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I ANALYSIS
A Summary of Benjamin Graham
and David Dodd's original work

Preston Pysh and Stig Brodersen

Table of Contents

A Note from the Summary Authors.......................... 1
Part I Survey and Approach...................................... 2
The Scope and Limits of Security Analysis.
The Concept of Intrinsic Value...........................................................3
Fundamental Elements in the Problem of Analysis.
Quantitative and Qualitative Factors.................................................7
Sources of Information.....................................................................11
Distinctions between Investment and Speculation.......................14
Classification of Securities............................................................... 18

Part II Fixed Value Investments............................... 20
The Selection of Fixed Value Investments..................................... 21
The Selection of Fixed Value Investments:
Second and Third Principles........................................................... 24
Specific Standards for Bond Investment........................................ 28
Specific Standards for Bond Investment (Continued)................ 32
Specific Standards for Bond Investment (Continued)................ 39
Specific Standards for Bond Investment (Concluded)................. 42
Special Factors in the Analysis of Railroad and Public
utility Bonds...................................................................................... 46
Other Special Factors in Bond Analysis.......................................... 51
The Theory of Preferred Stocks.......................................................54
Technique of Selecting Preferred
Stocks for Investment.................................................................... 58
Income Bonds and Guaranteed Securities..................................... 62
Guaranteed Securities (Continued)................................................ 65
Protective Covenants and Remedies
of Senior Security Holders............................................................... 69
Protective Covenants (Continued)..................................................73
Preferred-Stock Protective Provisions.
Maintenance of junior Capital......................................................... 76
Supervision of Investment Holdings...............................................80

Part ill Senior Securities
with Speculative Features......................................... 83
Privileged Issues....................................................
84
Technical Characteristics of
Privileged Senior Securities.......................................................... ...;...87
Technical Aspects of Convertible Issu es................ .................... ...... 91
Senior Securities with Warrants.
Participating Issues, Switching and Hedging................(.................. 9 4
Senior Securities of Questionable S afety.................................... 9 8

Part IV Theory of Common Stock Investment —
The Dividend Factor............................................... 101
The Theory of Common Stock In v estm en t................................1 0 2
Newer Canons of Common Stock In v estm en t...........................1 0 7
The Dividend Factor in Common Stock Analysis........................... I l l
Stock Dividends................................................................................... 1 1 5

Part V Analysis of the Income Account —
The Earnings Factor in Common Stock Valuation 119
Analysis of the Income Account........................................................1 2 0
Extraordinary Losses and
Other Special Items in The Incom e A ccoun t............................1 2 4
Misleading Artifices in The Incom e A ccount.
Earnings of Subsidiaries................................................................ 1 2 7
The Relation of Depreciation and
Similar Charges to Earning P o w er .............................................. 1 3 2
Public Utility Depreciation P o licies.............................................1 3 8
Amortization charges from
the investor's view poin t................................................................. 1 4 1
Significance of The Earnings R ecord.......................................... 1 4 6
Specific R easons for Questioning
or Rejecting The Past R ecord........................................................ 1 5 0
Price-Earnings Ratios for Common Stocks.
Adjustm ents for Changes in C apitalization.............................. 1 5 2
Capitalization Structure................................................................. ! 5 6

Low-Priced Common Stocks.
Analysis of The Source of Income.............................................160

Part VI Balance Sheet Analysis.
Implications of Asset Values..................................164
Balance Sheet Analysis
Significance of Book Value........................................................ 165
Significance of The Current Asset Value.................................169
Implications of Liquidating Value
Stockholder-Management R elationships..............................174
Balance Sheet Analysis (Concluded).......................................179

Part VII Additional Aspects of Security Analysis.
Discrepancies Between Price and Value............... 184
Stock-Option Warrants............................................................. 185
Cost of Financing and Management........................................ 189
Some Aspects of Corporate Pyramiding.................................192
Comparative Analysis of Companies
in The Same F ield...................................................................... 195
Discrepancies Between Price and Value................................199
Discrepancies Between Price and Value (Continued)........204
Market Analysis and Security Analysis.................................. 206

Themes Found Throughout The Book...................213
Intrinsic Value Calculation....................................215
About The Authors............................................... 216
About The Book.................................................... 220
About The Summary Authors............................... 221

‫ו‬

A Note from the
Summary Authors
Years ago, I read Security Analysis for the first time. Well, let m e rephrase that,
I tried to read Security Analysis for the first tim e. A lthough I knew th e bo o k
was full o f the m ost profound investm ent advice ever w ritten, I obviously
struggled with com prehending the inform ation. After talking w ith countless
investors, I found m any oth e r people shared the same struggle.
A lthough Security Analysis might be a difficult b ook to com prehend, its value
is lim itless once a firm understanding o f the term inology an d overarching
strategy is gained. That’s what we are trying to accom plish w ith this sum m ary
guide. We want this incredible book to be m ore accessible to th e w orld o f
investing.
Most importantly, we want to emphasize that this su m m ary guide is not a
substitute for the book itself. If anything, o u r intent is th at you read b o th
books, the original and this guide, in a chapter for chapter hand-off. If you
read this guide in lock-step with the full length book, you’ll find that we have
taken the liberty‫■׳‬o f sum m arizing very lengthy case studies an d im p o rta n t
financial findings. This wasn’t done to discredit the im p o rtan ce o f the subject
or the original authors. Instead it’s a tool for you to save tim e and prioritize
your focus into areas you deem m ost im p o rtan t to yo u r investm ent strategy.
In the end, we truly hope this guide cracks the code o f difficulty for Security
Analysis. As you go through this sum m ary, you m ight find topics o r
term inology that are difficult to understand. If that’s the case, we have ho u rs
o f completely free video c ontent that teaches the basics o f c o m m o n stocks,
preferred stocks, and bonds at BufFettsBooks.com. You will also find o u r u ser’s
forum where people can ask q uestions and get help on any topic. I know it’s a
location where we like to hangout and discuss potential stock b argains w ith
our valued readers.

’P'U&tM, <Mct Stity
BuffettsBooks.com

A.

P
art
Su
rveIyandApproach

Chapter 1—Summary
The Scope and Limits of Security Analysis.
The Concept of Intrinsic Value.
This chapter lays the core fun d am en tals o f Security Analysis. As you can
see, G raham im m ediately starts th e b o o k w ith th e discussion o f in trin sic
value. A lthough he doesn’t define th e details o f th e concept in th is chapter,
he indirectly im plies th a t intrinsic value is the result o f n u m e ro u s variables.
At the h e art o f the calculation is th e m eshing o f Book Value an d E arn in g s
Power. G raham also discusses his o p in io n th a t th e stock m ark et is im possible
to predict o r d e term ine in th e sh o rt term . H e m akes a very im p o rta n t claim
that the value o f your analysis decreases as th e elem ent for chance increases.
This is a very im p o rta n t idea because it’s G raham ’s scholarly w ay o f saying: I f
y o u ’re analyzing an unstable business, then y o u ’re analysis m ight be worthless.
He closes the first chapter by clearly d escribing Security A nalysis as a practice
o f applying facts and identifying unkn o w n s. A pplying th is p ractice to stable
businesses w ill help the analyst to ultim ately d e term in e th e elusive in trin sic
value figure and protect th e ir invested capital.

Chapter 1—Outline
Pre am b le
The term Analysis indicates a scientific a n d m eth o d ic al stu d y o f facts w hich
results in logical conclusions. But in v estm en t is n o t an exact science, an d
success derives in p a rt fro m p e rso n al skills a n d c hance.
Historically, the field o f secu rity analysis develo p ed progressively to 1927,
w hen it was c o rru p te d by a “new era” th a t w as follow ed b y th e 1929 m a rk e t
collapse. A nalysts w ere d iscred ited b o th for creatin g th e c rash a n d for n o t
preventing it.
T hree F u n c tio n s o f A nalysis:
G iven u n d e r th ree headings:
1. D escriptive
2. Selective
3. C ritical

1.

Descriptive Function
Descriptive analysis requires collecting all the important facts and presenting
them in an understandable manner. By doing this, you will:
• Reveal strong and weak points
• Make comparisons with similar issues
‫ י‬Appraise for future performance.
Such an analysis is appropriate not only for the investor but also for the
speculator.

2.

The Selective Function Of Security Analysis
Expresses specific judgment, by determining whether an issue should be
bought, held, sold, etc.
Examples of Analytical Judgments. In this section, Graham provides a
couple different examples of bonds and common stocks that traded at
bargain prices and expensive prices. The method for determining this
comparison was the company’s ability to earn and make payments to the
investor. He showed that as the market price on the security changed in
comparison to the company’s ability to earn, so did the intrinsic value of
the investment. This analytical comparison would be the framework for
Graham’s discussions on intrinsic value.
Intrinsic Value vs. Price. First, we establish the idea that intrinsic value is
an elusive idea. We must remember it is only an estimate and not a firm
fixed value. Valuation is based on the analyst’s opinion of the intrinsic
worth of the security:
• Assets
• Earnings
• Dividends
• Definite prospects
Prior to the publication of Security Analysis, many believed the value
of a business to be directly related to the book value. Graham cautions
readers against that perception and argues more variables are obviously
part of determining the intrinsic value of a business.
Intrinsic Value and “Earning Power.’’ In more recent times (about
the time when Security Analysis was first published), Graham talks
about the new metric for valuation, “earnings power”. This idea is that a
multiple over the company’s earnings is the best way to value a business.
This is often referred to as the P/E ratio. Graham also cautions readers
that valuing a business solely from the earnings power is also risky and

u n characteristic o f a wise analyst.
I he Role o f In trinsic Value in the W ork o f the A n a lyst. The analyst does
n ot attem pt to determ ine a precise intrinsic value. Instead, h e a ttem pts to
determ ine in relative term s w hether a co m m o n stock o r b o n d purchase
provides e nough safety to p rotect th e prin cip al invested. G raham then
provides historical exam ples o f com panies th a t trad ed for extrem ely low
prices com pared to their e arnings and health. H e uses these exam ples
to represent the idea th a t he did n ’t kn o w the exact intrinsic value, b u t
definitely knew the picks w ere undervalued.
F lexibility o f the C oncept o f In trin sic Value. G rah am discusses th at
the range for intrinsic value increases as th e u n c ertain ty for a business
increases. For example, if a com p an y is expected to have volatile num b ers
and they aren’t predictable, G raham says the in trin sic value co u ld be as
b road as $30 to $130 dollars. A lthough th is large r ange is v ery difficult to
predict, G raham suggests that if th e m arket price falls below th is range,
the investm ent m ay still m ake practical sense.
M ore D efinite Concept in Special Cases. G rah am discusses a scenario
w here a com pany had issued tw o different b on d s; O n e b o n d for 5% a n d
a n o th er for 7%. D ue to o utside c oncerns, b o th b o n d s w ere trad in g o n the
m arket for about the same price. From a m ath em atical sta n d p o in t, th e 7%
bo n d obviously offers a m uch b e tter retu rn if b o th th e b o n d s rep resen t
the sam e safety o f repaym ent. A lthough this scenario is lucrative to the
analyst, it’s existence is uncom m o n .
P rin cipal Obstacles to Success o f th e A n a lyst.
• In ad e q u ate o r in c o rre c t d a ta
• U n ce rtain ties o f th e F uture : G rah am suggests th a t p red ic tin g an
organizations future perform an ce is extrem ely difficult. H e says th a t
past perform ance is only a ro ugh guideline o f w h at to e xpect. Sen io r
Securities (i.e. b o n d s a nd preferred shares), are so m ew h at p ro tected
against a com pany’s change in future earn in g s. W h ereas c o m m o n
stocks are not. Also, c om panies th a t d em o n strate stability, o ften
reduce the risk for uncertainties.
• Irr a tio n a l B e havior o f th e M ark e t: G ra h am e n co u rag es analysts
to generally ignore m ark et prices. T he on ly tim e an analyst
should concern him self w ith th e prices is w h en th e y are trad in g
uncharacteristically high o r low. H e briefly m e n tio n s th e idea th a t
m any on W all Street believe th a t the sto ck m a rk e t p rices stocks
efficiently. G ra ham obviously disagrees.

Hazard of Tardy Adjustment of Price Value. Since the market price of
a particular pick may remain in or out of favor for an extremely long
period of time, the analyst may face a hazard with implementing a value
approach. By the time the security returns to the original value assessed
by the analyst, other factors may have changed the initial estimate.
Therefore it is important for the analyst to consistently review the
reporting requirements of the company to prevent this from happening.
Relationship of Intrinsic Value to Market Price. The market is akin
to a voting machine into which countless people insert their opinion.
Those opinions are either based on emotion or reason. The results of
those opinions in the short term are unstable and unpredictable. Later,
Grahams student, Warren Buffett, would say: “In the short term the
market is a voting machine, but in the long term it tracks value.”
Analysis and Speculation. Any belief that speculation can be made safe in
the short term because competent analysis will predict the market price
is doomed to failure. This is partly due to the factors described above and
largely because of unknown elements which have not been and cannot be
included in the analysis.
The Value of Analysis Diminishes as the Element o f Chance Increases.
Competent analysis provides an advantage but does not guarantee a profit.
Analysis is therefore best suited to investment and not to speculation.
Analysis maybe considered an accessory to speculation but n ot a guide.
3.

The Critical Function Of Security Analysis
“Analytical judgments are reached by applying standards to facts.” The analyst
should seek adequate protective provisions in bonds and preferred stocks. He
must be alert to the misrepresentation by accountants. He must be familiar
with the policies that management has set in place for the investment. His
analysis is directed to the avoidance of mistakes, the correction of abuse, and
the protection of the owner in the security.

Chapter 2—Summary
Fundamental Elements in the Problem of Analysis.
Quantitative and Qualitative Factors.
G raham starts this chapter with a description o f the elem ents that are
fundam ental to an analyst’s assessment o f a security. The descriptions are
fairly straight forward. The im portant highlights are: 1.) The value o f a security
changes w hen interest rates change. 2.) The price that an investor pays for a
security will im pact the return they should expect to receive. 3.) U nderstand
the size and type o f business you are analyzing and the stability it possesses.
This chapter then transitions into a discussion o f the differences between
quantitative and qualitative factors for an analyst. G raham is o f the opinion
that m ost factors are qualitative in nature despite having quantitative data. He
cautions analysts from form ing rock solid opinions about a com pany’s future
prospects simply by looking at its quantitative past perform ance. Again, he
stresses the im portance o f stability and its im pact on projecting future results.
G raham also states that larger businesses with longer historical results often
provided more predictable data for analysts.

Chapter 2—Outline
The purpose of security analysis is to develop a systematic m ethod for
determ ining w hether something should be bought, sold, or held. G raham
identifies four fundam ental elements for doing this.
FOUR FUNDAMENTAL ELEMENTS
• The Person: Conclusions from analysis are impersonal; selection
of the security rests on factors such as age, wealth, tax status, risk
aversion, etc.
. The T im e: Analytic conclusions will vary w ith changes in interest
rates, perform ance of the security, and general business outlooks etc.
• The Price: Particularly im portant in considering com m on stock;
fairly im portant in convertible bonds; of less im portance in prim e
investment b onds. Regardless o f the type o f security, price is always
a consideration.
• The Security:

Hazard of lardy Adjuttment of Price Value. Since the market price of
4 particular pick may remain in or out of favor for an extremely long
period of time, the analyst may face a hazard with implementing a value
approach. By the time the security returns to the original value assessed
by the analyst, other (actors may have changed the initial estimate.
Therefore it is important for the analyst to consistently review the
reporting requirement* of the company to prevent this from happening.
Relationship of Intrinsic Value to Market Price. The market is akin
to a voting machine into which countless people insert their opinion.
Those opinions are either based on emotion or reason. The results of
those opinions in the short term are unstable and unpredictable. Later,
Grahams student, Warren Buffett, would say: “In the short term the
market is a voting machine, but in the long term it tracks value.”
Analysis and Speculation. Any belief that speculation can be made safe in
the short term because competent analysis will predict the market price
is doomed to failure. This is partly due to the factors described above and
largely because of unknown elements which have not been and cannot be
included in the analysis.
The Value of Analysis Diminishes as the Element o f Chance Increases.
Competent analyst* provides an advantage but does not guarantee a profit.
Analysis i* therefore best suited to investment and not to speculation.
Andvsis may be considered an accessory to speculation but not a guide.
th e Critkal function Of Security Analysis
"Anaiyucai ■udgment* arc reached by applying standards to facts.” The analyst
should seek adequate protective provisions in bonds and preferred stocks. He
must be ak-n to the misrepresentation by accountants. He must be familiar
with the politic* that management has set in place for the investment. His
an*lv»i:< 15 directed to the avoidance of mistakes, the correction of abuse, and
the protection of the owner in the security.

Chapter 2—Summary
Fundamental Elements in the Problem of Analysis.
Quantitative and Qualitative Factors.
G raham starts this chapter w ith a description o f th e elem ents that are
fundam ental to an analyst’s assessm ent o f a security. The d escriptions are
fairly straight forward. The im p o rtan t highlights are: 1.) The value o f a security
changes w hen interest rates change. 2.) The price th at an investor pays for a
security will im pact the retu rn they should expect to receive. 3.) U nderstand
the size and type o f business you are analyzing an d the stability it possesses.
This chapter then transitions into a discussion o f the differences betw een
quantitative and qualitative factors for an analyst. G rah am is o f th e opin io n
that m ost factors are qualitative in nature d espite having quantitative data. He
c autions analysts from form ing rock solid opin io n s a b o u t a c om pany’s future
prospects sim ply by looking at its quantitative p ast perfo rm an ce. A gain, he
stresses the im portance o f stability a nd its im pact on p rojecting future results.
G raham also states th a t larger businesses w ith longer historical results often
provided m ore predictable data for analysts.

Chapter 2—Outline
The purpose o f security analysis is to develop a system atic m eth o d for
determ ining w hether som ething should be b ought, sold, o r held. G raham
identifies four fundam ental e lem ents for d o ing this.
FO U R FU N D A M ENTA L ELEM ENTS
. The Person: C onclusions from analysis are im personal; selection
o f the security rests on factors such as age, w ealth, tax status, risk
aversion, etc.
• T he T im e: Analytic conclusions will vary w ith changes in interest
rates, perform ance o f the security, an d general bu siness o u tlo o k s etc.
• T he Price: Particularly im p o rtan t in con sid erin g c o m m o n stock;
fairly im portant in convertible bonds; o f less im p o rtan ce in p rim e
investm ent bonds. Regardless o f th e type o f security, price is alw ays
a c onsideration.
• T he Security:

making a decision about an investment, the smart analyst w ill
not only look at the security and the price. Instead he w ill
also consider the entire enterprise and the terms proposed for
ownership. The later often involves an extensive am ount o f
research and work.
Examples o f Commitment on Unattractive Terms: Although
some forms of investment might seem favorable to the analyst,
further examination of the terms might uncover risk.
■ Provisions—Graham discusses the ideas o f a preferred
share that’s junior to a large mortgage (or debt) and
of the non-cumulative type (non-cumulative sim ply
means the divided on the preferred stock doesn’t have
to be paid). This is a security that lacks the safety o f a
bond and also lacks the rights to dividends or principal
payments.





Status of the Issue—Does the company you’re investing
in have the ability to finance more debt if it falls on
overruns or difficult times?



Price of the Issue—Do higher priority securities o f
the same issuer have higher yields? If so, w hy ow n a
preferred share if it produces a lower yield than the
issues ahead o f it.

• Note: When businesses are structured, securities follow a prioritization
of safety during bankruptcy. This means a bond for com pany X will
have a higher priority than a common stock from company X. This
becomes very important during liquidations (or the selling o f all the
companies assets during bankruptcy) in order to get your in vested
capital back from the business. If the only value that rem ains after
liquidation can pay for the principal on the bondholders, all other
securities would become worthless (i.e. the com m on stock). In
general, the priority of business securities is the following: (safest
to riskiest) 1. Loans 2. Bonds 3. Preferred Stock 4. C om m on Stock


Examples o f a Commitment on attractive Terms: In this section
Graham examines a 5% coupon on a railroad com pany’s bon d
that was due in 28 years. Its yield to maturity at the tim e o f
writing was 9.85%. Below is the same three criteria w e used
before for unattractive terms.
■ Provisions—This issue was ow ned by a com pany, but
their primary contract was with the city o f N ew York
to maintain the subways. Therefore the earnings were

both dependent on the com pany and the entire city.
Therefore the m agnitude and stability o f the earnings
w ere bigger than one m ight perceive.


Status o f the Issue—The com pany had fully capable
earnings to m eet payments.



Price of the Issue—It was priced to perform even better
the 6% issues by a com peting company.



G raham used this example to highlight a favorable
security based on the cu rren t circum stances at the
time.

Q u alitative a nd Q uantitative Factors in A nalysis
G raham poses the question; is it better to invest in an attractive enterprise
with unattractive term s or better to invest in an unattractive enterprise with
favorable term s. G raham sides with the form er.
G raham then recom m ends untrained security analysts to avoid low -grade
business on any terms. For the well trained analyst, G raham suggests any
security may be attractive depending on the price.
Q ualitative a nd Q uantitative Factors in A nalysis
Since research on a particular pick could involve unlim ited tim e and effort,
G raham suggests the level of detail should be based on the a m ount ot capital
invested. For example, $1,000 should require less focus and effort com pared
to a $500,000 investm ent.
Technique and Extent o f the Analysis Should be L im ited by Character
and Purposes o f the Com m itm ent: The analyst m ust preserve a sense
of com parison; analyze what matters, and ignore w hat is trivial. For
example, if a company owns a patent, should the analyst research the
durability of the patent? This can only be determ ined based on the tim e
available and am ount of funds being invested. Each situation is different.
Value o f D ata Varies with Type o f Enterprise: Statistics o f a large and
long-established corporation are more reliable than those o f a new and
small enterprise in an industry such as oil where com m odity prices
fluctuate. Therefore each enterprise needs to be looked at differently b ut
subject to the same principals o f value.
Q uantitative vs. Q ualitative Elem ents in Analysis: The quantitative
element is found in the figures on the balance sheet and incom e
statement. The qualitative element is less defined and in consequence less
im portance is sometim es attached to it:



N a tu re o f th e b u sin e ss



R e lativ e p o s itio n in th e in d u s try



Ph y sica l, g e o g ra p h ic c h a r a c te r is tic s



M anagem ent



O u tlo o k fo r th is c o rp o r a tio n , th is in d u s try , b u s in e s s in g e n e r a l.

Q u a lita t iv e F a cto rs: N a tu r e o f th e B u s in e s s a n d its F u tu r e P r o s p e c ts :
T h e tw o m o s t im p o r ta n t f a c to rs a re th e n a tu re o f th e b u s in e s s a n d its
m a n a g e m e n t. A b n o rm a lly g o o d o r b a d c o n d itio n s m a y n o t b e e v e r la s tin g
a n d th e re f o re a re h a rd to p r e d ic t. T h is in c re a s e s r is k f o r th e a n a ly s t .
T h e F a c to r o f M a n a g e m e n t: T ests o f m a n a g e m e n t a re n o t s c ie n tific , a n d
th e b e s t te s t is in th e r e s u lts o v e r a p e r io d o f tim e ; th e r e is a t e n d e n c y to
o v e rv a lu e g o o d m a n a g e m e n t w h ic h is a lre a d y re f le c te d in th e p r ic e a n d
th e re f o re n o a d d itio n a l p r e m i u m p a id o n th a t a c c o u n t.
T h e T r e n d o f F u tu r e E a r n in g s : D r a w in g c o n c lu s i o n s o f f u tu r e
p e rf o rm a n c e b a s e d o n p a s t p e r f o r m a n c e m u s t b e u s e d a s a r o u g h in d e x
a n d n o t h a r d fac ts. T h is id e a b e c o m e s e v e n m o r e i m p o r t a n t w h e n p a s t
p e rf o rm a n c e d e m o n s tr a te s e x p o n e n tia l g r o w i h o r d e c lin e . N o n - l i n e a r
p a s t p e rf o rm a n c e is lik e ly u n r e lia b le .
T r e n d E s s e n tia lly a Q u a lita t iv e F a c to r: G r a h a m a rg u e s th a t a n a ly s t s c a n t
p r e d ic t f u tu r e e a r n in g s fo re v e r; in s te a d all e s tim a te s h a v e t e r m l i m i t s to
r e a s o n a b le f o re c a sts. S in c e th e a n a ly s t is b o u n d b y th is lim it, e s t i m a t e s
s h o u ld b e c o n s id e r e d q u a lita tiv e f a c to rs.
Q u a lita t iv e F a c to rs R e s is t E v e n R e a s o n a b ly A c c u r a te A p p r a is a l : I n t h i s
s e c ti o n G r a h a m m a k e s a s tr o n g p o in t th a t th e a n a ly s t s h o u l d n o t m a k e
f u tu r e e a r n in g s p r e d ic tio n s w ith th e a im o f p r o f i t— th is is s p e c u l a t i o n .
I n s te a d , th e a n a ly s t s h o u ld m a k e f u tu r e e a r n in g s p r o je c tio n s t o g u a r d
a g a in s t th e r is k o f p a y in g to o m u c h f o r th e s e c u rity .
I n h e r e n t S ta b il ity a M a jo r Q u a lita t iv e F a c to r: T h e m o s t i m p o r t a n t
q u a lita tiv e f a c to r fo r th e a n a ly s t is th e s ta b ility o f th e in v e s tm e n t. S t a b il ity
m e a n s r e s is ta n c e to c h a n g e a n d p r e d ic ta b ility o f f u tu r e r e s u l ts . G r a h a m
s u g g e s ts th a t s ta b ility c a n b e q u a lita tiv e a n d q u a n tita tiv e a lik e . S t a b il ity
m a y d e p e n d o n th e n a tu re o f th e b u s in e s s , i.e. fo o d is a lw a y s in d e m a n d ,
a n d lu x u r y g o o d s m a y n o t b e.
S u m m a r y o f q u a n t i t a t i v e a n d q u a lita tiv e : T h e a n a ly s t’s c o n c l u s i o n s
m u s t h a v e a n u m e r i c a l b a sis, fo llo w s ta n d a r d s , a n d s u r v iv e t e s t i n g .
S t a b il ity is o f p r im e im p o r ta n c e fo r th e a n a ly s t a s th e y m a k e p r o j e c t i o n s
f o r f u tu r e c a s h flo w s f ro m d a ta c o lle c te d b y p a s t r e s u lts . T h e n u m b e r s
m a y b e o v e r t u r n e d b y k n o w le d g e o f o th e r, q u a lita tiv e f a c to r s .

Chapter 3— Summary
Sou rces of Inform ation
A s o n e m ig h t su sp e c t, a c h a p te r a b o u t sto ck sources from the 1930’s is
s o m e w h a t o u td a te d . A lth o u g h m o re so u rces o f inform ation are available
to d a y , th e o n e s G ra h a m m e n tio n s in th is c h ap te r are still relevant and often
p re fe ra b le . I f G ra h a m w ere alive today, h e w ould m ost likely caution investors
f ro m u sin g fin an c ia l d a ta fro m un reliab le sources— i.e. many places on
t h e in te r n e t. I ts im p o r ta n t to n o te th a t m o st co m p an y ’s provide their 10Q
( q u a r te rly r e p o r t) a n d 10K (an n u a l rep o rt) in th eir w ebsites investor relations
se c tio n . T h e s e re p o r ts will p ro v id e investors w ith th e m ost accurate financial
d a ta b e c a u se th e y a re req u ire d d o c u m e n ts by th e federal governm ent. This
d o e s n 't n e c e ssa rily m e a n th e d o c u m e n ts are 100% tru th fu l, bu t it does protect
th e a n a ly st a g a in st m is re p re se n te d da ta fo und on G oogle, or M orningstar,
w h ic h is c o m p ile d by a c o m p u te r p ro g ra m .

Chapter 3— Outline
T h e a n a ly st m ig h t se ek d a ta o n the:
• T e rm s o f th e specific issue
• T he com pany
• T h e in d u s try
F o r a b o n d c o n tra c t a n a n aly st w o u ld c o n su lt th e deed o f trust: for a stock
issu e h e w o u ld lo o k at th e c o m p an y c h arter. All o f th is inform ation is also
k e p t o n file w ith th e S e c u rities a n d Exchange C o m m issio n (SEC), an d /o r
fro m th e e x c h a n g e s d ire c tly (NYSE, AE, N asd aq etc.).

Data on the Company
In th is se c tio n , G ra h a m p ro v id es a b a ck g ro u n d on the rep o rtin g
r e q u ir e m e n ts o f h is e ra . A s o n e m ig h t expect, m an y o f o p tio n al reporting
r e q u ir e m e n ts in th e 1930’s a re n o w q u arterly req u ire m en ts by the SEC.
R e p o r ts to S to c k h o ld e rs ( In c lu d in g In te r im N ew s Releases): Reports
to sto c k h o ld e rs a re th e p rim e so u rce o f in fo rm atio n . D ep en d in g on the
in d u s try , th e se m a y h av e b e e n issu ed an y w here fro m m o n th ly to annually,
b u t q u a rte r ly is th e u su a l. T he b a lan c e sh eet will b e in the an n u al report.

The income account should show:
• Sales
• Net earnings
• Depreciation and depletion
• interest charges
• Non-operating income in detail
• Income taxes
• Dividends paid
• Surplus adjustments
The balance sheet is standardized. Graham criticizes the practice o f many
companies for only reporting the net figure on their property account. He
suggests that depreciation expenses should be shown next to the original
purchase price for the assets so the investor could see how much the asset
has been depreciated. It’s assumed this recommendation was made so the
analyst could try and determine the capital expenditures o f the business.
Periodic Reports to Public Agencies: Public utilities supply information
at regular intervals. This is also required o f companies under the
jurisdiction of the Interstate Commerce Commission, and even more
information is available from the reports o f the United States Department
o f Commerce. There are privately produced specialized reports from
sectors of the industry, for instance motor vehicles, oil and gas, and from
agencies such as the Dow Jones.
Listing Applications: When a company becomes a publically traded
business, listing applications must be filed with the SEC and stock
exchange. These applications often provided detailed information about
the company’s assets and protocol for doing business. These are a great
source o f information for any investor. Unfortunately, these applications
are only filed once.
R egistration Statem ents and Prospectuses: Extensive data for listing
with the SEC is required. Critical and relevant data must be included in
the underwriters’ prospectus for any new issues, but the mere volume o f
these may deter the average investor.
M iscellaneous Official Reports: Among the many potential sources o f
information are government commissions into particular industries and
the Interstate Commerce Commission. The emphasis for miscellaneous
reports should be on the authority that publishes it and whether or not
it’s official.

100 page summaries

Statistical and Financial Publications: Comprehensive manuals are
published annually by organizations such as Standard and Poor’s and
Fitch & Moody’s. These types o f reports will likely encompass a majority
of the analyst’s time and effort.
Requests fo r Direct Inform ation fro m the Company: The shareholder is
an owner of the business, he employs its staff and is entitled to information.
If the analyst has questions about the company’s performance, he should
not hesitate to contact the company’s investor relations division to get
answers.
Information Regarding the Industry
The United States Department of Commerce publishes on a monthly basis
the most comprehensive information. There are numerous almanacs and
trade-specific journals an analyst can use to uncover information about entire
industries.

C h a p t e r 4— Sum m ary

Distinctions between Investment and Speculation
This chapter is a key component of Graham’s value investing philosophy: the
distinction between investing and speculating. Graham makes the argument
that an investor should protect their principal while only accepting a
satisfactory return. This idea is clearly demonstrated by Graham’s star pupil,
Warren Buffett. Buffett has two quotes that represent this idea:
“Rule 1, don’t lose money. Rule 2, don’t forget rule 1.”
And
“7 don't look to jum p over 7-foot bars: I look around fo r 1-foot bars th a t I
can step over.”
Although many investors might treat these quotes as cliches, they are deeply
rooted fundamentals from this chapter. The first quote addresses the idea
of protecting your principal and the second quote represents the idea o f
accepting a satisfactory return. A firm understanding o f this definition is
what protects Graham’s students during market recessions. Throughout this
chapter, Graham mentions the idea that market price has a direct im pact
on the safety of a security. If analysts can’t account for a premium beyond a
calculated investment value for the asset, the security is considered a blend o f
speculation and investment.

C h a p te r 4— O u tline
General Considerations o f the Term “Investment”
“Investment is a word of many meanings.” It may mean putting m oney into a
business; it might be applied generically to all financial holdings. Regardless
o f how it’s applied, Graham strongly suggests there is a distinct difference
between investing and speculation. Failure to distinguish one from the other
has led to tragedies such as the collapse o f the market in 1929.
D istinctions Commonly Drawn Between the Two Terms: Graham
suggests that investments are bonds, outright purchases, permanent
holdings, and securities that produce income. Speculation on the
other hand is often common stocks, purchases on margin, “quick turn”
ventures, for profit securities in risky issues. After describing these
common interpretations, Graham provides counterarguments for each
perception.

Bonds versus Stocks: A lthough b o n d s are often view ed as having little
risk, this assum ption is not always true. In fact, there are low grade bon d s
w ith substantial risk and high grade investm ent stocks w ith less risk. This
section is provided to show that the conclusions that G raham draw s in
the previous paragraph is n ot absolute. Instead, it’s situational d ependent.
Outright vs. M argin Purchase: This idea refers to the m ethod
of purchase, no t the elem ent o f risk. It is im plied th at ow ning a stock
represents less risk then ow ning it on m argin, b u t G raham provides a
counterargum ent. He discusses how p enny stocks du rin g his era were
required to be purchased outright because they displayed too m uch risk
to the lender to allow them to be purchased on m argin.
P ermanent vs. Temporary Holding: This section refers to the
false im pression that perm anent holdings represent less risk than
tem porary holdings. G raham dispels this m yth by d em onstrating that
some speculators develop a p erm anent holding in hopes that they can
recuperate their losses over an extended period o f time.
Income vs. Profit: It is this com parison that G raham believes is the
m ost difficult to distinguish betw een speculation and investm ent. G raham
states that before 1928, many investors sought safety o f principal with a
respectable income. O ver time, the m indset shifted from a respectable
income to one that focused on increased future incom e and even an
increase in principal. This is w here the difference betw een incom e and
profit separates. Although this is a m ajor factor in d eterm ining the
difference between speculation and investm ent, G raham feels the
ultimate authority comes from the safety the investm ent represents.
Standards o f Safety: G raham argues that specific standards for m easuring
safety m ust be applied by the analyst to avoid speculation. He implies
that speculators use psychological m eans for d eterm ining “so u n d ” picks.
He discusses the idea that over paying for a security is often the biggest
risk to an analyst. Since speculators eventually develop the m indset th at
no price is too high to pay, investors m ust avoid this trap by applying
tangible standards to the appraisal o f each pick.
Proposed D efinition o f Investm ent: “An investm ent operation is one
which, upon thorough analysis, promises safety o f principal an d a
satisfactory return. O perations not m eeting these requirem ents are
speculative.”
All of the individual term s used in his definition have an elem ent
I of vagueness and are individually open to dispute; collectively, however,
the meaning is clear. G raham makes the po in t that “thorough analysis”
involves a profound application o f safety and value. To sim ply purchase

a common stock because it’s trading 40 times higher than its highest
earnings would not represent “thorough analysis.”
He clarifies his point further: “An investment operation is one that
can be justified on both qualitative and quantitative grounds.”
At the end of this section, Graham provides two examples which
demonstrate his definition for investment. He provides an example
where purchasing a callable preferred stock, on margin, is considered an
investment, and the idea of purchasing the same shares before the call
date were speculative. The example is provided to off-set preconceived
notions that anything is definitive or predictable and that analysts need
to possess a firm understanding of all the facts to arrive at an intelligent
conclusion. The example truly displays Grahams brilliance for the subject.
Other Aspects of Investment and Speculation
Relation of the Future to Investment and Speculation: Many believe
that investment is founded on the past and speculation looks ahead.
Graham opposes this idea and states that investment is also reliant on
future performance. He then makes the famous quote: "the future is
to be guarded against rather than profited from.” From this quote, he
further explains that the speculator is optimistic and dependant on an
improving future performance, whereas the investor doesn’t relv on an
improving future performance to justify selection.
Types of Investment: In this section, Graham simply defines four different
types of investment terminology.
• “Business investment: money held in a business”
• “Financial investment: securities”
• "Sheltered investment: securities with small risk due to prior claims
on earnings”
• “Analyst’s investment: detailed analysis that promises safety of
principal and an adequate return”
Types of Speculation: The New York Stock Exchange (NYSE) defines
gambling as taking risks without a need (betting on a horse race), whereas
speculation is the inherent risk that must be taken by someone.
‫“ י‬Intelligent speculation is taking a measured risk that seems justified
after analysis”
» “Unintelligent speculation is taking a risk without adequate
examination of the situation”
Investment and Speculative Components: Graham suggests that it
might be useful for the analyst to break down potential purchases into

speculative and investm ent categories. For example, if the m arket price
o f a com m on stock is $35 per share, the analyst may only find $25 o f
investm ent value in the pick w ith $10 o f speculative value due to
excellent long-term prospects. Therefore any purchase over $25 should
be considered partially speculative by the analyst.
Value: Investm ent, Speculative o r Intrinsic: The analyzed value o f a
com pany may have b oth an investm ent c om ponent, b u t also speculative
value, w hich may properly be considered intrinsic value provided it is
based on proper analysis. As a result, G raham suggests th at th e analyst
should act as an appraiser o f value.

C h a p t e r 5— Sum m ary

Classification of Securities
This chapter is a general overview of the different types o f securities available
to investors. Graham clearly identifies each type according to their associated
risk and reward. An important highlight in this chapter is the way analysts
should view the prioritization of equity for any organization. If an analyst
lacks this important knowledge, they won’t understand how each security
interacts with superior and subordinate issues of the same organization
during financial bankruptcy. The analyst should also be aware that bonds,
preferred shares, and common shares may be morphed into hybrid securities.
For example, there are convertible bonds which may be converted in com m on
stock. In the end, analysts must be ready to account for the numerous variables
associated with any particular pick.

C h a p ter 5— O u tlin e
The usual classification of securities is bonds and stocks, the latter subdivided
into preferred and common stocks. The critical difference between each
security is the legal structure o f its equity. Bond holders have prior claim on
principal and interest which the stockholders do not have. In contrast, the
common stockholders own the business and its potential for increased profits.
If the business enters bankruptcy, the common stockholder relinquishes
ownership of the tangible assets to the bond holder in order to recuperate the
principal lent the business.
Objections to the Conventional Grouping
/.

2.

3.

Preferred Stock Grouped with Common: preferred stocks should be
classified with bonds; it is purchased to receive a fixed incom e with
safety of the principal.
B ond Form Identified with Safety: safety o f a bond is totally
dependent on the fiscal stability of the company, they have no
inherent safety.
Failure o f Titles to Describe Issues with Accuracy: som e securities
are issued that do not fall conveniently into one or another of
these two groups. Although every conceivable variation has been
launched, in general they are patterned after bonds, preferred stock,
or common stock.

N ew C lassifications Suggested
G raham provides a b rief glim pse into his frustration w ith the nam ing
conventions o f his era. He suggests that new classifications are changed to the
following categories. This new n am ing convention is an effort to help inform
investors o f potential risks and their corresponding rewards. At the top o f his
list is the safest type of securities that protect an investors principal and still
pays incom e to the holder.
1.

Investm ent bonds and preferred stocks

2.

Speculative b onds and preferred stocks

3.

a.

Convertibles etc.

b.

Low grade senior issues

C om m on stocks

G roup “1” includes issues w here there is no anticipated change in value,
and are held for protection o f capital.
Group “2a” the investor looks for safety bu t also the possibility for profit.
Group “2b” the risk is increased b u t so is the potential for profit.
G roup “3” the intention is profit.
Variations and alternatives modify this sim plistic system, such as a bo n d that
would be in Group 1 moves to G roup 2a if it is selling at an unduly low price.
Furtherm ore, if a preferred stock holds such a large p o rtio n o f equity from
the com m on shareholder, the analyst should treat the preferred stock as a
substitute for the com m on equity stake. Frequently the distinction betw een
G roups is one of personal opinion held by the analyst. The im p o rtan t po in t is
not w hat the purchaser is entitled to dem and, b ut rather w hat the purchaser
will get from owning the security.

SecurityA—
n--alysis
------

P
aretdIValueInvestments
Fix

Chapter 6—Summary
The Selection of Fixed Value Investments
In this chapter, G rah am m akes a very strong case for finding healthy issuers o f
fixed incom e investm ents (bo n d s o r preferred stock). A fter briefly discussing
the different types o f fixed incom e investm ents, he quickly transitions into
all the risks associated w ith this form o f security. O ne o f the m o st im portant
highlights o f the c h ap ter is his discussion on valuing a fixed incom e investm ent
from a depression basis o pposed to a p rosperous one. G raham goes to great
lengths to dem o n strate to the reader that the safety associated with a fixed
incom e investm ent is p urely related to the issuers ability to m eet paym ents
w ith coupons o r d ividends and little else. His final guidance is straight
forw ard: W hen dealing w ith fixed incom e investm ents, avoid trouble from
the sta rt because recu p eratin g the principal after b ankruptcy is extremely
difficult a nd unlikely.

Chapter 6—Outline
The fixed value g roup in g comprises:
1.

“H igh grade straight bonds and preferred stocks.”

2.

“H igh grade privileged
consequence.”

3.

“C om m on stocks with guarantee o r privilege rendering them high
grade senior issues.”

issues with

rem ote privilege o f no

Basic A ttitu d e tow a rd H ig h -g ra d e P referred Stocks: G raham’s opinion is
that preferred stock o f the highest quality should be valued the same way as
high-grade bonds. A lthough preferred stock is inferior to bonds, it shouldn’t
m atter if the com pany has am ple financial capacity to m ake payment. Finding
preferred stock o f this quality is extrem ely rare and isn’t considered normal.
P re fe rre d Stocks n o t G en erally E q u iv alen t to B onds in In v estm en t M erit:
Usually, the average preferred stock should be ranked lower than the highgrade bond. The reason for this p osition is that preferred stock does n o t have
protection for a dividend paym ent “beyond reasonable doubt.” In fact, if the
preferred stock is non-cum ulative, the business has no obligation to make
dividend paym ents even w hen called.
Is B ond In v estm en t Logical?: In this section, G raham describes the market
crash (from 1929) and considers it an anom aly that would n ot be repeated.

He counters that idea with the caution that “complete security” for bonds does
Bond Form Inherently Unattractive: Quantitative Assurance o f Safety
Essentials: Analysts are cautioned against the mindset that bonds guarantee
security. If the analyst is surrendering their claim on the com pany’s profits,
they should be rewarded by a reasonable level o f safety for assum ing such a
limitation.
Major Emphasis on the Avoidance o f Loss: Bond selection is a negative a rt
that follows the axiom: “if there is difficulty or doubt, the security sh ould be
declined.”
Four principles for the Selection o f Issues o f the Fixed-Value Type:
• Safety is measured by the ability o f the issuer to m eet obligations—
not by contractual rights
• The ability to meet obligations should be assessed in term s o f
depression, not prosperity
• Lack of safety is not compensated by a high dividend or coupon
• Selection of bonds should follow rules o f exclusion and quantitative
tests (like banks perform when issuing loans)
I.

Safety Not Measured by Lien but by Ability to Pay

This section can be summarized by a basic question: If a friend ow ed you
money, but was broke, how would they repay you?— Graham suggests they
wouldn't.
In theory, if a business fails, the bond holder recovers his m oney from assets;
but that often fails because:
• Property values shrink when the business fails.
• There is difficulty in establishing legal rights.
• There are inherent delays in receivership.
Lien is No Guarantee against Shrinkage o f Values: The a ssessed value
o f the property is often related to its use; when it is not used, the value
declines. What value is a specialized factory if it produces T V antenn as
which have no market?
Impracticable to Enforce Basic Legal Rights o f Lien H old er: A lthou gh
bondholders might in theory be entitled to sell the property o f a failed
business, in reality the courts rarely allow the transaction; usually they
are given securities in a reorganized corporation. Only on rare o c ca sio n s
are bond holders paid in full during a corporate default. If o n e is lucky

enough to experience such a payment, it’s always the result o f a long and
tiresome delay.
Delays are W earisome: Going into receivership causes a loss o f value of
all property and holdings. The more value and assets involved, the longer
the receivership takes and the more the value is depreciated.
Note: Receivership is a bankruptcy situation in w hich a receiver is
appointed by courts or creditors to run the company. The receiver may
be appointed as a matter of private proceedings or by a governing body.
The ultimate decision is how the remaining assets will be m anaged and
distributed. This is typically done in a company liquidation situation.
Basic Principle is to Avoid Trouble: To avoid trouble is better than
seeking protection after it occurs. From this principle, three sim ple
explanations are provided:
1.

“The absence of a lien* is of minor consequence”; unsecured
debentures* of a strong company might be just as safe.

2.

To buy the “highest yielding obligation of a sound company” is
in itself unsound because if the junior issues are not safe, neither
are the senior issues.

3.

“Senior liens are to be favored, unless junior obligations offer a
substantial advantage.” This idea is valid only if the protection
of the total debt is adequate and the m onetary advantage is
substantial.

Special Status of Underlying Bonds: In this section, G raham describes
a practice during his era where underlying bonds out prioritized “first
ue” bonds. He provides examples of underlying bonds throughout the
I text and then concludes the section by saying ordinary investor should
I disregard these issues in their calculations.
1 *Note:
• A lien is a legal claim of one person/business upon the property of
another person/business to secure the payment of a debt.
• A debenture is an unsecured loan certificate issued by a company or
government that is backed by general credit rather than by specified
assets. Debentures have no collateral. Purchasing a treasury bo n d
is considered a debenture because the issue is not backed by any
tangible asset or security.

C h a p t e r 7— Sum m ary
T h e S e le c t io n o f F ix e d V a lu e In v e s t m e n t s :
S e c o n d a n d T h ird P r in c ip le s
The primary objective of this chapter is to identify further considerations
for the selection of fixed income securities. During the first section o f this
chapter, Graham reiterates the idea that bonds should be analyzed from a
depression basis. He warns the analyst that no sector is depression proof, but
analysis of past performance during previous recessions will provide clues
into a security’s success during such events. An important highlight from this
section is the idea that “good” debt is when the company is using financed
capital for an opportunity or expansion that might require a quick entry to
market. This type of debt can be handled by the company’s future earnings and
repaid from operating activities. “Bad” debt is when the business is required
to borrow in order to sustain operations. This determination is m uch easier
for modern investors due to the advent o f the cash flow statement. If analysts
are considering the financial health o f the fixed income issuer, they w ould be
strongly advised to assess the debt from the cash flow statement.
In the last section, Graham strongly encourages analysts to not com prom ise
their assumed risk for an increased reward. If risk is assumed, it should be in
the form of paying a cheaper price (therefore lowering the principal required
to acquire the security), instead o f accepting a higher coupon or dividend.
This is a very important concept for value investors because it once again
minimizes the loss o f principal.

C h a p te r 7— O u tlin e
II.

Bonds Should be Bought an a Depression Basis

A sound investment must be able to withstand adversity, and enterprises that
have withstood adversity may be favored by investors.
Presumption o f Safety Based upon Either the C haracter o f the
Industry or the Amount o f Protection: Investment in a depression
proof enterprise such as a utility may be safer than a major corporation
that’s not protected by demand or consumption during a depression.
N o Industry Entirely Depression-proof: There is no such thin g as
“depression proof.” The investor should look for industries least likely to
be affected by a depression—it’s all relative.

J

Inv estm ent Practice Recognizes Im p o rtan c e o f C h a rac ter o f the
In d u stry: Historically some industries and public utilities have been
more stable than others, and equally their degree o f stability has altered
with time. This changing dynamic is som ething the analyst m ust consider
when assessing an organizations ability to continue meeting future
paym ents on fixed income securities.
D epression Perform ance as a Test o f M erit: In this section, G raham
displays a graphical chart com paring the perform ance o f railroads to
public utilities. The importance o f the chart is to dem onstrate how both
sectors perform ed during a depression basis. He recommends that this
approach is applied to securities that analysts would like to assess in the
future.
Various Causes of Bond Collapses:
1.

“Excessive funded debt o f utilities”: defaults were caused by
over-extended debt, not by lack o f earnings.

2.

“Stability of railroad earnings overrated”: this resulted from
diminished earnings and a failure to recognize changes in
transportation methods.

3.

“Depression perform ance o f industrial bonds”: there was a
sudden disappearance o f earnings w hich was best tolerated
by the largest companies that were perform ing well before
the Depression struck.

Unavailability of Sound Bonds No Excuse for Buying Poor Ones: No
excuse can be made for the purchase of unsound securities. The investor
should never be tempted by the lack o f a good opportunity to venture
into a poor one.
Conflicting Views on Bond Financing: There are tw o incorrect theories:
a) that issuing a bond is a statement of financial weakness and b) that
bonds are only issued when companies cannot issue stock.
Proper Theory of Bond Financing: A reasonable am ount of funded debt
is an advantage (typically rooted in the company’s ability to take their
product or service to market quickly), provided it can be handled under
all conditions. If the company is obligated to acquire debt (m eaning
they need to issue debt to simply pay their bills and expenses), this is a
statement and signal that the bond is unsafe. This situation is not only
bad for the company, but also the bond holder.
U nsound Policies Followed in Practice: In this section, G raham
describes a situation in 19271929‫ ־‬where companies were frantically
trying to pay off debt. Com panies took the practice so far that they

started issuing new shares to raise capital, which in turn paid for the
debt obligations. Graham highlights the importance for shareholders to
consider the objective of such actions. Is the objective for m anagem ent to
simplify their problems or is the objective to pay off high interest debt? If
the objective is the later, shareholders may benefit from such an action. If
the objective is paying off low interest debt, shareholders are losing value
at the expense of poor management.
Significance of the Foregoing to the Investor: Graham suggests that
whenever there is money available to invest, it is invested. The problem
lies in the leaders inability to manage investments w hen higher yielding
securities disappear from the market place. During these situations,
analysts need to accept a lower yielding security to ensure the protection
of principal instead o f choosing more yield in a second rate issue.
Sum mary: Bonds should be bought on their ability to w ithstand a
depression or recession; relative safety is found in com panies of: a)
dominant size, and b) substantial margin o f earnings over bon d interest.
III.
Third Principle: U nsound To Sacrifice Safety for Y ield
Traditionally a numerical rating is applied to interest rates as com pared to
risk. This is similar to the actuarial methods o f the insurance industry to
investments. Graham discusses the proposed relationship betw een reward
and the statistical chance o f failure, but declares the idea im practical in reality.
No m athem atical R elationship betw een Yield a n d R isk: P rices and
yields often depend on popularity. Graham suggests that the public’s
familiarity with the issuing company and its ability to be quickly sold on
the market is a considerable factor in the market price o f bon ds.
Self-Insurance G enerally N ot Possible in In v estm en t: The investor is
interested in avoiding risk, not to be paid for assum ing it. In this section
Graham provides a great example of an investor that purchases a low
yielding bond for $1,000 that pays an annual coupon o f $20. H e then
describes a second bond that sells for the same price, but pays a $70 coupon
but runs a 1 in 20 risk o f complete failure. He suggests this situation is
similar to the same risk insurance companies assum e w hen offering full
coverage for a house fire. The difference is the insurance c o m p a n ies are
prepared to assess the statistical likelihood o f such a situation , where
the analyst must account for more variables. Graham argues that the
additional $50 isn’t worth the loss o f principal for o w n in g a secu rity that
has 1 in 20 odds o f failure. The 1 in 20 odds where d eterm in ed from a
previous discussion at the start o f this section; it’s located in the com plete
book after the title for the Third Principle: U nsound to Sacrifice S a fe ty fo r
Yield.

The Factor o f Cyclical Risks: A n insurance com pany spreads risk over a
large field; the investor has only a small field a nd c an n o t afford a program
entailing a sm all sam ple size w ith large risk.
Risk and Yield are Incom m ensurable: C om paring risk to yield is not
definitive. A nalysts can only m ake reasonable assum ptions on how
a pa rticula r security m ay perform an d then com pare it to th e level o f
rew ard they’re willing to assume. G raham m entions, yet again, that the
analyst should no t pay a par value for a risky b o n d that has a high yield.
Instead, he should pay a considerable d iscount below the p a r value,
therefore m inim izing his risk of principal.
Fallacy o f the “Businessm an’s Investm ent”: D uring G raham ’s era there
was an im pression that foreign bo n d s an d /o r risky b onds were considered
the “B usinessm an’s Investm ent”. He pokes fun at the idea and claim s it’s
illogical.
Reversal o f C ustom ary Procedure R ecomm ended: D on’t start with
inspecting the safest fixed incom e issues on a list and w ork dow n. Instead,
sta rt w ith the security that represents a m inim al threshold o f safety and
w ork up on the list. This way the analyst protects themselves from going
deep er into the list—likely resulting in the p urchase o f an unsafe issue.

Chapter 8—Summary
Specific Standards for Bond Investment
This chapter initiates the discussion of standards an analyst should apply to
the purchase of bonds. The dialogue initiated in this chapter extends over
the next three chapters as well. Graham forms his foundation for analysis by
starting with the criteria that the New York Savings Bank (NYSB) uses for
purchasing fixed income bonds. We find that the NYSB applies seven criteria
to their risk management procedures. Graham uses these criteria as a baseline
since the NYSB is obligated by law to protect the principal of th e ir clients.
After laying out his methodology for analysis, Graham discusses each o f the
seven criteria in detail. This chapter covers the first two criteria th e NYSB
uses.
1.

Nature and Location—Graham believes an analyst sh o u ld have a
broader pool of choices for the bonds they can select c o m p ared to
the NYSB. He doesn’t specifically name which types o f enterp rises
he would add to the NYSB list. It appears G raham agrees w ith the
Bank’s decision to limit the selection of Bonds to the U nited States—
with the exception of Canada.

2. Size—Graham discusses the specific benchmarks associated w ith
the bank’s basis for determining secure bonds. He argues that
more emphasis should be placed on the issuer’s ability to repay
the obligations than the sheer size of a municipal g o v ern m en t or
business.

Chapter 8—Outline
IV. Fourth Principle: Definite Standards of Safety m ust be a p p lied
The selection ofhigh-grade bonds is a process of elimination. As a result, the
process works quite well when applied to specific standards and rules. G raham
states that individual investors are generally exposed to the sam e risks as large
institutions that invest in similar securities. As a result, he reco m m en d s the
implementation of similar rules and regulations that savings b an k s use for
fixed income investments. Since they are required and obligated by law to
minimize their exposure to risk, Graham recommends their m o d el o f risk
management as a baseline for his analysis.
New York Savings Bank Law as a Point of D eparture: In th is section,
Graham recommends the New York Savings Bank as a rep u tab le source

for applying a tem plate o f risk m itigation. A lthough this bank is better
than many, G raham cautions the analyst that governm ent legislation
was draw n up in m an y different ways to impose regulations that did not
necessarily have the welfare o f the investor at heart. As a result, these
rules should be regarded loosely and am ended if new metrics prove more
useful a nd secure.
General Criteria Prescribed by the New York Statute: According to the
statute, bo n d investm ents should b e analyzed by the following criteria:
1.

Nature a nd location o f the business

2.

Size o f the business

3.

Terms o f Issue

4.

Record o f solvency and dividend payment

5.

Relation o f earnings to interest requirements

6.

Relation o f value o f the property to funded debt

7.

Relation o f stock capitalization to funded debt.

These seven criteria will be discussed in great detail over the next three
chapters. G raham will highlight areas where he agrees with the New York
Savings Bank and also offer recom m endations for improvement.
1.

Nature and Location

G raham describes the New York regulations for allowing the purchase of
some bonds and the exclusion o f others as “Striking”. At the time o f Graham s
writing, this was the bank’s protocol:
• “A dmitted: US governm ent and municipal bonds; bonds issued by
railroads and certain utilities; bonds secured by 1st m ortgage in real
estate.”
• “Excluded: Bonds o f foreign governments and corporations; bonds
o f street railways and w ater companies; public utility debentures; all
industrial bonds; financial companies bonds.”
The Fallacy o f Blanket Prohibitions: G raham considered the
“acceptable” list as too sweeping against industry and too narrow, and
that the narrow ness o f choice caused a lim iting factor in the size of the
market, driving investors to less w orthy choices in the categories that
were considered “acceptable”.
Individual Strength May Compensate for Inherent Weakness o f a
Class: Securities of individual companies should be examined rather
than blanket acceptance o f one class to the exclusion of others.

Chapter 8—Summary
Specific Standards for Bond Investment
This chapter initiates the discussion of standards an analyst should apply to
the purchase of bonds. The dialogue initiated in this chapter extends over
the next three chapters as well. Graham forms his foundation for analysis by
starting with the criteria that the New York Savings Bank (NYSB) uses for
purchasing fixed income bonds. We find that the NYSB applies seven criteria
to their risk management procedures. Graham uses these criteria as a baseline
since the NYSB is obligated by law to protect the principal o f their clients.
After laying out his methodology for analysis, Graham discusses each o f the
seven criteria in detail. This chapter covers the first two criteria the NYSB
1.

Nature and Location—Graham believes an analyst should have a
broader pool of choices for the bonds they can select com pared to
the NYSB. He doesn’t specifically name which types o f e nterprises
he would add to the NYSB list. It appears Graham agrees w ith the
Banks decision to limit the selection of Bonds to the U nited States—
with the exception of Canada.

2.

Size—Graham discusses the specific benchmarks associated with
the bank’s basis for determining secure bonds. He argues that
more emphasis should be placed on the issuer’s ability to repay
the obligations than the sheer size of a municipal g o v ern m en t or
business.

Chapter 8—Outline
IV. Fourth Principle: Definite Standards of Safety m ust be a p p lied
The selection of high-grade bonds is a process of elimination. As a result, the
process works quite well when applied to specific standards and rules. G raham
states that individual investors are generally exposed to the sam e risks as large
institutions that invest in similar securities. As a result, he rec o m m e n d s the
implementation of similar rules and regulations that savings b an k s use for
fixed income investments. Since they are required and obligated by law to
minimize their exposure to risk, Graham recommends th eir m o d e l o f risk
management as a baseline for his analysis.
New York Savings Bank Law as a Point o f D ep artu re: In th is section,
Graham recommends the New York Savings Bank as a rep u tab le source

for applying a tem plate o f risk m itigation. A lthough this b ank is better
than many, G raham cautions the analyst that governm ent legislation
was draw n up in m any different ways to impose regulations that did not
necessarily have the welfare o f the investor at heart. As a result, these
rules should be regarded loosely and am ended if new metrics prove more
useful and secure.
G eneral C rite ria Prescrib ed by th e New York Statute: A ccording to the
statute, bond investm ents should be analyzed by the following criteria:
2.

Nature and location o f the business

2.

Size o f the b usiness

3.

Terms o f Issue

4.

Record o f solvency and d ividend paym ent

5.

Relation o f earnings to interest requirem ents

6.

Relation o f value o f the property to funded debt

7.

Relation o f stock capitalization to funded debt.

These seven criteria will be discussed in great detail over the next three
chapters. G raham will highlight areas w here he agrees with the New York
Savings Bank a nd also offer recom m endations for improvem ent.
1.

N ature a n d L ocation

G raham describes the New York regulations for allowing the purchase o f
some bonds and the exclusion o f others as "Striking”. At the tim e o f Graham 's
w riting, this was the ban k s protocol:
• “A dmitted: US governm ent and municipal bonds; b onds issued by
railroads and certain utilities; bonds secured by 1st m ortgage in real
estate.”
• “Excluded: Bonds o f foreign governm ents and corporations; b onds
o f street railways and water companies; public utility debentures; all
industrial bonds; financial com panies bonds.”
The Fallacy o f B lanket Pro h ib itio n s: G raham considered the
“acceptable” list as too sweeping against in d u stry a n d too narrow , and
that the narrow ness o f choice caused a lim iting factor in the size o f the
m arket, driving investors to less worthy choices in the categories that
w ere considered “acceptable”.
Indiv id u a l Stre n g th May C o m p en sa te for In h e re n t W eakness o f a
Class: Securities o f individual com panies should be exam ined rath er
than blanket acceptance o f one class to the exclusion o f others.

The 1938 Amendment to the Banking Law: In 1938, NY legislature
changed their position on blanket provisions—due to the com plaints
that Graham and others raised. The new law was quite odd. A bank’s
restrictions on certain bonds were to be amended on an individual basis
if 20 savings banks requested it. In Graham’s view this worked well in
practice, but questions the logic o f setting up a list o f forbidden securities
only to have it amended on demand.
Obligations of Foreign Governments: Although Graham opposed
blanket exclusions, he agreed with the decision to disallow the purchase
of foreign bonds. His argument was fourfold.
The factor o f political expediency: If payment is withheld, foreign
government debt is not enforceable, and non-payment has becom e
familiar.
The foreign trade argument: Although foreign investment is needed
to increase the export trade of American businesses, the investor should
not make his personal financial decisions on idealistic reasoning.
The individual record argument: It is suggested som e countries are
more creditworthy than others, and some have been accepted as such by
the laws of particular States. At the conclusion o f this section, Graham
argues that only Canada, Holland, and Switzerland dem onstrated
“unquestionable investment ratings” during his era.
Twofold objection to purchase foreign governm ent bonds: Generally
speaking, foreign bonds should be avoided for two reasons. 1) the basis
for obtaining credit is fragile. 2) the past performance is unsatisfactory.
Graham then provides Canada as the sole exception to his doubts.
Bonds of Foreign Corporations: In theory no company should d o better
than the country in which it is located because the governm ent could
simply declare state ownership. Although this is a possibility, experience
has shown large and reliable foreign corporations, with bon ds issu ed in
US dollar denominations, proved reliable although their ow n country
was not. Nevertheless, foreign corporations are not, in general term s, any
more attractive than foreign governments.
2. Size
Small companies and small municipalities are vulnerable and their bon ds
should not be considered suitable for the conservative investor. N o
mathematical definition of when an issuing body was too “small” is given.
Provisions of New York Statute: Throughout this section, Graham
provides the specifics that the NYSB employed for determ inin g the
acceptable size of issuers in the 1930’s. For example, m unicipal bonds

A

3‫ו‬

required a p opulation o f 10,000 in adjacent states and 30,000 elsewhere;
railroads had to have 500 miles o f track and annual operating revenues o f
ten m illion no m inal dollars, etc.
Criticisms o f requirements: A lthough G raham agrees that the issuer
should be o f reasonable size, he disagrees w ith m any o f the m etrics used
by th e NYSB. He suggests that the underlying theory o f cash flow and
ability to repay the holder o f the security is m ore m eaningful.
Industrial Bonds and Factor o f Size: A lthough the NYSB is n ot able to
invest in industrial bonds, G raham disagrees w ith this decision and feels
these bon d s are safe if tested against strict standards. He recom m ends
lim iting selections to the six largest corporations in any particular
industry.
Large Size A lone No Guarantee o f Safety: Biggest is n ot universally best,
and in particular should not be applied to m unicipalities and utilities, b ut
only to industries.
Other Provisions Rejected: In this section, G raham rejects the idea that
a ten m illion dollar earnings requirem ent is im posed on the NYSB to
purchase railroad bonds. He assumes the provision is required so high
volum e securities will be acquired and therefore be m ore marketable
w hen sold. This way the bank could quickly sell the bonds if they desired.
G raham believes too m uch em phasis is place on securing marketable
bonds and therefore disagrees w ith the requirem ent.

Chapter 9—Summary
Specific Standards for Bond Investment
(Continued)
As mentioned in Chapter 8, Graham continues his assessment o f the seven
criteria the New York Savings Bank (NYSB) employs for finding sound b o n d
investments. Below is a brief summary of the three criteria discussed in this
chapter:
3. Terms of issue—In general, Graham finds the m ethods o f the NYSB
outdated with respect to its treatment of mortgage and d ebenture
investments. Graham illustrates that income bonds (different th an
regular bonds: refer to Chapter 16 for more inform ation) and
preferred stock should be analyzed similarly. He concludes this
section by cautioning analysts against the myth that sh o rt term
bonds are more secure than long term bonds. A lthough the NYSB
disagrees, Graham provides convincing arguments for his opinion.
4.

Record of solvency and dividend payments—Graham starts this
chapter by describing the importance of finding b ond issuers th at
have a long standing history of completing payment obligations.
When assessing the strength of a business’s bonds, the NYSB uses the
company’s dividend history as the primary means for d eterm ining
an ability to make payment. Although Graham acknow ledges
that this might represent financial strength, he cautions against
this practice and encourages analysts to draw conclusions from
the income statement and balance sheet. He even m akes th e valid
argument that if a company is paying a dividend, it’s releasing capital
to the owners without the ability to recall or use the m oney du rin g
difficult times. This, therefore, may inhibit the company’s ability to
meet future obligations on the bond.

5.

Relation of earnings to interest requirements—G raham describes
his opinion that the coverage ratio (or ratio of earnings to fixed
coupon obligations) is the most significant factor in d e term in in g
the safety of a bond. He provides three methods for determ in in g
the coverage ratio and recommends—the “overall m e th o d ”. This
method adds up all the fixed obligations, regardless o f th e issues
priority, and compares it to the company’s net income (o r profit
after tax). Although the NYSB has rigid coverage requirem ents,
Graham recommends that the standards be loosened. H e also

prescribes m ore flexibility for com panies that don’t m eet the NYSB
requirem ents w ith three considerations: (a) a rising trend o f profits;
(b) a good c urren t showing; and (c) a satisfactory coverage ratio in
all years studied. Finally, G raham discusses an extremely im portant
c oncept w ith respect to interest rates and the m arket price o f bonds.
He cautions investors from buying long term bonds when interest
rates are low due to the likelihood o f losing the principal on their
investm ent if sold on a secondary m arket.

C h a p te r 9 — O u tlin e
3. The Terms o f the Issue (Titled in the book: The Provisions o f the Issue)
Safety and Security is of prim e im portance. The laws by the State o f New York
accept public utility bonds only w hen secured by mortgages. An exception
is made for unsecured railroad and income bonds if earnings and dividend
records m eet severe stipulated rules.
• Note: A n incom e bo n d is one in which the issuer isn’t obligated to pay
any coupons, b u t m ust repay the par value at a specified term . The
provisions of incom e bonds vary greatly am ong the different issues,
the basic distinction being betw een those on which interest m ust
be paid if earned and those over which the directors have a greater
or lesser m easure o f discretion. Generally speaking, income bonds
are m ore sim ilar to preferred stocks than ordinary fixed obligations.
Refer to C hapter 16 for more information.
Obsolete and Illogical Restrictions: G raham argues that excluding
certain issues doesn’t make practical sense. He’s open to the idea o f
investing in various types o f fixed income securities; from first issues to
debentures. He emphasizes the im portance o f understanding w hether a
specific issue has lim itations on future issues being prioritized higher.
In the end, the com pany’s ability to meet its obligations is the top
consideration.
Income Bonds in Weaker Position than Debentures: In this section,
G raham debunks the idea that Debentures are less secure than income
bonds. To prove his point, G raham explains that d ebentures are required
to make paym ents (despite not being backed by tangible assets); where
as incom e bonds are n ot required to make coupon payments. Instead
income bonds are like preferred stock and m anagem ent has the discretion
to pay the holder w hen they feel necessary. As a result, G raham believes
the m a ndatory c oupon paym ent for a debenture provides less risk to the
holder than an incom e b ond.

Standards of Safety Should Not Be Relaxed Because of Early M a tu rity :
If a bond has a short-term maturity of three years the investor m ig h t
relax their standards and view a larger margin of safety. G raham cautions
analysts of this misperception. He argues that companies in financial
difficulties may launch short-term bonds only because their credit rating
could not justify a long-term issue.
Distinctions between Short and Long Maturities o f the Sam e Issue.
Graham makes the argument that if two different bonds, a sh o rt te rm and
a long term, are issued and secured by the same company, the risk is no
different for either bond if the short-term issue can’t be p aid at m aturity.
After explaining this idea, he provides multiple examples to d em o n strate
his conclusion.
4.

Record of Interest and Dividend Payments

The investor should ensure the issuer of the bond has a long record o f financial
stability and should avoid those which do not have a history o f success.
Provisions of New York Statute. Using this idea, the statute for th e State
of New York requires a 10 year history of payments on issues from o th er
states, and a 25 year history from municipalities, 6 years for railroads and
8 years from other public utilities. Graham then discusses the difficulty
in analyzing a municipality’s stability and aptitude to m ake future
payments. This is especially true when considering the lack o f control
one has over the municipality’s decision to issue m ore debt if new leaders
are elected. In this idea, Graham revisits the com m ent th at an investor
should not take a higher return for risk, instead they should pay a low er
principal. Therefore, when a municipal government issues new b o n d s at
higher interest rates, because of the risk of default, the investor sh o u ld be
skeptical of such investments.
A Dilemma and a Suggested Solution. Although m any variables im pact
the analyst’s ability to determine the financial health o f a m unicipality,
Graham suggests that strict quantitative tests could be developed. The
tests would focus on the population size, the revenues received, and
the current liabilities. In the end, if the analyst determ in es th e local
government can repay the obligation, then the h igher re tu rn isn’t a
function of assuming more risk. Instead it’s a higher yield for h is tim e
and effort to conduct the research to find such a security.
The Dividend Record. Many statutes for states in the 1930’s required
banks to only purchase corporate bonds from com panies th a t h a d a clean
5 year record of paying dividends.
Dividend Record Not Conclusive Evidence o f Financial Strength. A lthough

G raham agrees th at dividend paying com panies often dem onstrated
stronger perform ance, he argues that n o n-dividend paying com panies
should not be elim inated from consideration because o f this blanket
requirem ent. The alternative a rgum ent is the paym ent o f a dividend
financially weakens the c orporation (because the released capital can’t be
returned to the com pany accounts), w hich may n ot be in the interests o f
the bond-holder.
The Role o f the D ividend Record in Bond Investment. Make no mistake,
the balance sheet an d incom e statem ent provide be tter clues about a
com pany’s ability to m eet future coupon paym ents th an historical divided
perform ance. O ne advantage o f ow ning bon d s from a com pany that pays
dividends to its com m on shareholders is th at the dividend can be used
as a w arning signal to the analyst. If the dividend is w ithheld o r reduced
to the c om m on shareholders, the health o f the b o n d may be in jeopardy.
5.

R elation o f E arn in g s to In tere st R eq u irem e n ts

A lthough m any analysts judge the safety o f a b o n d by com paring the com pany’s
earnings to its interest obligations, the N ew York statute places em phasis
elsewhere. Instead, it approaches a b onds security from the com pany’s ability
to pay a dividend. G raham has serious objections to this position. He argues
that determ ining the h ealth o f a corporate b o n d is fairly straight forw ard
considering interest charges are fixed. Therefore, it’s very obvious to the
analyst w hat expenses need to be covered.
R e q u irem e n ts o f th e New York Law. In this section, G raham specifically
identifies the few requirem ents th a t were actually identified by the NYSB
for earnings coverage.
C om panies th a t specialize in railroad m ortgages and eq u ip m en t
obligations m ust earn 1.5 tim es the fixed charges in 5 o f the 6 previous
years.
O th e r railroad issues m ust have earned 2 tim es the fixed charges in
5 o f the 6 previous years.
For public utilities, the previous 5 years earnings m u st be 2 tim es the
total interest charges.
T hree Phases o f th e E arn in g s C overage: atten tio n is given to th e way in
w hich e arnings are calculated, h ow m uch needs to be coverage over fixed
fees, and the tim e to validate the test.
1.

M e th o d o f C o m p u ta tio n .

The Prior-deductions M ethod. This m eth o d was com m o n ly used
before 1933, b u t was found to be m isleading an d invalid after th e G reat

Depression. The method subtracts fixed interest from the earnings
for each preceding bond. The coverage ratio is determined after each
subtraction. For example:
Average Earnings

$1,500,000

Deducting Interest on first 6s__________ $500,000 earned 3 tim es
Balance

$1,000,000

Interest on debenture 7s

$300,000 earned 3.3 tim es

As one can see, it appears the debenture 7s have more coverage than
the first issue. This method is obviously misleading.
The Cumulative-deductions Method. Under this m ethod, interest on
junior and senior bonds are combined and compared to the company’s
earnings. For example, if a company’s earnings were $1,000,000, and the
interest on the first issue was $200,000, and the interest on the second
issue was $300,000, the following coverage ratios w ould exist:
The first issue
($l,000,000/$200,000)

would have

The second issue
($1,000,000/$500,000)

would have

a coverage
a

ratio

coverage

of

ratio

5.0—
2.0—

The ratio o f earnings divided by the combined interest payments is
the essence of this method. Many investors would regard this as a sound
procedure for assessing the risk of a security.
The Total-deductions or “Over-all” Method. Although this method
is similar to the cumulative deductions method, it offers a more
conservative approach. Since Graham suggests that all bonds (regardless
of priority) are dependent upon each other, he expects all issues to fail
if the payment of one cannot be completed. Using the same example as
above, the coverage ratio would be 2.0 for both the first and second issue.
This is the method that the NYSB uses and it’s also the m ethod Graham
endorses.
2. Minimum Requirements for Earnings Coverage. In this section,
Graham suggests that the coverage ratios that the NYSB used are longer
relevant. He suggested that the following coverage ratios where used in
the 1930’s: 1.75 for public utilities, 2 for railroads, and 3 for industrials.
3. The Period Comprised by the Earnings Test. Although the NYSB
assesses the five previous years for determining the safety o f an issue,
Graham suggests that the most recent years are the m ost im portant. An
analyst that adopts the methods o f the NYSB may invest in companies
that have demonstrated a strong average performance, but currently

dem onstrates insufficient earnings to support safety o f future payments.
This is undesirable and should be avoided. G raham recom m ends
adjusting the average w indow o f perform ance to suit a representative
tim efram e of typical business perform ance.
Other Phases o f the Earnings Record. The analyst is encouraged to pay
attention to o ther factors like the current trend, the m inim um figure,
and the c urrent figure. These considerations are im portant but don’t
necessarily allow the analyst to employ fixed rules against their selection.
As discussed in earlier chapters, an understanding o f these qualitative
features is im portant.
Unfavorable Factors May Be Offset. As an analyst considers (a) a rising
trend o f profits (b) a good current showing, and (c) an acceptable m argin
over interest charges in all the years studied, they m ight find a bond
that doesn’t m eet every criterion. In this case, the analyst should not
im m ediately dism iss the security. Instead, they should potentially raise
the average coverage ratio viewed over a certain num ber o f years to see
if average trends represent a more holistic view o f the company. If poor
current conditions overshadow such an assessment, this approach is not
recom m ended. In the end, the analyst m ust make sound judgm ents of
their ow n to determ ine which course o f action is m ost secure.
The Relation o f the Coupon Rate to the Earnings Coverage. In this
section, G raham raises a thoughtful question: Can a bond be safe sim ply
because it has a low interest rate? For example, if company 1 has a 2%
bond issued, and company 2 has a 4% bond issued, the coverage ratio
for com pany 1 will be twice the coverage o f company 2 (assum ing the
earnings are exactly the same for b oth businesses).
1. Effect o f Coupon Rate on Safety. G raham’s m ain point in this
section is that good companies fetch a lower interest rate compared to
risky companies. This means that good credit produces better credit.
2. Effect o f a Rise in Interest Rates on Safety A m ajor consideration
for the bond investor is the idea that rising interest rates negatively affect
the m arket value of bond. From the company’s point o f view, coverage
ratios will rem ain intact during rises in interest rates as long as the bond
doesn’t mature. If the bond matures during rises in interest rates, the
com pany may be forced to issue new bonds at higher rates. “The practical
conclusion m ust be that if the investor considers a rise in interest rates
probable, he should not buy long-term , low -coupon bonds, no m atter
how strong the company.” Instead the investor should consider shortterm issues. Inversely, if an investor considers a drop in interest rates

probable, he should buy long-term bonds that meet significant levels o f
safety.
3. Relative Attractiveness o f the Two Bonds. Graham discu sses the
idea that a 5.5% bond may be less attractive than a 3% b o n d b ecause the
company may fall into difficult times due to less cash flow from paying
high obligation. This would likely result in a reduced market price for the
5.5% bond. Graham then caveats his entire position by claim ing the 3%
bond also represents risk because it will be discounted m ore severely if
interest rates rise. This section is a great example o f Graham’s relentless
methods for identifying risk and the countless variables o n e m ust
consider before choosing a safe security. He leaves the reader qu estion in g
which approach is more preferable, but prescribes no definitive solution.
In short, he leaves the reader thinking about the com plexities they face.

C h a p te r 10— S u m m a ry

Specific Standards for Bond Investment
(Continued)
This chapter is a continuation o f the tw o previous chapters and it addresses
the sixth criteria the New York Savings Bank (NYSB) uses for securing safe
bonds. Below is a sum m ary o f the sixth criteria:
6.

Relation of value o f the property to funded debt—G raham makes
no hesitations in discounting the value of tangible assets that secure
a bond investment. He insists that earnings power is a true display
of safety opposed to the tangible asset that back the bond. He argues
that as the earnings power diminishes, so does the value of the
tangible asset that produces the earnings. G raham also describes
the idea that many o f the assets are specialized and may be cheaper
to reproduce than sell on a secondary market. He describes the
practice of many appraisers m isrepresenting assets in an effort to
mislead m anagement or investors. G raham is o f the opinion that
m any tangible assets will not fetch the asking price the company lists
on the balance sheet due to numerous different factors. As a result,
the type of property and its u sefulness/demand to society is a major
factor in determ ining the safety that property' provides for the bondholder.

C h a p ter 10— O u tlin e
The Relation of the Value o f the Property to the Funded Debt
The soundness of the bond rests on the ability of the issuing corporation
to support its financial obligations, and much less on the potential value of
its property for a lien. W ith that in mind, there is no purpose in devising a
minimal pledged level of property value to support the bond, although that is
not the view of the State authorities who may require, for instance, property
to the value of two thirds in excess of the b ond issue.
Special Types of Obligations.
!.Equipment Obligations: Equipment that can be put up for sale and
used elsewhere, such as a car, has a market value and is therefore a
better safeguard than a lien on non-removable property. Equipment trust
certificates may be issued against specific items of use by the corporation,
for instance, again, a car. Although these certificates promise safety at


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