Monday, July 7, 2008

Security Analysis: Chapter 6

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

Having divided the various types of securities into the three categories described in the preceding chapter, Graham and Dodd delve into selection criteria for the first category of securities: Fixed Income Investments.

The authors take issue with how conventional wisdom has propagated the myth that fixed income instruments are by their nature safe investments. The authors argue for a more critical attitude toward bond selection than is currently done. Though they concede fixed income instruments are senior claims (to equity instruments), they argue that “neither priority nor promise is itself an assurance of payment”.

As fixed income instruments do not get to participate in the upside of the business, investors in such instruments need to be absolutely convinced in the ability of the company to pay its obligations.

Therefore, they view fixed income selection as a “negative art”, where investors look for reasons not to invest, throw those securities out, and are thus left with those worth investing in. Since there is little upside in these securities, the idea is to avoid any downside.

With this approach in mind, Graham and Dodd lay out the first of four principles to further guide the investor in selecting fixed income instruments: A lien is worth little

This principle goes against conventional wisdom. However, Graham and Dodd argue that in practice, the equipment/plant/property used to borrow against undergoes great devaluation at the same time as the company undergoes its business problems, thereby reducing the usefulness of a lien. Furthermore, they argue (and back up with examples) that delays and difficulties in asserting bondholders’ legal rights further render this lien almost worthless.

From this, it follows that if it is clear that a company can cover its obligations, investors should choose the security with the highest yield, however junior. If it is not clear that a company can cover its obligations, then a substantial yield advantage is required to go with the junior security.

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