toward a science of security analysis

8/12/2019 Toward a Science of Security Analysis

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Toward a Science of Security AnalysisBenjamin Graham

THE SClEN I IRC M ETHO DAs H. D. W olfe pointed out in his pape r in the las tJOURNAL Science as a Tr us tw or th y Tool) 1, scientificmethod includes among i ts factors the wide obser-vat ion and recording of events , the construct ion ofra t ional and plausible theor ies or formulas , andthe ir va l idat ion th rough the me d ium of r easonab lydependable predic t ions . There are many var ie t iesof scientific or quasiscientific disciplines, and thecharacter of the predic t ions based on them wil lvary great ly f rom one to another.1

At one ex t reme t ake the mic rophone . An

electrical engineer, having rigged it up carefully,c a n predic t that a word spoken into i t wi l l beimmediate ly ampli f ied. The predic t ion is precise ;the ver i f icat ion prompt and unquest ionable . At theother extreme le t us take psychoanalysis- - -a disc i -p l ine somet imes compared wi th our own secur i tyanalysis . Here predic t ion and ver i f icat ion are lessdef ini te . A layman who f inances psychoanalyt icalt reatmen t for one of h is family is apt to be s l ightlyin the dark about such deta i ls as the nature of thei l lness, the me tho d an d dura t ion of the t reatment ,and the extent of the cure , i f any. A bou t the onlything he can predic t wi th cer ta inty is how much i t

wi ll cost per hour. Betwe en these tw o extremes l iesactuar ia l sc ience, which to my mind is more re le-vant than the others to the scientific possibili t ies Osecur i ty analysis . The l i fe insurance actuary ma kespredic t ions concerning morta l i ty ra tes , the ra te ofearnings on invested reserves , and factors of ex-pense and prof i t - - in a l l ins tances based largely oncareful ly analyz ed past exper ience, w i th a l lowancefor t rends and n ew factors . Out of these predic-t ions , wi th the a id of mathemat ical techn iques , hefashions sui table prem ium schedules for var ioustypes of insurance. What is most important for usabou t his wor k and his conclusions is that he deals

no t wi th ind iv idua l c ases bu t wi th the p robab leaggregate result of a large number of similar cases.Diversification is of the e ssence in actuarial sde nce.

Thus o ur fi rs t pract ical quest ion abo ut sc ien-tific security ana lysis is wh eth er i t is actuarial incharacter, and has diversification as i ts essential

Reprinted romThe Analysts Journal August 1952):97-99.

ingredient . One plausible answer may be thatdiversification is essential for certain types andobjectives of security analYsis but not for others.Let us classify the things that security analysis triesto do and see how the e lement of d ivers i f icat ionappl ies to each. At the same t ime we may ra iseother quest ions concerning the sc ient i f ic methodsand predic t ions ope rat ing in each of the c lasses .

I sugges t tha t the end p roduc t o f our workfalls into four different categories, as follows:

1. The selection of safe securit ies, of the bo ndtype.

2 . T he se lect ion of und erv alue d secur it ies.3. The selection of gro wt h securit ies, that is,

common s tocks that are expected to increase thei rearning power a t considerably bet ter than theaverage ra te .

4 . The se lection of near- term o pportu ni t ies ,that i s , common s tocks that have bet ter- than-aver-age prospects of pr ice advance, w i thin , say, thenext 12 months .

This l i s t does not include s tock market analy-s is and predic t ions based thereon. Let me com-ment briefly on this point. If security analysis is tobe scientific, i t will have to be so in i ts own right

and no t by depe nd ing on marke t t echn iques . I t i seasy to dismiss th is point complete ly by sayingthat , i f market analysis is good, i t doesn ' t n eedsecurity analysis; and, if i t isn' t good, securityana lys i s doesn ' t wan t it. But th is may be toocaval ier an a t t i tude toward an area of act iv i ty thatengag es the in teres t of a host of reputable secur i tyanalysts . That s tock market analysis and secur i tyanalysis combined may be able to do abetter jobthan security an alysis by itself is at least a conceiv-able proposi t ion and perhaps a plausible one. Butthe burden i s on those w ho wou ld es t ab li sh th isthes is to demonstra te i t to the res t of us in un-

equivocal and convincing fashion. Cer ta inly thepubl ished record is far too meager, as yet , towarrant conceding a sc ient i f ic s tanding to a com-binat ion of the two analyses .

FOUR CATEGORIESTo re turn to our four categor ies of secur i ty analy-s is , choosing safe bonds and preferred s tocks iscer ta inly the mos t respectable i f not the most

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exci t ing occupat ion of our gui ld . Not only has i tmajor im portance of i t s own , b ut a lso i t can offeruseful analogies and ins ights for o ther branches ofour work. The emp hasis of bon d analysis is onpas t pe r fo rmance , t empe red b y a conse rva tiveview of future cha nges a nd dangers . I t s chiefre l iance is on a margin of safe ty that grows out of

a small ratio of debt to total real value of theenterpr ise . I t requires broad divers i f icat ion to as-sure a representa t ive or average over-a l l resul t .These v iewpoin t s have made bond inves tmen t , a spract iced by our f inancia l ins t i tu t ions , a soundlyscient i f ic procedure . In fact , bond investment nowappe ars to be a lmost a branch of actuaria l sc ience.There are interesting similarit ies (as well as differ-ences) between insur ing a man 's l i fe for $1,000against a premi um of $34 per year, and len ding$1,000 on a long- term bond a lso paying $35 peryear. The calcula ted morta l i ty ra te for me n ag ed 35is about 4 out of 1,000, or 4/10% per year. A

comp arable morta l i ty ra te might be appl ied tocorporate enterpr ises in the best f inancia l andoperat ing heal th , to es t imate the r isk a t taching tohigh-grade bond investment . Such a f igure , say1/2%, might then proper ly measure the r isk andyield di fferent ia l between the s t rongest corporatebonds and U. S . Government ob l iga t ions .

BON D INVESTM ENT: A SCIENTIFICPROCEDUREBond inves tmen t shou ld t ake on more o f thecharacter of a sc ient if ic proc edur e w he n the mon-umenta l co rpora te bond s tudy, ca r r i ed on by theNat iona l Bureau o f Economic Resea rch and o the ragencies , i s f inal ly completed and the mass ofstatistical data and findings is made available tosecur i ty analysts . The greates t wea kne ss of ourprofess ion, I have long bel ieved, i s our fa i lure toprovid e real ly com preh ensiv e records of the re-sul ts of investments in i t ia ted or carr ied on by usunder va r ious p r inc ip les and t echn iques . W e haveasked for unl imited s ta t is t ics f rom others cover ingthe r e su l ts o f thei r ope ra t ions , bu t w e have beenmore than backward in compil ing fa i r and ade-quate s ta t is t ics re la t ing to the resul ts of our ownwork. I shal l have a suggest ion to make on thatpoint a little later.

SELECTION OF UNDERVALUED SECURm ESThe select ion of und erv alue d secur i ties appea rsnext on my l ist because of it s logical re la t ionship toinvestment in safe bonds or preferred s tocks . Themargin-of-safe ty concept i s the dominant one inb o t h g r o u p s . A c o m m o n s t oc k is u n d e r v a l u e d ,

typical ly, i f the analyst can soundly es tabl ish thatthe enterpr ise as a whole is worth wel l above themarket price of all i ts securit ies. There is a closeanalogy here wi th bond select ion, which a lso re-quires an enterpr ise value wel l in excess of thedebt . But the rewards for es tabl ishing that a com-mon s tock is underva lued a re, o f course , incompa-

rably greater ; for in the a verage case a ll or a goodpar t of the margin of safe ty should eventual ly bereal ized as a prof i t to the buyer of a t ru ly under-valued issue.

In th is connect ion I want to throw out a broadand chal lenging idea-- that f rom a sc ient i f ic s tand-po in t common s tocksas a wh olemay be r ega rded asan es sen t ia l ly unde rva luedsecurity form.This pointgrows out of the basic di fference between individ-ual r isk and overal l or group r isk . P eople ins is t ona substant ia l ly higher dividend re turn and a s t i l llarger excess in earnings yie ld for common s tocksthan for bonds, because the r isk of loss in theaverage single common s tock i s sue i s undoub ted lygreater than in the averagesingle bond . But thecomparison has not been t rue his tor ical ly of adiversified group of common s tocks , s ince commonstocks as a whole have had a wel l -def ined upwardbias or long- term upwa rd movem ent . This in turn isreadily explicable in terms of the country's growth,plus the s teady re investm ent of undis t r ibuted prof-its, plus the strong net inflationary trend since theturn of the century.

RRE AND CASUALTY RARESThe analogy here is wi th f i re and casual ty insur-ance ra tes. P eople pa y abou t twice as mu ch for f i reinsurance as thei r own actuar ia l ly determined ex-p o s u r e w o u l d i n d i c a t e - - b e c a u s e t h e y c a n n o tsoundly afford to carry the individual r isk them-selves . For s imilar reasons the overal l re turn oncomm on s tocks appea r s to have been a t leas t tw iceas much as thei r t rue overal l r i sk has required. Aninteres t ing re la t ionship a t th is point appears f romthe Keys tone cha r t showing the t r end o f the Dow-Jones industr ia l average s ince 1899. Both the uppe rand lower l ines happen to r ise a t the ra te of onethird eve ry ten years . You wil l recognize th is as the

2.90% rate of com pou nd interes t real ized on U. S.Savings Bonds, Ser ies E. What th is means is thecons i s t en t Dow-Jones inves to r has ob ta ined thesame increase in principal value as the savingsbon ds offer in l ieu of in terest ; an d in a ddi t ion theDow-Jones s tock investor has obta ined a l l theannua l d iv idends f rom h i s ho ld ings a s a bonusabove the Government bond in te res t r a t e .

The reasoning I have jus t indulged in is , I

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believe, both scientifically valid and psychologi-cal ly dangerous . I t s val id i ty depends on the main-tenance in the s tock market of the substant ia ld i spa r ity be tw een b ond y ie lds and the p r i ce-ea rn -ings ra t ios on s tocks . I f as happened in the1920s-- this very thes is i s twis ted in to the s loganthat common s tocks are a t t ract ive investments ,

regardless of ho w high the y sel l, then we wou ldf ind ourselves beginning as sc ient is ts and endingas heedless and i l l -s tarred gamblers . I t may be afair generalization to assert that the top levels ofmos t norm al bul l markets are character ized by atendency to equate s tock r isks wi th bond r isks .These h igh va lua t ions may indeed have somejust i f ica t ion in pure theory, but the importantthing for us to bear in mind as pract ic ing analystsis that , when you pay ful l value for commonstocks , you are in great danger of la ter appear ingto have pa id too much .

INDIVIDUAL UNDERVALUATIONSTurning now to the f ie ld ofindividual underva lua -t ions , we f ind ourselves on more famil iar ground.Our work with th is group readi ly admits of thescient i f ic processes of wide observat ion and thetes t ing out of predic t ions or hypotheses by thei rseque ls . The theory o f underv a lued i s sues mus tnecessar i ly require an explanat ion of thei r or igin .The explanat ions are in t ruth qui te var ied andtaken together form what may be cal led a pathol-ogy o f marke t p r i ces. They range f rom obv iouscauses , such as an undu ly low d iv idend o r atemporary se tback in earnings , to more subt le andspecia l condi t ions such as too much common s tockin the capi ta l s t ructure or even too much cash inthe bank . In be tween l i e numerous o the r causessuch as the prese nce of importan t l i tigat ion, or thecombinat ion of two diss imilar businesses , or theuse o f the now d i sc red it ed ho ld ing c ompa nysetup.

ORIGINS OF UND ERVALUATIONUNDERSTOODThe or igins of undervaluat ion are pret ty wel l un-de r s tood by now and cou ld no doub t be se t fo r thin an acceptably sc ient i f ic s tudy. We do not knowas mu ch ab out the cure of undervalu at ions . Inwhat propor t ion of cases is the discrepancy cor-rec ted? How or why does the co r rec t ion occur?Ho w long does the p rocess t ake? These ques t ionsremind us some wha t o f those we ra ised abou tpsychoanalysis a t the outset . But one th ing ofimportance we do know, and that i s that thepurch ase of und erv alue d issues on a divers i fied

basis does produce consis tent ly prof i table resul ts .Thus we have a worthwhi le f ie ld for more sc ien-t if ic cul t ivat ion. H ere induct ive s tudies carr ied o ninte l l igent ly and systemat ical ly over a per iod ofyears are a lmost cer ta in to be rewarding.

S E L E CT I O N O F G R O W T H S TO C K S

The third objective of security analysis is the selec-t ion of growth s tocks . How scient i f ic a procedureis th is now, and how scient i f ic can i t be made tobe? Here I enter d i ff icul t waters . Most growthcomp anies are the mselve s t ied in c losely wi thtechnological progress ; by choosing thei r sharesthe secur i ty analyst la tches on, as i t were , to thecoattails of science. In the 40 or more plant inspec-t ions that are on yo ur sc hedu led f ie ld tr ips for th isconven t ion week , no doub t your ch ie f emphas i swi l l be p laced on new produc t s and new processdevelopments ; and these in turn wi l l s t ronglyinf luence your conclusions about the long-pul l

prospects of the var ious companies . But in mostinstances this is primarily aqualitative approach.Can your work in this field be truly scientificunless i t i s sol id ly based on dependablemeasure-ments, that i s , specif ic or minimum project ions offuture earnings , and a capita l izat ion of such pro-jected profits at a rate or multiplier that can becal led reasonably conservat ive in the l ight of pas texper ience? Can a def ini teprice be pu t on fu tu regrowth- - -be low which the s tock i s a sound pur-chase , above which i t i s dear, or in any eventspeculat ive? What is the r isk that the expectedgrowth will fail to materialize? What is the risk ofan impor tan t downward change in the marke t ' sevaluat ion of favorable prospects? A great deal ofsystemat ic s tudy in th is f ie ld is necessary beforedependab le answers to such ques t ions wi l l befor thcoming.

STOCK INV ES rMENT IN P RESCIENTIFICSTAGEIn the mea nt ime I cannot help b ut feel that grow thstock inve stm ent is stil l in the prescien tific stage. Iti s a t the same t ime more fascinat ing and lessprecise than the se lect ion of safe bonds or under-valued secur i t ies . In the growth s tock f ie ld , theconcep t of margin of safe ty loses the c lar i ty and thepr imacy i t enjoys in those other two classes ofsecur i ty analysis . True, there is safe ty in growth,and some of us wi l l go so far as to declare thatthere can be no real safe ty except in growth. Butthese sound to me more l ike s logans than sc ient i f -ically formula ted and ver i f ied proposi t ions . Again,in the g row th f ie ld the e le ment of se lect iv ity is so

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prominent as to place divers i f icat ion in a second-ary and perhaps dubious posi t ion. A case can bemade for put t ing a l l your growth eggs in the onebest or a re la t ively few best baskets . Thus in th isbranch of secur i ty analysis the actuar ia l e lementmay be miss ing , and tha t c i r cums tance undoub t -edly mil i ta tes against t ru ly sc ient i f ic procedures

and resul ts .INVERTED RELATIONSHIPThere i s undoub ted ly an o rgan ic bu t inve r t edre la t ionsh ip be tween the g rowth s tock con-cep t and the theory o f underva lued secur i ti e s. Theat t ract ion of grow th is l ike a t idal pul l which causesh igh t ides in one a rea , the a s sumed g rowth com-pan ies , and low t ides in ano the r a rea , the a s su mednongrowth compan ies . We can measure , in asense , scientifically the distor ting effect of thisin f luence by us ing as our s t andard them i n i m u mbusiness value of en te rp r i ses in the n onfavored

group. By wa y of i llus t ra t ion le t us a pply thatthought to three Cal i fornia concerns . The shares ofRoos Brothers, a local retail enterprise, will in thenature of th ings tend to sel l belo w their analyti -cal ly determined value for bas ical ly the same rea-sons tha t a re bound to p roduce overva lua t ions inthe sha res o f Superio r Oi l o r Kern Cou n ty Land .

I come f inal ly to the s tandard occupat ion ofb rokerage house ana lys t s and adv i so ry se rv ices ,name ly, th e se lect ion of i ssues favorably s i tuatedfor a near- term market advance. The usual as-sum ption here is that , i f the earnings wi l l improv eor the dividend wil l be ra ised, then the pr ice wi l limprove. Thus the process consis ts essent ia l ly ofloca t ing and recommending those compan ies tha tare l ikely to increase thei r earnings or d ividends inthe near term. You al l know the three basic haz-ards encountered in th is work: that the expectedimprovement wi l l not take place , that i t i s a l readydisco unted in the curren t pr ice , that for some othe rreason or for no known reason the pr ice wi l l notmove the way i t shou ld .

I t may be that despi te these hazards i t i sposs ible to obta in worthwhi le resul ts on the aver-age f rom compe ten t shor t - t e rm ana lyses and p re -

dic t ions . W ho of us can say wh ethe r or not th is i st rue? In view of the importance of th is analyt icalwork, in terms of t ime, energy, and m on ey cost , itmight n ot be a bad idea to subject i t to a thorough-going evaluat ion.

SEARCHING SELF-EXAMIN ATIONThis b r ings me to my conc lus ion and my oneconcrete proposal . Secur i ty analysis has nowreached the s tage where i t i s ready for a cont inu-ous and searching sel f -examinat ion by the use ofestablished statistical tools. We should collect thes tud ies and recomm enda t ions o f num erous ana -lys ts, c lass ify them in accordance wi th thei r objec-t ives (perhaps in the four groups suggested in th ispaper) , and then do our best to evaluate thei raccuracy and success . The purpo se of such arecord would no t be to show who i s a goodsecur i ty analyst and who is a poor one, but ra ther

t o s h o w w h a t m e t h o d s a n d a p p r o a c h e s a r e s o u n dand f rui t ful and which ones fa i l to meet the tes t ofexper ience.

This suggest ion was or iginal ly made in thea r t i c l e s pub l i shed under the pseudonym ofCogita-tor in THE ANALYSTSJOURNALsix years ago. At thatt ime I wrote : I t is unl ikely that secur i ty analysiscould develop profess ional s ta ture in the absenceof reasonab ly def ini te and plausible tes ts of thesoundn ess o f ind iv idua l and g roup rec omme nda-t ions. ' '2 The N ew York Socie ty is no w taking thef i rs t posit ive s teps to es tabl ish a quasiprofess ion alra t ing or t i t le for secur i ty analysts who meet spec-ified requirements. I t is virtually certain that thismovement wi l l develop ul t imately in ful l - f ledgedprofess ional s ta tus for our cal l ing. The t ime maywel l be r ipe for the Federat ion and i ts const i tuentSocie t ies to begin a systemat ic accumulat ion ofcase his tor ies , which should make poss ible thet ransmiss ion o f a con t inuous , eve r-g rowing bod yof knowledg e and t echn ique f rom the ana lys t s o fthe past to those of the future .

When th i s work i s we l l under way secur i tya n a l y s i s m a y b e g i n - - m o d e s t y, b u t h o p e f u l l y - - t orefer to i tself as a scientific discipline.

Foo rNOTES

1. H.D . Wolfe, Science as a Trustworthy Tool,The AnalystsJournal (March 1952):45-49.

2. Cogitator, On Being Right in Security Analysis,The Ana-

lysts Journal(1st Quarter 1946):18-21, especially at p. 18 forquoted material.

2 8 Financial Analysts Journal / January-February 1995

toward a science of security analysis

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