The first chapter of the iconic novel, Security Analysis, defines what security analysis actually means and focuses on distinguishing the value investor from the speculators. The chapter is divided into three sections, each explaining a fundamental function of security analysis: the descriptive function, the selective function, and the critical function.
1. The Descriptive Function
By far the most important, yet simple part of security analysis is the descriptive function. The descriptive function is the process of gathering circumstantial information about a company, including risk factors, different exposures, and situations that impact the company. This research process forms the base for the rest of the analysis.
2. The Selective Function
The selective function of security analysis is the process in which the investor determines whether to buy, sell, hold, or exchange shares of a company by calculating the intrinsic value of the company. Intrinsic value is the “real” value of the company, and, in theory, share prices will always gravitate toward intrinsic value. The authors repeatedly emphasize the fact that intrinsic value must take into account all aspects of the company, including those that are not seen on the balance sheet, such as competitive advantages that companies develop. Graham and Dodd make it clear that intrinsic value could only be expressed as a range of numbers due to the multiple risk factors that cannot be accurately predicted. In true Graham and Dodd fashion, they include multiple examples of this type of valuation, with the most enlightening one being J.I. Case Common. They outline one case of where the company was undervalued at $8 per share and one case where the company is overpriced at $280 per share to prove that intrinsic value can only be adequately expressed as a range of values. The authors end the section by describing the three obstacles of the value investor (incorrect information, uncertainties of the future, and the irrationality of the market) as well as explaining how the stock markets are a voting machine rather than a weighing machine.
3. The Critical Function
Simply put, the critical function of value investing is to set aside emotions, eliminate biases, and only act on facts. The investor must be able to make impartial decisions solely based on the available information and cut losses when necessary. This then allows for more accurate and successful decision making.
Synopsis (Taken from Goodreads)
With nearly a million copies sold, Security Analysis has been continuously in print for more than sixty years. No investment book in history had either the immediate impact, or the long-term relevance and value, of its first edition in 1934. By 1951, seventeen years past its original publication and more than a decade beyond its revised and acclaimed 1940 second edition, authors Benjamin Graham and David Dodd had seen business and investment markets travel from the depths of Depression to the heights of recovery, and had observed investor behavior during both the calm of peacetime and the chaos of World War II.