11. Security Analysis
The author refers to securities analysis as a well-established and flourishing "semiprofession." There are textbooks and courses on the subject, a national association, and a wide array of publications devoted to the topic, all of which give it the semblance of an academic pursuit rather than a relatively simple task that a layman can perform.
Even the practice of analysis has about it the semblance of complexity, with the various mathematical formulas representing an equally complicated body of theories that have about them the notion of science, but for all their years of development and consideration are still capable of yielding a result that can merely be considered a "best guess" that has little likelihood of accuracy.
In fact, most of the theory and practice of financial analysis boils down to a simple assumption - that past performance may be relied upon to forecast the future. However sophisticated the process or complicated the equations, they are based on this same basic fallacy that sometimes bears out in reality, but quite often does not.
Stripped of all pretension, securities analysis is a simple task that lends itself readily to interpretation and practice by any individual with basic mathematical skills.
Bond Analysis
The most reliable branch of securities analysis concerns itself with the quality of bond issues, which includes all manner of bonds and investment-grade preferred stock. It is most reliable as pertains to the return that a bond will pay, as the issuer is under contractual obligation (the bond itself being a contract) to do so in exactly the amount specified, but less reliable only inasmuch as the issuer has the potential to fail to meet this obligation.
The exact standards of assessment vary with different authorities, and none can be said to be precise, but many are more or less reliable. The most basic assessment pertains to the comparison of the profit earned by a stock to its debt obligation to bondholders during the same period - expressed in the statistic of "times interest earned." The assumption is that a company that earns several times as much profit as it owes in interest is more likely to service its debt than one whose profit levels provide a lower margin of safety.
As a basic example, a company with $20 million in revenues in a given year, and which owes $2 million in interest to its bondholders during the same year, is said to have earned 10 times the interest it owes. Should the company's revenues drop to $15 million in the same year, it will have earned only 7.5 times interest.
(EN: The exact figure a bondholder should seek is not disclosed, and my sense form the tables the author presents is that the stability of a firm may be considered compared to that of other firms in its industry group and.or of the market as a whole, to ensure that it is well in order. He later suggests that even a firm whose times-interest-earned was a distressingly low 1.1 still managed to service its debt for a few decades before it became utterly bankrupt.)
To consider this statistic over a period of years, three figures are generally considered: the average, the "poorest year" and the "best year." These figures may also be considered on a before-tax or after-tax basis. (EN: Though I have not, and still do not, see the relevance of the latter, as interest on debt is a before-tax expense, and given that most companies are taxed at the same levels, there is little comparative value to be gleaned from the distinction, except inasmuch as one company may have more tax-effective accounting methods than another.)
The value of a bond may be derived by comparing the interest rate it offers to the current rate of interest offered by new issues available to a prospective consumer, but this may be adjusted downward for a firm whose finances cause concern to investors. Likely, this was considered at the time the bond was issued, in setting its rate, but it also merits some regard as the financial situation of a firm changes over the years.
In addition to considering the earnings in proportion to interest, a few other factors may be taken into account:
- The size of the firm, relative to others in its industry, in like with the notion that the firms that have grown largest are the most competent, and that they are most likely to remain solvent.
- The stock-to-queity ratio. This compares the market price of stock to the total amount of debt owed by a firm, indicating the "cushion" that the price of the stock provides to the holders of bonds.
- Property Value. The net asset value of a firm indicates the total amount of cash that can be had for its liquidation - which, in case of bankruptcy, will be divided among bondholders. If the cash value of a firm is less than its debts, bondholders will get back a fraction of the face value of their holdings.
Ultimately, there is the question of how dependable these tests of safety have proven to be in past performance - given that the past is not a perfect guarantor of the future. The author asserts that in the majority of instances, excepting only unexpected disaster, they have been relatively reliable. Even looking at the disaster of railroad bonds, an investor who applied the criterion of times interest earned would have been warned well in advance of the collapse of the industry, of its impending doom and the disaster that befell its bondholders.
More is said on the topic of railroad and utility bonds (EN: which must hav been a matter of excessive concern during the period in which the book was written, but are now likely a matter of historical curiosity.)
Few defaults on bonds have occurred since 1950, though the author feels this is attributed largely to the lack of a major financial crisis during this same period, though it is of increasing concern as companies at the time this edition was published were taking on increasing amounts of debt and that "overbonded" companies are becoming all too common.
So in general, assessment of a bond should be highly attentive when considering its purchase - but afterward can be given a casual eye, a mere spot-check from time to time to determine whether the find remains solvent and is not headed for disaster.
Stock Analysis
The ideal valuation of a stock is the comparison of its present market price to the inherent value of the firm. The price of the stock will fluctuate with the wiles of the buyers and sellers in the market, but the value of the company is inexorably connected to the value of its assets and the income it derives from them.
The standard accounting procedure for determining the earnings of a firm bases itself on historical data of sales volume, prices received, and the expenses of production. Future sales are projected on the basis of assumptions as to the amount of change that has been witnessed over time, and can be predicted as a result of changes one can reasonably expect both within the firm and in the general economic condition of the market.
The author presents a table of five-year forecasts for all the firms of the DJIA: it's noted that a number of individual forecasts were wide of the mark, but when all were combined, the estimate seems relatively accurate, which further underscores the importance of diversification and dismisses the notion of "selectivity" to which many investment firms and mutual fund companies subscribe.
It is also noted that the degree of familiarity with a firm necessary to make such a prediction may be beyond the capabilities of the layman. It is not that the information is invisible or incomprehensible, but the gross volume of data requires considerable time to gather and analyze, and that these tasks must be performed on a regular basis to keep track of the ongoing performance of the firm.
As such, the need to rely on professional financial analysis is apparent - not because a professional is capable of feats a layman cannot accomplish, but because he is capable of devoting the necessary time to the endeavor.
Factors Affecting the Capitalization Rate
While the earnings of a stock are supposed to be the driver of its value, stock analysis must include a number of other factors.
General Long-Term Prospects
There is no definite way of knowing what will happen in the distant future, but buyers in the market have strong views on the subject that drive the degree to which they will value a given issue.
For example, there has historically been favor given to specific industries based on the belief that they will, as a group, fare well. There is often sound basis for this belief, and it has caused stocks in sectors such as chemicals or oil to become attractive to long-term investors, impacting their prices.
Naturally, this is based on vague expectations that may not come to pass, hence for the examples given, oil stocks have fared better than chemical ones, though both were at one time believed to have considerably better future prospects than the average stock.
Management
Managerial competence is a topic of much concern, though it seems to be viewed "through a fog." It is believed that the poor performance of a firm can be improved by replacing its management, and those managers who have been successful acquire something of a hero-status and it is expected they will bring a golden touch to any firm that gains their talent. In some instances, this bears out, and in any instance, the operations of a firm are strongly influenced by those who are given executive authority.
The same is true when one firm acquires another: the belief is that the acquiring firm's management will make the acquired firm more efficient of effective in its operations. And indeed, dramatic reversals in fortune have been evident when companies have been acquired by others, or when there has been a significant improvement as a result of a change in management.
Capital Structure
In general, a cash-rich company is seen as a better purchase at a given price than another with the same per-share earnings that is heavily leveraged.
Form one perspective, a cash-rich company pays less interest to its creditors and keeps more of its profits to itself. And from another, it has greater credit at its disposal to acquire funds as needed to capitalize on any opportunities that arise.
Dividends
Another consideration in stock prices is the rate of return from dividends. More conservative stockholders see dividends as a means of gaining immediate income from a stock, and show a preference or companies with a continuous record of stable diffident payments over a long period of time. This attraction makes the stock more valuable, hence more costly.
The current dividend rate may be given an inordinate level of attention, for much the same reason: if a company pays a generous dividend, it may be seen as enjoying an increasing level of success; or if the dividend in the current year is decreased, it may be suffering some difficulty. However, this must be considered in regard to capital investment, as a firm that offers a lower dividend may be reserving a greater portion of its earnings for reinvestment that will yield improved performance in future.
Industry Analysis
One method of analysis considers the growth rate of an industry basis for comparison: one may compare the growth of a given industry to the growth of the entire market to determine whether the industry is promising, and one may consider the growth of an individual firm within an industry to determine whether it is above or below the average of its peers.
The author takes a dim view of this practice: it has been widely attempted, and rarely does one find a study that points out, with a convincing array of facts, that any given industry is going to prosper or fall in the years ahead. On this level of abstraction, it is no less accurate than gut-feeing and common sense.
The author does concede that with the rapid growth of technology in recent years, the ability to collect and analyze data is greatly improved, and is expected to gain greater breadth and accuracy in future - but ultimately, the ability to perform a greater number of calculations on a greater number of factors is of little use if the premises of the calculations whose premises are themselves mistaken.