Tuesday, July 8, 2008

Security Analysis: Chapter 7, Part I

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

The first half of Chapter 7 describes the reasoning behind the second principle of fixed-income investing:

Consider these investments on a Depression basis.

All fixed-income investments can do well when conditions are favourable, but investors must attempt to determine how safe these securities are when times are bad before they can make a purchase decision.

Graham and Dodd suggest there are two ways a security can be Depression-proof:

1) Its industry does not lose much earning power during bad times
2) Interest coverage is so high that despite a large drop in earnings, there is no resultant danger

The authors discuss the cyclicality of various industries, suggesting that certain utilities (electric, gas, water) show little earnings erosion during recessions, and would qualify under #1 above. Nevertheless, the authors demonstrate that an equal share of utilities went bankrupt during the Depression as did companies in other industries. However, this is demonstrated to be as a result of the capital structures of such safer industries. These companies loaded up on debt (expecting that they were recession-proof) such that even though they did not lose substantial earnings power, they were no longer able to cover their obligations.

Meanwhile, Graham and Dodd argue that in order to qualify as investments, most industrial companies would have to fall under category #2 above. However, despite having high coverage ratios in normal years, the drop in earnings (often into losses) during The Depression was such that insolvency was unavoidable for most of these companies. Their study of such industrials demonstrates that across industries, it was the largest companies that most avoided default.

The authors thus conclude that investments in fixed-income securities should be confined to reasonably capitalized companies in stable industries along with industrial companies of dominant size with substantial interest coverage ratios.

Onto Part II

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