Early Writings of Benjamin Graham: A Case Study of US Steel

Benjamin Graham

It is always a pleasure to read some early writings of Benjamin Graham.Jason Zweig just came out with a book featuring a collection of Graham’s writings. The book is titled Benjamin Graham, Building a Profession: The Early Writings of the Father of Security Analysis.

Jason Zweig is an investing and personal finance columnist for The Wall Street Journal.  He is the editor of the revised edition of Benjamin Graham’s “ The Intelligent Investor, the classic text that Warren Buffett has called “by far the best book about investing ever written.” Zweig serves on the editorial boards of Financial History magazine and The Journal of Behavioral Finance.

I will doing a book review shortly, however there was a passage earlier in the book which I thought was very informative and wanted to write a separate article about.

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Benjamin Graham discusses US steel in an article written in 1946. Graham discusses proper security analysis using US Steel as a case study. US Steel is currently at $80 a share the question Graham asks by what criteria to we measure whether the investment is prudent? Do we want the stock to go up by x percentage this year, x% more than the market, or that the stock meet certain criteria in respect to dividends and earnings in the next five years?

Graham then goes on to look at four methods of evaluating evaluating US steel based on its valuation.

1. US Steel averages $13 per share in earnings giving the stock a P/E of 6.2

2. US Steel is currently cheaper than the Dow Jones Industrial Average

3. US Steel’s earnings should increase dramatically next year.

4. US Steel is trading much lower than the peak it reached in two previous bull markets.

Graham goes on to examine all four methods of valuation.

Reason #1 provides criteria by which the company should provide satisfactory earnings and dividends for at least the next five years. If the stock was bought in 1937 the five year return would have been 57%, however earnings only averaged $5 per share from 1937-1944. Even though the investor would have made money this would be due to a rise in the P/E ratio and not because of a prudent investment decision.

The assumption according to criteria #2 is that although US Steel may be trading above it’s intrinsic value  it should be bought because it is cheaper than the overall market. In this case as long as the stock does better than the overall market even though both may decline, the analyst would be proven correctly.

Assumption #3 is the most common on Wall Street. Assuming the analyst is right that earnings will increase this is most likely already priced into the stock current price.

Assumption #4, Graham states that opinions differ.

Assumption #4 I take issue with, if Graham believes in buying stocks on intrinsic value argument #4 is completely invalid. Maybe US Steel was trading at a ridiculously high price in the previous two bull markets. That does not mean it is undervalued. For example, Cisco was trading above $75 per share in 2000. Cisco is now trading at $25 per share, and at 3.5x book value. Maybe the stock is not extemely overvalued at 3.5 x book value but if it was trading at $75 per share it would be trading at 11x book value. I doubt the case can be made that Cisco is undervalued. I humbly take issue with Graham on this point.

Overall I like the case study because it shows how Graham always examined things logically. He thought what makes a stock undervalued, what are the criteria. He examined these complex topics in a rational way.