Security Analysis: Chapter 5

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

Graham and Dodd begin this chapter by arguing that securities often do not fall into the standard categories of bonds and stocks. They cite examples of convertible issues, callable issues, participating preferreds, and other non-standard securities that are not adequately represented by their titles.

To remedy this, Graham and Dodd reclassify all securities into the following categories:

1) Fixed-Value Type: Containing high-grade bonds and preferreds
2) Senior Securities of Variable Value: Convertibles or low-grade fixed income
3) Common Stock

They go on to argue that securities of the can fall in different categories despite having the same title. For example, a convertible bond, where the conversion takes place at a remote price,would fall in Category 1, but a convertible bond that trades at a level where investors are expecting to convert, would fall into Category 3.

Part I, which lays out the justification, resources, and methods for the analyst with which to think about securities, is thus complete. The reader is now ready to delve into the analysis of "fixed-value" investments.

Onto Chapter 6

Are Home Builder Write Downs Complete?

Last week we heard quite an optimistic statement from Stuart Miller, CEO of Lennar, a billion dollar (for now!) US home builder:

"...aggregate levels of impairment and losses are more the nature of clean up rather than reconciliation to unknown market conditions. We have done the heavy lifting on impairment and are now situated with stated assets that can and will produce improving margins when the rate of declining market pricing subsides. We are very confident that even with continued degradation of market conditions our stated asset base will not suffer nearly the levels of impairment we saw in 2007." (source: SeekingAlpha.com)

This suggests Lennar has taken a big bath, and decided to write down inventory to the point where they actually make a "profit" on home sales. Nevertheless, it's impossible for Miller to know just how far the market will degrade. We saw here that home prices continue to fall. Obviously, they won't fall forever, but who knows whether they'll turn up next month or drop for more than two years. Miller is obviously making some sort of prediction that prices won't drop below a certain level, which is strange, considering some of the other comments on that same conference call:

"The housing market has continued to deteriorate throughout the first half of 2008 and as I noted in our press release this morning we expect this trend is going to continue for at least the remainder of the year."

"Demand patterns are inconsistent and erratic and we find that there is a constant and increasing flow of foreclosures that are maintaining downward pressure on prices and appraisals. In many markets it is apparent that the flow of foreclosed homes is expanding rather than subsiding."

"I am asked regularly as to whether or not we are at the bottom. I feel overall that we are not there yet."

Miller most likely knows more about Lennar than anybody, however, and as such, perhaps he has reliable indicators that suggest prices won't drop below a certain level. In the same call, he did note that inventory levels have been declining, and that construction costs are as much as 20% lower, allowing Lennar to produce homes more cheaply, with less homes coming online in the market (suggesting an increase in pricing power for builders).

While Miller may believe the bulk of write downs has already taken place, I believe it's irresponsible of him to state that "even with continued degradation of market conditions our stated asset base will not suffer nearly the levels of impairment we saw in 2007.", as this could dupe investors. Nobody knows how bad (or how good, to be fair) market conditions will be, so it is premature to make this call before prices have stabilized on the way down.

Reinvest Dividends to Protect your Portfolio:

For patient investors, dividends that are reinvested in their originating securities can have a dramatic positive effect on investment performance. I like reinvesting dividends because 1) many brokerages offer this as a free service (known as DRIP or a dividend reinvestment plan), 2) it imparts the discipline of buying more shares regardless of a stock price drop and 3) new shares are acquired without requiring outside funds. In this article I will illustrate how reinvesting dividends in the original stock can enhance the returns of an investment if the stock price has dropped substantially.

When a stock price undergoes a severe price drop, an unaltered dividend payout will result in a dramatically higher dividend yield. For example, if a stock pays a $5 dividend with a $100 stock price, the dividend yield is 5%. If the stock price falls by 50% to $50, the new dividend yield would be a lofty 10%. With a higher dividend yield, a higher percentage of shares can be accumulated from the dividend payout than previously possible. It is these extra shares that will enhance the returns on your investment once the share price recovers. Of course, if the share price continues to decline over a long holding period, you would have done better to not reinvest the dividends. Hopefully with diligent value investing, you won't be in that situation.

Consider a stock that sells for $100 per share, pays a $5 dividend and has an intrinsic value of $151.5 per share. Suppose you buy the security with a 33% margin of safety making your entry price $100 (.66 x $151.5 = $100). If the stock price falls in the first year by 50% to $50 per share and takes another eight years to reach its intrinsic value of $151.5 per share, how would the dividend reinvestment strategy fare? The results are in presented in Table 1.

Table 1: Investment results with "stock A" after 8 years with a share dividend reinvestment strategy and having a year 1 price drop of 50%

The new shares represent the extra shares added from dividend reinvestments and the excess cash is the amount of cash left over after purchasing as many whole shares as the dividends allow in a given year. For this dividend reinvestment model it is assumed that the excess cash distributed does not generate interest. The intrinsic value of the company is reached with the stock price in the eighth year of the investment. The astounding observation is that even with a 50% price decline in the first year a patient investor who reinvests dividends would be rewarded with a total compounded return of 11.6% per annum after 8 years.

What if the stock price had only steadily climbed throughout the 8 years and we had reinvested the dividends in stock purchases under similar conditions as before? The results of this model are presented in Table 2.

Table 2: Investment results with “stock A” after 8 years with a share dividend reinvestment strategy and a steadily increasing stock price

The investment held for the full eight years modeled in table 2 yields a compounded return of 9.4% per annum. It’s remarkable to observe that the dividend reinvestment strategy with the sharp stock price decline outperforms the scenario of a steadily increasing stock price. The sharp price decline scenario produced an extra $3,590 or 17.5% over the eight years. This demonstrates how reinvesting dividends can protect your portfolio against early stock price drops and rewards patient long-term investors.

In the book “The Future for Investors”, Jeremy Siegel explains how reinvesting dividends can protect your portfolio against bear markets and help enhance returns of a portfolio. Perhaps the most compelling example that Jeremy illustrates is during the era of the Great Depression. In his book he shows that long term investors that allowed dividends to reinvest in the market would have fared much better with the Great Depression than if the Great Depression had never occurred and share prices and dividend yields had remained stable.

Stock price declines in companies that survive and thrive in the long-term are opportunities to acquire more shares at cheaper prices. For the long-term investor, an automatic dividend reinvestment plan will provide some protection against bear markets and enhance your portfolio returns when prices cycle back up.

Security Analysis: Chapters 3 and 4

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

In Chapter 3, Graham and Dodd delve into the informational sources that are available to the analyst. Annual reports, interim reports, trade journals, and company filings with regulatory authorities are all sources of various kinds of relevant information.

The authors also encourage investors to ask management for information they feel they are entitled. It's important for the investor to recognize that he is after all the owner, and management should be providing him with the information he needs. The authors reveal from experience that even the most tight-lipped of management are willing to divulge of information that their competition readily provides.

In Chapter 4, the authors attempt to define the differences between investment and speculation. They argue against some conventional definitions: specifically, that investments cannot be made on margin, require immediate income, and are in safe securities. For example, they argue that buying a wide array of unsafe securities below liquidation value can be sound investment practice, but nevertheless involve unsafe securities.

Onto Chapter 5

It's got profits! But is it profitable?

Let's say Company A and Company B both make $1000 / year, and have been growing their profits at 10% per year. Company A and Company B are in the same industry and are similar, except for the fact that Company A has assets worth $500, while Company B has assets of $2000. Assuming they were selling for the same price, which company would you rather own?

It may seem like Company B is more desirable. After all, who wouldn't want to own $2000 worth of assets rather than $500? But actually, if you believe in the growth prospects of this industry, Company A is the better investment! It comes down to "return on assets" (which is sometimes substituted for it's cousin, return on invested capital), which is a measure of what kind of return an investor gets on his money.

For each dollar Company A invests in its assets, it gets $2 in earnings, while Company B only manages 50 cents. If these companies were to grow their earnings by $100 this year, the owner of Company A would only have to invest $50 for that return. On the other hand, the owner of Company B would have to invest $200, which eats up quite a chunk of his $1000 profit.

All too often, investors see growth in a company's future, but fail to consider the costs of that growth. All companies require investments in assets in order to support growth, whether it's in the form of fixed assets, accounts receivable or inventory. The companies with the best return on assets (or return on invested capital) are the ones that reward their investors with cash, not just paper profits.

Security Analysis: Chapter 2

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

In Chapter 2, Graham and Dodd start out by identifying four factors which the analyst should consider before making a decision on a purchase:

The Security: What exactly is being purchased
The Price: To avoid paying too much
The Time: Timing can change a valuation, e.g. if interest rates change
The Person: What makes sense for a businessman may not for a widower.

In evaluating the security, it is not enough to simply consider the issuing company and industry. The authors take us through examples of great companies in solid industries where the securities were on unfavourable terms, thus duping investors.The authors argue with conventional wisdom which suggests that it's better to invest in an unattractive security with an attractive company than an attractive security with an unattractive company...for the trained analyst.

Finally, the authors discuss how an analysis can be divided into two components: qualitative and quantitative. They argue that qualitative factors are far more difficult to analyze, and that projecting the trend of the past into the future, which many consider to be a quantitative action, is actually a qualitative one. Projecting trends will either overvalue or undervalue the security, as qualitative factors are often overestimated. The authors use the example of "good management" as a factor that is given double the credence: first in the company's earnings, and then again as an added qualitative factor.

Nevertheless, a proper analysis must consider both quantitative as well as qualitative factors. The authors demonstrate this with an example showing one company's coverage ratios being higher than another over the past decade, yet because of its industry, the security with the lower coverage ratio is still the more attractive issue.

Onto Chapter 3

Security Analysis: Chapter 1

Security Analysis by Ben Graham and David Dodd is a must read for anyone serious about value investing. Here follows a review of the first chapter.

The authors provide justification for the rest of the book. They are unimpressed with the "pseudo-analysis" that has taken place throughout the boom and bust of the late 20s and early 30s. They offer examples as to how investors of sound practice would have actually profited from market events of that time period.

They introduce the concept of intrinsic value, suggesting that each stock has an intrinsic value that is independent of its market price. Nevertheless, there are challenges with determining what the precise intrinsic value is, however, it can be estimated within certain ranges. Some companies will have wider ranges than others. Nevertheless, the idea is to find companies where the market price is below the bottom of this range, and the authors offer various examples of this having occurred in the market.

The authors go on to separate obstacles to successful analysis into three categories:

1. Inadequate or Incorrect Data
2. Uncertainties of the Future
3. Irrational Market Behaviour

A model suggesting the relationship between intrinsic value and market value is discussed, attempting to show how market prices are influenced by a variety of factors unrelated to intrinsic value (e.g. psychological factors).

Finally, arguments are made against "speculation" as opposed to investing. In speculation, there are far more elements of chance involved, which make it unclear whether success is the result of sound behaviour or the result of chance. Frequent trading also results in high fees...the odds are thus stacked in favour of the house, as it is on a roulette table.

Onto Chapter 2