SECURITY INVESTMENT ANALYSIS

Security Investment Analysis



Security Investment Analysis

What Value Investing Is

Value investing in the manner initially defined by Benjamin Graham and David Dodd rests on three key characteristics of financial markets:

The prices of financial securities are subject to significant and capricious movements. Mr. Market, Graham's famous personification of the impersonal forces that determine the price of securities at any moment, shows up every day to buy or sell any financial asset. He is a strange fellow, subject to all sorts of unpredictable mood swings that affect the price at which he is willing to do business (Greenwald & Kahn, 2004).

Despite these gyrations in the market prices of financial assets, many of them do have underlying or fundamental economic values that are relatively stable and that can be measured with reasonable accuracy by a diligent and disciplined investor. In other words, the intrinsic value of the security is one thing; the current price at which it is trading is something else. Though value and price may, on any given day, be identical, they often diverge.

A strategy of buying securities only when their market prices are significantly below the calculated intrinsic value will produce superior returns in the long run. Graham referred to this gap between value and price as 'the margin of safety'; ideally, the gap should amount to about one-half, and not be less than one-third, of the fundamental value. He wanted to buy a dollar for 50 cents; the eventual gain would be large and, more important, secure (Greenwald & Kahn, 2004).

Starting with these three assumptions, the central process of value investing is disarmingly simple. A value investor estimates the fundamental value of a financial security and compares that value to the current price Mr. Market is offering for it. If price is lower than value by a sufficient margin of safety, the value investor buys the security. We can think of this formula as the master recipe of Graham and Dodd value investing. Where their legitimate descendants differ from one another--where each may add his or her unique flavor--is in the precise way they handle some of the steps involved in the process:

Selecting securities for valuation

Estimating their fundamental values

Calculating the appropriate margin of safety required for each security

Deciding how much of each security to buy, which encompasses the construction of a portfolio and a choice about the amount of diversification the investor desires

Deciding when to sell securities

What Value Investing Isn't

No rational investor admits to searching for securities selling for more than their underlying value. Everyone is looking to buy low and sell high. 1 What is it that differentiates real value investors, who are actually quite rare, from all the others who trade in the securities markets? They care nothing for its economic value. Instead, they focus on trading data, that is, the price movements and volume figures for any security. They believe that the history of these movements, reflecting the supply and demand for that security over time, traces patterns that they can analyze to infer future ...