Security Analysis: Chapter 15

Hello friends, in today’s article, we see a summary of chapter 15 of the Security Analysis book by Benjamin Graham and David Dodd. Chapter 15 is about the Technique of Selecting Preferred Stocks for Investment. so let’s see

Previous Chapter 14

The technique of Selecting Preferred Stocks for Investment:-Security Analysis: Chapter 15

In this chapter, the author explains, if we decide to buy the preferred stocks while seeing their disadvantages, so author gives some techniques to select preferred stocks.

The Author Says, ” For preferred stocks, we required to stringent the minimum requirement as compared to bond. So what is the minimum requirement for interest coverage ratio, this given in the following table (image)

Security Analysis Chapter 15

Now you can see, in three industry Segments

So for preferred stocks required more high multiple like in public utility is 1.75 of Fixed charges and for preferred stocks earning is 2 times of Fixed charges and Preferred stocks dividend.

Now Come for minimum stock Value requirement, in this also as compare bond and preferred stocks.

In this, you can see for preferred stocks required more. (Security Analysis: Chapter 15)

In public utilities, required 50% more than bond means 1/2 and for preferred stocks, 66.67% means 2/3 ( Bond + Preferred stocks equal)

So in this chapter 15, we discuss both tables and how to calculate this value.

 

How to calculate Rations?

The first thing is to use the method name is ” Total Deductions method“, for interest coverage ratio to compare with minimum coverage ratio.

So in this method, we have to divide earning by Bond interest + Preferred dividend.

In Bond, we only divide by bond interest but in this, we use both ( bond interest + Preferred dividend)

so some of you say, why not we use the prior deduction method,

Because, we know that, by using the prior deduction method

the result looks like Preferred stocks are more secure than Bond. so that’s why the author uses the total deduction method.

Let’s come in Stock Value Ratios

Security Analysis Chapter 15

For Bond, we use in the numerator, stocks equity( common stocks) and divided by funded debt( bonded debt).

For the preferred Stocks case, in the Numerator, We take only common stocks and in the denominator, we take bonded debt + Preferred stocks.

If Suppose You want the stock value ratio, for this preferred stocks are two type

1st Seniority preferred stocks

2nd Seniority preferred stocks

so for this type of preferred stock using the following method

  • If we want to calculate for 1st seniority preferred stocks Value ratio. so In 1st seniority of preferred stocks in the Nenomenator of equation presents 2nd seniority preferred stocks + common stocks and in the denominator, we can use Bonded debt + 1st preferred stocks. (Security Analysis: Chapter 15)

In Bond, we have to take face value, and 1st preferred stocks we have to take market value.

1st preferred stocks face value we can’t take, because, preferred stocks’ actual par value is different than the stated value.

for this, the author gives example to understand the above statement

e.g, The preferred stocks and this stated par value is $1 but those are preferred stocks holders, they have to get $100 for liquidating preferred stocks.

so the actual par value of that stock is $100, not $1. so for this, we have to use Market Value.

We can see tables(for referring above note page image) in that we say, for Preferred stocks the minimum requirement is more as compared to bonds.

So for seeing this formula, we know that, let’s take

The interest coverage ratio, in the numerator same ( EBIT- earning before interest tax) but in the bond case, we divided by fixed charges, and in the case of the preferred stock, we divided by fixed charges + preferred stocks dividend.

so those are preferred stock coverage is found less, because, we required maximum, as the author gives us

Let’s see in Public utility examples, for the preferred stocks the interest coverage ratio is 2 times. (as given in table by author)

Means, Interest coverage ratio = EBIT / Bond interest + preferred dividend.

            Interest Coverage ratio = 2

so, for Bond ( Interest coverage ratio = EBIT / Interest charges )

Now we surprise

so its value is more than 2 times because the denominator is small

If for preferred stocks is 2, so then bond interest coverage ratio is more than 2. obviously by math

So then the author says, ” Yes, the interest coverage ratio for the bond is more than 2, but people thinks, for preferred stocks coverage ratio is have to be lenient or less stringent, (Security Analysis: Chapter 15)

Because, preferred stocks coverage ratios denominator is more, so the value may be small,”

then Author says, This type of thinking is wrong.

Because, in any company have a bond and preferred stocks, and in this company preferred stocks is when safe, then this company bond is safer, with a good margin of safety.

If the bond is less safe then how are preferred stocks safe? ( common sense)

If the coverage ratio is minimum then this is only limited to bond coverage ratio, not for preferred stocks.

that’s why the author takes 2 times the interest coverage ratio for preferred stocks and for bonds only 1.75.

then the author talks about cumulative Issues and Non Cumulative issues

 

Non-cumulative stocks Issues/ cumulative Stock issues:-

Cumulative Stock issues:- Cumulative preferred stocks are those, in them, the dividend is suspended by the director, so this dividend is accumulated and this dividend is paid later.

But in Non-Cumulative Stock Issues:- In this, if the dividend is suspended, then they are not be recovered or accumulated. So those are new continued dividends, that are only given by the company.

That dividend is missed by the director, that dividend is gone forever.

Then the author says, ” Buying cumulative stocks is better than the Non-cumulative stocks.

Because, in non-cumulative stock problem is, those are common stockholder, they taking advantage, because, the director can suspend, your dividend. in those years also when companies earning is good, and this money is used by the director to improve the company. By this activity, the direct benefit to the common stockholder.

And Your dividend is missed by the company is not given in the next dividend time.

so there is not any benefit for non-cumulative stocks means full loss

On this Non-cumulative Preferred stocks lose, taking benefit by a company means on your expense, taking other profits. (Security Analysis: Chapter 15)

So those are company directors they play in trick, is that

Firstly they suspend your dividend and when they give a dividend to common stocks holder before some time that they give the dividend to the non-cumulative stockholder.

When a company wants to suspend its dividend, so for this they stop the first dividend of the common stockholder and some time after they stop the dividend of preferred stockholders also.

after this difference, the author talks about, ” those 21 preferred stocks, that do good in depression also.

Out of 440 listed stocks on NYSE in 1932, that on 21 stocks is doing good and perform well in depression with any loss.

So those are 440 listed stocks on NYSE in them only 40 (9%) are Non-cumulative preferred stocks.

By knowing this, you may be surprised, those are 21 stocks, that do good in depression, so in them,

the author gives 3 observations, they are as follows.

  1. The number of Non-cumulative issues was higher than cumulative issues, in those 21.
  2. No. of preferred stocks proceeded by bonds were higher than without bonds in those 21. ( as we discussed, in those company, that have only preferred stocks, that’s is good for the preferred stockholder.)
  3. The industry best represented is the snuff business, with three companies.”

(snuff business is a type of business of Tobacco)

So, the author says, ” Buy seeing the only result, we can’t say, non-cumulative stocks is superior.

or we can’t have to say, preferred stocks with the bond is better than, only preferred stocks companies.

or we can’t say, Snuff business is the safe business”

Logically the author says, ” This reverse is best means, the cumulative issue is better and preferred stocks without bond is better. (Security Analysis: Chapter 15)

But this result occurs, it only proves that if this thing does not matter most and maybe desirable but you become successful or not on this things, this observation not affect.

Then the author says, In conclusion

What matters most to success.

  1. Outstanding record of the company for a long period in past
  2. The strong inherent stability of the company
  3. Absence of concrete reason to expect substantial change for worse in the future.

so this is all about chapter 15 of the security Analysis book by Benjamin Graham and David Dodd.

Security Analysis Book Introduction

Hello friends, in today’s article we see the introduction of the Security analysis book written by Benjamin Graham and David Dodd. This book also called as Bible of Value Investing. If you want to do an analysis of stocks individually then read this book. According to warren buffet, this is the best ever written on value investing, this line is written by Warren Buffett on the book cover. If you want to buy this book then click on the below image.

Security Analysis Book Introduction
Security Analysis Book Introduction:

The author gives advice about this book while you are reading this book

About this book(security analysis):-

  • This book is intended for those who have a serious interest in Security Analysis.
  • Not Addressed to complete Novice you should know about basic financial terms to understand this book.
  • So that those are nothing know about financial terms, then this is a book not for you.
  • In this book, we learn, how to analyze stock individually and general principles and standards to select companies.

In the introduction, part author talks about three timelines i.e. 1911-1913, 1923-25, and 1936-38.

Authors say about 1911-1913, this time is normal but market time also changes and shows volatility.

In 1911-13, this timeline the market very less fluctuates.

In 1923-25, this timeline the market is less fluctuated.

In 1936-38, in this timeline, the market is more fluctuation

So in this book whatever we talk about is in the past in 1940, so imagine yourself in 1940.

so let’s start,

The author says, ” Whenever the time is changing, with that market also changing and bring the new problem to the investors.”

This all discussion we see in the introduction part, let’s start with step-by-step which type of problem actually we face in different securities. (Security Analysis Book Introduction)

  1. High-Grade bonds and preferred stocks
  2. Speculative bonds and preferred stocks
  3. Common Stocks

so let’s start with first

1) high-Grade bonds and Preferred stocks:

The author says, ” in past people is buying the securities blindly and keep them in a safe place and forget about that securities and after some(year) time they see that securities are doing well, and this strategy is working good.”

But in today’s ( means 1940) Investors have to face three major problems.

A) Safety of principal and interest

B) Future of Interest rates and bond price

C) Value of a dollar

let’s start with the first problem

A) Safety of principal and Interest:

in these we see, in past old idea is to buy securities and say this is the permanent investment and nothing happen this security we buy and keep this safe and then also strategy is working, but these things do not happen yet now.

Now time, nothing is a permanent investment, no one a single thing in which you can put money and forget about that things. (Security Analysis Book Introduction)

Principal and interest safety, if you apply very strict standard to buy this security. so this mistake does not happen. (Security Analysis Book Introduction)

B) Future of interest rates and Bond prices:

In the past, bond yield is very high, but before 1940, the yield of bonds is going low.

So the author is now in two situations, is that yield is permanent or temporary.

If yield is temporary, then the yield is going to increase so 20-25 bond prices are falling, then we have to be ready for this.

If yield is permanent then this investment is in high-grade bonds and preferred stocks, then this investment is not good enough, Because you get very low on that investment.

The authors say, to be safe from this then you can buy medium-term bonds, those that have 15 years maturity, so those not more longer or not shorter in the year. so the investment is also going in cash as compared to longer periods bonds. (Security Analysis Book Introduction)

let’s see the third problem,

C) Value of a Dollar:

If the value of a dollar is down then people buy the common stocks.

this is because, for example, if you buy bonds for five years and you get the time to time got payment.

Let’s suppose you get $20 each after 6 months for long five years

so you get 10 time $2o if the value of the dollar is minimum (means that earning power is going less)

So you earn $20 earnings from bonds, but you can not buy some value of things, before $20 then after $20 means

In the future, you get $20 dollars then work less than past $20 and buy the minimum things as compare to the past $20.

So this is because of dollar price is going down, so this investment is not benefited because your payment is fixed.

When the dollar price goes down, your earning power has to increase to buy some amount of the same things in past and future also.

For this, there is only one solution, which is that put your surplus money in both, bonds as well as stocks.

2) Speculative Bonds and Preferred stocks

In this, we see some problems, lets stats

A) Risk of principal loss, not offset by a higher yield done:

This author says, Losing of principal is not offset by a higher yield, because this type of bond is very risky.

In this bond, we can lose our principal so, that’s why they give maximum yield than before we discussed ( High-grade bonds)

Because High-grade bonds have minimum yield and this has a maximum yield.

So in this bond, only a high yield is not benefited because we required the chance to profit our principal means then we have the advantage of invest in this bond. (Security Analysis Book Introduction)

B) Approach them as common stocks with limited claims:

Think like this, this is not senior security of inferior type.

 

3) Common Stocks:

The author defines firstly, which are the good stocks? the good stocks who called those are leading company in their industry and those have good records and in future also have good prospects, and thinking is doing good in future also as like in past. and they are in a leading company.

The author gives for this an example of General Electrics

Other good stocks of those company which is rightly financed and there is future prospects very attractive means past record is not good but future is bright and does a better performance in future. e.g. Abert Laboratories

the author says, ” people are neglecting the quantitative standards nowadays and mostly depends on future and future and says future earning is going high.

if suddenly earning increases then people don’t take average earning, they take high earning points and forget about the past earning and they find out the P/E ratio. (Security Analysis Book Introduction)

suppose companies earning is same as first not big much change, then you can take previous year earnings, and take the P/E ratio.

But earning first is very less and suddenly increases, then and you take the same previous ratio this is not the right way.

And some people buy stocks on the only basis of P/E and they think the P/E ratio is standard.

So the authors say, ” P/E ratio is not any standard.”

The P/E ratio is not controlled by your investment. your investment and other people’s investment control the P/E RATIO.

The authors say, ” those are investment trust, they make the speculation in strong company, and by the strong and leading company shares.

You can see nowadays also many famous mutual funds, everyone is doing same and everyone has the same leading company shares.

you can go to any industry that company is leading company, then this investment trust has that company shares.

So those people don’t do any analysis and some people almost forget about analysis they only do speculation in a good and leading company.

the author then gives examples of General Electrics. In 1937 the General Electrics value is about 1.87 billion dollars and after one year in 1938, this company value going to is about 0.78 billion dollar

Means in one year this company lose their value almost 50 %.

So the author says, what happened in 12 months this big company value go down up to 50% destroyed.

The author says, ” This is only happening because in 1937 people are optimistic about the company and those people also pessimistic in 1938 on the company. (Security Analysis Book Introduction)

So the company is doing the same as the previous year and now also doing the same, so the company doesn’t to any better in the year and not any do badly in this year to say the reason for that in the year 1938.

Then the author says, “people speak like in 1937, whatever the price of that company is really the price and in 1938 whatever the price of the company is as real like in 1937 of our investment. So this value is going down and people say this is the reality of this company.

If you speak like this, its means, you understand the language or you are stupid.

you don’t have the common sense

In common stocks, there will be four major problems, let’s see one by one

A) General future of Corporate Profits:

the author says, ” No one predicts the future, and people say, ‘ railway stocks are safe and sometime after automobiles company come and compete with daily company and perform well than daily stocks.

so nothing is sure about the future.

So about this, The author says, ” You can pay for only past and current earning and don’t pay for the future earning, try to get future earning in free.”

 

B) Quality differential between companies:

In this problem, Those are good stocks ( leading company stocks) these stocks trade very high multiple in the marketplace, then the secondary companies stocks. (that company is smaller than the leading company)

People think that companies are big, they are going bigger and those companies are small they go vanish or disappear in the coming future.

the author says, ” this company has two problems, the first problem is that their size is big so growth is not increased by the company and another second problem is this return on invested capital they get a minimum return.

Those companies are big, so there are so many companies that try to compete, and get the advantage from that come of leading company if any competitor doesn’t do anything to collapse them then the government does with that leading company. ( understand with examples of Apple and Microsoft, Microsoft company know that government is a mess with us when apple company goes bankrupt, that why Bill gates, buy the non-voting shares of the company and save the apple company while dealing with the Steve jobs. This is the most time happen with the company, so those are leading company that has to be competitive or government will mesh with them.)

C) Interest Rates:

We firstly talk about the bond yield, in the above point in the past there is a high yield, but now the day yield is low.

If this is permanent then the stocks yield average go also minimum. (Security Analysis Book Introduction)

Because, people also invest in stocks, instead of a bond, and then crowd increase and common stocks yield also come.

 

D) Factor of Timing:

The author says, according to him, time the market with successfully is the impossible thing.

Until that right time has come, and when we get the attractive price, the author says, this Is a good time to market.

If this is not happening, then there is no right time to buying the stocks.

The author says, ” timing principles is when the market shows the uptrend means, from now market goes high and they decide now the uptrend, like people to do technical analysis.”

this philosophy of timing is opposite to the investment nature.

This philosophy says, that, ” investor has to be patient until the market is encouraging himself too says, now I am going high and you now do investment in me.

The author says in the conclusion part of the Introduction of security analysis.

Investors should wait for periods of depressed business and market levels to buy representative common stocks. otherwise, he will have to acquire them at prices that the future may cause him to regret.

and Secondary companies offer great opportunities except in the overall bull market. then the leading company in the industry.