My Key Takeaways From Chapter 11 and Commentary 11 of the Intelligent Investor. Part 12/16. To Be Continued.

Chapter 11 Security Analysis for the Lay Investor: General Approach

The security analyst deals with the past, the present, and the future of any given security issue. He describes the business; he summarizes its operating results and financial position; he sets forth its strong and weak points, its possibilities and risks; he estimates its future earning power under various assumptions, or as a “best guess.” He makes elaborate comparisons of various companies, or of the same company at various times. Finally, he expresses an opinion as to the safety of the issue, if it is a bond or investment grade preferred stock, or as to its attractiveness as a purchase, if it is a common stock.

We must point out a troublesome paradox here, which is that the mathematical valuations have become most prevalent precisely in those areas where one might consider them least reliable. For the more dependent the valuation becomes on anticipations of the future-and the less it is tied to a figure demonstrated by past performance-the more vulnerable it becomes to possible miscalculation and serious error. A large part of the value found for a high-multiplier growth stock is derived from future projections which differ markedly from past performance-expect perhaps in the growth rate itself. Thus it may be said that security analysts today find themselves compelled to become most mathematical and scientific in the very situations which lend themselves least auspiciously to exact treatment.

Bond Analysis

The most dependable and hence the most respectable branch of security analysis concerns itself with the safety, or quality, of bond issues and investment-grade preferred stocks. The chief criterion used for corporate bonds is the number of times that total interest charges have been covered by available earnings for some years in the past. In the case of preferred stocks, it is the number of times that bond interest and preferred dividends combined have been covered.

*Table 11-1 Recommended Minimum “Coverage” for Bonds and Preferred Stocks

It may be objected that the large increase in bond interest rates since 1961 would justify some offsetting reduction in the coverage of charges required. To meet this changed situation we now suggest an alternative requirement related to the percent earned on the principal amount of the debt. These figures might be 33% before taxes for an industrial company, 20% for a public utility, and 25% for a railroad.

In addition to the earnings-coverage test, a number of others are generally applied. These include the following:

1. Size of Enterprise
   There is a minimum standard in terms of volume of business for a corporation-varying as between industrials, utilities, and railroads-and of population for municipality.
2. Stock/Equity Ratio
   This is the ratio of the market price of the junior stock issues to the total face amount of the debt, or debt plus preferred stock. It is a rough measure of the protection, or “cushion,” afforded by the presence of a junior investment that must first bear the brunt of unfavorable developments. This factor includes the market’s appraisal of the future prospects of the enterprise.
3. Property Value
   The asset values, as shown on the balance sheet or as appraised, were formerly considered the chief security and protection for a bond issue. Experience has shown that in most cases safety resides in the earning power, and if this is deficient the assets lose most of their reputed value. Asset values, however, retain importance as a separate test of ample security for bonds and preferred stocks in 3 enterprise groups: public utilities (because rates may depend largely on the property investment), real-estate concerns, and investment companies.

Common-Stock Analysis

This valuation, in turn, would ordinarily be found by estimating the average earnings over a period of years in the future and then multiplying that estimate by an appropriate “capitalization factor.”

Through average future earnings are supposed to be the chief determinant of value, the security analyst takes into account a number of other factors of a more or less definite nature. Most of these will enter into his capitalization rate, which can vary over a wide range, depending upon the “quality” of the stock issue.
Let us deal briefly with some of the considerations that enter into these divergent multipliers.

1. General Long-Term Prospects
   These views are reflected in the substantial differentials between the price/earnings ratios of individual companies and of industry groups.
2. Management
3. Financial Strength and Capital Structure
   Stock of a company with a lot of surplus cash and nothing ahead of the common is clearly a better purchase (at the same price) than another one with the same per share earnings but large bank loans and senior securities. (Incidentally, a top-heavy structure-too little common stock in relation to bonds and preferred-may under favorable conditions make for a huge speculative profit in the common. This is the factor known as “leverage.”)
4. Dividend Record
   We think that a record of continuous dividend payments for the last 20 years or more is an important plus factor in the company’s quality rating.
5. Current Dividend Rate
   The majority of companies have come to follow what may be called a standard dividend policy. This has meant the distribution of two-thirds of their average earnings, except that in the recent period of high profits and inflationary demands for more capital the figure has tended to be lower. However, an increasing number of growth companies are departing from the once standard policy of paying out 60% or more of earnings in dividends, on the grounds that the shareholders’ interests will be better severed by retaining nearly all the profits to finance expansion.

Capitalization Rates for Growth Stocks

Most of the writing of security analysts on formal appraisals relates to the valuation of growth stocks. Our study of the various methods has led us to suggest a foreshortened and quite simple formula for the valuation of growth stocks, which is intended to produce figures fairly close to those resulting from the more refined mathematical calculations. Our formula is:

Value=Current(Normal) Earnings x (8.5 plus twice the expected annual growth rate)

The growth figure should be that expected over the next 7 to 10 years.

We should have added a caution somewhat as follows: The valuations of expected high-growth stocks are necessarily on the low side, if we were to assume these growth rates will actually be realized.

We should point out that any “scientific,” or at least reasonably dependable, stock evaluation based on anticipated future results must take future interest rates into account. A given schedule of expected earnings, or dividends, would have a smaller present value if we assume a higher than if we assume a lower interest structure.

Industry Analysis

We must recognize, however, that the rapid and pervasive growth of technology in recent years is not without major effect on the attitude and labors of the security analyst. More so than in the past, the progress or retrogression of the typical company in the coming decade may depend on its relation to new products and new processes, which the analyst may have a chance to study and evaluate in advance.

A 2-Part Appraisal Process

We suggest that analyst work out first what we call the “past-performance value,” which is based solely on the past record. This would indicate what the stock would be worth-absolutely, or as a percentage of the DJIA or of the S&P composite-if it is assumed that its relative past performance will continue unchanged in the future. (This includes the assumption that its relative growth rate, as shown in the last 7 years, will also continue unchanged over the next 7 years.) This process could be carried out mechanically by applying a formula that gives individual weights to past figures for profitability, stability, and growth, and also for current financial condition. The 2nd part of the analysis should consider to what extent the value based solely on past performance should be modified because of new conditions expected in the future.

Commentary on Chapter 11

“Would you tell me please, which way I ought to go from here?”
“That depends a good deal on where you want to get to,” said the Cat.
- Lewis Carroll, Alice’s Adventures in Wonderland

Putting a Price on the Future

Graham feels that 5 elements are decisive. He summarizes them as:

• The company’s general long-term prospects”
• The quality of management
• It’s financial strength and capital structure
• Its dividend record
• And its current dividend rate

The Long-Term Prospects

Nowadays, the intelligent investor should begin downloading at least 5 years’ worth of annual reports (Form 10-K) from the company’s website or from the EDGAR database at www.sec.gov. Then comb through the financial statements, gathering evidence to help you answer 2 overriding questions. What makes this company grow? Where do (and where will) its profits come from. Among the problems to watch for:

• The company is a “serial acquirer.” An average of more than 2 or 3 acquisitions a year is a sign of potential trouble. Watch out for corporate bulimics-firms that wolf down big acquisitions, only to end up vomiting them back out.
• The company is an OPM addict, borrowing debt or selling stock to raise boatloads of Other People’s Money. These fat infusions of OPM is labeled “cash from financing activities” on the statement of cash flows in the annual report. They can make a sick company appear to be growing even if its underlying businesses are not generating enough cash.
• The company is a Johnny-One-Note, relying on one customer (or a handful) for most of its revenues.

As you study the sources of growth and profit, stay on the lookout for positives as well as negatives. Among the good signs:

• The company has a wide “moat,” or competitive advantage. Several forces can widen a company’s moat: strong brand identity; a monopoly or near-monopoly on the market; economies of scale; a unique intangible asset (think of Coca Cola, whose secret formula for flavored syrup has no real physical value but maintains a priceless hold on consumers); a resistance to substitution (most businesses have no alternative to electricity so utility companies are unlikely to be supplanted any time soon).
• The company is a marathoner, not a sprinter. By looking back at the income statements, you can see whether revenues and net earnings have grown smoothly and steadily over the previous 10 years. If earnings are growing at a long-term rate of 10% pretax (or 6% to 7% after-tax), that may be sustainable. But the 15% growth hurdle that many companies set for themselves is delusional.
• The company sows and reaps. No matter how good its products or how powerful its brands, a company must spend some money to develop new business. In the long run, a company that spends nothing on R&D is at least as vulnerable as one that spends too much.

The Quality and Conduct of Management

A company’s executives should say what they will do, then do what they said. Read the past annual reports to see what forecasts the managers made and if they fulfilled them or fell short. Managers should forthrightly admit their failures and take responsibility for them, rather than blaming all-purpose scapegoats like “the economy,” “uncertainty,” or “weak demand.” Check out the tone and substance of the chairman’s letter stay constant, or fluctuate with the latest fads on Wall Street. Pay special attention to boom years like 1999. Did the executives of a cement of underwear company suddenly declare that they were “on the leading edge of the transformative software revolution”?) These questions can also help you determine whether the people who run the company will act in the interests of the people who own the company:

• *Are they looking out for No. 1?
A firm that pays its CEO $100 million in a year have better have a very good reason.
If a company reprices (or “reissues” or “exchanges”) its stock options for insiders, stay away.
By looking in the annual report for the mandatory footnote about stock options, you can see how large the “option overhang” is. You should factor in the potential flood of new shares from stock options whenever you estimate a company’s future value.
Form 4, available through the EDGAR database at www.sec.gov, shows whether a firm’s senior executives and directors have been buying or selling shares. There can be legitimate reasons for an insider sell-diversification, a bigger house, a divorce settlement-but repeated big sales are a bright red flag.
• *Are they managers or promoters?
Finally, ask whether the company’s accounting practices are designed to make its financial results transparent-or opaque. If “nonrecurring” charges keep recurring, “extraordinary” items crop up so often that they seem ordinary, acronyms like EBITDA take priority over net income, or “pro forma” earnings are used to cloak actual losses, you may be looking at a firm that has not yet learned how to put its shareholders’ long-term interests first.

Financial Strength and Capital Structure

The most basic possible definition of a good business is this: It generates more cash than it consumes. See whether cash from operations has grown steadily throughout the past 10 years. Then you can go further. Warren Buffett has popularized the concept of owner earnings, or net income plus amortization and depreciation, minus normal capital expenditures. Because it adjusts for accounting entries like amortization and depreciation that do not affect the company’s cash balances, owner earnings can be a better measure than reported net income. To fine-tune the definition of owner earnings, you should also subtract from reported net income:

• Any costs of granting stock options, which divert earnings away from existing shareholders into the hands of new inside owners
• Any “unusual,” “nonrecurring,” or “extraordinary” charges
• Any “income” from the company’s pension fund

If owner earnings per share have grown at a steady average of at least 6% or 7% over the past 10 years, the company is a stable generator of cash, and its prospects for growth are good.

Next, look at the company’s capital structure.

Turn to the balance sheet to see how much debt (including preferred stock) the company has; in general, long-term debt should be under 50% of total capital. In the footnotes to the financial statements, determine whether the long-term debt is fixed rate (with constant interest payments) or variable (with payments that fluctuate, which could become costly if interest rates rise). Look in the annual report for the exhibit or statement showing the “ratio of earnings to fixed charges.”
A few words on dividends and stock policy (for more, please see chapter 19):

• Proof that you are better off if it doesn’t pay a dividend
• Companies that repeatedly split their shares treat their investors like dolts
• Repurchasing overpriced stock enable top executives to reap big paydays by selling their own stock options