Security Analysis

through life’s countless financial decisions, building lasting wealth requires more than just quick moves and market timing. great investors follow clear principles, examining value through a careful lens that brings opportunities into focus. a steady approach to analysis and decision-making can transform your relationship with money and markets.

this wisdom, first shared by benjamin graham and david dodd in 1934 and now in its seventh edition, continues to guide the world’s most successful investors. edited by seth a. klarman to reflect modern contexts and challenges, this edition bridges the foundational principles of the great depression era with the complexities of today’s financial landscape. despite evolving markets, their insights offer timeless principles that remain remarkably relevant.

in this chapter, you’ll learn the core practices that turn market participants into thoughtful investors who see past daily price swings. these principles of analysis will sharpen your perception of true market value and build the quiet confidence that comes from solid knowledge.

your journey toward financial clarity starts here – time to step through the looking glass and see the market as it truly is. let’s discover why these enduring lessons have guided generations of investors to success.

the stock market creates both fortunes and failures through the same basic mechanisms. two people can buy the exact same stock with radically different results. the secret lies not in picking the right securities, but in the method behind each choice. a true investment needs to deliver two simple things: your money stays safe, and you earn a fair return.

picture two investors facing the market chaos of the early 1930s. the first carefully studied company reports and balance sheets, buying only when shares sold far below their proven worth. she focused on fundamentals: hard assets, strong management, and genuine earning power. meanwhile, the second investor chased whatever soared highest. he borrowed heavily, snapped up stocks on rumor and momentum, and clung to the hope that prices would keep climbing. 

when the massive crash hit, the diligent investor preserved her capital and even found new bargains, while the gambler lost nearly everything. both held similar shares once, but how they selected and valued those shares shaped their fates.

just as the careful investor’s thorough examination of fundamentals allowed her to survive the crash, good analysis requires looking at both numbers and the bigger picture. start with financial statements – those yearly and quarterly reports that show profits, debts, and cash flow. but then look deeper at the company’s position in its market, the quality of its leadership team, and how healthy its whole industry looks. imagine if you were buying a small business in your town – you’d want to know both what the books say and how well it competes with other local shops. stock investments need that same thorough review.

bonds make a perfect example. say a company needs to pay interest on its bonds for the next 20 years. smart investors check if the company can make those payments during both good times and bad. they study past downturns, look at how much cash the company keeps on hand, and consider what might go wrong. this careful approach helps avoid nasty surprises.

taking risks can work out well, but only with proper homework first. maybe a struggling company’s bonds sell for pennies – that could be smart if solid research shows a path to recovery. just following price trends or hoping for the best invites trouble. knowledge and preparation matter more than the size of the risk.

the real power of this analytical approach shows in how successful investors handle market swings. when solid companies see their stock prices drop sharply, careful investors check their financial strength first. if a business holds twice the cash it needs for operations and maintains conservative practices, these price drops become buying opportunities. many of the greatest fortunes grew from buying strong companies during temporary market panics.

the principles of careful analysis apply across every type of investment, but they become especially clear in fixed-income securities. these steady investments show exactly how strong businesses generate reliable returns, creating a perfect laboratory for learning smart investment practices.

fixed-income securities, particularly bonds, form the foundation of investment analysis. when a company issues bonds, it makes a simple promise: to pay interest at regular intervals and return the principal at a set date. this straightforward commitment makes bonds perfect for learning how to evaluate business strength – if a company can’t make these basic payments, it can’t do anything else.

the first question any bond investor asks seems simple: can the company make its payments? this analysis starts with the coverage ratio – how many times over can a company’s earnings cover its required bond payments? new york central railroad learned this lesson the hard way in 1929. their earnings covered interest payments 3.5 times over during good years, but by 1932, they barely scraped together enough cash to pay bondholders.

this coverage ratio tells only part of the story. the real safety net lies in working capital – the cash and easily sold assets a business keeps on hand minus what it owes in the short term. picture working capital as a company’s breathing room. u.s. steel showed how this matters by keeping working capital at triple its short-term debts throughout the 1920s. when steel demand collapsed in the depression, they paid their bills while competitors folded.

most businesses need at least two dollars in current assets for every dollar of short-term debt. but this basic rule gains meaning when you track it over time and compare it across similar companies. a declining ratio often signals trouble ahead, while a consistently strong position lets companies weather storms and grab opportunities when rivals struggle.

bond contracts come with built-in protections to keep companies honest. they limit how much more money a business can borrow, require them to maintain healthy financial ratios, and set clear rules about missed payments. but as many investors learned during the depression, these legal safeguards only work when backed by solid business performance.

at&t proved why business strength matters more than legal protections. through the worst of the depression, they maintained steady revenues from telephone service – an essential utility customers kept paying for even in hard times. this reliable cash flow meant they never missed a bond payment. while other companies with similar legal protections defaulted, at&t’s fundamental business strength made those protections unnecessary.

interest rates add one final consideration to bond investing. when rates rise, existing bonds become less valuable because newer bonds offer better returns. smart investors adapt by buying shorter-term bonds when rates are low, protecting against future rate increases. when rates run high, they look for longer-term bonds from strong companies like at&t.

the steady, predictable nature of bond payments makes them perfect for learning investment analysis. they teach an important lesson: study the numbers, understand the business, and always leave room for error. these same principles reveal even deeper truths about how markets really work – truths that become clear when we examine the gap between market price and real value.

price and value tell two different stories in the stock market. price swings up and down with market moods, while value builds slowly through business performance. understanding this difference – and spotting the gaps between them – creates the richest opportunities for careful investors.

the market’s shifting moods often push stock prices far from business reality. take manhattan shirt company during the great depression. here’s what happened: if you added up the value of all its shares – the market price – you got a number that was smaller than the amount of cash the company had in its bank accounts. that’s like saying a store is worth less than the money in its cash register – ignoring all its inventory, building, and business value. even with lower profits during tough times, manhattan shirt kept paying dividends and had plenty of cash. the market’s fear had created a price that made no logical sense.

this gap between price and value emerges from how markets view earnings power. a company reporting a million dollars in yearly profit might look attractive at first glance, but smart investors dig deeper. do those earnings stay steady or bounce around? does maintaining them require constant new investment? northern pipe line company demonstrated the importance of thorough analysis. beyond its modest pipeline profits, the company held hidden value in its government bond portfolio and prime real estate, which were recorded at outdated, significantly lower prices. the company was worth far more than both its value and market price, but most investors missed this completely.

finding these opportunities requires protection against mistakes – investors call this a margin of safety. think of a bridge built to hold 30 tons when the heaviest truck weighs 10 tons. in investing terms, this means buying assets so cheaply that even partial mistakes don’t cause permanent losses. during the 1930s crash, only investors who bought stocks at deep discounts managed to protect their money.

these lessons about price and value shine brightest during market extremes. the steel industry in the 1920s provides a perfect example. companies with modern plants, strong balance sheets, and experienced management survived the depression, while those focusing purely on growth projections failed. the numbers told the true story – but only for investors who knew how to read them.

such careful analysis often reveals its greatest rewards when studying troubled situations. american express demonstrated this in 1940, when employee fraud caused massive losses. while the market panicked, careful investors recognized that the company’s core business remained strong, its reputation would survive, and its cash reserves could cover all damages. those who bought during the crisis saw their investment triple within five years.

these opportunities to profit from market misconceptions require more than surface-level reading of financial statements. like detectives piecing together clues, smart investors must learn to spot differences between reported numbers and economic reality. this detective work begins with understanding income statements – where companies tell their earnings stories, and where the most important clues often hide in plain sight.

every company tells its earnings story through financial reports, but these stories need careful readers. the income statement – a document mapping profits and losses over time – reveals both triumphs and troubles for those who know where to look. within its rows of numbers hide both straightforward facts and subtle clues about business reality. the skill lies in learning to separate what companies want to show from what their businesses actually earn.

this separation between reported numbers and business reality showed up dramatically in companies like u.s. industrial alcohol during the 1920s. while their financial statements painted a picture of steadily rising profits year after year, careful analysis told a different story. management systematically buried regular losses under “special charges” while highlighting optimistic earnings figures. when the depression hit, this accounting facade crumbled, exposing the true weakness that lay beneath the numbers all along.

real earning power means looking at profits across many years, through both good times and bad. think of your own paycheck – getting one big bonus doesn’t mean you’re suddenly rich. the same goes for companies. a single good year doesn’t tell the whole story. smart investors look at how a business performs over many years, through ups and downs. when the market gets excited about one good year, it often misses the bigger picture.

this principle of looking beyond surface numbers proved vital in cases like interborough-metropolitan. the company boasted impressive profits in its income statements while systematically undercounting basic maintenance costs. year after year, rails and equipment slowly deteriorated even as reported earnings looked strong. smart investors recognized that these delayed maintenance costs would eventually come due – profits that depend on neglecting basic repairs can’t last.

even simple changes to income statement calculations can hide problems. the income statement includes a line for equipment costs, spread across many years. one manufacturer made its profits look twice as big by suddenly spreading these costs over 20 years instead of 10. smart investors learn to spot and adjust for these moves, always seeking the true earning power beneath accounting choices.

this detective work reaches its peak when examining so-called “extraordinary” expenses, usually at the bottom of income statements. u.s. steel repeatedly classified basic plant maintenance as “extraordinary,” making regular earnings appear better than reality. true analysis means questioning every such adjustment, always asking what these costs really represent.

success in reading income statements requires thinking like a business owner rather than a stock trader. would these earnings adjustments make sense if you owned the entire company? do these “extraordinary” expenses really seem unusual? this ownership mindset cuts through accounting complexity to reveal sustainable profits. with this foundation in earnings analysis, we can turn to the balance sheet, where a company’s true financial strength – or weakness – comes into sharp focus.

every business has two financial stories to tell. the income statement shows how much money flows in and out, but the balance sheet reveals something even more fundamental – it’s a snapshot of everything a company owns and owes at a single moment in time. think of it as a business’s financial photograph, showing assets on one side and debts on the other. the difference between these numbers tells us about a company’s true financial strength.

white motor company showed why balance sheets matter so much during the market crash. everyone was worried about falling earnings, but the balance sheet told a better story. the company had more cash in the bank than what you’d need to buy all its stock. plus, it had warehouses full of inventory – trucks and parts ready to sell. the market price made no sense – it was like saying this whole truck-making business, with all its assets, was worth less than nothing.

working capital tells another crucial story about business resilience. remember manhattan shirt company? their success during the depression goes deeper than their market value. beyond their strong cash position that we saw earlier, their balance sheet revealed another key strength: they maintained current assets at three times their short-term debts. this financial cushion allowed them to pay bills, keep inventory flowing, and acquire struggling competitors’ assets during the depression. while other clothing manufacturers closed their doors, manhattan shirt’s strong balance sheet turned market panic into opportunity.

the relationship between debt and equity also reveals critical insights about business stability. during the 1930s, many seemingly profitable companies collapsed under their debt burdens when revenues temporarily declined. those with conservative debt levels survived and ultimately thrived, demonstrating why balance sheet strength matters more than short-term earnings power.

most importantly, a balance sheet reveals how efficiently a company turns its assets into profits over time. strong businesses generate steady returns using the same core assets year after year, often signaling lasting competitive advantages. other companies need constant new investment in equipment and facilities just to maintain their earnings – a pattern that often destroys value for shareholders despite healthy-looking profits. these patterns of asset use and return often tell a deeper story about business quality than earnings alone.

these principles of careful balance sheet analysis transform how successful investors evaluate opportunities. this analytical approach demands patience and discipline, but it provides a framework for making intelligent investment decisions regardless of market conditions. while others chase momentary trends, the investor grounded in thorough analysis of balance sheets and income statements builds lasting wealth through careful study and prudent action.

the main takeaway of this chapter to security analysis by benjamin graham, david dodd, and seth a. klarman is that investing genius lies not in picking hot stocks, but in having an analytical method that protects your money while generating steady returns.

smart investors look beyond surface numbers and market excitement, studying working capital, debt levels, and true earning power across many years. this careful approach, combined with buying assets at a significant discount, creates a margin of safety that protects wealth during market downturns. while others chase trends and react to market swings, patient investors who focus on fundamental business strength build lasting wealth through disciplined analysis and prudent decision-making.

okay, that’s it for this chapter. we hope you enjoyed it. if you can, please take the time to leave us a rating – we always appreciate your feedback. see you in the next chapter.