Book Review of Benjamin Graham, Building a Profession: The Early Writings of the Father of Security Analysis by Rodney Sullivan

Genre: Business & Finance
Author: Rodney Sullivan
Title: Benjamin Graham, Building a Profession: The Early Writings of the Father of Security Analysis (But the Book)

Summary

Benjamin Graham is one of the most famous investors of all time, best known as the father of value investing and the forbearer of generations of successful investors, including Irving Kahn and Warren Buffett, among countless others. What is less well-known is his part in transforming the role of the financial analyst from its cottage industry stages in the early 20^th century to the profession it is today.

Benjamin Graham: Building a Profession is a collection of writings spanning several decades, in which Graham’s thinking on what defines securities analysis, and by extension what defines a securities analyst evolves over time.

Many aspects of the financial profession we take for granted today were unheard of in Graham’s time. For example, the Chartered Financial Analyst designation did not exist, nor did any similar accreditation or license. Graham recognized early on that a professional designation of this sort was important both in raising the esteem of the profession, and in ensuring a set of common knowledge and practices among its practitioners.

In his writings, he proposes what he calls the “Qualified Security Analyst” rating, as well as systems of accurately determining analyst performance, to better standardize the profession.

Graham also recognized the importance of addressing the work of a securities analyst through the lens of a science, rather than as an art, as it was practiced in the industry’s early days. Rather than making decisions based on subjective factors, analysts should approach their work systematically, proposing and testing hypotheses objectively, as any other scientist would.

In “Toward a Science of Security Analysis” (1952), Graham encourages adherence to the scientific method, diligent data collection and preservation, and the practice of honest self-examination by analysts to ensure an ever-growing body of knowledge and technique in the field.

Graham demonstrates this scientific approach through a series of essays on specific investment topics, including discussions of valuation methods, the differences between investment and speculation, analysis of arbitrage opportunities, and the proper treatment of corporate cash reserves.

The book also includes extensive writing on broader topics related to the securities analyst profession. One essay, for example, uses a survey Graham sent out to fellow securities analysts to assess their opinions on the relationship between shareholders and corporate management.

He found strongly held opinions about the fiduciary importance of standing up to poor management, in stark contrast to what he felt was a lack of shareholder activism in practice. He also tackles the issues of double taxation of corporate profits, the effect of war-time economies on stock prices, and conflicts of interest between management and shareholders with regard to dividend policy.

Graham’s later writings are more reflective, but also look toward the future of the financial profession. He argues for an increased focus on client circumstances and investment needs, rather than a narrow focus on securities pricing, as well as for more humility in the profession.

In his opinion, despite the intelligence and work ethic of many analysts, too many overestimate themselves and make pronouncements about topics they have yet to fully understand. From a more detached viewpoint, he advises investors to look at the big picture and not focus too much on current fluctuations in markets.

Through this collection of writings and interviews from such a broad stretch of time, the thought progression of Benjamin Graham and the impact of those thoughts on the security analysis profession is realized.

From being introduced to Wall Street at such a young age to gaining decades of experience, Graham has revolutionized the industry, giving an ambiguous profession fundamental foundations and support. Graham is the father of security analysis, and his valuable insight, discussions, thoughts, and ideas continue to be important and relevant today.

INTRODUCTION

In a collection of writings and interviews of Mr. Benjamin Graham, Benjamin Graham: Building a Profession follows Graham’s thinking from 1932 to 1977 in which the transformation of the financial analyst profession took place from its early stages of a cottage industry to the industry it is today.

The first Chartered Financial Analyst designation was not awarded until 1963 – more than two decades after Graham had proposed a formal standard.

Today, 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.

When Benjamin Graham first got to Wall Street in 1914 at the age of 20 he had no experience, money, or conventional qualifications. He obtained a degree from Columbia University and after completion joined a small firm becoming a statistician focused on bonds.

Being a correct statistician, or security analyst, was viewed as much more of an art than a skill. Securities were evaluated in the heat of the moment, emphasizing the subjective factors regarded as unique, and future price movements were estimates in relation to the market trends swirling around it. If correct calls were made, the quality of the judgment was an illusion. Often correct calls were viewed as a validation to unsound methods.

Graham set about to putting financial analysis on a sounder footing. He dug into assets, liabilities, earnings, and dividends, placing a burden of proof squarely on the quantitative data. He revolutionized the idea that any security could become an investment verses a speculation at the proper price.

He championed the scientific method in security analysis as well as shareholders rights. The stock market served as his experimental laboratory, and from his work the industry was revolutionized completely.

As shown through the details of his writings, perhaps no man has done more for the securities industry than Benjamin Graham. As Warren Buffett later wrote, “Walter Lippmann spoke of men who plant trees that other men will sit under. Ben Graham was such a man.”

THE FOUNDATIONS OF THE PROFESSION

The security analyst profession at the time had been based on fragmented and unsound foundations. There was no process of becoming a Chartered Financial Analyst, no way of measuring ones performance and the rationale behind that performance, no disciplined method to follow in analysis, and very little ways to standardize proper valuations and pricing for others to audit.

In this collection of four writings, Mr. Graham recognizes these problems and offers solutions in an attempt to stand the financial analyst profession up on a streamlined and sound foundation.

In developing the profession Benjamin Graham discusses the affirmative case to the question, “Should Security Analysts Have a Professional Rating?” (1945).

Through this affirmative case Graham begins to persuade to the recognition of the idea of security analyst as a profession. In 1942, the Committee on Standards of the New York Society of Security Analysts proposed the idea for a rating known as the Q.S.A. (Qualified Security Analyst). Graham affirms this proposition in this writing discussing advantages as well as answers to objections.

Graham recognizes this industry, which has been misunderstood and ignorantly practiced for decades, needs a standardized rating to propel it into a recognized profession. It is in having this rating that analysts can practice their trade equipped with more knowledge, more competence, and higher character, propelling the industry.

The most important and most interesting work of the analyst leads up to and includes the recommendation that one or more stocks be purchased. In “On Being Right in Security Analysis” (1946) Graham asks the question, “How can it be determined if the recommendation is right or wrong?”

There is no scoring system for security analysis, and therefore no batting average. It is unlikely that security analysis could develop professional stature without tests of the soundness of recommendations. These tests must be examined not only on the recommendation, but the rationale behind the recommendation. Good reasoning provides the glue to link a good market tip to a good security analyst.

Measuring this recommendation can be done in examining the reasoning or in subsequent market action. In doing this, a crude batting average for analysts can be developed based solely on the percentage of times right out of total recommendations. Fixing this problem will help to give the industry a more professional appeal.

All of those devoted to the advancement of security analysis realize that it is as yet a largely undisciplined calling.

Discussing this, Graham in “The Hippocratic Method in Security Analysis” (1946) draws a parallel between security analysis and medicine in that the Hippocratic method of the medical profession can be used similarly by security analysts. In using this, the analyst must be cautious in moving forward based on rule-of-thumb recommendations.

Instead, they must refer to empirical evidence amassed from decades of data. The main problem with this is that doctors have a deeper body of knowledge to draw on and analysts, in contrast, must face a lack of systematic knowledge to draw upon regarding historical behavior of securities with defined characteristics.

If this information is composed and this method is used going forward, the analyst must also realize that the simple discovery of market anomalies lays the groundwork for their destruction. Once a strategy is used and performance is strong, others will rush to it, possibly prohibiting it from being used in the future.

The most careful and complete work in security analysis during the recent years has undoubtedly been done by the S.E.C. In “The S.E.C. Method of Security Analysis” (1946), Graham shows a gratefulness towards the Commission for their attempt to wrestle with problems facing valuation.

Required to perform certain duties by law, the S.E.C. had no choice but to indulge in full-scale security analysis. The intrinsic valuation of securities done by the S.E.C. was used to carry out its task. The parallel drawn here is that if the S.E.C. values securities intrinsically through a thorough process, and has given reasoning to these valuations, it must be appropriate for the Wall Street analyst to employ the same procedure for every security.

A rational basis for pricing and valuation results, with multiple parties determining the figures in concert with justified assumptions.

DEFINING THE NEW PROFESSION

With a newfound profession, Graham sets out to further define it. Areas needing a concrete definition include giving the profession a disciplined approach, understanding valuation and its relation to past growth, the difference in investment and speculation, special situations, market behavior, and stockholder responsibility and rights. It is the defining of these aspects that further progresses the security analyst industry.

Analysts in security analysis should be guided by a systematic approach to their profession such as the scientific method.

In “Toward a Science of Security Analysis” (1952), the scientific method is defined as the observation of specific facts, the development of theories based on those observations, and the test of those theories through predictions about future results.

While professionals should continue to follow this method, the ability to observe, develop, and test theories cannot be done properly without data collection and preservation. Moreover, it is this data collection and preservation that the security industry lacks.

In order to fix this, self- examination needs to be performed. Graham proposes the collection of studies and recommendations of numerous analysts, the classification of these in accordance with objectives, and the evaluation of their accuracy and success.

The purpose of collecting this data would be to show what methods and approaches are sound and fruitful and which ones fail to meet the test of experience. Once completed, the transmission of a continuous, ever-growing body of knowledge and technique from the analysts of the past to those of the future is made possible. When this is done, concludes Graham, the scientific method can be used to its fullest potential benefitting the industry as a whole.

One of the most widely accepted basic approaches to common-stock valuation involves discounting cash flows.

Two methods of valuation follow this idea in “Two Illustrative Approaches to Formula Valuations of Common Stocks” (1957). In discussing valuation, the first method attempts to derive an independent value using five factors to be compared with the market price while the second method uses the market price to back into future earnings.

In tying the two methods together, it is concluded a large part of the discrepancies between the calculated and market values lies in the growth factor. The market often has concepts of future earnings changes which cannot be derived from the companies’ past performance. Thus, historical growth does not reflect future growth.

It is in the two valuation calculations that give a concrete and elaborated picture of the past record which provides the analyst a point of departure for his individual exploration and discoveries in the field of investment values into the future.

Speculation verses investment has always been fundamentally distinct from one another according to Graham. In “The New Speculation in Common Stocks” (1958), the term speculation is further defined. Graham had always viewed speculation as anything unworthy of being considered an investment.

Graham viewed investments as fulfilling his rigorous standards and obtaining an almost guarantee of principle in the future.

However, a new element of speculation exists and it is coming from the attitude and viewpoint of the stock buying public and their advisors. This new speculation gives primary emphasis upon future expectations with precise mathematics.

The problem with this is that the combination of precise formulae with highly imprecise assumptions can be used to establish, or rather justify, practically any value one wishes, however high, for an outstanding issue. Intelligent investors as a result must be aware of the firm itself as well as look to the future, as the nature of speculation has changed securities pricing in that they could be so high as to carry a great degree of risk.

The glamorous issues are paid much more attention to, and the shrewd investor must adjust his margin of safety. Speculation has changed, and the investor must be aware of this and adjust himself accordingly.

By 1942 many on Wall Street had come to believe that the real and dependable income was made in special situations.

Graham writes in “Special Situations” (1946) various arbitrage opportunities have come about in the markets, and he gives his attempt to define and understand them. A special situation is one in which a particular development, such as a reorganization or recapitalization, is counted upon to yield a satisfactory profit in the security even though the general market does not advance.

Here the analyst calculates, in advance, his average profits and average holding period, then adjusts for possible downside risks. Experience is crucial here for the security professional, yet it must be supplemented by careful study of each situation and the possession of sound though somewhat specialized judgment. Graham considers these situations to be an investment due to the high probability of the situation happening.

Many arguments surfaced around 1962 that a new stock market era was emerging. At the time of “Some Investment Aspects of Accumulation through Equities” (1962), the stock market was seeing unprecedented levels of stock prices and earnings multiples.

A single bull market had lasted roughly the past 12 years, much longer than the traditional long-term bull market. It was argued by many investors the market had permanently changed character and future thanks to robust and stable economic growth, sound fiscal and monetary policy, stocks becoming hedges for inflation, and the floods of new cash from investment firms such as mutual funds and pension plans.

Graham recognizes that the this bullish viewpoint could be right, as in stocks do deserve higher valuations than the past, yet concludes that the fundamental character of the stock market must be as unchanging as that of the human nature.

“Are stockholders part-owners of their companies, or just suckers?”

Graham writes in “Inflated Treasuries and Deflated Stockholders: Are Corporations Milking Their Owners?” (1932) corporation treasurers are sleeping soundly while stockholders walk the floor. Corporations are flush with cash, using it as security after coming off the stock market collapse of 1929. Yet as companies hold more assets on their balance sheet many of these companies are selling for less than their cash position.

Stockholders deserve better selling prices as well as better allocation of this cash, yet they also must realize these are not management problems; these are ownership problems. Graham calls for stockholders to become more ownership conscious; by doing this they are realizing their rights as owners. They must do more to thwart the fact that treasuries are bloated with mismanaged cash worth nothing to the company from the markets perspective.

The disparity between the cash asset position of many companies and the price of their stock can be examined further. In “Should Rich Corporations Return Stockholders’ Cash?” (1932), Graham states due to their loaded treasuries, corporations should return to their stockholders the surplus cash holdings not needed for the normal conduct of their business.

The results would bring benefit to the stockholder in the form of a cash disbursement and the capital gains of their shares. Additionally, with less cash, more commercial loans could be granted to corporations improving the balance of our banking structure.

These strange happenings flow from the failure of the stockholders to realize that he occupies the same fundamental position and enjoys the same legal rights as the part-owner in a private business. The illusions and complexities of Wall Street have obscured this simple fact.

A conflict of interest exists between officials who draw salaries from businesses and the owners of those businesses whose capital is at stake.

In “Should Rich but Losing Corporations Be Liquidated?” (1932), Graham argues the point that if a company’s shares sell persistently below their liquidating value, the question of liquidation should be raised. Stockholders must recognize this dissatisfaction with management, and instead of simply selling stock to exit the company as a result, they should demand that if the business is not worth its realizable value it should be wound up.

Directors are simply human, the stockholders must realize their capital is being destructed for the sole purpose of providing employment. This issue must be constantly evaluated and possibly acted on by the demoralized army of American stockholders.

BROADENING THE PROFESSION

With the profession now on a sound foundation and problematic areas defined, Graham sets out to broaden the profession. Through an analyst questionnaire and further writings aspects such as stockholder management relationship, double dividend tax, shareholder democracy, and the impact of a war economy are discussed. Through these points the breadth of the industry is further examined.

How do analysts define competence in corporate management, and what steps are regarded as appropriate to take when management falls short? These questions are answered in “A Questionnaire on Stockholder-Management Relationship” (1947) in which Graham reports the results of a survey he collected from 573 members of the New York Society of Security Analysts.

Conclusions from this data set show analysts believe in the concept of poor management, and it is the shareholders’ ability and duty to act in their best interest when management fails in their fiduciary duty. While these opinions are generally a large majority, shareholder activism is still not up to par in Graham’s perspective. He notes investors love to complain about bad corporate management but hate to do anything about it. The difference here between the opinion of the security analysts and what actually happens indicates clearly that stockholders should wake up.

The double dividend tax on corporations and shareholders is universally unsupported, yet everyone sets out to condemn the policy without a practical approach for its relief. Graham offers such a practical approach in “Which Way to Relief from the Double Tax on Corporate Profits” (1954). Two reliefs to the tax are introduced, one for the corporation in the form of a tax benefit for dividend payment, and the second for shareholders in bridging the gap between capital gains and dividends taxes.

Which group’s tax burden is better to reduce? Tax relief to the shareholder is not so logical as equivalent relief to the corporation from a broad perspective, but it is likely to have more of a personal voter appeal. Expectations should point to the shareholders if a solution is ever reached.

Shareholders voices are very far from being a corporate democracy in any sense analogous to our political democracy.

While this scenario is examined by Graham in “Controlling versus Outside Stockholders” (1953), various conditions must be met for this to be practical.

In fact, Graham notes to translate theoretical power into effective democratic action requires a great advance in stockholder education. The most practical application for democratic action is in addressing the conflict of interest between the management and shareholders regarding the dividend policy.

The market favors relatively high dividend yields, yet managers are reluctant to distribute them due to many tax implications as well as keeping the share price low to increase their own holdings or take the company private cheaply.

A democracy, with various conditions met, could make strides in ensuring the fiduciary duty of managers is sufficient in protecting minority shareholders from serious loss due to an essentially arbitrary or selfish dividend policy.

With the Korean crisis bursting the previous June, Wall Street began to predict lower stock prices widespread.

A near or full-war economy was to blame with its price controls, rationing, and heavy excess profits tax. As Graham notes, however, in “The War Economy and Stock Values” (1951), the stock market has gone up since the war began.

What explains this? The recent rise in stock prices has reflected essentially the public’s conviction that a war economy is an inflationary economy, and that, in the long run, inflation means higher average prices for common stocks. Graham says the public is right in pricing in inflation, and while stocks are not perfect hedge for inflation, high inflation and a low dollar are a recipe for high stock prices. The concept of inflation is a new guiding force that is entering into the psychology of the investing public made evident by this real world scenario.

THE VOICE OF THE PROFESSION

With his fingerprints seemingly all over the financial analyst profession, Graham has become a spokesman whose thoughts are constantly sought. Graham, much older now, reflects on the progression of the industry and where it stands today including his viewpoints on market participants, additional issues facing the marketplace, and giving advice to the up and coming generations. Graham’s age-old wisdom is still reflected in our society today.

Later in his years, Graham has seen an industry transform before his eyes from the help of his own contributions. In “The Future of Financial Analysis” (1963), Graham puts fourth some thoughts on the progression of the industry as well as where it stands today.

In his commentary, Graham changes his long-standing term of security analyst to investment analyst as more senior analysts must now be prepared to go beyond the impersonal study of securities and to consider the requirements of the individual client. This idea is reinforced with the introduction of the Level 3 to the C.F.A., which covers investment management.

The Chartered Financial Analyst is now required to prescribe for the financial health of his “patient” the same way a doctor does for physical or mental health. It is his hope in the future all printed material that analyzes and / or recommends a security will have to appear over the signature and with the responsibility of a C.F.A. These rules have yet to be realized but such a vision could be impactful.

In late 1912, a short time before the death of J.P. Morgan, the legendary financier famously testified before Congress.

When asked what the stock market would do, Morgan replied “It will fluctuate.” Building off this conclusion, Graham in “The Future of Common Stocks” (1974) further reiterated Morgan’s point, stating in future years as in the past, stocks will advance too far and decline too far and that investors, like speculators, will have their periods of enchantment and disenchantment with equities.

Knowing this important advice the investor must realize common stock purchases will prove satisfactory when made at appropriate price levels. In the future, stock prices may languish, but the true investor would be pleased, rather than discouraged, at the prospect of investing his new savings on very satisfactory terms.

From the Financial Analyst Journal “A Conversation with Benjamin Graham” (1976), Graham states his viewpoint on Wall Street and the investment community. Wall Street, in Graham’s eyes, is a tale full of sound and fury, signifying nothing.

The stock market resembles a huge laundry in which institutions take in large blocks of each other’s washing without rhyme or reason.

He notes the stockbrokers, analysts, and advisors making up Wall Street are above average in intelligence, business honesty, and sincerity, but they lack adequate experience in analysis and overall understanding of the markets. They tend to take the market and themselves too seriously, spending too much time trying to understand and do things they cannot do or understand well.

Also from this writing, Graham gives his views on institutional investors and individual investors. Institutional funds cannot obtain better results than the Dow Jones Industrial Average or the Standard & Poor’s Index over the years.

If they could produce better results, stock market experts as a whole would be beating themselves, which is a logical contradiction. The average institutional client should be content with the DJIA results or the equivalent.

The individual investor has a great advantage over larger institutions claims Graham.

While institutions have larger resources, superior facilities, etc., the individual has an advantage because he has a larger stock pool to choose from. Institutions are limited to 300 – 400 huge corporations due to constraints, but the individual can choose from 3,000 issues at which he should at all times be able to locate at least 1% of the total list to be attractive buying opportunities.

The individual needs to follow three rules in his approach: (1) he should act consistently as an investor and not as a speculator. This means he should be able to justify every purchase made along with each price by impersonal, objective reasoning that satisfies his margin of safety. (2) The investor should have a definite selling policy for all his common stock commitments, corresponding to his buying techniques. (3) Portfolio allocation should be roughly 50-50 of common stocks and bond equivalents with adjustments for changes in market level.

In an article titled “Benjamin Graham: Thoughts on Security Analysis” (1972), Graham continues to reiterate the ideas he’s written about for decades. These ideas include what leads to failure, false value in investments, and thoughts on financial disclosure.

The primary cause of failure for the individual investor is that they pay too much attention to what the stock market is doing currently. They feel that what’s going on now will continue indefinitely or long enough for them to benefit substantially. They want to make more money than they deserve to, and because of that, they frequently lose out.

Additionally, one has to be very smart to be smarter than the experts who make up the stock market. That is to be smart enough to outperform the averages which is difficult to do. People tend to think if you know just a little more than the average person about securities, you’ll do better than the average person. Individuals are trying to be smart, but they are not going to be smart enough.

False value has been introduced into the marketplace and this false value is given the name “water” by Mr. Graham.

This water has been put back in the stock market by investors and speculators themselves. Historically, what was known as water represented a secret markup of the value of the company’s assets, chiefly its fixed assets, above their actual cost and above their replacement value.

As those semi-fraudulent balance sheets have been corrected thanks to regulation, it has been replaced with water fooling with the prices the investor pays. The difference between the stock market’s valuation against true book value has created another watered stock phenomenon.

This leads into another discussion around financial disclosure and its effect on pricing. From one point of view, Graham views disclosure as excessive. A public offering circular has 100 pages crammed with important and unimportant information with really nobody reading the prospectus in full. It takes an expert to dig out the important information, which usually is the analyst.

With the prospectus so excessive, the question rises of whether the public can protect itself from the mispricing of offerings. Can the public be protected against itself by emphasizing the absurdity of the price level for second– and third- grade stocks which have had enormous advances in price, with very little value behind them in many cases?

If it is difficult for industry professionals to dig into the prospectus, this difficulty must be amplified in the public’s case. If only the prospectus could say in big bold letters, “This stock is not worth what it is selling for.” Disclosure is necessary, yet excessive, but the problem here lies with the public.

In an interview type setting, Mr. Graham shares further insights into the sudden efficient market craze as well as advice for the young analyst in “An Hour with Mr. Graham” (1977). As the book A Random Walk Down Wall Street gained in popularity, Graham refutes its theories presented as he emphasizes that it’s hard to draw a connection between those professors working on A Random Walk Down Wall Street and practical investment results.

The idea of saying that the fact that the information is so widely spread that the resulting prices are logical prices is all wrong. It cannot be said that the prices made in Wall Street are the right prices in any intelligent definition of what right prices would be. Reflecting on his 60 years on Wall Street, he concludes people do not succeed in forecasting what is going to happen to the stock market and price it in. Everyone has opinions, but that doesn’t mean their opinions are correct.

Speaking from a perch of wisdom and experience, Graham continues his reoccurring theories in advising young industry professionals on how to become successful on Wall Street. There are two requirements for success in Wall Street. One, you have to think correctly; and two, you have to think independently. To the young C.F.A. candidate, study the past record of the stock market, study their own capabilities, and find out the approach to investment they deem satisfactory.

If they’ve done this, pursue that without any reference to what other people do or think or say. Stick to their own methods and do not ever follow the crowd. One thing is for sure in the future: The present optimism is going to be overdone, and the next pessimism will be overdone. These such experiences will be duplicated throughout the years.

CONCLUSION

Through this collection of writings and interviews from such a broad stretch of time, the thought progression of Benjamin Graham and the impact of those thoughts on the security analysis profession is realized. From being introduced to Wall Street at such a young age to gaining decades of experience, Graham has revolutionized the industry, giving an ambiguous profession fundamental foundations and support. Graham is the father of security analysis, and his valuable insight, discussions, thoughts, and ideas continue to be important and relevant today.

Britt always taught us Titans that Wisdom is Cheap, and principal can find treasure troves of the good stuff in books. We hope only will also express their thanks to the Titans if the book review brought wisdom into their lives.

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