The “Einstein of money” wasn’t much of a husband or father.
His first divorce was in 1937, when divorce was still taboo. He left his wife for a young actress, and became an absentee father to his four stigmatised children.
When he tired of her, he married a secretary.
After his son’s suicide, the funeral was barely over before he informed his third wife that he planned to spend half the year with his dead son’s former lover!
And in between, his other affairs were so legion that his biographer used the word “swinger” to describe him in the 2012 book, The Einstein of Money.
His total lack of shame shines through in the very first sentence of his memoir, as he writes, “Let me describe my first extramarital affair in the soberest fashion.”
Just six sentences later, he ungallantly describes his affair with the “by no means beautiful” Jenny as being “one part attraction and four parts opportunity.”
Obviously, this man wasn’t much for family values. But there was one kind of value Benjamin Graham understood. And he may have understood it better than anyone else in the world.
The father of security analysis
To be fair, Benjamin Graham – Warren Buffett’s mentor and the author of The Intelligent Investor – had a reputation for being scrupulously honest outside of his personal life.
When the Great Depression hit, he paid back investors in his fund for their losses. And his reputation for brilliance was also well-deserved.
He graduated almost two years early from Columbia University, second in his class, and went on to become the only person offered professorships there in three different departments – English, maths, and the classics.
But he turned to Wall Street, earning $700,000 in 1928 – the equivalent of $7.5 million today – thanks to the style of value investing he pioneered.
Today, Graham is known as the “father of security analysis.” His investing philosophy was deeply risk-averse – and yet it achieved results that vastly outperformed the market.
His fund, the Graham-Newman Corporation, beat the market by an average of 2.5% a year for 20 years. That may not sound like much, but compounded over 20 years, it amounted to a 65% beat. And much more importantly to Graham, he made the return while shouldering significantly less risk.
Graham’s approach to investing was to buy a share only if he would consider buying the entire company. Know what the company is worth intrinsically – assets minus liabilities – and if intrinsic value is higher than the current stock price, it may be time to pounce on the undervalued security – but only if the difference is substantial.
This substantial difference between a share price and its intrinsic value was what Graham called a “margin of safety”. The bigger your “margin of safety”, the cheaper the stock and the better the deal you get as a shareholder – and the less risk you run of taking a loss.
Maximising returns while minimising risk may sound like a contradiction to many investors who associate increased risk with higher potential returns. But as Graham showed, it’s possible to cut risk to the bone while beating the overall market. Graham and his fellow value investors had their cake at massive discounts and ate it, too.
If there was one wrinkle to Graham’s investing theory, it was the word “eventually”.
A stock that was discounted and beaten down beyond all reason should rise to its intrinsic value price level – eventually. But this rise could take months or years – and in the meantime, the cheap stock could always fall further.
So patience was required. As Graham’s star-eyed pupil Warren Buffett would later say, “The stockmarket is a device for transferring money from the impatient to the patient.”
What Graham would say about today’s markets
Graham’s method of value investing was perfectly suited to the Depression-battered markets of the 1930s, where many stocks were heavily discounted.
Today, it’s a different story…
Take a favoured stock today like Tesla. It has a price-to-earnings (PE) ratio of approximately 680 – that is, its current earnings are small enough, relative to its stock price, that it would take 680 years for one share to earn enough to “pay for itself.”
Overall, the Dow has a PE ratio of 29. That’s a long way from Tesla’s stratospheric valuation. So would he and his fellow value investors be greedy or fearful of today’s market?
Graham had a formula for determining whether or not a stock was a good deal. From Chapter 14 of The Intelligent Investor:
Our basic recommendation is that the stock portfolio, when acquired, should have an overall earnings/price ratio – the reverse of the P/E ratio – at least as high as the current high-grade bond rate. This would mean a P/E ratio no higher than 13.3 against an AA bond yield of 7.5%.
– Chapter 14: Stock Selection for the Defensive Investor, The Intelligent Investor
Today, high-grade bonds yield 2.77%. That means that Graham would accept a PE ratio of 36.6 – meaning that, incredibly after a 12-year bull market run, Graham might see today’s stocks as attractively priced.
The FTSE All-Share, with a PE ratio of just over 21, might seem even more tempting. But remember – a cheap stock, and cheap markets, can always get cheaper…
UK and US markets may be objectively cheap today, when placed in the context of low interest rates that Graham’s formula takes into account.
Yet in June 2007, UK markets had an even lower PE ratio of around 12. But you probably remember what happened after 2007 as well as I do…
Today, the FTSE 100 is barely 7% higher than it was in mid-2007. US markets fared significantly better, taking just over five years to regain the lost ground from the 2008-2009 crisis.
Now, does the collapse of cheap markets prove that value investing is dead? Not exactly…
Graham’s emphasis on value worked because he had a long time frame to work with – the stocks he picked eventually saw their prices catch up their fundamentals, as his theory predicted.
But I recognise that many readers can’t afford to wait decades, as Graham’s fund could. The next crisis, when it comes, could drag markets down for five years as the last did in the US, or almost seven years as it did for the FTSE. Or anything outside that range or in between.
Now, I realise that’s not very specific or helpful. I could give you a prediction about what’s coming and when – but I’d be guessing.
The truth is, it’s impossible to predict – but you can prepare.
Next Thursday 8 July, Southbank Investment Research will broadcast an event, The Final Rally, with a guest who warned investors to get out of markets in late February 2020, when the accelerating pandemic was days away from crashing markets.
He was laughed at on the Florida stage when he told of his decision to go 97% cash on 27 February. But you know what happened then as well as I do.
Likewise, people thought he was crazy to dive back into markets in late March 2020, when panic and uncertainty were at all-time highs. Yet markets have returned more than 65% since.
In our free event next week, he’ll explain how he knew – and why his breakthrough could position investors to handle what’s coming next.
Regards,
William Dahl
Editor, Southbank Investment Daily
PS To Benjamin Graham, value was the most important measure of a stock’s potential return – and in that era of higher interest rates, it may well have been. But our guest next week will reveal what he considers “the most important number in finance” – and it’s not value, or earnings growth, or any metric mainstream analysts cover. He’ll explain it all next week.
Category: Economics