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Sunday, February 22, 2009

Security Analysis:Chapter 4

In this chapter, Graham attempts to define "investment." The difference between investment and speculation is hard to define.

Many people believe that investment is:

-in bonds
-outright purchases
-for permanent holding
-for income
-in safe securities

and speculation is:

-in stocks
-purchases on margin
-for a "quick turn"
-for profit
-in risky issues

but, he shows examples of investment that fall under all the speculative criteria listed above. So, these are not good guidelines. He arrives at the proper definition of:

An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory rate of return. Operations not meeting these requirements are speculative.

We agree with this definition.

Next, we learn that an investment must be justified on both qualitative and quantitative terms.
We then take a look at speculation and how it is affected by analysis - the value of analysis is lessened as the factor of chance increases. There is intelligent and unintelligent speculation, but we will study neither of these. We are investors.

He gives us an analogy of speculation versus investment. In the game of Monte Carlo, the odds are 19 to 18 in favor of the proprietor. In an speculative operation, the analysis would allow somebody to win MORE if his number turns up on the roulette table, but it only helps if the element of chance is on his side. In an investment operation, the investor would reverse the odds to 19 to 18 in his favor, so, whichever number turns up, he is certain to win a moderate amount.

Next, we learn of what is perhaps the most distinguishing factor in our investment strategy, the margin of safety concept. This is gives us room for error. For bonds and preferred stock, the margin of safety is determined by the excess of earning power over dividen and interest requirements, or, rephrased, the value of the enterprise above the senior claims against it. For common stock we find the margin of safety by the excess of calculated intrinsic value over the price of the stock. This approach does not usually work with the biggest companies, so, for them, there is another margin of safety: the excess of expected earnings and dividends for a period of years above a normal interest return.

Finally, we learn of the concept of diversification. By diversifying, you reduce your chances of loss - if you make a mistake, it won't affect your whole portfolio. While this is taught in the book, I personally do not believe in diversification. Money works best when concentrated. Warren Buffett touts Security Analysis as the greatest book on stock investing, but he himself said that diversification is a valuable tool against ignorance. When he was studying under Graham, he invested almost all of his funds into GEICO, even though Graham was telling him to diversify the whole time. So, for our purposes, we will study Graham's principle of diversification, but we will not adopt it into our investment strategy.

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