There is a raging discussion going on in one of the Linkedin groups I’m a member of that has taken many twists and turns and highlights why Graham and Dodd are relevant today.
The current discussion is on whether or not Apple Inc (NASDAQ: AAPL) represents a Graham and Dodd stock at today’s prices.
The only way to answer this question is to:
- Identify the criteria that constitutes what a Graham and Dodd stock is and
- apply those criteria to Apple to see whether it fits the bill
The Sixth Edition of Security Anlaysis by Benjamin Graham and David Dodd is widely regarded as the most authoritative version written by both men.
For expediency, I shall use the sixth edition as the authoritative text for what constitutes a Graham and Dodd stock.
It is clear, even without regard to the chapters on fixed income investments, that Graham and Dodd promoted the analysis of assets as the best way an investor can achieve satisfactory returns from common stock investing.
In chapter 28 ‘Newer Canons Of Common Stock Investment’, Graham and Dodd recount the difficulty of investing in growth stocks because determining when a growth stock is or is not speculative in nature can be troublesome due to the pitfalls of trying to calculate it’s future prospects.
It’s not that Graham and Dodd were against growth stock investing per se, it’s just that they concerned themselves with safety which in and of itself is the first principle of value investing:
It is not impossible to study these points [growth stocks] successfully, but the task is not easy, and the chance of error is great – Graham and Dodd
Graham and Dodd express their idea of safety by stating that stocks should be bought when they are on offer for considerably less than the business would be worth to a private owner:
We incline strongly to the belief that this last criterion—a price far less than value to a private owner—will constitute a sound touchstone for the discovery of true investment opportunities in common stocks – Graham and Dodd
Although earnings are important, Graham and Dodd warn investors not to rely on earnings as the sole factor to determine value because of their fluctuations and sometimes arbitrary determination.
Personally I like the way Graham and Dodd introduce the reader to the balance sheet and it’s importance:
the balance sheet deserves more attention than Wall Street has been willing to accord it for many years past – Graham and Dodd
From here, Graham and Dodd quickly introduce to the reader the definition of book value:
by adding up all the tangible assets, subtracting all liabilities and stock issues ahead of the common and then dividing by the number of shares – Graham and Dodd
Then current asset value:
The current-asset value of a stock consists of the current assets alone, minus all liabilities and claims ahead of the issue – Graham and Dodd
And finally cash asset value:
The cash-asset value of a stock consists of the cash assets alone, minus all liabilities and claims ahead of the issue – Graham and Dodd
Graham and Dodd dedicated an entire chapter to current asset value and the most important paragraph from this chapter (and from the entire book) is reproduced below:
Common stocks that (1) are selling below their liquid-asset value, (2) are apparently in no danger of dissipating these assets, and (3) have formerly shown a large earning power on the market price, may be said truthfully to constitute a class of investment bargains. They are indubitably worth considerably more than they are selling for, and there is a reasonably good chance that this greater worth will sooner or later reflect itself in the market price. At their low price these bargain stocks actually enjoy a high degree of safety, meaning by safety a relatively small risk of loss of principal – Graham and Dodd
This is what constitutes a Graham and Dodd stock.
Seasoned value investors would have had an inkling that Apple does not represent a Graham and Dodd stock. It’s too big and it has seen tremendous growth both in its stock price and market share. At today’s prices Graham and Dodd would have determined Apple as a growth stock trading at fair value.
For completness, here’s a copy of Apple’s latest quarterly balance sheet filed 28th January 2014:
Apple Inc (NASDAQ: AAPL) Balance Sheet 28th January 2014
Apple’s Net Current Asset Value
From here it’s a quick calucaulation of current assets ($80.347) minus total liabilities ($95,500) equals a Net Current Asset Value of -$15,153 which means Apple has a negative liquidation value and is not a Graham and Dodd stock – see more about balance sheets and Apple’s liquidation value on this post.
Why Graham And Dodd Matters Today
Look, Security Analysis was first published in 1934 and the Sixth Edition in 2009 which is a shiney new updated version including contributions from modern day succesful value investors and academics that positively and massively enhances the original text.
But the real reason Graham and Dodd matter today is because in 2014, at this time, their asset based value approach still works.
If you look at the results of my own asset-value based approach from 2013, you will notice that it returned 48% over twelve months. The S&P returned 29% over the same time period.
You may not always find a stock that has a positive net current asset value which also happens to be selling far below that value. There will be many balance sheets to analyse during this process.
You should not let the process itself sway you from attempting it if you want to find Graham and Dodd stocks and to make the process easier on yourself, you should start your research from the daily list of 52 week lows.