SECURITY ANALYSIS (BY BENJAMIN GRAHAM)

Summary

This video script delves into the distinction between investment and speculation, emphasizing the importance of thorough analysis for portfolio returns. It outlines the principles of value investing as defined by Benjamin Graham, including 'margin of safety' and the subjective nature of 'satisfactory return.' The script also classifies securities, discusses the balance between quantitative and qualitative analysis, and acknowledges the challenges analysts face due to data inaccuracies, market uncertainties, and irrational behaviors. Ultimately, it highlights that exceptional investment opportunities do exist for those who conduct diligent analysis.

Takeaways

• 👔 Investment vs. Speculation: The distinction lies in the approach, not the attire or location. It's about thorough analysis and a margin of safety rather than gambling on expectations.
• 📊 Graham's Definition: An investment is an operation that, after careful study, promises safety of principal and satisfactory returns, while anything else is speculative.
• 📚 Thorough Analysis: It's about examining available facts logically and based on established principles, not just relying on future expectations.
• 💰 Margin of Safety: Invest in securities only when there's a reasonable margin between their price and intrinsic value to protect against analysis errors.
• 🤔 Subjective Returns: A 'satisfactory return' varies by investor and must be intelligently determined, not just chasing higher risk for lower returns.
• 🏦 Classification of Securities: Understand the traditional types like bonds, preferred stocks, and common stocks, and their respective rights and risks.
• 🔄 Market Behavior: Securities should be categorized by their typical post-purchase behavior for a unified investment approach.
• 📈 Quantitative vs. Qualitative: Both types of data are crucial for a comprehensive investment analysis, with quantitative often hinting at qualitative factors.
• 🚧 Analyst Obstacles: Overcome challenges like inadequate data, future uncertainties, and market irrationalities to make informed investment decisions.
• 🔍 Exceptional Cases: Successful investing often involves identifying and acting on exceptional opportunities where both safety and return are attainable.
• 📊 Reasonable Accuracy: Investors should aim for a reasonable approximation of a security's value rather than an exact figure, given the unpredictability of the future.

Q & A

What is the primary distinction between an investor and a speculator according to Benjamin Graham?

Benjamin Graham distinguishes between an investor and a speculator by the thoroughness of analysis and the focus on safety of principal and satisfactory return. An investor conducts a careful study of available facts with sound logic and established principles, while a speculator often relies on expectations about the future rather than available facts.

What does the term 'thorough analysis' imply in the context of investment?

In the context of investment, 'thorough analysis' refers to the careful study of available facts with the attempt to draw conclusions from them with sound logic and based on established principles, ensuring that the investment promises safety of principal and a satisfactory return.

What is the concept of 'margin of safety' in investing?

The 'margin of safety' is a concept introduced by Benjamin Graham, which suggests that a security should be bought only when its value can be obtained with a margin to the price. This margin allows for protection in case the analysis is wrong and provides a buffer against potential losses.

Why is the term 'satisfactory return' considered subjective in investing?

The term 'satisfactory return' is subjective in investing because it depends on the individual investor's willingness to accept a certain level of return. It is based on the investor's personal financial goals, risk tolerance, and the level of return they consider adequate for the investment made.

How does Benjamin Graham classify different types of securities for investment purposes?

Benjamin Graham classifies securities into three categories based on their normal behavior after purchase: fixed value type (high-grade bonds and preferred stocks), senior securities of variable value (high grade with profit possibilities and inadequate quality issues), and common stocks.

What is the difference between quantitative and qualitative analysis in investing?

Quantitative analysis in investing involves the examination of numerical data such as capitalization, earnings, dividends, assets, liabilities, and operating statistics. Qualitative analysis, on the other hand, considers non-numerical factors like the quality of management, customer preferences, competitive landscape, and technological change.

Why is it important for an investor to consider both quantitative and qualitative data?

It is important for an investor to consider both quantitative and qualitative data because quantitative data provides a numerical basis for analysis, while qualitative data offers insights into the intangible aspects of a company that can significantly impact its future performance and the value of its securities.

What are the three primary obstacles that analysts face in security analysis?

The three primary obstacles that analysts face in security analysis are inadequate or incorrect data, uncertainties of the future, and irrational behavior of the markets. These obstacles make it challenging for analysts to accurately assess the value and potential of securities.

Why is it suggested that analysts should only act in exceptional cases?

It is suggested that analysts should only act in exceptional cases because security analysis is not an exact science, and the future does not always align with past data. By focusing on exceptional cases where both a margin of safety and satisfactory return are obtainable, analysts can increase the likelihood of successful investment outcomes.

How does Benjamin Graham illustrate the concept of not needing exactitude in investment decisions?

Benjamin Graham illustrates the concept of not needing exactitude in investment decisions by using the example of Wright Aeronautical's common stock, which was priced at $8 per share with earnings of $2 per share and over $8 in cash per share. The exact intrinsic value was uncertain, but it was clear that the stock was attractive at $8, demonstrating that reasonable accuracy is sufficient for investment decisions.

Outlines

00:00

📊 Investment vs. Speculation: The Essence of Security Analysis

This paragraph delves into the distinction between investing and speculation, emphasizing the importance of thorough analysis for informed investment decisions. It references Benjamin Graham and David Dodd's definition of investment as an operation that promises safety of principal and a satisfactory return after careful study of available facts. The concept of 'margin of safety' is introduced, suggesting that investments should be made when there's a buffer between the purchase price and the estimated value. The paragraph also challenges the common misconception that bonds are always investments and stocks are speculative, highlighting that the nature of an investment is determined by the analysis and rationale behind it, not the type of security.

05:03

🏢 Classification of Securities: A Guide for Investors

The second paragraph outlines the traditional classification of securities, including bonds, preferred stocks, and common stocks, detailing their rights and characteristics. It clarifies that bonds offer fixed interest payments and principal repayment but no participation in company profits. Preferred stocks are similar to bonds but have some priority in dividend and bankruptcy payments. Common stocks provide rights to assets and profits after bond and preferred stock claims. The paragraph also introduces Benjamin Graham's suggestion to classify securities based on their post-purchase behavior into fixed value, variable value with high grade and profit potential, and variable value with lower quality. This classification aims to treat securities similarly from an investment perspective.

10:09

🔍 Quantitative vs. Qualitative Analysis: A Balanced Approach

This paragraph discusses the importance of both quantitative and qualitative analysis in investment operations. Quantitative data, which includes capitalization, earnings, assets, liabilities, and operating statistics, is essential but must be supported by qualitative insights such as management quality, customer preferences, competitive landscape, and technological changes. While quantitative data is favored for its clarity and reliability, qualitative factors provide context and depth to the numbers. The intelligent investor seeks a balance, ensuring that investments are validated by both types of data to form dependable conclusions.

15:15

🚧 Obstacles in Security Analysis: Navigating Challenges

The fourth paragraph identifies three primary obstacles in security analysis: inadequate or incorrect data, uncertainties of the future, and irrational market behavior. It warns against questionable accounting practices and suggests avoiding companies with such issues. The paragraph acknowledges that even well-analyzed investments may not align with market movements, and investors must be prepared for the market's irrationality. It emphasizes that despite these challenges, the role of the analyst is not negated, as they can focus on exceptional cases where the margin of safety and satisfactory return are evident.

💼 The Intelligent Investor's Approach: Exceptional Cases and Analysis

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 investment criteria are met. The paragraph provides an example of Wright Aeronautical's stock, illustrating how significant discrepancies between price and intrinsic value can offer attractive investment opportunities. It concludes by emphasizing the importance of reasonable accuracy over exactitude in security analysis, given the limitations of past data in predicting the future.

Keywords

💡Investment

Investment refers to the act of committing money or capital to an endeavor expected to yield a profit or income. In the context of the video, it is distinguished from speculation by the criteria of thorough analysis, safety of principal, and a satisfactory return. The script uses the term to emphasize the importance of a careful, logical approach to deploying capital in the market, as opposed to the more risky and uncertain nature of speculation.

💡Speculation

Speculation is the act of investing in an asset with the hope of making a profit without a thorough analysis or guarantee of safety of the principal. It is often driven by expectations of future performance rather than current facts. The video script contrasts speculation with investment, using the example of buying Netflix stock at a high valuation as a speculative act because it relies on future expectations rather than established data.

💡Security Analysis

Security analysis is the investigation of an investment's value and risks. It is central to the video's theme as it forms the basis for distinguishing between investment and speculation. The script highlights that understanding security analysis is essential for portfolio returns, and it involves evaluating both quantitative and qualitative factors of a potential investment.

💡Margin of Safety

Margin of safety is a concept introduced by Benjamin Graham, which suggests that an investment should be purchased at a price lower than its estimated intrinsic value, providing a buffer against the possibility of being wrong in one's analysis. The script explains that this concept is crucial for investors to protect themselves and ensure that the value of a security is obtained with a margin to the price.

💡Intrinsic Value

Intrinsic value is an estimate of the true value of a company based on its underlying assets and earnings power, irrespective 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 majority being speculative based on market and future value factors.

💡Quantitative Analysis

Quantitative analysis involves the use of numerical data to analyze an investment, including metrics such as capitalization, earnings, dividends, assets, liabilities, and operating statistics. The script emphasizes that while quantitative data is crucial for forming dependable conclusions, it must also be supported by qualitative observations for a thorough investment analysis.

💡Qualitative Analysis

Qualitative analysis assesses non-numerical factors that can impact an investment, such as management quality, customer preferences, competitive landscape, and technological changes. The video script points out that although quantitative data is more easily obtainable, qualitative data is equally important and should validate the quantitative findings for a complete investment evaluation.

💡Bonds

Bonds are debt securities that represent a loan made by an investor to a borrower, usually a corporation or government, which obligates the borrower to pay back the loan with interest. The script explains that bonds have an unqualified right to fixed interest payments and repayment of the principal amount, but they do not participate in the company's profits beyond the interest received.

💡Preferred Stocks

Preferred stocks are a type of equity that combines characteristics of both common stock and bonds. They typically offer a fixed dividend and priority in the payment of dividends and assets over common stockholders in the event of liquidation. The script notes that preferred stocks are more like bonds than stocks and do not participate in excess company profits.

💡Common Stocks

Common stocks represent ownership shares in a company and come with the right to participate in the company's profits and assets after all other claims have been met. The video script clarifies that common stocks are often mistakenly considered speculative due to their lack of guaranteed returns, but they can be investments if purchased with a margin of safety and thorough analysis.

💡Market Irrationality

Market irrationality refers to the unpredictable and sometimes illogical behavior of financial markets, which may not always reflect the intrinsic value of securities. The script discusses how the market may remain irrational for extended periods, challenging the analyst's original thesis and potentially leading to the sale of a security at a loss.

Highlights

Investment vs. speculation: The distinction is crucial for portfolio returns and requires a clear definition beyond stereotypes.

Benjamin Graham's perspective: Even Wall Street professionals might be considered speculators if they gamble on stocks without thorough analysis.

Graham and Dodd's definition: Investment is an operation promising safety of principle and a satisfactory return based on thorough analysis.

Thorough analysis involves careful study of available facts, sound logic, and established principles, contrasting with speculation based on future expectations.

The concept of 'margin of safety' introduced by Graham suggests buying a security only when its value offers a margin over the purchase price.

A 'satisfactory return' is subjective and varies based on the investor's willingness and intelligence in accepting returns.

Investment operations should be justified on both quantitative and qualitative grounds, emphasizing the need for comprehensive analysis.

Netflix example illustrates the difference between investment and speculation in stock valuation, highlighting the speculative component of market price.

Classification of securities includes bonds, preferred stocks, and common stocks, each with different rights and potential for returns.

Common misconception that bonds are always investments and stocks are speculative is debunked; the nature of the security depends on its financial position.

Graham suggests organizing securities based on their normal behavior post-purchase rather than their titles for a more coherent investment approach.

Quantitative analysis includes capitalization, earnings, assets, liabilities, and operating statistics, which are crucial for forming dependable conclusions.

Qualitative information such as management quality, customer preferences, and competitive landscape is essential to support quantitative data.

The importance of both quantitative and qualitative validation for investments cannot be overstated for the intelligent investor.

Three primary obstacles for analysts include inadequate data, future uncertainties, and market irrationalities, complicating but not nullifying the analysis.

Investing is about searching for exceptional cases where both margin of safety and satisfactory return are obtainable, despite market complexities.

The intelligent investor focuses on reasonable accuracy rather than exactitude, acknowledging the limitations of past data in predicting the future.

Upcoming content will delve into income statement and balance sheet analysis, common stock investment, and senior securities, providing further insights into investment strategies.

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!