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Equity Analysis Issues, Lessons, and Techniques
know so many things before they happened. In fact,the 5 May 1974 edition of the
New York Times
quotedhim as saying: “[My books] have probably been readand disregarded by more people than any book onfinance that I know of.” Much as Mark Twain saidabout the weather, Graham understood that peoplewould read the ideas in his books but that nobodywould do anything about them. So, I struggled withthis issue: How relevant is Graham’s book today?I had read the book twice myself. It was the first book I read when I became a financial journalist in1987, and I had read it again in the early 1990s. Butwhen I started this project, I had not read the bookfrom cover to cover in a decade, although I hadalways kept it on my shelf and frequently referred toindividual chapters or specific passages. When I readit again at the beginning of this project, I could not believe how good it was—and how relevant.
Why Graham Fell Out of Fashionand Why He Is Famous
Graham is often regarded as a kind of judgmental orformulaic market timer, not in the sense that ElliotSpitzer has made famous but in the sense that oneshould get out of stocks when they are overvaluedand stay in cash or bonds until stocks get cheap again.A lot of the early chapters in Graham’s book are givenover to his ruminations on when investors should bein the market and when they should be out. Suchemphasis on market timing is largely out of fashiontoday. His basic formula is that when investors thinkstocks are cheap, they should have up to 75 percentof their assets in stock. When stocks are expensive,they should reduce their holdings to as low as 25percent and keep the rest in bonds or cash. It is aninteresting formula—and not all that different fromthe kind of tactical asset allocation that many pensionfunds currently use.Graham is probably most famous for the variousvaluation metrics that he spelled out in
The Intelligent Investor
. Graham wouldroll over in his grave if he heard me use the word“metrics” in the sense that was made popular in thelate 1990s, but it is good shorthand and, as rules ofthumb, the formulas are familiar to many of us. Forexample, on the one hand, Graham said that investorsshould stay away from growth stocks when theirnormalized P/Es go above 25. On the other hand,when the product of a stock’s normalized P/E and itsprice-to-book ratio (price/book) is less than 22.5—Normalized P/E × (price/book) < 22.5—it is at leasta good value. So, if the normalized P/E is below 15and the price/book is below 1.5, the stock should beattractive. Another valuation metric that he madefamous is that when the price of a stock is less than1.3 times the tangible book value, it should be a goodvalue for the investor.Graham is also well known for his idea of “netnets,” which means, in essence, that if investors can buy stocks for less than the value of net workingcapital, they will always do well. And historicalevidence has shown this axiom to be true. Unfortu-nately, history also shows that the market providessuch opportunities, on average, perhaps once every27 years. One such opportunity occurred in the early1970s and another occurred in the wake of the 1999stock market bubble, but it appears to be gonealready. Such windows open quickly and close justas fast.Graham wrote a series of articles in
in1932 in which he talked extensively about the signif-icance of buying stocks for less than net workingcapital and why no one was doing so but him. It isin these articles that he coined the phrase “those withthe enterprise haven’t the money, and those with themoney haven’t the enterprise,”
which is almost, bydefinition, why valuation can go so low: The peoplewho could buy are too scared to make a move, andthe ones who know they should buy do not haveenough capital to do so.
I would not presume to tell an audience of CFAcharterholders what Graham’s valuation formulaswould be today. For one thing, they would not be theformulas for which he is well known because, as I willshow, one of the things that Graham
be famousfor is that he was a great American tinkerer. In thesame tradition as Edison and the Wright Brothers,Graham was constantly experimenting and retestinghis assumptions and seeking out what works—notwhat worked yesterday but what works today. Ineach revised edition of
The Intelligent Investor
, Gra-ham discarded the formulas he presented in the pre-vious edition and replaced them with new ones,declaring, in a sense, that “those do not work anymore, or they do not work as well as they used to;these are the formulas that seem to work better now.”One of the common criticisms made of Grahamis that all the formulas in the 1972 edition are anti-quated. The only proper response to this criticism isto say: “Of course they are! They are the ones he usedto replace the formulas in the 1965 edition, whichreplaced the formulas in the 1954 edition, which, inturn, replaced the ones from the 1949 edition, whichwere used to augment the original formulas that he
(1 June 1932):11.