CHAPTER 16
Graham and Dodd Placed in Context*
The OPMI Perspective of Analysis
The Going Concern and Investment Company Views of Businesses
Primacy of the Income Account and Wealth Creation
Primacy of the Income Account, Dividends, and Corporate Uses of Cash
Primacy of the Income Account and the Appraisal of Managements
Primacy of the Income Account and Top-Down versus Bottom-Up Analysis
Primacy of the Income Account and Diversification
Primacy of the Income Account and Growth Stocks
Market Risk versus Investment Risk and Margin of Safety
The Importance of Market Performance
Uses and Limitations of Financial Accounting
Do Stock Market Prices Reflect Corporate Values?
Modern Capital Theory versus Graham and Dodd
Benjamin Graham and David Dodd (G&D) were prolific writers, publishing volumes in 1934, 1940, 1951, and 1962 and by Ben Graham alone in 1949 and subsequent revised editions.1 A principal problem with G&D is that almost everyone in finance talks about G&D but very few seem to have actually read G&D. This discussion is based on the 1962 edition of Security Analysis Principles and Technique (McGraw-Hill) by Graham, Dodd, and Cottle; and the 1971 edition of The Intelligent Investor, by Graham.
Because so many have such a superficial understanding of G&D, their names have become synonymous with the term value investing. This, in turn, has led to some confusion about what it is that value investors do. Though we are influenced by G&D, our methods are basically different.
As we have already pointed out, value investing is one area of fundamental finance (FF). It involves investments in marketable securities by non-control outside passive minority investors (OPMIs) using a fundamental finance approach to analysis. The other areas of fundamental finance involve the following:
Modern capital theory (MCT), like value investing, focuses on investments by OPMIs. Unlike value investors, MCT focuses strictly on near-term changes in market prices. In a number of special cases the factors important in MCT are also important in value investing. MCT is discussed briefly at the end of this chapter and discussed at length in Chapter 17.
G&D made four very important contributions to value investing:
Any so-called value investor follows the basic rule promulgated by G&D:
acquire at attractive prices the common stocks issued by primary companies in their industries.
In this chapter we briefly summarize and discuss the differences between our approach to value investing and that of G&D. Many of the differences are foundational in nature, and these foundations have been explained in detail in Part One of this book.
THE OPMI DEFINED
Some participants in investment operations are outside, passive minority investors (OPMIs); others are activists. OPMIs are members of the public and are distinguishable from others in three respects. First, individually they have no control or influence over the businesses whose securities they hold or contemplate holding. Second, they do not have access to information other than that which is generally available to the public. Third, they are those whom the U.S. securities laws and regulations have been designed to protect.2
Throughout the book, we refer to them as OPMIs, as well as non-control and unaffiliated security holders. The key is that they are inactive in management and not connected with the company issuing securities in any way other than as security holders. OPMIs run the gamut from day traders to most institutional investors to safe and cheap investors who do not seek elements of control over the companies in which they hold securities positions. The reason for using the term OPMI rather than investor is that the word investor is one of the most misused and misunderstood words on Wall Street and is often used to describe what G&D and we would refer to as speculators.
Non-control investors are also supposed to be the beneficiaries of various state laws and regulations, including blue sky statutes governing terms and conditions under which new issues may be offered;3 antitakeover statutes; statutes aimed at controlling going-private transactions; more generalized common law and state statutory requirements covering the fiduciary obligations of those in control of corporations to unaffiliated common stockholders; and statutes defining appraisal remedies when stockholders dissent from force-out mergers or similar force-out transactions. OPMIs are additionally protected by rules promulgated by quasi-public bodies, particularly the Financial Institutions Regulatory Authority (FINRA) and the Public Company Accounting Oversight Board (PCAOB).
We regard as activists those participants in U.S. financial operations who have elements of control or influence over the businesses in which they invest, who have or can obtain nonpublic information and whom federal securities regulation is intended to control rather than to protect. We believe the materials in this book are of interest to both activists and OPMIs.
THE OPMI PERSPECTIVE OF ANALYSIS
Both G&D and MCT focus on the investment operation from the point of view of the OPMI. Little, or no, attention is paid to other points of view and the particular factors needed to understand the dynamics driving individual companies, particular industries, control persons, and putative control persons, as well as creditors. This emphasis on the OPMI is in sharp contrast to other areas of FF—control investing, distress investing, and first- and second-stage venture capital investing. Here, the analysis does not focus on OPMI needs and decisions, but is rather a four-legged stool:
As value investors, our analytic techniques, unlike G&D’s, are the same as control investors, distress investors, and creditors. The emphasis is on understanding in depth, from the bottom up, the company and the securities it issues; and also the character and motivations of managements, other control entities, and others senior to the common stock, ranging from secured lending by commercial banks to trade creditors to holders of subordinated debentures to holders of preferred stocks. There is a de-emphasis of top-down factors emphasized by G&D and MCT, a primacy of the income account, general stock market levels, near-term stock price movements, a primacy of dividend income, quality or growth as defined by general recognition of such in the general market.
Many of the best value investors graduate into other areas of fundamental finance, especially control investing and distress investing. Names of such “graduates” which come to mind are Warren Buffett, Sam Zell, Carl Icahn, Bill Ackman and David Einhorn.
A subgroup of control investing is what we call “Pain in the Ass” (PITA) investing. PITA investing seems to be carried on very skillfully by Messrs. Icahn, Ackman, and Einhorn. PITA investing involves either buying small- to medium-sized stakes in the equity of underperforming, undervalued companies, or shorting securities that are overpriced and where managements lack integrity or where there might be suspicions of fraud or unsound accounting practices. The PITA investor in these situations has access to large amounts of publicity and using that publicity tries to influence market prices in OPMI markets. PITA investing involves elements of control, but most of the time, the PITA investor does not seek actual control of the business.
Our modus operandi is to think like owners, private acquirers, or creditors, emphasizing elements of FF that differentiate us from G&D.
In their analysis of common stocks, G&D emphasize the following factors:
As we highlighted, two reasons underlie their focus on these factors of analysis. With minor exceptions, G&D had only one type of investor in mind, the OPMI, and they viewed businesses as pure going concerns.
THE GOING CONCERN AND INVESTMENT COMPANY VIEWS OF BUSINESSES
We differ from G&D and most others writing about fundamental security analysis and corporate finance. Other fundamentalists have a tendency to apply to all companies tools of analysis that in fact are applicable only to that small minority of businesses that are strict going concerns—that is, companies that are engaged in a particular type of operation to be financed, managed, and controlled in the future in about the same way they have been in the past. The analysis of strict going concerns is of limited help when applied to businesses that are also involved in what we call resource conversion activities like mergers, acquisitions, or the purchase, sale, or distribution of assets in bulk; major financial restructurings or recapitalizations; sales of control or contests for control; or the creation of tax shelter. Since most companies, to a greater or lesser extent, are involved in these types of activities, analysis must take into consideration both their static and dynamic investment vehicle attributes.
There are crucial differences between the analysis of companies as going concerns and the analysis of companies as investment vehicles. Most companies have both going concern characteristics and investment company characteristics. In going concern analysis, great weight is given to flows, whether cash or earnings. In investment vehicle analysis, great weight is given to asset values, especially realizable asset values. For both going concerns and investment vehicles, creditworthiness is paramount for the company and its securities holders (except perhaps for adequately secured creditors). G&D emphasize going concerns except for a short description of net nets, which focuses only on classified balance sheets and never mentions creditworthiness or prospects for resource conversion, especially changes of control or going private.
PRIMACY OF THE INCOME ACCOUNT AND WEALTH CREATION
For G&D values for stockholders are created by earnings that are then valued in the market by a price-earnings ratio (or capitalization rate) and/or dividends, which are valued by the market on a current return basis.
In FF, stockholder values flow out of creating corporate values. There are four different methods of creating corporate values:
G&D do not distinguish between cash return investing and total return investing. In cash return investing, returns are measured by current yield (or dividend return), yield to maturity, yield to a worst case, or yield to an event. In total return investing, returns are measured in price paid relative to cash returns plus (or minus) capital appreciation (or depreciation) in given periods of time. Many portfolios have to be invested only for cash return into high-grade credits, such as bank securities portfolios; insurance company portfolios, at least as to the amount of liabilities; certain pension plans. (In the current low-interest environment, it seems almost impossible to be a rational cash-return investor.) For G&D, the higher the dividend, the higher the price at which a common stock would sell. G&D imply that the higher-dividend issue should be acquired. G&D ignore that the lower-priced security may be more attractive to the total return investor because of the lower price and the larger amount of retained earnings.
Two facts stand out in comparing dividend income in the U.S. with interest income:
PRIMACY OF THE INCOME ACCOUNT, DIVIDENDS, AND CORPORATE USES OF CASH
G&D emphasize the importance of dividends for OPMIs. In contrast, FFs look instead at the corporation optimizing its uses of cash. In general, corporate cash can be dispensed in three areas:
There are comparative advantages and disadvantages for dividends and buybacks, which are never discussed by G&D, because they only mention the stock buyback alternative as it relates to stock options for management. There is no discussion by G&D of stock buybacks as a method of enhancing a common stock’s market price over the long run, giving the management the flexibility to retain cash in troubled times, and also increasing the percentage ownership interest of each nonselling stockholder.
From a corporate point of view, distributing cash to shareholders has to be a residual use of cash, compared to expanding assets or reducing liabilities most of the time. Probably the most important exception to this exists where the payments of common stock dividends in cash give a corporation better long-term access to capital markets than would otherwise exist. This seems to be the case for companies, which by the nature of their operations consume cash in order to create wealth and are required to raise outside equity capital periodically, such as integrated electric utilities and certain financial companies.
PRIMACY OF THE INCOME ACCOUNT AND THE APPRAISAL OF MANAGEMENTS
In a G&D primacy of the income account approach (or any other primacy of the income account approach), managements are appraised almost solely as operators. For FF, managements are appraised using a three-pronged approach:
In appraising managements as financiers, the emphasis ought to be on a primacy of creditworthiness for either the company or for various securities in the capital structure.
G&D agree that the securities of secondary companies and workout situations can be attractive for Enterprising OPMIs, whom they distinguish from Defensive OPMIs. However, very little is really voiced by G&D as to how secondary situations and workout situations ought to be analyzed, compared with their views on how to analyze the securities of primary companies, other than to state that secondary common stocks should not be acquired except at prices of two-thirds or less of underlying value.
PRIMACY OF THE INCOME ACCOUNT AND TOP-DOWN VERSUS BOTTOM-UP ANALYSIS
G&D is mostly a tool for top-down analysis; while FF, in contrast, is almost completely bottom up. G&D describe how to forecast earnings for a coming 5-to-10-year period:
In FF, the essential analysis is of the individual company and the current price of the security versus its estimated intrinsic value. Instead of just forecasting earnings, in FF, prognostications are made about:
PRIMACY OF THE INCOME ACCOUNT AND DIVERSIFICATION
Diversification, quite properly, is key in a G&D analysis. It is an OPMI analysis, which relies heavily on predicting future earnings and future dividends, something extremely hard to do well. In FF there is much less need for diversification which is viewed as only a surrogate, and usually a damn poor surrogate, for knowledge, control, and price consciousness. Non-control value investors need a modicum of diversification, but nowhere near to the degree emphasized by G&D, MCT, and academics in general.
PRIMACY OF THE INCOME ACCOUNT AND GROWTH STOCKS
In writing about growth stocks, G&D seem to define growth as that which is generally recognized in the marketplace as growth. Growth analysis focuses strictly on forecasting future flows, whether such flows are revenues, earnings, or cash. An attractive common stock purchase is deemed to exist where future forecasted growth rates are greater than current ratios of price to flows.
In FF there is no emphasis on estimating future flows. Rather we recognize that growth in common stock prices can come, and frequently does come, from sources other than corporate operations. Growth can come from judicious acquisitions; creating unrealized, and unrecorded, appreciation in asset values, creating “hidden assets” in the form of increases in adjusted book value; having companies taken over by others at premium prices; and possibly participating in corporate restructurings. Many of these growth stocks do not have general recognition, and so they sell at very modest prices. Examples in mid-2012 included Applied Materials, Brookfield Asset Management, Cheung Kong Holdings, Hang Lung Group, and Wheelock & Co.
MARKET RISK VERSUS INVESTMENT RISK AND MARGIN OF SAFETY
G&D believe it is important to guard against market risk, that is, fluctuations in security prices. Thus, it becomes important in their analysis to have views about general stock market levels. FF practitioners guard only against investment risk, that is, the problems of companies and/or the securities they issue. In FF analysis, market risk is mostly ignored except when dealing with sudden death securities—derivatives and risk arbitrage securities; when dealing with portfolios financed by heavy borrowing; and when companies have to access capital markets, especially equity markets.
In the analysis of performing credits acquired at or near par, emphasis by G&D is on quantitative data relevant to overall interest coverage, rather than any emphasis on covenants and/or collateral. FF emphasizes covenants and collateral in credit analysis. No matter how favorable the quantitative data, such as coverage and debt ratios, FF practitioners examining most corporate credits assume that the quantitative facts are likely to deteriorate over the long-term life (say a 5-to-15-year life) of a debt instrument. Such an assumption creates a margin of safety for a creditor.
Analysts really ought not to use the word risk without putting an adjective in front of it. G&D really do not distinguish often enough between market risk and investment risk, even though they recognize in measuring market risk that Mr. Market tends to be utterly irrational some of the time. Market risk refers to short-term fluctuations in securities prices. Investment risk refers to something going wrong with the company issuing securities or with the securities (such as dilution).
We largely disagree with G&D as to when low pricing creates a margin of safety. For G&D the margin of safety is created mostly by depressed prices in the general market. For FF, the margin of safety is derived largely from micro factors affecting a company and its securities, not general stock market levels. G&D seem to have a valid point in terms of guarding against market risk. FF is involved with investment risk, not market risk.
THE IMPORTANCE OF MARKET PERFORMANCE
The importance of market price depends primarily on three factors:
Generally, market prices are much less important if a portfolio consists of performing loans. Indeed, in some portfolios, such as high-grade municipal bonds held by individuals, almost no attention is paid to market prices. Market prices are almost always important in evaluating common stocks, except in instances where the common stocks are being accumulated with the idea of obtaining control or elements of control. Market prices are almost always of critical importance where the portfolio is financed by margin borrowings where the collateral for the borrowing are the securities that make up the portfolio.
Sometimes analysis takes funny turns. In a poorly financed company, would one prefer to have had the company issue subordinated debentures or a preferred stock, which is, of course, subordinated to the debentures? If there is a failure to pay interest or principal on a subordinated debenture, the one remedy available to the subordinated creditor is to declare an event of default. Then, either the indenture trustee, or usually 25 percent of the subordinated creditors, can accelerate the debt, declaring it due and payable. For a subordinate class, the right to accelerate most often is the right to commit suicide, because this action would likely result in a reorganization or liquidation where almost all, or all, the value will go to senior creditors. In contrast to an event of default, the preferred shareholder accumulates dividend arrearages. The company has less need to reorganize or liquidate. If an investor is making a capital infusion into a troubled company, the investor frequently is much better off from a safety point of view by having the issuer issue a preferred stock, rather than a subordinate.
USES AND LIMITATIONS OF FINANCIAL ACCOUNTING
In valuing assets, G&D seem to rely strictly on a classified balance sheet produced in accordance with Generally Accepted Accounting Principles (GAAP). Thus, inventory is viewed as a current asset and real property as a fixed asset. In FF, we focus more on what the numbers mean rather than what they are, and the analysis tends to get different results. In the case of a retail chain, which is a going concern, inventories usually are a fixed asset of the worst sort—subject to markdowns, shrinkage, obsolescence, and misplacement. On the other hand Class A, fully leased income-producing office buildings tend to be current assets, probably an area where price agreement can be reached via one phone call.
For FF, GAAP in the United States is an essential disclosure tool, the best objective benchmark available to the OPMI analyst in the vast majority of cases. However, GAAP and related accounting measures, unadjusted by the analyst, are almost always misleading, in one context or another.
G&D stress the importance of adjusting GAAP to determine true earnings for a period. In FF, the analyst always adjusts GAAP, not only to determine earnings from operations, but also to determine creditworthiness and asset values.
GAAP recognizes three classifications on the right-hand side of the balance sheet: liabilities, redeemable preferred stock, and net worth. In economic fact, there are many liabilities that have an equity component. It is up to the analyst to decide what percentages of certain liabilities are close to equivalent to payables and what percentages are close to equivalent to net worth. Take the liability account, deferred income taxes payable, in a going concern. If the cash saved from deferring income taxes is invested in depreciable assets, the tax may never become payable. However, the deferred tax payable account can never be worth as much as tax paid retained earnings (part of net worth) because the tax may someday become payable, especially if the company engages in resource conversion activity, such as being acquired in a change of control transaction. So, maybe there is as much as a 90 percent equity value in the deferred income tax accounts payable. On the other hand, deferred income taxes payable can never be as much of a liability as current accounts payable or interest-bearing debt. Maybe, at the maximum, there is a 5 to 10 percent equity in the deferred tax payable account. GAAP is based on a rigid set of rules; it is no longer principles based. The appraisal of an account, such as deferred income taxes payable, is in the province of the users of financial statements, not the preparers of financial statements.
SUBSTANTIVE CONSOLIDATION
Most OPMIs involved with common stock believe in substantively consolidating the company with its common stock owners. They believe they are buying General Electric (GE), not GE common stock. In FF, the company is a standalone, separate and distinct from its shareholders, its management, its control group, and its creditors. Essential for understanding the dynamics of many companies are not only consolidated financial statements but, also, how financial statements are consolidated. In many cases, it is important to know which liabilities of particular parents or subsidiaries are assumed or guaranteed by other companies, which are part of a consolidation.
COMPENSATION OF PROMOTERS
G&D seem utterly silent about the compensation of professionals and promoters, which has to be understood if one is to understand Wall Street and/or corporate managements. Nothing happens in the financial community that does not entail huge transaction costs for clients, whether those clients are retail, institutional, or corporate. Huge transaction costs for clients mean huge transaction incomes for certain Wall Street participants who incur relatively small costs to create those incomes (i.e., the earning, by these promoters and professionals, of excess returns).
Excess returns are far from the exclusive province of Wall Street. Excess returns also seem to be earned relatively persistently by top corporate executives. These executives include not only principal owners, or sole owners of businesses, but also professional managements that may not be significant corporate stockholders.
Economists have it wrong when they say, “There is no free lunch.” What they should say is, “Somebody has to pay for lunch.” Those who most commonly pay are OPMIs.
DO STOCK MARKET PRICES REFLECT CORPORATE VALUES?
While ignored by G&D, we are of the strong opinion that common stock prices never have to be rational in the absence of catalysts that are the bedrock of resource conversion. The most important catalyst seems to be changes of control and/or potential changes of control. In a conservative, non-control, FF investment, the common stocks that we have purchased are those of blue-chip companies selling at substantial discounts from readily ascertainable net asset values (NAV). The exit strategies are based on the belief that NAVs will grow over the next three to seven years and that the discounts from NAV will not widen materially. Without catalysts, though, it appears as if the discounts from NAV are just a random walk at any particular time.
Where there are no prospects for changes of control or no Wall Street sponsorship (induced by generous compensation arrangements for managers and securities sales persons), prices in OPMI markets can be utterly irrational persistently. The very best companies whose common stocks are publicly traded and where no catalyst exists usually sell at discounts to NAV. Sometimes these discounts from NAV reach 60 percent or greater.
Many of these companies are extremely well financed and have most impressive long-term records of increasing NAVs and earnings per share persistently. Such companies include Brookfield Asset Management, Capital Southwest, Investor AB, and Cheung Kong Holdings. In contrast, there is a huge market for private equity that OPMIs spend billions of dollars to get into and that are priced at substantial premiums above NAV. These are the hedge funds. Typically their premiums above NAV are reflected in the present value of promotes paid to hedge fund managers. Those promotes normally run to 2 percent of assets under management plus 20 percent of annual profits after the OPMIs receive a preferred return of, say, 6 percent. Further, lengthy lock-up periods tend to exist for OPMIs owning hedge funds, while the publicly traded common stocks cited above are all marketable. From a value point of view, there does not seem to be any rational reason why the publicly traded issues mentioned above should sell at steep discounts, while the hedge funds are priced at premiums.
In FF, potential resource conversions, catalysts, and access to capital markets are included in the valuation process. FF puts a great premium on the value of control, something ignored by G&D. Asset values are very important insofar as they are readily ascertainable and exist in well-financed companies. Asset values are of limited importance in companies that are not well financed and where the principal assets are single purpose, useful only to a going concern. These asset values can have a positive or negative effect on underlying value. They can help predict that future earnings will be high based on an ROE analysis (book value equals E), or they can indicate, and often do, very high overhead and very high fixed costs. A large book value is a negative factor where the book value consists largely of single-purpose assets, which are costly to keep open, surplus, or obsolete. In the early 2000s this described many U.S. automobile assembly plants and steel mills.
TRADE-OFFS
There are always trade-offs in FF investing. For example, a strong financial position in 2011 means one is dealing with a management willing to sacrifice returns on equity, for the safety and opportunism inherent in a strong financial position. Also, and this is a possibility that G&D do not consider, there are incentives for certain control people to prefer low prices for publicly traded common stocks:
MODERN CAPITAL THEORY VERSUS GRAHAM AND DODD
MCT, like G&D, is focused on looking at economic and financial phenomena from the point of view of OPMIs. Unlike G&D, the entire focus of MCT is on near-term changes in market prices. MCT operates on the false assumption that markets are efficient for all participants. Unlike one of G&D’s great conceptual teachings, MCT does not distinguish between market price and intrinsic value.
When it comes to corporate finance, MCT offers a valuable approach to project finance, but contributes little to corporate finance as visualized by FF participants. The concept of net present value (NPV) is essential for understanding project finance. For a project to make sense, estimates of the present value (PV) of cash flows generated by the project have to exceed the PV of cash costs of the project. In terms of corporate finance, there can be other reasons for undertaking (or not undertaking) a project than positive (or negative) net cash generation.
In terms of capitalization, most MCT believers sign off on the Modigliani-Miller Theorem that if a management is working in the best interest of shareholders, the capitalization is a matter of indifference. The Modigliani-Miller Theorem is an absolute nonstarter in FF. One can’t measure creditworthiness without also appraising capitalizations.
In FF, quarterly earnings reports tend to lack significance. However, there are instances where quarterly earnings reports can be important. This tends to be the case for most poorly financed companies, which need virtually continual access to capital markets. FF and MCT tend to coalesce when dealing in sudden-death securities or absolutely creditworthy debt obligations. Such securities seem a special case and encompass the following:
In much of what MCT and G&D do, the goal is to estimate the probable effect of certain items on near-term market prices in OPMI markets. Thus, G&D emphasize the importance of determining “true” earnings for a period. In contrast, for FF, the possible or probable effect on OPMI market prices is pretty much ignored in most, but not all, cases. Rather, the goal is to understand the underlying values of a business as well as the business’s dynamics. Such understanding requires a study not only of flows—whether cash or earnings—but also, resource conversion possibilities, access to capital markets, and the quality and motivations of management and control persons.
As we practice it, value investing is a component of FF that stresses intellectual rigor and a long time horizon. The contributions of Graham and Dodd to this approach have been valuable, but they are only part of a much richer story.
SUMMARY
Value investing is one area of fundamental finance (FF). It involves investments in marketable securities by noncontrol outside passive minority investors (OPMIs) using a fundamental finance approach to analysis. The other areas of FF are distress investing, control investing, credit analysis, and first- and second-stage venture capital investing. Graham and Dodd made four very important contributions to value investing: (1) they clearly articulated a usable definition of investing as opposed to speculation; (2) they distinguished between market price and intrinsic value (a concept that still seems alien to MCT); (3) they pioneered the concept of investing with a margin of safety, and (4) they promulgated the belief that investment decisions ought to be based on ascertainable facts. In this chapter we briefly summarize and discuss the substantive differences between the safe and cheap approach to value investing and the approach advocated by Graham and Dodd.
* This chapter contains original material and material contained in the 2011 4Q letter to shareholders.
1 Benjamin Graham, The Intelligent Investor: A Guide for the General Reader to Wise Investment Practice Under Today’s Financial Conditions, First Edition (New York: Harper & Brothers, 1949). Later revised editions were renamed as The Intelligent Investor: A Book of Practical Council.
2 The relevant laws and regulations are the federal securities laws administered by the Securities and Exchange Commission: the Federal Securities Act of 1933 as amended, the Securities Exchange Act of 1934 as amended, the Investment Company Act of 1940 as amended, the Investment Advisers Act of 1940 as amended, the Trust Indenture Act of 1939, and the Securities Investors Protection Act of 1970.
3 The term blue sky statutes refers to state statutes governing the terms and conditions on which offerings to sell securities to the public or to buy them from the public can be made in that jurisdiction.