Wednesday, July 2, 2008

Security Analysis: Chapter 2

Security Analysis by Ben Graham and David Dodd is a must read for anyone serious about value investing.

In Chapter 2, Graham and Dodd start out by identifying four factors which the analyst should consider before making a decision on a purchase:

The Security: What exactly is being purchased
The Price: To avoid paying too much
The Time: Timing can change a valuation, e.g. if interest rates change
The Person: What makes sense for a businessman may not for a widower.

In evaluating the security, it is not enough to simply consider the issuing company and industry. The authors take us through examples of great companies in solid industries where the securities were on unfavourable terms, thus duping investors.The authors argue with conventional wisdom which suggests that it's better to invest in an unattractive security with an attractive company than an attractive security with an unattractive company...for the trained analyst.

Finally, the authors discuss how an analysis can be divided into two components: qualitative and quantitative. They argue that qualitative factors are far more difficult to analyze, and that projecting the trend of the past into the future, which many consider to be a quantitative action, is actually a qualitative one. Projecting trends will either overvalue or undervalue the security, as qualitative factors are often overestimated. The authors use the example of "good management" as a factor that is given double the credence: first in the company's earnings, and then again as an added qualitative factor.

Nevertheless, a proper analysis must consider both quantitative as well as qualitative factors. The authors demonstrate this with an example showing one company's coverage ratios being higher than another over the past decade, yet because of its industry, the security with the lower coverage ratio is still the more attractive issue.

Onto Chapter 3

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