Book Review: Investors Give Graham and Dodd a Much-Needed Update
In "Modern Security Analysis," two stars of value investing offer fresh advice for today's market conditions.
To be sure, at a few sheets shy of 500 pages, Modern Security Analysis does not make for beach reading. It's a monster of a text, and I had to reread a few chapters after I had the opportunity to sit down with the authors. Both writers are heavyweights in the field: Whitman is the founder and portfolio manager of the Third Avenue Value Fund, and Diz is a Professor of Finance at the Martin Whitman Business School and a Director at the Ballentine Investment Institute.
In terms of investing strategies, their book's main takeaway is that value investors in particular should seek out creditworthy companies that the market is pricing below their readily ascertainable book value (the authors refer to it as net asset value, or NAV). This way, when unforeseen economic or monetary events occur, the company will retain access to capital markets and be able to proceed advantageously once the shock subsides. It's a strategy that seems particularly wise in the modern world and in today's market, as global credit has exploded and the ups and downs of economic cycles are becoming more volatile.
I noticed a telling difference between the authors' investing principles and those of Graham and Dodd: Diz and Whitman do not put a premium on investing in stocks that carry higher dividend yields, such as REITs and utilities, which investors have been flocking to as of late. Specifically, Diz and Whitman feel that unless a dividend yield accompanies solid growth and a discount to NAV, the company does not offer any better value than one with a much lower dividend. I asked Whitman whether he believed that the recent phenomenon of issuing debt to fund stock buybacks or dividends was an effective use of a company’s capital resources. He said he didn't see a problem with the practice in some cases, such as with Intel Corporation (NASDAQ:INTC), where the company was able to significantly lower its cost of capital without jeopardizing its access to capital markets.
During our discussion, Whitman also remarked, with a sly grin, that he would never purchase a stock that did not have a price at 70% or 80% of its NAV. By comparison, the S&P 500 (INDEXSP:.INX) today has a price to book of almost three times (300% of NAV), or about 2.25x according to forward annual estimates. Looking forward, the authors believe that either company growth will catch up to stock prices, or stock prices will revert to actual growth. When the time comes -- and it will -- to purchase a stock with a discount to its book value, investors should focus on quality companies. In the long run, however, 90% to 95% of companies’ book values will expand each year.
Hot-Button Topics: "Too Important to Be Reorganized" Institutions and US Debt
A number of hot-button issues were discussed in the book, which came as a welcome change of pace for me since much of the book was about the nitty-gritty of finance. One prodigious subject that has drawn much discussion in recent years, and which Diz and Whitman tackle, is the concept of Too Big To Fail (TBTF), or the more progressive term, Systemically Important Financial Institution (SIFI).
These terms, of course, are applied to businesses that have become so extensive and so ingrained in the economy that their failure would supposedly have a disastrous ripple effect on the economy. The belief is that the government must step in to provide assistance, when necessary, to prevent such businesses from failing.
But the authors have coined a slightly different term, calling these institutions “Too Important to Be Reorganized,” since major institutions like American International Group Inc (NYSE:AIG) and Citigroup Inc (NYSE:C) did, in fact, fail. Given the outsized liabilities of these institutions, the authors view the process of Chapter 11 default as too expensive and too harmful.
The size of US debt had a chapter all its own in the book, and I believe investors can gain important knowledge from it. The authors acknowledged that many leading economists and policymakers incorrectly obsess over the total debt in the US and other developed nations versus the total GDP as a detractor from future growth. Conventional theory says that once the debt/GDP level passes a certain point (90% to 100%, depending upon the opinion), it begins to hamper economic growth.
The authors had a much different take from the mainstream thinking on this, however. Instead, in conjunction with their investment ideas about individual companies, they feel it is more important to look at a country’s ability to borrow and access capital markets rather than the size of its debt. In the history of the industrial world, debt has always grown in the aggregate and is rarely repaid. It is either defaulted on or effectively rolled over ad infinum. If a sovereign nation or company continues to have access to capital markets, it stands little chance of being forced into a default scenario.
Two Main Risks
Although market players have to contend with a large number of financial dangers, the authors view market risk and investment risk as the most prevalent hazards in the modern world. Whitman and Diz believe that market risk, which is largely out of investors' control, should be avoided at all costs by taking a longer-term approach to the market. When it comes to investment risk, in the long-term, investors can be wrong in their analysis; sometimes events -- such as a change of control in a company -- are unpredictable. But market risk is also affected by speculation-driven movement in the short-term.
On a related subject, the authors stress the importance of only parking one's money with companies where investors have the ability to understand the company’s financials. In other words, look for easily parsed audit reports and financial disclosures that allow investors to make clear choices. Whitman offered with a chuckle that, if you can’t understand or value a company’s books, then you obviously shouldn’t be investing in it. This quick and easy guideline is an effective way to avoid the Enrons of the world.
The authors believe investors’ views toward valuing and purchasing companies have detrimentally changed. Specifically, they feel investors have become too focused on short termism, or the primacy of income (i.e. cash flow and earnings). They also think investors place too much emphasis on top-down rather than bottom-up analysis, and have too strong a belief in equilibrium pricing. Additionally, the authors feel that it's easier to manage a portfolio by focusing on a smaller subset of companies instead of on “timing” the market. They acknowledge, though, that timing is extremely difficult in the short term, and that longer-term timing makes investing much easier.
Management Is Key
Throughout the book, the authors focus on management’s role in a company and the importance of being able to separate management's performance from that of the stock and other linked securities -- something I found very eye-opening. The authors say that good management plays three roles: operator, investor, and financier. In that sense, good management knows how to pull every last cent from a company. In the book, the authors use the example of the $2 billion acquisition of Hertz Global Holdings, Inc. (NYSE:HTZ) in 2006 by The Carlyle Group, Clayton Dubilier & Rice, and Merrill Lynch Private Equity. Between 2006 and 2012, HTZ's new management was able to extract $5 billion from the company despite declining earnings. Other recent examples include Apollo Global Management LLC (NASDAQ:APO) issuing a equity secondary that allowed internal executives to sell large chunks of stock, and Sam Zell historically selling his real estate holdings into the market top in 2006.
Shift Your Outlook
I did not agree with everything I read in Whitman and Diz's book, and you likely won’t either, as there is no Holy Grail for investing. The authors even acknowledge potential shortcomings in their investing principles as there are always two sides to every trade or investment. Overall, however, the book was highly beneficial to me as an investor because it explored and offered counterpoints to the generic playbook that many are taught.
The authors offer differing views from Graham and Dodd’s original analysis, but they were quick to point out to me that Graham and Dodd's ideas were originally conceived as far back as 80 years ago, and that the market has made quantum leaps since then in areas like disclosure and the speed of information flow. At the very least, I believe the book will encourage readers to look at the market and companies in a different light as we all have become conditioned to pay attention to each tick rather than the longer term picture.
You can check the book out here.
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