Sunday, August 24, 2008

Security Analysis: Chapter 52, Part II, Conclusion of Book

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

In the latter half of this the final chapter, the authors discuss the second type of market analysis as defined earlier. This type of market analysis involves using factors outside of the stock market (e.g. interest rates, steel production) in order to attempt to predict the movement of prices.

The authors discuss various methodologies that have been used as predictors, including one that suggested security prices had reached a bottom when aggregate blast furnace use ran at 60% of capacity, and another that theorized that bond prices reached a high 14 months after a low point in pig-iron production.

Some of the methods employed derive their adoption due to the fact that they are vaguely plausible (for example, it is an agreeable thing to say that a rise in interest rates will lead to a sharp decline in stock prices), and they rely on the fact that they have worked in the past. On this final point, the authors argue that once again this form of market analysis suffers from the same drawbacks as those of chart reading (the past does not necessarily equal the future).

Though security analysis is also an art, as the analyst must often rely on his knowledge and ability, security analysis has the advantage over market analysis. In market analysis, there are no margins of safety. The price either goes up, or it goes down. In security analysis, the investor can protect himself such that even if the results are negative, the purchase might still prove satisfactory.

Furthermore, the market analyst requires constant buying and selling. Therefore, transactional costs have a taxing effect on overall results.

A third disadvantage is that success in market analysis requires one to win a battle against others who are also employing market analysis. The security analyst, on the other hand, is not usually buying and selling from someone who has carried out a similar analysis. Therefore, the market analyst is counting on being more clever than his competitors.

Finally, the authors discuss the prevailing opinion on Wall Street that a favourable short-term outlook for a company should result in positive stock movements. However, this line of reasoning does not take into consideration that such outlook is already baked into the stock price. Should an analyst prove particularly successful as compared to others in determining the outlook, he is still making the assumption the current stock price is reflective of its intrinsic value.

Thus ends the final chapter of Security Analysis. An appendix of approximately 80 pages follows which describes various examples to help illuminate points that have been made throughout the book.

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