Benjamin Graham is considered to be the godfather of value investing and one of the creators of fundamental investing in general. Graham’s first book, Security Analysis, co-written with David Dodd, quickly became the bible for security analysts when it was published in 1934, and it remains relevant today, but Ben Graham’s Security Analysis lectures were also important.
As well as his books, Graham taught hundreds of students the process of fundamental value investing at the Columbia Business School, and once again, even though these lessons are out of date, they remain relevant today.
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This series is devoted to notes of Ben Graham’s Security Analysis lectures between September 1946 and February 1947 at the New York Institute of Finance. The series of lectures was titled Current Problems in Security Analysis, and it gives a great insight into Graham’s process and investing mentality.
Ben Graham’s Security Analysis lectures
Current Problems in Security Analysis was a series of lectures that in Graham’s words were intended to “bring our textbook “Security Analysis” up to date.” Graham starts by dividing the subject of security analysis into three separate brackets. First, the techniques of security analysis. Second, standards of safety and common stock valuation. And third, the relationship of the analyst to the security market. Another way of considering the subject Graham opines might be to consider the analyst as an investigator, who “gathers all the relevant facts and serves them up in the most palatable and illuminating fashion he can.” He goes on to say that the judgment of security analysts on securities is so much influenced by market conditions that they are not able to “express valuation judgments as good analysts.” Despite the vast improvement in the availability of financial information and understanding of company fundamentals that have taken place between the first publication of Security Analysis, Graham notes that analysts continued to evaluate companies with “one eye on the balance sheet and income account, and the other eye on the stock ticker.” In many ways, the same remains true today.
The topic of this first lecture in the series from Ben Graham’s Security Analysis lectures was the aspect of the security analyst’s work and his relation to the market. The correct attitude of the analyst, Graham believed, should be:
“…that of a man toward his wife. He shouldn’t pay too much attention to what the lady says, but he can’t afford to ignore it entirely. That is pretty much the position that most of us find ourselves vis-à-vis the stock market.”
There are two areas of fundamental importance Graham felt every analyst should recognize and understand. The first was the principle of continuity, and the other is something he called the principle of deceptive selectivity.
The principle of continuity, is, in some ways outdated today. According Ben Graham’s Security Analysis lectures notes, the continuity principle was Graham’s idea that the market will always return to its previous lows, and the index will never break out from its trading range.
“If you look at this chart of the Dow Jones Industrial Average, you can see there has never been a time in which the price level has broken out, in a once-for-all or permanent way, from its past area of fluctuations.”
He also believed the earnings of the Dow Jones would never rise sustainably above $10:
“We have figures here running back to 1915, which is more than thirty years, and it is extraordinary to see the persistence with which the earnings of the Dow-Jones Industrial Average return to a figure of about $10 per unit. It is true that they got away from it repeatedly. In 1917, for example, they got up to $22 a unit; but in 1921 they earned nothing. And a few years later they were back to $10. In 1915 the earnings of the unit were $10.59; in 1945 they were practically the same.”
As we know today, this advice from Ben Graham’s Security Analysis lectures was fairly incorrect.
Deceptive selectivity refers to the selection of securities by analysts that they believe will do better than the rest of the market when the market is rising, something Graham believed was impossible based on past trends.
The reason why he decided to dive into these two particular areas is that he wanted to show that “you are not going to get good results in Security analysis by doing the simple, obvious thing of picking out the companies that apparently have good prospects… that method is just too simple and too obvious—and the main fact about it is that it does not work as well.”
The lecturer then goes on to discuss “the area of new common stock offerings.” Like Warren Buffett, Benjamin Graham was known for his dislike of IPOs. Rather than acquiring a company when it first came to market, he preferred to wait until these businesses lost their initial group of cheerleaders and traded down to a more attractive valuation. In the lecture, he declares that the recent IPOs were “bought by people who, I am quite sure, didn’t know what they were doing and were thus subject to very sudden changes of heart and attitude with regard to their investments.” Interestingly, Graham also refers to a statement from the SEC at the end of August 1946 which declared, “The rapidity with which many new securities, whose evident hazards are plainly stated in a registration statement and prospectus, are gobbled up at prices far exceeding any reasonable likelihood of return gives ample evidence that the prevalent demand for securities includes a marked element of blind recklessness. Registration cannot cure that.” So, it seems Graham wasn’t the only one advising investors to stay away from new issues.
Ben Graham's Security Analysis lectures on IPO euphoria
To illustrate the euphoria that had overtaken the market, Graham went on to critique the fundamentals of two businesses, Northern Engraving and Manufacturing Company and the Taylorcraft Company. Northern Engraving was looking to go public at $16 a share valuing the firm at $4 million. The company had $1.4 million of tangible equity, and for the five years ending 1945, earnings per share averaged $0.65, for a five-year average P/E of 25. However, for the six months ending June 13, 1946, the company earned $1.27 a share giving an annualized earnings rate of $2.54 and a multiple of six or seven times earnings on a share price of $16.
“That, I believe, illustrates quite well what the public had been offered in this recent new security market. There are countless other illustrations that I could give. I would like to mention one that is worth referring to, I think, because of its contrast with other situations”
Taylorcraft Company may have been an even worse offender. For the period ending June 13, 1946, the company had working capital of only $103,000, that’s after including the proceeds of the sale of