Benjamin Graham on Corporate Governance

Graham's 1955 testimony before the U.S. Senate Banking Committee's Stock Market Study is the document in which Graham, summoned to Washington to discuss the state of the equity market, gave his most direct assessment of the market's structure and of the regulator's proper role in it. Graham's testimony opens with the observation that the equity market of 1955 had recovered substantially from the troughs of the 1930s and 1940s, and that the market's recovery had been accompanied by an increase in participation by individual investors who had been absent from the market in the immediate postwar years. Graham's instruction to the Committee is that the market's recovery is, on the whole, a healthy development, and that the regulator's proper role is not to constrain the market's general direction but to ensure that the market's participants are operating honestly, with adequate disclosure, and without the manipulative practices that had disfigured the market in earlier eras. Graham's testimony on the question of market forecasting is the document's most instructive passage. Graham tells the Committee that he does not regard market forecasting as a respectable analytical activity, and that the analyst who claims to forecast the market's general direction is, in his view, claiming a knowledge the analyst does not have. Graham's instruction is that the analyst's proper work is to estimate the value of individual securities, not to forecast the market's direction, and that the analyst who confines himself to the former activity will, over a long horizon, do better than the analyst who attempts the latter. Graham's testimony is, in this sense, an early statement of what later generations would call the efficient-market critique of market forecasting: the market's direction is a function of the aggregate expectations of all participants, and the analyst who attempts to forecast the aggregate expectations is attempting to forecast a forecast. Graham's testimony on the question of margin and leverage is the document's other instructive passage. Graham tells the Committee 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 regulator's proper role in the postwar market was to maintain margin requirements at a level that would prevent the leverage cycle from repeating. Graham's instruction is that the regulator's margin requirements are the structural protection against the leverage cycle, and that the regulator should resist the pressure to lower margin requirements in periods of market enthusiasm. The 1955 testimony is, in this sense, the document in which Graham's views on the market's structure, the regulator's role, and the proper discipline of the analyst are most directly recorded, and it is the document on which subsequent generations of value analysts have drawn for Graham's most direct statements on the market as a system rather than as a collection of individual securities.

The record of the session closes with the senators returning to the practical question: what, in Graham's judgment, should be done? His answers were characteristically structural rather than prophetic. He supported the committee's attention to margin requirements as the most workable lever on speculative borrowing. He favored fuller disclosure of what companies and funds actually were, on the principle that the public's protection began with the public's information. And he returned, once more, to the education of the investor as the safeguard no regulation could substitute for: the buyer who understood the difference between investing and speculating, and knew which one he was doing, carried his own protection with him. The 1955 transcript remains the most complete public statement of Graham's views at the summit of his career — a value philosophy translated, under oath, into the language of public responsibility.

Graham's fifth chapter reminds the investor that he is a part-owner of the businesses whose shares he buys, not the owner of a ticker symbol whose value is set by the market's daily mood. The reminder is not rhetorical; it is methodological. The investor who treats himself as an owner asks different questions of his holdings than the investor who treats himself as a trader. The owner asks whether the business is being run well, whether the managers are paying themselves honestly, whether the balance sheet is being protected, and whether the dividend policy matches the realities of the business cycle. The trader asks whether the chart shows support, whether momentum is positive, and whether the next earnings print will clear the consensus. Graham's chapter is an argument that the owner's questions, asked consistently, will produce better long-run outcomes than the trader's questions. The chapter also takes up the question of the shareholder's role in corporate governance. Graham's view is that the shareholder has, in practice, abdicated his governance role, and that the abdication is a structural weakness of the American equity market. Managers run companies as if they owned them; shareholders, in aggregate, act as if their only power were to sell. Graham argues that the shareholder's voting right is a real right, and that institutional investors in particular have a fiduciary duty to exercise it. He points to compensation plans, acquisition proposals, and accounting choices as the categories of decision where shareholder voice should be heard. The chapter is, in this sense, an early sketch of what later generations would call shareholder activism. Graham's position is not that shareholders should run the company; it is that shareholders should hold managers honestly accountable for the major decisions that affect the value of the owners' stake. Graham's most practical instruction in the chapter is that the investor should read the proxy statement, not just the annual report. The annual report is management's narrative; the proxy is the contract between managers and owners. The proxy discloses compensation, related-party transactions, director nominations, and the items on which shareholders will vote. The investor who reads the proxy can see what he is being asked to approve, and can withhold his vote where the proposal is not in the owners' interest. Graham's argument is that the proxy is the instrument by which the investor exercises the rights that come with ownership, and that an investor who never reads the proxy is, in effect, an owner who has declined to act like one. The chapter is a small but pointed insistence that ownership is not a passive condition; it is a set of rights that, exercised consistently, constrain managers to act in the owners' interest.

Graham's fourteenth chapter takes up the relationship between the stockholder who owns the company and the managers who run it. The relationship is, in principle, one of principal and agent: the stockholder is the principal, the manager is the agent, and the manager's duty is to act in the stockholder's interest. In practice, Graham argues, the relationship has been inverted. Managers behave as if they own the company; stockholders behave as if they own a tradable symbol. The inversion is the structural weakness of the American equity market, and Graham is unsentimental about the cost of it. Managers pay themselves more than the principal would have authorized; managers make acquisitions the principal would not have approved; managers retain earnings the principal would have preferred distributed, all on the theory that the manager knows best. The cost of the inversion is, in Graham's account, the slow erosion of the owner's claim on the cash the business produces. Graham's prescription is that the stockholder should reassert his ownership. The mechanism for reassertion is the proxy. The proxy is the document by which the stockholder instructs the manager on the items the manager is asking the stockholder to approve. Graham's instruction is that the investor should read the proxy, vote his shares on every item, and withhold his vote from any item that is not in the owner's interest. He should pay particular attention to compensation plans, because compensation is the area where the manager's interest and the owner's interest most consistently diverge; to acquisition proposals, because acquisitions are the most common route by which managers spend the owner's capital on projects of dubious value; and to accounting choices, because accounting is the language in which the manager reports the owner's results to him. A manager who controls the accounting language can conceal the owner's actual position, and the proxy is the instrument by which the owner reclaims the language. Graham is candid that the individual stockholder's vote is small, and that the individual stockholder's influence on management is correspondingly small. The leverage, in his account, lies with the institutional investors who hold large blocks of shares and whose votes can decide the close items on the proxy. Graham's view, written in the late 1940s, is that institutions have a fiduciary duty to exercise the votes that come with the shares they hold for their beneficiaries, and that institutions have, in his time, been too passive in exercising them. The fourteenth chapter is, in this sense, an early sketch of the institutional-shareholder-stewardship argument that has since become standard in the corporate-governance literature. Graham's insistence is that ownership carries responsibility, and that the investor who declines the responsibility has, in effect, ceded to the manager the authority that belongs to the owner.