Tuesday, July 15, 2008

Security Analysis: Chapters 12 and 13

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

In Chapters 12 and 13, Graham and Dodd discuss various special factors to be aware of when it comes to making a purchase as a fixed-income investment.

The authors suggest that investors in this type of security do not need to be experts in the business. If the investor is uncertain about the ability of the business as a going concern, he should simply demand higher interest coverage and higher residual value requirements (as discussed in Chapters 10 and 11), rather than attempt to analyze industry metrics he knows nothing about.

When calculating interest coverage, investors should be sure to include depreciation as a prior fixed charge. In order for the business to survive, it must maintain its capital assets, and as such it is not free to spend its maintenance requirements on interest charges. The authors scold the investment banking industry for skirting this issue, and discuss examples where bond issue prospectuses are on the verge of fraud as interest coverage is calculated without subtracting depreciation expenses.

Graham and Dodd are also unimpressed with the way junior debt interest coverage is calculated. As discussed in Chapters 8 and 9, interest coverage should be determined by using total debt as the denominator, and not junior debt in the denominator with a senior charge against the numerator. The following example illustrates the argument:

Operating Income.........................1,000
Senior Debt Interest........................400
Junior Debt Interest........................100

The authors argue that junior interest coverage should be calculated as follows: 1000 / (400 + 100) = 2. However, in order to dupe the public into buying this issue, many banks would subtract the senior charge from the operating income first, and then divide by the junior charge as follows: (1000 - 400) / 100 = 6. This suggests interest coverage for the junior debt is higher than that of the senior debt, which is ridiculous since the senior charge will always take precedent.

The authors argue that the finance industry also tends to make companies look like they're in stable industries even when they are not. Investors are cautioned and asked to think critically about the industries in which they are investing, and to once again consider the business as it is in times of depression, as discussed in Chapter 7, Part I, rather than accept at face value the statements of the investment banks.

Readers are also warned to include as fixed charges any preferred stock of subsidiaries, since these often act senior to the parent's bonds: before a subsidiary can pay its parent company, it has to pay its pref shares.

Graham and Dodd also caution investors to subtract income owed to minority interest from operating earnings in order to calculate earnings that can be used to pay debt interest. On most income statements, minority interest is subtracted only after debt interest charges.

Finally, in calculating debt to stock ratios (in order to determine if there is an adaquate residual value above the debt as a margin of safety), debt should include capitalized fixed charges (e.g. operating leases). This is done by discounting all future lease obligations to a present value.

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