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To examine the relevance of Security Analysis to fixed income invest- ments, I reviewed Graham and Dodd’s process for bond investing, and I compared their approach to the one applied by my firm, Oaktree Capital Management, L.P.

The bottom line is that, while Graham and Dodd’s thoughts may be expressed differently, most are highly applicable to today’s investment world. In fact, they strongly parallel the approach and methodology

developed and applied in the area of high yield bonds over the last 30 years by my partner, Sheldon Stone, and me.

1. Our entire approach is based on recognition of the asymmetry that underlies all nondistressed bond investing. Gains are limited to the promised yield plus perhaps a few points of appreciation, while credit losses can cause the disappearance of most or all of one’s principal. Thus the key to success lies in avoiding losers, not in searching for winners. As Graham and Dodd note:

Instead of associating bonds primarily with the presumption of safety— as has long been the practice—it would be sounder to start with what is not presumption but fact, viz., that a (straight) bond is an investment with limited return. . . .

Our primary conception of the bond as a commitment with limited return leads us to another important viewpoint toward bond investment. Since the chief emphasis must be placed on avoidance of loss, bond selection is primarily a negative art. It is a process of exclusion and rejec- tion, rather than of search and acceptance. (p. 143)

2. Our high yield bond portfolios are focused.We work mostly in that part of the curve where healthy yields on B-rated bonds can be earned and where the risk of default is limited. For us, higher-rated bonds don’t have enough yield, and lower-rated bonds have too much uncertainty. This B zone is where our clients expect us to operate.

It would be sounder procedure to start with minimum standards of safety, which all bonds must be required to meet in order to be eligible for further consideration. Issues failing to meet these minimum requirements should be automatically disqualified as straight investments, regardless of high yield, attractive prospects, or other grounds for partiality. . . . Essentially, bond selection should consist of working upward from definite minimum standards rather than working downward in haphazard fashion from some ideal but unacceptable level of maximum security. (pp. 167–168)

3. Credit risk stems primarily from the quantum of leverage and the firm’s basic instability, the interaction of which in tough times can erode the margin by which interest coverage exceeds debt service requirements.A company with very stable cash flows can support high leverage and a heavy debt service. By the same token, a company with limited lever- age and modest debt service requirements can survive severe fluctu- ations in its cash flow. But the combination of high leverage and undependable cash flow can result in a failure to service debt, as investors are reminded painfully from time to time. Graham and Dodd cite the very same elements.

Studying the 1931–1933 record, we note that price collapses [among industrial bonds] were not due primarily to unsound financial structures, as in the case of utility bonds, nor to a miscalculation by investors as to the margin of safety needed, as in the case of railroad bonds. We are con- fronted in many cases by a sudden disappearance of earning power, and a disconcerting question as to whether the business can survive. (p. 157)

4. Analysis of individual issues calls for a multifaceted approach.Since 1985, my team of analysts has applied an eight-factor credit analysis process developed by Sheldon Stone. Most of the elements are reflected in—perhaps ultimately were inspired by—aspects of Gra- ham and Dodd’s thinking. Our concerns are with industry, company standing, management, interest coverage, capital structure, alterna- tive sources of liquidity, liquidation value, and covenants. Security Analysisreflects many of these same concerns.

On company standing:“The experience of the past decade indicates that dominant or at least substantial size affords an element of protection against the hazards of instability.” (p. 178)

On interest coverage: “The present-day investor is accustomed to regard the ratio of earnings to interest charges as the most impor- tant specific test of safety.” (p. 128 on accompanying CD)

On capital structure:“The biggest company may be the weakest if its bonded debt is disproportionately large.” (p. 179)

5. “Buy-and-hold” investing is inconsistent with the responsibilities of the professional investor, and the creditworthiness of every issuer repre- sented in the portfolio must be revisited no less than quarterly.

Even before the market collapse of 1929, the danger ensuing from neglect of investments previously made, and the need for periodic scrutiny or supervision of all holdings, had been recognized as a new canon in Wall Street. This principle, directly opposed to the former practice, is frequently summed up in the dictum, “There are no permanent investments.” (p. 253)

6. Don’t engage in market timing based on interest rate forecasts. Instead, we confine our efforts to “knowing the knowable,” which can result only from superior efforts to understand industries, companies, and securities.

It is doubtful if trading in bonds, to catch the market swings, can be carried on successfully by the investor. . . . We are sceptical of the ability of any paid agency to provide reliable forecasts of the market action of either bonds or stocks. Furthermore we are convinced that any combined effort to advise upon the choice of individual high-grade investments and upon the course of bond pricesis fundamentally illogical and confusing. Much as the investor would like to be able to buy at just the right time and to sell out when prices are about to fall, experience shows that he is not likely to be brilliantly successful in such efforts and that by injecting the trading element into his investment operations he will . . . inevitably shift his inter- est into speculative directions. (p. 261)

7. Despite our best efforts, defaults will creep into our portfolios, whether due to failings in credit analysis or bad luck.In order for the incremental yield gained from taking risks to regularly exceed the losses incurred as a result of defaults, individual holdings have to be small enough so that a single default won’t dissipate a large amount of the portfolio’s

capital. We have always thought of our approach to risk as being akin to that of an insurance company. In order for the actuarial process to work, the risk has to be spread over many small holdings and the expected return given a chance to prove out. Thus, you should not invest in high yield bonds unless you can be thoroughly diversified.

The investor cannot prudently turn himself into an insurance company and incur risks of losing his principal in exchange for annual premiums in the form of extra-large interest coupons. One objection to such a policy is that sound insurance practice requires a very wide distribution of risk, in order to minimize the influence of luck and to allow maximum play to the law of probability. The investor may endeavor to attain this end by diversifying his holdings, but as a practical matter, he cannot approach the division of risk attained by an insurance company. (pp. 165–166)

To wrap up on the subject of investment approach, we feel the suc- cessful assumption of credit risk in the fixed income universe depends on the successful assessment of the company’s ability to service its debts. Extensive financial statement analysis is not nearly as important as a few skilled judgments regarding the company’s prospects.

The selection of a fixed-value security for limited-income return should be, relatively, at least, a simple operation. The investor must make certain by quantitative tests that the income has been amply above the interest charges and that the current value of the business is well in excess of its debts. In addition, he must be satisfied in his own judgment that the char- acter of the enterprise is such as to promise continued success in the future, or more accurately speaking, to make failure a highly unlikely occur- rence. (p. 160 on accompanying CD)

In the end, though, we diverge from Graham and Dodd in one impor- tant way. In selecting bonds for purchase, we make judgments about the issuers’ prospects, and here’s why: When I began to analyze and manage high yield bonds in 1978, the widely held view was that investing in bonds and assessing the future are fundamentally incompatible, and that

prudent bond investing must be based on solid inferences from past data as opposed to speculation regarding future events. But credit risk is prospective, and thus substantial credit risk can be borne intelligently only on the basis of skilled judgments about the future.

In large part, the old position represented a prejudice: that buying stocks—an inherently riskier proposition—can be done intelligently on the basis of judgments regarding the future, but depending on those same judgments in the more conservative world of bond investing just isn’t right. Some of the greatest—and most profitable—market inefficien- cies I have encountered have been the result of prejudices that walled off certain opportunities from “proper investing” . . . and thus left them for flexible investors to pick off far below their fair value. This seems to be one of these prejudices.

One of the reasons I started First National City Bank’s high yield bond portfolio in 1978 was my immediately prior experience as the bank’s director of research for equities. All I had to do, then, was apply the future-oriented process for analyzing common stocks to the universe of bonds rated below triple B.

Few walls still stand in the investment world today, and it is widely understood that forward-looking analysis can be profitably applied to instruments of all sorts. That lesson remained to be learned in 1940.