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

and patience. Nevertheless, the Great Illusion persists, maybe because, like Woody Allen’s film character Zelig, the market is a chameleon that changes its appearance to suit the times. Sometimes, it shows up as a tech stock bubble. Other times, it manifestsitself as a ludicrously overvalued stock market as seen in the late 1980s in Japan. In a current incarnation, a raft of financial institutions across America are trying to emulate the success of David Swensen and his colleagues who manage Yale University’s endowment by allocating large percentages of the capital to “alternative investment managers.”
    But the Great Illusion is just that—an illusion. If you want to get wealthy in the financial markets, you’ll need to engage in “hard and systematic work.” And for that, many sections of Part VII of
Security Analysis
are still essential. Given the drastic changes in the world since the book first appeared, it should come as no surprise that some of the material is no longer relevant for today’s investor, and these shortcomings bear mentioning. So as we take a quick tour through this part, I’ll point out some deficiencies along with the authors’ nuggets of wisdom that still ring true.
    One of the shortcomings shows up early in the first chapter of Part VII , in Chapter 46, “Stock-option Warrants,” which is on the accompanying CD. This chapter may well be the most dated. When the book was first published, the derivatives market was still in its infancy. Fischer Black and Myron Scholes had not yet developed their famous formula for valuing stock options, and the products that now pervade the financial markets—options, interest rate futures, swaps, swaptions, and so on—were not fixtures in the financial markets. Chapter 46 homes in on stock warrants, one of the few derivative securities available at that time. The authors make some good points with their few specific examples, but their analysis is not sophisticated enough for today’s world.
    Take their example of Barnsdall Oil warrants. Graham and Dodd correctly conclude that these warrants were undervalued because the market priced them at their intrinsic value. It’s not terribly relevant in today’s world because such mispricing wouldn’t last long. Besides pointing out the obvious—it’s better to own a warrant trading at its intrinsic valuethan to own the underlying stock—Graham and Dodd note the leverage inherent in warrants and options. This analysis is good as far as it goes, but it just doesn’t go far enough. The authors were able to identify that the Barnsdall Oil warrants were mispriced relative to the common stock, but they weren’t able to provide the reader with an intellectual framework or the tools needed to value the warrants properly.
    I should make it clear that just because an asset is overvalued or undervalued, it’s not necessarily a good idea to try to capitalize on that mispricing. If the derivatives market fully understands the misvaluation of the underlying security, there is no particular edge to owning the derivative. However, if the market undervalues the derivatives on a mispriced security or group of securities, the odds to the derivative investor can be
very
favorable. In effect, the investor benefits from the double leverage of two mispriced securities—the underlying
and
the derivative. Although such a situation doesn’t arise often, it can be particularly profitable. The ability to capture the compound mispricings can lead to extraordinary profits.
    Perhaps the most famous example of this phenomenon occurred in the late 1980s, when the Japanese stock market rose to greater and greater heights, ultimately reaching an absurd level of overvaluation. While some believed that this was a “new era” in which Japan would economically dominate the world, value investors took a different view, believing instead that it was simply a case of a financial bubble that would ultimately correct itself. On Wall Street, there was a growing and widespread understanding that the Japanese stock market would eventually decline to more reasonable and rational levels, which spelled opportunity for those able to capitalize on what promised to be a dramatic price movement.
    Against this backdrop, options sellers were, amazingly, willing to offer puts on the Nikkei Index at a remarkably cheap price. I remember askingthe brokers who sold these options, “Who is taking the other side of these trades?” “European