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Chapter 7: Quantitative and Qualitative Factors in Security Analysis. The Margin of Safety Concept.

·         Analyzing a security involves an analysis of the business. Such a study can be carried out to an unlimited degree of detail and hence must include a sense of proportion in the use of his technique. He must not be misled by the availability of a mass of data into making elaborate studies of nonessentials.

·         Analyst must recognize that the value of a particular kind of data varies greatly with the type of enterprise which is being studied. The 5 year record of net earnings of a railroad or large chain-store may afford, if not a conclusive basis, a reasonably sound one measuring the attractiveness of common shares. But same statistics supplied by one for smaller oil producing companies may well prove more deceptive than useful since they are chiefly resultant of two factors viz. price received and production, both of which are likely to be radically different in the future than in the past.

·         It is convenient at times to classify the elements entering into an analysis under two headings: the quantitative and the qualitative.

·         Quantitative items might be called the company’s statistical exhibit and may be sub classified under (1) capitalization (2) earnings and dividends (3) assets and liabilities, and (4) operating statistics.

·         Qualitative factors on the other hand deal with such matters as the nature of the business; the relative position of the company in the industry; its physical, geographical and operating characteristics; the character of the management; the outlook for the unit, industry and for business in general. Questions of this sort are not dealt with ordinarily in the company’s reports.

·         Quantitative factors are more easily obtainable and much better suited to forming of definite and dependable conclusions. Furthermore the financial results will themselves epitomize many of the qualitative elements, so that a detailed study of the latter may not add much of importance to the picture.

·         Graham expresses serious reservation about the practice of first selecting the most promising industry or industries and then picking out the best companies in those industries.

·         If the future of an industry is definitely rosy, stock prices will almost always reflect this element quite fully; hence recommendations based on such “analysis” may be too obvious and come too late to offer much of value. Industry analysis can be most useful when it leads to well-founded conclusions differing from those in vogue. Typically, such conclusions would forecast the reversal of a condition or trend that had been so long continued as to be accepted as permanent in Wall Street. Such reversals of this kind are surprisingly common.

·         We shall assume that an intensive study of an individual security will carry with it the study of the industry-wide conditions which have contributed to the company’s performance.

·         Average Earnings vs. Trend of Future Earnings: Graham is critical of using past earnings growth rate trend into the future in valuing the business.

§  Economic adjustment militates against the maintenance of abnormal prosperity or depression are equally opposed to the indefinite continuance of an upward or downward trend. By the time the trend has become clearly noticeable, conditions may well be ripe for a change.

§  Graham disagrees with the objection that as far as the future is concerned it is just as logical to expect a past trend to be maintained as to expect a past average to be repeated. This is because, analysis does not assume that a past average will be repeated, but only that it supplies a rough index to what may be expected of the future. A trend, however, cannot be used as a rough index; it represents a definite prediction of either better or poorer results and for practical purposes it must be either right or wrong.

§  Emphasis on trend is likely to result in errors of overvaluation or under valuation. This is true because no limit may be fixed on how far ahead the trend should be projected; and therefore the process of valuation, while seemingly mathematical, is in reality psychological and quite arbitrary. Trend is essentially a qualitative factor.

·         Many are convinced that the dangers of overpaying for stocks of strong and promising companies are much less than those of buying poor quality issues because they seem to offer a lot of assets or earnings for the money. This might be true according to Graham for untrained security buyers as they are easily led astray by an apparently attractive price to buy low grade securities but that a competent analyst would have shown that these securities are not attractively priced in reality and that the untrained have been deceived by a temporarily good showing or had overlooked serious weakness.

·         It is advisable for the defensive investor to require first quality in all his securities. He will get this ordinarily by buying the securities of large, well known enterprises, which his adviser can certify to him as prosperous, well managed and strongly entrenched. He will do well to require of the analyst some assurance also that the price he is to pay is not inordinately high in terms of accepted standards of value.

·         The enterprising investor may range more freely over the area of varied quality. Within limits he may trade off, as it were, the qualitative factors against the quantitative ones, making sure that the composite result indicates an underlying value well in excess of price.

·         The kind of security analysis we regard as a most rewarding discipline is concerned primarily with values which are supported by the facts and not those which depend largely upon expectations.

§  The analyst must take possible future changes into account but his primary aim is not so much to profit from them as to guard against them.

§  Three offsets to the hazards of the future:

                              i.        He may place his prime emphasis upon the presence of a large margin of safety for the security, which should be able to absorb whatever adverse developments are reasonably likely to occur. In such cases he will be prepared to see unsatisfactory earnings for the issue during depression periods, but he will expect that the company’s financial strength will carry it unharmed through such a setback and its average earnings will be enough to justify fully the stock purchase.

                             ii.        He may emphasize the factor of inherent stability. Here the nature of the industry or the company is supposedly such as to immunize it in a large measure from the recurrent adversity that befalls most enterprises. Stability of this kind is possessed by nearly all public utility groups, well established chain-stores, by certain makes of trademarked goods for public consumption.

                            iii.        He may give considerable weight to the future prospects themselves and he should favor companies which his study and judgment tell him have better than average expectations. He will value such concerns more liberally than others. But he must be aware of carrying such liberality to the point of enthusiasm, for at that point he loses the sober moderation that distinguishes the investment approach from the speculative one. The security analyst is on safest ground when he treats favorable expectations as an added reason for a purchase which would not be unsound if based on the past record and the present situation.

§  The element of stability has particular appeal because it minimizes the risk that new conditions will upset his calculations derived from the past record. Stability may be expressed in quantitative terms but in our opinion stability is really a qualitative trait, because it derives from the character of the business and not from its statistical record.

·         Whenever the commitment depends to a substantial degree upon qualitative factors – whenever, that is, the price is considerably higher than the figures alone would justify – then the analytical basis of approval is lacking. In the mathematical phrase, a satisfactory statistical exhibit is a necessary though by no means a sufficient condition for a favorable decision by the analyst.

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