“The Scope and Limitations of Security Analysis. The Concept of Intrinsic Value”

Chapter Summary

Analysis is the study of available facts with the attempts to draw conclusions based on sound logic. That logic is applied via the scientific method, though in a relatively inexact way. (pg 61).

There exists three functions of security analysis: descriptive, selective, and critical. 1. Descriptive: Collection, organization, and presentation of relevant facts. (pg 62). 2. Selective: Value judgements are made based on description. The judgements include deciding to buy, sell, retain, or exchange. (pg 62). 3. Critical: The application of standards to descriptive facts, used in determining the “soundness and practicability” of the securities at hand. One must be a critic of accounting policies, management decisions, etc. (pg 74).

The difference between the intrinsic value and the price of a security is the primary concern of an analyst. This is the primary axiom of the whole value thesis. The collection, selection, and analytical interpretation of facts are made in this light. (pg 64). Note that intrinsic value is not akin to book value. It is an imprecise measure of what a price will tend towards in the long run given all available facts. This sounds inexact as a concept, and it is. Graham seems more eager to describe what intrinsic value is not, rather than what it is. Intrinsic value essentially cannot be calculated exactly, but rather as a range to which a security is valued fairy, below, or above its relative price.

Obstacles to success include accuracy of facts, uncertainty of future, and irrational behaviour of the market. (pg 68).

“Tardy Adjustment of Price Value” is a real danger in that returns can be wasted in years that they can’t compound due to a refusal of price to adjust. (pg 70).

KEY QUOTE: “The market is not a weighing machine, on which the 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 party of reason and party of emotion.” (pg. 70).

Analysis is of more use in situations for investment as compared to speculation. Graham compares this to a gambler who is able to reverse his odds, and win slightly against the house. If he bets it all on one number in roulette, his analysis is of little use despite offering a slight edge, as luck plays the primary role in determining the outcome. (pg 73).

Chapter Analysis and Thoughts

Graham’s description and analysis of his gambler analogy is partially correct, but largely not so. He is correct insofar as the gambler endangers his outcome – in reality – to a large increase in variance by placing his bet on one number. However, theoretically there is no real change in the expected value of the bet. The gambler’s edge via analysis still provides him profit in the long run. Thus, Graham is wrong that this implies analysis is moot in situations of luck, but rather is proving the need for diversification to reduce variance. If we apply this idea to the junior resource sector, where variance is extreme, we find those who apply value concepts earning above average returns on investment.

The key quote essentially epitomizes the efficient markets argument as compared to Graham’s value perspective. However, here he is simply stating his view, not justifying, and indeed it is an idea that must be explored further. It is particularly interesting that Graham himself discarded his own investing philosophy as irrelevant in the face of modern finance. This debate must be explored further, and is likely worthy of its own blog post of research.

The application of the economic concept of “utility” in finance and security analysis might be an interesting development to the field, and the argument listed above. The voting machine’s use of non-“rational” information to price can, and almost by necessity does, lead to discrepancies between price and value. For example, investing (or speculating, in the Graham sense) in a company such as Apple because you are a large fan of their products most definitely affects the process of markets in reaching price equilibrium. But where does this utility-based decision fit in to the theoretically efficient markets that are supposedly strictly efficient due to risk-reward? There is no regard for risk-reward, only price and utility. And perhaps it is at least partly in this way that value investors have been able to squeeze out profits above the normal market rate of return.

It is troubling that Graham cannot formulate a more precise definition of intrinsic value, as the concept is so central to his philosophy. Even in the summary provided above, it is primarily my own wording of his elusive discussion on the topic. Hopefully as I advance further in the book, it will become more clear as to exactly what the concept is.