No. of Recommendations: 20
Everything I need to know about investing I learned in Chapter 1 of Security Analysis (to paraphrase the ode to a solid Kindergarten education).

Here are my notes and comments:

During a period in which the market is behaving in a totally irrational manner, fundamental analysis will not be as successful. This fits with what fundamental analysis adherents saw during the three speculative run-ups of the 20th Century (late 20's, 60's, and 90's).

During a period in which values are unstable, fundamental analysis will not be as successful. Also, in unstable economic times, the number of investments that are subject to accurate analysis is greatly reduced. I.e., as earnings become more unpredictable, so does Intrinsic Value.


The Importance of Determining Intrinsic Value: It is necessary to determine the Intrinsic Value of an Investment in order to determine whether one should buy, hold, or sell that investment.

G/D say not to be misled by Book Value - it is no proxy for Intrinsic Value. Buffett and many others have also stated this - Book Value is an accounting number that rarely correlates to the current value of the company.

G/D point out that to determine Intrinsic Value it is essential to look at a company's probable future earnings power, not its past. While past earnings and growth might be a guide to future earnings power, one should not presume it to be so. An analyst needs to assess the future earnings prospects based on current and probable future conditions. This fact - that growth is a component of value, is often missed by those who are critical of Buffett and other so called "Value" investors. A high P/E or other ratio does not mean an investment is not a good Investment, if the company has a real probability (not possibility) of growth that would result in a rational Intrinsic Value in excess of its current price.

It is here in Chapter 1 that G/D start drilling in the concept of Margin of Safety. G/D warn not to adhere to a particular number for Intrinsic Value. Instead G/D say one should determine a range of potential Intrinsic Values for the investment (based on various future conditions), and determine if the current price is outside the range of Intrinsic Values. If price is not far less than the range, there is not enough margin of safety to make a purchase. On the other side, if Price wildly exceeds the range of Intrinsic Values, it is probably a decent time to sell (or at least forego a purchase).

G/D point out the three primary obstacles to successful analysis are a) bad data, b) uncertainty of the future, and c) the irrational behavior of the market.

G/D state that bad data is the least worrisome because true fraud is rare (even more so under current rules), and accounting tricks are usually detectable upon thorough analysis.

Future uncertainty is more of a problem. This is why Buffett-style investors often stay away from companies or industries where future prospects are unpredictable with any certainty. If earnings cannot be predicted with a decent level of certainty, G/D sate that Intrinsic Value analysis is fairly useless. Of course, one person's certainty is another person's rash speculation, depending on familiarity with the company and/or industry (and self-assuredness as to one's predictions).

G/D state that market irrationality is the biggest potential problem, because it can persist for a long time. If the market is irrationally undervaluing your investment when you want to sell (or overvaluing when you want to buy), you simply must be patient. To use this style of investing, you must believe that Intrinsic Value constantly acts as a kind of magnet, drawing price toward it the further price strays from Intrinsic Value. It sometimes takes a long time, however, for the price to get near Intrinsic Value.

Of course, market irrationality is also a benefit to Intrinsic Value investors, because there would be no undervalued companies if the market was never irrational.

G/D warn that one cannot ignore an investment after the purchase is made. One must stay informed as to the fundamentals underlying the company's value. An analyst must stay critical of any investment, constantly and thoroughly assessing a company's decisions with regard to anything that might affect the company's Intrinsic Value (dividend policy, capital allocation, capitalization, managerial compensation, etc.) If one learns that one's anlaysis was faulty, or if fundamentals change, one must incorporate these changes and change the Intrinsic Value estimates.

And, on page 23, G/D make the famous "Voting Machine/Weighing Machine analogy.

G/D also mention arbitrage investing briefly, and how it differs somewhat because one is comparing the prices of two directly related investments (keeping Intrinsic Value in mind) rather than only comparing Intrinsic Value to market price.

That's my take on Chapter 1, 13 pages of pure wisdom.
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No. of Recommendations: 5
Theseus, what an excellent summary!

One of the examples Graham & Dodd give of intrinsic value, J.I. Case Co on SA1 pp 18-19, is interesting because they were unable to say in 1933 whether the IV was nearer $30 or $130. That is a huge range. I had assumed from Buffett & Munger writings that IV was a number one ought to be able to pin down to within say 10 percent. But here we have a factor 4:1 and as G/D state, it is still possible to make a decision to buy if the price is $10.

Actually, that IV is more than $10 in the Case example is not clear from the presentation of earnings on pg 18, which shows a loss of $17.40 in 1932. Perhaps Case are on the verge of bankruptcy? More info would be needed. But at least one has a starting point for the decision to buy/sell/hold Case.


Graham & Dodd's definition of intrinsic value as "that value which is justified by the facts, e.g. the assets, earnings, dividends, definite prospects" is the point. What are the facts? Not how many analysts recommend the stock, not the momentum of the market, but a valuation which is based upon reality not perception.

That approach works best, as you observe, when one is in a market with other rational investors. Individuals differ in their interpretations of facts, in their timing and liquidity needs, in their interest in some business, and that creates differences in valuations which permits rational trading.


There's something in me that hesitates to take advantage of a irrational (manic depressive?) market. I will do it; the market is plural and anonymous and I don't know others' reasons. But I feel better if I can believe that, through study of the facts, I may perceive better than some other rational person that a particular security is mispriced and can be advantageously bought or sold.

In a sense, investing by following Graham and Dodd methodologies is like adopting a bidding convention in bridge. It might be more effective to devise a set of winks and flutters to communicate with one's partner, but it would not be intellectually honest. Graham and Dodd give one a methodology not only to make money, but to feel good about one's technique.

Woodstove
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