The sixth edition of Security Analysis is a strange amalgamation of Graham’s original work (styled in British English) and new commentary from prominent value-oriented investors (in American English). I find it impossible to read fluidly. Nonetheless the contributors make a strong independent showing, especially Seth Klarman and his protégé, David Abrams. They argue—as I have done in numerous essays—that market inefficiencies are smaller in magnitude and frequency than before.

I am especially pleased that both men acknowledge the hedging opportunities present in derivative securities. This has become my favorite area of study and action—and one that appears unlikely to be outmoded soon. (Elsewhere, I have found much of the “value investing” philosophy to be comparatively inadequate.)

Excerpts:

While formulas such as the classic “net working capital” test are necessary to support an investment analysis, value investing is not a paint-by-numbers exercise. Skepticism and judgment are always required. For one thing, not all elements affecting value are captured in a company’s financial statements—inventories can grow obsolete and receivables uncollectible; liabilities are sometimes unrecorded and property values over- or under-stated. Second, valuation is an art, not a science. Because the value of a business depends on numerous variables, it can typically be assessed only within a range. Third, the outcomes of all investments depend to some extent on the future, which cannot be predicted with certainty; for this reason, even some carefully analyzed investments fail to achieve profitable outcomes. Sometimes a stock becomes cheap for good reason: a broken business model, hidden liabilities, protracted litigation, or incompetent or corrupt management.

Nevertheless, 25 years of historically strong stock market performance have left the market far from bargain-priced. High valuations and intensified competition raise the specter of lower returns for value investors generally.

In addition, because growing numbers of competent buy-side and sell-side analysts are plying their trade with the assistance of sophisticated information technology, far fewer securities seem likely to fall through the cracks to become extremely undervalued.

Great innovations in technology have made vastly more information and analytical capability available to all investors. This democratization has not, however, made value investors any better off. With information more widely and inexpensively available, some of the greatest market inefficiencies have been corrected. Developing innovative sources of ideas and information, such as those available from business consultants and industry experts, has become increasingly important.

Even complex derivatives not imagined in an earlier era can be scrutinized with the value investor’s eye. While traders today typically price put and call options via the Black-Scholes model, one can instead use value-investing precepts—upside potential, downside risk, and the likelihood that each of various possible scenarios will occur—to analyze these instruments. An inexpensive option may, in effect, have the favorable risk-return characteristics of a value investment—regardless of what the Black-Scholes model dictates.

Ira pointed to a stock… and asked me this question: “What if you buy the $35 calls, sell the $40 calls, buy the $40 puts, and sell the $35 puts all at the same time?” After a few minutes with pencil and paper, I looked up, still a bit confused, and said, “It’s always worth $5.” “Right,” he said. But still the light did not flicker in my brain until Ira asked, “What if you could buy it for $4.50?” Bingo! I finally got it. Even though I was new to Wall Street, I had done enough arbitrage to understand what Ira was saying. Typically, the most liquid option contracts are those with expiration dates relatively close by; which means that if you could buy this “box,” as it is called, consisting of two pairs of options for $4.50, you would make a guaranteed 11% on your money in less than six months.

It was my turn to pose a question. “Can you really buy them for $4.50?” I asked. “Sometimes,” he said. And then I realized who had been the proverbial patsy at the poker game. It was me. By relying on Graham and Dodd’s overly simplistic approach to the options market and not fully understanding the mathematics of the instruments in which I was investing, I didn’t appreciate how the trade might look to the person on the other side.

Unlike the world in which Graham and Dodd lived and worked, today’s security analyst is at a disadvantage without a good understanding of how option pricing models work and what their limitations are. Not only are derivatives pervasive in the financial markets but many corporations and investment entities use them for purposes both prudent and reckless.