” To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.” Quote by Benjamin Graham
How Benjamin Invested
Most stock investors have heard of Benjamin Graham, but for many new and beginner investors, they are not sure how he actually invested.
The general impression is that he was a traditional value investor. After all he is referred to as the father of value investing.
While it is true he is a value investor, his tactics used are for the most part not the conventional strategies used by most value investors, as Benjamin was essentially a hedge fund manager.
Benjamin formed a partnership with Jerome Newman in 1926 called the Graham-Newman partnership which was later renamed to Graham-Newman Corporation.
This partnership was basically an open-ended mutual fund which operated more like a modern day hedge fund.
Benjamin Graham would have been at odds with the Efficient Market Theory.
The theory is based on the notion that all information from analysts and fund managers is reflected in the stock price and therefore the stock price is its fundamental value.
This theory is based on the stock valuation rather than the business valuation which is what Benjamin Graham was interested in.
The stock price is what a share can be bought or sold at any given point in time, but Benjamin Graham was interested in at what price level was the stock price considered cheap compared to what the business was worth as a private enterprise.
This formed the foundations for Benjamin’s value investing strategies.
Investing Strategies of Graham-Newman Corporation
Benjamin Graham actually started his career in Corporate Bonds and through his investing career also applied his value concepts to corporate bonds.
In fact his portfolios generally held around 50% in bonds. He was however not a bond holder as such, but more a speculative bond investor who bought bonds while they were cheap and sold them when he considered them overvalued.
The value strategies Benjamin mostly used with the Graham-Newman Corporation can be broadly summarized as follows:
Arbitrages
Arbitrage strategies were commonly applied by Benjamin to reorganizations, mergers and takeovers (acquisitions).
An arbitrage existed when a stock or bond could be purchased and a price they could be sold for was essentially known in advance.
Arbitrages also existed when the risk could be effectively hedged away.
The hedged version of this strategy involves the purchase of a security and the simultaneous sale of one or more other securities.
If a takeover was considered undesirable, he would buy shares in the takeover company and short sell shares in the acquiring company.
Un-hedged, Benjamin would buy shares in a company that was splitting up or spinning off part of its operations or a division as a separate company.
He would buy if the end resulting value would be higher than the stock price he paid.
Another tactic was to buy shares in a holding company when the shares in the companies held were worth more than the holding companies own stock price.
Liquidations
With this strategy Benjamin would purchase bonds or preferred stock at a deep discount in companies being liquidated. Benjamin would analyze the financial statements to determine whether the liquidated value was greater than the net tangible assets recorded on the balance sheet.
The success of this strategy was reliant on the liquidated value being higher than the recorded value as the creditors were first in line for payment.
Benjamin through his financial statement analysis would ensure the liquidated value was sufficient to cover the bond and even the preferred stock holders.
The companies Benjamin Graham was interested in had significant hard assets, especially real estate such as land, buildings and factories.
He was after the cash payment returned and favored bonds and preferred stock as these had priority over common stock for payment.
In Benjamin’s days, fundamental analysis was in its infancy which meant most investors had no idea of whether the liquidated value was higher than the book value.
These investors sold their stock in a panic frenzy when bankruptcy threatened and had no idea of the cheap prices they where selling their stock. Benjamin Graham would buy sufficient bonds and preferred stock in order to become a substantial holder and could force a companies’ liquidation along with its creditors.
This strategy is nowadays basically referred to as distressed investing as it involves taking a position in a financially distressed company facing bankruptcy.
Related Hedges
Related hedges as Benjamin called this strategy, involved the purchase of convertible bonds or convertible preferred shares, and the simultaneous sale of common stock into which they were exchangeable.
The position was established at close to parity, which is when the bond or preferred stock conversion price was close to the common stock price.
This strategy was profitable during market corrections and bear markets in general.
The strategy would be profitable when the short sold common stock fell considerably more in price than the bond or preferred stock.
A small loss would result if the common stock price went up. In this case the bond or preferred stock would simply be converted to common stock to cover the short sold common stock and thus exit the position.
What made this strategy profitable was that common stock is far more volatile in price movements than that of either bonds or preferred stock.
The reference to ‘Related’ means that the bond or preferred stock and the common stock are from same company. Benjamin Graham also held some Unrelated Hedges, but he found that these were not as profitable and stopped using unrelated hedges after several years of testing the strategy.
Benjamin Graham’s related hedge strategy is nowadays referred to as convertible arbitrage.
Net Current Asset
This strategy simply involved purchasing companies when their stock price was less than two-thirds of their net current assets (also known as working capital).
This is the bargain hunting strategy for which Benjamin Graham is most famous for and is the ultimate in deep discount buying of companies which have a solid long-term fundamental outlook.
Benjamin only normally used this tactic with large-cap companies which were relatively unpopular because of their short-term recent financial performance, but the company has a solid long-term financial history and were considered fundamentally sound.
These companies usually have poor recent earnings history, but solid assets.
The large companies have the resources in capital and management to carry them through the temporary set back and the market will respond within time when the company regains its previous financial performance.
The market typically overvalues companies with excellent recent growth that are currently in favor and undervalues companies which are out of favor because of their short-term recent financial performance.
This is the fundamental law of the stock market.
The market undervalues companies which are out
of favor – due to short-term financial problems
The strategy essentially requires some short-term financial underperformance.
This is because for a company’s stock price to be driven all the way down to two-thirds of its working capital, it required an extreme amount of pessimism from the market, which would only occur when the company was currently experiencing some short-term financial or business conditions which give the impression of a deteriorating company.
The working capital for most companies is less than its net tangible assets.
The working capital can only ever equal the net tangible assets when the long-term debt equals its noncurrent assets, which was something Benjamin Graham avoided.
Benjamin Graham used similar principles for locating corporate bonds that were priced well below what they would be worth once the company regained its former solid financial position.
With the net current asset strategy, Benjamin stated that either the price was way too cheap and must rise or if the price does not rise then the company should be liquidated.
The portfolio generally held at least 100 such stocks to provide safety in numbers as some of these companies actually wound up in bankruptcy.
The large diversification meant that the few companies that went bankrupt did not weigh too heavily on the portfolios returns.
Benjamin used a variety of exit strategies and the strategy profits from a price increase or the company itself may become a takeover or merger opportunity.
Benjamin was more of a short-term to medium-term investor. As a general rule his stocks where not held as long-term investments but were sold once the stock price went up past tangible book value.
He also had a policy to sell any stocks after two years if their stock price was not going up, so that the capital could be used to buy another company.
Acquisitions
Benjamin also made some acquisitions with Graham-Newman Corporation.
This is where they bought the entire company rather than just a portion (in other words he would buy all of the shares).
Graham-Newman Corporation’s most famous acquisition was the Government Employees Insurance Co. (GEICO) in 1948.
GEICO was acquired because its price was attractive based on the company’s earnings and asset value which satisfied Benjamin’s value investing principles.
Over the following years the share price of GEICO increased well over a hundred times and was their best performing investment.
Summary
Benjamin and his partner Jerome, these two well known partners spend their lives handling their own money and that of others.
They learnt from hard experience that it was better to be safe and cautious rather than attempting to make as much money as they could.
Graham-Newman Corporation averaged around 20% per year over a thirty year period from 1926 to 1956, which even included the biggest stock market crash in history of 1929 and the subsequent great depression of the 1930s.
They had some fantastic years and some bad years, but Benjamin instead of fearing bear markets he embraced them which was his secret to profiting when the next bull market began.
The related hedges performed well in bear markets and the working capital bargains profited well in bull markets.
While Benjamin was not called a hedge fund manager as the term was not used in those days, his rather radical investing strategies are still widely used by the modern day hedge fund managers.
Benjamin Graham placed relatively little emphasis in forecasting the future course of stock market or in the future prospects of companies, his general portfolio operations were to buy securities when general sentiment is pessimistic and prices are low, and sell them when optimism and prices are high.
Benjamin’s strategies are not the usual strategies retail investors are used to seeing.
His strategies are actually professional tactics used by hedge fund managers and experienced investors and are mostly not suited to beginner or inexperienced investors.