By Rupert Hargreaves. Originally published at ValueWalk.
This is the fifth part of a series devoted to notes of Graham’s lectures between September 1946 and February 1947 at the New York Institute of Finance. The series of lectures was titled Current Problems in Security Analysis, and this fifth part focuses on the Security Analyst and why he usually fails.
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This article is devoted to Graham’s sixth lecture in the lecture series. Part six is relatively short, but it contains a valuable lesson nonetheless. Up to this point, Graham discussed Wall Street’s biggest failings, as well as the appropriate mindset a security analyst should have. A large chunk of the lectures was also devoted to the process of valuing securities, particularly calculating future earnings potential.
Ben Graham On The Benefits Of Security Analyst Failures
Part six continues with the theme of estimation runs through the lectures. Throughout the series, Graham makes it clear that the security analyst should not seek to produce a perfect set of figures for each company they are studying as these numbers will almost certainly be wrong. Instead, Graham recommends an approximation of values and averages be used to compute a company’s earnings potential over a period such as five years. Specifically, in part six he declares:
“I don’t believe any of us have the pretension of believing that by being very good analysts, or by going through very elaborate computations, we can be pretty sure of the correctness of our results. The only thing that we can be pretty sure of, perhaps, is that we are acting reasonably and intelligently.”
The rest of the lecture carries on this theme. Graham continues to make it clear to his class that a Security Analyst will never be able to compute a correct intrinsic value for a business, due to the whims of the market and adverse developments. Therefore, the best way to obtain “insurance against adverse developments” is to ” buy securities that are not only too high but that, on the basis of the analysis, appear to be very much too low.” To add a further layer of insurance, Graham recommends using a “group operation,” or diversification as we know it today:
“When we talk about buying bargain issues, for example, the emphasis on group operation becomes even greater, because you then get into what could practically be known as an insurance type of operation. Here you have an edge, apparently, on each individual company. That advantage may conceivably disappear or not be realized in the individual case, but if you are any good at all as an analyst you ought to realize that advantage in the group.”
One solution he offers to this problem is buying the entire Dow Jones Industrial Average although he “never heard of anybody doing it.” Buying the entire index, rather than just picking individual stocks on the basis of analysis would “make a great deal of sense,” according to Graham.
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