A Modern Approach to Graham and Dodd Investing

An updated approach to classic security analysis
The principles of value investing outlined by Graham and Dodd in the 1940s continues to be used today by individuals and companies who face challenging investment decisions. A Modern Approach to Graham and Dodd Investing examines the classic Graham and Dodd approach to valuation and updates it for the twenty-first century. Thomas Au, a credentialed analyst with a leading insurance company and an ex-Value Line analyst, reworks the basics of value investing from net present value, financial statement analysis, and return on capital to return and leverage, asset allocation, and diversification. Through case studies and real-time analysis, A Modern Approach to Graham and Dodd Investing presents readers with examples that will make analysis and portfolio theory more relevant and powerful.
Thomas P. Au (Hartford, CT) is a Vice President and Portfolio Manager for the investment arm of a large insurance and healthcare provider. His specialty is emerging and international markets. He received his BA, cum laude, with a double major in economics and history, from Yale University, and an MBA in finance from New York University.

PREFACE xi

PART I Basic Concepts 1

CHAPTER 1 Introduction 3

CHAPTER 2 Investment Evaluations and Strategies 16

PART II Fixed-Income Evaluation 29

CHAPTER 3 Foundation of Fixed Income 31

CHAPTER 4 Fixed-Income Issues of Corporations 47

CHAPTER 5 Distressed Fixed Income 63

PART III Equity Evaluation 79

CHAPTER 6 Cash Flows and Capital Expenditures 81

CHAPTER 7 Analysis of Asset Value 96

CHAPTER 8 Some Observations on the Value of Dividends 112

CHAPTER 9 Some Warnings about the Use of Earnings in Valuation 127

CHAPTER 10 Sales Analysis 143

PART IV Special Vehicles for Investment 157

CHAPTER 11 A Graham and Dodd Approach to Mutual Funds 159

CHAPTER 12 A Graham and Dodd Approach to International Investing 174

CHAPTER 13 A Graham and Dodd View of Real Estate 187

PART V Portfolio Management 203

CHAPTER 14 The Question of Asset Allocation 205

CHAPTER 15 The Concepts of Graham and Dodd versus Modern Theories and Practices 220

CHAPTER 16 Case Studies in Graham and Dodd Investing 234

CHAPTER 17 A Real-Time Experiment 257

PART VI Some Contemporary Issues 271

CHAPTER 18 A Historical View of the Dow and the “Market” 273

CHAPTER 19 Some Disquieting Thoughts on Excessive Credit Creation 292

CHAPTER 20 Generational Cycles in the American Stock Market 306

ENDNOTES 321

BIBLIOGRAPHY 327

INDEX 329

“A worthwhile read for investors interested in fundamental analysis following along upon the concepts of Benjamin Graham and David Dodd. The author remains true to the general principles and discipline of the two original fundamental investors when evaluating . . . more modern investments. Many readers may find these sections of particular interest. . . Mr. Au has attempted to extrapolate the thinking of two great investment authors of yesteryear. On balance, he has successfully completed the mission.”(Seeking Alpha)

THOMAS P. AU is a Vice President and Portfolio Manager for the investment arm of a large insurance and healthcare provider. His specialty is emerging and international markets. He has also worked for Unifund, an emerging markets firm in Geneva, Switzerland. Previously, he was an analyst for Value Line, an investment information company in New York City, serving in various capacities from 1983 to 1994. Mr. Au has received his BA, cum laude, with a double major in economics and history, from Yale University, and an MBA in finance from New York University.

Benjamin Graham and David Dodd were among the first investors to make the transition from thinking like traders to thinking like owners. In the shadow of the 1929 stock market crash, they posed a set of questions that are still applicable today: What would a reasonable businessperson, as opposed to a speculator, pay for a company and still considerthat he or she was getting a bargain? What entry price would almost guarantee at least an eventual return of capital with good prospect for gains? Could a prudent investor reasonably allow for a margin of safety in his or her purchase?

Although the questions have remained the same, the ways to answer them have changed. A Modern Approach to Graham and Dodd Investing examines the classic Graham and Dodd approach to valuation and updates it for the twenty-first century. Thomas Au, a portfolio manager with a leading insurance company and ex-Value Line analyst, reworks the basics of value investing from net present value, financial statement analysis, and return on capital to return and leverage, asset allocation, and diversification.

Before learning about the modifications to Graham and Dodd’s principles of value investing, you’ll be introduced to some basic investment concepts and mathematical measures forthe calculation of investment returns. From there—although the focus of the book is on stocks—you’ll first become familiar with bonds, because an understanding of the risk and return characteristics for bonds underpins an understanding of those for equities.

Recent examples, including Enron and WorldCom, are introduced throughout these pages, to illustrate exactly how you can use this updated approach to your advantage. Topics ­explored in this comprehensive book, include:

Part I: Basic Concepts

Part II: Fixed Income Evaluation—bills, notes, bonds

Part III: Equity Evaluation—cash flows, capital expenditures, asset value, dividends, ­earnings

Part IV: Special Vehicles for Investment—mutual funds, international investing, real estate

Part V: Portfolio Management—asset allocation, modern theories vs. Graham and Dodd

Part VI: Some Contemporary Issues—the Dow, excessive credit creation, generational ­cycles in the American stock market

A Modem Approach to Graham and Dodd Investing examines the changes that have taken place in the financial world since the days of Graham and Dodd, and reveals the necessary modifications you must make in order to apply these value investing principles in today’s markets. Filled with in-depth insight and practical advice, this valuable resource offers an updated form of Graham and Dodd that will help you face today’s market realities.