Ideas of Graham and Dodd - Part VII (Last Part)

25-9-06

PART VII

DISCREPANCIES BETWEEN PRICE AND VALUE

Page 684

Since we have emphasized that analysis will lead to a positive conclusion only in the exceptional case, it follows that many securities must be examined before one is found that has real possibilities for the analyst. By what practical means does he proceed to make his discoveries?


Page 685

A quick glance at a hundred of such reports may reveal between five and ten that look interesting enough from the earnings or current-asset standpoint to warrant more intensive study.


Page 691

Yet judging from observations made over a number of years, it would seem that investment in apparently undervalued common stocks can be carried on with a very fair degree of over-all success, provided average alertness and good judgment are used in passing on the future-prospect question- and provided also that commitments are avoided at times when the general market is statistically much too high.

Page 692

Market Behavior of Standard and Nonstandard Issues

Standard or leading issues almost always respond rapidly to changes in their reported profits-so much so that they tend regularly to exaggerate marketwise the significance of year-to-year fluctuations in earnings.

The action of less familiar issues depends largely upon what attitude is taken towards them by professional market operators. If interest is lacking, the price may lag far behind the statistical showing. If interest is attracted to the issue, either manipulatively or more legitimately, the opposite result can readily be attained, and the price will respond in extreme fashion to changes in the company’s exhibit.

Page 694

Market exaggerations Due to Factors Other than Changes in Earnings

The inveterate tendency of the stock market to exaggerate extends to factors other than changes in earnings. Overemphasis is laid upon such matters as dividend changes, stock split-ups, mergers and segregations.

An increase in the cash dividend is a favorable development, but it is absurd to add $20 to the price of a stock just because the dividend rate is advanced from $5 to $6 annually.

The excited responses often made to stock dividends are even more illogical, since they are in essence nothing more than pieces of paper. The same is true of split-ups, which create more share but give the stockholder nothing he did not have before-except the minor advantage of a possibly broader market due to the lower price level.

Page 695

Wall Street becomes easily enthusiastic over mergers and just as ebullient over segregations, which are the exact opposite.

The exaggerated response made by the stock market to developments that seem relatively unimportant in themselves is readily explained in terms of the psychology of the speculator. He want “action,” first of all; and he is willing to contribute to this action ie he can be given any pretext for bullish excitement.

The tendency of Wall Street to go to extremes is illustrated in the opposite direction by its tremendous dislike of litigation.

Page 707

…the analyst should not urge a security exchange unless either (1) the issue to be bought is attractive, regarded by itself, or (2) there is a definite contractual relationship between the two issues in question.

Page 713

Market Analysis and Security Analysis

Forecasting security prices is not properly a part of security analysis.

However, the two activities are generally thought to be closely allied, and they are frequently carried on by the same individuals and organizations.

Endeavors to predict the course of prices have a variety of objectives and a still greater variety of techniques.

If as many believe, one can dependably foretell the movements of stock prices without any reference to the underlying values, then it would be sensible to confine security analysis to the selection of fixed-value investments only.

Many other people believe that the best results can be obtained by an analysis of the market position of a stock in conjunction with an analysis of its intrinsic value. If this is so, the securities analyst who ventures outside the fixed-value field must qualify as a market analyst as well and be prepared to view each situation from both standpoints at the same time.

Page 714

(Graham and Dodd recognized the existing practice of market analysis in a separate chapter and offered their views on various methods of market analysis in use at that time [around 1940]).

Two Kinds of Market Analysis

A distinction may be made between two kinds of market analysis. The first finds the materials for its predictions exclusively in the past action of the stock market. The second considers all sorts of economic factors, e.g., business conditions, general and specific; money rates; the political outlook.

Those who devote themselves primarily to a study of these price movements are know as “chartists,” and their procedure is often called “chart reading.”

Page 715

It must be realized that the vogue of such “technical study” has increased immensely during the past fifteen years.

Such consideration, we believe should lead to the following conclusions:

1. Chart reading cannot possible be science.
2. It has not proved itself in the past to be a dependable method of making profits in the stock market.
3. Its theoretical basis rests upon faulty logic or else upon mere assertion.
4. Its vogue is due to certain advantages it possesses over haphazard speculation, but these advantages tend to diminish as the number of chart students increases.

Page 716

The past earnings of a company supply a useful indication of its future earnings-useful, but not infallible. Security analysis and market analysis are alike, therefore, in the fact that they deal with data that are not conclusive as to the future. The difference, as we shall point out, is that the security analyst can protect himself by a margin of safety that is denied to the market analyst.

Page 718

The Second type of Mechanical Forecasting

As far as the general market is concerned, the usual procedure is to construct indices representing various economic factors, e.g., money rates, car loadings, steel production, and to deduce impending changes in the market from an observation of a recent change in these indices.

Page 719

Broadly speaking, therefore, the endeavor to forecast security-price changes by reference to mechanical indices is open to the same objections as the methods of the chart readers. They are not truly scientific, because there is no convincing reasoning to support them and because, furthermore, really scientific i.e., entirely dependable) forecasting in the economic field is logical impossibility.

Page 721

Prophesies based on Near-term Prospects

A good part of the analysis and advice supplied in the financial district rests upon the ner-term business prospects of the company considered. It is assumed that, if the outlook favors increased earnings, the issue should be bought in the expectation of a higher price when the larger profits are actually reported. In this reasoning, security analysis and market analysis are made to coincide.

If markets generally reflected only this year’s earnings, then a good estimate of next year’s results would be of inestimable value. But the premise is not correct.

(over the period 1902-1927), it is difficult to establish any definite correlation between fluctuations in earnings and fluctuations in market quotations (of United States Steel Corporation common).

Page 722
We are skeptical of the ability of the analyst to forecast with a fair degree of success the market behavior of individual issues over the near-term future-whether he base his predictions upon the technical position of the market or upon the general outlook for business or upon the specific outlook for the individual companies.

More satisfactory results are to be obtained, in our opinion, by confining the positive conclusions of the analyst to the following fields of endeavor (in case of equity shares):

The discovery of common stocks, or speculative senior issues, that appear to be selling at far less than their intrinsic value.
The determination of definite price discrepancies existing between related securities, which situations may justify making exchanges or initiating hedging or arbitrage operations.


Comments by KVSSNRAO

The second edition of Graham and Dodd published in 1940 is a 851 page book. The important ideas related to equity investment are presented in seven parts by me. I hope the readers of these seven parts will take up reading the full book of Graham and Dodd to understand the methodology of analysis advocated by them for investors and analysts. They made a brief comment that their analytical method can be used by small investors also but they advised the investor to consult a professional analyst for approval of his analysis. But as they repeated mentioned (it was there in one of the parts), an investor has to study a number of securities to find the one that satisfies their conditions. It is difficult for the investors to do analysis themselves. It will be more practical, if investors are given the responsibility to study the equity research report prepared by the analysts and agree with its analysis based investor’s knowledge of the analytical method. The simplicity of Graham and Dodd’s security analysis would be of immense help in this regard. Graham-Rao method is one of the attempts in this context.