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What Would Ben Graham Do in This Market?

|Includes: Brookfield Asset Management Inc. (BAM), NBR, PM

I just published my 6th of 10 monthly reviews of “Timeless Investment Classics” – investment books that have stood the test of time.  My criteria is that they must have thrived through at least 40 (and up to 170) years – at least complete 2 generations -- of investors, many of whom think “it’s different this time.”  In fact, from the very first such classic, Extraordinary Popular Delusions and the Madness of Crowds, written in 1841, more than 8 generations back, to the most recent, these manuscripts prove that there is nothing new under the sun.


Given that the most recent in this series was Benjamin Graham and David Dodd’s Security Analysis (1934), Mr. Graham’s thinking is uppermost in my mind.  In 1934, he and Mr. Dodd surveyed a market rather similar to our own.  After a stellar rise in the 1920s, it plunged into chaos. It had a brilliant recovery year in 1933, during which it rose some 66%, then settled into a sideways pattern, ratcheting up with cyclical bull rallies and down with cyclical bear declines.  How might Mssrs. Graham and Dodd view our current markets -- and what might they be buying today?


For those who have read Security Analysis or any of its revisions except #5 (written by a distant collaborator who apparently needed to sell a textbook he authored – poorly – to his own students) or those who have read my review or others, you already know that Graham and Dodd are all about ascertaining value – as differentiated from price.  “Cheap” in price may indicate a security that is unpopular, passed by in a rush to discover The Next Big Thing (that usually isn’t), is in a sector or industry that is seen as boring or passé, or is too complicated to yield to easy analysis by lazy researchers.  Or it may not.  “Cheap” may sometimes reflect a realistic valuation placed on a security by those who have done their security analysis as well as by those who haven’t. 


To Graham and Dodd, cheap does not merely mean low-priced!  If Ben Graham found a company selling for $600 a share (which had zoomed up from $400 in the past year) that today had a $1000 tangible-assets book value, sold at 6 times current earnings, had a quick ratio of 2.5:1, $450 cash per share in liquid securities and cash equivalents, and a business that has undeniable market power to raise the prices of what they sell or service as appropriate, he would say that security was a much more compelling purchase than a stock selling for $6 a share (even if down from $30 in the past year) that sold at 5 times book, 25 times earnings, a 1:1 quick ratio, no cash to speak of, and was the 7th or 8th largest player in an industry, dooming them to compete primarily on price in the marketplace.


Cheap is often defined by Graham and Dodd adherents as something that sells below its “intrinsic value.”  Intrinsic value is the value of a company based on an assessment of its worth as a going concern or a buyout prospect to a knowledgeable competitor.  This value includes both tangible and intangible factors, and qualitative (often subjective) aspects like leadership and marketing prowess, as well as quantitative aspects like financial statement analysis and valuation ratios.  The idea is to find anomalies in which the intrinsic value is judged (with a subjective element as well) to be above the current selling price.


It is these market anomalies that Graham and Dodd seek to exploit.  The stocks that are cheap are those that are below intrinsic value based primarily on the balance sheet and the outlook for the market, the sector, the industry and the company under consideration – not the income statement where reported earnings are often the punch line to the old accounting joke: “How much do you want them to be?”


That’s not to say that Graham and Dodd don’t look at earnings – or at the growth outlook for a particular company.  But a security has to meet high standards of asset value, dividends, and earnings – roughly in that order -- to pass the basic sniff test for further analysis.  It’s important to make this distinction; too many people contrast the concepts of “value investing” and “growth investing” as if they were opposed.  Since “growth” offers more front-page stories of skyrocketing stocks, many new investors reject value investing as being incompatible with growth investing.  We Graham and Dodd value investors love growth as much as the next guy – we just aren’t willing to pay $2 for $1 bills!  If we can find Growth At a Reasonable Price (read: “value”) we’ll buy it.


You can read much more on this subject in many places, including the best of all, Graham and Dodd’s Security Analysis.  So let’s move on to take a look at some of the leading lights / gurus who practice Graham and Dodd value investing, as well as some securities and mutual funds (which I doubt Graham and Dodd would ever buy without a thorough analysis of the management biases, turnover, and each stock in the portfolio!) which might merit your further due diligence.


Plenty of people “say” they are value adherents in the Graham and Dodd mode.  But among those who have demonstrated a commitment in practice as well as in theory over cyclical bull and bear markets as well as secular bulls and bears, we aren’t alone.  Warren Buffett, David Dreman, Tom P. Au ( an SA contributor who has chosen to write under a pseudonym) and Joel Greenblatt, all of whom have written books of and on value since my 1970 cutoff date for Timeless Investment Classics, are others among a small group of disciplined investors.  (Maybe I’ll do a 2011 companion series on “Timely” Investment Classics and review some of these books written since 1970!)  There are many more, of course, including the entire portfolio teams at mutual fund companies like Tweedy Brown and Third Avenue.  (These are today two of just three mutual funds our clients own.)


To determine what securities might qualify for inclusion in a Graham and Dodd type portfolio you can read Security Analysis and start digging into 10ks, annual reports, balance sheets, and cash flow statements, et al.  Some of us get a kick out of this for two reasons: (1) the thrill of finding the occasional diamond in the rough that others have overlooked and (2) the fact that it drives us so batty sometimes it increases our physical fitness program by propelling us out of the office to mountain bike, kayak, ski or anything else that clears our minds for awhile! 


If reading balance sheet footnotes doesn’t fire up the detective in you, then plug in the Graham and Dodd parameters of value to any of a score of websites that offer you screening capabilities.  If that’s still too arcane, take a look at the writings of some of the authors above, all of whom write for public media and are interviewed from time to time, or check out the top holdings of mutual funds like those above.  Neither are pure Graham and Dodd, though Third Avenue Value Fund comes closest.  


Here are some of the fund’s top holdings: Henderson Land Development (OTCPK:HLDCY) and Cheung Kong Holdings (CHEUF).  Both are Hong Kong-based holding companies engaged mostly in mainland China  property development, construction and infrastructure, and hotels.  Next is Toyota Industries (OTCPK:TYIDY), which spun off Toyota Motors in 1937 and is today primarily an auto supplier, electronics and materials handling firm (it’s the biggest forklift company in the world…), Brookfield Asset Management (NYSE:BAM) which we also owned until just recently when it exceeded our “would we still buy it today?” value parameters, and Nabors Industries (NYSE:NBR), the big land drilling contractor which we’ve owned before and are looking at for possible purchase once again.


Tweedy Browne’s Global Value Fund, which provides an even greater international component for your consideration, includes among its top holdings publishing giant Axel Springer AG (traded in Frankfurt), the world’s biggest water and food company, Nestle (OTCPK:NSRGY), which we also hold, Heineken (HINKY – great symbol) which we have owned as well, Philip Morris International (NYSE:PM), which we owned but sold when it moved beyond our own value parameters, and Schibsted ASA (SBSNF – warning! Thinly traded ordinary shares, not ADRs), one of the many Norwegian companies with solid management and cost control that typically expands during the bad times.


In short, I believe were Mr. Graham investing today he would eschew listed options, commodities futures, leveraged ETFs, index ETFs, open-end mutual funds, and all closed-end funds except those selling below their 10-year average discount, with very low turnover, and holding companies he had completely analyzed. 


He would do exactly as he did 76 years ago, 66 years ago and 56 years ago – he would buy the stocks, bonds, and preferred shares of companies selling below their intrinsic value, secure in the knowledge that the underlying company has the assets, deep pockets and future prospects to weather any market storm that comes along.  If he couldn’t find any such companies, he’d be content to sit in cash, continually analyzing new firms and old, until he found those that met his standards.  When asked why, he might furrow his brow quizzically, as if the question made no sense.  For Ben Graham, investing required discipline; anything less is nothing but speculation. 


Author's Disclosure:  We and those clients for whom it is appropriate own almost none of the securities mentioned above right now!   (A smidgen of NSRGY remains.)  On what I expect will be a pretty good pullback, however, we’ll be buyers of many of the companies mentioned above and others like them.



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