Wednesday, August 20, 2008

Security Analysis: Chapter 51

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

In this chapter, the authors discuss price discrepancies among senior issues selling at speculative levels, and across various types of securities, demonstrating that the market can be woefully inaccurate in its valuations.

Seasoned issues, defined as senior securities of companies the public has known for a long period of time, have a certain price inertia to them. Many buyers of these issues simply bought by reputation, rather than sound financial analysis. Therefore, despite degradation in the statistical exhibit of the bonds, these investors do not sell them readily, resulting in high valuations.

On the other hand, any adverse development will result in a severe decline for unseasoned issues, defined as senior securities of companies which are relatively new. Therefore, the authors advise against participating in the purchase of new senior issues for companies with relatively short statistical exhibits.

Although this may suggest that unseasoned issues may be purchased after an overreaction to an adverse development, the authors caution against this modus operandi. Usually, such companies have not been around long enough to prove they can weather economic downturns, and furthermore, the authors point to their research disclosed in an earlier chapter that companies of dominant size are best able to maintain strong financial status through such downturns.

The authors also demonstrate comparisons of senior issues, offering advice on when one security should be exchanged for another. Care is advised in such situations, and investors are warned not to exchange simply due to a slightly higher performing statistical exhibit of past results. The only time a switch between senior securities should occur is when the issue to be purchased is attractive absolutely (not just relatively), or if there is a definite relationship between the securities being exchanged. This latter group can include switches across categories of securities, e.g. a cumulative preferred with a large dividend backlog trading below the common of the same company.

Finally, the authors note some rather striking price disparities that occur due to supply and demand factors of market players which result in hedging opportunities.

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