Thursday, March 18, 2010

Review of Benjamin Graham and David Dodd's Security Analysis: Sixth Edition, Foreword by Warren Buffett

When reading about the history of the Great Depression, you are forced to conclude that over the last decade we made, or are making, the same mistakes, or worse ones.

For example, in Graham and Dodd's Security Analysis: Sixth Edition, they mention the "Misleading Character of Appraisals" during the 1920s, when appraisals were "purely artificial valuations, to which the appraisers were willing to attach their names for a fee." Familiar?

Another example of history repeating itself: during the 1920s credit bubble, companies were established to guarantee real estate mortgages. Just like the modern mortgage guarantors and Credit Bubble Stocks shorts MBI and MTG, "for many years the[y] were conservatively managed," but abandoned credit standards during the boom:

"only a very small fraction of the mortgages outstanding in 1932 were created under the conservative conditions and principles that had ruled" prior to the bubble.
And, as with MBI and MTG,
"the face amount of the mortgages guaranteed rose to so high a multiple of the capital of the guarantor companies that it should have been obvious that the guaranty would afford only the flimsiest of protection." 
One frequent observation about Graham and Dodd's era is that they had it kinda easy, what with being able to buy lots of net-nets - companies selling for less than their current assets minus total liabilities. Here's how common these opportunities were:
"Our computations indicate that over 40% of all the industrial companies listed on the New York Stock Exchange were quoted at some time in 1932 at less than their net current assets."
I have never heard anyone stop to reflect on why valuations were so low during the Great Depression. Why didn't anyone buy those compelling values? Those valuations indicate revulsion, which Hussman defines as:
"A growing impatience among investors who conclude that stocks are simply bad investments, that the economy will continue to languish, and that nothing will work to help it recover. Revulsion is not based so much on fear or panic, but instead on despair and disillusionment. In a very real sense, investors abandon stocks at the end of a bear market because stocks have repeatedly proved themselves to be unreliable and disappointing."
Impatience also with fraud. Shame with being scammed by a flimflam mortgage guarantor or a stock scam.

To read the Lehman Brothers bankruptcy examiner's report, or the New Century Financial report [pdf], is to realize that we might reach 1932 valuations before this is over.

If you can't trust a financial institution's balance sheet and you can't rely on the auditors or the bank regulators to do anything, you are going to demand a huge risk premium for the surviving institutions' securities.

This edition of Security Analysis (the newest and most popular) is ranked #9,000 on The much more useful Distressed Debt Analysis: Strategies for Speculative Investors by Stephen Moyer (a Credit Bubble Stocks favorite) is around #57,000!

So I guess the trade would be to short Securities Analysis, which I give a 4/5 and buy the much "cheaper" (reputationally) Distressed Debt Analysis, which is a 5/5.


ngogerty said...

Brilliant Analog with the 30's and some of the different mechanisms and methods. you may enjoy reading. Since yesterday.

It is written in a first person and covers the day of the peak to the invasion of the czech republic. Great stuff and scary how "modern it reads"

CP said...

Yes, I have
Only Yesterday: An Informal History of the 1920s
Since Yesterday: The 1930's in America, September 3, 1929 to September 3, 1939
in my stack of books to read.

I will probably do a joint review of them on the blog.

David Merkel said...

I have read both of the "Yesterday" books. Both are good, but what makes them fascinating was that most contemporaneous histories often miss what later historians with more perspective latch onto as important. The author shows early insight that later historians would validate.

CP said...

David - that's interesting. Can you give an example?