On Benjamin Graham

In a wonderful book “Benjamin Graham, Building a Profession”, edited by Jason Zweig, which is a collection of Ben Graham’s writings, here is a superb introduction by the editor.

“More than thirty years after his death and nearly sixty-five years after he put forth the radical proposition that financial analysis ought to be both a science and a profession, Benjamin Graham still stands with the sun at his back. He is a towering example of Ralph Waldo Emerson's pronouncement that “an institution is the lengthened shadow of one man." The nearly 90,000 holders of the Chartered Financial Analyst designation in more than 135 countries and territories and more than 200,000 students seeking formal membership in the profession are living testimony to the power of Graham's ideas and the colossal length of his shadow.

Emerson understood that great institutions are created by lone crusaders-those with the brilliance to see the same old world in a radically new light, with the vision to build castles in the air, and with the stubbornness to build a foundation under those castles, brick by brick.

If Benjamin Graham had not founded the profession of financial analysis, someone else might have done so. But we should not be too sure. At the outset, Lucien Hooper, one of the most influential analysts in the United States, protested that Graham's proposal was "unnecessary formalism" that would do nothing to make analysts more ethical, intellectually honest, or competent. The first Chartered Financial Analyst designation was not awarded until 1963-more than two decades after Graham had proposed a formal standard. Think of seeing your newborn child all the way through to graduation from college, and you will have some idea of how long and patiently Graham nurtured the idea that financial analysis should be formalized as a profession.

Throughout those intervening decades, Graham pushed his colleagues to recognize that analyzing and evaluating securities should be regarded as a structured process patterned after the scientific method. He also stood stubbornly for the principle that financial analysis must always conform to the highest standards of ethical conduct.

When Benjamin Graham came to Wall Street in 1914, he had no experience, no money, and no conventional qualifications. Graham had never even completed a class in economics. He did, however, have assets: prodigious energy, a rigorous education in mathematics and classical philosophy, extraordinary gifts as a writer, a passionate belief that business should be conducted fairly and honestly, and one of the most subtle and powerful minds the investing world has ever seen.

Graham later described his way of thinking as "searching, reflective, and critical." He also had "a good instinct for what was important in a problem. . . the ability to avoid wasting time on inessentials. . . a drive towards the practical, towards getting things done, towards finding solutions, and especially towards devising new approaches and techniques." His most famous student, Warren Buffett, sums up Graham's mind in two words: "terribly rational."

Graham arrived on Wall Street at the age of twenty. He had not passed through college; he had burned through it. Graham entered Columbia at age sixteen and completed all his coursework in three and a half years, skipping a full semester to conduct operations research for a shipping company. The month before Graham graduated as salutatorian of his class, he was offered faculty positions in three departments: mathematics, philosophy, and English.

Graham declined, prodded by his college dean into joining the firm of Newburger, Henderson & Loeb as a back-office boy for $12 a week. Graham promptly memorized the relevant details on more than 100 prominent bond issues and was soon poring over the financial statements of leading railroad and industrial companies. In no time, he had risen to become a "statistician," as a security analyst was then called.

Wall Street in 1914 was chaotic and lawless-a netherworld where rules were unwritten, ethics were loose, and information had to be pulled out of companies like splinters from lions' paws. The U.S. Federal Reserve was barely a year old. The first "blue-sky" law, enacted in Kansas to mandate basic disclosure of a security's risks before any public offering, had come only in 1911. There was no Securities and Exchange Commission. Companies published rudimentary financial statements at sporadic intervals; often, investors could view an annual report only by going to the library of the New York Stock Exchange. To stymie the prying eyes of outsiders, family-controlled firms hid assets and earnings through accounting chicanery and deliberate disregard.

In such an environment, "statisticians" had grown accustomed to thinking of their craft as much more art than science. Most of them stuck to bonds, where rigorous evaluation of long-term trends seemed to matter more; those who ventured into stocks rarely took a company's financial statements as the foundation for their labors. "The figures were not ignored," Graham recalled, "but they were studied superficially and with little interest." Instead, who was buying and selling was of paramount importance. Advance notice of takeovers and mergers, in an age before trading on inside information had been banned, could make traders a quick killing. Early word of cattle disease in the Chicago stockyards, or a blight in the wheat fields of the Ukraine, could put a speculator out in front of soaring stock or option prices in New York. As Graham recalled, "To old Wall Street hands it seemed silly to pore over dry statistics when the determiners of price change were thought to be an entirely different set of factors-all of them very human."

For all these reasons, analysts in Graham's day regarded themselves as diagnosticians, using their contacts and their own intuitions to size up the "feel" of the market. They applied what the great psychologist Paul Meehl would later call "clinical judgment," evaluating each security in the heat of the moment, emphasizing the subjective factors they regarded as unique, and estimating its future price movements in relation to the market trends swirling around it.

Analysts prided themselves on the belief that this sort of judgment required great sensitivity, diligence, and skill. And so it did. But their belief in the quality of their judgments was an illusion. Most statisticians' “intelligence had been corrupted by their experience," Graham said. Whenever they made a correct call, they took it as validation of their methods. On all other occasions, they blamed forces beyond their control: the capriciousness of the market, the tides of global politics, the power of market giants like the Morgans, Rockefellers, or Vanderbilts.

What analysts did not do was verify whether their Qualitative judgments had any Quantitative validity: Could the subjective analysis of securities reliably distinguish, over time, those that were cheap from those that were dear?

From his earliest days, Graham sensed that the answer was a resounding No. He set about putting financial analysis on sounder footing. Instead of forecasting the price of a security by taking the psychological temperature of the market or by getting wind of news before anyone else could, Graham dug into assets and liabilities, earnings and dividends. An astronomer in a world of astrologists, he placed the burden of proof squarely on the Quantitative data.

Graham broke ranks with tradition in another, more basic way. Wall Street had long drawn a distinction between "investment" and "speculation." An investor cared primarily about obtaining a stable and constant stream of income-which could be provided only by bonds whose strict covenants and solid assets ensured that the principal value of the investment would not be impaired. A speculator, on the other hand, was interested in cashing in on big movements in market price-which, in those days of relatively steady interest rates, could be found only in stocks. For the investor, what mattered was protecting principal from fluctuations in value; for the speculator, what mattered was exposing it to fluctuations in price.

Thus, as a general rule, bonds were the proper domain of investors, and stocks were the natural habitat of speculators. When Edgar Lawrence Smith published his 1924 book Common Stocks as Long-Term Investments, he intended the title to be a provocative slap in the face: No respectable person believed that stocks should be regarded as investments at all. (Thus went the popular sayings: "Gentlemen prefer bonds" and "Bonds for income, stocks for profit") In 1931, after the Great Crash had seemingly made mincemeat of Smith's arguments, Lawrence Chamberlain's best-selling Investment and Speculation declared that only bonds could be considered investments; stocks were inherently speculative.

After starting as a bond analyst and then gradually switching most of his attention to stocks, Graham realized that the prevailing view was a lazy oversimplification. He was exasperated by the popular notion that bonds were only for investors and stocks only for speculators. "The bond of a business without assets or earning power would be every whit as valueless as the stock of such an enterprise," thundered Graham in 1934. "Yet because of the traditional association of the bond form with superior safety, the investor has often been persuaded that by the mere act of limiting his return he obtained an assurance against loss."

Graham understood that the intrinsic value of stocks need not be ignored merely because they constituted a junior claim on a company's assets. Nor should the market price of bonds be regarded as irrelevant just because they promised return of principal.

What should separate investors from speculators, Graham argued, was not what they chose to buy but how they chose it. At one price, any security could be a speculation; at another (lower) price, it became an investment. And in the hands of different people, the same security-even at the same price-could be either a speculation or an investment, depending on how well they understood it and how honestly they assessed their own limitations. Most shockingly of all to readers traumatized by the Crash of 1929, Graham insisted that even a margined trade on a merger arbitrage need not be speculative. Analyzed properly from the right point of view, it turned into an investment. The task of the financial analyst, Graham proposed, was to think like an investor regardless of the form of the security being analyzed.

In immortal words that should be inscribed upon the doorposts of every fiduciary, Graham wrote: "An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative."

With inexorable logic, Graham defined each of his terms. There was nothing "either/or" about his definition. The analysis must be thorough, safety must be assured, and the return must be adequate. By thorough analysis, Graham meant "the study of the facts in the light of established standards of safety and value." Safety signified "protection against loss under all normal or reasonably likely conditions or variations." A satisfactory return was "any rate or amount of return, however low, which the investor is willing to accept, provided he acts with reasonable intelligence."

In one mighty blow, Graham had shattered the false dichotomy between bonds as investments and stocks as speculations. Bonds could be speculative, and stocks most assuredly could be investments. The job of the analyst was to determine which was which-based not upon the form of the security but rather upon its quality and its price relative to value.

And its quality must be determined quantitatively. Graham was the ideal person to solve the problem of evaluating securities by the rigorous discipline imposed by the scientific method. His love of Euclidean geometry and calculus-Graham had published a paper on the teaching of integrals in the American Mathematical Monthly at the age of twenty-three-supplemented his mastery of logic and classical philosophy.

The time was also right. In 1927, Alfred Cowles had begun compiling the massive database of stock returns and market forecasts that became the raw material for the Center for Research in Security Prices at the University of Chicago. Meanwhile, Frederick Macaulay was beavering away on the mathematics of bond duration. In late 1934, only a few months after Graham and David Dodd published Security Analysis, the philosopher Karl R. Popper published the first edition of his influential book The Logic of Scientific Discovery. The renowned mathematician-philosophers Alfred North Whitehead and Bertrand Russell were preaching, like a new gospel, the virtues of applying the scientific method to all walks of life.

“In arriving at a scientific law there are three main stages," wrote Russell in 1931. "The first consists in observing the significant facts; the second in arriving at a hypothesis, which, if it is true, would account for these facts; the third in deducing from this hypothesis consequences which can be tested by observation." Added Russell: "The most essential characteristic of scientific technique is that it proceeds from experiment, not tradition."

In the stock market, of course, Graham had at his disposal the world's largest and most active experimental laboratory. And he knew it. In the second sentence in Chapter 1 of Security Analysis, Graham made the radical declaration that the process of determining the value of stocks and bond “is part of the scientific method."

When Graham, armored with the techniques of science, hit the stock market head-on, tradition died instantly in the collision: The old belief that analysis is more art than science was done for.

In short, Benjamin Graham had found his calling. And he shaped it for all those who have come after him.”