Sunday, July 13, 2008

Security Analysis: Chapters 10 and 11

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

In these two chapters, Graham and Dodd complete the set of minimum requirements for fixed-income investments.

In Chapter 10, they explore various types of liens and discuss the relative merits of each. Although in Chapter 6, the authors made clear that in practice liens are worth little, in this chapter they delve into various types of liens and allow some exceptions where they believe investors do have backup protection in case the business can't make its obligations.

One special case where liens hold value is when a loan is secured against a specific property which has independent salable value. The authors use an analogy to a pawnbroker who loans money but does not care about the creditworthiness of his client, because he holds in his possession property worth in excess of the loan.

However, its very easy to fall victim to supposed security. In many cases, the value of the asset is tied directly to the business' earnings, even though it may not always be clear. The authors illustrate this with a typical real-estate example. Consider a house that is purchased for rental purposes with a loan secured against it. If rental rates decrease and no longer cover the required interest payments, the house has actually lost much of its value as a result of its decreased rental power. As such, the supposed security of the loan against the house is of little benefit to the lender, unless the value of the house to begin with was far greater than that of the loan.

In Chapter 11, Graham and Dodd add one more requirement to the test for whether a bond should be thrown out as a potential investment. The authors want to make sure there is value in the company above and beyond the value of the debt. This residual value acts as a margin of safety, for the larger it is, the more the fixed-income security is protected from a drop in the value of the company. The authors argue that the best measure of the residual value above the debt is the market value of the stock.

The authors are careful to mention that by no means is the market value of the stock used as a reliable measure of the instrinsic value of the company, but rather only as a rough index that there is substantial equity behind the bonds.

Book value is judged to be inadaquate as a measure of the value above the bonds, since the assets on the balance sheet may be over or understated, and therefore the market value of the stock is a better measure of the fair value of the equity of the company.

The authors go on to demonstrate examples of various bonds selling with adaquate interest coverages (average earnings over interest requirements) but where certain companies have stock values far in excess of others (and better bond yields as well!), and suggest that these companies are clearly better choices as debt investments.

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