Friday, July 25, 2008

Security Analysis: Chapters 22, 23, 24 and 25

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

In the next several chapters, the authors discuss the purchase of senior issues not for fixed-income (which was covered in the last several chapters) but instead for capital gains. But first,
Graham and Dodd demonstrate by example that hybrids between fixed-income and investments in senior securities for gains do exist. Because the market is inefficient, sometimes securities which do fall under all the fixed-income requirements discussed in previous chapters still sell for bargains.

In these four chapters, securities which have large upsides due to conversion privileges are discussed. These securities are the most attractive in form of any security, as they enjoy the seniority of bonds with the upside of stocks. However, their track records have been less than stellar. Graham and Dodd surmise that this is due to the fact that it is companies which are in trouble that need to enhance offerings in such manner in order to induce investment.

The authors argue that if a convertible security sells close to par, then it must meet either the criteria for fixed-income investment (as discussed in previous chapters), or for stock investment (to be discussed in later chapters). If the investor relaxes certain requirements because the issue is convertible, he will find himself in trouble. Whether the investor purchased the security from the point of view of a fixed-income investment or from the point of view of gains also determines when he should sell. For example, someone who bought a convertible under the criteria of fixed-income at $100 has no business holding onto the security to $150, as this has now become a speculative issue, and so his downside is no longer protected.

Finally, the authors examine various criteria of privileged securities which add or remove the relative attractiveness of a security: namely, the extent of the profit-sharing, the proximity the security is to achieving those profits, and the duration of the privilege (the longer the duration, the larger the chance that the conversion will yield a profit). Within this discussion, the relative merits of participating (debtholders receiving dividends along with stockholders) vs convertible (debtholders switch to stockholders) vs warrants (debtholders remain as such, but also receive stock) are also discussed.

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