Tuesday, July 29, 2008

Security Analysis: Chapters 27 and 28

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

In these chapters is discussed the theory of common stock investment. The authors state that for the typical public company, it is very difficult to tell whether a stock is currently over- or under-priced. However, there are nevertheless many individual cases whereby this answer is clear (to be discussed specifically in later chapters).

A divergence of public behaviour when it comes to stock analysis is discussed. Before the roaring 1920s, stocks were valued in a similar manner to investments in private enterprises: an investor would consider the asset values, the earnings history, and a determination of the company's weaknesses in being able to continue its business going forward.

At a certain point during the 20s, however, investment turned into speculation. Asset values and earnings power were seen to have no relationship, and past earnings were used only as a measuring stick against future earnings (and this "trend" used to extrapolate dangerously into the future).

Furthermore, stocks of a certain breed, termed "blue chips", were viewed as good investments regardless of price. As "investors" paid no attention to price, stocks continued to rise, and as they rose, arguments were laid forth that stock purchases were the fastest path to prosperity, since the historical record served as proof.

The authors make it clear that price is an integral part of any stock investment. Furthermore, they will go so far as to say diversification is also an integral part of investment. Purchasing just one or two securities, even on sound principles, is speculative because the buyer cannot be sure of the results, whereas with diversification along with sound principles, there is reasonable assurance of returns.

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