INTELLIGENT INVESTING Investing Practice in the Early Twentieth Century: Benjamin Graham and the Birth of Value Investing

by Ryan Shayan Sepassi

A thesis submitted to the Department of History in partial fulfillment of the requirements for the Degree of Bachelor of Arts with Honors

Harvard University

Cambridge Massachusetts

11 March 2010

TABLE OF CONTENTS Introduction: An Unexamined Legend................................................................................1 1. Early Investing Practice: 1915-1925..............................................................................13 Rise of Mass Participation.........................................................................................13 Schools of Thought....................................................................................................19 2. Benjamin Graham: 1894-1929.......................................................................................27 The Early Years: 1894-1911......................................................................................27 Beginnings on Wall Street: 1912-1919.....................................................................31 Rise on Wall Street: 1920-1929.................................................................................37 3. The Great Crash & Its Aftermath: 1929-1934.............................................................43 The Boom...................................................................................................................43 The Bust.....................................................................................................................47 The Response.............................................................................................................52 4. Security Analysis: 1934-1940.........................................................................................60 An Investing Philosophy............................................................................................61 Critiques of Competing Schools of Thought.............................................................64 Reception....................................................................................................................67 5. Benjamin Graham’s Impact: 1940- ..............................................................................70 Graham’s Life: 1940-1976.........................................................................................70 Security Analysis Becomes a Profession..................................................................72 Superinvestors of Graham-and-Doddsville...............................................................74 Graham and the Efficient Market Hypothesis...........................................................77 Conclusion: Value Endures.................................................................................................81 Bibliography...........................................................................................................................84

INTRODUCTION

AN UNEXAMINED LEGEND
Warren Buffett is no stranger to even the most infrequent follower of the stock market; he has spent his fair share of time among and atop the billionaire list, and since 1970, he has served as Chairman and Chief Executive Officer of Berkshire Hathaway, his investment holding company. Buffett has used Berkshire to build one of the best investment records in history, and as his fame and fortune grew, he became an icon in the investing communities: more than 60 books have been written about him and his investing strategies – including at least 3 biographies – and each year, nearly 30,000 of his most devoted fans descend upon Omaha, Nebraska for Berkshire Hathaway’s annual meeting.1 The highlight of what has turned into a weekend event is a six-hour-long question and answer session with Buffett – or the “Oracle of Omaha,” as some call him – and his partner Charlie Munger. The event has come to be half-jokingly known as “Woodstock for Capitalists” (which also happens to be the title of a documentary made about the annual meeting).2 Less well known to those outside the cloistered world of finance, however, is a man named Benjamin Graham. Graham, by and large, formulated the very investing framework that Buffett has put to such good use over the years. Buffett studied under Graham at Columbia, where Graham was teaching an investing course, and would later work for Graham as an investment analyst, before striking out on his own in 1956.3 Buffett idolized
1

Warren Buffett, Letter to Shareholders (2008), http://www.berkshirehathaway.com. Compounded annual gain of 20.8% from 1965-2008 versus 8.9% for the S&P 500. These returns translate into a cumulative return of 362,319% for Berkshire versus 4,276% for the S&P 500 over the same time period. 2 Woodstock for Capitalists, TV, directed by Ian Darling (March 15, 2001), Australian Broadcasting Corporation. Can be found at http://www.abc.net.au/tv/documentaries/. 3 Alice Schroeder, The Snowball (New York: Bantam Books, 2008). Schroeder’s biography is by far the

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Graham, and to this day, he cites Graham’s 1949 book The Intelligent Investor as “by far the best book about investing ever written.”4 Buffett is 79 years old, and given his grandfatherly reputation and the fact that he attended Columbia to study under Graham in 1951, its no surprise that he cites a 1949 investing book as the best ever written. But Graham’s place in Buffett’s personal pantheon is not so unique. That book, The Intelligent Investor, is still in print, and it is actually considered the layman’s guide to Graham’s masterwork, Security Analysis, first published in 1934. Indeed, Security Analysis, co-authored with junior colleague David Dodd, has been in print for more than 75 years and enjoyed the publication of a sixth edition in 2008.5 Seth Klarman, who served as editor of the latest edition, is a highly successful and highly respected investor who cites Graham as his teacher, despite having never studied under him or even met him. Klarman’s introductory essay to the sixth edition calls Graham and Dodd’s work “timeless wisdom,” and he cites a “coterie of modern-day value investors [who] remain deeply indebted to them [Graham and Dodd].”6 Those who adhere to Graham’s ideas have come to be called “value investors,” because of the investing philosophy’s emphasis on the intrinsic value of companies.
most comprehensive of the Buffett biographies, and includes a short but thorough biography on Graham as well as the best treatment of Graham’s relationship with and influence on Buffett. Schroeder was able to have unfettered access to Buffett, his papers, and his friends, which make for a remarkably thorough and insightful look into his life. Buffett: The Making of an American Capitalist by Roger Lowenstein (New York: Random House, 1995) is also an exceptional Buffett biography but was written without the benefit of such access to Buffett and considering Buffett’s prolific activity since 1995, was beginning to seem out-ofdate. The last of the major Buffett biographies is Of Permanent Value: The Story of Warren Buffett by Andrew Kilpatrick (New York: McGraw Hill, 1998), but this biography comes in a very distant third in thoroughness and quality; Buffett himself has called it “a bit skimpy,” and there is little in it that the first two biographies do not do better. Finally, while not biography, the most complete source of information on Buffett’s ideas – many of which are based on Graham’s – is the archive of his annual letter to the shareholders of Berkshire Hathaway, which can be accessed online at www.berkshirehathaway.com. They have also been compiled and edited into various subject categories in The Essays of Warren Buffett: Lessons for Corporate America ed. by Lawrence A. Cunningham (New York: L. Cunningham, 2008). 4 Warren Buffett, Preface, The Intelligent Investor by Benjamin Graham (New York: Harper & Row, 1985), ix. 5 Benjamin Graham and David Dodd, Security Analysis, 6th ed. (New York: McGraw-Hill, 2008). 6 Ibid, xiii-xl.

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Klarman goes on to say that “the financial markets have morphed since 1934 in almost unimaginable ways, but Graham and Dodd’s approach to investing remains remarkably applicable today.”7 This statement is all the more striking since the 2008 edition is really just a reprint of the 1940 edition. Few ideas in the financial world carry much weight for more than the few years following their initial dissemination; 75 years, is nearly unheard of, and in unaltered form no less. What were Graham’s ideas, and why have they carried so much weight over so many years? Despite Graham’s modern-day relative obscurity amongst the general public, he is well known amongst practitioners, and his importance to the field of security analysis is nary underplayed. In addition to the continuous publication of Security Analysis and The Intelligent Investor, nearly every book about value investing or about Buffett cites Graham as the initial fount of wisdom from which they draw – manna from the investing heavens, if you will; indeed, Bruce Greenwald of Columbia Business School, who is generally considered to be the current academic successor to Graham, published a value investing book entitled Value Investing: From Graham to Buffett and Beyond.8 Value investing begins with Graham. Graham is also given prominent placement in such popular investment books as Adam Smith’s9 The Money Game and Supermoney as well as John Train’s The Money Masters and its sequel Money Masters of Our Time; these books profile the investing world’s most influential and brightest players, and their treatment of Graham is generally uniform. Supermoney describes Graham in this way: “There is only one Dean of our profession, if security analysis can be said to be a profession. The reason that Benjamin
7 8

Ibid. Bruce Greenwald, Value Investing: From Graham to Buffett and Beyond (New York: Wiley, 2001). 9 Clearly this is not the Adam Smith of Wealth of Nations fame, but the chosen pseudonym for author George Goodman.

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Graham is undisputed Dean is that before him there was no profession and after him they began to call it that.”10 The Money Masters is not so far off: “Benjamin Graham ranks as this country’s (and perhaps history’s) most important thinker on applied portfolio investment, taking it from an art, based on impressions, inside information, and flair, to a proto-science, an orderly discipline.”11 Much of what is written about Graham by practitioners and fellow value investors is similar to these grandiose characterizations. Even among the more recent texts that mention Graham, this seemingly superficial view persists. Money Masters of Our Time cites Graham as “the greatest investment theorist of his day,”12 The Myth of the Rational Market calls him a “value-investing legend,”13 and Greenwald’s Value Investing echoes Train and Smith in arguing that “the publication of Security Analysis with David Dodd in 1934 marks the start of a profession.”14 None of these claims or regal titles would be remiss if some justification were given, but it is not within the scope of many of these books to embark on a historical analysis of Graham’s contribution to the field. Despite this clear popularity amongst investors, there is little about Graham by way of academic scholarship, or even biography. Only one biography has been written, and without the benefit of Graham’s posthumously published memoirs no less. 15 Indeed, as far as academic circles in finance and economics go, Graham is all but totally ignored as an antiquated practitioner with little to offer to those in search of the theoretical underpinnings
10 11

Adam Smith, Supermoney (Hoboken: Wiley & Sons, 1972), 172. John Train, The Money Masters (New York: Harper & Row, 1980), 82. 12 John Train, Money Masters of Our Time (New York: HarperBusiness, 2000), 108. 13 Justin Fox, The Myth of the Rational Market (New York: HarperBusiness, 2009), 323. 14 Greenwald, Value Investing, xv. Greenwald also quotes the New York Society of Security Analysts as going so far as to say of Graham that he “is to investing what Euclid is to geometry, and Darwin is to the study of evolution” (xv). The quote could not be verified (probably because of changes to the Society’s website since publication of the book), but it shows the extent to which the investing community reveres Graham. 15 Janet Lowe, Benjamin Graham on Value Investing (Chicago: Dearborn Financial, 1994); Benjamin Graham, The Memoirs of the Dean of Wall Street (New York: McGraw-Hill, 1996).

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of investing, the stock market, and general finance. Furthermore, the rise of the academic efficient market hypothesis (EMH) – which basically argues that the market is always perfectly priced and that it is impossible to exploit it – is directly at odds with Graham’s basic premise of finding mispriced securities – that is, hunting for bargains. Justin Fox, in his history of the modern-day EMH, recounts how Harry Markowitz, an early player in the hypothesis’ development, “read every word and every footnote [of Security Analysis], but found no inspiration. The book is a brilliant guide to bargain hunting, but isn’t much help to someone looking for a general theory of investing.”16 Markowitz’s opinion was furthered in academic circles by Burton Malkiel, who would go on to establish some of the crucial building blocks of EMH: “Graham and Dodd’s Security Analysis, the erstwhile bible of the security analyst, had lost touch with the realities of the new ‘new era’ of common-stock valuation.”17 To the academics, Graham’s work was simply too narrow and too old to be of any worth to them. However, these two historically stable views of Graham have been joined by a third in recent years as the rise of behavioral finance and the 2007-2008 financial crisis have rekindled a skepticism of the EMH. As academics have begun to question whether markets are truly as efficient – that is, perfectly priced – as their prized theories have argued, they have looked to financial history to understand if those theories still hold or if they were ever even accurate. Because of this look back, Graham has enjoyed some renewed attention as a thinker who may have had an alternate view of how financial markets work. However, those that do cite him seem to have conflicting interpretations about exactly which side of the debate Graham’s ideas fall.

16 17

Fox, Myth of the Rational Market, 53. Ibid, 118.

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Economists Owen Lamont and Richard Thaler, in a paper questioning the conclusions of the EMH, argue, “As the Benjamin Graham [1923 GM-Du Pont arbitrage] episode shows, despite enormous changes in capital markets and information technology, it is not clear that financial markets have gotten more Law abiding since 1923” – that is, markets have not gotten more efficient.18 Here, these economists point to Graham as the quintessential example of an inefficiency opportunist, firmly opposed to the theoretical efficiency that supposedly existed. However, another economist, Burton Malkiel, seems to repurpose Graham as an advocate of the EMH: “But I am convinced that Benjamin Graham (1965) was correct in suggesting that while the stock market in the short run may be a voting mechanism, in the long run it is a weighing mechanism. True value will win out in the end. Before the fact, there is no way in which investors can reliably exploit any anomalies or patterns that might exist.”19 Malkiel here seems to argue that Graham’s conception of the market is that of the EMH advocates – that the market cannot be beaten, that bargains do not exist, in direct opposition to Lamont and Thaler’s conception of Graham. Justin Fox flip-flops a bit, in his history of the EMH, when speaking of Graham in relation to the EMH, paradoxically arguing that Graham was on one and the other side of the debate in two different parts of the book. At one point, Fox quotes Graham “sounding a bit like a Chicago economist”20 and characterizes Graham’s statements as “the essence of the efficient market hypothesis, as formulated loosely and reasonably by someone with

18

Owen A. Lamont and Richard H. Thaler, “The Law of One Price in Financial Markets,” The Journal of Economic Perspectives, v17, no4, Autumn 2003, 199-200. 19 Burton G. Malkiel, “The Efficient Market Hypothesis and Its Critics,” The Journal of Economic Perspectives 17 (Winter 2003), 61. 20 The University of Chicago is the generally accepted birthplace and bastion of the modern version of the EMH.

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actual market experience.”21 Here again is Graham being put on the same side as the EMH professors through an interpretation of Graham’s own words. However, Fox later argues that Graham did not at all cave into the EMH school of thought, but that Graham had a consistent philosophy of the existence of market efficiencies; the way Fox puts it is that “all [Graham] was trying to say was that there were no easy pickings” – that is, Graham agreed that most securities were fairly enough priced, but that periodically the market got it wrong.22 If this is the case, then once again, Graham’s ideas are fundamentally opposed to the EMH school because bargains cannot exist in a perfectly priced market. The importance of this difference – most securities efficiently priced versus all securities efficiently priced – cannot be overstated; the EMH is the central pillar of academic finance and its fundamental argument is that there is no difference between the value of the security and the price of the security – that is, the market always gets it right. If this is not true, the entire edifice of academic finance would rest on a very shaky foundation indeed. However, its veracity is not for this study to decide; what is for this study to decide, rather, is what implications Graham’s ideas hold for the EMH and how he fits into the current debate. The scant literature on Graham ultimately seems to be divided into three camps, none of which provides much justification for Graham’s historical importance or much insight into the development of his ideas. In the first camp, practitioners and fans of value investing hold Graham in the highest regard and argue that he revolutionized – or created – the field, but they lack any historical treatment or convincing evidence of such a

21 22

Fox, Myth of the Rational Market, 119. Ibid, 131.

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contribution. This is not to say that Graham did not make such a powerful contribution – only that the literature that argues so simply does not spend the time to provide the requisite historical evidence, perhaps justifiably so given that the vast majority of the books are how-to’s rather than histories and given that Graham may have been so well-known in certain circles and certain times that such treatment would have been unnecessary. Suffice it to say that today’s investors and other interested persons are far enough removed from Graham in time that such a historical treatment would be necessary and valuable. The second camp, of course, has a nearly diametrically opposed view of Graham; academics and scholars view Graham as little more than a successful practitioner in his time who, despite his influence on a small group of investors, has little significance or relevance to the broader questions of investing or finance theory. Similarly to the first camp, this camp too does little to convince a reader of its viewpoint. And finally, the third camp seems to have some conflicting interpretations of what Graham’s ideas mean in the context of the current financial crisis and rethinking of the EMH. In short, a thorough study of Graham’s ideas in their historical context has not been thus far undertaken, nor have his ideas been revisited in depth in the current context. Given this scant literature on a man who so clearly has influenced large sections of the investing population over the course of several decades, such a study would contribute greatly to our understanding of the origin of Graham’s ideas, their place in his time, his true contribution to the field, and finally, their place in our time. This study is the first attempt to place Graham firmly in the historical context of the 1920s and 1930s, and to cement his position among the modern debates surrounding the EMH. Furthermore, this is the first lengthy look at Graham since Janet Lowe’s 1994

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biography, and since then, the primary and secondary source base has expanded considerably, warranting a fresh overview of the sources available.23 Most of the focus will be on Graham’s major investing work Security Analysis, as it is indisputably his most important work, as well as the one that contains the most detailed and thorough exposition of his core ideas. Nonetheless, his lesser works will be touched upon briefly in the course of the chronology, but more in the manner of biographical highlight than of in-depth analysis. A thesis discussing the fields of finance and investing may strike a nerve in today’s chaotic financial environment, and one might be quick to dismiss the fields entirely as an enormous and useless game of chance in which charlatans and daredevils risk the capital and financial well-being of the unsuspecting public for the chance at untold riches. No doubt this characterization captures some truths about financial markets – particularly those of the present day – but those who subscribe to this view even in part would be wise to recognize its limitations lest they forget the fundamental importance and benefits of a developed financial system to economic growth and societal well-being. Finance, at its foundations, is meant to allow capital to flow effectively and efficiently from those who have it to those who need it: the entrepreneur with a clever idea, the established manufacturing company with plans to expand, the family looking to own a home, the business with a need to manage cash-flow, and more.24 This capital comes at a price to those accessing it – the interest on bonds or an ownership stake in the case of stock – and an efficiently priced market ensures that the capital is going not only to those who need it, but to those who can also afford it. Practitioners like Benjamin Graham are of the utmost
23 24

Please see note 5. Thomas McCraw, “Chapter Seven: The Financial System” in American Business Since 1920: How It Worked (Wheeling: Harlan Davidson, 2009), 184-211. McCraw discusses in this chapter the basic functions of the financial system and its dramatic rise in importance in the United States since 1920.

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importance in the markets because they are looking for the inefficiencies – the places where the market as a whole is getting the price of capital wrong – and by their actions are helping to correct those inefficiencies – and make a profit in the process. This underlying significance warrants historical study of its many facets, including the major practitioners and thinkers like Benjamin Graham. The author hopes that the following work can answer some of the questions that deserve to be asked about Graham: What were his ideas? How did they change investing practice and theory in their time? And how have they influenced investing over the decades? To answer these questions, the study begins with a chapter on the financial and investing context of the 1920s to understand the circumstances under which Graham became an established practitioner and teacher, and to see what existed before Graham’s major contributions in order to then understand how those contributions fit in the historical context. A chapter on Graham himself follows, tracking his rise in the investing community and the development of his ideas through an analysis of his memoirs and his publications in financial periodicals of the time, again over the course of the 1920s. The Great Crash of 1929 was a defining moment in American financial history; it precipitated the Great Depression and dramatically changed the investing landscape. The third chapter describes exactly how that landscape changed – both practically and psychologically – and sets the stage for Graham’s publication of Security Analysis in 1934, which is discussed at length in chapter four with specific emphasis on a detailed examination of its principles for investing. While the goal of the thesis is to study Graham historically, the impact of his work has been so far-reaching that a brief discussion of the trends of that impact is warranted; chapter five briefly deals with Benjamin Graham’s impact in the years

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immediately subsequent to the text’s publication and the decades thereafter. Ultimately, Graham was entering an environment that was rapidly changing and not very well understood in the 1920s in regards to the stock market. As general financial participation rose, and then shifted from bonds to stocks, many of the dominant schools of thought about markets would prove to be inadequate. Furthermore, the rise of the financial markets in general, and the stock market in particular, was accompanied by increased financial disclosure from individual companies, revealing myriad facts about the nature and state of their business. Graham entered the scene when these statistics were first becoming available and were yet to be fully understood or incorporated; he began to carve out a niche as an expert in the analysis of these seemingly trivial data sets. As Graham rose on Wall Street, he began to put this developed expertise to good use, and did quite well for himself and his clients. The Great Crash caused widespread disillusionment and uncertainty about the future, and largely discredited the major forecasting services that were dominant in the 1920s. Graham would enter this breach with Security Analysis in 1934, which presented an investing framework that addressed much of the disillusionment with other systems. The text advocated the thorough analysis of individual securities and the adherence to bargainhunting – only buying when the security was very cheap relative to its true worth. These ideas quickly came to dominate the field of security analysis, and the text would become standard across the country. Graham would help establish security analysis as an organized profession, and would give rise to “value investing” through the generation of investors that carry on his legacy.

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CHAPTER 1

EARLY INVESTING PRACTICE: 1915-1925
I. Rise of Mass Participation Financial markets from the mid-1910s to the mid-1920s were dominated by the bond markets and it would not be until the mid-to-late-1920s that the stock market would explode in size and participation. The stock market’s rise, however, was firmly rooted in the developments of this earlier period; specifically, the rise of the middle class, the Liberty Loans of WWI, and the development of statistical services and methods of analysis made possible the stock market’s later prominence. Furthermore, it was the analytical methods and investing principles of this time – focused on bond analysis, technical analysis, and business forecasting – that would persist throughout the 1920s, and would ultimately prove to have been inadequate in light of the Great Crash of 1929 and subsequent Great Depression. In those days [pre-1920s] the record of daily stock exchange transactions occupied hardly a newspaper column…And if there was anything Mrs. Smith was certain not to have on her mind as she went shopping, it was the price of stocks.25 -Frederick Lewis Allen, Only Yesterday Prior to the 1920s, the stock market was the speculative backwater of the financial world. Annual volume – the total number shares traded – on the largest of the exchanges – the New York Stock Exchange – hovered at around 48 million shares in 1914, a pittance compared to the volume only a few years later in 1925 of 454 million shares (volume would peak in 1929 at over 1 billion shares).26 Much of the public believed that small
25

Frederick Lewis Allen, Only Yesterday: An Informal History of the 1920’s (New York: Harper & Brothers, 1931), 8. 26 United States Bureau of the Census, Historical Statistics of the United States: Colonial Times to 1970 (Washington: US Dept of Commerce, 1975), 1007.

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wealthy groups controlled the market through trading in insider information and organized speculation that effectively made the group rich off the backs of the unsuspecting small investor. The general sentiment regarding financial markets in general was colored by such a work as soon-to-be Supreme Court Justice Louis Brandeis’ Other People’s Money and How the Bankers Use It (1913), a scathing indictment of “the world according to J.P. Morgan” and the “money trust.”27 Brandeis basically argued that men like J.P. Morgan and the system that they had constructed constantly gambled with “other people’s money,” and that this privileged and reckless few had control over the economic destiny of millions. All this was to change over the course of the next few years, but before the public was ready to jump onto the stock-market bandwagon, the financial economy itself had to develop and draw the masses into its workings – and that it did.28 The institutional and regulatory foundations to the later rise of finance were laid in the early twentieth century. Between 1900 and 1914, the number of state banks tripled, and by 1913, more than 1,800 trust companies and 2,000 savings banks were at work.29 In that same year, Congress passed the Federal Reserve Act, and the system began operation on November 16, 1914.30 The first securities regulations – called “blue sky” laws – went into effect during this same time period; the first “blue sky” law went into effect in Kansas in 1911 and was targeted mostly at outright frauds.31 The Interstate Commerce Commission (ICC), which was the main regulatory body for the railroads, began in 1906 to mandate
27 28

Steve Fraser, Every Man a Speculator (New York: HaperCollins, 2005), 295-297. Julia Ott’s dissertation “When Wall Street Met Main Street: the Quest for an Investors’ Democracy and the Emergence of the Retail Investor in the United States, 1890-1930” (Yale University, 2007) provides a detailed account of the changes in sentiment and institutions that led to the tremendous expansion of “main street” participation in the financial markets, beginning with the WWI Liberty Loan campaigns. 29 Jerry W. Markahm, A Financial History of the United States, v.II (Armonk: M.E. Sharpe), 56. 30 Peter Wyckoff, Wall Street and the Stock Markets (Philadelphia: Chilton Book Co., 1972), 53. 31 Michael E. Parrish, Securities Regulation and the New Deal (New Haven: Yale University Press, 1970), 5-6. Parrish also discusses the origins of the term “blue sky”: “The epithet “blue sky” was attached to the laws by one midwestern state legislator who, during the course of heated debate, declared that if securities legislation was not passed, financial pirates would sell citizens everything in his state but the blue sky.”

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uniform accounting methodologies for the railroads’ regular reports to external investors after the passage of the Hepburn Act;32 in 1917, the American Institute of Accountants bolstered such efforts with the publication of a set of guidelines for financial audits.33 And it was around the time the Federal Reserve system began that large commercial banks decided to push into the securities markets, which at the time were “confined almost exclusively to the bond market.”34 These institutional and regulatory advances laid the groundwork for the coming increased participation in financial markets. As the securities markets were dominated by the bond market, the public, if they invested in financial instruments at all, would have owned bonds. But the numbers were miniscule. As late as 1917, bankers had estimated that the total bond market consisted of about 350,000 people, and fewer than 500,000 people owned any type of financial security (bond or stock).35 The outbreak of World War I and the subsequent Liberty Loan campaign would dramatically alter the demographics of the investor class. By the end, more than 20 million individuals had bought Liberty bonds – raising a total of over $21 billion – dwarfing the estimate of a 350,000-person market and bringing to light the existence of a previously untapped market.36 With a total population in the United States at the time of below 100 million, the 20 million bond owners put the participation at over 20%.37 Part of the issues’ success was due to the massive marketing effort of the Treasury, the small denominations of the bonds, and the surprising lack of selling commissions. But Wall Street was happy to forgo these commissions; as Charles Geisst explains, “Inadvertently,
32

Jonathan Barron Baskin and Paul J. Miranti, Jr., A History of Corporate Finance (New York: Cambridge University Press, 1997), 183-184. 33 Markham, Financial History, 91. 34 Charles R. Geisst, Wall Street: A History (New York: Oxford University Press, 2004), 150. 35 Geisst, Wall Street, 151; Ott, Wall Street to Main Street, 8. 36 Ott, Wall Street to Main Street, 8. 37 US Bureau of the Census, Historical Statistics, 8.

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the Treasury’s marketing effort was bringing in millions of customers who were assumed not to have existed before.” Whereas the bankers and brokers previously thought that the investing class was limited to the upper echelons of society – bonds were thought to be “the preeminent investment in the country among the wealthy” – the rise of the American middle class in the early twentieth century had created a new potential market and the Liberty Loan campaign had drawn them into the financial system as new investors.38 Once this new mass of investors had been drawn into the bond market, it wasn’t long before their newfound interest in financial securities led them to the stock market. By 1920, estimates put the stock-owning population at more than 2 million individuals, and by 1929, five times that number were participating (more than one-third of households).39 AT&T was owned by more than 700,000 individuals in 1924, and the ownership base of Standard Oil Company of New Jersey went from 7,500 in 1917 to 77,000 in 1926.40 The Liberty Loan campaign had not only drawn the public into financial markets, it had also inextricably linked the ownership of financial securities to the fundamental principles of democracy – everybody was to own a piece of America in the interest of democratic principles of equality and civic participation. Capitalizing on such a shift in ideology, the government as well as financial firms – brokerages and security firms in particular – began to link the same conception to stock ownership. It was this participation and propaganda that began to change public sentiment regarding the stock market – people brought up on

38 39

Geisst, Wall Street, 150-151. Ott, Wall Street to Main Street, 13. Estimates of stock market participation vary wildly with some sources citing as many as 15 million stock-owning individuals as early as 1922, and up to 30 million at the market’s peak in 1929. However, most of these figures, as Julia Ott notes in her dissertation, are aggregates of the number of individuals owning each stock, which would lead to multiple counting of the same individual. These lesser figures are more reasonable estimates that still represent significant increases in stock-ownership over the course of the 1910s and 1920s; these figures are also cited by Ott and Miranti in their respective works. 40 Markham, Financial History, 123.

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Brandeis’ Other People’s Money were willing to give the market a shot.41 Investor participation in the stock market took firm root in the mid-1920s, and by then, investor sentiment had changed radically. “Business itself was regarded with a new veneration,” recounts Frederick Lewis Allen in his popular history of the 1920s Only Yesterday (1931). “Once it had been considered less dignified and distinguished than the learned professions, but now people thought they praised the clergyman highly when they called him a good businessman.”42 Business and finance began to push into the lives of huge swaths of the American public. The Wall Street Journal doubled its circulation between 1912 and 1920 and steadily rose throughout the new decade, and it was during the 1920s that the Dow Jones Industrial Average (the same DJIA that market commentators still quote today) attained prominence as a barometer of stock market performance.43 This increased awareness and participation pushed the DJIA from a 1924 value of about 100 to a 1925 value of over 380.44 Perhaps most significantly for stock market sentiment, the investing public began to shift their conception of stocks to one of stocks as long-term investments; the study most credited with creating such a shift is Edgar Allen Smith’s Common Stocks as Long-Term Investments (1924) which reconstructed historical stock and bond returns, and ultimately showed that in nearly every scenario, stocks outperformed bonds over the long-term.45 Furthermore, Americans participated through newly conceived investment vehicles,

41 42

Ott, Wall Street to Main Street, 1-15. Allen, Only Yesterday, 146-147. 43 Markham, Financial History, 89 and 128. Standard Statistics Services would create the precursor to the S&P 500 index (officially created in 1957) only a few years later in 1923 as an alternative to the Dow Jones indices. The new index was a capitalization-weighted index as opposed to the Dow’s price-weighted index; the new system would arguably track the performance of the market much more accurately. 44 Markham, Financial History, 128. 45 Fox, Myth of the Rational Market, 22.

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most notably investment companies and employee stock ownership plans.46 By 1925, over 160 employee stock ownership plans had sprung up – hundreds more would follow over the next few years – and similarly, 140 investment companies had been founded by 1926.47 As an indication of the enormous inflows of capital into investment companies, less than $15 million were invested in these vehicles prior to 1924, but the figured leaped upward to nearly $75 million in 1924, and to $150 million in 1925.48 And the money was chasing an ever-expanding pack of securities, increasingly stock; in 1917, stocks had accounted for less than one-third of all listings on the NYSE, but accounted for nearly 50% by 1926 and in that same year exceeded in total value that of all listed bonds.49 Ultimately, by the mid-1920s, the stock market was well on its way to becoming the dominant segment of the financial world. It certainly had made much progress in moving into the mainstream for both the public and professionals. This rapid transformation of the landscape called for the creation and development of new systems of thought to guide both the individual and professional investor in the stock market. It is these systems of thought that this study will next explore. II. Schools of Thought The second storyline of the 1920s that is perhaps more central to this study is the development and distribution of statistical and economic services and theories for the purposes of business planning, stock market analysis, and stock and bond analysis. That is, while it has become clear that beginning with the Liberty Loan campaigns of WWI, the
46

Investment companies were precursors to modern-day open-end mutual funds, both offering the small investor a level of diversification that he did not have access to on his own. According to Markham, the open-end mutual funds that are abundant in today’s markets trace their roots to 1924 Boston with the formation of the first such fund: the Massachusetts Investor Trust. 47 Markham, Financial History, 1-4 and 137. 48 Ibid, 137. 49 Parrish, Securities Regulation, 39.

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public became increasingly involved in financial markets, it is not yet clear what systems of thought and methods of analysis they were following. It would be this specific context of investing methods and theories that Benjamin Graham would later be responding to directly in the exposition of his own principles and critiques of the forerunners. The ideas that governed the marketplace at the time could be divided into three dominant camps: technical analysis, business forecasting, and security rating. While technical analysis had been a significant market strategy since the 1870s, business forecasting and security rating agencies were relatively new to the market because of the previous dearth of statistical information available to analyze. As statistical information became more readily available, these business forecasting and security rating agencies flourished and came to have significant influence over investors and businesses alike. Technical analysis was certainly the oldest of the three approaches and had been a significant market strategy as early as the 1870s.50 The basic premise of technical analysis – which is still practiced today in some investing circles despite its waning popularity – is that future price movements can be divined by studying past price movements. The most famous advocate of such a system was Charles Dow, founder and editor of the Wall Street Journal; his system of investing came to be known as the Dow Theory, which is based on his writings while he was editor and was further developed by subsequent editors of the Journal. Its basic argument is that rising markets will continue to rise while falling markets will continue to fall until the market gives some signal of reversal; the prescription for the investor, then, is to invest during the up markets and retreat during the down ones. Subscribing to technical analysis basically meant following the trend.

50

Peter Eisenstadt, “The Origins and Development of Technical Analysis,” in Essays in Economic and Business History (1997), 335.

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The central development for the next two schools of thought was the increasing aggregation of economic statistics and the increasingly transparent financial disclosure of publicly traded companies. While the direction of causality is unclear, what is readily apparent is that as the level of available information rose, so too did the level of stock market participation. It would be difficult to maintain the viewpoint that investing in the stock market was an utterly speculative activity beholden to the knowledge and actions of a privileged insider few when more of the investing public knew exactly how the corporations and the broader economy were performing. Justin Fox argues that “good information about stocks and bonds was getting easier for the ‘speculative public’ to obtain. Corporations had become too big and too interested in respectability to be controlled by just a few cronies.”51 As stock ownership became more widespread, corporations wanted to cater to their new shareholders and would release better and better information, while the better information would draw even more people into the market. Granted, in comparison to the amount and quality of information accessible today, the resources in the 1920s seem rudimentary and inadequate, but for their time, they represented a level of transparency that simply did not exist before. The initial attempts at more transparent and uniform financial disclosure have already been discussed with the states’ “blue sky” laws, the ICC’s mandate for uniform disclosure for railroads, and the American Institute of Accountants’ guidelines for financial audits. Efforts in the early-to-mid-1920s yielded even better results. The NYSE attempted to persuade the companies listed on the exchange to provide more full financial statements, and about two-thirds of the listed companies agreed to do so in addition to the

51

Fox, Myth of the Rational Market, 4.

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approximately 200 that were already required to do so by the ICC.52 By 1926, nearly all listed companies issued audited financial reports.53 Furthermore, the government’s early pushes to acquire and compile statistical data was beginning to pay off in dissemination to the public through private corporations. According to Baskin and Miranti, the governmental push for statistical reporting of the nation’s growing industrial and commercial sectors began under the administration of President Theodore Roosevelt; the Department of Commerce would later publish detailed statistical series with corporate information such as sales and inventories to “assist businessmen in their planning.”54 Statistical information on individual companies as well as aggregate economic statistics were available to the public at this point, but their prominence would rest on the shoulders of private corporations focused on the compilation and dissemination of the flood of statistical data. The major services that would come to serve that need through the distribution and analysis of statistical information could be generally divided into two groups: the business forecasting agencies and the security rating agencies. While some of the organizations performed both functions, each had a dominant function. The prominent forecasting agencies were the Babson Statistical Organization, the Harvard Economic Society, and the Brookmire Economic Service. The prominent security rating agencies were Moody’s Investors Service, Fitch Publishing Company, Poor’s Publishing Company, and the Standard Statistical Corporation. All these corporations married the dissemination of statistical information to an analysis of such information which made them more than just publishing companies – they were forecasting and rating agencies, aiding businesses and
52 53

Markham, Financial History, 128. Ibid, 187. 54 Baskin and Miranti, Corporate Finance, 186.

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investors in their capital allocation planning. The rapidly growing industrial corporation and the new masses of investors were clamoring for some method of forecasting or taking advantage of the market’s seemingly unintelligible gyrations. These statistical services attempted to serve that need.55 While these two groups – forecasting agencies and rating agencies – are often lumped together as employing “fundamental” data in their analysis, they represent two distinctly different approaches: those that published and analyzed the economic data took what is commonly referred to today as a “top-down” approach, while the others took a “bottom-up” approach by analyzing individual securities and companies. The difference is akin to that between micro- and macro-economics; the first is concerned with the firm or actor while the second is concerned with the aggregate of firms or actors. The business forecasting agencies focused on aggregating and analyzing economic data – production figures, industry inventory levels, commodity price movements, and the like.56 Interestingly enough, these business forecasting services employed the same basic method of technical analysis, but instead of using past price information, they would use past economic data – that is, they, too, followed the trends. Business historian Walter Friedman argues that the abundance of statistical information did not necessarily make their forecasts more accurate – it simply allowed them to identify more trends.57 Without true models, these business forecasting agencies were employing methods that were fundamentally not altogether different than those employed by the technical analysts. However, while the area of application of technical analysis was most definitely meant to
55 56

Fox, Myth of the Rational Market, 16. A detailed discussion of the methods and people involved with the major forecasting agencies, with special attention given to Roger Babson, can be found in Horace Given’s dissertation “Roger W. Babson and His Major Contemporaries” (New York University, 1975). 57 Walter A. Friedman, “The Rise of Business Forecasting Agencies in the United States,” unpublished article, 31.

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be the stock market, the business forecasting agencies targeted their services at large corporations that could potentially use the analysis to time large purchases of inventory or capital investments. Nevertheless, nearly all of the major services would publish popular versions of their more detailed corporate reports in weekly and monthly newsletters or pamphlets providing forecasts of general business and economic conditions.58 The last of the dominant schools of thought was the securities rating agencies that focused on the collection, publication, and analysis of statistical information for individual companies and securities. They would use basic statistics – sales, profit margins, dividend rates, debt levels, and the like – to determine recommendations. Initially, when the bond market was the only game in town, these agencies focused primarily on bond issues, but as the stock market became more prominent, many began to include statistical information and analysis on stock issues as well. However, despite their foray into the world of public equity (stocks) their methods of analysis did not change; these agencies for the most part simply applied the same methods and mentality of credit (bonds) analysis to equity analysis. However, bonds and stocks are enormously different securities; why would these rating agencies use bond analysis on stocks? There are two main reasons: first, using the language and analytical techniques that people usually associate with bonds made the stocks more marketable in a market that was initially skeptical about stocks,59 and second, principles and theories of stock market investing were not sufficiently developed or distributed to take the place of the more common and understood principles of bond investing.

58 59

Ibid, 33. Baskin and Miranti, Corporate Finance, 181-182.

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The use of bond analysis methods on stock and the consequences of that misuse revealed a rudimentary understanding of common stock. A prime example of the unsophisticated understanding of stocks was the sustained use of a stock’s par value in both quoting its price and analyzing its dividend yield. The par value of a stock was the price at which it was initially sold in the initial public offering (IPO), but after the issue, it had no connection with the market price or value of the company. Nevertheless, the NYSE would quote stocks as a percentage of par value until October 1915, when an official shift was made to quoting prices based on dollar value,60 and even then, the government did not recognize the insignificance of par value until the Supreme Court ruled as much in Eisner v. Macomber in 1920.61 Quotes on bonds were (and still are) reported in that manner – that is, as a percentage of face value. However, with bonds, the face value makes a significant difference in its characteristics as the coupon on the bond is always based on the face value. The mentality regarding par value had changed significantly by the 1920s, but its sustained use for so long is indicative of the general misuse of bond analysis for stocks. The emphasis on the stability of and ability to pay a dividend was akin to the emphasis on interest coverage for bonds, but once again, the false analogy obscured the fact that with a bond, the interest payment is all the compensation the investor receives, while with a stock, the investor has, in addition to the paid-out portion of earnings, a proportional claim to the total earnings of the business. A leading investment text of the time corroborates the ultimate importance of the dividend to most investors as well as their misconception regarding the nature of common stock: “The principle of greatest practical importance is that regularity in the dividend rate is highly desirable…They [most investors]

60 61

Markham, Financial History, 86. Baskin and Miranti, Corporate Finance, 181-182.

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regard their ownership of a company’s stock purely as an investment of capital that will bring them an income. They buy a railroad or industrial stock with much the same purpose as they would have in buying a real estate mortgage.”62 This basically exclusive emphasis on income – that is, the dividend rate – leaves an investor open to the dangers of overvaluation and blind to the opportunities potentially presented by corporations with enormous potential for growth that have yet to pay a dividend. In essence, this mentality leaves the investor in the dark about the true nature of common stock ownership. The rating agencies were complicit in perpetuating the misunderstood nature of common stocks. Companies like Moody’s, Poor’s, and Standard issued ratings on various common stock issues with many of the same – or very similar – metrics they used for their ratings on bonds or preferred stock, which shared many of the characteristics of bonds. Ratings would focus on items such as interest coverage, dividend coverage, and stability of earnings and dividends, which reveal a strong influence from the principles of bond analysis.63 Of course, the agencies also included many other statistics on the business’ condition, but the basic misconception persisted. This sort of method could result in excellent ratings for dramatically overvalued securities because of the overemphasis on stocks as income instruments much like bonds. Ultimately, as the stock market rose in popularity over the 1920s, these three systems of thought were the dominant influences on the masses of investors looking to make some money in the market. Investors would soon find, however, that the principles of technical analysis, business forecasting, and security rating did not, for the most part, accurately capture the dynamics or true nature of the stock market.
62

William H. Lough, Business Finance: A Practical Study of Financial Management in Private Business Concerns (New York: Ronald Press Co., 1917), 440-441. 63 Charles Dice, The Stock Market, (Chicago: A.W. Shaw, 1926).

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CHAPTER 2

BENJAMIN GRAHAM: 1894-1929
This chapter depicts Benjamin Graham’s experiences from his youth through his beginnings and rise on Wall Street until the late-1920s. Because so little has been written about Graham, the account presented here draws primarily on his memoirs and published magazine articles, supplemented with the few newspaper accounts that exist; the two secondary sources available were able to provide some additional details not found in the primary sources.64 This narrative is meant to not only familiarize the reader with the man, but to track Graham’s progression as an investor and investment thinker through his writings and experiences. I. The Early Years: 1894-1911 Benjamin Graham was born Benjamin Grossbaum, the youngest of three boys, to Isaac and Dora (later Dorothy) Grossbaum, on May 9, 1984 in London, England.65 The Grossbaums soon moved to New York City in 1895 when the family’s import business opened up a branch in the city to be headed by Graham’s father. It would be in New York City that Graham would spend most of his childhood and adult life, rising in the ranks of Wall Street to one day be remembered as its undisputed Dean.
64

The main secondary sources are Benjamin Graham on Value Investing by Janet Lowe (Chicago: Dearborn Financial, 1994) – a biography – and Benjamin Graham, the Father of Financial Analysis by Irving Kahn and Robert D. Milne (Charlottesville: Financial Analysts Research Foundation, 1977) – a short biographical sketch commissioned by the Financial Analysts Research Foundation. 65 Benjamin Graham, The Memoirs of the Dean of Wall Street (New York: McGraw-Hill, 1996). Unless otherwise noted, all the facts of Graham’s life and his perspectives on them are taken from his posthumously published memoirs. What is presented here is a concise version of his early years, with special attention paid to those events and remembrances that seem most relevant to Graham’s professional career. The memoirs provide a much fuller account of Graham’s childhood and adult life, and should be consulted especially for further insight into his personal life. Graham wrote his memoirs in the late 1950s and early 1960s. Janet Lowe’s Benjamin Graham on Value Investing provides a biographical account of Graham’s personal and professional lives but without the benefit of his memoirs.

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Tragedy, however, marked the early years. Graham’s father died in 1903 at the age of 35; Graham was only 8 years old, and years later, when writing his memoirs, he remembered little of the man. The loss, however, left the family financially fragile. Despite efforts by various family members to keep the family business thriving, it soon failed, was shut down, and the remaining parts sold with little to show for it. Dorothy, Graham’s mother, opened up the family home to renters, but the boardinghouse operation failed too and was discontinued after two years. In another attempt to generate some money for the family, Dorothy had begun to speculate in the stock market, but this endeavor, too, would prove to be ill-fated. Ultimately, the family survived on the generosity of relatives for several years. The tight financial situation must have affected Graham in some deep way. He remembers pouring over the then unintelligible financial page to track his mother’s holdings, knowing enough to be pleased when the numbers went up and disappointed when the numbers went down. The Panic of 1907 ultimately wiped out his mother’s margin account, which left the family in an even sorrier state. Graham clearly remembers going to cash a $5 check for his mother and hearing the teller whisper to a colleague, “Is Dorothy Grossbaum good for five dollars?” The pain of such a humiliation shows through in his memoirs. He relishes in describing the ignominious fall of the very brokerage firm with which his mother had her account, and notes, “Little did I or anyone else suspect that many years later the financial pages were to become an open book to me and that the dreamy, impractical, ink-stained Benny G. would become a figure on Wall Street.” While his family struggled financially, Graham, no more than 9, decided to become a salesman for the Saturday Evening Post; he would buy issues at 3 cents per copy and sell

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them at 5. Later, he would invent a small apparatus that allowed him to open the front door to the house from afar (to spare himself the irritation of trekking to the door when the bell rang), and dreamed of the vast wealth he could derive from it: “I had visions of my invention being installed in every flat in the whole world…The impractical dreamer of the family was going to restore its fortunes, nay, raise it to new heights of affluence.” One can only speculate whether these events of childhood distress pushed young Graham to ultimately pursue a financial career, but these years seemed to have certainly given Graham deep inner strength and a mind for money. Friends and colleagues would later comment that Graham was so fiercely independent that he was an island unto himself, that he was brilliant but unreachable. Graham treasured this independence and credited it to those few years following his father’s death: those years taught him “above all, to rely mainly upon myself for understanding, encouragement, and pretty nearly everything else.” Whatever it is he learned over the course of those few years certainly lasted; reflecting on his life and success in his memoirs, Graham writes, “Over the years I learned a lot from the teaching and example of others, though what I learned never prevented me from making my own blunders, large and small, nor did it contribute very much to whatever success I have achieved. (This judgment probably reflects that unconscious vanity which makes even a veracious and reasonably modest autobiographer conveniently forget what he owes to others.)” Regardless of accuracy, this statement (and its subsequent half-retraction) showcases a significant ego – if Graham wasn’t actually independent, he certainly believes he was. This sense of self-reliance would not only be a lasting feature of Graham’s personality, but it would also be, in a significant way, part of the investment philosophy he

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would develop and espouse later in his life. This independent and somewhat defiant streak revealed itself early on. Some time in 1899 when Graham was five, he was given permission on a family vacation to go to a restaurant, order, and eat on his own – Graham was “too proud for words.” He ordered an item on the menu he had never seen before – Grape-Nuts – and when the waiter advised him against the choice, Graham insisted. Not to be made a fool, Graham ate every last piece of that “gravel” as the waiter looked on, and upon finishing, Graham “added a defiant, mendacious: ‘I liked ‘em.’” Far be it from Benjamin Graham to trust any but his own mind, even at the age of five. All the while, Graham excelled in school. By the time Graham was 10 years old, he had skipped ahead four times, which had him in class with the seventh graders. He was very much a bookish type with a special talent in mathematics and a general interest in all subjects erudite. It was around this time that he, in fact, began tutoring fellow students – some ahead of him in school – and “vowed that [he] too would become a scholar of Latin and Greek,” after a cousin flashed his knowledge of Classics. By the summer of 1910, young Graham had gone through every book in the family library save the Magna Instauratio, or the Advancement of Learning by Francis Bacon, which he would read that summer, along with The Palmer Method for Perfect Penmanship, and two works in Greek, all while working as a farm hand in New Milford, New York. The passion for learning certainly paid off when he was able to attend Columbia University on a full scholarship. II. Beginnings on Wall Street: 1912-1919 Graham would graduate Columbia in less than three years in 1914, second in his class and Phi Beta Kappa. His range of study was as wide as it possibly could have been;

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French, history, German literature, mathematics, philosophy, and English were all felled by his sharp mind – all while he worked full time at the U.S. Express Company. In the graduation issue of Columbian magazine – in which each graduate is featured with a photo, a quote, and a list of their extracurricular activities – Graham’s entry seems rather sparse, no doubt due to his condensed time at Columbia and his employment. His chosen quote was “A friend in need is a friend indeed,” which seems to betray a certain quality when compared to the quotes from those alphabetically adjacent (“Wake me up when the class is over” and “All the world loves a fat man” are two that show the contrast nicely). While students around him were involved in the “Menorah Society,” the “Churchmen’s Association,” and “Class Water Polo,” Graham was either studying or working.66 Academically, he had excelled so dramatically that upon graduating, three departments – philosophy, English, and mathematics (in which he officially majored) – offered him teaching positions. Columbia Law School, too, had deemed Graham, now just 20 years old, worthy of acceptance and a full scholarship. But Graham turned down all of these offers. Wall Street beckoned. He spoke of the great opportunities in Wall Street for the right kind of man. I knew it only by hearsay and in novels as a place of drama and excitement. I felt the urge to participate in its mysterious rites and momentous events…As I rose to leave, he said to me, with ministerial solemnity, holding a long finger in the air: ‘One last warning, young man. If you speculate, you'll lose your money. Always remember that.’ With these somewhat forbidding words, the interview was over, the bargain was closed, and my lifetime career was determined. -Benjamin Graham, The Memoirs of the Dean of Wall Street The interview was with Alfred H. Newburger of the Wall Street brokerage firm Newburger, Henderson, and Loeb, and it represented Graham’s first step into finance. Graham would later repeat the advice that Alfred Newburger gave him in his publication of
66

Columbian (1915), 335. Accessed through the Columbia University Archives.

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Security Analysis and The Intelligent Investor; indeed, the difference between investment and speculation – and the importance of engaging in the former rather than the latter – would be a central tenet of Graham’s later philosophy. For now, however, Graham was no more than a back office runner earning $12 per week. After four weeks as a runner, Graham was moved to the bond department where his taste for statistics first shone through. He began writing down in a small notebook the size, interest rate, maturity date, and seniority of the various railroad bond issues in which the firm traded, and soon enough, had memorized the lot of them. Soon after, the firm began to send him out to finally earn his salt by making some sales and generating some commissions; Graham did not make a single sale, but commented that the businessman’s ‘no’ was “invariably polite.” But Graham would prove useful in another way. While poring over various bond issues, he took an interest in a bond issue of the Missouri Pacific Railroad and wrote a report on its merits; having shown it around, the firm of J.S. Bache and Company made Graham an offer – Graham could join as a statistician at $18 per week. A 50% pay raise and a chance to study the very statistics he had grown so fond of sounded like an excellent opportunity; and considering his dismal sales record at Newburger, Graham suspected that the firm would be happy to be rid of him. He suspected wrong. Upon informing Samuel Newburger of his offer, Newburger was furious – indignant at what he saw as a complete lack of loyalty. When Graham insisted that it was not loyalty that was the issue, but his ability as a salesman – “I’m sure I’d do better at statistical work” – Newburger simply responded: “That’s fine. It’s time we had a statistical department here. You can be it.” And so it was – Benjamin Graham was his own one-man statistical department at the ripe age of 21.

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Statisticians, of course, were a rather new phenomenon on Wall Street – precursors of security analysts. Their rise was a direct result of the statistics that were beginning to be published about various companies and the economy, and Graham was taking full advantage: “In 1914 this mass of financial information was largely going to waste…The figures were not ignored, but they were studied superficially and with little interest…To a large degree, therefore, I found Wall Street virgin territory for examination by a genuine, penetrating analysis of security values.” Drawn into this new world of statistical information, Graham applied himself vigorously to just such penetrating analyses. He was very much on the cutting-edge of the financial world, and his future success would be in no small part due to this new deluge of unexamined and misunderstood financial information. Graham’s first major investment analysis reveals much about his developing mentality on security values and investment principles. The Guggenheim Exploration Company was in liquidation in 1915, and Graham saw some unappreciated value in its shares.67 The company owned substantial stakes in several publicly traded copper mines, and had proposed that as part of the liquidation, Guggenheim shareholders would receive prorated shares of those underlying securities. Using the statistical information he was able to gather from the company and governmental agencies, Graham calculated that for every share of Guggenheim then selling at $68.88, the payout of the underlying copper mine stock combined with other assets would yield $76.23, a premium of nearly 11%. And to protect against the possible decline in the underlying securities, Graham recommended a simultaneous short sale of those securities, basically locking in that profit of $7.35.68 This
67

A more detailed account of the Guggenheim Exploration Company arbitrage can be found in Kahn and Milne’s Father of Financial Analysis, 4-5. 68 A short sale involves borrowing the shares from a third party and selling them immediately at the market price, with the expectation that the shares will be returned to the lender at a later date. While short sales are often used to bet on the decline in share price (selling immediately and then buying the shares back at a lower price), Graham was using the short sale in this case to hedge out any move in the price of the copper

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type of operation is called arbitrage; it takes advantage of price discrepancies of the same security in two different markets (or in this case, of the same securities in Guggenheim and the open market). This particular arbitrage worked out just as Graham suspected, to the great appreciation of Newburger, Henderson, and Loeb. By September 1916, Graham’s salary was at $50 per week. My initial success with the Guggenheim Exploration dissolution had given me a strong interest in specialized operations of this kind - arbitrages and hedges - and also in the wider field of undervalued securities, which I staked out as my own particular domain on Wall Street. Among other things, I concluded that money could be made both conservatively and plentifully by buying common stock which analysis showed to be selling too low and selling against the other common stocks which a similar analysis indicated to be overpriced. -Benjamin Graham, Memoirs These special situations and undervalued securities were the anomalies of the market, and Graham had concluded early on that he would focus on these anomalies. It would seem that few on Wall Street were pursuing the same situations – not least demonstrated by the plentiful opportunity that Graham encountered. Furthermore, far from seeking out high-risk situations that could make Graham a fortune – or leave him destitute – Graham was specifically looking for those situations that would produce returns “conservatively and plentifully” – a low-risk, high-reward situation that would become a hallmark of Graham’s investing philosophy. His specialty did not go unnoticed, and Graham submitted his first article to The Magazine of Wall Street in September 1917 titled “Curiosities of the Bond List.”69 The article lists several bond issues that Graham believed to be mispriced because of the
mine shares. By selling short those shares, he locks in the current market price, and could return the borrowed shares once he got the distribution of such shares through the Guggenheim liquidation. He would be protected from any decline in the copper shares, but would also not benefit from any rise. 69 Benjamin Graham, “Curiosities of the Bond List,” Magazine of Wall Street (September 1917), reprinted in Benjamin Graham on Investing (New York: McGraw-Hill, 2009), 13-17. Benjamin Graham on Investing is a compilation of all of Graham’s writings for the Magazine of Wall Street, for which Graham wrote regularly from 1917-1927.

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market’s misunderstanding of their characteristics; Graham attempts to correct their understanding and does so in great detail. This article reinforces the view that Graham had latched onto undervalued securities early in his career, and that the field was still dramatically understudied. Furthermore, the article reveals the development of Graham’s investing philosophy and how he was beginning to criticize the prevailing views, specifically those that claim market efficiency. “The test of the market, like that of Barrie’s policeman,70 is popularly supposed to be ‘infallible,’” Graham begins. “Economists picture a thousand buyers and sellers congregating in the market place to match their keen wits and finally evolve the correct price for each commodity. In the securities market particularly, the word of the ticker is accepted as law, so that one often thinks of prices as determining values, instead of vice versa.” This observation may seem astounding because it is a nearly exact reproduction of the basic tenet of the efficient market hypothesis, except that the EMH would not come into being in its modern form until at least four decades later – Graham was writing in 1917. However, the EMH is an evolution of the application of statistical and mathematical methods to the market, and it does indeed trace its roots to the early 1900s.71 Its inclusion in an article in a widely circulated business and financial magazine tells us that the EMH’s general premise was rather broadly accepted in financial markets during
70

This is a reference to a character from one of J.M. Barrie’s plays – the same Barrie who wrote Peter Pan. Graham had a wide range of interests, which included theater. Graham himself would write a Broadway play later in life titled Baby Pompadour (changed from the original title True to the Marines); it did not do very well. 71 Louis Bachelier is credited to be first to argue and show that market movements are random and that the market itself is efficient. The Myth of the Rational Market by Justin Fox (New York: HarperBusiness, 2009) and Forerunners of Modern Financial Economics by Donald R. Stabile (Northampton: Edward Elgar, 2005) provide the best histories of the EMH and its various corollaries. Fox’s, of course, was written post(or mid-, depending on how things turn out) financial crisis, which gives him the benefit of what is generally seen as a failure of the EMH; the subtitle is indicative of Fox’s perspective: A History of Risk, Reward, and Delusion on Wall Street.

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that time. And Graham’s reply shows his early perspective on the working of the market as a whole: “Accurate as markets generally are, they cannot claim infallibility.” This is Graham’s first recorded argument on market efficiency, and it is clear at this point that he simply did not believe in it; his entire system of investing – finding undervalued securities – was predicated on the existence of a fallible market, even one in which most of the securities were efficiently priced. But Graham’s early years were not totally devoid of setbacks. In 1916, his former English professor at Columbia, Professor Algernon Tassin, sought Graham out as an investment counselor, and agreed to supply $10,000 of capital for Graham to manage, the profits and losses to be split evenly between the two. The first year went very well, but the general market decline beginning in 1917 nearly wiped the account out because Graham had been investing on margin – that is, he had been borrowing money to buy securities in the account. Furthermore, as the account’s losses were to be split evenly, Graham was in debt and did not have the funds to repay it immediately. Professor Tassin graciously allowed Graham to pay off his debt over time, and for two years, Graham paid in $60 per month until he had repaid in full. By the end of the decade, Graham had published several times in The Magazine of Wall Street, found and executed numerous special situation investments on behalf of his firm, and had begun to develop a distinctive approach to investing. These beginnings were indeed impressive, even without mention of the fact that he was younger than most in his position. But the 1920s had much more in store for him. III. Rise on Wall Street: 1920-1929 We take pleasure in announcing that Mr. Daniel Loeb, Mr. Harold A. Rouse, and Mr. Benjamin Graham have this day been admitted to an interest in our firm.

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Newburger, Henderson, & Loeb 100 Broadway, New York -New York Times advertisement, January 1, 192072 Graham was made partner in the firm of Newburger, Henderson, & Loeb in 1920, at the age of 25, two years younger than both Daniel Loeb and Harold Rouse – and Loeb was the nephew of named partner Jake Loeb. The partnership – which granted Graham 2.5% in the profits of the firm with no liability for losses – was actually a direct result of a rather lucrative competing offer from The Magazine of Wall Street. Graham had been contributing regularly to the magazine since 1917, and in 1919, Carrie G. Wyckoff – owner of the magazine and wife to former editor Richard D. Wyckoff – offered Graham the position of editor-in-chief, which offered a lofty salary and a share in the profits. Alfred Newburger, though, was able to talk Graham out of taking the job by offering him junior partnership in the firm, where Graham had continued to hold his post as head of the statistical department, which was steadily rising in importance. And so, on January 1, 1920, Newburger, Henderson, & Loeb took out advertisements in the major newspapers announcing the three new partners of the firm. Graham had continued writing, and in early 1920, he published a series of pamphlets entitled “Lessons for Investors,” which were distributed to colleagues and customers. In them, Graham advocated the “purchase of sound common stocks at reasonable prices…if its market value is substantially less than its intrinsic value;” once again, Graham here made a distinction between the market price and the intrinsic value of a security, and advocated buying when the two diverge significantly. Graham had argued this before, but in these pamphlets, he explicitly extended the concept of undervaluation to common stocks.
72

New York Times (New York), January 1, 1920.

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More telling than his writings, however, were his actual investment activities. While no complete records of those activities are available, he detailed several investments in his memoirs, and despite the inherent selectivity of such accounts, they still prove valuable in understanding how his evolving ideas about investments were manifesting in his actual investments. Friends and colleagues were becoming increasingly aware of Graham’s expertise in the rigorous analysis of securities and in the execution of arbitrage and hedging operations; they began to seek him out as investment adviser, and he began to take them on as clients, managing tens of thousands of dollars for men like his uncle Maurice Gerard, childhood friend Sydney Rogow, and Professor Tassin (who had stuck with Graham despite earlier setbacks). It was the development of this advisory capacity that would lead to Graham’s next major career move. In 1923, after moving to the suburbs a few years earlier and joining the Mt. Vernon Country Club, Graham became acquainted, through a country club friend, with Lou Harris of the successful Harris Raincoat Company. The Harrises proposed putting up $250,000 for Graham to invest for them, with an annual salary of $10,000 and a share in the profits. Thus began the Graham Corporation. Graham was finally managing his own firm, and with the substantial start-up capital, he took leave of Newburger, Henderson, & Loeb on amicable terms after 9 years of employment. The activities of the Graham Corporation were limited to Graham’s specialties: arbitrage, hedging, and undervalued securities. A characteristic investment was the GM-Du Pont arbitrage that Graham effected in 1923: the investment was similar to the Guggenheim situation in that Du Pont shares were trading for no more than their underlying holdings of GM, which basically meant that the market was putting no value on Du Pont’s other assets nor its successful operating business. This type

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of conservative, but profitable investment was a favorite of Graham’s. Its conservativeness demonstrates a strong risk aversion; while that sort of risk aversion would usually lead an investor to settle for meager returns from high-quality bonds, Graham’s diligent and indepth analysis of securities allowed him to unearth situations that seemed to offer excellent returns with a minimal amount of risk – little more, in Graham’s view, of what an investor would face in those high-quality bonds. In 1925, Graham dissolved the Graham Corporation and replaced it with the Benjamin Graham Joint Account, which began operation on January 1, 1926 with about $400,000 in capital. Graham took no salary and charged on a sliding scale of profit sharing – that is, the higher the returns, the higher Graham’s percentage take. It was in this same year that Graham hired Jerry Newman, who two years later would become an equal partner in the firm, and would remain so until Graham’s retirement in 1956. Over the course of the next few years, the Joint Account was a great success. One of Graham’s largest, and certainly his most public, investment in these early days was his investment in the Northern Pipeline Company in 1926. Northern Pipeline was one of the eight Standard Oil Pipeline Companies, which had all been created following the 1911 breakup of Standard Oil. These companies, being small and rather ignored by most investors, published only the most abbreviated of financial statements, consisting of a single-line income statement and a similarly abridged balance sheet. Graham, however, became curious to know whether any further data on these companies was available after he read a note in the covering brokerage’s report that mentioned the company’s annual report. Checking with the ICC, Graham found out that the companies did indeed file reports with the commission, and that these reports were highly detailed, including data on

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operations, assets, and more. Upon visiting the ICC’s headquarters to look through the reports, Graham found that some of the companies had massive investment portfolios of high-grade bonds; these portfolios were sometimes worth more than the price of the entire company – that is, owners of the pipeline stock were basically getting the pipeline business for free, or better, given the valuable underlying investments. Northern Pipeline, in particular, was a gold mine, from Graham’s perspective; the company had $95 per share of cash and high-quality bonds, paid an annual dividend of $6 per share, and was selling for only $65. Graham decided that Northern Pipeline should either sell its investment portfolio – which he saw as excess capital – and dividend out the proceeds to the shareholders, or distribute the portfolio itself pro rata to the shareholders. But the company’s management resisted, and the largest shareholder – the Rockefeller Foundation – was determined to remain passive. Graham took to the company’s annual meeting in January 1927 to air his grievances, but management quickly silenced him; the meeting consisted of four Northern Pipeline employees and himself, and when he motioned to read his statement regarding the company's finances into the record, he was refused for lack of a second. Determined to come back from this disappointment, Graham enlisted the help of some lawyers, and mounted a proxy battle to have himself and a colleague elected to the board of directors of Northern Pipeline with the express purpose of effecting a dividend of those excess assets. After lobbying a great number of individual shareholders by mail and in person, Graham succeeded, and at the next annual meeting on January 19, 1928, the shareholders voted Graham and his compatriot onto the Board of Directors.73 The New York Times and Wall Street Journal both reported on the proxy battle as it happened, and the Times called the
73

“Win Two Directors in Fight for Assets,” New York Times (New York), January 20, 1928.

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election an “important victory” for the campaign to dividend the assets. Once Graham had wrested his way onto the board, the company’s management caved to his demands. On March 29, 1928, the New York Times reported that the directors had called “a special meeting of stockholders…to consider a reduction in capital…which, if approved, probably will be followed by a cash distribution of $50 a share…It is expected that the stockholders in turn will grant their approval.”74 By the time it was all over, each original $65 share had appreciated to $110, including $70 in cash distributions, which worked out to a 70% total return over less than 3 years. Just like the Guggenheim and Du Pont arbitrages before, Graham had unearthed a treasure trove of underappreciated assets that offered him and his investors a low-risk, high-return situation. Graham’s success as an investor and his continuing development as an investment thinker eventually led him to begin thinking about publishing a textbook on security analysis. He decided to first teach a class on the topic to flesh out his ideas, and thus was born his first “Security Analysis” class at Columbia University in 1927. It was initially offered in the Extension Division of the University, then the college, and was not moved to the business school until 1951. The first class in 1927 was met with overwhelming interest with over 150 registrants; many of them were signing up in the hopes of hearing Graham’s investment tips, and many attempted to retake the class the next year in order to hear even more tips. One of the students in the original 1927 class was David Dodd, then an assistant professor at the business school. Dodd would soon begin teaching the class alongside Graham, and years later, they would publish Security Analysis together, largely based on the material taught from 1927-1934. The oversubscription of the class in 1927 and 1928 was a sign of the times – with
74

“To Act on Lower Capital,” New York Times (New York), March 29, 1928.

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the stock market heating up, many were looking to jump on the bandwagon. The subsequent explosive rise and fall in the markets would be unprecedented in U.S. financial history, and would dramatically alter the investing landscape.

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CHAPTER 3

THE GREAT CRASH & ITS AFTERMATH: 1929-1934
I. The Boom By the late 1920s, the public’s burgeoning interest in the financial markets in general, and the stock market, in particular, had grown to a definite obsession. The Dow Jones Industrial Average surged more than 200% between 1925 and 1928, and the volume of shares traded continually rose – the New York Stock Exchange saw its first 5 million share day on June 12, 1928, and only five months later saw its first 7 million share day on November 23, 1928.75 Low interest rates and low margin requirements (commonly 1020%) fueled evermore participation and speculation. Despite the level of the stock market, the Federal Reserve lowered the discount rate from 4% to 3.5% in August 1927; in that year alone, the amount of money lent out to margin accounts leapt 25%. The market surged ahead with automobile and radio stocks leading the way.76 Everybody seemed to be “displaying an inordinate desire to get rich quickly with a minimum of physical effort,” observed John Kenneth Galbraith in his classic tome on the boom and bust of 1929.77 This desire led to an explosion in participation and an explosion in speculation. Far from being the realm of an elite few, the stock market had become America’s playground, home to the affluent aristocrat, the middle-class professional, and large swaths of the ranks below. Both quantitatively and anecdotally, the numbers involved had skyrocketed. By 1929, more than one-third of all households owned stocks, and if anecdotes were representative, one would believe that stock fever had overrun the whole of
75 76

Peter Wyckoff, Wall Street and the Stock Markets (Philadelphia: Chilton Book Co., 1972), 69. Frederick Lewis Allen, Only Yesterday (New York: Harper & Brothers, 1931), 241-242. 77 John Kenneth Galbraith, The Great Crash of 1929 (Boston: Houghton Mifflin, 1955), 8.

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the country, from the mechanic down the street, to the local barber, to the chatty housewives, all the way up to the professional speculators and corporate lawyers.78 Stories of fortunes made overnight were on everybody’s lips. One financial commentator reported that his doctor found patients talking about the market to the exclusion of everything else and that his barber was punctuating with the hot towel more than one account of the prospects of Montgomery Ward. Wives were asking their husbands why they were so slow, why they weren’t getting in on all this, only to hear that their husbands had bought a hundred shares of American Linseed that very morning. -Frederick Lewis Allen, Only Yesterday79 The stock market, it would seem, had infiltrated every corner of American society – doctor’s offices, barber shops, and marriages were surely only the beginning. These levels of participation were far above what anybody could have expected or hoped for when the Liberty Loan campaigns first began in 1917, or when Common Stocks as Long-Term Investments was first published in 1924. Many investors opened up individual accounts in which to trade at brokerages, which were all too happy to have them, but many invested in the investment trusts that catered specifically to the smaller investor, offering professional management and a level of diversification that the individual did not have access to on his or her own. By 1929, a new investment trust opened at the rate of one per day; 1928 had seen a rate of only one every other day. Assets quickly grew from $75 million in 1924 to $150 million in 1925; by 1928, the amount stood at over $1 billion, and 1929 saw it balloon to over $3 billion.80 Some estimates of investment trust assets put the amount at over $7 billion by 1929; the discrepancy is probably due to the fact that many of these trusts were investing on margin, and the borrowed money significantly inflated the initial capital.81 The reach of the market seemed to be all-encompassing.
78

Julia Ott, “When Wall Street Met Main Street: the Quest for an Investors’ Democracy and the Emergence of the Retail Investor in the United States, 1890-1930,” PhD dissertation, (Yale University, 2007), 13. 79 Allen, Only Yesterday, 247. 80 Jerry W. Markham, A Financial History of the United States (Armonk: M.E. Sharpe, 2002), 137. 81 Jonathan Barron Baskin and Paul J. Miranti, Jr., A History of Corporate Finance (New York: Cambridge

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Politicians, economists, financiers, and commentators all seemed to be egging on the speculative masses with market endorsements and high-sounding rationalizations. President Coolidge, upon leaving office, declared the market a “good buy,” and economists assured the public that investing, forecasting, and risk-management had evolved into a science, which provided a strong and reliable foundation that was unlikely to be shaken.82 “The way to wealth,” wrote journalist John J. Raskob in Ladies Home Journal, “is to get into the profit end of wealth production in this country.” And, of course, the way to do so was to save up one’s money and invest it in common stocks at every opportunity, because years later, the investments would surely be worth multiples of the initial capital.83 The common mentality was one of very optimistic expectations of the future success of various enterprises and industries. Public mania surely had an influence on the statements of socalled “experts,” who in turn further fueled the public mania for stocks. The stock market boom was mirrored by – and surely initially rooted in – the economic boom of the 1920s. New technologies like the automobile and the radio were overtaking the country, generating consumer demand, which in turn increased industrial production (which rose 50% between 1920 and 1929). Radios were in particularly high demand; the 60 million radio sets of 1922 had multiplied into the 842 million sets of 1929.84 Automobiles, too, were popular items, with over 4 million sold in 1926; that number would grow to over 5 million in 1929. Between 1925 and 1929, the number of manufacturing concerns grew from around 180,000 to over 200,000.85 Gross national product grew at an average rate of over 4% over the 1920s, and total personal consumption
University Press, 1997), 196. 82 Charles R. Geisst, Wall Street: A History (New York: Oxford University Press, 2004), 175; Steve Fraser, Every Man a Speculator (New York: HaperCollins, 2005), 398. 83 Allen, Only Yesterday, 258. 84 Fraser, Every Man a Speculator, 384-385. 85 Galbraith, Great Crash, 6-8.

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expenditures increased over 40%.86 President Coolidge rightly stated, on the eve of 1929, that the country was experiencing “the highest record of years of prosperity.” Unfortunately, his call to “anticipate the future with optimism” was ill fated.87 These advances were impressive economic feats, to be sure, but they could not sustain the enormous leaps upward in the stock market for much longer. Graham, too, had his own professional boom in the late 1920s. His “Security Analysis” course at Columbia was extremely popular, and the Benjamin Graham Joint Account had been performing well. His clients were as satisfied as ever with his performance, and others were taking notice. As the market was roaring in the late 1920s, many of the brokerage firms, seemingly jealous of the profit sharing fees investment managers were charging, decided to open their own private funds; one of these firms was Hentz & Company, which offered Graham the management position of one such fund, with a capital base of about $25 million. Graham’s Joint Account would peak in 1929 at a healthy $2.5 million in capital, which simply paled in comparison to the amounts he could have managed had he taken advantage of the massive inflows of capital into the system. At around the same time, Bernard Baruch, the famous financier, offered Graham a full partnership in his business; Baruch explained the offer in this way: “I am now fifty-seven years old, and it’s time I slowed up a bit, and let a younger man like you share my burden and my profits.” Graham and Baruch had met only a year before, when Graham had suggested to Baruch various investments, which had turned out satisfactorily for both, but Graham was stunned by the offer. However, Graham refused the Baruch offer, citing his qualms about so suddenly shutting down the Joint Account, which counted among its
86

United States Bureau of the Census, Historical Statistics of the United States: Colonial Times to 1970 (Washington: US Dept of Commerce, 1975), 226 and 320. 87 Galbraith, Great Crash, 6.

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investors many friends and family members. The Hentz offer was in discussion for some months, but then came “the market’s first serious sinking spell in August.” The discussions were put on hold indefinitely, and they were never to be resumed. The crash was beginning.88 II. The Bust When the market crossed the line from reasonably optimistic to outright speculative is unclear, but one can be sure that by the boom’s end, it was clear that prices had gone too far. According to Galbraith, it was early 1928 when the public began to indulge in financial fantasy, running up prices far past reasonable expectations of earnings. The “true speculative orgy started in earnest.” Margin loans by the end of 1928 reached nearly $6 billion, and the loans were in such demand that the interest rate on them reached 12% (the rate stood at 5% at the beginning of the year).89 In addition, the economy itself had begun to slow by 1929; production was down, shipping fell, and home-building had been falling for years.90 The market could not maintain its stratospheric heights. In retrospect, it is easy for one to see the danger of the speculative market of 1929, but while it was happening, the future was not so clear. Nevertheless, the boom itself was clear, and, while nobody would expect anybody to correctly time its end, an end had to arrive. The Dow Jones Industrial Average peaked on September 3, 1929 at 381.17; the average had stood at around 145 just four years earlier. Prices began to slide in September, and by the end of the month, the DJIA stood at 343.45, a decline of nearly 10%. Even then, many experts were loathe to call it the beginning of the end, nor were many even willing to admit that prices had reached unsustainable levels. Most famously, Irving Fisher
88 89

Benjamin Graham, The Memoirs of the Dean of Wall Street (New York: McGraw-Hill, 1996), 250-253. Galbraith, Great Crash, 16. 90 Ibid, 93.

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– the most well known economist of the time – declared on October 15, 1929 that stock prices had reached “what looks like a permanently high plateau.” Fisher was speaking to members of the Purchasing Agents Association, and during the informal question and answer that followed his speech, upon further prodding about the level of stock prices, Fisher went further to say that he expected “to see the stock market a good deal higher than it is today, within a few months,” arguing that realized and expected earnings justified the high level of prices.91 Unfortunately, stocks would not even reach the September 1929 peak again until 1954. And doubly unfortunately for Fisher, Black Thursday was just around the corner. To be fair, not all the experts were with Fisher; some had warned of the dangerous levels in the market, but none expected a crash as sharp or as devastating as what was to come. Roger Babson, a prominent technical analysis guru, had been warning of a crash for years, and he reiterated his concerns in early September 1929, arguing that stock prices had climbed far too high above the trend line, and that a massive loss was due to even out the imbalance (he theorized that the area above and below the trend line had to be equal, based on the Newtonian law of ‘equal and opposite reaction’). Many of the fundamental forecasting services also warned of a correction – Moody’s, Standard Statistics, Poor’s, and the Harvard Economic Society among them. But none predicted the magnitude of the crash. Standard argued that “over the next few months, the trend of common-stock prices will be toward lower levels,” and Harvard described the business and market situation as “another period of readjustment” and that “serious consequences for business” were “not indicated at present.” And even Babson – seemingly the most bearish of all – had

91

“Fisher Sees Stocks Permanently High,” New York Times (New York), October 15, 1929.

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predicted a decline of only 60 or 80 points in the DJIA.92 But despite their error in the magnitude of the drop, they got the direction right. Unfortunately, few were listening. Black Thursday was October 24, 1929. Over 12 million shares were traded on that day – nearly double the previous day’s volume. The market had fallen 30 points in the two days ending on October 24, and despite attempts by a cabal of financiers to prop up the market, the deluge continued the next week.93 Black Monday, October 28, saw a nearly 13% fall in the DJIA, only to be immediately followed on Black Tuesday, October 29, by another 12% decline. The market had lost 33% of its value in a single month. But the losses paled in comparison to the losses the market would sustain over the next three years. The DJIA would not hit rock bottom until July 8, 1932 at 41.22, for a loss of nearly 90% from the 1929 peak. These losses were in no small part due to the magnifying nature of margin in both gains and losses; when the market is rising, margin helps investors maximize their returns, but when the market is declining, margin calls come pouring in, forcing sales, which further drive down prices (which cause more margin calls). Investment trusts – one of the favorite investment vehicles of the time, especially for the smaller investor – were using enormous amounts of leverage, and as John Kenneth Galbraith details, investors had begun to differentiate between the trusts based on the amount of leverage employed.94 With over $7 billion in extended margin loans by the middle of 1929, declines in prices forced indiscriminate sales of securities.95 Falling market prices led to falling market prices, partly because of a correction in rational value – that is, a correction of the speculative values – but largely because of the pervasive extension of credit.
92 93

Allen, Only Yesterday, 268. Geisst, Wall Street, 190-192. 94 Galbraith, Great Crash, 61. 95 Ibid, 72.

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The economic and financial losses in the years following the Great Crash of 1929 were tremendous, as the Great Depression took root. Despite the initial enormous drops in 1929, though, confidence was not lost all at once. President Hoover, in May 1930, declared, “we have now passed the worst and…shall rapidly recover,” and announced that normalcy would return by fall of 1930.96 Rallies would periodically and temporarily restore a modicum of confidence in the market – the most significant of which was in the first few months of 1930 – but despite these spats of optimism, the trend continued downward. According to economist and current Chair of the Council of Economic Advisers Christina Romer, uncertainty about the future began to grip the nation, dramatically reducing consumption, which in turn crippled business (which, of course, further fueled the fear and uncertainty). All measures of economic productivity and output plunged, unemployment skyrocketed, and financial markets crumbled. Banks and other financial institutions were some of the hardest hit; annual bank failures numbered in the thousands for several years, which further tightened an already shrinking money supply. Needless to say, the public retreated from financial markets and remained skeptical for decades. The Crash and ensuing Depression were indeed the most severe global economic and financial calamity of the twentieth century, and it was a critical turning point in the development of the modern economic and financial system.97 Benjamin Graham, expert security analyst that he was notwithstanding, suffered severe losses, too, from 1929-1932. Graham had felt that the market was at unjustifiably stratospheric heights in 1929, but his focus on finding individual market mispricings – his trademark investments by this point – led him to remain nearly fully invested in a large
96 97

Allen, Only Yesterday, 282-284. Christina D. Romer, “The Great Crash and the Onset of the Great Depression,” Quarterly Journal of Economics 105 (August 1990), 597-624.

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number of situations. The Account had $2.5 million in capital, but positions significantly above that number; $2.5 million in long positions had been taken against an equal amount of short positions, and an additional $4.5 million had been invested in long positions, backed by $2 million of borrowed money. The long-short positions required little capital, because the short sales provided the necessary funds to purchase the long positions, which left the $4.5 million less the $2 million of borrowed money as capital ($2.5 million). Even in the event of a market crash, which he expected to occur at some indeterminate point, Graham believed that the situations in which he was invested would hold up because of their preexisting undervaluation. Graham was wrong. As the market began to tumble and margin calls came pouring in, investors were quickest to dump their more obscure holdings, and because Graham was invested almost totally in obscure securities – as they were excellent bargain hunting grounds – his portfolio took an enormous hit. The Joint Account saw a 20% loss for 1929, but the worst was yet to come. The Account lost another 50% in 1930, 16% in 1931, and 3% in 1932 before bottoming out. In all, the Account had lost 70% of its value from its $2.5 million peak.98 The losses were an enormous blemish on Graham’s professional record, and it is clear that his model of investing, at that point, was unable to help him avoid them. Most peculiar about Graham’s operations during this time, though, was his use of margin in the Joint Account. Margin, of course, dramatically increases the risk of major losses, and is generally considered a hallmark of speculation. To be fair, the amount of margin in the Account was significantly less than the average margin used by other investors at the time, and was considered quite conservative. Nevertheless, it contributed in no small way to the portfolio’s dramatic decline in the period from 1929-1932. Graham, of course, could not
98

Graham, Memoirs, 252-260

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have controlled the general decline in prices that hit the securities he owned as hard as all the others, but his use of margin certainly exacerbated that decline. Despite these enormous losses, though, Graham still believed that the securities he owned in the Account were significantly undervalued. His analysis proved to be correct; the Joint Account recovered its peak value dramatically faster than the market as a whole (1935 vs. 1954). III. The Response “To say that people lost confidence in the Stock Market during the 1930s is to commit a gross understatement…The popular imagination transformed Wall Street into a menagerie of parasites…and fools. Fools because mixed in with all the predictable anger at the Street’s pernicious omnipotence was an even more chilling sense of its baleful omni-incompetence.” -Steven Fraser, Every Man a Speculator99 The dramatic losses of the Great Crash and subsequent Great Depression caused widespread disillusionment with the dominant schools of thought about the market. The general popular conception that professionals and government officials had engineered a well-oiled and efficient system was quickly shattered, and the more “sophisticated” schools of thought – such as technical analysis and business forecasting services – were not far behind in the loss of stature. On the way down from the 1929 peak, many of the forecasters – even the ones that had predicted the decline – repeatedly forecasted a leveling of the market, which only served to increase disillusionment when the leveling repeatedly did not come. The Harvard Economic Society had been bearish in 1929, but after the crash, declared that “the present recession, both for stocks and business, is not the precursor of business depression,” and later forecasted “recovery of business next spring [of 1930].” The Society would continue to make similar forecasts through 1931, and each time, its stature shrank.100
99 100

Fraser, Every Man a Speculator, 414. Galbraith, Great Crash, 149-150.

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Continued uncertainty on the part of the forecasters further fueled public disillusionment with them. In her analysis of uncertainty and its role in the Great Crash and Great Depression, Christina Romer demonstrates that many of the major forecasting agencies – Harvard, Moody’s, Standard, and Business Week among them – became increasingly uncertain about their own forecasts immediately following the 1929 crash. Furthermore, the differences between these services’ forecasts increased in magnitude postCrash, which would have led to confusion on the part of consumers and producers who were reading them. Romer also shows that the extent of the uncertainty and difference in forecasts was unique to the Great Crash; such conditions did not exist in the market declines of the early 1920s. The uncertainty not only caused a general retreat from the market, but it also contributed to a general distrust of and disillusionment with the forecasting agencies.101 Quite possibly the most damning event for the forecasting agencies, technical analysts, and stock-pickers was the publication of Alfred Cowles’ “Can Stock Market Forecasters Forecast?” in July 1933. Cowles conducted a thorough study of 45 market forecasting agencies – 20 general market forecasters, and 25 agencies that recommended individual stocks – over the 4.5 years ending June 1, 1932. Admittedly, the period in question was an extremely difficult one for the market as a whole, but Cowles repeated the study with a smaller subset of the agencies in 1944, analyzing a much longer record; however, his conclusions were unchanged. Cowles’ results in the 1933 study were very damaging. Cowles found that, on average, the forecasters – those that made general market predictions and those that recommended individual securities – produced a record worse than one achieved by pure chance. Furthermore, Cowles also studied the 26-year record of
101

Romer, Uncertainty, 612-615.

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the Dow Theory – the most prominent technical analysis theory – under William Peter Hamilton, editor of the Wall Street Journal; Cowles found that Hamilton’s technical recommendations, too, performed worse than the general market. In fact, of the 90 market calls Hamilton made (up or down) over the 26 years, 45 were successful and 45 unsuccessful. Ultimately, the public became disillusioned with the inadequacy of the dominant schools of thought regarding the stock market – technical analysis, market forecasting, business forecasting, and individual security selection did not work, as practiced by the dominant players. Not only were the forecasters generally uncertain, they were also generally wrong.102 In 1932, at the nadir of the market and in the midst of disillusionment, Benjamin Graham published a series of articles in Forbes magazine that reflected both his frustration with what he saw as the prolonged undervaluation of the market, and his confusion at the dramatic mispricing of many securities. The series was, rather sensationally, titled “Is American Business Worth More Dead Than Alive?”103 Investors at this time were sitting on the sidelines, very uncertain about the future of the general economy or the direction of the stock market. Graham argued that instead of occupying themselves with those types of forecasts, investors should be mindful of the real underlying values of market securities, and how ridiculously large the difference between price and value really was. In the articles, Graham began “pointing out the extraordinary discrepancies between the low prices of important common stocks and the much larger current assets (even cash assets) that were behind each share.”104 At the time, he found, over one-third of all industrial stocks were trading for less than their net quick assets – that is, less than the sum of cash,
102 103

Alfred Cowles, “Can Stock Market Forecasters Forecast?,” Econometrica 1 (July 1933), 309-324. Benjamin Graham, “Is American Business Worth More Dead Than Alive?,” Forbes (June 1, 1932), reprinted in The Rediscovered Benjamin Graham (New York: Wiley, 1999), 7-15. 104 Graham, Memoirs, 264.

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receivables, and liquid securities less all liabilities – and many were trading for less than cash assets alone.105 On the one hand, investors were clearly not investing rationally, and on the other, corporate managements were not acting in the best interest of their shareholders by hoarding their assets even though dissolution may have been in the best interest of the shareholders. One such example that Graham presented was White Motors: the company had $8.5 million in cash and U.S. government bonds, $15 million in receivables and inventory, $14 million in fixed assets (factories, real estate, etc.), and only $1.3 million in debt, which gave it an overall net worth or book value of just over $36 million. Each share of the company was trading in the open market at less than $8; with 650,000 shares outstanding, the entire company was effectively on sale for at around $5 million, over $2 million less than the cash and government bonds on the books, even after subtracting the $1.3 million debt. The article even includes a list of 20 example companies that were also selling for less than their cash assets.106 Graham argued that the situation was a result of an overemphasis on earnings and a mistaken byproduct of uncertainty. While the earnings of a company were certainly neglected as a benchmark of value in the early 1920s and before, the later exclusive emphasis on earnings took the benchmark too far, posited Graham. Exclusively relying on earnings led to a complete disregard of asset values, which in turn led to a situation in which securities were selling for less than cash assets. Investors were not paying attention to the balance sheet, which recorded the company’s assets and liabilities. However, Graham recognized the uncertainty of the future of many of these businesses: investors

105 106

Graham, Rediscovered Benjamin Graham, 8. Ibid, 10-11.

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may have believed that future losses would eat into these asset values before they would ever be distributed or reflected in the market price. Investors’ uncertainty, though, led to prices that implied that fully one-third of industrial companies would eat through their asset base, which was extremely unlikely. Uncertainty had produced a situation in which prices implied a scenario that was outside the band of the initial uncertainty – that is, investors may have been uncertain whether companies would, hypothetically, lose 10-50% of their assets (a rather wide band), avoided the securities because of their uncertainty, thereby leading to a situation in which the price implied a 70% loss, which investors did not believe would happen. Furthermore, Graham argued that since stockholders were, in fact, owners of a business, they had the means, collectively, to effect a distribution of assets before a company could deplete them. Activist investing, it seemed, was beyond what most investors, even professional ones, were willing to do. Graham, here, was demonstrating a rational and conservative analysis of the relationship between price and value, and advocating that investors invest based on that relationship.107 In response to the massive loss of wealth, and in an effort to restore faith in the financial system, the federal government, under the direction of President Franklin Delano Roosevelt, instituted a series of financial reforms that would serve as the regulatory framework for decades to come. While the reforms were far-reaching and spanned nearly every facet of the financial world, the focus here will be on securities legislation. The most important of these pieces of legislation were the Securities Act of 1933 and the Securities Exchange Act of 1934. Later legislation, in 1940, would regulate the mutual fund industry and investment advisers as further protection for investors, who by and large did not invest directly in the market, but rather availed themselves of the services of a mutual fund or
107

Ibid, 12-14.

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adviser. However, it was the legislation of the early 1930s that established the regulation of the issuing companies and the exchanges on which they trade. The first federal securities legislation came in the midst of the Great Depression. Public outrage towards Wall Street served as the catalyst for a Congressional investigation of the financial community and its practices. These hearings led to revelations of pervasive and extreme speculation, greed, and financial trickery, which in turn led to the passage of the securities legislation in 1933 and 1934.108 The Securities Act of 1933 regulated the initial offering of securities, requiring registration documents that provided extensive information about the securities and about the issuer, including thorough and audited financial statements. The Securities Exchange Act of 1934 established the Securities and Exchange Commission (SEC), and established regulation of the secondary market, where securities are traded after their initial issue (as opposed to the 1933 regulation of the primary market). This act required the regular and uniform disclosure of financial statements – annually and quarterly – for all exchange-listed public companies with at least 500 shareholders and $10 million in assets; a 1936 SEC regulation would extend this requirement to non-exchange-listed, or over-the-counter, securities, as well. These initial advances in regulation were an enormous change from the previously unregulated capital markets. Statistics that were previously difficult to come by were now mandated to be made public, and were all centrally filed with the SEC. Because of the cases of fraud that were uncovered and the prevalence of speculation – that is, trading not tied to investment value – transparency was of the utmost importance, and such transparency would be a boon to security analysts who were primarily concerned with ascertaining the values of the

108

Markham, Financial History, 177-186

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various securities.109 With uncertainty reigning and investors largely disillusioned with the previously dominant schools of thought, investors were hungry for a coherent framework to guide them; Benjamin Graham would soon attempt to provide that framework. Even during the dark times of the early 1930s, Graham had continued to teach his class at Columbia, albeit to fewer students, and he decided that the time was ripe to finally write his own textbook. Graham had originally envisioned the textbook in 1927, when he first began teaching at Columbia, but it was not until 1932 that he set to work on the text. David Dodd would aid Graham in writing the text, mostly through suggestions and compilation work for the statistics, tables, and other data that were to be used; Graham would be the senior author. With a year and a half of work after the contract was signed with McGraw-Hill in 1932, the first edition of Security Analysis appeared in 1934.110

109 110

Ibid, 184-186. Graham, Memoirs, 264-265.

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CHAPTER 4

SECURITY ANALYSIS: 1934-1940
Benjamin Graham and David Dodd published the first edition of Security Analysis in 1934, largely based on Graham’s lectures in the Columbia “Security Analysis” class that he had been teaching since 1927. The text was over 700 pages long and was extremely thorough in its scope, covering everything from the broad principles of investing, to the detailed analysis of individual line items in the income statements and balance sheets of corporations. The authors included myriad examples and tables, for the purpose of demonstration and evidence in their analyses of individual securities, industries, or the market as a whole. The investing community recognized its merits, and the text relatively quickly became a standard one. Published during the midst of the Great Depression, Security Analysis, while based on ideas Graham had developed over the course of his career, was in some way a response to the tremendous losses of the Crash and Depression, and a critique of the ideas that enabled them. An investing public – at this point a much smaller group than a few years prior – was hungry for a sensible and coherent framework with which to make sense of what many saw as a fickle and irrational market. Graham attempted to provide such a framework, and its commonsensical, analytical, and conservative approach seems to have appealed to the public at large and to budding security analysts. This chapter focuses on the framework for investing advocated by Graham and Dodd in Security Analysis – that is, the principles set forth, rather than the methods of analysis – and on the text’s critique of popular and professional conceptions of investing, particularly technical analysis and market forecasting. Finally, the chapter depicts the 57

financial community’s reception of the text in the years following its publication. I. An Investing Philosophy While the methods and techniques of analysis Graham laid out in Security Analysis were of tremendous value given the paucity of knowledge about the true meaning behind companies’ financial statements, the primary value of the text rests with the investing principles that Graham established. He provided a way to think about the market and about investing in general. It is this framework that is still cited and used by many investors today, 75 years after the text’s publication. The general framework rested on three central pillars: a focus on intrinsic value, the enforcement of a margin of safety, and the irrationality of market fluctuations. Of these central pillars, it was intrinsic value that was by far the most important in understanding Graham’s overall framework because the entire framework sprang out of this singular concept. The intrinsic value of a company is, generally speaking, the amount a rational private buyer would pay for a business or a share of a business, regardless of any market price; this amount could be based on the assets of the business or its earnings power. But Graham made an interesting distinction when explaining how the intrinsic value mattered to the analyst: The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish either that the value is adequate – e.g., to protect a bond or to justify a stock purchase – or else that the value is considerably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient. To use a homely simile, it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age, or that a man is heavier than he should be without knowing his exact weight.111 This explanation of the role intrinsic value played in the work of the security analyst had
111

Benjamin Graham, Security Analysis (New York: McGraw-Hill, 1934), 18-19.

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myriad implications. First, the fact that intrinsic value existed as separate from market price meant that Graham was arguing that the markets sometimes get it wrong – that is, a diligent analyst could find mispricings. Second, the fact that the price deviates from value, at times, meant that investor psychology played a significant role in the market in creating these mispricings – a perfectly rational investor would never let the price deviate very far from the value. Third, the fact that the analyst need not determine the exact value was an admittance that intrinsic value itself was an elusive concept, and that an analyst must usually find a significant mispricing to be confident in his conclusion that the situation was, in fact, a mispricing – just like the woman must be some years over voting age for an observer to be able to state with confidence that she, in fact, was of voting age. Fourth, the existence of an intrinsic value as opposed to market price debunked one of the most common misconceptions about the market, which was that buying “blue-chip” companies was absolutely safe; with the framework of intrinsic value though, every company must be compared to the price – even the “blue-chip” could be a terrible investment if the intrinsic value did not warrant the price paid. And fifth, the concept of intrinsic value commanded the analyst to solely devote himself to finding discrepancies between price and value in individual securities. Put more simply, if “intrinsic values” existed separate from market prices, and market prices were generally tethered to these intrinsic values, then the rational investor – he who wished to make the most money – should, then, have looked for discrepancies between price and value. Furthermore, if the precise determination of intrinsic value was generally impossible, then the investor must have diligently sought out situations in which the mispricing was significant enough to lead to a confident conclusion of over or

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undervaluation – that is, the investor must have maintained a margin of safety in his estimates and generally remained skeptical and conservative. And lastly, because intrinsic value and market price could potentially diverge, the investor must have only been mindful of their divergences, and not have taken the movement in market prices as indicative of anything more than fickle and irrational investor psychology. In general, these were the very principles that Graham advocated in Security Analysis, and while he elaborated on each of the principles, they all in essence boiled down to a belief in intrinsic value. Given this primacy of intrinsic value, Graham detailed the principles and methods the analyst should have engaged in attempting to analyze intrinsic value. One of the first items he discussed was the use of quantitative versus qualitative data in coming to conclusions about the nature of the enterprise; Graham endorsed analysis of the quantitative factors wholeheartedly, but he was skeptical of using qualitative factors, especially those that engaged with an outlook on the future for the industry or company, and with the ability of the management team. On the topic of outlook, Graham argued that “abnormally good or abnormally bad conditions do not last forever,” and that an investor would often be wrong if he invested in the most recently successful corporations. And exceptional management teams should not have been given additional credit, according to Graham; if they truly were exceptional, then the quantitative data would say so.112 This perspective was reflective of the generally conservative stance the text took, focusing on the margin of safety – the cushion between estimated value and price that protected the investor from being wrong, from future business changes, and from myriad other unforeseen events. The margin of safety helped to protect the investor from major
112

Ibid, 34-40.

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losses. At its core, Graham’s investing framework was about bargain-hunting. The analyst would patiently seek out potentially mispriced securities, carry out thorough analysis of those securities, and then ultimately conclude whether or not there was enough of a discrepancy between price and value to justify an investment. As simple as the framework was, it was by no means easy, and the simple concepts were extremely powerful. II. Critiques of Competing Schools of Thought Graham spends a significant amount of time critiquing popular misconceptions about investment versus speculation, and argues that the mechanical rules of the past did not suffice for protecting investors. One of the most prominent of these mechanical rules had in fact cut both ways already – whether stocks were the territory of investors or speculators. The ‘old-fashioned’ viewpoint would have argued that stocks were all speculative, but since the explosion of interest and participation in the mid to late-1920s – and the publication of Common Stocks as Long-Term Investments – the rule had flipped completely: stocks were all investments. Graham argues that this latter viewpoint contributed to the speculative boom of 1929, and that it was a decent theory mistakenly taken to its extreme. That is, stocks could be sound investments, as long as they met the core criteria of being undervalued and having a margin of safety baked into the price to help ensure safety of principal. Loathe to speculate, Graham defined an investment as an “operation in which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”113 The definition is decidedly broader than the mechanical rules of investment versus speculation (stocks vs. bonds, margin vs. no
113

Ibid, 54.

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margin, short holding period vs. long, to name a few). This definition, Graham argued, gave the analyst more flexibility and more safety because it requires the analyst to actually study the security in depth rather than using arbitrary rules of thumb to determine the security’s safety and probable return. Graham believed that the mechanical rules of thumb that many people used were simply not adequate and were, in fact, useless.114 Another example of what Graham saw as speculative was the investors who would forecast earnings years out into the future on the basis on an earnings trend line; Graham considered this type of forecasting especially pernicious because the mathematical models used gave an aura of precision and accuracy. However, the results of the model were only as good as the assumptions entered, which were all to often just an extension of an earnings trend line.115 This critique of the use of qualitative factors in the analysis of intrinsic values demonstrates how certain Graham wanted to be of the intrinsic value he estimated; it seemed that he wanted an enormous margin of safety. Graham did not disagree that qualitative factors regarding the future affected intrinsic value; he just did not condone paying for a future so uncertain, and which could potentially cause the investor to lose money. One of the theoretical champions of this method of forecasting earnings to arrive at a value for the company was John Burr Williams, who published a book titled The Theory of Investment Value in 1938.116 That text laid out the mathematical formulas that still serve today as the basis for modern “Discounted Cash Flow” models that are used the world over by very sophisticated investors to calculate the value of a company based on estimates of future earnings and dividends. Benjamin Graham actually reviewed the book, when it was
114 115

Ibid, 50-56. Ibid, 36-37. 116 Williams, John Burr. 1938. The Theory of Investment Value. Cambridge: Harvard University Press.

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first published, in The Journal of Political Economy. While Graham believed that Williams’ formulas provided analysts with a sound quantitative tool to avoid “undisciplined wagering upon the future,” he remained skeptical of its ultimate efficacy in actually reigning in speculation. “Clearly, Mr. Williams’ method stands or falls not on his formulas (which are unimpeachable) but on his assumptions with respect to their numerous variables… One wonders whether there may not be too great a discrepancy between the necessarily hit-or-miss character of these assumptions and the highly refined mathematical treatment to which they are subjected.”117 The formula itself required myriad inputs from the analyst, including several years of future earnings data, growth rates for many more years, and a discount rate for the whole model. While the result of the formula would certainly be very precise – that is, the analyst could calculate out to 10 decimal places if he so chose – its accuracy was still suspect because of the myriad assumptions about the future. It was this discrepancy between precision and accuracy that Graham was pointing out. Graham’s most direct critique in Security Analysis was directed at market analysis, which included both the technical analysts, such as the proponents of the Dow Theory, and the economic forecasting agencies that used not price data, but other economic indicators to forecast the future of business. Graham simply argues that “forecasting security prices is not properly a part of security analysis,” regardless of the timeframe or scope. Technical analysis, Graham contends, is not a science (as it is not dependable), is not successful over the long-run, is devoid of any margin of safety, and is ultimately an “art” – that is, a gamble. The second type of market forecasting, based on economic indicators, suffers the same problems, and is ultimately an unreliable gamble. Furthermore, Graham argues,

117

Benjamin Graham, Review of The Theory of Investment Value by John Burr Williams, The Journal of Political Economy 47 (April 1939): 276-278.

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security analysis as set forth in the text has several distinct advantages over the forecasters, one of the most important of which is access to a margin of safety through thorough analysis – that is, a good security analyst has a better opportunity to protect capital. Forecasters do not have the same luxury: “In market analysis there are no margins of safety; you are either right or wrong, and if you are wrong, you lose money.”118 Graham focuses on bargain-hunting in as conservative a manner as possible. The emphasis is on safety of principle, usually through a strict enforcement of a margin of safety. The security analyst is to constantly hunt for significant mispricings and conduct thorough analyses on the company’s accounts to determine whether or not the intrinsic value is significantly above the market price. III. Reception Reviewers and other professionals immediately recognized Graham’s clarity of thought and thoroughness of analysis, and Security Analysis rather quickly became the standard text of the field. The initial reviews were nothing short of glowing. Two of the first were titled “Rational Investment” and “Sagacity and Securities” in the Economist and the New York Times, respectively.119 Louis Rich, the Times reviewer, wrote of the text, “It is a full-bodied, mature, meticulous and wholly meritorious outgrowth of scholarly probing and practical sagacity…[and is] one of the most authoritative as well as useful [volumes] in the whole range of literature existing on the subject.”120 Security Analysis was clearly off to a good start in the popular periodicals. But it did not disappoint in the more professional journals either: its review in The Accounting Review declared, “Without the slightest

118 119

Graham, Security Analysis, 607-616. “Rational Investment,” Economist, December 11, 1934, 2; Louis Rich, “Sagacity and Securities,” New York Times, December 2, 1934. 120 Rich, “Sagacity and Securities.”

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hesitation, the reviewer pronounces this volume the best thing of the kind in print.”121 The reception of Security Analysis was fantastic. Furthermore, the points of the reviewers reinforce the contextual factors in the shaping of Security Analysis. In the Economist review, the reviewer addresses the increasing financial disclosure of corporations: “Confronted by [Security Analysis], the general investor may be inclined to complain that a friend among the directors may be worth more than all the statistical tests which can be devised. This complaint, however, becomes less and less true as companies can be persuaded, by legislation or good example, to publish prompt and full information regarding their current position.”122 The text was, in part, capitalizing on the rise in statistics during the early twentieth century. Furthermore, the securities legislation of 1933 and 1934 mandated regular financial reports for publicly traded corporations in the United States, which further fueled the importance and necessity of a book like Security Analysis. As a second contextual factor, the Times review points out that one of the main arguments of the text “is that the safer and more sensible way of making commitments in stocks or bonds is through security analysis and not through market analysis.”123 The technical analysts and business forecasters of the 1920s proved that tracking the trend was simply inadequate when it came to safely and responsibly investing in the stock market. Security Analysis emphasized a bottom-up approach, which fit nicely with the public disillusionment surrounding market forecasters. These excellent reviews reveal that while Graham may not have been the first one to have any or all of the individual ideas that appear in Security Analysis, he was certainly the first to coherently put them together. The framework and philosophy that he was able
121

E.A. Kincaid, Review of Security Analysis by Benjamin Graham and David Dodd, The Accounting Review 10 (March 1935): 127-128. 122 “Rational Investment,” Economist. 123 Rich, “Sagacity and Securities.”

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to articulate would come to help create and for a time dominate the field of security analysis. Soon after the text was published, professional classes began adopting it as their official text. In December 1934, the New York Stock Exchange Institute – the educational arm of the NYSE – officially adopted the text for two of its courses.124 Over the years to come, Security Analysis would become a standard text in security analysis courses the world over, and each new edition would take the place of the old.

124

Wall Street Journal, December 6, 1935.

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CHAPTER 5

BENJAMIN GRAHAM’S IMPACT: 1940While the primary focus of this thesis has been on Graham and his ideas in the early twentieth century, this chapter briefly recounts Graham’s longer-term impact on the field of security analysis and investing in general. The chapter begins with a brief summary of Graham’s life and career after the publication of Security Analysis until his death in 1976. It then goes on to show his influence in establishing security analysis as a profession in the latter half of the twentieth century. Graham’s most lasting impact is, of course, his ideas about and framework of investing, which are carried forward by some of the most successful investors of our time; the third section of the chapter briefly discusses the impact of Graham’s acolytes, and the evolution of the concept of “value investing,” with an emphasis on Warren Buffett. The final section discusses Graham’s place in today’s debates surrounding academic finance and the efficient market hypothesis; Graham’s ideas were definitely and fundamentally opposed to the premises and conclusions of the efficient market hypothesis, and work in the growing field of behavioral finance has begun to look at value investing in an academic context for the first time. I. Graham’s Life: 1940-1976 Benjamin Graham’s prominence grew further still with the publication of Security Analysis, and he quickly rose to the position of reigning expert on security analysis. Indeed, in the mid-1930s, Graham began to testify in court as an expert witness on valuation issues, and he would go on to do so again, dozens of times, over the subsequent decades.125 Updated editions of Security Analysis appeared in 1951, 1962, 1988, and 2008,
125

Benjamin Graham, The Memoirs of the Dean of Wall Street (New York: McGraw-Hill, 1996), 269-270.

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which generally kept Graham in the investing community’s collective memory and discussions. The Intelligent Investor also was very successful and was also revised several times over the years, with the last revision published in 1973. Graham also had ventured into economics with his invention and publication of a plan to have commodities serve as backing for currency (it was called the commodity-reserve currency). While the plan was never adopted, it was seriously considered during the 1930s and 1940s, and was a topic of debate among some prominent economists, including John Maynard Keynes and Friedrich von Hayek.126 Graham even wrote a play that appeared on Broadway – though, it didn’t do very well.127 As his investing career progressed, he was involved in several high-profile investments, the most famous of which is his purchase of a significant stake (half the company) in the Government Employee Insurance Company (GEICO), the very same GEICO that Warren Buffett’s Berkshire Hathaway owns today. Graham, in fact, helped take the company public in 1948 by spinning off his investment firm’s GEICO shares to its investors.128 The Joint Account – which had changed its name to the Graham-Newman Corporation in 1936 for tax reasons – continued to do well over the years, and in 1956, Graham decided to retire, at the age of 62, to Beverly Hills, California.129 Over the decades from the 1930s to the 1950s, and even more so after his retirement, Graham was a sought-after market expert; popular newsmagazines, business

126

Benjamin Graham, Storage and Stability (New York: McGraw-Hill, 1937) and Benjamin Graham, World Commodities and World Currency (New York: McGraw-Hill, 1944) were his two major economic works. Interestingly enough, in Graham’s memoirs, he states, “If my name has any chance of being remembered by future generations…it will be as inventor of the Commodity Reserve Currency Plan.” Instead, Graham is remembered for his contribution of principles of investing. 127 Graham, Memoirs, 283-285. 128 Irving Kahn and Robert D. Milne, Benjamin Graham, the Father of Financial Analysis (Charlottesville: Financial Analysts Research Foundation, 1977), 27-29. 129 Graham, Memoirs, 323.

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publications, and financial journals would regularly publish his articles or publish an interview with him.130 Congress even sought out his expertise during the 1955 Congressional hearings on the stock market.131 Graham spoke at various conventions and seminars, and continued to teach, now as an Adjunct Professor at the University of California at Los Angeles (UCLA). Graham died on September 21, 1976, in Aix-en-Provence, France, at the age of 82. His New York Times obituary cited him as “the founding father of modern security analysis…who influenced a whole generation of security analysts with is pioneering book Security Analysis.” According to the Times, Security Analysis had become a “standard text, in use at business schools and universities” and had “sold more than 100,000 copies.”132 His death was commemorated with an article in Forbes and by a commissioned retrospective by the Financial Analysts Research Foundation, which declared, “All financial analysts owe so much to the pioneering efforts and works of Benjamin Graham – truly, the Dean of our profession.”133 II. Security Analysis Becomes a Profession During his lifetime, Graham had been an enthusiastic advocate of establishing security analysis as an organized and learned profession, complete with principles of conduct and standards for admittance. Not only had Graham educated many of the brightest minds in security analysis through his work at Columbia and UCLA, and provided a text to serve as a foundation for the new profession, he also helped organize and advance some of the first associations of professional security analysts. In 1935, he helped
130

Benjamin Graham, “Part Six: Interviews with Benjamin Graham,” The Rediscovered Benjamin Graham (New York: Wiley, 1999), 247-275. 131 Benjamin Graham, Testimony Before the Committee on Banking and Currency, United States Senate (March 11, 1955), reprinted in Rediscovered Benjamin Graham, 99-147. 132 “Benjamin Graham, Securities Expert,” New York Times (New York), September 23, 1976. 133 Kahn and Milne, Benjamin Graham, 30.

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organized and became one of the founding members of the New York Society of Security Analysts, and in 1947, Graham addressed the first annual conference of the Financial Analysts Federation and advocated greater professionalism in the field.134 He began arguing for a professional designation in the field in 1942, and in 1963, his ideas came to fruition with the establishment of the Chartered Financial Analyst (CFA) designation and exams, which still exist today.135 Much of the curriculum in the CFA exams has developed beyond the principles and methods in Graham and Dodd’s Security Analysis, and has come to include more modern topics, particularly from academic finance, such as portfolio management, statistical analysis, and alternative and derivative investments. While much of the exam still focuses on fundamental analysis, in the mode initially advocated by Graham and Dodd, many of the segments seem to violate basic principles of the text.136 Such flexibility in method and principle indicates an evolution of the broader security analysis community beyond Graham and Dodd; that is, because other styles of analysis have become popular, security analysts are expected to know those styles, despite their conflict with the original principles.

III. Superinvestors of Graham-and-Doddsville One group of investors that have made a point of adhering to the principles of Security Analysis are so-called “value investors.” As security analysis developed, various styles of analysis came into being – some outside of the bounds of Graham and Dodd – and
134 135

Ibid, 26-27. CFA Institute, “About Us: History of the CFA Institute,” http://www.cfainstitute.org/aboutus/overview/history. 136 Ibid.

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those that stuck with the original principles came to be known as “value investors.” The most famous of the value investors is, of course, Warren Buffett. Graham’s legacy was indeed carried forward by those who studied under him at Columbia and at the GrahamNewman Corporation. His lasting popularity is in no small part due to the dramatic success of several of his acolytes. Buffett is his most famous student, having studied under Graham at Columbia and worked for him for nearly 2 years at the Graham-Newman Corporation. Buffett, however, was not the only prominent investor to have benefited from Graham’s tutelage. Walter Schloss was another student and employee who amassed an excellent record as an investor after leaving Graham’s firm. Other prominent investors in that first generation after Graham include Tom Knapp, Ed Anderson, and Bill Ruane. All three of these investors founded firms that are still around today: Tom Knapp and Ed Anderson were founding partners of Tweedy, Browne Partners, and Bill Ruane was the longtime manager of the Sequoia Fund, currently of Ruane, Cunniff, & Goldfarb. All of their records were detailed in a 1984 article by Warren Buffett, entitled “The Superinvestors of Graham-and-Doddsville,” which argued that Graham and Dodd’s principles first established in 1934 continued to produce excellent returns with minimized risk, despite the disbelief and arguments to the contrary by the efficient market academics.137 Warren Buffett was certainly the driving force behind the rise in popularity of value investing over the past 20 years, due to his excellent investment returns and his prolific and lucid writings as Chairman of Berkshire Hathaway. In the 1990s, Buffett began entering

137

Warren Buffett, “Superinvestors of Graham-and-Doddsville,” Hermes (1984), reprinted in The Intelligent Investor by Benjamin Graham (New York: Harper & Row, 1985), 537-560.

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the financial mainstream as his letters gained wider circulation and attendance at his annual meetings began to skyrocket. The explosion of mutual funds and increased participation throughout the 1990s was certainly a factor in generally increased interest in financial markets. Buffett has come to be seen as a grandfatherly investing genius, freely doling out advice to all. His frequent mention of Graham and Graham’s ideas have certainly gone a long way in maintaining and growing Graham’s legend and importance in modern-day investing.138 ‘If it’s good enough for Buffett,’ the thinking probably goes, ‘then it is good enough for most investors.’139 The concept of “value investing” as a distinct style has definitely become part of the financial mainstream. Mutual fund companies advertise numerous funds as “value” funds that invest in securities that the manager believes are generally undervalued. Morningstar, the popular financial information juggernaut, introduced the Morningstar Style Box in 1992 to categorize mutual funds by size and style – one of the style categories was “Value,” alongside “Blend,” and opposite “Growth.”140 As value has become more popular in the mainstream and through the increased popularity of investors like Buffett, a small niche group have created a vibrant culture around it. Berkshire Hathaway’s annual meetings are central to that culture, but the community does not end there. Value investors have their own conferences – the Value Investing Congress and the Value Investing Conference – several of their own magazines – among them are Value Investor Insight, Outstanding Investor Digest, SuperInvestor Insight, and Value Line – and an enormous number of books – a search for “value investing” on Amazon.com produces 189 results.
138 139

Warren Buffett, Letter to Shareholders, http://www.berkshirehathaway.com. Bruce Greenwald, Value Investing: From Graham to Buffett and Beyond (New York: Wiley, 2001), 161196. 140 Morningstar, Inc., “Fact Sheet: The New Morningstar Style Box Methodology” (2002), http://news.morningstar.com/pdfs/FactSheet_StyleBox_Final.pdf.

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The massive growth and community-building in this once small group of investors indicates both the continuing popularity of the investing style, as well as the fervor with which followers believe in the principles. Certainly, “value investing” has evolved in meaning over the years through the reinterpretation of the ideas by various “gurus.” And it may be less of an evolution than it is a splintering. Buffet himself has admittedly redefined Graham’s conservative conceptions of value by adding that “franchise value” enters his calculations – that is, while Graham would have used asset values and conservative earnings power estimates to value the company, Buffett is willing to attach additional value to a company that he believes to possess a protected position in the marketplace that allows it to earn higher returns over long periods of time.141 On the other hand, investors like Seth Klarman of the Baupost Group, attempt to adhere more rigorously to the initial Graham and Dodd principles by seeking out obscure and complicated securities that present some similar features to that of Graham’s earlier signature investments – that is, more definite cases of mispricing based on very conservative and thorough analyses.142 Many “value investors” fall somewhere in between on the spectrum between the more strict or liberal interpretations of “intrinsic value.” IV. Graham and the Efficient Market Hypothesis Modern academic finance and the efficient market hypothesis compose the dominant school of thought in finance today. Its roots reach back to the 1950s, and ever since then, it steadily rose in prominence and acceptance, well into the 2000s. Its rise was accompanied by a relative decline in the prominence of fundamental analysis, but the
141

Greenwald, Value Investing, 161-196. Greenwald’s text is not only an excellent primer on value investing, but it also has in-depth profiles on individual value investors and their styles. 142 Ibid, 231-244.

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nascent field of behavioral finance and the financial collapse of the last few years have served to spark a reexamination of the EMH and fundamental analysis, specifically value investing. There has been a long-standing debate raging between academics on the one hand and value investors, in particular, on the other. While the academics have been applying statistical techniques to market returns and arguing that the market is perfectly efficient, value investors have been analyzing individual securities and arguing that sometimes, the market serves up mispricings that can be taken advantage of. In terms of background, the efficient market advocates are nearly all academics – that is, researchers – with doctorates in economics, statistics, or some other quantitative field, and with little to no practical experience in markets. Value investors are nearly all practitioners, with years of experience in markets, but little to no research experience. These divergent posts – researcher vs. practitioner – lead to each looking down on the experience of the other, seeing it as irrelevant and of little use. One of the most famous critiques of the EMH from a value investor is Buffet’s “Superinvestors of Graham-and-Doddsville,” which blasts the EMH and its various academic finance corollaries. In general, value investors are harsh critics and staunch opponents of academic finance and the EMH.143 Unfortunately, despite what is seemingly a clear division between the two approaches – one sees the market as perfectly priced, the other sees it as periodically irrational – several mentions of Graham misinterpret his ideas to support an argument of market efficiency. To be clear, the difference between Graham’s conception of the market as set forth in his major investing texts, and the conception set forth by academics cannot be overstated. While on the surface it seems that the difference between arguing ‘perfectly
143

Buffet, “Superinvestors.”

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priced’ and ‘close to perfectly priced’ is small, that is simply not the case. If the market is perfectly priced, then all efforts at security analysis are totally futile, and the premise has profound implications for how to regulate markets – specifically, if markets are always right, then no regulation is needed. Arguing that markets are ‘close to perfectly priced’ leaves room for the practice of security analysis in uncovering those (rare) securities that are mispriced; furthermore, the implications of this conception of markets for regulation leave open the possibility of market irrationality that may require intervention or prevention. Furthermore, the former model denies the existence of bubbles and busts, while the latter accepts them as possible and, at some points, probable states of the market. Graham stated in interviews that he had generally moved closer into the camp of the efficient market people, but only in that he believed securities were generally fairly priced – not universally.144 Just because the mispricings are rare, doesn’t mean they don’t exist. Behavioral finance had begun to question some of the conclusions of the EMH when it began to catalog instances of clear investor irrationality – things like forced selling, institutional constraints, and market overreaction. Alongside with these findings, academics also began to examine “value investing” in an empirical way by constructing hypothetical portfolios based on simple measures of value (like price to earnings or book value); interestingly enough, they found that the use of these metrics worked very well – that is, buying cheap, even on these extremely simple metrics, outperformed the market as a whole by a significant margin over a long period of time.145 As investors begin to see the mounting evidence of the efficacy of value investing, behavioral finance is beginning to

144 145

Justin Fox, The Myth of the Rational Market (New York: HarperCollins, 2009), 119. Andrew Dubinsky, “Value Investing Retrospective,” Heilbrunn Center for Graham & Dodd Investing, http://www4.gsb.columbia.edu/valueinvesting/research/vi/vi_intro. This retrospective compiles many of the academic studies on the outperformance of “value” in mechanically selected portfolios.

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furnish explanations as to why such a strategy works over such a long period of time.146 Investor psychology generally does not change much over time, and if investors continue making the same behavioral and psychological mistakes as they always have (i.e. greed and fear), then ‘value’ should continue to perform as it has in the past. While ‘value investing’ is still not by any means the dominant school of thought in the investing world and especially not in academic circles, it is beginning to gain some credibility. In 1988 – the same year Graham was elected to the United States Business Hall of Fame – Robert Heilbrunn established a Professorship of Asset Management and Finance at Columbia University as a “cornerstone of a Graham and Dodd Research Institute.”147 Today, the Heilbrunn Center for Graham & Dodd Investing hosts events with guest value investors, maintains an archive with various documents related to Graham & Dodd, and supports a value investing curriculum at Columbia Business School, with Professor Bruce Greenwald. It seems fitting that the birthplace of value investing was home to its rebirth and continued development.148 The recent financial collapse and the shaking of the foundations of the EMH seems to have reinvigorated value investors. With the sixth edition of Security Analysis published in 2008, 20 years after the fifth edition and nearly 75 years after the original publication, value investors seem to be going back to their roots of Graham and Dodd.

146

James Montier, Value Investing (New York: Wiley, 2009) and James Montier, Behavioural Investing (New York: Wiley, 2007) both build the connection between behavioral finance and value investing. 147 Graham, Memoirs, 325. 148 Heilbrunn Center for Graham & Dodd Investing, http://www4.gsb.columbia.edu/valueinvesting.

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CONCLUSION

VALUE ENDURES
Ultimately, this thesis has attempted to tell the story of Benjamin Graham and his ideas in the context of his time. With the financial and cultural rise of the stock market in the 1920s and the accompanying release of statistical information, Benjamin Graham began to develop an investing philosophy in parallel to those dominant at the time. Graham dug deep into the statistical information on individual companies to find obscure mispricings – basically, opportunities for healthy returns with minimal risk. With the boom and bust of the late 1920s and early 1930s, the public’s disillusionment with the stock market and the inadequate schools of thought paved the way for Graham’s analytical, commonsensical, and conservative reply. While the previous schools of thought emphasized general trends in market prices or the economy, Security Analysis established a framework of investing that emphasized intrinsic value and conservatism; Graham’s conception of the stock market was the first coherent explanation of what the market is generally trying to do (ascertain intrinsic value), and how an individual could procure a healthy and safe return on capital (by exclusively paying attention to intrinsic value). Furthermore, the conception of the market as an irrational force appealed to many at the time, as did Graham’s direct discrediting of the various previously dominant schools of thought (particularly technical analysis, forecasting, and market efficiency). While it may be a bit speculative to argue with any degree of certainty the reasons for the text’s persistence, it certainly doesn’t hurt that the framework itself makes sense on a very fundamental level, and that many of its students attain excellent results with it. Warren Buffet’s fame and remarkable investment returns surely had something to do with 77

the persistence of Graham’s ideas, and the more recent studies done in academic circles are beginning to lend some academic, or empirical, credibility to Graham’s investing ideas. While Graham’s ideas may have lasted a relatively long time, they are still by no means dominant. Self-proclaimed value investors cling to Graham’s principles, but others remain skeptical (and some simply cannot engage in it because of psychological or institutional barriers). Intrinsic value is a difficult value to ascertain, and even an estimate of it can be difficult to make. Graham advocated patience – that is, wait for a security that is easy enough to estimate an intrinsic value, then hope that it is significantly mispriced. Some investors simply don’t have the patience, but others would argue that such certain investments do not exist. While the general framework seems rock-solid, the principles’ lack of precision may make it difficult to implement correctly. Especially given the myriad successful value investors who all interpret the original principles slightly differently, it becomes difficult to determine what exactly a value investment is or whether or not an investor is being a good value investor. Nonetheless, the principles themselves do correspond to the realities of the marketplace, and the best evidence of that is in the relatively transparent success of the framework’s followers, and its success in academic studies. While the final chapter of the thesis briefly traced Benjamin Graham’s impact since the mid-twentieth century onwards, this time period is ripe for further study, especially in the context of the rise of the efficient market hypothesis. As academic finance adjusts itself in light of the events of the past few years, and as behavioral finance continues to make further strides, academia’s relationship to value investing may undergo a dramatic change. Bubbles and busts force societies to reexamine their core beliefs about how markets work,

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and such a reexamination is happening here and now. It will be interesting to see whether Graham’s investing principles will be consulted in the quest for a new framework. Seth Klarman was quoted in the opening of this thesis saying that Security Analysis and the principles that it advocates are “timeless wisdom,” to be consulted and used under any conceivable investing circumstances. So far, the principles have held up remarkably well for over 75 years, through multiple cycles of booms and busts, and seem to have survived this past boom and bust as well. “Value investing” is not without its critics, but its most disciplined practitioners continue to post excellent returns over the long-term, and nearly all parrot the same principles – focus on intrinsic value, enforce a strict margin of safety, don’t pay attention to the market. Even if the principles are a bit vague, it is still astounding to hear so many successful investors agree on them. Whether they will continue to agree on them is anybody’s guess, but if the success of the past 75 years is any indication, it seems that value is here to stay. In a rapidly changing world, many of the most successful investors continue to embrace the investing framework of Benjamin Graham as a constant.

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