Benjamin Graham on Bubbles & Crashes

Graham's memoirs, published posthumously in 1996, include the chapter in which Graham records his experience of the 1929 crash and the years of drawdown that followed. Graham writes that he had been running an investment account with margin leverage when the crash began, and that the leverage had amplified the losses the account took as the market fell. Graham records that the account's losses across 1929 through 1932 approached seventy percent, an experience Graham describes as the formative financial event of his life. Graham's instruction is that the experience had taught him the discipline of avoiding leverage and the discipline of buying only with a margin of safety, and that the experience had been the analytical origin of the methods he would later codify in Security Analysis and The Intelligent Investor. The memoirs' chapter on the 1929 crash is, in this sense, the autobiographical source for the analytical discipline Graham would spend the rest of his career teaching. Graham's discussion of the leverage cycle is the chapter's most instructive passage. Graham writes that the use of margin and leverage by individual investors had, in the 1920s, contributed substantially to the severity of the 1929 crash, and that the leverage cycle had been the mechanism by which the market's general decline had become, for many investors, a complete wipeout. Graham's instruction is that the leverage cycle is the structural weakness of the leveraged investor, and that the investor who avoids leverage avoids the cycle's worst consequences. Graham is candid that he had not avoided the cycle himself in 1929, and that the lesson had been learned at the cost of the seventy-percent drawdown the account had taken. The memoirs' chapter is, in this sense, the autobiographical source for Graham's most direct statement on the discipline of avoiding leverage, and it is the document on which subsequent generations of value analysts have drawn for Graham's most candid reflection on his own analytical errors. Graham's discussion of the recovery is the chapter's other instructive passage. Graham writes that the account had recovered its 1929 high by 1937, and that the recovery had been the analytical wage for the partnership's disciplined application of the methods Graham had codified in the years after the crash. Graham's instruction is that the recovery had been slower than the crash, and that the discipline of holding through the recovery had been as demanding as the discipline of avoiding leverage through the crash. The memoirs' chapter is, in this sense, the autobiographical source for Graham's most direct statement on the discipline of patience, and it is the document on which subsequent generations of value analysts have drawn for Graham's most candid reflection on the long horizon the value method requires. The chapter is also the document in which Graham's most direct statement on the relationship between analytical method and lived experience is recorded, and it is the document that grounds the autobiographical basis of the value-analytical discipline.

In his memoirs, Graham records that he was running an investment account with margin leverage when the 1929 crash began, and that the wipeout was severe even though he had been cautious about speculation by the standards of the era. The fund's losses across 1929 through 1932 approached seventy percent, an experience Graham describes as the formative financial event of his life. He kept the fund alive without selling the better positions into the panic, but only by forgoing his management salary for several years. Graham is candid that his 1929 problems were not only a matter of bad markets. He had financed positions partly with borrowed money and had used holding-company structures that compounded in illiquidity when the market turned. He writes that the experience forced him to reconsider the role of leverage in an investment operation: a margin of safety against analytical error was insufficient if the portfolio could be liquidated at the bottom by lenders who did not share the analyst's view. The 1929-1932 drawdown shaped Graham's later insistence on a wider margin of safety, his distrust of leverage as a permanent feature of an investment operation, and his insistence on balance-sheet tests before earnings tests. He writes in the memoirs that he had been rescued by his partners' loyalty and by the underlying quality of the positions, and that the experience gave him a lifelong sympathy for the analyst who is right in his valuation but wrong in his financing.

substantial companies, however, fell outside these favored categories and sold at bargain-counter prices, even below their minimum values as judged by ordinary standards. Among these were Plymouth Cordage, Pepperell Manufacturing Co., and Heywood & Wakefield, the leader in the baby carriage industry, each selling below working capital. Bernard Baruch bought substantial amounts of these issues, confirming the soundness of Ben's analyses. Baruch egotistically believed that his concurrence was a sufficient reward for Ben's efforts. Both agreed that the market had advanced to inordinate heights and, with such frenzied speculation, it would ultimately end in a major crash. Baruch commented that it was ridiculous for short-term interest rates to be eight percent while the Dow Jones Industrials provided only a two percent yield. Ben replied: "By the law of compensation, someday the reverse should happen." Some years later after the crash when the law of compensation took effect, Ben realized that it was strange that, despite his accurate projection, he did not realize that all operations involving borrowing, including his own, would be affected by the ultimate collapse. One day in 1929, Baruch invited Ben to his office. For the first time in his life he wanted a partner. "I'm now 57 and it's time to slow up a bit and let a younger man like you share my burdens and my profits."

Next, investment trusts were formed that could be managed, patterned after the investment trusts that had long operated successfully in England. The speculative atmosphere of the late 1920's led many investment banking firms to launch their own investment trusts-to obtain management fees, as well as commissions on the sale of shares in the trust plus commissions on the trust's business. The H. Hentz partners thought they should have an investment trust and that Ben Graham should run it. They were planning a $25 million fund, which would supply adequate compensation for all concerned. The details of organizing the trust delayed the initial sale for some months and when September came, the 1929 stock market crash ended any possibility for establishing the Hentz-Graham Fund. Ben had enough to do to keep up with the Joint Account. At mid-1929, the capital was $2.5 million, about where it was at the start of the year. The Account had a large number of arbitrage and hedging operations involving long positions of $2.5 million and an equal amount of short positions. In addition, $4.5 million of other securities were held on which $2 million was borrowed, leaving $2.5 million of equity. These securities were not Wall Street favorites, but rather issues that had in trinsic values above their market prices. The hedge operations generally involved the purchase of a convertible preferred and a short sale of the equivalent amount of common.

The record of the accoun t during the crash was as follows: Benjamin Graham Dow Jones Ioint Account Industrials S&P 500 1929 -20% -15% - 7% 1930 -50 -29 -25 1931 -16 -48 -44 1932 - 3 -17 - 8 F or entire period -70% -74% -64% From 1930 on, Ben's main effort was to reduce the margin debt without sacrificing too much of the values inherent in the portfolio. All through this period, quarterly distributions of 1~4 percent of capital were made. A number of the participants withdrew all or part of their capital at various year-ends. The only one to make a new investment in the fund during these difficult years was Jerry Newman's father-in-law.

Kahn. This material remains as the heart of the course still being offered by the New York Institute of Finance. No other single course reached or held so large a student body as this one. During 1931-1933, Ben also presented a series of lectures at the New School for Social Research. He became a friend of the New School's President, Alvin Johnson, participating in an informal group meeting weekly to discuss possible solutions to the economic crisis. Among the members of the group were William McChesney Martin, A. A. Berle, and a great many other distinguished and thoughtful leaders. These efforts led to Ben's development of an important economic theory, described later in this narrative. SECURITY ANALYSIS By 1932, Ben had adjusted the Joint Account to a secure position and began searching for lessons from the stock market crash. In June 1932, he wrote a series of three articles for Forbes magazine under the title "Is American Business Worth More Dead Than Alive?" Over 40 percent of the stocks listed on the New York Stock Exchange were selling at less than their net working capital and many were selling below even their cash assets. Ben concluded that the stock market was placing an inordinately low value on American business. It was time to set to work on the writing of the textbook that he had first projected six years earlier. Professor Dodd agreed to collaborate on the book. Ben would be the senior author and write the entire text in his style.

BENJAMIN GRAHAM AS A PORTFOLIO MANAGER In these days of sophisticated techniques for measuring portfolio performance, it is interesting to read Ben's impressionistic comments about the profits of the investment funds that he managed. No information is available on the Grahar Corporation except that the two and a half years ended with "a substantial profit," after providing him with a salary that amounted to four percent of the starting capital plus six percent annually for distributions to the investors. Thus, the total annual return must have exceeded 10 percent. The return for the Dow Jones Industrial Average would have been as follows: Index Including Dow .Iones Dividend Reinvested Dividends Annual compounded rate of return 6-1-23 12-31-23 12-31-24 12-31-25 95.36 95.52 120.51 156.66 2.30 4.27 4.17 100.00 102.58 134.00 178.84 26.2% The record of the Benjamin Graham Joint Account can only be approximated for the intermediate years, from references supplied in Ben's memoirs. The record for the entire period of ten years is, however, reasonably correct since it was not until the tenth year, 1935, that the ravages of the crash were recovered in full and, for the first time since 1928, Ben became eligible for profit-sharing. The following figures are only approximations: 12-31 1925 1926 1927 1928 1~29 1930 1931 1932 1933 1934 1935 Indexes-Including Reinvested Dividends Ben Graham S&P Dow Jones Joint Account* 500 Industrials 100 100.00 100.00 110 111.60 104.40 150 153.56 138.

HB: Looking back at your own life in the investment field, what are some of the key developments or key happenings, would you say? You went to Wall Street in 1914? Graham: Well, the first thing that happened was typical. As a special favor, I was paid $12 a week instead 0 f $10 to begin. The next thing that happened was World War I broke out two months later and the stock exchange was closed. My salary was reduced to $10-that is one of the things more or less typical of any young man's beginnings. The next thing that was really important to me-outside of having made a rather continuous success for 15 years-was the market crash of 1929. HB: Did you see that coming at all-were you scared? Graham: No. All I knew was that prices were too high. I stayed away from the speculative favorites. I felt I had good investments. But lowed money, which was a mistake, and I had to sweat through the period 1929-1932. I didn't repeat that error after that. HB: Did anybody really see this coming-the crash of 1929? Graham: Babson did, but he started selling five years earlier. HB: Then in 1932, you began to come back? Graham: Well, we sweated through that period. By 1937, we had restored our financial position as it was in 1929. From then on, we went along pretty smoothly. HB: The 1937-1938 decline, were you better prepared for that? Graham: Well, that led us to make some changes in our procedures that one of our directors had suggested to us, which was sound, and we followed his advice.

The 1975 article engages the inflation question directly. Graham notes that the 1970s had seen both rising consumer prices and falling equity valuations, contradicting the then-common view that equities were an automatic inflation hedge. Graham argues that the relationship between inflation and equity returns is more complicated than the simple hedge thesis: high inflation raises interest rates, which raises the capitalisation rate applied to earnings, which compresses multiples even if nominal earnings rise. Graham's framework treats inflation as a tax on purchasing power that the equity investor pays indirectly through a higher discount rate. The implication for the analyst is that the equity investor cannot simply assume that nominal earnings growth will translate into real returns; the capitalisation rate matters as much as the earnings trend. Graham's article predates the formalised discounted-cash-flow language, but the underlying argument is the same: equity returns are determined by the entry multiple as well as by the cash-flow path. The 1975 article concludes that the 1973-1974 bear market had repriced equities at a level where, on Graham's central-value framework, the equity allocation should be increased. He notes that the same framework had called equities expensive through the 1968-1972 Nifty Fifty peak, and that an investor who had rebalanced according to the rule would have entered the 1973-1975 bear with a defensive posture. Graham treats this as evidence that the central-value framework, while imprecise, did its job across the decade.

On the wave of new participants entering the market in 1954 and 1955 — many buying shares for the first time — Graham cautioned the committee against the assumption that the recent past was a sample of the future. The new investors had known only rising prices, he observed, and the confidence that experience produced was precisely the confidence that damage would later exploit. He did not testify that a crash was coming; he declined, characteristically, to predict the market at all. What he offered was the observation that expectations formed in an uninterrupted advance are not evidence about long-run returns, and that the public's introduction to equities through a period of exceptional performance was a hazard in itself. The statement stood as the hearing's clearest warning about extrapolation — the error he considered the most dependable of all the market's recurring mistakes.