Getting Started in Security Analysis. P. Klein

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You are about to begin a journey into the science of investment analysis. Many of you may think that using the word science to describe the activities of Wall Street is a misnomer. Luck, chance, or voodoo are probably closer to your explanation of investment activity. I hope to convince you otherwise. As you make this journey, it should become obvious that investment analysis and its related extensions are rigorous enough to be taken as an actual science. Like other scientific disciplines, investment analysis requires a working knowledge of its basic concepts. Part One explores these concepts, with considerable emphasis on exercises that hone awareness, expertise, and understanding of this once arcane subject. A century ago, the task of investment counseling belonged to men of prudence who, for fear of being wrong, usually invested funds with guaranteed returns and did not rely on scientific discipline. The fear of not being beyond reproach—otherwise known as ''reputation fear"—provided enough guidance for these men.

Typically the wealthy and elite, they did not see the utility of investment analysis for the simple reason that they did not have to—they were already rich. Today, investment analysis plays a meaningful role in planning for a comfortable financial future. This book provides the reader with a firm foothold on this important subject (although the basic concepts may prove helpful in many of life's other exercises). Mastery of investment analysis takes much more than a cursory read through this text; it requires years of study and perhaps decades of
practical experience. My hope is to provide today's investor, novice or seasoned, with enough understanding to simulate the workings of Wall Street analysts.

An investor, after reading this manual, will have a fundamental store of financial information; will understand the terms, pricing, and research of a financial services provider; and will find the daily financial papers more interesting. Many investors of the 1990s are well aware of the basics of financial planning through exposure to myriad seminars, books, magazines, and Web sites. They need the next level of information. Just think about how many of your friends understand the risk-return trade-off (more risk, more return), asset allocation (spreading assets around into many classes), and the need for long-term investing habits. But how many wish they understood how a company's shares are valued, or how the workings of regression analysis and the typical economic releases in a given month directly affect the value of their investments? Part One is designed to provide this essential background. Part Two, "Fundamental Financial Security Analysis," sets forth the notion that the tools described in Part One can be of practical use only if the investor understands how a given company is valued. Thus in this Part, I explain the methodology behind the valuation techniques of a company's equity and debt securities:

With tomes of data available, how should we quantify the value of this company? Which calculations must be executed to ascertain the true value of this company?

Consequently these valuation techniques build on the lessons of Part One. Without a firm understanding of the tools analysts use, it is impossible to firmly grasp the true valuation process. Part Three, "Portfolio Management," is a discussion of the investment management process—the symbiosis of the tools and valuation techniques with the financial planning process. It includes an examination of the laws and regulations that govern this highly regulated industry. To fully grasp these legal constraints, today's serious investor must understand and be able to use the investment management process. Lastly, as a housekeeping item, the reader should be aware of some literary licenses taken in this text. The pronouns "he" and "she" are used interchangeably throughout; this is done for stylistic simplicity and does not reflect the current percentage breakdown in the investment analysis field.

The terms VFII (Very Financially Interested Individual—pronounced "vif-fee") and NFII (Not Financially Interested Individual—pronounced "nif-fee'') are introduced early on in this text and refer to the current investment-user market. People who have started to read this book should consider themselves either a VFII or a reformed NFII. The terms analyst, practitioner, and investor (seasoned or novice) are also interchangeable throughout this work, and in each case the word refers to the user of investment analysis. From professional to novice, all analysts should be in the continual learning phase.

The professional analyst specializing in real estate may require a briefing on the workings of the equity market, just as a seasoned investor could be brought up to date on the changing dynamics of macroeconomics releases. While the ultimate purpose of this book is to educate today's proactive investor in the science of investing, by no means can it serve as a proxy for a complete education in this expansive field. It can, however, provide the investor with a solid foundation of knowledge. Any interested investor (VFII) can request an incessant flow of research reports from either his representative at the issuing firm or the company itself (most companies will release the research reports; however, they require the prior permission of the analyst's firm to do so); but understanding jargon-laden reports usually takes more than a cursory background in the subject.

As a first step toward a better comprehension of the research reports issued by firms, it is a good idea to study what the professional groups look for in a quality report. The Association of Investment Management and Research (AIMR) has published a new (1996) version of its Standards of Practice Handbook. It is the source of the following checklist (reprinted with permission). This list is used for illustrative purposes only and is not intended to be all-inclusive. These investor guidelines are helpful for when determining whether the writer of the research report exercised diligence and thoroughness.

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