- Richard A. Dixon
I’ve often mentioned that during times of market highs - when I can find almost no new investment opportunities - I tend to go back to the basics and ground my thinking in the value investment classics. As of March 2019, my individual and institutional accounts are roughly 20 - 25% in cash as a percent of total assets under management. With the run up in Q12019, I could see this number going higher.
My go-to classic is Benjamin Graham and David Dodd’s classic “Security Analysis” (1934 edition). I find there are many diamonds in what could be called a “literary rough.” Although it’s a tough slog, I suggest everyone read it from front to back at least once a year. (No cheating either! Though Bob Abbott on GuruFocus does a great job summarizing the classics, this one needs to be read in unadulterated form).
Graham and Dodd’s Security Analyst: Job Description
Almost everyone skips the beginning chapters of the book eagerly looking to investigate the authors’ descriptions of margin of safety and other core concepts of value investing. I think most readers miss some of the most important thinking in the history of value investing by giving a fleeting glance to Chapter One entitled The Scope and Limitations of Security Analysis: The Concept of Intrinsic Value. This first chapter is essential to understanding why your role as a security analyst is essential to being a successful value investor. It isn’t often that you hear an individual or institutional investor call themselves a security analyst. Rather they refer to themselves as a value investor. I would posit that Graham and Dodd argue that one cannot be a value investor without mastering the requirements of being a security analyst. In today’s world, most would think of a security analyst as someone with a specific degree (MBA) or professional license (CFA) than as an investor with a broader set of research/evaluation skills and personal behavioral characteristics. But as a reader digs deeper into Chapter 1 of Security Analysis, Graham and Dodd outline the necessary skill sets, intellectual framework, and emotional tools that make not only a qualified security analyst, but a successful value investor.
They break the role and skills of a security analyst into three buckets – descriptive, selective, and critical. It isn’t – and can’t be - in the scope of this article to fully describe each of Graham/Dodd’s three attributes, but I thought it might be helpful to briefly describe each and discuss their relevance to effective value investing.
As described by Graham and Dodd, descriptive security analysis consists of “marshalling the necessary forces” and presenting the company’s data in a clear and concise fashion. Descriptive can also include a deeper dive into the company’s strengths and weaknesses including its financials, competitive strength, operating markets, and strategic outlook. At Nintai Investments, we see this as an essential component of building out the business case used to make the decision about an investment's role in the portfolio. Descriptive security analysis is truly business analysis and requires an enormous amount of learning - marketplace characteristics, competition, regulatory, technological innovations, etc. If you’ve listened to successful value investors, it’s always surprising the level of detail these individuals retain about their portfolio holdings. Whether it’s discussing the company’s research & development budget and projected return on investments or the vital statistics in product design, these investors see descriptive security analysis as the foundation for their competitive advantage.
Selective collates the descriptive analysis and uses it to suggest or recommend whether the security should be bought, sold, or held in its respective portfolio. This part of security analysis is where the role of intrinsic value versus market pricing plays an enormous role. Great value investors can utilize the selective process to make quick judgements on potential investments. A great example was Warren Buffett’s decision to invest in CNOOC (CEO). He stated at the time that he made the decision to invest in about half-an-hour based on selective analysis alone. When combined with robust descriptive research, value investors can achieve markedly improved chances at reducing permanent impairment of capital.
An example of this at work was Nintai Investments purchase of Veeva Systems (VEEV). An enormous amount of work went into the descriptive portion of the security’s analysis. Understanding the company’s product, its deep relationships in life sciences, its powerful value in the discovery, development and sales/promotion of drugs, and its wide competitive moat made the selective portion of the Veeva analysis much, much easier. By the time it came to make the decision to add or not add the company to the portfolio (and at what size), the answer practically delivered itself. Being a security analyst made my job as an investment manager that much easier and (hopefully) that much more successful.
As an investor who takes long positions in equities only, critical security analysis has less to do with the strength of the offering placement (as a common stock holder I will be - after all - at the end of the bankruptcy asset line). Rather my concern will focus on the totality of obligations the company has (common stock, preferred stock, short and long-term debt, warrants, off-balance sheet entities, etc.) and the overall strength of the company to meet its obligations. If a company’s debt is selling at a 35% discount to par, then I’m going to want to know what bondholders know. Th difference between the thinking and concerns of stock holders is quite different than those holding the company’s debt obligations. When Wall Street was pumping Enron stock as the latest and greatest, it was obvious to security analysts who did their critical security analysis that something was terribly wrong with company’s financial structure - in particular its off-balance sheet entities and its ability to support such a financial structure.
Before Graham and Dodd introduced the idea of margin of safety and other themes that have become the foundation of value investing, they created the idea that security analysis as a profession was essential to understanding the concept of intrinsic value. Without the structure of researching key components of a potential investment - its business, finances, markets, competitors, and structure of its public financial offerings - then investors simply could not derive an intrinsic value of their potential asset they were looking to purchase. At Nintai Investments we couldn’t agree more. Many times, we refer to ourselves as security analysts. Sometimes people ask if we work with prisons. Sometimes they think we are in the business of protecting homes or business data. That’s all fine with us. The less people know what security analysis entails or its importance to being a successful value investor, the happier we are as it relates to our competitive strength. We encourage our readers to break out their green eyeshades and embrace their own security analyst genes. It’s unlikely you will regret it in the long run.
As always I look forward to your thoughts and comments
DISCLOSURE: I own Veeva Systems in individual and institutional portfolios I personally manag