“corporations are merely structures of human conception – a simple way for groups of people to act and organize.”
Edition Five should be titled Ratio Analysis. Many professionals, like some of Six’s essayists, claim not to have studied the classic even once. Why bother with more than one edition?
Five misrepresented Graham’s ideas. Indeed, Horace’s vengeance was nowhere to be found:
“Many shall be restored that now are fallen and many shall fall that now are in honour.”
Its exclusion was justified: Five focussed on peering forwards, comparative analysis, and the return on total capital. The purpose behind this edition was to detect change earlier than the market.
If you only read Two (Warren’s favorite) or Three (Walter Schloss edited), your “value investing” anchor would be different. Reading only Five would leave the student with an erroneous understanding of Benjamin Graham’s thought. Some may lambast Six and Seven for reprinting Two but neither edition captures its essence.
Granted, a book’s appendix is named after a tiny hollow vestigial tube in the human intestines – pretty irrelevant…
appendix ~ /əˈpɛndɪks/ ~ noun
noun: appendix; plural noun: appendices; plural noun: appendixes
1.
ANATOMY
a tube-shaped sac attached to and opening into the lower end of the large intestine in humans and some other mammals. In humans the appendix is small and has no known function, but in rabbits, hares, and some other herbivores it is involved in the digestion of cellulose.
2.
a section or table of subsidiary matter at the end of a book or document.
… Wrong. Two’s 101-page appendix is over 12 per cent of Graham’s Magnum Opus: it is replete with precise examples of past and present (at the time) securities. Anti-vestigial, more like.
Five’s epigraph could be:
"Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return—even if you originally buy it at a huge discount.” ~ Charlie Munger.
All editions concur that quantitative data is meaningless without qualitative analysis but the editions use quantitative data for different purposes. One, Two, and Three view equities through the lens of senior security analysis whereas Five focuses on quantitative metrics to tease out the qualitative nuances between similar companies.
In what ways did Five’s ideas diverge from Graham’s originals (One, Two, and Three)?
Examples. Examples. Examples.
At the outset, each edition describes the different functions of security analysis:
Descriptive
Valuation
Judgement
In Five, Part III (Analysis of Fixed Income Securities) mentioned eight securities. All were described but zero were valued or judged. Within eight pages of Two’s Part II (Fixed Value Investments), Graham and Dodd recommended the Cudahy debentures as a better choice than the more senior First Mortgage 5s.1
Five was true to Graham’s originals by granting little air time to the Net Current Assets investment strategy. Despite that, Five revealed its other type:
Type I: Wittgenstein’s Cube.2 Macroeconomic depressions reduce the prices of all securities in a market or industry due to increasingly negative expectations. Stable assets, changed expectations.
Type II: Shannon entropy optimization: uncertainty, rather than negativity, creates the opportunity. Profitable companies build up a cash surplus because they don’t reinvest. Changed assets, stable expectations.
Both opportunity types are behavioral. Type I is a bet on mean reversion (contrarianism) whereas Type II is a willingness to embrace the unknown.
In a similar vein, a long-term bond or common stock investor both analyze the future earning power of an enterprise. The historical record is deemed a rough proxy for the future and situations less susceptible to change are chosen, for value investors. To be successful in either field, however, requires an opposite mindset: acceptance of the unknown in equities vs the “negative art” of senior security selection.
Five analyzed seven grocers using ratio analysis. A core belief of this edition is that ratio analysis negates the effect of size and enables an apples-to-apples comparison of homogenous companies. No valuation was performed on any of the retailers, though a judgment was given.
In the anti-vestigial Appendix, Two comparatively analyzed railroads. It provided a description, and judgement by recommending the exchange of New York Central Holdings for Atchison to obtain a higher dividend yield with better quantitative and qualitative exhibits.3
Five’s history of capital markets is unique in the Security Analysis collection. It detailed the changing nature of bond market strategies such as immunization, cash matching, and duration.
Five performed a retrospective comparative analysis of two chemical companies Hercules, Inc. and Rohm & Haas Company. An investor would have been rewarded for judging Rohm & Haas to have a more rapid increase in earnings over several years but the historical figures and ratios provided suggested Hercules was the cheaper security and the quality of both issues was the same. Qualitative analysis is hard…
2. Share repurchases.
When you think Singleton, you think Buyback King – a pioneer. Reputable investors say share repurchases were never performed at such a scale. That’s untrue. Simms Petroleum Company repurchased c. 45% or so of its shares outstanding in under three years.4 Many companies did so during the Great Depression.
Graham would have looked down on Singleton’s method of share repurchase during the 1970s, despite the massive increase in value per share. In Two, Graham criticized Westmoreland Coal Company for the following:
“In 1935, according to its annual reports, [Westmoreland] began to repurchase its own stock in the open market. By the end of 1938 it had thus acquired 44,634 shares, which were more than 22% of the entire issue…
If this situation is analyzed, the following facts appear clear:
The low market price of the stock was due to the absence of earnings and the irregular dividend
The true obligation of managements is to recognize the realities of such a situation and to do all in their power to protect every stockholder against unwarranted depreciation of his investment, and particularly against unnecessary sacrifice of a large part of the true value of his shares
The anomaly presented by exceptionally large cash holdings and an absurdly low market price was obviously preventable.
All cash that could possibly be spared should have been returned to the stockholders on a pro rata basis. The use of some of it to buy in shares as cheaply as possible is unjust to the many stockholders induced by need or ignorance to sell. It favors those strong enough to hold their shares indefinitely. It particularly advantages those in control of the company, for in their case the company’s cash applicable to their stock is readily available to them if they should need it.”5 (own emphasis added)
In contrast, Five cited Teledyne Inc. as one of the various companies that carried out “judicious” repurchases. Its authors said:
“The fundamental investor usually has a long-term horizon and is concerned with personal gains and losses – not those of other stockholders who come and go.”6
There is no mention of Teledyne Inc.’s many tender offers. Graham’s position was akin to the Golden Rule: a departing partner should not be squeezed out of every last cent when selling.
A related, and unrelated, point is that Five and Henry Singleton7 both point towards Sydney Homer’s A History of Interest Rates (1977).
3. Dividends
The idea that high-growth companies with long runways should retain earnings instead of issuing liberal dividends is obvious. Five alludes to stock dividend issuance. Two, being more thorough, shows that stock dividends can manipulate unintelligent investors into speculative frenzies in two ways:
I. Stock dividends appear higher than cash dividends, when the market price of a company’s shares increases. A higher price — to the ignorant — justifies an even higher price.
II. Companies paying higher periodic stock dividends receive higher multiples in the market.
Two argues that the issuance of periodic stock dividends results in higher theoretical cash dividends in the future…
“For example, if a company earnings $12 pays out $5 in cash and 5% in stock, in the next year it will most probably pay $5 in cash on the new capitalization, equivalent to $5.25 on the previous holdings. Without the stock dividend, it would probably continue the $5 rate unchanged.”8
Instead of a strength, I think that lures investors into a trap:
III. To the intelligent investor, stock dividends appear to provide the optionality of cash dividends and deferred income taxes. In the long term, they’re a perpetual dilution of all future earning power, all things being equal (of course, they never are).
Ada Lovelag:
There are 39 ratios on the inside of the book’s covers. You know most already.
Five’s premise is that security analysis is the measurement of economic reality. By studying the recent and historical business results, the analyst can detect changes in the long-term nature and future results before the market does.
That premise does not support the book’s purpose of anticipating long-term change through ratio analysis. At the most fundamental level, investors are students of human systems (businesses). The further forward you look, the more determinative non-measurable factors are (people, culture, and structure).
Economics is scarcity. Scarcity is a second-order effect of individual human actions. Which actions caused today’s results?
The authors argue that the more volatile a company’s results, the less predictable its earning power is. If stock price volatility (beta) is not risk, what happens when you apply that line of reasoning to business results? Why do investors view businesses with stable results as less risky?
In capital-intensive industries, e.g. semiconductor manufacturing, multi-year time lags and investing frameworks may make 3-5-year ratios more appropriate. If analysts were truly interested – why would they be? – in what will happen to earnings in the next 12 months, then a detailed study of the news and company actions 2-4 four years (depending on the industry’s capital cycle length) prior would be more informational as to the next three to four quarters’ results rather than the latest earnings calls.
The duration of non-current assets makes them more risky. Thus, the ratio of current assets to total assets is a measure of risk. It will take a longer time for cash to appear so there is more time for something to go wrong. The current ratio is important in measuring both liquidity and risk.
The authors stated that equity markets are becoming more efficient due to better-trained analysts. Five stated there were 2.7 million active U.S. corporations, in 1988. In 2023, Companies House reported 5.1 million active U.K. companies. Are public markets simultaneously growing and becoming more efficient? Are there more security analysts per public equity market capitalization available?
Four argued 20 times earnings four years hence was the boundary for investment vs speculation whereas Five suggested not paying more than 2x the index’s multiple.
17. Return on capital before depreciation
With two opposite actions, management can falsify earnings in the same way: both lengthening an asset’s estimated life or writing down an asset reduces the depreciation charged against earnings.
Conversely, management can reduce earnings with inappropriately high depreciation and circumvent tax.
Tax laws changed post World War II to enable faster depreciation rates. High inflation resulted in depreciation charges derived from past replacement costs being inadequate. In such macroeconomic environments, acquirers may be more inclined to purchase companies at higher multiples of book value because they understand it no longer maps well as an economic measure.
This is a steady-state tool that enables us to view similar companies’ return on capital if they had the same depreciation policy. So it's useful to compare similar companies that have different depreciation policies.
On stability
When judging a company’s stability, investors often look at how gross and/or operating margins change with revenue changes. A strong gross margin, throughout the cycle, implies a company controls its prices.
Five introduced two new ratios to use when judging a company’s stability:
22. Maximum decline in coverage of senior charges
23. Percent decline in return on capital
I urge modern readers to start with Five. The language is more digestible than Graham’s INTP prose and death by example. That being said, one can’t help but feel that the solid foundations laid down by studying One, Two, and Three before Five brought out the qualities of Five more so than if one were to read it fresh with no prior reading of Security Analysis.
Benjamin Graham & David Dodd, Security Analysis (1940), pg. 85.
Ludwig Wittgenstein, Tractatus Logico-Philosophicus (1921), pg. 111 of D.F. Pears & B,F McGuinness Translation (1963).
Graham & Dodd, Security Analysis (1940), pg. 815.
Graham & Dodd, Security Analysis (1934), pg 518.
Graham & Dodd, Security Analysis (1940), pp. 608-609.
Sidney Cottle, Roger Murray, and Frank Block, Security Analysis (1988), pg. 331.
James Nisbet, The Entrepreneur (1976), pg. 146.
Graham & Dodd, Security Analysis (1940), pg. 393.