Chapter 2: The Scope and Limitations of Security Analysis

Analysis connotes the careful study of available facts with the attempt to draw conclusions there from based on established principles and sound logic. But applying analysis to the field of securities we encounter the serious problem that investment is by nature not an exact science. The same is true for law and medicine, for here also both individual skill (art) and chance are important factors in determining success or failure. Nevertheless, in these professions analysis is not only useful but also indispensable, so that the same should probably be true in the field of investment and possibly that of speculation.

Functions of Security Analysis

1.    Descriptive Function: Limits itself to marshaling the important facts relating to an issue and presenting them in a coherent, readily intelligible manner.

• The least imaginative type is what is presented by various securities manuals (Valueline). Here the material is accepted in the form supplied by the company.
• A more penetrating descriptive analysis is by various kinds of adjustments in order to bring the true operating results in the period covered and particularly in order to place the data of a number of companies on a fairly comparable plane. (LIFO vs. FIFO, non-recurring gains/losses, nonconsolidated subsidiaries, reserves)
• On a still higher level would include consideration of the changes in the company’s position over a long period of years, also a detailed comparison with others in the same field, also projects of earning power on various assumptions as to future conditions.

2.    The Selective Function: The analyst must be ready to pass judgment on the merits of securities and is expected to advice others on their sale, purchase, retention or exchange.

• Graham says that the laymen belief that analyst should be able to give advice of this sort about any stock or bond issue at any time is incorrect. There are times and situations that are propitious for a sound analytical judgment; others which is poorly qualified to handle; many others for which his study and his conclusions may be better than nothing, but still of questionable value to the investor.
• A proper analysis of common stock will take into account all the important points in the company’s past record and present position, and it will apply informed judgment to the projection of future results.
• The approach Graham suggests to select common stocks is to value the stock independently of its market price and to purchase it when it is available at a substantial discount to this value. This independent value is called Intrinsic Value or Central Value.
• Intrinsic value is defined as “that value which is justified by the facts e.g., assets, earnings, dividends, definite prospects.”. In the usual case the most important single factor determining value is now held to be the indicated average future earning power. IV would then be found by first estimating this earnings power, and then multiplying that estimate by an appropriate capitalization factor. The multiplier takes into account a large number of valuation elements, such as the expected stability of earnings, the expected growth factor, the expected dividend policy – all of which may be comprehended in the quality of the company – and perhaps the assets behind the shares.
• Graham says that experience affirms that the price and the independently ascertained value do tend to converge as time goes on.
• The weakness of this method is lack of precision and un-dependable nature of any calculation of economic future. A valuation may be very skillfully done in the light of all pertinent data and the soundest judgment of future probabilities; yet the market may delay adjusting itself to the indicated value for so long a period that new conditions may supervene and bring with them a new value. Thus even though the price ultimately converges with that new value, the old valuation may have proved undependable.
• These limitations should be acknowledged by the analyst and must use good judgment in distinguishing between securities and situations that are better suited and those that are worse suited to value analysis. Its working assumption is that the past record affords at least a rough guide to the future. The more questionable this assumption, the less valuable is the analysis. Hence this technique is more useful when applied to a business of inherently stable character than to one subject to wide variations and more useful when carried on under fairly normal general conditions than in times of great uncertainty and radical change.
• There are three general areas in which value analysis will operate successfully

§  Inherently stable securities – conservatively capitalized public utilities and strongly entrenched industrials.

§  Cases of extreme disparity between price and indicated value. Here the analyst relies upon a large initial margin of safety to absorb and offset the uncertainties of the future. Here diversification is especially valuable.

§  Comparative analysis to determine if one if preferable to the other.

• There are two types of issues that do not lend themselves satisfactorily to the intrinsic value approach.

§  Those that are essentially speculative in character, meaning thereby that their apparent value is almost entirely dependent upon the vicissitudes of the future. Ex. Shares of high cost or marginal producers and those with speculative capital structure.

§  The other type is the common stock of a strong enterprise that is considered to have unusually favorable prospects of continued growth. The difficulty for the analyst here is to place a sound arithmetical valuation on an optimistic outlook.

3.    The Critical Function: The analyst must be highly critical of accounting methods. He must also concern himself with all corporate policies affecting the security owner, for the value may be largely dependent upon the acts of the management. In this category are included questions of capitalization setup, of dividend and expansion policies, of managerial competence and compensation, and even of continuing or liquidating an unprofitable business.