What would Benjamin Graham write today? In a new foreword to the 1949 classic The“ Intelligent Investor“, by Benjamin Graham, noted investor John Bogle wrote a brilliant piece which investor would do well to read and re-read. He is as incisive as Ben Graham himself. “THE FIRST EDITION of The Intelligent Investor was published in 1949. It quickly became a classic, endorsed by Warren Buffett as “by far the best book on investing ever written.” Over the years, the slim 304 page initial edition was revised and expanded. By the fourth edition, published in 1973, it had grown to 340 pages. In that final edition, Benjamin Graham acknowledged that he was “greatly aided by my collaborator, Warren Buffett, whose counsel and practical aid have proved invaluable.” By curious coincidence, my own long investment career also began in 1949, when an articleFortune in magazine introduced me to the mutual fund industry. My first encounter with the Graham book didn’t take place until 1965, when I bought (for $5.95, new!) the third revised edition. There, Graham recognized the extraordinary changes that had taken place in the investment environment over the previous half century, yet took comfort in the fact that “through all its vicissitudes and casualties, as earthshaking as they were unforeseen, it remained true that sound investment principles produced generally sound results. We must act on the assumption that they will continue to do so.” As an eyewitness to the earthshaking vicissitudes and casualties ofthis past half century, coincident with the life of Graham’s investment classic, I’m honored to contribute this foreword, for it gives me the opportunity to reflect on my own experience with sound investment principles during thislong span. I often muse, sort of whimsically, that “a lot can happen in fifty years,” and despite another fifty years of mind-boggling change, Ben Graham’s assumption was again borne out:Sound investment principles produced generally sound investment results. What might Benjamin Graham write today, nearly thirty years after hisdeath? Of course we can’t be sure. But he was well aware that change was inevitable, warning us on the first page of the first edition that “the precepts crystallized out of past experience” many become obsolete with the passage of time. As a long-time student of his investment philosophy, I have allowed myself the temerity to reflect on what he might have to say were he to look down from above, which would surely be his vantage point. While the activities of investors, the investments of choice, and the ownership of stocks today bear little resemblance to those that characterized the world of investing when Graham wrote this original edition in 1949, the basic principles of telligentin investing that he set forth there have remained virtually intact and unassailable. www.capitalideasonline.com Page - 1 What would Benjamin Graham write today? The Ebb and Flow of Investment Values During the past half century, by almost every standard, the financial markets have changed. Begin with the vast increase of the importance of stocks in our economy. In 1949, the total value of listings on the New York Stock Exchange was $150 billion. (The over-the-counter market was tiny, perhaps $6 billion.) Today, the value of Big Board listings are $20 trillion, with another $3 trillion of stocks listed on NASDAQ. Stock valuations had changed, too. In the appendix, Graham takes readers through a methodology for determining the “central value” of the Dow Jones Industrial Average, using as a guide its annualized earnings for the previous ten years, divided by twice the corporate bond yield. In 1949, with the Dow at 177 and a value range of 158-236, the market appeared fairly valued. Looking back, this methodology showed that the stock market was clearly overvalued in the late 1920s and undervalued in the mid-1930s, the early 1950s, and during most of the mid-1970s. The system worked! Alas, however, when the Great Bull Market began in 1982, it also showed the market about 70% overvalued. Under the central-value system, stocks were fully 550% overvalued at the 2000 high, only to fall to a mere 195% overvalued at the 2002 low, just before the rebound. Clearly, Graham had found a good indicator of relative value over the near term. But he had also found yet one more indication of how valuation standards can change with the times. Bond valuations also changed sharply. In 1949, with a 2.6% yield on AAA corporate bonds and a 2.1 % yield on long-term U.S. Treasury bonds, Graham came down firmly in favor of U.S. savings bonds, then yielding 2.9%, as a “boon to investors. and a satisfactory answer to every problem of (fixed income) investment.” Today savings bonds have little attraction, and the 2% yield on long bonds has vanished. After rising to a high of 14.8% in 1981, the yield on Treasury bonds gradually eased back to its current 5% level. On balance, even as bond yields soared, stock yields plummeted. Graham cites the 1949 dividend yield on the Dow Jones Industrials at 5.5%, and the price-earnings multiple at 8 times. Currently, the dividend yield on the Dow is 2.1 %, and the price-earnings multiple is 18.1 times. (The Dow has now been eclipsed by the Standard and Poor’s 500 Stock Index as the accepted measure of the broad stock market; its yield is 1.7%, its multiple 21.2 times.) www.capitalideasonline.com Page - 2 What would Benjamin Graham write today? “Mr. Market,” Trading, and Institutionalization As market valuations changed, market volumes changed as well. In 1949, one million shares were traded each day on the New York Stock Exchange; in 2004, 1.5billion shares changed hands daily (another 2 billion shares were traded on NASDAQ). Graham was not keen about all that trading, warning investors not to succumb to the wiles of his metaphorical “Mr. Market,” who drops by every day and “tells you what he thinks your interest (in your business) is worth and furthermore offers either to buy you out or sell you an additional interest on that basis.” Graham cautioned that, unless the price Mr. Market offers is either ridiculously high or ridiculously low, the prudent investor would be wise to ignore the market’s continual bids and offers and form his own ideas of the value of his holdings. But with Mr. Market now persuading investors to do 1500times (!) as much business with him as they did a near-half-century ago, most investors have failed abjectly to follow Graham’s sound advice. This explosion in trading activity reflects, in part, another vast change: the “democratization,” if you will, of the world of investing. In 1949, stocks were owned by about two million investors, almost solely individuals of well- above-average means. Today, some 90 million Americans from all walks of life own shares of stock. Even more astonishing, the lion’s share of those holdings is owned not directly but indirectly through financial institutions – mutual funds, pension funds, endowment funds, hedge funds, and the like. The mutual fund industry has led the way, growing from a mere $2 billion of assets into a colossus managing $7.6 trillion of other people’s money, including $4 trillion of equities. This institutionalization has left the last-line investor in stocks a step removed from ownership, relying on his managers to be faithful stewards in fulfilling the responsibilities of good corporate citizenship. At the same time, as a trading mentality came to dominate the market, a new rent-a-stock philosophy came to hold sway over the former tried and true own-a-stock philosophy. Together, these two trends have served to sharply dilute the role of the investor as a business owner. Stockholders and Management Graham would not have been amused. His first edition includes fully thirty-seven pages of discussion on the optimal relationship between stockholders and management. He makes his point unequivocally: [investors] are owners of the country’s larger enterprises. They make money not out of each other but out of these businesses. www.capitalideasonline.com Page - 3 What would Benjamin Graham write today? Hence their major energies and wisdom as investors should-in theory at least-be directed toward assuring them- selves of the best operating results from their corporations. This in turn means assuring themselves of fully honest and competent managements. “Nothing in finance is more fatuous and harmful, in our opinion, than the firmly established attitude of common stock investors and their Wall Street advisers regarding questions of corporate management. That attitude is summed up in the phrase: ‘If you don’t like the management, sell the stock.’ Obviously such action does nothing at all to improve bad management; it only puts down the price of the stock and shifts the ownership to someone else. Investors as a whole. seem to have abandoned all claim to control over the paid superintendents of their property.” He held the conviction that “the best opportunity for demonstrating investor intelligence is in the field of stockholder-management relationships; for here investors can act as a class and not as individuals. a novel but important branch of the science of investment.” Surely Graham would have been discouraged, if not disgusted, by the failure of today’s investors especially our giant financial institutions-to assume the rights and responsibilities of stock ownership and corporate citizenship. The Defensive Investor In his original edition, Graham makes an important and timeless distinction, one that in a sense prefigured this vast institutionalization of investing.