The Intelligent Investor

Andrew Carnegie once offered some free advice on how to get rich: “Put all your eggs in one basket, and then WATCH THAT BASKET .” His friend, Mark Twain, borrowed the remark but had a bad habit of not practicing what he preached, and he was often in severe money trouble.

But Andrew Carnegie followed his own advice with a basket called the Carnegie Steel Company. He watched it very carefully indeed while it grew over thirty years from nothing to the largest—and by far the most profitable—steel company on the face of the earth.

Carnegie was, at least in this respect, a typical progenitor of a great American fortune. The majority of such fortunes have come about because someone saw opportunity in a dawning technology and ran a business that exploited that technology better than his competitors did. That’s what Cornelius Vanderbilt, a generation older than Carnegie, had done with railroads, what John D. Rockefeller, Carnegie’s contemporary, did with oil, and what Bill Gates, young enough to be Carnegie’s great-great-grandson, has done with software.

Warren Buffett, currently second only to Gates on the FORBES Four Hundred List, is a twelve-billion-dollar exception to this rule. Buffett is an investor, not a manager. In other words, he puts his eggs into a number of other people’s baskets and expects them, not himself, to turn the eggs into chickens.

In theory this should be an easier way to make a fortune. There are no messy corporate decisions to make about expansion, retrenchment, mergers, or prices. Instead there are only the clean, either-or decisions of buy, sell, or hold.

Of course, bettors at a roulette table face equally clean-cut decisions and, like all too many investors, make the wrong one. But picking investments, unlike roulette, is not a matter of pure chance. Mr. Buffett, after all, has for the last thirty-five years been making consistently great choices.

But even for lesser mortals, there are reliable guidelines for investing that have been around for more than sixty years. They are in fact the very ones Buffett uses, for—if Sir Isaac Newton will forgive me—if Buffett has seen farther in the art of making investment decisions, it is because he has stood upon the shoulders of a giant, Benjamin Graham.

Graham was born Benjamin Grossbaum in London in 1894. (The family name was changed in 1917 when America’s entrance into World War I made German-sounding names highly unpopular.) His parents, importers of china and bric-a-brac, were immigrants from Russian Poland, where his grandfather had been the grand rabbi of Warsaw. Benjamin was a year old when the family emigrated again, this time to New York City, where they continued importing china.

Graham’s father died when he was nine, and his mother had to struggle hard to raise her children without him. Graham proved himself an extraordinarily good student. Math was always his best subject, but he learned to read no fewer than six languages, including Latin and Greek, while attending Boys High School in Brooklyn, one of the city’s premier public schools, and then Columbia University.

After college he was offered several teaching jobs at Columbia, but he preferred to work on Wall Street. He married at this time and had five children by his first wife (there also would be a child by his third wife). Emotional relationships were always difficult for Graham, who preferred the neat, reliable truths of numbers. All three of his marriages failed, and he was distant with his children.

But because numbers sang to him as they sing to few others, he was drawn to the statistics issued by the government and to the annual reports of companies whose securities were traded on Wall Street. He quickly realized that these were gold mines of information useful for picking investments. That this seems monumentally obvious today is in fact a monument to Benjamin Graham, who pioneered a field named only in the 1930s: securities analysis.

The annual report, like the accounting profession, had become a regular part of the American business scene in the 189Os. But because it was bankers who had caused their creation, the reports were not very forthcoming with information that was of use to investors. Instead they emphasized what was important to bankers: creditworthiness.

Graham soon made a name for himself as someone who could spot value in the numbers. In 1915 the Guggenheim interests decided to liquidate a company called Guggenheim Exploration, then selling for $68.88 a share. Graham quickly noticed that many of the assets of the corporation were in the form of shares of other publicly traded companies and that even with the most conservative valuation of the company’s fixed assets, the net asset value of each share was at least $76.23, a virtually guaranteed profit of more than 10 percent. Graham lacked the money to invest himself, but he handled the matter for others, taking a 20 percent cut of the profits.

Similarly, in the early 1920s Graham noted that the market value of Du Pont stock was no more than the market value of the General Motors stock the Du Pont company owned. (Du Pont was a major shareholder in General Motors until antitrust action forced it to divest itself of GM stock in the 1950s). Since Du Pont owned vast other assets besides the GM stock, the market must have been valuing Du Pont stock too low or GM stock too high. But which was it?

Graham didn’t need to know. He simply loaded up on Du Pont while selling an equivalent amount of GM short and waited for the market to notice the discrepancy. When it did, Du Pont rose substantially while GM held steady, allowing him to close his short at no loss while making a bundle on Du Pont.

Both these investments display fully Graham’s technique: Look for undervalued companies, invest, and wait for the market to notice them. He especially looked at working capital and cash—and only then turned his attention to such fixed assets as plant and equipment. He advised investors to be very wary of “intangibles,” such as goodwill. To Graham the most important calculation was net current assets, minus all current liabilities. If this number was high, then the security had a “margin of safety” that limited any downside risk while providing an upside potential. The only other thing needed was patience, a virtue often in short supply on Wall Street, where the measure of eternity is the end of the current quarter.

Some people, especially professional investment advisers, find this technique annoyingly simple. After all, as Warren Buffett explained, “If you’ve gone and gotten a Ph.D. and spent years learning how to do all kinds of tough things mathematically, to have it come back to this—it’s like studying for the priesthood and finding out that the Ten Commandments were all you needed.”

Soon Graham’s reputation as a stock wizard spread, and he was able to open his own investment firm, on January 1, 1926, with $450,000 under management. Three years later he was managing $2,500,000 in what today would be called a mutual fund.

It was easy to make money on Wall Street in the late 1920s, of course. But Graham consistently beat the Dow Jones Industrial average, which is more than can be said for all too many investment advisers then and now. He did this so well that the legendary investor Bernard Baruch offered him a partnership, an offer Graham had enough self-confidence to turn down.

By the end of the decade Graham and his family were living in a duplex in the majestic Beresford apartment building, overlooking Central Park. The securities under his management grew by 60 percent in 1928, while the Dow Jones average rose 51 percent.

The next four years, however, would be a very different story. Thanks to the huge run-up in stocks in the early months of 1929, the Dow Jones declined only 15 percent for the year as a whole, despite the crash in October. But Graham saw a 20 percent decline in the value of his fund’s investments.

In the early months of 1930 the stock market rallied strongly, and Graham was convinced, as were many others, that the worst was over. He invested aggressively in what turned out to be the greatest mistake of his career. By the end of 1930 the Dow Jones had fallen an additional 29 percent, while Graham’s fund had suffered a staggering 50 percent decline in value. Graham moved to stem the losses, and in 1931 the fund declined by only 16 percent while the Dow Jones fell 48 percent. The following year Graham lost only 3 percent while the Dow Jones went down another 17.

In fact only a timely infusion of cash from his partner’s father-in-law saved the firm from failure. During those years Graham took no salary and moved from the splendor of the Beresford to a much more modest apartment. But when the market finally hit bottom in 1932, stocks that met Graham’s criteria for investment abounded, and by the end of the decade he had earned back all the money lost in the Crash and its awful aftermath.

In the meantime Graham had had to find other sources of income, and this turned out to be fortunate for posterity. He started teaching at Columbia, where his course (which carried the description “Investment theories subjected to practical market tests. Origin and detection of discrepancies between price and value”) soon became legendary, taken as often by Wall Street professionals as by Columbia students.

In 1934 he and his coauthor David L. Dodd published Security Analysis: Principles and Techniques , a college-level textbook. In 1949 he followed that with The Intelligent Investor , intended for its namesake. Both have been in print since they were first published, selling hundreds of thousands of copies each.

The reason for their success, of course, is easy to explain. “No one has ever become poor reading Graham,” Warren Buffett once said.