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Intelligent Investor PO Box 1158 Bondi Junction NSW 2022 T 02 8305 6000 F 02 9387 8674 [email protected] www.intelligentinvestor.com.au Masterclass: Benjamin Graham REPORT PUBLISHED DECEMBER 2005

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Intelligent InvestorPO Box 1158 Bondi Junction NSW 2022T 02 8305 6000 F 02 9387 [email protected] www.intelligentinvestor.com.au

Masterclass:Benjamin Graham

rePOrT PuBliShed decemBer 2005

Share adviSor 2

PO Box Q744 Queen Victoria Bldg. NSW 1230T 1800 620 414F 02 9387 8674info@intelligentinvestor.com.aushares.intelligentinvestor.com.au

DISCLAIMER This publication is general in nature and does not take your personal situation into consideration. You should seek financial advice specific to your situation before making any financial decision.

Past performance is not a reliable indicator of future performance. We encourage you to think of investing as a long-term pursuit.

COPYRIGHT© The Intelligent Investor Publishing Pty Ltd 2011. Intelligent Investor and associated websites and publications are published by The Intelligent Investor Publishing Pty Ltd ABN 12 108 915 233 (AFSL No. 282288). PO Box 1158 Bondi Junction NSW 1355. Ph: (02) 8305 6000 Fax: (02) 9387 8674.DATE OF PUBLICATION 20 December 2005, layout updated Sep 2014

CONTENTS

investing lessons from Ben Graham, the father 3 of value investing

The value investing philosophy 6

Graham’s approach to stock selection 8

conclusion 10

Further reading 10

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Investing lessons from Ben Graham, the father of value investing

“Over forty years after publication of the book that brought structure and logic to a disorderly and confused activity, it is difficult to think of possible candidates for even the runner-up position in the field of security analysis. In an area where much looks foolish within weeks or months after publication, Ben’s principles have remained sound – their value often enhanced and better understood in the wake of financial storms that demolished flimsier intellectual structures”.

These words from history’s most successful investor, Warren Buffett, sum up Ben Graham’s contribution to investment thinking. Graham reintroduced the stockmarket to the idea of value, when it had seemed all but forgotten, and even since his death in 1976 he remains the guiding light of value investors the world over. His books, Security Analysis, co-written with his former student David Dodd in 1934, and The Intelligent Investor (1949), are synonymous with the value investing approach (see page 10 for more about these books). Our own publication, you will have noticed, is named in his honour.

Graham’s principles for ‘intelligent investing’ have been incredibly successful, with a large proportion of the most successful investors in the second half of the twentieth century following the value investing framework that he set out. Indeed there was such a concentration of ‘Graham and Dodders’ in the list of top-performing investors that Warren Buffett, the most famous disciple of all, examined the point in a famous lecture titled ‘The Superinvestors of Graham-and-Doddsville’.

BEACON OF LIGHT

But Graham’s influence on the value investing world extends far beyond a framework for making money. He was renowned for being a kind, generous man with a great sense of humour. Investing was an intellectual pursuit – one of many in his life – and, once his financial situation was comfortable, money was of little consequence to him. He always conducted his affairs with the greatest of honesty and integrity and this approach has been maintained by his most famous followers. In an industry that’s dominated by greed and outrageous fees, long may this little beacon of light continue to shine.

Benjamin Grossbaum (later Graham) was born in London on 8 May 1894, reportedly a grand nephew of the Chief Rabbi of Warsaw. When he was about a year old, however, he sailed for New York with his parents. His early childhood, and indeed his life, was characterised by more than his fair share of misfortune.

A few years after their arrival in New York, Ben’s father died, leaving his wife, Dora, and their three sons struggling with an ailing import business. The subsequent years saw

the business fail, with Dora and the children turning to running a boarding house to make ends meet. Despite years of determined work, that business also failed. So things were already looking grim when Dora purchased a variety of steel shares on margin only to see 49% of their value wiped out in the 1907 stockmarket crash.

EDUCATION

The one light in Ben’s life was education. For many of Ben’s early years, the Grossbaums lived with Maurice Gerard, Dora’s older brother, and his family. A scientific thinker and disciplinarian, Maurice had a strong influence on Ben’s intellectual development.

Ben had a phenomenal memory and he could read in six languages, and his schooling progressed so well that he was entered for a national scholarship examination. His family was certain he’d be awarded a scholarship and was stunned when he failed to receive an offer. To make matters worse, a relative had received the second-highest mark ever given in the test and was awarded a scholarship to Columbia University.

After a few months, the University noticed two things: that the Grossbaum with the scholarship was not performing so well and that the scholarship tests had been mixed up. It was Ben who was supposed to be studying at Columbia not his cousin.

THE MOST BRILLIANT FINANCIAL STRATEGY

On entering the university, he took courses in language and literature, history and philosophy – business or similar studies were conspicuous by their absence. On graduating, he was offered teaching positions in the English, philosophy and mathematics departments. But childhood poverty had left a lasting impact on Graham and he left Columbia for Wall Street. Having chosen a profession that would ensure him a degree of financial security, he discovered that ‘the most brilliant financial strategy consists of living well within one’s means’.

Within a couple of months of starting work as a runner for the Wall Street broking firm of Newburger, Henderson and Loeb for US$12 a week, the Great War broke out, the stock exchange was closed and his wage was reduced to US$10 a week. Undaunted by this,

Graham set about learning everything he could about the stockmarket. No doubt his bosses quickly recognized that they had a rare talent on their hands and, when the market reopened, he was soon writing investment reports and the firm’s daily market letter. In 1920, at the age of 26, Graham was promoted to full partner.

GEICO

GGeicO was founded in 1936 as the Government employees insurance company and Graham bought half of it in 1948. The investment was initially made for the Joint Account, but he was forced to distribute the shares to his individual investors because of a rule that only permitted investment funds to own up to 10% of any insurance company.

At the time of the purchase, Graham apparently said to his former student and employee Walter Schloss (who went on to become one of the very successful ‘Graham-and-dodders’) ‘Walter, if this purchase doesn’t work out, we can always liquidate it and get our money back.’ The purchase did work out and GeicO has subsequently branched out to become one of the largest insurers in America with assets of more than uS$21bn. By 1996, when the company was bought out in its entirety by Berkshire hathaway.

Warren Buffett’s investment vehicle, the shares had increased in value by approx. 3,000 times. Graham would have been the first to concede that the GeicO investment performed way beyond his wildest expectations, but it sums up his value approach extremely well. By ensuring that you have a wide margin of safety against any downside, you effectively get the benefit of any upside for free.

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number-crunching and with the key concepts introduced in more accessible fashion. A particularly famous example is ‘The parable of Mr Market’, which is shown on page 7.

The Joint Account generated returns of 17% per year over a 20-year period following the 1929 crash, compared to 14% for the S&P 500 index, yet this doesn’t include the returns from GEICO (see page 3), which was probably the most successful investment that Graham ever made.

Graham eventually retired from the world of investment in 1956 and the Graham–Newman partnership was disbanded. As he said in an interview for Financial Analysts Journal in 1976, shortly before his death:

I felt that I had established a way of doing business to a point where it no longer presented any basic problems to be solved. We were going along on what I thought was a satisfactory basis, and the things that presented themselves were typically repetitions of old problems which I found no special interest in solving.

Since several of Graham–Newman’s employees went on to become extremely successful investors in their own right, it’s ironic that the reason given for winding up the partnership was that there was no natural successor to Graham. A large number of Graham’s clients did, however, migrate naturally to his former employees: Warren Buffett, Walter Schloss and Tom Knapp.

LIFE OF THE MIND

Throughout his life, Graham pursued a life of the mind. An adherent of Platonic reasoning, he applied his devastating skills to his own profession whilst finding time to write three plays, undertake translations of Latin, French and German poetry, Uruguayan literature, and write a little poetry of his own. As he himself acknowledged, his poetry will turn fewer heads than his theories on finance, and his one play that made the Broadway stage, Baby Pompadour, was withdrawn after only four nights. Nonetheless, he derived great joy from the arts and in a speech on his eightieth birthday he reflected on a life of learning:

I want to say that at least half of all the pleasures that I have enjoyed in life have come from the world of the mind, from things of beauty and culture in literature and in art. All this is offered to everybody, virtually free of charge, except for the interest to start and the relatively slight effort to appreciate the riches spread out before you…take that initial interest, if possible: make that continued effort. Once you have found it – the life of culture – never let it go.

LOvE AND LOSS

Graham’s personal life existed in stark contrast to the ordered recesses of his mind.

His first son, Isaac Newton, died of meningitis aged 9 plunging his family into a grief that lasted until the birth of their second son, Newton. Tragedy was to strike again when Newton was drafted to fight in the Korean war. During the war, Newton became mentally ill and took his own life.

THE GREAT CRASH

In 1923, Graham established an investment vehicle, Grahar Corporation, but this was replaced by what became known simply as the Joint Account in 1926. The Joint Account had grown to about US$2.5m in assets by 1929, when Graham formed the Graham–Newman Partnership with Jerome

Newman. When the crash came in October that year, the undervalued shares on which Graham focused merely deflated gently while the bubble was bursting elsewhere and the Joint Account lost a tolerable 20%.

Unfortunately, however, the crash in 1929 was merely a harbinger of what was to come. By 1930, the market was offering up a large number of attractive value situations and Graham borrowed money so that he could increase the Joint Account’s investments. By now, however, the market was gripped by fear, and investors weren’t interested in making distinctions between overvalued and undervalued: they didn’t really want to own any shares all. So when the bottom fell out of the market, it took Graham’s brand of value share down with it.

By 1932, the leveraged Joint Account had fallen 70%, compared with the index’s 74% fall, and Graham was on the brink of ruin. By ignoring the market’s ‘sentiment’, it looked as though he had been hoist by his own petard. But the truth is more mundane. Graham’s strategy was perfectly sound, but it also required patience and, by borrowing money, he had restricted his ability to wait for the market to return to more rational valuations and increased his losses through leverage.

You’ll have guessed, however, that the story has a happy ending. The Graham family battened down its hatches and moved from a luxury duplex apartment overlooking Central Park to cheaper accommodation around the corner. Graham himself stopped his own pay from the partnership and his wife went back to work as a dance teacher. Most crucially of all, perhaps, was the injection of US$75,000 of capital by a relative of Jerome Newman, which enabled the partnership to survive.

SECURITY ANALYSIS

With the stockmarket almost comatose, Graham had plenty of time to write Security Analysis with former student David Dodd. He had originally considered writing a book on investment in 1925, but decided to learn everything he could about the subject before getting started. To this end, he took a post teaching investment at his alma mater, the University of Columbia, in 1928. Many of the investors who later became famous by following his principles, most notably Warren Buffett, first learned them on his course at Columbia. But it was one of his first students, David Dodd, that was his collaborator on Security Analysis.

The book was and is an astonishing success, being still considered the bible of the profession to this day. In 1949, Graham published The Intelligent Investor, which was more directed towards smart amateurs than towards the investment profession. The book deals with the same basic philosophy as Security Analysis, but with less

an adherent of Platonic reasoning, he applied his devastating skills to his own profession whilst finding time to write three plays, undertake translations of Latin, French and german poetry, Uruguayan literature, and write a little poetry of his own.

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Graham spent a large part of his life looking for, and trying to understand, love. He was married three times – to Hazel Mazur, Carol Wade and Estelle Messing – and had a string of extramarital affairs. In his memoirs, he admits to having difficulty in relation to women. The illogical nature of love confounded him, and he compared irrational investing to choosing a wife in Chapter 10 of The Intelligent Investor:

It is difficult to describe how most investors go about the business of choosing common stocks. By exactly what mental process does A decide that he wants Bethlehem Steel at 35, while B prefers Woolworth at 46, and C selects Allied Chemical at 190? The operation seems to be something like choosing a wife. A number of concrete factors are weighed more or less carefully, to which is then added a strong and perhaps controlling component of favouritism.

He reflected in his memoirs how he became wary of romantic love after his divorce from Hazel:

It seemed to me that the ideal relationship, for my

temperament at least and perhaps for people generally, would be a combination of sincere friendship with sex. This combination appeared to offer most of the advantages of romantic love without any of its serious disadvantages.

At age 60, he resolved to begin his emotional development all over again; he was to accept love not as an experience of life, but as the experience of life. A lifelong disciple of learning, Graham had an ability to constantly examine himself and his beliefs. In his later years, he sought the emotional development to match his mastery of the rational world. In his last interview before he died, he said:

On the whole I’ve had a very happy life, but perhaps I have not had enough enthusiasms. I was never enough of a gourmand, for example, or really appreciated nature or the aesthetic part of life. Perhaps I should regret not having made more mistakes.’

Benjamin Graham died during the night of 21 September, 1976. He was 82 years old.

in 1984, to celebrate the 50th anniversary of Security Analysis, columbia university hosted a debate on the efficient market hypothesis, which maintains that all available information about a company is quickly reflected in its stock price, so that consistently achieving superior investing results by selecting individual stocks is impossible. Speaking in favour of the theory, the university of rochester’s michael Jensen dismissed successful stock pickers as a statistical aberration, saying:

if i survey a field of untalented analysts all of whom are doing nothing but flipping coins, i expect to see some who have tossed two heads in a row and even some who have tossed ten heads in a row.

Graham’s former friend and star pupil, Warren Buffett countered this assertion with a speech that has become known as ‘The Superinvestors of Graham-and-doddsville’. he took his opponent’s lead on coin-flipping and suggested a national contest. everyone in the united States would wager a dollar on a winner-takesall coin-flipping contest. every day, those remaining would flip a coin with those calling their flip incorrectly dropping out. After 10 days, only 220,000 would be left. in Buffett’s words:

Now this group will probably start getting a little puffed up about this, human nature being what it is. They may try to be modest, but at cocktail parties they will occasionally admit to attractive members of the opposite sex what their technique is, and what marvellous insights they bring to the field of flipping … in another ten days we will have 215 people … By then, this group will really lose their heads. They will probably write books on “how i turned a dollar into a million in Twenty days Working Thirty Seconds a morning”. Worse yet, they’ll probably start jetting around the country attending seminars on efficient coin-flipping techniques and tackling skeptical professors with, “if it can’t be done, why are there 215 of us?”. But then some business school professor will probably be rude enough to bring up the fact that if 225 million orangutans had engaged in a similar exercise, the results would be much the same – 215 egotistical orangutans with 20 straight winning flips. i would argue, however, that there are

THE SUPERINvESTORS OF GRAHAM-AND-DODDSvILLE

some important differences in the examples i am going to present. For one thing, if (a) you had taken 225 million orangutans distributed roughly as the uS population is; if (b) 215 winners were left after 20 days; and if (c) you found that 40 came from a particular zoo in Omaha, you would be pretty sure you were on to something … i submit to you that there are ways of defining origin other than by geography. in addition to geographical origins, there can be what i call an intellectual origin. i think you will find that a disproportionate number of successful coin-flippers in the investment world come from a very small intellectual village that could be called Graham-and-doddsville.Buffett then went on to describe the careers of a number of Graham’s students, employees and followers who, crucially, he had picked out in advance as above average investors, and whose results had subsequently proved them to be so. Walter Schloss, Tom Knapp, ed Anderson, Warren Buffett, charlie munger, Bill ruane, rick Guerin and Stan Perlmeter had all, independently, developed Graham’s ideas and absolutely hammered the S&P 500 index over a number of years. Very few from outside the Graham-and-dodd school of investing had achieved such sparkling results. The message was, and is, quite clear: the success of those following Ben Graham’s teachings cannot be put down to chance.

each of these ‘superinvestors’ generated their extraordinary returns independently and developed Graham’s ideas to suit their own personality and skills. Walter Schloss would own as many as 800 stocks at any one time, while charlie munger’s portfolio was concentrated in the few opportunities he thought were exceptional value.

What they all had in common was Graham’s value approach. They all valued shares in a businesslike way and tried to buy them for significantly less than their ‘intrinsic value’ (of course some of them still do so).

how the actual value is calculated differed between them but, as you can see for yourself, the results are impressive whichever way you skin the cat.

SUPERINvESTORS’ RESULTS

WALTER SCHLOSS (WJS LTD PARTNERS)

PERIOD: 1956–1984 INDEx RETURN: 8.4% (S&P 500) FUND RETURN: 21.3%

TOM KNAPP, ED ANDERSON (TWEEDY, BROWN)

PERIOD: 1968–1983 INDEx RETURN: 7.0% (S&P 500) FUND RETURN: 20.0%

WARREN BUFFETT (BUFFETT PARTNERSHIP)

PERIOD: 1957–1969 INDEx RETURN: 7.4% (dJiA) FUND RETURN: 29.5%

BILL RUANE (SEqUOIA FUND)

PERIOD: 1970–1984 INDEx RETURN: 10.0% (S&P 500) FUND RETURN: 18.2%

CHARLES MUNGER (MUNGER PARTNERSHIP)

PERIOD: 1962–1975 INDEx RETURN: 5.0% (dJiA) FUND RETURN: 19.8%

RICK GUERIN (PACIFIC PARTNERS)

PERIOD: 1965–1983 INDEx RETURN: 7.8% (S&P 500) FUND RETURN: 32.9%

STAN PERLMETER PERLMETER INvESTMENTS

PERIOD: 1965–1983 INDEx RETURN: 7.0% (dJiA) FUND RETURN: 23.0%

The illogical nature of love confounded him, and he compared irrational investing to choosing a wife.

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typical bond buyer. The chief weakness of these investment principles was the difficulty of adhering firmly to them in the speculative contagion of 1928 and 1929.

Graham had certainly not lost faith in his methods – they had far too firm an intellectual foundation for that – but he had clearly thought long and hard about the crash and how best it could have been managed at the time. Lessons hold true today There are two important lessons from Graham’s experience of the Great Depression that still hold true today. Firstly, the stockmarket can swing wildly in both directions and massively overshoot any rational estimate of underlying value. Back in the twenties, much of the frenzy surrounded radio shares. Around the turn of the new century, it was the internet. The crucial link, apart from the obvious, is that few companies caught up in the contagion were making a profit and most were impossible to value. That only encouraged the market to push the prices of companies higher and higher, using whatever valuation metric people could dream up. During the internet bubble, ‘analysts’ started using eyeballs as a valuation metric. We can only guess that it was eardrums in the 1920s.

Importantly, though, in the aftermath of both collapses, the good – that is, undervalued – shares were dragged down with the rest and investors operating on the basis of value should have done reasonably well, so long as they were able to stick to their basic principles. They would have been miles away from the most overvalued stocks in 1999 and 2000 and, while they might have jumped into some value situations a little early in 2001 and 2002, patience would have provided some wonderful rewards.

DANGERS OF DEBT

The second lesson from Graham’s Depression experience relates to the dangers of debt, and it’s especially relevant in today’s market where margin loans seem almost to be treated as a lifestyle accessory. When markets turn sour they can become just as irrational on the downside as they were on the upside. That’s the time to be buying shares, not selling them to meet a margin call.

As Graham understood only too well, his main problem had been that, by borrowing money, he had restricted his ability to be patient. That was easily solved – he never borrowed money to invest in shares again – but he was still concerned about the fact that some of his value shares had been able to fall by such a large amount. He responded to this by increasingly restricting himself to opportunities where the value was so clear and so far above the current share price that there was virtually no downside risk at all. This principle became known as the margin of safety.

While the rest of the market was mostly concerned with watching the price of stocks on the ticker tape and buying the ones that appeared to be going up, Graham was interested in buying value.

Every share, he reasoned, had an intrinsic value. And this value was often not reflected, in the short term, by their see-sawing stock prices. Over the longer term, however, stock prices would reflect the value of the underlying business.

As Graham explained it: ‘In the short run, the market is a voting machine, but in the long run it is a weighing machine.’ The voting is essentially speculation based on guessing what others in the market are going to do. If they tend to buy, then the price will go up and if they tend to sell, then the price will go down. As Graham and Dodd noted in Security Analysis, it’s ‘largely a matter of A trying to decide what B, C and D are likely to think – with B, C and D trying to do the same’.

Such speculators failed (and still fail more than seventy years later) to recognise the fundamental paradox of the market trying to chase its own tail in this manner. Such behaviour, however, frequently causes stock prices to depart dramatically from their intrinsic value. This allows smart investors to buy them cheap and make a profit – either by selling when they return to a more realistic price or simply by holding forever and collecting the undervalued dividends.

SPECULATIvE FRENzY

If anything, the speculative frenzy in the late 1920s and the crash itself reaffirmed Graham’s commitment to the value approach. But you can almost see the grimace on his face in the following passage from the introduction to Security Analysis.

Not only is the doctrine of common stocks as the best long-term investments in eclipse, but no less an authority than Lawrence Chamberlain has not hesitated to express the view that all stocks are by their nature essentially and unavoidably speculative…But a rigid observance of old-time canons of common-stock investment would have dictated the sale of one’s holdings at a substantial profit very early in the upswing and a heroic abstinence from further participation in the market until at some point after the 1929 collapse when prices were again attractive in relation to earnings and other analytical factors.

No doubt this would have resulted in making repurchases too soon – as matters turned out – with consequent paper or actual losses. But whatever the net result, the fact remains that the common-stock investor, proceeding along old-time conservative lines, had opportunities of profit commensurate with any risks he ran – an advantage not possessed by the

The value investing philosophyGraham began to formulate his revolutionary ideas on stockmarket investment in the 1920s. A t the time, investment in stocks and shares appeared nothing short of gambling, with selections based mainly on rumours, fads and insider information. Graham looked through all this to see the stock exchange for what it was (and is): a market for buying and selling small pieces of real businesses.

To achieve satisfactory results is easier than most people realize; to achieve superior results is harder than it looks.

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INTRINSIC vALUE

intrinsic value is the key concept in all value investing and, not surprisingly, Graham introduced it in the very first chapter of Security Analysis: [The investor is] concerned with the intrinsic value of the security and more particularly with the discovery of discrepancies between intrinsic value and the market price. We must recognize, however, that intrinsic value is an elusive concept. in general terms it is understood to be that value which is justified by the facts, eg the assets, earnings, dividends, definite prospects, as distinct, let us say, from market quotations established by artificial manipulation or distorted by psychological excesses. But it is a great mistake to imagine that intrinsic value is as definite and as determinable as is the market price.

Share prices swing around wildly, depending on the stockmarket’s prevailing sentiment, but you can imagine that they are attached to a share’s intrinsic value by a piece of elastic. Prices can’t depart from rational valuation forever and, in fact, the further they depart from that rational valuation, the more violent will be the eventual pullback. So much so, in fact, that they will typically overshoot in the other direction.

To make a good investment, you need to buy when you can be confident that the market price is below the intrinsic value and then wait patiently for the elastic to pull the price back up towards the intrinsic value. So value investors are concerned with two principal objectives: they need to produce good estimates of intrinsic value and they need to build in a margin of safety, so they can be confident they’re getting a bargain.

MARGIN OF SAFETY

The concept of a margin of safety had previously been used in the analysis of bonds but, in Security Analysis, Ben Graham extended its meaning to embrace shares. By the time he wrote The intelligent investor, it had become such a central concept in his investing philosophy that it was given pride of place in the concluding chapter: ‘margin of Safety’ as the central concept of investment. Graham began the chapter in grand fashion:

in the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, “This too will pass.” confronted with a like challenge to distil the secret of sound investment into three words, we venture the motto, mArGiN OF SAFeTY. This is the thread that runs through all the preceding discussion of investment policy – often explicitly, sometimes in a less direct fashion.

The most basic instance of a margin of safety, according to Graham, is where a company’s shares are selling for less than the total amount of bonds that could safely be issued against its assets and earning power. After all, the bondholders could only look to the company’s assets and earnings for the return of their capital and interest – just the same as the company’s shareholders. So the shareholders would have the same margin of safety as our hypothetical bondholders, but would also have the benefit of any pleasant surprises that came their way in terms of income and capital appreciation.

Graham conceded, however, that such opportunities were rare. more normally, the margin of safety in a share ‘lies in an expected earning power considerably in excess of the going rate for bonds’. The ‘going rate for bonds’ is the yield on long-dated government bonds. if we assume that this is 5%, then it implies that we might be prepared to accept a Per of 20 (that is, 100 divided by 5) for a security which is entirely free of risk. For a share in a company with uncertain earnings, however, the earning power needs to be considerably in excess of the going rate for bonds. So we might imagine that it should be able to generate earnings per share of at least 8% of its share price, which would imply a Per of less than 12.5.

The precise level of the margin of safety, however, must depend on the degree to which the investor can reasonably place confidence in the earnings power of a particular security. So for a company with a long history of stable, even growing, earnings, and where there is no reason to suppose that this will not continue to be the case, a slightly lower earnings yield and a slightly higher Per may be acceptable. Where, however, a company has highly variable or unpredictable earnings, then a much lower Per would be justified.

THE PARABLE OF MR MARKET

From chapter 8 of The intelligent investor: imagine that in some private business you own a small share that cost you uS$1,000. One of your partners, named mr market, is very obliging indeed. every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, mr market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.

if you are a prudent investor or a sensible businessman, will you let mr market’s daily communication determine your view of the value of a uS$1,000 interest in the enterprise? Only in case you agree with him, or you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on the full reports from the company about its operations and financial position.

The true investor is in that very position when he owns a listed common stock. he can take advantage of the daily market price or leave it alone, as dictated by his own judgment and inclination. he must take cognizance of the important price movements, for otherwise his judgment will have nothing to work on. conceivably they may give him a warning signal which he will do well to heed – this in plain english means that he is to sell his shares because the price has gone down, foreboding worse things to come. in our view such signals are misleading at least as often as they are helpful. Basically price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when the prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stockmarket and pays attention to his dividend returns and to the operating results of his companies.

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year, such as plant and machinery and intangible assets, are of far less certain value and Graham therefore chose to ignore them. From the current asset figure, you deduct all the company’s debts, both short-term and long-term and both ‘trading’ and ‘financial’, to arrive at a figure for the net current assets.

The value of these net current assets should be a reasonable proxy for the minimum value a company might be expected to deliver if it were liquidated. In Security Analysis, Graham noted that there were a large number of common stocks selling for less than their net current asset value and described it as fundamentally illogical:

It means that a serious error is being committed, either: (a) in the judgment of the stockmarket; (b) in the policies of the company’s management; or (c) in the attitude of the stockholders towards their property.

After a couple of pages of intellectual i-dotting and t-crossing, he then concluded:

When a common stock sells persistently below its liquidating value, then either the price is too low or the company should be liquidated … The truth of the principle above should be self-evident. There can be no sound reason for a stock’s selling continuously below its liquidation value. If the company is not worth more as a going concern than in liquidation, it should be liquidated. If it is worth more as a going concern, then the stock should sell for more than its liquidating value. Hence, on either premise, a price below liquidating value is unjustifiable.

The greatest risk in buying stocks at a discount to their net current assets was that the management may refuse to liquidate the business while continuing to dissipate the assets that make the investment attractive. So Graham aimed to find stocks that combined a discount to net current assets with reliable earning power: Common stocks which: (a) are selling below liquid-asset values; (b) are apparently in no danger of dissipating these assets; and (c) have formerly shown a large earning power on the market price, may be said truthfully to constitute a class of investment bargains.

They are indubitably worth considerably more than they are selling for, and there is a reasonably good chance that this greater worth will sooner or later reflect itself in the market price. Happily for Graham, throughout most of his investing career there were plenty of these opportunities. They have become scarcer since, but they do arise from time to time, as we saw with SecureNet (see table) in 2002.

The concepts of intrinsic value and margin of safety – which we set out on pages 6 and 7 – are the twin pillars of value investing and both are central to every value investor’s methodology. But, as we saw earlier in The Superinvestors of Graham-and-Doddsville, even amongst Graham’s direct students the application of these principles varies from investor to investor.

One of Graham’s favourite authors, Baruch Spinoza, wrote ‘all things excellent are as difficult as they are rare’ – and investing is certainly no exception. If successful investing was as simple as plugging some numbers into a formula, everyone would do it and the extraordinary returns would disappear. John Train writes in The Money Masters: ‘Any formula is likely to be rendered obsolete by events. Its own success will eventually be its undoing, as more and more imitators plunge in and muddy the waters.’

So before we look at Graham’s principal stock-picking method, it’s important to remember that times do change and what worked in Graham’s time doesn’t necessarily work today. Train quotes Graham on the subject from the transcript of a 1976 seminar:

I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago when our textbook ‘Graham and Dodd’ was first published; but the situation has changed a good deal since then.

The most successful investors since Graham have been able to combine his fundamental framework with independent thought. The fact that you are buying a part of a business will never change, but investors like Warren Buffett and Charlie Munger have been able to recognise that a company’s value can be a lot more than the value of the assets on its balance sheet. With those thoughts in mind, let’s take a look at Graham’s most famous stock-selection method.

GRAHAM’S NET CURRENT ASSETS APPROACH

Some purchases can be justified on the basis of a company’s asset position and others can be justified on the basis of a company’s earning power. Graham, however, was a man of numbers and, perhaps influenced by the 1929 crash, he was always very suspicious of a company’s future earning potential.

Graham’s preferred method for finding stocks trading below intrinsic value was to look at a company’s net current assets. Current assets comprise cash and any assets that the company expects to turn into cash within one year: such as debtors and unsold stock. Fixed assets, that is those that will not be turned into cash within one

Graham’s approach to stock selection

The investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizeable declines nor become excited by sizeable advances. he should always remember that market quotations are there for his convenience, either to be taken advantage of or to be ignored. he should never buy a stock because it has gone up or sell one because it has gone down. – Graham on portfolio management

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THE DISCOUNT TO NET CURRENT ASSETS APPROACH

THEN AND NOW

NORTHERN PIPE LINE

A famous early coup for the Joint Account concerned Northern Pipe line, an oil transporter conspicuous to the rest of the market only by its dullness. Graham, however, noticed that, in addition to its pipeline assets, the company owned a portfolio of ‘liberty Bonds’ and other gilt-edged securities worth about uS$80 per share – well above the company’s stock price, which sank to uS$64 in 1926. he built a large stake at prices below uS$70 and set about pressuring the board to liquidate the bond portfolio because he felt it was ‘inconsistent for most of the capital of a pipeline enterprise actually to be employed in the ownership of bonds’. The company duly sold the bonds and paid special dividends of uS$70 per share, leaving Graham with his money back and a fair slice of the, albeit lacklustre, pipeline business.

THE OTIS COMPANY

in June 1929, when the rest of the market was off buying radio shares, Graham was able to buy shares in the Otis company for uS$35, even though it had uS$101 per share in net current assets, including uS$23.50 in cash. in September 1929 the company returned uS$4 to shareholders via a special dividend and, in 1930, the company made a further distribution of uS$20. By April 1931, the shares were selling for uS$45, giving a combined total of uS$69 including the two distributions, almost double the 1929 price. Which isn’t bad, given that the worst stockmarket crash in history had taken place in the meantime.

SECURENET

in the carnage that followed the bursting of the dotcom bubble, SecureNet, a producer of iT security products, saw its share price slump from more than $10 to $0.65. in amongst all the despair, though, investors overlooked $1.30 per share in cash on the company’s balance sheet. We were delighted to follow in Ben Graham’s footsteps and upgrade the company to an outright Buy in issue 101/Apr 02 (Buy – $0.85). We were rewarded with a cash takeover at $1.57 per share a little more than a year later.

ASSET PLAYS

COMPANY YEAR SHARE NET vALUE PRICE CURRENT REALISATION LOW ASSETS

NORTHERN 1926 uS$64 Net current assets Special dividends Pipeline of uS$82 per of uS$70 per share, including share plus uS$79 per share remaining in gilt-edged pipeline securities business

OTIS COMPANY 1929 uS$35 Net current assets Special dividends of uS$101per share of uS$24 per including net cash share, plus uS$23.50 per share remaining business priced at uS$45 per share in 1931

SECURENET 2002 $0.65 Net current assets of cash takeover $1.38 per share at $1.57 per including cash of share $1.30 per share

graham’s preferred method for finding stocks trading below intrinsic value was to look at a company’s net current assets.

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3. ‘do not enter upon an operation –  that is, manufacturing or trading an item unless a reliable calculation shows that it has a fair chance to yield a reasonable profit. in particular, keep away from ventures in which you have little to gain and much to lose.’

For the enterprising investor, this means that his operations for profit should be based not on optimism but on arithmetic. For every investor it means that when he limits his return to a small figure he must demand convincing evidence that he is not risking a substantial part of his principal.

4. ‘have the courage of your knowledge and experience. if you have formed a conclusion from the facts and if you know your judgment is sound, act on it – even though others may hesitate or differ.’

You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right. Similarly, in the world of securities, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand. Finally Graham concluded: Fortunately for the typical investor, it is by no means necessary for his success that he bring these qualities to bear upon his program – provided he limits his ambition to his capacity and confines his activities within the safe and narrow path of standard, defensive investment. To achieve satisfactory results is easier than most people realize; to achieve superior results is harder than it looks.

In summing up the final chapter to The Intelligent Investor, Graham wrote that ‘investment is most intelligent when it is most businesslike’. He continued:

Every security may best be viewed, in the first instance, as an ownership interest in, or a claim against, a specific business enterprise.’ And if a person sets out to make profits from security purchases and sales, he is embarking on a business venture of his own, which must be run in accordance with accepted business principles if is to have a chance of success.

Graham then went on to list four fundamental principles for business management which the investor should take with him into the world of investment.

1. ‘Know what you are doing – know your business’. Do not try to make ‘business profits’ out of shares – that is, returns in excess of normal interest and dividend income – unless you know as much about security values as you would need to know about the value of merchandise that you proposed to manufacture or deal in.

2. ‘do not let anyone else run your business, unless (1) you can supervise his performance with adequate care and comprehension or (2) you have unusually strong reasons for placing implicit confidence in his integrity and ability.’

For the investor, this rule should determine the conditions under which he will permit someone else to decide what is done with his money.

There have been a fair few books written about Ben Graham and his approach to investing, but the good news is that he wrote the best of them himself. These are undoubtedly the place to start your further reading.

Security Analysis, written by Ben Graham and his former pupil David Dodd, remains the bible of the investment analysis industry (at least the best bits of it) more than 70 years after it was first published. There are numerous editions and reprints, so be careful which you get. The original 1934 edition, most recently reprinted in 1997, scores highly for authenticity, but the fifth edition from 1988 is the most up-to-date. The fourth edition from 1962 was the last by Graham and Dodd, while Warren Buffett reportedly prefers the second edition from 1940 (reprinted in 2002).

The Intelligent Investor was written by Graham more with the savvy amateur in mind than the professional

investment analyst, and it’s therefore an easier read than Security Analysis. Warren Buffett has described it as ‘by far the best book on investing ever written’ and you can’t say much fairer than that. The fourth edition dates from 1973 and has been revised, most recently in 2003, but the original 1949 edition is also still in print.

Benjamin Graham: Memoirs of The Dean Of Wall Street, written by Graham and last published in 1996, is no longer in print, but copies may be available from second-hand booksellers (try www.AbeBooks.com).

Of books written by others, the standouts are The Rediscovered Benjamin Graham, Janet Lowe (1999), Benjamin Graham on Value Investing, Janet Lowe (1994) and How to Think Like Benjamin Graham and Invest Like Warren Buffett, Lawrence Cunningham (2001).

Conclusion

Further reading

You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.

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