In the classic book, Security Analysis, Benjamin Graham presents an in depth thesis on how the "margin of safety" determines the attractiveness of an investment. Graham wrote the book based on a thorough analysis of one of the most severe investing environments of this country, the Great Depression from 1929 – 1939.
Currently, our security market is on a downward trend comparable to that historic time. Looking at the historical data regarding the fall of earnings of the industrial companies during the Great Depression, you can see why there was a 90% drop in market cap from peak to trough.
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Comparing this to the current drop in profits at major industrials, we can see that we are in an equivalent downward trend with downward pressures comparable to the Depression.
But the analogy to press is that over 1929 to 1932, the Dow had equivalent to three consecutive 50% drops in value. The value of the Dow fell from peak value of 10, 5, 2.5, 1.2. With this in mind, 2009 will not drop by as much points wise, but the percentage loss will be equivalent to last year. In any case, the market is still very much on track to match the largest fall ever recorded.
So what to do?
To learn how to handle a potential future depression, it is wise to learn from the last one. When Benjamin Graham wrote Security Analysis, he did so to provide text to support the most secure methods of investing based on the test cases of the Great Depression. He wrote…
Click to enlargeThe economy today involves faster business cycles due to technology, but still contains industries which hold promise to meet Graham’s criteria of a stable enterprise. Using Graham’s profit data over the course of the Great Depression, it is observed that regulated utilities held 66% of their pre-Depression earnings. This is a quite impressive feat compared to 99% reduction of industrial company earnings in aggregate, and 100% loss of earnings for railroad companies in aggregate.
Click to enlargeWhat wisdom is to be passed to the wise retail investor? Whereas the broader industrial sectors suffered seriously from decreased consumer consumption and capital spending associated with major downturns, the earnings of the regulated utility industry remained relatively insulated. Although not very attractive for an equity investment where growth of profits is required for returns on a stock, this situation underlines the large "margin of safety" risk-reward propositions for fixed income investors of regulated utilities for the next five to ten years.
As profits slide with the general economy, equity holdings for all companies will be comprised. But the debt holder of a regulated utility is not as concerned about a fluctuation in profitability as the ability of the issuer to continue to be current on existing claims. Thus, in these humble times, the prudent will be buying securities in preparation for years of lean corporate profits. One place Benjamin Graham has told us this can be found is in debt and preferred shares of regulated utilities. (To be continued).
 Security Analysis, Benjamin Graham, P. 290
 Security Analysis, Benjamin Graham, P. 508
Disclosure: The author is long ALZ, KTH.