Geoff Gannon

On Ben Graham, Bank Stocks, Jason Zweig and Tom Brown

Alex,

Graham's idea of “new conditions expected in the future” differs considerably from what I think many people today might mean when they use that phrase. Basically, we’re talking about some sort of normal earnings power. That’s why I used a bank like Valley National as an example. It’s not cheap and Ben Graham would never buy it for that reason. However, it is the kind of company where one could believe the past record will help you come up with an idea regarding future earnings. Graham wouldn’t use a single year P/E. He wouldn’t assume ROEs could be what they had been recently. However, he might look at banks with long records of operating in a relatively consistent manner.

My point in this post and the last (responding to Zweig’s article) is that the stumbling block for Graham wouldn’t be the black box nature of financials, or some credit terra incognita, but rather the price. I felt that portraying Graham as avoiding stocks where the internal workings of the business could be glimpsed only dimly at best was inaccurate. If Graham got both a good past record and a good price on a stock, he’d be willing to buy it even if major qualitative concerns were present. He simply wasn’t the kind of investor who would ignore an entire sector because of a major crisis in that industry.

Finally, re-read the quote you used careful. It actually doesn’t refer to future prospects at all. What it refers to is the reliability of the past record in predicting the future. For example, Graham didn’t want to buy a munitions company after years of war and assume it would do what it had in the past. However, and here we may disagree, I think there are banks (not all banks – probably not even most banks, but some banks) that have done business in a relatively consistent way over long periods of time. Eventually, these banks will return to delivering “normal” results that could be gleaned by looking at their past record.

No. Graham wouldn’t look at Washington Mutual and think that he could rely on the past record at all. He would look for banks with long records of operating under a variety of different conditions.
I stand by my statement that: “(Graham) spent almost no time worrying about a business’s management, corporate culture, or future prospects." Countless sources support this statement. Too many people have attributed certain qualitatively conservative stances to Graham that he never possessed. He was a conservative investor; however, he was a quantitatively conservative investor.

For Graham, most bank stocks today fail on quantitative grounds, not qualitative grounds. They lack the combination of a solid past record and a low price-to-book ratio that he would demand if he were to invest in financials.
By the way, I just started doing a weekly chapter-by-chapter commentary / reading group on Graham’s Security Analysis (1940 ed.). Please check out my blog next Monday (or any Monday) and share your thoughts on Graham – I’d love to have a dissenting voice present.

On Ben Graham, Bank Stocks, Jason Zweig and Tom Brown

Regarding going long the preferred and short the common – I suppose Graham would call this a related hedge in all cases (when he wrote “related”, he just meant he wasn’t hedging by shorting another company, or a basket of stocks – like an ETF today).

However, Graham’s operations involved convertible senior securities. He did, however, do a lot of other long/short combinations in a do it yourself kind of way. Most notable was when he bought DuPont and shorted GM, when DuPont owned a lot of GM, thereby buying DuPont for next to nothing regardless of how GM traded. The most common opportunity for this kind of operation today is when a smaller, faster growing partial IPO goes through the roof while the larger, slower-growing parent initially holds a lot of its stock in the new entity.

I almost mentioned the idea of trading a company’s debt one way and the common the other in this post – however, I decided Graham would never do that in the current environment, because the possibility of bailouts, gov’t assistance, etc. could make the debt too unresponsive as your common got crushed. If this wasn’t the case, Graham would probably look for situations in which he thought you could somehow hedge the risk of a financial collapse while betting that, absent a total collapse, the common was way too cheap.

Anyway, if the preferred was convertible, then yes that fits Graham exactly. If not, I’d still say it’s a related hedge; but, it’s not quite what Graham did.

Jason Zweig on Graham and Bank Stocks: 'The Un-Intelligent Investor'

"Do you happen to know if Graham ever invested during a massive credit crunch?"

Graham ran a partnership (in some form) from 1926 - 1956. His worst period was 1930 - 1932. The fund (which like a lot of investors had done some buying on margin) declined by 50.5% in 1930, 16% in 1931, and 3% in 1932. This was largely because Graham was unable to maintain his normal hedges (he had to cover his shorts in 1929 - 1930). Throughout the entire period, Graham was still making quarterly distributions to owners of 1.25% a quarter. As a result, the fund's capital was badly depleted by 1932.

Several investors withdraw all their money. However, Graham eventually recovered - making over 50% in 1933 alone.

As a side not, it was at the near nadir of his career (in 1932) that Graham began work on Security Analysis. That book was shaped by his experiences in '29 - '32.

Sorry if that doesn't answer your question directly - it's as close as I could come to giving a good answer to Graham's investing in extreme circumstances.