Sunday, July 27, 2008

Security Analysis: Chapter 26

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

In this chapter, the authors discuss investing in senior securities of questionable safety, for the purpose of achieving gains in principal. Of course, such securities must be trading at discounts to their par values, and even under great recoveries, they can not go much higher than par. As such, they have an upper bound that stocks do not have. Graham and Dodd argue that such a ceiling is not a real drawback in practice, since gains achievable on stocks much higher than they are on bargain bonds lend themselves to over exuberance.

The authors argue that bonds trading at bargain prices can be looked at in relation to two different viewpoints: 1) fixed-income standards (as discussed in previous chapters) and 2) stock standards (to be discussed in the next few chapters). The common stock standard is the approach the authors believe to be more fruitful, as it offers a more thorough understanding of the corporate picture.

Therefore, the authors do not discuss separate standards just for investing in fixed-income for gains (since investors can apply the framework for stocks that will be discussed in the next section). Instead, they offer some important distinctions between stocks and senior issues from the point of view of an investor looking for principal appreciation.

Senior issues derive important advantages over stocks due to their contractual rights. The obligation of a company to pay interest, no matter how difficult, is one such advantage. The authors also demonstrate the importance of net quick asset coverage over the senior issue as a gauge of the safety of a senior issue.

Finally, investors are warned about the lack of safety in preferred stocks, and how the market treats them quite paradoxically. Often, preferreds of companies in trouble can have accumulated large dividends, and the market tends to overemphasize the value of these securities as a result. The authors put forth a principle that the market value of preferred shares (or any type of security for that matter) cannot be more than what the market value of common stock would be of this same company if there were no securities more senior than common.

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