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"Security Analysis", Benjamin Graham and David Dodd


Returns not inherent to an asset class; capital flowing in impairs ability to replicate historically attractive returns… 1930’s annual turnover as a percentage of listed shares struggled to reach 50%... Businesses are just as fragile and mortal as the people who own them… Companies can try to cook books, but can’t manufacture cash. When income statement and cash flow statement diverge, signal something is amiss… Must wrestle with a three-fold problem: 1) safety and interest of principal 2) the future of bond yields and prices 3) the future value of the dollar… If purchasing power to decline own stocks over commodities and bonds… Speculative senior issues risk of loss must be offset by higher yield and commensurate chance of principal profit; approach these issues as if stocks, recognize limited claims or inferior type of senior security… No stock speculation analysis, stock investment, or analysis of value and controlled by standards of safety of principal… Employ wholesale skepticism as to the soundness of the stock market’s judgment on all broad matters relating to the future… Beware widespread recognition of the factor of future growth or contraction… Leading companies more resistant to depression and more complete recoveries… High rate of earnings on invested capital makes company vulnerable to attack by competition and regulation… If low bond yields are permanent they must produce a corresponding decline in average stock yields and an advance in the value of a dollar of expected earnings, UNLESS decline in the average profitability of invested capital… Stock market timing cannot be done UNLESS the time to buy is related to an ATTRACTIVE PRICE LEVEL… Investor has been one with patience and courage of convictions who buys when the harried or disheartened speculator was selling… The thousands of so-called secondary companies should offer at least a MODERATE number of true investment opportunities under all conditions, EXCEPT PERHAPS IN THE HEYDEY OF A BULL MARKET… The ‘new era’ commencing in 1927 involved at bottom the abandonment of the analytical approach; and while emphasis was still seemingly placed on facts and figures, these were manipulated by a sort of pseudo analysis to support the delusions of the period… In the field of bonds and preferred stocks we believe that sound principles of selection and rejection have served themselves quite well. In the common stock arena the partialities of the market have tended to confound the conservative viewpoint, and conversely many issues appearing cheap under analysis have given a disappointing performance (1933-1940)… 3 functions of analysis 1) Descriptive: marshaling important facts related to an issue and presenting them in a coherent, readily intelligible manner i.e. S&P. A more penetrating type of analysis seeks to reveal the strong and weak points in the position of an issue compared to other of similar character, and appraise the FACTORS which are likely to influence its future performance 2) Selective: determine whether a given issue hold be bought, sold, retained, or exchanged for some other 3) Critical: intrinsic value far less than quotation… INTRINSIC VALUE IS AN ELUSIVE concept. In general terms it is understood to be justified by the facts i.e. the assets, earnings, dividends, definite prospects as distinct, let us say, from MKT quotations established by artificial manipulation or distorted by psychological excesses. But is a great mistake to imagine that intrinsic value is as definite or determinable by the MKT price. Hence this idea was superseded by a newer view, viz., that the intrinsic value of a business was determined by its earnings power. But the phrase ‘earnings power’ must imply a fairly confident expectation of certain future results. It is NOT SUFFICIENT to know what the past earnings have averaged, or even that they disclose a definite line of growth or decline. There must be plausible grounds for believing that this average or this trend is a dependable guide to the future. Experience has shown only TOO FORCIBLY that in many instances this is far from true. This means that the concept of ‘earnings power’ expressed as a definite figure, and the derived concept of intrinsic value, as something equally definite and ascertainable, cannot be safely accepted as a general premise of security analysis… Security analysis does not seek to determine exactly what an intrinsic value is, but that the value is adequate to protect a bond or justify a stock purchase… It would have been difficult to determine whether Wright Aero was worth $20 or $40 but was not necessary to decide that shares were attractive at $8 and unattractive at $280… Obstacles 1) inadequacy of data 2) uncertainty of future 3) IRRATIONAL BEHAVIOR of MKT… Future changes largely unpredictable; must ordinarily proceed on assumption that past records afford at least a rough guide to the future. The more questionable this assumption, the less valuable the analysis. Hence, the technique more useful when applied to senior securities (which are protected against change) than to common stocks; more useful when applied to a business of inherently stable character than to one subject to wide variations… Undervaluation caused by neglect or prejudice may persist for an inconveniently long time, and the same applies to inflated prices caused by overenthusiasm or artificial stimulants… By the time the price finally does reflect value, this value may have changed considerably and the facts and reasoning on which the decision was based may no longer be applicable… TEMPER ACTIVITIES to the general FINANCIAL SITUATION- laying more emphasis on the discovery of undervalued securities when business and market conditions on a fairly even keel, and PROCEEDING WITH GREATER CAUTION IN TIMES OF ABNORMAL STRESS AND UNCERTAINTY… The market is not a weighing machine, on which value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities. Rather should we say that the market is a VOTING MACHINE, whereon countless individuals register choices which are the product partly of reason and partly of emotion… Relationship of intrinsic value factors to market prices: Market factors(Speculative): technical, manipulative, psychological Future value factors(Investment): Management and reputation, competitive conditions and prospects, possible and probable changes in volume, price and cost Intrinsic value factors(Investment): assets, capital structure, terms of the issue, others- Attitude of Public AFFECTS ALL THREE… The underlying analytical factors in speculative situations are subject to swift and sudden revision. Intrinsic value may change BEFORE the market price reflects that value; is therefore much more serious (to act swiftly) in speculative vs. investment situations… The value of analysis diminishes as the element of chance increases; analysis can give the speculator a mathematical advantage, it does not assure him a profit… Roulette analogy page 29; if odds shifted in favor and spread out bets then certain to win a moderate amount, if all on one single number then no value when luck against you… The same mathematical advantage which practically assures good results in the investment field may prove entirely ineffective where luck is the overshadowing influence. It is only when luck plays a subordinate role that the analyst can properly speak in an authoritative voice and accept responsibility for the results… Must be highly critical of accounting methods and be concerned with all corporate policies, for the value of the issue may be largely dependent upon the acts of management: question of capitalization set up, of dividend and expansion policies, of managerial compensation, and even of continuing or liquidating an unprofitable business…. Nearly all security commitments are INFLUENCED SO SOME EXTENT BY THE CURRENT VIEW OF THE FINANCIAL AND BUSINESS OUTLOOK.  While conservative investment is ordinarily supposed to disregard these elements, in times of stress and uncertainty they may not be ignored… THE DANGER OF PAYING THE WRONG PRICE IS ALMOST AS GREAT AS THAT OF BUYING THE WRONG ISSUE…  Instead of asking 1) What security? and 2) At what price? Let us ask 1) In what enterprise? and 2) On what terms is the commitment proposed? An investment in the soundest type of enterprise may be made on unsound and unfavorable terms… Must pay respectful attention to the judgment of the market place and the enterprise which it strongly favors but he must retain an independent and critical viewpoint. Nor should he hesitate to condemn the popular and espouse the unpopular when reasons sufficiently weighty and convincing are at hand… It is at ties convenient at times to classify elements into qualitative and quantitative… Qualitative: Nature of business, relative position of the individual company in the industry, its physical, geographical and operating characteristic, the character of management; and finally the outlook for the unit, for the industry, and for business in general… Nature of business and character of management exceedingly important but also exceedingly difficult to deal with intelligently… Abnormally good or abnormally bad conditions do not last forever… Strong tendency for stock market to value the MGMT factor twice in its calculations: stock prices reflect the large earnings which the good management has produces plus a substantial increment for ‘good management’ considered separately. This amounts to ‘counting the same trick twice’…. While a trend shown in the past is a fact, a ‘future trend’ is only an assumption. The factors mentioned previously as militating against the maintenance of abnormal prosperity or depression are equally opposes to the indefinite continuance of an upward or downward trend… Preponderant emphasis on the trend is likely to result in overvaluation or undervaluation; the trend is PROJECTED thus is in reality is psychological and quite arbitrary so trend is Qualitative… Stability is really a qualitative trait, because it derives in the first instance from the character of the business and not from its statistical record… Rapid inventory turnover is stabilizing factor… Quantitative figures alone are not sufficient; they must be completely vitiated by qualitative considerations of an opposite import… Prime importance of stability means that conclusions based on past results are not so likely to be upset by unexpected developments… It is also true that he will be far more confident in his selection of an issue if he can buttress an adequate quantitative exhibit with unusually favorable qualitative factors… A satisfactory statistical exhibit is a necessary though by no means sufficient condition for a favorable decision by the analyst… Intangible vs. tangible assets closely examined… Depreciation relative to comps as well as volatility critical… Stockholder owner of the business and an employer of its officers and entitled not only to ask legitimate questions but also to have them answered… Trade journals invaluable source of info… A poorly secured bond may not only be thoroughly speculative but the most unattractive form of speculation as well… Safety must be assured, or at least strongly indicated, by the application of definite and well established standards… ALWAYS CONSIDER THE PRICE as well as the quality of the security… An investment operation is one that can be justified on both qualitative and quantitative grounds… If the future brings improvement so much the better, but investment as such cannot be founded in any important degree upon the expectation of improvement. Speculation on the other hand, may always properly and often soundly- derive its basis and its justification from prospective developments that differ from past performance… Page 66,67 table categorizing TYPE OF INVESTMENT: analysts investment-upon thorough study, promise safety of principal and adequate return, intelligent speculation- the taking of a risk that appears justified after careful weighing of the pros and cons… Nor is the primary emphasis placed upon what the owner is legally entitled to demand, but upon what he is likely to get, or is justified in expecting, under conditions which appear to be probable at the time of purchase or analysis… Since the speculative factors bulk particularly large in common stocks, it follows that he analysis of such issues is likely to prove inconclusive and unsatisfactory; and even where it appears to be inconclusive, there is danger that it may be misleading… Even when the underlying motive of purchase is mere speculative greed, human nature desires to conceal this unlovely impulse behind a screen of apparent logic and good sense… It would follow that analysis is of positive or scientific value only in the case of the exceptional common stock, and that for common stocks in general it must be regarded either as a somewhat questionable aid to speculative judgment or as a highly illusory method of aiming at values that defy calculation and that must somehow be calculated nonetheless… It was speculative for three good and sufficient reasons: 1) it paid no dividend 2) its earnings were small and irregular 3) the issue was ‘watered’ i.e. a substantial part of its value represented no actual investment in the business.  In contrast three good and sufficient reasons to be regarded as a common stock investment: 1) satisfactory record of continued dividends 2) the earnings were reasonably stable 3) each dollar of stock was backed by a dollar or more of actual investment in the business… Search for elements of weakness in the picture: 1) if earnings not properly stated 2) if balance sheet reveals a poor current picture or the funded debt is growing too rapidly 3) if physical PP&E not properly maintained 4) if dangerous new competition is threatening or if company is losing ground in the industry 5) if management is deteriorating or likely to change for the worse 6) if reason to fear for the future of the industry as a whole. Any of these defects or some other one might be sufficient to condemn the issue… If prime emphasis was laid upon what was expected in the future, instead of what had been accomplished in the past, a speculative attitude was thereby taken… Standpoint of taking an interest in a private business; an interest in a private business may of course be sold for more or less than its proportionate asset value, but the book value is still invariably the starting point of the calculation…  Beware the turn of attention from dividends, asset value, and AVERAGE earnings to transfer it almost exclusively to the earnings trend i.e. to the changes in earnings EXPECTED in the future… History of industrial companies was a hodge-podge of violent changes, in which the benefits of prosperity were so unequally and so impermanently distributed as to bring about the most unexpected failures alongside of the most dazzling successes: past earnings and divs. could no longer be considered, future earnings showed no tendency whatsoever to be controlled by the amount of the actual investment in the business. In numerous cases of receivership, the current assets dwindled, and the fixed assets proved almost worthless… Making money in the stock market was now the easiest thing in the world… In ’29 were buying an earnings power no greater than the bond interest rate, without the extra protection afforded by a prior claim… In the broad economic sense, there is the law of diminishing returns and of increasing competition which must finally flatten out any sharply upward curve of growth. There is also the ebb and flow of the business cycle… Gospel of common stocks as safe and satisfactory investments was preached and avidly accepted by the American public… The trend of earnings although most dangerous as a SOLE basis for selection, may prove a useful indication of investment merit. If this approach is a sound one, there may be formulated an acceptable canon of common stock investment, containing the following elements: 1) Investment is conceived as a group operation, in which diversification of risk is depended upon to yield a favorable average result 2) The individual issues are selected by means of qualitative and quantitative tests corresponding to those employed in the choice of fixed-value investments 3) A greater effort is made, than in the case of bond selection, to determine the future outlook of the issues considered… Companies whose earnings move forward from CYCLE TO CYCLE and are only temporarily interrupted by periodic depressions- offer the most effective medium of investment in the field of common stock. Investor who can successfully identify ‘growth companies’ when their shares are available at reasonable prices is certain to do superlatively with his capital… Natural enthusiasm for such excellent records is tempered somewhat by a sobering consideration. Viewed historically most successful companies have a well-defined life cycle 1) series of struggles and setbacks 2) a halcyon period of prosperity and persistent growth, which in turn passes over into a final phase of supermaturity- characterized by a slackening of expansion and perhaps an actual loss of leadership or even profitability. Hence, the seeker of growth stocks faces a dilemma, for if he chooses newer companies with a short record of expansion, he runs the risk of being deceived by a temporary prosperity; and if he chooses enterprises that have advanced through several business cycles, he may find this apparent strength to be the harbinger of coming weakness…  Cannot be accomplished by an examination of statistics and records but requires a considerable supplement of special investigation and of business judgment… In the absence of general business expansion, exceptional gains are likely to be made by companies supplying new products or processes. These in turn are likely to emerge from research laboratories… The investor must pay heed to the kind of facilities owned, the abilities of the researchers and the potentialities of the field under investigation. It is not impossible to study these points successfully, but the task is not easy, and the chance of error is great… Once an investor pays a substantial amount for the growth factor, he is inevitably assuming certain kinds of risk… If on the other hand you choose companies which are personally optimistic, although they are not favorites of the market. No doubt this will prove most remunerative if sound… Emphasis placed on pitfalls of investing but can be done if pursued with skill, intelligence and diligent study: if examined with real care and a wholesome skepticism and second if price paid is not substantially different from what prudent business man would be willing to pay for a similar opportunity presented in a private undertaking… Margin of safety: if worth more than paid for it and are reasonably optimistic as to the company’s future. This method of attack lends to two possible techniques: 1) when general market is low representative and fairly active issues 2) discover undervalued individual stocks, which are PRESUMABLY available even when the general market is not particularly low… Prices are recurrently too high and too low so should be repeated opps. to buy stocks at less than their value and sell them out later at fair value of higher… 1) select diversified list of leading industrial common stocks 2) determine a base or normal value by capitalizing their earnings at some suitable figure, related to the going long term interest rate 3) determine buying point at some percentage below this normal value… Generally involves buying and selling when the prevalent psychology favors the opposite course, watching one’s shares go lower after purchase and higher after sale and often staying out of the market for long periods… An investment operation can be justified on both qualitative and quantitative grounds… Common stocks that appear cheap but have average prospects… Last criterion a price far less than value to a private owner, will constitute a sound touchstone for the discovery of true investment opportunities in common stocks… The dividend rate’s significance is exceedingly difficult to appraise. From one point of view it is all-important, but from another and EQUALLY VALID standpoint it must be considered an accidental and minor factor…          Two distinct assumptions: the first is that it is advantageous to the stockholders to leave a substantial part of the annual earnings in the business; the second is that it is desirable to maintain a steady dividend rate in the face of fluctuations in profits… Taking money away from the stockholders (no div’s) and presenting it to the company will undoubtedly strengthen the enterprise, but whether or not it is to the owner’s advantage is an entirely different question… An inductive study would undoubtedly show that the earnings power of corporations does not in general expand proportionately with increases in accumulated surplus… Officers are naturally desirous of retaining earnings as much cash as possible in the treasury, in order to simplify their financial problems; they are also inclined to expand the business persistently for the sake of personal aggrandizement… Dividend polices are often so arbitrarily managed as to introduce an additional uncertainty in the analysis of a common stock (similar to tax sale basis). Besides the difficult of predicting earnings power, there is the second difficulty of predicting what part of the earnings the directors will see fit to disburse in dividends… Desire to retain large amounts of earnings, instead of paying them out was due in part to eliminate intangible items (pay off debt, inventory, receivables, etc.)… IF dividend is disproportionately small, an investment purchase will be justified only on an exceptionally impressive showing of earnings; on the other an extra-liberal dividend policy cannot compensate for inadequate earnings… Earnings retained to protect the company’s earnings are not true earnings at all; should be deducted in IS as necessary reserves... Paradox: value created by taking earnings away, but the more the stockholder subtracts dividends from the capital and surplus fund; the larger value placed upon what is left… Some cases, stockholders derive positive benefits from ultraconservative dividend policy through much larger eventual earnings and div’s but far more frequently stockholders derive much greater benefits from dividend payments than from additions to surplus b/c a) the reinvested profits fail to add proportionately to earnings power or b) they are not true profits at all but reserves that had to be retained to merely protect the business… Loose or ‘purposive’ account is a highly contagious disease… Delve into substantial carrying/depreciation charges, very frequently these appraisals are based on mob psychology, on faulty reasoning and on the most superficial examination of inadequate information… Subsidiary contributions… Dep/Amort policies vs. comps and vs. life of asset… Value of leases worth above payment value… Charges made against book value of the patent, have ordinarily little relevance to the real situation… “All machinery is on an irresistible march to the junk heap”… Be aware of discretionary deductions… EPS of company 1) pays 10k for truck 2) pays 5k and writes down 25% a year 3) pays 5k and writes down to $1, EPS multiple HUGE discrepancy… Depreciation factor in obsolescence and ultimate Capex…  A generation ago, when investors consulted balance sheets to ascertain net worth behind their shares, this net worth was artificially inflated by writing UP the book. Then, it was to erase the plant account to eliminate the depreciation charge… EASY to miscalculate value of patents… Company’s charges may be reduced or increased based on if they regularly exceed cash expenditures on property or if don’t account for obsolescence etc...  Reserves can be used in threefold purpose: 1) to permit losses to be charged against surplus or BS account instead of income 2) to gloss over the actual taking of the loss and 3) in some cases to lay the groundwork for inflated earnings subsequent years… Setting up an inventory reserve out of surplus, whatever the theory behind it, almost invariable results in overstating the reported profits over a period of years…Concept of Earnings power: combines a statement of actual earnings, shown over a period of time, with a reasonable expectation that these will be approximated in the future, unless extraordinary conditions supervene. The record must cover a number of years, first b/c a continued or repeated performance is always more impressive than a single occurrence and secondly b/c the average of a fairly long periods will tend to absorb and equalize the distorting influences of the business cycle… Quantitative data are useful only to the extent that they are supported by a qualitative survey of the enterprise… The market level of common stocks is governed more by their current earnings than by their long term average… Obviously the stock market is quite irrational in thus varying its valuation of a company proportionately with the temporary changes in its reported profits. Errors should afford profitable opportunities to the more logically minded to buy common stocks at the low prices occasioned by temporarily reduced earnings and to sell them at inflated levels created by abnormal prosperity… The analyst cannot follow the stock MKT in its indiscriminate tendency to value issues on the basis of current earnings. He may on occasion attach predominant weight to the recent figures rather than to the average, but only when persuasive evidence is at hand pointing to the continuance of these current results… IT MUST BE REMEMBERED that the automatic or normal economic forces militate against the indefinite continuance of a given trend. Competition, regulation, the law of diminishing returns, etc., are powerful foes to unlimited expansion, and in smaller degree opposite elements may operate to check a continued decline… Neither expected increases nor even past results under conditions of abnormal business activity may be taken as basis… Price levels ruling for the so-called good stocks under normal market conditions are likely to appear overgenerous for the conservative student; would call a substantial part of the price a speculative component in the sense that it is paid not for demonstrated but expected results. Will be equally chary about any hasty conclusion to the effect that the company’s outlook is hopeless, that its earnings are certain to disappear entirely and that the stock is therefore without merit or value… The ability to see what is coming is of inestimable value, but it cannot be expected to be part of the analyst’s stock in trade… Flood of capital being poured into what industry? to result in overcapacity and keen competition… Where two quite different properties are involved, you have two virtually separate enterprises… Preceding examples related to the future continuance of the rate of output and the operating costs upon which the past record of earnings was predicted. We must also consider such indications as may be available in regard to the future selling PRICE of the product… The prices of common stocks are not carefully thought out computations but the resultants of a welter of human reactions. The stock market is a voting machine rather than a weighing machine. Confronted by this mixture of changing facts and fluctuation human fancies, may set up 1) a basis for conservative or investment valuations 2) significance of capitalization structure and the source of income (disruptive strategy?) 3) unusual elements in the balance sheet which affect implications of the earnings picture… People who habitually purchase common stocks at more than about 20 times their AVERAGE earnings are likely to lose considerable money in the long run… If 20 times AVERAGE earnings is taken as upper limit of price for an investment purchase then 12.5 times may be suitable for the typical case of a company with neutral prospects… Common stock investment operations as we define them, will occupy a middle ground in the MKT, lying b/w low-price issues that are speculative b/c of doubtful quality and well-entrenched issues that are speculative b/c of their high price… Prospects of enterprise must be at least reasonably favorable… Warrants/convertible obviously need to be examined, management contracts, restricted shares-div’s on which are contingent upon earnings or other considerations…Optimum capital structure  for any enterprise includes senior securities to the extent that they may be safely issued and bought for investment... Tendency for speculatively capitalized enterprises to sell at relatively high values in the aggregate good times or good markets. Securities of highly levered enterprises, when selling on a deflated basis due to depression, can advance much further than they can decline… EPS of common not taken seriously, since no div’s being paid on the second preferred… Effect of wide variations in net profit and the effect of these variations on the common stock is immensely magnified by reason of the small amount of common stock in comparison with the senior securities… The overdeflation of a speculative issue like Staley common in unfavorable markets creates the possibility of an amazing price advance when conditions improve, b/c the EPS then show so violent an increase… In speculatively capitalized enterprise, the common stockholder is operating with a little of his own money in a ‘heads I win, tails you lose’, ‘cheap call’ scenario… In making such highly speculative purchases, partiality should evidently be shown to those companies in which most of the senior capital is in the form of preferred stock rather than bonds. Such an arrangement removes or minimizes the danger of extinction of the junior equity through default in bad times and thus permits the shoe-string common stockholder (speculative cap structure) to maintain his position until prosperity returns (and clearly disadvantages the preferred stockholder)… Just as convertible bond loses its distinctive advantage when the price rises to a point, so too does a shoe string commitment lose its advantage as the price rises… Low prices common stocks appear to possess an inherent arithmetical advantage arising from the fact that they can advance so much more than they can decline. It seems that 1) low prices stocks tend to fluctuate relatively more than high price stocks and 2) in a ‘bull’ market the low-price stocks tend to up relatively more than high-price stocks. A genuinely low priced common stock will show an aggregate value for the issue which is small in relation to the company’s assets, sales and past or protective profits… Stocks of companies facing receivership are likely to be more active than those which are very low in price merely b/c of poor earnings. This explains why the public almost always buys the wrong low-priced issues and ignores the really promising opportunities… Contrary to the general impression in Wall Street, the stocks of high-cost producers are more logical commitments than those of the low-cost producers when the buyer is convinced that a rise in the price of the product is imminent and he wishes to exploit this conviction to the upmost. Exactly the same advantage attaches to the purchase of speculatively capitalized common stocks when a pronounced improvement in sales and profits is confidently anticipated… Different multipliers are used for different sorts of enterprises, which are subject to change with the changing times… In calculating the book value of a preferred stock it is treated as a common stock and the issues junior to it are left out of consideration… What value is the stock buyer setting on the business and second, what is he actually getting for his money in terms of tangible resources… Object of liquidating value calculation is not to determine the exact liquidating value but to form a rough idea in order to ascertain whether or not the shares are selling for less than the stockholders could actually take out of the business… Avoid issues that have been losing their current assets at a rapid rate and show no definite signs of ceasing to do so… Bargains – Common stocks that 1) are selling below their liquid asset value 2) are apparently in no danger of dissipating these assets and 3) have formerly shown a large earnings power on the market price, may be said truthfully to constitute a class of investment bargains… When all stocks are very cheap-as in 1932- there would seem to be fully as much reason to buy undervalued leading issues as to pick out less popular stocks, even though these may be selling at even lower prices by comparison… It is little short of lunacy to assume that the stock holders would be better off if they surrendered their complete ownership of the company in exchange for a limited claim against the same property at a rate of 5 0r 6% on the investment (highlights unlimited claim of stock vs. fixed claim; depending on cap structure obviously)… Unsound viewpoints: 1) Mgmt. knows more about the business than stockholders and therefore its judgment on all matters of policy is to be accepted 2) Mgmt. has no interest in or responsibility for the prices at which the company’s securities sell 3) If a stockholder disapproves of any major policy of the mgmt. his proper move is to sell his stock…  Conflict of stockholders/officers 1) compensation to officers 2) Expansion of the business, involving the right to larger salaries/power 3) Div. payments; remain under control of mgmt. or stockholder 4) Should business continue as before, although unprofitable, or should come capital be withdrawn, or should it be wound down completely 5) information: should some stay private to remain ahead of competition… Beware however, wars against corporate mgmt. take time, energy and money… Liquidation of an unprofitable company holding substantial assets (particularly current) is almost certain to realize for the stockholders considerably more than the previously existing market price. The reason of course, is that the MKT price is governed chiefly by the earnings, whereas the proceeds of liquidation depend upon the assets… Indebtedness of near maturity that may threaten to develop into a refinancing problem? Acid test (even him) current assets exclusive of inventories must be at least equal to current liabilities… Financial difficulties are almost always heralded by the presence of bank loans or of other debt due in a short time… Financial strength can be strengthened despite losses; inventory asset sale, etc… There is a necessity of making general rather than exact allowance for the distorting effect of inventory price changes… New developments in products, processes or other factors- including war profits- may change the picture for the better, but this has become a matter of speculative anticipation of future improvements rather than a reasonable expectation based on past performance (NEEDS TO BE TREATED DIFFERENTLY; MUCH MORE SUSCEPTIBLE TO PSYCHOLOGICAL ERRORS so can trade around position)… Desirable warrant qualities: 1) low price 2) long duration 3) option price close to MKT… Warrant/convert dilution can be enormous… Typical stock buyer will neither read the long prospectus carefully nor understand the implications of all it contains… Whenever it becomes easy to raise capital for a particular industry, both the chances of unfair deals are magnified and the danger of overdevelopment of the industry itself becomes very real… The memory of the financial community is proverbially and distressingly short… Earnings cycle should be just long enough to cover a full cyclical fluctuation but not so long as to include factors or results that are totally out of date… Beware of trying to draw conclusions as to the relative attractiveness of two railroad common stocks when one is speculatively and the other is conservatively capitalized. Two such issues will respond quite differently to changes for the better or worse… Railroads: Variations in the depreciation rate are fully as important as variations in the railroad maintenance ratios. If wide difference amongst ratios, question should be investigated as thoroughly as possible (must grasp investment required to maintain or grow)… List: Subsidiary income or loss, no attempt should be made to subject depreciation figures to exact comparisons- are useful only in disclosing wide and obvious disparities in rates, show percentage earned on total capitalization, not safe to rely upon the fact that the earnings ratio for the common stock is higher than the average for the industry, unless the percentage earned on the total cap. is also higher, if company with poorer earnings exhibit shows much larger sales-per-dollar- of common stock it may have better possibilities in the event of general business improvement. The balance sheet computations do not have primary significance unless they indicate either definite financial weakness or a substantial excess of current asset value over the market price… The division b/w the importance as between the current results, the seven year average, and the trend is something entirely for the analyst’s judgment to decide…  When one issue seems to be selling much too low on the basis of the exhibit in relation to that of another in the same field, there may be adequate reasons that the statistics do not disclose. Among such valid reasons may be a definitely poorer outlook or a questionable management (qual.)… Basic question is whether future developments are likely to affect all the companies in the group similarly or dissimilarly… Must be most cautious about drawing comparative conclusions from statistical data when dealing with companies in a heterogeneous group; as a general rule the less homogenous the group the more attention must be paid to the qualitative factors in making comparisons…


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