I recently stumbled across collection of notes from Benjamin Graham’s lectures when he was a professor at Columbia University.
The notes were taken during lectures given in 1946, six years after the 1940 version of “Security Analysis” was published.
Actually, the name of the course was “Current Problems in Security Analysis”, and was, in Graham’s words an“attempt to bring our textbook ” Security Analysis” up to date, in the light of the experience of the last six years since the 1940 revision was published.”
Ben Graham: Still relevant
“The subject matter of security analysis can be divided in various ways. One division might be in three parts: First, the techniques of security analysis; secondly, standards of safety and common stock valuation; and thirdly, the relationship of the analyst to the security market.”
It has been nearly 70 years since Ben Graham gave these lectures, and clearly, the financial world has changed dramatically in this time. Nevertheless, the principles behind value investing remain the same however.
Graham starts his lecture by trying to get students to forget about stock prices. The analyst’s relation with the market should be, as Graham describes it, “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.”
Straight off, Ben Graham is trying to draw a line between stock prices and the underlying business.
However, Graham then goes on to discuss the market and its movements. Specifically, the predictability of the market; it won’t go up forever but it also won’t go down forever.
“When you look at the stock market as a whole, you will find from experience that after it has advanced a good deal it not only goes down — that is obvious — but it goes down to levels substantially below earlier high levels. Hence, it has always been possible to buy stocks at lower prices than the highest of previous moves, not of the current move.”
“…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. That is the thing I have been trying to point out in the last few minutes.”
Then Graham gets straight into the subject of security analysis.
Ben Graham – Security analysis
Ben Graham’s first analysis is that of a new issue, Northern Engraving and Manufacturing Company, which was looking to sell around 250,000 shares at $16 per share. That meant that this company was to be valued at $4 million in the market.
“Now, what did the new stockholder get for his share of the $4-million? In the first place, he got $1,350,000 worth of tangible equity. Hence he was paying three times the amount of money invested in the business. In the second place, he got earnings which can be summarized rather quickly. For the five years 1936-40, they averaged 21 cents a share; for the five years ended 1945, they averaged 65 cents a share. In other words, the stock was being sold at about 25 times the prewar earnings.”
Even by today’s standards, a valuation of 25 times historic earnings is excessive for a manufacturing company. But that’s not the whole story.
“But naturally there must have been some factor that made such a thing possible, and we find it in the six months ending June 30, 1946, when the company earned $1.27 a share. In the usual parlance of Wall Street, it could be said that the stock was being sold at six and a half times its earnings, the point being the earnings are at the annual rate of $2.54, and $16 is six or seven times that much.”
So, Northern was being offered at six or seven times forward earnings, which Graham notes, is unbelievable. What’s more, as Graham delves into the numbers (“we don’t stress industrial analysis particularly in our course in security analysis”) he determined that Northern Engraving’s profit margin was excessively high for the six-month period being used to value the company pre-IPO. Northern Engraving’s sales margins had jumped from 3% or 4% to 15%.
Ben Graham – Ignoring company specifics
Ben Graham goes on to give further valuation case studies, although he continues to ignore company-specific factors, such as management, brand power and reputation.
One long example, given at the end of the first lecture is a comparison of three different aircraft manufacturers and an analysis of their financial position as well as valuation.
The first company was named the Taylorcraft Company, with a market capitalization of $3 million, working capital of only $103,000, with stock and surplus of $2.3 million but $1.15 million of this was what Ben Graham called an “arbitrary plant markup”.
Also, Taylorcraft had serious financial issues. The company hadn’t issues financial reports for several years, which isn’t the sign of a financially sound company.
Additionally, the company arranged to sell its shares in an amount which did not require registration with the SEC. A four-for-one split was also undertaken to reduce the stock price to $3. Graham then considers another company, Curtiss-Wright:
“Taylorcraft and Curtiss-Wright apparently were selling about the same price, but that doesn’t mean very much…the Curtiss-Wright Company has built up its working capital from a figure perhaps of $12-million to $130-million, approximately. It turns out that this company is selling in the market for considerably less than two thirds of its working capital.”
“The Curtiss-Wright Company happens to be the largest airplane producer in the field, and the Taylorcraft Company probably is one of the smallest. There are sometimes advantages in small size and disadvantages in large size; but it is hard to believe that a small company in a financially weak position can be worth a great deal more than its tangible investment, when the largest companies in the same field are selling at very large discounts from their working capital. During the period in which Taylorcraft was marking up its fixed assets by means of this appraisal figure, the large companies like United Aircraft and Curtiss-Wright marked down their plants to practically nothing, although the number of square feet which they owned was tremendous.”
Curtiss-Wright had been sold off because investors were concerned about the company’s prospects after the war. However, investors were failing to take into account the company’s hefty land ownership, which had been written down to zero.
Of course, there was no guarantee that Curtiss-Wright’s prospects would improve, but the discount to working capital and fact that investors were missing the property opportunity gave a margin of safety.
A rough summary
This is just a rough summary of the first lecture in the series of ten Ben Graham archived lectures. If you’re interest in going through all ten articles, you can find them here.