SECURITY ANALYSIS (BY BENJAMIN GRAHAM) | PART 1

Conclusion number 1: Investment versus speculation What is the difference between an investor and a speculator? Could it be that the first wears a tie and works in some elegant office on some elegant street in cities like New York, London or Stockholm, and the second is gambling with his mortgage at the casino? No, I think we need a more useful definition than that. Distinguishing between investment and speculation lies at the very heart of

security

analysis

, because it is absolutely essential for the sake of your portfolio's returns to understand which one you are involved in. In fact, Benjamin Graham would call most of the aforementioned links: dressing Wall Street speculators.

The thing is that they cover their gambling very well with "speculation in shares of strong companies." This is what Benjamin Graham and David Dodd say: "An investment transaction is one that, after thorough

analysis

, promises

security

of principle and a satisfactory return. Transactions that do not meet these requirements are speculative." This quote probably raises more questions than it answers, so let's break it down. By "comprehensive analysis," Benjamin Graham means the importance of a careful study of the available facts, with the attempt to draw conclusions from them with sound logic and based on established principles. For example, buying Netflix at a price 140 times its highest reported annual earnings is speculation, not investment, since the valuation clearly depends on expectations about the future, rather than available facts. "Safety" in the securities markets can never be achieved under all circumstances, but the investor must protect himself under all normal or reasonably probable conditions.

Benjamin Graham is famous for coining the phrase "margin of safety," which allows protection by insisting that the value of a security should be purchased only when it can be obtained with a margin over the price. For example, buying Apple at $210 per share, if you believe it is actually worth $220 per share, would be considered speculation. You should always take into account the possibility of being wrong in your analysis, but we will talk more about this in The Intelligent Investor. "Satisfactory performance" is truly subjective. Any return the investor is willing to accept will do here, as long as he acts with some kind of intelligence.

If it is possible to purchase US Treasury bills with an annual return of 5%, but for some reason you decide to invest your money in microcap mining stocks, with an expected return of 4%, it would not be considered an investment transaction. even if it has security and extensive analysis. In summary, or perhaps in addition: an investment operation is one that can be justified on both quantitative and qualitative grounds. But more on this in conclusion number three. Going back to the Netflix case mentioned above. This does not mean that the analyst is convinced that Netflix's market valuation is wrong, but rather that he is not convinced that his valuation is correct.

I would call a substantial

part

of the price a speculative component, in the sense that you pay not for demonstrated results, but for expected results. Benjamin Graham provides an excellent chart of how a security's price is determined and points out which components can be considered an investment and which are speculative. In the case of Netflix, a large portion of the current market capitalization of almost $170 billion is made up of market factors, which are 100% speculative, and future value factors, which are

part

speculative and part investment. Only a small portion is made up of the true value of the investment, what Benjamin Graham refers to as intrinsic value factors.

Conclusion number 2: Classification of securities So, now we have a brief understanding of what is the difference between an investment and speculation. We will focus on the first one in this series. However, there are many different types of securities that could qualify for investment purposes and we will now briefly describe them. The traditional classification is: Bonds Preferred shares and... Common shares Bonds have an unconditional right to receive fixed interest payments, an unconditional right to repayment of the loan (or the principal amount), but no other right to participate in any of assets or profits. A preferred stock, despite its name, is more like a bond than a stock.

It has a stated dividend, but nothing is due if the common shares receive nothing as well. He is entitled to his principal if the company goes bankrupt and gets money before any common shareholder. Like the bonus, it does not participate in any excess profits obtained by the company. Common stock is entitled to all assets and earnings that exceed anything paid to bond and preferred stock shareholders. This kind of value is what people often refer to when they talk about "stocks." Because common stocks are basically promised nothing, many mistakenly think that stocks are always speculative and bonds are always investments.

This is not true. A bondholder is promised that he or she will be repaid, but that promise is only as good as the financial position of the company issuing it. Instead of organizing securities according to their titles, Benjamin Graham suggests that securities should be organized according to their normal behavior after purchase. Because? Because then, the categories can be treated similarly from an investment perspective. The suggestion is: The first category is composed of values ​​of the fixed value type. It's made up of high-quality bonds and preferred stocks and you're supposed to more or less be able to forget about them and collect interest payments.

The second category is made up of senior securities of variable value. It is divided into two parts: Issues of high quality, but at the same time have the potential for profitability, such as convertible bonds, and issues of inadequate quality, such as low quality bonds and preferred shares. The last category is common stocks. We will examine these categories in greater detail in the third and fourth videos of this series. Conclusion number three: quantitative analysis versus qualitative analysis In conclusion number one, we learned that an investment operation must be able to be justified on both quantitative and qualitative grounds.

Now let's figure out what that means in practice. An analysis must be exhaustive to be considered an investment operation. The problem is that, even in Graham's day, the supply of single-value information was typically more than an analyst could take advantage of, and Graham only lived to see the beginning of the information age. The supply of information has increased exponentially over the last few decades. It goes without saying that an investor can only consume a limited amount. Therefore, the depth of your analysis should depend on the amount invested, as it is a good indicator of how much value additional analysis can add.

If Warren Buffett can increase his annual returns by 1%, that would mean about $800 million more in income that year. If the average Swede can increase his income by the same percentage, he will only increase his income by approximately $1,900. Depending on how much time you have to invest to achieve that extra return, it may or may not be time well spent. The information is of two types: quantitative and qualitative. Quantitative data can be divided into: capitalization; profits and dividends; actives and pasives; and operational statistics. And qualitative information is things like: quality of management; customer preferences and trends; competitive landscape; and technological change.

This book is heavily weighted toward quantitative data. After all, it is called value investing, and Benjamin Graham states that: "The former are fewer in number, easier to obtain, and much better suited to reaching definitive and reliable conclusions." Furthermore, quantitative data usually also reveals a lot about qualitative factors. Is the management competent? Well, have the company's profits, assets and dividends increased under his leadership? In that case yes, very competent! That being said... Quantitative data is only useful to the extent that it is supported by a qualitative survey of the company. The intelligent investor should insist on both quantitative and qualitative validation of his investments.

Conclusion number 4: Obstacles for the analyst There are three main obstacles that make a successful security analysis more difficult than it seems at first glance. These are: Inadequate or incorrect data Uncertainties of the future and Irrational behavior of the markets We will talk about the first point in much more detail in a second video, when we dive into the two main financial statements of a company: the income statement and the balance sheet. balances. For now it will suffice to say that the data in company reports does not always present the situation in a way that is useful to the investor.

In general, when he suspects that he has encountered a company that follows questionable accounting principles, he will avoid all of that company's values. "You cannot make a quantitative deduction to allow unscrupulous management. The only way to deal with this type of situation is to avoid it." Take a look at this list of companies. What do you think is the common denominator? If you said, "they were all Fortune 500 companies in 1955, but they're no longer on the list," well done! In fact, by 2014, 88% of the companies on the Fortune 500 list from 1955 had been replaced, either by closure, overtaken by new companies, or acquired by other major players.

These were some of the companies with the highest profit margins, the biggest earnings trends, and the best financial positions. But in investing, the future often does not respect statistical data. Even if the investor concludes that there is a discrepancy between the true so-called "intrinsic value" of a security and its price, the market may not realize his 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 thesis is no longer true, so he will have to sell that security at a loss.

Conclusion number 5: Investing is the search for exceptional cases So... Investing seems quite difficult. Is it even so that the factors mentioned in the previous conclusion nullify any efforts of the analyst? The answer is yes. In most cases, but not all. The intelligent investor will have to analyze a lot of companies. In most cases, he will conclude that his securities cannot be purchased with the aforementioned margin of safety and, at the same time, produce a satisfactory return. But he will eventually find investments where he can get both. Security analysis is not an exact science. You should only act in exceptional cases.

Benjamin Graham gives a great example of this in Wright Aeronautical's common stock, which was priced at $8 a share in 1922, when for some time it had been earning $2 a share and had more than $8 a share in cash alone. . . It would have been difficult at this point to decide whether Wright Aeronautical was worth $20 or perhaps even $40, but fortunately, it was not necessary to conclude that it was attractive to buy the shares at $8. "It is easy to see that a man weighs more than he should without knowing his exact weight." For this reason, the buyer of securities should not be interested in accuracy, but rather in reasonable accuracy.

After all, the analyst is dealing with data that represents the past, which, as we have already discussed, is not always respected by the future. Here is a brief summary: an investment operation is one that, after exhaustive analysis, promises security of principle and a satisfactory return. There are many different types of securities suitable for investment operations. However, they are not purchased under the same premises. Quantitative data should always be validated by qualitative observations. The incorrectness of the data, the uncertainties of the future and the irrationalities of the markets complicate the analyst's work but DO NOT cancel it.

One of the greatest advantages of the analyst is that he can (and should) only act in exceptional cases. In the following video I will present the most important aspects of analyzing an income statement and a balance sheet. After that, I will introduce the ins and outs of investing in common stocks and finally, investing in senior securities. Health!