Security Analysis : Sixth Edition, Foreword by Warren Buffett: Additional Aspects of Security Analysis. Discrepencies Between Price and Value

The mistakes of the market are thus the mistakes of groups or masses of individuals. Most of them can be traced to one or more of three basic causes: exaggeration, oversimplification or neglect.
    In this chapter and the next we shall attempt a concise review of the various aberrations of the securities market. We shall approach the subject from the standpoint of the practical activities of the analyst, seeking in each case to determine the extent to which it offers an opportunity for profitable action on his part. This inquiry will thus constitute an amplification of our early chapter on the scope and limitations of security analysis, drawing upon the material developed in the succeeding discussions, to which a number of references will be made.
    General Procedure of the Analyst. Since we have emphasized that analysis will lead to a positive conclusion only in the exceptional case, it follows that many securities must be examined before one is found that has real possibilities for the analyst. By what practical means does he proceed to make his discoveries? Mainly by hard and systematic work. There are two broad methods that he may follow. The first consists of a series of comparative analyses by industrial groups along the lines described in the previous chapter. Such studies will give him a fair idea of the standard or usual characteristics of each group and also point out those companies which deviate widely from the modal exhibit. If, for example, he discoversthat a certain steel common stock has been earning about twice as much on its market price as the industry as a whole, he has a clue to work on—or rather a suggestion to be pursued by dint of a thoroughgoing investigation of all the important qualitative and quantitative factors relating to the enterprise.
    The same type of methodical inquiry may be applied to the field of bonds and preferred stocks. The wide area of receivership railroad bonds can best be explored by means of a comparative analysis of the showing of the bonds of roughly the same rank issued by, say, a dozen of the major carriers in trusteeship. Or a large number of public-utility preferred stocks could be listed according to: (1) their over-all dividend and interest coverage, (2) their stock-value ratio and (3) their price and yield. Such a simple grouping might indicate a few issues that either were well secured and returned more than the average or else were clearly selling too high in view of their inadequate statistical protection. And so on.
    The second general method consists in scrutinizing corporate reports as they make their appearance and relating their showing to the market price of their bonds or stocks. These reports can be seen—in summary form, at least—in various daily papers; a more comprehensive presentation can be found in the daily corporation-report sheets of the financial services or weekly in the
Commercial and Financial Chronicle
. A quick glance at a hundred of such reports may reveal between five and ten that look interesting enough from the earnings or current-asset standpoint to warrant more intensive study.
    Can Cyclical Swings of Prices Be Exploited? The best understood disparities between price and value are those which accompany the recurrent broad swings of the market through boom and depression. It is a mere truism that stocks sell too high in a bull market and too low in a bear market. For at bottom this is simply equivalent to saying that any upward or downward movement of prices must finally reach a limit, and since prices do not remain at such limits (or at any other level) permanently, it must turn out in retrospect that prices will have advanced or declined too far.
    Can the analyst exploit successfully the repeated exaggerations of the general market? Experience suggests that a procedure somewhat like the following should turn out to be reasonably satisfactory:
    1. Select a diversified list of leading common stocks,
e.g.
, those in the “Dow-Jones Industrial Average.”
    2. Determine an indicated “normal” value for this group by applying a suitable multiplier to average earnings. The multiplier might be equivalent to capitalizing the earnings at, say, twice the current interest rate on highest grade industrial bonds. The period for averaging earnings would ordinarily be seven to ten years, but exceptional conditions such as occurred in 1931–1933 might suggest a different method,
e.g.
, basing the average on the period beginning in 1934,