No series on the mistakes of the world’s greatest investors would be complete without looking at the mistakes made by the Godfather of value investing Benjamin Graham, in the early part of his career.
Graham survived the 1929 crash but only just, and in the years after, he re-built his investing methods around what he had learned at the time and compiled these lessons into his first book, Security Analysis.
Benjamin Graham: A strategy built on crises
Graham’s initial investment strategy was shaped by the stock market crash of 1907 when his mother lost the family savings. He was only 14 at the time.
This grounding helped him quickly make a name for himself on Wall Street, opening the Graham-Newman Partnership with Jerome Newman in 1926 and profiting handsomely as the market rallied towards the end of the decade.
Then came the crash of 1929.
Heading into 1929, Graham was well hedged. According to this source, in mid-2017, the Graham Newman partnership portfolio was comprised of “$2.5 million and an equal amount of short positions. In addition, $4.5 million of other securities were held on which $2 million was borrowed, leaving $2.5 million of equity. These securities were not Wall Street favourites, but rather issues that had intrinsic values above their market prices.”
To protect his portfolio, Graham had been buying convertible preferred stock, while conducting a short sale of the equivalent common stock. The idea behind this was that in weak markets, common stock would decline faster than the preferred stock allowing Ben and team to unwind the position profitably. However, due to the problems of buying back the preferred stock, usually at a worse price than it was previously acquired, Ben would only sell the common, holding on to the preferred in anticipation of re-entering the position.
When the market began to slide in 1929, Graham did just that. He sold the common stock part of his hedge, leaving the preferred in place. This generated “good profits” for his investors in 1929. However, as the decline continued in 1930, Graham had “already covered nearly all of the short positions, leaving a large long position in securities whose declining market values were accentuated by the substantial margin debt of the Joint Account.” The account lost 50% in 1930, compared to just -29% for the Dow Jones. Between 1929 and 1932, the Joint Account lost 70%, compared to the S&P 500’s performance of -64%.
This was a disaster for Graham and his reputation, but he didn’t give up. Instead, he continued to hunt for bargains, and by 1932, he’d recovered investors’ capital:
“By 1932, Ben had adjusted the Joint Account to a secure position and began searching for lessons from the stock market crash. In June 1932, he wrote a series of three articles for Forbes magazine under the title “Is American Business Worth More Dead Than Alive?” Over 40 percent of the stocks listed on the New York Stock Exchange were selling at less than their net working capital and many were selling below even their cash assets. Ben concluded that the stock market was placing an inordinately low value on American business.” Source
Following these articles, McGraw-Hill bought the first copy of Security Analysis to market in 1934 and the rest, as they say, is history.