Pearl Invest

The first edition of Security Analysis, published in 1934, forever changed the theory and practice of successful investing. Yet the remainder of that tumultuous decade brought unprecedented upheaval to the financial world, compelling Benjamin Graham and David Dodd to produce a comprehensively revised second edition.

It is that edition, out of print for decades, that you now hold in your hands. Security Analysis, Second Edition, published in 1940, is considered by many (including legendary Graham student Warren Buffett) to be vastly superior to the first. Yet after three subsequent editions and over six decades, the insightful and instructive second edition could be found only in rare bookshops and closely-guarded private collections.

McGraw-Hill, the book’s original publisher, is honored to publish Security Analysis: The Classic 1940 Edition. Identical in every meaningful aspect to the classic original, this is the long-awaited book that set the tone for decades of value investors. Let it provide you with a greater understanding of this country’s financial heritage, along with timeless value investing insights that have proven relevant and profitable in all types of markets and financial environments–and will never go out of style.

“The lapse of six years since first publication of this work supplies the excuse, if not the necessity, for the present comprehensive revision … We have revised our text with a number of objectives in view. There are weaknesses to be corrected and some new judgments to be substituted.”–From the Preface

The names Graham and Dodd have come to be inextricably linked in the minds of thoughtful, disciplined investors. Their 1934 book Security Analysis made the two synonymous with intelligent, long-term investing, and forever changed the face of Wall Street. While post-Crash traders and investors treasured the book for its rigorous honesty, determined logic, and unequalled track record of success, the authors saw only the “weaknesses to be corrected.”

The second edition of Security Analysis, published in 1940, allowed Ben Graham and David Dodd to set the record straight. It was considered by many then, and is considered by many now–including Graham student and disciple Warren Buffett, to be superior in many ways to the first. Still, as subsequent revised editions appeared, the once-indispensable second edition fell out of print and became virtually impossible to locate.

With Security Analysis: The Classic 1940 Edition, McGraw-Hill returns this long-sought investment classic to the marketplace. While its timeless advice–that investors should ignore social trends, company prospects, and management styles to focus on the balance sheet–is as vital today as it was in 1940, it is the book’s updated insights and observations that justify its importance in the annals of both investing and publishing.

Even as the financial world sang the praises of 1934’s groundbreaking Security Analysis, Benjamin Graham and David Dodd knew they could improve it. And that they did, with the 1940 publication of a brilliant second edition. Now, after having been unavailable for decades, this influential book returns in Security Analysis: The Classic 1940 Edition. As powerful today as it was for investors six decades back, it will reacquaint you with the foundations of value investing–more relevant than ever in tumultuous 21st century markets–and allow you to own the only book that could rightfully claim to have improved upon the eloquent first edition of Security Analysis.

Benjamin Graham the mental founder of value investing always emphasized that it´s extremely important to know the difference between an investment and speculation. Nowadays many people believe that they are investors just because they read some news about the company they buy stocks of and think that the price will go up just because the stock chart is so and so.

However that´s not true in most cases value investors actually even don´t care about stock prices. An investment is present if it promises the safety of the set in capital as well as a profit on the set in capital after a detailed analysis, everything else is speculation. So according to Benjamin Graham if somebody buys a stock without analysing the balance, the environment and the cash flow statement of a company he is a speculator. Even if this person has read some news about the company and is sure that the price of the shares will rise this person is a speculator.

On the other hand an investor always analyses the balance and combines it results with the news and information of a company. In the end an investor should always get a value which defines what the company is worth in his eyes right now. Based on this value his either buys or sells a stock, but he would never buy a stock because he read a great article about this stock or the 38-days line crosses the 200 days line or something like this.

Nevertheless it has to be said that it´s not forbidden to practice speculation, there are also some guys who are quite good in this field. But it´s important to understand that there is a difference between building up a fortune by growing with a company and trying to get rich quick by trading in shares of a company.

In this Chapter we want to discuss why value investing works, but at first I want to do a little experiment. Image we trow a coin 6 times and everytime we do that we either get head (H) or a number (N), so what do you think which sequence is more likely to appear ? (H), (H), (N), (H), (N), (N)   or  (H), (H), (H), (H), (H), (H) the fact is that they are statistically completely similar. So what we can learn from this experiment is that the most people, despite they are well in numbers and stochastic would say that the first sequence is more likely to happen, because for them it´s not sound that the head of the coin appears six times in a row.

However why is this experiment interesting in order to understand why value investing works ? Well because that shows us that humans have their own subjective view of how the things are and these views are reflected in the sometimes strange movements of the stock markets. The Israeli psychologist Daniel Kahneman for example has won the Nobel price in economics for his work on behavioral finance, in which he discovered that irrational movements of the markets are the result of the collaborative opinions of single persons. Benjamin Graham the spiritual founder of the modern value investing described this phenomena with the help of the insane Mr.Market. He wrote, imagine there is a guy who comes to your home every day, just to tell you the price of your stocks. Actually this is a fine thing wouldn´t there be the fact that Mr.Market has a serious problem, because sometimes he is far too optimistic and tells you that your stocks will reach the heaven soon. And sometimes he is so the most depressive man in the world and predicts that your stocks will be worth nothing anymore soon. What Mr.Graham describes is just the behavior of the crowds. When they see that the markets are going up they want to participate on that, but when they see that the markets are falling they are feared to loose their money and start to sell their securities.

In order to explain how the reactions of the average investor are I took the following 10 years chart of the German stock index DAX.

1. The average investor starts to buy mostly overvalued stocks because he wants to participate at the rising markets.

2. The rally is over and the most winnings of the most average investors are zero again.

3. The average investor thinks that this was just a little break of the rally and buys again.

4. The markets are crashing the average investor sells his stocks and is frustrated.

5. Because the average investor is frustrated from his losses he made in 2003 his just starts to buy stocks in the year 2007 again and the whole game starts from scratch.

So the reason why value investing works is that value investors don´t care about subjective market fluctuations. Everything which counts for them are objective facts about the companies they buy. So the company is in their opinion undervalued because the for example the market capitalisation is worth far less than the actual assets of the company are.  Actually they don´t care about stock rates, because they know that they struck a bargain and on the long run the market will realize that.

The genius investor Warren Buffett once called it “buying one dollar for 70 cent”, the Margin of safety which was developed by the brilliant man Benjamin Graham in 1934. The precept of the margin of safety is very logic and works as follows.

Most people believe that the stock markets are rational, so that the stock-rate always reflects the actual value of a company. But that´s not true , you can prove that very easily. We you look back to the big ups and downs in times of a market crash. It´s definitely not logical that a company looses 60 % of its value and wins 120 % back in a short period of 2 years while the earnings constantly grow by 5 %. So we can conclude that the markets are irrational because sometimes the people become too afraid and sell very cheap stocks and sometimes they are just too optimistic and buy too expensive stocks. It´s not very intelligent but most people like to follow the herd.

But now, let´s get back to the margin of safety. If you know that the stock markets are irrational then why don´t make profit of it? First you look for very unpopular “cheap” stocks, the market capitalisation has to be far below the intrinsic value. That could be companies in trouble, after they reported bad news or complete industries with problems.

Now you calculate the value of the company in order to do that you can use different methods. 1. The Earning-capacity value 2. The Net asset value 3. The liquidation value. So for example, if you calculated that the intrinsic value of a company has the value of 100 Million USD, but the market capitalisation just lies at 70 Million USD, you get a margin of safety of 30% or 30 Million USD. You buy this stock and when the market capitalisation achieves the intrinsic value again you sell it.

Note: The margin of safety has not to be exactly 30 percent, but the higher it is the safer is the investment.