“Fundamental Elements in the Problem of Analysis. Quantitative and Qualitative Factors”

Chapter Summary

The four fundamental elements: 1. The security 2. Price 3. Time 4. The person “Should security S be bought (or sold, or retained) at price P, at this time T, by individual I?” (pg 75).

The person… Has tax-consideration elements; but namely the risk-tolerance, temperament, and time-preference are the keys.

The time… Relative yields at different points in time make certain securities more attractive than others.

The price… Price has relatively differing importance across different security types. For example, fixed income might be more concerned with the safety of the issue rather than the price. In common stocks, paying the wrong price is perhaps worse than buying the wrong issue. Price is half of the fundamental value-investing formula of price and value. While it may not always reflect the reality of value, it is a reality of its own and must not be ignored.

The security… What terms, in what business/industry, in what investment vehicle are we making the purchase? An attractive enterprise on unattractive terms is not better than an unattractive enterprise on attractive terms. (pg 79). KEY QUOTE: “Nearly every issue might conceivably be cheap in one price range and dear in another.” (pg 80). The lynchpin of value investing is the relation of price to value, and this quote summarizes that concisely. Graham cites stocks that were of unquestionable status in their industry, only to collapse to a price below their net asset value a few years later.

Security analysis is necessarily limited in its detail. Judgement is required to determine how much research is needed, and it should be correlated to potential return. It takes a significant amount of work to find an unquestioned bargain in common stocks. (pg 81).

Information and data is relative to the type of enterprise that is under study; impressive earnings in one industry might simply not be so comparatively to another. (pg 82).

There exists quantitative, and qualitative elements to analysis: Qualitatively of importance are the “character of management” and also the nature of the business. The nature of the business, be it favourable or not so, is subject to rapid and frequent change. Abnormal levels of profit, either for better or worse, will likely be levelled out eventually. This is a supply and demand question. In terms of management, it is acceptable to pay a premium on management, but not to pay “twice”, in paying for good management, as well as their produced impressive earnings. (pg 84). “Trend” is also a qualitative factor largely (to be discussed further later). It is exceptionally difficult to quantify trend; we must base intelligent investment on facts, not expectations of facts. One final qualitative factor is the concept of stability. Stability is something to value, but varies from industry to industry, and is also difficult to quantify. Graham cites as an example the automobile industry: in itself is relatively stable, however individual companies are not so, as demand is capable of shifting quickly to another company/model. The grocery chain industry, on the other hand, is stable through and through. Quantitative factors are analyzed in much later chapters.



Chapter Analysis and Thoughts

Not only does data vary with the “type of enterprise”, the relative value of data or information varies from security to security. The safety of principal in a fixed income investment may not require remarkable earning power if the debt is easily covered by assets, and vice versa for common stock investment. Appropriate weightings to information must be made in accordance with both the security and the industry itself; and perhaps, even on a company to company micro level.

What premium are we/should we be paying for stability in an industry? And why should we necessarily be paying this premium? On the other hand, industries particularly renowned for their stability are perhaps to be avoided for the very characteristic that Graham prizes. This is for two reasons: Firstly, stability is naturally an attractive aspect to risk averse investors. Thus, the herd mentality involved with defining an industry or company as stable will naturally bring about a certain percentage premium that would have to be paid in order to compensate for the causation in higher demand from stability. And as Graham would likely put forth himself, industries that are neglected for any reason ought to be paid extra attention to in seeking quality value, unstable industries included. This is another excellent example of why I believe higher margins can be made in inherently unstable industries like resource juniors. While they are clearly still dictated by the laws of supply and demand, making excess returns by virtue of industry instability perhaps fairly small, profit is made on the margin. Any excess rents generated, especially in light of the long run, can make the difference between a profitable investment and an unprofitable one. This idea may have to be expanded upon in its own article.

Graham’s appreciation of the human element in investing is extremely insightful. Often investing ideas exist in the realm of pure theory, with no human variables considered. However, human variables are too impactful to be ignored. What is one’s risk tolerance? One’s time preference? Stomaching a devastating loss in an investment is difficult emotionally, and becomes even more stressful when consideration of joint or family finances is given. Lastly, the primary human aspect in investing must be humility. Are you willing to constantly challenge yourself, and your thesis? Because any applicable ideas developed in the realm of theory are necessarily affected by your ability to adapt your thesis in the face of new circumstances. So in this sense, the human element drives the theoretical, and not vice-versa as conventionally thought.

The idea of paying a premium for management “twice” according to Graham is fascinating. And it is indeed logical; growing earnings of a company bring about price premiums, while accreditation of the management team for those earnings bring about the second premium. What is of far more interest to me is not the paying of management premiums twofold, but not paying a premium for management at all. If a roaring earnings report brings about double charging for management, the opposite logically must be that for a depressed industry or company with poor earnings, high quality management teams are available at no extra cost. This is exceptionally tantalizing for the junior resource industry at the moment. An important caveat to this point is to consider whether the market truly is attributing the success or failure of earnings to management, so as to not make a mistake in adjusting value calculations based on poor assumptions.

