Reading: Introduction to the Sixth Edition—Benjamin Graham and Security Analysis: The Historical Backdrop
One Minute Summary:
The chapter gives a brief historical overview of the U.S. economy and Wall Street since the Great Depression, as well as the Dean of Wall Street himself.
Chapter in Detail:
· Between the publication of the first (1934) and second (1940) edition of Security Analysis, the U.S. economy and the U.S. financial industry were in a terrible shape.
o DJIA had lost 87% of its value from its peak in 1929 to trough in 1932; unemployment rate was approximately 25%.
o DJIA again lost 50% of its value from 1937 to 1938; unemployment was 18.8%.
o NYSE, the exchange itself, was running at a loss every year from 1933 to 1940, with the exception of 1935 with a small nominal profit.
o Total share volume traded was 207.6 million in 1940—about two hours worth of trading in today’s market or 18.5% of 1929.
o One in five NYSE-listed industrial companies was under its net current assets value.
o Merrill Lynch & Co. only required a single floor at 40 Wall Street for the entire company; Morgan Stanley only occupied a single floor as well at 2 Wall Street, and it was the leader for corporate securities underwriting in 1936 —with originations worth of $195 million.
· Major federal regulations of the securities markets were introduced in the 1930’s.
o Public companies need to publish quarterly and annual report to stockholders.
o Institutions regulating the securities markets were established, along with federal insurance of bank deposits.
· Benjamin Graham, the Dean of Wall Street.
o Intrinsic value, defined by Graham, is “that value which is justified by the facts, e.g., the assets, earnings, dividends, definite prospects, as distinct, let us say, from market quotations established by artificial manipulation or distorted by psychological excess.”
o Graham stated that since the future is unknown, an investor must defend himself or herself again that unknown by paying less than the “intrinsic” value of a stock (“Margin of Safety”).
New terminology / Concepts / Ideas / Technical Items / Useful Examples:
“Nexting” – Animals learn to recognize patterns around their world and use the knowledge to expect what would happen next. Humans are masters of this ability and often mistakenly believe the knowledge is a sound base for future predictions; however, “Nexting” is really just combining the experience of the present and past to arrive at a conclusion for the unknown future. This term is coined by Daniel Gilbert, author of “Stumbling on Happiness” and a Harvard psychology professor. Benjamin Graham understood the foolishness of projecting current experience into the unpredictable future; thus, he urged adhering to the concept of “Margin of Safety”—purchase of a stock significantly below its intrinsic value. In the chapter, an example of “Nexting” is the prediction made in 1939 by Alvin Hansen and Joseph Schumpeter, two Harvard economics professors, that U.S. would experience continued decline in population growth; this idea was echoed by Chelcie Bosland, assistant professor of economics at Brown, in his publication of “The Common Stock Theory of Investment” (1937) that U.S. population growth would stop by 1975.
Use of Leverage – In 1929, Graham-Newman partnership had $2.5 million capital. They had $2.5 million in long/short hedged positions, as well as $4.5 million in long positions. Graham realized later that the stocks they owned, no matter how cheap they appeared to be, were imminent to major financial blows. Even after a careful selection of stocks, the partnership showed a cumulative loss of 70% from the fourth quarter 1929 to the end of 1932.
Issues Disagree With:
N/A
Practical Application:
1. Consider stocks that are under its net current assets value.
2. Special situation, Graham and Klarman’s specialty: assesses the liquidation value of a company with insolvency potential. After a thorough analysis, acquire the stocks if the market value is significantly below the liquidation value.
3. Apply long/short strategy when applicable situation arise. In the chapter, the example involved with a company faced with insolvency. Graham would enter a long position in the liquidating company, again after thorough analysis, that had a much higher liquidation value than its market value, and subsequently, short the stocks of companies in which the liquidating company owns.
Three Quotes:
1. “I blamed myself not so much for my failure to protect myself against the disaster I had been predicting (the 1929-1932 market collapse)…as for having slipped into an extravagant way of life which I hadn’t the temperament or capacity to enjoy. I quickly convinced myself that the true key to material happiness lay in a modest standard of living which could be achieved with little difficulty under almost all economic conditions.” –Benjamin Graham
2. “Even when the underlying motive of purchase is mere speculative greed, human nature desires to conceal this unlovely impulse behind a screen of apparent logic and good sense. To adapt the aphorism of Voltaire, it may be said that if there were no such thing as common-stock analysis, it would be necessary to counterfeit it.” –Benjamin Graham
3. “If an investor had purchased 100 shares of the 20 most popular dividend-paying stocks on December 31, 1901, and held them through 1936, adding, in the meantime, all the melons in the form of stock dividends, and all the plums in the form of stock split-ups, and had exercised all the valuable rights to subscribe to additional stock, the aggregate market value of his total holdings on December 31, 1936, would have shown a shrinkage of 39% as compared with the cost of his original investment.” –Robert A. Lovett
Three questions to the group to test understanding:
1. What is “intrinsic” value and how is it determined?
2. What would be an example of the “aphorism of Voltaire” we have seen in the past decade?
3. Why is “Margin of Safety” an important investment concept?
Clarifications & Group Discussion:
1. 10 times earnings, 20 times earnings, or 50 times earnings – Are we creating another New Era theory or time has really changed?
2. Use of Leverage — Should leverage be used? If yes, on what level?
3. The Great Depression – Is this an anomaly?
4. Think about stocks the way a businessperson would think about his or her own family business — Is this the case in today’s market or its relevance has disappeared?
5. Nexting – How can we avoid the folly in making future predictions?
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