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Lessons and Ideas from Benjamin Graham

Jason Zweig

Investing Columnist

Money

Magazine New York City

n June 2003, HarperCollins Publishers asked if Iwould be interested in updating Benjamin Gra-ham’s classic

The

Intelligent Investor

After determin-ing that the proposal was not somebody’s idea of apractical joke, I agreed to take on the project. And asI worked on revising the book, I was reminded, onceagain, what a genius Graham was. So, in the courseof this presentation, I will discuss the following:•the things that made him famous,•the factors that caused his reputation to drop outof fashion,•the insights that make him relevant today, and•the many ways in which he showed himself to be a man of brilliance.

Becoming Reacquainted withGraham

My work on Graham’s book took about five months.Before that, however, I spent several months throw-ing ideas back and forth with the HarperCollins edi-tors to settle on an appropriate way to approach theproject. What we decided on was this: I could notchange the original text. After all, you do not rewritethe Bible. So, if I was not going to change the originaltext, we had to come up with something for me to do.As it turned out, my role was twofold.One part of my job was to annotate the existingtext (the 1972 edition, which was Graham’s fourthrevision)—the purpose being to make the book morecomprehensible for contemporary readers, bothretail investors and investment professionals. Forexample, many of the businesses that Graham dis-cussed in the last edition of the text had to be placedin their historical context, and some required moreexplanation than others. For instance, most invest-ment professionals know that Studebaker was oncea stock, but far fewer of them know much about theNorthern Pipeline Company or the other companiesthat are integral to Graham’s discussions.The other part of my job was to write commen-taries to accompany all of Graham’s chapters. Eachof my commentaries explains the basic principle thatGraham addressed in the chapter, describes whathas happened in recent years to the investors whodid—and did not—listen to him, and suggests howGraham’s principles might apply in the future.As I worked on the project, one of the questionsI kept asking myself was: Is Graham still relevant?After all, this was a man who was born in 1894, began working on Wall Street in 1914, wrote

Security Analysis

in 1934,

and wrote the first edition of

TheIntelligent Investor

in 1949, primarily using ideas thatwere fully formed in his mind by the early 1930s. Alot has changed since then, and Graham came undera great deal of criticism in the late 1990s. For exam-ple, consider the following remark from Jim Cramer:“You have to throw out all of the matrices andformulas and texts that existed before the Web. . . .If we used any of what Graham or Dodd teach us,we wouldn’t have a dime under management.”

But Graham anticipated comments such as thisone. Graham knew that people were going to saysuch things about him someday, just as he seemed toBenjamin Graham wrote his first book on investing in 1934, and although he refined thesethoughts over time, his message (and the truth therein) has remained the same. Thus,Graham was not a man ahead of his time; he was a man for all time.

Benjamin Graham,

The Intelligent Investor

, rev. ed., updated withnew commentary by Jason Zweig (New York: HarperBusiness,2003). The first edition was published in 1949 by Harper, and afourth revised edition was published in 1972 by Harper & Row. Iwill refer to these three editions throughout my presentation.

Benjamin Graham and David L. Dodd,

Security Analysis

(NewYork: Whittlesey House, McGraw Hill Book Company, 1934).

James J. Cramer, thestreet.com (29 February 2000).

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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

Security Analysis

and

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

Forbes

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.

Why Graham

Should

Be Famous

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

should

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

Forbes

(1 June 1932):11.

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Lessons and Ideas from Benjamin Graham

presented in

Security Analysis

in 1934.” Graham con-stantly retested his assumptions and tinkered withhis formulas, so anyone who tries to follow them inany sort of slavish manner is not doing what Grahamhimself would do if he were alive today.So, what

should

Graham be famous for? Well,perhaps he should be famous for being one of the most brilliant men who ever lived. And he shone not with just one kind of brilliance but with at least five kinds:•intellectual brilliance,•financial brilliance,•prophetic brilliance,•psychological brilliance, and•explanatory brilliance.

Intellectual Brilliance.

Let me begin by sayingthat Graham had an intellectual firepower that thestock market has probably seen only one time since—in the person of Warren Buffett. At the age of 20,Graham graduated from Columbia University sec-ond in his class. He had actually been admitted whenhe was 15, but because of an administrative error, hedid not enter the university until he was 16. Other-wise, he would have graduated when he was 19.Before the end of his senior year, he was offeredfaculty positions in three different departments. Howmany of us, I wonder, can imagine ourselves beingasked to join the faculty of any college, much less anelite one, before we graduated? And consider thefaculty positions that he was offered—one in thedepartment of English, one in the department ofphilosophy with a specialty in Greek and Latin, andone in mathematics. If that does not define a renais-sance man—or boy—I do not know what does.Besides his sheer intellectual capacity, Grahamdisplayed extraordinary skill in hypothesis testing.He observed the financial world through the eyes ofa scientist and a classicist, someone who was trainedin rhetoric and logic. Because of his training andintellect, Graham was profoundly skeptical of back-tested proofs and methodologies that promote the belief that a certain investing approach is superiorwhile another is inferior. His writing is full of warn-ings about time-period dependency. By shifting thestarting or ending date for data samples, he demon-strated that the results change dramatically. That is alesson we should all keep in mind, both as consumersof investment analysis and as producers of investingarguments in presentations to clients. Graham arguedfor slicing data as many different ways as possible,across as many different periods as possible, to pro-vide a picture that is likely to be more durable overtime and out of sample.Graham also wrote about survivorship bias before anyone ever used the term. In his discussionof long-term stock returns, he apologized for the factthat he was using data from the late 19th century,saying essentially that he did not think the data sam-ple was very good. That suggests that all of us needto be concerned about using any long-term data thatgo back generations. Unless we know what has fallenaway from the dataset, we do not know how goodthe data actually are.In contrast, in a particularly interesting passage(in Chapter 7), Graham apologized to the reader forhaving only 22 years of data to support a particularhypothesis (see the 2003 edition, p. 157). How manydata providers today are going to offer such an apol-ogy? Yet, it is an apology (and a warning) that today’sinvestors should be hearing: We should always besuspicious of short-term data when formulating ahypothesis.Finally, and this trait arises from his propensityfor tinkering that I mentioned earlier, Graham dis-played an exemplary intellectual honesty. Again andagain, he pointed out where he was wrong in the pastand how he had revised his thinking to improve theaccuracy of his ideas.

Financial Brilliance.

It is one thing to have animpressive intellect, but does that intellect necessar-ily translate into financial success? For all of his bril-liant ideas, one might ask: Was Graham actually anygood as an investor? The best way to answer thatquestion is to consider the data.He started investing independently in 1925, butperformance numbers from that period are unreli-able, so a discussion of his early investment career isnot very fruitful. But in 1936, he started the Graham–Newman Corp., which was an open-end mutualfund, and his work with that fund is the financialwork for which he is best known. He ran the fund forabout 21 years, and during that period, the fundcompounded at least 14.7 percent annually while theS&P 500 Index earned an annualized 12.2 percent.Most people will tell you that Graham–Newman didabout 17 percent a year on a compound basis. That isthe number that Buffett has often used, but when Iwent back and recalculated the numbers by hand, itwas not clear to me whether the 17 percent was beforefees or after fees. But even using the more conserva-tive figure of 14.7 percent, Graham consistently beatthe market by 250 bps a year for more than twodecades. The answer to the question, then, is yes,Graham was an extraordinarily good investor.

Prophetic Brilliance.

Graham was also a pro-phetic genius. He had an ability to see into thefuture—and not just the financial future—that wasnothing short of phenomenal. Consider the following