Important Points from Graham and Dodd - Part IV

20-9-2006

Page 368

Selection based on Margin-of-Safety principle – If the analyst is convinced that a stock is worth more than he pays for it, and he is reasonably optimistic as to the company’s future, he would regard the issue as a suitable component of a group investment in common stocks.

Page 372

A natural classification of the elements entering into the valuation of a common stock would be under the three headings:

The dividend rate and record
Income account factors (earning power)
Balance sheet factors (asset value)

Page 402

…the Wall-Street method of appraising common stocks has been simplified to the following standard formula:

Find out what the stock is earning. (This usually means the earnings pre share as shown in the last report.)
Multiply these per-share earnings by some sutable ‘coefficient of quality” which will reflect:

the dividend rate and record
the standing of the company-its size, reputation, financial position, and prospects.
The type of business 9e.g., a cigarette manufacturer will sell ast a higher multiple of earnings than a cigar company).
The timer of the general market. (Bull-market multipliers are larger than those used in bear markets.)

The foregoing may be summarized in the following formula:
Price = current earnings per share * quality coefficient1
(Foot note 1 on page 403 Where there are no earnings or where the amount is recognized as being far below “normal,” Wall Street is reluctantly compelled to apply what is at bottom a more rational method of valuation, i.e., one ascribing greater weight to average earning power, working capital, etc. But this is the exceptional procedure.)

The result of this procedure is that in most cases the “earnings per share” have attained a weight in determining value that is equivalent to the weight of all the factors taken together. The truth of this is evident if it be remembered that the quality coefficient is itself largely determined by the earnings trend, which in turn is taken from the stated earnings over a period.



21-9-06

The past exhibit remains a sufficiently dependable guide, in a sufficient proportion of cases, to warrant its continued use as the chief point of departure in the valuation and selection of securities.

The concept of earning power has a definite and important place in investment theory. It combines a statement of actual earnings, shown over a period of years, with a reasonable expectation that these will be approximated in the future, unless extraordinary conditions supervene. The record must cover a number of years, first because a continued or repeated performance is always more impressive than a single occurrence and secondly because the average of a fairly long period will tend to absorb and equalize the distorting influences of the business cycle.

A distinction must be drawn, however, between an average that is the mere arithmetical resultant of an assortment of disconnected figures and an average that is “normal” or “modal,” in the sense that the annual results show a definite tendency to approximate the average.

Page 508

In studying earnings records an important principle of security analysis must be borne in mind:

Quantitative data are useful only to the extent that they are supported by a qualitative survey of the enterprise.

In order for a company’s business to be regarded as reasonably stable, it does not suffice that the past record should show stability. The nature of the undertaking, considered apart from any figures, must be such as ot indicate an inherent permanence of earning power.

Page 510

The market level of common stocks is governed more by their current earnings than by their long-term average. This fact accounts n good part for the wide fluctuations in common-stock prices, which largely (though by no means invariably) parallel the changes in their earnings between good years and bad.

(The above statement supports my contention in my classes that Security Analysis has at least four different categories of analysis: Analysis of Value; Analysis of Market Price, Analysis of Trend, and Analysis of Market Excess. Graham and Dodd’s book focuses on Analysis of Value either by absolute number or by a judgment that states the current value of the security is far above the current market price.)

Page 511

The analyst* cannot follow the stock market in its indiscriminate tendency to value issues on the basis of current earnings. He may on occasion attach predominant weight to the recent figures rather than to the average, but only when persuasive evidence is at hand pointing to the continuance of these current results.

* (Graham and Dodd mean analyst of value)

Page 512

…it must be remembered that the automatic or normal economic forces militate gainst the indefinite continuance of a given trend. Competition, regulation, the law of diminishing returns, etc., are powerful foes to unlimited expansion, and in smaller degree opposite elements may operate to check a continued decline. Hence instead of taking the maintenance of a favorable trend for granted-as the stock market is wont to do-the analyst must approach the matter with caution, seeking to determine the causes of the superior showing and to weigh the specific elements of strength in the company’s position against the general obstacle in the way of continued growth.

If such a qualitative study leads to a favorable verdict-as frequently it should-the analyst’s philosophy must still impel him to base his investment valuation on an assumed earning power no large than the company has already achieved in a period of normal business. This is suggested because, in our opinion, investment values can be related only to demonstrated performance; so that neither expected increases nor even past results under conditions of abnormal business activity may be taken as a basis.

(According to Graham and Dodd, an average for seven to ten years is the preferred way of calculating the earning power. But as they state in the above paragraph, the analyst make take an average of a shorter period, or a the current earnings figure or earnings figure of a more representative year provided he has strong reasons to demonstrate that the trend will continue)

…this assumed earning power may properly be capitalized more liberally when the prospects appear excellent than in the ordinary case, but we shall also suggest that the maximum multiplier be held to a conservative figure (say, 20, under the conditions of 1940) if the valuation reached is to be kept within strictly investment limits.

(The above condition was incorporated in the Graham-Rao Method of Analyzing Shares for Buy and Hold Investment.)

The divergence in method between the stock market and the analyst-as we define his viewpoint-would mean in general that the price levels ruling for the so-called “good stocks” under normal market conditions are likely to appear overgenerous to the conservative student. This does not mean that the analyst is convinced that the market valuation is wrong but rather that he is not convinced that is valuation is right. He would call a substantial part of the price a “speculative component,” in the sense that it is paid not for demonstrated but for expected results.

Attitude of Analyst Where Trend is Downward.- … Here again a qualitative study of the company’s situation and prospects is essential to forming an opinion whether at some price, relatively low, of course, the issue may not be a bargain, despite its declining earnings trend.

KVSSNRAO
6.45 a.m.
22-9-06