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Author: theseus One star, 50 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 1933  
Subject: Chapter 2 - The Fab Four Date: 5/21/2000 11:50 PM
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In Chapter 2, G/D say there are four essential elements one must understand to perform security analysis: your personality, pricing factors, timing factors, and the nature of the security.

1) Personality: Know yourself. Don't invest in securities you don't feel you understand. Don't use methods that make you uncomfortable (taking high risks even though it makes you unable to sleep).

2) Time: Be aware of timing when performing analysis. G/D did not appear to be speaking of market timing, however. They seemed to mean to be aware that many companies' numbers can fluctuate dramatically throughout the year, due to seasonality or other factors. Know whether the company you are looking at is subject to such timing issues.

Also, G/D say to understand that time will cause ALL businesses to change (or die). G/D stress that one must try to assess the future conditions in which the company will operate, and how well-suited the company is to adapt to future conditions; because some of today's powerhouses will be tomorrow's outhouses.

3) Price: When investing in common stocks, price always matters. Always. My favorite quote from this chapter is, the danger of paying the wrong price is almost as great as that of buying the wrong issue. My translation, Cisco at $150 is almost as bad as Dr.Koop.com at $5.

With bonds, price matters, but rarely so much, since price rarely goes far above value; and bond investors expect return mainly from interest, not price appreciation.

In all situations, try to determine if there is a less risky investment that will probably have the same or greater return than the one that you are analyzing.

4) Nature of the Security (Quantitative and Qualitative):

If buying for interest or dividends, determine where the security ranks for payment (e.g., is it paid last, first, or maybe not at all?) How sound is the company or entity issuing the security?

Untrained investors are usually slightly better served (despite the Cisco/Dr. Koop statement above) by buying great companies at high prices than bad companies at any price, if the investor has a diversified portfolio of great companies.

Well-trained investors, on the other hand can often find great investment values in any quality level of company. Even bad companies can be good investments at the right price. However, it takes skill to recognize when such a value exists. A key is to maintain cold objectivity - be willing to recognize fault even with one's favorite companies, and find strength in the most despised. In that way, one will be able to locate value and weakness.

To understand a security, one must understand the company and its industry. To assess the company, one must know what key quantitative data to look at for that company. Key data can vary by industry. Also, in some industries, even the most recent past data can be nearly useless in predicting future performance.

However, qualitative assessment is often extremely difficult. Some common qualitative factors can be best assessed through quantitative analysis (e.g., management excellence might be best shown by many years of high return on investment). The market often gives too much weight to management performance, because it factors in earnings and growth (which often are a result of great management) and then factors in the great management separately.

A key thing to accept is that all predictions of future performance are qualitative judgements, no matter how complex the formula used to predict such performance.

That one woke me up.

G/D point out that hugely complex methods of calculating growth rates based on past performance are only useful if the product coincides with one's qualitative analysis of the future prospects for the business.

G/D warn that one should never rely on hopeful predictions as a basis for investment. Instead one should use predctions to determine, if the future isn't as rosy as one might hope for this company, is it still a great investment? In that way one uses predictions to guard against an unfavorable future, rather than trying to assess a rosy future.

Therefore, while one's Intrinsic Value price is determined based on cold hard calculations, one must recognize that the numbers that go into the equation are based on qualitative judgements of future conditions.

And I can hear the critics already: "If everyone invested this way, there would have been no Cisco, no Microsoft, no Yahoo!." And, of course, the world would crack if everyone jumped at the same time. Of course, only a very tiny percentage will jump, and very few more will invest with the cold detachment of Graham; so at least some of the future Yahoo!s will always find capital.
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