The Economics of Security Analysis

Haitao Mo headshotHaitao Mo

June 21, 2022

BATON ROUGE- In their 1934 magnum opus Security Analysis, Benjamin Graham and David Dodd pioneered the concept of value investing, an investment philosophy that buys undervalued securities selling below their fundamental values. This philosophy has had a long-lasting impact on the asset management industry and helped create the financial analyst profession. Many famous investors, such as Warren Buffett, follow the Graham-Dodd philosophy.

The efficacy of security analysis has long been attributed to mispricing in financial markets. This contrasts with the famous theory of efficient markets, whereby no one can consistently outperform the standard of simply buying and holding a portfolio of equivalent risk. In other words, how can the Graham and Dodd approach “beat the market?”

In a new paper titled “The Economics of Security Analysis,” forthcoming in the prestigious journal Management Science, LSU Department of Finance Associate Professor Haitao Mo, along with colleagues Kewei Hou and Lu Zhang of the Ohio State University and Chen Xue of the University of Cincinnati, reconcile the apparent inconsistency of Graham-Dodd’s fundamental security analysis with the notion that stock prices reflect all there is to know.

The key to reconciliation is understanding security analysis through the lens of a concept called investment CAPM (Capital Asset Pricing Model), which provides an economic foundation. The basic philosophy of investment CAPM is to price stocks from the perspective of their issuers. The investment CAPM predicts that in efficient markets, a stock’s expected return is positively related to specific quality metrics, such as a firm's expected profitability and expected growth, and negatively related to valuation metrics. As such, to earn high expected returns, the investment CAPM recommends that investors buy high-quality stocks, meaning those with solid financial metrics, at bargain prices, a prescription that is exactly in line with Graham and Dodd’s approach, though without having to address whether a stock is mispriced.  

This new paper provides an economic foundation that validates the existence of the large profession of security analysis within the context of a world of relatively efficient markets. As a result of their research, the authors advocate that investors should always collect the best possible information on a firm’s expected profitability, expected growth, and valuation metrics. These three aspects are the only factors the investment CAPM (economic foundation) predicts to matter to a stock’s expected return.

 

Read the complete study.

 

About Management Science

Management Science is a scholarly journal that publishes scientific research on the theory and practice of management. The journal includes within its scope all aspects of management related to strategy, entrepreneurship, innovation, technology, and organizations as well as all functional areas of business, such as accounting, finance, information systems, marketing, and operations. The journal includes studies on organizational, managerial, group and individual decision making, from both normative and descriptive perspectives. The articles are primarily based on the foundational disciplines of computer science, economics, mathematics, psychology, sociology, and statistics, but cross-functional, multidisciplinary research that reflects the diversity of the management science professions is also encouraged. The journal interest extends to managerial issues in diverse organizational forms, such as for-profit and nonprofit firms, private and public sector institutions, and formal and informal networks of individuals. We welcome theoretical, experimental (field or lab) and empirical contributions.

The unifying thread of all Management Science articles is an analytical focus on improving the understanding of management. An acceptable manuscript must be relevant to the theory or practice of management, must meet high standards of rigor, and must be of broad interest to the community of management science scholars.

 

About the Department of Finance

The Department of Finance offers high-quality curricula to undergraduate and graduate students interested in careers in corporate finance, asset management, real estate, insurance, banking, financial planning and business law. The department boasts internationally renowned research faculty in several areas, including derivatives, asset management, banking and spatial econometrics. The department’s Securities Markets Analysis Research & Trading Lab utilizes the Bloomberg Professional service, the platform used by more than 300,000 leading business and financial professionals worldwide to make informed business decisions, and an extensive library of financial databases including the Wharton WRDS System. Additionally, the department encourages, supports and conducts research in real estate by housing the nationally renowned Real Estate Research Institute. For more information, visit lsu.edu/business/finance or call 225-578-6291.

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Contact:
Bridget Conrad
E. J. Ourso College of Business
225-578-4184
bconra2@lsu.edu