[2025–2026] Week 4: Benjamin Graham’s Security Analysis, Part 4
Reading assignment and questions for week 4 of the Value Investing Seminar
(Note: If you are just joining the seminar, please start by reading the Introduction)
In Part 3, we are now moving away from high-grade bonds which have limited, defined upside and into a category of securities in between them and equities. While all of the securities mentioned here by Graham offer a wider range of upside than high-grade bonds, they differ in a number of ways.
Securities with speculative features usually combine the characteristics of a bond with that of a call option on the equity. In some cases, as with convertible bonds, the two are inseparable in a single package. In the case of bonds packaged with warrants the call option can be detached and sold separately.
Even though we are approaching Graham’s teachings as investors, we should pause here and put on our CFO hats. Why would we, as a CFO of a company raising capital, issue converts or offer a sweetener to a straight bond in the form of warrants? The answer is simple: because the market won’t let us issue straight debt as a high-grade borrower.
Perhaps it’s because the company has a limited history. Or it does not have the cashflow to support normal coupon payments. It could also be because it has exhausted its regular debt capacity subject to the constraints that would still put it within the high-grade category.
The reason matters less than the point that there is a negative selection bias that companies issuing hybrid securities, as a group, are weaker credits than those able to issue straight high-grade bonds.
To entice the market to overlook the weakness of the credit, the company then has to part ways with a portion of the equity upside. In other words, because the downside is greater, the upside must be as well.
With respect to high-yield or junk bonds, Graham has a very specific approach. He is looking for equity-like returns, which is why he sets the bar by only looking at distressed bonds trading at or below 70% of par value. That would translate into an annualized rate of return over 3-5 years well into the teens.
Finally, preferred stock when purchased near par value combines the worst characteristics of these securities: negative selection bias of weaker issuers with limited upside and few if any contractual protections. To Graham the answer is simple: just pass.
Part 3 also contains one of the most important passages in the whole book. I was confused the first couple of times that I read it, and it took me a bit of thinking to reason it out. I would suggest that if you were not at all confused upon reading it you are either already an expert investor or you haven’t thought about it deeply enough:
As between the two factors, it is undoubtedly true that it is more profitable to select the right company than to select the issue with the most desirable terms. There is certainly no mathematical basis on which the attractiveness of the enterprise may be offset against the terms of the privilege, and a balance struck between these two entirely dissociated elements of value. But in analyzing privileged issues of the investment grade, the terms of the privilege must receive the greater attention, not because they are more important but because they can be more definitely dealt with. It may seem a comparatively easy matter to determine that one enterprise is more promising than another. But it is by no means so easy to establish that one common stock at a given price is clearly preferable to another stock at its current price.
-Page 300 (6th Edition)
If you unpack what Graham is telling us here, I think you will reach the conclusion that his point is that two random stock whose securities you are comparing are very likely to be efficiently priced regardless of the differences between the underlying companies. For example, even if one business is demonstrably superior to the other, he is saying that the market likely already reflects this in the stock price, and that is the reason we should focus on analyzing the differences in the terms of the securities.
Graham’s point boils down to this: most stocks are approximately correctly priced by the market most of the time.
Also, bringing this back to dimensions of an investing style – this is a key dimension: do you want to be more of a business analyst or more of a security analyst? As we study different investors, keep this important dimension in mind.
Regarding Question 2 Patrick wrote: “He says their long-term record has been poor because the extra features rarely protect investors when things go bad. History supports that. Preferred shares dropped hard in the 2008 crisis, 2020, and 2022 rate spike. Contingent convertibles, or CoCos, and AT1s are a modern version. They pay a high coupon but can be written down or converted in stress. Credit Suisse AT1 holders were wiped out in 2023, and only this year did a Swiss court partly reverse that decision. Convertibles have done better, but many still end up “busted.” So overall, the record fits what Graham warned about.”
Week 4 assignment is to read Part 4 of Security Analysis and answer the following questions:
Question 1: What does Graham mean when he says that as far as a typical common stock is concerned, that analysis is unlikely to yield a dependable conclusion as to the attractiveness or real value of the stock? Do you agree/disagree?
Question 2: Why does Graham believe it is dangerous to project an earnings growth trend into the future? Do you agree/disagree? Is it also dangerous to project a company’s level of average earnings into the future? Why/why not?
Question 3: What are the challenges that Graham identifies with Growth Investing? What are your thoughts on this topic?
Question 4: How does a company’s dividend track record and current policy impact its attractiveness as an investment?
Question 5: When should a company be reinvesting earnings and when should it be paying them out as a dividend?
Question 6: Create an AI prompt based on the material covered by Graham in Part 4 that would aid you in your investing.
Now it’s your turn:
Submit your answers in the comments below this article with all your answers in a single comment. I will engage with some of the answers each week and highlight some of the ones I find most insightful in next week’s seminar assignment article.
Engage with the answers of some of your fellow seminar members in the comments below. Remember – the goal is to learn together. Be kind, be respectful and try to add to our learning as a community.
Feel free to ask any questions about the reading in your comment.
Until next week,
Gary
About the author
Gary Mishuris, CFA is the Managing Partner and Chief Investment Officer of Silver Ring Value Partners, an investment firm that seeks to apply its intrinsic value approach to safely compound capital over the long-term. He also teaches the Value Investing Seminar at the F.W. Olin Graduate School of Business.
Question 1:
What does Graham mean when he says that as far as a typical common stock is concerned, that analysis is unlikely to yield a dependable conclusion as to the attractiveness or real value of the stock? Do you agree/disagree?
Benjamin Graham in Security Analysis is deeply doubtful of buying companies for their supposedly bright futures. He says:
"Characteristically, stocks thought to have good prospects sell at relatively high prices. How can the investor tell whether or not the price is too high? We think that there is no good answer to this question - in fact we are inclined to think that even if one knew for a certainty just what such a company is fated to earn over a long period of years, it would still be impossible to tell what is a fair price to pay for it today."
Really? This to me is one of the key weaknesses to pure value investing. By throwing up his hands and discounting future growth as unknowable, and not susceptible to analysis he essentially ignores it and assigns it no significant value. The trouble is that it clearly does have value, and moreover in the best cases, massive value that outweighs everything else. It may be difficult to evaluate, and more uncertain, but that means we must try harder than he did to evaluate it, rather than simply putting it in the "too difficult" bucket. If we can find no answer, the rational thing is to buy the whole index in a tracker, and catch the difficult to spot winners that way along with all the losers and hope the average proves as good in the future as it has in the past. A solution that an increasing proportion of the market has gravitated towards. A value approach that specifically filters out candidates that are "overpriced" or in his words "speculative" is likely to exclude the small number of really big winners, making it likely to underperform the index.
Question 2:
Why does Graham believe it is dangerous to project an earnings growth trend into the future? Do you agree/disagree? Is it also dangerous to project a company’s level of average earnings into the future? Why/why not?
Graham seems to believe quite strongly in reversion to the mean:
"The answer to this problem derives from common sense rather than formal or a priori logic. The favourable trend of Company A's results must certainly be taken into account, but not by a mere automatic projection of the line of growth into the distant future. On the contrary, it must be remembered that the automatic or normal economic forces militate against the indefinite continuance of a given trend."
The trouble with common sense is that it implies that the point is obvious and needs no further examination. But this one does. While blind projection is clearly foolhardy, if the company has a strong track record of growth, identification of new markets, successful occupation of those markets and expansion of market share, it would be unreasonable to expect it to revert to some former mean from the past automatically. Rather the analyst should assess the size of the addressable market, look at the company's assumptions and make a reasoned estimate of it's future size and prospects, rather than a "what goes up must come down" attitude.
he goes on to say "the analyst's philosophy must still impel him to base his investment valuation on an assumed earnings power no larger than the company has already achieved in some year of normal business"
If a company is growing we would expect it to regularly post new high earnings, and it would be unreasonable to assume it would necessarily revert to some former earnings in previous years.
He seemed to think it was safer to assume that a company's earnings would keep coming if it had a strong capital position. He quotes Intertype Corporation as being attractive despite it's distinctly spotty 10 year earnings because both the earnings and the share price were likely to revert to the mean and the chances of loss slight. A classic value play that worked. He compared it to Coca Cola, on 24 times earnings, which went down in the same period. I could not have picked a better example myself of both the strength and weakness of his investment style viewed with the power of hindsight.
Any projection, up down or flat is only as reasonable as the assumptions that underpin it. There is no avoiding having to appraise conditions which the company operates in, and the market it inhabits if you want to make any reasonable projection into the future. If the company is in a mature sector, with a large market share, conservative but competent management and limited growth opportunity a flat projection of earnings in line with the sector growth and inflation is the most reasonable assumption and in the majority of cases will prove right. But if the management is planning a big acquisition, or the market is beginning to shift against it to more nimble competition, that can change quickly.
In summary I think projection is a poor and lazy way of doing it. Assessment of the addressable market is a better way. For example, in the UK there are roughly 1200 towns of population greater than 5000. Each of these can support roughly one successful branch of a store, or two for really popular universal venues like cafes. So if you see a retailer with 600 small store formats, it can't really grow more than twice it's current size at most. If it tries to it will end up with unprofitable locations and hit trouble. McDonalds has 1,477 restaurants, and that's about the limit. It's a good company and knows this. Greggs has 2,675 outlets in the UK. It's no surprise to me that it has hit trouble. that is just too many. I have seen this happen to many different retailers over the years. Projections simply don't capture this kind of detail, you have to know your market.
If you want an example of a growth story susceptible to very solid analysis have a look at Action, majority owned by 3i a UK listed FTSE investment trust company. Estimate the final number of stores across Europe, multiply by sales per mature store and therefore the final size and profitability the company should be able to achieve. You can also calculate the growth rate, capex per store, cashflow model, the effect of opening each new store on cashflow and warehouse efficiency. The resulting model is pretty much Graham's thought experiment in my answer to question 1.
Question 3:
What are the challenges that Graham identifies with Growth Investing? What are your thoughts on this topic?
He identifies 3 challenges, What is a growth company? Can they be identified with reasonable accuracy? To what extent does the price paid for such stocks affect the success of the program?
My thoughts are:
A growth company should be increasing sales and market share independent of the business cycle. It may sacrifice profits for faster growth, but it should be able to demonstrate good margins early on, usually rapidly followed by EBITDA growth, and eventual profitability.
A good indicator to identify them is both high growth and a high ROCE or cROCE. Efficient use of capital is an essential tool for objectively assessing the quality of an enterprise. A metric known to Graham, but which he did not seem to rate very highly. (it was developed by F. Donaldson Brown at DuPont in 1910 to assess business performance) In the introduction he says "Companies with a high rate of earnings on invested capital can attract competition or regulation - so high returns are not an unalloyed good" This is true but an oddly negative attitude - a better question is how the companies achieve it and whether it is sustainable.
The price paid is important of course. But never being prepared to pay any significant premium, which is his position, is oddly lacking in common sense. Did he always shop at the cheapest store, wear the cheapest suit or buy the cheapest house, perhaps valuing the bricks the house was built with and refusing to pay more than the price of the bricks? We assess value for money when we make purchases, and the same principle should apply to buying a stock. A decent stock should command a decent price, just like any other purchase. It is also more likely to sell for a decent price when we finally want to dispose of it.
1. Graham’s point here is that the vast majority of businesses lack the stability required to evaluate their investment potential with a sufficient degree of confidence when viewed in isolation. This is due to their susceptibility to unpredictable events on the stock specific level (disruption) and the vagaries of the business cycle.
This ties in with his assertion that investment is a group operation, implying that diversification is a prudent course of action- better to tilt the odds in one’s favour by owning a selection of stocks with relatively favourable characteristics.
I agree with Graham for the most part, I’d say that the precise intrinsic value of a stock is unknowable; in certain cases a floor can be reliably assessed via asset backing and from there it’s a case of determining a ceiling based on conservative assumptions. Where Graham’s insight offers the most value for me is in warning against deriving misplaced confidence from artificial precision when it comes to valuation- better to be roughly right on average with diversification than to be precisely wrong with concentration.
2. Graham believes that projecting growth trends exposes the investor to avoidable failures of judgement- assuming greater stability than is warranted and over exuberance nearest the top of the business cycle.
I agree to an extent, of the factors that drive a stock’s return it’s important to remember that topline growth is by far the most fragile (and hence the most prized and prone to overvaluation). However, I think it’s useful to consider the potential range of outcomes and their likely probabilities and I would tend to base any assumptions on historic performance along with base rates.
It’s dangerous to project a company’s average level of earnings into the future without considering how those earnings have varied across a full business cycle, or preferably several cycles. This is a very high bar as it limits the universe for consideration to long established businesses whose markets/business models/distribution channels etc… have remained stable over extended periods of time.
3. Graham identifies 3 challenges,
i. Defining what a growth company is- given all businesses are sensitive to at least some degree to broader economic cycles, and the vast majority to other related cycles (commodities, interest rates, housing…), it’s difficult to define what constitutes ‘real’ growth from the effect of a rising cyclical tide.
ii. Identifying growth companies- most companies follow the business lifecycle of growth, consolidation and decline. For those in the growth phase it is difficult (perhaps impossible) to predict how long before growth slows, stops or reverses.
iii. Establishing a fair price- given the role that sentiment plays in establishing price, paying up for growth businesses increases the risk of a disappointing outcome due to (perceived) business underperformance and/or worsening sentiment at the asset class, sector, region, business level.
The flipside is that buying even the best business at a depressed valuation requires a strong stomach, and staying with them while sentiment sours further or remains depressed is psychologically more taxing that most are willing to endure.
I agree with Graham’s assessment of the challenges, and also with his assertion that if you can buy a quality business at or near the point of weakest sentiment, the returns can be excellent. The challenge is finding sufficient opportunities that fit the description.
As I see it the choices are be prepared to remain idle for extended periods, be prepared to pay up (within reason) for quality/growth on occasion or be prepared to compromise on growth/quality when valuations are sufficiently attractive. I’ve found the 3rd course of action the most damaging, followed by the 2nd.
4. Graham argues that dividends had historically been a key determinant of stock price performance, with consistency of dividends being particularly important. He’s unconvinced that the market assesses this sensibly, however, and believes that the overall quantum of dividends paid over an extended period of time is what really matters as opposed to how stable the level of the payout is.
He believes that the dividend yield, when used along with the earnings yield is a useful tool for assessing the merits of a stock investment when compared to its peer group- all else being equal, it’s reasonable to expect that businesses in the same industry with similar prospects ought to trade within a valuation range which can be determined by earnings and dividend yields and where there is an outlier it’s potentially worthy of attention.
5. If we accept that Graham favoured businesses with strong balance sheets, which I think is fair, I’d suggest that his prescription would be as follows:
1) Ensure financial survival- balance sheet strength.
2) Ensure business survival- maintenance capex.
3) Only where there is a high degree of confidence in a positive outcome for shareholders, invest in growth.
4) Pay the rest out in dividends.