Intelligent Investor Chapter 11 Summary : Security Analysis for the lay investor

Security Analysis for the lay investor: General Approach

• Security analysis mainly deals with examination and evaluation of stocks and bonds, financial analysis is security analysis plus determination of investment policy and substantial amount of general economic analysis.
• Security analyst deals with the past/present/future of any given security. He describes business, summarizes operating results and financial position,sets froth strong and weak points, possibilities and risks, estimates future earning power under various assumptions, makes elaborate comparisons, finally expresses an opinion on safety of bond/preferred stock and attractiveness of a common stock. All this is done using lot of techniques. But the use of mathematics in future anticipations(unpredictable) may give a possibility of miscalculations.
• This starts with interpretation of a company's financial report. The Interpretation of Financial Statements and Security Analysis books are a good start.

Bond Analysis:

• Analysis of safety/quality of bond issues and investment grade preferred stocks is dependable.
• For corporate bonds, chief criterion is the number of times total interest charges have been covered by available earnings in past. For preferred stocks, it's the number of times bond interest and preferred dividends combined.
• Basic test - average results over 7 years in the past are over a minimum coverage criterion. Poor year is another alternative to average results. But fluctuating interest rates may offset this. So alternative is % earned on the principal amount before taxes- 33% for industrial, 20% for public utility, 25% for railroad.
• Other tests:
• Size of enterprise - minimum standard in terms of volume of business.
• Stock/Equity ratio: Common stocks/Total face amount of debt + preferred stock.
• Property Value: Safety resides in earning power for most companies, if that's deficient assets lose most of their reputed value. But asset value from recent balance sheet is good consideration for public utilities, real estate, investment companies.

• The reliability of all these tests can only be known from experience.
• History shows that bonds and preferred stocks that have met stringent tests of safety in past mostly do better in future. Railroad, electric utility have all failed such tests and went bankrupt.
• Industrial bonds and preferred stocks of such companies which are in large size and can withstand depression are good.

Common Stock Analysis:

• Valuation: Estimating future average earnings and multiplying by capitalization factor.
• Average past data for physical volume, prices, operating margin and amount of chnage expected in them based on assumptions, general economic forecasts, special conditions applicable to the industry/company.
• Composite/group estimates are more dependable than those for individual companies. Pick 3/4 companies you know best.
• As it's difficult to account for the margin of error in individual forecasts, diversification is suggested.

Factors affecting the capitalization:

• Depending on the quality, it varies.
•  General long term prospects in future: by differentials in P/E.
• Management with good past record. Look out for recent changes that haven't impacted yet.
• Financial strength and capital structure: Stock of company with lot of surplus cash is better than the one with large bank loans and preferred stocks if both have same per share earnings.
• Dividend record: at least 20 years record of uninterrupted dividend and good quality rating.
• Current dividend rate/Dividend payout ratio: Ideally distribution of 2/3rds of average earnings. But that's not the case today as companies instead choose to reinvest profits instead of paying dividends.

Capitalization rates for growth stocks:

• Value=Current Earnings * (8.5 + 2* expected annual growth rate)
• Take future interest rates into consideration.

Industry analysis:

• Mostly already known to public about position of industry and company.
• Vision into future(tech) may present great opportunities but with great risks.

Two part appraisal process:

• 1)Past performance by giving individual weights to profitability, stability, growth and financial condition. 2) To what extent this should be modified because of new conditions expected in future.

Commentary:

Long term prospects:

• At least 5 years worth of annual reports.
• Problems to watch for are 
• when a company is a serial acquirer and even disgorges acquisitions at losses or make chronic write offs proving that they overpaid for acquisition 
• too much debt which can be seen in financial statement cash flows-negative operating income and high financing activities income. 
• Relies just on one big fat customer. 
• Positives include 
• competitive advantage -strong brand identity(Harley Davidson), monopoly or near monopoly, ability to produce bulk goods quickly for cheap(Gillette), unique intangible asset(Coca cola), resistance to substitution(electricity public utility). 
• Smooth and steady revenues and returns instead of overheating and flaming out companies 
• Spends on Research and Development in new businesses.

Management:

• Check forecasts of management, if they took responsibility for failures, if they keep changing their words with market.
• Stay away from companies with overpaid CEO/managers, stock reissues to insiders, conflict in interests(they are selling when you are buying).
• Too much promotion instead of just keep their stock from hitting too low or too high.
• Transparent accounting methods. Recurring "non-recurring" charges and extraordinary items, EBITDA over Net income and other obscurities don't serve shareholders' interests.

Financial strength and capital structure:

• Cash put to productive use.
• Owner earnings = net income+ amortization & depreciation - (capital expenditures+ reissue of stock options to insiders+ unusual/non-recurring/extraordinary charges+ income from company's pension fund)
• if owner earnings have grown at 6-7% over 10 years, company is stable.

• Capital structure: long term debt < 50%*(total capital). Check footnotes for fixed/variable rate debts.
• Ratio of earnings/fixed charges. 
• Company should outperform competition if not paying dividends, otherwise management is misusing it.
• Hyped up split shares fuel worst instincts of public.
• Companies should buy back shares when they are cheap. If they are bought at overpriced rates, then it's for top executives to reap benefits when sold in the name of "enhancing shareholder value".

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