Chapter 8: Classification of Securities

Securities are customarily divided into the two main groups of bonds and stocks, with the latter subdivided into preferred stocks and common stocks. The first and basic division recognises and conforms to the fundamental legal distinction between the creditor's position and the partner's position. The bondholder has a fixed and prior claim for principle and interest; the stockholder assumes the major risks and shares in the profits of ownership. It follows that a higher degree of safety should inhere in bonds as a class, while greater opportunity of speculative gain- to offset the greater hazard- is to be found in the field of stocks.

Classification

1) Securities of the fixed-income and stable-value type: A high-grade bond or preferred stock

2) Senior securities of the fluctuating-value type
A. Well-protected issues with profit possibilities: A high-grade convertible bond
B. Inadequately protected issues: A lower-grade bond or preferred stock

3) Common stock type: A common stock

Chapter 7: Quantitative & Qualitative Factors in Security Analysis. The Margin-Of-Safety Concept

After the analyst has learned what information he can get and where to find it, he faces the harder question of what to make of it. Analysing a security involves an analysis of the business.

Quantitative might be called the company's statistical exhibit. Included in it would be all the useful items in the income account and balance sheet, together with such additional specific data as may be provided with respect to production and unit prices, costs, capacity, unfilled orders,etc. These various items may be subclassified under 1) capitalisation, 2) earnings & dividends, 3) assets & liabilities, and 4) operating statistics.

The qualitative factors, on the other hand, deal with such matters as the nature of the business; the relative position of the individual company in the industry; its physical, geographical, and operating characteristics; the character of the management; and, finally, the outlook for the unit, for the industry, and for business in general.

Qualitative Factors (these factors are important, but also difficult to deal with intelligently)

Nature and Prospects of the Business. Industry Analysis. It is an established canon of investment in common stocks that one should first select the most promising industry or industries and then picking out the best companies in those industries. Many statistics are compiled and studied, the trade papers are read with care, and interviews are sought with well-informed people in each industry.

The Factor of Management. Picking a company with a good management is considered by many to be even more important than picking a company in a promising industry. The most convincing proof of capable management lies in a superior comparative record over a period of time. (which brings us back to quantitative data)

The Trend of Future Earnings. Financial theory sometimes sought to estimate future earnings by projecting the past trend into the future, and it has then used this projection as a basis for valuing the business. But while a trend shown in the past is a fact, a "future trend" is only an assumption.

Security Analysis and the Future. The kind of security analysis we regard as a most rewarding principle is concerned primarily with values which are supported by the facts and not those which depend largely upon expectations. In this respect the analyst's approach is diametrically opposed to that of a speculator, meaning thereby one whose success turns upon his ability to predict or guess future developments. Needless to say, the analyst must take possible future changes into account, but his primary aim is not so much to profit from them as to guard against them. Broadly speaking, he views the business future as a hazard which his conclusion must encounter rather than as the source of his vindication.

Margin of Safety as the Basic Quantitative Factor

Offsets to the Hazards of the Future. Place prime emphasis upon the presence of a large margin of safety for the security, which should be able to absorb whatever adverse developments are reasonably likely to occur. In such cases, he will be prepared to see unsatisfactory earnings for the issue during depression periods, but he will expect that (1) the company's financial strength will carry it unharmed through such a setback, and (2) its average earnings will be enough to justify fully the bond or stock purchase he is recommending.

Chapter 6: Nature & Sources of the Analyst's Information

All the information regarding this chapter is based on US rules and regulations by the US Securities and Exchange Commission (SEC). Hence, it is a bit challenging for me to interpret the information into Singapore's context. However, I shall give the information for the part on US and then Singapore as accurate as possible with my current knowledge. Older and more experienced investors please correct me for any mistakes I made. Thank you!

Most of the corporate data used by the security analyst will have come originally from 2 parallel sources. The first is material filled with a regulatory body- most often the SEC. For Singapore, its the Singapore Stock Exchange (SGX) and the Monetary Authority of Singapore (MAS). The second is information sent by the company to the stockholders or the press. Nearly all this information is reproduced or condensed by the financial services, as it becomes available. For many analytical purposes it is sufficient to take the material, at second hand, from the various manuals, supplements or "daily sheets". But for a full-scale analysis the practitioner will generally find it advisable to consult the original sources, to make sure that nothing of importance is overlooked.

3 Types of Material available for analysis

1) The Basic Registration Statement (Prospectus): This statement provides a detailed description of the company's business and properties and will often serve as a starting point for detailed analysis. When companies are applying for Initial Public Offerings (IPOs) they will give out a prospectus. Can be found in the companies' or SGX website.

2) The Annual Report: It is here that the dualism between voluntary and required data is most manifest. Listed securities must file with the SEC a form (10-K for most companies) which contains a balance sheet, income account and cash flow statement in prescribed detail, and which also adds material that may be needed to bring the registration statement up to date. For Singapore listed securities, go to SGX website and look in announcements for financial statements.

3) Interim Figures: Quarterly net income figures. It was originally the accepted view that companies with a pronounced seasonal bias in their results should not publish interim figures, on the ground that these could be misleading. One method of overcoming the objection to seasonally unstable interim figures is by publication of successive 12 month totals at quarterly intervals.

Some important information still not generally available

1. Explanation of important differences between the income reported and that on which income tax was computed.

2. Where last-in, first-out inventory ("LIFO") basis is used, the equivalent value on a first-in, first-out ("FIFO") basis.

3. The present insured or appraised value of the fixed assets.

The analyst would like to have the following material if he can get it:

a) Orders booked and unfilled orders
b) Productive capacity where relevant
c) Production in units where relevant
d) Division of products by principal classes or departments, in dollar amounts or in percentage of total.
e) Data on concentration of business with few customers, if it exists, and any significant dependence on exports.
f) Description of property owned, including types of buildings and combined floor area.

Supplementary Information

The security analyst uses a vast amount of economic statistics, which relate either to business as a whole or to a particular industry. Most of this material is found in the Department of Commerce. For Singapore it is the Ministry of Trade and Industry (MIT).

Trade Journals: Detailed information of the current and prospective state of the industry. eg. its history and problems or in some cases unofficial data relating to individual concerns.

Chapter 5: Investment Policy

There are 2 types of investment policy, for institutions and individuals. I will only focus on individual investment policies as most of us are individual investors.

There are 2 classes of security buyers, the defensive investor and the aggressive or enterprising investor.

Defensive investor

Defensive investors are those who should place their chief emphasis upon the avoidance of any serious mistakes or losses and their second emphasis upon freedom from effort, annoyance, and the necessity for making frequent investment decisions.

Their portfolio should be divided into 2 parts between a 75%-25% stocks and bonds or 25%-75% depending largely on the subjective feeling of the investor.

The defensive investor may properly do his common stock purchasing through the medium of investment-fund shares or diversify in a list of leading common stocks, purchased at a reasonable price level.

Enterprising investor

The distinguishing feature of individuals in this class is their willingness and ability to devote time and care to the selection of sound and attractive investments. The enterprising investor may take calculated risk at times if he is convinced that his chances of profit sufficiently outweigh the hazard of loss.

The enterprising investor need not be a full-fledged security analyst in his own right. He may depend on others for detailed analysis, and for ideas and advice as well. But the decisions will be his own, and in the last reckoning he must rely upon his own understanding and judgment. The first rule of intelligent action by the enterprising investor must be that he will never embark upon a security operation which he does not fully comprehend and which he cannot justify by reference to the results of his own study and experience.

The endeavor to make money in securities is a business undertaking, and it must be conducted in accordance with business principles.

An enterprising investor may follow the simple 2 part policy of the defensive investor with respect to some portion of his funds, and employ the remainder to more aggressive operations. There is no single pattern for the latter. He may endeavor to buy in low markets and sell in high markets, in accordance with the age-old principle of shrewd investment. He may try to select companies that have unusual prospects for long-term growth, making sure he is not paying too much in advance for these favorable possibilities. Or he may place his prime emphasis upon the purchase of "bargain issues" which are selling considerably below their true value, as measured by reasonably dependable techniques.

My conclusion

The individual investor should be both enterprising and defensive when investing. Defensive in not speculating and to avoid serious mistakes. Enterprising in investing in your own circle of competence and having a margin of safety in the purchase of common stocks. I believe that enterprising investors should be 100% in stocks and not diversify.

Formula-timing Plans

The investor automatically does some selling of common stocks when the market advances substantially, and some repurchasing or original purchasing when the market has a significant decline.

Dollar Averaging

An increasing amount of favorable attention in recent years has been directed toward the comparatively simple idea of placing the same amount of money in the same stock, or group of stocks, in successive months, quarters or years. In a period of wide fluctuations in stock prices, dollar averaging will show better results than the method of purchasing a fixed number of shares each year regardless of price.

The real implication of dollar averaging is that investors should be wary of putting more money in stocks at higher prices than they did at lower prices--which is a common failing --and that they should never let a lower price level scare them away from buying.

Chapter 4: Investment and Speculation

General Connotations of the Term "Investment"

1) Putting or having money in a business. eg. A man "invests" $1000 in opening a grocery store.
Note, however, that it accepts rather than rejects the element of risk- the ordinary business investment is said to be made "at the risk of the business."

2) All securities(stocks, bonds, warrants, etc) are "investments".
No real distinction is made between investment and other types of financial operations such as speculation.

3) It is commonly thought that investment is good for everybody and at all times.
Such a distinction is generally taken for granted.

A Proposed Definition of Investment

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

The "safety" sought in investment is not absolute or complete; the word means, rather, protection against loss under all normal or reasonably likely conditions or variations.

Eg. A safe bond is one which would suffer default only under exceptional and highly improbable circumstances. Similarly, a safe stock is one which holds every prospect of being worth the price paid except under quite unlikely contingencies. Where study and experience indicate that a chance of loss must be recognised and allowed for, we have a speculative situation.

Additional Criterion of Investment

An investment operation is one that can be justified on both qualitative and quantitative(price) grounds.

Many have the misconception that "blue chips" were safe investments. They may be good quality stocks, but the public unconsciously assume that no price would be too high for a good stock. Carried to its logical extreme, such an issue was equally "safe" after it had advanced to 50 as it had been at 2. The issue then becomes speculative without quantitative grounds or a margin of safety in price.

Types of Speculation

1) Intelligent speculation- the taking of a risk that appears justified after careful weighing of the pros and cons.

2) Unintelligent speculation- risk taking without adequate study of the situation

Margin-of-Safety concept

In the case of bond or preferred-stock investment this margin is usually represented by the excess of earning power over interest or dividend requirements, or of the value of enterprise above the senior claims against it.

In the case of a common stock it should be represented either by the excess of calculated intrinsic value over the price paid, or else by excess of expected earnings and dividends for a period of years above a normal interest return.

Chapter 3: The Behaviour of the Security Markets

The price to be paid or received for a security is an integral part of any complete analysis. We do not believe that short-run price movements--the day-to-day or month-to-month variations--are a valid or profitable concern. But the broader concept of business cycles should not be left out.

The relationship between Intrinsic Value and Market Price

The chart above traces various factors like speculation and valuation which contributes to the market price. Rather we should say that the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion.

Undervalued Situations When The Market Appears High

When the general market is high there are always a number of individual issues that appear undervalued. One maybe tempted to buy these issues. But that is a time that calls for especial caution. Not only may the 'neglected issue' continue neglected for the remainder of the bull market, but when the downturn comes it is likely to decline in price along with the general market and to fully as great as an extent.

In a word, beware of 'bargains' when most stocks seem very high.

The Factor Of Marketability

The speculator or market trader has a real need for marketability because he may want to buy or sell in a few minutes' time. The typical investor has no similar requirement. It is better to sacrifice quick marketability to attract value rather than vice versa. For every point lost in the spread between bids and offers, the buyers of a true bargain issue may expect to gain perhaps 10 points in increased dividend returns plus ultimate improvement in selling price.

Much of the emphasis on marketability comes from the stock-brokerage business. Brokers are in business to earn commissions. It is easier for them to get orders in active than in inactive stocks. Hence, they are likely to overemphasize the popular and active issues in their work. This attitude tends to create something of a vicious cycle, since it makes active issues more active and inactive ones more inactive.

Summary

The security analyst should be concerned with those fluctuations in security prices which tend to create opportunities to buy at less than indicated value and to sell at more than such value.

Chapter 2: The Scope & Limitations of Security Analysis

'Analysis' connotes the careful study of available facts with the attempt to draw conclusions therefrom based on established principles and sound logic. It is part of the scientific method. But in applying analysis to the field of securities we encounter the serious obstacle that investment is by nature not an exact science. Individual skill (art) and chance are important factors in determining success or failure. Nevertheless, analysis is not only useful but indispensable in the field of investment and possible in that of speculation.

Three functions of security analysis:

Descriptive function- Make adjustments in the financial figures to bring out the true operating results in the period covered, and particularly in order to place the data of a number of companies on a fairly comparable plane. Evaluation of favorable and unfavorable factors in the position of the issue compared with others in the same field, also projections of earning power on various assumptions as to future conditions.

Selective function- Pass judgment on the merits of securities.

1) Bonds and preferred stocks- Make sure that interest payments will be met in the future without difficulty or doubt through an ample margin of safety in the past to protect against possible adverse developments that lie ahead.

2) Common stock- Selecting those that will pay a good return or increase in price or both. There are 2 approaches. The older approach places its chief emphasis on anticipation of an increase in price of the stock in the longer term, whereby, the present market is by and large an appropriate reflection of the present situation of the stock. The newer approach attempts to value a common stock independently of its market price. If the 'intrinsic value' found is substantially above or below the current price, the analyst concludes that the issue should be bought or sold.

A general definition of intrinsic value would be 'that value which is justified by assets, earnings, dividends, definite prospects'. The most important single factor determining value is now held to be the indicated average future earning power. Intrinsic value would then be found by first estimating this earning power, and then multiplying that estimate by an appropriate 'capitalisation factor' or multiplier.

"Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life. The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised." --Warren Buffett

Critical function- Security analysis may be competent to express critical judgments, looking to the avoidance of mistakes, to the correction of abuses, and to the better protection of those owning bonds or stocks. Questions largely dependent upon the act of management include capitalisation setup, dividend and expansion policies, managerial competence and compensation, and even continuing or liquidating an unprofitable business.

Security Analysis Part 1: Survey and Approach

Chapter 1: Introduction

To analyse securities creditably, one needs to understand security forms, corporate accounting, the basic elements that make for the success and failure of various kinds of businesses, the general workings of the economy and the characteristics of security markets.

One must be able to dig for facts, to evaluate them critically, and to apply his conclusions with good judgment and a fair amount of imagination.

One must be able to resist human nature itself sufficiently to mistrust his own feelings when they are part of mass psychology.

One must have courage commensurate with his own competence.

The array of securities

Civil obligations eg. Singapore government securities
-Government bonds and Treasury bills(T-bills)

Corporate Securities- Unlisted private companies

Preferred and Common Stocks

Economic background

The soundness of a security purchase is determined by future developments and not by past history or statistics.

But the future cannot be analysed; we can seek only to participate intelligently and to prepare for it prudently.

Past performance as a foundation- Long experience tells us that investment anticipations cannot be sound or dependable unless they are closely related to past performance.

5 matters that concern the investor

General price level- The long-term trend would be inflationary with rising oil prices and basic necessities . Common stocks are by no means an ideal protection or 'hedge' against inflation, but they do more for the investor on this point than either bonds or cash.

Interest rates- The price history of bonds is the reverse of the course of interest rates.

Business conditions and profits

Dividends- The pattern of corporate dividends follows closely with earnings. They also exert a prime influence on the status of individual common-stock issues.

Security prices- A promise of excellent gains when purchases are made in depressed markets and a warning of permanent loss if the investor buys when bullish sentiment is at its strongest.