Benjamin Graham on Debt Discipline

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.

accounts that had experienced much greater losses. Near the close of the year, some recovery developed and most investors believed the worst was over. In early 1930, the market continued its recovery, but soon the economic picture clouded over. Ben went down to Florida in January. He met a 93 year old man, John Dix, a successful retired businessman. Mr. Dix asked a great number of penetrating questions, displaying a keen mind, and then said with great earnestness: Mr. Graham, I want you to do something of the greatest importance. Get on the train to New York tomorrow. Sell out your securities. Payoff your debts and return the capital to the partners in the Joint Account. I wouldn't be able to sleep at night if I were in your position. Ben thanked the old gentleman and said he would consider his advice. Actually, he then thought the advice was preposterous, as Mr. Dix was probably not far from his dotage and could not possibly have really understood Ben's methods. It turned out, of course, that Mr. Dix was absolutely right and Ben should have been content to keep his position as a "near-millionaire." The market recovery continued through April but then the market headed down again. Thus, 1930 was to prove to be the most disastrous year in all of Ben's active career. He had already covered nearly all of the short positions, leaving a large long position in securities whose declining market values were accentuated by the substantial margin debt of the Joint Account.

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.

Since this was near the low point, his show of confidence enabled him to reap a large reward when the recovery began. Considering the fact that the Benjamin Graham Joint Account began this period with approximately 44 percent margin debt, performance equal to the Standard & Poor's would have wiped out the account sometime in 1930. Thus, keeping the fund alive was a great achievement. The small losses of 1931 and 1932 were especially impressive. A TEACHING CAREER BEGINS In 1925, after eleven years on Wall Street, Ben decided to write a book to impart his knowledge of the investment world. However, he thought it would first be best to organize his material and to see how it could be used most effectively. He had the inspiration to start teaching if he could. Most Wall Streeters who were interested in teaching became associated with New York University's Graduate School of Finance, because of the convenient location. Ben, however, applied at his alma mater, Columbia, and in 1928 began a 28-year career as a lecturer in the evening division of the School of Business Administration. Ben taught a two-hour course one evening a week on current investments using rigorous security analysis. Most of his students worked on Wall Street and attended because Ben's teaching worked in actual practice. A number of finance majors attended, as well as faculty members such as David L. Dodd, who enrolled in Ben's first class in order to gain practical insights.

Graham and Dodd devote a substantial chapter to preferred stock, and the 1940 edition's treatment is sharper than the 1934 version. They argue that the typical preferred stock is a hybrid security with the downside of a bond — no participation in earnings above the dividend — and the call feature of an equity claim. The result is that most preferreds offer bond-like returns with equity-like risk, a combination the analytical investor should approach with scepticism. The book lays out specific tests. The preferred dividend should be covered by normalised earnings several times over, the issue should be backed by a tangible asset position that meaningfully exceeds par, and the company should have a record of earning power through adverse cycles. Graham and Dodd warn that many industrial preferreds fail these tests, while many utility and railroad preferreds pass them — the analytical distinction is by financial structure, not by label. On capital structure, Graham and Dodd argue that a moderate amount of senior debt can enhance the equity's return on the senior's capital without unduly impairing safety, but that there is a clear line beyond which leverage stops adding to equity returns and starts impairing solvency. The analytical investor's job is to find companies whose capital structure sits on the productive side of that line, and to avoid companies whose leverage has crossed into fragility.

Graham and Dodd treat bond and preferred-stock analysis as the foundation of security analysis, not as a sidelight. The discipline of estimating whether a company can service its fixed charges under adverse conditions forces the analyst to confront the downside, the cycle, and the balance sheet, in a way that bull-market equity analysis too easily skips. Equity valuation inherits rigour from bond analysis, not the other way around. The book lays out specific quantitative tests for bond safety. The company should have earned its interest charges by a substantial margin across a span of years, including the worst years; the principal value of the debt should be amply covered by tangible assets; and the issue should be small relative to the company's total earning power. Graham and Dodd warn that advertised coupon is not safety, and that the high-grade label is routinely misapplied to issues that would not survive a real stress. For equities, the bond analyst's discipline becomes a demand that the equity buyer understand the company's fixed-charge structure, its working-capital position, and its earnings variability. Graham and Dodd argue that an equity buyer who ignores the bondholder's perspective is buying a residual claim without understanding what is senior to it. The same balance sheet that supports the bond supports the equity, and the analyst who skips the bond side misses half the company.