripts

Takeaway number 1: Investment vs speculation

What's the difference between an investor and a speculator?

Is it that the former wears a tie and is working in some fancy office at some fancy street in cities like, New York

London or Stockholm, and the latter is gambling with his mortgage at the casino?

Nah, I think we need a more useful definition than that.

Distinguishing between investing and speculation lies at the very heart of security analysis, because it's

absolutely essential for the sake of your portfolio returns to understand which one you are engaged in.

As a matter of fact, Benjamin Graham would call most of the aforementioned

tie-wearing Wall Streeters speculators. It's just that they cover their gambling really well with

"speculation in stocks of strong companies".

Here's what Benjamin Graham and David Dodd says:

"An investment operation is one which, upon thorough analysis,

promises safety of principle and a satisfactory return.

Operations not meeting these requirements are speculative."

This quote probably raises more questions than it gives answers, so let's break it down.

By "thorough analysis",

Benjamin Graham refers to the importance of a careful study of

available facts, with the attempt to draw conclusions from that with sound logic and based on established principles.

For instance, buying Netflix at a price of

140 times its highest reported yearly earnings is speculation, not investment, as

the valuation clearly relies on expectations about the future, rather than available facts.

"Safety" in the security markets, is never achievable under all circumstances,

but the investor must protect himself under all normal, or reasonably likely conditions.

Benjamin Graham is famous for coining the expression "margin of safety", which allows for protection by insisting that the value of a security

should be bought only when it can be obtained with a margin to the price.

For example, buying Apple at $210 per share,

if you think that it's actually worth $220 per share, would be considered speculation.

You should always factor in the possibility of being wrong in your analysis, but

more on this in The Intelligent Investor.

A "satisfactory return" is truly subjective.

Any return that the investor is willing to accept will actually do here, as long as he acts with some kind of intelligence.

If it's possible to acquire US Treasury bills at a

5% annual return, but for some reason he decides to invest his money in

micro-cap mining stock, at an expected 4% return, it would fail to be regarded as an investment operation,

even if he has safety and a thorough analysis in place.

In summary, or perhaps in addition: an investment operation is one that can be justified based on both quantitative and qualitative grounds.

But more on this in takeaway number three.

Going back to the previously mentioned Netflix case.

This does not mean that the analyst is convinced that the market valuation of Netflix is wrong,

but rather that he is not convinced that its valuation is right.

He would call a substantial part of the price a speculative component, in the sense that it is paid, not for

demonstrated, but for expected results.

Benjamín Graham provides an excellent chart of how the price of a security is determined and

points out which components that may be regarded as investment and which that are speculative.

In the case of Netflix, a great portion of the current market cap of almost $170B is

Made up of the market factors, which are 100%

speculative, and the future value factors, which are part speculative and part investment.

Only a small portion is made up of true investment value, which Benjamin Graham refers to as the

intrinsic value factors.

Takeaway number 2: Classification of securities

So, we now have a brief understanding of what the difference between an investment and a speculation is.

We are going to focus on the former in this series.

There are many different types of securities that could qualify for investment purposes though, and we will now outline them briefly.

The traditional classification is:

Bonds

Preferred stocks, and ...

Common stocks

Bonds have an unqualified right to fixed interest payments, an

unqualified right to the repayment of the loan (or principal amount),

but no other participation rights in in either assets nor profits.

A preferred stock, despite its name, is more like a bond than a stock.

It has a stated dividend, but nothing must be paid if the common stock doesn't receive anything either.

It has the right to its principal if the company goes bankrupt, and gets money before any common stockholder.

Like the bond, it doesn't participate in any excess profits made by the company.

The common stock has the right to all assets and profits in excess of everything paid to bond and preferred stockholders.

This class of security is what people typically refer to when they talk about "stocks".

Because common stocks basically aren't promised anything,

many mistakenly think that stocks are always speculative, and that bonds are always investments. This is not true.

A bond holder is promised that he'll be repaid, but that promise is only as good as the financial position of the company that's making it.

Rather than organizing securities according with their titles,

Benjamin Graham suggests that securities should be organized based on their normal behavior after purchase.

Why?

Because then, the categories can be treated similarly from an investment perspective.

The suggestion is:

The first category is made up of securities of the fixed value type. It consists of high-grade

bonds and preferred stocks and the assumption is that you more or less should be able to forget about these and collect the interest payments.

The second category is made up of senior securities of variable value.

It's divided in two parts:

Issues of high grade, but that at the same time have profit possibilities, such as convertible bonds, and

issues of inadequate quality such as low grade bonds and preferred stocks.

The last category is common stocks.

We'll examine these categories in greater detail in the third and fourth video of this series.

Takeaway number three: Quantitative analysis versus qualitative analysis

In takeaway number one,

we learned that an investment operation must be able to be justified both on quantitative and qualitative grounds.

We're now going to decipher what that means in practice.

An analysis should be thorough for it to be considered an investment operation. The issue is that,

already in Graham's days, the supply of information of a single security was typically more than an analyst could plow through, and

Graham only lived to see the very beginning of the information age.

The supply of information has increased exponentially during the last decades.

Needless to say, an investor can only consume so much of it.

The depth of his analysis should therefore depend on his invested amount, as that is a good indicator of how much value

additional analysis can add.

If Warren Buffett can increase his yearly returns by 1%, that would mean about

$800 million more in income that year. If the average Swede can increase his return by the same percentage,

he will only increase his income by approximately $1,900.

Depending on how much time he must invest to achieve that extra return, it may or may not be time well spent.

Information is of two types - quantitative and qualitative. Quantitative data may be divided into:

capitalization; earnings and dividends; assets and liabilities; and operating statistics.

And qualitative information are things such as:

quality of management;

customer preferences and trends;

competitive landscape; and

technological change.

This book is heavily tilted towards the quantitative data.

After all, it's called value investing, and Benjamin Graham states that:

"The former [quantitative data] are fewer in numbers, more easily obtainable and much better suited to the forming of

definite and dependable conclusions."

Moreover,

quantitative data typically reveals a lot about the qualitative factors as well.

Is the management competent?

Well, have the earnings,

assets and dividends of the company increased under their lead? In that case yes, very competent!

With that said ...

Quantitative data are useful only to the extent that they are supported by the qualitative survey of the enterprise.

The intelligent investor should insist on having both a quantitative and a qualitative validation of his investments.

Takeaway number 4: Obstacles for the analyst

There are three primary obstacles that makes successful security analysis more difficult than it might seem at first glance.

These are:

Inadequate or incorrect data

Uncertainties of the future, and

Irrational behavior of the markets

We will discuss the first point in much greater detail in a second video,

when we dive into the two major financial statements of a company - the income statement and the balance sheet.

For now,

it will be sufficient to say that data in company reports,

may not always present the situation in a useful manner to the investor.

In general, when you suspect that you've encountered a company that pursues questionable accounting principles,

avoid all securities of that company.

"You cannot make a quantitative deduction to allow for an unscrupulous management.

The only way to deal with such situations is to avoid them."

Have a look at this list of companies.

What do you think the common denominator is?

If you said: "they were all fortune 500 companies back in 1955, but are no longer on the list",

well done! As a matter of fact,

in 2014, 88% of companies on the fortune 500 list from

1955 had been replaced, either by going out of business, being surpassed by new companies or

by being acquired by other major players.

These were some of the companies with the greatest profit margins, the greatest earning trends, with the best financial positions.

But in investing, the future is often no respecter of statistical data.

Even if the investor concludes that there's a discrepancy between the true so-called "intrinsic value" of a security and its price,

the market may not realize its mistake.

And after holding on to that same security for years,

during which the market remains irrational, the investor may have to witness how his original theses no longer holds true,

whereupon he will have to sell that security off with a loss.

Takeaway number 5: Investing is the search for exceptional cases

So ..

Investing seems like it's quite tough. Is it even so that the factors mentioned in the previous takeaway nullifies any effort of the analyst?

The answer is yes. In most cases, but not all.

The intelligent investor will have to analyze a whole bunch of companies. In most cases,

he will conclude that its securities can't be bought with the aforementioned

margin of safety, and at the same time yield a satisfactory return.

But eventually, he will find investments where both are obtainable.

Security analysis isn't an exact science.

You should only act in exceptional cases.

Benjamin Graham gives a great example of this in the common stock of Wright Aeronautical, that was priced at $8 per share back in

1922 when it had, for some time, been earning $2 per share, and had more than $8 per share in cash only.

It would have been difficult at this point to decide whether Wright Aeronautical was worth $20 or perhaps even $40,

but luckily, that wasn't necessary to conclude that it was attractive to buy the stock at $8.

"It's easy to see that a man is heavier than he should be without knowing his exact weight."

Because of this, the buyer of securities shouldn't be interested in exactitude, but rather, in

reasonable accuracy. After all, the analyst is dealing with data representing the past, which, as we've discussed already

isn't always respected by the future.

Here's a quick summary:

An investment operation is one which, upon thorough analysis, promises safety of principle and a satisfactory return.

There are many different types of securities suitable for investment operations. They are, however, not bought under the same premises.

Quantitative data must always be validated by qualitative observations.

The incorrectness of data, uncertainties of the future, and irrationalities of markets,

complicate the work of the analyst but they do NOT nullify it.

One of the greatest advantages of the analyst is that he can (and should) only act in exceptional cases.

In the next video I will present the most important aspects of analyzing an income statement and a balance sheet.

After that, I will present the ins and outs of common stock investment, and lastly, that of senior securities.

Cheers!