Friday, July 11, 2008

Security Analysis: Chapters 8 and 9

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

As discussed in Chapter 6, choosing fixed-income securities is an exercise in exclusion. You start with a basket of possibilities, and discard those which do not meet a certain set of requirements. In these two chapters, and the two that follow, Graham and Dodd go into the details of what those requirements should be.

The most important requirement deals with earnings coverage, i.e. how well earnings cover the interest requirements of the company. There are three components to earnings coverage for an issue that the authors define:

1) The methodology for it's calculation
2) Its minimum requirements
3) The period of time we are interested in knowing earnings coverage

Graham and Dodd argue that the earnings coverage calculation of even the most senior debt should equal earnings over total interest, where total interest includes even the most junior interest obligations. They also argue for definite minimum coverage requirements that vary by industry. In order to avoid looking at only prosperous years for the company, the authors suggest using a length of time commensurate with including recessionary years.

The authors argue that a company's size is a determinant factor in its ability to pay off its debts, based on knowledge of the past, as discussed in Chapter 7, Part I. Small companies are more vulnerable to the unexpected, and lack strong banking connections and technical resources. Nevertheless, size is far from a guarantee of safety, and therefore a security must pass several more tests.

The authors argue against those who would ignore securities in certain industries or countries. Although more care has to be given to ensure larger safety margins in certain industries, to blanket out certain industries would leave the investor with too little to choose from, and thus encourage the purchase of weak securities simply because the company is a utility or in some other stable industry. In the same way, investments in many countries have proven to be unsound, but the authors argue that certain countries are proven to be safe and investors should not count these out.

The authors are also against throwing out securities without liens to fixed assets. As discussed in Chapter 6, in practice, debts secured against assets are of little value versus debts that are unsecured.

Often, investors will not have as stringent requirements for bonds of shorter maturity due to the fact that principal repayment is just around the corner, and so there are less years for something to go wrong with the company. Graham and Dodd argue that this is a mistake, since the company has the added burden of having to refinance fairly quickly, and thus must not have anything go wrong during this period. They therefore find no reason to differentiate between bonds of long and bonds of short maturity periods.

The authors also disagree with conventional wisdom that only companies that pay dividends should qualify as fixed-income investments. Though companies that pay dividends are often more successful than those that do not (since they can afford to pay out), often many companies are actually worse-off by paying out dividends that dwindle the company's financial resources, thus making them less attractive to bond holders.

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