Moving beyond Graham & Dodd

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This article is the first in a series of tutorials about the techniques of post-modern securities analysis. Click the RSS button in the sidebar to get a free subscription to the whole set.

Definition of “Security Analysis”

Security Analysis is the study of facts about negotiable instruments for the purpose of determining whether a particular instrument is appropriate for a specific investor at a particular time and the intrinsic value of the security compared to its market price, if any.

Observe closely and get the facts ...

This analysis is usually conducted by gathering facts about the legal jurisdiction governing the security, the terms and conditions of the issue, data on the organization issuing the security, and information on operations, laws, rules, and other factors related to the instrument or the issuer.

The determination of the appropriateness of a security is made by a critical evaluation of a wide range of facts about the instrument in terms of the current price and the needs of a specific investor.

Security analysis is not able to predict the future price of a security. It is an art, rather than a science, aimed at arriving at practical determinations as to prudent behavior, based on commonsense.

See: “Is security analysis a science?”

Matching securities to investors

A security that may be appropriate for one investor may not be suitable for another.

The success of security analysis should not be measured in terms of price appreciation of a security over a particular period, but rather with respect to how well a recommendation matches the requirements of a specific investor concerning safety of principal, income, and liquidity.

For example, a seventy-five year old pensioner living off investment income might have been better served with a portfolio of short or medium term US Treasury Bonds than with a highly leveraged hedge fund in the Crash of 2008 — although the hedge fund may have appreciated more in the years preceding the market collapse.

The dual tasks of security analysis

Because security analysis is defined in terms of the determination of appropriate investments for particular individuals, the technique needs to be divided into two distinct practices:

Truth ... above all.

1. Fact gathering and analysis: This is the practice of finding, collating, and analyzing data that is relevant to the aims of security analysis.This task can be judged in terms of the truth, relevance, completeness, and manner of presentation of the facts assembled. It is the first and essential task of the security analyst.With insufficient, false, or misinterpreted data, the purpose of the analysis is defeated. Fancy statistics and clever sophistry cannot overcome a false factual basis for decisions.
2. Matching securities with particular investors: Every investment opportunity is different, as are the needs of investors concerning ability to accept risk, assurance of income, safety of principal, and the eventual necessity of re-converting an investment into cash.

Many who claim to be “security analysts”, even with impressive certification, fail in their professional duty because of sloppy work in one or both of these two essential elements.

See: A security analysts greatest challenge: Laziness

Buy-sell-hold analysts

So-called analysts on financial news channels commonly issue “buy, sell, or hold” recommendations, without any qualification as to the relevance of their opinions to specific classes of investors. Nor do they provide sufficient information about the facts on which their “recommendations” are based for an audience to judge merit.

Stock-brokers and investment bankers routinely issue ratings and recommendations on securities without matching the securities to the needs of specific investors.

Standard & Poor’s, one of the largest securities rating services, publishes “stock reports” on equities with “buy, sell, or hold” recommendations and a “star system”, without qualification whatsoever as to the validity of the recommendation for particular classes of investors. (These reports also publish summaries of recommendations of other “analysts” without detailed explanation of any kind).

See: Why rating agencies may overlook toxic assets

The profession of “security analyst”?

The Crash of 2008 revealed professional short-comings in securities analysis, both on the part of well-known rating services and of analysts of leading investment banks and brokerage firms.

A security analyst is any person who performs the tasks described above. Most security analysts are private investors trying to select investments for their own portfolio or for their family.

How do we measure an analyst?

In the United States, anyone can call them-self a “security analyst”.

The US Securities and Exchange Commission does not define the term nor require that “security analysts” be registered or licensed. There are no educational requirements.

However, whoever engages in providing investment advice for a fee to more than a certain number of clients may be required to file a form with the SEC. (Some countries have more rigorous requirements for the profession of security analyst or investment advisor.)

The US SEC does not oversee the issuance of credentials for security analyst, financial analyst, or investment advisor. A person may have no education and still advertise as a securities analyst.

At the same time, anyone can establish a “diploma mill” and issue “degrees” or “certifications” in security analysis. In most parts of the United States it is more difficult to become a licensed securities broker (or even a manicurist) than a securities analyst.

In view of the failure of the US SEC to protect investors in cases such as the diversion of dividends to corporate executives through the mechanism of stock buybacks (See: The Great Misleading) or by timely investigation of the Bernard Madoff fraud, it is best that the SEC does not, in fact, try to “certify” security analysts, for this certainly would do more harm than good.

Qualifications for security analysts

The only reliable way to judge the qualifications of a securities analyst is to assign him or her the task of researching a particular security and by comparing the written, documented results with those of someone who is known to be an accomplished and careful analyst.

However, this “test” could take weeks (or months) and would not be practical as a hiring method for institutions.

See: “Wiki reputation” for how this might be accomplished.

Is ‘past performance’ a qualification?

Often, security analysts are evaluated not in terms of proven research skills but rather on the basis of short-term market returns on recommendations.

However, since market results can easily be due to chance (and be totally unrelated to depth of research or the appropriateness of an investment to a particular investor), by the “results” method one might as easily choose a monkey with a handful of darts as a skilled security analyst.

Hard work is essential in security analysis.

The following background, skills, and traits are useful for post-modern security analysis:

1. Computer literacy, especially skills in Internet research.
2. Curiosity, skepticism, independence of mind, and the ability and eagerness to be self-taught in new areas as necessary.
3. Persistence, patience, determination, perseverance, diligence, industry, and the ability to focus and concentrate on a task for a long period until resolved.
4. An elementary knowledge of accounting (what is a debit, credit, balance sheet, and income statement).
5. An elementary knowledge of law (contracts, instruments, corporations, different legal jurisdictions and systems).
6. A logical mindset. The ability to sort, select, outline and organize facts.
7. Basic familiarity with the scientific method.
8. Elementary mathematics.
9. Writing skills of a high level.

A person with these traits, even without formal training in economics or finance, may be an excellent security analyst.

Note: Benjamin Graham, perhaps the most famous security analyst and the mentor of Warren Buffett, studied Greek and Latin Philosophy, English, and Mathematics. He wrote a Broadway play (“True to the Marines”), patented an improved slide rule, translated Mario Beneditti’s “The Truce” into English, and had the hobby of translating Homer into Latin and Virgil into Greek.

The evolution of security analysis

Security analysis developed slowly over five hundred years, from early commercial paper negotiation in Medieval Italy, to securities trading in the 17th century coffee houses of London, to the formation of the US Securities and Exchange Commission in 1932, down to the complex derivatives markets of modern times.

Earliest analysts were business people.

Many thousands of books and pamphlets have been written on the subject, but all have one thing in common — they all deal with the type and quality of information available and relevant to the practices at the time written and almost all become obsolete subsequently. (Exceptions are such things as books describing the mathematics of calculating bond yields.)

The four main epochs of security analysis are as follows:

1. The Pre-Classic Period: This includes everything prior to 1934, when the US Securities and Exchange Commission began operations and the first edition of Graham & Dodd’s “Security Analysis” was published.During most of this period, securities markets were small, most “analysts” were investors, making decisions for their own account, financial information was sparse and difficult to obtain, and the security analysis was not recognized as a distinct profession, but rather just part of ordinary business skills.Markets were often dominated by speculators and stock manipulators. Fraud was common.
   

   East India House, Leadenhall Street, London, 1828

   Investment during this period might be best classified as “venture analysis”, often based on commonsense and first-hand knowledge of the people involved, combined with rudimentary financial analysis.

   The bond market drew more investors than the stock market and emphasis was placed on collateral and guarantees.

   Towards the end of this period, governments would exchange money for gold or silver at a fixed rate and income taxes were non-existent or minor.

   This was also the time of fanciful, exotic speculative techniques, such as W.D. Gann’s “Theory of Vibrations”, or the variety of practices based on price and volume patterns, from Japanese candlestick charts to ticker tape reading — all relevant to short-term trading. (Many of these techniques employed charts, numerology, and astrology and persist to this day.)

2. The Classic Era (1934-1966): During the Great Depression, World War II, and the early post-war years, New York City has the financial capital of the world and dollar bills were no longer convertible into gold.Security analysis was profoundly influenced by the text of Benjamin Graham and David Dodd (1934), as well as by a paper published by John Burr Williams on the valuation of common stock (1938).

This was the golden age of “fundamental analysis” — the notion that either by commonsense and attention to the facts (Ben Graham) or by using John Burr William’s formulas, the intrinsic value of common stock could be estimated. When this was far less than market value, an opportunity for profit existed.

During this period, the yield on common stocks was generally higher than the yield on bonds. Only a small percentage of the population invested in securities. Furthermore, coming out of the Great Depression into post-war boom times, the climate for investment, in general was favorable.



By the end of the period, mutual funds were being sold door-to-door and the price of stocks, relative to bonds, had risen. The dividend premium vanished. It was getting harder to find under-valued securities.

Benjamin Graham retired in 1956. His star pupil, Warren Buffet, closed down his investment partnership in 1966.

The first exams for Certified Financial Analyst were held in 1963. A new era was beginning.

3. “Modern” Security Analysis (1967-2008): The era of so-called “modern” security analysis lasted about two generations and encompassed massive structural changes in capital markets, as well as new theories that influenced the behavior of security analysts.The principal changes that impacted the markets were as follows:
   • Mass entrance of unsophisticated shareholders into the US markets: Following World War II, equities began to be marketed to the masses, by means of door-to-door sales of front-loaded mutual funds.In 1953, the New York Stock Exchange opened a campaign, “Own a share of America”.Tax deferred Individual Retirement Accounts were introduced in 1974 with the “Employee Retirement Income Security Act (ERISA)”.In 1952, only 4.2% of the US population held equities; by the end of the century, more than half of American households were shareholders.
   • Stock manipulation legalized: In 1982, the US Securities and Exchange Commission issued Rule 10b-18 that granted “safe harbor” to corporations that wanted to use shareholder funds to manipulate stock prices in order to give value to executive stock options.Over the next 26 years, about $5.7 trillion (2008 dollars) were diverted to this end, driving prices upwards during the period, despite market crashes in 1987 and 2000.
   

   During the modern era, there were many false gods.

   • Rise of the Efficient Market Hypothesis and Modern Portfolio Theory: In 1952, Harry Markowitz wrote a paper proposing that security risks should be measured in terms of past market fluctuations, rather than fundamental facts indicative of potential financial or operational dangers.In 1959, Miller and Modigliani published a paper suggesting that unrealized capital gains were just as good as dividends and that debt was equivalent to equity.In 1961, William Sharpe wrote a treatise on the “Capital Asset Pricing Model” that further promoted the mathematical theories of Harry Markowitz.In 1965, Eugene Fama published the “Efficient Market Hypothesis” that claimed, in effect, that market prices were equivalent to intrinsic value, leading to the development of unmanaged index funds and the decline of fundamental analysis as taught by Benjamin Graham and David Dodd in the earlier era.In 1973, Black and Scholes produced mathematical formulae for pricing options.None of these theories or hypotheses were based on scientific evidence or analyses of real markets and none were proposed by analysts with actual capital market experience.

     Nevertheless, the leading proponents of these strange ideas earned Nobel prizes (except for Eugene Fama) and their theories were firmly in the curricula for certification of financial analysts by the end of the century.

   

   Foreign trade based on dollars.

   • The US trade deficit and the bond market: In 1971, President Nixon took the US off the gold standard, leaving world currencies free to fluctuate.At the same time, the United States encouraged free trade and globalization, while most of the rest of the world embraced neo-mercantilist policies.The result was an ever-expanding trade deficit, leading to foreign investors holding $16.8 trillion in US financial assets by 2009.Since most of these foreign-held assets were invested in US fixed income securities, bond yields declined for twenty years — contributing (along with stock buybacks) to the persistent rise of equity prices and the widely held belief that an unmanaged, diversified portfolio of common stocks was the best investment for the long-run (the “Common Stock Legend“)
   • The Internet and the information explosion: In the last decade of the 20th century, the Internet was developed on a global basis.At the same time, new securities markets were being created in developing and former communist block countries.
     

     Libraries, web servers, home computers ... a new world.

     The traditional sources of data for security analysts, such as Standard & Poor’s and Moody’s were unable to keep up with the flow of information, while markets, instruments, institutions, and operations became infinitely more complicated than in the days of Graham & Dodd.

     The Crash of 2008 was largely a crisis of information in which, long-lulled by the false promises of the Efficient Market Hypothesis, bankers and investors suddenly realized that they were unprepared to determine the intrinsic value of securities.

The post-modern era of security analysis

Modern Economic Theory meltdown.

The era of “modern” security analysis ended abruptly with the Crash of 2008. The reputations of the major financial statistic publishers were in tatters. Security analysts no longer trusted doctrines that they had been required to memorize for professional certification a few years before.

“The Economist” magazine showed on its cover in July 2009 that “modern economic theory” was melting down. Nobel prize economist Paul Krugman expressed what many others had concluded, saying that much of the past 30 years of macroeconomics was “spectacularly useless at best and positively harmful at worst”.

Between the high in stock prices on October 9, 2007, and the low point on March 9, 2009, the market value of US equities, as measured by the Wilshire 5000 index, declined about 9 trillion dollars. Worldwide, in all instruments, losses were perhaps double that.

Clearly, “modern” security analysis had not lived up to its billing.

However, the world and markets had changed. It was not possible to go back to Graham & Dodd and earlier times — things were too complicated now and there was too much information to dig up and analyze.

New techniques are needed to meet this challenge.

These techniques might be called “post-modern security analysis.”

Next lesson: Intrinsic value.