Benjamin Graham Market Portfolio - Valuewalk

BENJAMIN GRAHAM

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PART ONE

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An Introduction To The Godfather Of Activism Most investors will have heard of Benjamin Graham. Often called the ‘Godfather of value investing,’ Benjamin Graham revolutionized Wall Street during the first half of the last century. Indeed, Graham wasn’t just a value investor. When Graham first came to Wall Street, the market was mostly populated by high net worth speculators. Graham introduced to the market the notion that shareholders should view their shareholding as an ownership interest, rather than a betting slip for the world’s largest casino. And nearly fifty years after his death, Graham’s teachings are still relevant. His out-of-date books, Security Analysis, and the Intelligent Investor are still in print and teaching today’s investors how to think about the market. The tremendous success of Benjamin Graham’s students is also a testament to his legacy. Investing greats such as Warren Buffett, Walter Schloss, Bill Ruane and Irving Kahn all learned their trade from Benjamin Graham. Benjamin Graham: Not just a value investor You could be forgiven for thinking that Benjamin Graham was a value investor through and through, but this couldn’t be further from the truth. Many of investment strategies being used on Wall Street today, were at some point used by Graham. For example, in many ways the Graham-Newman investment partnership was the world’s first hedge fund, shorting securities and collecting performance fees years before A.W. Jones founded what was considered by many to be the first hedge fund in 1949. But the most far-reaching impact Benjamin Graham made the finance industry, was that of shareholder activism. Jeff Gramm’s upcoming book: Dear Chairman: Boardroom Battles and the Rise of Shareholder Activismdetails Graham’s relatively unknown activist career.

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Benjamin Graham: Intrinsic value Graham essentially invented the notion of “intrinsic value.” Prior to his arrival on Wall Street, many analysts didn’t even bother to read financial reports, as Graham wrote in his memoirs,“…financial information was largely going to waste in the area of common stock analysis…I found Wall Street virgin territory for examination by a genuine, penetrating analysis of security values.” These findings became the cornerstone of Graham’s teachings. Financial information not price fluctuations was the most important factor of security analysis. To illustrate this point, Graham invested his now famous “Mr. Market” analogy: “…Imagine that in some private business you own a small share that cost you $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 $1,000 interest in the enterprise? Only in case you agree with him, or in case 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 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 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 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 stock market and pays attention to his dividend returns and to the operating results of his companies.” “Summary The most realistic distinction between the investor and the speculator is found in their attitude toward stock-market movements. The speculator’s primary interest lies in anticipating and profiting from market fluctuations. The investor’s primary interest lies in acquiring and holding suitable securities at suitable prices. Market movements are important to him in a practical sense, because they alternately create low price levels at which he would be wise to buy and high price levels at which he certainly should refrain from buying and probably would be wise to sell.” — The Intelligent Investor by Benjamin Graham 4th Revised Edition, 1973, Chapter 8, the Investor and Market Fluctuations, pgs 204 — 205.

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BENJAMIN GRAHAM Jason Zweig, who currently writes for The Wall Street Journal and who likely read more about investing than most people alive today, updated the Mr. Market analogy in one of the more recent versions of The The Intelligent Investor: “Stocks are crashing, so you turn on the television to catch the latest market news. But instead of CNBC or CNN, imagine that you can tune in to the Benjamin Graham Financial Network…” “…the image that fills your TV screen is the facade of the New York Stock Exchange, festooned with a huge banner reading: “SALE! 50% OFF!”…Then the anchorman announces brightly, “Stocks became more attractive yet again today, as the Dow dropped another 2.5% on heavy volume-the fourth day in a row that stocks have gotten cheaper. Tech investors fared even better, as leading companies like Microsoft lost nearly 5% on the day, making them even more affordable. That comes on top of the good news of the past year, in which stocks have already lost 50%, putting them at bargain levels not seen in years. And some prominent analysts are optimistic that prices may drop still further in the weeks and months to come”. — The Intelligent Investor by Benjamin Graham 4th Revised Edition, 1973, Commentary to Chapter 8, the Investor and Market Fluctuations, pg 222. Benjamin Graham the activist As Graham was one of the first stock investors to study balance sheets, it was only going to be a matter of time before he became an activist investor. His first target was Northern Pipeline, a company created after the breakup of Standard Oil. Graham first found the company in 1926 and as Jeff Gramm’s upcoming book Dear Chairman explains, Graham quickly moved to unlock value from Northern’s balance sheet. When Graham first stumbled on Northern, the company’s shares were trading at $72, but due to the fact that shareholders literally couldn’t be bothered to read Northern’s financial figures, the market was severely undervaluing the company. It turned out that Northern had $89.60 per share in cash & investments and the pipeline business was worth an additional $21.30 per share on top of this. Total book value per share was $110.90. Northern wasn’t an isolated case. Two other pipeline companies, N.Y. Transit and Eureka, were both trading for less than the value of the cash and securities on their balance sheets, with no value whatsoever placed on the pipeline businesses. When Graham discovered N.Y. Transit and Eureka the companies were trading at a discount to net asset value per share of 66% and 77% respectively. After a short battle with Northern’s board of directors, Graham was granted two seats on the company’s board and the excess cash was returned to investors.

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PART TWO

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The Graham–Newman Partnership The Graham–Newman Partnership is considered by some to have been the world’s first hedge fund. However, information on the partnership is limited, so if readers have any feedback or sources for the information below it would be greatly appreciated. This is just a brief overview of Graham–Newman’s endeavours between 1926 and 1958, I’m going to take a more detailed look at their investment strategy in part three of this series. Benjamin Graham first went to Wall Street in 1914, two months before World War 1 broke out, as a chalker on Wall Street with Newburger, Henderson and Loeb. As a special favor, he was paid $12 a week instead of $10 to begin. Then when the war broke out, the stock exchange closed, and Graham’s salary was reduced back to $10. Still, Graham continued to work for the firm and his hard work paid off when he was promoted to partner during 1920. According to several sources around 12 years later, during 1926, Graham formed his investment partnership with Jerome Newman and started perfecting his deep-value investment strategy. Graham--Newman: Wiped out From 1914 to 1929 Graham experience 15 years of continuous success but the crash of 1929 floored Graham. It is claimed that he was personally wiped out as, like many investors at the time, he had an enormous pile of margin debt. “...I knew was that prices were too high. I stayed away from the speculative favorites. I felt I had good investments. But lowed money, which was a mistake, and I had to sweat through the period 19291932. I didn’t repeat that error after that.” -- Source: An Hour With Ben Graham The crash of 1929 helped Graham develop his deep value strategy. Losing everything pushed Graham only to take positions in securities where the risk of permanent capital loss was low. And by concentrating on deep value situations, the Graham--Newman Partnership had recovered its losses from 1929 by 1937, just in time to ride out yet another period of market turbulence. “HB: The 1937-1938 decline, were you better prepared for that? Graham: Well, that led us to make some changes in our procedures that one of our directors had suggested to us, which was sound, and we followed his advice. We gave up certain things we had been trying to do and concentrated more on others that had been more consistently successful. We went along fine.” -- Source: An Hour With Ben Graham This is where things begin to get complex. As far as I can determine, the Graham--Newman Partnership closed in 1936 to be replaced by the Graham-Newman Corporation. The letters for the Graham--Newman Corporation are available online, so from here on out returns are a lot easier to calculate, However, up to 1936 I have been unable to find (online at least) and concrete evidence of the Graham--Newman Partnership’s performance. The Graham--Newman Corporation was run as a sort of mutual fund. Shares were issued at $99, and the company reported earnings per share for the year, alongside a net asset value and dividends. Most of the company’s profits were returned to shareholders via dividends.

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Graham--Newman: Impressive returns For the ten-year period from 1936 to 1946, the Graham--Newman company earned $245 per share, before contingent compensation. Of this sum, $204 accrued to shareholders, $161 was paid out in dividends, and $41 per share was paid in compensation to managers, just under 17% of total earnings during the period. The average percentage gain to stockholders over this first decade of operation was 17.6% per annum. And while Graham is best known for his analysis of common stocks, during this early part of his career his portfolio was built around bonds and preferred stocks. On January 31, 1946, the Graham--Newman Corporation’s portfolio totalled $4.17 million, of which $2.2 million was invested in bonds ($1.4 million in railroad bonds alone), and $863,000 was invested in preferred stock. Only $1.1 million or 26.4% was devoted to common stocks (of this $122,192 was in railroad shares, and $320,075 was invested in investment company common stock).

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BENJAMIN GRAHAM According to one source, by 1958, the year of liquidation, a total distribution of $840.62 per share had been made to investors as Graham--Newman’s enterprise wound down -- that’s a total return of 750% over 30 years, excluding distributions made. Including distributions, the Partnership boasted an average annual return of 17%. Over the same period, the Dow Jones Industrial Average returned 4.7% per annum, excluding dividends but including the 1929 market crash. However, based on figures taken from the Graham--Newman Corporation letters, the returns for investors were much lower. The figures in the letters show that investors received total distributions of $484.42 per share including the initial purchase cost of $99.

Graham--Newman: Compensation The Graham--Newman Partnership also had an unusual (for the time) performance linked pay structure. Each director received a base salary of $15,000, just under $200,000 today based on CPI figures. In addition to this base salary, the directors were entitled to: a) 12.5% each, of the excess of the dividends paid during the year over an amount equal to $0.018 per share per day, b) 10% to each of the excess of the overall net profit, adjusted to reflect unrealized appreciation or depreciation in the market value of the securities. So, it’s fair to say that Benjamin Graham and Jerome Newman were well compensated for running the company. (C) ValueWalk 2016 - All rights Reserved Charlie Munger

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PART THREE

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BENJAMIN GRAHAM Looking For Bargains Unlike most hedge fund letters today, Ben Graham’s letters to the shareholders of the Graham-Newman corporation were brief. In most cases, the letters only included a one page a summary of the corporation’s earnings for the year, dividend distributions and net asset value per share. An auditor’s report was also attached. These short letters make it difficult to study the trades Graham was making and the rationale behind them. Luckily, the late Walter Schloss, who was a student, employee and disciple of Graham has spoken frequently about how Graham went about managing investments at the Graham–Newman Corporation. Benjamin Graham: Deep value After nearly being wiped out in the crash of 1929, Benjamin Graham set about developing his deep value strategy, which he believed would ensure that he would never have to deal with the losses of 1929 again. As Walter Schloss described at the 1999 Grant’s Interest Rate Observer Fall Investment Conference: “He [Benjamin Graham] was very upset about losing money. A lot of us are. So he worked on a number of ways of doing this and one of them was buying companies below working capital and in the ‘30s there were a lot of companies developed that way.” Graham described the strategy himself in an interview in March 6 1976: “...when we talk about buying stocks, as I do, I am talking very practically in terms of dollars and cents, profits and losses, mainly profits. I would say that if a stock with $50 working capital sells at $32, that would be an interesting stock. If you buy 30 companies of that sort, you’re bound to make money. You can’t lose when you do that…” “...what everybody else is trying to do pretty much is pick out the “Xerox” companies, the “3M’s”, because of their long-term futures or to decide that next year the semiconductor industry would be a good industry. These don’t seem to be dependable ways to do it.” “...they [the efficient market supporters] would claim that if they are correct in their basic contentions about the efficient market, the thing for people to do is to try to study the behavior of stock prices and try to profit from these interpretations. To me, that is not a very encouraging conclusion because if I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market.” Going back to Walter Schloss: “So, when I came to work for Ben, he had 37 common stocks in his common stock portfolio...They had $4,100,000 million of which $1.1 million was in common stocks...He had very small amounts of these stocks and you figure $1,100,000 with 37 stocks, it wasn’t very much.”

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BENJAMIN GRAHAM “Basically the rest of his portfolio was made up of bankrupt bonds, against which he sold ‘whenissued’ securities, some convertible preferred stocks where he shorted the common stocks against them.” All in all, when it came to portfolio management there were no limits on the types of securities Graham could buy. For this reason, many consider the Graham---Newman Corporation to be the world’s first hedge fund. As well as buying common and preferred stock, Graham shorted certain issues, occasionally took an activist stance (as covered in part one) and got involved in special situations. Irving Kahn another Graham disciple, wrote the following in a tribute to Graham after his death in 1974: “Graham-Newman concentrated on finding value in securities wherever they might be. This resulted in a heavy selection of over the counter issues, including companies with limited floats.” “What makes this result even more impressive was the high quality of the things they brought. While the names of the securities were often less than household names, their intrinsic high value made them far safer investments than most big listed companies.” “Other examples of how Ben’s principles and methods influenced the securities industry are his ethical standards. These included demanding full disclosure of pertinent facts both in the balance sheet and the income account, He was just as forthright in criticizing the obsolete dividend policies of AT&T as with some family-controlled company that accumulated massive cash to the detriment of their public shareholders.” Strict process Graham had a very strict set of rules for selecting securities to buy for his portfolio, which I’ll cover later in the series. But for now, here’s Walter Schloss again on Graham’s strict investment process: “…he [Ben Graham] had very strict rules. He wasn’t going to deviate. I had a fellow came to me from Adams & Peck…an old line railroad brokerage company…This fellow came to me, a nice guy, and he said “The Battelle Institute has done a study for the Haloid Company”…a small company that made photographic paper for, I think Eastman Kodak. Haloid had the rights to a new process and he wanted us to buy the stock. Haloid sold at between $13 and $17 a share during the depression and it was selling at $21 [1947-48]…I thought it was kind of interesting. You’re paying $4 for this possibility of a copying machine which could do this. Battelle though it was OK. I went into Graham and said, “you know, you were only paying a $4 premium for a company that has a possibility of a good gain,” and he said, “no Walter. It’s not our kind of stock.” -- Source: Grant’s Interest Rate Observer Fall Investment Conference. What’s really interesting to note is that after World War Two, Benjamin Graham actually struggled to make any money at all from net-nets situations and his strategy had to change as a result. Walter Schloss explained: “When Ben was operating in the 1930s and 1940s, there were a lot of companies selling below their net working capital (NET NET). Ben liked these stocks because they were obviously selling for less than they were worth but in most cases, one couldn’t get control of them and so, since they weren’t very profitable, no one wanted the,. Most of these companies were controlled by the founder or their relative and since the 30s was a poor period for business, the stocks remained depressed. What would bring about change?

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BENJAMIN GRAHAM • •

If the largest Controlling stockholder died, the Estate may want to sell control. If business got better, then the company would make money.

WW2 was a good example of this. The large asset base let many secondary companies earn good money in the war years, the excess profits tax didn’t apply to them and stocks did well. Graham-Newman didn’t do too well after the war in that type of security but their stockholders got rich when G-N distributed GEICO stock to the stockholders in 1949 and GEICO became a growth stock.” “I remember going to Chicago when I worked for Ben in the late 40s and talked to Mr. Bush the President of Diamon T Motors. A Mr. Tilt owned 50.1% of the stock and wouldn’t sell. The stock sold for $10 and had working capital of $20…when Mr. Tilt finally died at the age of 90…the stock was sold at a premium over $20…” Graham’s GEICO investment revolutionized his returns after the World War Two. If Graham hadn’t decided to take a position in the then, up-and-coming insurer, history would have been very different...

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PART FOUR

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GEICO And The End Of Graham–Newman In 1948, Benjamin Graham made one of the most significant investments of his career: GEICO. GEICO, or to give the company its full name, the Government Employees Insurance Company officially started operating in 1936, the same year the Graham–Newman Corporation was set up. Then in 1948, Graham paid $712,000 for a 50% stake in the company and secured the position of Chairman of the Board. This was somewhat of a gamble for Graham. GEICO was never considered to be a value play; it was a high-flying, expensive growth stock, which was exactly the type of company Graham had spent his whole career trying to avoid. It’s ironic then that GEICO turned out to be Graham’s greatest investment. Graham–Newman--Benjamin Graham: Buying GEICO Graham’s decision to acquire 50% of GEICO (around 25% of his capital) also attracted the attention of a young man named Warren Buffett. After learning that Graham had acquired a position on GEICO’s board, a 21-year-old Buffett took the train to Washington on a Saturday to find out more about GEICO. Buffett found the office closed, but a janitor directed him to Lorimer Davidson, an executive at GEICO who spent 4 hours with this “highly unusual young man”. After the meeting, Buffett purchased $13,000 of GEICO stock, which was around 65% of his savings at the time. A few years later he wrote about GEICO in The Commercial and Financial Chronicle — Warren Buffett: The Security I Like Best. I would like to be able to say that Graham’s decision to buy such a huge slug of GEICO was based on thorough analysis, an attractive valuation and a great deal of skill, but it seems most agree that Graham got lucky with GEICO. As Jason Zweig, Intelligent Investor columnist for The Wall Street Journal has put it: “In short, they [Graham and Newman] broke their rules to buy the stock, and they broke their rules to keep it.” Graham, is his own words, admits to the theory of luck as the cause of GEICO’s success: “Ironically enough, the aggregate of profits accruing from this single investment decision far exceeded the sum of all the others realized through 20 years of wide-ranging operations in the partners’ specialized fields, involving much investigation, endless pondering, and countless individual decisions. Are there morals to this story of value to the intelligent investor? [One] is that one lucky break, or one supremely shrewd decision — can we tell them apart? — may count for more than a lifetime of journeyman efforts.” (The Intelligent Investor, 4th revised edition, Postscript, pg. 289)

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BENJAMIN GRAHAM 25 years after Graham purchased his stake in GEICO for $712,000 the 50% shareholder was worth more than $400 million. If anything, the GEICO chapter in Graham’s life is a lesson to be alert and always prepared for an opportunity to hit the homerun ball. “In 1948, we made our GEICO investment and from then on, we seemed to be very brilliant people.” — Benjamin Graham March 6 1976 Graham and his partner, Jerome Newman made the decision to distribute the corporation’s holding in GEICO to shareholders during 1948, the same year the holding was acquired. GEICO shares were trading at $54 in the market on 31 January 1949, around the time of distribution, compared to a purchase price of $21.21. The screenshot below shows the total returned to investors.

And this chart shows the GEICO distribution compared to the returns of the Graham–Newman Corporation over its 20-year life. If you’re interested in reading more about Graham and GEICO I’ve included some links at the bottom of this article. Graham–Newman – Distributing GEICO and losing interest GEICO market a turning point in Graham’s career. After decades of deep value investing, Graham was starting to get

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BENJAMIN GRAHAM bored, opportunities for profit were disappearing as the markets became more efficient: “That’s why I kind of lost interest. We were no longer very challenged after 1950. About 1956, I decided to quit…the things that presented themselves were typically repetition of old problems which I found no special interest in solving.” — Benjamin Graham March 6, 1976 Or to put it another way, Graham could no longer find opportunities that would generate outsized returns: “…we decided to liquidate Graham-Newman Corporation-to end it primarily because the succession of management had not been satisfactorily established. We felt we had nothing special to look forward to that interested us. We could have built up an enormous business had we wanted to, but we limited ourselves to a maximum of $15 million of capital-only a drop in the bucket these days. The question of whether we could earn the maximum percentage per year was what interested us. It was not the question of total sums, but annual rates of return that we were able to accomplish.” — Benjamin Graham March 6 1976.

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PART FIVE

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Benjamin Graham’s “Last Will & Testament” In part four of this series I looked at, what turned out to be the best investment of Benjamin Graham’s career, GEICO and the closure of the Graham–Newman Corporation. But Graham’s legacy didn’t fade with the end of the Graham–Newman Corporation. In fact, even after his investment company shut its doors, Graham remained a figurehead of the financial community. Indeed, while much of Graham’s work was published while he was running Graham–Newman, it was refined in the years after he left the corporation. The Dean of Wall Street updated both The Intelligent Investor and Security Analysis several times before his death in 1976, gave multiple interviews and published several essays on the topic of value investing after he officially retired from money management. But perhaps Graham’s most significant contribution to value investing came after his death with the publication of what has become known as Graham’s “Last Will & Testament.” Benjamin Graham and James Rea Graham’s last will was developed with James Rea, who wrote to Graham after reading one of his articles in Barron’s titled, “Renaissance of Value.” Rea had been working on a stock selection methodology and after reading Graham’s article, discovered that his approach seemed similar to Graham’s. The two value investors then began a three-year working relationship during which they developed Graham and Rea’s ten criteria for selecting stocks. The criteria were backtested over a 50-year period. Rea likened his method of picking stocks to that of selecting a milk cow. When choosing a milk cow, you ideally want a cow that gives lots of milk (earnings), but also will give more milk year over year (growth in earnings). Milk can be turned into cheese, and Rea would want a lot of cheese from his milk (a high dividend yield). This was a high reward cow. The risk was that the cow would stop producing milk, in which case degree of risk was how much you paid for the cow relative to what you could get for the “meat on its bones” (the liquidation value). Graham and Rea then worked with this analogy to come up with the ten rules for stock selection that are so well known today. Here are the ten criteria in full. The first five are susceptible to changes in prices and earnings while the second five are not. Criteria number five through eight measure a company’s financial strength. A potential investment must meet two of these three criteria. Benjamin Graham – First five 1. Earnings Yield: Rea and Graham used required that the earnings yield be at least twice the average AAA corporate bond yield. 2. Price Shrinkage: A stock should have a price-earnings ratio that is 60% below its previous two-year average high. (Graham initially was only interested in stocks that were down at least 50% from their previous high but Rea convinced him that it was illogical to require a company’s price be down 50% from its high when earnings were growing rapidly. Eventually, the two reached a compromise.) 3. Discount to Tangible Book Value: The stock’s price should be less than or equal to two-thirds of the tangible book value. 4. Dividend Yield: The dividend yield should be greater than or equal to two-thirds of the average AAA bond yield. Therefore, if the AAA bond yield is 5%, a stock must have a dividend yield of at least 3.35%. 5. Net Current Asset Value: The stock should be trading below its per share net current asset value (NCAV) or

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BENJAMIN GRAHAM “net quick” asset value. NCAV = Current assets – current liabilities – long-term debt – preferred equity. Second five 1. Current Ratio: Current ratio must be greater than or equal to two. 2. Debt to Equity: Total debt (total liabilities) must be less than the company’s net worth. Debt-to-equity ratio < one. 3. Debt to NCAV: total debt (total liabilities) be less than the net current asset value. 4. Earnings Growth: The company in question should have doubled earnings over the last ten years (7% annualized). 5. Earnings declines: No more than two declines in annual earnings over the last 10 years (defined as a year-overyear drop of 5% or more). Some of these criteria were more important than others. For example, according to Graham’s research, conducted over a 50-year period, buying stocks with an earnings yield at least twice that of the AAA bond rate would have generated an annualized return of 19.9%; Buying stocks where the dividend yield was at least two-thirds the AAA bond yield would have generated an annualized return of 19.5%; and buying stocks with a price less than or equal to twothirds of the tangible book value would have generated an average compounded growth rate of 14.2%. Over the same period, 1925 to 1975, the Dow Jones Industrial Average returned less than 8% per annum. Benjamin Graham – Difficult to find For Graham and Rea, there was more to selecting stocks than just screening for the above criteria. This is where Graham’s rules often become misinterpreted. Many value investors believe that just screening the market according to the above criteria will be enough to unearth bargains. But a strategy developed by the Dean of Wall Street was never going to be that simple. Graham and Rea knew it would be difficult to find companies that would satisfy all ten criteria above (SociétéGénérale points out that over the past 18 years only three companies have passed all ten criteria). As a result, the two partners developed a scoring scale. The scale is simple. If a company meets a criterion it receives one point. There is a maximum of ten points available. It is also possible for a company to score half a point, although it’s not entirely clear what qualities a company had to exhibit to be awarded a half point. Only two explicit examples were given of what qualifies for a half point. Dividend Yield: A whole point is awarded if the dividend yield is at least two-thirds that of the AAA bond yield. A half point is awarded if the dividend yield is between one-half and two-thirds of the AAA bond yield. Earnings Growth: A whole point is awarded if the company has no more than two 5% or greater annual declines in earnings over the last 10 years. A half point is awarded if there are three declines of 5% or greater over the last ten years. Benjamin Graham – Looking for bargains When they’d developed their scoring system, Benjamin Graham, and James Rea started looking for bargains, and they started with the second five criteria. To be considered, stocks trading on the New York Stock Exchange had to score at least three-and-a-half out of five; a score of four or more was required for American Stock Exchange and overthe-counter (OTC) stocks. The NASDAQ exchange didn’t begin trading until 1971 so it was excluded from Graham and Rea’s analysis. (C) ValueWalk 2016 - All rights Reserved Charlie Munger

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BENJAMIN GRAHAM Only if a company scored highly on the second set of five criteria would Graham and Rea move on to the first set. When it came to the first set of five criteria, the stock was considered a buy if it traded on the New York Stock Exchange and scored at least three-and-a-half out of five. For American Stock Exchange and OTC stocks, it was a “buy” if it scored four or more on the first five criteria. Benjamin Graham – Diversification Even though the rules laid out within Graham’s “Last Will & Testament” are strict and designed to weed out the best opportunities, Graham was always an advocate of diversification, investing in as many as 100 companies or more. And the reason for this was simple, towards the end of his life Graham had grown skeptical of the benefits of indepth company analysis. Indeed, he was quoted as saying: “I do not have much confidence in the practical worth for most analysts of detailed studies of individual companies, with emphasis placed on either their comparative performance or on predictions of their relative future performance over a one-to-five-years time span.” As a result, Graham and Rea’s advised that investors should always try to invest in at least 30 companies at a time. Benjamin Graham – Does it work? Graham and Rea back tested their strategy based on five decades of market data and claimed that it produced “market-beating returns,” although they failed to provide any specific figures. However, subsequent testing by Henry R. Oppenheimer from 1974 to 1981 produced some more concrete data: “By using Graham’s criteria (1) and (6) to select securities from the combined NYSE-AMEX universe, an investor could have achieved a mean annual return of 38 per cent! Use of criteria (3) and (6) and (1), (3) and (6) would have resulted in mean annual returns of 26 per cent and 29 per cent, respectively”.

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PART SIX

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Security In An Insecure World Part six of this series is devoted to a speech Benjamin Graham gave in San Francisco one week before John F. Kennedy was assassinated in 1963. In the speech, titled “Security In An Insecure World,” Graham discusses how investors should go about developing their process, how to pick stocks wisely, develop an asset allocation strategy and determine if the market is overvalued. The full presentation stretches out over 12 full pages of text, which makes it tough going, despite the valuable nuggets of information contained within the text. Rather than reprint the whole speech, I’ve pulled some key paragraphs and takeaways from the document. For those interested in reading the whole piece, a link to the PDF can be found here. Benjamin Graham on market fluctuations Benjamin’s Graham starts his speech by discussing the general problem of market volatility: “The problem of price fluctuations, or market fluctuation, is a very real one for investors as well as speculators, although there has been a tendency in Wall Street to deny that for a number of years in the past and even currently. Actually, the real problem is not whether price fluctuations are important to the investor; it is rather the opposite, that is to find some good workable distinction between the investor and the speculator in common stocks. As will be pointed out later that distinction has almost vanished from Wall Street, a fact which has caused a great deal of trouble in the past and will cause a great deal of trouble in the future.” “…the idea that for the smart investor the question of stock market fluctuations does not have to be considered to any great extent. There is a two-fold emphasis here, which slurs over the reality of stock market fluctuations. The first is the general conviction that the market can be counted on to advance so emphatically through the years that whatever decline take place are comparatively unimportant; hence if you have the true investor’s attitude you don’t have to concern yourself with them. The second claim is a denial that the “stock market” exists at all, meaning thereby that what the market averages do is of no real importance to the intelligent, well-advised investor or speculator.” But how valid are these two arguments? “The first one…involves a very fundamental and important fallacy. This is the idea that the better the past record of the stock market as such the more certain it is that common stocks are sound investments for the future…we know that if a corporation has had a very good record over the past years that is a fair indication…that its record is likely to be good in the future…But you cannot say that the fact that the stock market has risen continuously…over a long period in the past is a guarantee that it will continue to act in the same way in the future…As I see it, the real truth is exactly the opposite, for the higher the stock market advances the more reason there is to mistrust its future action…”

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Benjamin Graham: The old and new standards of value Benjamin Graham then moved on to talk about the “old and new standards of value”: “The old standards of value–which were pretty well accepted up to say 1955 were reached by a number of different approaches based on reasoning or experience. The one I like best of course was my own, which has been known as the “Graham.” It was derived from the Central Value average earnings of the 30 stocks in the Dow Jones Industrial Average for ten years past, capitalized at twice the interest rate on high grade bonds. For example at the present time the average earnings for the last ten years are about $33 on the Dow Jones unit and the present rate on high grade bonds is 4.3 per cent. If you capitalize $33 at 8.6% — which is a multiplier of about 12 you would get a Central Value on the old basis of about 380, as compared with the present price of about 750.” Then Graham went on to give a word of warning: “There is a lot of juggling with figures that can be done now as always; but none of these methods in itself gives a dependable results. To a great extent the figures selected are determined by the general attitude of the man who is selecting them, and that general attitude is very often determined in turn by what the stock market has been doing. When the stock market is at 750 you take an optimistic attitude and use some favorable figures; but if it should have a severe decline most people would jump back to the older and more conservative evaluation methods.” Benjamin Graham on market forecasting Benjamin Graham on market forecasting: “Now, with respect to stock market forecasting as such, as a separate occupation or amusement, I don’t there is any good evidence that a recognized and publicly used method of stock market forecasting can be relied upon to be profitable. Let me illustrate what I mean by reference to the famous “Dow Theory”…I found that when I studied the record from 1898 to 1933, a period of about 35 years–the results from following this mechanical method were remarkably good…in the 1920’s and early 1930’s, the public’s interest in the Theory increased enormously…The Dow Theory became extremely popular after 1933. I studied the consequences of using exactly the same method in the market after 1933, and I found peculiarly enough that in no case in the next 25 years did one benefit through following the Dow signals mechanically.” It’s here that Benjamin Graham moves onto the real argument in his presentation. “Let me now make a general observation. For obvious reasons it is impossible for investors as a whole, and therefore for the average investor or speculator, to do better than the general market. The reason is that you are the general market and you can’t do better than yourselves.” Further: “I do believe that it is possible for a minority of investors to get significantly better results than av-

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BENJAMIN GRAHAM erage. Two conditions are necessary for that. One is that they must follow some sound principles of selection which are related to the value of the securities and not to their market price action. The other is that their method of operation must be basically different than that of the majority of security buyers. They have to cut themselves off from the general public and put themselves into a special category.” Benjamin Graham: Portfolio management After discussing the general market environment during the first part of his speech, in the second part of his speech, Benjamin Graham moves onto portfolio management and his famous deep-value investing strategy. “In my nearly fifty years of experience in Wall Street I’ve found that I know less and less about what the stock market is going to do but I know more and more about what investors ought to do; and that’s a pretty vital change in attitude.” “The first point is that the investor is required by the very insecurity ruling in the world of today to maintain at all times some division of his funds between bonds and stocks…MY suggestion is that the minimum position of this portfolio held in common stocks should be 25% and the maximum should be 75%…Any variations should be clearly based on value considerations, which would lead him to own more common stocks when the market seems low in relation to value and less common stocks when the market seems high in relation to value…it is amazing how many people think in exactly opposite terms.” A more sophisticated method: “Use a fixed 50-50 division between bonds and stocks. When the market level of the stocks rises to a point where they constitute 55% of the total or maybe 60%, you would then sell out enough the bring your proportion back to 50%…conversely when the market went down so that your common stock proportion had fallen 45% or 40%, you would use some of your bond money to buy common stocks and bring it back to the 50%.” Another approach: “Another approach…is the “Dollar Averaging” method, in which you put the same amount of money in common stocks year after year…In that way you buy more shares of stocks when the market level is low and fewer shares when it is high…” Benjamin Graham -- Security selection On to the problem of security selection: “Now let me come to the problems of security selection. We have talked about a bond component…and a common stock component. There’s a wide choice in the bond component, but the decision is not of too much importance in most cases. [Here Benjamin Graham gives a broad analysis of the bonds currently available on the market and tax advantages/disadvantages of different instruments.] ” “We come finally to common stock investment. My recommendation is that the investor choose

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BENJAMIN GRAHAM either his own list of, say 20 or 30 representative and leading companies, or else put his money in several of the well-established mutual funds. Many investors would think my prescription too simple. If they can get results equal to the averages in this easy way why shouldn’t they try to get a substantially higher return by careful and competently-advised selection? My short answer has already been given: If the investment funds as a whole can’t beat the averages, even pretty clever investors as a whole can’t do it either.” “As I see it, the fundamental problem in common stocks is the market’s injection of a large speculative element into the strongest and best companies…This has added greatly to the confusion between investment and speculation, because it is easy to tell oneself that the shares of a good company are always a sound investment, regardless of price.” “My recent crusade has been to persuade Wall Street that it has made a mistake, and harmed itself, in suppressing the word “speculation” from its vocabulary…It is important that the public should have a fairly good idea of the extent to which it is speculating…To my mind the most valuable contribution that security analysts could make to the art of investing would be the determination of the investment and speculative components in the current price of any give common stock, so that the intending buyer might have some notion of the risks he is taking as well as what profit he might make.” One final question: “Let me raise a final question: Despite rather discouraging results from endeavors to predict market moves or to select the most attractive companies, can the intelligent investor follow any policies of common-stock selection that promise better than average results? I think it is possible for some strong minded investors to do this, by buying value rather than prospects or popularity. Some examples of this approach: (1) Select stocks of important companies which sell on a no-glamour basis…(2) Buy definitely “bargain issues.” Typically these would be shares that sold for less their value in working-capital alone, with nothing paid for fixed assets and goodwill… (3) Finally there is the wide field of “special situations” — reorganizations, mergers, take-overs, liquidations, etc.” And the concluding statement of Graham’s speech:

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PART SEVEN

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Lecture Notes Part six of this series is devoted to a speech Benjamin Graham gave in San Francisco one week before John F. KenPart seven of this series is devoted to a collection of notes from Benjamin Graham’s lectures when he was a professor at Columbia University. The notes were taken during lectures given in 1946, six years after the 1940 version of “Security Analysis” was published. The name of the course was “Current Problems in Security Analysis”, and was in Graham’s words, an“attempt to bring our textbook ” Security Analysis” up to date, in the light of the experience of the last six years since the 1940 revision was published.” This is just a rough summary of the first lecture in the series of ten Ben Graham archived lectures. If you’re interest in going through all ten articles, you can find them here. Ben Graham: Still relevant “The subject matter of security analysis can be divided in various ways. One division might be in three parts: First, the techniques of security analysis; secondly, standards of safety and common stock valuation; and thirdly, the relationship of the analyst to the security market.” It has been nearly 70 years since Ben Graham gave these lectures, and clearly, the financial world has changed dramatically in this time. Nevertheless, the principles behind value investing remain the same. Graham starts his lecture by trying to get students to forget about stock prices. The analyst’s relation with the market should be, as Graham describes it, “that of a man toward his wife. He shouldn’t pay too much attention to what the lady says, but he can’t afford to ignore it entirely.” Straight off, Ben Graham is trying to draw a line between stock prices and the underlying business. Graham then goes on to discuss the market and its movements. Specifically, the predictability of the market; it won’t go up forever, but it also won’t go down forever. “When you look at the stock market as a whole, you will find from experience that after it has advanced a good deal it not only goes down -- that is obvious -- but it goes down to levels substantially below earlier high levels. Hence, it has always been possible to buy stocks at lower prices than the highest of previous moves, not of the current move.” “...if you look at this chart of the Dow Jones Industrial Average, you can see there has never been a time in which the price level has broken out, in a once-for-all or permanent way, from its past area of fluctuations. That is the thing I have been trying to point out in the last few minutes.” Then Graham gets straight into the subject of security analysis. Ben Graham - Security analysis Ben Graham’s first analysis is that of a new issue, Northern Engraving and Manufacturing Company, which was looking to sell around 250,000 shares at $16 per share. That meant that this company was to be valued at $4 million in the market. (C) ValueWalk 2016 - All rights Reserved Charlie Munger

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BENJAMIN GRAHAM “Now, what did the new stockholder get for his share of the $4-million? In the first place, he got $1,350,000 worth of tangible equity. Hence he was paying three times the amount of money invested in the business. In the second place, he got earnings which can be summarized rather quickly. For the five years 1936-40, they averaged 21 cents a share; for the five years ended 1945, they averaged 65 cents a share. In other words, the stock was being sold at about 25 times the pre-war earnings.” Even by today’s standards, a valuation of 25 times historic earnings is excessive for a manufacturing company. But that’s not the whole story. “But naturally there must have been some factor that made such a thing possible, and we find it in the six months ending June 30, 1946, when the company earned $1.27 a share. In the usual parlance of Wall Street, it could be said that the stock was being sold at six and a half times its earnings, the point being the earnings are at the annual rate of $2.54, and $16 is six or seven times that much.” So, Northern was being offered at six or seven times forward earnings, which Graham as notes, was an unbelievably low valuation multiple. However, as Graham delved into the numbers (Graham stressed that he was only interested in the figures, not industry trends -- “we don’t stress industrial analysis particularly in our course in security analysis”) he determined that Northern Engraving’s profit margin was excessively high for the six-month period being used to value the company pre-IPO. Northern Engraving’s sales margins had jumped from 3% or 4% to 15%. Ben Graham -- Ignoring company specifics Ben Graham goes on to detail further case studies in company valuation, although throughout the demonstrations he continues to ignore company-specific factors, such as management, brand power and reputation. One great example, given at the end of the first lecture is a comparison of two different aircraft manufacturers and an analysis of their financial position as well as valuation. The first company was named the Taylorcraft Company, with a market capitalization of $3 million, working capital of only $103,000, with stock and surplus of $2.3 million but $1.15 million of this was what Ben Graham called an “arbitrary plant markup”. The company arranged to sell its shares to the market in an amount that did not require registration with the SEC and a four-for-one split was undertaken to reduce the stock price to $3. Also, Taylorcraft hadn’t issued financial reports for several years -- hardly the sign of a financially sound company. Graham then considers another company, Curtiss-Wright: “Taylorcraft and Curtiss-Wright apparently were selling about the same price, but that doesn’t mean very much...the Curtiss-Wright Company has built up its working capital from a figure perhaps of $12-million to $130-million, approximately. It turns out that this company is selling in the market for considerably less than two-thirds of its working capital.”

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BENJAMIN GRAHAM “The Curtiss-Wright Company happens to be the largest airplane producer in the field, and the Taylorcraft Company probably is one of the smallest. There are sometimes advantages in small size and disadvantages in large size; but it is hard to believe that a small company in a financially weak position can be worth a great deal more than its tangible investment, when the largest companies in the same field are selling at very large discounts from their working capital. During the period in which Taylorcraft was marking up its fixed assets by means of this appraisal figure, the large companies like United Aircraft and Curtiss-Wright marked down their plants to practically nothing, although the number of square feet which they owned was tremendous.” Curtiss-Wright had been sold off because investors were concerned about the company’s prospects after the war. But, investors were failing to take into account the company’s hefty land ownership, which had been written down to zero. Of course, there was no guarantee that Curtiss-Wright’s prospects would improve, but the discount to working capital and the fact that investors were missing the property opportunity gave a margin of safety. For those interested in the whole Taylorcraft--Curtiss-Wright story, the whole case study is included at the end of this ebook.

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PART EIGHT

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Rules For Investing In the second half of this series, I’m looking at Benjamin Graham’s most important advice, tips and rules for investors looking to make money from the market. In part five, I covered Graham’s “Last Will & Testament”. In part six I covered Graham’s speech on portfolio construction and long-term investing, titled “Security In An Insecure World.” And in part seven, I summarized a selection of Graham’s lectures he gave while teaching at Columbia University. In this, part eight of a ten-part series on Benjamin Graham I’m once again looking at some of Graham’s lecture notes; the rules for the appraisal of common stock for investment purposes. Below is a carbon copy of Benjamin Graham’s lecture notes on his 11 rules for appraising stocks. You can find a copy of the original set of notes here, although they are essentially illegible. The original document misses off the final rule, which is mentioned elsewhere. OUTLIER OF NOVEMBER 6TH LECTURE Benjamin Graham RULES FOR APPRAISAL OF COMMON STOCK FOR INVESTMENT PURPOSES 1.Appraised Value is determined by (a) estimating the Earnings Power (b) applying the appropriate multiplier (c) adjusting, if necessary, for asset value. 2. Earning Power should ordinarily represent an estimate of average earnings for the next five years. 3. Earning Power should ordinarily be derived from actual earning over some period in the past. Where the trend has been neutral, the period should be five to seven years. Where definite trend is shown, actual earnings for last year of reasonably normal general business may be taken, if it seem desirable. 4. In deriving Earning Power, the past earnings may be adjusted for known or highly probable developments -- e.g.. changes in capitalization, properties, tax rates. Changes of a qualitative nature -- e.g. in competitive conditions, products, management -- should be reflected in the multiplier. 5. The multiplier should reflect prospective changes in earnings. A multiplier of 12 is suitable for stocks with neutral prospects. Increases or decreases from this figure must depend on the judgement and preference of the appraiser. However, in all but the most exceptional cases the maximum multiple should be 20 and minimum should be 4. 6. If tangible asset value is less than earning power value (earning power X multiplier). the latter should be reduced by 20% of the deficiency to give the final Appraised Value. (Do not increase for excess tangible value except as under 7). 7. If Net Current Asset Value exceeds earning power value, the latter should be increased by 50% of the excess to give the final Appraised Value. 8. Where extraordinary conditions prevail -- e.g.. war profits or war restrictions, temporary royalty or rental situation -- the amount of the probable gain or loss per share due to such conditions should be estimated, and added to or subtracted from appraised value as determined without considering the abnormal conditions. 9. Where the capitalisation structure is highly speculative -- i.e.. the total of senior securities is disproportionately larger -- than the value of the entire enterprise should first be determined as if it had common stock only. This value should be apportioned between the senior securities and the common stock on a basis which recognises the going-

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BENJAMIN GRAHAM concern value of the senior claims. (Note difference between this treatment and a valuation based on dissolution rights of the senior securities). If an adjustment is needed for extraordinary conditions, referred to in (8) this should be made in the total enterprise value, not on a per-share-of-common basis. 10. The more speculative the position of the common stock -- for whatever reason -- the less practical dependence can be accorded to the Appraised Value found. 11. When a stock’s appraisal is a third higher or lower than its current market value, that can be the basis for a decision to buy or sell. When the differential is less, the appraisal is merely another fact to consider in the analysis. 16 factors needed to make money in the stock market From Benjamin Graham’s student, Walter Schloss, who later became a value legend in his own right, here are the 16 factors needed to make money in the stock market.

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PART NINE

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Investing Wisdom It’s difficult to gather all of Benjamin Graham’s work together in one ten-part series and try to pick out only the most important lessons. Nonetheless, in this part of the ten-part series, I’ve gathered together a selection of quotes from other famous investors on Graham. These quotes are not only a round-up of Graham’s wisdom but also a starting point for further research as there’s an important story behind each one and summarize nicely some of his most valuable lessons. First from one of Graham’s students, Marshall Weinberg: “One sentence changed my life…Ben Graham opened the course by saying: ‘If you want to make money in Wall Street you must have the proper psychological attitude. No one expresses it better than Spinoza the philosopher.’ When he said that, I nearly jumped out of my course. What? I suddenly look up, and he said, and I remember exactly what he said:’ Spinoza said you must look at things in the aspect of eternity.’ And that’s what suddenly hooked me on Ben Graham.” Next is a quote from Irving Khan, who worked closely with Benjamin Graham over his career. He had the unique opportunity of working as Graham’s teaching assistant at Columbia University Business School and also contributed to Graham’s bible on value investing, Security Analysis, by providing some statistical help. “What makes this result even more impressive was the high quality of the things they brought. While the names of the securities were often less than household names, their intrinsic high value made them far safer investments than most big listed companies.” And from another former student Henry Schneider, who talks about Graham’s desire to unlock value through activism. “He believed that you could become an activist in Wall Street and benefit. A lot of companies were not operating on all their cylinders like they should, and you could push ‘em into doing more which would in itself benefit society.” From Graham’s most famous student, Warren Buffett: “He bought a little of everything. So he was widely diversified, which was not the style that I would go for.” Here’s Walter Schloss, another of Graham’s students, employees and talented value investor in his own right, on Graham’s strict investment process: “…he [Ben Graham] had very strict rules. He wasn’t going to deviate. I had a fellow came to me from Adams & Peck…an old line railroad brokerage company…This fellow came to me, a nice guy, and he said “The Battelle Institute has done a study for the Haloid Company”…a small company that made photographic paper for, I think Eastman Kodak. Haloid had the rights to a new process and he wanted us to buy the stock. Haloid sold at between $13 and $17 a share during the depression and it was selling at $21 [1947-48]…I thought it was kind of interesting. You’re paying $4 for this

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BENJAMIN GRAHAM possibility of a copying machine which could do this. Battelle though it was OK. I went into Graham and said, “you know, you were only paying a $4 premium for a company that has a possibility of a good gain,” and he said, “no Walter. It’s not our kind of stock.” And Edwin Schloss, Walter Schloss’ son on Graham’s definition of risk: “I think he talked about risk based on the fact that he wanted to buy something at less than $0.50 on the dollar. He just wanted to buy something that was undervalued. He was very aware that he was going against the tide. He was buying companies that were trouble, he was willing to buy something that nobody else wanted.” Lastly, four great quotes from Warren Buffett’s right-hand man, and Berkshire Hathaway’s vice chairman, Charlie Munger: “Graham didn’t want to ever talk to management. And his reason was that, like the best sort of professor aiming his teaching at a mass audience, he was trying to invent a system that anybody could use.” “Ben Graham had this concept of value to a private owner – what the whole enterprise would sell for if it were available…if you could take the stock price and multiply it by the number of shares and get something that was one third or less of sellout value, he would say that you’ve got a lot of edge going for you. Even with an elderly alcoholic running a stodgy business…You had a huge margin of safety…” “The idea of a margin of safety, a Graham precept, will never be obsolete. The idea of making the market your servant will never be obsolete. The idea of being objective and dispassionate will never be obsolete.” “To Graham, it was a blessing to be in business with a manic-depressive who gave you this series of options all the time. That was a very significant mental construct.”

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PART TEN

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Final Takeaways “The individual investor should act consistently as an investor and not as a speculator. This means.. that he should be able to justify every purchase he makes and each price he pays by impersonal, objective reasoning that satisfies him that he is getting more than his money’s worth for his purchase.” -- Benjamin Graham It’s difficult to sum up all of Benjamin Graham’s wisdom in a short ten-part series, but hopefully, I’ve able to summarize effectively Graham’s life and wisdom without leaving too many gaps. In this, the final part of the series, I have grouped together a few more nuggets of wisdom from the Dean of Wall Street, along with a description of his first, and most important trade on Wall Street, as written by Bruce Greenwald. Benjamin Graham: The first trade “Graham began by looking at situations where the intrinsic value of a stock could be calculated with some precision. In 1915, the Guggenheim Exploration Company planned to dissolve and distribute its holdings to shareholders. These holdings consisted of shares in other copper mining companies, which, like Guggenheim shares, were quoted on the New York Stock Exchange. Graham calculated that the value of such non-Guggenheim shares held by Guggenheim exceeded the value of Guggenheim stock. As a result, buying Guggenheim represented an advantageous purchase of known assets—in Graham’s terms an “investment,” not a “speculation.” Furthermore, by selling appropriate amounts of the shares of the constituent holdings (this could be done even if one did not currently own the stock, a practice known as “shorting”), Graham could lock in this gain. When the Guggenheim Company dissolved and distributed the constituent shares, these shares could be delivered to satisfy the earlier purchases. The success of this operation contributed both to Graham’s reputation and his emerging investment philosophy.” Ben Graham by Bruce Greenwald Selection of Growth Stocks “The third objective of security analysis is the selection of growth stocks. How scientific a procedure is this now, and how scientific can it be made to be? Here I enter difficult waters. Most growth companies are themselves tied in closely with technological progress; by choosing their shares the security analyst latches on, as it were, to the coattails of science. In the 40 or more plant inspections that are on your scheduled field trips for this convention week, no doubt your chief emphasis will be placed on new products and new process developments; and these in turn will strongly influence your conclusions about the long-pull prospects of the various companies. But in most instances this is primarily a qualitative approach. Can your work in this field be truly scientific unless it is solidly based on dependable measurements, that is, specific or minimum projections of future earnings, and a capitalization of such projected profits at a rate or multiplier that can be called reasonably conservative in the light of past experience? Can a definite price be put on future growth---below which the stock is a sound purchase, above which it is dear, or in any event speculative? What is the risk that the expected growth will fail to materialize? What is the risk of an important downward change in the market’s evaluation of favorable prospects? A great deal of systematic study in this field is necessary before dependable answers to such questions will be forthcoming.” -- Benjamin Graham

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BENJAMIN GRAHAM Source: The Papers of Ben Graham Stock Investment in Pre-Scientific Stage “In the meantime I cannot help but feel that growth stock investment is still in the pre-scientific stage. It is at the same time more fascinating and less precise than the selection of safe bonds or undervalued securities. In the growth stock field, the concept of margin of safety loses the clarity and the primacy it enjoys in those other two classes of security analysis. True, there is safety in growth, and some of us will go so far as to declare that there can be no real safety except in growth. But these sound to me more like slogans than scientifically formulated and verified propositions. Again, in the growth field the element of selectivity is so prominent as to place diversification in a secondary and perhaps dubious position. A case can be made for putting all your growth eggs in the one best or a relatively few best baskets. Thus in this branch of security analysis the actuarial element may be missing, and that circumstance undoubtedly militates against truly scientific procedures and results.” -- Benjamin Graham Source: The Papers of Ben Graham Inverted Relationship “There is undoubtedly an organic but inverted relationship between the growth stock concept and the theory of undervalued securities. The attraction of growth is like a tidal pull which causes high tides in one area, the assumed growth companies, and low tides in another area, the assumed nongrowth companies. We can measure, in a sense, scientifically the distorting effect of this influence by using as our standard the minimum business value of enterprises in the non favored group. By way of illustration let us apply that thought to three California concerns. The shares of Roos Brothers, a local retail enterprise, will in the nature of things tend to sell below their analytically determined value for basically the same reasons that are bound to produce over valuations in the shares of Superior Oil or Kern County Land.” -- Benjamin Graham Source: The Papers of Ben Graham The Beta Coefficient “So far I have been talking about the virtues of the value approach as if I had never heard of such newer discoveries as “the random walk”, “the efficient market”, “efficient portfolios”, the Beta coefficient, and others such. I have heard about them, and I want to talk first for a moment about Beta. This is a more or less useful measure of past stock price fluctuations of common stocks. What bothers me is that authorities now equate the Beta idea with the concept of “risk”. Price variability yes; risk no. Real investment risk is measured not by the percent that a stock may decline in price in relation to the general market in a given period, but by the danger of a loss of quality and earning power through economic changes or deterioration in management. In the five editions of The Intelligent Investor I have used the example of A & P shares in 1936-1939 to illustrate the basic difference between fluctuations in price and changes in value. By contrast, in the last decade, the price of A & P shares from 43 to 8 paralleled pretty well a corresponding loss of trade position profitability, and intrinsic value. The idea of measuring investment risks by price fluctuations is repugnant to me, for the very reason that it confuses what the stock market says with what actually happens to the owners’ stake in the business.” -- Benjamin Graham (C) ValueWalk 2016 - All rights Reserved Charlie Munger

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CASE STUDY

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BENJAMIN GRAHAM

Taylorcraft-Curtiss Wright From Benjamin Graham’s lecture notes: That, I believe, illustrates quite well what the public had been offered in this recent new security market. There are countless other illustrations that I could give. I would like to mention one that is worth referring to, I think, because of its contrast with other situations. The Taylorcraft Company is a maker of small airplanes. In June, 1946, they sold 20,000 shares of stock to the public at $13, the company getting one dollar; and then they voted a four-for-one split up. The stock is now quoted around two and a half or two and three quarters, the equivalent of about $11 for the stock that was sold. If you look at the Taylorcraft Company, you find some rather extraordinary things in its picture. To begin with, the company is today selling for about $3-million, and this is supposedly in a rather weak market. The working capital shown as of June 30, 1946, is only $103,000. It is able to show even that much working capital, first, after including the proceeds of the sale of this stock, and secondly, after not showing as a current liability an excess profits tax of $196,000 which they are trying to avoid by means of a “Section 722” claim. Well, practically every corporation that I know of has filed Section 722 claims to try to cut down their excess profits taxes. This is the only corporation I know of that, on the strength of filing that claim, does not show its excess profits tax as a current liability. They also show advances payable, due over one year, of $130,000, which of course don’t have to be shown as current liabilities. Finally, the company shows $2,300,000 for stock and surplus, which is not as much as the market price of the stock. But even here we note that the plant was marked up by $1,150,000, so that just about half of the stock and surplus is represented by what I would call an arbitrary plant mark-up. Now, there are several other interesting things about the Taylorcraft Company itself, and there are still other things even more interesting when you compare it with other aircraft companies. For one thing, the Taylorcraft Company did not publish reports for a while and it evidently was not in too comfortable a financial position. Thus it arranged to sell these shares of stock in an amount which did not require registration with the SEC. But it is also a most extraordinary thing for a company in bad financial condition to arrange to sell stock to tide it over, and at the same time to arrange to split up its stock four for one. That kind of operation -- to split a stock from $11 to three dollars -- seems to me to be going pretty far in the direction of trading on the most unintelligent elements in Wall Street stock purchasing that you can find. But the really astonishing thing is to take Taylorcraft and compare it, let us say, with another company like CurtissWright. Before the split-up, Taylorcraft and CurtissWright apparently were selling about the same price, but that doesn’t mean very much. The Curtiss-Wright Company is similar to United Aircraft in that its price is now considerably lower than its 1939 average. The latter was eight and three quarters, and its recent price was five and three quarters. In the meantime, the Curtiss-Wright Company has built up its working capital from a figure perhaps of $12-million to $130- million, approximately. It turns out that this company is selling in the market for considerably less than two thirds of its working capital. The Curtiss-Wright Company happens to be the largest airplane producer in the field, and the Taylorcraft Company probably is one of the smallest. There are sometimes advantages in small size and disadvantages in large size; but it is hard to believe that a small company in a financially weak position can be worth a great deal more than its tangible investment, when the largest companies in the same field are selling at very large discounts from their working capital. During the period in which Taylorcraft was marking up its fixed assets by means of this appraisal figure, the

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BENJAMIN GRAHAM large companies like United Aircraft and Curtiss-Wright marked down their plants to practically nothing, although the number of square feet which they owned was tremendous. So you have exactly the opposite situation in those two types of companies. The contrast that I am giving you illustrates to my mind not only the obvious abuses of the securities market in the last two years, but it also illustrates the fact that the security analyst can in many cases come to pretty definite conclusions that one security is relatively unattractive and other securities are attractive. I think the same situation exists in today’s market as has existed in security markets always, namely, that there are great and demonstrable discrepancies in value -- not in the majority of cases, but in enough cases to make this work interesting for the security analyst. When I mentioned Curtiss-Wright selling at two thirds or less of its working capital alone, my mind goes back again to the last war; and I think this might be a good point more or less to close on, because it gives you an idea of the continuity of the security markets. During the last war, when you were just beginning with airplanes, the Wright Aeronautical Company was the chief factor in that business, and it did pretty well in its small way, earning quite a bit of money. In 1922 nobody seemed to have any confidence in the future of the Wright Aeronautical Company. Some of you will remember our reference to it in Security Analysis. That stock sold then at eight dollars a share, when its working capital was about $18 a share at the time. Presumably “the market” felt that its prospects were very unattractive. That stock subsequently, as you may know, advanced to $280 a share. Now it is interesting to see Curtiss-Wright again, after World War II, being regarded as presumably a completely unattractive company. For it is selling again at only a small percentage of its asset value, in spite of the fact that it has earned a great deal of money. I am not predicting that Curtiss-Wright will advance in the next ten years the way Wright Aeronautical did after 1922. The odds are very much against it. Because, if I remember my figures, Wright Aeronautical had only about 250,000 shares in 1922 and Curtiss-Wright has about 7,250,000 shares, which is a matter of great importance. But it is interesting to see how unpopular companies can become, merely because their immediate prospects are clouded in the speculative mind. I want to say one other thing about the Curtiss-Wright picture, which leads us over into the field of techniques of analysis, about which I intend to speak at the next session. When you study the earnings of Curtiss-Wright in the last ten years, you will find that the earnings shown year by year are quite good; but the true earnings have been substantially higher still, because of the fact that large reserves were charged off against these earnings which have finally appeared in the form of current assets in the balance sheet. That point is one of great importance in the present-day technique of analysis. In analyzing a company’s showing over the war period it is quite important that you should do it by the balance sheet method, or at least use the balance sheet as a check. That is to say, subtract the balance sheet value shown at the beginning from that at the end of the period, and add back the dividends. This sum -- adjusted for capital transactions -- will give you the earnings that were actually realized by the company over the period. In the case of Curtiss-Wright we have as much as $44-million difference between the earnings as shown by the single reports and the earnings as shown by a comparison of surplus and reserves at the beginning and end of the period. These excess or unravelled earnings alone are more than six dollars a share on the stock, which is selling today at only about that figure. By Rupert Hargreaves for (C) ValueWalk 2016 - All rights reserved. All materials in this PDF are protected by United States and international copyright and other applicable laws. You may print the PDF website for personal or nonprofit educational purposes only. All copies must include any copyright notice originally included with the material and a link to ValueWalk.com. All other uses requires the prior explicit written permission by ValueWalk (C) ValueWalk 2016 - All rights Reserved Charlie Munger

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