This is the second article in a series of tutorials about post-modern security analysis.

Classic “Intrinsic Value”

The central concept of classical security analysis is “intrinsic value”.

This term is defined as follows in the first chapter of “Security Analysis (1940 Edition)” by Benjamin Graham and David Dodd:

… intrinsic value is an elusive concept. In general terms, it is understood to be that value which is justified by the facts, e.g., the assets, earnings, dividends, definite prospects, as distinct, let us say, from market quotations established by artificial manipulation or distorted by psychological excesses. But it is a mistake to imagine that intrinsic value is a definite and as determinable as is the market price.

Our notion of intrinsic value may be more or less distinct, depending on the particular case. The degree of indistinctness may be expressed by a very hypothetical “range of approximate value”, which would grow wider as the uncertainty of the picture increased … It would follow that even a very indefinite idea of the intrinsic value may still justify a conclusion if the current price falls far outside the maximum or minimum appraisal.

The “facts” on which “intrinsic value” was to be based were considered to be relatively simple and easily acquired at the time Graham & Dodd published the first edition of “Security Analysis”, which stated:

Descriptive analysis consists of marshalling the important facts related to an issue and presenting them in a coherent, readily intelligible manner. This function is adequately performed for the entire range of marketable corporate securities by the various manuals, the Standard Statistics and Fitch services, and others.

Because of this assumption (reasonable at the time), almost the entire volume of “Security Analysis” (often considered to be the Bible of “fundamental analysis”) was devoted to the analysis of data from these standard, easily obtained secondary sources. Little attention was devoted to the job of collating and researching data from original sources (OSINT).

Intrinsic value and the Efficient Market Hypothesis

In 1965, nine years after Benjamin Graham had retired and at about the same time that his star pupil, Warren Buffet, was closing his partnership, Eugene Fama, a graduate student at the University of Chicago published a paper advancing what came to be called, the “Efficient Market Hypothesis”.

These were the “go-go” years of the 1960s with soaring stock prices, “performance funds”, and a wave of mergers and acquisitions. However, rising prices did not float the “fundamental analysis boat”.

The following quotes from “Buffett”, by Roger Lowenstein, indicate the problems that classical security analysts were having in a market in which current prices generally exceeded “intrinsic value”:

At the start of 1967, Buffett felt compelled to advise his partners that some of the newer mutual funds had better returns than his own. Moreover, he warned that his stream of new ideas was down to a “trickle”. Though he was working day and night to keep them coming, his tone was ominous. If his idea flow “should dry up completely, you will be informed honestly and promptly so that we may all take alternative action.”

The strategy of classical security analysis was to acquire securities for which market price was considerably lower than “intrinsic value” and then hold these securities until market prices caught up with intrinsic value.

Warren Buffett’s partnership operated like a hedge fund; he invested other people’s money (along with his own), earning a fat percentage on capital gains that exceeded a certain base return. When market prices, in general, exceeded or equaled what he considered to be “intrinsic value”, there was no reason to continue in the business. The honest thing to do would be to return the partner’s money and become a long-term investor — which is what he did by setting up Berkshire Hathaway.

In the “go-go” climate of the 1960s, it is easy to see how a young graduate student, with no experience in Wall Street and with a historical perspective that went back only a few years, would not understand the investment climate of the New Era boom and bust of 1927-1933 that shaped the thinking of Benjamin Graham (an actual investor and fund manager in those years).

Eugene Fama, the graduate student, surrounded and encouraged by theoretical economists at the University of Chicago, could easily conclude that markets were indeed “efficient”, populated by “rational men”, and that market price was equivalent to “intrinsic value” — as so many non-scientific economists postulated.

The Efficient Market Hypothesis flourishes

Although markets had ups and downs over the next generation, there was no true “learning moment” like 1929 — until the Crash of 2008.

The reasons for this lack of awareness can be found in Federal Reserve flow of funds accounts over the period that show how Security and Exchange Commission Rule 10b-18 of 1982, permitting massive market manipulation of a scale never before seen, together with growing trade deficits that followed the final de-linking of the dollar from gold in 1971, created an irrational, over-priced stock market, leading to a shortage of equities and blind belief in the “Common Stock Legend” — an environment that persisted for more than a generation. See: The Hidden Equity Shortage.

For most purposes, classical security analysis was now abandoned in the US market, primarily because it was exceedingly difficult to find securities that were “under-valued” in the sense employed by Graham & Dodd and because the availability of information far exceeded the disposition of analysts to exploit the tsunami of raw data.

Now, theories proposed by economists without practical experience in either fundamental security analysis or market operations, came to the fore.

Statistical analysis of market price trends and abstruse mathematical formulae based on unproven theories, took the place of commonsense. Like a fungus living off the remains of classical security analysis, the EMH spread through markets.

Some continued to call themselves “fundamental analysts”, professing allegiance to the teachings of Benjamin Graham, but the world had changed. The old concept of “intrinsic value” was increasingly difficult to apply in practice. It became ever harder to find companies with the organizational, legal, and operational simplicity of the 1930s.

Warren Buffett now ran Berkshire Hathaway, using his legendary commonsense to manage a long-term portfolio of a relatively small number of selected equities, sometimes with a controlling interest. Graham & Dodd continued to be a best-seller in the finance section of bookstores, along with a bevy of titles on “Buffettology”.

However, “Modern Portfolio Theory” and un-managed “Index Funds” were now in fashion. Billions came from those that the SEC considered to be “sophisticated” investors and poured into highly-leveraged “hedge funds”, the managers of which, unlike the fair deal offered by Mr. Buffet a generation earlier, earned exorbitant fees on wildly speculative portfolios, whether investors won or lost.

Increasing complexity and changes in perception

Meanwhile, and most importantly, markets had become much more complex, expanding across the globe into hundreds of new jurisdictions, subject to foreign laws, taxes, regulations, and operational rules that no one could completely grasp. A common stock in Algeria was not the same as an equity share in Indonesia. On top of this jurisdictional confusion, investment instruments became more abstruse and difficult to understand, while factual coverage by the remaining small oligarchy of financial publishers was reduced relative to the expanded size of the market.

The Crash of 2008 produced some notable changes in perception:

1. The Efficient Market Hypothesis died. See: British CFAs reject the Efficient Market Hypothesis , “The Economist” trashes Modern Economic Theory, and Free information and the Efficient Market Hypothesis.
2. Traditional sources of information were not trusted. See: Why rating agencies may overlook toxic assets, How the rating agencies helped bring down the economy , and Innovation in investment research: dealing with free information.
3. The competency of financial institutions to understand markets and instruments, including their own operations, was severely questioned. See: Is big bank complexity irreversible? The McKinsey Heresy and Some banks have become too complex to manage.

What this meant was that security analysis was now ready to move beyond Modern Portfolio Theory and the Efficient Market Hypothesis and that new approaches could now be entertained.

No return to the 1930s: Post Modern Intrinsic Value

Some aspects of classic security analysis are as valid today as in the 1930s. For example, the emphasis on facts, commonsense, maintaining an independent mindset, and skeptical analysis.

However, the world of finance has changed so much that it is better to think in terms of Post-Modern Security Analysis rather than a return to Graham & Dodd. (See: Investment Analysis: Moving beyond Graham & Dodd and The heroic, solitary investment analyst is long gone.

The concept of Intrinsic Value is worthwhile keeping, although with changes to bring the notion in line with current market realities:

1. Multiple Intrinsic Values: Graham & Dodd considered “intrinsic value” to cover an indistinct “range of values” that could be compared to market price. This definition needs to be modernized to include multiple bands, with different intrinsic values for different types of investors under varying monetary systems and legal jurisdictions. The same dollar bond has a different intrinsic value for a resident of Indonesia, thinking in terms of Rupiah, than it does for a resident of New Jersey thinking in terms of dollars. Each has a different tax situation and monetary frame of reference. Legal safeguards may vary with the nationality of the investor, along with transaction costs and other factors. Securities are essentially legal rights and obligations, generally involving payment at some future date, in one or more specified currencies. However, these legal rights are not the same for all investors. An investor in one jurisdiction will be taxed differently from investors in another jurisdiction. Some countries treat foreign investor with preference or prejudice, compared to local investors.
2. Multiple comparative values: The classic definition of “intrinsic value” was that of an indistinct band of values to be compared to a market price. This led to the presumption that security analysis was mainly concerned with the maximizing of capital gains. Graham & Dodd was written in a deflationary environment and in terms of a dollar that was still pegged to gold (although no longer directly convertible). Today, we are in the realm of un-pegged fiat money with persistent inflation, even in recessions. Furthermore, contemporary readers of Graham & Dodd were thinking in terms of US dollars or British pounds, with securities traded in New York or London, under some variant of English Common Law. Today, investors hold securities under Japanese, Chinese, Indian, Brazilian and many other legal systems and traded on many exchanges, often subject to rules they do not know and written in languages with which they are not familiar. In this environment, a prudent investor should be interested in much more than intrinsic value versus market price, but also in such things as protection offered by the law, defenses against inflation, and in the liquidity and settlement guarantees offered by a particular trading system. These other comparisons are not necessarily expressed in monetary terms, but, nevertheless, are useful. For example, does security A offer more or less protection against inflation than security B?

In this light, intrinsic value is a concept involving comparisons made by individuals in terms of their own particular requirements. Think of an oculist measuring your eyes for glasses. He asks, can you see the bottom line better with this lens, or with this one? You can’t put a monetary value on the comparison, but the question is worth answering.

Also, you don’t care if Dr. See Good fitted glasses perfectly for Harry if he can’t do the same for you. In the final analysis, investment is personal. Would you be happy if your eye doctor told you that your prescription was based on the average eye exams of the last fifty patients and that you should have a 85% chance of seeing more of less adequately with your new glasses. Of course not. However, this is the level of treatment investors routinely received from investment fund managers during the age of Modern Security Analysis.

Above all, post-modern security analysis should be aimed at improving the fortunes of investors.

Definition: Post-modern Intrinsic Value

We may now define “Intrinsic Value” in a way as to be useful in markets that follow the Crash of 2008.

We can’t exactly return to Graham & Dodd, but we can retain the core ideas and the spirit of reliance on fact, rather than theory, with the following definition:

The Intrinsic Value of a security is its comparative worth, based on relevant factual evidence, and measured in terms of one or more other values that are pertinent to the goals of a specific investor, such as probability of falling significantly below current market price, protection against inflation, capacity to afford cash income, persistence of liquidity, or safety of principal.

The Intrinsic Value of a security is not measured in precise monetary terms, but rather is expressed by comparative qualifiers, such as “about equal to”, “less than” or “more than”, which may be further qualified by adverbs or adjectives such as “somewhat”, “significantly”, or “far”, with a clear indication of the trait being measured. For example: “Stock A is far less liquid than the government bonds of Country X”; or “Bond B is about equal to US Treasury Bonds with regards to safety of principal”; or “Stock C, in terms of cash dividends, likelihood of continued payment, and earnings coverage, offers a significantly higher value for price than comparable securities of its class in today’s market”.

This Post-modern definition of “Intrinsic Value” does not attempt to qualify a security as “cheap” or “expensive” in a general, imprecise way, but rather to make a series of strict comparisons with respect to various aspects of a security that are relevant to the interests to a specific investor (or type of investor). In this sense, there is no single generic qualification of a under-valued or over-valued security, but only comparisons based on named characteristics.

Next lesson: The economics of security analysis

Photo credits: “Lenses” by Mr. John from flickr.; “Out of Focus” by Sara ‘New Killer Star’ from Flickr ; “Warren Buffett’s home in Omaha”, by Joseph Vieira (adapted) from Flickr; “Abandoned Boat II” by Vito from Flickr; “Through the Fungi” by Jnthnhys from flickr; “Management of Complexity” by Michael Heiss from flickr.

This entry was posted on Thursday, August 6th, 2009 at 9:34 am and is filed under Economic Theory, Investment Theory. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

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