Lessons from Benjamin Graham, Part 1

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.

click to enlarge

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…

The 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.

What 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).

[1] Security Analysis, Benjamin Graham, P. 290

[2] Security Analysis, Benjamin Graham, P. 508

Disclosure: The author is long ALZ, KTH.

Comments

[nym:]

But what about inflation?

Mar 03 10:55 PM

[phat cat:]

This may be the case during the last depression, but what happens if hyperinflation kicks in along with the economic depression this time? investing in bonds and preferred will equally destroy wealth. I'd think investing in actual productive assets, such as commercial or some residential real estate, would be the best hedge against depression and the impending hyperinflation.

btw, I am a believer that the current monetary and fiscal policies will inevitably cause hyperinflation, it's just a matter of time.

Mar 03 11:06 PM

[Paul Killinger:]

Well done, sir.

The difference in the current climate for utiities is the government has targeted electricity users for a +/- 50% rate increase to fund their cap and trade folly. This new hidden tax on consumers will require massive new investments and corresponding lower earnings. Utility share prices are already beginning to reflect this evenuality.

Mar 04 09:15 AM

[kelm:]

You do realize Graham went broke twice following his own advice don't you?

Mar 04 10:38 AM

[fran:]

unless the utility is already highly renewable/low fossil fuel use--eg. FPL.


On Mar 04 09:15 AM Paul Killinger wrote:

> Well done, sir.
>
> The difference in the current climate for utiities is the government
> has targeted electricity users for a +/- 50% rate increase to fund
> their cap and trade folly. This new hidden tax on consumers will
> require massive new investments and corresponding lower earnings.
> Utility share prices are already beginning to reflect this evenuality.

Mar 04 10:41 AM

[User 369371:]

It is interesting to judge critically these theories and put them to empirical testing. As mentioned above, the old guru Graham did go broke applying his own teachings. His most illustrious pupil Buffet was luckier in that he rode the coattails of the long bull market of 1974-200, yet after 40 years of value investing, his portfolio is back at cost basis!

Mar 04 10:47 AM

[Dave Shafer:]

"Buffet was luckier in that he rode the coattails of the long bull market of 1974-200, yet after 40 years of value investing, his portfolio is back at cost basis!"

Does anyone ever think before their post? The book value of Berkshire is up 362,319% since Buffett took it over. I'll take that, how about you?

Mar 04 02:27 PM

[User 369371:]

You are confusing the value of Berkshire as a conglomerate with the equity portion of the company. Buffet has been one of the best businessmen ever and as a result the book value of Bewrkshire has increased tremendously (so far). However, his EQUITY PORTFOLIO has been flat after 40 years of investing whereas SP500 has been up 8-fold since the mid-70s. Mr Buffet would have done much better in the equity part of his portfolio if he had just bought the SP500 instead of trying to outsmart the market.

Mar 04 06:01 PM

[Regis Capital:]

There was not much inflation after the depression. In spite of pouring tons of money into the system, the deflationary forces kept inflation at bay. I initially thought that coming inflation would be huge -- there are many people thinking that we will head into an inflationary boom; however deflationary cycles last longer and are deeper than most expect. For inflation to happen, it requires buyers -- consumers. The fear of the economic situation today has driven buyers underground. It will be interesting to see if inflation ultimately results. Before we have inflation, I think we will see the Dow below 1500.

Mar 04 06:33 PM

[Afamiii:]

Deflation, inflation, hyperinflation, recession one thing I have learn't in life is that it is very difficult to predict the future. The 3 body problem and the whole of chaos theory and fractal algebra is sufficient proof for me that the complex interactions of more than 3 players cannot be predicted with any degree of certainty.

So if we must look to the future we are left only with probabilities and the probability is that over the next five years (and that is really the only practical time period to look at - whilst 10 years is the longest time period that has real meaning) there will be either inflation or deflation.

Which ever we have, I doubt if it will spare any asset class (definately not stocks, nor real estate, even bonds will be hurt by deflation as well as inflation) the real questions are which asset classes will be punished the least AND as an investor do I want to be focused on income or capital gains.

Funnily enough the answer to the investors dilema has not changed from what it would have been 24 months ago. Have a good balance between quality stocks, quality bonds, quality real estate and cash - bought at fair prices. And at the end of the day you will come out with most of your capital intact and if things don't get too bad with a reasonable gain.

In all labour there is profit (proverbs 14:23.)

It is not our investments that will make us rich they only sustain and multiply the wealth which emanates from our labour. smartinvestorafrica.co...

Mar 12 02:02 PM

[Afamiii:]

This is perhaps the other reason that the customers (of Wall Street) don't have yachts.

On Mar 12 02:02 PM Afamiii wrote:

>
> In all labour there is profit (proverbs 14:23.)
>
> It is not our investments that will make us rich they only sustain
> and multiply the wealth which emanates from our labour. smartinvestorafrica.co...

Mar 12 02:08 PM

[Bharper:]

On Mar 04 06:01 PM User 369371 wrote:

> You are confusing the value of Berkshire as a conglomerate with the
> equity portion of the company. Buffet has been one of the best businessmen
> ever and as a result the book value of Bewrkshire has increased tremendously
> (so far). However, his EQUITY PORTFOLIO has been flat after 40 years
> of investing whereas SP500 has been up 8-fold since the mid-70s.
> Mr Buffet would have done much better in the equity part of his portfolio
> if he had just bought the SP500 instead of trying to outsmart the
> market.

Completely false, his portfolio is at cost because he engages in sales, overwhelmingly at profits, but mostly because in dollar terms he has added to berkshire's equity holdings over time, thus increasing its gross cost basis. The overwhelming majority of equity investors portfolios are now at unrealized losses simply due to the fact that nearly anything bought in the past 10 years is down in price since then.

Mar 12 02:10 PM

[Bharper:]

On Mar 04 06:01 PM User 369371 wrote:

> You are confusing the value of Berkshire as a conglomerate with the
> equity portion of the company. Buffet has been one of the best businessmen
> ever and as a result the book value of Bewrkshire has increased tremendously
> (so far). However, his EQUITY PORTFOLIO has been flat after 40 years
> of investing whereas SP500 has been up 8-fold since the mid-70s.
> Mr Buffet would have done much better in the equity part of his portfolio
> if he had just bought the SP500 instead of trying to outsmart the
> market.

Your statement that he would have done better buying the S&P is wildly inaccurate. For the first decade or so of operations, Berkshire did little else but buy equities, compounding book significantly over that period. And he has done a lot of selling over time, more recently he sold H&R Block at a huge profit, PetroChina, and others. This isn't reflected in the current cost basis of the portfolio. And his gross dollar value by cost has grown as Berkshire has grown, so the "breakeven" level of the equities portfolio has no resemblance to long-term performance.

Mar 12 02:16 PM