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Security Analysis – excerpt and analysis

Security Analysis by Benjamin Graham and David Dodd is the most recommended book for any layman interested in the study of financial markets and investing. Below is an excerpt from the book:

…. it need not be so destructive to the notion of investment in common stock as a first impression would suggest. The instability of individual companies may conceivably be offset by means of thoroughgoing diversification. Moreover, the trend of earnings, while most dangerous as a sole basis for selection, may prove a useful indication of investment merit. If this approach is a sound one, there may be formulated an acceptable canon of common-stock investment, containing the following elements:

1. Investment is conceived as a group operation, in which diversification of risk is depended upon to yield a favourable average result.

2. The individual issues are selected by means of qualitative and quantitative tests corresponding to those employed in the choice of fixed-value investments.

3. A greater effort is made, than in the case of bond selection, to determine the future outlook of the issues considered.

Basic Conditions – May the ownership of a carefully selected diversified group of common stocks, purchased at reasonable prices, be characterized as a sound investment policy? The affirmative answer depends on the assumption that certain basic and long-established elements in this country’s economic experience may still be counted upon. These are: (1) that our national wealth and earning power will increase; (2) that such increase will reflect itself in increased resources and profits of our important corporations, and (2) that such increases will in the main take place through the normal process of investment of new capital and reinvestment of undistributed earnings. The third assumption signifies that a broad casual connection exists between accumulating surplus and future earning power, so that common stock selection is not a matter purely of chance or guesswork, but should be governed by an analysis of past records in relation to current market prices.

I agree with the above analysis that past earnings behaviour does incorporate itself into future earnings power. Currently, we are focusing solely on the future earnings potential (IPO of linkedIN, Groupon). For example, Groupon ‘s IPO on November 4, 2011, valued the company at $12.7 billion (LA Times) with an estimated revenue of $500 million, a P/E ratio of 25, quite high, which signifies that the the common stock is expected grow in double digits for the next couple of years. It is easier said than done, given that hundreds of Groupon-like sites have popped up across the web and there is no distinction between any of the websites. Groupon does not hold market dominance of specialized web deals nor it owns s defined product or information systems (Facebook & Google respectively) that will give it the edge in the future.

More analysis to follow.

Alpha