Security Analysis: Introduction (Part 1)

The introduction to Security Analysis is a treasure trove of Grahamian thought. It is impossible to fully plumb the depths of this Grahamian gold mine in a single post. Therefore, I have separated my comments into two posts. This post explores the opening paragraph of the introduction with special attention to Graham’s style.

We should begin with the most general point made in Graham’s introduction: It is impossible to completely separate analysis and action, theory and practice. Therefore, while the title of Graham’s book is Security Analysis, the scope is necessarily wider:

Although, strictly speaking, security analysis may be carried on without reference to any definite program or standards of investment, such specialization of functions would be quite unrealistic. Critical examination of balance sheets and income accounts, comparisons of related or similar issues, studies of the terms and protective covenants behind bonds and preferred stocks – these typical activities of the securities analyst are invariably carried on with some practical idea of purchase or sale in mind, and they must be viewed against a broader background of investment principles, or perhaps of speculative principles.

This is vintage Graham. In many ways, it is a sort of cold open into the book and the mind of the man who wrote it. He begins with a logical and overly literal opening sentence; to Graham, “strictly speaking” means speaking strictly – nothing more or less. He adds a word we wouldn’t think necessary – “definite” – but in Graham’s mind it is a necessary and meaningful modifier. Finally, he interjects his personality with the word “quite”, which we will see repeated again and again throughout Security Analysis (Graham was born in Britain).

Next, we have a catalogue. The activities Graham lists are all activities he’ll cover in Security Analysis. If you wonder what Graham means by security analysis, look no further than these lines. He lists three main activities: “critical examination” of corporate financial statements, “comparisons of related or similar issues”, and finally “studies of the terms” of senior securities.

This is an especially excellent introduction for the modern reader, because we learn just how different Graham and his book are from what we might expect – and we learn our lesson well within the first few sentences.

What is the most unusual feature of this paragraph? Can you find the words almost no other writer would have included?

I’ll give you a hint. In Graham’s list of activities undertaken by the security analyst, there are two words that stick out like a sore thumb – a seemingly redundant sore thumb – can you find them?

Here they are:

“Critical examination of balance sheets and income accounts, comparisons of related or similar issues, studies of the terms…”

These two words tell you more about Graham and Security Analysis than anything else in that opening paragraph.

Why?

Because they are peculiar. What tells most is often what is said least. The appearance of these extra words in this sentence is something almost …

Upcoming Festival of Stocks

Attention Investment Bloggers:

I’m hosting this week’s Festival of Stocks (on Monday).

Please send me your best post of the last week.

Thank you.…

20 Questions for Jeff of Circle of Competence

Jeff, author of Circle of Competence, is a young and learning investor not yet out of college. He derives his investing framework from Superinvestors ranging from Ben Graham and John Maynard Keynes to Joel Greenblatt and Eddie Lampert. Jeff believes the most effective approach to investing is that of a business owner and entrepreneur looking for misunderstood businesses selling very cheaply with little risk of capital impairment.

Visit Circle of Competence

1. Are you a value investor?

No doubt. There’s no other approach I’ve ever been comfortable with. The thing is, value investing, as we tend to think of it, is not the only path to investing success. I’ve read about plenty of individuals who have been successful trading, making macro calls, and reading tea leaves for all I know. Value investing, business investing, is the one I hit it off with, so I’m with it for better or worse.

2. What is value investing?

Value investing is this really simple approach that’s not so easy to practice. In my eyes, value investing is a mentality that assets have some value independent of their selling price. They might be the same, they might not be, but if you can find the ones selling for some large amount less than they’re worth, there’s an opportunity to make a ton of money down the road. Buffett, Graham, Klarman, I mean these guys have proved this thesis true over and over with their successes. It takes some hubris, a confidence that you’re right and everyone else is wrong, and the courage to basically not let your humanity interfere with rationality. That’s the toughest part of value investing.

3. What is your approach to investing?

I’m basically just looking to own a small handful of companies that I know pretty well, selling for way less than they are worth. I want to find 5-10 companies where I can be extremely confident that I know what the heck is going on. It’s the only approach to investing that makes sense to me. I approach investing like I was a control investor, a buy-out specialist, or an entrepreneur. To find these opportunities, I’m search for companies that are being subject to some devil: neglect, myopia, or misunderstanding. If I can find a solid business with a solid balance sheet, run by competent management, being subject to one of those devils, and it’s something that I understand, I’m probably researching or buying it. That means spinoffs, small caps, distressed businesses, companies with multiple divisions; all of these are fair game. I want to find situations where the risk I’m being asked to take is out of whack with the potential upside. I’m okay with an investment that doesn’t make me any money. I’m not okay with losing money.

4. How do you evaluate a stock?

I don’t really evaluate stocks. I (try to) evaluate businesses. As I said before, I’m thinking like a control investor. What is the company worth now, and what is it going …

On Liquid Courage

There are two recent pieces on morality and credit worth reading. One is written by David Brooks; the other by Jim Grant.

Brook’s piece is good; Grant’s is better. Brooks takes the matter as far as he can. He sees the importance of the everyday examples that constitute a culture; but fails to see the overwhelming importance of incentives – incentives that have been both perverse and pervasive throughout the third millennium.

(The borrower) and the lenders were not only shaped by deteriorating norms, they helped degrade them. Despite all the subterranean social influences, there still is that final stage of decision-making when individual choice matters. Each time an avid lender struck a deal with an avid borrower, it reinforced a new definition of acceptable behavior for neighbors, family and friends. In a community, behavior sets off ripples. Every decision is a public contribution or a destructive act.

Great.

Unfortunately, he goes on to write:

Meanwhile, social institutions are trying to re-right the norms. The government is sending some messages. The Treasury and the Fed are trying to stabilize the system while still ensuring that those who made mistakes feel the pain.

Brooks is out of his depths here.

Ultimately, the pain will come in the form of inflation. It has to. Either the Fed will realize it has assumed weaknesses that are mostly illusory – or the Fed will cure those weaknesses the only way it can. Either the Fed’s balance sheet will turn out to be solid, or the Fed will have to counterfeit that solidity.

Unlike Brooks, Grant resorts to numbers:

In June 2007, Treasury securities constituted 92% of the Fed’s earning assets. Nowadays, they amount to just 54%. In their place are, among other things, loans to the nation’s banks and brokerage firms, the very institutions whose share prices have been in a tail spin. Such lending has risen from no part of the Fed’s assets on the eve of the crisis to 22% today. Once upon a time, economists taught that a currency draws its strength from the balance sheet of the central bank that issues it. I expect that this doctrine, which went out with the gold standard, will have its day again.

John Bethel of Controlled Greed recalls a past phrase from Grant – “the democratization of credit and the socialization of risk”. There is no clearer example of this phenomenon than the weakening of a public balance sheet to strengthen private balance sheets.

The first part of that phrase is as important as the second. When do you hear someone told they shouldn’t buy that house or take out that student loan? Is anyone ever told they can’t afford to own a house, or attend a four-year school?

No. These are the new unalienable rights. Unfortunately, they still have to be paid for out of pocket. No amount of money is too much to spend on your education or your abode…

But if that’s true, what difference does the …

Blogger Roundtable: July 2008

Note: My continuing weekly commentary on Benjamin Graham’s Security Analysis is being bumped for this roundtable; the commentary will appear here tomorrow morning. Sorry for the inconvenience.

This is a new format for Gannon On Investing – a pseudo-roundtable, where the same questions were posed to different bloggers simultaneously (via email). In this first post, we have answers from the authors of four of my favorite blogs: Fat Pitch Financials (GEORGE), Cheap Stocks (JON), Bill Rempel (BILL), and Controlled Greed (JOHN).

Performance

How have you fared so far in ’08?

George: It’s been a rough year for my portfolios so far. My Fat Pitch Financials Portfolio, which tracks my longer term value investment picks, is down 15.9% year to date (as of July 11th). My Special Situations Real Money Portfolio is down 6.7% year to date.

Jon: It’s been very challenging, especially the past month. Even some of the illiquid names I hold have started to come under pressure.

Bill: YTD as of 7/18 close, -1.67%.

John: My portfolio is down 12% through June 30th of this year.

What’s been your greatest success this year?

Bill: I’m not viewing the individual trade results as being composed of individual successes or failures. I view the process as one of methodology applied consistently, with individual trade results being somewhat randomly distributed over time, around an average result for that system. That holds true for relative value traders, GARP traders, cigar-butt traders, special situation traders, and other types of system traders. Sticking to a chosen system is the “success.” Currently I trade one of the four systems I track; in time, with a larger account, I’ll probably trade two simultaneously.

George: In my Fat Pitch Financials Portfolio, my position in Western Union (WU) seems to be holding up the best so far.

My greatest success this year in my Special Situations Real Money Portfolio was my investment in JACLYN INC (JLN) that I bought for $7.65 on April 4, 2008 and I was cashed out (since this company went private) for $10.21 per share on May 22nd.

John: ArmorGroup International, which traded in London, got taken over by a UK company called G4S for a gain this year of 147%. You’ll remember I talked about ArmorGroup in the “20 Questions” interview we did previously. I originally bought the company in September 2006. My gain from start to finish was 61.3%, or more than 36% on an annualized basis.

Jon: The launch of the Cheap Stocks 21 Net/Net Index, the first index that tracks a basket of companies trading below net current asset value has had some very interesting results. Since inception (2/12/08), it’s up more than 9%, while the closest benchmark, The Russell Microcap Index is down 10%. Pico Holdings has also made a very nice recovery

What’s been your greatest failure this year?

John: General Motors (GM), down 51.8% through June 30.

George: I recently made a big mistake not selling a stock immediately when its …

Security Analysis: First and Second Preface

This book is intended for all those who have a serious interest in security values. It is not addressed to the complete novice, however, for it presupposes some acquaintance with the terminology and the simpler concepts of finance. The scope of the work is wider than its title may suggest. It deals not only with the methods of analyzing individual issues, but also with the establishment of general principles of selection and protection of security holdings. Hence much emphasis has been laid upon distinguishing the investment from the speculative approach, upon setting up sound and workable tests of safety, and upon an understanding of the rights and true interests of investors in senior securities and owners of common stocks.

(Preface to the First Edition)

And so Graham begins his magnum opus – or at least the preface to its first edition. Here we have a full introduction to the entire work – much fuller than a first-time reader might suspect. First, we are introduced to Graham’s ideal reader (“…have a serious interest in security values…not…a complete novice…some acquaintance with the terminology and the simpler concepts of finance.”) Next, the scope of the work is delimited. We are told that it shall encompass not only analysis proper, but the related issues of “selection” and “protection”. Finally, Graham informs us of his own special concerns: the distinction between investment and speculation, practical methods, and shareholder rights.

This last – and in 1940, most peculiar – concern of Graham’s will be explored in two ways: 1) through an exhaustive – and for some readers exhausting – discussion of senior securities (e.g., corporate debt) and 2) through glimpses of shareholder activism.

Graham was an early pioneer of shareholder activism. For more information, see On the Northern Pipeline Contest.

The two prefaces also introduce us to Graham’s idiosyncratic – and to some readers intimidating – writing style. I’ll take up this subject in my next commentary post. For now, just read over the two prefaces (or the passage above) and note how the writing is neither confused nor convoluted. It may be stylistically unfamiliar, but it is very easy to follow. Graham’s sentences are not especially long and they are syntactically streamlined for the modern American reader. Words and clauses appear exactly where you would expect them to appear to perform their standard functions.

Therefore, you’re unlikely to get lost in one of Graham’s sentences. However, you may get lost in one of his paragraphs.

As a general rule, you should not back-track when reading Graham, because his prose is strung together more logically than most people’s. If you don’t think you understand something perfectly, just keep reading. However, if you find you’re truly lost, go back to the first sentence in the paragraph. Even back up another entire paragraph if you must, but don’t try to back-track within a paragraph, because Graham’s paragraphs are threaded together with a logical strand that’s hard to pick up without a good reference …

Second Largest Bank Failure in U.S. History: Feds Seize IndyMac

It’s no longer a rumor; it’s now news. IndyMac (IMB) has failed.

From Reuters:

The FDIC said the estimated cost of the California-based bank’s failure to its insurance fund is between $4 billion and $8 billion. The regulator said it will operate IndyMac to maximize the value of the firm for future sale.

IndyMac’s primary regulator, the Office of Thrift Supervision, blamed a senior lawmaker’s comments for causing a run on the deposits at the largest independent publicly traded U.S. mortgage lender.

From Bloomberg:

IndyMac came under fire last month from U.S. Senator Charles Schumer, who said lax lending standards and deposits purchased from third parties left it on the brink of failure. In the 11 business days after Schumer explained his concerns in a June 26 letter, depositors withdrew more than $1.3 billion, the OTS said.

“This institution failed due to a liquidity crisis,” OTS Director John Reich said in the statement. “Although this institution was already in distress, I am troubled by any interference in the regulatory process.”

Office of Thrift Supervision Shuts Down IndyMac (AP)

IndyMac Seized (Bloomberg)

IndyMac Taken Over By Regulators (Reuters)

Federal Regulators Take Control of IndyMac (LA Times)

IndyMac Bancorp Is Seized By Federal Regulators (WSJ PREVIEW)…

Security Analysis: Homework for Monday, July 14th, 2008

Get

Security Analysis: The Classic 1940 Edition

The Interpretation of Financial Statements

Read
Security Analysis: Preface to the Second Edition, Preface to the First Edition (pg. vii – x)

The Interpretation of Financial Statements: Introduction to Chapter XX (read to pg. 48)

Note

I will post the first commentaries on Monday. The chapter commentary will only cover the two prefaces to give everyone an extra week to acquire a copy of Security Analysis.

There will also be commentaries on general subjects interspersed with the chapter specific commentaries. The entire Security Analysis “course” will be collected together and made available through a Security Analysis link under the CATEGORIES heading on the right sidebar starting Monday.

By the way, if you have any accounting background, you can skip The Interpretation of Financial Statements.…

Whitney Tilson is Short Hanesbrands

According to this post at Seeking Alpha, Whitney Tilson is short Hanesbrands (HBI). I mentioned Hanes (which was then my favorite stock) during a “roundtable” discussion on October 20, 2006:

However, there are many situations (and here is usually where you find some bargains) where the EV/EBIT measure is not the most useful. When I can predict a high free cash flow margin with confidence, I use a very long-term discounted cash flows calculation. For instance, this is what I would do with HanesBrands (HBI), which was recently spun-off from Sara Lee (SLE). On an EV/EBIT basis, it may not look cheap. But, looking truly long-term, I’m convinced the intrinsic value of each share is much closer to the $45 – $65 range than the roughly $23.00 a share at which it now trades. But, that’s a special case – Hanes is a special business.

I wrote a post on Hanes back on July 23, 2007. That’s also where I mentioned that Hanes had been the sole idea slated for the October 2006 issue of my newsletter, but I shut down the newsletter because I felt one idea couldn’t justify the $75 price tag.

Three days earlier (July 20th, 2007) I had written:

If you’re looking for a stock where leverage will amplify your returns, I still like Hanes Brands (HBI). It’s not as leveraged as Journal Register (though it has plenty of leverage) and it’s a much better business. Hanes was the most interesting spin-off of last year and the stock did well enough but has since cooled off a bit.

Note that I’ve yet to find someone who agrees with me on Hanes. I’m not sure if that’s a good sign or a bad sign.

I loved Hanes at the spin-off price. I still like it at today’s price. It’s probably not ridiculously undervalued as a business, but the debt will amplify the difference that does exist. Last October, I wrote that Hanes was probably worth more like $45 – $65 a share than $25 a share. I still think that’s true; however, the spin-off, plant closings, and debt might obscure the business value for a time. Be patient.

My only post focused solely on Hanes was written on July 20th, 2007 and is basically a collage made from the much longer newsletter piece I had written for October of 2006.

That issue was never published, so I made a blog post out of the scraps.

Although it’s an old post; you may enjoy reading it.

Regardless, you should definitely read Tilson’s Seeking Alpha post and the accompanying PDF.

They’re both good.…

John Templeton Interview

John Bethel of Controlled Greed has a post on John Templeton.

He links to a 1997 interview with Charlie Rose.

This interview reminds me how good Charlie is interviewing an investor. Many financial journalists don’t manage to get as much out of their subjects as Charlie does.

Value Discipline also has a post.…