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

understanding the mathematics of the instruments in which I was investing, I didn’t appreciate how the trade might look to the person on the other side. I was ripe for the picking, as they say. Perhaps my trades had been the other side of someone’s buying a box for $4.50. I realized that, in all likelihood, the guy on the other side was probably smarter than I was. Embarrassed by my own ignorance, I vowed to wade into new situations with a greater respect for those on the other side of the trade and with more humility about the limits of my own knowledge. Never again would I be the patsy. That approach has served me well throughout my career.
    Unlike the world in which Graham and Dodd lived and worked, today’s security analyst is at a disadvantage without a good understanding of how option pricing models work and what their limitations are. Not only are derivatives pervasive in the financial markets but many corporations and investment entities use them for purposes both prudent and reckless.
    As I continued to acquire experience and learned more about options and the models used to value them, I became aware of a major weakness in options theory. By and large, the academic work underpinning derivatives analysis, work that so many on Wall Street rely on, is predicated on the assumption that the markets are “efficient.” The authors of
Security Analysis
would have had a good time arguing with these academics. They understood that the underlying premise of efficiency is not always true, writing:
    Evidently the processes by which the securities market arrives at its appraisals are frequently illogical and erroneous. These processes, as we pointed out in our first chapter, are not automatic or mechanical but psychological, for they go on in the minds of people who buy and sell. (p. 669)
    Ahead of their time when it came to the question of market efficiency, Graham and Dodd weren’t able to foresee a need for the more complex mathematical relationships pointed out by my boss. They looked only at the relationship between the derivative security and the underlying instrument, which made for a somewhat primitive method of warrant analysis. Nevertheless, they did possess a keen understanding of how option and warrant issuance can affect the future value of the issuing company’s common stock. In fact, they understood it better than many of today’s accountants and Wall Street analysts. In a subsection entitled “A Dangerous Device for Diluting Stock Values,” the authors write,
    The public’s failure to comprehend that all the value of option warrants is derived at the expense of the common stock has led to a practice that would be ridiculous if it were not so mischievous. (p. 653 on accompanying CD)
    Those words could just as easily have been penned any time in the last decade, as some of the compensation schemes recently adopted at certain corporations have been shortchanging shareholders by masking the dilutive impact and inflating the income statement.
    Until recently, companies recorded no expense on their income statements for the cost of options issued to management and directors. A couple of years ago, the rules were changed, and Generally Accepted Accounting Principles (GAAP) began requiring companies to use one of several methods to value the cost of their stock options. It’s a big improvement over the prior practice of recording no expense, but themethods mandated by GAAP are the same as those used by analysts to value derivatives not issued by the company. Clearly, something is amiss. There is a huge difference between derivative contracts with third parties that do not result in more shares being issued and company-issued options that increase the number of its shares outstanding in the future, thereby diluting the interests of the current stockholders. Long-term shareholders need to fully appreciate the impact of these options issued by corporations to management; otherwise they’ll find themselves short-changed in the years to come.
Beware of the Investment Bankers!
    Moving on to Chapter 47 , “Cost of Financing and Management,” Graham and Dodd might more aptly have named it, “Beware of the Investment Bankers!” As the saying goes, “The more things change, the more they stay the same.” Or, as a friend once told me with regard to conflicts of interest on Wall Street, “Where there’s no conflict, there’s no interest.” The reader will find it interesting to learn about ancient