Ideas, Opinions and Thoughts from Graham and Dodd - part II

From Graham and Dodd, Second Edition

Page 57

Investment or investing, … is “a word of many meanings.” Of these three will concern us. The first meaning, or set of meanings, relates to putting or having money in business. …
It accepts rather than rejects element of risk – the ordinary business investment is said to be made “at the risk of business.”
The second set of uses applies the term in a similar manner to the field of finance. In this sense all securities are “investments.” We have investment dealers or brokers, investment companies or trusts, investment lists. Here, again, no real distinction is made between investment and other types of financial operations such as speculation. It is a convenient omnibus word, with perhaps an admixture of euphemism - i.e., a desire to lend a certain respectability to financial dealing of miscellaneous character.

Alongside of these two indiscriminate uses of the term “investment” has always been a third and more limited connotation-that of investment as opposed to speculation.

Page 62 & 63

A Proposed Definition of Investment

An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculation.

The phrases thorough analysis, promises safety and satisfactory return are all chargeable with indefiniteness, but the important point is that their meaning is clear enough to prevent serious misunderstanding.

By thorough analysis we mean, of course, the study of the facts in the light of established standards of safety and value.

The safety sought in investment is not absolute or complete; the word means, rather protection against loss under all normal or reasonably expected conditions or variations. A safe bond for example, is one which could suffer default only under exceptional and highly improbable circumstances. Similarly, a safe stock is one which holds every prospect of being worth the price paid except under quite unlikely contingencies. Where study and experience indicate that an appreciable chance of loss must be recognized and allowed for, we have a speculative situation.

Page 64

“Satisfactory” is a subjective term; it covers any rate or amount of return, however low, which the investor is willing to accept, provided he acts with reasonable intelligence.

It may be helpful to elaborate our definition from a somewhat different angle, which will stress the fact that investment must always consider the price as well as the quality of the security.

…in our opinion the great majority of common stocks of strong companies must be considered speculative during most of the time, simply because their price is too high to warrant safety of principal in any intelligible sense of the phrase.

… we shall embody our principle in the following additional criterion of investment:

An investment operation is one that can be justified on both qualitative and quantitative grounds.

Page 66

Both investment and speculation must meet the test of the future; they are subject to its vicissitudes and are judged by its verdict.

For investment, the future is essentially something to be guarded against rather than to be profited from. If the future brings improvement, so much the better; but investment as such cannot be founded in any important degree upon expectation of improvement. Speculation, on the other hand, may always properly-and often soundly-derive its basis and its justification form prospective developments that differ from past performance.

Types of investments

It might be useful if some descriptive adjective were regularly employed, when care is needed, to designate the particular meaning intended. Let us tentatively suggest the following:

1 Business investment – Referring to money put or held in a business
2 Financial investment or investment generally – Referring to securities generally
3 Sheltered investment – Referring to securities regarded as subject to small risk by reason of their prior claim on earnings or because they rest upon an adequate taxing power.
4 Analyst’s investment – Referring to operations that, upon thorough study, promise safety of principal and an adequate return.

Unless we specify otherwise, we shall employ the word “investment,” and its relatives, in the sense of “analyst’s investment,” as developed in this chapter.

Page 68

It is important to recognize that such value (intrinsic value) is by no means limited to “value for investment”- i.e., to the investment component of total value-but may properly include a substantial component of speculative value, provided that such speculative value is intelligently arrived at. Hence the market price maybe said to exceed intrinsic value only when the market price is clearly the reflection of unintelligent speculation.

Generally speaking, it is the function of the stock market, and not of the analyst, to appraise the speculative factors in a given common-stock picture. To this important extent the market, not the analyst, determines intrinsic value. The range of such appraisal may be very wide, as illustrated by our former suggestion that the intrinsic value of J.I. Case common in 1933 might conceivably have been as high as 130 or as low as 30. At any point between these broad limits it would have been necessary to accept the market’s verdict-changeable as it was from day to day-as representing the best available determination of the intrinsic value of this volatile issue.