Hey Guys, found a backup of my Evernote, in which around 2014ish I used to journal all trading-related info/trivia/insights. Thought I’d share this in case it’s useful to someone. Let’s start all the way back with Benjamin Graham and eventually come down to modern Hedge Fund Managers and Quants.
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Benjamin Graham pioneered a rigorous, quantitative approach to security analysis. Graham started investing during the early 1900s. The landscape then was very different. For example, investing was not considered a respectable profession. It was viewed more like astrology or a game of chance—run by crooks and people with inside information. Using inside information was legal at the time. His investment strategy had its roots in his own personal hardship.
Brief Bio :
Benjamin Graham was born Benjamin Grossbaum in London in 1894. He moved with his family to New York when he was a year old. His father, Isaac, ran successful retail businesses selling high-end chinaware and figurines. The family led a comfortable life on Fifth Avenue in Manhattan.
When Graham was 9 years old, his father died, and the business quickly went downhill. Then his mother, Dorothy, was wiped out trading stocks during the Crash of 1907.
Graham was an excellent student and received a scholarship to Columbia University. After graduating second in his class in 1914, his Wall Street career began with the firm of Newburger, Henderson and Loeb. He quickly rose through the ranks and made partner at the age of 26.
He left Newburger in 1923 to set up his own firm with business partner Jerome Newman. The investment vehicles related to this business agreement became known as the Graham Newman Partnerships.
In 1928, he finally returned to Columbia to teach. His 1934 book, Security Analysis, which has since become known on Wall Street as the bible of value investing, was created in large part from the lecture notes of his classes.
Graham’s Investment Philosophy
One of Graham’s principles was that if you had the money, you shouldn’t buy a share of stock in a company unless you would be willing to buy the company itself. With that caveat, you would certainly be interested in the firm’s financials.
You probably would also want a business that had stood the test of time. For example, you might want to make sure it had survived a couple of recessions.
You probably would also like to buy the business at a discount to what you thought it was worth, just in case something went wrong or you miscalculated its value.
Graham summarized these ideas into the concept margin of safety. He phrased it this way:
“To have a true investment, there must be a true margin of safety. And a true margin of
safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience.”
Graham focused on quantitative measures of value. He first looked at the value of existing assets, such as cash, inventory, and property, by examining a target company’s financial statements. Next, Graham looked at current earnings. Lastly, and only in rare circumstances, he considered future profits, but only in the core competence area of a firm with a sustainable competitive advantage.
Mean Reversion
The concept of mean reversion is a major underpinning of the value investing philosophy. It means that past winners often become future losers, while past losers often become future winners.
Graham was also early to recognize the role of market psychology in investing. Today, the field of investor psychology is known by academics and practitioners as behavioral finance.
Value investments often occur because of market psychology, with fear and greed moving prices away from their long run or equilibrium prices.
Net–Net
One of Graham’s favorite value-oriented strategies to pick investments was to find companies selling for less than their cash liquidation value. He called this deep-value strategy Net–Net.
Graham’s Net–Net calculation started with the cash and cash equivalents item on a firm’s balance sheet and then added a conservative portion of accounts receivable and inventory. Then he subtracted all liabilities.
He compared this aggregate amount of cash and hard assets to the stock market value of the firm. If the company was selling for less than market value, Graham would consider it a
bargain under his Net–Net deep-value approach.
He estimated that his Net–Net strategy provided his partnerships with returns of approximately 20% a year, double the market’s historical return.
Great Trades :
1. Northern Pipeline
The investment that put Graham on the map was known as the Northern Pipeline Affair, a Net–Net investment. Northern Pipeline Company was one of Standard Oil’s 34 spinoff companies. Its
business involved transporting crude oil to a Standard Oil refineries.
After the Supreme Court decision breaking up Standard Oil,Graham combed through the forms that energy firms filed with the Interstate Commerce Commission. He found that Northern Pipeline had $95 a share in railroad bonds and other liquid assets. Yet the stock was trading for only $65 a share, and it paid a hefty 9% annual dividend yield.
In 1926, Graham’s partnership acquired roughly a 5% stake in Northern Pipeline, and he asked the company to distribute more cash to shareholders. Northern Pipeline’s management wasn’t pleased at being told what to do and actively avoided his requests.
In 1928, after contacting other shareholders and requesting their help, Graham put together proxies, or voting power, equal to 38% of Northern Pipeline’s shares and was able to get himself appointed to the firm’s board of directors.
Over time he persuaded the company to pay out $70 a share in special or extra dividends. Coming in the midst of the Great Depression, it was a very attractive return from Graham and his partners.
Government Employee Insurance Company
2. GEICO
GEICO was Graham’s most famous investment. GEICO wasn’t Net–Net, but it had unique value, such as its superior business model of selling car insurance. Graham purchased almost half of
the company for his investment partnerships in 1948, at a 10% discount to its book value.
GEICO rode the wave of the post-World War II American automobile industry. Among its advantages was the clever business model of selling directly through the mail at discount prices. Drivers benefited from lower car insurance prices, while GEICO benefited from its lean infrastructure, avoiding the need to
build a costly network of offices and salespeople.
Seven Defensive Investing Strategies :
Graham made a distinction between the enterprising investor and the defensive investor. The difference was based on the ability of the investor to put time and effort into the research process.
For the defensive investor, Graham suggested 7 factors in selecting a common stock. Unlike his Net–Net strategy, there will almost always be a fair number of firms that meet these 7 criteria.
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Adequate Size. Graham viewed adequate size in a target company as more than $100 million in 1971 dollars, or about $600 million today. He viewed traditional, government regulated utilities as safer than industrial firms, so you could cut the adequate size threshold in half for utilities. Graham reasoned that larger firms are less likely to go out of business; that they probably have resources, scale, and experience to weather any storm.
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Sufficiently Strong Financial Condition. Graham defined this term as current assets at least twice the size of current liabilities. He also thought total liabilities should not be higher than working capital (that is, current assets minus current liabilities).
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Earnings Stability. Graham defined earnings stability as positive earnings for at least 10 consecutive years. This rule eliminates many cyclical firms and those younger than 10 years.
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A Strong Dividend Record. This criterion recommends 20 years or more of uninterrupted dividends. This rule eliminates most growth stocks, since the vast majority don’t pay dividends.
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Organic Earnings Growth of at Least 33% over the Past 10 Years.
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A Moderate Price-to-Earnings Ratio. Graham defined this term to be the current price of the stock as not more than 15 times its average earnings over the past 3 years. This number makes sense to many investors, since the long-term P/E ratio for U.S. stocks is about 15.
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A Moderate Ratio of Price to Assets. Graham defined a moderate price-to-assets ratio as a firm trading for less than 1.5 times its book value. Book value is also known as accounting net worth. It’s equal to all of the firm’s assets minus all of its liabilities. This factor of less than 1.5 times book value also rules out most growth stocks since they often trade at a high multiple of Price to Book.
In his later years, Graham suggested another simple value formula: Create a portfolio that consists of at least 30 stocks with P/E ratios less than 10 and debt-to-equity ratios less than 50%. Hold each stock until it returns 50%. If it doesn’t achieve a 50% return after 2 years, sell it no matter what. Graham back-tested this formula and found it to earn about 15% a year over the previous half-century.
Graham’s Legacy
Benjamin Graham made maverick contributions to measuring value, viewing stock as the ownership of a business, and investing with a margin of safety. He made clear the distinction between speculation and investment: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting the requirements are speculative.”
Many of the most successful investors of the 20th and early 21st centuries were hugely influenced by his work.
Value investing requires analytical rigor, discipline, patience, and willingness to go against the crowd. Graham was able to follow this approach, and his investment firm posted annualized returns of about 20% per year from 1936 to 1956—roughly double that of the market.