Benjamin Graham in

By Dennis Butler

casts a long shadow over the field’s methods and professional structure, and his Security Analysis (1934) is known as the “Bible of Wall Street.” Terms such as “intrinsic value” and “margin of safety” are attributed to Graham. A school of investing — the “value approach”— views him as its patriarch. He helped to create profes- sional organizations, including the New York Society of Security Ana- lysts. Historical analysis reveals, how- ever, that Graham’s contributions to investment theory were less significant S

I for their originality than for their syn- B R

O thesizing quality. His actual contribu- C / n

n tion was to bring together and focus a m t

t currents in investment thought already e B in existence. To appreciate that vital Benjamin Graham (L), pictured here with General R.E.Wood, an official of Sears, Roebuck and Co., 1955. contribution and place his legacy in perspective, we must examine how The history of investment thinking cal history does to statesmen. There is, conceptions of investing changed dur- is a neglected field, yet one of obvious to be sure, an ongoing fascination ing the early 1900s. value: our basic ways of approaching with the market’s historical patterns In 1920, Graham issued a report security analysis and investment, such and reactions to events. However, stating, “if a common stock is a good as “growth” or “value,” are rooted in practitioners’ thinking about invest- investment, it is also an attractive historical experience, practice, and ment is a story lost to the majority of speculation.” Although Graham (who ways of thinking. Names and instru- busy, practically-oriented investors. in six years had risen from “gofer” to mentalities change over time, but Perhaps nowhere is the historical analyst at a brokerage firm) later underlying issues, as well as the abili- record less clearly understood than claimed his assertion had been revolu- ties and psychological makeup of when it concerns Benjamin Graham, a tionary, he was not alone. In 1917, investors, do not. A study of the craft’s central figure in 20th century invest- Albert Atwood, in The Exchanges and past masters offers perspective and ment practice and thought called the Speculation, had similarly argued that guidance to investors, much as politi- “father of financial analysis.” Graham “For a stock to be a good investment

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Benjamin Graham’s two most notable works are The Intelligent Investor (1949) and Security Analysis (1934). it must be a good speculation.” The experience or knowledge of the issu- system—in the “prudent man rule,” language of these statements, familiar ing companies, and usually on thin and in state laws regulating savings to market participants of the day, is margins, were gamblers. institutions. Nevertheless, the tradi- somewhat puzzling to the modern These distinctions were taken seri- tional view was not universally held, reader, as is the reason why such pro- ously. “Are common stocks invest- and the line demarcating investments nouncements were controversial. ments?” was a legitimate, if quaint- and speculations had always been The “traditional view” held that sounding, question subject to stormy fuzzy. The idea that one could only securities transactions could be distin- debate into the 1930s. Other observa- invest in fixed-income instruments or guished by the intentions and knowl- tions appear equally odd or comical to that investment was indifferent to edge of the “operator.” An investor the modern reader. For example, a appreciation came increasingly into aimed for secure income, with speculator forced to hold a position question at the time Graham entered absolute safety of principal. Only longer than anticipated “became an Wall Street. bonds, protected by legal covenants investor” inadvertently. Conversely, Contemporary observations reveal and issuer assets, met these require- investors with substantial profits this tension. In 1911 Thomas Conway ments. If your interest was to benefit would sometimes realize them, claimed in Investment and Speculation from a change in market value—to thereby “becoming speculators.” Peo- that the investment-speculation issue buy “for the rise” or sell “for the ple were surprised at the number of was “an academic question to which fall”—then you were a speculator. “speculations”— what we would now we need give but little attention.” Spec- Common stocks, with volatile prices refer to as alternative, private equity, ulators and investors alike were alert to and no secure income, were the pri- and venture capital holdings, or sim- price trends. The speculator was an mary focus, and speculators battled ply stocks—held in the estates of some opportunist. The investor, although on the “fields of speculation,”—the of the era's great financiers, including seeing himself as a long-term business stock exchanges. Investing had an the banker George F. Baker. partner, still was happy to see gains, aura of permanence, speculation, of The investment-speculation distinc- and was inclined to sell if prices rose opportunism. Finally, those who tion permeates the financial literature sufficiently. Edward Jones (Investment, traded stocks recklessly, with little of the time. It was codified in the legal 1918) said the investor must take

www.financialhistory.org25 Financial History ~ Summer 2006 advantage of long-term price swings, purchasing power. Purchasing power Philip Carret’s The Art of Speculation weighing price and “intrinsic value,” was also an issue for Dwight Rose in (1930) carries the concept of specula- and selling when securities were most A Scientific Approach To Investment tion as far as it can go; for his subject profitable. David Jordan, author of Jor- Management (1928). He writes of the is not really speculation, but invest- dan on Investments (1919), a college difficulty equating conservatism with ment in the same sense that Graham text, wrote (employing a theme that fig- bonds, and speculation with stocks, if would articulate it four years later. ures prominently in Graham’s book) the result is to erode purchasing “The investor must speculate,” says that “the name of a security has little to power. “Total return” is the proper Carret. To protect wealth from infla- do with its investment status.” While objective of investment: both income tion, the investor “must consciously not an “ideal investment,” a stock’s and appreciation of principal. purchase a portion of security hold- investment status lay in the issuer’s For the new investment advisers, ings with an expectation of profit.” financial status (the ability to pay its the investment-speculation distinction Carret emphasizes the study of busi- dividend was crucial). Even Lawrence as traditionally identified with types of nesses, not market forecasts, and Chamberlain, author of the standard securities was disintegrating. Stocks, advocates purchasing “out of favor” text The Principles of Bond Invest- no longer ipso facto speculations, stocks that are undervalued based on ment, acknowledged that investment were, instead, a legitimate part of an their earning power. In a phrase pre- and speculation were “inseparably investor’s portfolio. Interestingly, saging Graham: “The road to success related” and that appreciation was these views predated the publication in speculation is the study of values.” “properly and studiously sought for in of Edgar Lawrence Smith’s Common A common thread in these writings an investment.” Investors were obliged Stocks As Long Term Investments is a stress on “value.” As Gaines to speculate to “obtain the greatest (1925) and Kenneth Van Strum’s noted: “In the abstract, the investor possible security for an investment.” Investing In Purchasing Power needs to know only two things — the Around 1920 a new “profession of (1926), works implying that stocks value of his security and the price at investment,”—investment counsel- were superior to bonds as invest- which it is selling.” Likewise, in a line ing—came into its own. Investment ments, precisely because of stocks’ hinting at Graham’s later “Mr. Mar- counselors were professionals dedi- inflation-protection qualities. Unfor- ket” parable: “The habit must be cated to the intelligent deployment of tunately, Smith and Van Strum pro- formed of sitting as a court of inde- client capital based on research and vided a theoretical justification for the pendent review on prices, aloof from experience, independent and free of the disastrous New Era of the late 1920s, the enthusiasms and pessimisms of conflicts plaguing brokers and bankers. whose ultimate outcome — the 1929 the market place itself.” For Sturgis, The work of these counselors expresses crash—for a time undermined the idea investing was a matter of common that era’s evolving thought about the that stocks could be legitimate invest- sense, “based on a knowledge of what nature of investing. ments. To their credit, a few of the constitutes security values.” Rose Morrell Gaines’s The Art of Invest- new investment counselors had observed that stocks had an advan- ment (1922) offers an interesting tran- warned of New Era excesses. tage over bonds when purchased at sition from the traditional view. “Con- There were other indications that an earnings yield (the ratio of earn- structive investment,” as he terms it, is the investment-speculation dichotomy ings to stock price) exceeding bond neither speculation nor the commit- was becoming increasingly strained. yields — a value yardstick often ment of funds solely for income. John Durand, addressing the equiva- employed by Graham. The reinvest- Enhancing principal value is a legiti- lent of today’s “momentum” traders, ment of earnings gave stocks a long- mate goal, as long as income is main- writes, in The New Technique of term advantage, but in a Graham-like tained securely. Henry Sturgis, in Uncovering Security Bargains of note of caution Rose says stocks Investment, A New Profession (1924), 1928, of the modern “spec-investor” could be purchased with confidence argues that investment entails specula- looking for capital appreciation “so long as the major part of excess tion to some degree, speculation being opportunities. Common Stocks and earnings is not discounted in a greatly (in a phrase suggesting Graham’s later the Average Man (1930) by J. George inflated market value.” definition of investment) “a transac- Frederick encourages the average man Thus, the notion of investment tion engaged in after careful study and to “regard himself as an investment- “value” predated Security Analysis. consideration of all the relevant speculator,” owning some bonds—tra- Indeed, the idea that securities had facts.” Stocks, says Sturgis, were “less ditionally the only appropriate invest- “intrinsic value” had appeared in unconservative” than blindly buying ments for people of limited means—as financial literature for centuries and supposedly safe bonds. Acquired care- well as “good common stocks” in was incorporated into investment fully, stocks’ profits offset the loss of order to share in the nation’s growth. practice. Around 1720, Daniel Defoe

Financial History ~ Summer 200626 www.financialhistory.org wrote of the hazardous purchase of securities at prices exceeding “intrinsik A Different Perspective on Graham values” (Defoe had been caught up in the South Sea Bubble). Stockbroker By Jason Zweig and journalist William Fowler, in s the editor of Graham’s book The f central Asia. Does it matter how Inside Life In Wall Street (1873), fre- A o Intelligent Investor, thought I knew many people said it before Solomon? quently refers to a stock’s intrinsic I ost of what there is to know about The quality of ideas is not dimin- value and the significance of value to m ished merely because they have prece- operators such as Cornelius Vander- where Graham’s ideas came from. I dents. Anyone who has studied the bilt. Henry Clews, a prominent banker was wrong. Dennis Butler’s article covers a great history of innovation knows that even of the late 1800s, wrote of buying stocks below their intrinsic values in deal of ground the most radical ideas do not come out his Twenty-Eight Years In Wall Street that was new of nowhere; they all depend on every- (1888). Likewise, “margin of safety” to me. I was thing that has come before. The tele- was a well-worn phrase used most particularly graph was “invented” several times often in bond analysis to refer to an struck by Mr. before Morse came along, Leonardo issuer’s coverage of interest expense by Butler’s exten- da Vinci learned from Verrocchio and earnings (or of dividends in the case of sive citations of Pacioli, Beethoven built on Haydn, “investment grade stocks”), although investing writ- and the Wright brothers and Henry ers who came Ford benefited from the collective tin- this is not how Graham uses it. before Graham kering of several generations. When The “study of values” implies prin- or were his Sir Isaac Newton explained his own ciples and procedures. The first contemporaries. This discussion is an breakthroughs, he declared, “If I have attempts to articulate fundamental important reminder that Graham was seen further, it is by standing on the investment principles began around 1900, and by Graham’s time, security not a complete iconoclast but was also shoulders of giants.” That does not analysis was playing an increasingly a product of his time. negate Newton’s achievement. Nor is important and organized role. The However, the fact that most of Gra- Graham’s greatness dimmed by know- evolution of investment thinking par- ham’s ideas came from somewhere ing that some of his ideas had already alleled a transformation in American else does not mean he was an unorigi- been expressed, in weaker form, by business. The early 1900s saw indus- nal thinker. Graham had the genius to other people. trial corporations replace railroads as pull together strands of thought from Graham lives on, while his prede- the dominant business entities. Large many different sources and weave cessors have been forgotten, because corporations, increasingly better them into a precious new fabric that he turned many small thoughts into a financed and managed, gained greater still bedazzles readers more than 70 handful of huge thoughts. His legacy political acceptance. Industrial stocks years later. Graham blended insights is not about borrowing ideas, but had become the “principal media of from his mastery of mathematics, his owning them. Other writers may have all Street, gin speculation” on the stock exchanges, decades of experience on W defined “value,” discussed the mar his encyclopedic knowledge of classic taking over that role from railroad of safety, hinted at “Mr. Market,” or securities. With the growing capital literature and philosophy, and his pro- touched on the distinction between needs of these organizations, Wall found understanding of human psy- investing and speculating. But none of Street firms rose to the challenge. In chology – combining all these forms of them unified all these ideas in a single demand were specialists trained to learning into an analysis of investing masterpiece of writing and analysis. analyze the expanding number of no one has ever surpassed before or There’s a very simple reason Graham issuers. Schools of business, such as since. If Graham is not an original is immortal: While he may have had those at New York University, Whar- investing thinker, then who is? precedents, he has never had peers. King Solomon, in the Biblical book ton, and Columbia, provided this For Further Reading: of Ecclesiastes, says that “There is training. Textbooks on industrial Benjamin Graham (with Jason Zweig), security analysis began to appear. nothing new under the sun.” Solomon was almost certainly restating an The Intelligent Investor, 2003. Clinton Collver’s How To Analyze insight he got from some Hittite who, Robert K. Merton, On the Shoulders of Industrial Securities was published in in turn, heard it from an Amalekite, Giants, 1965. 1921; Walter Lagerquist’s Investment who got it from a Babylonian, whose Analysis, the same year; Ralph Bad- ancestors picked it up on the steppes ger’s Valuation of Industrial Securi-

www.financialhistory.org27 Financial History ~ Summer 2006 ties, 1925; and Carl Kraft and Louis thought during the previous 20 years, lished at the Columbia Business Starkweather’s Analysis of Industrial and a synthesis of the traditional view School and was popular among Wall Securities, 1930. Other texts, such as and the ideas of the new investment Streeters. His course offered a theo- Chamberlain’s standard work on professionals, forged after the 1929 retical foundation and also an oppor- bonds, first published in 1911, went debacle. The effect was to opera- tunity for practical application (stu- through several editions, as did Jor- tionalize investing, making it a matter dents often attended just to get dan’s Jordan on Investments of 1919. of procedure and measurement—and investment ideas). He developed a fol- The emphasis was on bond analysis consequently no longer identified lowing that would carry his methods — especially in the earlier volumes. with any particular type of security. forward to the present day—an ongo- Many analytical themes from these Hence, Security Analysis was not ing tribute to the master. These more volumes, as well as an emphasis on organized according to the system of practical considerations are what has careful analysis and the analyst’s duty security types customary in finance really attracted attention to Graham to make the accounting adjustments texts—“corporation loan,” “civil and his writings over the years. More needed to reveal true earning power, loan,” and so on—but according to esoteric matters, including his role in later made their way into Graham’s the analytical procedure appropriate the old debate over investment and Security Analysis. in any given case: for example, speculation, are largely forgotten. The preceding discussion should “fixed-value investments” or “senior In The Intelligent Investor, Gra- make the opening chapters of the securities with speculative features.” ham laments the loss of the invest- 1934 text — encompassing Graham’s Investment dealt with the security’s ment-speculation distinction, arguing remarks on investment and specula- actual interest in, or claim upon, an that its simple conceptions of motiva- tion, the breakdown of the traditional economic entity. Stocks were invest- tion and risk facilitated clear think- view, and the impact of the Great ments if selected according to analyti- ing about securities. When investors Crash on investment thinking—more cal procedures and safeguards relat- bought bonds and speculators traded understandable to the modern reader. ing to valuation and diversification. A stocks, even mentally lazy “opera- Remaining to be considered is why the bond could be a speculation—even a tors” knew where they stood. How- book is considered groundbreaking. gamble — if purchased blindly, with- ever, when investment became a mat- There is, for example, no indication out proper analysis. ter of procedures instead of titles, that Graham sought to invent a “value These philosophical matters do not everyone played with the same toys. approach” (the term does not appear in account for the acceptance, popularity, The distinctions were less obvious, his writings until years later): that way and enduring influence of Graham’s and the costs of laziness greater. Gra- of examining securities was not new. work. Denizens of Wall Street are of a ham warned of the risks resulting Nor did Security Analysis make its more practical and materialistic bent, from people not clearly understand- chief author the “father of financial so we must look for more worldly ing what they are doing, and of the analysis”—an already flourishing field. explanations. Graham’s prior experi- danger to Wall Street’s credibility and Instead, Security Analysis occupies an ence probably had much to do with the capital. Ironically, the fading away of important place in the history of invest- success of Security Analysis. He had the old investment terminology may ment thought due to its “proposed def- been a brilliant practitioner for two very well be one of Graham’s own inition of investment,” namely: “An decades prior to becoming the author legacies: his endeavor to more clearly investment operation is one which, of Wall Street’s “bible.” An established define investment has helped to foster upon thorough analysis, promises reputation brought credibility. He was the belief that mere ownership of a safety of principal and a satisfactory an engaging writer. For readers of other few shares of stock makes one an return. Operations not meeting these texts of that period, his book stands investor—even when they were requirements are speculative.” out. It is laced with examples—some acquired as a speculation. FH This definition’s basic elements— current at the time of publication. It is “thorough analysis,” “safety of prin- written with a clarity and ease of style, Dennis C. Butler, CFA, is president of cipal,” and a “satisfactory return”— even humor, seldom found in such Centre Street Cambridge Corporation, were not only familiar, but lay at the works. The text was a practical “how investment counsel. He has been a prac- heart of the traditional view. They to” manual that explained the “study titioner in the investment field for over were also essential to advocates of of values” in concrete terms. Its appeal 23 years and has been published in “value” in security selection—to avoid to those seeking to divine the secrets of Barron's. His quarterly newsletter can “greatly inflated” market values. Gra- Wall Street was understandable. be found at www.businessforum.com. ham’s definition is, indeed, a culmina- Graham was also an outstanding He holds an MBA from Wharton and a tion of the trends in investment teacher. By 1934 he was well estab- BA in History from Brown University.

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