Monday, August 18, 2008

Security Analysis: Chapter 50

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

Throughout the book thus far, the authors have repeatedly demonstrated (through example) various companies that the markets have under and over valued. The authors discuss the various types of mistakes that the market makes in the cases where its valuations are errant, namely: exaggeration, oversimplification, or neglect.

Graham and Dodd offer a simple way to beat the market by taking advantage of cyclical price swings: purchase a diversified group of leading common stocks when P/E multiples are below 10, and sell them at 15. Psychologically, humans have a very difficult time implementing this in practice. For example, this strategy would have called for purchasing stocks during the downturn of 1921, and selling out in 1925, missing out completely on the incredible bull market of 1927-29. Furthermore, it would have called for purchasing again in 1931, at which point market values were to continue to contract by a large margin.

While leading companies are only subject to undervaluation during times when the market is pessimistic, the authors suggest that at all times there will be several less prominent stocks selling at discounts. In fact, during times when market leaders are cheap, less prominent stocks will often sell for cheaper. At the same time, stocks which are less prominent may also attain valuations far higher than they otherwise would. In general, such stocks have valuations which are exaggerated in either direction. This phenomenon is demonstrated using several examples.

The authors also discuss market exaggerations of the following events: dividend changes, stock splits, mergers, and break-ups. Although an increase in the cash dividend is favourable, in most cases the market is willing to pay such a higher premium for the stock that buyers no longer benefit from the increase in the dividend! Stock splits, on the other hand, result in share price increases despite giving the stockholder absolutely nothing he did not have before!

On the issue of mergers and acquisitions, the authors offer the following quote:

“Wall Street becomes easily enthusiastic over mergers and just as ebullient over segregations, which are the exact opposite. Putting two and two together frequently produces five in the stock market; and this five may later be split up into three and three.”

The authors believe psychology plays a large role in these seemingly non-sensical market movements. The investor wants action, and he is willing to contribute to this action if there is any bullish sentiment whatsoever.

On the negative side, Wall Street will often punish stocks far more than is warranted during litigation. Examples are offered where at worst the litigation would have caused damage to a company far less than the stock had been punished by the market.

Finally, the discussion returns to one which took place in the chapters on fixed-income investments. There, it was discussed that if a company should enter receivership, the value of the bonds will often far well below the value of the company’s assets minus its liabilities. Therefore, companies in receivership are pointed out as another area where the market unjustly punishes issues, and thus offer the investor another avenue in which to find value.

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