BENJAMIN GRAHAM: PRICE AND VALUE, Voting Machine or Weighing Machine?

BENJAMIN GRAHAM: PRICE AND VALUE

Voting Machine or Weighing Machine?

Benjamin Graham insists that the relationship between intrinsic value and the market price may be made clearer by the thinking through the following speculative and investment considerations:

1. Market Factors
2. Technical
3. Manipulative
4. Psychological
5. Attitude of the public
6. Future Value Factors
7. Management and reputation
8. Competitive conditions and prospects

Possible and probable changes in volume, price and costs
1. Intrinsic Value Factors
2. Earnings
3. Dividends
4. Assets
5. Capital structure
6. Terms of the issue

The market price of a share is the result of the cumulative effect of all these complex factors on any given day, hour or minute. It is evident from these bullet points above that the influence of what we call analytical factors over the market price is both practical and indirect--practical, because it frequently competes with purely speculative factors which influence the price in the opposite direction; and indirect, because it acts through the intermediary of people’s sentiments and decisions.

In other words, the market is not a weighing machine, where the value of each stock is recorded by an exact and impersonal process, according to its specific and measurable qualities. Rather, the market is more like a voting machine, where countless individuals register choices that are based partly on reason and partly of emotion.

Analysis and Speculation
You might think that sound analysis should produce successful results in any type of situation, including the confessedly speculative, i.e., those subject to substantial uncertainty and risk. You would expect to gain some advantage by basing your stock selection on careful analysis. Admitting that the future is filled with uncertainty, shouldn’t you expect favorable and unfavorable events to cancel each other out--thus allowing the initial sound analysis to carry through and achieve superior investment profits?

Graham finds this argument to be plausible, but a deceptive one that has led mean analysts astray. He then goes on to detail several valid arguments against relying on analysis in speculative situations.

First, the mechanics of speculation involve serious handicaps to the speculator, which outweigh the benefits of analytical study. These disadvantages include the payment of commissions and interest charges, the spread between bid and ask prices, and, most important of all, an inherent tendency for the average loss to exceed the average profit, unless a certain technique of trading is followed, which is opposed to the analytical approach.

The second objection is that the underlying analytical factors in speculative situations are subject to swift and sudden revision. The danger is that the intrinsic value may change before the market price reflects that value, which is much more serious in speculations than for investments. A third difficulty involves unknown factors, which are necessarily left out of security analysis. Theoretically these unknown factors should have an equal chance of being good or bad, thus neutralizing their effects over time. But this may not be the case in practice, as insiders or investors very close to the situation may know things you do not know, which gives them an advantage that nullifies the premise that good and bad changes in the future will offset each other, and loads the dice against the analyst working with some important facts concealed to him.

The final objection is based on more abstract grounds, but, nevertheless, its practical importance is very great. Even if we grant that analysis can give the speculator a mathematical advantage, it does not assure him a profit. His ventures remain hazardous; in any individual case a loss may occur; and after the trade is concluded, it is difficult to determine whether the analyst’s contribution has been a benefit or a detriment. Therefore, the analyst’s position in the speculative field is at best uncertain and somewhat lacking in professional dignity.
Graham tells a casino story to convince us that analysis is inherently better suited to investment (expected safety) than to speculation (acknowledged risk). In Monte Carlo the roulette wheel odds are tilted 19 to 18 in favor of the house, so that on average the house wins one dollar out of each 37 wagered by the public. Graham compares this to the odds against the untrained investor or speculator. Let us assume that, through some equivalent of careful analysis, a roulette player is able to reverse the odds for a limited number of wagers, so that they are now 18 to 19 in his favor. If he distributes his wagers evenly over all the numbers, then whichever one turns up he is certain to win a moderate amount. Graham compares this to an investment strategy based on sound analysis and disciplined application.

But if the player wagers all his money on a single number, the small odds in his favor are not nearly enough to make up for the critical question of whether chance will elect the number he has chosen. His analysis will enable him to win a little more if he is lucky; it will be of no value when luck is against him. This, in slightly exaggerated form perhaps, describes the position of the analyst dealing with speculative situations. Exactly the same mathematical advantage which practically assures good results in the investment field may prove entirely ineffective where luck is the overshadowing influence.

Graham concludes that it is prudent to consider analysis as an adjunct or auxiliary rather than as a guide in speculation. It is only where chance plays a subordinate role that the analyst can properly speak in an authoritative voice and accept responsibility for the results of his judgments.

The Critical Function of Security Analysis

To Benjamin Graham, the principles of investment finance and the methods of corporate finance fall necessarily within the province of security analysis. Analytical judgments are reached by applying standards to facts. The analyst is concerned, therefore, with the soundness and practicability of the standards of selection. He is also interested to see that securities, especially bonds and preferred stocks, be issued with adequate protective provisions, and--more important still--that proper methods of enforcement of these covenants be part of accepted financial practice.

The analyst insists that the facts be fairly presented, and this means that he must be highly critical of accounting methods. Finally, he must be concerned about corporate policies that affect shareholders, for the value of the stock being analyzed may be largely dependent on acts of management. He must consider questions of capitalization set-up, of dividend and expansion policies, of managerial compensation, and even of continuing or liquidating an unprofitable business. Competent analysts should be able to make useful judgments, help investors to avoid mistakes, point out any corporate abuses, and better protect shareholders.

Sage@wallstraits.com

Credits: Benjamin Graham’s thoughts presented here are adopted from his book, Security Analysis, published in 1934.